Order Code RL31356

Free Trade Agreements: Impact on U.S. Trade

and Implications for U.S. Trade Policy

Updated November 1, 2007

William H. Cooper
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division
 Free Trade Agreements: Impact on U.S. Trade and
Implications for U.S. Trade Policy

Summary
Free trade areas (FTAs) are arrangements among two or more countries under
which they agree to eliminate tariffs and nontariff barriers on trade in goods among
themselves. However, each country maintains its own policies, including tariffs, on
trade outside the region.

In the last few years, the United States has engaged or has proposed to engage
in negotiations to establish bilateral and regional free trade arrangements with a
number of trading partners. Such arrangements are not new in U.S. trade policy.
The United States has had a free trade arrangement with Israel since 1985 and with
Canada since 1989, which was expanded to include Mexico and became the North
American Free Trade Agreement (NAFTA) effective in January 1994.

U.S. interest in bilateral and regional free trade arrangements has surged and the
Bush Administration has accelerated the pace of negotiations since the enactment of
the Trade Promotion Authority in August 2002. These efforts are of direct interest
to the 110th Congress. U.S. participation in free trade agreements can occur only with
the concurrence of the Congress. In addition, FTAs will affect the U.S. economy,
with the impact varying across sectors. The House is expected to consider the
implementing legislation (H.R. 3688) for the U.S.-Peru FTA during the week of
November 5, 2007.

After several months of discussions, congressional leaders and the Bush

Administration announced an agreement on May 10, 2007, on policy priorities that
are to be included in pending FTAs. These priorities included the enforcement of
five core labor standards that are part of the International Labor Organization’s
Declaration on Fundamental Principles and Rights of Work, commitment to enforce
seven multilateral environmental agreements to which FTA partners are parties, the
availability affordable generic pharmaceuticals, port security, and foreign investor
rights in investor-state disputes.

FTAs raise some important policy issues for the 110th Congress as it considers
implementing legislation and monitors negotiations as part of its oversight
responsibilities: Do FTAs serve or impede U.S. long-term national interests and
trade policy objectives? Which type of an FTA arrangement meets U.S. national
interests? What should U.S. criteria be in choosing FTA partners? Are FTAs a
substitute for or a complement to U.S. commitments and interests in promoting a
multilateral trading system via the World Trade Organization (WTO)? TPA expired
as of July 1, 2007. What effect will that have on the future of FTAs as a trade policy
strategy? This report will be updated as events warrant.
Contents

What Are Free Trade Areas? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

Why Countries Form FTAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

FTAs in the Context of U.S. Trade Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Bush Administration Policy and Recent Developments . . . . . . . . . . . . . . . . . . . . 5

Economic Impact of FTAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

FTAs and the WTO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

The Debate Over FTAs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

Conclusions and Implications for Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

List of Tables
Table 1. U.S. Free Trade Agreements . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
 Free Trade Agreements: Impact on U.S.
Trade and Implications for U.S. Trade Policy

In the last few years, the United States has considered bilateral and regional free
trade areas (FTAs) with a number of trading partners. Such arrangements are not
new in U.S. trade policy. The United States has had a free trade arrangement with
Israel since 1985 and with Canada since 1989. The latter was suspended when the
North American Free Trade Agreement (NAFTA) that included the United States,
Canada, and Mexico, went into effect in January 1994.

Perhaps encouraged by the passage and enactment of legislation granting the

President trade promotion authority (TPA), as contained in the Trade Act of 2002
(P.L. 107-210 — signed into law on August 6, 2002), the Bush Administration
moved ahead with a trade agenda that contains an unprecedented number of FTAs.
These efforts are important to Congress. United States participation in free trade
agreements can occur only with the legislative concurrence of the Congress. In
addition, FTAs will affect the U.S. economy, with the impact varying across sectors.
The House is expected to consider the implementing legislation (H.R. 3688) for the
U.S-Peru FTA during the week of November 5, 2007.

After several months of discussions, congressional leaders and the Bush

Administration announced an agreement on May 10, 2007, on policy priorities that
are to be included in pending FTAs. These priorities included the enforcement of
five core labor standards that are part of the International Labor Organization’s
Declaration on Fundamental Principles and Rights of Work, commitment to enforce
seven multilateral environmental agreements to which FTA partners are parties, the
availability affordable generic pharmaceuticals, port security, and foreign investor
rights in investor-state disputes.

The 110th Congress could be asked to consider legislation to implement FTAs

with Colombia, Peru, and Panama and possibly with South Korea and Malaysia. In
considering these bills, Members will likely consider the merits of each agreement
separately. But the emergence of FTAs raises some more general policy issues for
the 110th Congress to consider: Do FTAs serve or impede U.S. long term national
interests and trade policy objectives? What criteria should be used in choosing FTA
partners? Which type of FTA meets U.S. national interests? Are FTAs a substitute
or a complement to U.S. commitments and interests in promoting a multilateral
trading system via the World Trade Organization (WTO)? TPA expired as of July
1, 2007. What effect will that have on the future of FTAs as a trade policy strategy?

