FTAs and RTAs: The political imperative
Business Standard, India
FTAs and RTAs: The political imperative
OKONOMOS
T C A Srinivasa-Raghavan / New Delhi
4 August 2006
RTA’s achieve more-or-less the same outcome as multilateral trading arrangements.
Last week, Sanjaya Baru, the media advisor to the prime minister, and an economist in a previous avatar, published a book called The Strategic Consequences of India’s Economic Performance. Amongst other things in it, he argues for more regional trading agreements.
With the collapse of the Doha Round, this is going to happen anyway. Some would say that the Doha Round collapsed because of regional trade agreements (RTAs).
But Sonia Gandhi is likely to take a dim view of these developments. After all, did she not, last May, write to the prime minister asking him asking him to “very carefully scrutinise” the India-ASEAN free trade agreement (FTA) to safeguard the interests of domestic farmers?
An answer can be found in a widely cited paper* last year Emanuel Ornelas, a young economist at the University of Georgia. He wrote about the political viability of FTAs.
The question he asked was what happens to the rents that producers earn when such agreements come into force. And the answer, of course, was that they get eliminated because their unearned incomes vanish.
What makes Ornelas’ paper worth reading is the political context. He shows that “the prospect of rent destruction can critically undermine, and in some cases rule out entirely, the political viability of FTAs.... In contrast to the earlier literature showing how politically motivated governments may have a penchant for welfare-reducing trade arrangements, I show just the reverse. Politically viable free trade agreements, that is, any individually rational agreement for a contribution-loving government, tend to be overall welfare enhancing.”
The key to understanding the issue lies in the money that lobbies pay to politicians to further their interests. “Contributions by special interests induce the government to set the country’s import tariffs above the welfare-maximising level. These higher import tariffs shift surplus from consumers to producers through the higher local price the tariff causes. As a result, profits (producers’ surplus) of import-competing industries are enhanced.”
Another startling result is that under an FTA, far from increasing the lobbying against the countries that are not members of the FTA, the reverse happens, because if you have higher tariffs for imports from outside countries, the surplus has to be shared with everyone within the FTA. It doesn’t stay within the domestic boundaries.
Therefore, “the domestic producers become less willing to compensate the government for higher external tariffs on excluded countries.” From this, I would infer that RTA’s achieve more-or-less the same outcome as multilateral trading arrangements. However, politicians, anticipating “adopt only FTAs that raise national welfare enough to compensate for the lower rents - that is, those that are sufficiently trade-creating.” Another important factor that may influence the decision to sign an FTA or not is if “the role of ‘politics’ in the governments’ objective function is ‘moderate’.”
That is, it must provide enough balancing mechanism so as to “sufficiently disconnect the criterion to adopt the FTA from the socially desirable criterion but low enough to avoid destruction of too much rents.” In other words, this is the essence of democracy and, perhaps, the unintended driver of Sonia Gandhi’s letter to the prime minister.
Economists have earlier argued that “politically motivated governments are more likely to form preferential arrangements when they reduce national welfare, as a result of pervasive rent-creating trade diversion.”
But says Ornelas, this approach assumes that tariffs are exogenously given. In fact, however, “it is precisely the endogeneity of these tariffs that allows for the rent destruction effect.”
Assuming all this is approximately correct, I have a slightly different question for economists: given the politics of trade, what is the optimum number countries that should be members of an FTA? Also, does it make sense for smaller countries to enter into an FTA of which a gorilla, like the US , China or India, is also a member?
* Rent destruction and the political viability of Free Trade Agreements, The Quarterly Journal of Economics, 2005, Vol. 120. Also available at ideas.repec.org/a/tpr/qjecon/v120y2005i4p1475-1506.html
