By Douglas A. Irwin
“Economists have likened free trade to technological progress: although some narrow interests may be harmed, the overall benefits to society are substantial.”
The theory of international trade and commercial policy is one of the oldest branches of economic thought. From the ancient Greeks to the present; government officials, intellectuals, and economists have pondered the determinants of trade between countries, asking whether trade bring benefits or harm to a nation, and, more importantly, trying to determine what trade policy is best for any particular country.
Since the time of the ancient Greek philosophers, there has been a dual view of trade: a recognition of the benefits of international exchange combined with a concern that certain domestic industries (or laborers, or culture) would be harmed by foreign competition. Depending upon the weights put on the overall gains from trade or on the losses of those harmed by imports, different analysts have arrived at different conclusions about the desirability of having free trade. But economists have likened free trade to technological progress: although some narrow interests may be harmed, the overall benefits to society are substantial. Still, as evidenced by the intense debates over trade today, the tensions inherent in this dual view of trade have never been overcome.
The first reasonably systematic body of thought devoted to international trade is called “mercantilism” and emerged in seventeenth and eighteenth century Europe. An outpouring of pamphlets on economic issues, particularly in England and especially related to trade, began during this time. Although many different viewpoints are expressed in this literature, several core beliefs are pervasive and tend to get restated time and time again. For much of this period, mercantilist writers argued that a key objective of trade should be to promote a favorable balance of trade. A “favorable” balance of trade is one in which the value of domestic goods exported exceeds the value of foreign goods imported. Trade with a given country or region was judged profitable by the extent to which the value of exports exceeded the value of imports, thereby resulting in a balance of trade surplus and adding precious metals and treasure to the country’s stock. Scholars later disputed the degree to which mercantilists confused the accumulation of precious metals with increases in national wealth. But without a doubt, mercantilists tended to view exports favorably and imports unfavorably.
Even if the balance of trade was not a specific source of concern, the commodity composition of trade was. Exports of manufactured goods were considered beneficial, and exports of raw materials (for use by foreign manufacturers) were considered harmful; imports of raw materials were viewed as advantageous and imports of manufactured goods were viewed as damaging. This ranking of activities was based not only on employment grounds, where processing and adding value to raw materials was thought to generate better employment opportunities than just extraction or primary production of basic goods, but also for building up industries that would strengthen the economy and the national defense.
Mercantilists advocated that government policy be directed to arranging the flow of commerce to conform to these beliefs. They sought a highly interventionist agenda, using taxes on trade to manipulate the balance of trade or commodity composition of trade in favor of the home country. But even if the logic of mercantilism was correct, this strategy could never work if all nations tried to follow it simultaneously. Not every country can have a balance of trade surplus, and not every country can export manufactured goods and import raw materials.
Adam Smith’s Wealth of Nations
While there were anti-mercantilist economic writers during this period, few advocated complete free trade or set out systematic reasons for believing that free trade might be desirable. The big breakthrough came with Adam Smith’s ‘An Inquiry into the Nature and Causes of the Wealth of Nations,’ published in 1776. With this book, Smith fundamentally changed economic thinking about international trade. Smith argued that economic growth depended upon specialization and the division of labor (see Book I, Chapter 3).
Specialization helped promote greater productivity—that is, producing more goods from the same resources, which is essential for achieving higher standards of living. According to Smith, the division of labor was limited by the extent of the market; in other words, small markets would not be able to support a great deal of specialization, whereas larger markets could. (A small town usually has fewer specialty shops than a large city.) Therefore, international trade effectively increased the size of the market for any given country, allowed for more refined specialization, created an international division of labor, and thereby benefited all countries by increasing the world’s productivity and output.
Even more than his discussion of the gains from trade, Smith is remembered for his incisive analysis of trade policy, where he details not just the benefits of free trade but the costs of government intervention. Book IV of the Wealth of Nations was a sustained and compelling attack on mercantilism. Smith argued that “the great object” of mercantilism was “to diminish as much as possible the importation of foreign goods for home consumption, and to increase as much as possible the exportation of the produce of domestic industry.” (Book IV, Chapter 1.) These goals were to be achieved through import restrictions (to reduce imports), on the one hand, and export subsidies (to increase exports). Smith argued against both actions.
Smith quickly dispensed with export subsidies, which are payments to domestic firms that enable them to reduce their price to foreign consumers. “We cannot force foreigners to buy their goods as we have done our own countrymen,” Smith wrote. “The next best expedient, it has been thought, therefore, is to pay them for buying. It is in this manner that the mercantile system proposes to enrich the whole country, and to put money into all our pockets by means of the balance of trade.” (Book IV, Chapter 5.) Smith argued that if a certain trade was unprofitable for private merchants, it was unlikely that it would be profitable for the nation:
“The trades, it is to be observed, which are carried on by means of bounties [subsidies], are the only ones which can be carried on between two nations for any considerable time together, in such a manner as that one of them shall always and regularly lose, or sell its goods for less than it really costs to send them to market. But if the bounty did not repay to the merchant what he would otherwise lose upon the price of his goods, his own interest would soon oblige him to employ his stock in another way, or to find out a trade in which the price of the goods would replace to him, with the ordinary profit, the capital employment in sending them to market. The effect of bounties, like that of all the other expedients of the mercantile system, can only be to force the trade of a country into a channel much less advantageous than that in which it would naturally run of its own accord.” (Book IV, Chapter 5.)