This report will monitor pending and possible proposals for U.S. FTAs, relevant
legislation and other congressional interest in U.S. FTAs. The report will be revised
as events warrant.
 CRS-2

What Are Free Trade Areas?

Free trade areas are part of the broad category of trade arrangements under
which member-countries grant one another preferential treatment in trade.
Preferential trade arrangements include the following:

! free trade areas (FTAs) under which member countries agree to

eliminate tariffs and nontariff barriers on trade in goods within the
FTA, but each country maintains its own trade policies, including
tariffs on trade outside the region;

! customs unions in which members conduct free trade among

themselves and maintain common tariffs and other trade policies
outside the arrangement;

! common markets in which member countries go beyond a customs

union by eliminating barriers to labor and capital flows across
national borders within the market; and

! economic unions where members merge their economies even

further by establishing a common currency, and therefore a unified
monetary policy, along with other common economic institutions.
The European Union is the most significant example of a group of
countries that has gone from a customs union to an economic union.1

The process of forming an FTA usually begins with discussions between trading
partners to ascertain the feasibility of forming an FTA. If they agree to go forward,
then the countries undertake negotiations on what the FTA would look like. At a
minimum, participants in an FTA agree to eliminate tariffs and some other nontariff
trade barriers and agree to do so over a specific time period. In addition, the partner
countries usually agree on rules of origin, that is a definition of what constitutes a
product manufactured within the FTA and therefore is eligible to receive duty-free
and other preferential trade treatment. Rules of origin prevent products from
nonmembers entering an FTA market over the lowest tariff wall. Most FTAs also
include procedures on the settlement of disputes arising among members and rules
on the implementation of border controls, such as product safety certification and
sanitary and phytosanitary requirements. Most recent FTAs contain rules on
economic activities besides trade in goods, including foreign investment, intellectual
property rights protection, treatment of labor and environment, and trade in services.

1
Besides the arrangements described above under which member countries extend
reciprocal preferential treatment, there are trade arrangements under which one party agrees
to extend nonreciprocal preferential treatment to the imports of a country or group of
countries unilaterally. Such arrangements involve primarily developed countries extending
nonreciprocal preferential treatment to the imports from developing countries. For example,
the United States employs the Generalized System of Preferences (GSP), the Andean Trade
Preferences Act (ATPA), the Carribean Basin Initiative (CBI), and the Africa Growth and
Opportunity Act (AGOA). The main objective of these nonreciprocal arrangements is to
encourage economic development in developing countries.
 CRS-3

The size and complexity of the FTA will largely reflect the size and complexity of
the economic relations. U.S. FTAs with Israel and Jordan are relatively basic, while
the NAFTA is very complex.

Why Countries Form FTAs

Countries form free trade areas for a number of economic and political reasons.
Most basically, by eliminating tariffs and some nontariff barriers, FTAs permit the
products of FTA partners easier access to one another’s markets. The 1989 FTA
between the United States and Canada was arguably formed for this purpose.
Developed countries have also formed FTAs with developing countries to encourage
them toward trade and investment liberalization.

FTAs may be used to protect local exporters from losing out to foreign
companies that might receive preferential treatment under other FTAs. For example,
some supporters of a U.S.-Chile FTA argued that U.S. firms are at a disadvantage
vis-a-vis their Canadian competitors whose exports face no Chilean tariffs under the
Canada-Chile FTA. Slow progress in multilateral negotiations has been another
impetus for FTAs. For example, when the 1986-1994 Uruguay Round negotiations
got bogged down, the impetus for the United States, Mexico, and Canada to form
NAFTA seemed to increase. Arguably the surge in FTA formation worldwide in the
past few years has been a result of the difficulties encountered in launching and
implementing the Dona Development Agenda round of negotiations in the WTO.

Political considerations are also a motivation to form FTAs. The United States
formed FTAs with Israel and with Jordan to reaffirm American support of those
countries and to strengthen relations with them.

FTAs in the Context of U.S. Trade Policy

Post-World War II trade policy under various presidential administrations has
had several interrelated objectives. One has been to secure open markets for U.S.
exports. A second has been to protect domestic producers from foreign unfair trade
practices and from rapid surges in fairly traded imports. A third has been to control
trade for foreign policy and national security reasons. A fourth objective has been
to help foster global trade to promote world economic growth.

In fulfilling these objectives, U.S. political leaders have formed and conducted
trade policy along three tracks. One track has been the use of multilateral
negotiations to establish and develop a rules-based trading system. The United States
was a major player in the development and signing of the General Agreement on
Tariffs and Trade (GATT) in 1947. It was a leader in eight rounds of negotiations
that have expanded the coverage of GATT and that led to the establishment in 1995
of the World Trade Organization (WTO), the body that administers the GATT and
other multilateral trade agreements. The United States has continued this approach
by leading the effort in launching another round at the November 2001 WTO
Ministerial in Doha, Qatar.
 CRS-4

U.S. policymakers have used a second track which can be labeled the
“unilateral” track. Unlike traditional negotiations where partners make balancing
concessions, under this approach, the United States used threats of retaliation, usually
in the form of restricting trade partners’ access to the vast U.S. market, in order to get
the partner to open its markets to U.S. exports or to cease other offensive commercial
practices and policies. The United States has employed this approach primarily
against foreign practices not covered by GATT/WTO rules or because the
multilateral dispute settlement process proved too slow and ineffective to meet U.S.
needs. For several decades, especially in the 1970s and 1980s, the United States
conducted its trade policy with Japan “unilaterally” to get Japan to amend domestic
laws, regulations and practices that prevented U.S. exporters from securing what they
considered to be a fair share of the Japanese market.

