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Free trade
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Free trade is a type of trade policy that allows traders to act and transact without coercive interference from government. Thus, the policy permits trading partners mutual gains from trade, with goods and services produced according to the law of comparative advantage. Under a free trade policy, prices are a reflection of true supply and demand, and are the sole determinant of resource allocation. Free trade differs from other forms of trade policy where the allocation of goods and services amongst trading countries are determined by artificial prices that do not reflect the true nature of supply and demand.
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Free trade is a type of trade policy that allows traders to act and transact without coercive interference from government. Thus, the policy permits trading partners mutual gains from trade, with goods and services produced according to the law of comparative advantage. Under a free trade policy, prices are a reflection of true supply and demand, and are the sole determinant of resource allocation. Free trade differs from other forms of trade policy where the allocation of goods and services amongst trading countries are determined by artificial prices that do not reflect the true nature of supply and demand. These artificial prices are the result of protectionist trade policies, whereby governments intervene in the market through price adjustments and supply restrictions. Such government interventions generally increase the cost of goods and services to both consumers and producers. Interventions include subsidies, taxes and tariffs, non-tariff barriers, such as regulatory legislation and quotas, and even inter-government managed trade agreements such as the North American Free Trade Agreement (NAFTA) and Central America Free Trade Agreement (CAFTA) (contrary to their formal titles.)--any governmental market intervention resulting in artificial prices that do not reflect the principles of supply and demand. Most states conduct trade polices that are to a lesser or greater degree protectionist. One ubiquitous protectionist policy employed by states comes in the form agricultural subsidies whereby countries attempt to protect their agricultural industries from outside competition by creating artificial low prices for their agricultural goods.
The value of free trade was first observed and documented by Adam Smith in his masterpiece, The Wealth of Nations in 1776. In his book, Smith made his case for free trade by arguing that specialization through division of labor would yield greater gains in trade than otherwise permitted. The classical economist David Ricardo firmly established the case for free trade when he developed an economic proof featuring a single factor of production with constant productivity of labor in two goods, but with relative productivity between the goods different across two countries. Ricardo's model demonstrated the benefits of trading via specialization--states could acquire more than their labor alone would permit them to produce. This basic model ultimately led to the formation of one of Economic's fundamental laws: The Law of Comparative Advantage. The Law of Comparative Advantage states that each member in a group of trading partners should specialize in and produce the goods in which they possess lowest opportunity costs relative to other trading partners. This specialization permits trading partners to then exchange their goods produced as a function of specialization. Under a policy of free trade, trade via specialization maximizes labor, wealth and quantity of goods produce, exceeding what an equal number of autarkic states could produce.
Opposition to free trade. There are two types of opponents to free trade, the protectionists, and those who believe free trade is immoral. The protectionists have many faces, they can be individual companies, trade unions, politicians, and governments. Trade unions or companies who are experiencing competition from international firms, and therefore petition governments to institute protective barriers (isolationism) as import controls and limit competition. The protectionist can cry "unfair trade" and attempt by virtue of trade restrictions to balance burdens (intrusionism) to change the domestic policies of a state. Then there are those who believe that free trade is immoral or the source of some kind of social injustice. Such as, but not limited to, environmental degradation, race to the bottom, wage slavery,accentuating poverty in poor countries,child labor,loss of jobs in advanced countries.
Free trade implies the following features:
- trade of goods without taxes (including tariffs) or other trade barriers (e.g., quotas on imports or subsidies for producers)
- trade in services without taxes or other trade barriers
- The absence of "trade-distorting" policies (such as taxes, subsidies, regulations or laws) that give some firms, households or factors of production an advantage over others
- Free access to markets
- Free access to market information
- Inability of firms to distort markets through government-imposed (or non-government-imposed?) monopoly or oligopoly power
- The free movement of labor between and within countries
- The free movement of capital between and within countries
- For more detailed arguments in favor of and against free trade, see: Free trade debate.
