Lessons from Europe for U.S. Trade Policy: Is It Time to Separate Trade Liberalization and Investment Protection?

In his state of the union speech last week, European Commission President Jean-Claude Juncker announced new EU trade negotiations with Australia and New Zealand. The proposed negotiating mandates for these trade agreements focus on trade liberalization, and do not include rules protecting foreign investment. Although Trade Commissioner Cecilia Malmstrom hedged a bit on the EU’s policies when asked about it the next day (she said this is “for the moment,” “doesn’t prejudge the future,” and would be “case by case”), there appears to be a developing split between trade liberalization and investment protection in EU policy.

For the reasons set out below, separating these very different issues makes a great deal of sense. To make its trade negotiations go more smoothly, the United States should consider breaking them up as well.

The great philosopher George Costanza warned us of the problems that occur when worlds collide. In trade policy, this collision took place in the original NAFTA, when investment protection was included in a trade agreement for the first time. Under the special dispute settlement rules for investment protection, known as investor state dispute settlement (ISDS), foreign investors can sue host governments in an international arbitral tribunal when they consider that certain of their rights (e.g. property rights, due process rights) have been violated. With the exception of the U.S. – Australia free trade agreement, all U.S. trade agreements since 2002 have included ISDS.

When it was signed, NAFTA was controversial in the sense of the long-standing free trade versus protectionism debate, but ISDS was not well understood at that time. Previously, it had been covered through a separate regime of bilateral investment treaties, but few cases had been brought. Thus, when Al Gore and Ross Perot had their famous debate over NAFTA, it was about traditional trade issues, not ISDS.

As litigation under these investment protection rules proliferated, however, it became a lightning rod for criticism. When large corporations challenged domestic laws and regulations before international tribunals, people raised concerns about sovereignty and the regulatory autonomy of national governments.

In spite of these criticisms, the EU recently made its own attempt to merge the two regimes in EU trade policy, with investment protection/ISDS added to the scope of EU trade powers. After several years, though, it has become clear that the resulting political controversy is a major impediment to getting EU trade deals ratified. A deal with friendly Canada has been tied up in political and legal battles, leading to doubts in the EU about including investment protection/ISDS in these agreements.

Learning from this experience, the European Union appears to be moving towards splitting the two issues. If the new approach proposed by the Commission is followed (the member states still need to approve it, and the policy may vary depending on the trading partner), trade liberalization will be done in traditional trade deals, whereas investment protection will be carried out through some combination of bilateral investment agreements and an EU project to create a multilateral investment court. The full details of the new EU policy are not finalized yet, but some degree of separation is likely to take place.

This approach was developed in response to political concerns, but it also makes sense in terms of policy. Trade liberalization and investor protection are fundamentally distinct, which joining the two in trade agreements has obscured. Two key differences between the fields are:

  • Trade liberalization and investment protection address different problems: The promotion of trade liberalization through trade agreements originated in part as an effort to use international rules to constrain special interests. When domestic industry groups lobby for protection from foreign competition, governments often give in to these demands, and trade barriers proliferate. Trade agreements have served as an effective constraint, offering rules that are mostly targeted at reining in this protectionism, along with a traditional state-state dispute procedure that can be used to ensure some degree of compliance. By contrast, investment protection and ISDS have a very different foundation, and function differently as well. Their modern emergence stems mainly from the end of colonialism and some newly independent states nationalizing foreign-owned factories. Investment protection/ISDS were a response. However, the rules actually cover more than just expropriation, and are often quite vague and broad, relying on language that evokes concepts such as due process. And the procedures allow foreign investors to sue governments directly, which is unusual in international law.
  • The economics of trade liberalization and investment protection are very different: Free trade and protectionism have undergone decades of economic study, and economists almost uniformly support free trade. In theory and in practice, the evidence supports free trade as the better policy. Removing tariffs and other forms of protectionism increases competition, makes consumers better off, and improves overall economic welfare. By contrast, there is not much evidence that investment protection and ISDS offer any benefits to the economy. Some proponents suggest that the system increases investment flows, but the evidence is mixed.

These distinctions indicate that trade liberalization and investment protection policies deserve a separate hearing. Grouping them together has led to a strange narrative from critics that trade agreements are designed to benefit big corporations, which in the case of limits on protectionism makes little sense (corporations are the main ones demanding protectionism). The debate over trade agreements has been less substantive and more hyperbolic as a result. Splitting the two policies would allow for a more substantive debate on each issue.

This would be particularly helpful for evaluating investment protection and ISDS, as many questions about them remain. What precisely are the problems the investment law system seeks to address? Does investment protection lead to increased investment flows? Do the existing rules infringe too much on domestic regulatory autonomy? These issues need to be front and center in a political debate, rather than buried in a larger trade discussion, as they have been when part of trade agreements.

As for the politics in the United States, while you can debate the merits of investment protection, the fact that it adds controversy to any trade deal is not debatable. Senator Elizabeth Warren and others on the left have been very critical of this type of provision, and even U.S. Trade Representative Robert Lighthizer has noted with concern the impact on sovereignty.

Early reports have indicated that the Trump administration is considering making these rules optional in the NAFTA, in the sense that the NAFTA governments would have to opt in. This willingness to reconsider these policies suggests that a broader reform is possible, with a full split of trade and investment protection not out of the question in the future, perhaps even in NAFTA. In this regard, people argue that there are concerns about the degree of protection offered to U.S. investment in Mexico. There may be a basis for this concern, but if there is, a U.S. – Mexico bilateral investment treaty is a better answer than an investment chapter in NAFTA. (The United States has bilateral investment treaties with many countries.) Thus, investment protection does not have to be abandoned, but rather separated out into its own process.

Obviously, there are no guarantees for getting a trade agreement through Congress, and NAFTA will be controversial regardless of whether investment protection and ISDS are included. But these provisions have been a particular focus of criticism. Taking them out of NAFTA and other trade agreements will put critics on the defensive. They will have just received a giant concession from the trade establishment. Continued objections at that point will make them look unreasonable, which could make passing new trade agreements into law much easier.

Policy-making is a learning experience, and we should be willing to adapt and change. The Europeans have faced a greater struggle with investment protection and ISDS than has been the case in the United States, but these provisions have been a problem here as well. If we want to make it easier to get trade negotiations completed and trade agreements passed by Congress, we should consider following the EU’s lead.