Why Free Trade Doesn’t Always Work

By | 2017-06-02T18:30:05+00:00 October 3, 2017|
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Everyone and their dog has heard of Adam Smith, John Maynard Keynes, and Milton Friedman. Not only are they some of history’s most influential economic thinkers, they are intellectual celebrities. Books like the Wealth of Nations are commonly cited. But unless you are a lonely economist, you probably have never heard of David Ricardo (d. 1823) or his book On the Principles of Political Economy and Taxation. That’s a shame. Ricardo might be the most important of the bunch. His big idea, the theory of comparative advantage, underpins modern economic globalization, if not international free trade itself.

Globalization is the house Ricardo built.

One tiny problem, though: comparative advantage doesn’t always work. In fact, its misapplication is largely to blame for the decline of Victorian Britain in the 19th century, and America’s decline since the 1970s.

 

What Is Comparative Advantage?
At its heart, the theory is straightforward: countries should trade things they are relatively good at making for things they are relatively bad at making. This makes the economy more efficient, and therefore makes everyone richer (since more stuff is made with less overall work).

To illustrate his point, Ricardo came up with a now-classic example. It goes like this: suppose there are two countries, England and Portugal. And suppose that both of them make cloth and wine. Now pretend it takes England 100 man-hours to make a bolt of cloth, and 120 hours to make a barrel of wine (it would take 220 hours to make one unit of each). In this case, England is relatively better at making cloth than wine.

Now suppose in Portugal it takes only 90 hours to make a bolt of cloth, and 80 hours to make the wine (170 hours to make one unit of each). Notice how that Portugal is absolutely better at making both cloth and wine, since it takes the Portuguese less time to make either commodity. However, Portugal is relatively better at making wine than cloth. Therefore, it can be said that, relative to England, Portugal has a comparative advantage in making wine, and that England has one in making cloth—each country is better at making one thing than in making the other, and it would make logical sense for them to specialize in making only the thing they each make best (England should focus on cloth; Portugal on wine), and trade with each other to acquire the other product.  

Logically and mathematically, comparative advantage makes sense. If neither country specialized, it would take 220 hours for England to make one unit of cloth and one unit of wine, while Portugal would take 170 hours. However, if they both specialized and traded, then the same labor could make 2.2 units of cloth and 2.125 units of wine—like magic, specialization and trade makes everyone richer.

When applying comparative advantage globally, it follows that if every region specialized in making goods for which it has a comparative advantage, then the global economy would be maximally efficient, and therefore the world would be richer.

Well . . . is it?

The extrapolation doesn’t work. It is time to bring down global free trade’s edifice.

 

Why Comparative Advantage Fails

Ironically, the best critique of comparative advantage comes from David Ricardo himself. In his book, he acknowledges that his theory is domain-specific, meaning that it only applies when certain antecedent conditions are met. In a way, the theory of comparative advantage contains the seeds of its own destruction. Ricardo writes:

…it would undoubtedly be advantageous to the capitalists [and consumers] of England… [that] the wine and cloth should both be made in Portugal [and that] the capital and labour of England employed in making cloth should be removed to Portugal for that purpose. 

Ricardo explicitly states that, according to his theory, it makes sense for England to import both cloth and wine from Portugal (since Portugal can make them more efficiently), and that England’s cloth-making industry should be—to use contemporary parlance—offshored to Portugal. This would result in offshoring and trade deficits—exactly what has happened in real life whenever America signs a trade deal with a developing nation.

Of course, Ricardo is not a stupid man, and he knows full well this would be a losing strategy for England—if England imported everything and made nothing, it would have no economy. Furthermore, England would be vulnerable to foreign suppliers, just as the United States depends upon Saudi Arabia and other fair-weather friends and sometimes hostile nations for its oil. So Ricardo adds an intellectual buttress to ensure that the temple of trade will not collapse: he says “most men of property [will be] satisfied with a low rate of profits in their own country, rather than seek[ing] a more advantageous employment for their wealth in foreign nations.”

