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Fundamentals of the International Trading System

D.

In continuation of this series, the previous article: How Free Trade Costs Canada its Sovereignty, analyzes the overview of the problems free trade poses for the Canadian economy.

However, in order to fully understand the root cause of these issues, one must first understand the fundamental ideologies inherent within the international trading system.

The international trading system is composed of two major ideologies on trade, and they both differ on the degree or extent of government interference.

  1. Free Trade
  2. Protectionism

 

Free Trade

 

One of the fundamental principles of free trade is that governments should not interfere in the trading activities of the economy.

Free Trade proponents (otherwise known as “free traders”) call for trade deregulation in order to reduce government interference in the economy. Trade deregulation refers to the elimination of trade barriers among various nations.

They claim there are a number of other advantages to participating in free trade.

These advantages include;

  1. Freedom of Choice
  2. Economic Efficiency
  3. Globalization

1. Freedom of Choice

For some, free trade presents a moral issue since they believe people should have the right to be able to purchase and sell legal goods and services to each other.

In fact, economist Milton Friedman once argued that a total free trade system would protect individuals from market monopolies.

He expressed this opinion in an 1980 interview titled Free to Choose  when he said,

In my opinion, the strongest argument for free enterprise [free trade] is that it prevents anybody from having too much power whether that person is a government official, a trade union official or a business executive. It forces them to put up or shut up; they either have to deliver the goods and produce something that people are willing to pay for, or willing to buy, or else they have to go into a different business.

A brief clip of the interview is below.



Friedman also believed free trade treated all businesses equally and maximized economic growth and efficiency in the economy.

French economist Frédéric Bastiat also advocated for free trade, however he argued that it could only operate if there was freedom of choice.

Bastiat outlined his views in the book titled Frederic Bastiat: A Man Alone, where he wrote,

If society were not a very real association, anyone who wanted a suit of clothes would be reduced to working in isolation, that is, to performing himself the innumerable operations in this series, from the first blow of the pickaxe that initiates it right down to the last thrust of the needle that terminates it. But thanks to that readiness to associate which is the distinctive characteristic of our species, these operations have been distributed among a multitude of workers, and they keep subdividing themselves more and more for the common good to the point where, as consumption increases, a single specialized operation can support a new industry. Then comes the distribution of the proceeds, according to the portion of value each one has contributed to the total work.

Here, Bastiat argued that  the specialization of goods and services would  help the common good since goods and services would be created more efficiently.

 2. Economic Efficiency

Interestingly, the above mentioned arguments for free trade had been echoed by economist David Ricardo over 200 years earlier.

Ricardo had argued in favour of the free trade model based on his concept of comparative advantage.

Comparative advantage is the concept that each country should specialize in the production of goods and services in which they have a comparative advantage in.

To clearly understand comparative advantage, consider the following example.

 

As illustrated by the above graph, the Bakery decides to make pastries, then it has an opportunity cost of 1/2 crust. Opportunity cost refers to the cost of choosing one alternative over another.

This means that for every pastry the Bakery creates, it must give up the ability to make 1/2 crust.

On the other hand, if the Pizza parlor decides to make pastries, then it has an opportunity cost of 2 crusts. This means that for every pastry they create, they must give up the ability to make 2 crusts.

This example clearly shows that the Bakery has an comparative advantage in preparing pastries, while the Pizza parlor has a comparative advantage preparing crusts.

Ricardo argued that competitive advantage would increase economic efficiency through specialization and would prevent the wastage of resources.

The idea behind specialization is that each country that is best suited for specific goods and services would engage in producing more of that good or service.

Ricardo outlined the advantages of specialization in his book titled On the Principles of Political Economy and Taxation where he wrote,

Under a system of perfectly free commerce, each country naturally devotes its capital and labour to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the universal good of the whole. By stimulating industry, by rewarding ingenuity, and by using most efficaciously the peculiar powers bestowed by nature, it distributes labour most effectively and most economically: while, by increasing the general mass of productions, it diffuses general benefit, and binds together, by one common tie of interest and intercourse, the universal society of nations throughout the civilized world.

Here, Ricardo states that free trade benefits the global economy by distributing labor effectively and creating economic efficiency.

3. Globalization

Free traders argue that countries are less likely to conflict with each other under the international trading system since trading provides mutual benefits to both parties.

This sentiment is also shared in the Liberal school of thought within International Relations (IR) theory. Liberalism is a concept that encourages individuals to seek and achieve peace through cooperation among various nations.

Free traders also argue that these relationships promote cultural diversity since goods and services from different parts of the world are able to reach to people with various cultural backgrounds.

Despite the arguments presented by free traders, critics have argued that it’s numerous drawbacks far outweigh its advantages.