More and more, however, U.S. trade policy is becoming dominated by a third
track — bilateral and regional negotiations to establish FTAs. The United States
completed its first FTA with Israel in 1985 under President Reagan. It completed its
second with Canada under President Bush in 1989, whose Administration was
involved in the process of expanding it to Mexico, a process that was completed by
the Clinton Administration in 1993. However, even after the completion of NAFTA,
it was still unclear whether bilateral and regional FTAs had become a fixture in U.S.
foreign trade policymaking or anomalies to cement already strong economic
relationships.

By 1994 it seemed apparent that FTAs were becoming a fixture when the United
States, under the Clinton Administration, led a group of trade ministers from 33 other
Western Hemispheric countries in agreeing to work toward establishing a Free Trade
Area of the Americas (FTAA) by 2005. In the same year, political leaders from the
United States and other member-countries of the Asian-Pacific Economic
Cooperation (APEC) forum signed a declaration in Bogor, Indonesia, to work toward
free trade and investment in the region by 2010 for developed countries and by 2020
for all member-countries. Both of those efforts have flagged.

The pursuit of FTAs continued when, on June 6, 2000, President Clinton and
Jordanian King Abdullah announced that their two countries would begin
negotiations on establishing a free trade area. An agreement was quickly reached and
was signed on October 24, 2001. Similarly, President Clinton and Singapore Prime
Minister Goh Chok Tong announced, somewhat unexpectedly, on November 16,
2000, that their two nations would launch negotiations to complete a free trade
agreement. And on December 6, 2000, the United States and Chile started
negotiations to establish an FTA. Chile had long been mentioned as a potential
addition to NAFTA or as a partner in a stand-alone FTA.

In the meantime, many countries, including the other major trading powers,
were actively negotiating free trade agreements. The WTO has reported that since
1995 it has received notification of more than 130 FTAs, roughly more than double
the number that was reported to the GATT from 1947 to 1995. For example, Canada
formed an FTA with Chile as did Mexico. The EU has formed FTAs with a number
of countries. Japan, which had shunned the use of FTAs, recently completed
negotiations with Singapore and is exploring the possibility of forming an FTA with
Korea, although those negotiations have been suspended.
 CRS-5

Bush Administration Policy and

Recent Developments
The Bush Administration has affirmed the strategy of pursuing U.S. trade policy
goals through the multilateral trade system but is giving strong emphasis to building
bilateral and regional trade ties through free trade agreements. Lamenting that the
United States was involved in only two FTAs while most of its major trading partners
were negotiating many more, then-USTR Robert Zoellick stated early in the
Administration:

America’s absence from the proliferation of trade accords hurts our exporters...
If other countries go ahead with free trade agreements and the United States does
not, we must blame ourselves. We have to get back into the game and take the
lead. We are certainly in a position to do so. Indeed, the United States will be
pursuing a number of regional free trade agreements in the years ahead, though
not to the exclusion of global talks and the WTO process. The fact that the
United States can move on multiple fronts increases our leverage in the global
round, just as the Clinton Administration used the North American Free Trade
Agreement and the APEC summit to help squeeze the European Union to
complete the Uruguay Round of GATT.2

Zoellick also stated, “By moving on multiple fronts, [the United States] can create
a competition in liberalization (italics added) that will increase U.S. leverage and
promote open markets in our hemisphere and around the world.”3

The Bush Administration continued negotiations that the Clinton Administration

initiated. At the end of 2002, the Bush Administration completed FTA negotiations
with Chile and Singapore first begun by the Clinton Administration in 2000. The
FTAs with Chile and Singapore entered into force on January 1, 2004.

Perhaps encouraged by the passage and enactment of legislation granting the

President trade promotion authority (TPA), as contained in the Trade Act of 2002
(P.L. 107-210 — signed into law on August 6, 2002), the Bush Administration has
moved ahead with a trade agenda that contains an unprecedented number of FTAs.
In 2004, agreements with Australia and Morocco were signed, approved by the
Congress. The agreement with Australia entered into force on January 1, 2005 and
the one with Morocco on January 1, 2006. An agreement with Central American
countries and one with the Dominican Republic were also signed and combined into
one agreement, the DR-CAFTA. The President sent Congress draft implementing
legislation on June 23, 2005. The House and Senate passed the legislation (H.R.
3045) on July 27 and 28, 2005, respectively, and President Bush signed it into law
on August 2, 2005 (P.L. 109-182). The agreement with El Salvador entered into

2
Office of the United States Trade Representative. 2001 Trade Policy Agenda and 2000
Annual Report. Washington. 2001. p. 4.
3
Statement of the Honorable Robert B. Zoellick, United States Trade Representative.
Testimony Before the Subcommittee on Trade of the House Committee on Ways and
Means. Hearing on Summit of the Americas and Prospects for Free Trade in the
Hemisphere. May 8, 2001.
 CRS-6

force on March 1, 2006, with Honduras and Nicaragua on April 1, 2006, with
Guatemala on July 1, 2006 and with the Dominican Republic on March 1, 2007.
Ratification by Costa Rica is still pending.

