Regional Trade Agreements: Implications for U.S. Trade Policy

Regional Trade Agreements: Implications for U.S. Trade Policy

97-663 E
CRS Report for Congress
Received through the CRS Web
Regional Trade Agreements: Implications for U.S.
Trade Policy
Updated December 12, 1997
George Holliday
Specialist in International Trade and Finance
Economics Division
Congressional Research Service ˜ The Library of Congress

Regional Trade Agreements: Implications for U.S. Trade
Policy
Summary
Since the 1980s, the United States and other major trading countries have begun
to complement their efforts to liberalize trade at the multilateral level with regional
trade agreements. Today almost all major economies belong to one or more regional
arrangements.
The negotiation of regional trading arrangements is a relatively recent
phenomenon in U.S. trade policy. Through much of the post-World War II era, U.S.
policymakers emphasized the importance of multilateral trade liberalization, carried
out primarily through the General Agreement on Tariffs and Trade (GATT) and the
World Trade Organization (WTO). During the 1970s and 1980s, however, many
policymakers became impatient with the slow pace of multilateral trade liberalization
and the apparent inability of the multilateral system to address new trade issues. The
United States concluded free trade agreements with Israel and Canada in the 1980s
the North American Free Trade Agreement (NAFTA) in 1993. The Clinton
Administration is pursuing additional regional arrangements in Asia and the Western
Hemisphere.
The effects of reducing trade barriers at the regional level are quite different than
multilateral liberalization. The GATT/WTO multilateral system is based on the
principle of most-favored-nation treatment — extending reductions in trade barriers
to all trading partners on a nondiscriminatory basis. In contrast, regional liberalization
introduces elements of freer trade among the members of the arrangement while
maintaining some level of protection against nonmembers. Some economists and
trade policymakers argue that the growth of regionalism in world trade is contributing
to a more open trading system by reducing trade barriers within regional blocs and
fostering deeper forms of economic integration. Others are concerned that the new
emphasis on regionalism may undermine the multilateral system and lead to the
development of antagonistic and protectionist trade blocs.
The 105th Congress is considering important legislation that would influence
U.S. policy toward future regional free trade agreements or modify existing
agreements. One set of bills would extend “fast-track” authority for congressional
approval of future trade agreements, including regional free trade agreements. (Fast-
track authority provides that Congress will consider trade agreements within
mandatory deadlines, with limited debate, and without amendment.) Several bills
would require renegotiation of, or withdrawal from, NAFTA. Other proposals would
authorize tariff and quota treatment for Caribbean countries that is equivalent to
treatment of imports from Mexico under NAFTA. Some observers have proposed
free trade areas with other regions, such as Europe or Sub-Saharan Africa.

Contents
Trends in Regional Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Types of Regional Integration Arrangements . . . . . . . . . . . . . . . . . . . . . . . 2
The WTO and Regional Integration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
The Proliferation of Regional Agreements . . . . . . . . . . . . . . . . . . . . . . . . . 4
Major Regional Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Motivations for Forming Regional Integration Arrangements . . . . . . . 6
Changes in U.S. Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
The Effects of Regional Trading Arrangements . . . . . . . . . . . . . . . . . . . . . . . . . 8
Economic Effects . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
Effects on the Multilateral Trading System . . . . . . . . . . . . . . . . . . . . . . . . 12
Implications for U.S. Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Achieving U.S. Trade Negotiating Objectives
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Accomplishments in GATT/WTO Negotiations . . . . . . . . . . . . . . . . 16
Criticisms of Multilateral Trade Agreements . . . . . . . . . . . . . . . . . . . 16
Are Regional Negotiations a Better Approach . . . . . . . . . . . . . . . . . 17
Reconciling Regional and Multilateral Trade Agreements . . . . . . . . . . . . . 18
New Rules for Regional Trade Agreements . . . . . . . . . . . . . . . . . . . 19
Open Regionalism . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
A Stronger Multilateral Trading System . . . . . . . . . . . . . . . . . . . . . . 20
List of Tables
Table 1. Potential for Trade Creation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Table 2. Potential for Trade Diversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Table 3. Share of Intra-Regional Trade in Total Trade (Exports plus Imports) in
Seven Geographic Regions, 1948-1955, Selected Years
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Regional Trade Agreements: Implications for
U.S. Trade Policy
Regional trade agreements are expanding rapidly around the world. Almost all
major trading countries either participate in, or are currently negotiating, such
agreements, and they have become a major focus of U.S. trade policy. The Clinton
Administration has begun preliminary negotiations to extend the North American Free
Trade Agreement (NAFTA) to other Western Hemisphere countries, and has actively
promoted the Free Trade Area of the Americas (FTAA) and the Asia Pacific
Economic Cooperation forum (APEC) to eliminate barriers to trade on a regional
basis.1
The 105th Congress is considering important legislation that would influence
U.S. policy toward future regional free trade agreements or modify existing
agreements. One set of bills would extend “fast-track” authority for congressional
approval of future trade agreements, including regional free trade agreements. (Fast-
track authority provides that Congress will consider trade agreements within
mandatory deadlines, with limited debate, and without amendment.) Several bills
would require renegotiation of, or withdrawal from, NAFTA. Other proposals would
authorize tariff and quota treatment for Caribbean countries that is equivalent to
treatment of imports from Mexico under NAFTA. Some observers have proposed
free trade areas with other regions, such as Europe or Sub-Saharan Africa.
The emphasis on regional agreements is a departure from the principle of
nondiscrimination, which has been a centerpiece of U.S. trade policy and the
multilateral trade system administered under the General Agreement on Tariffs and
Trade (GATT) and the World Trade Organization (WTO).2 Although the
GATT/WTO allows exceptions to the principle, the rapid proliferation of regional
trade agreements has raised important policy questions in the United States and
elsewhere. What are their effects on the domestic economies of member and
nonmember countries? Are they an effective means of trade liberalization? And, how
do they affect the multilateral trading system? This report examines the growth of
1 The FTAA , a plan to create a free trade area for North and South America by 2005,
was adopted by the United States and 33 other countries in December 1994. APEC is a group
of 18 governments in the Asia Pacific region, including the United States, that agreed in
November 1994 to eliminate barriers to trade in the region by 2010 or 2020, depending on
each country’s level of development.
2 The GATT is a multilateral agreement that was signed in 1947 and administered by
a secretariat in Geneva that was replaced by the WTO in 1995. The WTO has 131 member
countries that account for over 90% of world trade. The GATT is a complex set of rules and
procedures that encourages liberalization of trade through successive rounds of negotiations.

