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Can Trade Ever Harm a Country?

January 5, 2006

A recent article from the Guardian joins the growing outcry against free trade. Its central message is that countries adopting "neo-liberal" market reforms, recommended by academic economists, have done worse than those countries that ignored the supposed experts and spurned free trade. Every time I reread the article—with the subtitle "A look at Vietnam and Mexico exposes the myth of market liberalization"—I discover more and more fallacies. To economize on the reader’s precious time, I finally decided to quit digging for more errors and jot down the ones I’d already found.

FAULTY MEASURE

Although questioning the wisdom of the professional economists, the Guardian piece manages to find PhDs touting its message:

The Harvard economist Dani Rodrik is one trade sceptic. Take Mexico and Vietnam, he says. One has a long border with the richest country in the world and has had a free-trade agreement with its neighbour across the Rio Grande. It receives oodles of inward investment and sends its workers across the border in droves. It is fully plugged in to the global economy. The other was the subject of a US trade embargo until 1994 and suffered from trade restrictions for years after that.  Unlike Mexico, Vietnam is not even a member of the WTO.

So which of the two has the better recent economic record? The question should be a no-brainer if all the free-trade theories are right—Mexico should be streets ahead of Vietnam.  In fact, the opposite is true.  Since Mexico signed the Nafta . . . deal with the US and Canada in 1992, its annual per capita growth rate has barely been above 1%.  Vietnam has grown by around 5% a year for the past two decades.

There are several problems with this passage.  First, NAFTA is not a free trade agreement, just as the PATRIOT Act was not about patriotism and the Social Security Act was neither social nor secure.  The NAFTA is over 1,000 pages, detailing all sorts of environmental and labor regulations and establishing supranational boards to rule on disputes.  If NAFTA really did nothing but establish free trade, it would be the size of a postcard, and there would currently be no tariffs between Mexico and the US.

But even setting aside this problem, Dr. Rodrik is wrong to claim that free trade is supposed to achieve higher rates of growth than protectionism.  (In fairness, many pro-trade economists make just this argument.)  Lowering trade barriers will cause an immediate increase in real income, but it won’t necessarily lead to perpetual increases year after year.  Per capita economic growth (and even here we run into all of the difficulties in GDP calculation) is due to such factors as technological innovation, institutional reform, and net capital investment.  Free trade will thus cause higher rates of growth in the long run only if it works through these other factors.

For an analogy, suppose a manager hires a green worker fresh out of college.  Naturally the new employee will have rising productivity as he learns on the job. Now one day the manager discovers that her new hire works with his left arm tied behind his back. After she unshackles his left arm, the new worker experiences an immediate boost in productivity. But after this initial surge, there is no reason to suppose that the percentage increase in productivity growth will continue to be higher, year after year, than it was while he worked with an artificial handicap.

A third major problem with the quotation above is that it presumes that economic laws can be trumped by statistical evidence. As we shall see, in the entire article there is scarcely any attempt to refute the logic of comparative advantage. The case for free trade is that, other things equal, a given country will be materially richer if its government doesn’t impose taxes on its own people when they buy foreign goods.  As such, the proposition is not open to empirical testing. Those wishing to demonstrate that free trade does not bring a higher standard of living need to demonstrate the flaw in the argument for it; relying on historical episodes (in which many other variables can change) is an inconclusive test, and may lead the researcher to confuse correlation with causation.

Of course the opponents of free trade will be exasperated with such an argument; how obvious it must seem that the orthodox economists are blind to reality when they ignore the clear counterexample Rodrik has presented! But let me illustrate the flawed method in the block quotation above by changing the argument ever so slightly: One could equally well argue that the cases of Mexico and Vietnam "prove" that in order to achieve high economic growth, a country should strive to be bombed mercilessly by US warplanes, or that being hit by bird flu is the surest path to development.

