Time Inconsistency of Trade Policy and Multilateralism

Abstract

In this paper we address the issue of multilateralism versus bilateralism in a situation where a home government's optimal policy is time-inconsistent and the time-consistent policy sub-optimal. Short-run production and wage rigidities create incentive for the government to surprise private agents, ex post, with excessive protection. The problem is shown to be particularly severe when the intended beneficiaries (members of the lobby) cannot coordinate on their (investment) decisions fully. A commitment to multilateral free trade may then be welfare enhancing and politically feasible. However, once a discriminatory Preferential Trade Agreement is formed, it undermines any incentive for further multilateral trade liberalization. Thus, we propose another reason why Article XXIV of GATT/WTO may be a stumbling bloc for wider multilateral trade liberalization. Our result is based on the trade deflection effect and the market power effect of Preferential Trade Agreements.