Free trade

A South Korean shipping container approaching the Bay Bridge in San Francisco Bay.

See also: Free market
laissez-faire

In international trade, free trade is an idealized market model, often stated as a political objective, in which trade of goods and services between countries flows unhindered by government-imposed tariff and non-tariff barriers. Economic analysis and nearly all economists support the proposition that free trade is a net gain to both trading partners and that the gains from free trade outweigh the losses. It is opposed by anti-globalization and some labour campaigners due to a variety of perceived problems.

The term is given to economic policies, as well as political parties that support increases in such trade.

Free trade is a concept in economics and government, encompassing:

• International trade of goods without tariffs (taxes on imports) or other trade barriers (e.g., quotas on imports)
• International trade in services without tariffs or other trade barriers
• The absence of trade-distorting policies (such as taxes, subsidies, regulations or laws) that give domestic firms, households or factors of production an advantage over foreign ones

Related, but different concepts are:

• The free movement of labour between countries
• The free movement of capital between countries

For more detailed arguments in favor of and against free trade, see: Free trade debate.

History of free trade

The history of free trade is a history of international trade focusing on the development of open markets.

It is known that various prosperous world cultures throughout history have engaged in trade. Based on this, theoretical rationalizations as to why a policy of free trade would be beneficial to nations developed over time. These theories were developed in its academic modern sense from the commercial culture of England, and more broadly Europe, in the past five centuries. In opposition to free trade, a policy of mercantilism had developed in Europe in the 1500s and persists in various forms to this day. Early free trade theorists who were opposed to mercantilism were David Ricardo and Adam Smith. Free trade theorists offered trade as the reason why certain cultures prospered economically. Adam Smith, for example, pointed to increased trading as being the reason for the flourishing of not just Mediterranean cultures such as Egypt, Greece, and Rome, but also of Bengal (East India) and China.

Free trade policies have battled with mercantilist, protectionist, isolationist, communist, and other policies over the centuries. Wars, such as the Opium Wars and other colonial wars, have been fought primarily over trade.

All developed countries have used protectionism, but usually reduced it as they gained more wealth.

The Constitution of the United States explicitly prohibits state governments from enacting barriers to trade between citizens and firms of the various 50 states, making the United States the largest empirical example of free trade in the world.

Present day

Since World War II, the US has become one of the largest and most consistent proponent of reduced tariff barriers and free trade, having helped establish the General Agreement on Tariffs and Trade (GATT) and later the World Trade Organization (WTO). The US has negotiated numerous free trade agreements, such as the North American Free Trade Agreement (NAFTA), the Dominican Republic-Central America Free Trade Agreement (CAFTA), and a number of bilateral agreements (such as with Jordan).

Economics of free trade

The literature analyzing the economics of free trade is extremely rich with extensive work having been done on the theoretical and empirical effects. Though it creates winners and losers, the broad consensus among members of the economics profession in the U.S. is that free trade is a large and unambiguous net gain for society. In a 2006 survey of economists, "87.5% agree that the U.S. should eliminate remaining tariffs and other barriers to trade" and "90.1% disagree with the suggestion that the U.S. should restrict employers from outsourcing work to foreign countries." Quoting Harvard economics professor Gregory Mankiw, "Few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards." Two simple ways to understand the benefits of free trade are through David Ricardo's theory of comparative advantage and by analyzing the impact of a tariff or import quota.

Simple theoretical framework

The pink regions are the net loss to society caused by the existence of the tariff.

A simple economic analysis using the law of supply and demand and the economic effects of a tax can be used to show the theoretical benefits of free trade.

The chart at the right analyzes the effect of the imposition of an import tariff on some imaginary good. Prior to the tariff, the price of the good in the world market (and hence in the domestic market) is P^world. The tariff increases the domestic price to P^tariff. The higher price causes domestic production to increase from Q^S1 to Q^S2 and causes domestic consumption to decline from Q^C1 to Q^C2. This has three main effects on societal welfare. Consumers are made worse off because the consumer surplus (green region) becomes smaller. Producers are better off because the producer surplus (yellow region) is made larger. The government also has additional tax revenue (blue region). However, the loss to consumers is greater than the gains by producers and the government. The magnitude of this societal loss is shown by the two pink triangles. Removing the tariff and having free trade would be a net gain for society.

