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CAP impact on world trade

Asked by essence83 | May 18, 2008 | A Level > Economics > Revision
essence83 asks:

(a) Examine the impact of te European Union's Common Agricultural Policy on the world trade in agricultural goods. (40 marks)

(b) Evaluate the implications of a significant reduction in barriers to the trade in goods and services for the global economy. (60 marks)

etutor answers:

Farming has enjoyed a special status within the European Union ever since it was created as the European Economic Community, in 1958. Its origin was in the food shortages of the 1940s and 1950s, together with concern over rural poverty. The Common Agricultural Policy (CAP) was introduced in 1962 and, despite periodic reform, has remained intact ever since, reflecting the power of the agricultural lobby in general, and the French attachment to farm subsidies in particular. Over the decades farming has gone from being an object of celebration to one of mounting budgetary debate. The CAP has wide-ranging and far-reaching effects on many different sectors of the British, European and international economy. It affects not only farmers, but also industries that supply and support farmers, food manufacturers and the environment.

The objectives of the CAP were set out in Article 39 of the Treaty of Rome: to make the area self-sufficient in agricultural produce; to increase agricultural productivity to guarantee food supplies; to stabilise agricultural markets; to ensure a fair standard of living for farmers; and to ensure affordable prices for consumers. The first three of these objectives have been broadly achieved. Climactic variations in farm output from year to year have been significantly reduced by developments in agricultural technology and biotechnology, so much so that the EU nowadays has a surplus of food. Competitive agricultural markets and technological innovation have guaranteed increased farm production and higher yields (indeed, the CAP is no longer needed to achieve this aim, since in a market-based system, farmers would be forced to produce efficiently to remain profitable). Agricultural markets have been stabilised, though only at great economic and environmental cost. The fourth and fifth objectives have, however, been the subject of constant controversy. The CAP does not deliver an equitable outcome - there is a division between large-scale and small-scale farmers within the EU, while the accession of new countries after 2004 has exposed the extent to which farm support affects farmers of different size. CAP has increased European food prices, leading to a loss of consumer welfare.

The CAP is a collection of packages of policy instruments applied to different commodities and sectors. Traditionally, price support and intervention schemes have been at the heart of policies protecting EU farming. Originally the most visible characteristic of the CAP was the practice of setting prices above the market equilibrium, with the resulting surpluses bought up by the European Commission. Some of this surplus is stored, some of it is destroyed and some of it is exported outside the EU at low, subsidised prices. A common external tariff is imposed on all imports of agricultural produce from outside the EU and is set such that the price of imports is at least as high as that of the least efficient EU producers. In more recent years, set aside payments (payments for leaving a percentage of arable land fallow) were introduced, as well as additional subsidies for switching to organic farming. Reforms introduced in 2003 have altered this system of farm support.

Guaranteed Minimum Prices: The intervention price is set above normal world price levels. This encourages an expansion of supply, but a contraction of demand. The excess supply is bought up by the European Commission and put into storage. Reforms of the CAP have gradually reduce the scale of intervention purchases, though the cost of storage remains an issue.

Export Refunds: Export refunds are paid to an exporter of produce to countries outside the EU in order to compensate for the difference between EU and world prices. Hence producers have an incentive to offload their surplus production onto world markets. The strategy is highly controversial since, at times of falling world food prices, generous export subsidies can reduce EU export prices well below the production costs of farmers in less developed countries.

Import Tariffs: The EU sets Minimum Import Prices, achieved through a variable import levy on food coming into the EU. The tariff leads to an expansion of EU farm output, but the higher prices cause a contraction of demand. Hence the volume of imports into the EU declines. If world food prices fall, the EU import levy will increase to maintain the minimum import price, which then insulates the EU from falls in real world price levels. Tariffs provide protection for EU farmers and thereby boost output and protect farm employment and incomes, but reduce consumer welfare. And while price supports keep smaller farmers in business in the short run, the greatest benefits are obtained by larger farmers.

