International_Economics_Tenth_Edition (1)

In addition to complicated multilateral trade negotiations involving the World Trade Organization, the United States has pursued simpler bilateral agreements that are expected to be less politically sensitive and thus more likely to win congressional approval. This occurred in 2003, when the United States and Chile signed a bilateral free-trade agreement, concluding a 14round negotiation process than began in 2000. The free-trade agreement took effect on January 1, 2004.

With the implementation of the U.S.-ehile free-trade agreement, Chile joined a selectgroup of only five other countries that have a free-trade agreement with the United States: Canada, Mexico, Jordan, Israel, and Singapore. Market access is a major portion of the agreement. When the agreement went into effect in 2004, 87 percent of U.s.-ehilean bilateral trade in consumer and industrial products became duty-free immediately, with the rest receiving reduced tariff treatment over time. Some 75 percent of U.S. farm exports will enter Chile duty-free by 2008, and duties on all goods will be fully phased out by 2016. The agreement also phases out export subsidies on agricultural products and increases market access for a broad range of services including banking and insurance.

Proponents of the U.s.-Chile free-trade agreement maintained that it offered both economic and political benefits, with Chile seen as a crucial foothold in South America, a region historically linked closely with Europe and Asia. From an economic perspective, U.S. businesses considered Chile a main target for expanding exports and repeatedly emphasized the need to decreasethe higher tariffs they faced relative to Canada and other countries that already had free-trade agreements with Chile. Lower-cost U.S. imports from Chile also provided benefits to individual and business consumers. U.s. investors also saw Chile'spolitical and economic stability as attractive for foreign investment. From a trade-strategy perspective, it was

argued that a free-trade agreement with Chile would support U.s. initiatives with the Free Trade Area of the Americas, currently under negotiation, by fostering greater Chilean support for U.S. issues and helping define key negotiating parameters (labor and environment provisions) that could be precedent setting. Finally, Chile was seen as an opportunity for the United States to encourage economic and trade reform in Latin America, for which Chile had become a regional model.

Chile also saw a logic in forming a free-trade agreement with the United States because export promotion has been a foundation of its growth and development strategy. Guaranteed Chilean access to the large U.S. market provides opportunities for increased and more diversified trade. Chile also envisioned increasedforeign investment as a benefit of the free-trade agreement.

However, opposition to a bilateral free-trade agreement was strong for both economic and political reasons. Some economists, even those who support free trade, noted that bilateral and regional agreements are poor substitutes for multilateral arrangements. Although both Chile and the United States saw their welfare increasing through trade creation, critics noted that the agreement would likely also causetrade diversion, which would negatively affect both those inside and outside of the agreement. There was also strong opposition by interest groups, especially import-competing industries that absorb the brunt of the adjustment costsofthe agreement. Other groups protesting globalization in general noted that the agreement did not adequately address the adverse effects on labor and the environment. At the writing of this text, the U.s.-Chile freetrade agreement is in its infancy. It remains to be seen whether or not the agreement will live up to the expectations of its advocates.

Source: Drawn from J. Hornbeck. The U.S.-ChileFree-Trade Agreement.

Congressional Research Service. Washington. DC. September 2003.

Skeptics note that an FTAA should not merely reflect the interests of the hemisphere's two largest economies, the United States and Brazil.

Yet another challenge revolves around agricultural issues. Agricultural makes up, on average, 7 percent of Latin America's GDP and a significantly

280 Regional Trading Arrangements

larger share of its exports. In FTAA negotiations, the United States has refused to lower subsidies and tariffs that protect U.S. farmers, arguing that those protections should be negotiated in global trade agreements, not regional ones, because the European Union is the biggest subsidizer of agriculture. But Brazil contends that its farmers cannot compete in U.S. markets, so it demands that subsidies and tariffs be on the bargaining table. However, farmers in the United States fear that a flood of cheap agricultural products from Brazil and other Latin American nations would occur if trade barriers are removed, which would wipe them out. Other difficult negotiating issues for the FTAA involve honoring intellectual property rights and opening of government contracts to foreign bidders.

These differences have kept the region's governments from uniting the two halves of the Americas. To keep the region on the road to forming an FTAA, in 2003 the governments put together a less ambitious compromise. Out went the wide-ranging accord they had spent years negotiating. Instead, they will seek a flexible, 34-country agreement, comprising only a few common standards and

. some tariff cuts.

The FTAA is perhaps the most ambitious economic initiative in the Western Hemisphere's history and one that would have a tremendous effect on the lives of its inhabitants. Many roadblocks and detours will likely have to be faced before it is completed.

