The purpose of this series is to demonstrate why libertarianism and free trade are on weak ground with their contention that national borders are insignificant to trade and therefore should not be barriers to trade under any circumstances. Contrary to the libertarian hypothesis, national borders are not arbitrary or irrelevant. As Ian Fletcher has pointed out in his classic defense of mercantilism, Free Trade Doesn’t Work, intranational commerce plays a much larger role in any nation’s economy than international trade. Fletcher has further demonstrated that most international trade occurs within certain regional trade blocs composed of nations of a common racial background. Therefore libertarians are incorrect when they suggest that national boundaries are irrelevant to trade.
Furthermore, it is wrong to suggest that mercantilists are in principle opposed to all trade, as libertarians such as Hoppe, Rothbard, or North would suggest. Fletcher makes a compelling case for a relatively open trade policy which also takes into account the nation’s economic interest. It is entirely natural to establish economic loyalty the same way we understand social loyalty. Our loyalties form a set of concentric circles with our immediate family being our closest ties, followed by our extended family or clan, our ethnic group, our race, and finally humanity in general. For the economy to truly serve humanity rather than the reverse, the economy must reflect the priorities of our natural loyalties.
While Fletcher doesn’t focus on the question of why nations are significant, he does accept that nations and national economies are important and that nations should have a conscious commitment to preserving their economic welfare. In order to establish his case, Fletcher first critiques the basis of the free trade argument in the theory of comparative advantage. While free trade and laissez-faire capitalism have caused many problems in the economy as well as society, almost all economists continue to support free trade policies. This is true even of left-leaning economists that defend the welfare state. This is also true of virtually all mainstream politicians, ranging from committed libertarians to neoconservatives and liberals. The reason that mainstream economists and politicians are supportive of the policy of free trade is because of the theory of comparative advantage. The consensus among academics is that free trade must work because the theory of comparative advantage is sound.
The perceived strength of the argument for free trade does not derive from any historical success that free trade policies have accomplished in the past. In the previous two articles on trade, we investigated the history of the trade policies of Great Britain and the United States. In both cases, we observed how these nations built their economies on mercantilist trade policies and declined under free trade policies. Since the history of trade seems straightforward and indicates that mercantilism is superior to free trade, why has free trade persisted as the dominant theory on commercial policy? The position of free trade theory is so secure that those who question it are often ridiculed as reactionaries who know nothing about the intricacies of economics or the benefits of free markets.
There are a couple of reasons that free trade policy is still so ingrained in the Western psyche. One reason is that people have a poor grasp of the history of trade that we previously discussed. Another reason is that free trade proponents often employ arguments against mercantilism (however weak), such as the ones that we discussed in the first article in this series. But the major reason that free trade holds an unchallenged position in mainstream politics and academia is due to the supposedly irrefutable arguments based upon comparative advantage, as formulated by David Ricardo in the early nineteenth century. Hans-Hermann Hoppe states as much when he writes, “Since the days of Ricardo, the case for free trade has been logically unassailable.”1
The purpose of this article is to investigate the arguments advanced by David Ricardo in support of the concept of free trade. Because the arguments from history are so definitively opposed to free trade theory, its proponents must explain why free trade must work. As William Cunningham explains, “The free trader hardly professes to base his opinions on experience; he is content to adduce illustrations from actual life of what he believes must happen.”2 Thus the case for free trade largely exists in theory, and it is this theory which we will examine here.
The Theory of Comparative Advantage
The theory of comparative advantage as the basis for trade policy was formulated by London merchant David Ricardo in the early nineteenth century. In order to understand comparative advantage, we first have to understand the notion of absolute advantage. Absolute advantage obtains when a nation produces something more efficiently than another nation. If nation A produces corn more efficiently than nation B, then the theory of absolute advantage would stipulate that nation B should import corn from nation A to the benefit of both nations. Nation A will benefit from the sale of its corn and nation B will receive corn in greater quantities and at lower cost than it could produce on its own. The issue with this simplistic understanding of trade is that this doesn’t actually happen in practice.
