Free Trade

I FREE TRADE

Free Trade, interchange of commodities across political boundaries without restrictions such as tariffs, quotas, or foreign exchange controls. This economic policy contrasts with protectionist policies that use trade restrictions to protect or stimulate domestic industries. See Tariff; Tariffs, United States.

II EARLY TRADE DOCTRINES

Foreign trade doctrines began to develop during the 1400s. One early form of economic policy, known as mercantilism, dominated Western Europe from about 1500 to about 1800. Supporters of this policy worked to promote national unity and to increase the strength of the nation-state. They considered wealth a necessary condition of power, and the accumulation of gold and silver specie, or coins, a necessary condition of wealth. Countries without gold or silver mines acquired specie by maintaining a surplus of exports over imports through strict governmental control of foreign trade.

A reaction against such control occurred in France in the 1700s. This led to the formulation of the first theory of free trade by a group of economic philosophers known as the physiocrats, who were followers of the French economist François Quesnay. The physiocrats maintained that the free movement of goods was in accordance with the principles of natural liberty. Although their ideas had little effect in France, they influenced the British economist Adam Smith, whose free trade theories contributed to the later development of trade policy in Britain.

Smith refuted the protectionist conclusions of mercantilist thought. He pointed out that wealth consisted not in specie itself but in the material that specie could purchase. Governmental regulation of trade actually reduced the wealth of nations, because it prevented them from purchasing the maximum amount of commodities at the lowest possible price. With free trade, each nation could increase its wealth by exporting the goods it produced most cheaply and importing goods that were produced cheaper elsewhere.

According to Smith, each country would specialize in the production and export of goods in which it had an absolute advantage—that is, it could produce the goods more cheaply than any of its trading partners. Another British economist, David Ricardo, extended that analysis early in the 19th century to encompass the more general case of comparative advantage. Ricardo noted that some nations lack an absolute advantage in the production of any commodity.

However, even these nations could gain from free trade if they concentrated on producing commodities in which they had the smallest disadvantage. This enables the nation to trade goods that are easiest to produce for goods that are more difficult to produce. When nations practice the principle of comparative advantage, more goods are produced between the trading countries, and the wealth of both countries increases. The principle of comparative advantage forms the theoretical basis of the argument for free trade.

Ricardo assumed that all nations would share in the gains from free trade. The British philosopher and economist John Stuart Mill later demonstrated that such gains depend on the strength of reciprocal demand for imports and exports. The stronger the demand for the exports of a country relative to its demand for imports, the greater its gain from free trade. The gain would be reflected in an improvement in the international terms of trade for the country, as expressed by the ratio of its export prices to its import prices.

III MODERN TRADE THEORY

The classical theory of trade developed by Smith, Ricardo, and Mill was concerned primarily with the analysis of the gains from trade. Modern trade theory, by contrast, takes the principle of comparative advantage for granted. It is mainly concerned with the analysis of the basis for trade and with accounting for differences in comparative advantage.

Classical theorists assumed that differences in comparative advantage resulted from differences in the productivity of resources, reflecting the unequal distribution of technologies and labor skills among nations. A more complete explanation was offered by several 20th-century economists, who noted that differences in the prices of final goods tend to reflect differences in the prices of resources used to produce the goods, and that these differences reflect differences in the availability of the resources. Countries specialize in the production and export of goods requiring relatively large amounts of those resources that they possess in abundance, and they import goods requiring relatively large amounts of resources that are scarce within their borders.

IV ARGUMENTS FOR PROTECTION

Despite the arguments of classical trade theory, few countries ever adopted a thoroughgoing policy of free trade. The major exception was Britain, which, from the 1840s until the 1930s, levied no import duties of any kind. The historical prevalence of protectionist policies reflects in part the strong influence of industries fearful of foreign competition, and in part the strength of various theoretical arguments for protection. Such arguments include the infant-industry argument, the national defense argument, the counter-dumping argument, and arguments focused on protecting domestic employment and income. Under appropriate circumstances all of these arguments have theoretical validity as well as limitations.

One of the oldest arguments for protection is the so-called infant-industry argument. According to this theory, when foreign competition is reduced or eliminated by import barriers, domestic industries can develop rapidly. After their development is complete, they should theoretically be able to hold their own in competition with industries of other nations, and protection should no longer be required. In practice, however, protection frequently cannot be removed, because the domestic industries never develop sufficient competitive strength. The limitation of the infant-industry argument is its inability to identify those industries that are capable of growing to genuine maturity.

The national defense argument for protection seeks to avoid dependence on foreign sources for supplies of essential materials or finished products that might be denied in time of war. The limitation of this argument is that identification of those industries indispensable for national defense is difficult.

A third instance in which protection is advocated is to counter dumping from abroad. Dumping occurs when products are made available as imports at prices lower than the prices prevailing in the exporting country. Protection may be justified in these circumstances, but only if the clear intention of foreign suppliers is to drive domestic suppliers out of business.

During periods of high unemployment, protection is often urged as a means of increasing employment. With imports reduced, demand for domestic substitutes will be stimulated, expanding production at home. Economists call this a “beggar-my-neighbor” policy: The improvement of employment at home is achieved entirely at the expense of employment elsewhere. The limitation of such a practice is that it invites retaliation from other nations suffering from similar problems of high unemployment.

Protection can be used to redistribute income either within nations or between nations. For example, if a nation finds that the demand for its exports is relatively strong, it can gain income at the expense of other countries by imposing tariffs or other import barriers. Foreigners will then find it more difficult to earn the income to pay for the exports they desire. Consequently, they will be forced to reduce their prices, thus improving the terms of trade for the protectionist nation. Like the employment argument, this method invites retaliation from abroad.

V RECENT DEVELOPMENTS

Since World War II ended in 1945 the leading trading nations have generally made a concerted effort to promote freer trade and remove protectionist barriers. In 1948 the General Agreement on Tariffs and Trade (GATT) went into effect. GATT was a treaty and international trade organization that worked to reduce or eliminate tariffs and other barriers to trade. GATT was originally signed by 23 nations, including the United States. A succession of trade “rounds” or negotiations significantly reduced tariffs on a large number of manufactured goods. In 1994 Canada, Mexico, and the United States took a major step toward removing trade barriers by ratifying the North American Free Trade Agreement (NAFTA).

Then in 1995 GATT was replaced by the World Trade Organization (WTO). By 2001, 142 nations were members of the WTO. The trade round that created the WTO further liberalized trade in manufactured goods and expanded the scope of the international trade agreement. The WTO began to reduce trade barriers and limit subsidies for agricultural products. It phased out protectionist measures for textiles and apparel, and it imposed limits on the ability of participating nations to enact or maintain nontariff trade barriers such as regulatory standards that discriminate against imports. The WTO also established a more effective system for adjudicating trade disputes.

Despite the apparent role of free trade in promoting strong economic growth during the 1990s, both NAFTA and the WTO proved highly controversial. Large and often violent demonstrations at a WTO meeting in Seattle, Washington, in 1999 revealed a substantial public backlash against trade liberalization in the United States. Many critics argued that free trade had led to reduced wages, job displacement, and harm to the environment. Many environmental organizations, for example, objected that domestic regulations to protect the environment could be overturned under the WTO if they were shown to restrict imports.