Political Commitment Theory of Trade Agreements

Tang and Wei (JIE, 2009) found that countries which undertook more stringent tariff reductions as part of their accession to the WTO subsequently had higher growth. Explain how these results support or refute the political- commitment theory of trade agreements.

The political commitment theory of trade agreements argues that trade agreements arise due to the desire of the government to signal to private investors that they wish to pursue pro-growth policies. If announced unilaterally, this signal is not binding and so may not induce investors to invest, as they may not be confident that the government will stick to its announcement. However, when signalled via the signing of an international treaty, this may increase confidence that the government will stick to its promise, because the punishment from breaking its international commitments is much higher than if it broke a unilaterally declared promise. This theory therefore complements are understanding of why governments sign-up to trade agreements, and more importantly, explains why small countries enact tariff reductions when they don’t benefit from reductions in the terms of trade externality, due to their economic size.

Grossman and Helpman point out that because lobbies compensate the government for distortions created by trade policy which protects domestic industries, there is no incentive for the government to want to move away from this regime. In other words, a politically minded government (i.e. one which wishes to maximise its revenue) would be better off by maintain protection for domestic industries, so that it receives tariff revenue and funds from domestic lobbies, than to reduce protection and see higher growth but less tariff revenue and lobby funds. Maggi and Rodriguez-Clare develop a model which contradicts this finding, by incorporating capital mobility (in the long run). They argue that if capital is domestically mobile, then the expectation that a particular industry will receive protection will lead to over investment in this industry, and this will happen before governments and lobbies have started negotiating the degree of protection. This expanded industry is now a more salient issue and so the government may have to enact protection (so that workers don’t lose jobs and create a political disturbance), as a result it will lose out on funds because the lobbies don’t need to lobby as effectively. These authors conclude that we should see deeper trade liberalisation where capital is free to move, because these firms will resist trade liberalisation (through lobbying) less than sectors with low capital mobility. They point to the casual evidence that there has been little trade liberalisation in agriculture (where land means capital is fixed) to support their model.

Tang and Wei examine this theory, as described by Maggi and Rodriguez-Clare, by examining WTO/GATT accessions and observing whether countries who had to make rigid policy commitments saw higher growth than those who didn’t. They are able to analyse this by using a difference-in-difference method, studying Article XXVI 5(c) countries (those who are able to join the WTO without having to enact stringent trade policy) and non-Article countries (those who do have to enact stringent trade policy), where this allows us to see how much growth arises through being a member of a trade agreement (and the associated reductions in terms of trade externality) and how much arises through policy commitments which fall under the political commitment motive. They acknowledge that there may be an endogeneity issue in that countries which have pro-growth domestic policies may be more likely to want to be a member of the WTO/GATT anyway, but by utilising the gap between the dates of application and final accession find that this isn’t a significant affect. In short, they find that found that countries which undertook more stringent tariff reductions as part of their accession to the WTO subsequently had higher growth: pre and post accession, Article countries saw a change in growth of -0.2% whilst non-Article countries saw a change in growth of 4.1%, a statistically significant difference. Hence, this supports our political commitment theory, since countries which had to commit stringent tariff reductions – and thereby signal their free-trade policies to domestic investors – saw higher growth than those who simply joined the WTO for the benefits of freer trade and involvement in a global organisation, rather than to necessarily signal their intention of pro-growth policies to domestic industries.

Rodrik further supports this argument of trade policy being used as a commitment device, pointing out that Argentina’s 1970s reform had such low credibility that private investors failed to respond. In essence we have an asymmetric information situation, whereby the government knows its intention to commit to free-trade policy but struggles to inform the private sector of this, as it obviously has an incentive to deviate. His model, while applied to the World Bank/IMF, demonstrates that a government’s policy needs to have significant credibility in order to induce the private sector to respond; by investing in export-producing industries and moving away from import-substitution industries. We can use Tang and Wei’s findings to suggest that the policies enforced by the WTO (assuming no special treatment such as Article XXVI 5(c)) is such a commitment device.

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