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Global EconomicsEco 6367

Dr. Vera Adamchik

Regional

Trading Arrangements

Chapter 8

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Chapter outline

• To understand the differences between the basic levels of economic integration.

• To identify the effects of economic integration.

• To grasp the real-world progress of economic integration in Europe, the Americas, Asia, and Africa.

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• Economic integration: countries join together to create a larger economic unit with special relationship among the members.

• Regional economic integration refers to agreements between countries in a geographic region.

• Economic integration often takes place in stages. Five basic types of formal regional economic arrangements are usually distinguished.

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Types of

economic integration

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Levels of economic integration

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1. Free-trade area (FTA)

All members of a free trade area remove tariffs on each other’s products, while each member retains its independence in establishing trading policies with non-members.

Example: the North American Free Trade Agreement (NAFTA).

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• The ‘no-tariff’ scheme is usually assumed to apply to all products between member countries, but it can clearly involve a mix of free trade in some products and preferential, but still protected, treatment in others.

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• Potential concerns: Non-member countries may export a product to the member country with the lowest level of outside protection and then through it to other member countries with higher levels of protection (the transshipment strategy).

• In this case, member countries must use rules of origin and maintain customs administration on the borders between themselves.

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2. Customs union

• All tariffs are removed between members of a customs union and the group adopts a common external commercial policy toward non-members. Furthermore, the group acts as one body in the negotiation of all trade agreements with non-members.

• Example: Southern Cone Common Market (MERCOSUR).

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• The existence of the common external tariff takes away the possibility of transshipment by non-members.

• Potential concerns: member nations give up independence in setting tariff rates.

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3. Common market

• All tariffs are removed between the members of a common market; a common external trade policy is adopted for non-members; and all barriers to factor movements among the member countries are removed.

• Examples: European Union is a true common market since 1992; MERCOSUR is aiming for common market status.

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Potential concerns:

• A further reduction in national control of the individual economy;

• Members give up sovereignty in immigration and capital flows;

• Factor integration has proven to be very difficult.

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4. Economic union• Economic union includes all features of a

common market but also implies the unification of economic institutions and the coordination of economic policy (i.e., a harmonized monetary and fiscal policy) throughout all member countries.

• While separate political entities are still present, an economic union generally establishes several supranational institutions whose decisions are binding upon all members.

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• When an economic union adopts a common currency, it becomes a monetary union as well.

• Potential concerns: It is extraordinarily difficult to give up the domestic sovereignty and autonomy in monetary policy.

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• Example: The EU is an imperfect economic union since not all members of the EU have adopted the euro, and differences in tax rates across countries still remain.

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5. Political union

• If the policies are not just harmonized by separate governments, but actually decided by a unified government with binding commitments on all members, then an economic bloc amounts to full economic nationhood. Some authors call this full economic integration or political union.

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Examples:

• Most nations are full economic/political unions.

• The EU is on a path toward full economic unity/at least partial political union.

• Belgium and Luxembourg have had a political union since 1921.

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The economic case for regional integration

• Regional economic integration is an attempt by each participating country to exploit the gains from free trade and investment.

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The political case for regional integration

Linking countries together • makes them more dependent on each

other;• creates incentives for political cooperation

and reduces the likelihood of violent conflict;

• gives countries greater political clout when dealing with other nations.

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Impediments to integration

Economic integration can be difficult because:

• the net impact of economic integration on a participating country may be negative;

• even when a nation as a whole benefits from a regional free trade agreement, certain groups may lose;

• it may imply a loss of national sovereignty.

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Trade blocs &

The static and dynamic effects of economic

integration

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• The first two types of economic integration -- FTA and customs union – are simply trade blocs.

• Trade blocs remove trade barriers within the bloc but keep their national barriers to the flow of labor and capital and their fiscal and monetary autonomy.

• Trade blocs have proved easier to form than common markets or full unions among sovereign nations.

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• Currently, there are about 130 separate preferential trade agreements in force in the world, and nearly half of them had begun operating since 2000.

• Only a few countries, including Mongolia and Taiwan, were not members of some trade bloc.

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• Regional trade agreements are designed to promote free trade, but instead many regional groupings discriminate (in trade alone or on all fronts) between insiders and outsiders.

• Hence, a trade bloc is often considered as a trade barrier that is designed to discriminate. [As opposed to an equal-opportunity trade barriers, ones that tax or restrict all imports regardless of country of origin.]