An agreement with Bahrain was signed on September 14, 2004, for which
Congress passed and the President signed implementing legislation (H.R. 4340/P.L.
109-169, January 11, 2006). The agreement entered into force on August 1, 2006.
The Congress passed and the President signed implementing legislation (P.L. 109-
283) for an FTA with Oman, which will enter into force pending ratification by
Oman. The United States has signed FTAs with Colombia, Peru, Panama and South
Korea. (See Table 1.)

After several months of negotiations, congressional leaders and the Bush

Administration reached an agreement announced an agreement on new policy
priorities that are to be included in pending FTAs. These priorities included the
enforcement of five core labor standards that are part of the International Labor
Organization’s Declaration on Fundamental Principles and Rights of Work,
commitment to enforce seven multilateral environmental agreements to which FTA
partners are parties; the availability affordable generic pharmaceuticals, port security,
and foreign investor rights in investor-state disputes.
 CRS-7

Table 1. U.S. Free Trade Agreements

FTAs in Force
U.S.-Israel FTA Implemented by P.L. 99-47 (June 11, 1985)
Entered into force September 1, 1985.
U.S.-Canada FTA Implemented by P.L. 100-449 (September 28,
1988). Entered into force January 1, 1989.
Suspended with implementation of NAFTA.
North American Free Trade Agreement Implemented by P.L. 103-182 (December 8,
(NAFTA) 1993). Entered into force January 1, 1994.
U.S.-Jordan FTA Implemented by P.L. 107-43 (September 28,
2001. Entered into force December 17, 2001.
U.S.-Singapore FTA Implemented by P.L. 108-78 (September 3,
2003) Entered into force January 1, 2004.
U.S.-Chile FTA Implemented by P.L. 108-77, (September 3,
2003). Entered into force January 1, 2004.
U.S.-Australia FTA Implemented by P.L. 108-286 (August 3,
2004). Entered into force on January 1, 2005.
U.S.-Morocco FTA Implemented by P.L. 108-302, August 17,
2004. Entered into force on January 1, 2006.
U.S.-Bahrain FTA President signed into law January 11, 2006
(P.L. 109-169). Entered into force August 1,
2006
U.S.-Dominican Republic- Central President signed implementing bill (H.R.
American FTA (DR-CAFTA) 3045) on August 2, 2005 (P.L. 109-53).
Entered into force with El Salvador (March 1,
2006), Honduras and Nicaragua (April 1,
2006, Guatemala (July 1, 2006), and the
Dominican Republic (March 1, 2007).
Implementation with Costa Rica pending.
FTAs Under Negotiation or Completed
U.S.-Andean nations FTA Agreement with Peru signed April 12, 2006.
House to consider implementing bill (H.R.
3688) the week of November 5, 2007.
Agreement signed with Colombia on
November 22, 2006. Negotiations with
Bolivia and Ecuador are dormant.
U.S.-Oman FTA President signed implementing bill on
September 26, 2006 (P.L. 109-283). Awaits
ratification by Oman.
U.S.-Panama FTA Agreement signed on June 28, 2007.
U.S.-South Korea FTA Agreement signed on June 30, 2007.

U.S. -Malaysia FTA Negotiations underway.

U.S.-Thailand FTA Negotiations dormant.
U.S.-Southern African Customs Union Negotiations dormant.
FTA
U.S.-United Arab Emirates FTA Negotiations dormant.
 CRS-8

Economic Impact of FTAs

The surge in U.S. interest in FTAs and in the formation of FTAs worldwide
raises the question of their impact on the countries included in an FTA and on the rest
of the world. It is an issue that economists have long studied and debated. Interest
in the issue has peaked at various times in the post-World War II period. The first
time was the formation of the European Common market. Interest has peaked again
with the current trends in FTAs. The debate has relied largely on theory since
empirical data are scarce save for the experience of the European Union. The debate
has also divided economists between those who strongly oppose FTAs as an
economically inefficient mechanism and those who support them as a means to build
freer trade.

Economists usually base their analysis of the impact of FTAs on the concepts
of trade creation and trade diversion. These concepts were first developed by
economist Jacob Viner in 1950.4 Viner focused his work on the economic effects of
customs unions, but his conclusions have been largely applied to FTAs and other
preferential trade arrangements. His analysis was also confined to static (one-time)
effects of these arrangements.

