Free Trade Agreements: NAFTA, GATT Rules, and Trade Policy

Introduction to Free Trade Agreements

A Free Trade Agreement (FTA) refers to a deal between at least two countries aimed at reducing obstacles to exports and imports between them. Under free trade policies (FTPs), services and products may be purchased and sold across international borders without — or with very few — governmental tariffs, subsidies, prohibitions, or quotas hampering their exchange (Amadeo, 2021). The free trade principle stands in contrast to economic isolationism or trade protectionism. In the contemporary era, FTPs are typically implemented through a formal, mutual agreement between the countries involved. However, an FTP might simply reflect the absence of trade restrictions. Governments do not have to take any particular action to promote free trade — a hands-off stance termed trade liberalization or laissez-faire trade (Barone, 2020). Governments that adopt FTPs or trade agreements do not always have to surrender total control over exports and imports or eliminate every protectionist policy. In the contemporary global trade environment, only a small number of FTAs result in completely free trade.

The North American Free Trade Agreement (NAFTA) is one notable example of an FTA. Although it has since been superseded by the updated U.S.-Mexico-Canada Agreement (USMCA), which took effect on July 1, 2020, NAFTA remains significant to discussions of FTAs because it represented the world's largest free trade area when it was created in 1994 (Alvarez, 1996). This treaty among the three member nations eliminated the majority of tariffs between them. Prior to NAFTA, no developed country had ever entered into a trade pact with an emerging market nation. Through this Agreement, the three nations agreed to remove obstacles to trade among themselves. By eliminating tariffs, NAFTA created greater investment opportunities. For these reasons, this paper uses NAFTA as its primary reference FTA.

Benefits of FTAs to Trade

Global trade forms the contemporary foundation of prosperity. Free trade policies have opened new areas to invention and competition, resulting in improved jobs, greater investment, and fresh market opportunities. Beyond services and products, free trade also disseminates ideas and values. Because international trade depends on parties adhering to agreements, firms and nations are more accountable and, consequently, more stable.

Trade aims at providing access to a greater number and variety of services and products. The Heritage Foundation argues that free trade promotes competition, encouraging organizations to innovate and develop improved products while maintaining superior quality and lower prices (Froning, 2000). It enables firms and regions to specialize in the services or products they produce most efficiently. International trade helps companies acquire larger market share, reduce costs, and enhance productivity, thereby generating higher production rates.

In free trade, risk-taking is rewarded through greater market share and sales. When large economies such as the United States make the most of free trade, they experience economic growth that can spill over into economically unstable, poverty-ridden, smaller nations that are open to trade. The Heritage Foundation notes that poorer nations trade for capital gains because their private sector returns are more immediate (Froning, 2000).

Free trade compels organizations to abide by the rule of law. All WTO member nations are required to honor every agreement and follow every WTO rule. Nations that fail to enforce agreements lose business, with investors redirecting capital elsewhere. For a nation to benefit from free trade, it must adhere to the rules. The Heritage Foundation further argues that free trade transmits values and ideas (Froning, 2000) that help foster more stable and robust governments within smaller nations.

Free trade enhances global resource allocation. When individuals or nations can trade for necessary services and products, they are free to concentrate on producing what they do best. Imports tend to suppress inflation because individual services and products can be sourced from their most efficient supplier. The Cato Institute argues that Americans benefit from lower prices for imported goods, and that the money saved can be used to purchase domestic services and products (Glassman, 1998).

Trade agreements help open markets while also providing protection and business incentives. They include commitments to safeguarding labor rights and intellectual property, and open sectors to competition. They also regulate environmental standards and enhance customs facilitation. Typically, exporters are more technologically advanced and contribute to greater and better-quality job creation (Drozdz & Miškinis, 2011). Finance and trade are mutually reinforcing, and global investment facilitates increased risk-sharing and diversification.

How FTAs Can Violate GATT Rules

The meaning of the phrase "substantially all trade" is among the most contested elements of Article XXIV of the GATT, particularly with respect to the exclusion of economic sectors from FTAs (Grimmett & Tatelman, 2004). This phrase has not been defined by joint GATT parties, and working GATT parties have produced only inconclusive reports (Davey, 1998). The 1994 Understanding does not clearly define the term either. However, its preamble asserts that trade expansion promoted by regional agreements is enhanced when restrictive business rules — including obligations between constituent territories extending to total trade — are eliminated, and that excluding any major sector diminishes those benefits. In assessing whether FTAs comply with this requirement, working parties consider both qualitative and quantitative factors (Davey, 1998). Working parties expressed concern about the specific exclusion of certain agricultural trade under U.S. FTAs with Canada and Israel; however, neither panel recommended FTA disapproval, and both reports were subsequently adopted.

Article XIX of the GATT, elaborated upon in the WTO's Safeguards Agreement, permits parties to impose short-term import restrictions when imports surge. Article 2.1 of the Safeguards Agreement establishes a general rule: WTO members may apply safeguard measures to goods only when they determine that those goods are being imported in such increased quantities — in absolute or relative terms compared to domestic production — and under conditions that cause or threaten to cause serious injury to the domestic industry producing directly competitive or similar goods (Oza, 1995).

Paragraph 8(b) of Article XXIV does not list Article XIX as an exception applicable to FTAs; further, the Safeguards Agreement raises the question of how safeguards relate to FTAs. WTO member states have voiced divergent opinions on this topic, contending that: (1) safeguards cannot be imposed against FTA partners because paragraph 8(b) does not exempt these measures; (2) safeguards apply on a most-favored-nation (MFN) basis, partly due to the requirement in Article 2.2 of the Safeguards Agreement that safeguards "be applied to a product being imported irrespective of source"; and (3) safeguards between FTA parties are permissible as long as no third-party rights are infringed (Davey, 1998, pp. 22–23).

Although neither the Appellate Body nor WTO panels have definitively ruled on the link between Article XXIV and the imposition of safeguards, they have established a "parallelism" requirement within the Safeguards Agreement. This requirement holds that if a finding of serious injury is based on imports from all sources, including FTA partners, then any resulting safeguard measure must apply to those imports as well. For instance, in a WTO challenge to a U.S. steel import safeguard imposed in March 2002, both the WTO panel and the Appellate Body censured the United States for including imports from American FTA partners in its injury investigation while excluding those same nations' imports from the remedial safeguard measures, without providing a sufficient or reasoned justification for why only safeguard-covered imports satisfied the requirements for imposing the measure (Grossman & Sykes, 2007).

Paragraph 12 of the 1994 Understanding on Article XXIV provides that WTO dispute resolution procedures may be invoked with respect to matters arising under the Article's provisions concerning interim agreements and free trade areas. This provision clarifies that Article XXIV's review provisions are not the only means of examining FTAs' compatibility with GATT rules (Grimmett & Tatelman, 2004). Additionally, WTO dispute resolution is available with respect to all GATS obligations.