How do Free Trade Agreements Affect the Domestic Economy? Evidence from the United States

November 7, 2016

Public opinion in many developed countries is clearly becoming more hostile to Free Trade Agreements. Nearly 3.5 million Europeans have now voted against both the Transatlantic Trade and Investment Partnership (TTIP) and the EU-Canada Comprehensive Economic and Trade Agreement (CETA). Protectionist policies are also on the rise. The use of protectionist measures in 2015 was up 50% on that seen in 2014, according to the Centre for Economic and Policy Research.

While it might be several years before the UK enters formal trade agreements with third countries, the protectionist retrenchment across the world still threatens to undermine the Government’s plans to reset its global trading relationships. It is very unlikely that Britain will be able to negotiate new FTAs without strong public support at home and abroad in favour of free trade.

The growing hostility to FTAs may lie in the fact that it is often easier to identify the losers than the winners from these deals. Most economists would share the view that bilateral FTAs are sub-optimal arrangements. They distort trade flows, and theoretically reduce consumer welfare by diverting trade through discrimination from the most efficient supplier (i.e. lowest cost) to the preferred trading partner. The EU’s Common External Tariff, for example, imposes tariffs on all goods imported from outside, artificially increasing the price of some goods made more cheaply in third countries.

An interesting study published recently by the United States Congressional Budget Office (CBO) casts light on some of these issues. The CBO study summarises the evidence on FTAs between America and its top 20 trading partners, assessing the direct and indirect impact on trade flows, productivity, employment, wages and consumer spending.

In short, the CBO study shows that these preferential deals have boosted trade by a small amount but had damaging consequences for the workers it has displaced. The impact on trade was small because of the relative size of the US in relation to other partners and because trade barriers were already low. Only NAFTA, the preferential trade deal between the US, Canada, and Mexico, has had a material impact on US trade activity.

FTAs have substantially hurt some US workers, particularly those in low skilled occupations or manufacturing. Workers displaced by FTAs often face a costly transition to a new job, and lower lifetime earnings as a result of the displacement. The increased competition from FTAs has also stifled wage growth in certain occupations and industries. One study cited suggests that NAFTA decreased the cumulative growth rate of wages of low skilled workers by 16 percentage points in the US textiles and plastics industries between 1990 and 2000, compared to workers with no decrease in tariff rates under NAFTA.

Assessing the impact of FTAs is not straightforward. It is difficult to isolate their effects from other factors that affect the performance of an economy such as relative prices, automation, and free trade more generally. Studies that directly attribute job losses to FTAs should therefore be treated with caution.

The impact of FTAs on the economy will also vary by country. FTAs have only had a small impact on overall trade activity in the US because it already has a very large internal market. For a relatively small country like Britain, FTAs will have much greater potential to improve productivity and output by significantly lowering the costs to business of accessing much bigger markets overseas.

Ultimately, the CBO study shows what we have always known – free trade is preferable in the long-run but produces losers in the short-term. Government has always had the unenviable task of trying to maintain their support for free trade despite the fact that a certain subsection of the population is being permanently displaced by it. The task for the new Government will be to ensure that its plans for an Industrial Strategy are properly targeted at alleviating the worst affects of free trade on vulnerable workers.

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