Multilateral vs. Regional Economic Integration? - The Middle East and North African Region

  MULTILATERAL VS. REGIONAL ECONOMIC INTEGRATION?  

  THE MIDDLE EAST AND NORTH AFRICAN REGION  

TABLE OF  CONTENTS  

  LIST OF FIGURES  5

  LIST OF TABLES  6

  LIST OF ABBREVIATIONS  7

  INTRODUCTION  9

I.  TRADE AND WELFARE  11

II.  REGIONAL ECONOMIC INTEGRATION  16

  a) Regional Economic Integration from a Historical Perspective  17

1.  Old Regionalism  18

2.  New Regionalism  18

  b) Stages of Regional Economic Integration  19

  c) Economic Causes and Effects of Regional Economic Integration  20

1.  Static Effects of Regional Economic Integration  21

i.  Trade Creation Trade Diversion Effects  21

ii.  Demand Side Effects  22

iii.  Terms of Trade Effects  23

2.  Dynamic Effects of Regional Economic Integration  23

i.  Increased Competition  23

ii.  Scale Effects  24

iii.  Increased Efficiency  24

iv.  FDI  24

v.  Convergence/Divergence  26

vi.  Agglomeration and Flow of Knowledge  27

  d) Political Causes of Regional Economic Integration  28

i.  Lobbies  29

ii.  Domino Theory  33

iii.  Bargaining Power  35

iv.  Signalling, Credibility and Reputation  37

v.  Security  38

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  e) Overlapping Regional Integration Agreements (RIAs)  

  and the “Spaghetti Bowl Problem  39

III.  MULTILATERALISM AND THE WORLD TRADE ORGANIZATION (WTO)  41

  a) The Emergence of the WTO  41

  b) The Nature of the WTO  42

  c) Principles of the WTO  42

1.  The Most-Favoured Nation Treatment  43

2.  The International Treatment Obligation  43

3.  The Principle of Reciprocity  44

  d) Structure of the WTO  44

  e) Achievements and Omissions of the WTO  47

IV.  MULTILATERALISM VERSUS REGIONALISM?  49

  a) Regional Integration Agreements (RIA) and the WTO  49

1.  GATT Article XXIV  49

2.  Enabling Clause  50

3.  GATS Article V  50

4.  WTO Transparency Mechanisms for RIAs  50

  b) Regional Integration Agreements  

  as “Building Blocs or “Stumbling Blocs ?  53

1.  RIAs as “Stumbling Blocs  53

2.  RIAs as “Building Blocs  55

  c) RIAs and Trade in Services  56

  d) The Potential of “South-South Integration Agreements  57

V.  THE MENA REGION  58

  a) The MENA -Countries - One Region?  58

  b) MENA ´s Economic Integration on a Regional and on a Global Level  62

  c) The Arab League (AL) The Forerunner of Arab Economic Integration  73

  d) Regional Integration Agreements (RIA) in the MENA Region  78

1.  The Gulf Cooperation Council (G)CC Subregional  78

i.  The Agreement  78

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ii.  Trade in Services  80

iii.  Intellectual Property Rights (IPR)  

  and Harmonization of Standards  82

iv.  GCC and International Law  82

v.  Supervision  83

vi.  Rules of Origin  83

vii.  Dispute Settlement  83

viii.  Beyond the Border Measures  84

ix.  Customs  84

2.  The Greater Arab Free Trade Area (GAFTA) Intraregional  85

i.  The Agreement  85

ii.  Trade in Services  87

iii.  Intellectual Property Rights (IPR)  

  and Harmonization of Standards  87

iv.  GAFTA and International Law  87

v.  Supervision  88

vi.  Rules of Origin  89

vii.  Dispute Settlement  90

viii.  Beyond the Border Measures  90

ix.  Customs  91

3.  The EU - Mediterranean Partnership (EMP) Interregional  92

i.  The Agreement  92

ii.  Trade in Services  96

iii.  Intellectual Property Rights (IPR)  

