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INTERNATIONALECONOMIC LAWSemester 11. IntroductionInternational economic law is an increasingly seminal field of international law that involves the regulation and conduct of states, international organizations, and private firms operating in the international economic arena.The theory of internatio...

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INTERNATIONAL ECONOMIC LAW Semester 1

1. Introduction International economic law is an increasingly seminal field of international law that involves the regulation and conduct of states, international organizations, and private firms operating in the international economic arena. The theory of international trade is customarily divided into two major branches: 

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The Theory of International Values which is the Pure or Real Theory of International Trade Equilibrium o Concerned with the determination of relative prices and real incomes in international trade, abstracting from the intervention of money. The implicit assumption that whatever adjustments of money wage and price levels or exchange rates required to preserve international monetary equilibrium do actually take place is a potent source of difficulty and confusion in applying the theory to actual problems. The theory of the mechanism of adjustment which is the Monetary Theory of Balance-of Payments Adjustment o in its classical formulation, was concerned with the automatic mechanism by which international monetary equilibrium was attained or preserved under the gold standard and, subsequently, with the automatic mechanisms of adjustment under fixed and floating exchange rate systems.

1.1 Trade Theories 1.1.1 The Pure Theory of International Trade 

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The central concern of the pure theory of international trade is to explain the causes of international trade and the determination of the equilibrium prices and quantities of traded goods and to analyse the effects of trade on economic welfare; that is, the theory is concerned with both positive and normative questions. The normative concern is particularly dominant in the theory on the effects of tariffs and other governmental interventions in international trade a perennial problem that has acquired new interest in the modern world of planned economic development based on protected industrialization and deliberate import-substitution.

1.1.2 The Classical Theory 

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The classical economists developed the basic concepts of the theory in two steps: o Ricardo contributed the theory of comparative costs, which explained both the cause and the mutual beneficiality of international trade by international differences in relative costs of production; and o John Stuart Mill added the principle that the relative prices of the goods exchanged must be such that the quantities demanded in international trade are equal to the quantities supplied. The fundamental point that the beneficiality of international trade depends in no way on the absolute levels of economic efficiency or “stages of economic development” of the trading partners but only on differences in their relative costs of production in the absence of trade. The theory is reformulated here to bring out the essential point that what matters is differences in the alternative opportunity costs of commodities in the absence of trade. Ricardo’s own formulation, with its assumption of a single factor of production producing goods at constant costs and its concept of a fundamental unit of real cost (hours of work), unnecessarily tied trade theory to the labour theory of value. The modern approach can incorporate theories of production of any desired degree of complexity and specifically allows alternative opportunity cost to vary with changes in the production pattern. However, as soon as more than one factor of production is introduced, the analysis of the effect FDs of trade on economic welfare becomes more complex than in the classical system, and the demonstration of gain from trade requires considerably more conceptual sophistication

1.1.3 The Modern Theory 

The modern approach to the question of the gains from trade recognizes that the inauguration of trade or a change in the conditions of trade, such as that involved in the erection or removal of tariff barriers, will have differential effects on the welfare of individuals either by changing the relative Page 1 of 115

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prices facing them as consumers or by changing the relative prices paid for the factors of production. In their absence, welfare conclusions can only be derived either on the assumption that a social judgment of the desirable distribution of real income exists and is implemented consistently or in terms of potential welfare, that is, in the sense that in one situation everyone could be made no worse off and some be made better off than they would be in the alternative situation, by means of appropriate compensations through transfers of income. Ethical neutrality requires that this result should be true for all possible distributions of economic welfare among individuals, not merely for the distribution that happens to prevail before or after a change of situation. This requirement is satisfied by any change that makes more of all commodities available to the economy or, in the limit, no less of any commodity, regardless of how the community allocates its consumption among commodities.

1.1.3.1 Gains in International Trade 

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The gains from international trade are obviously dependent on the difference between the prices for exports in terms of imports established in international trade and the prices that would rule in a closed economy. The classical economists attempted to relate the distribution of the gains from trade to the precise point between the closed-economy comparative cost ratios at which the equilibrium international price ratio fell. In practice, while this approach has been applied in specialist studies of the welfare cost of protection, economists have generally been content to analyse changes in countries’ gains from trade by reference to changes in an index expressing one or another concept of the terms of trade.

