The previous article gave a brief explanation of the theory of comparative advantage as formulated by economist David Ricardo, which has heretofore served as the intellectual bedrock of free trade. Many economists promoting free trade believe that the position free trade enjoys in the world is impregnable due to its sturdy intellectual foundation. Precious few try to explain why free trade is best in terms of real-world outcomes; and we saw in the history of British and American commerce that free trade has produced problematic outcomes. We began to delve into what Ian Fletcher calls the dubious assumptions of comparative advantage, showing the flaws in this argument from comparative advantage. In this article we will continue with the remaining dubious assumptions that Fletcher proposes.
Dubious Assumption #4: Trade Does Not Raise Income Inequality
Fletcher points out that the gains promised by free trade are promised for the economy as a whole. But these gains are not automatically distributed throughout the economy. This isn’t necessarily a problem, for all financial transactions often benefit different parties unequally. The issue, however, is the nature in which free trade impacts income inequality. What often happens with free trade is that working class or middle class jobs are undermined by cheaper imports, such that these workers and their families experience a net loss of income and financial welfare. While the economy might grow as a whole, it still means that many or even most workers lose income.
Fletcher uses the example of a nation who begins to export more airplanes and less clothing as a result of free trade. As is the case with many different industries, the transition to airplane manufacturing from clothing production entails more white-collar labor as opposed to blue-collar labor. Thus as free trade progresses, the demand for white-collar workers increases and the demand for blue-collar workers decreases. The problem rests on the fact that most workers are blue-collar workers who cannot easily be transitioned into white-collar jobs (see dubious assumption #3). Therefore free trade lowers the wages of most of the workers in the economy. Dani Rodrik of Harvard estimates that free trade reshuffles five dollars between groups domestically for every dollar it adds to the economy as a whole.1 If the wages of most of the workers in the economy are lowered, then these same workers will also be poor consumers, and the long-term result will be a lowering of the standard of living throughout the economy. Even the upper classes, who benefit from free trade in the short term, will be harmed in the long term as they run out of consumers to whom they can sell their products (see dubious assumption #1).
Dubious Assumption #5: Capital is Not Internationally Mobile
The theory of free trade does not take into account one of the biggest problems that we have experienced as a result of free trade policies, namely, the outsourcing of jobs and offshoring of production. The closing of shops and factories domestically and the employment of cheap foreign labor isn’t trade; it is simply the flight of capital from one country to another. While most modern proponents of free trade seem oblivious to the problems caused by outsourcing or offshoring, David Ricardo was not.
To begin with, Ricardo acknowledged that capital flight could be advantageous for capitalists; he used his classic example of the trade of English cloth for Portuguese wine: “It would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances the wine and the cloth should be made in Portugal, and therefore that the capital and labor of England employed in making cloth should be removed to Portugal for that purpose.”2 Ricardo acknowledged that offshoring all production to Portugal might help English consumers and would definitely harm English workers. Since consumers and workers are the same people, then it is at best a toss-up whether this would actually help or hurt England in the aggregate. In reality, the loss of jobs is more detrimental in the long term than cheaper prices for consumers in the short term are beneficial (see dubious assumptions #3 and #4).
Ricardo didn’t think capital flight would be a problem, for he argued that capital cannot move easily between countries the way that it can between provinces. Ricardo explains, “The difference in this respect, between a single country and many, is easily accounted for, by considering the difficulty with which capital moves from one country to another, to seek a more profitable employment, and the activity with which it invariably passes from one province to another of the same country.”3 The presumption is that it is too difficult to move capital easily between different countries, but whatever validity this assumption might have had in the early nineteenth century, it has been entirely discredited as we’ve progressed into the early twenty-first century. It is much easier to move capital today than it was in the time of Ricardo, and this is done frequently as companies move production overseas to gain a cost advantage. While this is certainly accomplished more easily with modern technology, Ricardo’s assertion that capital flight was too difficult to be problematic was proven to be false within just a few years. As Britain transitioned to free trade, billions of pounds were invested overseas, and by 1914, an unprecedented and since unequaled 35 percent of Britain’s national wealth was held abroad.4
Another reason that Ricardo doesn’t believe that capital flight would prove problematic is that natural inclinations would prevent most people from betraying the interests of their own nation. Ricardo argues:
Experience, however, shows that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connections, and entrust himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.5
Notice how Ricardo argues that nations are real and legitimate sources of identity, and he assumes that our natural inclinations are sufficient to prevent us from allowing capital flight to dilute our national welfare. Again, whatever basis there was for Ricardo to make this assertion in early-nineteenth-century Britain, he clearly underestimated the profound lack of loyalty that today’s international financiers have to their native countries. Modern proponents of free trade don’t deny that free trade has caused capital to shift; they simply deny that any nation has the right to complain about this. Recall Gary North’s assertion that protectionism was derived from “the religion of state worship”6 and that nations are essentially arbitrary economic boundaries. It is certainly interesting that while modern proponents of free trade are willing to acknowledge that nations may well be harmed by capital flight, David Ricardo, one of the original formulators of free trade, conceded that capital flight would dismantle his theory, although he wrote it off as improbable. Those who find themselves out of work, their jobs having been moved overseas, know very well that what Ricardo thought was improbable has become all too real.
