Free Trade and Protectionism

Free Trade and Protectionism

Why Most Economists are Wrong

Russell Trenholme

Preface

In this book, I carefully examine the central argument cited by economists for adopting free trade and for rejecting protectionist policies. This argument—the comparative advantage argument—is one of the most praised dogmas of orthodox economic theory. Yet a careful examination shows that it is deeply flawed and fails to refute protectionist policies. I also examine a number of arguments for protectionism offered by economists over the past two hundred years and demonstrate why much of the orthodox economic criticism of these arguments is unpersuasive. Finally, I consider research on developing Third World economies, and show how this research undermines the near-universal advocacy of free trade and related free market policies. A persistent theme is that the choice of economic policies is a matter of considering a variety of economic, social, political and cultural conditions that characterize a country at a particular time. General theory is a terrible guide to policy making.

Background

I began working on the book in 2004, long before the financial crisis of 2008 had appeared on the horizon. During late 2008, observers, particularly those on the left, proclaimed the end of capitalism and the emergence of a new era of government intervention in the economy. However, with the passage of time, panic has abated and the ideology of free enterprise capitalism has emerged largely unscathed. Economists retain their status as caretakers of the economy, counselors to the American President and to leaders of other advanced industrialized nations. Free trade continues to be nearly universally defended, although many of the accompanying doctrines of the “Washington Consensus”—deregulation, privatization, and fiscal austerity—have yet to recover their former status. Since this book is principally about free trade, and the theoretical and empirical evidence offered in support of it, I think it is just as relevant now as before the current economic crisis.

The book began as a byproduct of a larger project: a critical examination of modern economic theory. That project began out of a personal desire to understand “economic science,” an academic discipline whose practitioners have had a profound influence on the opinions of political leaders and educated members of the general public over the past several decades. It was apparent at the outset that the respect accorded economics and the trust in the policies advocated by many of its leading practitioners had little if anything to do with the arcane mathematical formalism of fundamental economic theory, which is unintelligible to almost anyone other than mathematically-trained students of economics. In fact, the respect accorded economics is similar to the respect accorded the natural sciences and its practitioners—well-known physicists, biologists, and chemists who hold prestigious university positions and win Nobel prizes for work that is incomprehensible to non-specialists.

Modern economic theory is a highly abstract, formalized version of a way of conceptualizing economic activities that emerged in the latter half of the nineteenth century. It borrowed analytical tools from early nineteenth century physics, in particular from the mathematical analysis known to physicists as “least action principles.” Initially this approach to economic theorizing was simply called “marginal analysis” in deference to one of the principal mathematical techniques it employs. Later, as it sought to claim continuity with the work of the earlier “classical” laissez-faire economists Smith, Bentham, and Ricardo, it came to be called “neoclassical economic theory.” In fact, the claims of continuity are highly misleading. Adam Smith, for example, provided an astute defense of policies that would benefit the economy of late eighteenth century, just before the radical changes that would occur with the industrial revolution. His analysis is filled with psychological insights and practical reflections that are completely absent from the formal models of neoclassical theory that emerged a hundred years later. For decades the new neoclassical theory competed with alternative conceptions such as historicism and institutionalism, but since the Second World War it has become so dominant in the United States and other industrialized countries that the descriptive label “neoclassical” has been dropped in most popular discussions, and it is usually referred to as “economic science.”

Once I began to study neoclassical economic theory, initial intellectual curiosity developed into skepticism and eventually into astonishment that a theory so clearly non-descriptive of real economic activities could have achieved the reputation and the influence it currently possesses. My negative conclusions about the validity of economics resulted from careful reading of economics text books and academic papers by prominent economists, and was strengthened through personal reflection on how poorly neoclassical economic theory described real business activities (pricing, production, and employment) as I knew them through my personal experience in operating a successful business for many years. Although I had limited academic training in economics, I did have a sufficient grasp of mathematics to understand most of the theoretical issues. Moreover, my training in the history and philosophy of science (I received a Ph.D. from Princeton in that field) provided the tools needed to think critically about scientific theorizing. I cannot claim anything approaching the level of knowledge of academically trained economists; however, the task I had set myself was limited to an investigation of the conceptual foundations of economics rather than a detailed study of the myriad applications of economic theory.