An almost identical analysis of this tariff from the perspective of a net producing country yields parallel results. From that country's perspective, the tariff leaves producers worse off and consumers better off, but the net loss to producers is larger than the benefit to consumers (there is no tax revenue in this case because the country being analyzed is not collecting the tariff). Under similar analysis, export tariffs, import quotas, and export quotas all yield nearly identical results. Sometimes consumers are better off and producers worse off, and sometimes consumers are worse off and producers are better off, but the imposition of trade restrictions causes a net loss to society because the losses from trade restrictions are larger than the gains from trade restrictions. Free trade creates winners and losers, but theory and empirical evidence show that the size of the winnings from free trade are larger than the losses.

Illustrative story

This story is a simplistic example that helps explain part of the above theoretical argument. The numbers are entirely made up.

Imagine an orange farmer that produces 20 oranges a year. It costs him $5 to grow each orange and he sells each one for $10. His total profits are therefore $100. The world price for oranges is $4 per orange, but a $7 per orange tariff makes importing oranges uneconomical (the price for imported oranges is $11 because of the tariff).

Now imagine that the tariff is removed. First, the farmer is wiped out of business because the world price ($4) is below the farmer's production costs ($5). His $100 profit is gone.

On the other hand, consumers are made more than $100 better off. Previously, consumers had purchased 20 oranges at $10 each, for a total of $200. After the tariff is removed, 20 oranges can be purchased for $80, but even this underestimates how much better off consumers are because consumers will buy more than 20 oranges now that oranges cost $4 instead of $10.

More complicated and precise stories/examples can be constructed, but the general point remains that the monetary gains from free trade are larger than the monetary losses.

Trade diversion

According to economic theory, global free trade is a net benefit to society, but the selective application of free trade agreements to some countries and tariffs on others can sometimes lead to economic inefficiency through the process of trade diversion. It is economically efficient for a good to be produced by the country which is the lowest cost producer, but this will not always take place if a high cost producer has a free trade agreement while the low cost producer faces a high tariff. Applying free trade to the high cost producer (and not the low cost producer as well) can lead to trade diversion and a net economic loss. This is why many economists place such high importance on negotiations for global tariff reductions, such as the Doha Round.

The Free Trade Debate

Main article: Free trade debate.

Free trade is one of the most debated topics of the 20th and 21st centuries. The issues debated can be divided in economic, moral and sociopolitical arguments.

Groups opposing free trade

Free trade is often opposed by domestic industries that would be directly hurt by free trade. For example, if United States trade restrictions on sugar were reduced, US sugar producers would be hurt, US sugar consumers would benefit, and economic says that consumers would gain more than producers would lose. However, sugar producers would have large incentives to politically oppose the implementation of free trade.

Free trade is also opposed by many anti-globalization groups for a variety of ideological reasons.

Miscellaneous

The relative costs, benefits and beneficiaries of free trade are debated by academics, governments and interest groups. While the academic debate is essentially settled in favor of free trade, a number of arguments for and against in the ongoing public debate can be seen in the free trade debate article.

Depending on the specific context, use of the term free trade can signify one or more of the above conditions. However, it is fundamental that only governments can restrict trade: they have the legal monopoly over the use of physical force in a geographical area.

The term free trade has become very politically based, and it is not uncommon for so-called "free trade agreements" to impose additional trade restrictions. Such restrictions on trade are often due to domestic political pressure by powerful corporate, environmental or labor interest groups seeking special protections of their perceived interests.

Free trade agreements are a key element of customs unions and free trade areas. The details and differences of these agreements are covered in their respective articles.

Alternatives to free trade

Tobin Tax

Main article: Tobin Tax.

A Tobin tax is the suggested tax on all trade of currency across borders. This is intended to put a penalty on short-term speculation in currencies. This policy is an alternative to the free flow of capital across borders. This policy has little if nothing to do with the free flow of goods and services.

Fair trade

Main article: Fair trade.

The fair trade movement, also known as the trade justice movement, promotes international labor, environment and social standards for the production of traded goods and services. The movement focuses in particular on exports from the Third and Second Worlds to the First World.

Balanced trade

Main article: Balanced trade.

Balanced trade is an alternative economic model to free trade. Under balanced trade, nations are required to provide a fairly even reciprocal trade pattern; they cannot run large trade deficits. If deficits appear, the surplus nation must find a way to balance out trade or risk sanctions, fees, or quotas. Critics say this may discourage innovation as one country may reduce its efforts to produce products needed by the other.

Many economists would call balanced trade a modern day form of mercantilism (a discredited economic policy). Though it is has intuitive appeal, there is absolutely no economic reason why a trade deficit is automatically bad. For example, if a country is running a trade deficit, this automatically implies it is running an investment surplus. If this investment increases the capital stock, sparks new innovation, and increases productivity, there is absolutely no reason why a trade deficit would cause a problem. Empirically this also appears to be true as a number of countries, such as the U.S., have run large trade deficits for years with no discernable adverse impact.

