Monday, November 14, 2011

Trade diversion, trade creation & the Trans Pacific Partnership

In an earlier post, A PhD student, 1983, I mentioned that one of the first things that I did upon returning to the Department of Industry and Commerce early in 1983 after a period as a full time student was a study into the possible benefits to Australia of a Pacific Free Trade Area. I noted that, somewhat to our surprise, we reached a positive conclusion despite the obvious implementation problems.

I was reminded of this today by the announcements that Japan was considering joining the Trans Pacific Partnership Agreement (press release here, Australian PM/Minister for Trade press conference transcript here).

   In earlier posts I explored Australia's evolving position and the way that was reflected in the Government's attempts to negotiate fee trade agreements. In Australia's Free Trade Agreements I simply listed current agreements.

In considering the benefits of trade agreements, economists distinguish between trade diversion and trade creation. Trade diversion occurs where trade is diverted from an external to an internal supplier. Trade creation involves an overall increase in the volume of trade.

Trade diversion can involve direct costs and is an especial feature of customs unions such as the EU or the Australian Federation.

In a customs union, the members impose a common external tariff. This leads to trade being diverted to higher cost suppliers within the union. Buyers face increased costs because new tariffs force them to buy more expensive union product. Those supplying that product benefit. Part of the increased costs flow to them in greater sales. However, overall income can be reduced.

Unlike a customs union, free trade agreements leave external barriers as they are. Trade diversion may still occur, but now buyers experienced lower costs as trade is diverted from higher price external suppliers to lower price internal suppliers. Internal suppliers still benefit, but the purchaser's retain benefits.

Both customs unions and free trade agreements may lead to trade creation because trade in goods and services is facilitated. Here there are likely to be net benefits.

As a general rule of thumb, trade creation is greatest where economies produce similar mixes of goods and services and also have significant barriers to trade. Herein lies the rub with the Trans Pacific Partnership. The countries involved -  Australia, Brunei, Chile, Malaysia, New Zealand, Peru, Singapore, the United States and Vietnam - are different and have very different trade patterns. Even adding Japan, the scope for short term trade creation is limited.

I make this point because some of the reporting in this country on the TPP has focused on local jobs benefits. Don't hold your breath!

We concluded that a broad Pacific Free Trade Agreement would benefit Australia because of the way that it would reduce impediments to trade within a a very large group. Our view was that over a long time period the scope for benefits was substantial. The TPP is far more limited. 

This doesn't mean that it isn't worthwhile at a time when general trade liberalisation has slowed. Just that the benefits should not be over-hyped. 


Winton Bates said...

Hmmm, TPP seems to be yet more political diversion rather than trade creation.

Jim Belshaw said...

You may well be right. What I'm trying to work out in my head is just what dynamic impacts there might be, if any, accepting that the process will inevitably be a slow one.

Winton Bates said...

I'm sorry it has taken me so long to get back, Jim.
Other things occupied my mind. The other 'Jim' wanted me to think about dumping - and Sophie Mirabella (see my blog).

Dynamics! OK, they could lead us in the right direction. I remember trying to convince some New Zealanders back in the early 1980s that CER with Australia was a waste of time. They argued that this was just the first step towards free trade - and they were more or less right about that.

So, the question is whether TPP actually leads to something bigger and better.

Jim Belshaw said...

I agree with your last comment. CER was always in NZ's interests, whereas the benefits to Australia were smaller. Treasury pointed this out at the time. Noted the dumping post. I have been meaning to comment.