Neoclassical theory assumes that there are two types of economic agents, individuals (consumers) and firms (producers). Both are considered to be completely rational and in possession of full knowledge of prices and costs. According to the theory, individuals attempt to rationally maximize their “utility” by spending their incomes to purchase a preferred commodity basket of goods and services. Firms are conceived of as operating in a fully competitive market where each firm produces a product identical to that produced by competing firms. Firms attempt to maximize profits, but due to the nature of the competitive market, their profits are reduced to zero. There are never surpluses or shortages (economists say that competitive markets “clear” at an equilibrium price). This rigid and simplistic conceptual structure is quite alien to the pragmatic and nuanced analysis given by Adam Smith.

Economists often claim that economics is a “value-free positive science” like physics or chemistry. However, it is obvious that most economists are strong advocates for policies that (purportedly) move real economies in the direction of the idealized conceptual model described above. They claim that utility is simply a short-hand way of talking about (theoretically) observable individual preferences, and that individual utilities cannot be aggregated to yield any overall concept of general welfare—yet they constantly extol “free” markets as superior to regulated markets (because they produce greater general welfare). For economists welfare is explicitly linked to maximizing consumption. This largely explains the emphasis on economic growth—a concept missing from core neo-classical theory. I’ll discuss the conceptual structure of neo-classical theory in more detail in Chapter 2. However, it should be apparent at the outset that aside from the artificiality of the underlying conception, there is something very wrong with the fundamental assumption that the more we consume the better off we are. This assumption ignores what are known as “negative externalities,” negative effects of economic activities which are not captured in the basic model of production and consumption. The most salient example is global warming. The greater the level of production and consumption, at least using current technology, the greater the production of green-house gases with all their frightening effects. Although most of this book is concerned with strategies for economic development, the unfortunate reality is that in addition to concern for the economic welfare of a particular society, the negative externality of green-house gas emissions has to be incorporated into decisions regarding economic policies. I do not deal much with this issue in this book since the focus is on free trade and protectionism. But the obvious deficiencies of the fundamental conceptual model of neo-classical economic theory should make readers question the identification of welfare with consumption, an identification which explains the near-universal praise of economic growth by economists.

Free Trade and Globalization

After I became convinced of the falsity of the foundations of neoclassical economic theory, I went on to question the way it has been invoked to persuade voters and elected officials to support and implement policies of market deregulation, privatization, and other so-called “economic reforms.” Although empirical arguments are sometimes offered in support of these policies, the strongest and most commonly encountered arguments are theoretical, allegedly derived from fundamental “economic science.” I then came to realize that the controversy over “globalization” was closely associated with the merits of these same policies when applied internationally.

Free trade plays a central role in the debate over globalization. The principal argument in favor of free trade, the comparative advantage argument, is theoretical, although it relates to fundamental neoclassical theory only indirectly, as a corollary of the fundamental neoclassical belief in the self-regulating nature of markets. In fact, the comparative advantage argument predates neoclassical theory and is independent of it. It has attained a prestige among economists that is unique; and in part because of that prestige, free trade is more widely supported by economists than any other neoclassical doctrine. Even economists who have rejected key elements of neoclassical theory (notably John Maynard Keynes) have generally supported free trade. Because of the importance of the contemporary debate over free trade, and because the principal arguments in favor of globalization and free trade are conceptually simpler than arguments based on fundamental neoclassical theory, I thought it would be appropriate to write a short book on free trade and globalization directed towards non-economists. My ultimate goal was to supply some of the intellectual tools needed to counter “expert” support for free trade policies, and ideally to facilitate more intelligent discussion regarding the course economic development should take in various countries.

This book is far shorter and far more accessible than the larger work on neoclassical theory that I began several years ago. This is because the theoretical arguments for free trade, and related arguments against protectionism are a lot simpler—and much less technical—than arguments rooted in the highly complex and technical conceptual structure of foundational neoclassical theory. Moreover, the topics covered here are of greater practical importance since free trade and related free-market policies are being urged upon—or imposed upon—Third Worldcountries by the World Trade Organization, the World Bank, and the International Monetary Fund. It seems clear that, despite rising doubts, both the majority of citizens and political leaders of the advanced industrialized nations continue to believe that free trade is almost universally beneficial and we are helping Third Worldcountries by urging (or pressuring) them to adopt free trade and related free-market policies.[1]

In this book I argue that the intellectual backing for these policies, in particular for free trade, is based on numerous errors. It might be objected that the general reader is not interested in economic theory, only in the practical consequences of various policies. However, the primary interpreters of globalization are professional economists and economic journalists who are generally convinced of the fundamental truth of (neoclassical) economic theory and of the benefits of various free-market policies supported by that theory. Given this strong bias, it is obvious why these interpreters have so readily accepted and endorsed arguments and facts that support their convictions. And most educated readers in turn have come to accept the views of these “experts.” Nevertheless, I believe that those readers who take the trouble to read through the analysis presented here will, for the most part, come to the conclusion that many of these highly praised arguments are, in fact, invalid. If so, they will be far more skeptical of the policy recommendations of economists and economic journalists, and will assess the empirical evidence relevant to one or another trade policy far more critically.