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• Trade discrimination can be either good or bad.

• Because differential treatment for member and non-member countries can lead to shifts in the pattern of trade among countries, the net impact on a participating country is, in general, ambiguous and must be judged on the basis of each individual country.

Static effects of

economic integration

• Static effects of economic integration, occur directly on the formation of the integration project.

• The two static effects of economic integration are called trade creation and trade diversion. These terms were coined by Jacob Viner (1950).

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Trade creation

• Integration represents a movement to free trade on the part of member countries.

• Integration facilitates new trade within the trade bloc through displacement of high-cost domestic producers by lower-cost partner suppliers.

• The net volume of new trade resulting from forming or joining a trade bloc is called trade creation.

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Trade diversion

• At the same time, integration can lead to the diversion of trade from a lower-cost non-member source (which still faces the external tariff of the group) to a higher-cost member-country source (which no longer faces any tariffs).

• The volume of trade shifted from low-cost outside exporters to higher-cost bloc-partner exporters is called trade diversion.

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• The gains from a trade bloc are tied to trade creation, and the losses are tied to trade diversion.

• The net effect (that is, gains minus losses) could be positive or negative.

• Any conclusions on whether the net effect of joining a trade bloc will be positive or negative must be based on an analysis of each particular coalition formation.

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In-class exercise

• Trade creation and trade diversion (a numerical example from the textbook).

• Assume a world is composed of three countries: Luxembourg, Germany, and the US.

• Suppose that Luxemburg and Germany decide to form a customs union, and that the US is a non-member.

• Assume that Luxemburg is very small relative to Germany and to the US (that is, cannot influence foreign prices).

• The US is assumed to be the most efficient supplier of grain ($3 per bushel).

• Germany’s supply price is $3.25 per bushel.

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Static Effects of Trade Arrangements

With Free Trade:

red triangle = consumer surplus

green triangle = producer surplus

Static Effects of Trade Arrangements

With Tariff:(before customs union)

red triangle = consumer surplus

green triangle = producer surplus

black rectangle = tariff revenue

2 orange triangles = deadweight loss (DWL)

Static Effects of Trade Arrangements

With Customs Union:

agreement with Germany will lower the price to SG

trade-creation effect (welfare gain):

a = production effect b = consumption effect

trade-diversion effect(welfare loss):

area c

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• Because both trade creation and trade diversion are clearly possible with economic integration, economic integration represents only a partial movement to free trade.

• Whether or not it produces a net benefit to participating countries is an empirical issue.

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Note of caution• There is considerable feeling among

economists that economic coalitions among regional groupings of countries may not be as economically desirable as an alternative – nondiscriminatory decreases in trade barriers worldwide.

• In other words, the world may be moving toward blocs of countries and away from global integration.

• Political tensions and frictions can also result from the current discriminatory policy actions.

Dynamic effects of

economic integration

Additional gains from forming the trade bloc:

(1) An increase in competition can reduce prices.

(2) An increase in competition can lower costs of production. Reasons: Monopolies in national markets competition in the trade bloc innovation, R&D, investment.

(3) Firms can lower costs by expanding their scale of production. Reasons: Before the bloc is formed, the size of a firm is largely limited by the size of its own market. In the trade bloc a larger market to serve economies of scale.

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Static and dynamic effects

When dynamic effects are considered, the presumption is more likely that the partners will benefit from the union, and the outside world may also gain.

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Regional economic integration in Europe

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Europe has two trade blocs:

• The European Union (EU) with 27 members.

• The European Free Trade Association (EFTA) with 4 members – Iceland, Liechtenstein, Norway, and Switzerland.

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Member states of the European Union in 2007

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Evolution of the EU

The EU was formed as a result of • the devastation of two world wars in

Western Europe and the desire for a lasting peace, and

• the desire by the European nations to hold their own on the world’s political and economic stage. Some thought that the continued existence of internal barriers was an important retardant to better European performance.

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In-class exercise

• Read “Postwar Trade Integration in Europe” (a handout).

Evolution of the EUThe Treaty of Rome (1957) established the European Community – precursor to the European Union (the name was changed in 1994)

1957: Belgium, France, Italy, Luxembourg, Netherlands, West Germany1973: United Kingdom, Ireland, Denmark1981: Greece1986: Spain, Portugal1995: Austria, Finland, Sweden2004: Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia2007: Bulgaria, Romania

Evolution of the EU

• Article 3 of the Treaty of Rome (1957) called for the creation of a common market.

