Good news on free trade agreements

Free trade agreements can be controversial. While they promote trade between the member countries, they may also divert trade away from non-member countries, potentially reducing welfare. A new column by James Anderson and Yoto V. Yotov at VoxEU.org provides evidence that, even when trade diversion is taken into account, the overall effects are still strongly positive.

Back in 1950 Jacob Viner put for ward the idea of trade diversion and since then it has been an issue of concern in the academic literature on free trade agreements (FTAs). Simply there has been a concern about the potential harm to outsiders from trade diversion away them towards the insiders of the trade agreement. But economists are still not clear on the magnitude of trade diversion.

• How large is the harm from trade diversion?
• Does the gain to current FTA partners from trade diversion create a stumbling block to further expansion because that gain would have to be given up?

Recent research sheds new light on these questions.

Anderson and Yotov look at the basic economic logic:

Free trade agreements divert trade from outsiders to insiders because the relative cost of insider business falls. Tariffs between partners disappear while remaining in place for non-partners. More important in the modern setting of already low tariffs are the non-tariff barriers that fall between partners as regulatory barriers are reduced and the greater security of trade relations stimulates potential traders to invest in deals with insider counter-parties.

To understand the effects of trade diversion through non-tariff barrier reductions, an empirical analysis of trade flows before and after implementation of FTAs is required. Enter Anderson and Yotov. Their recent work tackles these questions (Anderson and Yotov 2011) and their findings are reassuring:

• FTAs provide gains to partners, large for the smaller partners, while inflicting very small losses on outsiders.
• Regional trade agreements appear to be building blocks rather than stumbling blocks.
• Direct gains to new partners are big, while indirect effects on outsiders are small.

An upshot of this is that an expansion of FTAs appears in the future is unlikely to be hampered by insiders having to give up important previous gains at the expense of outsiders. The Anderson and Yotov findings of very small terms-of-trade losses to outsiders, less than 0.2%, suggest that such potential stumbling blocks would be too small to notice while the size of the direct benefits to partners that join suggest much larger building blocks.

Anderson and Yotov provide further evidence of this overall effect in a counterfactual analysis by removing Mexico from NAFTA, reverting to the previous Canada-US FTA. In that scenario, all parties lose, while Mexico’s loss is larger by far, wiping out over 80% of its 7.6% terms-of-trade gain from its 1990s FTA implementations.

• Anderson, James E and Yoto V. Yotov (2011), "Terms of Trade and Global Efficiency Effects of Free Trade Agreements, 1990-2002", NBER Working Paper 17003.