Brief History of Regional Integration

Brief History of Regional Integration 

Regional integration agreements (RIAs), either formed for economic reasons or for non
economic reasons, have been on the stage of international trade for hundred of years. To be
able to study the brief history of these agreements, a good starting point would be the
establishment of the GATT system, because with the  introduction of the GATT system
RIAs gained their legal legitimacy. After giving some remarks on the history of regional
integration prior to the GATT system, the next section will study the key concepts of the
GATT system, together with the underlying rationale for the introduction of the GATT
Article XXIV, which is the first legal clause governing RIAs. On the other hand, in the
final section, history of regional integration that spans from the initiation of GATT to the
present day will be studied.

                                                
1
 Due to political considerations, the number of countries tends to change according to the various sources.
For example, the US accepts 194 countries, the inclusion of countries like Northern Cyprus, Taiwan, etc.,
brings this number to 200 (and even more).

Second wave of globalization

After the World War II (WWII), protectionist tendencies of the past thirty years had been
partly eliminated by the attempts of two powers, namely Britain and the United States. The
intention was to reform the world order. The scope  for change involved not only
international trade, but also the financial system  and the growth of national economies.
Global reconstruction was concentrated on the formation of international (multinational or
supranational) institutions to organize financial relations, developmental issues and
international trade. One of the resulting institutions of the so called “Bretton Woods
Conference” (1944) held in Bretton Woods (New Hampshire) was the International
Monetary Fund (IMF) which was supposed to provide an orderly framework for monetary
relations. Another one was the International Bank for Reconstruction and Development
(IBRD, later the World Bank, WB) that was formed in order to mobilize available
resources for reconstruction and development. 

In the international trade side, the Economic and Social Council of the United Nations
(formed in 1945) was the responsible body of multilateral trade negotiations. However, the
Council adopted a resolution that envisaged the formation of International Trade
Organization (ITO) (Matsushita, Schoenbaum & Mavroidis, 2003, p.1). The following
negotiations on this formation were held in New York (1947), in Geneva (1947) and in
Havana (1948). With the Geneva meetings, it was decided to prepare a multilateral treaty
that aimed to clarify the codes of international trade. As a result, the General Agreement on
Tariffs and Trade (GATT) that aimed to direct the orderly conduct of trade and to promote
trade liberalization had been completed by the end of 1947. However, for the formation of
the ITO, the planned program did not work well. Even though being the ideological
founder of the new order, the United States whose decision was vital for this formation did   31
not approve the legislation that would enable the establishment of ITO1
. Hence, the ITO
was dead before its birth. However, international trade should not be left alone; as a result,
the establishment of ITO had been substituted by “a Protocol of Provisional Application to
apply the GATT provisionally on and after January 1, 1948” (ibid., p.2).

The seeds of the second wave of globalization came  into existence through these
international institutions. At first sight, one big difference between the first and second
waves of globalization can be noticed. It is the existence of international organizations.
The role of these institutions is to arrange, when it is necessary, the smooth working of the
international system on their subject area. Additionally, the role of hegemonic power        
–namely, the United States, at this time– and the other leading countries should also be
clear in this new system. Hence, while the first era of globalization was obviously
characterized by the imperialist ideology of the leading powers, the second era can also be
said to be characterized by hegemonic powers, but in this case in a disguised form, i.e. via
Bretton Woods Institutions and the GATT system2
. 

Taking into account the ratio of world trade to world output leads the conclusion that
although there has been a general trend toward freer trade after WWII, trade as a share of
world output does not seem to have improved to its  1913 level until the mid 1970s
(Krugman et al., 1995, p.330).  Albeit it is not easy to compare two periods due to the
different time related characteristic features of the history and present, when it is looked at
the statistical figures, the following comparison can be noted about the two (O’Rourke &
Williamson, 2002a, p.422):

The growth of world trade was pretty much the same  in the nineteenth and
twentieth centuries, roughly 3.7 or 3.8 per cent per annum. This is a surprising fact,
given that world GDP growth doubled from 1.5 to 3 percent per annum between
1820 1913 and 1913 1992. Since the growth of world trade was almost identical in
the two centuries, it follows that trade shares rose much faster in the nineteenth
                                                
1
 In fact, with the success of the Republicans in the 1948 election, President Truman did not send the
legislation for the ITO to the Congress (Matsushita et al., 2003, p.2). 
2
 During the first decade after the WWII, the US was the unique hegemonic power.   32
century than in the twentieth century. So far, it looks as though the nineteenth
century is the canonical globalization epoch par excellence. 

In the second wave of globalization, declining political barriers to trade and fast income
growth –especially in the late twentieth century– have also been seen as a link between
distant markets. Moreover, there are several new features of the modern trade relative to
the past experience such as the rise of intra trade (trade in similar industries),   splitting
production process into different geographic areas  and the emergence of countries that
have high ratios of trade to GDP (like Singapore and Hong Kong). While in the first wave,
trade was mainly based on the comparative advantage (countries traded what they could
not produce themselves), in the second wave, with declined transportation costs, trade in
similar goods or intermediary products has become significant and resulted in increased
bilateral trade ties between countries that have similar endowments. Expansion of trade in
services, developments in the commercial law, increased acquaintance with doing business
abroad have further contributed to the growth of world trade (Krugman et al., 1995, p.332). 

