Free international trade is a lot like free beer & brats. They don’t really exist except in somebody’s mind. Like pure or perfect competition, free trade is a polar state that has very desirable properties and its extreme form probably never did nor ever will exist. But that doesn’t mean that we can’t think about freer trade. We can ask the very practical question – can we or should we try to bring about freer international trade?  

International Trade implies an exchange is being made between two parties – whether it involves people, goods, services, real capital, financial capital, foreign currencies, cukoo clocks, or anything else exchanged between parties in two or more countries.  Free trade further implies that there are no artificial or “constructed” obstacles to that trade. If two willing parties of an exchange lived 10,000 kilometers apart, the distance might provide hurdles to overcome but we would call that an inherent cost of distance rather than a lack of free trade. For free trade to be lacking, we think of some form of power or corruption that is exerted to reduce or prevent the trade. More will be said about specific barriers that impede free trade below.

A world of perfectly free trade would be totally free of all such barriers. Most people think that such an extreme would be impossible – sort of like finding the Holy Grail or the Fountain of Youth. The more common goal, therefore, is to move towards “freer” trade – implying some reduction in the barriers to free trade.

Another way to understand free trade is to note that transactions are guided by free market principles. This wording connects international free trade to our notions about domestic market economies or capitalist economic systems. Recall Adam Smith’s notion of the “invisible hand.” The invisible hand is a way of saying that there is some inherent force of nature in unfettered market capitalism that brings about the best results. It implies that there is no need for a “visible hand” of the government to solve economic problems. According to the invisible hand, there would be no need for the government to regulate prices or to administer labor policies. There would be no role for tariffs on imported goods and no rationale for quotas that prevent cross-border trade in specific goods. Those transactions would best be left to the firms and workers and consumers involved with the transactions.

While most economists believe in the invisible hand, most of them also know there are limits to it and admit that there is an economic role for governments. For example, most economists do not consider it a trade barrier when the government enacts and enforces anti-trust or anti-corruption regulations aimed at firms that cheat.  Most people agree that some from of government social policy is necessary to bring about better solutions for poverty and unemployment. The role of governments in pollution control and education are often lauded.

Inasmuch, the real situation is that while we believe in Adam Smith’s invisible hand, most economists approve of some forms of government intervention into market transactions – both domestically and internationally. They say that one person’s garbage is another one’s treasure.

When it comes to various forms of government intervention, economists often disagree about whether an action is a necessary reaction to a failure of a market or whether it is an unnecessary intervention that reduces national welfare. Thus we admit that there is no such thing as perfect competition domestically and no such thing as free trade internationally. Despite this lack of consensus about the role of government, it is probably true to say that most economists favor freer competition. What they don’t always agree on is how to accomplish that.

Why is free trade desirable?

The World Trade Organization offers its views on 10 benefits of a WTO trading system. These are benefits derived from more countries participating in a system whose main objective is freer trade. Leaving the trading system aside, the standard view of why free trade is desirable is found below in numbers 4, 5, 6, 7, 8, 9, and 10. (note: clicking on any of these 10 links takes you to a more complete discussion by the WTO.

The ten benefits of the WTO trading system

  1. The system helps promote peace
  2. Disputes are handled constructively
  3. Rules make life easier for all
  4. Freer trade cuts the costs of living
  5. It provides more choice of products and qualities
  6. Trade raises incomes
  7. Trade stimulates economic growth
  8. The basic principles make life more efficient
  9. Governments are shielded from lobbying
  10. The system encourages good government

Here is a brief synopsis of the benefits of freer trade. Fewer impediments to trade mean that the true buy and sell signals come through more clearly – producers produce what is demanded and less is wasted. That leads to more efficiency. Because obstacles can reduce competition and/or lead to protection for firms, that allows them to raise their prices higher than necessary. Thus free trade makes goods cheaper. When goods and services are cheaper, households can buy more of the same goods or since they can buy the same amount as before and have money left over to spend – that leads to production of even more goods. When a country produces more, it increases the incomes of its citizens. If freer trade creates clearer incentives and does not allow for arbitrary impediments against particular goods or services, then it is easier for a greater variety of goods and services to be produced and made available to consumers. Firms may be freer to experiment with (high and low) quality and features and packaging and other aspects.

