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Defending Free Trade

Arvind Panagariya

             Mathematician Stanislaw Ulam once asked economics Nobel Laureate Paul Samuelson whether he could point to an idea in economics that was universally true and not obvious at the same time.  Samuelson’s response was the “principle of comparative advantage,” according to which two countries necessarily benefit from engaging in free trade with each other provided their relative production costs are not identical.  Being based on a mathematical relationship, the principle easily passes the test of universal validity.  And centuries of assertions by politicians, journalists and policy analysts directly contradicting the principle testify to its subtle nature.

             If you are among free-trade sceptics, consider the following parable. 

During the 1970s, a trade economist was invited to visit China.  As he toured the country, he noticed that construction workers invariably used shovels.  He could not resist suggesting to his host that importing a few bulldozers and replacing shovels by them could drastically cut costs.  The host was horrified and reminded him that such a change would lead to huge unemployment.  In that case, rejoined the trade economist, you may as well replace the shovels by spoons!

This parable dramatizes the fallacy underlying the twin arguments that freeing up imports and substituting capital for labour lead to unemployment.  Thus, for example, when I recently wrote that we must free up the imports of used cars, L. Ganesh (ET, Letters, November 6) was quick to assert that this would lead to unemployment: “half a million people cannot all move to the United States of America to find jobs there.”

The problem with such arguments is that they focus exclusively on employment in the liberalized sector.  They entirely ignore the fact that to import more, you must export more.  The employment lost in the inefficient import-competing sector is regained in the more efficient export sectors.  This is why economists generally agree that aggregate employment is determined primarily by macroeconomic policies; trade and tax policies only determine the allocation of resources.

Likewise, substituting capital for labour may lower employment in a specific sector but not the economy as a whole.  Indeed, if such substitution leads to sufficiently large efficiency gains, as the use of shovels over spoons definitely would and of bulldozers over shovels might, employment may rise even within the sector in which capital substitutes for labour.  Due to increased profitability, the sector may expand so much that the total employment in it rises even as employment per-unit of capital declines.

Of course, just as we cannot blame free trade for increased (aggregate) unemployment, we should not credit it with the taming of inflation.  While freer trade lowers the prices of importable goods, it also raises the prices of exportable goods.  All Indians are aware of the contribution of exports to at least temporary spikes in onion prices and hence the price level.  Even when increased competition due to trade liberalization lower the price level overall, it is a one-time reduction rather than a reduction in the inflation rate.  Ultimately, the rate of inflation is determined by macroeconomic variables; trade tax policies mainly influence relative prices.

An argument against free trade that has gained some currency in recent years in developed countries is that due to low wages, poor countries enjoy an unfair advantage against them.  But this is silly since higher wages in developed countries reflect higher productivity.  Symmetrically, developing countries can claim that developed countries enjoy an unfair advantage due to the availability of cheap capital and skilled labour and superior technology.  But that too will be silly since these differences are the very basis of gainful trade.  If we were to artificially eliminate the differences in technology and factor prices, in the absence of economies of scale, no basis for gainful trade will be left. 

The argument against free trade that is more difficult to counter is that it may lead to adverse income-distribution effects.  In the United States, it has been argued that the expansion of labour-intensive imports during the last two decades has led to increased wage inequality between skilled and unskilled workers.  There are at least three problems with this argument, however.  First, developed countries spend less than 2 percent of their income on the imports from developing countries, which can hardly lead to the observed 30 percent reduction in the wages of unskilled relative to skilled workers.  Second, technological change that is biased in favour of skilled labour is the more plausible explanation for the increased wage inequality.  Finally, in the ultimate, income distribution concerns are best addressed through adjustment assistance, training programs and social-safety nets.  The overall benefits from trade should not be sacrificed in perpetuity.  After all, if there is a technological breakthrough such as the handling of soft material by robots, which can potentially eliminates the need for labour in the apparel industry, we will not ban its application on the ground that it worsens income distribution.  Why should trade be any different?

The income distribution argument has also been invoked in India in the context of liberalization.  The argument, based on evidence of questionable quality, is that liberalization has led to increased poverty.  I have argued systematically in a previous column (ET May 24, ’00) that this is an ill-conceived argument.  For one thing, even based on faulty data, states that have grown rapidly do show a continued reduction in poverty.  In addition, rapid growth, which trade liberalization and other economic reforms seek, is the best hope for the removal of poverty.  Without that, we will lack resources to provide for education, health and other poverty-reduction programs.

Of course, the centuries old tradition of misguided arguments against free trade is not about to come to an end.  We will continue to hear about the damage trade does to the environment, labour rights, employment, technological upgrading, foreign-exchange reserves, poor people, children, women, consumers, tribal communities, rural life, animals, and so on. 

And that is just as well for trade economists!

Economic Times November 22 2000