The WTO's Free Trade Philosophy

Criticisms of the WTO - Should be read first.

Introduction And Summary

Free trade (or at least very low tariffs) is the very heart of the WTO’s philosophy. Free trade means more than just no tariffs, it also means no indirect obstacles to trade hence the WTO is also in favour of deregulation and liberalisation at least where it relates to trade. Whether it shares the strong preference for market-based solutions (or even laissez faire) of the so-called ‘Washington Consensus’ in general is a moot question. It is also not that important since the WTO’s main concern is with trade and it is to this area we will confine ourselves.

Question 1: What is free trade? How does it relate to liberalisation and deregulation? In theory should it be good or bad and for whom?

Question 2: What have been the practical effects of free trade and liberalisation/deregulation policies

Question 3: In particular how do the above questions relate to the question of developing countries?

The main conclusions reached are:

• Theoretically there are very good reasons to support free trade for both developed and developing countries.
• The empirical evidence does give limited support to the view that greater openness is good for developing countries. Controlling imports through tariffs is not a good idea. However government intervention in some forms may be beneficial (though it is very hard on the basis of the available evidence to reach any firm conclusions).
• Hence the WTO’s advocacy of free trade is compatible with its support of development from both a theoretical and empirical perspective. Finally I should add, that in a summary as brief as this, it is impossible to do justice to the complex issues in this area and the arguments surrounding them. Preferentially this article should be considered as an invitation to further reading, for example that containted in the references section.

The Economics of Trade

Why trade at all?

There are the following reasons:

1. If relative prices of goods differ between (two) countries in the abscence of trade both countries can realise welfare gains by trading goods (at an intermediate price ratio). Note the ‘relative’. It does not matter if in one country the cost of all goods is ten times the cost of the same goods abroad the country will still gain from trade. Welfare gains in this context mean increase in total utility value for a country (normally considered as an increasing function of consumption). The following give rise to differing relative prices:

• Differing resource endowments between countries
• Differing tastes between countries
• Differing factor (labour and capital) endowments between countries
• [Comparative Advantage Argument] Differing opportunity costs between countries would lead to differing relative prices between countries. Opportunity costs measure the relative time it takes to produce a unit of different goods (they measure the amount of one good (opportunity) foregone if the other is produced). Thus if it takes 1 hour to produce 1 unit of wheat and 4 hours to produce 1 unit of cloth then the opportunity cost of cloth in terms of wheat is 4 (for each unit of cloth produced one has given up 4 units of wheat).

2. Specialization. Countries can specialize in producing the good they are best (i.e. have the greatest comparative advantage) in. Production then benefits from the economies of scale deriving from the greater aggregrate demand on the world market.
3. International trade allows a country to learn from the rest of the world about both new technologies and new market possibilites abroad.

The Argument for Free Trade

Having established the benefits of trade we now turn to the arguments for free trade (for a definition of free trade see footnote 1¹). [3] summarizes them as follows:

1. The conventionally measured costs of deviating from free trade are large.
2. There are other benefits from free trade that add to the costs of protectionist policies.
3. Any attempt to pursue sophisticated deviations from free trade will be subverted by the political process

Elaborating on these points:

A and B: This the Efficiency Case for Free Trade. All the gains of trade discussed above either only exist or are maximized in the free trade case. Moreover these gains essentially derive from efficiency improvements of some kind or another (In the case of point 1 it was the reallocation of resources (of all kinds: labour, commodities, capital) in a more efficient manner (trading at the intermediate price ratio). In the case of point 2 it was that trade leads to a bigger market and thus more efficient larger scale production. Point 3 similarly.) C: ‘A Political Argument for Free Trade reflects the fact that a political commitment to free trade may be a good idea in practice even though there may be better policies in principle. . . . Economists can sometimes show that in theory a selective set of tariffs and export subsidies could increase national welfare, but in reality any government agency attempting to pursue a sophisticated program of intervention in trade would probably be captured by interest groups and converted into a device for redistributing income to politically influential sectors. If this argument is correct, it may be better to advocate free trade without exceptions, even though on purely economic grounds free trade may not always be the best conceivable policy.’ [3, p. 221].