Trade creation occurs when a member of an FTA replaces domestic production

of a good with imports of the good from another member of the FTA, because the
formation of the FTA has made it cheaper to import rather than produce
domestically. The creation of the trade is said to improve economic welfare within
the group because resources are being shifted to more efficient uses. Trade diversion
occurs when a member of an FTA switches its import of a good from an efficient
nonmember to a less efficient member because the removal of tariffs within the group
and the continuation of tariffs on imports from nonmembers make it cheaper to do
so. Trade diversion is said to reduce economic welfare because resources are being
diverted from an efficient producer to a less efficient producer.

In most cases, it appears that FTAs lead to both trade diversion and creation
with the net effects determined by the structure of the FTA. Therefore, even if two
or more countries are moving toward freer trade among themselves in an FTA, the
FTA could make those countries and the world as a whole worse off if the FTA
diverts more trade than it creates, according to economic theory.5 (See box below for
illustrative examples of trade diversion and trade creation.)

4
Viner, Jacob. The Customs Union Issue. Carnegie Endowment for International Peace.
1950. New York.
5
This conclusion is called the General Theory of the Second Best and was developed by
economists Richard Lipsey and Kelvin Lancaster. Lipsey, Richard and Kelvin Lancaster.
The General Theory of the Second Best. Review of Economic Studies. vol 24. p. 11-32.
Cited and discussed in Lawrence, Robert Z. International National Economies:
Regionalism, Multilateralism, and Deeper Integration. Brookings Institution. Washington.
1996. p. 22.
 CRS-9

Trade Creation or Trade Diversion?

Economist Robert Z. Lawrence has provided the following example to
illustrate the difference between trade creation and trade diversion:

Assume that prior to implementing a free trade agreement with the

United States, all television sets purchased in Mexico are subject
to a tariff of 10 percent. Assume that Japan produces TVs under
competitive conditions, which it sells at a cost of $100, but the
United States could only produce such sets at $105. Initially, all
TVs sold in Mexico and elsewhere would be Japanese. These
would be imported at a price of $100 from Japan and sold to
Mexican consumers for $110, with the additional $10 representing
the tariff that would be paid by Mexican consumers to the Mexican
government. Assume now that a free trade agreement is signed
between Mexico and the United States which removes tariffs
between Mexico and the United States but retains Mexican tariffs
on other countries. Mexican consumers will now have a choice
between buying American TVs, which will sell in Mexico at $105,
or Japanese TVs, which will sell at $110. They will buy the U.S.
TVs and be better off. However, the Mexican economy as a whole
will be worse off. Before the agreement, Mexico bought TVs from
Japan. Although consumers paid $110, $10 was just a transfer
from Mexican consumers to the Mexican government. The
economy as a whole, therefore, spent $100 per TV. After the
agreement, however, Mexico is spending $105 per TV. TV prices
in Mexico do not reflect their social opportunity costs. The impact
of the agreement is to expand TV production in the United States,
which is relatively less efficient, and to reduce it in Japan, which
is relatively more efficient.

Of course, not all of the increased trade between partners will

represent expansion from a less efficient source. Pure trade
creation would also result. Assume in the example that initially
Mexico could produce TV sets for $107. In this case, prior to the
agreement Mexico would not have imported them from Japan,
instead it would have supplied these TV sets domestically. In this
case, Mexico would benefit from the agreement, which would
allow it [to] pay only $105 per TV, although of course it would
have done better by liberalizing fully and buying the sets from
Japan.

Source: Lawrence, Robert Z. International National Economies: Regionalism, Multilateralism,

and Deeper Integration. Brookings Institution. Washington. 1996. pp. 24-25.

Trade policymakers encounter circumstances much more complicated than what

are depicted in economic theory. Many functioning and proposed FTAs encompass
more than two countries and involve a range of products, both goods and services,
making it much more challenging to evaluate their economic impact. To provide an
analytical framework, some economists have developed sets of conditions under
which, they have concluded, an FTA would create more trade than its diverts. They
state that trade creation is likely to exceed trade diversion —
 CRS-10

! the larger the tariffs or other trade barriers among members before
the FTA is formed;

! the lower the tariffs and other barriers in trade with nonmembers;

! the greater the number of countries included in the FTA;

! the more competitive or the less complementary the economies

joining the FTA; and

! the closer the economic relationship among the members before the
FTA was formed.6

Economists also have determined that, along with the immediate, static effects
of trade diversion and creation, FTAs generate long-term dynamic effects that might
include the following:

! increased efficiency of production as producers face increased

competition with the removal of trade barriers;

! economies of scale, that is decreased unit costs of production as

producers can have larger production runs since the markets for their
goods have been enlarged; and

! increased foreign investment from outside the FTA as firms seek to

locate operations within the borders of the FTA to take advantage
of the preferential trade arrangements.7

Until recently not many FTAs were in operation; therefore, available data on
their impact have been limited to the experience of the formation of the European
Common Market and subsequently the European Union. Most studies have
concluded that the European Community has resulted in more trade creation than
trade diversion, but in some sectors such as agriculture, the net effect has been trade
diversion because of the EU’s Common Agricultural Policy that raised barriers to
agricultural trade outside the EU.8

