The World Trading System at the Crossroads

Date January 24, 2019
Speaker Uri DADUSH (Senior Fellow, Policy Center for the New South and Non-Resident Scholar, Bruegel)
Moderator HATTORI Takashi (Consulting Fellow, RIETI / Associate Professor, The Research Center for Advanced Policy Studies (CAPS) Institute of Economic Research, Kyoto University)

The world economy has never been more integrated, yet the world trading system is under the most severe threat since the 1930s. Whether the world economy will lapse into protectionism or sustain its current path of growth and increased integration depends on the answer to three questions. First, is President Trump's trade policy an aberration or is it a new normal in the United States? Second, if the US leaves the WTO, does that spell the end of the organization? Third, does and can China fit in the WTO? One may not provide definitive answers to these questions, but one should at least try to sketch the possible outcomes. What is certain is that third parties, such as the European Union and Japan should not be be passive observers of the present crisis: the way they respond can help determine the outcome.


Uri DADUSH's Photo


This presentation will describe the present crisis in the world trading system, identify its causes, explore some scenarios for the next one to two decades, and suggest how countries should respond to the current situation.

The sources used for this presentation include my paper titled "The Future of the World Trading System," the RIETI Policy Brief "The Crisis in World Trade," and a number of my writings. The contents of this presentation are completely my views.

The main points covered in the presentation are that 1) the trading system has been extraordinarily successful, however, it is now being jeopardized, and 2) the causes are not easily resolved because they are complex and likely to persist; 3) globalization will continue even though the trading system is in trouble; 4) the future of the trading system depends on how three questions are answered i) what is the future of the World Trade Organization (WTO), and ii) what will happen in the U.S. and iii) what will happen in China; and 5) policy-makers must create a plan that will cover a normal scenario and a back-up plan which will cover a scenario where the WTO is partially or not-at-all functional.

The governance of world trade

Even though the WTO is the core of the world trading system, other factors are involved. One of these factors is preferential agreements which include preferences granted to developing countries, but even more important are bilateral agreements, regional agreements, and mega regional agreements. Another critical factor is domestic laws. The rule of law on the domestic level is a fundamental part of the trading system because international disputes are resolved in domestic court.

Success of the world trade system

Evidence of the system’s success is seen when comparing the world trade as a share of gross domestic product (GDP) between the mid-1980s and today. In the mid-1980s, world trade as a share of GDP was around 35%. Today, world trade as a share of GDP is close to 60%. In addition, most favored nation (MFN) tariffs have been greatly cut, and effectively applied tariffs have been cut even more. The difference in tariff cuts is because MFN applied tariffs are what is agreed to in the WTO, and effectively applied tariffs regard all of the preferential agreements. Many advanced countries have around a 2% effectively applied tariff, which is essentially free trade aside from some minor anomalies. In developing countries, the effectively applied tariffs are down to 4% on average. Moreover, the WTO and preferential trade agreements (PTA) govern many aspects of trade, such as certain subsidies and aspects of intellectual property. Also, over the last 30 years, developing countries have transitioned from import substitution policies to export-orientation policies. Additionally, since there have been substantial investments by the public and private sectors in the trading system, because they assume that open and predictable trade will continue. For example, a number of large, successful companies and some Latin American and African countries are enhancing trading avenues in order to facilitate more trade in the future. One reason why the system is so resilient is because of the large amount of investment, so the system will not abruptly fail.

The trading system in crisis

Despite the resiliency of the system, it is now in crisis. It is in crisis because the WTO is being doubted for its negotiation worth, and it has not concluded deals in the recent past decades. Also, the U.S. has taken unilateral actions which go against the WTO. Some lawyers believe the actions are not illegal, however, economists believe that when the U.S. appeals to national security to raise tariffs on steel and aluminum against their allies, it is a violation of the WTO. An example if these actions is the use of Section 301 against China. In addition to being dissatisfied with the negotiations in the WTO, the U.S. is challenging the dispute settlement in the WTO directly, by not replacing members of the appellate body. Therefore, the appellate body may cease to function by the end of this year. Moreover, there is a trade conflict between China and the U.S. which is still unresolved, and the U.S. has obtained some support from allies who are also concerned about China.

