Stephen King: Free trade is not perfect, but it's all we've got

The western world's uncertainty is a reflection of its own schizophrenic attitude towards free trade and development. The US supports free trade (although the recent experiment with steel tariffs suggests that this support is rather equivocal) but coughs up very little to support overseas development. As a result, would-be competitors, particularly in agriculture, find it very difficult to get a foot on the development ladder. The European Union is a lot more generous in its development aid but, by subsidising its own agricultural production through the Common Agricultural Policy (in effect, a trade barrier imposed on non-European agricultural producers), the EU's policies depress world prices so much that the aid paid out to other countries provides little in the way of lasting benefit to them.

When it comes to economic success in China and India, however, the US and the EU seem to be particularly unsure of their footing, partly because the world is being transformed by the emergence of these two preciously sleeping giants (see charts). Washington and Brussels are, of course, full of lobby groups but the messages coming from those groups are hardly consistent. If you're a Portuguese textiles manufacturer, the last thing you need is cheap bras coming in from China because you don't want to go out of business and your workers don't want to lose their jobs. If, though, you're WalMart or Hennes & Mauritz, you don't want to be paying higher prices for your stock than you need to. And US and European consumers may have similar sentiments - unless they happen to work in the textiles industry.

The intellectual case for free trade is well established, but my sense is that the arguments in its favour are too often applied with little thought and, as a result, can seem overly callous. There are two difficulties with the free trade approach. First, free trade arguments are focused on maximising output for a given level of inputs. They say little about the distribution of that output and politicians can easily exploit this potential weakness. Second, free trade arguments are based on assumptions that, in themselves, should perhaps be subject to a little more scrutiny. By allowing this scrutiny, adherents of free trade would be doing themselves a favour: they would come across more as economic rationalists than as quasi-religious evangelists.

The classical statement in favour of free trade comes from David Ricardo, with his theory of comparative advantage. It's a straightforward story. Take two countries that don't trade with each other but which both produce only two goods, A and B. Assume both countries are completely efficient in their allocation of existing resources. Then allow them to trade with each other. So long as one country is relatively better than the other at producing good A than good B (even if the country is not absolutely better at producing good A), Ricardian comparative advantage shows both countries end up with a higher standard of living through specialisation of production and the opening up of trade relations. Relative to the alternative of continued autarky, this is a win-win situation.

Ricardo's argument is incredibly powerful and, on the whole, very difficult to refute. The golden age of economic growth in the 1950s and 1960s was clearly associated with the dismantling of pre-war trade barriers. China's decision to embrace autarky in the fifteenth century, and its subsequent prolonged economic stagnation, is an example of the economic consequences associated with a failure to embrace free trade.

I wonder, though, whether Ricardo's argument applies quite so coherently in current circumstances. The argument depends on the twin assumptions that resources are efficiently allocated within a situation of autarky but that they can be allocated even more efficiently if interested nations start talking to each other. That's why free trade zones, along the lines of the European Union or the North American Free Trade Association, are created in the first place.

What happens, though, if certain parts of the world have been held back not because of an absence of trade but, rather, through a lack of access to capital? That absence might reflect geographical constraints (distance, navigable rivers, etc) or political constraints (capitalism versus communism) or technological constraints (absence of cheap telecommunications). In this situation, it's not so obvious that trade brings an improvement in the standard of living to all concerned.

Take two countries. For the sake of argument, call them the United States and China. Assume that, because of the constraints outlined in the previous paragraph, the US has all the capital and China has none. Then assume that the constraints that kept all the capital in the US - political, geographical and technological - are removed. What happens? Either labour moves to where the capital is plentiful - Chinese workers migrate to the US - or, more likely in this day and age, capital moves to where the workers are.

Using Paul Samuelson's approach ("Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization", Journal of Economic Perspectives, summer 2004), assume also the huge increase in capital spending in China implies the comparative advantage that seems to come from trade is removed (in other words, the upgrade to the Chinese capital stock leaves the Chinese as productive in all things as the Americans, only at a much lower price). Then what happens? China ends up better off, the world economy ends up better off (there are, after all, lots of Chinese workers getting richer through their access to capital) but US workers may now be collectively worse off. The goods they were producing have, after all, now become a lot more plentiful and, as a result, prices have come down. For the US, the terms of trade have worsened.

The argument suggests that attempts to introduce Ricardian comparative advantage do not, in all circumstances, imply everyone can win. If the west started off with monopoly access to capital and that access is removed, westerners will inevitably be threatened. Ricardian comparative advantage works best if it's assumed each country has a given stock of capital and the capital is immobile. Drop this assumption, introduce capital mobility, and the story doesn't progress quite so easily.

Even though Ricardo's arguments don't apply in all circumstances, there is still a weaker defence of free trade. In the absence of free trade, what are the viable alternatives? Rationally, there are very few. Peter Mandelson, the EU's Trade Commissioner, has no doubt discovered this paucity of choice over the last few weeks. His attempt to pursue managed trade with the Chinese - under pressure from the French, Italians and the Portuguese - has ended ignominiously. Too many bras in warehouses, too few in the shops and too much pressure from the agents provocateurs - not, by the way, the purveyors of saucy underwear - who seek to disrupt the patterns of free trade to suit their own, protectionist, agenda. And free trade is not all bad news in the west: workers may feel threatened but consumers benefit from lower prices and shareholders - pensioners and would-be pensioners included - benefit from the more efficient use of capital in markets with cheaper labour. We may not always like the implications of free trade. However, to paraphrase Winston Churchill, while many no doubt think that free trade is absurd, all other systems are worse.

Stephen King is managing director of economics at HSBC

stephenking@hsbcib.com