• 1958-1968 import duties among the member-nations are dismantled (FTA) and their external barriers are unified in stages (customs union).

• By the early 1980, it was clear that the EC had fallen short of its objectives. The EC responded by creating the Delors Commission.

Evolution of the EU• The Delors Commission proposed that all

impediments to the formation of a single market be eliminated by December 31, 1992.

• The result was the Single European Act, which was independently ratified by the parliaments of each member country and became EC law in 1987.

Evolution of the EU

The Single European Act proposed:

• Remove all frontier controls;

• Mutual recognition of product standards;

• Open public procurement to nonnational suppliers;

• Lift barriers to competition in the retail banking and insurance business;

• Remove all restrictions on foreign exchange transactions.

EU Agricultural Policy

• No restrictions on agricultural products traded internally;

• A common agricultural policy replaced the agricultural stabilization policies of individual member states;

• The support of prices through a system of variable levies and export subsidies.

Variable levieso Variable levies to

protect EU farmers from low-cost foreign competition

o Falling world prices automatic increases in the EU’s import tariff

o Variable levies are more restrictive than a fixed tariff

Export subsidies

o EU producers sell abroad for low price but receive higher price

o EU purchases any surplus. Surplus then sold on world market for lower price

Government Procurement Policies

• Government procurement has been used to support national and regional firms for several reasons:

(1) national security;

(2) compensation for local communities near environmentally damaging public industries (such as nuclear fuels);

(3) support for emerging high-tech industries;

(4) politics (as in assistance to highly visible industries).

• Government purchases previously limited primarily to domestic producers

• 1992 EU required bidding process from EU firms. Benefits:

(1) governments purchase from the cheapest foreign supplier (static effect);

(2) increased competition (dynamic effect);

(3) surviving firms produce with economies of scale (restructuring effect).

• A liberalized procurement policy permits the UK gvt to buy computers from the cheapest EU supplier, Germany.

Evolution of the EU

• The Maastricht Treaty (1991) established a monetary union and committed the member-countries to adopting a common currency (the Euro) by January 1, 1999.

• Establishing of the euro required participating national governments not only to give up their own currencies but also to give up control over monetary policy.

Evolution of the EU• The Maastricht Treaty mandated the

specific convergence criteria:– Price stability: inflation ≤ 1.5% above

average inflation of three countries with lowest inflation

– Low long term interest rates ≤ 2.0% above average of same three countries

– Stable exchange rate within target bands of monetary union for 2 years

– Sound public finances: budget deficit ≤ 3.0% of GDP; government debt ≤ 60.0% of a year’s GDP

Evolution of the EU• A common currency also implied the need

for a single European Central Bank (ECB) responsible for all monetary and exchange rate policies of the EMU.

• The ECB is based in Frankfurt, Germany.• The ECB sets interest rates and

determines monetary policy across the euro zone.

• The ECB is meant to be independent from political pressure, although critics question this.

Evolution of the EU• The 13 countries (the euro zone) of the 27

member states adopted the euro by January 1, 1999.

• Three long-term EU members – the United Kingdom, Denmark and Sweden – did not adopt the euro.

• Euro notes and coins were not actually issued until January 1, 2002.

Evolution of the EU

• One of the drawbacks of the euro is that the EU is not what economists would call an optimal currency area.

• In the optimal currency area, similarities in the underlying structure of economic activity make it feasible to adopt a single currency and use a single exchange rate as an instrument of macroeconomic policy.

Evolution of the EU

Success of common currency area:– similar business cycles – similar economic structures– single monetary policy affecting all members

in same manner– absence of legal or cultural barriers that would

limit labor mobility– wage flexibility– stabilizing transfer system

Evolution of the EU

• Many of the European economies in the euro zone, however, are very dissimilar: wages, tax regimes, business cycles, limited labor mobility tied to cultural factors, etc.

• Under the circumstances, a common monetary policy may mean that interest rates are too high for depressed regions and too low for booming regions.

Political structure of the EUThere are five main institutions of the EU:1.The European Council

2.The Council of the EU (Council of Ministers)

3.The European Commission

4.The European Parliament

5.The Court of Justice of the EU

http://europa.eu

http://europa.eu/index_en.htm

choose the “institutions” tab.

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1. The European Council is a summit of the Heads of State or Government of the Member States of the European Union and the President of the Commission. The Council meets at least twice a year (in practice, four times a year + special meetings).