In addition to these, although they do not represent complete diversion from the elements
of the first wave of globalization, there are some significant factors that contributed to the
integration pace of the second wave (SavaL, 2004, p.31 35). First of all, the adoption of
floating exchange rate system instead of fixed exchange rate system has changed the
working of underlying principles in international economics. Secondly, “import
substitution” strategy in which states apply domestic protection on vulnerable sectors has
been substituted with the “export promotion” strategy that emphasized the place of
openness and trade for economic development. Thirdly, advances in information
technology have resulted in increase in the speed of capital mobility. Technological
innovations, trade and capital account liberalizations are the integral parts in both waves of
globalization. While in the first wave technological developments depicted themselves in
railroads, steamships, and the advances in communication, developments in the airfreight
and advances in the information technology that skyrocketed via computers, mobile
phones, and internet have been the primary technological advancements of the second
wave. The technological and organizational innovations in the production system, i.e.
changing the pattern of production from “fordism” to “post fordism”, have also   33
significantly facilitated international integration. Moreover, while there had been both
trade and capital liberalization mainly as an end result of colonialism in the first wave, in
the second wave, related liberalizations are either employed unilaterally, or enforced by the
international institutions. 

Beside gradual decreases in the level of trade restrictions through the successive “rounds”
of the GATT and advances in production systems, afterwar period has also witnessed rapid
increase in the number of countries. While in 1920, there were 69 countries in the world,
the number increased to 89 in 1950 and 192 in 1995 (Alesina et al., 2000, p.1292). Now,
there are approximately 200 countries in the world1
.  But this rise in the number of
countries does not represent the increased participation to the global management of
international trade, finance or politics.  It cannot be said that it is the game of equals.
Throughout the world, ‘triadization’ that emphasizes the dominance of Japan and the
newly industrialized states in the South and South East of Asia, Western Europe and North
America on the process of technological, economic and socio cultural integration is
another fact of the second wave of globalization (Adriana, 2008, p.315). 

HISTORICAL PERSPECTIVE ON GLOBALIZATION AND REGIONAL INTEGRATION

HISTORICAL PERSPECTIVE ON GLOBALIZATION AND
REGIONAL INTEGRATION
 
Regional economic integration and globalization are not new concepts to the world.
History of regional economic integration is much older than the one of globalization. But,
as globalization is much wider concept, in economic/political sense, than the regionalism
concept, this chapter will study firstly the brief history of globalization. After studying the
history of globalization, the history of regional economic integration will be covered
shortly. As the main concern of this study is regional economic integration prevailing in
the GATT/WTO system, this history will begin with the GATT (1947) as its inception. 

4.1 Brief History of Globalization
 
When it is measured by the ratio of world trade to  world output, the history of
globalization has been generally divided into two stages or waves as the first wave and the
second wave of globalization. While the first wave  of globalization involved the period
between the years 18701
 and 1914, the second wave that is related to the modern world has
started to develop in the 1950s and become dominant on the stage of international order
since the late 1980s. Hence, this section will initially study history of the first wave of
globalization, and then history of the second wave.
 
4.1.1 First wave of globalization

The factors behind the first wave of globalization were several. The leading contributors
were as follows: the industrial revolution in the Western countries; the colonization
policies of the hegemonic powers like Britain, France, Spain, Netherlands, Italy and
Belgium; the technological advances in transportation and communication; the
                                                
1
 For the period 1500 1800, there were also growing trade volumes, especially in Europe, but the main reason
for such an increase was the “…outward expansion of European import demand fuelled by population growth
or Asian export supply rather than by market integration per se” (O’Rourke & Williamson, 2002a, p.426).    27
international monetary system of the time; the hegemonic power and ‘the last resort’ role
of Britain; bilateral trade agreements throughout Europe and the lower tariff levels
prevailing in the international trading system. 

Industrialization had resulted in increase in the intensity of trade via the advances in
production techniques. Industrialized countries of Western Europe exported manufactured
goods and capital which in turn “fueled the growth of primary exports, such as wheat and
beef from Argentina, wool from Australia, rubber from Malaya, tea from Ceylon”
(Findlay, 1996, p.49). The industrial revolution had changed not only the economic
patterns of the old world, but also the political balances. With increased military and
industrial power, West European countries consequently started to search for new markets
to dominate in the 1840s. This search eventually gave rise to the colonization period. The
emergence of colonial empires at the end of the nineteenth century can be stated as a
reaction to stagnant trade among European countries and “the need to expand markets in a
period when protectionism on the rise” (Alesina, Spolaore & Wacziarg, 2000, p.1291). 