History of free trade
Also: History of international trade.
It is known that various prosperous world civilizations 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, especially in Europe, and especially in England, over the past five centuries. Before the appearance of Free Trade doctrine, and continuing in opposition to it to this day, the policy of mercantilism had developed in Europe in the 1500s. Early economists opposed to mercantilism were David Ricardo and Adam Smith.
Economists that advocated free trade believed trade was the reason why certain civilizations 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. The great prosperity of the Netherlands after throwing off Spanish Imperial rule, and declaring Free Trade and Freedom of thought, made the Free Trade/Mercantilist dispute the most important question in economics for centuries. Free trade policies have battled with mercantilist, protectionist, isolationist, communist, and other policies over the centuries.
Wars have been fought over trade, such as the Peloponnesian War between Athens and Sparta, the Opium Wars between China and Great Britain, and other colonial wars. All developed countries have used protectionism due to an interest in raising revenues, protecting infant industries, special interest pressure, and, prior to the 19th century, a belief in mercantilism.
Many classical liberals, especially in 19th and early 20th century Britain (e.g. John Stuart Mill) and in the United States for much of the 20th century (e.g. Cordell Hull), believed that free trade promoted peace. The British economist John Maynard Keynes (1883-1946) was brought up on this belief, which underpinned his criticism of the Treaty of Versailles in 1919 for the damage it did to the interdependent European economy. After a brief flirtation with protectionism in the early 1930s, he came again to favour free trade so long as it was combined with internationally coordinated domestic economic policies to promote high levels of employment, and international economic institutions that meant that the interests of countries were not pitted against each other. In these circumstances, 'the wisdom of Adam Smith' again applied, he said.
Some degree of Protectionism is nevertheless the norm throughout the world. In most developed nations, controversial agricultural tariffs are maintained. From 1820 to 1980, the average tariffs on manufactures in twelve industrial countries ranged from 11 to 32%. In the developing world, average tariffs on manufactured goods are approximately 34%.
Currently, the World Bank believes that, at most, rates of 20% can be allowed [!] by developing nations ; but Ha-Joon Chang believes higher levels may be justified because the productivity gap between developing and developed nations is much higher than the productivity gap which industrial countries faced. (A general feature is that the underdeveloped nations of today are not in the same position that the developed nations were in when they had a similar level of technology, because they are weak players in a competitive system; the developed nations have always been strong players, although formerly at an overall lower level.) If the main defense of tariffs is to stimulate infant industries, a tariff must be high enough to allow domestic manufactured goods to compete for the tariff to be possibly successful. This theory, known as import substitution industrialization, is largely considered to be ineffective for currently developing nations, and studies by the World Bank have determined that export-oriented industrialization policies correlate with higher economic growth as observed with the Four Asian Tigers. These assessments are based mainly on theory and observational study of correlations, and thus suffer from a number of weaknesses such as small sample size and numerous confounding variables (see the critical review section below).
The US and free trade
Trade in colonial America was regulated by the British mercantile system through the Acts of Trade and Navigation. Until the 1760s, few colonists openly advocated for free trade, in part because regulations were not strictly enforced—New England was famous for smuggling—but also because colonial merchants did not want to compete with foreign goods and shipping. According to historian Oliver Dickerson, a desire for free trade was not one of the causes of the American Revolution. "The idea that the basic mercantile practices of the eighteenth century were wrong," wrote Dickerson, "was not a part of the thinking of the Revolutionary leaders". Free trade came to what would become the United States as a result of American Revolutionary War, when the British Parliament issued the Prohibitory Act, blockading colonial ports. The Continental Congress responded by effectively declaring economic independence, opening American ports to foreign trade on April 6, 1776. According to historian John W. Tyler, "Free trade had been forced on the Americans, like it or not."