1.1.4 The Heckscher-Ohlin     

The classical theory of international trade explained trade by differences in the comparative productivity of labour. The existence of the differences in comparative costs underlying international trade, however, was merely assumed and not explained by the theory. Contemporary international trade theory attempts the more fundamental task of explaining these differences by differences in the ratios in which countries are endowed with factors of production. As commonly expounded and applied, the theory employs a simple but elegant model of production and distribution in the national economy. Example: o The Heckscher–Ohlin model assumes a perfectly competitive economy in which two commodities (call them X and Y) are produced by two factors of production (call them K and L), utilizing production functions characterized by constant returns to scale and diminishing marginal rate of substitution between the factors. o The quantities of the factors available are assumed fixed, and the production functions are assumed to be such that at any given ratio of the price of K to the price of L, the production of X is K-intensive and the production of Y is L-intensive, in the sense that X employs a higher ratio of K to L than does Y. o For the analysis of international trade the world is assumed to be composed of two such national economies, the production functions and factors are assumed to be identical in the two countries, and the tastes of consumers in the two countries are assumed to be similar, in the sense that, at the same commodity price ratio, they will consume the two goods in roughly the same ratios. o The production side of this model has two fundamental properties, from which an extensive and elegant set of theorems can be derived.  These result from the assumption of constant returns to scale, which makes the ratios in which factors are employed in the two industries depend only on their relative prices.  The assumption of the invariance of relative factor intensity, which links relative factor prices uniquely to relative commodity prices; and the assumption of fixed factor endowments, which links the production pattern uniquely to commodity or factor prices.

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1.1.4.1 Stolper–Samuelson Relationship  

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It describes the relationship between relative prices of output and relative factor rewards; specifically, real wages and real returns to capital. Stolper-Samuelson theorem emphasizes that the increase in the price of one good, along with other conditions unchanged, increases the real income of production factor, which is intensively used in the production of good whose price has increased. The theorem states that under specific economic assumptions (constant returns to scale, perfect competition, equality of the number of factors to the number of products) a rise in the relative price of a good will lead to a rise in the real return to that factor which is used most intensively in the production of the good, and conversely, to a fall in the real return to the other factor. In the normal case, in which the two trading countries’ demands for each other’s exports are elastic, a tariff will improve a country’ terms of trade and raise the internal price of imports, thus shifting production toward import-substitutes and raising the real income of the factor used intensively in producing them. There are two “exceptional” cases: o If the country’s own demand for imports is inelastic and if those who spend the tariff proceeds have a stronger marginal preference for imports than the average consumer, the demand for imports may increase and the terms of trade turn against the country. o If the foreign country’s demand for imports is inelastic and if domestic consumers have a stronger marginal preference for the export good than do foreigners, the terms of trade may improve so much that the internal price of imports falls and the income-distribution effects are opposite to those normally expected.

1.1.5 The Theory Second Best 

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Protection has been a perennial policy issue since long before the origins of international trade theory, and international trade theorists in the main tradition of the subject have consistently been concerned with advocating freedom of trade and exposing the innumerable fallacies of protectionist thinking. Two arguments for tariffs have, traditionally been acknowledged as valid The terms of trade (“optimum tariff”) argument, and The infant industry argument, favouring temporary protection of industries capable eventually of establishing themselves in international competition. A customs union is, from the free trade point of view, a second-best arrangement; and the problems dealt with in Meade’s analysis all involve choices among alternatives when the first-best, or welfare-maximizing, solution is ruled out by assumption. This is the nature of most policy problems in economics, in other areas as well as international trade, so that Meade’s theoretical construction is of great general applicability.

1.1.6 Customs unions 

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Interest in the theory of tariffs has also been generated by the movement toward economic integration in Europe and by the associated problem of the economic effects of customs unions and free trade areas. Such arrangements entail a simultaneous movement toward free trade and protection. The problem is whether the net result is a gain or a loss of economic welfare for individual members, the union as a whole, outsiders, and the world as a whole. A customs union increases welfare to the extent that it creates trade by diverting demand from higher-cost domestic to lower-cost partner products and decreases welfare to the extent that it diverts trade from lower-cost, foreign to higher-cost, partner products.

1.1.7 The monetary theory of balance-of-payments adjustment  

The pure theory of international trade assumes that money prices and costs will adjust passively to the real equilibrium of the international economy. According to the theory, the stock of international money (which was initially identified with gold and silver, whose total quantity was assumed fixed, although the theory was subsequently extended to incorporate deposit money and the intervention of central banks) would tend automatically to be so distributed among nations that each would have the quantity it demanded, consistent with international equilibrium. Page 3 of 115

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An increase in the quantity of money in a particular country would raise prices there, decreasing exports and increasing imports, bringing the exchange rate to the gold-export point and inducing an outflow of gold, which would cause domestic prices to fall and foreign prices to rise until equilibrium was restored with a generally higher level of world prices.