Asia-Pacific Economic

Cooperation

Since 1989, the United States has been a member of Asia-Pacific Economic Cooperation (APEC),which also includes Australia, Brunei, Canada, Chile, China, Indonesia, Japan, Malaysia, Mexico, New Zealand, Papua New Guinea, the Philippines, Singapore, South Korea, Taiwan, and Thailand. In 1993, leaders of the APEC countries put forth their vision of an Asia-Pacific economic community in which barriers to trade and investment in the region would be eliminated by the year 2020. All countries would begin to liberalize at a common date, but the pace of implementation would take into account

the differing levelsof economic development among APEC economies: The industrialized countries would achieve free trade and investment no later than 2010, and the developing economies no later than 2020. It remains to be seen whether the APEC goal of economic integration will be achieved.

ITransition Economies

Trade preferences have also been extended to commercial and financial practices involving nations making the transition from a centrally planned economy to a market economy; such economies are known as the transition economies. Prior to the economic reforms in Eastern European nations in the 1990s, these nations were classified as nonmarket economies; the Western nations, including the United States, were classified as market economies. Table 8.7 shows the gross national income per capita for the transition economies as of 2002. Let us consider the major features of these economic systems.

In a market economy, the commercial decisions of independent buyers and sellers acting in their own interest govern both domestic and international trade. Market-determined prices value alternatives and allocate scarce resources. This means that prices play rationing and signaling roles that make the availability of goods consistent with buyer preferences and purchasing power.

In a nonmarket economy (one that is centrally planned), there is less regard for market considerations. State planning and control govern foreign and sometimes domestic trade. The central plan often controls the prices and output of goods bought and sold, with small recognition given to considerations of cost and efficiency. The state fixes prices to ration arbitrary quantities among buyers, and these prices are largely insulated from foreigntrade influences. Given these different pricing mechanisms, trade between market economies and centrally planned economies can be difficult. Because market-determined prices underlie the basis for trade according to the theory of comparative advantage, the theory has little to say about how nonmarket economies carry out their international trade policies.

The nonmarket nations of Eastern Europe and Asia historically have experienced only modest trade flows with the Western world. By the 1970s and 1980s, however, the nonmarket nations were increasingly looking to Western markets. In terms of the volume and composition of East-West trade, Western Europe has accounted for the largest share, whereas the u.s. share has been minor. Political considerations largely explain the small amount of U.S. trade with the East. The United States historically has placed controls on strategic exports of technology and goods to communist countries; it has also imposed restrictions on the credit terms extended to them.

Industrial Cooperation

Until recently, East-West trade was relatively simple: Exports to and imports from Eastern European countries were settled in hard currency or credit. But with the expansion of East-West trade has come countertrade, which establishes a greater degree of interdependence between the private corporations of Western economies and the state enterprises of the Eastern European countries.

Countertrade refers to all international trade in which goods are exchanged for goods- a kind of barter. If swapping

goods for goods sounds less efficient than using cash or credit, that's because it is. During tough economic times, however, shortages of hard currency and tight credit can hinder East-West trade. Instead of facing the possibility of reduced foreign sales, Western producers have viewed countertrade as the next best alternative.

Many Western nations conduct countertrade with the Eastern European countries, as shown in Table 8.8 on page 282. In the United States, General Motors, Sears, and General Electric have established trading companies that conduct countertrade. A simple form of countertrade occurs when an Eastern European country agrees to pay for the delivery of plant, machinery, or equipment with the goods produced by the plant. For example, Germany has sold Russia steel pipe in exchange for deliveries of natural gas; Austria has supplied Poland with technological expertise and equipment in exchange for diesel engines and truck

components. With the opening of the economies of the former Soviet Union, the role of countertrade has diminished in recent years.

Industrial cooperation has also resulted in coproduction agreements, by which Western companies establish production facilities in an Eastern European country. Because most Eastern European countries do not allow foreign ownership of such operations, an agreement is made whereby ownership is held by Eastern European nationals. Coproduction agreements are widely used in the areas of machine building, chemical products, electrical and electronic devices, and pharmaceutical goods.

Industrial cooperation may assume several other forms. Western companies have often made joint R6~D agreements with Eastern European countries, particularly in industrial processes and technical areas. The findings of such activities are patented jointly, and license royalties are shared between the partners. Also popular are contract manufacturing agreements: Western nations supply materials and design specifications to Eastern European enterprises, which produce the goods and ship them back to the Western nations.

