Why Abbott should dump FTAs

ScreenHunter_09 Oct. 08 07.36

By Leith van Onselen

So it’s official. As reported by Houses & Holes earlier this morning, the new Federal Government “has backed fast, practical trade deals with individual countries, including China, in an apparent shift away from the last government’s efforts to win comprehensive international agreements”.

The move towards so-called “free trade agreements” (FTAs) – essentially binding bilateral pacts between countries that provide preferential access to each other’s markets (e.g. lower tariffs) – aligns the new Government with the former Howard Government, which negotiated bilateral trade deals with Thailand, Singapore, and the United States in the early-to-mid 2000s.

While FTAs have the potential to provide some modest trade benefits, there are also a number of reasons to be wary of pursuing them on economic efficiency grounds.

First, an FTA with a trading partner that is not the lowest cost producer risks creating “trade diversion” – effectively a situation whereby the importing country shifts its buying from a more efficient, lower cost country whose goods are subject to a tariff towards the less efficient and higher cost FTA partner whose goods are not subject to a tariff. In such circumstances, the importing country loses the tariff revenue, whilst its consumers do not fully benefit from a price reduction, potentially making them worse-off.

In order to explain, consider the below stylised example.

Country A imposes a 10% tariff on motor vehicles and, prior to the FTA, imports these vehicles at a cost of $20,000 from the World, taking the total import cost to $22,000, and earning its government $2,000 per vehicle in tariff revenue.

Country A then negotiates an FTA with Country B, who is less efficient at producing motor vehicles, and can produce a virtually identical car for $21,500.

After the FTA is concluded, Country A shifts its car purchases from the World to Country B. As a result, the total import cost of motor vehicles into Country A falls to $21,500, providing consumers with a benefit of $500 ($22,000 less $21,500). However, the government loses $2,000 in tariff revenue, making Country A worse-off overall.

Obviously, this is simple stylised example only, designed merely to highlight one of the potential costs of FTAs via trade diversion. But these efficiency costs can be real, especially when FTAs are negotiated with parties that are not world’s best producers in goods and where high tariffs exist (e.g. clothing and footwear).

Another cost associated with FTAs is the complex rules of origin (ROO) that are typically attached to such agreements. ROOs are designed to stop imports coming from third party (non-FTA) countries via an FTA partner, in order to circumvent tariff requirements. The ROOs, which can be either based on value-added requirements (i.e. the percentage of value-added by the FTA partner) or product specific (i.e. individual rules for each individual product imported), can raise administrative costs for businesses (including complying with paperwork requirements) and custom services in administering and auditing the ROO, undermining the benefits from the FTA.

The costs associated with ROOs will be greatest where there is a large number of FTAs each with different requirements, resulting in a “spaghetti bowl effect” of increasing complexity.

Obviously, the first best option in trade policy is to seek trade liberalisation at the multilateral level, whereby all parties agree to drop trade barriers all at once. However, such liberalisation has proved time and again next to impossible, with successive multilateral trade negotiations collapsing during the 2000s.

With multilateral liberalisation off the agenda, this leaves bilateral liberalisation (as discussed above) or unilateral liberalisation. For mine, unilateral liberalisation is the second best option.

Most people wrongly view trade barriers, like tariffs, as merely a negotiating coin that can be traded-off in exchange for other nations dropping their trade barriers. However, such a view is misplaced – trade barriers impose real costs on the domestic economy, both to consumers in the form of higher prices and to productivity overall by reducing competitive pressures.

Reducing one’s own trade barriers, therefore, not only improves outcomes for consumers via lower prices, but also increases competitive pressures on domestic industry, helping to spur greater innovation and productivity in order to survive.

In my view, Australian trade policy and trade liberalisation needs to be viewed more in this light – as a form of domestic competition policy, rather than something that can be traded away for a bunch of questionable bilateral deals with spurious efficiency impacts.

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Unconventional Economist
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    • I agree. Realistically, we can never be “competitive” with countries that utilise child labour, prison labour, or lock their workers inside fire-trap factories, etc. Nor should we care to.

      I’m no Utopian – but if you take the big-picture view, the social stability that comes with assured minimum living standards, relative income equality (or perhaps I mean minimal stratification of income) and “fair play” ultimately benefits us all. People would be naïve, for instance, to think that the extent of gun-related violence in the US was all about the availability of firearms. Without safety nets and without hope, people do desperate things. Why shouldn’t they resent being treated as ‘disposable’?

      Frankly, even if some of our industries are ‘inefficient’ by some measures, if they keep people out of the dole queues and/or poverty, they are a success.

  1. Free trade agreements warrant considerable caution and very close examination of what forms part of the deal.

    A lot can be given up in exchange for crumbs especially when ideologues are driving the process and want to be seen to be doing something.

    As you point out – the easiest way to benefit from mercantalist practices of other countries is to buy their cheap goods.

    This goes beyond goods and services and includes capital. After all we eagerly buy the low cost savings habits of foreigners as much as we do their low cost TV’s and T-Shirts.

    The problem in both instances is that we are not producing enough stuff to support our purchasing habits and have to resort to selling our ‘silverware’ – capital assets like land, productive industries, non-renewable resources and claims upon our future income (especially those backed by the taxpayer).

