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Thursday, March 4, 2010

Pro and Cons of "Free Trade Doesn't Work"

TITLE: Free Trade Doesn’t Work: What Should Replace it and Why

AUTHOR: Ian Fletcher
GENRE: Nonfiction
TOPIC: Globalization/Economics/Political Science
PUBLISHER: U.S. Business & Industry Council
ISBN-13: 978-0578048208
FORMAT: Paperback, 348 pages, $24.95 on

Reviewed by Simon Lester for International Economic Law and Policy Blog

“Free Trade Doesn’t Work”
That’s the title of a new book by Ian Fletcher. (I came across it as a sponsored link in a Google search.) There are a number of different reasons people criticize free trade, so I was curious to see what exactly he had in mind. I asked him for a copy of the book so that I could review it on the blog, and he was kind enough to send one.

(Spoiler alert: If you don’t feel like reading to the end to see what he is proposing, it’s for the U.S. to impose an import tax, of about 30%, on all foreign goods and services).

As a preliminary point, let me just note that the book is mainly about tariffs and quotas. There’s not much about IP, labor rights, investor-state and similar recent additions to trade agreements. (Although, as indicated in the spoiler, services, another recent addition, is covered).

Now to the substance. The first four chapters contain a number of critiques of arguments and policies the author doesn’t like (including bad arguments for and against free trade). I’m going to start with Chapter 5, which deals with comparative advantage. Given the nature of the book (i.e., one that is critical of free trade), I was pleasantly surprised that he did a pretty good job of setting out this concept and explaining why it serves as an important basis for the free trade view. He acknowledges its value, and criticizes those who dismiss it out of hand. (In fact, this part was so good it could be used in a pro-free trade book!) However, he then identifies a number of “flaws” with comparative advantage. I’m just going to deal with one of these. (Otherwise this post would become far too long -- it’s already quite long as it is.)

To illustrate what he considers to be one flaw in the theory of comparative advantage, he asks, “What if a nation’s exports are unsustainable?” For example, a country may be exporting non-renewable natural resources, if this is where its comparative advantage lies. This will, he contends, maximize short-run efficiency at the expense of long-term prosperity. To deal with this problem, he notes, you would have to tax or restrict such exports, which is “not free trade.”

I hear this issue raised now and then in various contexts. However, I’m not convinced there is much to it. It is certainly true that, in most cases, you would not want to use up all your natural resources. But I don’t think the theory of comparative advantage requires you to do so. Even for free traders, comparative advantage is not the only basis for policy making. A country might have a comparative advantage in slaves, but it wouldn’t engage in slavery because we believe slavery is wrong. Similarly, if you have a comparative advantage in a particular natural resource, you don’t have to extract/produce it. If you want to deal with the threat of using up your resources, and you want to do it in a way that is consistent with “free trade,” just restrict their production, not their export. Doing it this way is likely to be permissible under trade rules. (There are some arguments you could make that production quotas violate trade rules, but my sense is most people don’t find these arguments very convincing). So, I’m not sure I see how the issue of non-renewable natural resources is a flaw in the theory of comparative advantage. It’s just a policy issue to be dealt with outside the context of trade.

Going further with comparative advantage, we now get a foreshadowing of the core idea of the book. He says that a nation’s wages are determined by its productivity in sectors where it has a comparative advantage. What he means by this, in essence, is that you would rather have a comparative advantage in high-wage industries. So, for example, it is better to have your comparative advantage in making airplanes than in cutting hair.

At this point, he takes us through a bit of free trade history. He explains that the British only became free traders after they used protection to establish themselves as the leading producers in industries such as wool-making. Similarly, the U.S. and Japan also used protection to develop their industries.

I don’t disagree with his contention that these three countries, and also other developed countries, were quite protectionist during their development period. I do, however, question whether this protection was the cause of their development. Speaking very generally, it seems to me that all countries have been fairly protectionist, at various times and in various industries. However, not all have developed. As a result, I’m not sure it’s sufficient to identify a correlation between protection and development in some countries and claim that this demonstrates cause and effect. To his credit, he does have an explanation of why protection worked better in East Asia than in Latin America, an issue which I’ve seen some critics of free trade overlook. (P. 202) However, one of his points here was that perhaps Latin America did not emphasize education enough, which, if true, suggests to me that education may be more important for development than protection.

