Cross-retaliation and International Dispute Settlement

Although politicians and the popular press often express the desire to link retaliation in trade agreements to non-trade issues, the WTO discourages and usually disallows cross-retaliation even among its own agreements. In this paper we analyze the welfare implications of cross-retaliation. We compare two different mechanisms in a two-country two-sector tariff-setting political-economy model with incomplete information. In a same-sector retaliation mechanism a safeguard action, or other limited violation of the international trade agreement, is punished by an equivalent suspension of concessions in the sector where the initial deviation takes place. In a linked, or cross-sector, retaliation mechanism, retaliatory actions may be taken in another sector or agreement. We next consider less-than-equivalent suspensions of concessions whereby the probability of retaliation is less than unity. We then endogenize this probability and derive its optimal level separately for same- and cross-sector retaliation. We also consider the long-run viability of these self-enforcing trade agreements. We show that whether retaliation is certain or probabilistic a cross-sector retaliation mechanism can generate greater welfare and self-enforcement capability than a same-sector mechanism unless export-oriented lobbies are strong in the cross-sector targeted for retaliation. Even when cross-sector retaliation is welfare improving, there may be little additional benefit to extending retaliation to a different agreement.