    No need to add that the ‘strength’ of the $AUS reflects our enthusiasm for selling valuable silverware to strangers than our capacity to sustainably generate and create things they want to buy.

    Considering that our performance in developing a balanced economy that is less dependent on selling off ‘silverware’ is dismal not withstanding multiple free trade agreements suggests extreme caution is warranted.

    No surprise that one of the ‘issues’ for discussion with the Chinese is that they want the ‘free trade’ agreement to facilitate their purchase of our ‘silverware’.

    I doubt there will be much enthusiasm for serious Australian control of Chinese ‘silverware’ in any agreement reached. We get to sell them dirt and they get to buy our capital assets.

    Not entirely surprising that the Communist Chinese are much more astute when it comes to the control of capital.

    • +1
      Is anyone in Canberra not a free trade ideologue? Australia has even earned the moniker “Free Trade Taliban” at international gatherings. I would think that National Interest should be the guide in all international trade negotiations.

      One concern, amongst others, is the continual watering down of our once strict quarantine laws to accomodate free trade deals.

      BTW, Where is the transparency regarding this TPP? What little we know about it is decidedly on the nose.


  2. Its a funny thing these ‘free trade agreements’.

    If the governments of the world really wanted free trade, they could just make it so and stop interfering.

    Instead it ends up being a game of horse trading between two governments.

    Somehow, we see the U.S insert clauses relating to digital copyright enforcement into many trade agreements, so our ISPs and music providers have to follow the whim of American recording studios and labels.

    • Funny how when we sign a “free trade” agreement with another country, we have to enforce that country’s monopolies against our citizens for as long at that country enforces them against its own.

      In the case of copyright, the resulting extension of Australian copyrights on existing works would appear to be unconstitutional.

  3. My biggest problem with these bilateral FTA’s is that Australia seems to drop its pants every time, they give up something valuable but get nothing real in return.

    Take the US FTA: Can anyone name a single Aussie industry that was advantaged by this FTA. I mean really able to capitalize on an advantage that resulted from the FTA.

    This US FTA was even touted as a best mates only deal by Johnny and George yet the cash-flow seems fairly one directional, makes me wonder how lopsided the FTA’s will be when we are not getting “best mates only deals”.

    • + 100 try selling the Thais a Ford (50% tariff, Honda accord 0% imported)….or buying land….

  4. It’s a fair point but as they say, one shouldn’t let the perfect be the enemy of the good.

    Ideally, global FTAs would be the way to go BUT due to the inherent dysfunctionality of politics, certain key stakeholders seem unable to commit to this.

    Consequently, bilateral FTAs are the next best thing. It puts pressure on the recalcitrant governments to ante-up on the free trade game.

    Incidentally, 99% of the discussion on free trade is about what benefits are to be derived for our export industries. What always gets ignored is the benefits FTAs can bring for Australian consumers.

    For generations, poor Australian families have been forced into an ankle grab position by inefficient Australian companies, protected behind tariff walls thanks to cozy arrangements between business and politicians.

    Just compare the cost of buying textbooks for your kids in Australia vs buying the same books abroad. That’s just one example.

    I sympathize for people made unemployed by changing trade dynamics but as a father trying to provide for a family I also advocate that it is within my right to insist on lower prices for essential cost of living items. I don’t feel the obligation to pay a “rent” to support domestic workers in inefficient industries.

    • That’s a priceless reply, can you identify any benefit Aussie consumers derived from the US FTA? Higher drug prices? Support of bogus US drug “patent evergreening”? Denial of certain generic drugs? Not to mention the Digital rights stuff, not much Aussie consumer benefit to be found in any of those changes. Maybe books got a little cheaper but I’d suggest that was more a result of Amazon than any FTA.

    • “Consequently, bilateral FTAs are the next best thing. It puts pressure on the recalcitrant governments to ante-up on the free trade game.”

      Why even do that?

      You don’t need a free trade agreement to reduce tariffs and other limitations on imported goods.

      The world is full of countries eager to force their citizens to subsidise (low wages, child labour, financial repression, environmental degradation) the price of the exports of some of their industries.

      Providing the reasons some imports are cheap is not of a concern then the only issue for Australia is the extent to which we exercise some self control to:

      1. Limiting our consumption of imports to the amounts we export. (i.e don’t consume imports by selling assets)

      2. Ensure that we maintain some productive capacity as protection in case the supply of some or all of the imports was to cease for reasons outside our control (war, blockade etc) and we find that we need to be able to start making the import again locally.

      Given those limited considerations there is no reason for a mum in Blacktown to pay $20 for a childs T-shirt that could be imported and sold to her for $5.

      Don’t worry about FTAs – just remove tariffs on imported goods.

      Keep in mind that if a foreign country refuses to buy our exports without an FTA that implies that they are looking for some additional price discount or some other inducement to make the purchase.

      Otherwise why else would they want to do it?

      The US did very nicely out of our agreement to extend copyright protection on all their intellectual property.

      The real risk is that FTA’s limit the scope of domestic economic policy for generations.

      • Your 2 considerations are incompatible with zero tariffs. It would be a mercantilistic picnic with us as the main course. The path to serfdom.