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Contributions of Jagdish Bhagwati to

The Theory of Preferential Trading Arvind Panagariya The literature on the theory of preferential trade areas (PTAs)1 and the contributions of Jagdish Bhagwati to it can be divided into two distinct phases with 1990 as the approximate dividing line. Phase I starts with the pioneering treatise The Customs Unions Issue by Jacob Viner in 1950 and focuses principally on what Jagdish has called static welfare questions. Phase II starts in the early 1990s and focuses instead on the politicaleconomy considerations behind PTAs and the dynamic time path question of whether PTAs are building or stumbling blocks of multilateral freeing of trade. Jagdish has made important contributions to the former literature and seminal contributions to the latter. This paper outlines the main developments in each Phase, drawing attention to Jagdishs role in particular while highlighting the work of others as well, including my own given my longstanding interest in this area of research. 1 Phase I: Static Theory Deploying the Traditional Tools Four distinct approaches can be identified in the pre-1990s literature: 1. The Vinerian welfare analysis using the influential concepts of trade creation and trade diversion; 2. The Kemp-Wan approach focusing on identifying customs unions that would be necessarily welfare improving;
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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.

3. The Cooper-Massell-Johnson-Bhagwati analysis of a customs union to minimize the cost of industrialization; and 4. Bhagwati-Brecher approach to analyzing the effect of changes in the exogenous variables such as the external tariff and the terms of trade on individual members of the union. Viner set out to answer the question why many free traders and protectionists agreed on the desirability of PTAs. In the process, he developed the important distinction between trade creating and trade diverting unions. A union was trade creating if

preferential liberalization by a member country allowed it to replace the higher-cost domestic supply by the lower-cost partner-country supply. Unions that were principally trade creating enhanced efficiency and were therefore beneficial to the member countries and the world. Unions were trade diverting if preferential liberalization by a member country led it to replace the lower-cost supply from non-member countries by the highercost supply by the partner country. Unions that were largely trade diverting reduced efficiency and lowered the welfare of the union members as well as the world. Viner concluded that free traders who supported PTAs probably had trade-creating customs unions in mind while protectionists who supported them expected them to be trade diverting. The ambiguity of the outcome in the Vinerian analysis has led economists to look for criteria that would allow them to determine whether a specific union would be largely trade creating or trade diverting. During the debate on the North American Free Trade Agreement, this search led Wonnacott and Lutz (1989), Summers (1991), Krugman (1991) and others to assert that if the member countries were geographically proximate 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 volume-of-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 volumeof-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 partialequilibrium 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
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Pravin Krishna, in his Panel contribution today, addresses the Kemp-Wan approach more fully.

developing countries wanting to achieve a certain level of industrialization. The essential idea was that if a group of developing countries wanted to achieve an exogenous level of industrialization [essentially in the form of a non-economic objective analyzed by Bhagwati and Srinivasan (1969)], they could do so at a lower cost by specializing among themselves through a customs union. Recently, Krishna and Bhagwati (1997) have

formally proved this result by ingeniously marrying the Kemp-Wan approach with the theory of non-economic objectives. Finally, Jagdish has shown how the analysis by Bhagwati and Brecher (1979) and Brecher and Bhagwati (1981), analyzing how national welfare in a small open economy is impacted due to exogenous changes in the terms of trade and outside tariffs in the presence of foreign-owned factors, has immediate applicability to the analysis of the welfare impact on members of a Common Market such as the European Union. The analysis easily lends itself to questions such as the welfare effects of exogenous changes in external EU tariff on individual member countries such as France. 2 Phase II: The Dynamic Time Path Analysis In what is perhaps the most influential post-1990s contribution on preferential 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 timepath 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. The interest-group politics may simply result in a very

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 world.

That is to say, within an incentive-theoretic framework, PTA expansion is likely to stop short of bringing about multilateral free trade.3 Using the terminology Bhagwati (1991) had introduced earlier, Question II amounts to asking whether PTAs would serve as building blocks or stumbling blocks of multilateral free trade. In particular, we may ask, as Levy (1997) does in his important paper: (i) whether multilateral free trade which is initially infeasible can be made feasible by the option to form PTAs (PTAs as building blocks) and (ii) whether multilateral free trade that is initially feasible can be rendered infeasible by the option to form PTAs (PTAs as stumbling blocks). Levy answers first question in the negative noting that a PTA will be formed only if it increases the value of the governments political support function. And if it does so, the value of the political support function is now even higher than under multilateral free trade, making it even less inclined to go for the latter. Thus, PTAs do not serve as building blocks. As for the second of these questions, Levy finds that in one of his models, the option to form PTAs does render a previously feasible multilateral liberalization infeasible: PTAs turn into stumbling blocks. Krishna (1998) reaches the same conclusion in a Cournot oligopoly model. In his analysis, the greater the trade diversion by the PTA, the more likely it turns into a stumbling block. In his 1993 paper, Bhagwati also conjectured that in a political-economy setting, formation of a PTA would actually raise trade barriers against outside countries through either increased tariff [if it is not bound under the General Agreement on Tariffs and Trade (GATT)] or more vigorous anti-dumping measures. This conjecture was subsequently

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.

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 The Policy Debate In the specific area of preferential trading, any account of the contributions made by 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 from the Hindu mythology. What we must do is to use the Doha Round to bring about
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For details, see Panagariya (1999). In the European Union, only five countries now pay its MFN tariff!

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.

Krishna, Pravin. 1998. "Regionalism and Multilateralism: Approach," Quart. J. of Econ., 113:1, pp. 227-251.

A Political Economy

Krishna, Pravin and Jagdish Bhagwati. 1997. "Necessarily Welfare-enhancing Customs Unions with Industrialization Constraints," Japan and the World Economy 9:4, pp. 441-446. Krugman, Paul. 1991. "The Move to Free Trade Zones," in Policy Implications of Trade and Currency Zones. Symposium Sponsored by the Federal Reserve Bank of Kansas City, pp. 7-41. Levy, Philip. 1997. "A Political-Economic Analysis of Free-Trade Agreements," Amer. Econ. Rev., 87:4, pp. 506-519. Lipsey, Richard. 1957. "The Theory of Customs Unions: Trade Diversion and Welfare," Economica 24:93, pp. 40-46. Panagariya, Arvind. 1996. 'The Free Trade Area of the Americas: America?' World Economy 19:5, pp. 485-515. Panagariya, Arvind. 2000. Preferential Trade Liberalization: The Traditional Theory and New Developments, Journal of Economic Literature 38, June, 287-331. Panagariya, Arvind and Ronald Findlay. 1996. "A Political Economy Analysis of Free Trade Areas and Customs Unions," in The Political Economy of Trade Reform: Essays in Honor of Jagdish Bhagwati. Robert Feenstra, Douglas Irwin and Gene Grossman, eds. Cambridge, Mass.: MIT Press, pp. 265-287. Panagariya, Arvind. 1999. The Regionalism Debate: An Overview, World Economy, June, 477-511 Good for Latin

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.