6
Salvatore, Dominick. International Economics. Fifth Edition. Englewood Cliffs, N.J.:
Prentice-Hall, 1995, pp. 305-306.
7
Ibid, p.307.
8
CRS Report 97-663. Regional Trade Agreements: Implications for U.S. Trade Policy, by
George Holiday.
 CRS-11

FTAs and the WTO

A basic principle of the General Agreement on Tariffs and Trade (GATT) that
is administered by the WTO is the most-favored nation (MFN) principle. Article I
of GATT requires that “any advantage, favor, privilege, or immunity granted by any
contracting party to any product originating in or destined for any other country shall
be accorded immediately and unconditionally to the like product originating in or
destined for the territories of all other contracting parties.” FTAs, by definition,
violate the MFN principle, since products of FTA member countries are given
preferential treatment over nonmember products. However, the original GATT
signatories recognized that FTAs and customs unions, while violating the MFN
principle, improve economic welfare of all members, if certain conditions are met to
minimize trade diversion.

Article XXIV of the GATT requires that FTA members shall not erect higher
or more restrictive tariff or nontariff barriers on trade with nonmembers than existed
prior to the formation of the FTA. Furthermore, Article XXIV requires the
elimination of tariffs and other trade restrictions be applied to “substantially all the
trade between the constituent territories in products originating in such territories.”
In addition, Article XXIV stipulates that the elimination of duties and other trade
restrictions on trade within the FTA to be accomplished “within a reasonable length
of time,” meaning a period of no longer than 10 years, according to the
“Understanding of the Interpretation of Article XXIV of the General Agreement on
Tariffs and Trade” reached during the Uruguay Round. Member countries are
required to report to the WTO their intention to form FTAs. In addition to Article
XXIV, the “Enabling Clause,” agreed to by GATT signatories in 1979, allows
developing countries to form preferential trading arrangements without the conditions
under Article XXIV.

Article V of the General Agreement on Trade in Services (GATS), the

agreement that governs trade in services under the WTO, provides for the preferential
treatment of trade in services within FTAs or similar regional trading arrangements.
Article V lays out requirements of substantial coverage of the elimination of trade
restrictions and the prohibition on the ex post facto imposition of higher restrictions
on services trade with nonmember countries.

The WTO formed the Committee on Regional Trade Agreements (CRTA) in

1996 to review pending and operating FTAs and customs unions to determine
whether they conform to WTO rules under the GATT and the GATS. However, the
rules are sufficiently ambiguous as to be the subject of continuing debate within the
CRTA. For example, the members have been unable to agree on what constitutes
“substantially all trade” under Article XXIV (GATT) or “substantially all sectors”
under Article V (GATS).9 The number of FTAs and customs worldwide has
increased at a rapid rate. As of October 2003, 285 FTAs and customs unions had
been notified to the GATT/WTO. Of these, 124 had been notified during the
existence of GATT (1948-1994) and 149 have been notified since 1995 under the
WTO. Some 215 FTAs and customs unions are in force. The remaining FTAs and

9
The CRTA meets several times during the year.
 CRS-12

customs unions were largely superseded by other agreements involving the same
participants.10

Yet, none of the reports of notifications has been completed because CRTA
members have not been able to reach a consensus on any of them. Nevertheless, the
vast majority of the FTAs have gone into operation. For example, the CRTA has not
completed its report on NAFTA, which went into effect in January 1994. The
proliferation of FTAs and disagreements on rules have crippled the WTO review
process and led WTO members to place review of the rules on regional agreements
on the agenda for the new round of negotiations, the so-called Doha Development
Agenda. The Doha Ministerial Declaration, which established the agenda for the
new round, states that the negotiations will strive at “clarifying and improving
disciplines and procedures under the existing WTO provisions applying to regional
trade agreements.”

The Debate Over FTAs

Interest in a new wave of FTAs is driving a spirited debate among experts,
policymakers, and other observers over whether they promote or damage U.S.
economic interests and the economic interests of the world at large. The differing
views can be categorized into three main groups. One group consists of those who
oppose FTAs because, they assert, FTAs undermine the development of the
multilateral trading system and act as a “stumbling block” to global trade
liberalization. A second group supports FTAs because, they believe, FTAs act as a
“building block” to multilateral trade liberalization. The third category are those
individuals and groups that are opposed to trade liberalization in general because they
believe trade liberalization’s impact on workers in import-sensitive sectors or on the
environment is unacceptable, or because, they assert, it undermines U.S. sovereignty.