 

Disadvantages of Free Trade

Much of the criticism against free trade comes in the form of;

  1. Concentration of Wealth
  2. Outsourcing of Domestic Labour
  3. Creation of Trade Dependencies
  4. Undermining Cultural Diversity

Each of these points is analyzed further below.

 

1. Concentration of Wealth

Opponents state that free trade concentrates the flow of wealth into fewer hands. They argue this is because foreign multinational corporations would be able to buy out local corporations and absorb all their profits.

Ultimately, this would lead to the creation of market monopolies and the concentration of domestic wealth into foreign corporations.

2. Outsourcing of Domestic Labour

Opponents argue that trade deregulation would incentivize domestic corporations into outsourcing labour services to foreign countries since they would provide cheaper labour.

A consequence is that it would lead to the reduction of domestic jobs, causing higher unemployment rates within the domestic country.


3. Creation of Trade Dependencies

Opponents also argue that free trade creates trade dependencies.

They argue that trade dependency leaves countries more vulnerable to economic shocks since a shock affecting one country will inevitably affect the other due to the trade dependencies that are created in the international trading system.

These critics cite Canada’s dependence on the U.S. as its greatest weakness since it is reliant on them to purchase vast amounts of its energy and natural resources.

With the current status quo, any potential problems that the U.S. faces will undoubtedly land a similar effect in Canada since it is dependent on U.S. imports for its export revenues.

4. Undermining Cultural Diversity

Another argument against free trade is that it undermines cultural diversity. Opponents argue that it encourages cultural homogeneity.

Cultural Homogeneity refers to the concept of a singular culture without any diversity or differences.  In other words, it refers to a culture that is uniform and singular instead of pluralistic and varied.

As one can see, there are numerous criticisms against free trade and its purported benefits.

Many of the above mentioned  criticisms have been addressed by numerous activists, economists and intellectuals.

Post Keynesian economist Steve Keen criticizes free trade on the economic efficiency’ argument proposed by free trade advocates.

Keen outlines the theoretical fallacies of free trade in his article titled; 1,000,000 economists can be wrong: the free trade fallacies where he writes,

[Free] trade argues that almost everyone’s material welfare will be increased if all countries specialize in what they are good at—a proposition that on the surface seems plausible, and a formidable body of mathematical economic theory has been erected to support it. The theoretical fallacies at its core have been there since David Ricardo first coined his model of comparative advantage during the political battle to repeal the “Corn Laws,” which restricted the importing of cereal crops into England. Some capital is necessarily destroyed by the opening up of trade…since capital is destroyed when trade is liberalized, the watertight argument that trade necessarily improves material welfare springs a leak.

Keen argues that in order for countries to specialize in the production of goods and services in which they have a competitive advantage, they must give up the ability to produce other goods and services.

This means that in order to specialize in the production of machinery (for example), a country must destroy or sell off capital in order to acquire the mechanical equipment necessary.

The fallacies of free trade has also been noted by economist John Kenneth Galbraith.

Galbraith criticized Ricardo’s concept of comparative advantage on the grounds that it could not function in the real world economy.

Galbraith noted these criticisms in his book titled The predatory State: How Conservatives Abandoned the Free Market and Why Liberals Should Too, where he wrote,

Comparative advantage operates on the assumption of unchanged technology and constant returns to scale. There are no economies of scale, no learning curve, no improvements in productivity as output increases. The only requirement is that conditions of production differ, so that one good—in terms of the other—is relatively more expensive in one country and relatively less so in the other. The only efficiency gained from trade stems from the reorganization of production and the reallocation of factors—labor, capital, land—to their best uses in the new, larger, common market … But the argument does not generalize to the real world. Given three countries and three commodities, it is not obvious that each country will always be the relatively most efficient producer of exactly one good. And then what? Does the country that has no comparative advantage produce nothing? Does it refuse to trade? If its “comparative advantage” lies in exporting labour and closing up shop, is this acceptable?

Here Galbraith argued that the comparative advantage principle followed by so many mainstream economists could not be applied to the real world.

Indeed, Galbraith’s argument has carried significant weight over the years in the recent case of Mongolia in the 1990s.

The Mongolia case is analyzed in greater detail in Part 3.

 

Despite the enormous debate behind free trade theory, no country in the world practices in total free trade.

Most countries around the world implement some level of trading restriction in order to protect their domestic industries.

These trading restrictions are a form of protectionism, another ideology that is inherent within the trading system.

 

Protectionism

One of the fundamental principles of protectionism is that governments should restrict the trading activities within the economy.

 

Forms of Protectionism

 

These are the types of protectionist measures that governments undertake in order to protect against the effects of free trade.

Such protectionist policies include;

  1. Tariffs
  2. Non-tariff charges
  3. Subsidies
  4. Import Quotas

 

1. Tariffs

When governments place heavy tariffs on imports it reduces the demand for foreign goods and services thus leading to a reduction in the foreign country’s exports because consumers would not want to spend more money on a foreign good due to the extra cost.

