July 23, 2018

Breaking down barriers

What are the spillover effects from free trade agreements?


America’s relationship with its trading partners is getting increasingly tense.

In addition to a full blown trade war with global power China, the US president has questioned agreements with other longtime partners and wants to renegotiate the NAFTA deal with Canada and Mexico.

The situation has concerned US producers who worry the heightened tension will harm exports to those countries. But the consequences of rising tariffs with China, Mexico, and Canada are likely to reverberate far beyond those markets.

“There are important spillover effects from trade agreements,” said Kamal Saggi, professor of economics at Vanderbilt University, in an interview with the AEA.

Saggi co-authored a paper in the American Economic Journal: Applied Economics that says trade deals have important consequences that spill over outside of the countries that agree to them. In particular, Saggi and his co-authors Andrey Stoyanov and Halis Murat Yildiz argue that liberalized trade between two nations can also open pathways with other countries that had nothing to do with the agreements.

The paper highlights the important and overlooked benefits that result from free trade agreements (FTAs), gains that are not currently being weighed by policymakers who want to stoke trade wars.

We’re trading with so many countries, the effect of any one country is not that large, but the cumulative effect is pretty significant.

Kamal Saggi

Previous research has shown that free trade agreements can nudge member countries to lower tariffs on other countries.

For example, if the US strikes a deal to import more Canadian oil, then the US might lower tariffs on Venezuelan imports of oil. After all, if the US is suddenly less dependent on Venezuelan oil because of the deal with Canada, then a tariff on Venezuelan oil becomes a less powerful tool for the US to improve its bilateral terms with Venezuela, making it more advantageous for the US to reduce its tariff on Venezuela. This is called the tariff complementarity effect.     

Saggi and his co-authors wondered whether this logic could be applied the other way. Could an FTA between two countries cause other nations outside the agreement to lower their tariffs as well? If Canada and the US have a more liberal relationship, boosting trade among themselves and lowering exports to other countries, then the tariffs imposed on Canada and the US by those outside countries become less valuable to them as well, an effect that could potentially induce them to reduce such tariffs. That’s the theory, anyway. The question is whether it actually happens.


To answer this question, the authors examined trade data for 192 importing and 253 exporting countries, as well as information on all FTAs formed between 1989 and 2011. Their empirical analysis confirmed the theory. They found that if a country’s exports increase by 10 percent as a result of a new FTA, and its share of imports of a nonmember country is 10 percent, then the latter drops its tariff by 0.08 percentage points.

“It’s not large in terms of magnitude,” Saggi said. “We’re trading with so many countries, the effect of any one country is not that large, but the cumulative effect is pretty significant.”

The lesson for policymakers is to avoid tunnel vision and consider the broader global consequences of the trade deals they sign. If FTAs can cause other countries to adopt more liberal trade policies, there’s an important upside to these arrangements that must be considered. The actions of a few — whether resulting in liberalizing trade or tighter tariffs — can have larger unintended consequences in the global economy.

“The (political) conversation has focused exclusively on what other countries outside the agreement lose,” Saggi said, “and has not given enough attention to what the world economy might gain.”

Do Free Trade Agreements Affect Tariffs of Nonmember Countries? A Theoretical and Empirical Investigation appears in the July issue of the American Economic Journal: Applied Economics.