October 2007

Inside the headquarters of the World Trade Organization along the Rue de Lausanne in Geneva, officials can peer across Lake Geneva to white-capped Swiss mountains. Of course, the famous Swiss cow bells can’t be heard. But these days, everyone in the building—including an increasingly concerned Pascal Lamy, the WTO’s director-general—hears the clanging sounds of the economic and political inequities that come with the territory of so-called Free Trade Agreements.

The EU's Peter Mandelson shakes hands with South Korea's trade minister earlier this year after a decision to enter free trade talks.

Seven years ago, there were 130 FTAs scattered around the world, an alarming development to a handful of economists who (accurately) forecast a serious threat to the stability of the world’s trading system. The academics understood that because FTAs confer competitive advantages upon those who are a party to them, while discriminating against all outsiders, they are the opposite of free trade. Columbia University economic theorist Jagdish Bhagwati had coined the metaphor of a “spaghetti bowl” in the mid-1990s, describing the crisscrossing strands of trade-distorting FTAs. While the phrase caught on, few business leaders or politicians listened. Now, some 300 more FTAs have been struck since 2000—including every Asian country except Mongolia—and more than half of all world trade flows through preferential routes. From Japan’s Keidanren to the Business Roundtable in Washington, D.C., business lobbyists are looking to strike even more deals to benefit themselves at the expense of their competitors—complaining only about the schemes they aren’t in on.

However, some serious questions are beginning to be raised in some of the more enlightened business circles. Michael Treschow, the chairman of Sweden’s telecommunications giant, Ericsson, has recently issued a strong public warning that FTAs are interfering with global trading flows, and that should worry global businesses. Mr. Treschow was encouraged to speak out by the WTO’s Mr. Lamy, who uses softer words to send signals that are the diplomatic equivalent of, “uh oh.”

Last month, Mr. Lamy summoned Mr. Treschow and other leading pooh bahs to a two-day conference in Geneva—pointedly making sure that Prof. Bhagwati, who gave a passionate keynote address calling the proliferating preferential trade deals “a pox on the world’s trading system” played a leading role. The short answer that Mr. Lamy received to his query as to what can be done to tie the preferential noodles back into the multilateral trading system: not much, given the lack of political will currently on display.

Preferential trade is here “to stay,” Mr. Lamy observed in his closing remarks on Sept. 12, “whether we like it or not.”

Asians sure like what they call the “noodle bowl” of proliferating FTAs, and have been busy adding more strands that are altering important patterns of Pacific trade. At the turn of this century, Japan, the world’s second-largest economy, had long abhorred discriminatory trade deals.

When Japan became an original signatory of the WTO’s predecessor organization, the General Agreement on Tariffs and Trade in 1947, memories of the disastrous Greater East Asia Co-Prosperity Sphere were still fresh. But in 2000, Tokyo fell off the wagon by striking an FTA with Singapore (responding to the FTA that the United States had struck in the 1990s with Mexico and Canada). The North American Free Trade Agreement was aimed at putting Japanese multinationals at a competitive disadvantage in North American markets.

After Singapore, Japan struck preferential deals with Mexico, Malaysia, and the Philippines. Four more deals—with Chile, Brunei, Thailand and Indonesia—were added this year. Not content to stop at eight, Tokyo is now looking to make India its ninth preferential trading partner—and as many more as possible in the future. There is more than economics going on here. There is increasing talk from Tokyo about protecting vital sea lanes, and Japan, along with the U.S., Australia and Singapore, conducted naval exercises in the Bay of Bengal last month (China was excluded). Officials in Tokyo have hardly concealed their interest in securing access to oil and natural gas from their smaller partners, who are poised to become export platforms for Japanese multinationals.

Meanwhile, China, with its own interests in protecting sea lanes, has its own deal with the 10 members of the Association of Southeast Asian Nations. Beyond Asean, Beijing has its eye on any country in the world that can be pressed to make concessions to help satisfy the Middle Kingdom’s thirst for raw materials. There is even serious talk about concluding a giant Free Trade Area of the Asia Pacific, which would involve all 21 member countries of the Asia Pacific Economic Forum. Its advocates praise an FTAAP as having the potential to encompass perhaps 60% of Chinese trade, and roughly the same for the U.S. Critics of preferential trade know their history—particularly that of the trade blocs of the 1930s—and would nip the trend in the bud if they could. But influential advocates for preferential trade are pressing ahead, arguing that history is on their side.