  and Harmonization of Standards  96

iv.  EMP and International Law  97

v.  Supervision  97

vi.  Rules of Origin  98

vii.  Dispute Settlement  99

viii.  Beyond the Border Measures  99

ix.  Customs  100

4.  Further RIAs in the Region  100

VI.  PROBLEMS WITH OVERLAPPING RIAs IN THE MENA REGION  104

  CONCLUSION  105

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  LIST OF FIGURES  

  Figure 1 Production Facilities of Syria in an self-sufficient situation  13

  Figure 2 Production Facilities of Lebanon in an self-sufficient situation  13

  Figure 3 Syria - Lebanon Economic Partnership  14

  Figure 4 No. of RTAs worldwide  17

  Figure 5 Political Explanatory Approach for Regional Integration  29

  Figure 6 Comparison of GDP for the USA, Japan and the  

  totality of Middle- and Low Income Countries  36

  Figure 7 WTO Structure  46

  Figure 8 Regional Exports as Percentage Share of World Exports (oil excluded)  63

  Figure 9 Share of Middle East Trade, Imports vs. Exports, 2003  64

  Figure 10 Share of Middle East Trade by Region, Imports and Exports, 2003  65

  Figure 11 Intraregional trade as a share of GDP in percent, 2002  66

  Figure 12 MENA Workers Remittances ( billion), 1991 2003  67

  Figure 13 Share of Region’s Net FDI Inflows in the Region’s  

  Total Investment (percent) for 1980 89 , 1990 99 and 2000 02  68

  Figure 14 Map of the Arab League  76

  Figure 15 Map of the GCC  79

  Figure 16 MENA´s Countries Net Services Trade Position 2006  81

  Figure 17 MENA´s Countries Attitude towards Reform,  

  as illustrated by GATS Commitments  81

  Figure 18 Ratio of Intraregional Trade to International Trade  

in  certain Regional Blocs, 2002 and 2004  86

  Figure 19 Overlapping Bilateral and Regional Integration Agreements  

in  the MENA Region  103

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  LIST OF TABLES  

Table 1  Opportunity Costs of Syria and Lebanon  13

Table 2  Stages of regional integration  20

Table 3  GATT/WTO trade rounds  47

Table 4  Comparison of requirements under  

  GATT Article XXIV and the Enabling Clause  52

Table 5  Annual FDI inflows of MENA states, percentage of world total  72

Table 6  Average Tariffs and Standard Deviations for Selected Countries  91

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LIST OF ABBREVIATIONS

ACC Arab Cooperation Council AL Arab League ALESCO Arab League Educational Scientific and Cultural Organisation AMU Arab Maghreb Union ASEAN Association of South East Asian Nations c Cloth CAP Common Agricultural Policy CET Common External Tariff CM Common Market COMESA Common Market for eastern and Southern Africa CRTA Committee on Regional Trade Agreements CTD Committee on Trade and Development CU Customs Union ECSC European Coal and Steel Community EDI Electronic Data Interchange EEC European Economic Community EFTA European Free Trade Area EMAA European Mediterranean Association Agreement EMFTA European Mediterranean Free Trade Area EMP European Mediterranean Partnership ENP European Neighbourhood Policy ESCWA Economic and Social Commission for Western Asia EU European Union EURO-MED European-Mediterranean FDI Foreign Direct Investment GAFTA Greater Arab Free Trade Area GATS General Agreement on Trade in Services GATT General Agreement on Tariffs and Trade GCB Gulf Central Bank GCC Gulf Cooperation Council GDP Gross Domestic Product GSO Gulf Standardisation Organisation GSTP General System of Trade Preferences

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ICT Information and Communication Technologies ILO International Labour Organisation IMF International Monetary Fund IPR Intellectual Property Rights ITO International Trade Organisation MAFTA Mediterranean Arab Free Trade Area MENA Middle East and North Africa MERCOSUR Southern Common Market (Spanish: Mercado Commún del Sur) MFN Most Favoured Nation MNC Multinational Corporation MPC Mediterranean Partner Country

NGR Negotiating Group on Rules NTB Non-Tariff Barrier OAS Organisation of American States OECD Organisation for Economic Co-operation and Development OIC Organisation of Islamic Conferences PAFTA Pan Arab Free Trade Area RIA Regional Integration Agreement RoO Rules of Origin RTA Regional Trade Agreement SPS Sanitary and Phytosanitary TBT Technical Barriers to Trade ToT Terms of Trade TRIPS Trade Related Aspects of Intellectual Property Rights UAE United Arab Emirates UN United Nations UNCTAD United Nations Conference on Trade and Development USA United States of America w Wine WTO World Trade Organisation 8

“...the individual human being cannot by himself obtain all the necessities of life. All human beings must cooperate to that end in their civilization. But what is obtained through the cooperation of a group of human beings satisfies the need of a number many times greater [than themselves].”