What objections, if any, are there?

• Terms of Trade Argument: If a country is large enough (to influence world markets) then the judicious use of tariffs can actually raise welfare by positively affecting the country’s terms of trade (NB. if a country is small and does not have much effect on world markets then tariffs will have an unambiguously negative effect on the country’s overall welfare). However even in this circumstance overall world welfare will have dropped and other countries will have been negatively affected. Hence the argument against this kind of protectionism is that it must be asymmetric (and unfair). If other countries in retaliation were to impose their own tariffs then there would be no gains even to the large country and world welfare would have dropped even further. Hence this system would only work if other countries were prevented from imposing their own tariffs or somehow deceived by the large country.
• Domestic Market Failure Argument: the analysis used to show gains from trade in point 1 above fails to adequately measure cost and benefits. In particular because of domestic market failures there are gains deriving from production that are not taken into account in this analysis and thus protection of this area of production would be justified. This argument is advocating using trade policy (i.e. interfering with external economic relations) to correct an internal problem and that is its weakness. For why would it not be better to correct this failure of the domestic market by domestic actions (e.g. a subsidy) rather than interference with trade policy particularly as the former allows a much more accurate targeting of the problem than the latter (imposing tariffs may well have repercussion far outside the intended industry). (See [3, pps. 225-9] for a more detailed discussion) Thus there is a strong case for free trade. But note one very important fact about argument 1: it deals with the instantaneous effects. In particular it tells us only what happens right now if we trade. The price levels at which goods are traded is determined by immediate present factors (in particular opportunity costs which derive from factor endowments and technology). These price levels on the international market determine what are called a country’s terms of trade (that is the relation between the prices of what a country exports and imports) and what none of the previous discussion deals with is long term changes in a country’s terms of trade. The point in is simplest form (and for two countries) is that a) there may be a benefit in producing a particular good or goods over the long run (for example manufactures over commodities) i.e. terms of trade will change over the long term and so b) a country should make an attempt to change its production pattern even though this will mean not following the course advocated by static comparative advantage or similar. Point a) in various forms (e.g. Prebisch-Singer - see below) is the basic motivation of development economics since if a country were able to get rich just as a commodity producer what need would there be to industrialize. This crucial area of terms of trade and development will be dealt with in the next section.

An excellent discussion of the objections to free trade both present and past can be found in [7] (see References).

As an endnote to this section, I include a brief discussion of some of the ‘non-economic’ reasoning that relates to the free trade/protection debate (and also some explanations of why people have, despite its supposed benefits, opposed free trade and supported protectionism).

• Many countries are unhappy to be totally dependent on imports for certain goods, usually for reasons of national security, example being basic foodstuffs and military equipment.
• Straightforward misunderstanding. Many see trade as a zero sum game which is not the case. Others either ignorant or unconvinced by comparative advantage arguments make statements such as ‘if the US produces everything more cheaply than [say] France then France will have no industry and it will just import everything from the US . . ‘. These points (unless followed by some quite serious economic argument) are simply and plainly wrong and indicate economic illiteracy on the part of the person making them.
• Closely allied to this first point is straightforward nationalism/patriotism of the kind: ‘I’m a true X therefore I drive an X car’ [substitute American/British Person/Frenchman or woman/German/Japanese etc. for X] but which again tends to derive from a viewpoint of trade as a zero sum game and little understanding of comparative advantage.
• In previous eras tariff taxation has been a major source of revenue to government when other forms of revenenue were difficult to collect. For example while today customs revenues are only 1% of the US federal budget in 1821 they formed 89%.([1] p. 221)
• When there is a move from protectionism (or autarky) to free trade there are always losers as well as winners. It is the fact that there are overall welfare gains if the winners compensate the losers, i.e. in a crude sense winners win more than losers lose (this shows that free trade is pareto efficient while protectionism is not) . Thus, by having some redistributive system it would be possible to ensure that all gained from free trade. However in the real world this is rarely what happens: apart from the practical difficulty of calculating the gains and losses accruing to each individual there are the almost insurmountable political difficulties, not only do losers complain much more than winners are satisfied but there is the basic fact that even in democracies well organised special interest groups often gain at the expense of the majority. [This is a problem of all large complex societies: the difficulty of organizing a group to secure benfits that are a collective gain to the group.²] If losers are not compensated it is not so clear that there are overall welfare gains, in fact it is possible that there are losses (depending on how the gains and losses from free trade are distributed). However as in most cases the average consumer is among the gainers from free trade and there are some forms of redistribution (the tax system) it is likely that much of the time there are overall welfare gains.

