1,000,000 economists can be wrong: the free trade fallacies

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Not only did the global financial crisis catch the vast majority of economists completely unawares, they instead expected tranquil and even buoyant times just as the biggest economic crisis since the Great Depression began. My favourite such observation is from the OECD‘s Economic Outlook for June 2007—in which the Chief Economist suggested that, “the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign.” But there are countless other such utterly wrong prognostications about the economy, from the profession that is supposed to be the font of wisdom on the economy.

Those “in the know” understand that this is not an isolated failing. The Neoclassical model that dominates economics today is riven with logical and empirical fallacies. If economics were a real science, it would have long ago been overthrown and replaced by something more realistic.

Yet at least 90% of academic economists believe in this model, as do almost all economists working in government and private industry. Left to their own devices, they will continue thinking that this model does describe the economy as the real economy falls deeper and deeper into a crisis, even though their model says that this can’t even happen.

Since economics has failed to clean out its own intellectual stable, it will be the public that finally forces reform upon it – as once-supporters like Anatole Kaletsky of The Times calls for “a revolution in economic thought” and George Soros funds an Institute for New Economic Thinking. With luck, in a decade or two, a more realistic approach to economics might emerge. But in the meantime, here’s a simple guide for the public: Anything the vast majority of economists believe is likely to be wrong.

Which brings me to “Free Trade.” The belief in Free Trade is one of the hallmarks not just of the Neoclassical school which began in the 1870s, but also of the original Classical school which began with Smith in 1776. It argues that almost everyone’s material welfare will be increased if all countries specialise in what they are good at—a proposition that on the surface seems plausible, and a formidable body of mathematical economic theory has been erected to support it.

Unfortunately, like so much else in economics the model of Free Trade is, to quote the humorist H.L. Mencken, “neat, plausible, and wrong.” The theoretical fallacies at its core have been there since David Ricardo first coined his model of comparative advantage during the political battle to repeal the “Corn Laws,” which restricted the importing of cereal crops into England.

The arguments in favour of the Corn Laws included the belief that if trade were unregulated, English industry—in particular its agriculture—might be wiped out by foreign competition. Ricardo, in a brilliant debating ploy, conceded his opponents’ case that a rival country (Portugal, which was then one of Britain’s major rivals) was better at both agriculture and manufacturing than England and then preceded to “prove” that England would still benefit from Free Trade.

He assumed that in Portugal 80 men could produce a quantity of wine (say, 1000 gallons), whereas England would need 120 men to produce the same amount and that Portugal was more efficient too at producing cloth—needing 90 men to produce a quantity of cloth (say, 100 square yards of cotton) whereas England needed 100.

Without trade, both countries would have to produce both goods for themselves so that per 1,000 workers, Portugal would produce some combination lying between the extremes of 12,500 gallons of wine and 1,100 yards of cotton, while England would produce a combination lying between 8,333 gallons of wine and 1,000 yards of cloth.

If however Portugal specialised only in wine and England specialised only in cloth, the total output would be 12,500 gallons of wine and 1,000 yards of cloth. This is more than the total output of the two countries in the absence of trade. With Free Trade, they could specialise in their comparative advantages and welfare in both countries would be higher.

This argument was so clever that it aided the campaign to repeal the Corn Laws and it has seduced almost all economists ever since.

But there is an obvious fallacy to this neat and plausible argument: To effect specialisation, England has to shift labour and capital from wine to cloth (and Portugal has to do the opposite). Arguably labour can be retrained—a vigneron can become a machinist—but how do you convert wine press into a spinning jenny?

The obvious answer is that you don’t. Instead, you sell the wine press and buy a spinning jenny with the proceeds. But because of the introduction of trade, the price of wine in England would have fallen, so that the sale price of the wine press will also fall (economists have modified Ricardo’s model to introduce curves where Ricardo had straight lines, so that total specialisation is no longer required and there would still be some wine production in England under the “new” model of Free Trade), while the price of spinning jennies will have risen, given the new export market to Portugal. Some capital is necessarily destroyed by the opening up of trade and it applies in reverse in Portugal as well.

