Is free trade always the answer?

As concerns over Donald Trump’s import tariffs intensify and Britain renegotiates its trading relationship with Europe, the postwar consensus towards ever-closer economic cooperation between wealthy nations is being unpicked.

Why is Trade Good?

Economists argue about a lot of things, yet many would probably agree on the benefits of free trade, which generates wealth by allowing the free flow of goods across international borders, without taxes and other such barriers.

The argument runs that billions of people around the world have been lifted out of poverty by the combined power of capitalism and free trade. We are taught that the world’s most powerful nations spurred their advance by tearing down the castle walls of protectionism during the latter half of the 19th century – ending centuries of beggar-thy-neighbour economic nationalism – opening up new markets to boost the industrial revolution and drive forward the development of the middle class.

John Stuart Mill wrote that, once upon a time, the average patriot “wished all countries weak, poor and ill-governed, but his own: he now sees in their wealth and progress a direct source of wealth and progress to his own country”.

Two ideas remain central to the theory of international trade more than 200 years later.

In his seminal work The Wealth of Nations, Adam Smith taught countries to concentrate their efforts on producing and selling goods in which they have an “absolute advantage” over their trading partners. Cheaper labour costs give modern-day China an absolute advantage over most western nations for manufacturing. But what happens when a country has absolute advantage in multiple industries?

In the 19th century, David Ricardo took the idea further by arguing that one country might have a comparative advantage over the other. He said it was possible for England to produce more wine and cloth than Portugal. However, it would require greater effort in England, handing Portugal a comparative advantage.

Read More: The New Geopolitics of Trade in Asia

Both theories teach nations to focus their time on making and selling goods in which they have an advantage over their rivals, for mutual benefit through free trade. Consumers will benefit from lower prices in both nations.

Classical economic theory does not, however, always work in practice, and the rules require all nations to sing from the same hymn sheet. Unfettered capitalism across borders still creates winners and losers, posing thorny social and political questions for policymakers where dry economic models cannot help.

There are thousands of ways nations can distort the playing field. The most extreme might be the use of military intervention, although far more common are subsidies for particular industries, tax, spending and the use of the legal system. Trump’s import tariffs are the most high-profile example.

Why are Tariffs Imposed?

Tariffs are border taxes charged on foreign imports. Importers pay the charges at the point of entry to the customs agency of the country or economic bloc imposing them.

Rather than being used to raise revenue, they are imposed to increase the price of foreign goods in order to make domestic produce comparatively cheaper, with the aim of encouraging domestic production and protecting firms from global competition.

Economists mostly agree higher tariffs are counterproductive. While they can protect jobs, they also tend to raise the price of goods for consumers and stifle innovation that could benefit the economy.

Besides using tariffs to protect domestic industries, countries often provide support to certain sectors through state subsidies, or impose quotas restricting the volume of goods imported from overseas. There are also non-tariff barriers; such as patent rules, health and safety regulations, labour and environmental standards, and rules of origin.

Non-tariff rules have forged countries’ domestic policies closer together in recent decades to enable greater levels of international trade.

Do Trade Deficits Matter?

Many economists would argue trade deficits are an irrelevance, although surpluses are often seen as economic virility symbols. Persistent deficits require funding via international borrowing, which becomes harder if confidence in a country falls.

There are other risks from reliance on imports over domestic production. National security is one: should a country sacrifice the ability to produce steel required for making tanks, for example. Trump is using national security legislation for much of his tariffs.

The other risk is that imports support jobs overseas, rather than at home. Workers in industries competing most with imports – typically in manufacturing – do tend to lose out, economists have found, while employment shifts towards sectors less exposed to trade.

Without smooth transitions for struggling industries, or the safety net of the welfare state – through job-seeker benefits, education and training – whole communities can be left bereft of work. Britain during the 1980s was a classic example, as the government of Margaret Thatcher chose to shut UK mines and import coal from South Africa and Argentina.

Is Free Trade the Panacea?

Trade deals always create winners and losers. But while the choice is a matter for politics, these decisions often come amid an onslaught of lobbying from powerful vested interests. Some observers argue free trade deals are, therefore, often simply the result of rent-seeking by politically well-connected parties.

The failed Transatlantic Trade and Investment Partnership between the US and the EU is one recent example, where corporate interests including the US private health industry wanted to expand to new markets in Europe. The deal ultimately failed amid widespread public opposition.

There are fears trade deals benefit larger corporations already operating across international borders, rather than smaller firms. Domestic producers can be squeezed out by global rivals with huge economies of scale.

The argument could be best put by the political theorist Isaiah Berlin who noted “freedom for the pike is death for the minnows”.

However, international firms often support networks of smaller companies in their supply chains. Greater trade barriers can make it more difficult for multinationals to operate across borders, meaning they could relocate elsewhere where it is easier for them to do so – directly and indirectly affecting jobs and economic growth. After the gradual advance of globalization in recent years, rapidly unpicking the progress may cause severe short-term pain.

Economists argue international competition stimulates greater innovation and productivity, while warning protectionism can hinder progress. The quantity and quality of Soviet cars and other eastern bloc goods serves as one example, while the poor reputation of cars made by the British motor industry during the 1970s might be another. Consumers have benefited as the quality of goods have improved and prices have fallen.

How big is global trade?

World exports of manufactured goods, agricultural products and fuel and raw materials were worth about $15.5tn in 2016, according to the WTO. Commercial services such as transport and communications exports were worth a further $4.8tn.

China is the world’s biggest exporter, shipping merchandise worth about $2.3tn, followed by the US with about $1.5tn and Germany with $1.4tn.

The United States exported goods worth about $1.5tn last year whereas its imports were worth almost $2.4tn, leaving a deficit of more than $800bn.

China accounts for the largest proportion of the US deficit, with Americans buying about $375bn more from China than they sell in return.