Turning to import restrictions, Smith argued that they would benefit certain domestic industries, but would also diminish competition and give those producers a monopoly in the home market, enabling them to charge higher prices. Monopolies also were prone to mismanagement and were likely to become inefficient. In explaining this, Smith set out his conception of the role of competition:
“Every individual is continually exerting himself to find to the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to the society.”
“As every individual, therefore, endeavors as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labors to render the annual revenue of the society as great as he can.” (Book IV, Chapter 2.)
What was the impact of trade regulations?
“No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain. It can only divert a part of it into a direction into which it might not otherwise have gone; and it is by no means certain that this artificial direction is likely to be more advantageous to the society than that into which it would have gone of its own accord.” (Book IV, Chapter 2.)
Indeed, import restrictions were essentially wasteful:
“What is prudence in the conduct of every private family can scarce be folly in that of a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in a way in which we have some advantage. The general industry of the country, being always in proportion to the capital which employs it, will not thereby be diminished, no more than that of the above-mentioned artificers; but only left to find out the way in which it can be employed with the greatest advantage. It is certainly not employed to the greatest advantage when it is thus directed towards an object which it can buy cheaper than it can make. The value of its annual produce is certainly more or less diminished when it is thus turned away from producing commodities evidently of more value than the commodity which it is directed to produce. According to the supposition, that commodity could be purchased from foreign countries cheaper than it can be made at home. It could, therefore, have been purchased with a part only of the commodities, or, what is the same thing, with a part only of the price of the commodities, which the industry employed by an equal capital would have produced at home, had it been left to follow its natural course. The industry of the country, therefore, is thus turned away from a more to a less advantageous employment, and the exchangeable value of its annual produce, instead of being increased, according to the intention of the lawgiver, must necessarily be diminished by every such regulation.” (Book IV, Chapter 2.)
Smith was also a keen analyst of the political economy of trade restrictions. Rather than being imposed by some independent authority that wished to best serve the general interests of society, regulations came about because of the pressure of special interests that sought to diminish competition for their own benefit. As Smith put it in a letter from 1783, trade regulations “may, I think, be demonstrated to be in every case a complete piece of dupery, by which the interests of the State and the nation is constantly sacrificed to that of some particular class of traders.”
Smith made a powerful case that government promotion of trade and government restriction of trade was unwise and harmful. He fundamentally changed the analysis of trade policy and essentially established the presumption that free trade was the best policy unless some other considerations overrode that presumption. Smith was writing at the time of the Enlightenment, and his writings in the economic sphere had as strong an impact as the writings of Voltaire and Hume in other realms of thought.
The case for free trade was reinforced by the classical economists writing in the first quarter of the nineteenth century. The theory of comparative advantage emerged during this period and strengthened our understanding of the nature of trade and its benefits. David Ricardo has received most of the credit for developing this important theory (in chapter 7 of his Principles of Political Economy, 1817), although James Mill and Robert Torrens had similar ideas around the same time.
The theory of comparative advantage suggests that a country export goods in which its relative cost advantage, and not their absolute cost advantage, is greatest in comparison to other countries. Suppose that the United States can produce both shirts and automobiles more efficiently than Mexico. But if it can produce shirts twice as efficiently as Mexico and can produce automobiles three times more efficiently than Mexico, the United States has an absolute productive advantage over Mexico in both goods but a relative advantage in producing automobiles. In this case, the United States might export automobiles in exchange for imports of shirts—even though it can produce shirts more efficiently than Mexico.
The practical import of the doctrine is that a country may export a good even if a foreign country could produce it more efficiently if that is where its relative advantage lies; similarly, a country may import a good even if it could produce that good more efficiently than the country from which it is importing the good. From Mexico’s standpoint, it lacks an absolute productive advantage in either commodity, but has a relative advantage in producing shirts (where its relative disadvantage is least). This trade is beneficial for both the United States and Mexico.
The comparative advantage proposition is incredibly counterintuitive: it states that a less developed country that lacks an absolute advantage in any good can still engage in mutually beneficial trade, and that an advanced country whose domestic industries are more efficient than those in any other country can still benefit from trade even as some of its industries facing intense import competition.
As developed by Adam Smith and the classical economists, the theory of international trade is an enormously powerful one due to its generality. Just like trade between citizens within a nation’s borders, international trade was an efficient mechanism for allocating resources and for increasing national welfare, regardless of the level of a country’s economic development. Any impediments to trade would detract from the gains from trade and therefore harm the economy. Smith and the classical economists made a powerful case for liberalizing trade from government restrictions (such as import tariffs and quotas) and moving toward free trade.
At the same time, these economists recognized that there may be situations in which a government might wish to sacrifice economic gains for some other political objective. There might be non-economic objectives that are so desirable that they are worth incurring economic losses. For example, Adam Smith argued that the British Navigation Acts, which restricted trade but promoted British shipping, were worthwhile.