The 1st U.S. Secretary of the Treasury, Alexander Hamilton, advocated tariffs to help protect infant industries in his "Report on Manufactures." This was a minority position, however, which the "Jeffersonians" strongly opposed for the most part. Later, in the 19th century, statesmen such as Senator Henry Clay continued Hamilton's themes within the Whig Party under the name "American System." The opposition Democratic Party contested several elections throughout the 1830s, 1840s, and 1850s in part over the issue of the tariff and protection of industry. The Democratic Party favored moderate tariffs used for government revenue only, while the Whig's favored higher protective tariffs to protect favored industries. The economist Henry Charles Carey became a leading proponent of the "American System" of economics. This mercantilist "American System" was opposed by the Democratic Party of Andrew Jackson, Martin Van Buren, James K. Polk, Franklin Pierce, and James Buchanan.
The fledgling Republican Party led by Abraham Lincoln, who called himself a "Henry Clay tariff Whig," strongly opposed free trade and implemented at 44 percent tariff during the Civil War in part to pay for railroad subsidies, the war effort, and to protect favored industries. President William McKinley stated the United States' stance under the Republican Party (which won every election for President until 1912, except the two non-consecutive terms of Grover Cleveland) as thus:
"Under free trade the trader is the master and the producer the slave. Protection is but the law of nature, the law of self-preservation, of self-development, of securing the highest and best destiny of the race of man. [It is said] that protection is immoral…. Why, if protection builds up and elevates 63,000,000 [the U.S. population] of people, the influence of those 63,000,000 of people elevates the rest of the world. We cannot take a step in the pathway of progress without benefitting mankind everywhere. Well, they say, ‘Buy where you can buy the cheapest'…. Of course, that applies to labor as to everything else. Let me give you a maxim that is a thousand times better than that, and it is the protection maxim: ‘Buy where you can pay the easiest.' And that spot of earth is where labor wins its highest rewards."
On the other side:
The growing Free Trade Movement sought an end to the tariffs and corruption in state and federal governments by every means available to them, leading to several outcomes. The first and most important was the rise of the Democratic Party with Grover Cleveland at its helm. The next most important were the rise of the "Mugwumps" within the Republican party. For many Jeffersonian radicals, neither went far enough or sufficiently effective in their efforts and looked for alternatives.
The first major movement of the radical Jeffersonians evolved from the insights of a young journalist and firebrand, Henry George. - Kenneth R. Gregg, George Mason University History News Network
The tariff and support of protection to support the growth of infrastructure and industrialization of the nation became a leading tenet of the Republican Party thereafter until the Eisenhower administration and the onset of the Cold War, when the Democratic and Republican parties switched positions.
In the 1930s, the US adopted the protectionist Hawley-Smoot Tariff Act which raised rates to all time highs beyond the Lincoln levels, which many economists believe exacerbated the Great Depression. Europe, which had less protectionism at the time, had largely come out of the depression while the US remained mired in the depression. Franklin D. Roosevelt resorted to Hamilton's earlier formula of tariff Reciprocity coupled with subsidy to industry which went unbroken until the 1970s when protectionism was reduced after the Kennedy Round of trade talks in the late sixties.
In 2006 American Economic Association conducted a poll which revealed that 87,5 percent of its members with Ph.D. agreed that "the U.S. should eliminate remaining tariffs and other barriers to trade."
Since the end of World War II, in part due to industrial supremacy and the onset of the Cold War, the U.S. government has become one of the most consistent proponents 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); although it had rejected an earlier version in the 1950s (International Trade Organization or ITO). Since the 1970s U.S. government has negotiated numerous managed trade agreements, such as the North American Free Trade Agreement (NAFTA) in the 1990s, the Dominican Republic-Central America Free Trade Agreement (CAFTA) in 2006, and a number of bilateral agreements (such as with Jordan).
