Why Free Trade is Misconceived

Over the past few years, the widely-held view of economists that free trade spurs global growth and increases consumer’s utility has been questioned by civil society and politicians alike. This piece will provide a line of argument for why free trade remains beneficial to nations and their citizens, but also where it might have gone sour.

Getting the rock but losing the stick?

Theoretical explanations of international trade were triggered by Ricardo in 1817 with his idea that every country produces some good relatively cheap to another country. Equipped with this comparative advantage, both nations focus on producing the respectively cheap good and trade among themselves. This will lead to both countries having more from both goods and consequently being be better off. The Heckscher-Ohlin model from 1933 expanded Ricardo’s idea by assuming all countries to be equal, except for their factor endowments, namely capital and labor. One key implication of their model is that free trade will lead to equal wages and interest rates (the cost of the factors of production, capital and labor) across trading countries. This works through the exploitation of different factor endowments, where the country rich in capital will export capital intensive goods and import labor intensive goods from the countries generously endowed with labor.

One of the interesting and highly relevant implications of this model is that it identifies the losers and winners of trade, namely the workers in capital-rich countries (sounds familiar?) and the capital owners in labor-rich countries. Let’s agree on the assumption that the countries of “the West” are rather capital-rich, opposed to rich in cheap labor. In the Heckscher-Ohlin world, capital would flow out of “the West” into the labor rich parts of the world, f.e. China, making manufacturing jobs in “the West” obsolete, while fostering employment in manufacturing in China, and increasing the return on capital for western capital-owners. It is easy to see that the loss of manufacturing jobs has disastrous consequences for workers in the respective sectors, but leaves one wondering for the policies that should counteract these. Bolstering investment in education for the young and retraining programs for the old should aim at moving workers into higher-skilled jobs that are still in demand. Heckscher-Ohlin also predict that in the long run costs of factors of production will equal out across countries, and even though we will all be dead in the long run, the first feeble signs of this mechanism that can already be seen at the example of China. Wages there have been on the rise, lifting approx. 500 Million people out of extreme poverty over the last 30 years, spurring a trend across firms (among them a few Chinese ones) to look for abundant labor elsewhere.

If you can’t make enough rocks, you’ll lose your sticks…

So far so good. Except for what happens to home grown industry if foreign firms suddenly have enough capital to produce their own goods, and free trade agreements open our markets for this new competition? With those cheap and decent quality products, they might steal our customers and we will have to close shop. Wait a minute… another great mind with the name Marc Melitz came up with a theory in 2003, which opens up the “black box” of the firm, which internal processes were not taken into account in earlier trade theory. In a very simplified nutshell, he assumes that firms vary in their productivity but that all firms face the same fixed export costs. If these export costs are decreased or even abolished completely due to a free trade agreement, he shows that firms with low productivity face a choice: innovate or exit. In other words, in this world uncompetitive firms are forced to become more productive due to fiercer competition on a globalized market, or they have to close shop. From a purely economic standpoint, a world in which a firm can optimize production costs and is subject to increasing competition that weeds out unproductive firms is a good one. The resulting overall increase in productivity should be cheered and supported, as it creates growth. This argument shall not diminish the disaster this mechanism could have brought onto manufacturing workers in the West. Still, again one can argue that this is the result of bad policy that failed to cushion the fall, creating a divided and increasingly unequal society. This is of course only one of the objections that transpire in discussions about the merits of free trade in general and recently the Transatlantic Trade and Investment Partnership (TTIP) in particular. Others, such as environmental degradation and deteriorated consumer security due to lower standards are, in my opinion, again policy issues that should be addressed in free trade agreements negotiations. If these were to impose higher environmental and quality standards, free trade would function as a tool to impose more sustainable standards on a larger share of the global economy.

Why sticks and stones shouldn’t break our bones

So, what have we gained from the lowering of barriers to trade in the past, and why should we continue the path of forging successful Free Trade Agreements (FTAs)? On a global level, developing countries had the chance to become part of global supply chains, enabling them to increase average income and wages. Furthermore, they became attractive sales markets in the process, handing firms facing crisis at home the opportunity to soften the blow with strong sales figures in other places. On a national level, one has to acknowledge that most countries, also in the West, have seen average incomes rising over the same period of increased globalization, while prices of consumer goods have decreased, leaving us with a significant increase in our standard of living. So why do we talk about protectionism as the new way to deal with the drawbacks of facilitated trade, instead of focusing on smarter policies to help the losers of globalization and negotiate clever trade agreements that honor high quality goods and sustainable production?

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