This Week in Geopolitics

Free Trade, Politics, and the Wealth of Nations

August 1, 2016

The controversy over the Trans-Pacific Partnership has escalated in the United States. At this point, both presidential candidates oppose it. Donald Trump appears to oppose most multinational agreements, including noneconomic ones. He believes that such treaties do more harm than good. According to some, it puts poor countries at a disadvantageat the mercy of multinational corporations.

Others say such treaties transfer jobs to low-wage countries, enriching multinational corporations and hurting workers. Interestingly, the Republican Party has aligned itself with those who demonstrate against globalism at every meeting of the G-20. It is interesting but not surprising, as the question of free trade has become a pivotal issue, transcending ideology.

Free Trade: Nice in Theory…

The argument that has increasingly dominated since World War II is that free trade (trade without tariffs or regulation) is superior to protectionism in principle. Bilateral and multilateral free trade agreements have proliferated since then. The issue is whether it is preferable pragmatically.

The argument for free trade was best made by David Ricardo in the early 19th century. At its heart was the theory of comparative advantages. It assumed that every nation had one product, or a group of products, in which it had some advantage over other countries. If that nation concentrated on its most valuable activity, it would maximize its revenue.

In addition, allowing others free access to your market will give you continual access to a wider variety of goods at lower prices. Therefore, opening your own market is beneficial, even when not reciprocated. In theory, this is a persuasive argument. The problem is reality.

The reality is that most nations, including the US, engaged in protectionist practices prior to World War II. Some were beneficial. Some were not. They were the rule in the 19th century and coincided with massive global economic growth. In the case of the US, the surge in the American economy after the Civil War catapulted it into the top tier of global economies, even surpassing the leading powers.

Some have said that the US would have surged further without tariffs, but that is unlikely. At most, they made no difference, and in all likelihood, they were critical to growth.

But What Happens in Practice?

The argument for free trade may be theoretically powerful, but it has several problems. First, in order to trade, you must make products that others need. If your markets aren’t protected, more advanced countries will constantly offer products at lower prices and better quality than your country can afford to produce at an early stage of development. As a result, you are unable to develop your own industry and will be unable to purchase even low-cost goods, thus perpetuating underdevelopment and poverty.

Early protectionist measures are required as a nation begins its industrial revolution… or else that revolution fails. The US practiced this in the 19th century. Germany practiced it in the 1950s. But free trade agreements emerging today lock out economies struggling to take off, and lock in advantages to established economies. This is the left-wing argument.

The (surprisingly) right-wing argument is that free trade doesn’t work when successful emerging economies like China take advantage of temporary low wages and their own formal or informal protectionism. In this case, lower wages can devastate important sectors of an advanced economy while keeping out exports that could compete in other sectors of the emerging economy. In other words, these developing countries use free trade to destroy some sectors of economies in advanced countries.

It is possible for both sides to be right. In the short run, free trade can devastate a particular economic segment. In the long run, this might be rectified, and on the whole, the wealth of nations might grow… but it might not grow equally. And time and the distribution of benefits pose a political problem.

Enter the Politicos

Politics is not meant to interfere with efficient economies, as many think. Classical economists like Ricardo or Adam Smith never used the term “economics” alone. They always spoke of political economy. This was not just loose terminology. Both understood that political agreements—such as creating corporations—make anything more than subsistence economies possible.

They also understood that a nation is not a homogenized whole and that growth by itself, without taking into account distribution, will fail. Smith made this point in The Theory of Moral Sentiments, a work that no one seems to read. The book approached the problem of economics from a different and necessary dimension than The Wealth of Nations.

Assume that free trade would create a 20% annual growth rate in a country but would devastate major sectors of the economy. The net worth of the nation would increase, but who would benefit from the growth?

Assume it is only certain sectors. Looking at aggregate numbers would indicate free trade is wonderful. Breaking down the aggregate numbers, you would find that from a political standpoint you have created two classes: beneficiaries and victims of free trade.