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regional trading arrangements, their economic effects, and their implications for U.S.
trade policy.
Trends in Regional Integration
Regional integration arrangements are among several types of preferential trade
arrangements that have been approved as exceptions to the multilateral rules
developed in the GATT/WTO. They are formed when countries agree to integrate
their economies by removing or eliminating barriers to economic transactions among
the members of the group. While free trade agreements have been the most popular
form of regional integration, governments have negotiated other types of regional
agreements.
Types of Regional Integration Arrangements
There are four basic types of regional integration agreements, each representing
a different stage of integration.
! The most common form of regional integration is a free trade area, in which
members of the group remove tariffs and some nontariff barriers to trade
among member countries. At the same time, each member retains its
independent trade policy, including its tariffs, toward nonmember countries.
! A second level of economic integration is a customs union, in which a free
trade area is established among members of the group, while the group adopts
a common external tariff.
! A third level of integration is a common market, in which a customs union is
established and supplemented by removal of barriers to capital and labor
movements among members.
! The deepest form of economic integration is an economic union, in which
members go beyond adoption of a common market to unify economic
institutions, coordinate economic policies, and adopt a common currency.
Each form of economic integration has different implications for international
trade. Since members of a free trade area retain separate trade policies toward
nonmembers, for example, each will have different levels of tariff and nontariff
protection. Such differences provide an incentive for exporters in nonmember
countries to ship their products to low-tariff members and then transship them to
high-tariff members. To avoid such transshipments and to maintain the integrity of
their independent trade policies, member countries must maintain strong customs
controls at borders inside the free trade area. In a customs union, on the other hand,
the common external tariff obviates the need to protect against transshipment.
A common market, by removing controls on capital and labor movements,
further facilitates trade and other economic transactions among member countries.
Citizens in one country who want to invest in, or take a job in, another country, for

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example, are free to do so. Free movement of capital and labor provides an additional
stimulus to trade in goods and services. Creation of an economic union further
facilitates trade. As countries move toward economic union, their trade tends to
resemble domestic trade, facing less regulation and fewer institutional barriers than
is common in international trade.
The two largest regional groupings, NAFTA and the European Union (EU),
provide examples of each stage of integration. NAFTA is a free-trade agreement
between Canada, the United States and Mexico, which went into effect in 1994. Like
other free-trade agreements, its central purpose is to eliminate all tariffs, most of
which will be phased out over 10 years, and many nontariff barriers. In terms of
regional integration, NAFTA goes beyond many other free trade agreements by
liberalizing restrictions on investment and trade in services, providing rules to protect
intellectual property rights, and establishing a special system for resolution of trade
disputes.
The EU has established a customs union and a common market and is moving
toward deeper integration. Between 1957 and 1968, all tariffs and quotas were
eliminated in trade among member states and a common external tariff was
established. The EU has also made major strides toward establishing a single market,
gradually removing barriers to movement of labor and capital among its members.
With few exceptions, citizens of one member country can freely travel, live, and work
in any other member country. Producers can sell their goods and services across
borders with few restrictions, and investors can invest in any member country. To
avoid nontariff barriers to trade, the EU promotes harmonization of laws, regulations,
and standards among member countries.
The ultimate goals of NAFTA and the EU are quite different. Whereas, NAFTA
aims to reduce barriers to trade among members, the goal of the EU, elaborated in the
1991 Treaty on European Union, is to develop into a political and economic union.
The EU has taken significant steps toward that goal. In addition to developing a
single market, it promotes cooperation on political and security issues among member
countries and is moving toward monetary union.
The WTO and Regional Integration
One of the key principles underlying the GATT/WTO multilateral system is
most-favored-nation (MFN) or nondiscriminatory treatment. In practice, the MFN
principle means that members of the WTO agree to extend any concessions that they
make on tariffs and other trade barriers to all other members. Since regional
integration arrangements provide for preferential treatment of their members, they
would appear to violate the principle of nondiscrimination.
The GATT/WTO allows exceptions to the MFN principle, however, for the
creation of free-trade areas and customs unions. Article I includes a grandfathe
3
r
3 The GATT/WTO allows other types of preferential trading arrangements as exceptions
to the MFN principle. The most common are agreements by the industrial countries to give
(continued...)

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clause for agreements that were in effect at the time the GATT was adopted, and
Article XXIV stipulates conditions under which GATT members may form new
preferential trade agreements. Such agreements are considered compatible with the
GATT if the signatories meet three conditions: they must eliminate trade barriers on
substantially all trade among members; they must impose no trade barriers on
nonmembers that are higher or more restrictive than those previously in effect; and
they must employ interim arrangements leading to the free trade area for only a
reasonable period of time. These conditions were intended to minimize the distortions
of trade patterns that often result from preferential trading arrangements.4
In practice, Article XXIV’s ambiguous wording has provided relatively little
discipline: the GATT/WTO has never formally disapproved a free trade agreement
or customs union. In most cases members have been unable to reach unanimous
decisions about whether proposed preferential agreements are compatible with
GATT/WTO rules. The Uruguay Round of multilateral trade negotiations, concluded
in 1994, resulted in modest changes to strengthen Article XXIV: it clarified the
conditions under which preferential agreements can be formed, strengthened GATT’s
review of new preferential arrangements, and provided for periodic reviews of
existing arrangements.
The Proliferation of Regional Agreements
Despite the changes introduced in the Uruguay Round, WTO members continue
to enjoy broad leeway to sign regional agreements, and the share of world trade
covered by such agreements has grown. Until the 1980s, there was only one effective
regional grouping among the major trading countries — the European Union. The
United States, while supporting European integration largely for political reasons,
generally opposed regional trade agreements. A number of smaller arrangements that
were formed in the 1960s and 1970s proved to be short-lived or ineffective in terms
of their ability to foster regional integration. But since the 1980s, the United States
and other major trading countries have begun to build regional groupings. In the
1990s regionalism has become a major force, with the creation of major new regional
arrangements and the reinvigoration of earlier arrangements. Now, almost all
members of the WTO belong to a regional trade agreement.
(...continued)
3
special tariff treatment, on a non-reciprocal basis, to the developing countries. The
generalized system of preferences (GSP), which provides low or zero tariffs to some imports
from developing countries, and special preferential tariffs provided by the United States and
the European Union to certain developing countries are prominent examples.
4 Under the so-called “Enabling Clause,” adopted by GATT members in 1979, regional
trade agreements that include only developing countries are exempt from the requirements of
Article XXIV if such agreements facilitate trade, do not create “undue difficulties” for
nonmembers, and do not impose new trade barriers.