The motivations for industrial cooperation vary. For a Western company, such agreements get around the hard-currency scarcities of the Eastern European countries and permit access to the markets of Eastern Europe. Western companies can

also tap additional supplies of raw materials and intermediate goods, or possibly maximize revenues by selling obsolete equipment. The Eastern European partner typically views industrial cooperation as a means of obtaining new technologies and expanding industrial capacity with small sacrifices of hard currency.

The Transition Toward a

Market-Oriented Economy

In 1989, the world began to witness unprecedented developments in Eastern Europe, as many countries moved toward democracy and economic reform. Countries such as Hungary, Poland, Czechoslovakia, and the Soviet Union discarded their centrally controlled state economies and moved toward systems in which private ownership of property predominated and most resources were allocated through markets. These transitions reflected the failure of central planning systems to provide either political freedom or a decent standard of living.

In 1990, for example, per capita real income in the Soviet Union was less than one-tenth of per capita real income in the United States. Another example is the case of the two Germanys. Starting from the same point at the end of World War II and sharing a common culture, East Germany and West Germany followed two different paths. East Germany became an industrial wasteland with run-

down, outmoded factories, and a polluted environment, while West Germany achieved one of the highest living standards in the world.

The fundamental motivation for change in Eastern Europe was the failure of the economies there to generate a high standard of living for their people. The economic policies pursued in these countries failed because they were unable to provide adequate incentives for producers to supply efficiently the goods and services that consumers wanted to purchase. Widespread use of price controls, reliance on inefficient public enterprises, extensive barriers to competition with the rest of the world, and government regulation of production and investment all obstructed the normal operation of markets. The lack of enforceable property rights severely restricted incentives for entrepreneurs.

In Eastern Europe, central plans decided production levels. As a result, there was no reason to expect that the output produced would meet the wants or needs of the people. Shortages and surpluses occurred frequently, but managers had little motivation to modify their output as long as quotas were realized. Government investment choices led to underproduction of consumer goods and widespread rationing. Incentives to innovate were almost completely absent, except in the defense sector; but the European countries were unable to transfer their high levels of defense technology into improvements for consumers. Inefficient stateowned enterprises were common, and public funds were channeled into favored industries irrespective of the economic consequences.

Over time, the weaknesses of the political and economic systems of Eastern Europe and the contrasting success of the market-oriented systems became obvious. This created pressure that led to the collapse of Eastern Europe's communist governments.

As the economies of the communist countries deteriorated, piecemeal reforms occurred. Many Eastern European countries attempted to combine economic decentralization with partial price decontrol; however, the removal of price controls has often led to destabilizing bouts of inflation. It was hoped that with reduced central control, state-owned enterprises would operate as if they were part of well-

functioning markets. Although national planning objectiveswere stillstipulated, individual firms could establish their own goals and be responsible for production decisions. The system of price controls became more flexible and some small-scale enterprise was allowed. These piecemeal reforms, however, were doomed to failure. Private property rights were generally absent, which limited profit incentives and discouraged entrepreneurship, and stateowned monopolies were maintained. Apparently, widespread economic reforms were needed to revitalize the Eastern European economies.

Economists generally agree that Eastern Europe's transition toward a healthy market economy requires major restructuring of their economies: Sound fiscal and monetary policies must be established, domestic price controls must be removed, economies must be opened to international market forces, private property rights must be established along with a legal system to protect these rights, domestic competition must be promoted, and government's involvement in the economy must be reduced.

Although there is general agreement on what the former communist economies need to do, much debate exists about the sequence and timing of specific reforms. Advocates of shock therapy (the "big bang" approach) maintain that the economies in transition should proceed immediately on all fronts. That is, they should privatize, abandon price controls, liberalize trade, develop market institutions, and so on as quickly as possible. Although the initial economic pain may be severe, it will subside as the transition to a market economy leads to rising livingstandards. Poland and East Germany, starting from different circumstances, are undergoing rapid transformations to a market economy. Although the output and employment costs of the transition have been greater than initially expected, the measures are seen as a basis for a significant improvement in living standards over the longer term.

Advocates of a gradualist approach fear that the big-bang approach will cause too great a shock to the economic system and that organizations cannot change so quickly; the initial economic disruptions might create excessive burdens for the people and even lead to a return to the former communist system. Gradualists maintain that

284 Regional Trading Arrangements

the best approach is to build up market institutions, gradually decontrol prices, and privatize only the most efficient government enterprises at first. Hungary, the Czech Republic, and Russia are examples of former communist countries that have adopted more gradual economic reforms. Table 8.9 shows the 2003 Index of Economic Freedom for selected transition economies as well as Hong Kong, Singapore, and the United States. The higher the score factor, the greater the level of government interference in the economy and the less economic freedom.