The free trader might say that’s just the way it goes, and losers are losers. The losers would say that the winners live in a fantasy world if they think that they will be permitted to maintain that situation.

People who believe that it is possible to pursue self-interest only in economic life make a fundamental mistake. Having established self-interest as a moral absolute, it is likely to spread to other dimensions of society, like politics.

In practice, this means that the outcome of this extreme model will be confiscatory taxes, redistribution of wealth, imposition of tariffs, and the like. The winner will say that he earned his wealth through his effort. The loser will say the winner earned it through stacking the deck. Those are irrelevant arguments.

More important is that both winner and loser will pursue their self-interest in the sphere that gives them the greatest advantage. Whatever your view of it, this is happening.

The Invisible Hand Takes Too Long

The long-run argument for free trade says that over time, the pain caused by free trade will lead to tremendous benefits that will be equitably distributed. This is a powerful case. The issue is this: how long is the long run? Assume that an industry moved to another country, eliminating jobs in one place and creating them in another lower-wage place. The wealth of the nation might increase.

However, the former employees in that industry might be devastated. Assume that it would take a generation for the benefits of increased national wealth to create new industries based on new inventions. While that is not a long time for a country, it is a very long time for an individual.

A 45-year-old who loses his job because an industry shifts may find that learning the skills needed for a new industry is impossibly expensive and takes too long. That worker may never be employed in a job that supports him as he had lived before. This creates a personal disaster that would affect large numbers of people. It is therefore a political problem.

The US practiced protectionism throughout the 19th century. It decided tariffs on two bases. One was economic: what industries should be protected in order to increase the wealth of the nation? The second was political: what are the political consequences of these decisions and the ensuing probability that the politicians making the decisions would get re-elected?

There is no answer to this in principle. Those supporting free trade don’t hesitate to demand that the government intervene when another country is said to cheat or to define free trade in ways that benefit them. Protectionists constantly shift their stance on what should be protected at any given time and to what degree.

The Bigger Picture: Anti-Globalism on the Rise

Leaving the philosophical question out of the discussion, as it is rarely a major factor anyway, each side approaches the question of free trade from the standpoint of their interests. They both use the state to shape the economic environment as they think best—which is almost always the situation in which they make the most money.

Therefore, leaving morals aside, the argument in favor of free trade in the US has shifted. Since World War II, the advocates of free trade have become increasingly powerful. Since 2008, the political balance between the free traders and the protectionists has shifted, supported by a significant sector of the population who believe that they have been hurt by intensifying free trade.

This sector is demanding an end to expanding free trade or a massive redefinition of its terms. The argument that on the whole it is beneficial has little impact on their competition. In the same way a CEO would oppose a shift in trade policy if it hurt his business, regardless of the national good, so too are individuals making the same decision.

The balance between free trade and protectionism has been a major political issue in the US since its founding. But now, free trade must demonstrate its worth, not simply assert it. The system is moving toward protectionism.

That will have significant effects, since the US makes up almost a quarter of the world’s economy. What it decides has disproportional effects on the world. Therefore, I would argue that the post-war trend toward free trade has reached its limits for this cycle. In other articles I have argued that the rise of nationalism is inevitable. This is merely the economic dimension of that rise.

George Friedman
George Friedman

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Simon Maughan 48114

Aug. 4, 2016, 5:50 a.m.

If I remember my economics correctly, an extension of Ricardo’s theory is that countries do not have to have an advantage over other countries in a particular area, just that they are relatively better at one thing than another. Thus the US may have superior capital and labour productivity to a developing nation, but the latter has a relative advantage in the supply of labour. Hence the US should focus on capital intensity at the expense of labour when trading with this country.

A multinational would therefore develop and design products in the US and manufacture them elsewhere, which is pretty much what happens.

For this to be sustainable it requires restraint on behalf of US labour and it is easy to see how this would create political strain. As George concludes, we may have reached a peak in free trade and globalisation.