Trade agreements

At a time when news on international trade makes the front pages, including the widespread coverage of the impending final phase of the Brexit deal, we take a closer look at trade deals.

A Brief history

While evidence of trade dates back to ancient Egypt (between c 6000 and c 3150 BC), with trade flowing between Upper and Lower Egypt, and then between Egypt and Mesopotamia (modern Iraq), evidence of ‘trade agreements’ is limited. It is likely that across the ancient world trade flows required local and informal agreements.

Later, with the development of the Hellenic trade routes it would have been necessary for traders to strike agreements with local leaders. Generally, traders were private individuals, and while some were sponsored by regional leaders, the responsibility for any enforcement of agreements rested with the traders themselves. (Source: ancient.eu)

As Roman, Ottoman, and British empires developed, access was needed to their colonial markets. The development of empires increased trade, but also increased military conflict, which altered trade flows, but also led to mutually beneficial alliances.

While all transactions require some form of agreement, ‘trade agreements’ as we know them today - arrangements between countries rather than individual traders – were unlikely because ‘nation states’ did not exist. It was not until the early 19th century and the Congress of Vienna, (1815) that distinct geographical territories in Europe were identified, with a single set of laws and a central government. At this time Europe was divided mostly into empires, kingdoms, and confederations, and agreements were through international treaties. It was not until the end of the First World War that European empires came to an end.

The rise of protectionism

As nation states emerged across Europe, trade disputes became increasingly common, and were often settled by military and naval might. For example, the First Anglo-Dutch War, (1652–1654) was a conflict fought entirely at sea between the navies of the Commonwealth of England and the United Provinces of the Netherlands. It was largely caused by disputes over trade, although English historians also emphasise political issues.[1] The British and Dutch went on to have three more wars, ending in 1784.

Protectionism became widespread, including the infamous Corn Laws which were designed to keep corn prices high and protect British farmers. The British were worried that an influx of cheap corn from France, following the end of the Napoleonic wars, would reduce corn prices and the profits of landowners, and as a result imposed tariffs and other restrictions on imported grains.

In 1820 manufacturers from Britain's largest cities - London, Manchester and Glasgow – petitioned the House of Commons to abolish all tariffs and lobbied for total 'free trade'. This led in 1823 to the Reciprocity of Duties Act, a radical initiative which enabled Britain to sign mutual trading agreements with foreign powers on an individual basis. In 1838 the Anti-Corn Law League was established, and it became widely accepted that free trade would make goods cheaper to manufacture, and make them more competitive in international markets. The Corn Laws were finally repealed in 1846, and by 1850, most protectionist policies on imports to Britain had been dropped – agriculture had given way to manufacturing.

The first modern trade agreement

The first ‘modern’ style formal trade agreement followed 10 years later with the Cobden-Chevalier Treaty of 1860, between Britain and France.  This treaty represented an agreement to end tariffs on a range of traded goods, including wine, silk, coal and iron ore, and led to several more agreements involving European countries, and this began a period of increasing co-operation and alliances. As well as being the first ‘modern’ trade agreement, it is also noted for the inclusion of a “most favoured nation” clause, which was to be duplicated in many later agreements with other nations, and forms a key pillar of modern trade agreements.

The Most Favoured Nation (MFN) clause

The Most Favoured Nation (MFN) clause is a ‘non-discrimination’ clause and is included in many types of contract. It asserts that if a country is given MFN status, it will be given equal benefits (such as the lowest tariffs) as the most favoured country. Hence if three countries are involved in a trade agreement with a MFN clause, then all countries will be treated the same.

Increased trade and the gold standard

Trade was booming, and by the 1870s several European countries sought to adopt a common gold standard. This guaranteed that governments would exchange any quantity of paper money for its current value in gold. This meant that international transactions did not need to be paid for with heavy gold bullion or metal coins, given that paper currency was guaranteed as its value was tied to gold. From 1880-1914, almost all of the world's leading economies had joined the gold standard.. While this increased trust and encouraged trade it also had the potential to create instability, as the value of gold itself could fluctuate. In 1913, the US Congress created the Federal Reserve to stabilise gold and currency values in the United States. When World War I broke out in 1914, the United States and European countries suspended the gold standard so they could print sufficient quantities of money to pay for their military involvement, without the need to back this with gold.

The Gold Standard was briefly reintroduced in some countries after the end of the First World War, including Great Britain from 1925-1931, but dropped in 1931 by Japan and Great Britain and, in 1933, by US President Franklin D. Roosevelt.

The military conflicts in the first part of the 20th century, including WW1 and WW11, the Great Depression of the 1930s, and the entry to and exit from the Gold Standard, greatly altered the pattern of global trade, with many countries looking inwards and developing their own industries and industrial base.