Hence, the colonization policies of the leading countries had been the utmost factor behind
the spread of globalization in the first wave. To increase their economic relationships with
the colonized countries, imperialist countries had  removed restrictions, be it tariffs or
quotas, on their mutual trade. As a result, the first examples of preferential trade relations,
i.e. RIAs, were seen in the colonial relationships of hegemonic powers.

Technological developments in transportation and communication were other contributing
factors behind the growth of world trade in the first wave of globalization. Improvements
in long distance transportation through completion  of the Suez Canal and of the Union
Pacific railroad in 1869, invention of the steamships and construction of the new railroads
made cross country transportation easier in this period. These factors together with other
productivity developments on long distance transportation led price gaps between Britain
and Asia to decrease (O’Rourke & Williamson, 2002b, p.38). Transport costs, which fell
significantly before 1914, but then increased sharply up to 1939 due to protectionist
policies, consequently played a significant role on the upward and the downward
movements of trade. The assembly of telephone and telegraph cables under the oceans, on   28
the other hand, had facilitated the overseas communication, as a result international trade,
since 1859. 

Additionally, the beginning and the end years of the first wave of globalization, i.e. 1870
and 1914, have another significant feature in the area of international economics. That
period has been dubbed as the period of international gold standard. Besides being the first
global monetary system, the international gold standard system depended on full
convertibility of currencies to the gold and free export and import of gold. When it is taken
account that “payment frictions associated with currency regime” is one of the barriers of
trade, it would be easy to conclude that the natural outcome of gold standard was increased
international trade (Estevadeordal, Frantz & Taylor, 2003, p.362). Hence, it has been
argued that the effect of common currency explained a large portion of the change in trade
volumes in the first wave of globalization. In addition to the common currency system, the
Napoleonic Code, which represented a common legal coding on international trade and
business, had further contributed to the development of international integration (SavaL,
2004, p.16).

The Great Britain’s financial and the “lender of last resort” roles on the first wave also
deserve attention. Free trade ideology prevailing in that period started with Britain’s
movement in the 1840s through the removal of exports and imports taxes, and the repeal of
the Corn Law. Accordingly, the repeal of the Corn Law was seen as the ultimate victory of
the Classical liberal economic doctrine over mercantilism (Chang, 2007, p.28). Bilateral
trade agreements, initiated through steps taken by Britain, were also one of the elements of
the first wave of globalization. The Cobden Chevalier treaty of 1860 that freed trade
between Britain and France was the first example of such agreements in the period1
. The
other countries had followed suit, and similar treaties had been signed all over the Europe
in those years. At the same time, the newly founded countries like Germany incorporated
the principle of free trade as their basic national policy. Eventually, free trade ideology had
been accepted, willingly or not, by most of the remaining countries
2
 through colonialism
                                                
1
 It is noted that the degree of protectionism in France was already quite low relative to the one in Britain on
the eve of the treaty (Chang, 2007, p.33).
2
 The US that maintained very high tariffs was the obivous exception to the free trade trend (Chang, 2007,
p.30).    29
and through “unequal treaties in the cases of a few nominally independent countries like
the Latin American countries, Thailand [formerly, Siam], China, and the Ottoman Empire”
(Chang, 2007, p.25). 

The factor of low tariff levels, although promoted  global integration, was not specific
element of the first wave of globalization. Since the idea of free trade was dominant prior
to the first wave of globalization, trade restrictions were low during the period. Among the
European countries, free trade ideology had further spreaded via the colonization process
and the political wars among the leading nations. On the other hand, for the leading power
of Asia, namely for Japan, the ‘Meiji renovation’ had taken free trade into account as an
integral part of the economic and social life. Nevertheless, the minimal role of tariffs
throughout the world continued until 1914, even though this situation had been reversed
after that time. 

The outbreak of the World War I (WWI) had ended the first globalization period of the
world. After World War I, many countries ran into severe financial disorders and rapid
inflation rates (hyperinflations for some). While Britain lost its hegemony through the
breakdown of its financial system, most of the countries turned into protectionist policies.
The Great Depression of 1929 had further worsened the situation. Until the World War II
(WWII), without any ruling power or the international institution, international order was
left to its own.  While the US raised tariffs via the Smooth Hawley Tariffs (1930), Britain
–the leader of the laissez-faire policies of the previous period– turned into tariff protection
in those years. Furthermore, many of the US trading partners like Canada, Cuba, France,
Mexico, Italy, Spain, Australia and New Zealand increased their tariff rates as a response
to the Smooth Hawley Tariff Act (Bagwell & Staiger, 2002, p.43). As Haberler (1964, p.7)
notes: “Tariffs everywhere were raised rapidly and almost all countries introduced quotas,
exchange control, import prohibitions, bilateral clearings – methods of international trading
which in peacetime had literally not been known for centuries.”

