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Panagariya Bhagwati Conference PTAs
Panagariya Bhagwati Conference PTAs
This phrase, insisted upon by Jagdish since it makes clear that we are talking about
discriminatory trade liberalization, has now come into widespread usage. So have his phrases
spaghetti bowl problem and stumbling versus building blocks in the dynamic time path
analysis of PTAs discussed in Section II. Jagdish has contributed not merely innovative analysis
to international economics but some of the most memorable and influential phrases in the field.
and already traded intensively with one another, they were natural trading partners and
the union among them would be largely trade creating.
Bhagwati (1993) first questioned the validity of this assertion, pointing to an
earlier important contribution by Lipsey (1957) that had spelt out the welfare
improvement criteria in a specific model that differed from the ones defining the natural
trading partners. Subsequently, Bhagwati and Panagariya (1996) offered a systematic
critique of the natural trading partners hypothesis. Regarding proximity as the basis of
welfare-improving unions, they demonstrated that ceteris paribus, a union with a
proximate partner could be more harmful than with a distant one. Regarding the volumeof-trade criterion, following Panagariya (1996), they pointed out that there was a
presumption that the more a small country imported from its union partner, the more it
would lose from liberalizing preferentially! As long as the country continued to import
from the outside world, the price facing its consumers and producers would not change.
Therefore, it would fail to reap any efficiency benefits that accrue via the decline in the
internal price when liberalization is non-discriminatory. Instead, the country would lose
tariff revenue on good imported from the partner country with the lost revenue transferred
to the latters exporters.
Bhagwati and Panagariya (1996) went on to further point out that it is easy to
construct models in which the initial volume of trade bears no relationship to the welfare
effects of preferential trade liberalization. Moreover, the large initial volume of trade
may itself be the result of existing trade preferences. Finally, they pointed out that the
volume-of-trade criterion was neither symmetric nor transitive. Being its largest trading
partner, the U.S. is a natural trading partner of India but the reverse is not true. Likewise,
the U.S. may be a natural trading partner of both Mexico and Canada but Mexico and
Canada may not be natural trading partners of each other.
It is fair to say that the powerful critique by Bhagwati and Panagariya (1996) has
now been widely accepted and one hears little justification of PTAs on the grounds of the
natural trading partners hypothesis. While the simple verifiable criteria that would allow
us to judge whether a union is welfare improving or welfare worsening remain illusive,
the Kemp-Wan approach to customs unions, recently extended to free trade areas (FTAs)
by Panagariya and Krishna (2002), does offer a neat trick to get around the trade
diversion problem by adjusting the external tariff appropriately.2
Kemp and Wan (1976) demonstrated that if two or more countries form a customs
union setting the common external tariff vector such that trade with outside countries
remains precisely at its pre-customs-union level, the outcome is necessarily weakly
welfare superior to the initial equilibrium for the union as a whole and the world. As I
illustrate in my comprehensive survey of the theory of PTAs (Panagariya 2000) using a
simple partial-equilibrium example, freezing the external trade vector would typically
require the union members to lower trade barriers on the outside countries as well, which
helps eliminate trade diversion that would otherwise result. Once trade diversion is
eliminated by giving the outside world trade opportunities that are as good as those prior
to the formation of the union, union members can improve their welfare by exploiting
trade creation opportunities among themselves. As noted above, Panagariya and Krishna
(2002) have recently extended the Kemp-Wan theorem to the case of FTAs.
Cooper and Massell (1965), Johnson (1965) and Bhagwati (1968) independently
developed an alternative approach to welfare-improving customs unions in the context of
2
Pravin Krishna, in his Panel contribution today, addresses the Kemp-Wan approach more fully.
trading, Bhagwati (1993) noted that with the United States having embraced preferential
trading, the more important question was not whether a specific PTA would improve or
worsen static efficiency but whether the PTA path would take the world more quickly
and efficiently and with greater certainty to multilateral free trade. Subsequently, in
Bhagwati and Panagariya (1996), Bhagwati went on to separate two questions relating to
the time-path analysis:
Question I: Assume that the time-path of MTN (multilateral trade negotiations) and the
time-path of PTAs are separable and do not influence each other, so that neither hurts nor
helps the other. Will then the PTA time-path be characterized by stagnant or negligible
expansion of membership; or will we have expanding membership, with this even turning
eventually into worldwide membership as in the WTO, thus arriving at nondiscriminatory
free trade for all? The analysis can be extended to a comparison of the two time-paths,
ranking the efficacy of the two methods of reducing trade barriers to achieve the goal of
worldwide free trade for all.
Question II: Assume instead, as is plausible, that if both the MTN and the PTA time-paths
are embraced simultaneously, they will interact. In particular, the policy of undertaking
PTAs will have a malign or a benign impact on the progress along the MTN time-path?
Regarding Question I, Bhagwati (1993) had noted that the time-path analysis
necessarily required a political-economy approach that takes into account the incentives
facing the governments and interest groups both within union members and outside
countries. The fact that Kemp-Wan theorem tells us that a path that improves welfare
every step of the way only ensures existence and says nothing about whether such a path
will actually be followed.
inefficient path being pursued and one that fails to reach multilateral free trade in the end.
This conjecture found support in the subsequent theoretical work of Andriamananjara
(1999) who demonstrated that once we make the decisions to both seek and grant entry
endogenous, the PTA expansion comes to an end before it can encompass the entire
This is in contrast to Baldwin (1995) who models only the outsiders incentive to seek entry.