International barter

Some nations have prohibited trade under monetary terms of trade. For example, Hjalmar Schacht arranged barter for Nazi Germany to bypass the free market which he thought was rigged by Anglo-American capitalists. The former Soviet Union occasionally arranged bilateral barter within its sphere of influence. See Comprehensive Program for Socialist Economic Integration or Comecon. Arab League nations have also occasionally replaced monetary trade with barter.

Increase the credit risk to international loans

George Soros and others argue that some of the most destructive free trade, such as developing world agricultural monoculture, is driven by export-oriented production targets set by the International Monetary Fund (IMF) and the governments it supports. He suggests that the volume of this trade would be lower if the lending banks were liable for credit default instead of receiving IMF bail-outs. If banks were responsible for default, the levels of lending would be lower and lead to more sustainable export programs due to the discipline of the free market, he believes.

International price floors

Some argue that free trade is responsible for the decline in international commodity prices. One reason for these low prices is the over-production of subsidized commodities in the developed world. Rather than removing the production subsidy for farmers in the rich world some suggest extending them to farmers in the developing world. For instance, producers in Poland lobbied to be included in the Common Agriculture Policy. The reason that rich-country farmers need subsidies to thrive is the comparative advantage of cheap land and labour enjoyed by their poor-country competitors.

Separating world prices from domestic prices

Foreign trade of Communist Czechoslovakia was conducted at "free trade" import prices, with the Ministry of Foreign Trade selling the goods on, into the internal market, at pre-determined prices for each good. In this way, Czechoslovakian consumers were insulated from shifts in world prices whilst having some access to foreign products.

It is difficult for governments to sustain different internal prices over the long term. If the internal price is set below world prices, smugglers try to profit from the differential by illegally exporting the product to nations where they can sell it at a higher price. To the extent smugglers succeed, the domestic government is indirectly subsidizing foreign consumers. This problem has been vividly illustrated in nations where fuel prices are subsidized below world prices; domestic shortages frequently occur as a significant portion of the good is illegally smuggled out of the country. Rationing and black markets are stimulated by artificially low prices; in Iraq the famously long petrol pump queues for petrol at 50 dinars/litre can be bypassed by buying on the black market at 250 dinars/litre. Unofficial markets are a common problem wherever the "official" price is below (or above) the free trade price.

Despite the difficulties of maintaining fixed commodity prices, many Governments that attempt it claim that doing so "immunizes" their economies against destabilizing price shocks. It is sometimes argued that the social and economic benefits alone, outweigh the disadvantages (of import-price stability).

On the other hand, international prices tell the costs of producing certain products and the benefits of consuming them. By separating the prices this flow of information is halted and therefore the local decisions are decoupled from the global needs and possibilities, thus hindering the producers in the country to produce the products where they have a comparative advantage and the consumers to consume the products that can elsewhere be produced so cheaply that they would like to consume them at those prices instead of consuming some other kind of products or less products (or services).

Regional trading blocs

James Goldsmith advocated free trade within regional trading blocs, but not between blocs (such as European Community countries). If countries within the "customs union" had similar living standards and norms of social and environmental policy they would not race to the bottom. He also proposed protectionism in the goods market, whilst allowing free trade in technology and capital.

See also

Concepts/topics

• fair trade
• free trade area
• free trade zone
• international trade
• trade barrier
• trade war
• trade war over genetically modified food
• offshore outsourcing
• offshoring
• Borderless Selling
• Balanced trade
• Trade bloc
• Globalization and health
• mercantilism

Trade organizations

• General Agreement on Tariffs and Trade (GATT)
• World Trade Organization (WTO)

Other lists

• List of free trade agreements
• List of trade blocs
• list of international trade topics

Criticism

• Lou Dobbs
• Anti-Globalism

Footnotes

1. See “Economic Freedom and Per Capita Income.”

External links

• Freetrade.org
• In Defence of Globalization, Free Trade and Free Market
• Stop Calling It “Free Trade!”
• BBC News - The argument for free trade
• Guardian Unlimited - Food & Trade - Hunger in a world of plenty
• Free Trade as Ideology, by Edward Luttwak, August 1 2001
• Why developing countries should liberalise trade
• Freedom to Work, to Earn, & to Buy by Harry Browne
• News Articles Critical Of The Free Trade Aspect Of The North American Union from Age Of Tyranny News