2. Brief Historical remarks on GATT, and associated Institutions 2.1 Brief History of GATT GATT is a legal agreement between many countries, whose overall purpose was to promote international trade by reducing or eliminating trade barriers such as tariffs or quotas. According to its preamble, its purpose was the "substantial reduction of tariffs and other trade barriers and the elimination of preferences, on a reciprocal and mutually advantageous basis." The GATT was first discussed during the United Nations Conference on Trade and Employment and was the outcome of the failure of negotiating governments to create the International Trade Organization (ITO). It remained in effect until the signature by 123 nations in Marrakesh on 14 April 1994, of the Uruguay Round Agreements, which established the World Trade Organization (WTO) on 1 January 1995. The WTO is the successor to the GATT, and the original GATT text (GATT 1947) is still in effect under the WTO framework, subject to the modifications of GATT 1994. The GATT, and its successor the WTO, have successfully reduced tariffs. The Bretton Woods Conference produced two of the most important international economic institutions of the postwar period: The International Monetary Fund (IMF) and the International Bank for Reconstruction and Development, commonly known as the World Bank. The beggar-thy-neighbor tariff policies of the 1930s had contributed to the environment that led to war, ministers discussed the need for a third post war institution, the International Trade Organization (ITO), but left the problem of designing it to their colleagues in government ministries with responsibility for trade. 

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Beggar thy neighbour: In economics, a beggar-thy-neighbor policy is an economic policy through which one country attempts to remedy its economic problems by means that tend to worsen the economic problems of other countries. It assumes that economics is a zero-sum game. In other words, if you want more income, you have to take it from other countries.

The goal was to create an agreement that would ensure postwar stability and avoid a repeat of the mistakes of the recent past, including the Smoot-Hawley tariffs and retaliatory responses, which had been a contributor to the devastating economic climate that culminated in the death and destruction of the Second World War. The 1947 GATT created a new basic template of rules and exceptions to regulate international trade between members (referred to as contracting parties) and locked in initial tariff reductions that these countries committed to establish.

2.2 Advantages and Disadvantages of GATT 2.2.1 Advantages      

Initially reduced tariffs By increasing trade, the GATT promoted world peace By showing how free trade works, GATT inspired other trade agreements. It set the stage for the European Union. GATT also improved communication between countries. It provided incentives for countries to learn, among others, English, one of the languages of the world's largest consumer markets. This adoption of a common language reduced misunderstanding. It also gave less developed countries a competitive advantage. English gave them insight into the developed country's culture, marketing, and product needs.

2.2.2 Disadvantages  

Low tariffs destroy some domestic industries, contributing to high unemployment in those sectors. Governments subsidized many industries to make them more competitive on a global scale. Like other free trade agreements, GATT reduced the rights of a nation to rule its own people. The agreement required them to change domestic laws to gain the trade benefits. Page 4 of 115

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Trade agreements like GATT often destabilize small, traditional economies. Countries like the United States that subsidize agricultural exports can put local family farmers out of business. Unable to compete with low-cost grains, the farmers migrate to cities looking for work, often in factories set up by multi-national corporations. Often these factories can move to other countries with lower cost labour, leaving the farmers unemployed.

2.3 Main provisions of GATT GATT 1947 had three main provisions: 

The First and the most important requirement was that each member must confer most favoured nation status to every other member. All members must be treated equally when it comes to tariffs. It excluded the special tariffs among members of the British Commonwealth and customs unions. It permitted tariffs if their removal would cause serious injury to domestic producers.

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The Second, GATT prohibited restriction on the number of imports and exports. The exceptions were: o When a government had a surplus of agricultural products. o If a country needed to protect its balance of payments because its foreign exchange reserves were low. o Emerging market countries that needed to protect fledgling industries. o In addition, countries could restrict trade for reasons of national security. These included protecting patents, copyrights, and public morals.

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The Third provision was added in 1965. That was because more developing countries joined GATT, and it wished to promote them. Developed countries agreed to eliminate tariffs on imports of developing countries to boost their economies. It was also in the stronger countries' best interests in the long run. It would increase the number of middle-class consumers throughout the world.

2.4 GATT and Beggar thy Neighbour Policies 2.4.1 Corporation Tax In a globalised world, there is a temptation for a country to cut corporation tax rates below the global average to attract more inward investment. The country cutting corporation tax benefits from more investment, and although tax rates are lower, they hope to make up tax revenue by attracting more firms. However, if one country cuts corporation tax, you effectively are attracting firms away from other countries, who lose out. Cutting corporation tax in many countries does not increase global economic welfare – it tries to increase the specific economy of the country cutting welfare at the expense of other countries. This can create a situation of tax competition – where countries keep cutting tax rates to attract investment. However, the total level of investment does not increase; it is just competition for a certain level of investment. In theory, strong tax competition could lead to very low corporation tax rates – and a situation where no one has gained any more investment. The only real winners are companies who benefit from lower global corporation tax rates.

2.4.2 Currency Manipulation For example, in a depression, a country may seek to devalue their currency to increase exports and domestic demand. However, if one country artificially keeps a currency undervalued – it means other countries suffer from being relatively over-valued and lower domestic demand. This currency manipulation is a charge often raised against China – claiming currency manipulation give Chinese exports a benefit over other countries. 2.4.2.1 Currency Devaluation Currency wars are said to occur when countries seek to devalue their currency to gain a competitive a...