IMF REFORMS NOT LIBERAL

The reader should not interpret my above complaints to mean that I completely disagree with Rodrik.  As the Guardian article explains, "[Rodrik] looks in vain for the success stories of three decades of neo-liberal orthodoxy: nations that have really made it after taking the advice . . . of the IMF and the World Bank."

This is something that socialist and other less radical critics of orthodox economics have been saying for years. The pattern is this: The government of an "underdeveloped" country, often controlled by a corrupt military dictatorship, runs its economy into the ground while piling up massive debt. At the point of bankruptcy, the regime turns to the International Monetary Fund and/or the World Bank, which bail out the fledgling despots from the hole they’ve dug. 

In return for the loans or aid, the rulers agree to "neo-liberal austerity reforms" such as lower tariffs, improved budget discipline, and privatized state enterprises. Not surprisingly, the benefits of the "laissez-faire" policies never materialize, and often the countries end up defaulting on their loans and plunging deeper into stagnation.

Genuine free marketeers need not be troubled by such sad stories, for their doctrines have yet to be put to the test. "One World" international bureaucracies such as the IMF are hardly staffed by radical anti-government ideologues.  Although couched as liberalization, the packages foisted upon the cash-strapped governments aren’t a blueprint derived from the works of Bastiat.  (For example, before Argentina could get its bailout, it had to agree to raise taxes since this would reduce the budget deficit.)  There is also every reason to suppose that corruption infests the loan process itself; after all, the IMF and World Bank are hardly private entities the shareholders of which stand to make or lose billions depending on the soundness of the loans.

In addition, we should consider the sampling bias of these "experiments."  In order to assess the empirical success of free trade, Rodrik should run regressions on all countries, and see how much significance can be attributed to high or low trade barriers.  What he has done instead is to look at economies dominated by corrupt authoritarians who, as a last ditch effort to maintain their rule, grudgingly submit to the advice of economists trained in leftist universities.  This is hardly a fair test of the efficacy of market liberalism.  (In contrast, the Fraser Institute’s famous studies demonstrate—surprise!—that freedom goes hand in hand with economic strength.)  Finally, as Lew Rockwell has recently explained, the very idea of forcing countries to be free is nonsensical; bribing them to be free is hardly better.

THE INFANT INDUSTRY ARGUMENT

After making its empirical case, the Guardian article switches gears (and economists) by moving to a more theoretical explanation of why free trade is bad.  It quotes Ha Joon Chang who argues that "there is a respectable historical case for tariff protection for industries that are not yet profitable. . . . By contrast, free trade works well only in the fantasy theoretical world of perfect competition."

I must confess that Chang’s latter comment is quite mystifying. The standard case for free trade, made back in the 19th century by David Ricardo, doesn’t at all rely on the assumption of perfectly competitive markets.  No, it relies on the quite simple insight that if another country can produce a particular good at a lower cost (in terms of potential other goods that could be produced with the country’s resources) then the domestic population will be richer if it imports that good from the foreign country and uses domestic resources to produce those items in which they have the advantage. If I tell a brain surgeon to not waste his time making his own sweaters and producing his own car, I certainly don’t rely on the assumptions of the perfect competition model.[1]

The article then goes on to make a particularly silly point that I have heard many times from tariff proponents:

Going right back to the mid-18th century, Chang says Pitt the Elder’s view was that the American colonists were not to be allowed to manufacture so much as a horseshoe nail.  Adam Smith agreed.  It would be better all round if the Americans concentrated on agricultural goods and left manufacturing to Britain.

Before continuing with the history lesson, I want to interject and point out the planning mentality of Chang and the Guardian writer. I strongly doubt that Adam Smith said that the American colonists "were not to be allowed" to do anything; in any event no modern free trader would say such a ridiculous thing.  What a genuine friend of liberty would say is that in the absence of government interference the American colonists would have concentrated on agricultural goods—and thereby would have been wealthier—if this is where they had the comparative advantage.  In a quite Orwellian twist, Chang thinks that by refraining from taxing the colonists when they purchased British goods, the US government would be telling American manufacturers that they were not allowed to operate.  But let us return to the analysis:

The lesson is clear, Chang says.  South Korea would still be exporting wigs made from human hair if it had liberalised its trade in line with current thinking.  Those countries that did liberalise prematurely under international pressure—Senegal, for example—saw their manufacturing firms wiped out by foreign competition.