The CAP has been criticised on a number of fronts. Even with the accession of ten new members in 2004 and two more in 2006, the proportion of the EU workforce employed in agriculture is below 5% and farming accounts for only 1.6% of EU GDP, yet the CAP accounts for the largest proportion (around 42%) of the EU’s annual £70B budget. Its share has in fact declined since the mid -1980s, when nearly 75% of the budget was devoted to it. The CAP reduces competitive pressure in the farming industry and raises prices for consumers, who also fund the policy through the taxes that they pay into the annual EU budget. It enables small and inefficient farmers to survive, inhibits restructuring, discourages diversification and harms the environment. It has frequently resulted in over-production, leading to the familiar butter and beef ‘mountains’ and wine ‘lakes’. It makes it difficult for developing countries to sell their produce in the EU, while at the same time floods their markets with subsidised surplus EU produce, thus making it impossible for much of the local industry to compete and to remain in production. CAP is a classic example of government failure because the pursuit of self-interest in protecting agriculture has over-ridden economic concerns, in large part because of the political influence that the farming lobby has brought to bear. Often, national governments have been 'captured' by the farming industry in blocking or diluting proposed CAP reforms. Governments have also failed to appreciate the longer term economic and environmental consequences of farm support policies, including the effects of dependency on farm subsidies and the high costs arising from surpluses and waste in many agricultural markets.

CAP is also increasingly out of step with the need for the EU to respond to the challenges of globalisation. Internationally, it continues to attract criticism, creates tensions in the EU's relations with trading partners, and imposes significant costs on developing countries.

Hence the main arguments against the CAP are:

1. Production inefficiency - CAP intervention prices have encouraged excess output and have allowed production inefficiencies and dependence upon farm subsidies - all of which represents a misallocation of resources.
2. Loss of allocative efficiency - the CAP fails to meet society's requirements from agriculture in terms of food safety, animal health and the rural environment; until recently, Cap was inconsistent with policies on sustainable development, and did not meet demands for high quality local and regional foods.
3. Fiscal costs: The budgetary cost of EU farm support has been huge and represents a large opportunity cost - the money might have been directed to more beneficial uses.
4. Fraud: There is endemic fraud within the system, as well as rising costs of administration and compliance.
5. Damage to consumer welfare: Farm support imposes higher food prices for EU consumers, which particularly penalises low income families. Consumers pay twice - first, because of import tariffs and second, through higher taxes to finance the CAP. In the UK, the Consumers' Association estimates that this costs each family £16 a week.
6. Environmental concerns: The CAP has encouraged intensive farming, prompting concern about its environmentakl impact.
7. Global market distortions: The CAP distorts domestic, EU and international markets, threatening the development potential of many low-income nations - a cause of tension in EU-rest of the world global trade negotiations. An OXFAM study in 2002 found that the EU's wheat export prices were 34% below the typical costs of production in developing countries.

Moreover, the huge spending on the CAP is simply not consistent with the declaration of EU leaders in 2000 that they were seeking to create the most competitive, knowledge-based economy in the world. It is the classic example of protectionism, and the world’s largest agricultural exporters constantly demand freer access to the EU market, and thus sharply lower tariffs on their exports.

If there were very significant cuts made in subsidies and in the external tariff, then it is estimated that between half and two-thirds of all French farms would become uneconomic and would be forced to close. Naturally smaller farmers would be most vulnerable. Beef farmers would face a huge increase in imports from Argentina and Brazil, and most would be forced to go up market in order to survive. Most arable farmers have already expanded by an average of 40% over the past decade, yet the average size of a French farm is less than a quarter of that of its American equivalent.

The CAP issue blighted attempts in June and December 2005 to achieve an EU budget deal for 2007-13. The EU budget is remarkably small, accounting for just over 1% of annual EU GDP. In June, Tony Blair stated that he would place the UK’s budgetary rebate, secured by Margaret Thatcher in 1984, on the table so long as there was fundamental CAP reform. Blair found himself isolated at the summit as other EU leaders were more concerned with cutting the UK’s rebate and thwarting British proposals to reduce regional aid and other spending than with CAP reform. The eventual outcome of the December summit predictably left the CAP unchanged until 2013, with a ‘review’ promised in 2008; indeed, the proportion of the budget devoted to the CAP is scheduled to rise to 44%. Chirac insisted that the budget deal struck in October 2002, and subsequently endorsed by every EU leader, was sacrosanct and was therefore not subject to re-negotiation. The deal had frozen CAP spending in real terms until 2013, while any change after the 2008 ‘review’ is highly unlikely, given the obvious threat of a French veto. By then, the ten countries that joined in 2004 will be receiving their full quota of farm subsidies and will naturally be anxious to protect them.

