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

Flattr this!

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.

Bookmark the permalink.

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.