In addition to questioning orthodox economics, Chang is also apparently a sorcerer who can tell us which goods South Korea would be exporting had history followed a different route.  This is just another example of confusing correlation with causation; just because the US adopted the tariff walls of Alexander Hamilton and turned into an economic powerhouse, does not prove that this is the path to industrialization.  (For a contrasting example, Great Britain grew to the height of its power during the golden era of free trade.)

Right now it would be ludicrous for Brazil to transplant all of its farm hands into car factories; the resulting impoverishment from such a move should even be clear to professional economists such as Chang.  That doesn’t mean that the Brazilians are forever doomed to agricultural exports; if, say, they adopted a pure gold standard, limited government spending to 1% of GDP, and saved 50% of their income every year, over time Brazil would probably have the most advanced economy in the world.  The point is, industrialization should only take place when it is economically warranted; to raise tariff barriers in order to artificially stimulate the process only masks the situation and makes it harder to pinpoint the loss in potential income.

THE CHILDREN ANALOGY

In a previous article, I pointed out that the alleged wisdom of protection for infant industries—namely to shield them from cutthroat competition until they could hold their own—can be handled perfectly well in the free market.  New businesses suffer losses all the time in their early years as they gain experience, build a customer base, etc.  If it really did make sense to foster a new industry that took time before it could compete with foreign firms, then the free market would do so, just as medical and law students can run up huge debts knowing that their future salaries will justify their behavior.

After making this argument, I offered (what I thought was) a fairly clever reductio ad absurdum:  If it makes sense to shield infant industries with tariff barriers, then we should also shield "infant workers" by placing extra taxes on those goods produced by workers over the age of 30.  Otherwise, how could a teenager ever compete on the job market?  If we followed the fantasy world dogma of Adam Smith, wouldn’t the shy 16-year-old be forever condemned to collecting movie ticket stubs or selling Big Macs?

Unfortunately, Chang too hits upon the analogy:

In the same way that we protect our children until they grow up and are able to compete with adults in the labour market, developing governments need to protect their newly emerging industries until they go through a period of learning and become able to compete with the producers from more advanced countries.

 Economics in One Lesson Hazlitt presents the logic: $10

In light of this shocking quotation I need to drop the cutesy stuff and spell it out plainly:  We in no way "protect" our children the way Chang and others want to "protect" domestic manufacturing. My father certainly never paid extra money to the local government every time he bought a product from an adult, instead of hiring me to make the item in question.  

And to the extent that a parent ever did do something even remotely analogous to tariffs—for example, hiring one’s own kid to cut the grass for $10 an hour even though the lawn service would do it for half as much—that would still be a voluntary use of one’s money.  Nobody ever goes around taking money from childless couples when they buy goods produced by adults, in order to "protect" the next generation of workers.  Yet this is what happens with tariff protection:  Consumers are forced to pay taxes to their governments if they dare buy products made by foreigners.

CONCLUSION

Admittedly, this article hasn’t focused on the positive case for free trade, as it has been made in countless other places.  What I have done above is merely illustrate the invalid (and sometimes downright silly) arguments that, unfortunately, even trained economists use to justify bigger government.



Robert P. Murphy teaches economics at Hillsdale College. He prepared the Home Study Course in Austrian Economics, which is available for $350 . Send him MAIL. Comments can be made on the blog.

[1] In mainstream economics, there are models in which a large country can beneficially alter the “terms of trade” with its trading partners by implementing an “optimal tariff.”  It is possible that this is what Chang had in mind, but without more of the context it is unclear.


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