Among representatives of the first group of experts are international economists

Jagdish Bhagwati and Anne O. Krueger, who have strongly advocated that the United
States and other national governments should not pursue FTAs at the expense of
multilateral negotiations in the WTO. Bhagwati has concluded that FTAs are by
definition discriminatory and therefore trade diverting. He argues that tariffs remain
high on many goods imported into developing countries and even on some labor-
intensive goods (such as wearing apparel and agricultural products) imported into
developed countries. Consequently, he asserts, trade diversion will likely result when
an FTA is formed. Bhagwati argues that firms actually prefer bilateral or regional
FTAs to multilateral trade liberalization because they are able to achieve preferential
treatment over their non-member country competitors.11

10
WTO Secretariat. Trade Agreements Section. Trade Policies Review Division. The
Changing Landscape of RTAs. A paper prepared for a seminar on Regional Trade
Agreements and the WTO. November 14, 2003. p. 2.
11
Bhagwati, Jagdish. The Wind of the Hundred Days: How Washington Mismanaged
Globalization. The MIT Press. Cambridge, Mass. 2000. p. 240-245.
 CRS-13

Both Bhagwati and Krueger cite the “rules of origin” and other conditions of an
FTA’s establishment for strong criticism. Bhagwati claims, for example, that the
rules of origin in one FTA more than likely do not coincide with the rules of origin
in many of the other FTAs. Furthermore, he argues, the schedule of implementation
of the tariff reductions and other conditions for one FTA will not match the schedule
of other FTAs. The incongruity of these regulations across FTAs has created what
Bhagwati sees as a customs administration nightmare and calls the spaghetti-bowl
phenomenon.12

In her criticism, Krueger claims that in order to meet the input thresholds of
rules of origin requirements, producers in one FTA partner will be encouraged to
purchase as many inputs as possible from other partner countries, even if a non-FTA
member can produce and sell the inputs more cheaply and even if the tariff rate on
inputs from non-FTA producers is zero. Importing inputs from within the FTA to
meet the rules of origin threshold allows the producer to sell the final product within
the FTA duty free. Under such circumstances imports of inputs are diverted from
efficient producers outside the FTA to less efficient producers inside the FTA. A
corollary to Krueger’s conclusion is that the higher the threshold established in the
rules of origin, the greater the chance that trade diversion will take place.13

A range of economists, policymakers, and other experts embrace a second view

that FTAs can enhance trade and should be pursued. Economist Robert Z. Lawrence
argues, for example, that recent FTAs involve much more economic integration than
the elimination of tariffs. NAFTA, he points out, has led to the reduction in barriers
on services trade, foreign investment, and other economic activities not covered by
the GATT/WTO. In addition, under NAFTA, Mexico has affirmed its commitment
to economic reform, making its economy more efficient. Lawrence asserts that the
theory traditionally applied to FTAs (by Bhagwati, Krueger, and others) does not take
into account these dynamic welfare enhancing characteristics of FTAs which he
believes are likely to outweigh any trade diversion that results from the elimination
of tariffs.14

A CATO Institute study by economist Edward L. Hudgins argues that while it

may be preferable to liberalize trade multilaterally, countries should take any
available avenue, including bilateral or regional FTAs, even if they lead to some
trade diversion. Furthermore, Hudgins asserts that FTAs can be more efficient
vehicles for addressing difficult trade barriers than the WTO, where the large
membership requires compromise to the least common denominator to achieve

12
Ibid.
13
Krueger, Anne O. “Free Trade Agreements As Protectionist Devices: Rules of Origin,”
in Melvin, James R., James C. Moore and Raymond Riezman (eds.). Trade, Theory, and
Econometrics: Essays in Honor of John C. Chipman. Routledge Press. New York. 1999.
pp. 91- 101.
14
Lawrence, Robert Z. Regionalism, Multilateralism, and Deeper Integration: Changing
Paradigms for Developing Countries. in Mendoza, Miguel Rodriquez, Patrick Low, and
Barbara Kotschwar (eds.). Trade Rules in the Making. Organization of American
States/Brookings Institution Press. Washington. 1999. p. 41-45.
 CRS-14

consensus. FTAs have also have provided momentum for GATT/WTO members
to move ahead with new trade rounds, he claims.15

Economist C. Fred Bergsten holds a position similar to the one expressed in the
CATO study, that in lieu of multilateral trade negotiations, FTAs are the next best
thing and promote global trade liberalization. Bergsten has advocated establishing
U.S. FTAs with New Zealand and with South Korea. Economist Jeffrey Schott
argues that some U.S. firms are being discriminated against because FTAs are rapidly
forming in which the United States is not a participant; therefore, in his review, the
United States must negotiate FTAs. He cites the example of Canadian firms which
have obtained competitive advantages over American firms because Canada has an
FTA with Chile.16

Bergsten and others have also advocated structuring FTAs in a manner that
could serve as building blocks of a global free trade system. Using the APEC plan
as a model, Bergsten argues for an FTA based on “open regionalism,” that is
establishing the road map for free trade and investment in the Asian-Pacific region
for 2010/2020 among the members but allowing other countries to join if they agree
to accede to the conditions. In order to minimize trade diversion, he suggests that
trade and investment could be implemented on an MFN principle, perhaps
conditional MFN in order to limit the “free rider” effects. Other countries, and other
regional groupings, Bergsten presumes, would be willing to accept the conditions
having been enticed by the trade and investment opportunities until most of the
membership of the WTO would be engaged in forming a free trade area.17 A Heritage
Foundation report draws up a similar proposal for a “Global Free Trade
Association.”18

