The Dynamics of Trade and Employment
A trade policy has always attracted the people’s attention. They wondered why some states, having a large number of resources, had remained poor, while other states, having only human resources, had become especially prosperous. The basis of free trade is a theory of a comparative competitive advantage of countries, formulated by Ricardo in his book Principles of Political Economy and Taxation. The essence of this theory lies in the fact that if countries specialize in goods, in which they have the greatest competitive advantage by selling the surplus in exchange for goods from other countries, then the total wealth of the economic agents’ increases.
A free trade movement originated from England in the last third of the 18th century. It was associated with the industrial revolution going on there. The struggle of the British free trade movement members was directed against agricultural duties, which maintained high agricultural prices hindering the development of the factory production. They were also directed on the reduction of customs duties in a mutual trade with other countries. It would help to increase the export of British goods abroad (Dunkley, 2003).
Under the pressure of free trade movement in the 20s of the 19th century, England had reformed customs system. Thus, the tariffs on many goods had been abolished or reduced significantly. In the middle of the 19th century, the free trade won a landslide victory in England. This fact had largely contributed to its transformation by that time to the most developed country in the world. In the second half of the 19th century, free trade trends became apparent in the trade policy of France (1852 – 1870), Russia (1850 – 1860), and other countries (Dunkley, 2003).
In the 20th century, after the World War II, the elimination of many obstacles to the free exchange contributed to an unprecedented economic and social development of many countries. It especially concerned those ones going further than the others by the way of trade liberalization (free trade zones, customs unions, and regional markets). On the contrary, the countries embarking on the path of autarchy and the protection of their economies from the effects of foreign competition were eventually forced to change their course and conduct more or less far-reaching reforms of foreign economic relations. They aimed at exempting foreign trade from an excessive state intervention (Dunkley, 2003).
Benefits of Free Trade
The principle of freedom of trade has appeared and improved as a reaction to the state protectionist measures in different periods of development of the national economy. It has started from the period of the primitive accumulation of capital and ending with the time of creation of the national industry in backward countries. Naturally, this principle along with criticism of protectionism provides the evidence of benefits of free trade.
The advantages of free trade are sufficiently multifaceted and proved both in theory and practice:
First, free trade allows improving the welfare of trading nations, since it opens up some opportunities to international specialization of production and exchange on the basis of a comparative advantage. The growth of welfare is due to the benefits obtained from international trade. Classics have offered to measure this gain by the difference between the rate of return in an international exchange of goods and the rate of profits in its absence. A. Marshall used another method, i.e. the determination of the value of surplus (profits) of producers and consumers;
Second, free trade facilitates the development of competition and supports the spirit of innovation, not only among domestic producers, but also concerning other countries. It ultimately improves the quality of products;
Third, free trade offers some opportunities for expanding markets and, consequently, for the international concentration of production and goods mass production being beneficial to consumers;
Fourth, free trade is a basis of optimizing the allocation of productive resources among countries and such international combination that increases the effectiveness of their use (Hanson, 2010).
Importance of Free Trade for Economies of Developing Countries
Countries enter trade relations with each other because international trade usually increases their welfare. Individual companies are competing at the international level. Meanwhile the citizens of trading countries experience economic benefits of free trade. Among them there is a great variety of goods and services offered at lower prices.
Let us assume that there is a country, which has decided to pursue a policy of the total economic isolation. The citizens of such state would need to produce their own goods and services. However, if it opens its borders to international trading, then the citizens will be able to do just what they are doing better than others. Specialization is known to trigger an increase in efficiency, gains, and standards of living.
One of basic principles of the economy is a comparative advantage.. If a country produces a large volume of a single product, then it will produce less of other types of products. Such communicating vessels occur due to resource constraints and the society’s desire to use them in a more efficient way.
On the contrary to a popular belief, the main question of the international trade is not an issue of the amount of money or resources that the country needs to produce, whether these are hats or cellphones in comparison with another country. The main question is how many hats it would cost to produce one cellphone if the production resources are shifted from producing hats to creating cellphones. The country that can produce more cellphones upon reducing the amount of hats has got a favorable condition for trading with another country. It cannot produce the same number of cellphones with the similar reduction in the number of hats created.
The benefits that accrue from a comparative advantage are particularly important for developing countries. A relationship of free trade and economic development is comprehensively studied. The majority of studies indicate that the more the country is open to the international trade, the more positive impact it has on its economy.
