Trade Diversion in South America
In 1991, four South American nations, Argentina, Brazil, Paraguay, and Uruguay, formed a free trade area known as Mercosur. The pact had an immediate and dramatic effect on trade: Within four years, the value of trade among the nations tripled. Leaders in the region proudly claimed Mercosur as a major success, part of a broader package of economic reform.
But while Mercosur clearly was successful in increasing intraregional trade, the theory of preferential trading areas tells us that this need not be a good thing: If the new trade came at the expense of trade that would otherwise have taken place with the rest of the world—that is, if the pact diverted trade instead of created it—it might actually have reduced welfare. And sure enough, in 1996 a study prepared by the World Bank’s chief trade economist concluded that despite Mercosur’s success in increasing regional trade—or rather, because that success came at the expense of other trade—the net effects on the economies involved were probably negative.
In essence, the report argued that as a result of Mercosur, consumers in the member countries were being induced to buy expensively produced manufactured goods from their neighbors rather than cheaper but heavily tariffed goods from other countries. In particular, because of Mercosur, Brazil’s highly protected and somewhat inefficient auto industry had in effect acquired a captive market in Argentina, thus displacing imports from elsewhere, just like our text example in which French wheat displaces American wheat in the British market. “These findings,” concluded the initial draft of the report, “appear to constitute the most convincing, and disturbing, evidence produced thus far concerning the potential adverse effects of regional trade arrangements.”
But that is not what the final, published report said. The initial draft was leaked to the press and generated a firestorm of protest from Mercosur governments, Brazil in particular. Under pressure, the World Bank first delayed publication, then eventually released a version that included a number of caveats. Still, even in its published version, the report made a fairly strong case that Mercosur, if not entirely counterproductive, nonetheless has produced a considerable amount of trade diversion.