Since capital is destroyed when trade is liberalised, the watertight argument that trade necessarily improves material welfare springs a leak. If economics were a real science, this real-world complication to Ricardo’s argument would be considered, but it has never been seriously addressed.

These and many other failings that explain why, when Dani Rodrik took a careful look at the empirical record of trade liberalisation, he found that it had frequently reduced material welfare rather than increasing it. Writing back in 2001, he summarised his findings for Foreign Policy magazine with the statement that:

“Advocates of global economic integration hold out utopian visions of the prosperity that developing countries will reap if they open their borders to commerce and capital. This hollow promise diverts poor nations’ attention and resources from the key domestic innovations needed to spur economic growth.”

As an economist who has specialised in dissecting the empirical claims for the role of free trade, Rodrik has the might of the majority of the profession against him. As noted above, that’s a good rule of thumb that Rodrik is right.

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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48 Responses to 1,000,000 economists can be wrong: the free trade fallacies

  1. Cahal says:

    The problem with people like Warren is that when someone challenges their theories, they indulge in some special pleading, add an epicycle and simply end up muddying the waters.

    ‘Your “refutation” of Ricardo is laughable.’

    You could be a bit more civil. This is why people don’t like to engage with libertarians, particularly Austrians.

    ‘Since England was more industrial, they would have a comparative advantage in the manufacture of wine presses. The productivity gains in both countries would enhance the purchasing power of everyone. The glut of wine presses in England would be exported.’

    This has nothing to do with what he said. He was talking about a world where cloth and wine are being produced by Portugal and England, and pointing out that heterogenous capital causes problems in the short term. You have not challenged this idea; in fact, your scenario suffers from a similar problem as new wine presses would need to be created.

    ‘The Keynesian theory of everything presumes a rising price level, ie. a diminishing purchasing power as excess credit pursues degraded workers. Ricardo’s argument presumes honest money.’

    Irrelevant.

  2. Cahal says:

    Warren* Jees I really need to proof read better.

  3. The argument as set up is that even though net output after specialization is 1.5 times higher than before, that there is a net destruction of capital because the surplus wine presses in England would have a lower selling price than before. Of course, the selling prices of surplus spinning jennies would have a higher selling price as well which would be a capital gain, so the capital destruction claim is washed out.

    The workers of both countries would enjoy a 1.5 times gain of purchasing power which, I rudely point out, would allow them to hoard a portion in their mattresses, further depressing prices and enhancing purchasing power, unless a madcap Keynesian were to come along and convince them that somehow that is a bad idea.

  4. SeanS says:

    An economist that questions the Free Trade mantra? You just went up 50 points on my estimation scale.

    There are just so many fallacies with the free trade agenda it ceases to be amusing.

    Those espousing the benefits of free trade theory (and these are usually people who do not and have never worked in the real world of international commerce) simply choose to ignore the realities of the practical application of such policies. Free trade works in theory because, like in many economic theories, there are critical assumptions that are made and have to be made to enable these principles to function in a beneficial rather than detrimental way.

    Of course there are numerous examples of countries that have not adopted free trade policies and, as a result, have been enormously successful at different stages of their development.

    Those that advocate free trade application generally fall into 2 categoreis:

    Cat. 1. Those that consider their country will, overall, be a big winner from the application of such policies – meaning that other trading partners will come off second best. This is the category that the United States traditionally considered itself to be in whilst simultaneously adopting some highly protective trade policies in certain areas to satisfy a domestic political agenda.
    For many years in this worked but of course the US has for some years been very much on the sucker end of the deal.

    Cat. 2. Those that are too lazy and inellectually stupid to set appropriate trade policies and to negotiate trade agreements with partners that will operate in the best interests of their economies and provide equitable and fair access for all parties. This is the hard option. Yes Governments and their officials have to work very hard to adopt this line and some are basically too lazy. This is most definitely the category Australia falls into – which frequently advocates a unilateral free trade agenda for heavens sake.