Dubious Assumption #6: Short-Term Efficiency Causes Long-Term Growth
Fletcher points out that the theory of comparative advantage is what economists call static analysis. Static analysis occurs when we are observing what is going on right now, similar to looking at a photograph. While there is nothing inherently wrong with static analysis, sound economic theory needs to take into account dynamic facts. Ricardo’s theory of comparative advantage purports to tell us what is in our best interest right now, without accounting for future consequences. We touched on this earlier when addressing dubious assumption #1 about the sustainability of trade. As Fletcher points out, even when comparative advantage provides an accurate picture of what is in our current interest, it does not follow that this would be best for us in the long term.
Fletcher uses Ricardo’s example of English textiles and Portuguese wine. The English economy flourished as a result of the textile industry, for the technology used to produce cloth was then used to develop new and prosperous industries (see dubious assumption #2 on externalities). Fletcher writes, “[T]extiles were produced in England with then-state-of-the-art technology like steam engines. The textile industry thus nurtured a sophisticated machine tool industry to make the parts for these engines, which drove forward the general technology capabilities of the British economy and helped it break into related industries like locomotives and steamships.”7 Portugal didn’t experience any of these benefits from their expanded market for wine. The process of wine-making would remain largely unchanged until the middle of the twentieth century. Fletcher therefore writes that the Methuen Treaty “merely switched suppliers for the English, who did not produce wine, but admitted a deluge of cheap English cloth into Portugal, which wiped out its previously promising textile industry. English capital eventually took control of Portugal’s vineyards as their owners went into debt to London banks, and English influence sabotaged attempts at industrial policy that might have pushed Portugal back into textiles or other manufacturing industry.”8
This is strikingly similar to the situation in which we find ourselves today with China. China has become a major owner of American debt and Chinese “investors” are now starting to purchase assets here in America. Remarkably, no one among America’s financial elite seems to think that this will prove to be very problematic in the future (or they don’t care). Those who demur from selling off America are deemed to be reactionary nationalists who don’t know just how great an absolute free market can be. Free trade rhetoric aside, there is no reason to believe that this situation will play out any better for America than it did for Portugal.
Dubious Assumption #7: Trade Does Not Induce Adverse Productivity Growth Abroad
Fletcher observes that the net result of free trade over a period of time can end up reversing its initial benefits. The free trade maxim is that we should import and export in order to maximize comparative advantage and keep opportunity costs as low as possible. Free trade can end up causing growth in a foreign trading partner which is actually adverse for a country like the United States. Why is growth in a foreign country bad for us? The reason is that it can very easily erase the benefits of free trade, such as cheap imported goods. As a foreign economy grows, as Japan did in 1960-1980 and Europe did after World War II, labor becomes more expensive, and what was once an inexpensive import is now less affordable.
This was (and is) a significant factor in American trade with countries like Japan. Instead of growing our own economy and spurring on valuable advancements in technology, we grew Japan’s economy by importing from them for so many decades. Free trade actually helped Japan catch up to us, providing a huge market in America in which the Japanese could sell; they grew their businesses and applied new technology (often developed in America or other Western countries) in lucrative new ways. Business and growth is a good thing, but in the case of American trade with Japan, it shows that we have allowed ourselves to be driven out of our most valuable industries. Since Japan has caught up with America in technological sophistication, Japanese products are no longer as cheap as they had been in the past. The short-term benefit of free trade that Americans received from Japan was inexpensive imports at the cost of long-term domestic growth. Now we have lost the short-term benefit of low prices and have lost our competitive edge in the industries that could benefit our domestic economy.
Conclusions on Free Trade Theory
As we discovered in previous articles on the history of trade and commerce policy, free trade hasn’t delivered what free trade proponents promised it would. Instead of making the world wealthier and more efficient, it has always and invariably led to the economic decline in nations that pursued these policies. The reason for this is that free trade rests upon a flimsy foundation. Ricardo’s argument from comparative advantage has too many dubious assumptions to make the theory valid. Ian Fletcher does an excellent job identifying these fallacies and demonstrating precisely why Ricardo’s assumptions don’t materialize in the real world. It is clear that always pursuing our present comparative advantages and lowest opportunity cost doesn’t always produce the best results. In the long term, there is an undeniable benefit to having strong industries which spur research and development that is useful across the economy. In the final edition of this series, we’ll provide some practical suggestions for an industrial policy that will help restore our prosperity and establish a secure future for our people.
- Dani Rodrik, Has Globalization Gone Too Far? (Washington: Institute for International Economics, 1997), p.30 ↩
- David Ricardo, The Principles of Political Economy and Taxation (Mineola, NY: Dover Publications, 2004), p. 83 ↩
- Ibid. ↩
- Lance E. Davis, Robert E. Gallman, Evolving Financial Markets and International Capital Flows: Britain, the Americas, and Australia, 1865-1914 (Cambridge, UK: Cambridge University Press, 2001), p. 58 ↩
- David Ricardo, The Principles of Political Economy and Taxation, p. 83 ↩
- Gary North, “Free Trade: The Litmus Test of Economics,” http://lewrockwell.com/north/north1153.html ↩
- Ian Fletcher, Free Trade Doesn’t Work, p. 113. See also Nathan Rosenberg, Inside the Black Box: Technology and Economics (New York: Cambridge University Press, 1982), p. 73. ↩
- Ian Fletcher, Free Trade Doesn’t Work, pp. 113-114 ↩