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Major Regional Arrangements. Member countries have notified the
GATT/WTO of 144 free trade agreements and customs unions,5 over a third of them
formed in the 1990s. A 1994 study by the International Monetary Fund surveyed
regional arrangements that had been recently created or reactivated. It highlighted
6
some of the major integration developments in Europe, Africa, the Western
Hemisphere, the Asia-Pacific region, and the Middle East and South Asia in the early
1990s.
! Europe. The European Union not only deepened integration internally, but
further developed its web of regional trade arrangements with third countries.
In 1994, it formed the European Economic Area (EEA) with Austria, Finland,
Sweden, Iceland, Liechtenstein, and Norway. (The first three became
members of the EU in 1995.) The EU also entered into association agreements
(which have the ultimate goal of membership) with several Central European
countries, partnership agreements (which may lead to free trade areas) with
several countries of the former Soviet Union, free trade agreements with the
Baltic countries, and a customs union with Turkey, and further liberalized
preferential trading arrangements with several Mediterranean countries. The
Central European countries and Baltic countries have formed regional trading
arrangements among themselves and negotiated free trade agreements with the
European Free Trade Association (EFTA — a grouping of Norway, Iceland,
Liechtenstein and Switzerland). Some of the countries of the former Soviet
Union have also negotiated regional integration agreements.
! Africa. Two regional agreements, the Central African Customs and Economic
Union (UDEAC) and the Cross-Border Initiative (CBI) are representative of
a general increase in regional economic cooperation. UDEAC, a common
market formed in 1966 by Cameroon, Central African Republic, Chad, the
Congo, Equatorial Guinea, and Gabon, made significant steps toward regional
integration with agreements to put in place a common external tariff, replace
quantitative restrictions with tariffs, and phase out tariffs on trade among
members. The CBI was formed in 1993, when 13 eastern and southern
African countries agreed to liberalize trade and capital flows among
themselves.
! Western Hemisphere. The inauguration of the North American Free Trade
Agreement (NAFTA) in 1994 by the United States, Canada, and Mexico was
particularly noteworthy because of its size and influence. Several South
American countries have expressed an interest in becoming members of
NAFTA. In 1991, Argentina, Brazil, Paraguay, and Uruguay formed
MERCOSUR, the Southern Cone Common Market. Among other regional
agreements, the Andean Pact, first formed in 1969 by Bolivia, Colombia,
Ecuador, Peru, and Venezuela, and the Central American Common Market
5 U.S. International Trade Commission. “A Closer Look at MERCOSUR,”
International Economic Review, February-March 1997, p. 9.
6 Harmsen, Richard and Michael Leidy. “Regional Trading Arrangements,” in Naheed
Kirmani, International Trade Policies: The Uruguay Round and Beyond. Volume II.
Background Papers, Washington, November 1994, pp. 170-250.

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(CACM) formed in 1961 by Costa Rica, El Salvador, Guatemala, Honduras,
and Nicaragua, were both revived in 1990. In 1994, 34 Western Hemisphere
countries adopted a plan, promoted by the U.S. Government, to create the
Free Trade Area of the Americas (FTAA) by the year 2005.
! Asia-Pacific. Recent developments include the establishment of the ASEAN
Free Trade Agreement (AFTA) in 1992 by Brunei, Indonesia, Malaysia,
Philippines, Singapore and Thailand, and an agreement in 1992 to form a
South Asian Association for Regional Cooperation (SAARC) preferential
trading arrangement. Eighteen Asian and Western Hemisphere governments
in the Asia Pacific Economic Cooperation Forum (APEC) agreed in 1994 to
a long-term plan to eliminate barriers to trade in the region.

! Middle East and South Asia. The Gulf Cooperation Council (GCC), a free
trade area formed in 1981 by Bahrain, Kuwait, Oman, Qatar, Saudi Arabia,
and the United Arab Emirates, liberalized movements of capital and labor and
worked toward establishing a common external tariff in the early 1990s. In
1992, the Economic Cooperation Organization (ECO), formed in 1985 by Iran,
Pakistan, and Turkey, added the seven former Central Asian Republics of the
Soviet Union and instituted a limited system of tariff preferences among
members.
Motivations for Forming Regional Integration Arrangements. Various
factors explain the increased interest in regional arrangements. Dissatisfaction with
multilateral trade negotiations has been one important motivation. While the
GATT/WTO has been successful in reducing tariffs, many critics are dissatisfied with
its ability to discipline nontariff barriers and to address new trade issues. They believe
that multilateral negotiations have been too slow, and that some WTO members have
benefitted from reduced barriers among their trading partners, without opening their
own markets sufficiently. Proponents of regional trade agreements think that
negotiations among a small number of like-minded governments can liberalize trade
more quickly and more effectively.
There are other important economic motivations for regional integration
arrangements. Most participants in recent arrangements have regarded regionalism
as an alternative way to increase their gains from trade. In particular, regional free-
trade agreements and customs unions are seen as a way to achieve economies of scale
and to attract foreign investment. For developing countries such agreements are often
seen as a means to protect infant industries on a regional basis. Policymakers in some
countries have argued that, if industries could first develop by competing in a regional
market, they would become more competitive in the global market. Other
governments have been motivated by the perceived need to avoid protectionist
policies by trading partners: regional agreements are seen as a means of ensuring that
the markets of other member countries will not be closed in the future. Some
governments of developing countries and countries in transition have seen regional
agreements as a way of locking in market-oriented reforms. Regional trade
agreements, they think, may prevent future governments from reversing the market
reforms.

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As the example of the European Union shows, regional integration can also be
motivated by noneconomic objectives, such as promoting political stability, avoidance
of war, and regional security. In addition, smaller governments have sometimes
regarded participation in a regional bloc as a way to enhance their influence in
negotiations with other governments.
Changes in U.S. Policy
The negotiation of preferential trading arrangements is a relatively recent
phenomenon in U.S. trade policy. Through much of the post-World War II era, U.S.
policymakers emphasized the importance of multilateral trade liberalization, carried
out primarily through the GATT.
GATT was established in the early postwar period to avoid the kind of unilateral
or bilateral discriminatory trade policies that led to a breakdown of the international
trading system in the 1930s. It was founded on the belief that nondiscrimination and
negotiated solutions to trade disputes should be fundamental principles of trade
policy. Although many U.S. trade policymakers have expressed misgivings about
GATT, Congress has continually provided the necessary authorization for GATT’s
tariff-cutting negotiations and the U.S. government has vigorously supported eight
rounds of multilateral negotiations to reduce trade barriers.
During the 1970s and 1980s, however, many U.S. policymakers became
impatient with the slow pace of multilateral trade liberalization. While GATT
negotiations had resulted in major cuts in tariffs for many industrial goods, U.S.
negotiators had more limited success in opening foreign markets for U.S. exporters
of agricultural products, high-technology goods, and services. Although negotiators
in the Uruguay Round made substantial progress in these areas, it required 8 years of
negotiation, and many of the agreements are being phased in over 5-10 years.
Moreover, many U.S. exporters were disappointed with the limited results of the
Uruguay Round agreements in some of the new trade areas, such as services,
intellectual property rights, and trade-related investment measures. U.S. critics also
maintained that the GATT was too tolerant of free riders — that some members were
benefitting from open U.S. markets, but not opening their markets to U.S. exporters.
Largely because of the perceived shortcomings of GATT, U.S. trade
policymakers have shown increasing interest in bilateral and regional free trade
agreements. Since 1974, Congress has continually authorized and encouraged the
executive branch to explore special trading arrangements with individual trading
partners as an alternative or complement to multilateral negotiations. The Trade Act
of 1974, for example, directed the President to enter into bilateral trade agreements
if he determined that such agreements would promote the economic interests of the
United States. Another provision of the 1974 Act expressed the sense of Congress
that the United States should enter into a trade agreement with Canada to establish
a free trade area. The Trade Agreements Act of 1979 amended the provision to
require the President to study the desirability of entering into trade agreements with
other countries in the northern portion of the Western Hemisphere.
The Trade and Tariff Act of 1984 authorized the President to enter into a
bilateral trade agreement with Israel to be implemented under fast-track procedures.

