Cross‐retaliation and international dispute settlement

Abstract 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. A country may temporarily raise trade barriers in response to political pressure and the extent of this pressure is private 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 political pressure in the cross‐sector targeted for retaliation is high. Although cross‐sector retaliation is usually welfare improving, there may be little additional benefit to extending retaliation to a different agreement.