Theoretical Challenges to Free Trade
Though the benefits of free trade achieved nearly universal assent among the leading economic thinkers by the early nineteenth century, these same economists and those of later generations probed instances in which there might be economic gains from deviating from free trade.
One case, proposed by John Stuart Mill in his Principles of Political Economy (1848), is that of promoting “infant industries.” In that book he stated:
“The only case in which, on mere principles of political economy, protecting duties can be defensible, is when they are imposed temporarily (especially in a young and rising nation) in hopes of naturalizing a foreign industry, in itself perfectly suitable to the circumstances of the country. The superiority of one country over another in a branch of production, often arises only from having begun it sooner. There may be no inherent advantage on one part, or disadvantage on the other, but only a present superiority of acquired skill and experience. . . . A protecting duty, continued for a reasonable time, might sometimes be the least inconvenient mode in which the nation can tax itself for the support of such an experiment. But it is essential that the protection should be confined to cases in which there is good ground of assurance that the industry which it fosters will after a time be able to dispense with it; nor should the domestic producers ever be allowed to expect that it will be continued to them beyond the time necessary for a fair trial of what they are capable of accomplishing.” (Book V, Chapter X.)
Although the infant industry argument did not originate with Mill, his recommendation gave it intellectual credibility but also generated intense controversy among economists. There was and is great skepticism about whether trade restrictions provide new industries with the proper incentives to acquire productive knowledge that will reduce their costs. In addition, economists were skeptical about whether governments could correctly identify “infant” industries and distinguish those that stood a chance of growing up from those that were destined to remain infants. Economists were also worried that protection would not be temporary, but would become permanent.
Another case for deviating from free trade, the “terms of trade” argument, deals with the ratio (i.e., the prices) at which countries exchanges exports for imports. The terms of trade are determined by international supply and demand, but those underlying factors could be manipulated by government policy to the benefit of one country. In the 1840s, Robert Torrens—one of the originators of the theory of comparative advantage—argued that reciprocity, not free trade, was the wisest trade policy because a unilateral tariff reduction would lead to a deterioration in the terms of trade. His argument was greeted with great skepticism until John Stuart Mill, in an essay in his book Essays on Some Unsettled Questions of Political Economy (1844), developed the theory of reciprocal demand and essentially showed that Torrens was right. Countries that possess the power to affect the prices of goods on the international market may find it advantageous to restrict trade.
For example, the Organization of Petroleum Exporting Countries (OPEC) restricts the exports of oil in order to drive up its price on world markets, thereby improving its terms of trade (the price of its exports relative to its imports) and enriching itself at the expense of other consuming nations. As this example indicates, trade restrictions that improve one country’s terms of trade necessarily imply that those terms deteriorate for other countries; the gain of the restricting countries comes at the expense of others. Indeed, the losses of the other countries exceed the gains so, for the world as a whole, free trade is still desirable. But this argument made clear that the distribution of the gains from trade across countries can be affected by tariffs.
Other, more technical challenges have focused on the possible benefits of deviating from free trade when markets do not function perfectly due to externalities, such that the first-best optimal policies cannot be imposed and trade policies might be a second-best policy, or when there are strategic interactions among firms that generate rents that can be shifted with trade interventions. In most of these cases, however, the case against free trade depends upon special and highly uncertain conditions. In addition, such arguments for government intervention have been countered with three arguments. First, governments generally lack the ability to identify externalities and rents and, even if they could, even then determining the optimal type and amount of intervention is exceedingly difficult. Second, even if a rationale for intervention existed and the government capable of imposing the optimal policy, actual policies are not determined in a scientific manner but result from the pressure of self-serving special interests. The interventions would therefore tend to serve private and not public interests, to the detriment of the economy. Third, an optimally-imposed intervention might engender retaliation by foreign countries that would erase any gains from that intervention.
For centuries, trade policy has the subject of intense and spirited debates. Since the beginning of trade between nations, that trade has brought general economic benefits but has also harmed specific domestic interest groups. Even during periods of economic growth, one hears complaints from some domestic firms about the damaging effects of foreign competition on their industry. Economic analysis has provided a systematic framework for examining the underlying issues of international trade. Economics provides a way of distinguishing the self-interested claims that trade is harmful to some groups from other arguments that certain trade policies might benefit the nation as a whole.
Although economists have consistently stressed the overall gains from international trade, and in recent years have stressed the measurement of those gains, the debate over trade policy is a never ending one. When it comes to free trade, as Adam Smith once opined, “Not only the prejudices of the public, but what is much more unconquerable, the private interests of many individuals, irresistibly oppose it.” (Book IV, Chapter 2.)
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*Douglas Irwin is professor of economics at Dartmouth College and a Research Associate at the National Bureau of Economic Research. He is author of Free Trade Under Fire (Princeton University Press, 2002) and Against the Tide: An Intellectual History of Free Trade (Princeton, 1996). His website is at http://www.dartmouth.edu/˜dirwin.
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