The return of protectionism

Governments around the world imposed tariffs, import quotas, and exchange controls to restrict spending on foreign goods, an approach that was labelled as ‘beggar-thy-neighbour’ retaliatory trade barriers, and which became a feature of the 1920s and 1930s.

The United States imposed the infamous Smoot-Hawley tariff in June 1930, raising the average tariff on imports by nearly 20 percent. The increase in American tariffs provoked retaliatory responses, notably from its largest trading partner, Canada, as well as from a several European countries. In 1932 the UK the introduced the Import Duties Act which placed a 10 percent tariff on all imports, and at the same time gave preferential treatment to goods from within the British Empire in return for concessions on British exports. The collective effect of trade barriers led to a sharp contraction in world trade in the early 1930s.

Reciprocal Trade Agreements

It was not long before US Congress authorised trade negotiations in the landmark Reciprocal Trade Agreements Act (RTAA) of 1934. This gave the US president, Franklin D. Roosevelt, the power to negotiate bilateral, reciprocal trade agreements with other countries and enabled Roosevelt to liberalise American trade policy. Between 1934 and 1945, the United States signed 32 reciprocal trade agreements with 27 countries. The Reciprocal Trade Agreements Act provided the framework that would be used by GATT (The General Agreement on Tariffs and Trade) in 1947.

The Atlantic Charter

In August 1941 British Prime Minister Churchill and US President Roosevelt rendezvoused mid Atlantic to agree a common approach to seeking deeper economic co-operation, as well as dealing with the more pressing issue of collaboration to establish peace. This ‘Atlantic Charter’ set the groundwork for the establishment of multilateral economic cooperation, and would help set the agenda for later talks in 1944.

GATT and Bretton Woods

As the second world war came to an end the conference at Bretton Woods (New Hampshire) in 1944 was, in large part, a concerted effort to avoid a repeat of the protectionism of the 1930s. The search for a new global trading system became the focus of the Bretton Woods talks, which culminated in the 3 pillars of post war reconstruction. The pillars involved:

  1. The liberalisation of trade via the GATT.
  2. Exchange rate stability through the International Monetary Fund (the IMF).
  3. Recovery and development of the global economy, via the International Bank for Reconstruction and Development (IBRD), the ‘World Bank’.

Multilateralism

Large scale multilateral agreements began with the GATT agreement of 1947. GATT was signed by 23 countries, and involved trade negotiations between members every 5 years in round of talks. The 6th round, the Kennedy Round, is often seen as pivotal in that there was a considerable shift in the USA’s position and increased support for a more ‘open’ US trade policy. In 1994, the Uruguay round of talks led to the formation of the World Trade Organisation (WTO) which was established a year later. When GATT started average tariffs were 22%, but by the time the WTO was established they had fallen to 5%.

The WTO

The Uruguay round of GATT paved the way for the establishment of the WTO in January 1995. While the GATT had dealt with trade in goods, the WTO also covered trade in services and, later, intellectual property.

Today, the WTO’s core principles are:

WTO principles list

Weaknesses of unilateral agreements

A country can decide to reduce or remove trade restrictions on its own - a unilateral trade agreement. These are uncommon because, in a sense, a country is giving up an economic tool (or weapon) without any specific and direct gain in return.

However, this is not necessarily true. Taking a free trade perspective, if the removal of tariffs by country X increases imports, then, by logic, countries (say trading partner Y) will increase their exports to country X, and create trade. As exports can make up a fairly large share of aggregate demand, which itself is a central driver of economic growth, the growth in country Y can lead to increased demand for imports firm country X, making country X ‘better off’ - the 'positive feedback effect'.

unilateral tariff removal diagram

Perhaps the most significant advantage of unilateral free trade is that a country can reap the benefits of free trade immediately.

However, the problem with a unilateral trade agreement is that ‘nothing is certain’ and it relies upon free market forces to drive economic adjustment. For example, if country X unilaterally removes a 20% tariff on motor vehicles from country Y, assuming no immediate adjustment of exchange rates, or planned profit margins, then motor vehicle prices in country X will fall. The consequences of this partly depends upon consumer’s elasticity of demand for the motor vehicles imported from Y. If we take a middle range view – that price elasticity of demand is unitary, then a 20% reduction in the tariff should lead to a 20% increase in demand for the vehicles from Y. Of course, the net effect of this depends upon whether country X produces cars, and whether consumers from X will switch their demand to vehicles from Y, with a resultant loss of revenue and possibly manufacturing jobs. If, however, country X does not produce vehicles, then the major effect of lower imported prices would be the indirect effects of how household budgets are reallocated, on domestic prices and inflation, and on longer term effects on externalities resulting from driving more vehicles.

From the perspective of country Y, increased sales of vehicles are likely, with increased production (assuming spare capacity) and jobs.

