A Full-Throated Defense of Free Trade

Let me start off by saying this is not a political piece.  It is about economic history and how we got where we are in global trade.

Trade is inherently good, and a source of wealth for both sides of the deal.  For most of human history, very little trading took place.  There were no supermarkets, no malls, and no Amazon.  People largely grew their own food, made their own clothes, and built their own shelter.  Doing so took from sunrise to sunset.  Anything beyond rudimentary education was a luxury for all but the wealthiest.

Over the years, it became clear that some had a greater advantage in terms of particular skills, ingenuity, or access to natural resources.  Wealth could be created through specialization, being so good at one thing that a person could sell his surplus and use the money to buy the other necessities of life.  But few would have specialized if it was merely a breakeven proposition.  Businesses took on capital partners and borrowed money to expand because of the power of specialization.  Trade must be good, otherwise we would have remained on our own, making our own food, clothing, and shelter.  And that’s all we would have today rather than the abundance of products and services we now enjoy.

A country need not be the best at anything in order to benefit from trade.  In 1817, David Ricardo introduced the theory of comparative advantage to international economics.  A country could generate excess wealth (production) by trading items in which it is the least inefficient producer in order to free a more efficient country to use its limited labor and capital resources to focus on those items where it enjoys the greatest advantage.

There are also weaknesses to the theory of comparative advantage that wouldn’t have been known in Ricardo’s day.  Technological change means lower levels of labor are needed for production, and today’s labor-cost advantage for one producer will likely mean less in a few years when a more automated producer appears.  Another weakness is that intricate supply chains have blurred the clear distinctions between products that once existed.  A car might be assembled in Mexico, but the components come from all over the world.  However, rising complexity of production doesn’t undercut the theory of comparative advantage.

Despite Ricardo’s theory, until the 20th century most countries practiced a form of mercantilism, which can be summed up simply as “exports good, imports bad.”  In the short term, and applied narrowly, mercantilism is good for a national economy because it brings more money into the country than it sends out.  The country becomes wealthier, and that is obviously good.

Applied over a longer period of time and multinationally, mercantilism loses its appeal.  One-sided trade should cause the exporter’s currency to rise in value and the importer’s currency to fall.  Eventually an equilibrium will be found such that the former importer is now a more cost-effective producer when its products are purchased with the exporter’s expensive currency.  Mercantilism can also invite tit-for-tat responses from other countries, which can lead to protectionism and trade wars.

China’s admission into the World Trade Organization (WTO) in 2001 was a great turning point in global trade.  For China, it was another step toward joining the world community.  For the rest of the world, it meant the opportunity to sell to over 1 billion potential new customers.  China’s admission to the WTO included carefully-negotiated provisions around opening up market access, protecting intellectual property rights, and reducing the role of the Chinese government in industry.

Fast forward over 16 years and it is difficult to name Chinese industries that are truly open to foreign competition.  In many cases, foreign companies wishing to do business in China must find a local Chinese partner, with which it is expected or required to share its business secrets surrounding technology and manufacturing know-how.  So much for respecting intellectual property.  Many of the most competitive U.S. businesses have either been denied access to the Chinese market, forced to compete against government-sponsored “national champions,” or have mortgaged their intellectual property for access to China’s now-1.4 billion customers.

China engaged in reforms of many of its state-owned industries, but remains heavily involved in most areas of its economy.  State-owned banks seem to lend freely to industries deemed strategically important by the Chinese Communist Party.  The Party feels it cannot shut down seemingly bankrupt companies out of concern of social unrest from rising unemployment.  I doubt China’s “state capitalism” is what the WTO had in mind.  It is mercantilism by another name, and mercantilism results in global imbalances that cannot last.

In an otherwise free market, China’s currency would appreciate and it would lose its cost advantage.  This has not been allowed to happen.  The imbalances have continued to mount and world frustration is showing with the rise of nationalist parties and politicians around the world.  The U.S. has a $336 billion trade deficit with China, while the European Union’s deficit with China is about $225 billion.

Is the U.S. going to get into a trade war with China?  Some would argue that the trade war has been going on for many years already.  The U.S. and China recently listed products against which they would levy import tariffs.  Both sides will be poorer for the experience, although there will be individual winners and losers on each side of the Pacific.  But the current system couldn’t last either without further reforms. I don’t know what shape those reforms will take but am making a full-throated endorsement of free trade, with the self-correcting mechanisms that have allowed market capitalism to enrich those countries that have embraced it.

Scott D. Horsburgh, CFA