For the international trading system, the conditions prevailing in the interwar period can be
summarized as (League of Nations, 1942, p.101; cited in Bagwell & Staiger, 2002, p.44):
“While there were frequent international conferences and committees in which   30
governments proclaimed their intentions to pursue ‘freer and more equal trade’, it is also
true that ‘never before in history were trade barriers raised so rapidly or discrimination so
greatly practiced.” Hence, in spite of the continued economic growth, due to protectionism
that grew in the 1920s, trade expansion of the previous decade had turned into a trade
contraction in the interwar period.

Studies on the Effects of Regional Integration on Members/Non4members

Studies on the Effects of Regional Integration on Members/Non4members

This section will survey the studies that consider  the effects of the formation of RIAs on
member and non member countries. For example, Brada and Méndez (1985) take into
account three developed (the EEC, EFTA and CMEA) and three developing country
(CACM, LAFTA and the Andean Pact) integration schemes. They conclude that an
effective integration is possible for both groups. They also note that while inter member
distances limit the benefits of integration in Latin America, the system and policy
differences of CMEA relative to the market economies do not change the expected results.
On another study, Brada and Méndez (1988) study dynamic effects of regional integration
on investment levels and factor productivity growth for six integration schemes (EEC,
EFTA, LAFTA, CACM, EACM and CMEA). For the period 1951 77, the study concludes
that the impact of dynamic effects of integration is no more than 1 per cent of members’
GNP. Hence, the dynamic effects are neither a reason of raised growth rates nor a raison
d'être for integration for the given sample.
   23
Shiells (1995) starting with the examination of economic and non economic motives for
the formation of RTAs emphasizes the necessity of considering the welfare gains of RTAs
beside their trade creation and trade diversion effects. Nationalization of existing industry
structures, FDI flows and dynamic gains from learning by doing, improved product
quality, greater product variety are proposed as further welfare gains entailed to such
agreements. 

Wonnacott (1996) states that trade diversion would  increase competition and
specialization, beside its supply switching effects. Overall, this process can make member
of an FTA the lowest cost source. The study also incorporates the hub and spoke analysis
1

to the issue of overlapping FTAs and concludes that diversion will increase as a result of
this overlap and hub (center of integration) rather than spokes is the probable gainer in
such a system.

Wei and Frankel (1998), on the other hand, state that in a world of increasing trade blocs,
an open regionalism (defined as the reduction in barriers on imports from third countries)
with a modest external liberalization can be welfare improving, but not as much as the one
that will attained as a result of multilateral tariff liberalization. Moreover, as it is stated in
Frankel, Stein and Wei (1996), the international trade rules should be modified to ensure
welfare improving RIAs. Rather than complete elimination of internal barriers (required by
Article XXIV), the partial internal liberalization serves better results in this respect.

Cadot, De Melo, and Olarreaga (1999) use three good, three country model to examine the
effects of regional integration on the external trade policies of member countries. The
study concludes that protectionist pressures against non member countries will increase as
a result of the deepening integration and states that trade diverting RIAs are the ones that
are politically most viable.

Antkiewicz and Whalley (2006) takes into account regional trade agreements covering
Brazil, Russia, China, South Africa and ASEAN as large population and rapidly growing
                                                
1
 The hub and spoke analysis of RIAs is as follows if one member of the agreement has also other RIAs with
a number of countries that keep trade barriers against each other, then this member becomes the hub, i.e. the
preferred location, for investment flows (Schiff & Winters, 2003, p.78).   24
non OECD economies. Accordingly, recent agreements  covering these countries include
WTO plus subjects like intellectual property, competition policy and mutual recognition,
beside their own dispute settlement procedures. For this group of countries, the study
emphasizes that although the agreements are in line with WTO disciplines, they represent
some kind of a response to multilateral failures like “Multilateral Agreement on Investment
(MAI) and the repeated Doha Round setbacks” (ibid., p.346)
1
.

Baharumshah, Onwuka and Habibullah (2007) investigates the (ASEAN 5)+3 economies 
(Malaysia, Indonesia, Philippines, Singapore and Thailand, plus Japan, China and South
Korea) in order to find out that whether regional integration is an obstacle in front of the
multilateral trade liberalization or not. For the period 1967 2000, the study tests the
existence of any long run relationship between regional and multilateral terms of trade and
concludes regional trade integration does not hinder the global integration in the region.
Accordingly, two forms of liberalization (preferential and multilateral) are complementary
to each other for the given sample of countries. 

Ornelas (2008) states that, in addition to endogenous external tariff formation (stated in
Ornelas (2005)), if RIAs provide non trade gains, like investment liberalization,
infrastructure cooperation and harmonization of competition policies, to their members,
distributive asymmetry arising from the formation of RIAs in favor of member countries
could be altered, and both members and non members could gain from regionalism.