Ibn Khaldun (1332-1406)

INTRODUCTION

When Ibn Khaldun - a medieval polymath of Arab descent from present-day Tunisia, often referred to as the father of sociology ¹ and a designated adept of the “Dar al Islam” ² - wrote the above statement on the benefits of the division of labour in his “Muqaddimah” ³ , Adam Smith (1723-1790) and his idea of the “invisible hand” were still far from being born. The person Khaldun and his thought is just one of the examples for the high agility which prevailed among the Islamic scholars both physically and intellectually during the Middle Ages, from which Europe benefited so greatly, and reminds us that the concept of socalled “globalization” is not a new one, neither in theory nor in practice. ⁴⁵ Yet primarily the exercise of this study should neither be the historical examination of the “Dar al Islam”, nor that of the phenomenon of globalization. Nevertheless one should bear in mind that - even in an economic analysis - historical and cultural background knowledge can certainly aid and deepen the comprehension of the “object of investigation”.

In this study it is intended to investigate today´s actual economic interdependence of what we would call the Middle East and North African (MENA) region ⁶ and to analyze its economic interweaving, both among its member countries and into the global trading system.

Being aware of the complexity and breadth of this topic, the author has chosen only three subset economic integration agreements, both between the countries of the MENA region (intraregional) - also comprising a subregional agreement - and between the MENA region and other regions (interregional), for closer analysis. Concerning the efforts made towards interregional economic integration, this thesis

1 Auer (2007), p.19.

2 The “House of Islam”, a term from Islamic theology.

3 This means “The Prolegomena” and was intended to be the introduction to his historical book “Kitāb al-ibar”. Today it is considered to be an independent work.

4 Auer (2007).

5 Akbar (2002), p. 27.

6 According to The World Bank´s definition, the MENA region includes: Algeria, Bahrain, Djibouti, Egypt, Iran, Iraq, Israel, Jordan, Kuwait, Lebanon, Libya, Malta, Morocco, Oman, Qatar, Saudi Arabia, Syria. Tunisia, United Arab Emirates, West Bank and Gaza, Yemen. Other definitions include additionally Afghanistan, Somalia, Sudan, Libya or Turkey.

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concentrates mainly on the so-called EU-MED Partnership which was initiated at the Barcelona Conference in 1995 and aims to establish an EU-Med Free Trade Area (EMFTA) by the year 2010 including the EU and the 12 so-called Mediterranean countries ⁷ which, apart from Malta, Cyprus and Turkey, all belong to the MENA region. In contrast, on the intraregional level, the latest initiative in 1997 will be examined, where 17 out of 22 Arab League member states ⁸ - all of which also belong to the MENA region ⁹ apart from Sudan - joined to constitute a “Greater Arab Free Trade Area” (GAFTA) ¹⁰ , mainly to get rid of traditional trade barriers for goods,. 11

On the smaller subregional level, the Gulf Cooperation Council (GCC), consisting of 6 Gulf countries ¹² , which plans the establishment of a common currency by 2010, will be examined more closely.

With GAFTA, GCC and the EU-MED Partnership all being in a different depth of integration and each representing one of the three different levels of integration (subregional, intraregional, interregional), the author holds the view that this choice reflects the actual state of integration in the region best.

In a nutshell, this study tests the compatibility and correlation of the two different integration trends - multilateral and regional - using the example of the MENA region. Are they supplements or substitutes? Does regional integration inhibit or facilitate multilateral integration or vice versa? Are the above-mentioned regional integration arrangements contradictory, compatible or even mutually dependent?

By approaching these questions the reader is to gain some insight into the so-called “Spaghetti Bowl” of cross-cutting integration agreements in the region. ¹³ But before doing so, the reader will receive the basic theoretical configuration in the form of a review of the theory of economic integration and the concepts of regionalism and of multilateral liberalization respectively.

7 Algeria, Cyprus, Egypt, Israel, Jordan, Lebanon, Malta, Morocco, Syria, Tunisia, Turkey and West Bank/Gaza Strip (although not a state).