Economics of free trade
The literature analysing 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 American economists (83 responders), "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 N. Gregory Mankiw, "Few propositions command as much consensus among professional economists as that open world trade increases economic growth and raises living standards." Nonetheless, quoting Prof. Peter Soderbaum of Malardalen University, Sweden, "This neoclassical trade theory focuses on one dimension, i.e., the price at which a commodity can be delivered and is extremely narrow in cutting off a large number of other considerations about impacts on employment in different parts of the world, about environmental impacts and on culture." Most free traders would agree that there are winners and losers from free trade, but argue that this is not a reason to argue against free trade, because free trade is supposed to bring overall gain due to idea that the winners have gained enough to make up for the losses of the losers and then some. Chang argues otherwise. The winners do not always make enough to compensate for the losers, as is the case when the economy gets smaller and even if the winners do make enough to compensate for the losers, this compensation is not always from the workings of the market meaning some people are worse off.
Adding to his argument is the idea that in order for the losers of free trade competition to be fully compensated, some sort of compensation vehicle such as a welfare program is needed to sustain them until they are able to find a job that is equal to or better than their previous job. If they do not find a job that is equal to or better than the one they had, they are worse off and America is worse off because if this trend continued, trading a better job for a worse job, then America would really be in trouble. The problem is that only economically developed, wealthy countries like the U.S. or Britain have effective welfare mechanisms whereas many developing countries have little to no welfare system to speak of and do not even have the opportunity to create one that functions because of the pace that they are being pushed to conform to a very open free trade system. 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.
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 Pworld. The tariff increases the domestic price to Ptariff. The higher price causes domestic production to increase from QS1 to QS2 and causes domestic consumption to decline from QC1 to QC2. 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.
Trade diversion
According to mainstream 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.
Critical review
In an assessment of the literature on the theory and empirical research relating to the benefits of free trade, Sonali Deraniyagala and Ben Fine found that much of the work was flawed, and concluded that the extent to which free trade benefits economic development is unknown. Theoretical arguments are largely dependent upon specific empirical assumptions which may or may not hold true. In the empirical literature, many studies suggest the relationship is ambiguous, and the data and econometrics underlying a set of empirical papers showing positive results have been critiqued. The best of these papers use a simplified model, and the worst involve the regression of an index of economic performance on an index of openness to trade, with a mix of these two approaches common. In some cases, Deraniyagala and Fine claim, these indexes of openness actually reflect trade volume rather than policy orientation. They also observe that it is difficult to disentangle the effects of reverse causality and numerous exogenous variables.
In Kicking Away the Ladder, Ha-Joon Chang reviews the history of free trade policies and economic growth, and notes that many of the now-industrialized countries had significant barriers to trade throughout their history. Protectionism under the auspices of the infant industry argument (related to import substitution industrialization), was first pursued by Alexander Hamilton in the 1790s in opposition to the admonition of Adam Smith, who advised that the United States focus on agriculture, where it had a comparative advantage. In the 1840s Friedrich List, known as the father of the infant industry argument, advocated the infant industry argument for Germany. Chang's research shows that the United States and Britain, sometimes considered to be the homes of free trade policy, were aggressive protectionists. Britain did end its protectionism when it achieved technological superiority in the late 1850s with the repeal of the Corn Laws, but tariffs on manufactured products had returned to 23% by 1950. The United States maintained weighted average tariffs on manufactured products of approximately 40-50% up until the 1950s, augmented by the natural protectionism of high transportation costs in the 1800s. The most consistent practitioners of free trade have been Switzerland, the Netherlands, and to a lesser degree Belgium.
Chang describes the export-oriented industrialization policies of the Asian Tigers as "far more sophisticated and fine-tuned than their historical equivalents".
Opposition
Free trade is often opposed by domestic industries that would have their profits and market share reduced by lower prices for imported goods. For example, if United States tariffs on imported sugar were reduced, US sugar producers would receive lower prices and profits, while US sugar consumers would spend less for the same amount of sugar because of those same lower prices. Economics says that consumers would necessarily gain more than producers would lose. Since each of those few domestic sugar producers would lose a lot as an individual while each of a much greater number of consumers would gain only a little, domestic producers are more likely to mobilize against the lifting of tariffs. More generally, producers often favor domestic subsidies and tariffs on imports in their home countries, while objecting to subsidies and tariffs in their export markets.