As a final note, it would be beneficial to cite the study of Abrego et al. (2006) which
relates the outcome of a given study to the model specification employed. Through
computational techniques, the authors test the validity of various propositions in the
literature on regional integration agreements.  The study compares free trade and three
country non cooperative (Nash) equilibria with partial cooperation regional agreement
equilibria where two countries form a customs union and play noncooperatively against the
non member country. Eight propositions that are taken into consideration are as follows: 1.
Both members benefit from a customs union relative to free trade. 2. Both members benefit
from a customs union relative to Nash equilibrium.  3. A customs union increases world
                                                
1
 Authors call MAI and Doha Round as ‘multilateral failures’, for these two initiatives couldn’t become
effective.   25
welfare relative to 3 country Nash equilibrium. 4. Customs unions are a “stepping stone”
to free trade (i.e. members are better off in CU relative to Nash, and members gain from
free trade). 5. A customs union results in higher external tariffs for member countries
relative to Nash equilibrium. 6. A customs union improves member countries’ terms of
trade relative to Nash equilibrium. 7. A customs union increases member countries’
volume of trade relative to free trade. 8. A customs union increases member countries’
volume of trade relative to Nash equilibrium. As a  conclusion, the authors state that the
given propositions related to regional integration are not largely true and the outcomes will
mainly depend on the model characteristics employed in a given study. 

Studies on the Relationship between Regional Integration and Globalization

Studies on the Relationship between Regional Integration and Globalization 

After 1980s, the Vinerian seminal work has considered as representing the static nature of
preferential trade agreements. Dynamic analysis that deals with the long run relationship of
regionalism and multilateralism has considered two  time path questions of Bhagwati
(1993). While the first time path question inserts the assumption that time path of regional
economic integration does not affect (or influence) the one of multilateral trade   18
negotiations, the second time path question considers the case where there is a
interrelationship between the trends of regional economic integration and multilateral trade
negotiations.   

The first question concerns the incentives of non members to be a member and the
willingness of the member countries to offer entry until the utmost outcome of global free
trade. Baldwin’s (1993) study is in line with this question. Baldwin employs the ‘domino
theory’ that emphasizes the existence of idiosyncratic events on creating economic
rationale for non members to participate in the RIA. These events consequently bring
about a multiplier effect that “knocked down bilateral import barriers like a row of
dominos” (Baldwin, 1997, p.877). In his framework, Baldwin gives the US Mexico FTA,
NAFTA, MERCOSUR, the completion of the EC’s Single Market and the weakening of
the USSR as the examples of shocks that triggered dominos, i.e. pushed non members to
apply for membership in RIAs. From this empirical evidence, Baldwin (1993) concludes
that the domino effect will eventually lead to global free trade. In response to the critiques
of not taking into account the resistance of members for new memberships, Baldwin (1997,
p.878) states this would not change the result and notes that “the new political economy
flames may find vent in preferential arrangements among excluded countries”.

The second time path analysis of Bhagwati (1993) focuses on the determination of whether
RIAs will be the ‘building blocs’ or the ‘stumbling blocs’ in front of the worldwide non
discriminatory free trade. In line with this distinction, present section will survey firstly
studies that emphasize regional integration as a contributing factor to the processes of
multilateral tariff liberalization and multilateral free trade. Secondly, the opposing
arguments on regional integration and multilateralism are to be studied.

Ethier (1998) employs many country, specific factors model in order to assess the
relationship between regionalism and multilateral world. The author, as a result,
emphasizes that rather than threatening multilateralism, regionalism is the direct
consequence of the success of of multilateral liberalization. In a similar vein, Freund
(2000) employs oligopolistic model of trade with three countries import and export one
imperfectly competitive good.  The study concludes that as welfare gain from membership   19
in an RIA is greater when tariffs are low, each round of multilateral tariff liberalization
should be accompanied by an increase in the number of RIAs.

Kim and Shin (2002) employ social network approach for the analysis of regionalism and
globalization. Their results indicate increase in overall network density between 1959 and
1996. According to this, they conclude that world trade has been globalized. Another result
that is increase in the intraregional density, on the other hand, supports the idea of
regionalized trade. The authors entail this two sided improvement in international trade to
the fact that globalization and regionalism are not contradictory processes.

Woolcock (2003) by comparing the provisions of the EU Poland, the EU Mexico, Euro
Med, NAFTA, Chile Canada FTA and Closer Economic Relations (CER) agreements with
the provisions of the GATT/WTO states that these agreements generally are WTO plus (or
GATS plus). As a result, Woolcock concludes that the RIAs tend to complement rather
than undermine multilateral rules. 

Ornelas (2005) asserts that when considering the effects of FTAs, both determination of
external tariff level and participation in an FTA should be treated as endogenously
determined concepts. Accordingly, taking into account endogeneity of these policies would
reduce the importance of special interests in an FTA. In this set up, when members of an
FTA lower their internal trade barriers, they tend  to reduce their external tariffs as well.
Consequently, an FTA formation would result in support for further multilateral
liberalization. 

