Trade agreements as incomplete contracts.

• Author: Maggi, Giovanni
• Position: Research Summaries

The traditional theory of international trade typically views trade agreements as complete, or as contracts that specify all the relevant policy instruments and cover all possible contingencies. Implicit in this approach is the assumption that all relevant policy instruments and contingencies can be specified in the contract and verified by a court. In reality, though, even the most elaborate trade agreement--the GATT/WTO--is a vastly incomplete contract: the constraints imposed by the agreement on governments' policy choices are largely non-contingent, and many relevant policy instruments are left out of the agreement.

Another counterfactual implication of the complete-contracting view of trade agreements is that judicial bodies, such as the WTO's Dispute Settlement Body, should play only a pure enforcement role. In reality, however, most trade disputes in the WTO concern not simply the enforcement of clearly specified obligations but rather the interpretation of vague provisions, or of instances in which the text of the agreement is silent. This

suggests that one important role for the WTO's court may be to "complete" an incomplete agreement.

All of this leads to important questions: How do we explain the particular structure that trade agreements take in reality? Can an incomplete-contracting perspective help us interpret the rules and institutions that have emerged in the world trading system?

Rigidity and Discretion in Trade Agreements

In one paper, Henrik Horn, Robert Staiger, and I propose a simple incomplete-contracting model of trade agreements in which the contractual incompleteness arises from the presence of contracting costs. (1) We argue that this incomplete-contracting perspective can help to explain some core features of the GATT/WTO. In particular, the agreement binds trade policy instruments, while leaving the choice of most domestic policy instruments to the discretion of governments. One exception is that the WTO has introduced some regulation of domestic subsidies. Second, the restrictions in the GATT/WTO are not usually conditioned on any information about the state of the economy, except for some "escape clauses" that allow for temporary protection under some specific circum stances. Finally, the agreement only stipulates upper bounds on the tariffs, thus leaving governments with discretion to go below the bounds.

Our key assumption is that it is costly to negotiate and draft a trade agreement, and that contracting costs are higher when the agreement is more detailed, both in terms of the policies that it seeks to constrain and the contingencies that it specifies. (2) We explicitly incorporate the costs of contracting over policies and contingencies into our model, and study the optimal design of a trade agreement in the presence of these costs. (3)

We find first that it cannot be optimal to contract over domestic subsidies while leaving tariffs to discretion. This result accords well with the emphasis on trade measures that characterizes the GATT/ WTO. And, while this feature is often informally explained as deriving from distinct levels of contracting costs across these instruments, our model imposes no such distinction and thus...