The economics and politics of free trade agreements

Philippe Martin, Thierry Mayer y Mathias Thoenig, VOXEU, 9 de abril de 2010

Free trade agreements have bad name among certain economists. They argue that such agreements are a threat to the carefully constructed postwar multilateral trade system (Bhagwati 2008).

During the last two decades, we have witnessed a very contrasted evolution of multilateral vs regional trade liberalisation. Whereas multilateral liberalisation has progressively slowed down to an almost complete halt, the number of free trade agreements (FTAs) has massively expanded and is now well above 300. The well known economic problem with these bilateral and regional agreements is that, although they create trade among members, they also generate distortions through their discriminatory nature.

Wider motivations

But economists have paid much less attention to the political and strategic motivations for regional integration, even though these motivations may have been key historically.

In the case of Europe, political scientists and historians have insisted on the fact that economic integration was viewed as an intermediate objective while its final objective was to prevent the killing and destruction of the two World Wars from ever happening again. French Minister of Foreign Affairs Robert Schumann famously declared in 1950:

“Through the consolidation of basic production and the institution of a new High Authority, whose decisions will bind France, Germany and the other countries that join, this proposal represents the first concrete step towards a European federation, imperative for the preservation of peace.

This was shortly before the set up of the European Coal and Steel Community in 1951 – a crucial precedent for the European Community six years later.

Even the recent creation of the euro, often interpreted by economists as a logical step towards more economic integration, has been discussed in these terms. Indeed, Jacques Delors (former president of the European Commission) declared:

“...people forget too often about the political objectives of the European constitution. The argument in favour of the single currency should be based on the desire to live together in peace”.

Outside Europe, the “common market of the south”, Mercosur, was created in South America in 1991 in part to curtail the military power in Argentina and Brazil, then two recent and fragile democracies with potential conflicts over natural resources.

Economics and politics as complements

That political and strategic motives may intervene into the decision of creating an FTA actually increases the distrust of many economists towards FTAs in comparison to multilateral trade agreements. The debate between economists and political scientists often interprets economic and political rationales for FTAs as substitutes. In a recent paper (Martin et al. 2010), we revisit the case for trade agreements by explicitly linking the economic and political rationales and show that the later are indeed important determinants of the geography of FTAs. However, we also show that the intrusion of politics into the decision to create FTAs does not make economic factors less important but more important. In other words, that economics and politics are complements in understanding FTAs.

Make trade not war

To understand the role of strategic factors in FTAs, we need to come back to an old argument, the so called “Liberal Peace” argument which states that bilateral trade flows reduce the probability of a bilateral war, a mechanism that has been analysed theoretically and on which some empirical evidence exists (see in particular, Hegre et al. forthcoming, Spolaore and Wacziarg 2009, Martin et al. 2008, Polachek and Seiglie 2007). Hence, FTAs, because they create trade, should reduce the probability of wars between countries.

This proposition is difficult to test however. Establishing the direction of causality is a complex task. Instead, we choose a different route by asking the following question:

- Is the geography of FTAs consistent with a model in which policymakers believe that FTAs are pacifying and therefore believe in the Liberal Peace argument?

What matters for free trade agreements?

In such a world, what would explain that certain country pairs sign FTAs and others do not? The first determinant is the standard economic gains of an FTA which come, in particular, from a lower price of imports. We estimate those for all country pairs over the period 1950-2000 and find that indeed they participate in predicting which country pairs sign FTAs. Economics does matter.

The political or strategic benefits of signing an FTA come in two parts. The first, which political scientists have called the “political forum channel”, is that FTAs come with various institutions in which countries negotiate about trade issues but often (this is clearly the case for the EU but also for Mercosur and ASEAN) those discussions spillover to political issues to attempt to diffuse political disputes that could escalate into conflicts.

How can we identify this perceived political gain from FTAs? Our argument is that the benefit of this political forum channel effect should be stronger for those country pairs that indeed run the risk of experiencing an escalation of a dispute into a military conflict. We proxy this risk by the history of old wars that countries experienced over the period 1870-1945. We indeed find that those country pairs that experienced a high number of conflicts in the past are more likely to sign FTAs. Politics does matter.

