The case for free trade, how and why economists overdo it: Part One

I’m generally in favour of free trade. So are quite a few economists who have reputations for being against it – even though they are not. At one point Keynes, who was a strong free trader argued (I think in the context of England being constrained by fixed exchange rates) that trade restrictions were a lesser evil if they were necessary to underpin economic expansion during a downturn. This caused its share of uproar and outrage. Was he a free trader or not?

Likewise when I outlined a departure from the case for unilaterally reducing our car tariffs to zero, various economist commenters got quite agitated about it. One said it was outrageous and assumed that I didn’t know the very first thing about the economics of trade.

Dani Rodrik is also supportive of free trade though he’s frequently been taken to be against it. Rodrik thinks that incursions on trade can generate more benefits than costs if done right – particularly in the context of economic development. He’s got lots of interesting things to say and think about regarding the whole subject.

And a recent post of his drew readers’ attention to a paper by Robert A. Driskill (pdf) which anatomises some of the foibles of the case for free trade. Just to repeat, it’s not against free trade, but it does outline the various shortcuts that economists take in making the case for free trade. How loose the arguments are sometimes and how much gets left out. If you’re interested in this I strongly suggest a squiz of the paper. If you have no economic training, you may find the terminology a bit off-putting, but there are no equations or anything as nasty as that.

I can’t prove it, but remain convinced in the face of plenty of circumstantial evidence, that the tribalism that economists show on this topic is to be explained by a certain kind of psychology. As Paul Samuelson once said, the case for free trade is one of the few findings of modern social science that is both counter-intuitive and yet at the same time in some fundamental sense true. It’s a piece of logical gold in a fuzzy set of disciplines about which it’s reasonable to ask how much they really know beyond the commonsense of most of us.

David Henderson has painted a perceptive portrait of professional economics battling popular economic misconceptions. Resisting the fallacies of what Henderson calls ‘do-it-yourself’ economics is a motivating preoccupation of much advocacy on public policy by economists. What could be more satisfying than showing the value of your own expertise, the essentially trivial silliness of so many others – including some pretty smart and powerful people – at the same time as being confident that you are on the side of social progress, that you’re doing well by doing good?

I’ve argued in other places that this orientation has led economists to downplay important information being provided by non-economists or even economists who are ‘tainted’ by their proximity to the ‘dark side’ of those with an axe to grind. Thus for instance it was business people who proposed ‘export facilitation’ in the car industry – a mechanism which effectively diverts the benefits from trade liberalisation into the hands of domestic exporters.

Is this as good as putting it in the hands of consumers? Well as far as growth is concerned, the experience of successful Asian countries who pursued the strategy suggests that it was more successful than giving it to consumers – the consumers got theirs in due course as economic development proceeded. Certainly the studies of the time suggested that ‘trade liberalisation on behalf of exporters’ was a very successful strategy, though of course we are in a different situation and this doesn’t necessarily carry over to our own experience.

But the choice between the surplus getting to consumers directly or via exporters is also a value choice. So if you had to choose between gradual trade liberalisation out of the textbook in which trade is liberalised gradually with the surplus going to consumers, and trade liberalisation that was faster because more of the surplus went into the hands of exporters from the industry, what would you choose? Well it’s a hard call.

But when export facilitation was cooked up by General Motors and sold to an economically illiterate Prime Minister Fraser some econocrats held up the cross to it as if they were in a Dracula movie. They were even prepared to support higher tariffs to avoid trade liberalisation on behalf of automotive exporters.

In effect their anti-mercantilist allegiance blinded them to the fruitful leads that were proposed by businessmen, economic amateurs and even some professional economists. A contributing factor might have been what I’d call the positivist culture of economic expertise. Because economics is such a technical discipline – in many ways necessarily so – economists are well trained in the quantitative manipulation of entities which can be reasonably assumed to be the same – tons of wheat for instance – or for which the assumption of being identical might be a bit of a stretch – but which assumption has to be made to get some piece of analysis going. But as J. R. Hicks put it, a lot of reasoning is about judicious analogies – not comparing like with like or counting and comparing quantities, but comparing ‘rather like’ with ‘rather like’ and working out when analogies are more valuable for the insight they provide than they are misleading for the things they leave out.

There are not many prizes in economics school for being good at this second kind of (informal) reasoning. And anyway, it’s the kind of reasoning that is ultimately much trickier to know whether you’re doing a good job at than technical reasoning. So not only don’t we teach it much, but my guess is that it’s pretty hard to teach and to learn. To some substantial extent you might have it or you might not. I don’t think historians – who are trained in this kind of informal thinking – would be so superior at catching onto the potential offered by that kind of reasoning than the smarter economists about.