Deep causes of the crisis

The causes of the crisis are complex and not easily resolved, and therefore, it is expected that they will persist in the foreseeable future. The causes are related to the following five factors.

Inequality and disruption
Inequality persists in many advanced countries as a large part of the population has not seen wage increases over the last three decades, and significant disruption has occurred as a result of various forces. Economists agree that the most significant source of inequality and disruption is automation, which they call skill-biased technological change. When a worker loses their job, they do not completely understand if they lost their job because of being replaced by automation or trade. It is difficult to tell the difference because the two are closely linked, but trade is more easily blamed.

Macroeconomic crisis
The effects of the macroeconomic crisis of 2008 and 2009 continue to reverberate. Only recently have we finally seen recovery of economic growth.

Global imbalances
In the past, big global imbalances and the current accounts of the U.S. and China were bigger issues. China now imports as much as it exports, and it is almost balanced in its current account. Since the financial crisis, the U.S. current account deficit has significantly reduced. The fact that the bilateral trade deficit between the U.S. and China is substantial should not matter because it is a natural result of comparative advantage, economic forces, globalization, etc. However, from a political point of view, it is significant when the President of the U.S. believes the bilateral trade deficit or surplus is of utmost importance. Sizeable surpluses should not be sources of tension in countries such as Germany, but in the current political climate, they are.

The rise of China
The issue with the rise of China is that its economic expansion happened so quickly that it rapidly shifted market shares in many industries around the world, with the U.S. and Japan as the economies most affected by this. Also, China is highly competitive in some labor intensive industries, due to their low per capita income compared to the U.S., which helps drive disruption.

Limits of multilateralism
In the WTO, the system utilizes the single undertaking/consensus approach, which has proven to be impossible with an organization of 164 countries with broad and varied issues. In other multilateral institution such as the International Monetary Fund (IMF), decisions are made by consensus, and rarely voted on, and agreement is not needed to undertake large loans. In the U.N., decisions about security issues are made by a council where permanent seats are held by certain countries.

Protectionism will not solve the issues

Economic theory indicates that protectionism is not the right answer to these issues. It clearly states that the community overall wins from free trade, but some parties will lose out if they belong to those sectors that lack comparative advantage. For everyone to gain, there has to be a redistribution of gains from winners to losers. In order for gains to be shared, ex ante policies that boost productivity and ex post policies that share the gains are required. Redistribution is good in theory, but it is difficult politically. Economic theory indicates the answers to these issues, but it is very difficult to take action.

The future of the system

The future is unknown, but we do know which questions to ask: can we reinvigorate the WTO? Are Mr. Trump's trade policies an aberration or will they persist under future administrations, and are they a new trend of isolationism and withdrawal? Does China fit into the WTO with its system of state capitalism which could be distorting world trade?

To answer the first question, there are good and bad scenarios behind the reinvigoration of the WTO. In the good-case scenario, the WTO members stop the current system of the single undertaking/consensus approach and adopt plurilateral agreements. The agreements can be either critical mass agreements where privileges are afforded to non-signatories, or closed agreements among a subset of countries which undertake certain obligations and privileges which are not extended to the rest of the membership. To have the latter type of plurilateral agreement, consensus would be needed to proceed, which is why it is unlikely to happen under the current WTO rules. On the other hand, critical mass agreements are more possible which would allow for selective action on specific issues, such as certain types of services, SOEs, etc. This scenario would result in a reinvigoration of the WTO.