8 Bahrain, Egypt, Iraq, Jordan, Kuwait, Lebanon, Libya, Morocco, Oman, Palestinian National Authority, Qatar, Saudi Arabia, Sudan, Syria,Tunisia, United Arab Emirates and Yemen.

9 According to The World Bank´s definition.

10 It is also called the “Pan-Arab Free Trade Area” (PAFTA).

11 They agreed on reducing their customs by 10% annually to reach an FTA by the end of 2007.

12 Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates.

13 In this manner the reader can obtain an overview of the economic relations in the region, hopefully lending inspiration for a deeper study of particular issues.

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“By means of glasses, hotbeds, and hotwalls, very good grapes can be raised in Scotland, and very good wine too can be made of them at about thirty times the expense for which at least equally good can be brought from foreign countries. Would it be a reasonable law to prohibit the importation of all foreign wines, merely to encourage the making of claret and burgundy in Scotland?” Adam Smith (1723-1790)

I. TRADE AND WELFARE

If one refers to history, countries have always been involved in trade. But why do they do that? Apparently because they benefit from doing so. Countries trade with each other basically for two reasons. First of all, countries are different in their endowment of resources and their factors of production. This means that some goods are simply not existent in one country or they cannot be produced because one or more factors of production are missing. In that case they have to be imported. ¹⁴ Yet even if a certain good is available in a country or it could be produced, it may still be beneficial to import it for reasons of economy.

Secondly, through trade, countries can achieve economies of scale in production. If each country focuses only on the production of certain goods - because it imports the rest from its trading partner - it has to produce a larger amount of the respective good, for its home requirements and for export. Consequently, the specialization and the higher volume in production allow for more efficiency.

It is generally accepted that it was the above-mentioned Adam Smith ¹⁵ with his Magnum Opus “The Wealth of Nations” ¹⁶ who laid the foundations for the theoretical understanding of trade and the mutual benefits for its participants, the so-called school of classical economic thought. 17

According to his theory, the concept of the international “division of labour” is accompanied by a more efficient factor, 'input', and therefore an increase in economic welfare for each country involved. Smith argued that each country should only produce those goods in which it had absolute cost advantages, which means that every country should specialize in producing only the good it can produce cheapest. David Ricardo ¹⁸ advanced Smith´s theory of absolute cost advantages by proving that trade is even beneficial for those countries which have lower productivity than its trading

14 Provided that they are vital to its population or, as the case may be, are felt to be vital.

15 Scottish moral philosopher and the founder of modern political economy (1723-1790).

16 Adam Smith (1776): An Inquiry into the Nature and Causes of the Wealth of Nations.

17 Issing (2002), p. 67.

18 David Ricardo (1772-1823) was an English promoter of classical political economy.

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partner in all industries. In the Ricardian Model, a country will export those goods its labour produces relatively efficiently and import goods that its labour produces relatively inefficiently. ¹⁹²⁰ The concept of comparative advantage was born. When Stanislaw Ulam 21

- a famous Polish mathematician - once asked the American neoclassical Nobel Prizewinning economist Paul Samuelson to name one theorem in all of the social sciences which is both true and not trivial, he answered: Comparative advantage. "That it is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.” ²² As there still seems to be the need for explanation, the theorem of comparative advantage will be illustrated and the question of whether economic cooperation can be profitable in principle will be answered in the following model.

We want to use a 2-country model mainly based on the explanations of Ricardo ²³ in which we compare the countries of Syria (S) and Lebanon (L) concerning their wine (w) and cloth (c) production. Both countries` production is subject to certain restrictions such as scarcity of resources which can be expressed in the following transformation curves:

S : w=600−2 c L : w=700−c and

Without trade, Syria produces and consumes according to its preferences 200 units of wine and 200 units of cloth.

Lebanon, by contrast, produces and consumes 300 units of wine and 400 units of cloth. Both countries use their entire resources for the period considered.

The following charts demonstrate the production facilities of the two countries in their selfsufficient situation.

19 Issing (2002).

20 Krugman and Obstfeld (2000).

21 1909-1984.

22 Samuelson (1969), p. 9.

23 Krugman and Obstfeld (2000), pp. 55.

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Fig. 1: Fig. 2:

As can be seen from the figures above, in this example Lebanon has absolute advantages in the production of both commodities. It could produce more wine as well as cloth than Syria. According to the theorem of comparative advantage, economic cooperation is even profitable when one country - the Lebanon in the case at hand - has an absolute advantage in the production of both commodities.