In the major study at the University of California in Los Angeles, it has been found that the countries, which liberalize international trade, have become more open. They have reduced tariffs and eliminated non-tariff trade barriers. Such countries also tend to develop faster, especially the third world countries (Edwards & Lederman, 1998). The Turkish study has confirmed a high probability of a positive correlation between the free trade and economic growth. One of the most important findings of the research is that the reduction of the public and other artificial intervention in free trade entails the economic growth. It also clearly shows how important the state policy in the field of trade and its impact on economic indicators is (Utkule & Ozdemir, 2004).
The recent Bolivian study has analyzed the relationship between economic prosperity and free trade for a period of more than half a century of the country’s history. The analysis has showed that a long and stable relationship between these two factors does exist. It is expressed in a positive economic growth depending on the degree of trade liberalization (Bojanic, 2012). This research is of the particular importance today. It is the time when the Bolivian government is trying to reverse many of the reforms carried out so hard in the 80s and 90s of the last century.
If the openness to the outside world is really so important for the economy, as it has been proved in this study, the current attempts to close the economy are not reasonable in any way. It concerns, in particular, the reluctance to sign a free trade agreement, the refusal to issue permits for the export of agricultural products, and increased export tariffs on textile products in order to protect the new state textile enterprises.
Criticism of Free Trade
There is a doctrine, which always was opposite to the concept of free trade, i.e. protectionism. The foundation of protectionism is a proof of inconsistency of conditions, for which the theory of comparative advantages has been formulated. It results in the fact that the most developed country gains a lion’s share from trade. It also results in a slowdown in the economic development of the most developed country’s partners without any corrective state tariff policy of the developing country. The most complete basic provisions of the protectionist theory are formulated by Daniel Friedrich List in his book The National System of Political Economy.
After the World War II, it seemed that the freedom of trade had won a landslide victory over protectionism. First, it has been proven by a number of economists that the protectionist customs’ tariff of Smoot-Hawley, introduced in 1930 in response to the Great Depression in the United States, extended and intensified the effects of the Great Depression (Irwin, 2011).
Second, the active pre-emptive foreign trade growth, compared with the industrial production till the 1980s, against the background of declining tariffs, has created a considerable amount of wealth. Meanwhile the economic growth was slowing in those countries using protectionist policies. Third, a prisoner’s dilemma in relation to foreign trade was formulated and empirically proved. The application of protectionism principles by individual countries has eventually led to the use of these principles by all countries and a decrease in the total wealth (Irwin, 2011).
However, the 1980s altered the situation. First, a number of countries in Africa and Latin America, which had refused from protectionism in favor of free trade in the 1960s, faced with an economic slowdown and a decline of the total wealth in the 1980s. Second, an increase in the structural unemployment in developed countries by increasing foreign competition was empirically proven. Third, protectionism has given a way to the wrongly fed monetary policy as a main cause of the Great Depression (Hanson, 2010).
Fourthly, the principle of tariff protection was formulated and empirically proved (but not explained). Maintaining the state tariff policy always improves the terms of trade. Thus, it increases the total wealth of the country. The costs of economic restructuring under free trade (clotting uncompetitive industries and retraining workers) and the costs of refusal to protect young and strategic industries under free trade have been also added as arguments of critics of free trade.
The 1990s with the widespread use of computers and the introduction of economic science in a difficult economic system brought a new defeat to the supporters of free trade. First, Laura D’Andrea Tyson has called into question the effectiveness of free trade for developing countries in her book The Dynamics of Trade and Employment. She has managed to prove three main provisions using her complex econometric study:
1) In the global economy, there are a number of anomalies (Tyson gives more than 50 of such anomalies). It is due to them that the freedom of trade worsens the terms of trade of the significant number of developing countries. This fact cannot be explained by the theory of competitive advantages;
2) Trade policies of developed countries make it difficult to use competitive advantages for developing countries, resulting in gaining the lion’s share from trade by a developed country;
3) Although free trade leads to the creation of more jobs in developing countries in a short term, its impact on employment is not defined in a long period. At the same time, free trade leads to the reduction of social and environmental standards in all countries because of the growing international competition.
Tyson explains a principle of customs protection using the fact of influence of anomalies in the international trade. He considers it necessary to establish a special theory of international trade for developing countries. However, the works of Graham Dunkley are a more significant challenge to supporters of free trade. He, as a senior fellow at the Hoover Institution at Stanford, has questioned the applicability of the theory of the comparative advantage in the today’s global economy in his series of articles in several scientific journals of America, written in 2001-2002.