In addition, I’m not sure that a comparison across eras has much value. It is true that the U.S. protected its domestic industries from their British competitors. But today, it might make more sense to offer your country up to a foreign company as a place to invest, instead of protecting domestic competitors. Why spend years with inefficient domestic industries when you could have a foreigner come over and build a state of the art factory tomorrow? That wasn’t an option for the U.S. in the 19th century, but it is for developing countries now.

Next up, in Chapter 8, he bashes the WTO, NAFTA and other trade agreements. This part seems to reflect criticisms of people like Lori Wallach and Dani Rodrik. Most readers are probably familiar with these arguments, so I’m going to skip them.

In Chapter 11, we get back to his key point, which is that it is better to have a comparative advantage in some industries than in others. He says you want industries with “increasing returns” (for a given increase in inputs, returns go up by more than the increase). And how do we achieve that? He proposes a “natural strategic tariff.” As an example of this, he suggests “a flat tax on all imported goods and services” as the best approach. He mentions a figure of 30%.

What he likes about this approach is that industries differ in “sensitivity and response to import competition.” Thus, a 30% tariff would not be enough to cause apparel production to come back to the U.S., as our competitiveness in such industries is far behind that of other countries. However, it would be enough to cause high-tech products like semiconductors to come back (as we are much closer there), which is great because these are the kind of increasing return, high-wage industries we want.

All right, that’s the crux of his argument. Now for some of my responses.

First off, let’s just ignore the WTO, NAFTA, etc. violations inherent in his proposal. He’s not interested in that part. Let’s just talk policy.

I’m going to start with a positive. There is one thing I like about his proposal: Because it is a flat rate for all goods/services, it removes the discretion a government has to give higher tariffs to some industries (often based on the effectiveness of their lobbying). I’ve always seen this as a huge flaw in the current system (and I very much like Chile’s one tariff rate approach).

But aside from that, not surprisingly, I have some concerns. I’m not going to go through them all, though, but rather just pick out some favorites I want to talk about. (Readers should feel free to add other thoughts in the comments).

One big concern I have is on competition within specific protected industries. Won’t taxing foreign competition at such a high rate turn many industries into domestic oligopolies? On p. 244, he suggests that domestic companies actually compete more intensely against each other than against foreigners. I’m pretty skeptical of this point. Unfortunately, it may be difficult to prove one way or the other empirically. But logically, it makes no sense to me. How is fewer competitors better? Imagine if there were no cars made by foreign-owned producers sold in the U.S. Wouldn’t U.S. consumers be considerably worse off if the U.S. auto makers had been competing only against each other all these years? Is there any doubt we’d be seeing more expensive, lower-quality cars?

A second big concern is the foreign response, which I think he vastly underestimates. He goes through some possible responses foreign governments might have -- such as subsidies, currency devaluation, and retaliatory tariffs -- if the U.S. were to adopt such a tariff but dismisses them pretty quickly. For example, with tariffs, he notes that foreign countries would probably raise their tariffs “somewhat,” but the process would not “get out of control.” Indeed, he suggests it might even cause them to lower some of their own barriers, if, after the strategic tariff is imposed, lower U.S. tariffs are subsequently offered as an incentive for them to lower their barriers. (P. 246)

In reaction to this, let me point out first that it’s hard to predict how our trading partners would respond to such a policy. It is extremely unlikely it would ever be adopted, so not many people have given a response serious consideration. But I’ll give it a shot anyway.

I know it is commonly said (and the author implies at various times) that most other countries are more protectionist than the U.S. (and thus in part this “natural strategic tariff” would just counterbalance foreign protectionism). But regardless of who is most protectionist, there is a good deal of support for relatively free trade in much of the developed world. As a result, I don’t think the response would be anything like he hopes. If I had to guess here, I think much of the rest of the world would band together in a free trade agreement of their own, and let us go our own way. More specifically, it seems to me that a possible response by the rest of the world (and especially the EU, Japan and other developed countries) would contain two elements:

-- impose an identical 30% tariff on all U.S. goods and services.

-- form a free trade agreement amongst themselves.

Now, in the 1950s or 1960s, his argument about the foreign response might have been more plausible. But today, the U.S. market, while very important, may not command the same power it once did. There are a lot of other markets in which to sell, and many foreign companies might be happy to have U.S. companies at such a disadvantage in their own markets.

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