The issue of trade causing economic growth and job growth is very controversial. One argument is that free trade and the resulting stronger competition creates more incentive for survival – it brings out the entrepreneurial juices. Some firms in some countries are too weak to compete with other firms. Thus free trade in those countries hurts companies and reduces incomes. This worry was voiced loudly as Mexico approached the North American Free Trade Agreement (NAFTA). This concern was voiced in Mexico but it was also registered in the U.S. where some U.S. firms felt they could not compete against low-wage Mexican firms. While these concerns have merit, they miss the whole point about the benefits of free trade. Why have a NAFTA if it isn’t going to cause change? Won’t many U.S. companies be made stronger by having access to cheaper goods in Mexico? Won’t Mexico be made stronger by having better access to U.S. technology and capital?  From a national standpoint free trade is a win-win situation – despite the fact that some firms will be injured by it.

So why is there a real debate? There are three things to discuss. First, is the issue of compensating the losers. There will be companies and persons that are harmed and cannot survive in the new competitive environment. Social policy must find ways to address this without reducing the ability to trade. Second, corruption must be expected, monitored, and eliminated. Too many free trade situations have failed essentially because the spoils went to a few unscrupulous persons in the private and public sectors. Free international trade cannot paper over domestic obstacles to commerce. Third, while it is easy to see why economic growth would increase, the issue over employment is murkier. It is quite possible for companies to increase output without a corresponding increase in labor input. It is very likely that new and higher levels of competition will lead to higher productivity – but productivity is a double-edge sword for employment.

The first edge of a productivity increase involves the cutting of jobs. But the second one finds that countries with strong productivity and economic growth tend to have increasing employment. Why is that? It is because when many companies want to increase output, they generally need to increase employment. This is the usual story of productivity growth – each year many jobs are destroyed as competition rewards winners and penalizes others. But the process of “most” companies seeing their outputs rise by 2-3% per year tends to “pull” the total level of employment upwards. Consider the U.S. experience. Both President Reagan and President Clinton bragged that employment in the U.S. increased by about 18 million jobs during each of their eight years in office. That’s a total of 36 million jobs in 16 years – an average of 2.25 million jobs per year! Over that time period many people lost jobs – many manufacturing jobs declined and went overseas, some jobs just ceased. So while productivity appears to be a double-edged sword – one edge is a lot bigger than the other one. Productivity growth tends to lead to much more employment – not less.

Industrial Application: Why Globalization Works

Arvind Panagariya wrote an excellent summary of a book by columnist Martin Wolf, Why Globalization Works. Panagariya’s summary, “The Miracle of Globalization: Free Trade’s Proponents Strike Back” appeared in Foreign Affairs, Sept/Oct 2004, pages 146-151. He summarizes the case for free trade as follows:

  • Critics says that globalization has not created faster economic growth. Wolfe says India and China are shining examples of opening up their economies to free trade and faster economic growth
  • Panagariya says that almost all cases of growth “miracles” between 1961 and 1999 experienced rapid trade growth. Countries that had declining per capita incomes tended to have dismal trade growth
  • Freer trade did not always produce growth miracles – when other aspects of good governance were missing. For example, stifling industrial licensing that used to typify India held back economic growth despite freer trade. Poor transportation facilities didn’t help either.
  • Wolf adds, “Poor performers have corrupt, predatory or brutal governments or, sometimes even worse, no government at all, but rather civil war among competing war lords.
  • Panagariya adds that while Latin America did try free trade reforms, they also borrowed too much and made themselves more subject to financial crises. Chile was the counterexample. It opened its economy to trade, grew rapidly, moderated its borrowing, and maintained macroeconomic stability.
  • Wolf notes that while developing countries will gain by having more access to other countries, the largest improvements will come from their own liberalization.
  • Wolf points out that multinational companies generally have not exploited local workers – in fact his evidence shows that they pay the workers more and treat them better than local firms.
  • Some critics worry that when firms and jobs leave the U.S. for foreign countries or when U.S. firms outsource – this leads to lower wages in the U.S. Wolf counters that the U.S. is a major recipient of inbound capital investment and insourcing. This tends to balance the impacts on employment and wages.   

A good recent article by Deloitte Consulting compares India and China as important world business locations. See “China and India: The Reality Beyond the Hype”