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On Free Trade and Economics Consensus

Author(s): Matias Vernengo

Arguments against the TPP agreement.

From Triple Crisis:

Mankiw tells us in his most recent NYTimes column that economists agree that Free Trade is good. He links to a poll in which, essentially, mainstream economists of different persuasions, some Keynesian and some not, and different political views, some liberal and some conservative, say that trade agreements are good. He backs his argument by suggesting that theoretically the argument is at the heart of the economics profession since the beginning; I guess an argument of authority.

And no better authority than Adam Smith. Mankiw says:

“The economic argument for free trade dates back to Adam Smith, the 18th-century author of ‘The Wealth of Nations‘ and the grandfather of modern economics. Smith recognized that the case for trading with other nations was no different from the case for trading with other individuals within a society.”

And it is true, Adam Smith was for laissez-faire, in general, and thought that less intervention in trade would be good. But there is in Mankiw’s argument an implication that does not follow from careful analysis of Smith’s doctrines, namely: that Adam Smith can be seen as a forerunner of modern neoclassical trade theory based on the Heckscher-Ohlin-Samuelson (HOS) comparative advantage argument (for the limitations of that theory go here).

 

Comparative advantage implies that countries should specialize on the production of commodities for which they have a lower opportunity cost. Specialization would increase productivity domestically, and importation of goods for which other countries have a lower opportunity cost would lead to mutual advantageous trade to all parties involved. This was actually first noted by Ricardo and Torrens more than 40 years after the publication of the Wealth of Nations. Smith believed that absolute advantage, meaning lower costs of production, not comparative advantage determined trade patterns.

Smith thought that free trade was a better policy than protectionism, since he believed that trade would expand the potential markets for home producers, which would lead to more division of labor, that is, higher productivity, leading to lower costs, more access to external markets and additional growth. A cumulative process of export growth and higher labor productivity, referred to as the vent-for-surplus model, was behind Smith trade optimism. It is important to note, however, that Smith’s vent-for-surplus works in both directions. Higher costs (e.g. higher real wages) may lead to loss of external markets, no incentives for additional division of labor, and stagnation of domestic industry. In his model, success breeds success, but failure breeds failure.

There were very good reasons for Smith to think that free trade would be good for England in the late 18th century, and there even might be good reasons in the United States now, or at least for American corporations that would gain access to markets abroad. But the argument is far from universal, and the dressing of Smith’s theory in modern garb is dangerous (for a classic explanation of Smith views on trade go here; subscription required; or here; also needs subscription).

The idea of absolute advantage, used by Smith, suggests that there is space for managing trade. I noted before that the opposite of Free Trade is not Protectionism, but Managed Trade. Nobody really wants to be in a completely closed economy, probably not even North Koreans. And once you admit a certain amount of management, say for sanitary rules to avoid importing poisoned toys, for example, or for security reasons to preclude defense secrets to leak out, you are discussing what are the good reasons for managing trade. Perhaps employment should be one of the reasons for managing trade. Free trade versus protectionism is a false dichotomy. The question is: how much management and for the benefit of whom (and who bears the costs of more or less trade as a result).

Note that comparative advantage theorems assume that employment is fixed, in the Ricardian system perhaps below full employment, and in the modern neoclassical HOS theory at full employment. Not surprisingly, on employment Mankiw tells us:

“Economists respond that full employment is possible with any pattern of trade. The main issue is not the number of jobs, but which jobs. Americans should work in those industries in which we have an advantage compared with other nations, and we should import from abroad those goods that can be produced more cheaply there.”

 

That full employment is possible with any pattern of trade is theoretically true. But from that does not follow that comparative advantage should guide trade. That is a theoretical non-sequitur and is simply wrong. The US could pursue using macroeconomic policies (not the lower taxes for the rich that Mankiw advocates, but that is another story) full employment.* That would lead to high current account deficits, which for the US, because of the privileged position of the dollar, are sustainable. But that is not true for most countries.

In that case, if free trade is pursued, absolute advantage might determine trade specialization, and lead to large current account deficits that would be unsustainable and lead to a balance of payments crisis, the need for austerity, with lower growth and unemployment following. Even in the US, patterns of trade integration might lead to the elimination of good manufacturing jobs being substituted by low paying service jobs, something that has led to trade unions’ reasonable rejection of Free Trade Agreements (FTAs). In other words, “which jobs” one can get if one “import[s] from abroad those goods that can be produced more cheaply there [sic; that’s actually absolute not comparative advantage]” might end up leading to lower wages at home.

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