Like many aspects of mainstream economic theory – free trade – is one of the concepts that sounds okay at first but the gloss quickly fades once you understand the basis of the theory and how it derives its seemingly ideal results. In practice, the textbook ‘model’ is never attainable in reality and so what goes for ‘free trade’ is really a stacked deck of cards that has increasingly allowed large financial capital interests to rough ride over workers, consumers and undermine the democratic status of elected governments. Further, even within the mainstream approach the terrain has moved. The old perfectly competitive ‘models’ of free trade, which go back to the Classical economist David Ricardo and were embodied in the so-called Heckscher-Ohlin model and were used to disabuse notions of government intervention (protection, tariffs, import duties etc), have been surpassed in the literature.
This blog is Part 1 in a two-part (might be three) series on why progressives should oppose moves to ‘free trade’ and instead adopt as a principle the concept of ‘fair trade’, as long as it doesn’t compromise the democratic legitimacy of the elected government. This is a further instalment to the manuscript I am currently finalising with co-author, Italian journalist Thomas Fazi. The book, which will hopefully be out soon, traces the way the Left fell prey to what we call the globalisation myth and formed the view that the state has become powerless (or severely constrained) in the face of the transnational movements of goods and services and capital flows. This segment fits into Part 3 which focuses on ‘what is to be done’.
Paul Krugman (1987: 131) wrote:
If there were an Economist’s Creed, it would surely contain the affirmations “I understand the principle of Comparative Advantage” and “I advocate Free Trade.” For one hundred seventy years, the appreciation that international trade benefits a country whether it is “fair” or not has been one of the touchstones of professionalism in economics. Comparative advantage is not just an idea both simple and profound; it is an idea that conflicts directly with both stubborn popular prejudices and powerful interests. This combination makes the defense of free trade is close to a sacred tenet is any idea in economics.
[Reference: Krugman, P. (1987) ‘Is Free Trade Passé’, The Journal of Economic Perspectives, 1(2), 131-144. LINK]
The Euclidean obsession among mainstream economists
Mainstream economists are a slippery lot. Behind closed doors and at their professional conferences they speak a language few outside the cogniscenti understand.
They present artificial worlds to each other and applaud the ingenuity that is required to relentlessly devote a lifetime to these ‘games’.
In 2008, Olivier Blanchard, while chief economist at the IMF, reviewed the understanding that macroeconomists had of the real world and claimed that the “state of macro is good” (Blanchard, 2008: 2). This was just before the Global Financial Crisis emerged.
Blanchard asserted that a “largely common vision has emerged” (p.5) in macroeconomics, with a “convergence in methodology” (p.3) such that research articles in macroeconomics ‘look very similar to each other in structure” (p.21).
This similarity in the structure of papers is because mainstream economists now follow, what Blanchard called “strict, haiku-like, rules” (p.26).
Mainstream economics (he was referring to the dominant ‘New Keynesian’ approach in macroeconomics, is “simple, analytically convenient … [and] … reduces a complex reality to a few simple equations” (p.9).
[Reference: Blanchard, O. (2008) ‘The State of Macro’, NBER Working Paper No. 14259, National Bureau of Economic Research, August.]
These ‘haiku-like rules’ (p.27) start:
… from a general equilibrium structure, in which individuals maximize the expected present value of utility, firms maximize their value, and markets clear.
While the twists that modern economists add to their standardised, rule-driven, ‘academic paper’ production approach have evolved, the same principle has governed the way mainstream economists have reasoned for decades.
Mathematics students will know that the Greek mathematician Euclid of Alexandria developed the basis of modern geometry from a set of well-founded axioms which then were used to deduce via mathematical reasoning a set of propositions or theorems.
The process was one where the logical deductions constituted a ‘formal mathematical proof’ of the theorem.
The axioms were generally incontestable (save perhaps for the parallel postulate). So we began geometric theorising with axioms such as “all right angles are equal to one another”.
From these axioms, applications were generated on the basis of the theories that were supported. For example, the knowledge of distances and angles that are permitted by the geometry created the science of surveying.
Mainstream (neo-classical) economists somehow thought they were the Euclids of the social sciences.
In this Inside Story article (March 16, 2010), Paul Samuelson, the so-called “father of modern economics” apparently:
… realised that the behaviour of people who are individualistic, self-interested, rational calculators could readily be modelled on a computer. This provided modern economics with its Euclidean axioms. On this basis, Samuelson was able to integrate the microeconomics of neoclassical theory and the macroeconomics of Keynes. And, just as architects applied Euclid’s principles to construct bigger and better buildings, economists could develop tools for business managers and government policy-makers.