The removal of tariffs will also reduce government revenue going to country X, which may result in the government of country X reallocating its finances.
So while a unilateral decision will not just impact on the country removing its tariffs, it will have direct and indirect effects on all countries affected, the effects are uncertain, and the gains difficult to assess.

Even worse, if we introduce a third country into the analysis, country Z, the analysis becomes more complex, and raises important questions, such as does Z produce vehicles or not? Does Z demand vehicles, or not? If Z demands them, but does not produce them, then what should it do with its tariffs? If X removes its 20% tariff, and Z keeps them at 20%, then country Y’s producers may switch their output towards X and away from Y – creating ‘trade diversion’. This would put downward pressure on the price of cars in X (assuming more supply) and upward pressure on the price of motor cars in Z (assuming less supply).

What this analysis inevitably leads to is that it will be in everyone’s interest to come up with single multilateral trade agreement between X, Y and Z, rather than have three separate bi-lateral agreements. (X-Y,Y-Z and X-Z).

While striking a multilateral agreement may be very time consuming, and will involve complex negotiations, it is likely to yield a more certain result than a free-for-all of several bi-lateral agreements. It also means that, if there is a dominant player, then bi-lateral agreements are more likely to favour one player, which can possibly be avoided with the checks, balances, and rules of multilateral agreements.

Of course, one problem (with all agreements) is that circumstances can change, and trade agreements which worked in the past, are no longer as a beneficial as they once were. But this is where clauses such as the MFN clause comes in – if there is a rule regarding how decisions are arrived at, then changes in circumstances can be automatically adopted by members, without renegotiating. For example if X agrees to reduce a tariff on a good from Y it will also confer the same benefit on Z without having to come up with a new contract.

It is easy to see why it is commonly argued that when agreements are easily negotiated, they will tend not to be very valuable. The greater the number of potential conflicts there are between the partners involved, the harder it is to achieve any agreements for an increase in trade, but the greater the benefits will be for both parties. (Source: www.bilaterals.org).

Regional trade agreements

Regional trading agreements (RTAs), have become increasingly popular since the second world war, but especially since the 1970s. The growth in RTAs can be seen in the following graph:

 

Whether they are bilateral agreements, trade pacts, or customs unions, all WTO members (as of 2018) have some sort of regional trade agreement in force. The growth in RTAs has clearly accelerated since the introduction of the WTO, which has led many to suggest that the popularity of such trading blocs reflects the failure of the WTO to facilitate multilateralism. However, the view of the WTO itself is quite the opposite.

The view of the WTO on RTAs is:

Normally, setting up a customs union or free trade area would violate the WTO’s principle of non-discrimination for all WTO members (“most-favoured-nation”). But Article 24 of the General Agreement on Tariffs and Trade (GATT), Article 5 of the General Agreement on Trade in Services (GATS) and the Enabling Clause (Paragraph 2(c)) allow WTO members to conclude RTAs, as a special exception, provided certain strict criteria are met.
In particular, the agreements should help trade flow more freely among the countries in the RTA without barriers being raised on trade with the outside world. In other words, regional integration should complement the multilateral trading system and not threaten it.

Hence, the WTO treats bilateral and regional trade agreements as exceptions to the general trade rules it has established because in their view they can facilitate increased trade as long as certain rules are agreed, including not imposing additional discriminatory tariffs on non-members. A more considered view is that RTAs complement and support the WTO rather than undermine it.

In 2006 the WTO established the Transparency Mechanism for RTA, which set down the rules by which parties to an RTA should notify the WTO. Disputes are heard (and often resolved) through the WTO’s dispute mechanism, whose ‘supreme court’ is called the Appellate Body is the key means by which RTAs are policed, but since 2019, this has not been fully functional given the US administration’s unwillingness to nominate new judges. The new Biden administration in the US is likely to reverse this, and return the US to adopting a more multilateral approach.

Components of a trade deal

Modern trade agreements share some common features, including:

  • The principle of reciprocity – that responsibilities and duties are shared by all parties, and all parties will gain – providing an incentive to implement the agreement.
  • The MFN principle (see above), which ensures that WTO members are not discriminated against.
  • Agreements on both tariff and non-tariff barriers (NTBs).
  • The ‘national treatment’ principle, that overseas companies or individuals should receive the same ‘treatment’ as domestic companies and individuals. For example, if an overseas producer is expected to list all the ingredients in a can of fruit, then local producers will also have to produce a list. (Sources: www.Britannica and ukandeu).

These components can be seen in most agreements – for example, the US-Chile agreement of 2004 states that:

The United States-Chile FTA eliminates tariffs and opens markets, reduces barriers for trade in services, provides protection for intellectual property, ensures regulatory transparency, guarantees non-discrimination in the trade of digital products, commits the Parties to maintain competition laws that prohibit anticompetitive business conduct, and requires effective labor and environmental enforcement. As of January 1, 2015, all goods originating from the United States enter Chile duty free.
  • Another feature is that there is often a considerable delay between the signing of an agreement, and when it finally takes effect, as indicated in the US-Chile agreement above.
  • A review clause – many trade deals have clauses which require a formal review of progress at point in the future – say, at 5 or 10 year intervals.

