POST-GAZETTE - Res Publica

The Fraud of Free Trade

by David Trumbull -- October 26, 2012

Recently, a friend passed along an article, written by libertarian author Arthur E. Foulkes, illustrating "The Magic of Free Trade," as predicted by 19th century economist's David Ricardo's theory of comparative advantage. The illustration was simple and, on the face, compelling. He gave a classroom full of fifth graders randomly selected gifts of approximately equal value and told them they were free to trade gifts among themselves. Nearly all the kids made trades, so that what started as random gifts that gave some pleasure to each kid, ended with each child feeling he was better off, having traded until he got the gift he really wanted. Well, so far so good, but what happens when, as the author does, you try to transfer comparative advantage to international trade? The ideology breaks down when applied to the real world.

Free trade comparative advantage theory assumes a world like that fifth grade classroom, where all actors operate under the same rules and approach the trading system as roughly equal participants. That does not describe the real world, and that is why free trade, which is based on a good premise -- the free market --, fails to delivery mutual prosperity as promised. The premise of free trade is that individuals, acting in their own self-interest, will create a more prosperous economy with more opportunities for all once market-distorting government regulations are removed. In Ricardo's time the tariff was one of the main ways governments distorted trade. Hence, liberal (as the term was used at the time, now we call them conservative or libertarian) theorists attacked the tariff. The situation today is quite different.

Today all major trading countries impose many distortions on international trade, with tariffs being just one of many, and frequently the most significant, barrier to free trade. However many free traders fail to take into account these trade distorting policies and scream "protectionism" whenever the U.S. tries to craft a remedy to offset some of our trading partners' trade distorting actions. Here are some ways in which world trade, as practiced, differs from the comparative advantage theory's assumption of roughly equal players operating under the same rules.

1. Tax policy and international trading rules. Taxes, aside from the particular rate, can distort trade in many ways by favoring or disfavoring certain industries. Even more important, in international trade, is the method of taxation and how the World Trade Organization ("WTO") rules treat the different types of taxes. WTO rules prohibit, as a trade distorting policy, tax rebates or other payments to companies as incentives to export. However the WTO rules do make an exemption in the case of "indirect" taxes, such as the value-added tax ("VAT") that all of our trading partners use as their principle means of raising revenue. In practical terms what this means is that if you make widgets in the U.S. you pay all of your U.S. taxes and when you ship them to, say, Germany, you also pay Germany's 16% VAT. If you make the widgets in Germany you pay 16% VAT, which is rebated when you export, and if you export to the U.S. you pay no U.S. taxes. The result is the U.S. producer shipping to Germany pays full U.S. and German tax, while the producer in Germany who ships to the U.S. pays no tax. This is a trade distortion of considerably magnitude, but if you propose, as I do, to impose a U.S. tax to offset it (thus creating the "roughly equal partners playing under the same rules" world assumed by comparative advantage theory) I'll be branded a "protectionist" and lectured at on the theories of Adam Smith and David Ricardo.

2. Social legislation. In the U.S., through our democratic process, we enact laws and regulations that distort trade by forcing employers to abide by certain standards regarding labor conditions, environmental protection, and consumer safety. These are constraints that a profit-maximizing firm might, absent government interference, eschew. Whatever one thinks of any particular regulation -- too lax or too rigid -- collectively they express what Americans believe is the minimum acceptable level of conduct and forbid trade in domestic goods or services violating those standards. However, under WTO rules, the U.S. is severely circumscribed as to imposing any limitations on imports from other countries that have lower standards. It is true that some of our free trade agreements contain labor, environmental, and sanitary provisions, but even they are slight in many cases compared to U.S. rules. And such international standards as there are are denounced by "free traders" as trade distorting policies, rather than being recognized for what they are, attempts to create at least somewhat similar rules for the different players, again, a basic assumption of, not a derogation from, "comparative advantage" theory. In theory one could calculate the advantage lax rules confer on a trader and impose a countervailing "social" tariff. To the extent that we believe that our laws implement minimum humane standards, a good case could be made that we should do so. However, I admit that any such calculation of social tariff could be abused in a trade distorting way. Nevertheless, the recognition that a nation, such as the U.S., which bans slavery, is highly censorable when it imports the products of forced labor ought to be something we can discuss. But alas, we cannot, or at least without being called a "protectionist" who wants to take us back to the days of Smoot-Hawley (the high tariff of the 1930s).

3. Currency manipulation, government subsidies, and other trade distorting government actions. Mitt Romney has said, repeatedly, that as President, he will, on day one, label China a currency manipulator. "Sticks and stones" aside, the determination that China undervalues its currency to promote exports in a market distorting way will be meaningful only if followed up by imposition of a trade remedy, in the form of countervailing duty or quantative limits, to "level the playing field." But consider the case of vehicle tires. The U.S. International Trade Commission (hardly a protectionist body) found market disruption due to undervalued tires of Chinese origin and President Obama responded with temporarily increased tariffs. It was an action explicitly permitted under WTO rules and China's WTO accession agreement as a mechanism to counter China's trade distorting policies. Free traders, including some I otherwise respect, cried "protectionist!" Classical economics teaches that, overtime, government manipulation of the market will be too costly to maintain, but in the meantime such policies, while they increase our imports from China, do not promote "free trade." Quite the opposite, they are anti-free trade, if you understand "free trade" as freeing markets to compete in the absence of government-imposed distortions.

And that leads to my conclusion: Today's "free traders" do not believe in free trade. They believe in maximizing imports. They disagree with America's social legislation, but not having a majority to overturn our child labor laws, anti-pollution laws, and product safety laws, they seek to get around them by having us import everything from nations that lack such regulations. That's why for all their talk about the benefit to the American consumer of more cheap stuff, they say very little about foreign market openings for American goods. True free trade would be reciprocal. In fact, there are many world markets that U.S. companies would love to get into, but cannot due to tariff and non-tariff barriers. Free traders, if they really were free traders, would be complaining about those real foreign barriers to free trade. Instead all their complaints are about the U.S. imposing, or even contemplating imposing, some trade remedy, recognized under international law as an appropriate free trade-consistent, response to another nation's anti-free trade actions. "Free trade," as practiced in Washington, is one of the biggest frauds on the American people. It distresses me that many otherwise thoughtful conservatives have embraced this flawed ideology.