The second political benefit in signing FTAs is that the Liberal Peace argument is based on the idea that the subsequent bilateral trade gains increase the opportunity cost of war as a military conflict would destroy those gains by destroying trade. This means that this second benefit is conditional on the existence of trade gains. Without trade gains the economic opportunity cost of war is lower. This mechanism is at work in the geography of FTAs for country pairs that both have large trade gains from signing an FTA (the size of the opportunity cost) and are at risk of a dispute that may escalate into a conflict. We indeed find that country pairs with large estimated trade gains from signing an FTA and who experienced a high number of conflicts in the past are more likely to sign FTAs. Economics and politics are complements.

Battle scars

We identify another political determinant of the geography of FTAs. We find that recent wars (in the past 20 years), between countries, contrary to old wars, have a negative impact on the probability of countries signing an FTA. We interpret this as showing that it is politically costly and difficult for countries that recently have experienced conflict to negotiate an FTA. The example of Pakistan and India comes to mind. Acemoglu and Yared (2010a and 2010b) show that even in the absence of outright conflict increased nationalism and militarism may constitute political limits to globalisation and trade. The opposite effect of old and recent wars on the probability of signing an FTA suggests the presence of windows of opportunity to lock-in FTAs. Hence periods of peace between old enemies should be exploited to sign a FTA and lock-in a more peaceful bilateral relationship.

Globalisation needs to be reinforced

Finally, we analyse how globalisation in the form of multilateral trade openness changes these political factors. We have shown in previous research (Martin et al. 2007 and 2008) that multilateral trade openness, because it reduces bilateral economic dependence and the opportunity cost of a bilateral war, actually increases the probability that a dispute escalates into a conflict. If so, countries should respond to the weakening of local economic ties (a side effect of multilateral trade liberalisation) and its potentially peace-harming consequences, by reinforcing local economic ties through a FTA. This is exactly what the data suggests. Country pairs more open to multilateral trade and with a history of old wars are more likely to sign FTAs. From this point of view, we interpret the multiplication of FTAs as a logical political response to globalisation.

Conclusion

Our results suggest that political scientists and historians are right to emphasise the political motivation behind FTAs, in particular the objective of pacifying relations. However, this does not mean that economics does not matter and that FTAs are signed without taking into account their economic benefits, the trade gains. On the contrary, without trade gains, the peace promoting effect of FTAs is greatly weakened. Hence, our story is one where politics and economics push in the same direction. Economic and security gains are complementary to explain the evolving geography of trade agreements. Trade gains may be used for a superior objective of peace but that makes them more, not less, important.

References

- Acemoglu, Daron and Pierre Yared (2010a), “Political Limits to Globalisation”, NBER Working Paper 15694, January.

- Acemoglu, Daron and Pierre Yared (2010b),”Trade and militarism: The political limits to globalisation”, VoxEU.org, 7 March.

- Bhagwati, Jagdish (2008). Termites in the Trading System, Oxford University Press.

- Hegre, Havard, John O'Neal and Bruce Russett (forthcoming) “Trade Does Promote Peace: The Perils of Simultaneous Estimation of the Reciprocal Effects of Trade and Conflict, Journal of Peace Research.

- Martin, Philippe, Thierry Mayer and Mathias Thoenig (2007), “Trade and/or War?” VoxEU.org, 4 July.

- Martin, Philippe, Thierry Mayer and Mathias Thoenig (2008), “Make Trade not war?”, Review of Economic Studies, 75(3):865-900.

- Martin, Philippe, Thierry Mayer and Mathias Thoenig (2010), “The geography of conflicts and free trade agreements”, CEPR Discussion Paper 7740.

- Polachek, Soloman and Carlos Seiglie (2007), “Trade, Peace and Democracy: An Analysis of Dyadic Dispute”, chapter 31 in Todd Sandler and Keith Hartley (eds), Handbook of Defence Economics, Volume 2, Elsevier Press:1017-1073.

- Spolaore, Enrico and Romain Wacziarg (2009), “War and Relatedness”, NBER Working Paper 15095, June.