It is not the legislature. The Council provides broad guidance and impetus to action: general political direction for the EU, fundamental questions related to the constitution and construction of the EU, and decisions on the most contentious issues.

http://europa.eu/european-council/index_en.htm

2. The Council of the EU (Council of Ministers) is the main policy-making body. This is the legislature of the Community and makes policy largely on the basis of proposals made by the European Commission, which is the executive. The council has many committees and working groups. Representatives are usually senior ministers of national government. The Presidency of the Council rotates every six months.

http://www.consilium.europa.eu/showPage.ASP?lang=en

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The Council (in some cases in cooperation with the European Parliament) can make three main types of legislation:

• Regulations have direct effect and are binding throughout the EU.

• Directives provide framework legislation which, though equally binding, is implemented by national legislation.

• Decisions which are binding on the member state, organization, firm, or individual to whom they are addressed.

Finally there are recommendations and opinions which have no binding force.

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3. The European Commission is the executive body. It is responsible for implementing aspects of EU law and monitoring member states to ensure they are complying with EU laws. It has the primary right to initiate legislations: it prepares proposals for decision by the Council.

http://ec.europa.eu/index_en.htm

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4. The European Parliament is elected by voters in the member countries (with a specified number of seats allocated to each country). It is a political driving force, supervising and questioning the Council and Commission (debates legislation proposed by the Commission and forwarded to it by the Council). Joint power to adopt legislation with Council. Supervises appointment of the Commission.

http://www.europarl.europa.eu/parliament.do

5. The Court of Justice is the supreme appeals court for EU law. It interprets the constitution and settles disputes.

http://curia.europa.eu/en/index.htm

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Regional economic integration

in the Americas

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Trade blocs in the Americas

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NAFTA• The North American Free Trade

Agreement (NAFTA) took effect on January 1, 1994.

• The U.S., Canada, and Mexico are the member countries.

• http://www.ustr.gov/Trade_Agreements/Regional/NAFTA/Section_Index.html

• NAFTA eliminates tariffs among the three member countries over a 15-year period and at the same time substantially reduces non-tariff barriers.

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• With respect to foreign investments, all barriers to the movement of capital were immediately dropped.

• At the same time, customs officials must enforce rules of origin to guard against a firm’s ruse of doing minimal processing within the area and then claiming that the product is locally produced.

• The NAFTA rules of origin are incredibly complex, covering over 200 pages with thousands of different rules for different products.

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Recall the ‘domestic content’ / ‘rules of origin’ provision:

• Under the NAFTA, members do not permit duty-free entry of automobiles from other members unless 62.5% of the value of the automobile originates in the NAFTA countries.

• To receive NAFTA tariff preferences, apparel must be manufactured in North America from the yarn-spinning stage forward.

• http://www.export.gov/fta/nafta/index.asp

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The impact of NAFTA• Trying to estimate the effects of NAFTA

almost became a new industry in itself.• Consulting firms, government economists,

and academics produced a variety of studies comparing the NAFTA world with a non-NAFTA world.

• The impact of NAFTA on the three participating economies has been hotly debated, and there have been widely varying estimates of the potential effects.

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The Andean Community• The Andean Pact was formed in 1969 by

Bolivia, Chile, Colombia, Ecuador, and Peru.

• The trade bloc more or less failed by the mid-1980s. It was was re-launched in 1990 by Bolivia, Colombia, Ecuador, Peru, and Venezuela, re-named the Andean Community of Nations in 1997 and now operates as a customs union.

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• The goal of establishing a common market by 1995 has not been reached.

• In 2003, the Andean Community signed an agreement with MERCOSUR to restart negotiations on the creation of a FTA between the two trading blocs. (Slow.)

• In 2006, Venezuela withdrew from the Andean Community as part of that country’s attempts to join MERCOSUR.

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MERCOSUR• The Southern Cone Common Market

(formed in 1991, Argentina, Brazil, Paraguay, and Uruguay) is a customs union.

• Venezuela became a full member in 2006.• Bolivia, Chile, Colombia, Ecuador, and

Peru (i.e., the Andean Community) have associate member status.

• By 1995, the MERCOSUR countries established internal free trade and common external tariff (averaging 12%) for most products.

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• One highly protected sector is automobiles, with an external tariff of about 34% (and an ERP of over 100%).