Russia and the World Trade Organization

Since 1995, Russia has been negotiating terms for accession to the World Trade Organization. Progress toward accession has been uneven over the years, with negotiations to date consisting of detailed examinations of Russia's trade policies and its legal and administrative framework for trade. However, the negotiations gained momentum fol-

lowing the September 11, 2001, terrorist attacks against the United States, when Russia and the United States became more closely allied in their efforts to eliminate terrorism.

Russia's WTO accession negotiations have been slow for several reasons. Still in transition from a nonmarket to a market economy since the breakup of the Soviet Union, Russia faces the ongoing challenges of restructuring its economy, privatizing gov- ernment-owned industries, and implementing mar- ket-oriented economic reforms. Reaching political consensus on reforms-particularly on reforms that would open the Russian economy to more efficient foreign competitors-often has proved difficult and time-consuming. A 1998 economic crisis, precipitated by a loss of the financial markets' confidence in Russia, was a significant setback that forced Russian policy makers to make domestic economic-crisis management their priority. Also, rising world oil prices beginning in 2000 (oil is Russia's major export) generated a windfall budget surplus and slowed the impetus in Russia

for domestic economic reforms and integration into the global economy.

The goal of wro membership has been the cornerstone of Russian economic policies to integrate Russia into the global economy following decades of Soviet self-imposed isolation. Although the WTO does not require that its members enact specificlegislation, its members have requested that Russia develop new laws and regulations in line with international standards, improve enforcement of regulations already compliant with WTO rules, and agree to terms that will open Russian markets to foreign competition before Russia's accession application is approved. Issues that must be addressed include Russian agricultural subsidies,

the Russian customs system, foreign investment regulations, market access in Russia's service sectors, Russian technical barriers to trade, and Russia's need to improve its administration and enforcement of intellectual property rights.

Accession to the WTO generally enjoys broad political support in Russia. Russian officials estimate that Russian trade gains could total as much as $18 billion over 5 years following wro accession as a result of reduced tariff and nontariff trade barriers of Russia's trading partners. However, critics fear that an open-trade regime could have an adverse impact on many Russian industries that are not globally competitive, such as autos, steel, and agriculture.

1.Trade liberalization has assumed two main forms. One involves the reciprocal reduction of trade barriers on a nondiscriminatory basis, as seen in the operation of the World Trade Organization. The other approach involves the establishment by a group of nations of regional trading arrangements among themselves. The European Union and the North American Free Trade Agreement are examples of regional trading arrangements.

2.The term economic integration refers to the process of eliminating restrictions on international trade, payments, and factor input mobility. The stages of economic integration are (a) free-trade area, (b) customs union, (c) common market, (d) economic union, and (e) monetary union.

3.The welfare implications of economic integration can be analyzed from two perspectives. First are the static welfare effects, resulting from trade creation and trade diversion. Second are the dynamic welfare effects that stem from greater competition, economies of scale, and the stimulus to investment spending that economic integration makes possible.

4.From a static perspective, the formation of a customs union yields net welfare gains if the consumption and production benefits of

trade creation more than offset the loss in world efficiency owing to trade diversion.

S.Several factors influence the extent of trade creation and trade diversion: (a) the degree of competitiveness that member-nation economies have prior to formation of the customs union,

(b) the number and size its members, and (c) the size of its external tariff against nonmembers.

6.The European Union was originally founded in 1957 by the Treaty of Rome. Today it consists of 25 members. By 1992, the EU had essentially reached the common-market stage of integration. Empirical evidence suggests that the EU has realized welfare benefits in trade creation that have outweighed the losses from trade diversion. One of the stumbling blocks confronting the EU has been its common agricultural policy, which has required large government subsidies to support European farmers. The Maastricht Treaty of 1991 called for the formation of a monetary union for eligible EU members, which was initiated in 1999.

7.The formation of the European Monetary Union in 1999 resulted in the creation of a single currency (the euro) and a European Central Bank. With a common central bank, the central bank of each participating nation

286 Regional Trading Arrangements

performs operations similar to those of the 12 regional Federal Reserve Banks in the United States.

8.Much of the analysis of the benefits and costs of Europe's common currency is based on the theory of optimum currency areas. According to this theory, the gains to be had from sharing a currency across countries' boundaries include more uniform prices, lower transactions costs, greater certainty for investors, and enhanced competition. These gains must be compared against the loss of an independent monetary policy and the option of changing the exchange rate.

