Trading Blocs and the World Trade Organisation (WTO)

What is a trading bloc?

A trading bloc is a group of countries which have preferential trading arrangements between members. This involves the partial or complete elimination of trade barriers.

Trading blocs are usually comprised of countries which are geographically close to each other. They are therefore sometimes known as regional trade agreements (RGA). Where there are just two parties to a trade agreement it is known as a bilateral trade agreement (BTA). This may comprise just two countries, such as China and the U.S.A, or it could be an agreement between a single country and a trading bloc, such as the CETA agreement between Canada and the European Union. A BTA could also comprise an agreement between two trading blocs, such as the European Economic Area (EEA), which is a trade agreement between the European Union (EU) and the small group of European countries that belong to the European Free Trade Agreement (EFTA).

Trading blocs take different forms according to the level of economic integration. These different forms are described below, going from the lowest to highest level of economic integration. The higher the level of integration, the closer the member countries are to operating as a single economy. For instance, the United Kingdom (England, Scotland, Wales and Northern Ireland) is a fully integrated single economy, with no trade barriers between members, free movement of people and capital, a common currency and a shared government which controls fisacal policy (taxes and public spending).

Free trade area (FTA)

There are no tariffs or quotas on trade in goods between member countries, but each country can set its own __tariffs __(a tax on imports) or __quotas __(a physical restriction on the quantity of imports) on goods from non-members. The most important example of a FTA is the north American Free Trade Agreement (NAFTA), comprising the USA, Canada and Mexico. MERCOSUR is another FTA in South America, which includes both Brazil and Argentina, the two biggest economies of the continent.

Customs Union (CU)

There are no tariffs on goods between members of a CU, but unlike a FTA, there is a common external tariff (CET), which means that all members impose the same level of tariffs on non-members. In some customs unions there may also collectively agreed quotas on imports from non-members. The European Union (EU), operates a CU. An example of its CET is the 10% tariff that all members impose on imports of cars from non-member countries. The point of the CU is that it prevents a non-member country from exporting cars into a member country with a low tariff and then shipping the cars into other member countries which would have imposed a higher tariff.

Common (or Single) Market

A common market involves not just a customs union, which covers only the movement of physical goods. It also involves free trade in services, such as air travel, banking & insurance, accountancy, healthcare and education.

A common market also requires a common set of regulations and standards. The EU sets product standards which all countries have to observe; for instance vehicles have emission limits, electrical goods have to meet safety standards. Without common standards, producers in one country could seek a competitive advantage by cutting costs by lowering safety or environmental standards.

A common market also involves the free movement of labour and capital amongst member countries For instance, in the European Union, workers are free to live and work in any member country. Firms in one member country are able to invest and operate in other member countries. For instance, much of the electricity supply in the U.K. is now run by German or French owned companies. Equally, British firms have operations in the rest of the E.U. Tesco is now a major supermarket chain in several EU countries.

Monetary (or Currency) Union

A monetary union exists when two or more countries share the same currency. The most important example is the eurozone. 19 members of the EU (out of 28) now use the euro.

Sharing a single currency is seen by many as a necessary measure to complete a single market between member countries, for the following reasons:

1. Elimination of exchange rate costs and risks – A British firm buying goods from Germany has to change pounds into euros, which involves a commission payment to a bank, unlike a French firm that already has a euro bank account. A British firm also faces the risk of a change in the value of the pound against the euro when exporting or importing to a eurozone country. A fall in the value of the pound makes imports more expensive, and a rise in its value may make British goods less competitive in Europe. Countries in the eurozone don’t face these risks when trading with each other. Exchange rate costs and risks are a kind of trade barrier that impede movement towards a single market.
2. Price transparency – A single currency improves the efficiency of a common market by making it easier for buyers and sellers to compare prices being charged in different countries. It makes it harder for multinationals to operate price discrimination (charging different prices in different countries) as all prices are in the same currency.

Monetary union requires a single monetary authority. In the eurozone this is the European Central Bank (ECB). It performs the same functions for all the eurozone countries as the Bank of England (B of E) does for the U.K. These functions are:

1. Setting interest rates – The ECB sets interest rates for the eurozone much as the B of E does for the U.K. (see notes on monetary policy in 2.6.2) The ECB sets interest rates at the level it believes is needed to keep inflation under control (around 2%).
2. Managing the foreign currency reserves of the eurozone – The ECB can intervene in the foreign exchange markets by buing or selling other currencies to keep the euro exchange rate at what it thinks is a desirable level.
3. Control of issuing notes and coins – The ECB oversees the issue of notes and coins in eurozone countries, to prevent countries printing too much money which would undermine the value of the euro and cause inflation.
4. Supervision of the banking and financial system – The ECB oversees the banking system to prevent bank failures that would threaten the stability of the euro.

