A political-economy theory of trade agreements giovanni maggi

NBER WORKING PAPER SERIES

A POLITICAL-ECONOMY THEORY OF TRADE AGREEMENTS Giovanni Maggi

Andres Rodriguez-Clare

Working Paper 11716 http://www.nber.org/papers/w11716

NATIONAL BUREAU OF ECONOMIC RESEARCH

1050 Massachusetts Avenue

Cambridge, MA 02138

October 2005

We thank Kyle Bagwell, Elhanan Helpman, Robert Staiger, Marcelo Olarreaga and seminar participants at UC Berkeley, ECARES, Ente Luigi Einaudi di Roma, Federal Reserve Bank of New York, FGV Rio de Janeiro, Harvard University, IADB, Penn State University, Southern Methodist University, Syracuse University, University of Texas at Austin, University of Virginia, University of Wisconsin, Vanderbilt University and the 2005 NBER Summer Institute for very useful comments. We also thank three anonymous referees for very useful comments and suggestions. Richard Chiburis provided outstanding research assistance. Giovanni Maggi acknowledges financial support from the National Science Foundation (SES-0351586).

© 2005 by Giovanni Maggi and Andres Rodriguez-Clare. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source.

A Political-Economy Theory of Trade Agreements Giovanni Maggi and Andres Rodriguez-Clare NBER Working Paper No. 11716

October 2005, Revised March 2007

JEL No. D72,F13

ABSTRACT

This paper presents a theory of trade agreements where "politics" play an central role. This stands in contrast with the standard theory, where even politically-motivated governments sign trade agreements only to deal with terms-of-trade externalities. We develop a model where governments may be motivated to sign a trade agreement both by the presence of standard terms-of-trade externalities and by the desire to commit vis-a-vis domestic industrial lobbies. The model is rich in implications. In particular, it predicts that trade agreements result in deeper trade liberalization when governments are more politically motivated (provided capital mobility is sufficiently high) and when capital can move more freely across sectors. Also, governments tend to prefer a commitment in the form of tariff ceilings rather than exact tariff levels. In a fully dynamic specification of the model, trade liberalization occurs in two stages: an immediate slashing of tariffs and a subsequent gradual reduction of tariffs. The immediate tariff cut is a reflection of the terms-of-trade motive for the agreement, while the domestic-commitment motive is reflected in the gradual phase of trade liberalization. Finally, the speed of trade liberalization is higher when capital is more mobile across sectors.

Giovanni Maggi Department of Economics Princeton University Princeton, NJ 08544

and NBER

maggi@princeton.edu

Andres Rodriguez-Clare Pennsylvania State University Department of Economics University Park, PA 16802 and NBER andres1000@gmail.com

1 Introduction

The history of trade liberalization after World War II is intimately related with the creation and expansion of the GATT (now WTO), and with the signing of countless bilateral and regional trade agreements. Clearly, there are strong forces pushing countries to sign international trade agreements, and it is important for economists and political scientists to understand what these forces are. Why do countries engage in trade agreements? What determines the extent and form of liberalization that takes place in such agreements?

The standard theory of trade agreements dates back to Johnson (1954), who argued that, in the absence of trade agreements, countries would attempt to exploit their international market power by taxing trade, and the resulting equilibrium – a trade war – would be ine¢cient for all countries involved. International trade agreements can be seen as a way to prevent such a trade war. This idea was later formalized in modern game-theoretic terms by Mayer (1981).

Grossman and Helpman (1995a) and Bagwell and Staiger (1999) have extended this frame- work to settings where governments are subject to political pressures. In these models, as Bagwell and Staiger emphasize, even politically-motivated governments engage in trade agree- ments only to correct for terms of trade externalities. Thus, "politics" does not a¤ect the motivation to engage in trade agreements.

In this paper we present a theory where politics is very much at the center of trade agree- ments. In particular, we consider a model where trade agreements help governments to deal with a time-inconsistency problem in their interaction with domestic lobbies. Maggi and Rodríguez- Clare (1998) showed how such a time-inconsistency problem may emerge in a small-open econ- omy when capital is …xed in the short run but mobile in the long run. The present paper builds on this idea to develop a fuller theory of trade agreements.1

We start by reviewing the logic behind the domestic-commitment problem that is at the basis of our theory. This logic is easily illustrated for the case of a small economy. According to the modern political-economy theory of trade policy, it is not clear why a small-country govern- ment would want to "tie its hands" and give up its ability to grant protection. For example, in Grossman and Helpman (1994), lobbies compensate the government for the distortions associ- ated with trade policy, and hence there is no reason why the government would want to commit

1 For a real-world illustration of the possible domestic-commitment role of trade agreements, we refer the reader to Fernando Salas and Jaime Zabludovsky (2004), who argue that the main bene…t of NAFTA for Mexico has been the strengthening of its commitment to maintain an open trade and investment regime.

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not to grant protection. In fact, if the government is able to extract rents from the political process it is strictly better o¤ in the political equilibrium than under free trade. But this may no longer be true when one takes into account that capital can move across sectors. This is because, given the expectation of protection in a sector, there will be excessive investment in that sector. Since this happens before the government and lobbies negotiate over protection, the government is not compensated for this "long-run" distortion. This allocation distortion is the essence of the domestic-commitment problem.

Next we explain how we develop a political-economy theory of trade agreements based on the domestic-commitment problem just described. We consider two large countries whose respective governments are subject to pressures from import-competing lobbies, and where capital is …xed in the short run but mobile in the long run. In this setting, the noncooperative equilibrium en- tails two types of ine¢ciency: a domestic time-inconsistency problem and a prisoner’s dilemma arising from the terms-of-trade externality. Starting from the noncooperative equilibrium, the two countries get a chance to sign a trade agreement. After the agreement is signed, investors can re-allocate their capital (subject to possible frictions), and then governments choose trade policies subject to the constraints set by the agreement. A key parameter of the model is the degree to which capital can move across sectors. This parameter captures the importance of the domestic-commitment problem: if capital mobility is zero, the model collapses to the standard one where the only motive for trade agreements is the terms-of-trade externality; as capital mobility increases, the domestic-commitment problem becomes more severe.

We distinguish between "ex-ante lobbying," which in‡uences the selection of the trade agree- ment, and "ex-post lobbying", which in‡uences the choice of trade policies subject to the con- straints set by the agreement. Of course, the notion of ex-post lobbying is meaningful only if the agreement leaves some discretion in the governments’ choice of trade policies after the agreement is signed. This is the case, for example, if the agreement imposes a tari¤ ceiling, so that a government is free to choose a tari¤ below the ceiling level. This way of thinking about trade agreements is a signi…cant departure from the existing models, where agreements leave no discretion to governments, and which therefore cannot make a meaningful distinction between ex-ante and ex-post lobbying.2

Another novel feature of our model relative to the existing literature is that it integrates both

2 A notable exception is Ornelas (2005), who explores the importance of ex-ante lobbying for the welfare implications of regional free-trade agreements.

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motives for trade agreements, namely terms-of-trade externalities and domestic-commitment problems. As we will show, these two motives interact in nontrivial ways, giving rise to inter- esting empirical predictions.

In the …rst part of the paper we present a simple two-period model that, in spite of its highly stylized nature, is capable of conveying most of our main points, and is useful to relate our results to

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