To understand this, we must consider the opportunity cost that these countries have to deal with. If a country decides to produce one more unit of a certain commodity, it has to forego a certain amount of units from the other commodity. These foregone benefits are the opportunity cost that this country has to face.

If we summarize the opportunity costs of the two countries in our example, we realize that even the “weak” country of Syria has an advantage.

Tab.1

In this respect Syria has an advantage regarding the opportunity cost, as it has to forego only a ½ unit of wine to produce 1 more unit of cloth. By contrast, Lebanon has to forego the production of 1 unit of wine to produce 1 more unit of cloth. This means that Syria has a comparative advantage in the production of cloth. Precisely this comparative advantage causes even the “strong” country of Lebanon to consider the economic cooperation with the “weaker” partner of Syria to be beneficial.

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If these two countries specialize according to their comparative advantages in a Syria-Lebanon economic partnership, this will bring an extension in consumption possibilities for both countries and therefore an increase in economic wealth. Without economic cooperation, both countries together produce 500 units of wine and 600 units of cloth. On the basis of the transformation curve of the Syria-Lebanon partnership we will demonstrate that an improvement through trade is possible for both countries.

If both countries direct all of their resources to the production of cloth, they could produce 1,300 units. If they want to enter wine production, they must consider who can do this at lower costs. In our example this is Lebanon, because it has a comparative advantage in the production of wine. For the production of 1 unit of wine it has to forego only 1 unit of cloth, by contrast with Syria, which would have to forego the production of 2 units of cloth to produce 1 unit of wine.

Up to a production of 700 units, only Lebanon will produce the need for wine in the community because it can do this at lower costs than Syria and the community has to face costs amounting to only 1 unit of wine for 1 unit of cloth. It is only when the community wants to produce and consume more than 700 units of wine that Syria has to enter wine production. This fact also explains the kink in the following transformation curve, because the community now has to pay with 2 units of cloth for the production of 1 unit of wine. Fig. 3

Source: Author

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All the commodities in the orange box constitute an improvement compared to the situation of independence we had before. The transformation curve of the 2-country community runs through the area of improvement, which proves the extension of consumption possibilities through economic cooperation.

Therefore economic units - acting in an economy based on the division of labour - can benefit from trade in as much as they can get certain commodities cheaper than their own opportunity cost. If Syria and Lebanon both specialize in production according to their comparative advantages, it necessarily results in trade between both parties. Global demand and supply on the common market will determine the prices for wine and cloth. Due to the existing opportunity cost, the upper and lower price limit can be determined. Consequently the price ranges:

between ½ and 1 unit of wine for 1 unit of cloth and •

between 1 and 2 units of cloth for 1 unit of wine. •

The example becomes clear after the following consideration:

On the one hand, Syria will demand more than a ½ unit of wine for a unit of cloth, because otherwise it could produce this ½ unit of wine on its own and forego just 1 unit of cloth. On the other hand, Lebanon will not be willing to pay more than 1 unit of wine for 1 unit of cloth because otherwise it could produce 1 unit of cloth on its own, foregoing only 1 unit of wine.

This first Ricardian approach was further developed by two Swedish economists, Eli Heckscher and Bertil Ohlin. ²⁴ While in the Ricardo model the relative cost differentials between the countries result from the differences in the productivity of the production factor (labour), Heckscher and Ohlin trace these differences back to the relative factor 'endowment' of the countries (land, labour and capital).

A country will produce and export exactly those commodities in relatively great quantities for which the factor used comparatively intensively in production is relatively abundant. According to this, countries with a relatively high endowment of land for instance are more likely to export land-intensive goods, while countries with a relatively high endowment of labour will export labour-intensive goods.

The owners of the abundant factor will benefit and the owners of the scarce factor will suffer losses. Therefore, foreign trade does not constitute winners only. However, from a

24 In 1977, Ohlin shared the Nobel Memorial Prize in Economics with the British Economist James Meade “for their pathbreaking contribution to the theory of international trade and international capital movements.”

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holistic view, the overall gains from foreign trade are greater than the losses, so that losers could be compensated by the winners. According to the Kaldor-Hicks efficiency criterion, a change has an overall positive welfare effect if the potential winners could theoretically compensate the potential losers for their losses and there would be still a part of the original gains left for them. 25

Both the Ricardian and the Heckscher-Ohlin models are helpful models to explain the causes and effects of external trade, although they have certain shortcomings if tested empirically. ²⁶ However, the basic finding holds true that trade brings gains in wealth for all countries involved via specialization and economies of scale.

