Domestic policies in self-enforcing trade agreements

If all cross-country externalities travel through the terms of trade, efficient trade agreements may simply target the terms of trade and ignore domestic policies. This argument has been advanced by several prominent studies. Simply put, it reads: terms-of-trade agreements are efficient. I show that this result breaks down if the following two standard conditions are met. First, a self-enforcement requirement constrains the agreement and, second, production possibilities are intertemporally linked. These conditions imply that a country׳s current policy mix affects future production possibilities and thus impacts payoffs under potential defection. Since a terms-of-trade agreement does not specify a country׳s policy mix, it effectively invites countries to manipulate their own defection temptation. To be self-enforcing, terms-of-trade agreement must ensure that no country, while optimizing its policies on the iso-terms-of-trade schedule, will abandon its zone of voluntary cooperation. This requirement implies that terms-of-trade agreements are inefficient and can be improved upon by agreements that target policies directly.