Whither the multilateral trading system?

Free trade seems to have few supporters these days. Though actual trade volumes are recovering from the post-crisis recession and drop in commodity prices, “globalisation” has become increasingly contentious, as exemplified by the election of US President Donald Trump on the back of a promise to rip up international agreements and get tough on trade partners. What does this mean for the future of the rules-based trading system?

Some 60 years ago, when the current rules-based global trading system was conceived, the United States was the world's sole economic “hyperpower”, possessing unquestioned dominance in the day's most advanced manufacturing industries. With enough power to impose rules, and enough dominance to be able to count on accruing the largest share of the benefits, it could — and did — perform the role of “benevolent hegemon.”

As Japan and Europe recovered from World War II — with the latter getting an added boost from economic integration — America’s lead began to dwindle, and by the 1970s and 1980s, the US was sharing power over the world's trade agenda with Europe. Nonetheless, because the US and Europe share so many common interests, they generally adhered to a cooperative approach.

It was not until imports began to overwhelm a growing number of industries in the US, fuelling the emergence of large and persistent external deficits, that the country’s trade policy became more defensive, creating friction with many of its partners. Yet, even then, US leaders understood the value of the liberal multilateral trading system, and supported the establishment, in 1995, of the World Trade Organization (WTO) as the successor to the General Agreement on Tariffs and Trade.

The WTO’s creation amounted to a major step forward, as it addressed not just tariffs, but also other trade barriers, including indirect barriers arising from domestic regulations. Given the complexity of assessing how domestic regulations might impede trade, especially compared to judging whether a tariff has been correctly applied, the WTO needed effective dispute-settlement mechanisms, with members agreeing to binding arbitration. The system worked, because its major members recognised the legitimacy of independent panels, even if they sometimes deliver politically inconvenient judgments.

Yet this recognition is now increasingly in doubt. Consider what type of economy would support a rules-based system. After World War II, the US supported such a system, because of its unassailable economic supremacy. An open rules-based system would also be highly appealing in a world comprising only small countries, none of which could hope to gain by relying on its relative economic power. Things become more complicated when the global economy includes a small number of economies of similar size, larger than the small economies from the previous example, but not large enough to dominate the system alone. That is the scenario Nobel laureate economist Paul Krugman considered in a 1989 paper on bilateralism, in which he reported that a world consisting of three major trading blocs constitutes the worst constellation for trade, as a lack of explicit cooperation among all three would lead to increasing trade barriers. Unfortunately, this is exactly the situation in which the global economy finds itself today. There are three dominant economies or trading blocs — China, the European Union (EU), and the US — with very similar trade volumes (exports plus imports) of around $4 trillion each. (Japan, which was a strong contender 25 years ago, now has a much smaller trade volume.) Together, the G3 (Group of 3) economies account for 40 per cent of world trade and 45 per cent of global gross domestic product (GDP).

With economic power distributed in this way, explicit cooperation by all three actors is crucial. Yet there are compelling reasons why they would be reticent to pursue such cooperation.

Even if Trump weren’t president, the current global trading system would present problems for the US, whose trade policy has long focused on manufactured goods. (Trade in raw materials has always been relatively free, and trade in agricultural goods has usually been considered special, and thus not subject to rules like the “most favoured nation” principle, which applies to manufactures.)

Because the US is now self-sufficient in energy, it needs to export fewer manufactured goods than industrialised countries with no domestic energy resources. Annual US exports of manufactured goods thus now amount to only about $1 trillion annually — significantly less than both the EU and China, which export almost twice as much in manufactured goods, despite having somewhat smaller economies.

To be sure, Trump is unlikely to start an outright trade war, because any US tariff would harm the interests of the country's largest companies, which have invested huge sums in production facilities abroad. Yet no individual firm will be willing to give up much of its political capital to defend the rulesbased system, either, because it would have to bear the losses, while its competitors shared the gains. The same goes for the G3 trading blocs: If the EU expends political capital to stop the US from undermining WTO mechanisms, China (and the rest of world) will reap most of the gains.

That dynamic goes some way toward explaining why China’s leaders, despite having proclaimed their support for the multilateral rules-based trading system, haven’t taken concrete action to reinforce it. Their reticence is probably intensified by the assumption that, within the current generation, their country will dominate the global economy; at that point, they might no longer want to be bound by somebody else’s rules.

It does not help matters that the Communist Party of China (CPC) has recently been empowered even further in all areas of the economy, with all major firms now having to accept a CPC representative on their board. It is difficult to see how a dominant economic power governed by a single party — especially one with such extensive control over the economy — would accept the primacy of international rules and procedures over domestic considerations.

The conclusion is clear. The world should prepare itself for the erosion of the rules-based trading system enshrined in the WTO.