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Free trade-off?

AUTHOR: Stewart Fist   DATE: 30.08.04   ISSUE 2, 2004

"Trade is a very important factor in many countries, including Australia. We have always exported 25–30 per cent of our production and imported about the same proportion of our consumption and investment needs."

Murray Kemp

Stewart Fist: More than two hundred years after free trader Adam Smith, we are still arguing the merits of free trade and protectionism. Doesn’t that suggest that the advantages and disadvantages of each are only marginal?

Murray Kemp: Trade is a very important factor in many countries, including Australia. We have always exported 25–30 per cent of our production and imported about the same proportion of our consumption and investment needs.

However, the assessment of international trade is extraordinarily difficult. For the extension of trading opportunities affects both the efficiency with which a country produces and the fairness with which aggregate income is distributed and each may be adversely affected.

Consider the question of efficiency. Twenty years ago Australia produced clothing and automobiles behind a high tariff wall, obtaining those commodities from inefficient domestic industries instead of from more efficient industries in China and Japan. If an economy is distorted (by commodity taxes, monopoly and pollution, for example), it might export the wrong commodities and thus become even less efficient. For example, Australia is still cutting down its forests (and, thereby, creating drought and floods) to export wood chips.

Stewart Fist: More than two hundred years after free trader Adam Smith, we are still arguing the merits of free trade and protectionism. Doesn’t that suggest that the advantages and disadvantages of each are only marginal?

Murray Kemp: Trade is a very important factor in many countries, including Australia. We have always exported 25–30 per cent of our production and imported about the same proportion of our consumption and investment needs.

However, the assessment of international trade is extraordinarily difficult. For the extension of trading opportunities affects both the efficiency with which a country produces and the fairness with which aggregate income is distributed and each may be adversely affected.

Consider the question of efficiency. Twenty years ago Australia produced clothing and automobiles behind a high tariff wall, obtaining those commodities from inefficient domestic industries instead of from more efficient industries in China and Japan. If an economy is distorted (by commodity taxes, monopoly and pollution, for example), it might export the wrong commodities and thus become even less efficient. For example, Australia is still cutting down its forests (and, thereby, creating drought and floods) to export wood chips.

Of course the proposition is not as broad as we would like since it is restricted by these two conditions. However, it is, in some respects, surprisingly broad. For example, it is valid whether or not some markets are missing (most futures markets don’t exist), and even when we recognise that the population comprises existing and future generations, most of which do not even overlap. Moreover, it is valid when markets are monopolistic rather than competitive.

SF: Are these economic propositions just elegant theories, or are they useful to governments and trade policy-makers?

MK: The gains-from-trade proposition is very beautiful, and I would like to think that it is also useful to policy-makers. However, the two conditions that support the proposition are also obstacles to policy-makers because they imply that the policy-maker can assess the state of the economy’s efficiency and also identify the precise effect of trade on the wellbeing of the country. Accurate and detailed information of this kind is not available.

Even if the information were available, awkward political questions concerning the desirable extent of the compensation would remain. In practice, therefore, policy formulation is handicapped by inadequate information and by the need to compromise the conflicting demands of different sections of the community. The price of agreement on commercial policies is the partial sacrifice of efficiency. For example, the US continues to sacrifice efficiency by insisting on protecting its sugar industry by retaining tariffs on its sugar imports.

SF: But free trade is still most desirable?

MK: Yes, but only as a general rule. Questions as to the desirability of free trade have been satisfactorily answered in aggregate terms, but there will always be an argument about the distribution of the gains from trade. The implied underlying objective of all GATT-type negotiations is that everybody must benefit. The question is: How do you achieve that?

So there has been a major argument about how this distribution should be carried out, either by lump-sum payments (such as poll taxes) or by re-distribution by means of commodity and income taxes.
SF: Are you talking here only about compensation for those individuals and corporations of a single country who have lost from new free trade conditions, or are you also suggesting an international compensation scheme between countries?

MK: This is entirely within a country. The government of each country is responsible for compensating the losers at the expense of those who gain.

The proposition we have been able to prove is that those who lose from new trading conditions are best compensated via lump-sum payments because then there are no distortions in the nation’s allocations of internal resources. The problem governments have always faced is that lump-sum payments require too much information about who are hurt and who have benefited from the opening up of trade or the relaxing of restrictions.

The alternative to the lump-sum compensation is to fiddle with commodity taxes – income, sales or excise taxes – but that does distort national markets and cannot always achieve complete compensation.

In summary, when the gains from trade are distributed equitably, then nations will benefit. Exceptions to this proposition are only found when a country’s markets are already distorted. So you can see why economists continue to argue about and qualify politicians’ gains-from-trade assumptions. The world is made up of distorted economies (to varying degrees) and it is, therefore, important to remember in any gains-from-trade debate that the opening of trade for an economy that is already distorted risks increasing productive inefficiency.

SF: So should the world be moving even faster towards free trade?

MK: If free trade could be imposed simultaneously on every country in an initially competitive but tariff-ridden world, the world would become more efficient. However, it is not certain that each country could compensate those of its households that would be harmed by the movement to free trade. For example, those countries that are initially mighty exploiters of their trading partners might well suffer from the abandonment of their tariffs and might, therefore, refuse to engage in tariff negotiations. In fact, the objective of universal free trade is never mentioned in the GATT – and wisely so because free trade would not necessarily make every country better off.

I think it is important to alert trade theorists and governments to the fact that unqualified promotion of free trade may be inappropriate.

SF: Your general proposition appears to be at odds with the idea that the individual’s pursuit of his or her own benefits will lead automatically to overall gains, because you presuppose government intervention to correct inequities?

MK: Yes, I think we’ve now left behind the simplistic interpretations of Adam Smith. All policy issues, whether they involve international trade or not, are impossible to assess without agreement on the ethical issues involved. Whether a country benefits from its foreign trade, or from its foreign borrowing and lending, can be assessed only if we have some guidance concerning the distribution of income.

As I have said, nations need to have efficient means of calculating and implementing lump-sum compensations for those adversely affected. Of course, the problem with this approach is that it is politically difficult to promote these ideas to an electorate. Any such scheme would be extremely complicated to implement, whereas the more idealistic theory of universal free trade is easy for politicians to preach and promote.

Professor Kemp has been a visiting scholar at the AGSM for three years. He has held positions overseas at Johns Hopkins University, McGill University and Massachusetts Institute of Technology, as well as becoming the first research professor at the University of New South Wales.

* Stewart Fist is a freelance writer.