Trade agreements as protection from risk

Introduction How do governments protect themselves from global market risk? The costs and benefits of globalisation cannot be measured solely in terms of predictable changes in trade. Rather, unpredictable changes - or volatility - in trade flows are also associated with high costs. As with any form of risk in the marketplace, volatility significantly dampens economic activity and reduces welfare. The adverse effects are felt at all levels of the market. In the aggregate, volatility destabilises exchange rates, inflates budget deficits and leads to more frequent and more extreme business cycles (Aizenman and Riera-Crichton 2008; Combes and Saadi-Sedik 2006). For individuals, it leads to decreases in wages and reduced job security (Scheve and Slaughter 2004). In general, domestic economies exposed to high levels of risk suffer many of the adverse welfare effects commonly linked to liberalisation (Blattman, Hwang and Williamson 2007). In light of these costs, governments have strong incentives to insulate their markets from global economic risk. Recent research shows that preferential trade agreements (PTAs) provide one form of insurance to states (Mansfield and Reinhardt 2008a). The core insight of this literature is that, by promoting the rule of international trade law, PTAs significantly reduce uncertainty in trade policy, which is a key source of market volatility. In the context of a more stable policy environment, members of trade agreements experience significantly less risk than nonmembers do.