• The Invisible Hand

A (Limited) Case Against Free Trade

Updated: Feb 17

Free trade is almost universally accepted by economists and that is no exception for this author. However, this article reviews whether any case can be made for limiting free trade.

Until recently it seemed that the benefits of free trade were the only certain thing in economics. Yet Donald Trump and his protectionist outbursts have challenged this consensus and institutional economists are arguing more vociferously that developing countries have been let down in their promises. Adam Smith established the rule book on free trade with his ground-breaking Wealth of Nations and David Ricardo finished it. Within economic theory it is remarkable that such a theory has remained relatively unchanged over such a period of time.

Free trade was a core part of Smith’s ideology; he believed that self-interested behaviourand competition would drive countries to produce the goods and services they are best suited. Protectionism would only serve to direct industry to areas it is not naturally best at. Forty years later, Ricardo showed that all countries can benefit from free trade, even if other countries are better than them at producing every good and service. These important laws are as relevant today in understanding the importance of free trade.

Yet below this monumental piece of literature is a less recognised, but perhaps equally important, passage in relation to this important question. Smith outlines a few limitations to when protectionism should not be used. First, tariffs are necessary to match the taxation system at home. Second, and more importantly, Smith argues that tariffs can be justified for security and natural defence. We should not be reliant on other countries for military technology, but also for vital resources like food.

The most important, and the one this post will focus on, is Smith’s third point that tariffs may be justified if they are merely part of a transition to free trade. This means that tariffs should be removed slowly to prevent domestic industries closing too quickly and give them enough time to transfer their resources to more productive uses. Otherwise cheap foreign goods flowing in will close domestic industries and create mass unemployment. If the transition was gradual, unemployment would be frictional rather than structural. This problem is particularly notable in developing countries because their industries are more vulnerable as, for example, their factors of production are not as mobile due to under developed infrastructure.

It is also important to keep tariffs for a transition period in developing countries because unlike in developed countries, import taxes make up a key part of the government’s revenue, often 10-20% of the total. It is understandable that removing this source of revenue instantly would significantly hurt a government’s finances and raise their budget deficit by 2-3%. In the long-run, this would not be a problem because greater economic growth from more free trade would increase domestic tax revenue. However, a sudden loss of revenue can be devastating. A large budget deficit could trigger large scale capital flight and a currency crisis. It would be hard for developing countries to fill this gap with taxation because this puts a burden on already poor citizens. Instead by gradually reducing tariffs, there is no sudden effect on the government’s budget and therefore no panic by investors. In the long-run this problem will become insignificant.

However, it is still questionable how much support these industries should be given. An infant can only be cared for for so long and they must learn to walk on their own two feet. Tariffs, even if are decreasing slowly, will keep inefficient industries in business and limit the economic growth of these countries. Trade liberalization quickly forced out inefficient businesses in East Asia and led to new foreign firms setting up. Now the Asian tigers are some of the most highly developed countries in the world. This may not apply to other countries, however, because the developments in South East Asia were accompanied by massive government assistance with education which provided the skilled workforce that was necessary to attract foreign investment. Africa is very different to South East Asia as it lacka the same political structures and instead is plagued by corruption and incompetence on a much greater level.

Port of Lomé, Togo

For countries like the US, free trade benefits all and tariffs hurt all. Even workers in the steel communities suffer over time. Their decline is only slowed down and not halted and their industries will come crashing down either way. In this time other countries are becoming more competitive and beating the US in international markets. US workers pay high prices as domestically produced goods are much more expensive to produce, so higher nominal wages will not translate into higher real wages. Short-term benefits are easy to grab for, but in the long-term no developed country can benefit from tariffs. Only Smith’s fourth reason for tariffs, as retaliation, is acceptable for introducing tariffs in developed countries, as this aims to reduce overall tariff levels in the long term. Therefore, this essay has focused exclusively on developing countries. Besides, it is West Africa which the European Parliament has deemed the region most vulnerable to sudden trade liberalization.

Some modern economists, most prominently Joseph Stiglitz, argue that free trade is good, but the way that trade liberalization has been done is wrong. It is not the policy that is wrong but the institutions and countries which deliver it. He believes that developed countries have in the past forced developing countries to remove their trade barriers while they have kept their own up. Powerful nations such as the USA have always been able to intimidate smaller nations and they have dominant power over international institutions such as the World Trade Organisation. Although China’s membership in 2001 marked a shifting of the power base in international trade. Stiglitz notes how it is ironic that nations such as the US have grown under the umbrella of tariffs, yet they wish to expose nascent developing countries to the hostilities of international trade.

This irrevocably connects these countries to the international economy which makes them more vulnerable to global shocks (contagion). This is part of the reason why the Global Financial Crisis (2008) was truly global. If countries accept foreign investment, they must accept diminished capital controls which puts them at risk of a sudden capital flight which caused the crisis in East Asia in 1997. Argentina has recently seen its exchange rate half in 2018 against, partly as a result of opening themselves up to trade which has exposed them to volatile flows of international capital.

It is important to note that this is not a complete write-off of free trade. It is massively important for economic development and has shaped our eclectic economy today by giving us access to many new goods. Traditional theory holds strong and all economic agents do truly benefit from trade. In most cases trade does enhance the economies of developing countries, as seen in the growth of South East Asia. However, policy makers should be careful to make sure it is done the right way given the context. Adam Smith is still right, tariffs should not be removed suddenly and Stiglitz is also right in saying that free trade should be done in the interests of developing countries not against them.

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