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The U.S. and Israeli governments signed an agreement establishing a free trade area
in April 1985, and the agreement was implemented later that year by the United
States-Israel Free Trade Area Implementation Act of 1985. The 1984 Act also
authorized fast-track approval procedures for free trade agreements negotiated with
other countries. In response to a request from the Canadian government, the United
States and Canada negotiated a bilateral free trade agreement, which was signed in
January 1988 and implemented by the United States-Canada Free-Trade Agreement
Implementation Act of 1988.
At the request of the Mexican government, negotiations to create the NAFTA
began in June 1991. Leaders of the three countries signed the agreement in December
1992, and the United States implemented the agreement by enacting the North
American Free Trade Agreement Implementation Act in 1993. In passing the NAFTA
Implementation Act, Congress found that “Efforts by the United States to obtain
greater market opening through multilateral negotiations have not produced
agreements that fully satisfy the trade negotiating objectives of the United States.”
Congress also directed the President to determine with which foreign countries the
United States should seek to negotiate additional free trade agreements.7
The Clinton Administration is pursuing additional regional integration
agreements. U.S. negotiators have begun preliminary negotiations to provide for
Chile’s accession to NAFTA, and several other Latin American countries have
expressed an interest in acceding to NAFTA in the future. The Administration has
proposed a Free Trade Area for the Americas (FTAA), a plan to create a free trade
area with 33 other countries in North and South America by 2005. Administration
officials have formulated a comprehensive agenda for the FTAA negotiations to deal
with a wide range of tariff and nontariff issues. The United States has also joined 17
other governments in the Asia Pacific region in the Asia Pacific Economic
Cooperation (APEC) forum to eliminate barriers to trade in the region by 2010 or
2020, depending on each country’s level of development.
The Effects of Regional Trading Arrangements
Economists and policymakers have debated two general issues about the effects
of regional trade agreements. How do they affect the economies of member and
nonmember countries? And, how do they affect the multilateral trading system?
Economic Effects
There are important differences between the economic effects of reducing trade
barriers on a multilateral, nondiscriminatory basis and reducing barriers on a regional
or bilateral basis. The case for nondiscrimination in trade — the cornerstone of
GATT/WTO — is based on the theory of comparative advantage. To the extent that
multilateral trade liberalization is successful in removing trade barriers, all goods are
produced at the location of lowest relative cost, and world efficiency and welfare are
7 P.L. 103-182, Sec. 108.

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maximized. Discriminatory barriers to trade, on the other hand, can distort trade
flows: relatively less efficient producers in some countries can be protected against
foreign competition, and consumers may not reap the full gains of trade liberalization.
Thus, while economic theory suggests that a country usually gains from
nondiscriminatory trade liberalization, it is ambiguous about preferential trade
arrangements. Preferential trading arrangements introduce elements of freer trade
among the members of the trading bloc, while maintaining some level of protection
against nonmembers. Consequently, they do not always maximize efficiency and
welfare gains.
Preferential trade arrangements generally lead to both trade creation and trade
diversion.
8 Trade creation occurs when the removal of trade barriers in a preferential
arrangement increases the trade of a good and the more efficient production of that
good. If, for example, removal of trade barriers under NAFTA leads Mexican
purchasers to substitute relatively low–cost U.S. computers for high–cost domestic
models, new trade is created. Trade creation leads to improved efficiency and welfare
because production is shifted from relatively higher cost producers in one member
country to lower cost producers in another.
Trade diversion occurs when the formation of a preferential trading arrangement
causes a shift in production from a relatively efficient nonmember producer to a less
efficient member country. If removal of tariffs under NAFTA induces U.S. importers
to buy clothing from Mexico rather than from more efficient producers in Caribbean
countries, for example, no new trade is created; it is merely diverted. Trade diversion,
because it shifts production from lower cost producers in nonmember countries to
higher cost producers in member countries, reduces the efficiency and welfare gains
of trade liberalization. (See Table 1 and Table 2)
Whether a particular free-trade agreement or customs union will lead to trade
creation or trade diversion is an empirical question: the outcome depends on the
specific provisions of the agreement and the nature of the economies involved. For
example, if countries have extensive trade relations before a regional integration
agreement, there is likely to be little diversion, because the agreement will probably
simply reinforce patterns of trade that are based on comparative advantage or
geographical proximity. Similarly, if a customs union adopts the least restrictive
tariffs of the member countries, it is likely to lead to trade creation rather than
diversion. If countries with high tariff barriers enter an agreement that maintains high
external barriers, on the other hand, the agreement is likely to lead to more diversion.
8 Jacob Viner first developed the concepts of trade creation and trade diversion. While
commonly called the theory of customs unions, Viner’s analysis is relevant to all preferential
trade agreements. Jacob Viner. The Customs Union Issue. New York, Carnegie Endowment
for International Peace, 1950.