A third group opposes FTAs but also trade liberalization or “globalization” in

general. Included in this group are representatives of import-sensitive industries, for
example labor unions, and representatives of social action groups such as some
environmentalists, who question the wisdom of trade liberalization whether done
through multilateral negotiations or through bilateral and regional trading
arrangements. They assert that trade liberalization unfairly affects workers by
exporting jobs to countries with lower wages and undermines the nation’s ability to
protect the environment by allowing companies to relocate to countries with less

15
Hudgins, Edward. L. Regional and Multilateral Trade Agreements: Complementary
Means to Open Markets. Cato Journal. Vol. 15. No. 23. Fall/Winter 1995/96.
16
Schott, Jeffrey J. Free Trade Agreements: The Cost of U.S. Nonparticipation. Testimony
before the Subcommittee on Trade. House Ways and Means Committee. March 29, 2001.
[http://www.iie.com].
17
Bergsten, C. Fred. Open Regionalism. Working paper 97. Institute for International
Economics. 1997.
18
Hulsman, John C. and Aaron Schavey. The Global Free Trade Association: A New Trade
Agenda. The Heritage Foundation Backgrounder No. 1441. May 16, 2001.
 CRS-15

stringent environmental regulations.19 For example, the United Auto Workers

(UAW) union has stated the following position regarding the FTAA:

Such an agreement would provide broader protections for the rights of

corporations, further undermine the ability of governments in the region to
regulate their economies in the interests of their citizens and intensify the
downward pressure on workers’ incomes through competition for jobs and
investments. All of this would take place in the absence of any counter-balancing
protections for workers, consumers or the environment. This is why the UAW
has consistently opposed the direction of these negotiations, the positions taken
by the U.S. government, and worked closely with other organizations in the
region to oppose the creation of an FTAA.20

Conclusions and Implications for Congress

Free trade agreements are viewed by many as a significant trade policy vehicle
for the United States and for other major trading nations. Over the last 5-10 years,
the debate in U.S. trade policy has shifted from, “Should the United States form
FTAs?” to “Should the United States form any more FTAs and, if so, with whom,
when, and under what conditions?” Congress has a direct role in addressing those
questions. Before any FTA can go into effect, the Congress must review it as part of
implementing legislation.

The 110th Congress may be asked to consider implementing legislation for FTAs
with Colombia, Peru, Panama, and South Korea. A number of questions regarding
FTAs could arise. One question pertains to the economic impact of an FTA. As with
any trade liberalizing measure, an FTA can have positive effects on some sectors and
adverse effects on others. An FTA may create trade for one sector of the U.S.
economy but divert trade away from others. A Member of Congress is placed in the
position of weighing the effects on his/her constituency versus the overall impact on
the United States and other trading partners. Because conditions can differ radically
from one FTA to another, the evaluation will likely differ in each case. Furthermore,
Members might take into account not only the immediate static effects of FTAs but
also the long-term, dynamic effects which could play an important role in evaluating
their contribution to U.S. economy.

A second, broader question is whether bilateral and regional FTAs are the
appropriate trade policy strategy to promote U.S. national interests. Economic
specialists differ sharply on this question with some viewing the proliferation of
FTAs as leading to confusion and serving as stumbling blocks to the development of
a rules-based multilateral trading system. Other specialists consider FTAs as
appropriate trade policy vehicles for promoting freer trade, as building blocks to a
multilateral system and as necessary to protect U.S. interests against the FTAs that

19
For more information, see for example, the United Auto Workers positions on trade policy
at [http://www.uaw.com] and the positions of Public Citizen’s Global Trade Watch at
[http://www.citizen.org].
20
[http://www.uaw.com].
 CRS-16

other countries are forming without the United States. Still others oppose trade
liberalization in any form as counter to U.S. interests.

A third question is whether the Office of the United States Trade Representative
and other trade policy agencies have sufficient time and human resources to negotiate
a number of FTAs simultaneously while managing trade policy in the WTO and other
fora. Others might find some U.S. interests being short-changed.

A fourth question is to what degree, if any, should non-trade concerns be

included in FTAs? This issue has emerged in a number of completed and ongoing
FTA negotiations.

A fifth overarching question is what criteria should the United States employ in
determining which countries would make appropriate FTA partners. For example,
to what degree should political factors be given weight over economic factors? The
countries that the Bush Administration has chosen for the next round of negotiations
include a several continents and levels of economic development.

Hanging over pending and future U.S. trade negotiations, both bilateral and
multilateral, is the question of the expiration of the Trade Promotion Authority.
Under the Bipartisan Trade Promotion Act of 2002, agreements must be signed
before July 1, 2007, in order to obtain the expedited congressional consideration.21

21
The debate over FTAs may also play a role in the expected debate over TPA renewal.
For more information see, CRS Report RL33743, Trade Promotion Authority (TPA): Issues,
Options, and Prospects for Renewal, by J. F. Hornbeck and William H. Cooper.