Anyway, enough from me. In our next exciting episode we show how the same thing has happened in the area of trade negotiation. You’ll laugh, you’ll cry. And you’ll find out why this sentence taken from an old Australian Financial Review in the 1990s is bollocks.

NAFTA is second best. It is trade liberalisation, but it is discriminatory liberalisation. . . . First best would have been a better GATT.

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Brendan Halfweeg
Brendan Halfweeg
14 years ago

Nicholas, what exactly are you trying to say here? What arguments are you saying that free traders overcook? Why exactly do you think some proponents of protectionist activity are actually free trade, or some free traders are mistakenly identified as protectionists.

Damien Eldridge
Damien Eldridge
14 years ago

Nick, this is simply ridiculous. If you want to claim that a reduction in car tariffs is unlikely to be a Pareto improvement, at least in the short-run, I am happy to agree with you. It will, however, be a Kaldor-Hicks improvement unless you believe there is some pre-existing distortion that the tariff corrects. If you believe that it is illegitimate to advocate policies that are Kaldor-Hicks improvements when such policies often come combined with adjustment assistance and, on top of that, we have policies aimed at modifying the income distribution in Australia anyway, then you may as well give up on any attempt to improve public policy in the first place. Very few changes in policy will result in a Pareto improvement.

BilB
BilB
14 years ago

I would be dead keen on free trade if all countries were created equal. But sadly, they are not. That is not to that all countries, imbalanced in many ways, cannot become equal, more it is unlikely that imbalanced countries will ever be equal at the same time. Some would argue that the trimming of inequalities is managed by the money markets which adjust trade pressure with the floating exchange rates, but there have been some glaring examples where this freedom magnifies imbalances rather than heal them (capital flight at times of political and market turmoil, for instance). My favourite example of imbalances is the European Farming Subsidy structure. At the beginning of this process it was very much about promoting growth of farm production across the, then, EU countries. But it very quickly became a device promoting stability of another kind. As European tourism expanded, and European prosperity returned, it became clear that the very unique European landscape could be threatened by the urban sprawl the has obliterated so many other beautiful countryscapes in rapidly growing nations. So the European Farm Subsidies became an urban sprawl defence device. This of course stuck in the throat of farm produce trade countries such as Australia and New Zealand. Who can forget the butter mountain? So very cleverly the Europeans have remoulded the Farm Subsidies into an Environment Protection subsidy. As a consequence free-er agricultural trade with Europe is closer than it ever has been in the past.

The biggest new threat, now, to free trade is global warming. And this very recent and very present danger may sound the death knoll to the dream of a flat trade environment. Global warming is proving more than capable of magnifying the differences between nations, in just days. It only takes a few days in the tropical belt to destroy a city or flaten a nations entire income source. Freedom of movement is only likely to be preserved, from hereon forward, for trade in energy and trade in money.

Sinclair Davidson
Sinclair Davidson
14 years ago

Damien, you’re jumping the gun. Sure, Nick is a tease, but he wants to develop an argument over a number (two?) of posts. When he is finished you may say he is ‘ridiculous’, if you still think so.

I am interested in your notion of Pareto optimality. I agree few, if any, real world policy changes are Pareto optimal. But it is not clear to me that policy makers even aspire to this goal. I would have thought that questions of whether the policy will achieve its stated goals, whether it can/will generate adverse unintended consequences, whether the benefits are greater than the costs, and those sorts of questions would be more important than whether nobody would be worse off. Even with Kaldor-Hicks I suspect the bar is set very high for a policy maker who may decide to stamp out rent-seeking. Anyway, just some thoughts. Feel free to say that Pareto optimality is taught in Econ 101 and the like (it isn’t actually, I did it in Econ 201).

harry clarke
14 years ago

Nick, Samuelson didn’t make the statement about free trade but about the principle of comparative advantage. The former is more obvious – give people more choices they are better off – the latter is less so – namely that even if one country can produce everything at lower cost than another country there is still a case for trade based on relative cost differentials.

Its a principle that does not seem clearly embedded in quite a few minds.

It is wrong to stylise and vulgarise the arguments economists make for free trade. Economists say that, given no distortions, on two identical islands (‘A’ with free trade, ‘B’ without) that total surplus will be higher on ‘A’. They do not necessarily say it is optimal to switch from B to A since that might involve adjustment costs. Also, the case is entirely efficiency-based.

It is quite inaccurate to suggest that the standard economic case for free trade is simplistic and driven by groupthink. It is a restrained case with many qualifications.

But maybe your post is just a tease or maybe you just cannot admit when you have got something wrong. You have not in the present post provided a single argument for maintaining non-zero tariffs in automobile assembly (there may be one but you have not provided it) and your previous arguments on this issue – namely, that low levels of protection in assembly could substitute for an optimal export tax on exported resources were clearly in error.

