The American Enterprise Institute presents ... Free Trade Foreign Policy; How Trade Myths Impede a key US Policy Tool.

Levy, Philip I.

For at least tour years, bilateral free trade agreements (FTAs) have been a battleground over which US trade skeptics and trade proponents have skirmished. While three such agreements--with South Korea, Colombia, and Panama--were condemned to a policy purgatory, the accord with Peru came into force in early 2009. That deal thus offers the best and most recent opportunity to separate the growing myths about FTAs from the more realistic benefits that such deals can offer to the United States. The Peru deal did not cast low-wage US workers into the streets, nor did it play any role in undermining the shaky global trading system. Instead, it helped solidify economic reforms that Peru had undertaken already, paved the way for Peru's formal integration into the world economy, drew investment into that country at a difficult time, and promised to cushion the blow when a one-time US antagonist ascended to the country's presidency. While Peru is not necessarily representative of all US FTA partners, these benefits are fairly common among developing countries, the most controversial partners. By projecting its economic insecurities onto these FTAs, the US polity has needlessly denied the country a vital foreign policy tool.

Part of the problem in discussing the impact of trade agreements on the United States is that discourse is dominated by an antiquated view of what a trade agreement does. In this conception, we imagine a pair of countries who hitherto have used tariffs and quotas to shield domestic industries from imports. The trade agreement promises to tear down these barriers and let low-cost goods flow-back and forth. As it has for centuries, this prospect of liberalization stokes fears: how can a high-wage economy compete with a low-wage one? Will this spur a race-to-the bottom for labor or environmental standards? Will we be rewarding the partner country for practices we find objectionable?

These are all fine questions, but the premise is badly flawed. The US economy is already broadly open to goods and services from other countries. That has been one of the secrets of our success. Furthermore, the US economy has been particularly open to exports from certain developing countries, whose prosperity we particularly care about. For example, the US government was eager to provide legitimate and viable market access to Peru as an alternative to the lucrative, but highly problematic, marker for narcotics. Thus, the United States adopted a set of trade preferences for Andean nations that reduced trade barriers below already-low levels. The upshot was that in 2006, the year the US-Peru Trade Promotion Agreement was signed, 98 percent of Peruvian exports to the United States entered without any tariff costs. This was years before any provisions of the new agreement came into effect, .so the trade agreement hardly constituted a closed door reluctantly swinging open.

Peru was not unique in this regard. Colombia has had access through the same programs. Panama and the countries in the contentious Central American Free Trade Agreement enjoyed similar access through the Caribbean Basin Initiative. This pervasive gap between perceived and actual liberalization of the US market through these FTAs resulted in a jarring disconnect between alarmist rhetoric and the more sober analysis of the non-partisan US International Trade Commission (ITC). The TIC is required to present Congress with an analysis of proposed trade agreements, including an estimate of their likely effects on the US economy. For the agreement with Peru, the ITC estimated that two US sectors would bear the brunt of the liberalization impact. Metals, not elsewhere classified, would see an employment drop of 0.16 percent; paddy (unprocessed) rice would see a fall of 0.12 percent. These were the only two sectors where employment drops were predicted to exceed 0.10 percent.

On balance, the ITC predicted that the Peru agreement would have a small, positive effect on the US economy. Whereas the United States was largely open to Peru ex ante, Peru had maintained higher barriers to protect its market. The ITC reported that more than half of Peru's import product lines featured tariff base rates between 11 and 20 percent. Thus, the agreement would work disproportionately In favor of US exporters. The ITC forecasts that US GDP would rise by just over US$2 billion (roughly 0.02 percent).

It may seem odd to be discussing ITC predictions almost three years after the agreement came into force. Can't we just look to see what happened? We can. From 2005--the last full year before the agreement was signed--to 2001 --the last full year for which we have data--Peru's exports to the United States fell from US$5.12 billion to $5.07 billion. Over the same period, US exports to Peru rose from US$2.31 billion to $6.75 billion. This proves nothing conclusively, however, as the five year stretch was a tumultuous time in global markets and trade figures swung wildly from year to year. The ITC predictions for employment effects in the United States look trivially small compared to the economic shocks that buffeted the economy. There is no good way to disentangle them.

[ILLUSTRATION OMITTED]

It is suggestive that US exports rose by more than US$4 billion. This contrasts with an ITC prediction of a US$1.1 billion increase, but that level only when Peru fully implements all its commitments under the agreement, a process that will take years. This is not an indicator of sloppiness on the part of the ITC, but rather a sign that much of the benefits of PTAs lie in areas other than the easier-to-estimate world of tariffs and quotas.

As a final note on the economic impact of the Peru FTA, the unexpected US export burst of US$4 billion should be put in context. In 2010, US exports of goods and services were US$1,838 trillion, of which the additional shipments to Peru constituted 0.2 percent. As with many of the United States' most hotly argued agreements--those with developing countries--the partner countries are small. While the benefits are real, they will not have a dramatic direct impact on the country's pressing employment problems.

