Mercosur Hasn’t Caused Trade Diversion

March 25, 1997 • Commentary
This article originally appeared in the Wall Street Journal.

Ever since Brazil, Argentina, Paraguay and Uruguay formed the Mercosur customs union in 1991, free‐​trade buffs have worried about whether the Southern Cone might become a protectionist fortress.

This fear has been further fueled by a recent World Bank study by Alexander Yeats, principal economist for the bank’s International Trade Division, contending that a significant amount of the increased trade within Mercosur is a result of trade diverted from more efficient non‐​Mercosur producers to less‐​efficient producers within the bloc.

If true, this would be bad news. The region is in desperate need of greater market openness; a Mercosur fortress would lead to a less competitive region. But such a conclusion is far from certain.

In order to judge Mr. Yeats’s work, it is first necessary to establish the criteria by which to judge any trade policy. As a rule of thumb, governments should take every opportunity to open markets. Trade barriers restrict the freedom of individuals to exchange their own property with citizens of other countries. Tariffs are taxes that punish individuals for making choices of which their governments disapprove. Further, economic liberty is the only known path to growing productivity, prosperity and good‐​paying jobs. Thus all trade liberalization, like all tax cuts, should be applauded.

Critics of Mercosur must show that it is a faux free‐​trade zone that reduces net liberty by increasing the cost of importing goods from other countries, and thus harms consumers within Mercosur. Mr. Yeats certainly does not succeed in doing this.

Mr. Yeats’s study shows that Mercosur exports have grown to $61.89 billion in 1994 from an annual average of S34 billion for the 1984–86 period. But he observes that a greater share of these exports is between Mercosur countries, 19.5% now compared to 6.7% in the mid‐​1980s. America and Western Europe have become less important destinations.. But Mr. Yeats ignores other reasons for shifting exports. For example, communism’s fall in Eastern Europe in the late 1980s no doubt has meant Western Europe turns more to those markets for trade.

Significantly, total imports into Mercosur jumped to $78 billion in 1995 from around $29 billion in 1990. Purchases from the U.S. grew to $17 billion in 1995 from $6.68 billion in 1990. This is not surprising, since the Mercosur countries have been reducing trade barriers to nonmember countries as part of their World Trade Organization commitments. This import surge certainly does not suggest a Fortress Mercosur in formation.

Mr. Yeats goes on to offer a calculation of trade intensity he says will “highlight the relative importance of (seemingly minor) changes in trade between countries that have relatively small global trade shares.” He looks at the variation from expected bilateral trade patterns based on a trading partner’s share of world trade. But the fact that a statistical microscope is needed to make such variations visible suggests that they are of little policy importance.

A seemingly more plausible concern is raised by Mr. Yeats’s calculation of expected exports by Mercosur countries in light of their comparative advantages. For example, auto manufacturing is one of Brazil’s largest industries. If that sector were growing more competitive, would one not expect its exports to take a greater share of both Mercosur and non‐​Mercosur markets? Mr. Yeats finds that in this key capital‐​intensive sector, Brazil is not penetrating third markets.

But it will require time and tough marketing for Brazilian cars to take market share away from American‐ and Japanese‐​made vehicles. In any case, customer choices, not mathematical calculations of theoretical comparative advantage, determine the “correct” share of a market.

The Mercosur auto story is more complex than can be encompassed in a single calculation. In the early 1990s Mercosur countries reduced tariffs on autos to 20% from as much as 100%. As auto imports into Mercosur surged, Brazilian auto manufacturers screamed that they would collapse without special protection.

Brazil’s government restored high tariffs and other restrictions, giving the industry three years to adjust to competition. This was unsound policy. It resembles America’s restrictions on Japanese imports in the 1980s. It limits the freedom of Brazilians to purchase foreign‐​made cars, though possibly no more than the situation before the creation of Mercosur. But it does not suggest a developing Fortress Mercosur.

The reaction of Brazil’s Mercosur partners to this auto arrangement perhaps is most instructive concerning the virtues and dynamics of regional agreements. These partners angered by Brazil’s move, did not follow its lead. Argentina kept its tariffs on autos low, guaranteeing its consumers greater access to vehicles from non‐​Brazilian suppliers. And its Mercosur partners will keep the pressure on Brazil to end its protectionism in three years, as it has promised.

What, then, are the lessons of this flap over Mercosur? First, regional trade agreements by definition give preferential treatment to suppliers in member countries and probably cause some trade diversion. But as long as no new barriers are erected to nonmember countries, there is no loss of freedom to citizens in the member countries. Yes, it would be better if each country eliminated its barriers to all other countries. But since that’s not politically possible, countries should establish free trade where they can and fight the next battles for open markets where the opportunities arise.

Second, statistics should not set off panics about inappropriate policies. For example, Mr. Yeats observes that the spreads in tariff rates between Mercosur countries and nonmembers are far higher than the spreads created by other regional arrangements, such as Nafta and the European Union. But Mercosur countries began with some of the world’s highest tariff rates. The spreads are not a result of new trade barriers. Mr. Yeats’s insight, if true, suggests no policy action.

Increased economic liberty should be the primary goal of trade policy. If Mercosur countries create a customs union by raising trade barriers to nonmembers, then citizens of member countries could have freedom restored with one hand and stolen with the other. Import substitution by any other name still would be a failure. Mercosur needs open markets to provide the consumer goods that are incentives for workers to be productive, the inputs for enterprises, and the competition to force enterprises to become efficient. And Mercosur countries need to continue to deregulate their domestic markets. They should avoid policy harmonization that preserves government control of economies and leads to the kind of stagnation experienced now by the EU.

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