• Trade within MERCOSUR has increased most rapidly in protected capital-intensive products like automobiles, machinery, and electronic goods – products that are not consistent with the member countries global comparative advantage.

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• It is likely that MERCOSUR is diverting trade rather than creating trade, and local firms are investing in industries that are not competitive on a worldwide basis.

• MERCOSUR is a success in terms of survival, but its net effects on the well-being of its member countries are not yet clear.

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CACM / CAFTA-DR

• The Central American Common Market was formed in the early 1960s by Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua.

• It collapsed in 1969 (a war between El Salvador and Honduras).

• It was revived in 2003 when the U.S. signaled its intention to enter into bilateral free trade negotiations with the group.

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• The U.S. – Central America Free Trade Agreement – Dominican Republic (CAFTA-DR), established in 2004, is a historic agreement that creates the second-largest free-trade zone in Latin America between the six countries and the U.S.

• http://www.ustr.gov/Trade_Agreements/Regional/CAFTA/Section_Index.html

• Upon entry into force, the CAFTA-DR agreement will eliminate 80% of the tariffs immediately, with the remaining tariffs phased out over 10 years.

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CARICOM• The Caribbean Community and Common

Market (CARICOM) was established in 1973 by the English-speaking Caribbean countries.

• It repeatedly failed to progress toward a customs union, leave alone economic and monetary union proclaimed in 1984.

• Despite this, CARICOM expanded to 15 members by 2005.

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CSME

• In early 2006, six CARICOM members established the Caribbean Single Market and Economy (CSME).

• The goal of CSME is to lower trade barriers and harmonize macroeconomic and monetary policy between member states.

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FTAA

• In 1994-1998, work was initiated at the meetings of 34 of the Western hemisphere’s trade ministers (Cuba did not participate) to create a Free Trade Area for the Americas (FTAA).

• The purpose of the meetings was to establish a hemispheric free-trade agreement by January 1, 2005 – something that did not occur.

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• Now support for the FTAA from the U.S. and Brazil (the largest economies in North and South America) is mixed.

• Furthermore, rising political tensions between Venezuela and the U.S. have impeded progress toward the completion of FTAA.

• http://www.ustr.gov/Trade_Agreements/Regional/FTAA/Section_Index.html

• http://www.ftaa-alca.org/alca_e.asp

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Regional economic integration in Asia

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ASEAN countries

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ASEAN• The Association of Southeast Asian

Nations (ASEAN) was formed in 1967 and wants to foster freer trade between member countries and to achieve some cooperation in their industrial policies.

• http://www.aseansec.org/

• An ASEAN Free Trade Area (AFTA) between the six original members of ASEAN came into effect in 2003.

• http://www.aseansec.org/4920.htm

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APEC members

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APEC• The Asia-Pacific Economic Cooperation

(APEC) forum was initiated in 1989 by Australia, with representatives from 12 countries.

• The association now has 21 members, including the U.S., Japan, China, and Russia.

• The goal is to achieve free trade and investment in the Asia-Pacific area by 2020.

• http://www.ustr.gov/Trade_Agreements/Regional/APEC/Section_Index.html

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Regional economic

integration in Africa

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• Progress toward the establishment of meaningful trade blocs in Africa has been slow.

• Many countries are members of more than one of the nine dormant blocs in the region.

• Kenya, Uganda, and Tanzania committed to re-launching the East African Community (EAC) in 2001, however so far, the effort appears futile.

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• Significant political turmoil in several African nations has persistently impeded any meaningful progress.

• Also, deep suspicion of free trade exists in several African countries. The argument most frequently heard is that because these countries have less developed and less diversified economies, they need to be “protected” by tariff barriers from unfair foreign competition. Given the prevalence of this argument, it has been hard to establish free trade areas or customs unions.

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• The various trade blocs in Africa have overlapping memberships with internal inconsistencies, conflicting regulations and rules, and different strategies and objectives which work to impede the expansion of domestic markets and discourage both domestic and foreign investment.

• These integration issues may also tend to intensify political problems and issues in the area.

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In-class exercise

• Discuss the trend toward regional economic integration in the world. Then focus on the role of regional trade initiatives in U.S. trade strategy. Go to the home page of the Office of the United States Trade Representative, http://www.ustr.gov/ , then click on “Trade Agreements” on the horizontal dark-blue menu bar. Review different regional trade agreements and initiatives and comment on one of them (that is, describe the member countries, goals, rules, etc.).