Baldwin (2006a), on the other hand, studies the political economy framework for the trade
liberalization by categorizing it into three mechanisms, as the ‘juggernaut effect’ for
multilateral trade liberalization, the ‘domino effect’ for regional trade liberalization, and
‘race to the bottom unilateralism’ for unilateral trade liberalization. The author also states
three ancillary political economy logics that are interacting with the above mechanisms.
These are intra sectoral special interest politics, asymmetric lobbying effects and the
magnification of footloose ness. Examining the period starting with the Reciprocal Trade
Agreement of 1934, Baldwin states that multilateralism, regionalism and unilateralism are   20
not substitutes, but complements of each other. Furthermore, the author calls the proposed
political economy framework as the ‘spaghetti bowls as building blocs’ mechanism.

Pomfret’s (2007) study examines regionalism issue from the historical perspective. The
author distinguishes three waves of regionalism as the first wave covering 1950s and 60s,
the second wave covering the period of 1980s until  the establishment of WTO, and the
third wave from the early 2000s onwards. He states that “regionalism has twice [in the first
and second waves] appeared as a terminal threat to the GATT system but multilateralism
emerged stronger ever after the Kennedy and Uruguay Rounds” (ibid., p.925). For the third
wave prevailing now, he again emphasizes the strength of WTO system in the international
economics. The author points out other factors like Multifibre Arrangement quotas and the
use of agricultural safeguards as elements that are more important types of discrimination
than RIAs. Accordingly, regionalism does not threaten multilateral trading system as
significantly as it is generally announced. 

There are also some studies that interpret regional integration as an impeding factor in
front of multilateralism. For example, Levy (1994)  forms his analysis through a median
voter model in which voters in two countries are opting for membership in an FTA or
sticking to multilateral liberalization. Accordingly, in a model based on the Heckscher
Ohlin framework, an FTA option can not make feasible multilateral liberalization as
infeasible; it can not also make previously infeasible multilateral liberalization as feasible.
However, when the model is extended to consider product differentiation, expected effects
arising from the formation of an FTA change significantly. With this kind of model, a
given FTA can constitute a stumbling bloc in front  of the global free trade due to trade
gains that result from differences in factor endowments and product variety.

Grossman and Helpman (1995), on the other hand, study the formation of an FTA in the
political economy framework that emphasizes the interaction between special interest
groups and governments.  The study concludes that governments respond to pressures of
industry special interests, but they also take into consideration the average voter. The
authors state that if some industries can be excluded from the scope of an agreement, then
the likelihood of signing this agreement would improve (ibid., p.687).    21
Krueger (1997) asserts that political economy of FTAs will lead these agreements to be
stumbling blocs in front of further multilateral trade liberalization than will customs
unions. This mainly derives from the fact that FTAs include rules of origins that are
governed by special interest groups.

Bagwell and Staiger (1998, 2002) employ a general model that includes governments that
are motivated by political and terms of trade considerations in order to evaluate the effects
of reciprocal trade agreements on multilateral trading system; especially on non
discrimination, reciprocity and enforcement mechanism. Through politically augmented
terms of trade approach, they show that these agreements may retard the effectiveness of
reciprocity and non discrimination. Accordingly, as free trade areas violate most favored
nation (MFN) principle, the efficiency properties of a multilateral system that depends on
the principles of reciprocity and non discrimination will be damaged. For the customs
union case, the only multilateral friend type is possible when all external tariffs are set to
conform to the principle of non discrimination. On the enforcement issue, the consequence
of RIAs is ambiguous and depends on the time period of analysis, the extent of trade
diversion and the extent of multilateral cooperation. The authors conclude that RIAs may
constitute a potential threat for multilateral trading system.

Krishna (1998) employs a model of imperfect competition with oligopolistic firms
producing substitutable goods, in order to study the conditions for partners’ support for a
bilateral agreement and the impact of FTA formation on the incentives of continuing on
multilateral trade liberalization. He asserts that the more trade diverting FTA between two
countries, the more likely it will be supported and more it counteracts against the
multilateral trade liberalization. Hence, with certain amount of trade diversion, the initially
feasible multilateral liberalization can become infeasible as a result of the special interests
based FTA. 

Bond, Riezman and Syropoulos (2004) work with a three country general equilibrium
model to determine the likely effects of an FTA formation on the tariff and welfare levels
of all countries. Accordingly, the formation of FTA may undermine multilateral trade
liberalization if member countries employ optimal external tariffs. However, it is stated   22
that as member countries tend to lower their external tariffs after the establishment of FTA,
this will improve terms of trade and welfare of the excluded country. If the member
countries are sufficiently large, then trade creation induced welfare improvement will
dominate and FTA will be beneficial for the members, too. As a result, the welfare gains
on both sides may undermine the attainment of global free trade. 

Limão (2006a), on the other hand, uses data on the US tariffs with the distinction of PTA
goods that are covered by PTA and non PTA goods that are excluded within the
integration. The study states that MFN tariffs for  PTA goods of the US are higher on
ninety percent of all goods than they would be in the case of not forming PTA. The study
concludes that PTAs of the US constitute a stumbling bloc to multilateral trade
liberalization of the US. Estimating the difference in MFN tariff reduction between PTA
and non PTA goods for the EU and the US cases, Limão (2006b) finds that PTAs of these
important traders result in delay on multilateral tariff liberalization and increased
discrimination via non tariff barriers.