In the bad-case scenario, even if the dispute settlement appellate body is allowed to remain functional, the inability to act on key issues makes the WTO less relevant, so, some WTO members question whether the benefits of the organization outweigh the costs or not. For example, the U.S. would start to doubt the benefits of the WTO if they wanted to make a limited trade agreement for industrial products with the EU, which is not allowed under WTO rules. This scenario is very worrying.

Regarding the second question, the good-case scenario is the U.S. taking a more reasonable position with its trading partners and the WTO, because the U.S. body politic is not supportive of power-based, unpredictable trade relations. In this scenario, tensions with China will still remain and action must be taken regarding this issue, but the U.S. is not challenging the WTO or ignoring the rules.

In the bad-case scenario, the U.S. reverts to protectionist and isolationist policies which were in place in the 19th and early 20th centuries; after which the WTO and trading countries need to deal with a trading system in which the U.S. is not playing by the same rules.

Considering the third question, the good-case scenario involves China acknowledging the great benefits it receives from the WTO and therefore continues to support it, lowering tariffs and downplaying its developing country status in order to take on more responsibilities, strengthening intellectual property rights (IPR) disciplines, increasing rigor and transparency in the governance of state-owned enterprises (SOEs) and supporting the private sector firms that will be active in the industries of the future. These reforms will take time as they are not easily done in a large country like China, and they will take continuous effort to implement. I am confident that China wants this scenario and is ready to make big changes in order to avoid being isolated or losing the WTO.

In the bad-case scenario, China refuses or is not able to undertake these reforms, and international criticism causes China to turn inwards and becomes hostile. Then, countries are forced to choose between economic ties with China or the U.S.

So, what should countries do?

To shed light on actions which countries could take, I will express what is known or assumed. Globalization will continue over the next 10 to 20 years, and economies will not be able to isolate themselves without incurring large costs. In addition, globalization will be highly supported by technology, particularly information technology.

The second thing that can be assumed is that the U.S. will remain the pre-eminent world power even if it withdrawals due to its dominant military and cultural attraction for a large part of the world.

The third assumption is that the Chinese system based on state capitalism will not quickly change. It will continue to be a successful economy with an exceptional system. Also, China will rise in importance as a trading partner and global player. To illustrate that, if China's growth rate decreases, China will still be 50% larger that the U.S. as a trading nation 20 years from now. Countries in proximity of China, such as Japan, should assume that their biggest trading partner in the future will be China.

Referring back to what was said earlier, policy makers must create a plan for a normal scenario (plan A) and a back-up to that (plan B), and they should be based on what is known. Plan A assumes the good-case scenarios, and it is a continuation of what is currently happening, but possibly accelerating a bit. It aims to accelerate bilateral agreement and competitiveness reform which are valuable because they make it expensive for other countries to drop out of the system. The U.S. has been worrying about the EU and Japan negotiating their free trade agreement because U.S. farmers are concerned about losing the European and Japanese markets. Plan A also aims to share gains domestically to support consensus in favor of trade and globalization; to push for plurilateral approaches in the WTO; to undertake reform of the dispute settlement system that improves it for all of the parties; to utilize the Dispute Settlement Understanding (DSU) to deter unilateral actions (retaliation must be taken when a country acts against another, and this is of utmost importance because it is the only way to politically deter these kinds of steps); to reduce large current account surpluses, such as in Germany; to encourage China to share the burden without alienating them within the multilateral context if possible; and to encourage the U.S. to work within the system. Plan A intends to preserve the system as much as possible.

The complicated plan B is when bad scenarios materialize. The WTO will lose strength due to the lack of revitalization of the negotiations, and the cost of membership will outweigh the benefits. Relations among the trade powers become based on power instead of rules which creates many complications. Small powers would get the worst of it because they have very little negotiating room.

Plan B is best explored in four groups of countries. The countries in the best position are the ones with a large number of free trade agreements, such as Mexico, Chile, and Morocco. They have opened 90% of their trade in trade agreements, and thus can operate quite well without a functioning WTO.

