The Optimal Design of Trade Policy Flexibility in the WTO

This paper is a contribution to the literature on rational design of trade agreements. The World Trade Organization (WTO) is an incomplete contract among sovereign states. Incomplete contracts contain gaps. Ex post, contractual gaps may leave gains from trade unrealized; they may create “regret” in signatories once unanticipated contingencies or sudden protectionist backlashes have occurred. Trade policy flexibility mechanisms, such as the “safeguards clause” under Art. XIX GATT, are geared towards seizing ex post regret by allowing parties affected by a protectionist shock to partially and temporarily withdraw from previously made trade liberalization concessions – given that they compensate the victim(s) of such backtracking behavior. This paper examines the somewhat understudied issue of optimal trade policy flexibility design in the WTO: In particular, we analyze whether ex post escape should be organized by means of a unilateral opt-out clause (a “liability rule” of escape), or a bilateral renegotiation provision (a “property rule” of escape). Modeling the WTO as a fully non-contingent tariff liberalization contract with contingencies (or “states of nature”) asymmetrically revealed, we find that a liability rule backed by expectation remedies payable to the affected victim Pareto-dominates both a renegotiation clause, as well as any other remedy arrangement connected to a liability rule. Only the remedial design of liability-cum-expectation damages yields the desirable incentives to liberalize ex ante, and to default ex post and therewith is able to replicate the outcomes of the hypothetical contracting ideal of the complete contingent contract.