    Those advocates of Free Trade (it can never be properly free by the way), just love to ignore the problems with such policies when applied to the real world economies. For example (and this is not exhaustive):

    1. You cannot achieve free trade because of hidden subsidies, or even transparent ones, that you are forced to accept and therefore should respond to in a balanced way. Such subsidies do not exist and acnnot be established in the theory.

    2. Agriculture is a major trade sector and a politically sensitive one. Where it has a choice, no sensible country is going to allow a situation where it is largely dependent upon foreigners for it’s food supply. (Just ask the EU). Of course in Australia our politicians and public servants don’t care and are quite content to preside over the near destruction of entire sectors of agriculture only to see them replaced with huge volumes of food imports under our poorly and ineptly negotiated trade agreements.

    3. Countries will abuse FTAs by exporting items at below full cost in order to destroy the local competition. In Free Trade theory dumping just never happens but unfortunately this does not match the real world. For example, Australia’s reponse to dumping is nothing short of pathetic and there is rarely any effective action to stop it despite the protestations of local firms. Indeed one line often dropped by the Canberra trade elite types is that dumping is, in reality, good because the producers are offering the products at a very cheap price to the local market. Just a reflection of their stupidity and typical of their laziness and ineptitude in applying anti-dumping regulations.

    4. Under Free Trade theory you will always export sufficient to pay for your imports. Unfortunately this does not match the real world. When you cannot pay for your imports you have to go into debt to maintain the flow. Ultimately your freely floating currency will devalue substantially and those nice cheap imports that you were enjoying so much are now so very expensive.

    Of course it is so much easier and much quicker to dismantle an entire industry than it is to re-establish it. So rather than having the option of import substitution you are forced to continue to pay for your very expensive imports. Those with capital and trying to re-establish local production find that they are unable to find the essential skilled empoyees as these have long since left the country and gone overseas to work or are now working in other industries. Essentially, the skills base you once had has been largely destroyed and takes many years to re-estabish.

    5. In free trade theory displaced workers in destroyed industry sectors always find employment in alternative sectors. Hence the electrical engineer can now now drive a tractor or the truck driver will become a chemical engineer. It all works just fine. The real world? Go visit Detroit , MI.

    6. Free trade works if you are happy to accept a much lower standard of living if you are on the losing side of the trade. In a free trade relationship in the real world there is always a winner and a loser. Those with the positive trade balances are the winners. Relatively high cost countries will often be the losers in such relationships but are, of course, usually unwilling to accept a lower standard of living to rectify their lack of competitiveness.

    I could go on but I am like an Australian government trade specialist. I am too lazy ………….to write anymore on this.

    I would like to leave you with a little gem told to me some years ago by a senior Australian government trade negotiator. This guy was waffling on with the usual free trade religion stuff . Interalia, I raised the issue of all of the protections, subsidies and regulations established by so many of our trading partners that make it impossible for our companies to access foreign markets on any reasonably equitable basis. “Oh” he said “do you know what we do in our trade negotiations with these countries.” “We tell them how economically inefficient such policies are and how they will increase the welfare of their people by dismantling all such policies.” Wow. That must really convince them. How’s that been going then?

  5. Steve Keen says:

    Spot on Sean. Decades ago (1979 from memory!) I ran a conference on trade where one of the IAC types gave a paper showing what would happen with a 25% tariff cut to Textiles, Autos and a couple of other sectors. There was a footnote to their predictions that said “Assuming good macroeconomic management”–which was defined as “no net change in employment as a consequence of the tariff cuts”!!!!

  6. pfitzsimmons says:

    In Ricardo’s example there is a big advantage to making textiles in place of wine. Development of the machinery for making textiles allowed for progressive gains in productivity while wine making as an industry has remained static until very recently. Also the skills and technologies necessary for the textile industry were transferable to other industries giving the nation comparative advantage in these new industries. As someone said “Only God can create a tree but any government can create a comparative advantage”. There is a case to be made that a nation should apply its resources to those industries that will yield the most in productivity and growth even if it has little or no expertise in those industries and shed other industries with which it may have great expertise but which offer no evolution to future prosperity.