There you have it, Ricardo’s argument—the entire theory of comparative advantage, global free trade itself—is premised on the assumption that most people love their country more than money, and will invest domestically out of the goodness of their hearts.

Of course, this is not true. Gordon Gekko was right to note that “greed is good” is the name of their game.

Capital is highly mobile in today’s economy. A factory can be relocated from the United States to China in short order, and transportation for bulk goods is incredibly (almost unbelievably) cheap. In fact, in the decades after Ricardo’s death in 1823, capital grew ever more mobile, and his hypothetical dilemma soon became real.

Ricardo also used a more technical defence of comparative advantage from this obvious flaw. He argued that offshoring is impossible because capital is immobile—that is, England’s textile mills could not be moved to Portugal anyway. This is the antecedent condition I mentioned before—comparative advantage is domain-specific because it only applies when capital is stuck and offshoring cannot occur (such as when trade happens within a nation, or when something prevents commerce from relocating).

To be fair, when Ricardo wrote his Principles, capital was indeed largely immobile. His theory of comparative advantage worked because, in the early 19th century, transportation was an order of magnitude more expensive, machinery could not legally be exported from Britain, tariffs on manufactured goods exceeded 50 percent, capital markets were undeveloped in most countries, and endemic warfare prevented a large-scale commodity trade. Therefore this hypothetical problem remained purely hypothetical for Ricardo. This is no longer true.

Capital is highly mobile in today’s economy. A factory can be relocated from the United States to China in short order, and transportation for bulk goods is incredibly (almost unbelievably) cheap. In fact, in the decades after Ricardo’s death in 1823, capital grew ever more mobile, and his hypothetical dilemma soon became real.

Throughout the 1800s there was a steady increase of capital outflows from Great Britain, as British investors built projects abroad seeking higher return. In 1815, £10 million was invested abroad. In 1825, this climbed to £100 million, and by 1870 it was £700 million. By 1914 (the peak) over 35 percent of Britain’s national wealth was held abroad—Britain suffered a severe, decades long shortfall in domestic investment. Likewise, economic and industrial growth slowed to a crawl, as the British market was flooded with German and American products. The same thing is happening to America today: between 2000 and 2015 we invested almost $4 trillion abroad (in terms of Foreign Direct Investment, or FDI), and accumulated $10 trillion in trade deficits.

These two basic truths—people are greedy and capital is mobile—completely destroy comparative advantage by invalidating its underlying premise, and relegate it to the intellectual curiosity shop of history. Ricardo was a smart man who recognized his theory’s limits, and it’s too bad his ideas have been bastardized to justify global free trade in a world where his theory was never meant to apply—ironically, the same thing happened to Adam Smith, as my colleague Bob Calco has shown.

May Ricardo’s monster rest in peace.

 

Theory Meets Reality

Perhaps the best way to end this article is to compare what happened to Ricardo’s hypothetical England and Portugal with what happened in the real countries. In his example, Portugal gets rich by maximizing its comparative advantage in wine, while England gets rich by doing so with cloth. Both countries trade, both benefit.

Reality is harsh. In 1703, the two countries signed the Treaty of Methuen, which, among other things, exempted English cloth from a Portuguese import-prohibition. In the following decades, cheap English imports destroyed Portugal’s textile industry, and Portugal indeed resorted to exporting wine. Soon afterward, England gained a textile monopoly in Portugal, which allowed Britain to drive up prices above-market, expand her increasingly-advanced textile industry (this stimulated the mechanical and engineering breakthroughs that birthed the Industrial Revolution), and buy up Portugal’s vineyards, thereby securing both industries. As it turns out, not all industries are of equal value—cloth was more lucrative than wine. In the end, the Treaty of Methuen deal helped England industrialize and grow rich—at Portugal’s expense.