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The essence of Dunkley’s ideas lies in the fact that the specialization based on the comparative advantage of countries that allows receiving gains from trade for all countries, is undermined by a high mobility of production factors. Countries with the policy of free trade, instead of structural adjustment of the economy, are experiencing the outflow of production factors to those countries with the highest productivity. Thus, the states with absolute advantages have the greatest factor productivity. This fact changes the nature of foreign trade (Dunkley, 2003).
Historically, there were significant barriers to the international mobility of production factors. Now, though the change of political systems in Eastern Europe and Asia has opened an access for western TNCs to a significant amount of cheap human resources and development of telecommunication technologies has led to the possibility of the integration of workers in services and high-tech sectors, regardless of their physical location.
All this has enabled TNCs to replace the expensive western human resources with cheap ones from developing countries. A wage gap between developed and developing countries has led to the emergence of absolute advantages among developing states, while the international mobility of production factors has led to the shift of both benefits of foreign trade and the inflow of production factors in developing states. The large number of cheap human resources in the third world countries means that this situation, in the absence of the corrective public policy, will continue in a long term. At the same time, there will be a rise in unemployment, the outflow of production factors and, thus, a decrease in the wealth and standards of living in developed countries.
It would seem that this development is beneficial for developing states. However, everything is not so simple. An analysis of results from the distribution of benefits of foreign trade, conducted within the resource based theory of the economic development, shows that the standards of living in developing countries increases slightly with the influx of western factors of production (in the form of foreign investments). Moreover, the loss of the social capital from lower social and environmental standards due to a stiff competition in developing countries for the foreign investment often covers the benefits of their receipt.
A significant number of unemployed human resources in developing countries allow international TNCs to hold low wages for attracted resources. Meanwhile low customs duties (often imposed due to entering of developing countries into international trade agreements), low taxes on TNCs, and repatriation of capital by them are preventing developing countries from receiving basic benefits from additional competitive advantages.
Alternative to the Free Trade Regime
As it has been mentioned above, protectionism is an alternative to the free trade policy. Consequences of such a policy are clear. They testify the costs of protectionism:
First, protectionism undermines the foundations of national production in the long term because it relieves pressure, required for the development of entrepreneurial initiative, from the international market. Routine and reluctance with the acquired privileges and the earned income prevail over the desire for progress and innovation. The determination to surround oneself with protective barriers is often determined not by national economic interests. It is a result of pressure from powerful private interests. They use the lobbyist support of political and parliamentary circles;
Second, protectionism is harmful from a point of view of a consumer, which makes it necessary for him/her overpay for goods and services, not only for imported ones, subjected to customs duties. It also is related to the products of national production, manufacture and sales being associated with a non-competitive pricing system;
Third, protectionism creates a risk of a chain reaction, because, after defending some sectors, the protection of others will be required sooner or later;
Fourth, the guard of national industries from foreign competition pushes them eventually into a trap of protectionism. It is because if the crutches were given for strengthening such productions, later it would be quite difficult to remove them without a risk of collapse. Thus, introduced as a temporary measure, protectionism can become an essential attribute of a long-term national economic policy;
Fifth, the protectionist policy enhances inter-state rivalry. It is a potential threat to the international stability and security. It weakens the bonds of interdependence among countries, hampers the development, and deepens the international division of labor, specialization, and cooperation of production, generating both enmity and mistrust.
The principle of protectionism along with the above drawbacks has several advantages. It makes the policy of government control of foreign trade attractive to many countries. The most common cause of restrictions on the foreign trade is the fact that some governments think in terms of national interests rather than the interests of humanity, as a whole. Both socio-political and economic arguments are usually nominated in favor of protectionism.
Socio-political benefits of protectionism consist of the following issues:
Maintaining the national security of the country, which, in case of failure of protective measures, would be jeopardized of the narrow specialization of economy;
Protection of the higher standards of living and high wages in richer countries in their competition with the states where the standards of living are much lower;
Possibility to save some social classes and activities (e.g., the traditional national crafts);
Economic arguments in favor of protectionist measures are reduced mainly to consider the maximization of the real income achieved at the expense of protectionist measures application. Such arguments may include:
The role of protectionism in increasing the level of employment of national resources;
Its ability to alleviate the crisis in some industries facing economic difficulties.
Any country, whether it is small or large, northern or southern, certainly benefits from the international free trade. Each individual country will have an advantage from the free trade. It is because each country can manufacture certain products relatively more effectively than other goods. It is especially true for developing countries.