For a monetary union to operate without causing major problems for some or all of its members , the following conditions need to be met:

1. Fiscal policy rules – There should be agreed limits on the level of government borrowing and the size of the national debts of member countries. In the eurozone the limits are 3% and 60% of GDP respectively. This is known as the Growth and Stability Pact. It is necessary to ensure that governments do not borrow such large sums that result in higher interest rates and inflation across the eurozone. Also, if some governments borrow more than they can repay (as happened in Greece, Spain Portugal and Ireland after the financial crisis of 2007/8) it can cause a crisis in the banking system (the banks are the main lenders to governments) and threaten economic stability and the value of the euro.
2. Free movement of labour and capital between countries – In a monetary union some countries are likely to be more competitive than others, resulting in lower growth, lower wages, spare capacity and unemployment. Outside of a monetary union, it is possible for a country to regain competitiveness by allowing its currency to depreciate. As this can’t happen in a monetay union, free movement of labour and capital is needed to restore employment and growth. Workers from low wage countries will migrate to richer ones, whilst capital will flow in the opposite direction, as firms in high wage countries seek to lower costs by opening factories in low wage countries. This has happened to a considerable extent in the eurozone. German and French car companies for instance now have factories in eastern Europe, whilst workers from poorer countries have migrated to richer ones. But there are limits to this, because of language and cultural barriers, and the possibility of political and social unrest resulting from mass migration.
3. Fiscal transfers – In the U.K. or USA there are large fiscal transfers from richer to poorer areas. This cushions poorer regions from the effects of asymmetric shocks, (an economic change that affects some industries or regions more than others). For instance Northern Ireland receives much more public spending than it pays in taxes, which helps to support the economy that has experienced a big decline in its shipbuilding, engineering and textiles industries. In the eurozone there are only very limited fiscal transfers, because richer countries such as Germany and France are unwilling to see taxpayers’ money used to support poorer countries like Greece. This can put the single currency zone under great strain and poorer countries may be better off leaving and having their own currency, which can fall to an exchange rate that makes them competitive.
4. Member countries are at same stage of the economic cycle – If some countries are in recession and others are in a boom, it will not be possible for a common monetary and fiscal policy to work for all members. For instance, in the period leading up to the financial crisis in 2007/8 Ireland had a rapidly growing economy whilst France and Germany had very slow growth. The ECB set interest rates at a low level, which was right for the big economies of France and Germany, but created a property boom and inflation in Ireland that eventually lead to a very severe crash in house prices and a banking crisis.

If all of the above conditions are met, plus __the member countries all have similar levels of productivity and competitiveness then it can be described as an optimal currency zone and it has a good chance of working and lasting. The eurozone is probably not an __optimal currency zone and Greece has already come very close to being forced out. It has a much weaker economy than northern European members, and struggles to be competitive inside the eurozone. It is forced to undergo severe deflation (cuts in government spending and increases in tax) in order to drive down prices and regain competitiveness. This is sometimes called an internal devaluation, which has resulted in a severe recession and very high unemployment. Outside the zone it could have its own currency and let it fall in value.

Advantages and Disadvantages of Regional Trade Agreements (RTAs)

Advantages:

Trade creation__ – Where the reduction or elimination of a tariff or other trade barrier amongst members of an RTA results in member countries buying from each other things they previously produced for themselves this is called __trade creation. It is an economic gain because it results in countries producing goods where they have comparative advantage and therefore lower opportunity cost.

Economies of scale – The elimination of trade barriers in an RTA gives producers in all countries access to a much bigger market. For instance the EU has over 500 million consumers, compared to less than 70 million in the UK. Access to a larger market enables firms to produce on a larger scale and at lower unit cost. This is particularly true within a common market where cross border mergers and takeovers may result in fewer, but bigger firms. The more similar the tastes of consumers in member countries, the greater the opportunity for economies of scale, as firms can produce larger quantities of similar products.

Increased competition and choice – Elimination of trade barriers gives consumers more choice as domestic firms now face increased competition from abroad. This should drive down prices, improve quality and lead to more innovation. Lower prices force firms to reduce costs, so increasing economic efficiency.

But note that these advantages of choice and competition may be reduced if there are unrestricted takeovers and mergers, resulting in oligopoly or monopoly. There needs to be sufficient market regulation to prevent this. The EU Competition Commission is responsible for maintaining competitive markets within the European Union.

NB: Trade creation is a static gain. It is a one off benefit from increased trade. The benefits of economies of scale and increased competition/choice are dynamic gains, because they occur over a period of time and there is an on-going incentive for firms to improve their competitiveness.

Disadvantages:

_Trade diversion _– An RTA is likely to result in some trade diversion. This occurs when the RTA imposes tariffs or other trade barriers on exports from non-members, resulting in a trade distortion that favours member countries over non-members.

Suppose, for instance that countries A&B form a customs union, with a 20% common external tariff on imported cars form non-members. Suppose also that before the customs union was created, country A, which does not have a domestic car industry, did not impose a tariff on car imports, a few of which were imported from country B, but mostly from other countries, which were lower cost producers. The customs union will continue to give country B tariff free access to country A’s market, but other countries will be at an artificially created competitive disadvantage as they face a 20% tariff. Some of their exports to country A will now be displaced by exports from country B. This is a loss of welfare as comparative advantage has been distorted (see notes on 4.1.6 for full discussion).