`We see societies establishing themselves, nations forming themselves, which in turn dominate over other nations or become subject to them. Empires rise and fall; laws, forms of government, one succeeding another; the arts, the sciences, are discovered and are cultivated; sometimes retarded and sometimes accelerated in their progress, they pass from one region to another. Self-interest, ambition, vainglory, perpetually change the scene of the world, inundate the earth with blood. Yet in the midst of their ravages manners are gradually softened, the human mind takes enlightenment, separate nations draw nearer to each other, commerce and policy connect at last all parts of the globe, and the total mass of the human race, by the alternations of calm and agitation, of good conditions and of bad, marches always, although slowly, towards still higher perfection...`

Anne Robert Jacques Turgot 27 (1727-1781)

II. REGIONAL ECONOMIC INTEGRATION

In the last 10 to 15 years, the number of Regional Trade Agreements (RTAs) on a global level increased sharply as shown in the figure below (Fig. 4).

In light of this fact and of the slow pace of progress in multilateral liberalization under the World Trading System (WTO) - which will be discuss later - it is not only a frequently asked but also a legitimate question - by economists and politicians alike - how the concepts of regional and multilateral economic integration interact. However, as Winters points out, to clarify this issue, first of all it is necessary to define both concepts. Winters defines regionalism “loosely as any policy designed to reduce trade barriers between a subset of countries regardless of whether these countries are

25 Luckenbach (2000).

26 Therefore see also Krugman and Obstfeld (2000), pp. 80 - 82 and pp. 13 - 119.

27 French statesman and economist.

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actually contiguous or even close to each other”. ²⁸ By contrast, for Baldwin and Venables the “geographically discriminatory trade policy is the defining characteristic of a regional integration agreement (RIA)”. ²⁹ This difference clarifies the importance of finding a common definition one can work with to avoid misunderstandings. As we are analyzing an actual geographical region in the second part of this study, we will use the term in the sense of the latter definition.

Fig. 4

From http://www.wto.org/english/tratop_e/region_e/regfac_e.htm ,

a) Regional Economic Integration from a Historical Perspective

Thus Regional Integration Agreements (RIAs) or Regional Trade Agreements (RTAs) ³⁰ are arrangements of countries mainly targeted at the reduction of barriers to trade between members.

They have a long tradition for example in conjunction with colonial trade agreements or as a level of development in the foundation of states such as the Deutsche Kaiserreich which

28 Winters (1996).

29 Baldwin and Venables (1997).

30 In literature, the expressions RIA, RTA or PTA (Preferential Trade Agreement) are often used interchangeably. For reasons of uniformity, only the term `RIA´ will be used in this paper. Moreover, according to the author´s view, this term best recognizes the fact that arrangements between countries often go beyond the level of trade liberalization, often up to the point of political harmonization.

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emerged from the Deutsche Zollverein, an association of German federal states in the area of customs and trade policy.

From a historical perspective, degrees of integration among countries can vary from “shallow” to “deep”. Whereas “shallow” integration only includes the cutting back or the removal of barriers to trade in commodities, “deep” integration targets the harmonization of the national policies in order to enable and boost the internal factor of mobility. 31

1. Old Regionalism

The first wave of regionalism during the post-war period (20-30 years after World War II) was a phase of “shallow” integration, which is often called “Old Regionalism”. Immediately after the foundation of the European Economic Community (EEC), this concept gained a great deal of attractiveness, especially in developing countries. Facing the given protection of the industrialized countries, they were following the ideal of the EEC and thus hoped to bring down the costs of their own industrialization by liberalizing amongst each other. ³² The Common External Tariff (CET) for the member countries was an exogenous determined given, which made simultaneous multilateral and regional advancement impossible. This protectionist attitude was mainly induced by the import substitution strategy of the developed countries, which found its theoretical foundation in the “Infant industry argument” from Friedrich List ³³ . Hence the “Old Regionalism” was quite a defensive concept - focused on protectionism - which seemed to present an alternative to the global trading system by assuring the trade relations to the most important partners at any rate. 34

