Trade wars and trade laws

The World Trade Organization (WTO) headquarters are pictured in Geneva, Switzerland, July 26, 2018.  REUTERS/Denis Balibouse - RC12C132FFE0

Trade policy has recently been rediscovered as a foreign policy instrument that can, at least in theory, deliver non-trade results. Tariffs and sanctions are increasingly being used to preempt nuclear armament, prevent weapons acquisition, and curb migration, internationally. Although the idea is not original—previously, globally-minded proposals suggested using tariff threats to promote better environmental and labor standards everywhere—the underlying nationalistic motive is in stark contrast with globalism. Can such unilateral tariffs and sanctions provide an endless source of enforcement power at a time of backsliding globalization?

For starters, international trade does not take place on an even playing field. If cross-border trade were a battlefield, large and advanced economies such as the U.S. and Europe would be Goliaths. With hefty purchasing power, they would have a greater ability to set the rules of the game to their liking. Small and poor economies are, however, no Davids. Selling few basic goods under cut-throat competition, and with trivial purchasing power, they would not be able to shape the conditions for cross-border trade.

Luckily, the modern trading system is not exactly a primeval battlefield. Bloody trade wars have frequently been avoided, and disagreements mediated through the dispute settlement mechanism of the World Trade Organization (WTO). Trade “crimes” are “punished,” but this takes place within a rule-based framework. For instance, when facing unfair trade barriers, countries can retaliate but only in a specific form: a similar barrier in a similar area, i.e., an eye for an eye. These are formulated by the Understanding on Rules and Procedures Governing the Settlement of Disputes (DSU) Article 22.3 (limited cross‐retaliation rule) and the General Agreement on Tariffs and Trade (GATT) Article XXVIII (limited punishment rule).

In practice, these laws protect the weak from being crushed by Goliaths, but they are by no means egalitarian. For small and poor economies, retaliation with such restrictions is daunting. As opposed to advanced economies who export and import a wide range of goods and services, small and poor countries often export basic products and import essential items like medicine and machinery. As a result, they often cannot afford to retaliate even when they are authorized to do so.

These laws also prevent small and poor countries from using the only “slingshots” they have: retaliating in one area where it counts, i.e., intellectual property rights (IPRs). This practice is strictly discouraged by the WTO’s “limited cross-retaliation” rule: If your banana is sent back unfairly, you cannot retaliate by copy-distributing Disney movies without licenses. Thus, although trade laws are binding for all participants, they bind more for small and poor economies. To quote Anatole France, “in its majestic equality, the law forbids rich and poor alike to sleep under bridges, beg in the streets and steal loaves of bread.”

Essentially, whereas the “limited punishment” rule dismisses disproportionate punishments, the “limited cross-retaliation” rule prohibits carrying enforcement power from one area to another. Thus, exposing the original motivation behind these rules can also shed light on the possible limitations of using tariffs and sanctions in foreign policy, an increasingly popular practice followed not by the poor, but by the rich.

In a recent study, Richard Chisik and I did just this. It turns out that the “limited cross-retaliation” and “limited punishment” rules help boost trade policy cooperation globally. Specifically:

  • Harsher punishments are not always more effective. Harsh punishments can increase crime in an unexpected way. If small crimes were to be punished by a death sentence, criminals may also shoot people. Likewise, if any breach of trade agreements can trigger maximum punishments, then those who breach the agreement would do so in an excessive manner. By linking the degree of punishment to the degree of crime, trade laws ensure that future changes in markets do not lead to a total collapse of the trading system.
  • Punishments may bite less when applied in different areas. When policy actions offset each other’s effectiveness (i.e., strategic substitutes), the punisher chooses to retaliate in a different area as it is less harmful to itself. But this also reduces the punishment for the cheater. For instance, emissions of both carbon dioxide (CO2) and sulfur dioxide (SO2) have increasingly damaging effects for everyone (global warming and ozone depletion, respectively). Thus, when one country increases emissions in one gas (cheating on a hypothetical agreement), then the other one would prefer to retaliate by increasing its emission of the other gas. Otherwise, the punishment would be too costly for the punisher as well.
  • When different issues are linked, cooperation may dissolve altogether. As all countries understand that punishment would be less biting, enforcing cooperation may not be possible at the outset in a world of linked issues.

These results clearly point to the risks associated with using trade policy instruments to solve non-trade problems. The enforcement power that is transferred from trade cooperation to other areas is not a free resource. As the leakage of enforcement away from trade cooperation grows, a large-scale dissolution of international cooperation will become more likely. How much slack enforcement will there be before such an avoidable cataclysm happens?