This incentive rises monotonically as the PTA gets larger so that in the absence of internal
political-economy barriers in the outside countries, the PTA is predicted to expand until it
encompasses all countries.
subsequently shown to be true by Panagariya and Findlay (1996) in a model that allowed
tariffs to be determined endogenously through lobbying. In effect, the formation of FTA
in this model makes it more lucrative for production lobbies to lobby for higher tariff on
goods imported from outside.
Post-1990s literature has also seen models that make the decision to form FTAs
endogenous. The pioneering paper on this issue is the Grossman-Helpman (1995) paper
which shows that FTAs are more likely to be accepted when export lobbies can gain
access to the partners market without a threat to domestic import-competing lobbies
from the partner countries. These situations typically rule out trade creating FTAs since
such FTAs necessarily bring import competition from partner country producers. Instead,
the politically acceptable FTAs are trade diverting since they help within-union producers
at the expense of outside suppliers.
3
Jagdish will be very incomplete without a brief reference to his role in the policy debate.
At the time that the NAFTA debate was taking place, he was just about the only leading
trade economist to have stood firm in his opposition to PTAs. Indeed, in the subsequent
multilateralism versus regionalism debate, multilateralism became synonymous with his
name. He wrote extensively and in outlets too numerous to name, offering critiques of
open regionalism and deep integration and coining memorable terms such as stumbling
blocks versus building blocks and the spaghetti bowl of tariffs. The latter term refers
to the fact that crisscrossing PTAs would systematically destroy the clean tariff regime
that the GATT had created by requiring each member country to adopt a single tariff rate
vis--vis all GTAT members. PTAs, which inevitably have different starting dates and
transition periods, instead create different tariff rates for different trading partners during
the transition to full free trade within the PTAs. Moreover, the rules of origin that differ
across different PTA partners continue to discriminate among various trading partners
even after the full implementation of the PTAs.4
It is perhaps fair to say that though Jagdishand with him this humble soldierlost
the policy battle, he won the intellectual debate on regionalism versus multilateralism.
Today, most policy makers recognize that the trade regime has turned into the spaghetti
bowl just as Jagdish had been saying for years and that it must be addressed through
further multilateral liberalization. The unfortunate part of the story, however, is that it
took a huge proliferation of PTAs to convince policy makers of what was an obvious
danger ex ante.
4
Concluding Remarks
With more than 300 PTAs already in place, a key original argument against them
fragmentation of the trading systemhas lost its force. As Jagdish has recently joked,
with every country having a special deal in each market, the most favored nation (MFN)
treatment has now turned into the least favored nation (LFN) treatment. 5 Indeed, even
the trade diversion argument carries less force today than when we began traveling on the
PTA route in the late 1980s since some of the new PTAs may now be reversing the trade
diversion caused by the previous ones.
This, of course, does not validate the havoc the PTAs have wrought. Quite the
contrary, it calls for the use of the ultimate weaponthe Brahmastra if I may use a term
4
5
from the Hindu mythology. What we must do is to use the Doha Round to bring about
complete multilateral free trade that would end the preferences at source: preferences
against zero tariffs are also zero. In industrial products, which are now subject to quite
low tariffs worldwide, this is a fully achievable goal by, say, 2015 for developed and
2020 for developing countries. The process will take longer in agriculture and services
but considerable progress is feasible even in these areas.
References
Baldwin, Richard. 1995. "A Domino Theory of Regionalism." in Expanding Membership
of the European Union. Richard Baldwin, P. Haaparnata, and J. Kiander, eds.
Cambridge, U.K: Cambridge University Press, pp. 25-53.
Bhagwati, Jagdish. 1991. The World Trading System at Risk. Princeton, N.J.: Princeton
University Press.
Bhagwati, Jagdish. 1993. "Regionalism and Multilateralism: An Overview," in New
Dimensions in Regional Integration. Jaime de Melo and Arvind Panagariya, eds.
pp. 22-51.
Bhagwati, Jagdish and Richard Brecher. 1979. National Welfare in an open economy the
presence of foreign-owned factors of production. Journal of International
Economics.
Bhagwati, Jagdish and Arvind Panagariya. 1996. "Preferential Trading Areas and
Multilateralism: Strangers, Friends or Foes?" in The Economics of Preferential
Trade Agreements. Jagdish Bhagwati and Arvind Panagariya, eds. Washington,
D.C: AEI Press, pp. 1-78.
Brecher, Richard and Jagdish Bhagwati. 1981 "Foreign Ownership and the Theory of
Trade and Welfare." J. of Polit. Econ., 89:3, pp. 497-511.
Grossman, Gene and Elhanan Helpman. 1995. "The Politics of Free Trade Agreements,"
Amer. Econ. Rev. 85:4, pp. 667-690.
Kemp, Murray and Henry Jr. Wan. 1976. "An Elementary Proposition Concerning the
Formation of Customs Unions", J. of Int. Econ. 6:1, pp. 95-98.
A Political Economy
Panagariya, Arvind and Pravin Krishna 2002. On Welfare Enhancing FTAs. Journal of
International Economics 57(2), August 2002, 353-367.
Summers, Lawrence. 1991. "Regionalism and the World Trading System," in Policy
Implications of Trade and Currency Zones. Symposium Sponsored by the Federal
Reserve Bank of Kansas City, pp. 295-301.
Viner, Jacob. 1950. The Customs Union Issue. New York: Carnegie Endowment for
International Peace.
Wonnacott, Paul and Mark Lutz. 1989. "Is There a Case for Free Trade Areas?" in Free
Trade Areas and U.S. Trade Policy. Schott, Jeffrey, Washington, D.C.: Institute for
International Economics, pp. 59-84.