Free Trade Doesn't Work

by Ian Fletcher

  This is not a trivial problem: Dani Rodrik of Harvard estimates that freeing up trade reshuffles five dollars of income between different groups of people domestically for every one dollar of net gain it brings to the economy as a whole.371 And on top of this, we still have all the related problems associated with the Stolper-Samuelson theorem we looked at in Chapter One.372

  Dubious Assumption #5: Capital is not internationally mobile.

  Despite the wide scope of its implications, the theory of comparative advantage is at bottom a very narrow theory. It is only about the best uses to which nations can put their factors of production. We have certain cards in hand, so to speak, the other players have certain cards, and the theory tells us the best way to play the hand we’ve been dealt. Or more precisely, it tells us to let the free market play our hand for us, so market forces can drive all our factors to their best uses in our economy.

  Unfortunately, this all relies upon the impossibility of these same market forces driving these factors right out of our economy. If that happens, all bets are off about driving these factors to their most productive use in our economy. Their most productive use may well be in another country, and if they are internationally mobile, then free trade will cause them to migrate there. This will benefit the world economy as a whole, and the nation they migrate to, but it will not necessarily benefit us.

  This problem actually applies to all factors of production. But because land and other fixed resources can’t migrate, labor is legally constrained in migrating, and people usually don’t try to stop technology or raw materials from migrating, the crux of the problem is capital. Capital mobility replaces comparative advantage, which applies when capital is forced to choose between alternative uses within a single national economy, with our old friend absolute advantage. And absolute advantage contains no guarantees whatsoever about the results being good for both trading partners. The win-win guarantee is purely an effect of the world economy being yoked to comparative advantage, and dies with it.

  Absolute advantage is really the natural order of things in capitalism and comparative advantage is a special case caused by the existence of national borders that factors of production can’t cross. Indeed, that is basically what a nation is, from the point of view of economics: a part of the world with political barriers to the entry and exit of factors of production.373 This forces national economies to interact indirectly, by exchanging goods and services made from those factors, which places comparative advantage in control. Without these barriers, nations would simply be regions of a single economy, which is why absolute advantage governs economic relations within nations. In 1950, Michigan had absolute advantage in automobiles and Alabama in cotton. But by 2000, automobile plants were closing in Michigan and opening in Alabama. This benefited Alabama, but it did not necessarily benefit Michigan. (It only would have if Michigan had been transitioning to a higher-value industry than automobiles. Helicopters?) The same scenario is possible for entire nations if capital is internationally mobile.

  Capital immobility doesn’t have to be absolute to put comparative advantage in control, but it has to be significant and as it melts away, trade shifts from a guarantee of win-win relations to a possibility of win-lose relations. David Ricardo, who was wiser than many of his own modern-day followers, knew this perfectly well. As he puts it:

  The difference in this respect, between a single country and many, is easily accounted for, by considering the difficulty with which capital moves from one country to another, to seek a more profitable employment, and the activity with which it invariably passes from one province to another of the same country.374

  Ricardo then elaborates, using his favorite example of the trade in English cloth for Portuguese wine and cutting right to the heart of present-day concerns:

  It would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances the wine and the cloth should both be made in Portugal, and therefore that the capital and labor of England employed in making cloth should be removed to Portugal for that purpose.375

  But he does not say it would be advantageous to the workers of England! This is precisely the problem Americans experience today: when imports replace goods produced here, capitalists like the higher profits and consumers like the lower prices—but workers don’t like the lost jobs. Given that consumers and workers are ultimately the same people, this means they may lose more as workers than they gain as consumers. And there is no theorem in economics which guarantees that their gains will exceed their losses.376 Things can go either way, which means that free trade is sometimes a losing move for them.

  Having observed that capital mobility would undo his theory, Ricardo then argues why capital will not, in fact, be mobile—as he knew he had to prove for his theory to hold water:

  Experience, however, shows that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connections, and entrust himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.377

  So in the end, the inventor of the theoretical keystone of free trade had to rely upon an instinctive economic localism in order to make his theory hold. Something has to anchor capital for it all to work.

  Interestingly, the above paragraph hasn’t just become untrue in the modern globalized era. It was already untrue a few years after Ricardo wrote it, when billions of pounds began flowing out of Britain to finance railways and other investments around the world. As a result, at its peak in 1914, an astounding 35 percent of Britain’s net national wealth was held abroad—a figure not even remotely approached by any major nation before or since.378 British investors’ preference for building up other nations’ industries, rather than their own, exacted a heavy toll on the once-dominant British economy, a story we will explore more in the next chapter.

  Dubious Assumption #6: Short-term efficiency causes long-term growth.