[Reference: Rowley, K. (2010) ‘Euclidean Economics’, Inside Story, March 16. LINK]
This embrace of the Euclidean deductivist approach was important because it (Inside Story, 2010):
… gave economics the look of a “hard” science akin to physics and chemistry. It was mathematical, abstract and universal in character, rigorous in its logic, and concrete and practical in its applications. This was in contrast to the biological sciences and what passed for social science, which lacked the fundamental unifying general principles, the mathematical methods and the precision that economics had now supposedly attained.
As American Post Keynesian economist, Alfred Eichner wrote in his In his brilliant 1979 exposition – A Guide to Post-Keynesian Economics:
The discipline of economics has so far successfully resisted all efforts to alter its character as an exercise in how to reason deductively from axiomatic principles. That is, it has insisted on remaining the Euclidean geometry of the social sciences.
[Reference: Eichner, A.S. (1979) A Guide to post-Keynesian Economics, Armonk, NY, M.E. Sharpe]
The use of mathematical techniques drawing on a set of axiomatic assumptions about human behaviour (we are always rational and can make complex calculations across our lifetimes that maximise our fortunes), information availability (typically, we can predict the future with an average error of zero), structure of markets (only small firms with no price setting power) and more, however, cannot give the social sciences the status of a physical (“hard”) science.
John Maynard Keynes understood this clearly. In discussing, the applicability of classical theory “to the problems of involuntary unemployment” (Keynes, 1936: 17), given that the theory only constructed stylised full employment models, Keynes said (1936: 17) that:
The classical theorists resemble Euclidean geometers in a non-Euclidean world who, discovering that in experience straight lines apparently parallel often meet, rebuke the lines for not keeping straight — as the only remedy for the unfortunate collisions which are occurring. Yet, in truth, there is no remedy except to throw over the axiom of parallels and to work out a non- Euclidean geometry.
[Reference: Keynes, J.M. (1936) The General Theory of Employment, Interest, and Money, London, Macmillan.]
In discussing free trade and the contribution of economists in this area, we must always be mindful of the way in which the theories are constructed before wondering whether they can be applied to the real world where human behaviour is not consistently rational; where we take decisions that can best be regarded as ‘satisficing’ rather than maximising; where we are heavily driven by patterned behaviour reflecting habits, culture and social background; where information in restricted and the future endemically uncertain; and, where firms have power to set prices.
If we go back to square one and outline the conditions mainstream economists assume must be present before ‘free trade’ between nations delivers optimal outcomes we immediately see the problem.
Even within the logic of the mainstream (neo-classical) trade theory approach there are obvious problems. A basic assumption is that there is full employment in each country and workers receive their contribution to production in the form of wage payments.
We need to go back to 1817, to David Ricardo’s notion of Comparative Advantage to see where free market trade theory comes from.
Ricardo conjectured that there were only two nations (England and Portugal) and they produce two goods (cloth and wine) which are identical in qualitative terms. Portugal was assumed to require less labour inputs to produce a given quantity of each good relative to England (that is, it was more ‘efficient’ in both goods).
But, he assumed that the ‘relative’ costs were different.
He wrote (1817: 7.16)
To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.
[Reference: Ricardo, D. (1817) On the Principles of Political Economy and Taxation, London, John Murray. LINK]
The most famous restatement of the notion of comparative advantage in trade theory was provided by two Swedish economists, Bertil Ohlin and Eli Heckscher in the 1930s. They were influential figures in the so-called Stockholm School of Economics.
In the Heckscher-Ohlin model of free trade, for example, which was developed in the 1930s and became the dominant approach to trade theory, the scenario is a two-nation, two-commodity, two-input world (the so-called ‘2x2x2 model’).
The primary insight of the ‘model’ was that without trade, each nation would produce a quantity of each of the two goods. However, the relative prices of the two goods will not be the same across the two nations because of technological differences.
The lowest priced good in each nation will be the one where that country holds the comparative advantage.
By introducing trade, the price differences between the goods across countries would motivate firms to export a good which that nation has a comparative advantage in at the higher price and pocket more profits.
So comparative (rather than absolute) advantage then describes the export patterns between nations.
The trade drives down prices in the higher priced nation (without the comparative advantage in that particular good) because the export inflow increases the supply of goods.
Similarly, the diversion of production into export markets rather than for domestic sales reduces supply in the home market and pushes up prices.
The export flows stop when the prices are equalised across countries for each good.
The obvious outcome is that nations will specialise in the production of the good in which they have a comparative advantage, which would squeeze the inputs available for producers of the good in which the nation is not so endowed and eventually, fire competitive processes drive the latter produces out of business.
The productive resources are assumed to move costlessly into the production specialisation and full employment is sustained.
By allowing these competitive forces to work, the free trade is beneficial for all citizens in both countries, who gain access to more consumption possibilities at the lowest possible price.
Free trade is thus hypothesised to increase productive efficiency, because in each country, the respective labour forces, who are fully employed at all times, now produce more goods in total than before.
To give you a flavour of the stylised world that this theory relies on, the following assumptions are required to generate the result that free trade is optimal.
