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Free Trade. Throughout history, free trade has been an important factor behind the prosperity of different civilizations. Adam Smith pointed to increased trade as the primary reason for the flourishing of the Mediterranean cultures, such as Egypt, Greece, and Rome, but also of Bengal (East India) and China. The great prosperity of the Netherlands, after it threw off Spanish imperial rule and came out in favor of free trade and freedom of thought, made the free trade versus mercantilist dispute the most important question in economics for centuries.Mercantilism is an economic theory that holds that the prosperity of a nation is dependent upon its supply of capital, and that the global volume of trade is “unchangeable.” Economic assets or capital are represented by bullion (gold, silver, and trade value) held by the state, which is best increased through a positive balance of trade with other nations (exports minus imports). Mercantilism suggests that the ruling government should advance these goals by playing a protectionist role in the economy through encouraging exports and discouraging imports, especially through the use of tariffs. Mercantilism was the dominant school of thought from the 16th to the 18th centuries. Domestically, this led to some of the first instances of significant government intervention and control over the economy, and it was during this period that much of the modern capitalist system was established. Internationally, mercantilism encouraged the many European wars of the period and fueled European imperialism. Belief in mercantilism began to fade in the late 18th century, as the arguments of Adam Smith and the other classical economists won out. Today, mercantilism (as a whole) is rejected by economists, though some elements are looked upon favorably by noneconomists. Ever since then, the “free-trade doctrine” has battled with mercantilist, protectionist, isolationist, and other trade doctrines and policies.
One of the strongest arguments for free trade was made by classical economist David Ricardo in his analysis of comparative advantage. Comparative advantage occurs when different parties (countries, regions, or individuals) have different opportunity costs of production. The theory is that free trade will induce countries to specialize in making the products that they are best at and that this will maximize the total wealth produced.
Adopting the free-trade doctrine means supporting and protecting (a) the trade of goods without taxes (including tariffs) or other trade barriers (e.g., quotas on imports or subsidies for producers); (b) trade in services without taxes or other trade barriers; (c) the absence of “trade-distorting” policies (such as taxes, subsidies, regulations, or laws) that give some firms, households, or factors of production an advantage over others; (d) free access to markets; (e) free access to market information; (f) efforts against firms trying to distort markets through monopoly or oligopoly power; (g) the free movement of labor between and within countries; and (h) the free movement of capital between and within nations.
Protectionism. Opposition to free trade, generally known as protectionism, is based on the notion that free trade is unrealistic or that the advantages are outweighed by considerations of national security, the importance of nurturing infant industries, preventing the exploitation of economically weak countries by stronger ones or of furthering various social goals.
Free trade is sometimes also opposed by domestic industries threatened by lower-priced imported goods. If U.S. tariffs on imported sugar were reduced, for example, U.S. sugar producers would have to lower their prices (and sacrifice profits). Of course, U.S. consumers would benefit from those lower prices. In fact, economics tells us that, collectively, consumers would gain more than the (domestic) producers would lose. However, since there are only a few domestic sugar producers, each one could lose a significant amount. This explains why domestic producers may be inclined to mobilize against the lifting of tariffs or, more generally, why they often favor domestic subsidies and tariffs on imports in their home countries, while objecting to subsidies and tariffs in their export markets.
Antiglobalization groups that maintain that, in reality, “free-trade agreements” often do not increase the economic freedom of the poor but rather make them poorer. These groups are another source of opposition to free trade. An example is the argument that letting subsidized corn from the United States into Mexico freely under NAFTA at prices well below production cost is ruinous to Mexican farmers. The real issue here, of course, is that such subsidies violate the principles of free trade and that this therefore exemplifies a flawed agreement rather than a valid argument against free trade.
As economic policy, protectionism is about restraining trade between nations, through methods such as tariffs on imported goods, restrictive quotas, and a variety of other restrictive government regulations designed to discourage imports and prevent foreign takeover of local markets and companies. This policy is closely aligned with antiglobalization and contrasts with free trade, where government barriers to trade are kept to a minimum. The term is mostly used in the context of economics, where protectionism refers to policies or doctrines that “protect” businesses and workers within a country by restricting or regulating trade between foreign nations.
Historically, protectionism was associated with economic theories such as mercantilism and import substitution. During that time, Adam Smith famously warned against the “interested sophistry” of industry, seeking to gain advantage at the cost of the consumers.Friedman and Friedman (1980). Virtually all modern-day economists agree that protectionism is harmful in that its costs outweigh the benefits and that it impedes economic growth. Economics Nobel Prize winner and trade theorist Paul Krugman once stated, “If there were an Economist’s Creed, it would surely contain the affirmations ‘I believe in the Principle of Comparative Advantage’ and ‘I believe in Free Trade.’”Krugman (1987).