  7. Cahal says:

    Warren you are not engaging in argument at all. You are going off on a tangent and muddying the waters, whilst simultaenously nursing your fetish for using ‘Keynesian’ as a self evident insult.

  8. Philip says:

    SeanS,

    A very good overview. This is not surprising to economic historians e.g. Paul Bairoch, who have examined the history of development and trade. The countries that really developed – UK, France, Germany, Netherlands, later the US – all had enormous trade protection in place, with tariffs going up to 60-80%!

    Conventional economic theory would stipulate that these economies should be backwaters, including Australia. But it is unsurprising that the real world is vastly different to economic theory.

    Strangely enough, the free flow of highly-paid professional and managerial services, government monopoly (IP), criminalized drugs, and rights for capital in the form of corporate charters never come up in discussion about the benefits of free trade. Perhaps its because these policies benefit the rich but that could just be a conspiracy theory.

  9. Derek R says:

    But if free trade is a bad thing surely that means that we should put trade barriers and tariffs on trade between Victoria, Queensland and New South Wales to improve the economic performance of the individual states. Logically speaking if free trade causes problems then reducing free trade even between the CBD, Paramatta and Chattswood should improve the overall performance of Sydney.

    Taking it to extremes, we surely end up saying that NIH syndrome is actually a benefit for an individual company rather than a drawback because NIH syndrome is a barrier to free trade between companies.

    Now I’m not trying to prejudge the case in favour of Free Trade by the above points. I’m a firm believer that empirical evidence trumps theoretical arguments. And if Steve says there’s empirical evidence against free trade, then I believe him. I’m just trying to point out that any theory of free trade which shows it to be bad at the level of countries has also to be able to show why it is good within a country. If it doesn’t (and it might be that it isn’t good within a country either), then the logical response is that not only should we be using protectionism at the international level: we also need to use it for internal trade.

  10. Steve Keen says:

    The proper logical deduction Derek is that free trade is a red herring, because it focuses attention on getting more out of your current resources and capabilities, rather than on developing new ones.

  11. Cahal – The problem I have with Keynesians is that the inflation makes household savings impossible. This along with the diminishment of the wage share reduces workers to the level of serfs.

    I don’t quite see what fallacy Steve is trying to point out.

  12. Derek R says:

    I think I understand what you mean, Steve. I can see that Free Trade would have the side-effects that you (and SeanS and Pfitzsimmons above) describe. But then you’ve got to ask why this is more of an issue for international trade than for interstate trade. After all surely Queensland is going to end up with a lack of development relative to NSW under free trade, isn’t it? Assuming that Queensland concentrates on resource extraction and that NSW concentrates on manufacturing.

    Of course the problems might be mitigated by other factors such as the free movement of labour between Queensland and NSW, the common currency, and the relative ease of moving intellectual capital and the smaller physical capital items between the two states.

    There is a similar issue where I live in Alberta. At the moment there is a plan to build a pipeline to pipe crude oil from the tarsands down to Texas for refining. We could refine the oil in Alberta but we don’t currently have the refinery capacity (not even in other parts of Canada apparently), hence the plan to ship the stuff to the US. I guess that the “free trade/comparative advantage” alternative would be to build a pipeline, whereas the “protectionist” alternative would be to build extra refinery capacity in Alberta.

    So perhaps it really would be a good idea for Queensland and Alberta to be more protectionist. That way you are definitely going to have more local development and keep more of the added value in local hands, even if it’s just the wage element and the fixed capital element.

    The US certainly managed to fight Imperial free trade policy using “the American system” to grow its economy during the nineteenth century. And that was basically a protectionist system. It’s only really during the late twentieth century that the US has switched to a free trade policy. So there’s no doubt that protectionist policies can improve the economic health of a country which uses them.