Theoretical Studies on the Effects of Regional Integration

Theoretical Studies on the Effects of Regional Integration

As it is stated, theory on the welfare effects of regional economic integration stems from
Viner’s (1950) “The Customs Union Issue”. Prior to  this study, the customs union was
seen as a movement toward free trade and as a way to increase world welfare. As the father
of the concepts of trade creation and trade diversion, Viner had showed that the formation
of customs union was not necessarily a welfare improving process. While trade creation
effect arises in the case of “one of the members of the customs union will now newly
import from the other but which it formerly did not import at all because the price of the
protected domestic product was lower than the price at any foreign source plus the duty”,
trade diversion effect arises in the case of “one of the members of the customs union will
now newly import from the other whereas before the customs union it imported them from
a third country, because that was the cheapest possible source of supply even after payment
of duty” (Viner, 1950, p.43). Accordingly, net welfare effect of customs union will depend
on the extent of these two effects. For a customs union to operate in the free trade
direction, Viner (1950, p.51) suggests the larger economic area, the lower average tariff
level on post integration imports from non members, the less degree of complementarity of
the member countries with respect to protected industries, etc.

The analysis presented in Viner (1950) had been critized from several points, and resulted
in extensions on the issue.  For example, Lancaster and Lipsey (1956 57) take the Vinerian
analysis as “The General Theory of the Second Best”. In this theory, if it is impossible to
satisfy all of the optimum conditions, then a change in some of these conditions could
cause better or worse outcomes (cited in Lipsey, 1960, p.498). In addition to this, they
criticize the Vinerian analysis further due to its focus on the trade shifts from one country
to another and its ignorance on the effect of the substitution between commodities that
derived from the changes in relative prices (ibid., p.499).  

The substitution effect in consumption entered into the customs union theory through the
works of Meade (1956), Gehrel (1956 57), and Lipsey (1957) (cited in Lipsey, 1960,
p.501). Gehrel’s conclusion in favor of the gains rather than the losses of the customs
union is criticized by Lipsey (1960) because of taking into account two commodity case.   15
Lipsey (1960) states that in order to derive the valid conclusions on the customs union
theory it is necessary to consider at least three types of commodities (domestic commodity,
imports from partners, imports from the outside world). Additionally, Lipsey (1960)
proposes the distinction of inter country substitution that would embody trade creation and
trade diversion effects of Viner (1950), and inter commodity substitution that would derive
from the changes in relative prices.  His analysis  together with the analysis of Meade
(1956) lead Lipsey to conclude that “when only some tariffs are to be changed, welfare is
more likely to be raised if these tariffs are merely reduced than if they are completely
removed” (ibid., p.507). Lipsey also makes another  generalization1
 that relates the gains
from inter commodity substitution to the size of expenditure on previously mentioned
three classes of goods. From these generalizations, Lipsey (1960, p.508) concludes that
“the sort of countries who ought to form customs unions are those doing a high proportion
of their foreign trade with their union partner, and making a high proportion of their total
expenditure on domestic trade”.

Another extension on the Vinerian analysis came from the study of Dam (1963). Dam
(1963) interpretes the Viner’s trade diversion and  trade creation effects as the model of
production side and includes consumption effects to measure the overall impact of RIAs
together with the production effects. Accordingly,  the ratio of prices paid for domestic
goods to that for partner goods and the ratio of prices paid for partner goods to that for
non member goods will be changed by the formation of FTA, and “consumers will tend to
find prices of member goods cheaper, relative to the pre free trade area situation, than
either local goods or nonmember goods” (ibid., p.626). Hence, this will result in favorable
(substitution of member goods for local goods) and  unfavorable consumption effects
(substitution of member goods for nonmember goods). Dam (1963, p.628) concludes as
“… the smaller the range of goods imported from nonmember countries relative to the
range of goods imported from member countries, the  smaller the unfavorable and the
greater the favorable consumption effects”.

The study of Cooper and Massell (1965), on the other hand, derives the pure theory of the
customs union theory which is based on the Lipsey’s extension of the Vinerian trade
                                                
1
 This generalization derives from Lipsey’s doctoral thesis: Lipsey, R.G., 1958, “The theory of customs
unions: A general equilibrium analysis”, Unpublished Ph.D. thesis,  University of London.   16
creation and trade diversion analysis. The study rules out the effects like terms of trade and
economies of scale from the pure theory. By splitting the welfare effects of a CU into two
as “tariff reduction component” and “pure trade diversion component” (ibid., p.743),
authors states that the former component is the only source of any gain in consumers’
welfare in the integrated union. Accordingly, this component accounts for the consumption
effect introduced by Lipsey (1960) and the trade creation effect of Viner (1950). The
overall effect of the union will depend on the relative magnitudes of the two components in
which tariff reduction component represents the gain side, pure trade diversion represents
the welfare loss side of a CU. In the welfare analysis, the study concludes that since a CU
necessarily causes in trade diversion, as a result welfare loss, appropriate policy of non
preferential protection would result in better welfare effects relative to the customs union
option. The authors further criticizes the Viner’s  analysis taking into account customs
union as an acceptable policy option but not taking into account a tariff reduction policy. 