While the employment implications tend to dominate political debates about free trade agreements, they are not the only objections lodged. Strong advocates of open trade express concern that that bilateral or plurilateral free trade agreements may undercut support for an already enfeebled multilateral trading system. The most trenchant proponent of this view has been Jagdish Bhagwati of Columbia University, who has characterized preferential trade agreements as "termites in the trading system."

There are at least two dimensions in which FTAs such as the one between the United States and Peru might undercut the gains promised by global trade liberalization. First, while there arc strong arguments for economic efficiency gains from liberalizing all trade, these arguments are weaker when applied to preferential agreements--those that include some trading countries but exclude others. Decades ago, the economist Jacob Viner wrote of trade creation and trade diversion. The latter of these is unique to preferential trade agreements. The concern is that the United States might buy a product from Peru (or vice versa) because of a preferential, low tariff rate, not because Peru is truly the low-cost producer The second possible obstacle that these agreements might pose to the multilateral system is that they could sap the limited vigor a country might have for liberalizing trade. The worry-would be that, after signing an agreement with the United States, Peru might be sated and either fail to pursue further agreements or actively oppose a multilateral accord that might threaten to undercut its preferential access.

In practice, neither of these fears was born out by the experience of the US-Peru FTA. The United States had signed multiple tree trade agreements before concluding the one with Peru and maintained low multilateral tariffs, thereby reducing the potential costs of trade diversion. Peru followed tip its FTA with the United States by pursuing and completing a torrent of bilateral free trade agreements with countries including Canada, China, and the European Union. That hardly seems to indicate a desire to exclude anyone. It is true that this occurred at a troubled time for the World Trade Organization, but there are other readily identifiable obstacles to a successful conclusion of the decade-old global round of trade talks.

Peruvian officials, who were involved in negotiating the agreement with the United States and subsequent agreements, argued that the US accord made ensuing ones substantially easier to conclude. The rapidity with which other agreements were reached seems to substantiate this claim. This alone suggests the need for a major reconsideration of our perception of free trade agreements. If free trade agreements were primarily concerned with elimination of border barriers, there is no reason why an FTA between Peru and the United States should facilitate an FFA between Peru and China. Tariff and quota negotiations deal with questions of how one country's sensitive import-competing industries match up against the partner country's successful exporting industries. Since the United States and China have distinctly different successful exporting industries, the concessions made in one negotiation would have little bearing on the other.

In fact, though, tariffs and quotas constitute only one part of modern trade agreements. Other chapters of the US agreement with Peru dealt with matters such as investment restrictions, dispute resolution, intellectual property protection, and regulatory barriers to trade. These describe general economic practices that can readily be ported from one agreement to the next. Peru's rapid and successful pursuit of a series of FTAs suggests that these rules governing the country's economic behavior and the rights of foreigners in commercial transactions play a much more significant role than is commonly believed.

Setting aside the concerns of US trade critics and enthusiasts for a moment, one might well ask what Peru sought in pursuing an FTA with the United States. It already had almost complete duty-tree access to the United States, which suggests it had other objectives in mind. In interviews with Peruvian officials, two broad goals stood out: a desire to attract investment to the country, and an effort to lock in place economic and governance reforms that the country had recently undertaken. The two are linked, of course. When foreign investors consider the possibility of putting money into Peru, a major consideration is their expectation of the investment climate over the years to come.

It was in this context that Peruvian officials cared about access to the US market and tariffs and quotas that might obstruct it. While Peru enjoyed broadly free access under US preference programs, those preference programs were looking increasingly tenuous. Programs that initially featured long-term commitments of US market access were getting shorter and shorter in duration. When the renewal durations shortened below the length of time it would take the average investment in Peru to pay off, the constancy of access to the US market became a concern for foreign investors. Peruvian officials feared that one day political wrangling in the US Congress could result in the expiration of the preferences, at least temporarily. In fact, this is exactly what happened earlier this year during a standoff between President Barack Obama and Congress. As an FTA partner, Peru was shielded from the effects. As a supplicant, Colombia was not.

More important, perhaps, was the need to persuade foreign investors of Peru's commitment to economic reforms and fair treatment. Investors who conducted even a cursory review of Peru's economic history might have had reason to doubt. In the 1980s, Peru suffered from hyperinflation, high poverty rates, and terror attacks. In that period, Peruvian tariffs ranged from 15 percent to 84 percent, with an average level of 46.5 percent. In 1990, Peruvian inflation peaked at 7,650 percent. The President of Peru, during this most tumultuous period, 1985-1990, was Alan Garcia. In the 2006 presidential election, as the FTA with the United States was concluding, the former President Garcia faced off against Ollanta Humala, a populist who emphasized economic redistribution.

In the intervening years, Peru had adopted an impressive series of economic reforms, lowering trade barriers and attaining economic stability. But how could a forward-looking investor be persuaded that these reforms were durable? Given Peru's history of dramatic swings in economic policy and the troubling resumes of the leading candidates for Peru's presidency, what could convince foreigners that this tune was different?