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Trade Creation and Trade Diversion
The static effects of trade creation and trade diversion can be demonstrated
with simple numerical examples. Table 1 shows the cost of producing a good
domestically in country A and the prices of the same good produced in countries
B and C, if the good were imported to country A with a tariff of $.50. Since the
tariff would make the price of imports higher than the price of the domestically
produced good, country A does not import, even though country B is a more
efficient producer. If a customs union is formed between countries A and B,
production will shift from the high-cost country A to the low-cost country B, and
A will import the good from B. Since the price of the good produced in country
C is not competitive with or without the tariff, it is not affected. Hence, there is
only trade creation, and countries A and B can be expected to enjoy efficiency and
welfare gains.
Table 1. Potential for Trade Creation
Country A
Country B
Country C
Cost of production
$2.00
$1.75
$2.50
Tariff
0
.50
.50
Price in Country A
2.00
2.25
3.00
Table 2 shows an example of potential trade diversion. The low-cost
producers in country C export to country A even after paying the tariff. However,
if countries A and B form a customs union, and country A removes the tariff on
imports from country B, trade will be diverted from the more efficient country C
to the less efficient country B. Such a customs union would result in trade
diversion and the three countries would suffer efficiency losses.
Table 2. Potential for Trade Diversion
Country A
Country B
Country C
Cost of Production
$2.00
$1.75
$1.35
Tariff
0
.50
.50
Price in Country A
2.00
2.25
1.85

CRS-11
In evaluating the effects of regional integration, it is important to consider
dynamic effects as well as the static effects of trade creation and diversion. By
creating a large regional market, for example, a free-trade area or customs union may
allow economies of scale that did not exist before. Removal of trade barriers may
introduce competitive pressures and promote the transfer of knowledge and
technology, thus promoting improvements in productivity. An enlarged market may
also attract increased foreign investment. In fact, some regional agreements have
raised concerns about diversion of investment from more productive uses in
nonmember countries. Such investment diversion may occur when regional
integration combines high external barriers with rules of origin that set highly
restrictive conditions under which a product will be eligible for preferential treatment.
Not surprisingly, most of the empirical studies of the effects of regional
integration have examined the EU, which provides the longest experience of major
trading countries with a preferential trading arrangement. Most of the studies have
concluded that for manufactured products, trade creation has far outweighed trade
diversion. At the same time, the EU’s Common Agricultural Policy, which establishes
high tariff and nontariff barriers to agricultural imports from nonmember countries,
has resulted in considerable trade diversion. Other studies have suggested important
dynamic gains from European integration.9
Because NAFTA has been in effect only since 1994, there is limited evidence of
its effects on trade flows. Most preliminary studies suggested little trade diversion
because the three members already traded intensively with each other and had already
lowered their barriers to trade.10 More recent studies have provided evidence that
NAFTA and other regional agreements have led to somewhat greater regional
concentration of trade — that trade among member countries has grown faster than
trade with nonmembers. They suggest that such concentration of trade may be in part
due to trade diversion.11
The experience of regional integration in Europe and other areas was analyzed
in a WTO study of regionalism in world trade. The study found that intra-regional
12
trade as a share of total West European trade increased from 53% to almost 70%
between 1958 and 1993. (See Table 3.) It found smaller increases in intra-regional
trade in Asia and North America and no major increases in other regions. There was
a sharp decline in intra-regional trade in Central and Eastern Europe, and a smaller
decline in the Middle East. The share of total world trade that is intra-regional
9 For a brief overview of studies of EU integration, see Caves, Richard E., Jeffrey A.
Frankel, and Ronald W. Jones. World Trade and Payments: An Introduction. 6th ed., New
York, HarperCollins, 1993, pp. 291-293.
10 The early studies are discussed in U.S. Library of Congress. Congressional Research
Service. North American Free Trade Agreement: Effects on Trade With Nonmember
Countries, by George D. Holliday. CRS Report 93-254 E.
11 Carnegie Endowment for International Peace. Reflections on Regionalism: Report of
the Study Group on International Trade. Washington, 1997, pp. 19-26.
12 World Trade Organization. Regionalism and the World Trading System. Geneva,
1995.

CRS-12
increased from 40.6% in 1958 to 50.4% in 1993, primarily due to the Western
European experience.
Table 3. Share of Intra-Regional Trade in Total Trade (Exports plus
Imports) in Seven Geographic Regions, 1948-1955, Selected Years
(Percentage of Each Region’s Merchandise Trade)
1948
1958
1963
1968
1973
1979
1983
1993
1995
Western
41.8
52.8
61.1
63.0
67.7
66.2
64.7
69.9
68.9
Europe
Central, East
61.2
71.3
63.5
58.8
54.0
54.0
57.3
19.7
18.9
Europe,
Former Soviet
Union
North
27.1
31.5
30.5
36.8
35.1
29.9
31.7
33.0
36.0
America*
Latin
20.0
16.8
16.3
18.7
27.9
20.2
17.7
19.4
20.8
America*
Asia
38.9
41.1
47.0
36.6
41.6
41.0
43.0
49.7
50.9
Africa
8.4
8.1
7.8
9.1
7.6
5.6
4.4
8.4
10.0
Middle East
20.3
12.1
8.7
8.1
6.1
6.4
7.9
9.4
8.0
World
32.9
40.6
44.1
47.0
49.3
45.8
44.2
50.4
52.1
*Mexico is included in Latin America.
Sources: World Trade Organization, WTO Focus, No. 3, May-June 1995, p. 11; 1995 data are
from World Trade Organization, Annual Report 1996, Vol. II, p. 23, Geneva, 1996.
The authors of the WTO study do not attribute the increase in European intra-
regional trade primarily to trade diversion. They note that the increase was not
associated with a significant decrease in European trade with other regions as a
percentage of total production in the region. Barriers to trade with nonmembers were
also lowered, and extra-regional trade grew commensurately with total European
production. Thus, the authors of the study suggest that the increase in intra-regional
trade primarily reflected the increasing importance of overall trade in Europe’s
economy, rather than diversion of trade from nonmembers.
Effects on the Multilateral Trading System
With the proliferation of new agreements, regional trading arrangements could, in
the future, lead to a larger share of intra-regional trade in the world. (Table 1 does not
reflect the influence of the many agreements that have been concluded in the 1990s:
they are too recent to have significantly affected the data presented in the table.) The
interaction of such trade blocs may in large part determine the future of the multilateral