Socialists frequently oppose free trade on the ground that it allows maximum exploitation of workers by capital. For example, Karl Marx wrote in The Communist Manifesto, "The bourgeoisie... has set up that single, unconscionable freedom -- Free Trade. In one word, for exploitation, veiled by religious and political illusions, it has substituted naked, shameless, direct, brutal exploitation."
"Free trade" is opposed by many anti-globalization groups, based on their assertion that so-called Free Trade agreements generally do not increase the economic freedom of the poor, and frequently make them poorer. Whether the "Free Trade" agreements are really for free trade or for government-managed trade is perhaps moot ; these opponents see the deals as being materially harmful to the common people. Nevertheless, if the deals are essentially for government-managed trade, arguing against them is not a direct argument against free trade per se. For example, it is argued that letting subsidized corn from the US into Mexico freely under NAFTA at prices well below production cost (dumping) is ruinous to Mexican farmers. Of course, such subsidies violate free trade, so this argument is not actually against free trade.
Some free trade economists have recently begun to express their own doubts concerning the concept and practice of free trade. Alan S. Blinder, for example, a professor of economics at Princeton University, and former Federal Reserve Board vice chairman and advisor to Democratic presidential candidates, had previously argued, along with most economists, that free trade enriches the U.S. and its trading partners. Jobs may be lost here in the short run, they say, but the total U.S. net national product must, by the economic laws of comparative advantage, be raised in the long run. The gains of the winners exceed the losses of the losers. This has been called "creative capitalist destruction."
However, some believe that new communication technology will put 30-40 million American jobs at risk in 10-20 years. The opponents have not completely rejected free trade or ideas about comparative advantage, but they advocate greater protection for displaced workers and an improved education system, since trade changes types of jobs, not the number. For example, technology has allowed Indians in call centers to do the work of Americans at lower wages. Which may cause tens of millions of additional American workers start to experience an element of job insecurity that has heretofore been reserved for manufacturing workers. The debate is, "Should government encourage forces of globalization or try to restrain them?" Latin America performed poorly since tariff cuts in 1980s and 1990s, compared to protectionist China and Southeast Asia.Ecuadorian President Rafael Correa has denounced the "sophistry of free trade", in an introduction he wrote for a book titled The Hidden Face of Free Trade Accords. One of the authors of that book is today Correa's Energy Minister, Alberto Acosta. Citing as his source the book, Kicking Away the Ladder, written by a Korean economist based at Cambridge University, Ha-Joon Chang, Correa identified the difference between an "American system" opposed to "a British System" of free trade. The latter, he says, was explicitly viewed by the Americans as "part of the British imperialist system." Correa wrote that Chang showed that it was Treasury Secretary Alexander Hamilton, and not Friedrich List who was the first to present a systematic argument defending industrial protectionism. (Correa includes List's National System of Political Economy in his bibliographic references.)
Following alternatives for free trade are proposed: balanced trade, fair trade, protectionism and Tobin tax.
Miscellaneous
The relative costs, benefits and beneficiaries of free trade are debated by academics, governments and interest groups. 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 to influence trade 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 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. Opportunities for free trade will likely increase with global warming, with the opening of new trade routes due to melting ice in the Northwest Passage and other similar areas.
See also
Concepts/topics
Trade organizations
Other lists
Criticism
Conservative opposition to free trade
External links
- by Antoine Bouët (2008)
- (FEE), one of the oldest free-market organizations in the United States.
- , Center for Trade Policy Studies, Cato Institute
- edited by Edward L. Hudgins (online version of the book)
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- speech by Federal Reserve chairman Ben Bernanke
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- , by Edward Luttwak, August 1 2001
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- For German-speaking visitors: see also by Gerd Zeitler.
- David Sirota, , Huffington Post, October 30, 2007.
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