[GRAPHIC OMITTED]

That was the principal role the FTA with the United States and the agreements around the world that followed was intended to play. The agreement commits Peru to numerous obligations regarding its investment climate. In its analysis of the agreement, the ITC described the investment chapter as requiring "a secure, predictable legal framework and an investor-state dispute settlement process." The transparency' chapter "requires that each party make publicly available all laws, regulations, and procedures regarding any and all matters covered by the agreement" and provides for anticorruption provisions with criminal prosecution and penalties for bribery and corruption. Foreign investors have access to a dispute settlement process that provides a comforting alternative to Peru's dubious legal system.

It is difficult to know when the "signaling" effect of such moves on investment should be expected to kick in. Should it be when the agreement is first discussed? Officially launched (2004)? Passed by the Peruvian Congress (2006)? Implemented (2009)? Whichever starting point one chooses. World Bank data shows that foreign direct investment in Peru grew rapidly, from US$1.3 billion in 2003, to $1.6 billion in 2004, to $3.5 billion in 2006, to $6.9 billion in 2008, before dropping to $4.8 billion amidst the global financial crisis in 2009.

Peruvian officials describing their hopes for the FTA in the spring of 2009 portrayed it as the linchpin of Peru's economic aspirations. They frequently suggested that the best measure of the agreement's ultimate success would not be a limited metric such as Peru's exports or inward foreign investment, but rather Peru's rate of economic growth or its success in reducing poverty. Many factors could drive such broad indicators, of course, but the effect of Peru's FTAs was expected to be sufficiently robust and broad that these would be fair measures. The effects, it was hoped, would extend beyond the relatively narrow realm of international commerce and help foster the rule of law in Peru.

From a US perspective, how could one assess the efficacy of the US-Peru FTA? The verdict should be closely tied to realistic ex ante expectations about what the agreement might do. There was never any reason to think that an FTA with a country as small as Peru would have a dramatic impact on the US employment situation nor on the country's trade balance, though exports did increase dramatically and the economically-meaningless bilateral trade balance shifted from a US deficit to a surplus. While all indications are that the US economy has enjoyed modest gains from this particular FTA, the real benefits come from a stable and prosperous ally. According to the World Bank, Peru's GDP grew by 0.9 percent in 2009, while much of the rest of the world's economies were shrinking. It enjoyed 8.8 percent growth in 2010. President Garcia, who returned to power in 2006, remained committed to economic reforms. Perhaps the truest test of the FTA's impact is yet to come, however. In June 2011, Ollanta Humala won election as Peru's president. In a Washington Post interview before taking office this summer, the President-elect was asked why businessmen should believe he would now be friendly toward business, given his earlier threats. He replied that" ... Peru has changed. It is no longer the Peru of 2005. It is the Peru of 2011, and it is different from when I campaigned in 2005. Obviously, we politicians have to adapt to these changes ... In 2005, we didn't have free-trade agreements. Now we have more than 15 free-trade agreements ... " It remains to be seen how President Humala governs, but this was exactly the response for which FTAs staunchest advocates might have hoped.

The experience suggests the need for a reassessment of where FTAs fit in die US economic arsenal. The vociferous debates about adopting pending FTAs with Panama and Colombia have been badly misguided. Nor does this bode well for looming discussions about developing countries such as Vietnam in the Trans-Pacific Partnership free trade discussions. While the elimination of border barriers may have a more noticeable impact on production and employment when it occurs with another developed nation, such as S. Korea, these effects will be relatively minor with economically smaller developing nations. That simultaneously means that fears of low-wage partners spurring a race to the bottom and expectations of a significant revival in US job creation are both likely overblown in the context of smaller, poorer FTA partners. The United States economy is already too big and too open for the marginal changes in border barriers to make much difference.

[ILLUSTRATION OMITTED]

The more dramatic effect should be in facilitating the entry of allied nations into a rules-based global trading system. Ideally, this would take place in a multilateral setting, such as the WTO, but that institution has been troubled both by difficulties reaching a new trade deal and by a history of asking very little of developing country-participants. If a developing country wishes to overcome a shaky history of economic malfeasance and commit itself to sound economic policy to persuade foreigners to invest, high-standards FTAs look like one of the few-tools available. This is even more true when it comes to broader questions of governance. While there is growing recognition in the academic literature of the importance of good governance for economic success, there are disappointingly few policy levers to be pulled that might do this. It is not the sort of thing that can be readily achieved through millions of dollars in foreign assistance spending. Even if there is a will to improve on the part of the developing nation, it could take many years to reap a payoff without some means of making that commitment firm, since investor expectations only shift after years of positive experience.

In this context, the beneficial aspects of US FFA.S with developing nations are even more striking: the United States gains market access, bonds of friendship are tightened, partner countries become active participants in bolstering the global trading system, and those countries have a rare means by which to commit to sound policies. The success of US FTAs with developing nations should be cause for celebration, if only we could strip away the dogma and misperception that have tainted the debates over trade agreements for a decade or more.