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In the simplest of terms, free trade is the total absence of government policies restricting the import and export of goods and services. While economists have long argued that trade among nations is the key to maintaining a healthy global economy, few efforts to actually implement pure free-trade policies have ever succeeded.
Definition
Free trade is a largely theoretical policy under which governments impose absolutely no tariffs, taxes or duties on imports, or quotas on exports. In this sense, free trade is the opposite of protectionism, a defensive trade policy intended to eliminate the possibility of foreign competition.
In reality, however, governments with generally free-trade policies still impose some measures to control imports and exports. Like the United States, most industrialized nations negotiate “free trade agreements” or FTAs with other nations which determine the tariffs, duties and subsidies the countries can impose on their imports and exports. For example, the North American Free Trade Agreement (NAFTA), between the United States, Canada and Mexico (It has now been replaced by USMCA) is one of the best-known FTAs. Now common in international trade, FTA’s rarely result in pure, unrestricted free trade.
In 1948, the United States along with more than 100 other countries agreed to the General Agreement on Tariffs and Trade (GATT), a pact that reduced tariffs and other barriers to trade between the signatory countries. In 1995, GATT was replaced by the World Trade Organization (WTO). Today, 164 countries, accounting for 98% of all world trade belong to the WTO.
Despite their participation in FTAs and global trade organizations like WTO, most governments still impose some protectionist trade restrictions such as tariffs and subsidies to protect local employment. For example, the so-called “Chicken Tax,” a 25% tariff on certain imported cars, light trucks and vans imposed by President Lyndon B. Johnson in 1963 to protect US automakers remains in effect today.
Free Trade Theories
Since the days of the Ancient Greeks, economists have studied and debated the theories and effects of international trade policy. Do trade restrictions help or hurt the countries that impose them? And which trade policy, from strict protectionism to totally free trade, is best for a given country? Through the years of debates over the benefits versus the costs of free trade policies to domestic industries, two predominant theories of free trade have emerged: mercantilism and comparative advantage.
1. Mercantilism
Mercantilism is the theory of maximizing revenue through exporting goods and services. The goal of mercantilism is a favourable balance of trade, in which the value of the goods a country exports exceeds the value of goods it imports. High tariffs on imported manufactured goods are a common characteristic of mercantilist policy. Advocates argue that mercantilist policy helps governments avoid trade deficits, in which expenditures for imports exceeds revenue from exports. For example, the United States, due to its elimination of mercantilist policies over time, has suffered a trade deficit since 1975.
Dominant in Europe from the 16th to the 18th centuries, mercantilism often led to colonial expansion and wars. As a result, it quickly declined in popularity. Today, as multinational organizations such as the WTO work to reduce tariffs globally, free trade agreements and non-tariff trade restrictions are supplanting mercantilist theory.
2. Comparative Advantage
Comparative advantage holds that all countries will always benefit from cooperation and participation in free trade. Popularly attributed to English economist David Ricardo and his 1817 book “Principles of Political Economy and Taxation,” the law of comparative advantage refers to a country’s ability to produce goods and provide services at a lower cost than other countries. Comparative advantage shares many of the characteristics of globalization.
Comparative advantage is the opposite of absolute advantage—a country’s ability to produce more goods at a lower unit cost than other countries. Countries that can charge less for its goods than other countries and still make a profit are said to have an absolute advantage.
Advantages
It stimulates economic growth: Even when limited restrictions like tariffs are applied, all countries involved tend to realize greater economic growth.
It helps consumers: Trade restrictions like tariffs and quotas are implemented to protect local businesses and industries. When trade restrictions are removed, consumers see lower prices because more products imported from countries with lower labour costs become available.
It increases foreign investment: When not faced with trade restrictions, foreign investors tend to pour money into local businesses helping them expand and compete. In addition, many developing and isolated countries benefit from an influx of money from foreign investors.
It reduces government spending: Governments often subsidize local industries, like agriculture, for their loss of income due to export quotas. Once the quotas are lifted, the government’s tax revenues can be used for other purposes.
It encourages technology transfer: In addition to human expertise, domestic businesses gain access to the latest technologies developed by their multinational partners.
Disadvantages
It causes job loss through outsourcing: Tariffs tend to prevent job outsourcing by keeping product pricing at competitive levels. Free of tariffs, products imported from foreign countries with lower wages cost less. While this may be seemingly good for consumers, it makes it hard for local companies to compete, forcing them to reduce their workforce. Indeed, one of the main objections to NAFTA was that it outsourced American jobs to Mexico.
It encourages theft of intellectual property: Many foreign governments, especially those in developing countries, often fail to take intellectual property rights seriously. Without the protection of patent laws, companies often have their innovations and new technologies stolen, forcing them to compete with lower-priced domestically-made fake products.
It allows for poor working conditions: Similarly, governments in developing countries rarely have laws to regulate and ensure safe and fair working conditions. Because free trade is partially dependent on a lack of government restrictions, women and children are often forced to work in factories doing heavy labour under grueling working conditions.
It can harm the environment: Emerging countries have few, if any environmental protection laws. Since many free trade opportunities involve the exporting of natural resources like lumber or iron ore, clear-cutting of forests and un-reclaimed strip mining often decimate local environments.
It reduces revenues: Due to the high level of competition spurred by unrestricted free trade, the businesses involved ultimately suffer reduced revenues. Smaller businesses in smaller countries are the most vulnerable to this effect.