CRS-13
trading system. Trade specialists are debating whether such arrangements will be
“stumbling blocs” or “building blocs” for a more liberal multilateral system.13
The development of large, rival trading blocs could, according to some observers,
undermine the multilateral system. Such arrangements inevitably result in some trade
diversion and, thus, harm the trading interests of nonmember countries. In fact,
concerns about trade diversion have already generated significant trade frictions. The
European Union’s successive enlargements and its free trade agreements with Central
European countries, for example, have led to complaints by the United States and
others about trade diversion. Similarly, Caribbean and Asian countries have expressed
concerns that NAFTA’s restrictive rules of origin for the textile and automobile
industries are diverting trade.14
Moreover, trading blocs with great market power, such as NAFTA or the
European Union, may have a greater temptation to impose restrictions on nonmembers
because the risk of retaliation from relatively small trading partners would be small. Of
particular concern is the possibility of greater resort to procedural protectionism (such
as the use of antidumping duties merely to protect domestic producers) or restrictive
rules of origin to reduce imports from nonmembers. Nonmember countries could react
by forming antagonistic trade blocs, thus reducing the gains from trade that have been
achieved through reduction of trade barriers in multilateral trade negotiations.
The negotiation of regional integration agreements could, on the other hand,
reinforce the multilateral trading system. They could serve as a model for multilateral
agreements that deal with many of the same issues that have already been addressed at
the regional level. NAFTA, for example, includes significant agreements on such issues
as trade in services, trade–related investment measures, intellectual property rights, and
dispute settlement, that for a long time stymied negotiators in the Uruguay Round.
NAFTA could also serve as a model for future trade agreements addressing issues
related to labor standards and environmental degradation — issues that have not been
addressed systematically in the WTO.
Renato Ruggiero, Director General of the WTO, reflected the ambivalence of
many trade officials toward regional trade agreements in a September 1996 speech.15
The increase in regional agreements, he said, “has generally been for the good.” They
had provided “stepping stones to global liberalization,” and “served as important
crucibles for trade policy innovation...” Ruggiero expressed concern, however, that,
13 For a further discussion of the debate, see de Melo, Jaime, and Arvind Panagariya.
The New Regionalism in Trade Policy. Washington, The World Bank, September 21, 1992.
14 Legislation has been introduced in the 105th Congress to provide preferential treatment
to the Caribbean countries that is roughly equivalent to that of Mexico under NAFTA, thus
avoiding trade diversion. See U.S. Library of Congress. Congressional Research Service.
Caribbean Basin Interim Trade Program (NAFTA/CBI Parity), by Vladimir N. Pregelj.
IB95050, continually updated.
15 Renato Ruggiero, “Beyond Borders: Managing a World of Free Trade and Deep
Interdependence,” Speech to the Argentinian Council on Foreign Relations, Buenos Aires,
September 10, 1996. World Trade Organization Press Release No. 55. Available at
http://www/wto.org/Whats_new/press55.htm.

CRS-14
if regionalism proceeds faster than the WTO process, “there is a danger that we will
lack a common framework of rules and disciplines.” He warned that the growth of
regionalism could lead to a “fragmented world — one which fosters inter-regional
frictions and rivalries, but lacks the global architecture of rules and procedures needed
to manage them.”16
In short, the effects of regional integration on the multilateral system, like its
effects on economic efficiency and welfare, are uncertain. Some economists and
policymakers argue that regional agreements could lead to the unravelling of the
intricate multilateral rules that promote an open trade regime. Others argue that
regional integration agreements are a “second best” solution: while they are not as
effective as multilateral trade liberalization in promoting economic efficiency, regional
integration arrangements are preferable to maintaining existing trade barriers.
Implications for U.S. Trade Policy
Questions about the economic and systemic effects of regional trade agreements
may play a role in the 105th Congress’ consideration of legislation to enact new
authority for fast-track implementation of trade agreements. In the past, Congress
delegated considerable discretionary authority to the President to decide which kinds
of agreements best served U.S. trade interests. The President was authorized, from
1975-1994, to negotiate on a wide variety of issues in multilateral, bilateral, or regional
negotiations and have the resulting agreements implemented with fast-track procedures.
In considering new fast-track authority, Congress may choose to continue such broad
authority, to provide more specific direction on negotiating objectives and on the kinds
of agreements that the President may submit to Congress for fast-track implementation,
or not to agree to fast-track authority at this time.
Since the inception of fast-track authority, Congress has conditioned fast-track
implementation of trade agreements on close consultation between the President and
Congress during trade negotiations and on the President’s success in achieving the
negotiating objectives that are spelled out in the authorizing legislation. Generally,
authorizing legislation has contained “overall” and “principal” trade negotiating
objectives. The former include broad, long-term goals of U.S. trade policy, such as
improving access for U.S. exporters to foreign markets, strengthening the multilateral
trading system, and fostering economic growth; the latter include specific, more
immediate goals, such as targeting foreign barriers in certain sectors or reforming
16 The WTO’s 1996 annual report gives examples of regional rules that take precedence
over multilateral rules. In dispute settlement on issues that arise under both NAFTA and the
WTO, for example, a complaining NAFTA member can choose which provisions to use. If
the two parties disagree on which to use, NAFTA provisions take priority. Similarly, in EU
association agreements with countries in Central Europe, the regional rules take precedence
in most cases. For example, the EU applied safeguards against steel imports from the Czech
and Slovak Republics in 1992 in a way that suggested that GATT obligations had been
suspended. World Trade Organization, Annual Report, 1996, Volume I, Geneva, 1996, p.
39.

CRS-15
certain trade rules. In passing fast-track authority, Congre
17
ss has directed the President
to keep the relevant committees informed of the progress of negotiations and, after
negotiations are completed, to report to Congress how the agreements have achieved
the legislated objectives.
Since 1994, the Clinton Administration and some Members of Congress have
continually advocated a renewal of fast-track authority. On September 16, 1997, the
President sent a legislative proposal to Congress that would provide fast-track authority
for any agreement — bilateral, regional, or multilateral — that met the conditions set
forth in the law and that was entered into before a stipulated date (October 1, 2001,
with a possible extension to October 1, 2005).
There is substantial opposition in the Congress to the Administration’s proposal
for broad fast-track authority. Some Members are concerned about the adverse effects
of past trade agreements. (NAFTA has been a particular target of fast-track critics.)
They oppose fast-track authority because they think that it will facilitate agreements that
increase import competition. Others approve of trade liberalization, but only after
careful consideration of the costs and benefits of trade agreements. The latter oppose
fast-track authority because they think that it prevents such careful consideration.
Other Members support the renewal of fast-track authority, but disagree with the
Administration’s negotiating objectives. In particular, the proposed use of trade
agreements to promote higher labor and environmental standards in other countries has
generated a major debate. Some Members have supported legislation to restrict the
President’s authority to include such provisions in trade agreements, while others have
insisted that future trade agreements contain provisions that require stronger labor and
environmental standards. On November 10, 1977, citing an inability to ensure victory
of a measure that had been approved by the House Ways and Means Committee,
President Clinton announced an agreement with the House leadership to postpone a
planned vote in the House. Administration officials have announced that they will try
again in 1998 to enact fast-track authority.
In deciding whether fast-track should be authorized and, if so, what kind of trade
agreements should be pursued, Congress may consider which approach —multilateral
or regional negotiations — is most likely to achieve the U.S. negotiating objectives that
are included in fast-track authority. If new fast-track legislation includes authority for
both multilateral and regional free trade agreements, it may also consider whether the
two kinds of agreements are mutually compatible.
17 For example Section 1101 of the Omnibus Trade and Competitiveness Act of 1988
(P.L. 100-418), which last authorized fast-track implementation included principal negotiating
objectives related to dispute settlement, the operation of the multilateral system, transparency,
developing countries, current account surpluses, trade and monetary coordination, agriculture,
unfair trade practices, trade in services, intellectual property, foreign direct investment,
safeguards, specific barriers to trade, worker rights, access to high technology, and border
taxes.