Of course, there is already considerable intellectual opposition to free-market policies from both within and without the academic community. For example, a number of development economists who focus on the details of various development policies have become skeptical of the applicability of core neoclassical doctrines to developing economies, and many have rejected doctrinaire free trade and free-market policies. Even so, the views of these economists are invariably shaped by their training as professional economists. They typically believe that one or another formal variant of neoclassical theory will eventually provide the key for discovering the optimal strategy for economic development. I discuss material from some of these economists extensively later in this book, and interested readers will find that works by these economists provide a valuable supplement to the necessarily brief summaries given here.[2] Unfortunately, the dissenting opinions of these economists have had relatively little effect on public attitudes. First, because the dissenting economists offer a variety of complex and often conflicting critiques. Second, because most of the dissenting opinions are found only in textbooks and specialized papers that have far less influence on public opinion than the best-sellers authored by the proponents of free market development policies, including influential journalists such as Thomas Friedman who endorse the standard package of “economic reforms” as the key to economic success.

There is a great deal of populist opposition to free trade policies and to “globalization” conceived of as the implementation of these policies. Unfortunately, most of this opposition lacks intellectual foundation. As a result the intellectual high ground in the debate over free trade and globalization is ceded to economists and sympathetic journalists who typically deride opponents of free-market policies as ignorant fanatics or selfish special interests. The dominance of neoclassical economic theory within the most vocal and influential sector of the economics profession coupled with the prestige and political power the profession has achieved in recent decades has discouraged the development and dissemination of alternative analyses thereby depriving voters and politicians of the intellectual resources needed to fairly evaluate alternative policies. The impoverished intellectual opposition to free-market policies consists of largely outdated Marxist theory supplemented by populist appeals and, in a few cases, romantic nativist theories. This book attempts to provide an intellectual foundation for a thoughtful opposition to the usual package of “reforms” by commending an empirical approach that is far more sensitive to differences in culture, in resources, and other country-specific factors that relate to economic development.

I do not claim that there are not beneficiaries of free trade policy. Some economies, most notably early nineteenth century England, have benefitted. And multi-national corporations are major beneficiaries when they freely move capital investments in manufacturing from country to country seeking an absolute advantage. Producing an identical branded product for less (generally due to lower wage rates) and selling that product into an existing market for a price at or little below the former price is highly profitable. The focus of this book is on the overall welfare benefit for the inhabitants of a country and on the claims that free trade maximizes welfare in all participating countries. I think this view is incorrect on both theoretical and empirical grounds (despite some exceptions).

Organization of the Book

The chapters of this book are divided into three parts which may largely be read independently of one another. Part I provides a critique of globalization—as it is conceived of by free-market advocates. After a brief discussion of some of the different conceptions of globalization, I offer a detailed critique of a best-seller entitled Why Globalization Works, by Martin Wolff which may be skipped without affecting an understanding of the rest of the book.

In Chapter 2, I provide a brief non-technical account of neoclassical economic theory, including a discussion of the normative belief structure implicitly shared by almost all professional economists and by popular defenders of free trade. Part I is readily accessible to general readers who may have unreflectively accepted the usual “received wisdom” with respect to free-market “reforms” and the benefits of globalization.

Part II is more technical. In particular, the appendix to Chapter 3(a graphical discussion of the comparative advantage argument) is primary addressed to students of economics. Part II consists of two chapters, the first devoted to a detailed critique of the highly-praised “comparative advantage” argument which is generally presented as an irrefutable argument for free trade, and the second devoted to an analysis of arguments offered by economists over the past 150 years in support of various types of protectionism or managed trade. In that chapter I carefully analyze criticisms of these protectionist arguments offered by a leading economist and defender of free trade, Douglas Irwin, demonstrating just how weak many of these criticisms are. I conclude that the optimal trade policy for a country depends on specific economic, social, and cultural conditions and that free trade is only one among many options.