If Mr. Bhagwati is the leading critic of preferential trade agreements, Fred Bergsten is their number one intellectual advocate. And like the professor, Mr. Bergsten also brings respectable economic credentials to the debate. Now the president of the Peterson Institute, a Washington think tank, Mr. Bergsten’s experience in international trade dates to 1969-71, when he helped drive U.S. trade policies as a high-powered 20-something aide to Henry Kissinger in the White House. In recent years, the Peterson Institute has published a number of studies supporting governments which have lobbied for FTAs with the U.S., including New Zealand, South Korea, Taiwan, India, Pakistan and Switzerland. “We should be thankful for the PTAs,” Mr. Bergsten says, smartly calling FTAs by the acronym for the term most often used in respectable academic circles, Preferential Trade Agreements. With the WTO’s ongoing multilateral Doha Round of trade liberalization negotiations still stalled six years into the talks, the preferential deals helpfully “keep the bicycle moving forward,” in Mr. Bergsten’s view.

While he does not dispute the fact that preferential trade is by definition, discriminatory, Mr. Bergsten takes the long view. Any trade liberalization between individual groupings of WTO members creates incentives for laggard countries to join in. President George W. Bush’s first top trade negotiator, Robert Zoellick, called the process “competitive liberalization.” Mr. Bergsten reasons that the U.S.-Korea accord has created an incentive for the European Union to strike its own deal with Seoul. A U.S.-Japan deal could follow, and a deal being negotiated between the EU and India is sparking interest in Washington about carving out its own special arrangements with New Delhi. Sooner or later, Mr. Bergsten believes, the proliferating FTA bowl of noodles will be brought into harmony with the multilateral system. Speaking to an APEC forum in Vietnam last November, Mr. Bergsten touted the grandiose-sounding Free Trade Area of the Asia Pacific as “the best, or perhaps only, way to catalyze a substantially successful Doha Round.”

Scott Miller, director of global trade policy for Procter & Gamble, says that while he recognizes the problems associated with the spaghetti bowl, “as a practical matter, you can take the strands and separate them individually.” Given the slowness of the WTO’s multilateral negotiations, Mr. Miller says,” give me preferential trade in the meantime.”

In Geneva last month, Mr. Lamy, a former chief EU trade negotiator himself, offered a more practical explanation rooted in politics. “The reality is that bilateral free trade agreements, in my view, have a political comparative advantage,” Mr. Lamy explained to his audience in Geneva. “If you are a politician and you want to increase your brownie points domestically...bilateral agreements are good.” They have a “sort of entertainment value,” the WTO head added. “I know by experience that if you appear on television with a friend of yours with whom you’re signing a bilateral agreement, it looks good. If you appear on television in a family photo with 151 members, it looks terrible.”

Creating Rival Trading Blocs

The proliferating spaghetti bowl certainly doesn’t look appetizing to the critics, who also cite their own realities to justify the criticisms. “We aren’t talking about making lasagna,” Mr. Bhagwati quips. “There is nothing tasty in this.”

At the recent WTO event in Geneva, some eyebrows were raised by some candid acknowledgments of the darker side of preferential trade made in a paper written by Gary Hufbauer and Jeffrey Schott, two luminaries of Mr. Bergsten’s Peterson Institute. The duo basically argued that while preferential trade can distort trade flows, overall, global trade is expanding. But the paper also said this: “The U.S.-Korea FTA will likely cause significant trade diversion away from Taiwanese exports to both Korean and U.S. exports. Future agreements that Japan might reach with Korea and the United States will do the same.” Taiwan, a WTO member that would love to have its own economic side deals with the Americans, Japanese and other major economies has no chance of doing so because of Chinese opposition.

Consider India, which wants to join APEC and the so-called Pacific-wide FTAAP. “From a geopolitical standpoint, China would find it hard to put out the welcome mat; from an economic standpoint, the U.S. is not enthusiastic about a new APEC member that maintains some of the highest trade barriers in the world,” the Hufbauer-Schott paper noted. “Unless India dramatically changes its commercial policy, and reaches a geopolitical accommodation with China, India will not be invited to join APEC or the FTAAP,” the authors add.

Messrs. Hufbauer and Schott also described a trend that is very worrisome to their critics: “If the last decade was an era of proliferation of FTAs within the Asia-Pacific region, the next decade could become an era of triangular consolidation of spheres of influence with competition between the three major powers, the United States, China and Japan.”

Moreover, the FTAs themselves sure don’t look like free trade among equals. Tokyo’s FTAs don’t liberalize trade for rice, which is famously protected in Japan with 400% to 500% tariffs. The U.S. also refuses to allow any reforms to its Draconian anti-dumping regime in FTAs, perhaps too conveniently arguing that, like Japanese rice, such business is best left to the WTO’s multilateral talks. Meanwhile, the Japanese are giving Thailand a better deal on exporting pineapples than Filipinos or Indonesians get. To buy off the little guys, the Indonesians and Filipinos are allowed to continue protecting some of their own uncompetitive manufacturers and farm products—simply terrible economic advice because it encourages continued economic dependencies. And of course, India’s preferential arrangements with neighbors including Thailand and Singapore contain sundry protectionist measures for the subcontinent’s hundreds of millions of subsistence farmers. It is difficult to see the incentives that all this protectionism gives to the WTO’s multilateral process. And to be sure, the list of disincentives to liberalization in more than 430 FTAs is very, very lengthy.