  13. Cahal says:

    Warren:

    Steve’s basic point is that CA depends on a starting point. Since capital is heterogenous, the removal of barriers can wipe out industries that will not immediately be replaced by that countries ‘comparative advantage’ industry, as Ricardo effectively implied.

    As for inflation, well I’m not sure why you attribute it to ‘Keynesians’ – I’m fairly certain you mean fiat currency, which in itself is not a Keynesian construct. In any case, it is not worth debating that here.

  14. Isn’t the case that greatest modern fallacy about free trade arises from ignoring the flows of capital and technology that are associated with offshoring jobs and outsourcing services from high-wage to low-wage economies?

    Ricardo was explicit that capitalists would not offshore their capital.

    This is clearly not the case today. So when people like Jeff Rubin, author of “Your World is about to get a whole lot smaller” tell you that Ricardo’s theory of comparative advantage proves that offshoring of jobs benefits us all, they are simply lying about what Ricardo said.

  15. Cahal says:

    CA is also irrelevant for developing countries if you buy the ‘infant industry’ argument. To try and demonstrate this briefly, here is a CA example from Wikipedia:

    ‘Suppose that in a particular city the best lawyer happens also to be the best secretary, that is he would be the most productive lawyer and he would also be the best secretary in town. However, if this lawyer focused on the task of being a lawyer and, instead of pursuing both occupations at once, employed a secretary, both the output of the lawyer and the secretary would increase, as it is more difficult to be a lawyer than a secretary.’

    What if the secretary trained to be an astronaut? Both society and the secretary would clearly be better off.

  16. The so-called ‘effective demand’ concept is pure Keynes, and focuses on demand stimulation while ignoring loss of purchasing power which goes along with rising price level.

    I believe the GFC is caused by the purchase power reaching its lower limit. Entropy is a real thing. The GFC is not merely speculation run amok.

  17. Nathan Scandella says:

    The idealized example of England and Portugal trading is also bogus, if it does not account for the costs of moving goods from country to country. Shipping is not free. If you’re one of the companies involved in making wine, or cloth, you might only concern yourself with the nominal cost to ship your goods. However, policymakers concerned with deciding on protectionist vs. free trade policies, must go a lot further than that simplistic cost benefit analysis.

    The true cost of transporting goods is not even close to accounted for in the nominal cost of international shipping. International shipping tends to be the least regulated way to move goods. The ships traversing our oceans use bunker fuel, which is basically the dirtiest, cheapest, most polluting possible kind of fossil fuel. The huge externality of climate change, or other pollution issues, is totally glossed over by the overwhelming majority of economists, whose oversimplification of everything is one of the primary causes of environmental damage. Then, there’s countries like the US, that actually subsidize oil companies, to make the marginal cost of oil for end-users appear even cheaper.

    Marginal cost analyses are frequently completely inappropriate. There’s no problem with one company using fossil fuels like there’s no tomorrow. It’s only an issue when everyone thinks that way.

    I often use the analogy of an overly simplistic strategy in gambling. You play blackjack (or whatever) by starting with a bet of 1 unit. If you lose, you double your bet. The idea is that eventually, you will win, and then you’ll always wind up ahead by at least the 1 unit. This strategy only fools simpletons, however, as it neglects the logistical detail of table limits, which ultimately will prevent you from achieving your goal by keeping you from doubling your bet past the table limit.

    This, “double when you lose” type of thinking is pervasive in economics. Easy to process, over-simplified models, that completely fall apart in the real world.

    NOTE: you could certainly argue that simply tacking on the cost of externalities to any consumption of fuel would be one way to implement a more protectionist strategy than the status quo, without resorting to explicit trade restrictions. However, determining and enforcing the collection of this cost is not something the free market could do by itself.

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  20. Suvy Boyina says:

    Dr. Keen,

    I know this post is from a while back, but I just saw it. My point is with something like protected industries. How long can you protect industries from competition abroad? At some point, it does become unsustainable and harmful right? You cannot keep protecting industries forever as they eventually start to fall behind.

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