I don’t imagine to a non-economist the full import of these assumptions will be understood. But I have explained them in relatively simple language, which should allow you to comprehend their lack of correspondence with any real world situation.
1. There is always full employment through price flexibility. Inputs can move freely within countries between technologies and commodities, which means that labour can move without any costs involved between two types of production (say farming and manufacturer). Capital can also move freely (it is assumed to be ‘malleable’).
2. Perfect competition exists in each country, which means that input suppliers cannot influence the price they receive and firms cannot influence the price they sell products at. The pure free market demand and supply forces determine prices.
3. Both countries have identical production technology which means that each nation can produce a given output of a particular commodity with the sampe capital and labour inputs should they choose.
3. There are constant returns to scale in production in both countries, which means that if the imputs of labour and capital are doubled, output will double.
4. The two commodities in question are produced using different technologies (different ratios of labour and capital), which means that a nation with lots of capital might be better placed to produce the more capital intensive good.
5. Inputs cannot move freely between countries, which means that capital cannot move freely.
Milton Friedman was wont to say that it didn’t matter that the assumptions deployed by economists were unrealistic, rather, the usefulness of a ‘theoretical model’ was how well it predicted – his famous “as if” argument, which he developed in his 1953 book – Essays in Positive Economics.
[Reference: Friedman, M. (1953) Essays in Positive Economics, Chicago, University of Chicago Press.]
In other words, one should not judge a theory by the realism of the assumptions underpinning the theory. Rather, if the real world behaves “as if” the theories are true then the ‘model’ is doing its job.
Friedman wrote (1953: 9):
… the relevant question to ask about the “assumptions” of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose in hand. And this question can be answered only by seeing whether the theory works, which means whether it yields sufficiently accurate predictions.
While that claim by Friedman is contentious and the topic of another blog altogether the fact is that the predictions of the Heckscher-Ohlin model performed poorly when confronted with empirical realities.
The Leontief Paradox was that the US, which is the nation with the most capital, was exporting goods and services that were more labour-intensive than capital-intensive, a major violation of the predictions of the Heckscher-Ohlin model.
This finding ran counter to the ‘comparative advantage’ model of free trade. The US imported more capital-intensive goods than it exported.
New developments in trade theory
The concept of free trade, derived from the early contributions of the Stockholm School and others, led to the conclusion that any government intervention to restrict the free exchange of goods and services across national borders (via, for example, tariffs and/or import controls) This, would undermine national prosperity.
The corollary, of course, was that unfettered trade movements would enhance national prosperity.
In other words, the idea that a national government might protect a local industry by restricting its exposure to competition from international firms was ‘proved’ to be anathema to maximising individual and national outcomes.
Of course, the ‘proof’ was only forthcoming in these stylised 2x2x2 ‘models’, which relied on a host of assumptions that were patently not a description of the real world.
The theoretical case for free trade was challenged in the 1980s, when developments within economic theory (the so-called ‘New Trade Theory’) essentially scrapped the Heckscher-Ohlin approach and incorporated the reality of increasing returns in production and imperfect competition (Krugman, 1987).
[Reference: Krugman, P. (1987) ‘Is Free Trade Passé’, The Journal of Economic Perspectives, 1(2), 131-144. LINK]
By altering these assumptions, economists could no longer argue that the results of the free-trade models held.
While Paul Krugman (1987: 131) considered “the defense of free trade is close to a sacred tenet is any idea in economics” (see full quote at beginning of this blog), he also noted that “the case for free trade is currently more in doubt than at any time since the 1817 publication of Ricardo’s Principles of Political Economy.”
He noted that this doubt was not a reflection of the “political pressures for protection” (p.131), which has been successfully headed off by the free trade lobby, but (p.131-32):
Rather, it is because of the changes that have recently taken place in the theory of international trade itself … the traditional constant returns, perfect competition models of international trade have been supplemented and to some extent supplanted by a new breed of models that emphasizes increasing returns an imperfect competition. These new models calling to doubt the extent to which actual trade can be explained by comparative advantage: they also open the possibility that government intervention in trade via import restrictions, export subsidies, and so on may under some circumstances be in national interest after all.
It is important to understand that economic theory evolved away from a blind acceptance of a proposition that free trade was always good, quite apart from other considerations, which we might categorise under ‘fair trade’ issues.
These ‘fair trade’ issues extend well beyond the nuances of assumptions that economists might deploy to generate one ‘result’ over another in the game of theorising.
But at this stage we just note, that the New Trade Theory could no longer be used to justify unfettered free trade.
It is possible (even within this narrow framework) that government trade regulations (for example, export subsidies and/or import controls) can advance national well-being.
In Part 2, we will continue to critique the ‘economists’ case for free trade and move onto to ‘fair trade’ issues and the current crop of so-called free trade agreements.