Development and the Terms of Trade

As already mentioned while the argument for free trade presented above are entirely valid over a very short period they have the crucial defect of not addressing the long term, in particular long term trends in the terms of trade and uncertainty.

1. Uncertainty: Suppose (in a simple case) that a country specialized in producing only the one commodity in which it enjoyed a comparative advantage. At the time this might lead to increased welfare but the situation is rather akin to the market goer who puts all his/her eggs in one basket. What happens if suddenly due to some new invention (or other new development) this good becomes obsolete or tastes change and demand falls precipitously? The country might well be in severe trouble particularly if making other goods required substantial experience and investment. Thus the uncertain nature of the future would suggest to the prudent that some degree of diversification was called for.
2. Terms of Trade: The main argument relating to terms of trade is called the Prebisch-Singer hypothesis and consists of two linked propositions³:
3. There is a long-term secular decline in the price of commodities in terms of manufactures. As LDCs mainly produced commodities rather than manufactures this would result in an ever growing gap between rich and poor countries. Thus LDCs must develop a manufacturing sector.
4. LDCs would only develop a manufacturing sector with the (temporary) assistance of protective tariffs for their infant industries.

Discussion:

1. Is this actually an argument for protectionism? It might be important to develop other industries but it does not follow that this would require tariffs or the like. Thus this is only an argument for protectionism if II.2 holds and so this point can be subsumed into II.
2. We can address each of the points seperately.
3. [2] contains a lengthy discussion of this point (decline in commodities relative to manufactures) and is also a comprehensive guide to the literature. There has now been an intense debate among econometricians for over 20 years and it still remains open. The best summary is probably that there is some evidence in support of it BUT the trend is not as strong as was once thought and perhaps does not exist at all (rather there is one or more structural breaks particularly in 1921.) It is also unclear how the fate of LDCs relate to commodity prices, since some LDCs actually import commodities (and most import oil). Despite all of this many (economists included) would agree that development does entail diversification of production outside of commodity production (perhaps because of questions of national power?). The main question then becomes: what is the best way to develop, i.e. to diversify out of commodity production? Hence we are led to 2.
4. The method of industrializing advocated by Prebisch involving the building up of a domestic manufacturing industry behind tariff barriers is known as Import Substitution Industrialization (ISI). While this model was massively influential from the 1950s to the 1970s in recent times it has been seriously criticized both empirically and theoretically⁴. First I will discuss the theory and then the evidence.

