Policy Linkage and Uncertainty in International Agreements

I. INTRODUCTION Negotiations over the North American Free Trade Agreement (NAFTA) brought issues concerning the environment and a country's environmental policies to the forefront of international trade negotiations. As a result, NAFTA includes several environmental provisions as well as an environmental "side agreement." The side agreement established a commission to review each country's environmental standards and environmental enforcement record. In addition, the side agreement includes an enforcement mechanism to ensure that each country upholds its standards by threatening the withdrawal of trade benefits for noncompliance. Thus NALFTA ties the benefits of the trade policy portion of the agreement to compliance in a side agreement concerning domestic policies. In this sense, NAFTA appears to reflect a belief in the benefits of linking issues (e.g., trade and domestic policy obligations) within an integrated agreement. The question of when issues should be linked will only grow in importance in coming years as issues of trade and the environment (or other domestic policy issues, like labor standards) move to the forefront. Indeed, at the ministerial meetings in 1994 (at the close of the Uruguay Round), many General Agreement on Tariffs and Trade (GATT) delegates renewed demands for the relationship between trade and various domestic policies (including environmental policy, labor standards, and competition policy) to be examined. The question of how to integrate environmental issues into the World Trade Organization (WTO) will no doubt be accompanied by questions of whether to enforce environmental obligations with the threat of the suspension of trade concessions. Many free trade advocates have argued that environmental issues (and other domestic concerns) should be negotiated in separate international agreements that are divorced from the GATT/WTO framework (in effect, calling for two separate, nonlinked agreements). Thei r primary concern is that disputes with respect to environmental policy will undermine the previous gains made in liberalizing trade barriers. In contrast, many environmentalists argue that environmental concerns should be more fully integrated into existing international agreements (a linked agreement). Their main concern is that any environmental agreement that is separate from the GATT/WTO framework will be unenforceable without the threat of trade policy retaliation. This article addresses these concerns with a theoretical analysis of the benefits (and costs) of linking issues like trade and domestic policy within a unified agreement under conditions of uncertainty. The theory of self-enforcing trade agreements has been well established by Dixit (1987), Bagwell and Staiger (1990), and Riezman (1991), who showed how countries can support low tariffs within a repeated relationship by configuring the tariff agreement so that each country fears that a decision to cheat on the agreement would trigger a costly retaliatory episode in the future. Ederington (2002) extended this repeated tariff game to include two policy instruments (trade and domestic policy) and showed that under conditions of perfect information, cross-retaliation (e.g., enforcing cooperative domestic policies with the threat of trade policy retaliation) does not help support a more efficient agreement. Intuitively, even though trade policy sanctions are a stronger punishment to cheating, they are not necessary because countries have less incentive to deviate from the agreement with their domestic policy. Thus, with perfect information, linked and nonlinked agreements are functionally equivalent. However, this leaves unanswered the question of whether or not cross-retaliation may be beneficial (or detrimental) under conditions of imperfect monitoring. It seems natural to relax the assumption of perfect information, especially with respect to domestic policies and other nontariff trade barriers. …