The concept of comparative advantage introduces another layer of complexity to show why absolute advantage doesn’t explain a country’s interests in international trade. Fletcher uses the example of professional football players who don’t mow their own lawns. While professional football players would usually have an absolute advantage in mowing lawns because they are in good physical condition, no one is surprised when they “import” the services of lawn care companies to mow their lawns for them. This is because professional football players have more valuable things to do with their time. At the national level, Fletcher explains that it is advantageous for nations like the United States to import some goods for which we have an absolute advantage, that we may free up our workforce to produce more valuable goods instead.
This is where the notion of comparative advantage enters in. Suppose that in terms of farm land, nation A can produce corn twice as efficiently as nation B, but A can produce wheat three times as efficiently as nation B. In this scenario, nation A has an absolute advantage over nation B in both the production of corn and the production of wheat. That is to say, A’s financial cost to produce wheat and its financial cost to produce corn are both lower than the financial costs for B. Comparative advantage adds another concept to this besides financial cost, namely, opportunity cost: what is given up by pursuing some economic choice – in this case, the corn production given up by choosing to produce wheat, or the wheat production given up by choosing to produce corn. Since A is more efficient than B to a greater degree in her production of wheat than in her production of corn, A has to give up more corn production in her choice to produce wheat than B would. Thus, since B has a lower opportunity cost for corn production, then according to the theory of comparative advantage, B ought to produce and export corn while A produces and exports wheat. According to this theory, so long as a country is not equally greater at producing all goods than another (e.g. such that A would be both twice as efficient in corn production and twice as efficient in wheat production), there will always be a comparative advantage and always a reason for countries to engage in this free trade.3 The argument from comparative advantage, in summary, posits that if countries all try to minimize their opportunity costs through the efficient allocation of resources,4 free trade naturally results. In the example, by importing corn from nation B, nation A frees up her acreage for the production of wheat. This way both nations sell their produce and make their greatest possible profit.
As Ian Fletcher observes:
[The] theory of comparative advantage thus sees international trade as an interlocking system of tradeoffs, in which nations use the ability to import and export to shed opportunity costs and reshuffle their factors of production to their most valuable uses. And this happens automatically, because if the owners of some factor of production find a more valuable use for it, they will find it profitable to move it to that use. The natural drive for profit will steer all factors of production to their most valuable uses, and opportunities will never be wasted.
It follows that any policy other than free trade just traps economies producing less-valuable output than they could have produced. It saddles them with higher opportunity costs—more opportunities thrown away—than they would otherwise incur. In fact, when imports drive a nation out of an industry, this must actually be good for that nation, as it means the nation must be allocating its factors of production to producing something more valuable instead. If it weren’t doing this, the logic of profit would never have driven its factors out of their former uses.5
Ricardo’s observations about comparative advantage are not entirely inaccurate. There is nothing inherently wrong with a nation focusing her assets on productivity that is suited to the available resources. However, there are several problems with the way that Ricardo concludes that nations should always pursue their current comparative advantages in production and import whatever goods and services in which they have a comparative disadvantage at the time. Fletcher lists several dubious assumptions that Ricardo makes when formulating his free trade policy. Fletcher argues several times that free trade economists are fond of telling us what must happen under free trade, but seldom actually demonstrate that free trade does work in the real world. By debunking these assumptions, Fletcher shows why free trade isn’t automatically successful, as its proponents would have us believe.
Dubious Assumption #1: Trade Is Sustainable
The first dubious assumption of free trade is that international trade is sustainable. Fletcher illustrates the problem of sustainability by demonstrating how free trade works between a decadent and a diligent nation. Once trade barriers are removed between the nations, they can not only trade but also lend each other money and sell off existing assets. In this scenario, the decadent nation will move to maximize her consumption through importation, assuming debt by borrowing money, and selling off existing assets to subsidize her consumption. In the short term, both nations are happy: the decadent nation gets to consume more in the immediate future, and the diligent nation is able to accumulate wealth. Both nations are happy and pursuing their happiness efficiently, which is the goal of economic transactions in the libertarian ethos. Yet we haven’t considered the long-term consequences of this relationship.