In reality France succeeded in holding both the EU budget summit and the WTO talks to ransom. The lack of progress at the December Hong Kong ministerial meeting to discuss the Doha Round of world trade talks can be linked directly to the EU’s intransigent refusal to open its markets more widely to overseas farm producers. In November 2005 Chirac had accused Peter Mandelson, the EU’s Trade Comissioner, of exceeding his mandate and declared that he might veto the Doha Round of trade negotiations rather than accept further changes to the CAP. In the event the threat failed to materialise, and the meeting did not collapse (as had those in Seattle in 1999 and Cancun in 2003) though little in practice was agreed. EU members settled on 2013 as the date for the elimination of export subsidies on agricultural produce. A spokesman for the EU described the pledge as ‘substantial’, but added that there would be no further concessions until emerging nations had opened their markets to industrial goods and services. Yet, according to the World Bank, the agreement on export subsidies is equivalent to a mere 2% of the theoretical gains from free trade; moreover, most of them will have disappeared anyway by 2013 as a result of earlier CAP reform.

There have been periodic reforms of the CAP, albeit only at the margin; the fundamental principles have remained intact. The MacSharry reforms (1992) reduced the level of quotas and support prices on a number of products, reduced intervention purchases for beef and introduced direct income support for larger farmers willing to set aside at least 15% of arable land. There were also moves towards encoraging less intensive farming techniques, forestation subsidies to encourage the planting of more trees and financial support to encourage the early retirement of farmers. The Fischler reforms (1999) began the process of fundamentally questioning the efficiency and equity of CAP support, introducing more cuts in guaranteed prices and shifting aid further from price support to direct income payments. The Agenda 2000 reforms included further cuts in intervention prices for cereals and beef and lower quotas for milk. Most recently, in 2003 (the Fischler Review), the blanket farm support arrangement was replaced by a single payment scheme (called 'decoupling') that subsidises farmers’ incomes directly (and in principle independent of production levels) rather than guaranteeing higher prices for their crops and livestock. Income payments are conditional on farmers meeting agreed standards of environmental care, food safety and animal welfare. A limit was also placed on CAP spending, while more spending was channelled into programmes that do not distort trade, such as rural development, and with a focus upon marketing and processing local foods (from 2007, there is a reduction in payments to larger farms in order to fund this objective). Yet production-linked subsidies were retained in most farm sectors, largely on account of powerful lobbying by France. Hence farmers are now on average paid only a third above the world market price for their produce, compared with 80% in the mid-1980s. Overall, subsidies have declined from over 40% of total farm receipts in the 1980s to below a third in 2007. When fully implemented, the 2003 changes mean that some 90% of EU farm support will be classified as ‘non trade-distorting’. But the changes amount only to partial reform, since they did not affect external tariff levels, the principal focus of dispute between the EU and the rest of the world.

The effects of the most recent reforms will clearly vary from nation to nation within the EU. In general, the winners are consumers, taxpayers, larger-scale commercial farmers and developing nations, while the losers are uncompetitive farmers, those least able to diversify and landowners. Any further CAP reform can only be of benefit to less developed economies, though the benefits will be limited in the cases of those nations that are rapidly diversifying their economies away from agricultural produce. This links with the globalisation debate, which in large part focuses upon removing barriers to trade in all goods and services (the role of the World Trade Organisation) and thus enabling countries to specialise according to the principle of comparative advantage, which has the effect of increasing growth and employment.

The World Trade Organisation was formed in 1995; it replaced the earlier GATT (formed in 1947); it now has 150 members, including China (2000), Vietnam (2007) and Russia (2007). Like GATT, it periodically hosts a series of ‘Rounds’ of meetings designed to reduce restrictions on international trade. The average tariff on manufactured products has fallen from some 40% after WW2 to about 3% today, though is again rising as more and more countries resort to protection against cheap imports from the emerging Asian economies (seen, for example, in the 'bra wars' in 2005, when the EU imposed quotas on Chinese clothing products). The WTO is now effectively the world’s ‘international policeman’ in the trade area, establishing rules and settling disputes between countries and trade blocs. Hence the WTO administers trade agreements, acts as a forum for trade negotiations, settles disputes, monitors national trade policies, and assists less developed countries in trade policy issues. Its overall aim is ‘to support a new era of global competition, reflecting the widespread desire to operate a fairer and more open multilateral trading system.’

The WTO’s fundamental problem is how to reconcile the benefits of free trade with the demands of individual or groups of countries, firms, workers or consumers for protection from the effects of international competition in an age of globalisation and domination of production by multinational companies. A range of ethical issues often makes WTO progress painfully slow – issues such as genetically modified food, animal welfare, child labour, environmental degradation, health and safety, and exploitation of low paid workers. Most of these issues are outside the remit of the WTO, and are frequently used as a pretext for erecting or maintaining trade barriers.

