Prof. Sven W. Arndt on global free trade: Don’t dump the system, fix the anomalies

By Sven W. Arndt
Charles M. Stone Professor of Money, Credit and Trade

The pros and cons of America’s international economic policies are receiving intense scrutiny from the new U.S. administration. Among the hot-button issues are free trade and tariff policy, exchange rate manipulation, preferential trade agreements and worker migration. How and to what extent these policies are changed will have important long-term implications on a number of economic, political, and strategic fronts.

It is important to recall that many of the institutions, agreements, and policies that today govern U.S. economic relations with nations around the world were put in place after World War II, while others have been added in the 70-plus years since then. So it is appropriate to ask whether and in what ways these ancient arrangements are still suitable or constitute best practices in the modern global economy.

The political impetus for the international economic architecture we know today arose from the exigencies of the Cold War, but it was underscored by a broadly shared desire among nations for a world order that would avoid the mistakes of the past. The push for free trade and economically open borders was amplified by recognition that the tariff wars of the war time contributed significantly to financial collapse and the Great Depression. Similarly, Europe’s early preferential trade agreements of the 1950s were strongly supported by America for Cold War reasons in spite of their open discrimination against U.S. exports.

The fiasco of the tariff wars made a compelling case against protection in favor of open trade under a system of international rules. These rules were put in place over decades of multilateral trade negotiations and are today administered by the World Trade Organization (WTO). In spite of these efforts, what we have today is not really free trade, but relatively unencumbered trade that responds to market forces. However, many nations – the U.S. and those that make up the European Union included – continue to protect so-called sensitive sectors like agriculture against foreign competition.

Free trade also has considerable intellectual support from research by economists, whose studies initially focused on the costs and benefits to a nation of alternative trade policy regimes. Those studies have made use of the crucial insight that show that, much like individuals, nations differ in terms of their endowments of basic productive resources – labor and capital, primarily, and arable land. This implies that if each nation specializes in producing goods and services that make heavy use of its relatively abundant factors of production, world output will be significantly higher. Intuitively, this confirms ordinary daily experience: humans organize sports teams, office staffs, and military cadres in ways that give each member responsibility for tasks best suited to his or her skills and talents. This allows the group as a whole to reap valuable benefits, be they win/loss records, income and output, or combat performance.

That’s the case for free trade in a well-functioning market economy: free trade works best when markets are free from imperfections and distortions. There are many sources of market dysfunction and failure, including government policies and excessive concentration in the private economy such as oligopolies and monopolies. Government and large businesses possess economic power that may be used to inhibit the proper working of market mechanisms. Critics of large government have a point in this respect, but the same point can be made about large companies, especially in the age of globalization and multinational enterprises. The clout of special interest groups in the political process may lead to policies that benefit the groups at the expense of the larger economy. Within large enterprises, strong managements represent an interest group that may appropriate profit shares that are not justified by their contribution to those profits.

The increase in world output that results from free trade raises living standards – but whose living standards and in what proportions? How is the increase in world output divided among the many who created it? In a well-functioning market system, workers’ wages, managers’ salaries, and the return to capital would rise to match the rise in the productivity of each. Many observers would find this kind of sharing of the gains from trade as fair. In our imperfect and distorted economies, however, that rarely happens. Nevertheless, the solution is not to eliminate free trade, but to improve the competitiveness of markets.

Still, the consequences of free trade are often more complex, because it actually creates losers as well as winners. Even when free trade creates more new jobs than it destroys, workers whose jobs are eliminated may not have the skills, or the means to acquire the skills, needed for the new jobs. The aggregate numbers show a decline in recent years in the share of men aged 55-64 in the labor force. Of course, this drop includes workers displaced by technological change and automation. In the case of trade, however, Congress in the 1960s created a program of Trade Adjustment Assistance (TAA), aimed at providing relief to workers, firms, and communities that can show they have been hurt by imports.

Many advanced countries have TAA policies in place, but among Organisation for Economic Co-operation and Development (OECD) members, the level of resources devoted to such programs is significantly higher than in the U.S. Economists have argued that if the winners can compensate the losers and still be better off under free trade, then TAA policies are worthwhile. Similar considerations apply to free-trade agreements, including the North American Free Trade Agreement (NAFTA) and the Trans-Pacific Partnership (TPP).

As noted above, the rules governing the current global trade regime may no longer be fully suitable for this time. The solution then is not to abolish the system, but to fix the anomalies.