9.In 1989, the United States and Canada successfully negotiated a free-trade agreement under which free trade between the two nations would be phased in over a Ifl-year period. This agreement was followed by negotiation of the North American Free

Trade Agreement (NAFTA) by the United States, Mexico, and Canada.

10.By the 1990s, nations of Eastern Europe and the former Soviet Union were making the transition from centrally planned economies to market economies. These transitions reflected the failure of central planning systems to provide either political freedom or a decent standard of living.

11.It is widely agreed that the transition of economies of Eastern Europe and the former Soviet Union into healthy market economies will require major restructuring: (a) establishing sound fiscal and monetary policies; (b) removing price controls; (c) opening economies to competitive market forces; (d) establishing private property rights and a legal system to protect those rights; and (e) reducing government's involvement in the economy.

•Asia-Pacific Economic Cooperation (APEC)

(page 280)

•Benelux (page 255)

•Common agricultural policy (page 263)

•Common market

(page 255)

•Convergence criteria

(page 261)

•Countertrade (page 281)

•Customs union (page 254)

•Dynamic effects of economic integration

(page 256)

•Economic integration

(page 254)

•Economic union (page 255)

•Euro (page 261)

•European Monetary Union (EMU) (page 261)

•European Union (EU)

(page 255)

•Export subsidies

(page 263)

•Free-trade area (page 254)

•Free Trade Area of the Americas (FTAA)

(page 278)

•Maastricht Treaty

(page 261)

•Market economy

(page 280)

•Monetary union (page 255)

•Nonmarket economy

(page 280)

•North American Free Trade Agreement (NAFTA)

(page 271)

•Optimum currency area

(page 268)

•Regional trading arrangement (page 253)

•Static effects of economic integration (page 256)

•Trade-creation effect

(page 256)

•Trade-diversion effect

(page 256)

•Transition economies

(page 280)

•Variable levies (page 263)

1.How can trade liberalization exist on a nondiscriminatory basis versus a discriminatory basis? What are some actual examples of each?

2.What is meant by the term economic integration? What are the various stages that economic integration can take?

3.How do the static welfare effects of trade creation and trade diversion relate to a nation's decision to form a customs union? Of what importance to this decision are the dynamic welfare effects?

4.Why has the so-called common agricultural policy been a controversial issue for the European Union?

5.What are the welfare effects of trade creation and trade diversion for the European Union, as determined by empirical studies?

6.Xtra! For a tutorial of this questi~n, go to

""H"W:' http://carbaughxtra.swlearnmg.com

Table 8.10 depicts the supply and demand schedules of gloves for Portugal, a small nation that is unable to affect the world price. On graph paper, draw the supply and demand schedules of gloves for Portugal.

a.Assume that Germany and France can supply gloves to Portugal at a price of $2 and $3, respectively. With free trade, which nation exports gloves to Portugal? How many gloves does Portugal produce, consume, and import?

b.Suppose Portugal levies a 100 percent nondiscriminatory tariff on its glove imports. Which nation exports gloves to

TABLE 8.10

Supply and Demand for Gloves: Portugal

Portugal? How many gloves will Portugal produce, consume, and import?

c.Suppose Portugal forms a customs union with France. Determine the trade-creation effect and the trade-diversion effect of the customs union. What is the customs union's overall effect on the welfare of

Portugal?

d.Suppose instead that Portugal forms a customs union with Germany. Is this a tradediverting or trade-creating customs union? By how much does the customs union increase or decrease the welfare of Portugal?

288 Regional Trading Arrangements

8.1 The home page of the proposed Free Trade Area of the Americas, a plan to integrate the economies of North and South America, can be found by setting your browser to this URL:

http://www,alca-ftaa,org

8.2 The Asia-Pacific Economic Cooperation is a regional organization of 18 countries that promotes free trade and economic coordination. Visit its Web site by setting your browser to this URL:

http://www.apecsec.org.sg

8.3 Information about the European Union can be found by visiting its home page, along with that of the Government & Social Science Information Service, administered by the University of

California, Berkeley. To find these two sites, set your browser to these URLs:

http://europa.eu.intl

and

http://www.1ib.berkeley. edu/doemoff/ gov_eugde.html

8.4 To get information on NAFTA, log onto the Web page of the North American Integration and Development (NAID) Center at the University of California at Los Angeles:

http://naid.sppsr.ucla.edu

8.5 The Association of Southeast Asian Nations (ASEAN) was established on August 8, 1967, to promote economic growth, social progress, and cultural development. Visit its Web site at this URL:

http://www.aseansec.org