CRS-16
Achieving U.S. Trade Negotiating Objectives
U.S. trade negotiators have had some notable successes in achieving U.S.
negotiating objectives at both the multilateral and regional levels, and the Clinton
Administration proposes continued negotiations both in the WTO and in regional fora
such as NAFTA, the FTAA, and APEC. Trade specialists offer different assessments
on which approach should be emphasized in furthering the U.S. negotiating objectives
that are being discussed today.
Accomplishments in GATT/WTO Negotiations. The record of successful trade
liberalization in the GATT/WTO, combined with the evidence that multilateral
liberalization maximizes the gains from trade, has led many trade specialists to urge
continued emphasis on multilateral trade negotiations. Eight rounds of trade
negotiations in the GATT have resulted in a major reduction in trade barriers,
contributing to a rapid increase in world trade. GATT’s accomplishments in lowering
tariff barriers are most apparent: among the industrial countries, average tariffs on
manufactured goods have fallen from 40% in the 1950s to less than 5% today.
In the Tokyo and Uruguay Rounds of GATT, negotiators also made significant
progress in reducing nontariff barriers and establishing rules for new trade issues. The
Tokyo Round (1973-1979), for example, resulted in important agreements on
government procurement, technical barriers to trade, customs valuation, import
licensing, antidumping, and subsidies. The Uruguay Round (1986-1993) reduced
barriers and established new rules in areas such as agriculture, textiles, services,
intellectual property rights, and trade-related investment measures, that had received
relatively little attention in previous rounds.
In future negotiations, some analysts see a particularly important role for
GATT/WTO in negotiating matters that involve a large number of producers in many
different countries. The Uruguay Round’s agreem
18
ent to liberalize trade in textiles and
apparel and its agreement to improve market access and reduce subsidies in agricultural
trade are examples of success in addressing difficult trade issues in such industries.
(While regional agreements have also liberalized trade in textiles and agriculture among
member countries, they have often maintained, or increased, protection against
producers in other countries.) Supporters of multilateral trade negotiations also claim
that post-Uruguay Round sectoral agreements, such as the Information Technology
Agreement that was initialled in 1996, will bring significant benefits to the economies
of the United States and its trading partners. The GATT/WTO’s record suggests to
some observers that it may be the best venue for reducing barriers to trade in similar
industries.
Criticisms of Multilateral Trade Agreements. Despite the considerable
achievements of GATT/WTO, U.S. trade negotiators, like their counterparts in other
countries, have become increasingly interested in regional agreements largely because
they perceive multilateral negotiations as slow and ineffective in addressing key issues
18 Hufbauer, Gary, and Anup Malani. “The World Trade Regime: GATT, Regional
Cooperation, Bilateral Confrontation.” The International Spectator, No. 2, April-June, 1993,
p. 66-68.

CRS-17
on the current trade agenda. Critics of GATT/WTO are particularly dissatisfied with
its slow progress on new trade issues––trade in services, trade–related investment
measures, intellectual property rights, and labor and environmental standards. Such
issues are precisely the areas that have been emphasized in U.S. negotiating objectives.
The Uruguay Round, for example, required over 8 years to complete, and many
observers were disappointed with achievements on the new trade issues. While the
Uruguay Round resulted in agreements on services, foreign investment, and intellectual
property rights, critics found many shortcomings. The agreement on services contains
exceptions for countries that choose not to extend nondiscriminatory or national
treatment for foreign providers, and mixed results with regard to market access for
specific service industries. Negotiators were unable to reach agreement on financial
services, maritime services, and basic telecommunications services. (Negotiations on
the telecommunications agreement were concluded in 1997; they are continuing for the
others.) The Uruguay Round agreement on trade–related investment measures,
according to some observers, did not bring significant reform; it discourages a limited
number of practices that discriminate against foreign investors, but allows exceptions
for developing countries. The agreement on intellectual property rights, while generally
credited with setting new standards for enforcement, has been criticized for allowing
long transition periods for developing countries.19
Those who advocate including provisions on labor and environmental standards
in trade agreements have been among the most vocal critics of the GATT/WTO. The
Clinton Administration acknowledged that U.S. negotiators failed to include workers
rights issues on the agenda in the Uruguay Round, and, at the first WTO ministerial
20
meeting in Singapore in 1996, members declined to undertake any future work in the
WTO on such issues. Many environmental groups were also dissatisfied with the
Round’s limited results on environmental issues — an agreement to establish a
committee in the WTO to carry out an environmental work plan.
Are Regional Negotiations a Better Approach. Those who favor greater
emphasis on regional trade agreements maintain that such arrangements, because their
membership is limited to a small number of like–minded governments, can resolve
differences on difficult new issues, more quickly and effectively. They compar
21
e
NAFTA’s achievements favorably with the Uruguay Round’s. In a relatively short time,
negotiators in NAFTA concluded agreements on investment rules, intellectual property
rights, and trade in services, that are in many respects more comprehensive and more
effective than the Uruguay Round agreements. NAFTA’s investment rules, provide
19 For an overview of the accomplishments and shortcomings of the Uruguay Round
agreements on new issues, see Schott, Jeffrey J., assisted by Johanna W. Buurman. The
Uruguay Round: An Assessment. Washington, Institute for International Economics,
November 1994. P. 99-123.
20 President of the United States, Uruguay Round Trade Agreements, Texts of
Agreements, Implementing Bill, Statement of Administrative Action, and Required Supporting
Statements. H.Doc. 103-316, v. 1, 103d Congress, 2d Session. Washington, U.S. Govt.
Print. Off., 1994, p. 1142.
21 See for example, Hufbauer, Gary and Jeffrey J. Schott. Toward Free Trade and
Investment in the Asia-Pacific. The Washington Quarterly, Summer 1995. P. 37-45.