The story of Methuen contains two morals worth mentioning. First, we should be careful not to value our theories more than we value empirical evidence—often things look good on paper, but fail miserably in real life. Second, we should endeavor to be like England, not Portugal. America’s trade policy should concentrate as much advanced industry in the nation as possible, even if that means imposing tariffs, or signing “unfair” deals with other countries. We need to stop thinking like economists, and think like businessmen.

 

About the Author:

Spencer P. Morrison
Spencer P. Morrison is a law student, writer, and author of "Bobbins, Not Gold." He is the editor-in-chief of the National Economics Editorial (https://www.nationaleconomicseditorial.com). Follow him on Twitter @SPMorrison_.
  • Americans can not have free trade with foreigners if the per capita capital spending by foreigners is less than it is for Americans.

    1. The return to capital is the source of wages.

    Where there is no capital, there can be no wages (e.g., much of Africa). Where there is high capital per capita, there is high wages (e.g., US, Canada, Norway, etc.) and where there is low capital per capita, there is low wages (e.g., China, India, third world, etc).

    2. Only under increasing returns to capital, can there be increasing wages.
    3. When there is a labor shortage, capital spending leads to productive gains, literally amplifying the workers. This leads to increasing returns to capital and thus increasing wages.
    4. But where there is an abundance of labor, capital spending will be low as returns to capital will be low.
    5. When a high-wage people enter into trade with a low wage, high population people, the net effect is as if the high-wage people have increased their population by the amount of the low-wage people.
    6. This leads to lower returns to capital in the high-wage country for the same kinds of production.
    7. As the return to capital falls, wages must fall.
    8. With falling wages, prices must fall as wages are the ultimate source of prices.
    9. On falling prices, the returns to extant capital must fall across all production for all products.
    10. At this point, the economy goes into the capitalism death whorl.

    This is where the USA has been for awhile now. This is why real wages continue to fall. Congress exacerbates the capitalism death whorl by importing over a million low-skill/no-skill immigrants a year and doing nothing about the millions of illegal alien low-skill/no-skill immigrants already in the USA.

    The neoliberals / globalizationists literally are destroying the USA and the livelihoods of Americans as well as future Americans by pursuing the folly of unfettered free trade with high-population, low per capita capital spending countries.

    Agnostic tariffs need to be levied on all countries with the rates set based on the per capita capital spending in the ideal. Short of that, the reciprocal of per capita GDP would suffice.

    So there should be about an 81% tariff on Mexican made goods and about an 8% tariff on Canadian made goods.

  • msher_1

    My simple explanation of it: Yes, but capital can easily move to developing countries and third world workers can come here, get jobs and benefits. Our workers can not go to developing countries and get benefits and work. The freedom is not reciprocal and there is nothing fair about it and it is disastrous for society. If we allow much more of this “freedom” we will not have a country or governable society. Let’s replace all the conservative pundits with pundits from other countries and we’ll see how long they espouse “free trade.”

    • zoomie

      Have you ever heard an economist tell anyone to get economic advice from another country because it is more cost effective ? Me either.

      Funny how the guys who claimed in the long run they would all be dead … are now dead. It is now our problem. We were sold out.

      You should read Michaels Phillip’s book, ” The Hundred Year Marathon “.

      I could only get through one chapter at a time … when I was lucky. It details china policy for the last 40 years, from the inside. He was there. It is a two hundred page apology letter. I have never seen or heard or read some one from the power elite apologize with such detail of how they got it so very wrong.

      Signed ,
      Ex machinist, who went to engineering school … and passed.

  • RT

    I don’t follow the logic of the conclusion: “We need to think like businessmen, not economists.” A businessman is free to invest where he or she likes, and is likely to follow profits and opportunity in the short and medium run, not just the long run.

    Moreover, Ricardo was following empirical evidence as much as anyone else, and empirical evidence can’t be separated from theory, as it is theory that interprets empirical evidence and puts it into a meaningful framework.

  • Anne Miller

    Yes the government should force everyone to purchase American made cell phones and computers and cars and TVs.