The study of Arndt (1968) starts from the ‘inferiority of the customs union relative to the
non preferential protection’ assertion suggested by Cooper and Massell (1965) and argues
that the argument is not valid due to not taking into account the effect of integration on the
terms of trade. With three country two goods model, the study concludes that two
countries acting together may gain in economic terms, relative to the case where one
country acts alone, due to the terms of trade effect of the union which result in a “net
improvement in welfare over any non preferential tariff situation” (ibid., p.976).  Kemp
and Wan (1976), on other hand, emphasizes the importance of the design of RIAs on the
expected outcomes. The study shows that the optimal tariff constructed so as to leave non
members’ trade unaffected would improve the welfare of member countries as well as the
welfare of world. The argument raised in Cooper and Massell (1965) is also critized by
Wonnacott and Wonnacott (1981). The study suggests  that small countries can gain from
the formation of regional integration in the presence of transport costs.  

With the advance of the new trade theory, the concepts of imperfect competition,
economies of scale and product differentiation has  become important determinants of
international trade. In this vein, Krugman (1991) studies the model consisting B identical
blocs and N identical countries, each producing one differentiated product. While transport   17
costs are not taken into account, the model is further based on the concept of natural
trading partners which states two countries as natural partners in case of high initial
volumes of bilateral trade and low distance between them. According to this setting, as the
number of blocs declines through further integration, each bloc starts to consume from the
share of the other blocs. The study finds the maximum number of blocs as three.

The extension of Krugman (1991) model comes from Frankel, Stein and Wei (1996). The
study emphasizes the role of transportation costs on determining the desirability of RIAs
and includes transport costs to the model of Krugman (1991). Accordingly, the magnitude
of these costs will determine the optimal level for the extent of regional integration. 

On the other hand, Panagariya (1998) offers an example in which the formation of a PTA
with a distant partner is superior relative to the  one with proximate partner. The author
states that the studies like Wonnacott and Wonnacott (1981) and Frankel et al. (1996) that
emphasize the importance of proximity or transport  costs on the formation of PTAs are
misleading due to their highly specific assumptions and/or selected variables of the
simulations.  Accordingly, all sources of cost (transportation costs, costs arising from
differences in technology/factor endowments) have equal significance for the trade flows. 

Goto and Hamada (1999) study the effects of regional integration under the assumptions of
constant tariffs and asymmetric bloc formation as an extension of the Krugman (1991)
framework which assumes symmetric blocs. The study  states that welfare first increases
with the expansion of the bloc, but when approximatley half of the world is participated
into this bloc, welfare starts to decrease with new members. 

LITERATURE REVIEW

LITERATURE REVIEW

The relationship between RIAs and globalization has been studied from different
perspectives throughout the literature. While Jacob Viner’s (1950) work on the Customs
Union was the first attempt of theorizing the welfare effects of RIAs, the following studies
like Lipsey (1960), Cooper and Massell (1965) were extensions of the Vinerian analysis

.
These studies significantly contributed to the development of this analysis. In the late
1980s, with the introduction of the New Trade Theory, several studies like Krugman
(1991) and Frankel et al. (1996) included new factors like economies of scale and product
differentiation in order to model regional economic integration. The 1990s, on the other
hand, witnessed the emergence of studies that emphasized the effects of regionalism on the
future multilateral trading system, like the ‘dynamic analysis’ of regional integration,
Bhagwati (1993). In a similar vein, the studies on  the political economy stance like Levy
(1994), Grossman and Helpman (1995) and Krishna (1998) provided significant insights
about RIAs and their effects on multilateral tariff liberalization.

Since there is a growing literature in regionalism debate, this chapter tries to survey some
of these studies through categorizing them into three subsections. The first section will
present a brief summary of selected studies that contributed to the theoretical development
of regionalism. The second section will try to enlist some of the literature that focused on
the relationship between regional economic integration and multilateral tariff liberalization,
and on the effects of regional integration on multilateral free trade. The final section, on
the other hand, will survey the literature studying the effects of regional economic
integration on member and non member countries.  


                                                
1
 Although classical economists like A.Smith (1776), Ricardo (1817) and McCulloch (1832) had mentioned
about trade diverting effects of of preferential commercial treaties, theory of economic integration dates back
to the 1940s that include the studies of de Beers (1941), Tinbergen (1945), Byé (1950) (Robson, 2000, p.8).
The study of Balassa (1961), on the other hand, was the first for the systematic analysis of this theory (cited
in Halıcıoğlu, 1996, p.4).