Theoretical: There are two seperate points of contention:

1. Why do infant industries need any assistance or intervention? If an industry is going to earn enough future returns for the various factors of production to make it worthwhile to promote it in the first place why would it not be funded by private investors? The only answer can be that there is some kind of market failure. Hence to justify any kind of intervention (ISI or otherwise) it is necessary first to show the existence of such a failure. The two most cited failures are: imperfect capital markets, and positive social externalities (i.e. benefits not captured by the entity responsible for them). Imperfect capital markets refers to the problem that a developing country does not have the financial institutions necessary to ‘allow savings from traditional sectors to be used to finance investment in new sectors (such as manufacturing). Thus growth in these new industries will be restricted by the ability of firms in these industries to earn current profits and hence low initial profits will be an obstacle to investment even if the long-term returns on this investment is high.’ [3, 257] Positive social externalities refers to the fact that firms in a new industry generate social benefits for which they are not compensated (e.g. opening up new markets, adapting technology, training labour). If these positive externalities exceeded the costs of creating the new industry then intervention would be justified since otherwise there might not be any private entrepreneur willing to enter. Note finally that even if there are market failures the case for intervention is not clear cut. In practice it may be difficult to evaluate which industries need protection and how much. Also there is always the problem that a policy designed to promote development will be captured by special interests or have unintended negative consequences in some other area.

2. Suppose now that there is a case for intervention. The question still remains: why ISI? First off we could try correcting the market failures directly (develop banks and capital markets; direct compensation to infant industries related to the social externalities). However this is often difficult to do so it is plausible that we turn to a second-best option like ISI. But there is still a choice: import substitution or export-oriented industrialization.⁵ The export-oriented model (EOM) as its name suggests involves fewer restrictions on imports and instead the promotion in various ways (subsidy, tax breaks, indirect trade assistance e.g. advertising etc) of exports. It was also believed (though perhaps incorrectly) that the export-oriented model would involve less government involvement. An obvious benefit of the EOM was that it would not necessitate interference with free trade nearly as much as ISI and would gain the benefits of openness lost under ISI (these being those mentioned in previous section as among the benefits of trade e.g. larger potential market permitting greater scale of manufacturing; more contact with other technologies etc). Empirical: All of these theoretical objections came second to the empirical criticisms of ISI. The following list of problems that were becoming apparent by the early 1970s is taken from [5] p. 919.

3. Much of the world was experiencing a boom or remarkable proportions in growth and output and especially of international trade [during the 1950s and 60s]. . . . The main effect of these boom decades was to undermine the argument that developing countries could not export.

4. Economic agents at all levels turned out to be more responsive to price incentives than was thought to be the case at the beginning of the 1950s.

5. [The] Physical planning [that was necessary in the ISI model] was not preventing bottlenecks and misallocations. 4. Imports rose faster than expected [these being the intermediate goods needed to support the infant industries], and hence balance of payments problems were widespread, and ‘economic independence’ was even lower than before 1940.

6. The work of Abramowitz, Kuznets, Denison, and Solow on the sources of growth made it increasingly clear that simply more physical capital was not sufficient for sustained growth. The productivity of resources had to increase if growth was to be maintained.

7. The transfer of technological, administrative, and marketing knowledge was proving to be much more complex than was expected in the early 1950s. With fixed production coefficients and imported physical capital, it was difficult to see why productivity could be lower in one country than another, and why it would not grow equally fast in all countries. The term ‘infant industry’ implied that simply getting older and larger would result in increased productivity, but this was not happening.

8. Items 5. and 6. provided strong evidence that indigenous learning processes generally were not emerging in the IS countries. The (implicit) assumption that simply changing the structure of an economy would also change its capacity to learn and to accumalate knowledge was evidently incorrect. The task was much more complex.

9. [p. 923] By 1970 or so it was also clear that government policies [in developing countries] were themselves the source of many of the distortions and other market failures [rather than the solution.] The idea of the government correcting market failures then seemed illogical. There was increasing evidence that import licenses, investment permits, government contracts, and similar devices created lucrative rents for those fortunate enough to obtain them. . . Costs of rent seeking plus the costs of distortions themselves, plus the limited ability of most bureaucracies to design, administer, and implement sensible plans an controls, offered strong evidence that the government was part of the problem rather than part of the solution.