Tom N.
Tom N.
14 years ago

CUTTING URBAN SPRAWL BY SUBSIDISING COWS!!

Regarding your argument about the EU, Bilb, I find it hard to see a valid and relevant point here. You seem to say that European nations get a benenfit from containing urban sprawl, and farm subsidies contribute to this. How does this undermine the economic case for free trade? Free trade is not the same as free markets. If an activity (such as urban sprawl) generates an external cost, then economics provides a justification* for taxing or regulating it. But economics would also point out that there are likely to be more efficient ways of containing urban sprawl than subsidising butter mountains, or curtailing competition from foreign dairy producers. Only if the act of undertaking dairy production in a particular place itself generates non-trivial external benefits (and, frankly, its hard to believe that it does) would the first best approach be to subsidise dairy activity.

___

* Subject to a couple of conditions, such as MF>GF.

Geoff Robinson
14 years ago

Reading the economic liberal Promefert’s Australia’s Trade Policies (1995), the specters of a recession-driven turn to protectionism incarnated in the figure of Phil Cleary informs the entire book just as Pauline Hanson and then John Howard overshadowed left-liberal writing on broader politics after 1996. Many people find the arguments for economic liberalism and free trade baffling but when they do see the point they are likley to do a U-turn and become zealous supporters, if you always found economic liberal arguments plausible you might be more doubtful about them.

jimmythespiv
jimmythespiv
14 years ago

“Is this as good as putting it in the hands of consumers? Well as far as growth is concerned, the experience of successful Asian countries who pursued the strategy suggests that it was more successful than giving it to consumers – the consumers got theirs in due course as economic development proceeded.”

This is a common argument trotted out by those who support the North Asian model. My problem is, Japan aside, you really need an undemocratic system (viz Korea until the 1990s) to make it work (forced savings, government use of soldiers to break strikes etc). That is, its profoundly undemocratic. So is the question you are asking not similar to that on democratic systems – ie is it better to have a benign dictatorship which over time morphs into a democracy as institutions are developed rather tha the chaos of democratic systems in underdeveloped countries with corruption and nepotism.

Brendan Halfweeg
Brendan Halfweeg
14 years ago

Nicholas, if you are simply trying to frame the next post, then say so. So far you haven’t made any argument or case, just identified that free traders are mistakenly identified as protectionists. I think you are trying to say that a mixed free trade/protectionist policy is the correct policy for states to pursue. I disagree.

Damien Eldridge
Damien Eldridge
14 years ago

Nick, the reason I focussed on the Kaldor-Hicks versus Pareto efficiency argument is that it is bought up by the Rodrik post and the Driscoll article to which he links. If this wasn’t part of the point you were making, why did you link to the article? Furthermore, I did address your optimal tariff argument here by noting that the conclusion can change in the presence of pre-existing distortiuons. Markt power would be a pre-existing distortion. As you know, I have addressed this point in much more detail on a previous post, including the fact that it is built in to the CGE models that are used to analyse these topics.

My comment does not illustrate your point at all. I was objecting to the presentation of a well known point as though it was something economists do not realise. When it comes to arguments for free trade, I would argue that economists are not giving knee jerk reactions based on some sort of group psychology. They are giving responses that are based on a great deal of study and judgement about what is important in the debate. Most economists realise that there are exceptions to the prinviple that a reductyion in protection will increase social welfare. If they are particularly relevant, then they will bring them up. The fact of the matter is that they are rarely particularly relevant.

On the other side of the coin, there are plenty of special interest groups out there who are quite happy to focus on the exceptions rather than the rule. Perhaps you should direct your criticisms at them instead.

Damien Eldridge
Damien Eldridge
14 years ago

Nick, I did only have a quick skim of the parts of the Rodrik post and Driscoll article last night before posting my comments. I have just had another quick skim of them and my impressions have not changed.

I think it worth noting that the points made in the article are rather like a toothless grandparent being taught to suck egs. Any serious student of economics will know the difference between the Pareto criterion and the Kaldor-Hicks criterion. They will know the difference between small countries and large countries in standard trade models. They will also know the limitations of partial equilibrium analysis, as opposed to general equilibrium analysis. They will be aware of the circumstances under which partial equilibrium analysis is a good approximation and the circumstances in which it is not a good approxmation.

Damien Eldridge
Damien Eldridge
14 years ago

Nick, I am not saying that there are no credible arguments against free trade, simply that there is usually more danger of the arguments against free trade being over-stated rather than under-stated.

As an aside, I personally find quarrantine and food safety type arguments much more convincing than market power arguments when it comes to measures that might be considered to have a protectionist impact.