Agreement structure and fine print

Free trade agreements will follow a typical format, including:

  • Legally written text covering the agreement, laid out in Chapters, and Articles.
  • Relevant definitions (such as what is the territory covered, how are customs values assessed).
  • Agreement on market access.
  • Tariff schedules (covering thousands of goods, and running to hundreds of pages)
  • De Minimis values – the value of trade below which duties will not be imposed, for example, de minimis values in India are $150, in the US $800 and in the UK (as with other EU countries) 150 euros.
  • Every possible exporting and importing eventuality needs to be covered, including details as specific as ‘how will goods that are returned to the exporting country for ‘repair’ and then returned, will be dealt with?'.
  • Most agreements have exclusions, which will have been hotly contested during the negotiations.
  • Dispute resolution procedures will need to be agreed, and, as with the Brexit trade deal, can prove a significant sticking point.
  • Exchanges of letters regarding ‘understandings’ – these are where representative of one party seek clarification from the other regard an aspect of the agreement.

What is covered in typical agreements will change over time, reflecting changes in the types of good being traded. For example, modern agreements will cover trade in intellectual property and trade through the digital economy.

Brexit

So what can we expect regarding the final Brexit trade deal?

The first thing to note is that a deal between former members of a common trading bloc (the EU) is a very unusual, if not a unique type of agreement.

So while the UK may have expected a straightforward trade deal because, as previous partners, they already enjoyed free trade and open market access, exiting the EU and then developing a new trade deal is fraught with far more difficultly (certainly on the UK’s side) than was imagined at the time of Brexit.

Previous trade deals involving the UK were wrapped up within EU trade deals, so exiting the EU means striking new deals to replace the previously shared deals, as well as striking a new deal with the EU – is a very tough ask in anyone’s language!

Common rules already exist

On one level, many elements of the agreement between the UK and EU should, indeed, be straightforward, given that the UK was a member and while it enjoyed the gains of membership, it shared the EU’s common rules, including those involving trading standards, environmental protection and worker’s rights. As a former member it has this advantage over countries negotiating for the first time.

Interlinked economies

Over the years of membership the economies of the UK an EU have become so intertwined that complete separation has become impossible and economically undesirable. Given the interconnected supply chains, it is almost inevitable that the approach adopted throughout the negotiations will have to be realistic, pragmatic rather than idealistic, and ideally speedy to prevent uncertainty which will affect both parties. However, given that exit from the EU first needed a Withdrawal Agreement, and only then moving on to a new trade deal, the ‘need for speed’ has clearly been not been met.

WTO 'fall-back'

If the deal fails to arrive, the UK will have to fall back on WTO rules. In any event it will continue its push for trade deals with other countries in addition to the EU. News reports have indicated that the deal is 95% done – but of course, the 5% left could prevent the whole deal going through.

Sticking points

So, the sticking points that we have heard about (the ‘5 percent’) – involve: EU access to UK fishing waters, access of UK financial services to the EU, state aid and the so-called level playing field with alignment of competition rules will inevitably involve compromise if there is any chance of a deal being agreed before deadline day.

It will be in no-one’s immediate interest to prevent French fishermen from fishing in UK waters, and it will be in no one’s immediate interest to prevent UK banks from accessing EU money markets.

The argument by the EU that the UK's geographically proximity to the EU means it cannot be given the same trade deal as Canada is not as convincing as it sounds. Shipping costs are not excessive, and with the instantaneous flow of digital products and information physical proximity is far less significant than in the past.

Since the late 20th century trade deals have been regularly negotiated with parties accepting them, implementing them, and then moving on to enjoy the benefits, and honour their obligations. What was true in the 19th Century, when David Ricardo highlighted the idea of countries mutually exploiting their comparative advantages, and then trading freely, is still true today. Of course, the level of complexity of modern trade deals reflects how the global economy has changed, and issues that once seemed less relevant (or were not recognised at all) - such as protecting the environment and intellectual property, access for developing economies, the digital economy and workers rights, are now center stage. Surely, the Covid-19 crisis has demonstrated just how interdependent economies and communities are, and why a multilateral approach is the only sensible and rational way forward.

So, in terms of Brexit, we can expect a deal because no-deal is simply unacceptable to both sides, and a bad outcome for the global economy. Necessity has meant that UK has quickly sought to complete roll-over trade deals (currently 15), and is in a race to sign other deals with remaining countries by December 31st, 2021.

While the pandemic threatens to bring widespread economic and social devastation, there is some reason to be optimistic as, in a post-pandemic era, the global economy has a clear opportunity to begin a new phase of co-operation and development.