In Canada’s case, there is a $2.42/tonne tariff on imports of wheat or meslin flour. A detailed list of Canadian import tariffs can be found at Canada Customs Tariff.

2. Non-Tariffs Barriers

Governments place Non-tariff barriers (i.e. licensing rights or visa entrance requirements) in order to make it more difficult for foreign countries to enter into the domestic marketplace.

This ensures that consumers buy more domestic goods.

 

3. Subsidies

Governments often subsidize domestic manufacturers in order to create a trade surplus.

The subsidy helps domestic manufacturers by giving them an advantage over foreign manufacturers since domestic goods and services can be produced at a cheaper cost.

These subsidies come in two forms; Direct Subsidies and Export Subsidies.

Direct subsidies are lump-sum payments or cheap loans provided to local businesses to compete against foreign imports.

Export subsidies are payments provided to exporters for the amount of their exports. It is essentially a bonus commission paid by the government to domestic exporters.

 

4. Import Quotas

Governments impose import quotas in order to maintain strict limits on the amount of goods imported into the country.

This ensures that there is not an overabundance of a certain good within the economy.

In China’s case, as of February 2012 they have accepted an import quota of 34 U.S. films.

 

Reasons for Protectionism

 

There a variety of reasons why countries restrict trade, many of which include;

  1. Protection of Domestic Jobs
  2. Equalizing the Market
  3. Government Revenue Creation
  4. Safeguarding the National Interest
  5. Protecting Start-up Industries
  6. Exporting Promotion

 

1. Protection of Domestic Jobs

Governments enlist in protectionism through trade restrictions which help to protect domestic industries and producers since they would not lose market share to foreign competitors.

As a result, domestic industries would then be able to employ more workers in the economy and raise the employment rate.

2. Equalizing the Market

Governments also place restrictions on foreign goods, helping to equalize the market since many foreign competitors may have natural “unfair advantages”.

These advantages can come in a variety of forms such as government subsidies.

3. Government Revenue Creation

Governments also place tariffs on foreign goods in order to help boost domestic government revenues.

The government can then spend this revenue on other areas of the economy, such as social welfare programs, infrastructure programs, or even additional military expenses.

4. Safeguarding the National Interest

Governments also restrict trade in order to retain their cultural identity.

This is evident in East Asian countries, most notably China, which places import quotas on the amount of pop culture mediums entering into their country from the United States.

5. Protecting Start-up Industries

Governments may also restrict free trade because of its potential to harm start-up (infant) businesses from attaining a competitive position in the economy.

One way to avoid this is to provide subsidies or other protections for growing firms; so that once they mature they will be able to contend with foreign competitors.

6. Export Promotion

Governments also restrict trade to protect themselves from export promotion. Many foreign governments may provide subsidies to their exporters so that they increase the amount of wealth and trade surpluses for their country at the expense of their neighbors.

The factors listed above explain the reasons why governments place various limitations on free trade.

Below we discuss the points critics make against protectionist measures.

 

 

Disadvantages of Protectionism


Many of the criticisms against protectionism are;

  1. Decreasing Economic Efficiency
  2. Incentivizing War
  3. Restricting Human Rights

1. Decreasing Economic Efficiency

Opponents of protectionism argue that if all countries restricted trade, then global exports would decrease since no country would want to import.

Eventually, under such a system, they argue that there would be no imports or exports and international trading would not occur, thus contributing to economic stagnation.

2. Incentivizing War

Opponents argue that protectionism plays a major role in the emergence of conflicts.

An example of how protectionist policies created a conflict is in the Boston Tea Party incident in 1773 which was primarily caused by British tariffs on imports of tea into the US colonies.

 

3. Restricting Human Rights

Opponents to protectionism also argue that trade restrictions present a moral issue because they restrict a human’s fundamental freedoms.

Libertarian and U.S. congressman Ron Paul is one of the most ardent opponents of protectionism.

Paul is critical of protectionism because it forces consumers to pay higher prices for domestic goods due to the import tariffs on foreign goods which artificially make them more expensive.

In a statement to the House of Representatives, Paul said the following,

“What most Washington Politicians really believe in is government managed trade, not free trade. True free trade, by definition, takes place only in the absence of government interference of any kind including tariffs.

The full speech presented by Paul can be found below.

 

In conclusion, this article covers two of the major fundamental ideologies within the international trading system; Free Trade and Protectionism.

Part 3 specifically discusses how the principles of the international trading system exploit the Canadian economy  through the contractual obligations found in the free trade deals.

Contents:

 How Free Trade Costs Canada its Sovereignty – Pt 1

Binding Clauses and the Hidden Cost of Free Trade – Pt 3

Canada US Debate over Trade Disputes on Free Trade Agreements – Pt 4

The Social Cost of Free Trade Agreements – Pt 5

Comments (5)

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