Wednesday 23 Jan 2019 | 20:16 | SYDNEY
Wednesday 23 Jan 2019 | 20:16 | SYDNEY

The economics and politics of FTAs



19 November 2014 08:26

This is two-part post. Part 1 here.

I've seen a few people claim to be free traders. And then say that, therefore, they are in favour of free trade agreements (FTAs).

I support free trade, but not necessarily FTAs. Indeed, the effects of FTAs could even be negative. How? Let's talk very quickly about the economics of FTAs. As part of earning your ticket as a trade economist, you have to master the concepts of trade creation and trade diversion as they apply to FTAs. A quick recap:

Trade creation

Suppose Australia imports cars from the US and China, and we apply a 50% tariff to these cars. Now suppose we sign an FTA with China, and China is really good at producing cars. Then the Chinese will supply lots of cars and the domestic price of cars will come down substantially, so we now import more cars. Trade is created. That's good.

Trade Diversion

Suppose now, instead, that the Chinese are not overly adept at producing cars. In that case the supply response will be muted and the price of cars will not come down very much. However, because there are no tariffs levied on Chinese cars, Chinese producers have an advantage over US producers. Chinese cars will likely displace US cars. Australian consumers don't benefit much because the price does not fall much. The upshot is that, as an economy, we have displaced cheaper (pre-tariff) US cars with more expensive Chinese cars. Trade is diverted. That's bad.

Congratulations, your trade economist certification is in the mail.

So, FTAs can be bad. They don't necessarily increase welfare. That is, in part, why economists are asked to model their effects. In a former life, many years ago, I worked on the report that modeled the US-Australia Free Trade Agreement.

We can peel the onion back another layer and ask: what kind of agreements will the political process likely deliver? Will they be those where trade is created or where trade is diverted? Two economists, Elhanan Helpman and Gene Grossman, asked this exact question (my two cents: Helpman was seriously stiff not to get the Nobel the same year as Krugman, but don't take my word for it, Krugman himself heaps praise on the guy).

Their paper contains a lot of maths, but buried beneath are some crucial insights that can be neatly explained. Importantly, the existing tariff structure, before the FTA is signed, is the product of a political game, where vested interests are played off against the welfare of the wider community. Why is that important? Take the car example above. Remember that 50% tariff? That tariff is so high because the car lobby is powerful. This powerful car lobby will not be happy with an agreement that creates trade because that will lower the price of cars. They will be OK with an agreement that diverts trade, because the price, in that case, will not fall by much.

I think this is a profound insight. Powerful interests will fight against welfare-improving FTAs, while accepting ones that reduce welfare. So there is a bias in the political process that will deliver FTAs which are trade diverting. To be clear, Grossman and Helpman don't claim that this will always be the case – they just note a bias.

Photo by Flickr user toesoxluver.

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