Just a peek into the paperwork helps explain how complex the business of distorting trade is. The Japan-Thai deal inked in April, 2007 ran to 119 pages, with another 855 pages in 7 annexes. Annex 2, for product-specific rules, ran to 129 pages. The Japan-Indonesia trade accord contained 12 annexes with another 835 pages of clarifications and exclusions. It’s much the same for America’s FTAs, and indeed, all across the spaghetti bowl. Nobody really knows how to quantify the hundreds upon hundreds of different rules of origin that are part and parcel of each of the 400-plus current FTAs. If this isn’t massive trade distortion, what could be?

Here is where the “real damage is being done to the global trading system,” as economist Joseph Francois, of Johannes Kepler University Linz, in Austria—a former senior WTO economist—concluded last month after participating in Mr. Lamy’s Geneva conference. Rules of origin define the country where a product was made, or finally assembled. In the WTO’s multilateral system where tariffs are equal for everyone, it doesn’t matter where products come from. But in the world of preferential trade where tariffs are reduced only for those party to them, the rules of origin matter very much. This is “dangerous” business for both insiders and those left on the outside, Mr. Francois believes.

Even FTA supporters like the Peterson Institute’s Mr. Bergsten agree that the rules of origin for the web of FTAs can be “nasty.” And Swedish executive Mr. Treschow has made it very plain that he sees a very different world of FTAs than the politicians who strike the deals see. In the WTO meetings last month in Geneva, the Ericsson chairman presented slide charts showing how preferential trade complicates trading patterns for multinationals that source globally. One slide showed that the components that go into a Volvo come from all over the world: Japan, Brazil, the U.S., England, Slovakia, Canada and so on. Mr. Treschow noted that Ericsson’s mobile phones have “900 components from 60 suppliers in 40 countries designed, shipped and assembled for end customers in 90 countries.” While politicians are negotiating special rules with countries, sophisticated corporations are using global supply chains, he pointed out. To comply with all these rules, the corporate bigwigs have to find good (expensive) lawyers.

Hire the Lawyers

Veteran Washington trade lawyer Lewis Leibowitz (who did not attend Mr. Lamy’s Geneva conference) explains how difficult various FTA rules can be. This is where the economic rubber hits the road, literally. In 1989, the U.S.-Canada FTA had rules specifying that auto parts assembled in Canada, with partly Japanese components, got tariff reductions as Canadian products. But in 1993, when that deal morphed into NAFTA, the Japanese portion of parts assembled in Canada were not allowed to be counted. Since NAFTA, the U.S. has negotiated different rules for the auto trade with Singapore, Chile, Australia and South Korea. The U.S. was willing to cut tariffs on trucks made in Australia (as General Motors owns that business anyway), but hasn’t been so eager to do the same with Thailand (where tough Japanese rivals like Toyota would also pick up export opportunities). Meanwhile, all automakers have to employ people whose jobs are to figure out how to trace the origins of the various components around the world. “Almost nobody is really paying attention to how these things fit together as a whole,” Mr. Leibowitz declares.

He cites a recent experience involving a client. As the Japanese and Europeans were upset that their multinationals were put at a tariff disadvantage when the Americans struck NAFTA in the mid-1990s, they started thinking of how to get even. The result came when the EU struck its own FTA with Mexico in 2000, turning the tables on the Yankees by making rules that gave the Europeans special preferences. The Japanese, no slouches at this game, then negotiated their own rules with the Japan-Mexico FTA in 2004. Mr. Leibowitz reports his client was finally forced to shift production from the U.S. to Europe to get around the strict NAFTA rule of origin. “My client is not happy” with this process, the lawyer adds.

Mr. Treschow cut the issue down to the core in Geneva last month when he asked: “When all this is happening, how can you claim that regionalism for business is a good idea?” While the major players can afford to pay for the unnecessary headaches, many smaller exporters who source globally can’t.

For 60 years—and for very valid historical and economic reasons that were played out in two world wars in the 20th century—the core principle of the multilateral international trading system that the WTO administers has been very simple: all members pledge to treat all of their trading partners equally, discriminating against none. Surely, it is a cause for great concern that politicians who should know better, especially those in Tokyo, Washington and Brussels, are increasingly in the business of dismantling the WTO, one trade-distorting FTA at a time.

Mr. Rushford is editor of The Rushford Report, an online journal that specializes in the politics of international trade and diplomacy.

(c) 2007 Dow Jones & Company, Inc.

Mr. Rushford is editor and publisher of the Rushford Report, a Washington-based newsletter that specializes in the politics of international trade