  The theory of comparative advantage is a case of what economists call static analysis. That is, it looks at the facts of a single instant in time and determines the best response to those facts at that instant. This is not an intrinsically invalid way of doing economics—balancing one’s checkbook is an exercise in static analysis—but it is vulnerable to a key problem: it says nothing about dynamic facts. That is, it says nothing about how today’s facts may change tomorrow. More importantly, it says nothing about how one might cause them to change in one’s favor.

  Imagine a photograph of a rock thrown up in the air. It is an accurate representation of the position of the rock at the instant it was taken. But one can’t tell, from the photograph alone, whether the rock is rising or falling. The only way to know that is either to have a series of photographs, or add the information contained in the laws of physics to the information contained in the photograph.

  The problem here is that even if the theory of comparative advantage tells us our best move today, given our productivities and opportunity costs in various industries, it doesn’t tell us the best way to raise those productivities tomorrow. That, however, is the essence of economic growth, and in the long run much more important than squeezing every last drop of advantage from the productivities we have today. Economic growth, that is, is ultimately less about using one’s factors of production than about transforming them—into more productive factors tomorrow.379 The difference between poor nations and rich ones mainly consists in the problem of turning from Burkina Faso into South Korea; it does not consist in being the most efficient possible Burkina Faso forever. The theory of comparative advantage is not so much wrong about long-term growth as simply silent.

  Analogo
usly, it is a valid application of personal comparative advantage for someone with secretarial skills to work as a secretary and someone with banking skills to work as a banker. In the short run, it is efficient for them both, as it results in both being better paid than if they tried to swap roles. (They would both be fired for inability to do their jobs and earn zero.) But the path to personal success doesn’t consist in being the best possible secretary forever; it consists in upgrading one’s skills to better-paid occupations, like banker. And there is very little about being the best possible secretary that tells one how to do this.

  Ricardo’s own favorite example, the trade in English textiles for Portuguese wine, is very revealing here, though not in a way he would have liked. In Ricardo’s day, textiles were produced in England with then-state-of-the-art technology like steam engines. The textile industry thus nurtured a sophisticated machine tool industry to make the parts for these engines, which drove forward the general technological capabilities of the British economy and helped it break into related industries like locomotives and steamships.380 Wine, on the other hand, was made by methods that had not changed in centuries (and have only begun to change since about 1960, by the way). So for hundreds of years, wine production contributed no technological advances to the Portuguese economy, no drivers of growth, no opportunities to raise economy-wide productivity. And its own productivity remained static: it did the same thing over and over again, year after year, decade after decade, century after century, because this was where Portugal’s immediate comparative advantage lay. It may have been Portugal’s best move in the short run, but it was a dead end in the long run.

  What happened to Portugal? It had actually been happening for over a century by the time Ricardo wrote, largely in rationalization of existing conditions. In 1703, in the Treaty of Methuen, Portugal exempted England from its prohibition on the importation of woolen cloth, while England agreed to admit Portuguese wines at a tariff one-third less than that applied to competitors. This treaty merely switched suppliers for the English, who did not produce wine, but it admitted a deluge of cheap English cloth into Portugal—which wiped out its previously promising textile industry. English capital eventually took control of Portugal’s vineyards as their owners went into debt to London banks, and English influence sabotaged attempts at industrial policy that might have pushed Portugal back into textiles or other manufacturing industry. As textiles were (as they remain today) the first stepping stone to more-sophisticated industries, this all but prevented Portugal’s further industrialization. Not until the 1960s, under the Salazar dictatorship, did any Portuguese government make a serious attempt to dig itself out of this trap and to this day, Portugal has not recovered its 17th-century position relative to other European economies, and remains the poorest country in Western Europe.

  Today, the theory of comparative advantage is similarly dangerous to poor and undeveloped nations because they tend, like Portugal, to have comparative advantage in industries that are economic dead ends. So despite being nominally free, free trade tends to lock them in place.

  Dubious Assumption #7: Trade does not induce adverse productivity growth abroad.

  As previously noted, our gains from free trade derive from the difference between our opportunity costs for producing products and the opportunity costs of our trading partners. This opens up a paradoxical but very real way for free trade to backfire. When we trade with a foreign nation, this will generally build up that nation’s industries, i.e., raise its productivity in them. Now it would be nice to assume that this productivity growth in our trading partners can only reduce their direct costs, therefore reduce their opportunity costs, and therefore increase our gains from trading with them. Our foreign suppliers will just become ever more efficient at supplying the things we want, and we will just get ever cheaper foreign goods in exchange for our own exports, right?