The countries in the worst position are the smaller countries with very few free trade agreements, such as Brazil, Argentina, India, and South Africa. The majority of their trade is based on WTO rules, and their power is limited.

The countries in the middle, like Japan, are in the middle because a portion of their trade is under regional and bilateral agreements, and because they are middle powers.

The fourth group of countries is the U.S., China, and the EU. In order for them to deal with each other in a power-based system without basing their relationship solely on power, a bilateral agreement is possible. In a world without the WTO, a bilateral agreement between the U.S. and EU is quite possible, covering certain aspects. Even if it were not possible, the U.S. and EU could, for example, agree to operate on the basis of the former trading system. This means that the WTO obligations are still the base, but the dispute settlement system is separate. It could act as an interim solution in which WTO rules are preserved.

It would be much more difficult for the U.S. and EU to deal with China individually. With the existing WTO arrangement, it is difficult to imagine the U.S. willingly operating with China.

Another challenge that should be considered is that the small- and medium-power countries would have to navigate between the three separate arrangements of the U.S., the EU, and China. In order to be included in the agreements, or to make bilateral deals, the smaller-power countries will have to redraw their red lines, and accept deals that are much less beneficial than ones they would accept today.

To reiterate the key messages of this presentation, the trading system has been remarkably successful but is under attack; the causes of the present crisis are deep and will not be quickly resolved; globalization will not stop; the future of the trading system depends on the WTO, the U.S., and China; we need a plan A, which is the plan we have, but we desperately need to think about a plan B.


Q1: What is the relationship of national security and the current trends? How should the current system respond to the fusion of national security discipline and trade norms?

Regarding national security, the U.S. tariffs on steel and aluminum should be challenged in the WTO and retaliated against instead of being accepted. The deeper issue is the link between national security and trade, and no trade agreements have been completed without geopolitical and national security considerations. Considering national security in the new world, I think it will play out in a different way in China, Japan, and the EU. From the Washington DC perspective, China is a rival in terms of national security; war with China is certainly to be avoided, but they also do not want to help China; and making things difficult for China is the approach. Regarding Japan and the EU, the situation is very different. As allies, there should be no critical national security concerns. The establishment believes in staying close to their allies, which is why I am optimistic that the situation will rebalance.

Q2: The good-case scenario requires a lot of work to be done especially to reduce inequality. How do you assess the appetite of governments and policy makers to embark on this serious agenda?

I think there is little or no appetite. Even when there is appetite and policy makers want to take action, the fiscal space is very limited, as is the case in Japan. The rising national populists coming to the fore in various countries are pushing an agenda of protectionism, downplaying the EU, and xenophobia. Two or three years ago, the U.S. could have taken action in the appropriate direction because they would have had some fiscal space, but under Mr. Trump, the U.S. wants protectionism, blames foreigners, and has enacted a tax reform that penalizes the lower and middle classes. I do not mean to say that the system is doomed, but I do believe that the issue will remain and continue to present difficulties.

Q3: According to your analysis, countries that are damaged from plan B are countries without free trade agreements; Brazil, Argentina, India, and South Africa. However, it seems that they have not generally changed their position in a big way towards WTO reform. What is the reason for that?

Those countries do not have free trade agreements because they do not believe that they should. An interesting question is if the current change in the world trading system will lead them to change their position. If it does, it will be a gradual process. Also, if the WTO dissolves in two or three years from now, it will be too late for those countries to change. Negotiating new trade agreements is going to take a long time. It is possible that their attitude will change over time, but it is also possible that it will have the opposite effect because there are strong protectionist factions in those countries which might use the unraveling of the WTO and the positions that the U.S. is taking as encouragement or proof to bolster their case, regardless of the difference in circumstances. All of those countries have sizeable domestic markets, so they could decide to operate without the WTO, but I would not be optimistic about them.

*This summary was compiled by RIETI Editorial staff.