The WTO is committed to ‘comprehensive negotiations’, aimed at substantial improvements in market access, the eventual phasing out of all forms of export subsidy, and substantial reductions in trade-distorting domestic agricultural support. It has registered many successes, particularly the removal of high tariffs (and non-tariff barriers) on the main non-agricultural exports of less developed countries, though progress in phasing out such arrangements (like the MultiFibre Agreement) has been painfully slow. This is partly because the WTO is not well equipped to deal with trading BLOCS (like the EU, NAFTA and MERCOSUR) as opposed to individual countries. Developing countries argue that agreements (and their enforcement) are still biased in favour of the developed world and demand ‘fair trade’. Anti-globalisation protests have focused on the theme that the WTO in reality protects the capitalist ‘big battalions’.

The requirement of LDCs to recognise intellectual property rights has been a large blow to those countries specialising in producing cheap imitations. Reduction of trade barriers has depressed agricultural prices and has opened up markets to cheap manufactured goods from the Far East. Environmental regulations have often reduced production or raised costs. The WTO has also made limited progress in opening up many services markets – especially in finance, sea transportation, airlines and telecommunications.

The Doha round of trade talks was launched in 2001 after several false starts, though it has collapsed on a number of occasions, notably in Cancun in 2003 and in Geneva in 2006, partly because of the complex and over-ambitious nature of the agenda, and the mounting tensions between trading blocs. The talks were designed to rebuild the world’s trading system in favour of low-income countries; indeed the 8th world trade round was deliberately called a ‘development agenda’, with a view to winning over LDCs and to ensuring that globalisation was 'more inclusive'. There are recent examples of progress, albeit on a limited front - Mexican tomato growers have benefited from opening up trade with the USA, US support for its cotton farmers has been ruled illegal, while the EU practice of dumping sugar surpluses on world markets was acknowledged as trade-distorting. A recent alliance between Brazil, China, India and South Africa highlights the determination of developing countries to have a greater impact on the WTO agenda.

The principal reason for the impasse over the Doha Round has been agricultural protection, primarily on the part of the EU and the USA. Farm trade is vital to developing nations, who are handicapped by export subsidies, domestic support programmes in the western world and lack of access to western markets. The average agricultural tariff is as high as 60%. A face-saving compromise was finally agreed in Hong Kong in December 2005, with the EU reluctantly agreeing to scrap agricultural export subsidies by 2013. Little progress has been made on reducing import tariffs on farm produce or on freer trade in manufactured goods. The World Bank argues that full liberalisation of agriculture would lead to trade gains worth $182B, of which half would accrue to LDCs (comparative advantage theory). But many countries have used the impasse in agriculture as a convenient excuse to resist pressure to negotiate away barriers to service markets and manufacturing tariffs. The USA is heavily criticised for demanding too much liberalisation from other countries, while failing to reciprocate. A proposed '20/20/20' deal seemed possible in 2006, by which the US would cut its farm subsidy levels below £20B, the EU would agree to the emerging economies' (G20) proposals for a 54% cut in farm tariffs, and the G20 would agree to cap their industrial tariffs at 20%. Negotiations were, however, formally suspended in Geneva in July 2006, with each side accusing the others of being prepared to yield too little. Brazil, China and India became increasingly obstructive, with India arguing that the WTO's professed aim of helping poorer countries should mean that they conceded nothing at all.

Countries such as China, Kong Kong, Singapore, Chile and India have all shown that opening their markets unilaterally can yield larger benefits than do trade rounds. Moreover, there has been a worldwide stampede into bilateral agreements since 1999, led by Japan and Singapore. This development threatens to segment the global market further into a patchwork of preferential arrangements, each with its own complex customs rules. Strong nations then bully their ‘partners’ into conditions dictated by the narrow interests of domestic producers. Regional and bilateral agreements, now numbering over 200, are clearly discriminatory. penalising those countries with limited bargaining power and leaving the poorest in the cold. This in turn brings ito question the value of the WTO’s disputes procedure, and signals a relapse into world protectionism, particularly as the BRIC economies (Brazil, Russia, India and China) increase in economic strength and significance. The changes in the global economy, fired largely by China and India, are often seen to dwarf the significance of WTO trade negotiations. Moreover, slower world growth and the fear of Chinese competition will make it still harder to take on special interests.

At the World Economic Forum, held in Davos (Switzerland) in January 2007, there was a renewed push by the leading trading blocs to clinch a global free trade deal. The outcome was further talks in Geneva, though these were, as ever, held more in hope than in expectation of success.

I hope this is helpful.

1 student responses

That was great.

Thank you!
responded May 31, 2008 5:09:19 PM BST
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