Rabobank: What If... The Protectionists Are Right And The Free Traders Are Wrong?

Submitted by Michael Every of Rabobank

“When I used to read fairy tales, I fancied that kind of thing never happened, and now here I am in the middle of one!” (Alice in Wonderland, Chapter 4, The Rabbit Sends in a Little Bill)

What if... the protectionists are right and the free traders are wrong?

2020 starts with markets feeling optimistic due to a US-China trade deal and a reworked NAFTA in the form of the USMCA. However, the tide towards protectionism may still be coming in, not going out.

The intellectual appeal of the basis for free trade, Ricardo’s theory of comparative advantage, where Portugal specializes in wine, and the UK in cloth, is still clearly there. Moreover, trade has always been a beneficial and enriching part of human culture. Yet the fact is that for the majority of the last 5,000 years global trade has been highly-politicized and heavily-regulated. Indeed, global free-trade only began following the abolition of the UK Corn Laws in 1846, which reduced British agricultural tariffs, brought in European wheat and corn, and allowed the UK to maximize its comparative advantage in industry. Yet it took until 1860 for the UK to fully embrace free trade, and even then the unpalatable historical record is that during this ‘golden age’, the British:

Destroyed the Indian textile industry to benefit their own cloth manufacturers;

  • Started the Opium Wars to balance UK-China trade by selling China addictive drugs;
  • Ignored the Irish Potato Famine and continued to allow Irish wheat exports;
  • Forced Siam (Thailand) to open up its economy to trade with gunboats (as the US did with Japan); and
  • Colonized much of Africa and Asia.

As we showed back in ‘Currency and Wars’, after an initial embrace of free trade, the major European powers and Japan saw that their relative comparative advantage meant they remained at the bottom of the development ladder as agricultural producers, an area where prices were also being depressed by huge US output; meanwhile, the UK sold industrial goods, ran a huge trade surplus, and ruled the waves militarily. This was politically unsustainable even though the UK vigorously backed the intellectual concept of free trade given it was such a winner from it.

Regardless, the first flowering of free trade collapsed back into nationalism and protectionism - bloodily so in 1914. Free trade was tried again from 1919 - but burned-out even more bloodily in the 1930s and 1940s. After WW2, most developed countries had moderately free trade - but most developing countries did not. We only started to reembrace global free trade from the 1990s onwards when the Cold War ended – and here it is under stress again. In short, only around 100 years in a total of 5,000 years of civilization has seen real global free trade, it has failed twice already, and it is once again coming under pressure.

What are we getting wrong? Perhaps that Ricardo’s theory has major flaws that don’t get included in our textbooks, as summarized in this overlooked quote

“It would undoubtedly be advantageous to the capitalists of England…[that] the wine and cloth should both be made in Portugal [and that] the capital and labour of England employed in making cloth should be removed to Portugal for that purpose.” Which is pretty much what happens today! However, Ricardo adds that this won’t happen because “Most men of property [will be] satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations,” which is simply not true at all! In other words, his premise is flawed in that:

  • It is atemporal in assuming countries move to their comparative advantage painlessly and instantly;
  • It assumes full employment when if there is unemployment a country is better off producing at home to reduce it, regardless of higher cost;
  • It assumes capital between countries is immobile, i.e., investors don’t shift money and technology abroad. (Which Adam Smith’s ‘Wealth of Nations’, Book IV, Chapter II also assumes doesn’t happen, as an “invisible hand” keeps money invested in one’s home country’s industry and not abroad: we don’t read him correctly either.);
  • It assumes trade balances under free trade - but since when has this been true? Rather we see large deficits and inverse capital flows, and so debts steadily increasing in deficit countries;
  • It assumes all goods are equal as in Ricardo’s example, cloth produced in the UK and wine produced in Portugal are equivalent. Yet some sectors provide well-paid and others badly-paid employment: why only produce the latter?

As Ricardo’s theory requires key conditions that are not met in reality most of the time, why are we surprised that most of reality fails to produce idealised free trade most of the time? Several past US presidents before Donald Trump made exactly that point. Munroe (1817-25) argued: “The conditions necessary for Free Trade’s success - reciprocity and international peace - have never occurred and cannot be expected”. Grant (1869-77) noted “Within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade”.

Yet arguably we are better, not worse, off regardless of these sentiments – so hooray! How so? Well, did you know that Adam Smith, who we equate with free markets, and who created the term “mercantile system” to describe the national-protectionist policies opposed to it, argued the US should remain an agricultural producer and buy its industrial goods from the UK? It was Founding Father Alexander Hamilton who rejected this approach, and his “infant industry” policy of industrialization and infrastructure spending saw the US emerge as the world’s leading economy instead. That was the same development model that, with tweaks, was then adopted by pre-WW1 Japan, France, and Germany to successfully rival the UK; and then post-WW2 by Japan (again) and South Korea; and then more recently by China, that key global growth driver. Would we really be better off if the US was still mainly growing cotton and wheat, China rice and apples, and the UK was making most of the world’s consumer goods? Thank the lack of free trade if you think otherwise!

Yet look at the examples above and there is a further argument for more protectionism ahead. Ricardo assumes a benign global political environment for free trade. Yet what if the UK and Portugal are rivals or enemies? What if the choice is between steel and wine? You can’t invade neighbours armed with wine as you can with steel! A large part of the trade tension between China and the US, just as between pre-WW1 Germany and the UK, is not about trade per se: for both sides, it is about who produces key inputs with national security implications - and hence is about relative power. This is why we hear US hawks underlining that they don’t want to export their highest technology to China, or to specialize only in agricultural exports to it as China moves up the value-chain. It also helps underline why for most of the past 5,000 years trade has not been free. Indeed, this argument also holds true for the other claimed benefit of free trade: the cross-flow of ideas and technology. That is great for friends, but not for those less trusted.

Of course, this doesn’t mean liked-minded groups of countries with similar-enough or sympathetic-enough economies and politics should avoid free trade: clearly for some states it can work out nicely - even if within the EU one could argue there are also underlying strains. However, it is a huge stretch to assume a one-size-fits-all free trade policy will always work best for all countries, as some would have it. That is a fairy tale. History shows it wasn’t the case; national security concerns show it can never always be the case; and Ricardo argues this logically won’t be the case.

Yet we need not despair. The track record also shows that global growth can continue even despite protectionism, and in some cases can benefit from it. That being said, should the US resort to more Hamiltonian policies versus everyone, not just China, then we are in for real financial market turbulence ahead given the role the US Dollar plays today compared to the role gold played for Smith and Ricardo! But that is a whole different fairy tale...