Free Trade - Policy and Outcomes

The view that free trade raises the wellbeing of economies is based on the theory of comparative advantage coined by economist David Ricardo in 1817. Ricardo believed that each country should focus its production efforts on those activities in which it has an advantage and import those products for which it does not. Arguments for free trade are that it increases employment and economic prosperity for all countries involved and facilitates new job growth.

Comparative advantage formed the basis for the transfer of labour intensive manufacturing to low wage countries. The 1994 creation of the North American Free Trade Agreement (NAFTA) between the US, Canada and Mexico was the largest free trade agreement in US history at the time. US President Bill Clinton predicted US exports to Mexico would generate a million American jobs over five years.

Over two decades from 1993 to 2013 merchandise traded between the three countries grew almost sixfold, from US$80 billion to US$459 billion. By 2011, US productivity had risen by over 170 percent but real wages grew only 16 percent over the same period. Similarly in Mexico, labour productivity rose by 76 percent between 1994 and 2011 but wage compensation declined by 20 percent over the same period.

As countries finalise the details on the Trans-Pacific Partnership, set to be the largest free trade agreement in history it is instructive to reflect on the outcomes of free trade.

The reality is that the policies of free trade based on Ricardo’s theory of comparative advantage are not that simple. Several factors mean that free trade benefits are greater for some countries than others.

Some Advantages Take Time

Some national and economic advantages take time to be realised. Some countries will become very wealthy from free trade in a short space of time where others may take longer. Domestic industry policies and both physical and institutional infrastructure are important factors. As some nations wealth grows faster by comparison they are able to develop economies of scale and expertise that puts other nations at an increasing disadvantage.

Free Trade is Not Equal for all Countries

Comparative advantage does not mean that all countries do equally well. It just means that countries should specialise in particular activities as best they can. Characteristics of geography, education, technology and skills will determine the extent to which an economy realises the benefits of free trade. A study by Hur and Park in 2012 showed a deeply significant difference in growth rates between countries in bilateral free trade agreements.

Political Power and Economic Power

Economic growth leads to growing political power. Disproportionate levels of political power can lead fast growing economies to influence slower growing nations to the extent that their comparative advantage diminishes further. This may not be overt. Maximising economic advantage makes some economies stronger than others in ways that can leave lesser economies at a significant disadvantage.

Free Trade Makes No Mention of Income Distribution

Theories of comparative advantage and free trade make no mention of how wealth is distributed within an economy itself. Policies around welfare and spending, the increasing concentration of economic activity and wealth in urban centres and rising income inequality all have major impacts on social and productivity issues. A 2014 study showed a strong relationship in falling economic growth due to rising income inequality in OECD nations.

History is showing that the combination of a low wage base with activist government policies designed to foster new industries extends this competitive advantage into more sophisticated industries. Andrew Jackson, Professor in Political Economy at Carleton University, describes how comparative advantage led Canada’s decision to specialise in exporting oil and resources rather than adopting industrial and trade policies designed to help industry restructure into higher-end manufacturing more resistant to low wage competition.

As global growth slows, we are currently seeing a renewed rise in nationalist, protectionist rhetoric in many parts of the developed world while global leaders champion the benefits of free trade. Fragmentation of political decision making in the US, UK, Australia and other western nations further complicates the ability to form a policy response to changing global economics and competition.

Economies and firms should indeed concentrate their efforts in those areas they can best compete and seek access to new markets. But as we can see, it’s just not that simple.

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