2. New Regionalism

With the second wave starting in the mid-1980s, as shown in Fig. 4, more and more RIAs with deeper integration qualities came into being, many of them between developed and developing countries. This second wave is called the “New Regionalism”. By contrast to its

31 Burfisher, Robinson et al. (2003), p. 2.

32 Langhammer and Wößmann (2002), p. 10.

33 Friedrich List (1789-1846) divided the historical development process of each economy into five levels. Not every country is located on the same level of development. According to List, these differences in the level of economic development among the countries would render the concept of one single “world economy” useless. In fact each country had to do everything within the realms of possibility to reach the highest level of economic process. Customs were a permitted instrument to protect the country's own economy from foreign competition as long as the advance gained was used to improve the own country's competitive capability. If all countries reached the same final level of development, a world federation could be established, where free trade and peace would dominate.

34 Carlowitz (2003), p.15.

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forerunner, the new wave of regionalism was much more a result of successful multilateral trade liberalization.

Burfisher et al. identified certain characteristics of New Regionalism, which are usually found in the deepest level of integration, the Total Economic Union. ³⁵ The characteristics are as follows:

improved real and financial capital and labour mobility between the RIAs •

consorted regional tax and subsidy policies •

consorted macroeconomic policy including fiscal, monetary and exchange rate • policy

common institutions which control and alleviate the integration process, for •

example by setting standards and dispute settlement mechanisms advanced transport and communication infrastructure to boost the flow of goods • and labour

aligned legal regulation of goods and factor markets, for example anti-trust •

legislation, economic law and social partners etc. introduction of a common currency •

b) Stages of Regional Economic Integration

Economic integration can be understood both as a dynamic process and as a static setting. According to Balassa ³⁶ , the dynamic process consists of economic and political actions “designed to eliminate discrimination between economic units that belong to different national states”.The static setting “represents the absence of various forms of discrimination between different national states.” 37

Balassa differentiates between 5 stages of regional economic integration ³⁸ , listed with an increasing degree of integration in the table below. They comprise different degrees of discrimination between the partner countries themselves and between the partner countries and non-partner countries: Tab. 2:

35 Burfisher, Robinson et al. (2003), pp. 2-3.

36 Béla Balassa (1928-1991) was a famous Hungarian economist.

37 Balassa (1987), p. 43.

38 Balassa (1961), p. 2.

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Yet in reality, the different forms of integration cannot be separated so easily. Instead there exists a multitude of different hybrids which complicate clear differentiation.

c) Economic Causes and Effects of Regional Economic Integration

In the theory of economic integration, the causes and effects of integration are closely related, as the anticipated positive effects of integration actually cause countries to join an existing RIA or to co-found a new one.

Academic literature on the economic effects of integration generally distinguishes between static and dynamic effects of integration. Whereas the static effects are about the short term consequences, the dynamic effects are about the long-term consequences of integration measures. On closer examination of integration effects and attempting to measure them, one notices that it is quite complicated to actually determine which effects can be exclusively ascribed to measures of integration and which effects are at least partially the result of other political and economic measures or social events. 39

39 De Lombaerde (2005), p. 23.

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In the following, some general economic motives for countries to integrate are elaborated, although each country may have its own specific reasons for joining an RIA. 40

1. Static Effects of Regional Economic Integration

i. Trade Creation & Trade Diversion Effects

It was Jacob Viner with his publication on The Theory of Customs Unions (1950) who officially introduced the terms of Trade Diversion and Trade Creation, although Friedrich List had already alluded to the concept of Trade Creation in his analysis of the Deutsche Zollverein in 1841. 41

In Viner's day, the establishment of Customs Unions (CU) was generally considered to be welfare increasing and therefore had to be supported. This position was justified with the argument that global free trade would bring a maximum of global welfare, and since a CU was a step in the direction of global free trade, it should bring an increase in welfare after all.

It was especially Jacob Viner who doubted this idea, because a CU only meant free trade within its boundaries and a protectionist attitude against the rest of the world. According to Viner, this could lead to trade creation as well as trade diversion.