  Wrong. As we saw in our initial discussion of absolute vs. comparative advantage, while productivity (output per unit of input) does determine direct costs, it doesn’t on its own determine opportunity costs. The alternative uses of factors of production do. As a result, productivity growth in some industries can actually raise our trading partners’ opportunity costs in other industries, by increasing what they give up producing in one industry in order to produce in another. If the number of rolls they can make from a pound of dough somehow goes up (rolls get fluffier?), this will make it more expensive for them to bake bread instead. So they may cease to supply us with such cheap bread! It sounds odd, but the logic is inescapable.

  Consider our present trade with China. Despite all the problems this trade causes us, we do get compensation in the form of some very cheap goods, thanks mainly to China’s very cheap labor. The same goes for other poor countries we import from. But labor is cheap in poor countries because it has poor alternative employment opportunities. What if these opportunities improve? Then this labor may cease to be so cheap, and our supply of cheap goods may dry up.

  This is actually what happened in Japan from the 1960s to the 1980s, as Japan’s economy transitioned from primitive to sophisticated manufacturing and the cheap merchandise readers over 40 will remember (the same things stamped “Made in China” today, only less ubiquitous) disappeared from America’s stores. Did this reduce the pressure of cheap Japanese labor on American workers? Indeed. But it also deprived us of some very cheap goods we used to get. (And it’s not like Japan stopped pressing us, either, as it moved upmarket and started competing in more sophisticated industries.)

  The same thing had happened with Western Europe as its economy recovered from WWII from 1945 to about 1960 and cheap European goods disappeared from our stores. Remember when BMWs were cheap little cars and Italian shoes were affordable?

  It’s as if our football player woke up one morning and found that his lawn man had quietly saved his pennies from mowing lawns and opened a garden shop. No more cheap lawn mowings for him! (Maybe it was a bad idea to hire him so often.)

  Now this is where things get slippery and non-economists tend to get lost. Because, as we saw earlier, gains from trade don’t derive from absolute but comparative advantage, these gains can be killed off without our trading partners getting anywhere near our own productivity levels. So the above problem doesn’t merely consist in our trading partners catching up to us in industrial sophistication. But if their relative tradeoffs for producing different goods cease to differ from ours, then our gains from trading with them will vanish. If Canada’s wheat vs. corn tradeoff is two units per acre vs. three and ours is four vs. six, all bets are off. Because both nations now face the same tradeoff ratio between producing one grain and the other,381 all possible trades will cost Canada exactly as much they benefit the US—leaving no profit, no motivation to trade, and no gain from doing so. And if free trade helped raise Canada’s productivity to this point, then free trade deprived us of benefits we used to get.

  It’s worth retracing the logic here until it makes sense, as this really is the way the economics works. When Paul Samuelson—Nobel Laureate, dean of the profession, inventor of the mathematical foundations of modern economics while still a graduate student, and author of the best-selling economics textbook in history—reminded economists of this problem in a (quite accessible) 2004 article, he drew scandalized gasps from one end of the discipline to the other.382 How could anyone so distinguished criticize the sacred truth of free trade? Then he politely reminded his critics that he was merely restating a conclusion he had first published in his Nobel Lecture of 1972!383 As Samuelson noted, Ricardo himself was well aware of the problem:384

  In Chapter 31 [of The Principles of Political Economy and Taxation] Ricardo discovers what he has elsewhere denied: that an improvement abroad can hurt Britain under free trade (or, as needs to be said today, that an improvement in Japan can hurt the American living standard).385

  Most of the time, this problem has low visibility because it consists in the silent change of invisible ratios between
the productivities of industries here and abroad. Few people worry about it because it has no easily understood face like cheap foreign labor. But it definitely does mean that free trade can “foul its own nest” and kill off the benefits of trade over time. Even within the most strictly orthodox Ricardian view, only the existence of gains from free trade is guaranteed.386 It is not guaranteed that changes induced by free trade will make these gains grow, rather than shrink. So free trade can do billions of dollars worth of damage even if Ricardo was right about everything else (which he wasn’t).

  There are two standard rejoinders to this problem. The first is that while it proves that gains from free trade can go down as well as up, it doesn’t actually prove that they can ever go below zero—which is what would have to happen for free trade to be literally bad for us. This is true. But this doesn’t change the fact that if free trade caused our gains from trade to go down, then it reduced our economic well-being. We would have been better off under some protectionist policy that avoided stimulating quite so much productivity growth abroad. The second rejoinder is that productivity abroad can rise even without free trade on our part. This is also true. But if free trade sometimes causes productivity abroad to rise in a way that has the effects just described, then free trade is sometimes bad for us.