A variety of policies can be used to achieve protectionist goals, including the enactment of the following items:
- Tariffs. Typically, tariffs (or taxes) are imposed on imported goods. Tariff rates vary according to the type of goods imported. Import tariffs will increase the cost to importers and increase the price of imported goods in the local markets, thus lowering the quantity of goods imported. Tariffs may also be imposed on exports, and in an economy with floating exchange rates, export tariffs have similar effects as import tariffs. However, for political reasons, such a policy is seldom implemented.
- Import quotas. Import quotas reduce the quantity, and therefore increase the market price, of imported goods. Their economic effect is therefore similar to that of tariffs, except that the tax revenue gain from a tariff will instead be distributed to those who receive import licenses. This explains why economists often suggest that import licenses be auctioned to the highest bidder or that import quotas be replaced by an equivalent tariff.
- Administrative barriers. Countries are sometimes accused of using their various administrative rules (e.g., regarding food safety, environmental standards, electrical safety) as a way to introduce barriers to imports.
- Antidumping legislation. Dumping is the act of charging a lower price for a good in a foreign market than is charged for the same good in the domestic market (i.e., selling at less than “fair value”). Under the World Trade Organization (WTO) agreement, dumping is condemned (but not prohibited) if it causes or threatens to cause material injury to a domestic industry in the importing country. Supporters of antidumping laws argue that they prevent “dumping” of cheaper foreign goods that would cause local firms to close down. In practice, however, antidumping laws are often used to impose trade tariffs on foreign exporters.
- Direct subsidies. Government subsidies (in the form of lump-sum payments or cheap loans) are sometimes given to local firms that cannot compete well against foreign imports. These subsidies are purported to “protect” local jobs and to help local firms adjust to the world markets.
- Export subsidies. Under export subsidies, exporters are paid a percentage of the value of their exports. Export subsidies increase the amount of trade, and, in a country with floating exchange rates, have effects similar to import subsidies.
- Exchange rate manipulation. A government may intervene in the foreign exchange market to lower the value of its currency by selling its currency in the foreign exchange market. Doing so will raise the cost of imports and lower the cost of exports, leading to an improvement in its trade balance. However, such a policy is only effective in the short run, as it will lead to higher price inflation in the country, which will in turn raise the cost of exports and reduce the relative price of imports.
In the modern trade arena, many other initiatives besides tariffs, quotas, and subsidies have been called protectionist. For example, some scholars, such as Jagdish Bhagwati, see developed countries’ efforts in imposing their own labor or environmental standards as forms of protectionism.Bhagwati (2004). The imposition of restrictive certification procedures on imports can also be seen in this light. Others point out that free-trade agreements often have protectionist provisions such as intellectual property, copyright, and patent restrictions that benefit large corporations. These provisions restrict trade in music, movies, drugs, software, and other manufactured items to high-cost producers with quotas from low-cost producers set to zero.
Arguments for protectionism. Opponents of free trade include those who argue that the comparative advantage argument for free trade has lost its legitimacy in a globally integrated world in which capital is free to move internationally. Herman Daly, a leading voice in the discipline of ecological economics, has stated that although Ricardo’s theory of comparative advantage is one of the most elegant theories in economics, its application to the present day is illogical: “Free capital mobility totally undercuts Ricardo’s comparative advantage argument for free trade in goods, because that argument is explicitly and essentially premised on capital (and other factors) being immobile between nations. Under the new globalization regime, capital tends simply to flow to wherever costs are lowest—that is, to pursue absolute advantage.”Daly (2007).
Others criticize free trade as being “reverse protectionism in disguise,” that is, of using tax policy to protect foreign manufacturers from domestic competition. By ruling out revenue tariffs on foreign products, government must fully rely on domestic taxation to provide its revenue, which falls disproportionately on domestic manufacturing. Or, in the words of Paul Craig Roberts, “[Foreign discrimination of U.S. products] is reinforced by the U.S. tax system, which imposes no appreciable tax burden on foreign goods and services sold in the U.S. but imposes a heavy tax burden on U.S. producers of goods and services regardless of whether they are sold within the U.S. or exported to other countries.”Roberts (2005, July 26).
Other defenses of protectionism include the idea that protecting newly founded, strategically important infant industries by imposing tariffs allows those domestic industries to grow and become self-sufficient within the international economy once they reach a reasonable size.
Arguments against protectionism. Most economists fundamentally believe in free trade and agree that protectionism reduces welfare. Nobel laureates Milton Friedman and Paul Krugman, for example, have argued that free trade helps third-world workers even though they may not be subject to the stringent health and labor standards of developed countries. This is because the growth of the manufacturing sector and the other jobs that a new export sector creates competition among producers, thereby lifting wages and living conditions.
Protectionism has also been accused of being one of the major causes of war. Proponents of this theory point to the constant warfare in the 17th and 18th centuries among European countries whose governments were predominantly mercantilist and protectionist; the American Revolution, which came about primarily due to British tariffs and taxes; as well as the protective policies preceding World War I and World War II.