Chapter 7 Government Policy and International Trade
The Revised Case for Free Trade
The strategic trade policy arguments of the new trade theorists suggest an economic justification
for government intervention in international trade. This justification challenges the rationale for
unrestricted free trade found in the work of classic trade theorists. In response to this challenge to
economic orthodoxy, a number of economists (including some of those responsible for the
development of the new trade theory, such as Paul Krugman) point out that although strategic
trade policy looks appealing in theory, in practice it may be unworkable.
Retaliation and trade war
Krugman argues that a strategic trade policy aimed at establishing domestic firms in a dominant
position in a global industry is a beggar-thy-neighbor policy that boosts national income at the
expense of other countries. A country that attempts to use such policies will probably provoke
retaliation. In many cases, the resulting trade war between two or more interventionist
governments will leave all countries involved worse off than if a hands-off approach had been
adopted in the first place.
Krugman may be right about the danger of a strategic trade policy leading to a trade war. The
problem, however, is how to respond when one’s competitors are already being supported by
government subsidies? According to Krugman, the answer is probably not to engage in
retaliatory action but to help establish rules of the game that minimize the use of trade-distorting
subsidies.
Domestic policies
Governments do not always act in the national interest when they intervene in the economy;
politically important interest groups often influence them. Thus, a further reason for not
embracing strategic trade policy, according to Krugman, is that such a policy is almost certain to
be captured by special-interest groups within the economy, which will distort it to their own
ends.
Development of the World Trading System
Strong economic arguments support unrestricted free trade. While many governments have
recognized the value of these arguments, they have been unwilling to lower their trade barriers
for fear that other nations might not follow suit. The essence of the problem is a lack of trust.
Both governments recognize that their respective nations will benefit from lower trade barriers
between them, but neither government is willing to lower barriers for fear that the other might
not follow.
Such a deadlock can be resolved if both countries negotiate a set of rules to govern cross-border
trade and lower trade barriers. But who is to monitor the governments to make sure they are
playing by the trade rules? And who is to impose sanctions on a government that cheats? Both
governments could set up an independent body to act as a referee. This referee could monitor
trade between the countries, make sure that no side cheats, and impose sanctions on a country if
it does cheat in the trade game.
While it might sound unlikely that any government would compromise its national sovereignty
by submitting to such an arrangement, since World War II an international trading framework
has evolved that has exactly these features. For its first 50 years, this framework was known as
the General Agreement on Tariffs and Trade (GATT). Since 1995, it has been known as the
World Trade Organization (WTO).
From Smith to the great depression
Adam Smith and David Ricardo's work on free trade in the late 18th century led to Great Britain
officially embracing it in 1846 when the Corn Laws were repealed. However, agricultural
protection was withdrawn due to a harvest failure and famine threat in Ireland. Despite pushing
for trade liberalization, the British government remained a voice in the wilderness, as the world's
largest exporting nation had more to lose from a trade war than any other country. The Great
Depression further exacerbated the economic problems, with the Smoot-Hawley tariff in 1930
causing a decline in U.S. exports and further escalating the Great Depression.
1947-1979 : GATT, trade liberalization, and economic growth
The Smoot-Hawley Act's trade policies significantly impacted post-World War II economic
institutions. The US emerged victorious and economically dominant, leading to the
establishment of the GATT in 1947. The GATT aimed to liberalize trade by eliminating tariffs,
subsidies, and import quotas. Its membership grew from 19 to over 120 nations, with the average
tariff declining by nearly 92% between the Geneva and Tokyo rounds.
1980-1993 : protectionist trends
During the 1980s and early 1990s, the global trading system was strained due to three factors:
Japan's economic success, the persistent trade deficit in the United States, and the rise of bilateral
voluntary export restraints (VERs). Japan's success in industries like automobiles and
semiconductors, combined with the perception that Japanese markets were closed to imports and
foreign investment, contributed to the strain. The U.S. deficit also strained the system, leading to
increased unemployment and demands for protection against imports. Additionally, many
countries circumvented GATT regulations through bilateral voluntary export restraints (VERs),
such as Japan's automobile VER between Japan and the U.S.
The Uruguay round and the world trade organization
Against the background of rising pressures for protectionism, in 1986, GATT members
embarked on their eighth round of negotiations to reduce tariffs, the Uruguay Round (so named
because it occurred in Uruguay). Until then, GATT rules had applied only to trade in
manufactured goods and commodities. In the Uruguay Round, member countries sought to
extend GATT rules to cover trade in services. They also sought to write rules governing the
protection of intellectual property, to reduce agricultural subsidies, and to strengthen the GATT’s
monitoring and enforcement mechanisms. The Uruguay Round dragged on for seven years
before an agreement was reached on December 15, 1993. It went into effect July 1, 1995.
The World Trade Organization
The WTO, a subsidiary of the GATT, has expanded its role to include two sister bodies,
one on services and the other on intellectual property. The GATS extends free trade
agreements to services, while the TRIPS aims to protect intellectual property rights
globally. The WTO now handles trade disputes and trade policy monitoring, adopting
arbitration reports automatically unless rejected. Violations can be appealed to a
permanent appellate body, with binding verdicts. The WTO has more teeth than the
GATT.
WTO : experience to date
The World Trade Organization (WTO) has 164 members, accounting for 98% of world trade. Its
founders hoped that its enforcement mechanisms would make it more effective at policing global
trade rules than the GATT. However, the WTO has struggled to reduce trade barriers since the
late 1990s, with slow progress in the Doha Round. The global financial crisis of 2008-2009 and
the 2016 British exit and US presidential election have raised questions about the WTO's future
direction.
WTO as global police
The World Trade Organization (WTO) has shown positive results in its first two decades,
handling over 500 trade disputes between member countries between 1995 and 2015.
Three-fourths of these cases were resolved through informal consultations, while the
remaining cases involved formal procedures. Countries generally adopted WTO's
recommendations, demonstrating confidence in its dispute resolution procedures.
Expanded trade agreements
The Uruguay Round of GATT negotiations extended global trading rules to cover trade
in services, allowing the WTO to broker future agreements to open up global trade in
services. Two industries targeted for reform were global telecommunication and financial
services. In February 1997, the WTO brokered a deal to open telecommunication markets
to competition, allowing foreign operators to purchase ownership stakes in domestic
providers. Most of the world's biggest markets were fully liberalized by January 1998. In
December 1997, the WTO liberalized cross-border trade in financial services, covering
over 95% of the world's market.
The future of the WTO : unresolved issues and the Doha round
The World Trade Organization (WTO) has struggled to make progress on international trade
since the 1990s due to a slower-growing world economy and growing political opposition. Issues
include high unemployment, environmental degradation, poor working conditions, falling real
wage rates, and rising income inequality. China's rise as a dominant trading nation has also
contributed to this. Four main WTO agenda issues include antidumping policies, protectionism
in agriculture, lack of intellectual property rights protection, and high tariff rates on
nonagricultural goods and services.
Antidumping actions
Antidumping actions, allowing countries to impose duties on foreign goods sold cheaper
or below their production costs, have become a significant issue in the 1990s and 2000s.
Between 1995 and mid-2016, 5,132 antidumping actions were reported by WTO
members, with India initiating the largest number. These actions are concentrated in
sectors like basic metal industries, chemicals, plastics, and machinery and electrical
equipment. The WTO is concerned about these policies, arguing they reflect persistent
protectionist tendencies and pushing for stronger regulations to protect domestic jobs
from unfair foreign competition. The process can become politicized, leading to
increased antidumping actions.