CRS-18
more effective restrictions on performance requirements than multilateral rules.
(Performance requirements stipulate that the foreign investor must achieve targets set
by the host government on exports, domestic employment, technology transfers, and
other matters.) While the Uruguay Round General Agreement on Trade in Services
applies only to service industries that are listed in the agreement, NAFTA adopted a
negative list approach; it lists services not subject to the agreement and extends national
treatment to all others. NAFTA’s agreement on intellectual property rights includes
products that were under development when the agreement was signed; the Uruguay
Round did not cover such products.22
Some observers also maintain that NAFTA achieved significant agreements on the
controversial issues of environmental and labor standards. It preserves national
environmental standards and commits member countries to work together to enhance
their standards through upward harmonization. A NAFTA side agreement on
environmental matters promotes enforcement of national environmental laws and
cooperation among the member governments on environmental matters. A side
agreement on labor promotes enforcement of each country’s labor laws. (The NAFTA
provisions gained the support of some environmental groups. The labor agreement,
however, received little support from U.S. organized labor. In fact, the perception that
NAFTA has had adverse effects on U.S. jobs and wages has led some Members of
Congress to propose that the United States negotiate revisions to NAFTA or withdraw
from it. )
23
Other observers question whether regional trade agreements are necessarily a
quicker and more effective way to negotiate such issues. U.S. negotiators may
experience greater difficulty as they attempt to negotiate regional agreements with a
larger group of more diverse countries. In fact, the schedules for the FTAA and APEC
suggest that the potential members of the larger regional arrangements may anticipate
difficult, time–consuming negotiations. Completion of the FTAA is planned for the year
2005; prospects for APEC are even more distant — 2010 for the industrial countries
and 2020 for the less developed countries. The schedule for the larger regional
agreements suggests to some observers that U.S. objectives could be better served by
concentrating on multilateral negotiations.
Reconciling Regional and Multilateral Trade Agreements
How can policymakers ensure that regional trade agreements serve as “building
blocs” rather than “stumbling blocs” for a more effective multilateral system? Many
observers, concerned that the limited reforms of the Uruguay Round will not provide
22 Lawrence, Robert Z. Regionalism, Multilateralism, and Deeper Integration.
Washington, The Brookings Institution, 1996, p. 71.
23 For example, H.R. 978, introduced in the 105 Congress by Rep. Kaptur, woul
th
d
require renegotiation of certain provisions of NAFTA, and withdrawal from NAFTA if certain
conditions are not met.

CRS-19
significantly greater discipline to regional arrangements, have proposed more
fundamental reforms to the GATT/WTO rules.24
New Rules for Regional Trade Agreements. Some economists have proposed
reforming GATT/WTO rules to allow only customs unions. That is, free trade
arrangements such as NAFTA would not be allowed. From those economists’
perspective, customs unions are preferable because they require a common external
tariff. Since the GATT requires that tariffs not be increased against nonmembers, the
reformers think that tariffs tend to be reduced to the lowest level prevailing in the
customs union. They also think that customs unions are less likely to use rules of origin
for protectionist purposes. (Rules of origin play a more prominent role in free trade
areas because they must be used to protect against transshipment through the member
countries with the lowest tariffs.) For many governments, however, there is a
disadvantage to customs unions: since they are required to adopt a common external
tariff, they must share the power to regulate their trade with nonmember countries.
Others have proposed establishing new conditions under which regional trade
agreements could be formed. Some economists have pointed out, for example, that the
rule requiring members of a regional agreement to eliminate barriers to “substantially
all” trade does not necessarily maximize global welfare. Since removal of some internal
barriers leads to trade diversion, while removal of others leads to trade creation, trade
theory suggests that partially removing internal barriers (that is, avoiding removal of
barriers that would lead to trade diversion) could improve welfare. While theoretically
sound, this proposal may have practical problems. First, it might be difficult to
determine whether removal of a certain barrier would create or divert trade. Second,
without the rule that all internal barriers be removed, members of regional arrangement
might not make decisions on the basis of world welfare. Instead, they might choose to
liberalize selectively to protect politically powerful producers from outside competition.
Another proposal is to revise the GATT/WTO rule that members of a new regional
arrangement must not raise tariffs on nonmembers. Instead, some propose that the rule
require all members of a regional arrangement to lower external tariffs sufficiently to
maintain existing levels of imports from nonmembers. Such a rule, it is argued, could
eliminate trade diversion by setting guidelines on the results of regional agreements.
This proposal would encounter both practical and conceptual problems. Most countries
want to know what the level of tariffs on nonmembers will be before they enter a
regional arrangement. A requirement that they maintain existing levels of imports
would create uncertainty. Moreover, a lower level of imports from nonmembers might
not be caused by trade diversion; it might be the result of improved efficiency of
producers within the regional group. One would not want to adopt a rule that
discouraged changes in trade that are based on new patterns of comparative advantage.
Open Regionalism. A more general proposal is that new regional arrangements
be based on the concept of “open regionalism” — that the elimination of barriers to
trade within a bloc be accompanied by simultaneously lowering barriers to nonmembers.
Some member governments of APEC, for example, have proposed that all trade
24 These proposals are summarized in Lawrence, Regionalism, Multilateralism, and
Deeper Integration, pp. 95-104.

CRS-20
liberalization measures undertaken by member countries simply be extended on a most-
favored-nation basis to nonmembers. In this manner, APEC would avoid becoming a
preferential bloc like NAFTA or the European Union. Such an approach, however, may
be difficult to implement. It would mean that APEC members would extend
concessions on tariffs and nontariff barriers on a non-reciprocal basis — an approach
that governments have been reluctant to follow in past trade negotiations.
Another proposal is to establish new WTO rules of accession for regional
arrangements. Some economists have proposed that the WTO encourage members of
regional arrangements to allow any country willing to abide by the rules and
responsibilities of an arrangement to join it. This approach would require that any new
member reciprocate by reducing its trade barriers to the same level as existing members.
Opening a regional arrangement to any country would tend to reduce trade diversion,
since nonmembers could avoid discrimination against their exports simply by joining
the arrangement. Such a rule, however would also reduce the power of member
governments to regulate their trade. Many governments would be reluctant to accept
new WTO rules that would diminish their power to choose their free trade partners.
A Stronger Multilateral Trading System. In short, there are formidable
obstacles to implementing any of the proposed fundamental reforms of regional trade
agreements. It appears unlikely that member governments will reach a consensus on
proposals that strictly limit their ability to form new regional arrangements.
Some observers think that a more practical way of discouraging the formation of
discriminatory trading blocs is to strengthen the WTO’s surveillance of regional trade
agreements. In 1996, the WTO moved in this direction by creating a new Committee
on Regional Arrangements to review the operation of free trade agreements and
customs unions and to try to ensure that they are compatible with WTO rules. In its
first year of operation, the Committee began to review the 31 regional agreements that
had been reported to the WTO but not examined. Among the first to be reviewed were
NAFTA, the enlargement of the European Union, and the Southern Common Market
Agreement (MERCOSUR).
Many observers think that another way to discourage discriminatory agreements
to pursue multilateral trade liberalization more energetically. As multilateral agreements
reduce tariffs worldwide, for example, the margin between MFN rates and preferential
rates becomes smaller, thus reducing the value of preferential tariffs in free trade
agreements and customs unions. Moreover, if future WTO negotiations succeed in
reducing non-tariff barriers and resolving more effectively the new trade issues, the
development of hostile trade blocs may become less likely.