NB: If the volume of trade creation exceeds the volume of trade diversion, then on balance the RTA will generate a net economic gain. This is more likely to occur if:

1. The level of tariffs between countries joining was high before the RTA was formed
2. The countries forming the RTA have a high volume of trade with each other
3. The tariffs on non-members is low

Advantages and Disadvantages of Monetary Unions

Advantages:

Elimination of exchange rate costs and risks

Price transparency

Price stability – In a monetary union there is a single central bank for all member countries. The ECB for instance sets interest rates for the entire eurozone, at whatever level is required to keep inflation to around 2%. The strict rules on government borrowing (see fiscal policy rules, above) also help to maintain low inflation for all members.

Disadvantages:

Loss of economic sovereignty__ __– Because a member country cannot set its own interest rates or increase government borrowing above set limits, it loses a great deal of control over its own economy. Also, as it does not have its own currency, a member cannot devalue or revalue its currency when it seems desirable.

Weaker economies in the eurozone, such as Greece can be trapped in high unemployment, recession and balance of payments deficits. Outside the euro, Greece could devalue to regain competitiveness and be more free to set its own interest rates and government borrowing to stimulate the economy.

The problems faced by weaker economies could be addressed by fiscal transfers. But there is little appetite for this in the eurozone. Richer countries like Germany are unwilling to hand over taxpayers’ money to prop up poorer countries.

However, it should be noted that leaving the euro would not be a painless way out of its problems. Inflation might increase and the country might struggle to find lenders to finance government borrowing.

Transition costs – When a country joins a monetary union there will be one-off costs associated with converting to the new currency. These include changes to vending machines and cash dispensers, and changes to accounting systems.

The World Trade Organisation (WTO)

The Great Depression of the 1930s resulted in countries trying to boost their economies by restricting imports in order to protect domestic industries. This resulted in ‘trade wars’ as each country imposed escalating retaliatory tariffs. There was also competitive devaluation, in which countries kept lowering their exchange rates below their trading partners in order to get a competitive advantage. The result was a collapse in world trade which simply made the depression even worse.

After the second world war there was a new international consensus that free trade was in everyone’s interest. This led to the creation of new global organisations to promote and maintain free trade, including the WTO (and its predecessor, called the General Agreement on Tariffs and Trade (GATT).

The WTO supervises a rules based system for international trade. Its aim is to promote free trade by the gradual removal of tariff and other trade barriers. It has achieved this by a series of negotiations between members called trade rounds. The most recent round which began in 2001, is called the Doha Round (because the first meeting took place there).

The WTO has two fundamental principles which help to promote free trade:

Non-discrimination (also known as the most favoured nation principle) – This means that if a member country reduces a tariff on imports from another member, it must offer the same tariff reduction to all other member countries. In other words it cannot discriminate in favour of some countries by treating them more favourably. For example, if the USA reduces its tariff on imported beef from Argentina, it must offer the same tariff reduction to all other countries.

Reciprocity__ __– This means that if a country benefits from a tariff reduction, it must offer some tariff reduction in exchange. For instance, in the above example, not only would Argentina would have to offer a tariff reduction on one of its imports, so too would all other countries that have benefited from the Americans reducing their tariff on beef imports.

The combination of these two principles means that any tariff reductions between two members (a bi-lateral trade deal), becomes a multi-lateral trade deal as it brings in many other countries too.

The WTO also operates a Disputes Panel to investigate and make judgements on claims by any member that it is a victim of an ‘unfair’ trading practice by another member. For instance, it will investigate a complaint from a member that another country is ‘dumping’ goods in its market (see notes on 4.1.6) or that a country is giving a state subsidy to its own producers, which is not allowed under WTO rules. Where the Disputes Panel finds the complaint to be justified, it allows the victim country to introduce a tariff or other retaliatory measure.

Evaluation of the WTO

In its early years the WTO and its GATT predecessor, there was a lot of progress in dismantling the high tariffs that were the legacy of the pre-war protectionism. In most developed countries, average tariffs are now below 10% and often less than 5%. The WTO has steadily increased in membership, and members now account for over 95% of global trade.

But developing countries tend to have higher tariffs, although these usually fall substantially when a country joins the WTO.

Tariffs are still much higher on agricultural products, as most countries protect their farmers for political as well as economic reasons. This has been a major reason for the failure of the Doha round to reach a new agreement on trade liberalisation. Developing countries are reluctant to open their markets to rich countries for financial services while rich countries continue to protect their markets from food exports.

The WTO has no power to prevent countries forming or joining RTOs, which have become more important in recent decades. The EU, for example has expanded from its six original members in 1957 to twenty eight today. As we have seen RTOs result in trade diversion which distorts comparative advantage and is an economic loss.

Protectionism isn’t just about tariffs. In recent decades there has been an increase in the use of non-tariff barriers (see notes on 4.1.6), including subsidies, quotas, product standards and exchange rate manipulation.

The United Kingdom (England, Scotland, Wales and Northern Ireland) is a monetary union, with a single currency. To what extent is it appropriate for these countries to share a currency?

Your answer should include: optimal currency zone / fiscal transfers / exchange rate risks / exchange rate costs / free movement of labour / asymmetric shocks / economic cycle