This system can sustain itself only as long as the decadent nation is able to subsidize her consumption through borrowing money and selling assets, but eventually she will run out of assets to sell or maximize her debt load. As a result, the decadent nation will become poorer than she would have been if protectionist trade barriers remained in place. Because the decadent nation has saddled herself with so much debt, her future consumption must decline as she diverts money to pay back debt. While the system of debt, borrowing, and consumption is certainly efficient for the short time, Fletcher correctly identifies this as a perverse efficiency. This allows decadent nations such as contemporary Western nations to sink into debt more efficiently. Short-term benefits of high consumption are offset within a few decades by the problems of massive debt, as these nations sacrifice long-term prosperity in favor of short-term living standards. When decadent nations like the contemporary United States run out of assets and assume too much debt, the system will necessarily come crashing down. While free trade might certainly function efficiently, it is a perverse efficiency which amounts to efficient self-destruction.
Dubious Assumption #2: There Are No Externalities
Ricardo’s theory posits no externalities when it comes to trade. Fletcher defines an externality as a hidden price tag, that is, when the price of an item doesn’t reflect its true cost or value. An example of a negative externality is environmental damage. An example of a positive externality is technology spillover: when one company’s invention provides technology that can be used by another company or industry, providing profit that the original company doesn’t capture. Fletcher comments, “The theory of comparative advantage, like all theories of free market economics, is driven by prices, so if prices are wrong due to positive or negative externalities, free trade will produce suboptimal results.”6
Consider the example of a nation with lax pollution standards like China or India. The goods that these nations export will be too cheap, since the costs of the pollution will be spread upon their populaces and not included in the prices (hence the term externalities). Other nations will consequently import too much from them. Likewise, these nations will export too much and concentrate too much of their economy on producing these goods, since they will view the industries as more profitable than they are, the cost of pollution damage being ignored. As a result, millions in China die of cancer and lack access to safe drinking water. Besides the obvious moral issues that this causes great suffering, economically these situations require much time and labor to resolve: costs which are not reflected in the prices of the exported goods whose production caused these conditions. Moreover, besides the resources devoted to correcting these environmental problems, this will have a dramatic effect on the future pool of Chinese labor. Free trade naturally encourages these kinds of problems, as skimping on pollution control is a way to grab a transient cost advantage.
Positive externalities are also a problem. Free trade allows industries that produce technological spillover to be wiped out by foreign competitors, thus incurring a loss in potential future profits not reflected in current prices. This can lead Michael Boskin, chairman of the Council of Economic Advisers, to quip, “It doesn’t matter whether American exports computer chips, potato chips, or poker chips! They’re all just chips!”7 The reason that this statement is ridiculous is because current prices don’t necessarily reflect present or future value, as based upon future potential earnings, particularly when those future earnings are partially contingent upon technology spillover from other domestic companies. Even if America could export the equivalent dollar amount of these goods, this still would not reflect equivalent value since there are potential future developments in technology that derive from the manufacture of computer chips but are absent in the production of potato chips or poker chips. Free trade is therefore built upon a weak foundation, since it only accounts for current prices without taking into account future value.
Dubious Assumption #3: Factors of Production Move Easily Between Industries
Gary North complains that protectionists represent a special interest group trying to protect a small minority of businesses against foreign competition. North notes that while internationally traded business is accounting for a greater percentage of commerce, the majority of Americans still work for businesses not engaged in such international trade. North writes,
Why is it that the interests of this collective entity known as the nation are best understood by a group of politicians who have the support of a small minority of manufacturers who are in direct competition with manufacturers outside the country? We are not talking about most manufacturers. As recently as 1970, only about 5% of the United States gross domestic product was a result of international trade. Today, it is closer to 25%, but any way that you define it, the vast majority of Americans do not work for companies that are in direct competition with foreign manufacturers.8
The reason that these jobs matter is because free trade can undermine the jobs of workers in internationally traded industries like manufacturing. These industries need to be profitable to drive wages up. If these jobs decline, workers who are unemployed or underemployed will seek employment in non-traded industries, thus saturating the labor market and driving down wages. North complains that protectionism is really just the aggrandizement of special interests, but his error is based upon the third dubious assumption of Ricardo’s theory: that factors of production move easily between industries.
