Trade policy-makers' current concerns that the proliferation of regional trade agreements may undermine multilateral cooperation under the GATT contrasts sharply with the early experience of the European Community. In Discussion Paper No. 962, Kyle Bagwell and Robert Staiger account for this change in perception using a model of countries' engagement in multilateral cooperation in which they balance the current gains from unilateral deviation against the discounted expected future benefits they will forfeit in any ensuing trade war. The removal of internal tariffs under a free trade agreement causes trade diversion, while the formation of a customs union also involves the harmonization of the common external tariff and thus enhances its members' market power vis-à-vis non-members.

Bagwell and Staiger note that a regional agreement has a greater impact on expected future than on current conditions during the transition period of its negotiation and implementation. Trade diversion increases both multilateral tariffs and trade policy tensions, since members and non-members both know that the substantial volumes of their trade will soon fall, which increases their incentives to deviate unilaterally and tariffs between the two sets of countries must be raised accordingly. Bagwell and Staiger isolate the market power effect to show that this may temporarily reduce such tensions and lead to a `honeymoon' period, during which member countries' future market power is expected to increase so non-members are less likely to adopt a confrontational stance. This harmony will not be sustained, however, when a less favourable balance between current and expected future conditions eventually re-emerges.

Bagwell and Staiger offer two distinct explanations for the changing perception of the relationship between regional and multilateral trade cooperation: first, the recent wave of regionalism has emphasized the reduction of internal barriers rather than the harmonization of external trade policy, so the implementation of these agreements is increasing multilateral trade tensions; and second, the honeymoon period associated with the formation and subsequent enlargement of the original EC customs union has now passed.

Multilateral Tariff Cooperation During the Formation of Customs Unions
Kyle Bagwell and Robert W Staiger

Discussion Paper No. 962, July 1994 (IT)