One speaks about an RIA as being trade creative if a member country of an RIA increases its imports from its partner countries without reducing its imports from the rest of the world. This occurs because the liberalization of trade within the RIA through the reduction of tariffs decreases the price of imports from other RIA member countries. In case the producers of the partner countries are more efficient than the home country, the price for the imported good will be lower than before the integration. As a result, consumption and imports increase while the less-efficient domestic producers stop producing. Hence the expensive domestic production is substituted by cheaper production from partner countries. Trade creation is beneficial because it does not have an impact on the rest of the world. The more efficient the production within the member countries of the CU compared with the rest of the world, the more likely trade creation is to occur. The lower the internal tariffs, transport and other trade costs, the larger the new market and the more effective the external tariff is in protecting the internal production, this stronger this effect becomes. 42

40 Carlowitz (2003), p. 25.

41 Carlowitz (2003), p. 27.

42 Taalouch (2007), p. 5.

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One speaks about Trade Diversion when imports which came from the rest of the world in the past are substituted by more expensive imports from partner countries after the formation of the CU. After the formation of the CU, the partner countries do indeed have a price advantage because of the preferential treatment they experience (internal tariff reduction and common external tariff), but they do not necessarily have a cost advantage against the rest of the world. ⁴³ That means that trade is diverted from a more-efficient supplier outside of the CU towards a less-efficient supplier within the CU. That is why this effect is typically harmful.

Consequently the net welfare effect of a CU can be either negative or positive, depending on the relative strength of Trade Creation and Trade Diversion Effects. 44

II. Demand Side Effects

Viner´s theory came under criticism because in his analysis he neglected the effects of integration on the internal relative prices. Hence he did not observe changes in consumer welfare triggered by integration. If these consumption effects are incorporated in the analysis, under certain conditions it can result in an increase in welfare even though the integration´s net effect is trade diverting. This applies for the case that the consumption or import structures are changing because of a shift in relative prices after integration.

Viner was accused of basing his analysis on constant consumption coefficients and therefore not accounting for the possibility of changing consumption volumes. In reality the creation of a CU does change the relative prices, which leads to a substitution of consumption to the relatively cheaper good. Therefore if the consumption effect is positive

- because it can also be negative - and exceeds the negative trade diversion effect, a trade-diverting integration can still be welfare increasing for the member country. 45

Others interpret Viner's work differently. Bhagwati, for example, assumed that Viner kept the import volume constant and not the consumption volume. In this case a trade-diverting integration leads to a reduction of welfare, because if there are no additional imports the consumers cannot benefit from lower prices, because there is nothing more to buy.

Bhagwati also showed that even if the consumption volume is kept constant, an increase in welfare is possible. This is the case if the change in relative prices causes a shift in production which means that more or less of a product is being produced. This applies

43 Carlowitz (2003), p. 27.

44 El-Agraa (1997), p. 35.

45 Carlowitz (2003), p. 36.

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only for the assumption of a variable production structure. In this case the specialization according to the comparative advantages leads to efficiency gains and therefore has welfare-increasing effects.

III. Terms of Trade Effects 46

The Terms of Trade (ToT) delineate the ratio of export prices and import prices. An increase in a country´s terms of trade has - ceteris paribus - welfare-increasing effects, because the country now has to export less to receive the same amount of imports in exchange. 47

The fact that regional economic integration can change this ratio was already determined by Mundell in 1964 for instance. ⁴⁸ A trade diversion effect for the benefit of the RIA member countries results in less demand for imports from third countries. Also the introduction of import tariffs reduces the volume of imports from third countries, which in turn reduces the world price for the implied goods if the RIA has a large share in the world market. So the Terms of Trade for the non-member countries worsen and those of the RIA improve. 49

2. Dynamic Effects of Regional Economic Integration

i. Increased Competition

Increasing competitive pressure between the companies of integrating countries can lead to rationalization of inefficient production processes and enable an improvement of technological efficiency, which again leads to cost savings and price reductions from which consumers can benefit. The cost savings also raise the international competitiveness of the producers of the integrating region, which again boosts its economic growth.

A larger market leads to higher demand and also allows a larger supply of efficiently producing suppliers. The reduction of import duties in an RIA for example then allows the substitution of home-produced goods through similar imports from partner countries. This

46 According to Zorob, there is still academic discord about the question of whether Terms of Trade effects rank among static or dynamic effects. (Zorob (2006), p. 136)

47 Krugman and Obstfeld (2000), p. 112.

48 Mundell, Robert (1964) “Tariff Preferences and the Terms of Trade”, Manchester School Economic Social Studies, in Winters (1997).

49 WTO (2000), p. 94.

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