The theory of comparative advantage stipulates that factors of production (such as labor, farm land, or factories) should be moved from less valuable to more valuable uses. Fletcher explains the problem with this reasoning: “this assumes that the factors of production used to produce one product can switch to producing another. Because if they can’t then imports won’t push a nation’s economy into industries better suited to its comparative advantage. Imports will just kill off its existing industries and leave nothing in their place.”9 The free trade proponent insists that it doesn’t matter if imports undermine certain industries, since the market will push the resources used in those industries into something better suited to that nation’s comparative advantage. But since these factors of production cannot move easily between industries, this doesn’t materialize. Instead, free trade just winds up undermining domestic industries with cheaper imports and leaves behind unemployment or underemployment, not necessarily better or even different employment opportunities.
According to Fletcher, this is a problem for all production factors, but it is especially problematic for labor and real estate, because people and buildings are the least mobile factors of production. Thus Fletcher summarizes the problem, “When workers can’t move between industries—usually because they don’t have the right skills or don’t live in the right place—shifts in an economy’s comparative advantage won’t move them into an industry with lower opportunity costs, but into unemployment.”10 What often results from free trade is that domestic businesses in internationally traded industries are undermined by cheap foreign competition and the production factors used by those businesses remain underutilized. Cities that were once dominant in manufacturing are now dominated by boarded-up factories, abandoned buildings, and unemployment lines. Workers who have lost their jobs due to outsourcing are forced to acquire skills in other fields that compensate equally well, which is commonly easier said than done. What happens more often is that these workers who lose their jobs due to outsourcing seek employment in other non-traded industries, saturating the labor market in these non-traded industries and driving the cost of labor down.
The net effect of this is that the standard of living for the middle class declines as wages decline. Many of the workers that lose their job to outsourcing cannot find a job that can compensate for the loss of income and benefits that they had in their former occupations. Likewise, many college graduates are discovering that the mountain of debt that they have incurred while in school only manages to land them a job in the local mall or big box mart. In consequence of America’s fiscal and commercial policies, Americans find themselves in greater debt with less ability to service that debt because they are underemployed or even unemployed.
The theory of comparative advantage formulated by David Ricardo isn’t entirely without merit, and in the future we’ll discuss how the theory can usefully be modified and applied towards useful ends. The problem with Ricardo’s formulation is his conclusion: that it is always within a nation’s best interest to pursue traded industries in which it has a comparative advantage. Ricardo’s theory is premised upon several dubious assumptions, and there are several reasons why nations should not necessarily pursue their comparative advantage when it isn’t in their best interest. While free trade proponents promise that pursuing comparative advantage will yield wealth and prosperity, in practice free trade has led to unemployment, economic stagnation, and declining standards of living. In the next article, we will discuss why free trade theory doesn’t pan out in practice because of flaws in the basic premises of Ricardo’s theory.
- Hans-Hermann Hoppe, Democracy: The God That Failed (Ninth Edition, Transaction Publishers, New Brunswick, New Jersey) p. 151 ↩
- William Cunningham, The Case Against Free Trade (London: John Murray, 1911), p. 142 ↩
- For another explanation and example of comparative advantage and opportunity cost, see this video. ↩
- Resources used for production are called “factors of productions” by economists. In this case the factor of production would be farm land. ↩
- Ian Fletcher, Free Trade Doesn’t Work, p. 99 ↩
- Ian Fletcher, Free Trade Doesn’t Work, p. 105 ↩
- Lester Thurow, “Microchips, Not Potato Chips,” Foreign Affairs, July/August 1994. ↩
- Gary North, “The Statist Propositions of Protectionism,” http://lewrockwell.com/north/north1160.html ↩
- Ian Fletcher, Free Trade Doesn’t Work, pp. 106-107 ↩
- Ian Fletcher, Free Trade Doesn’t Work, p. 107 ↩