The most important empirical fact from the 1970s onwards was the growing evidence that countries following an export-oriented and/or liberalized route showed better growth rates than those following an ISI route. This whole topicis extensively discussed in [5] and [4] and I recommend the reader to look there. Ther result was that by the mid-to-late 1980s the new orthodoxy was outward orientation (EOM particularly) and minimal government. Interestingly in recent times this viewpoint has itself been seriously undermined.⁶ While there is still much debate of the role of trade and industrial policy in fostering growth and industrialization there is a growing consensus that regards these as only two (and not necessarily the most important) among many factors. For example: - Social factors such as high savings rate, education levels, and nature of prior history under a colonial power are cited as highly significant. - Rodrik in [6] emphasizes the importance of the ability to deal with conflict and the societal strains imposed by external shocks: ‘It was the ability to manage the domestic social conflicts triggered by the turbulence of the world economy in the 1970s that made the difference between continued growth and collapse.’ (Rodrik is also unusual in still being rather pro-ISI). - Bruton states: ‘The arguments of this paper are built around the notion that the primary sources of development are learning and knowledge accumalation.’ [5] p. 903.⁷ ‘Import substitution and outward orientation offered easy solutions to the development problems. Import substitution as implemented failed, and the justifications for outward orientation (as usually presented) are being increasingly undermined. The findings reviewed in this paper suggest strongly that no quick and easy fixes to development problems are available. To accept learning and knowledge accumalation both as the bottom line of growth and as roots deep in the ehtos and history of a society requires that explanation and policy prescription probe these areas that are so alien to mainstream thinking.’ [5] p. 933.

Conclusion

• The ISI model has been seriously discredited both theoretically and empirically since its heyday in the 1950s and 60s.
• There are good reasons to believe that correction of market failures and other intervention in the domestic economy should be carried out by other means than trade policy. Even if intervention in trade policy is desired protectionist measures are not the best option. Thus at most mild deviations from a free trade regime are a good idea.
• Liberalization and free trade are not necessarily the same. Free trade will involve some degree of deregulation and liberalization. However often liberalization is used to mean a much more extensive reduction of the government’s role in the economy (and as such derives from minimal government and/or laissez faire philosophies). Such forms of strong liberalization while often associated to free trade are not a necessary concominant. One can have free trade and at the same time have significant amounts of government intervention in the domestic economy. Whether such government intervention is beneficial is unclear, particularly in the case of developing countries, and obviously depends greatly on the nature of the state and government in that country.
• Thus the WTO’s advocacy of free trade is compatible with its support of development from both a theoretical and empirical perspective. Its support of liberalization, however, is more controversial.. The WTO should not consider its support of free trade in developing countries as actually promoting growth as the importance of openness and free trade to development are not necessarily that great.

References

[1] World Trade And Payments: An Introduction; Richard E. Caves, Jeffrey A. Frankel, Ronald W. Jones; (8th Edition Addison Wesley 1999). [2] Prebisch-Singer Redux; John T. Cuddington, Rodney Ludema, and Shamila A Jayasuriya (Georgetown University); Draft January 2002. See documents page [3] International Economics: Theory and Policy; Paul R. Krugman, Maurice Obstfeld; (Intl 5th Edition Addison Wesley 2000). [4] Openness, Trade Liberalization, and Growth in Developing Countries; Sebastian Edwards; Journal of Economic Literature, Vol. 31, No. 3, Sep., 1993, pps. 1358-1393. See documents page [5] A Reconsideration of Import Substitution; Henry J. Bruton; Journal of Economic Literature, Vol. 36, No. 2, Jun., 1998, pps. 903-936. See documents page [6] Globalization, Social Conflict and Economic Growth; Dani Rodrik; Dec. 1997; The 1997 Raul Prebisch lecture delivered at UNCTAD (published in The World Economy, March 1998). See documents page [7] Free Trade: Old and New Challenges; Jagdish Bhagwati; The Economic Journal, Vol. 104, No. 423. (Mar., 1994), pp. 231-246. See documents page

Created: 16-Jan-2002
Last Updated: 02-Apr-2002
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