DOMESTIC POLICIES, NATIONAL SOVEREIGNTY, AND INTERNATIONAL ECONOMIC INSTITUTIONS [*].

To what extent must nations cede control over their economic and social policies if global efficiency is to he achieved in an interdependent world? This question is at the center of the debate over the future role of the WTO (formerly GAIT) in the realm of labor and environmental standards. In this paper we establish that the market access focus of current WTO rules is well equipped to handle the problems associated with choices over labor and environmental standards. In principle, with relatively modest changes that grant governments more sovereignty, not less, these rules can deliver globally efficient outcomes.

I. INTRODUCTION

To what extent must nations cede control over their economic and social policies if global efficiency is to be achieved in an interdependent world? At a broad level, this question probes the limits of any international economic institution, whether geared toward real or financial concerns, that is designed to promote global efficiency while respecting national sovereignty. Naturally, the answer depends upon the particular problem that the institution is meant to solve. In other words, the answer depends upon the inefficiency that would arise under unilateral policy choices.

At a more specific level, this question is at the center of the debate concerning the appropriate scope of the World Trade Organization (WTO, formerly GATT). Recently, member countries have considered ways to broaden the WTO's orientation beyond conventional trade policy measures to include labor and environmental standards. There are now initiatives to introduce the issue of labor standards directly onto the negotiating agenda of the WTO, with the purpose of creating a WTO "social clause." The social clause would specify a set of minimum international labor standards, and then permit restrictions to be placed against imports from countries not complying with these minimum standards. With regard to environmental policies, a WTO Committee on Trade and Environment has been established to identify the relationships between trade and environmental measures, and to recommend necessary modifications to the WTO. To some degree, these labor and environmental initiatives are responsive to "race-to-the-bottom" concern s. In the face of falling trade barriers with weak-standards countries, it is feared that the labor and environmental standards of the industrialized world might be compromised in the name of international competitiveness. But such initiatives encroach on traditional limits of national sovereignty. They therefore raise difficult issues about the structure of international economic relations among sovereign states.

Motivated by the general question raised above, and by the recent debate surrounding the scope of the WTO, we ask here a more specific question: how should the issue of domestic standards be handled in the WTO? We answer this question in a setting where governments choose both trade and domestic standards policies, and countries affect each other through their market interactions, so that any externalities across countries are purely pecuniary in nature. By ruling out nonpecuniary externalities from the start, we are excluding "global commons" issues from our analysis, and so countries have no reason to care about each others' standards choices directly. We do not deny the importance of global commons concerns; however, we choose to exclude them from our ajialysis, since the need to involve the WTO in such concerns is far from obvious. [1] But even in the absence of such concerns, countries may still care about each others' standards choices indirectly, because of the trade effects that such choices could imp ly. Indeed, it is the competitive pressures exerted by these trade effects that are often identified as fueling a race to the bottom. And as these effects travel through trade, they are inextricably intertwined with the business of the WTO. Our paper considers the question of how labor and environmental standards should be handled in the WTO in light of their associated trade effects.

We are, of course, not the first to consider this question (see, for example, the influential volumes edited by Bhagwati and Hudec [1996]). However, analytical results are scarce, and of these even fewer are concerned with the interaction between negotiated reductions in trade barriers and the choice of domestic standards. [2] Yet it is from the backdrop of previous tariff reductions that the case for adding labor and environmental standards to the negotiating agenda of the WTO has been most forcefully made. Hence, an understanding of the interaction between tariff negotiations and the determination of domestic standards seems a necessary starting point for assessing the claim that these standards will suffer as a result of trade liberalization, and therefore necessary as well for considering how labor and environmental standards ought to be approached by the WTO. [3]

We study this question within a general equilibrium framework in which two countries trade two goods and governments make decisions over their trade policies (e.g., tariffs) and their domestic standards (e.g., labor and environmental policies) in pursuit of their own national objectives. In modeling government decisions, we build on our earlier work [Bagwell and Staiger 1999a] representing the objectives of each government as a general function of its local prices and terms of trade, and we extend this representation in order to incorporate the presence of local standards. The advantages of this approach are twofold. First, it is very general, being consistent (as we later show) both with the traditional view that governments maximize national income by their policy choices and with the view embodied in leading political-economy models that governments are concerned about the distributional impacts of their policy choices as well. Second, by representing government objectives in this way, the channel through which one government's policy choices affect another government's welfare is made transparent. This helps us to identify and interpret the inefficiency associated with unilateral po1icy choices, and this in turn helps to clarify both the potential problems that arise when governments focus their negotiations on tariffs alone and the manner in which various rules of negotiation may address these problems.