Keen questions economics of free trade

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In his trademark way, Steve Keen recently upset the apple cart of the economic mainstream by questioning the assumptions economists make to explain the benefits of free trade between nations. Free trade is yet another example of an economic principle that is sound at an individual level, but cannot be simply translated to a macro level.

Keen used the situation of England and Portugal reducing trade barriers for wine and cloth as his example.

 But there is an obvious fallacy to this neat and plausible argument: To effect specialisation, England has to shift labour and capital from wine to cloth (and Portugal has to do the opposite). Arguably labour can be retrained—a vigneron can become a machinist—but how do you convert wine press into a spinning jenny?

The obvious answer is that you don’t. Instead, you sell the wine press and buy a spinning jenny with the proceeds. But because of the introduction of trade, the price of wine in England would have fallen, so that the sale price of the wine press will also fall (economists have modified Ricardo’s model to introduce curves where Ricardo had straight lines, so that total specialisation is no longer required and there would still be some wine production in England under the “new” model of Free Trade), while the price of spinning jennies will have risen, given the new export market to Portugal. Some capital is necessarily destroyed by the opening up of trade and it applies in reverse in Portugal as well.

Since capital is destroyed when trade is liberalised, the watertight argument that trade necessarily improves material welfare springs a leak. If economics were a real science, this real-world complication to Ricardo’s argument would be considered, but it has never been seriously addressed.

I don’t believe Steve is questioning the merits of trade altogether. He is simply raising the point that the traditional microeconomic argument, where voluntary trade always results in pure benefits both parties, may be incomplete on a macro level. This occurs because those parties not involved in the trade, who used to produce the newly imported goods domestically, may incur substantial losses on their fixed capital investments. Whether these losses are outweighed by the benefits is an empirical question.

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There is a long intellectual history studying the virtues of trade, and a general rule of thumb if that the more advanced country to enter into bilateral free trade arrangements typically comes out on top. Keen’s observation is not unique in this respect. History also shows that substantial progress can be made with or without trade barriers.

Of course, Keen’s argument also applies to new technologies, which destroy the value of now out-dated physical capital. It is all part of the creative destruction that expands our productive capacity and typically improves our standard of living. However, the adoption of new technology is usually undertaken at a time that optimises the utilisation of current generation fixed capital. Is capital destruction from free trade also creative?

The critical consideration when analysing the benefits from trade is to consider the bargaining power of each participant. We can imagine a wealthy individual who wants for nothing, entering into a free trade agreement with someone desperate for wealthy man’s goods, but only able to supply a select few goods of their own. The wealthy man clearly has the upper hand in this ‘free’ trade agreement. He can dictate the methods of payment – gold, silver or cash only – or allow the ‘poor’ man to accumulated debts in return for goods. After some time, if the poor man has accumulated a large debt an is unable to repay, since all his increased earning are paying interest to the wealthy man, the wealthy man has an apparently legitimate excuse to make a claim on the poor man’s assets. I know what side of the free trade deal I would like to be on.

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Free trade agreements, and trade policies, enable already developed countries to exercise their bargaining power. You won’t read analysis suggesting that any current free trade agreement is also a fair trade agreement very often. Trade policies, and the theories underpinning them, are intrinsically political, forming a key part of global geo-political machinations.

How does one apply the knowledge of trade policy as a political tool? Politically. Economics can provide insights into the some short-term outcomes and industry impacts, but over the long term, there is no ‘right’ answer, and it very much depends on a countries global political position. Keen simply points out that there is no hard and fast economic justification for free trade at all costs.

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