TheMarketForIdeas

The fact that preventing free trade affects the economy has been known for a long time. The idea is as old as economics itself. Thus, in his book, The Wealth of Nations, which marks the birth of economics, Adam Smith justifies free trade at the international level, showing that, by specializing in the production of certain goods, all nations benefit from freedom of trade. Just as, within a national economy, the division of labor, specialization and free exchange of goods lead to increased productivity and, therefore, general well-being, at the level of the entire world economy, free trade leads to increased wealth of all nations and to world peace. However, Smith admits the establishment of customs duties in two situations: in the case of industries that are of strategic importance for national defense and in reaction to duties imposed by other countries on imports of goods from that country. According to Smith, protectionism is, therefore, an exceptional measure, which, as a general rule, hinders the proper functioning of the economy.

Along these lines, in the current literature, a distinction is made between the efficiency of free trade at the level of the national economy and the efficiency of free trade at the level of the world economy (cosmopolitan-efficiency argument).

Both approaches are based on the assumption that prices are freely determined by the market and that it does not present dysfunctions. However, it is known that the market can have certain dysfunctions, such as, for example, those caused by so-called “externalities”. Dysfunctions or “distortions” of the market can also occur through government action. Thus, governments can distort prices formed on the market by subsidizing the production of certain branches, by not properly protecting intellectual property, which prevents the emergence of new knowledge and technologies, or, conversely, by overprotecting indigenous holders of patents, licenses, know-how, trademarks and other similar rights and values, preventing the entry of new competitors into the market, etc. In such cases, production and exchange guided by distorted prices are inefficient.

The analysis of the efficiency of free trade at the level of the national economy aims to substantiate national trade policies. And, in fact, this was the main objective considered by Adam Smith. As for the analysis of the effects of free trade on the world economy (cosmopolitan-efficiency argument), this is relevant for the design of international trade regimes. For example, starting from the conclusions drawn from research of this kind, the WTO was conceived as a forum for discussions and negotiations on new, but also existing, trade rules, as well as a court for resolving disputes between member states. In turn, the International Monetary Fund (IMF), created by the Bretton Woods agreements (1944), had as its initial objective the supervision of the exchange rate policies of member states in order to avoid the devaluation of national currencies for competitive purposes. Later, the role of the IMF evolved, becoming a body for managing the international monetary system in order to ensure its stability. Although, in the current era of globalization, the importance of studies on the role of free trade in the sustainable development of the world economy, improving living standards and reducing poverty has increased, in the debates on free trade versus protectionism, economists usually consider the first case.

This case, widely analyzed by contemporary economists, shows the existence of two situations in which protectionism can contribute to increasing the welfare of a nation.

In the first case, as A. Smith also showed, a country can adopt protectionist measures in response to restrictions imposed by other countries on the import of goods from that country. In other words, protectionism can be used as a means of forcing the opening of closed foreign markets. Instead of the “Opium Wars” waged by England and France against China (1839-1842, 1856-1860) or the threat of American warships bombarding the Japanese port of Yokohama (1859), a country can threaten to impose restrictions, and if this strategy is successful, it gains twice: from its own trade remaining free and from the trade becoming free of its trading partners. However, both Smith and other economists doubted that such a policy actually works. They found that the threat of retaliation does not necessarily cause other countries to reduce their own trade barriers, and that retaliatory measures tend to become permanent and self-reinforcing.

This strategy is still used today. A striking example is the USA, which, although it declares itself in favor of free international trade, believes that the American domestic market can and should be closed in order to induce other countries to open their own markets. Thus, American legislation (Omnibus Foreign Trade and Competitiveness Act) allows and sometimes even obliges the American government to force other countries to accept new “trade obligations”, threatening with customs retaliation if they do not. However, these new obligations do not necessarily imply freer international trade. For example, these commitments can take the form of the voluntary establishment of quotas on the export of certain goods to the USA. In other words, the USA simply forces other nations to redirect their exports in accordance with American interests, violating the principle that international trade should be guided by market prices.

Another example is the measures mentioned at the beginning of this article, which have created chaos in the global economy, which has already faced major disruptions in recent years, from the 2008 financial crisis to the Covid-19 pandemic. Now, another force threatens to reshape the economic landscape: the protectionist trade policies of the Trump administration and the increase in reciprocal tariffs.

In the second case, protectionism is deemed to enhance the welfare of a nation when the country has a monopoly position in the production of a certain good. Thus, since the time of John Stuart Mill – who lived in the first half of the 19th century –, economists have argued that a country that holds a high share of the world’s production of a good can use an “optimal” price to take advantage of this monopoly position, thus gaining more from trade with other countries. This, of course, comes down to saying that a monopolistic producer can maximize its profits by raising the price and reducing production.

Currently, a similar form of selective protectionism, known as “strategic trade policy”, is recommended by some economists in cases where the market is controlled by a foreign company, in a state of monopoly (imperfect competition), and the entry costs of a new national company are high. In this situation, it is argued that the state should grant subsidies to this new company in order to increase competition. Thus, the advantages of the monopolistic company will be limited, and the new domestic company, which has become competitive as a result of the public aid, will be able to acquire a certain market share. It is worth noting the similarity between this argument and Mihail Manoilescu’s plea for protectionism as a way to support Romania’s industrialization in the interwar period. Currently, the most frequently cited example is that of aeronautics, a sector characterized by duopoly (Boeing – an old and strong manufacturer; and Airbus – a new, fragile manufacturer with an initial technological gap): the subsidization of Airbus by the French state allowed the reduction of the production costs of the new aircraft, especially the research and development costs, and therefore led to the recovery of the technological lag and, in this way, to the winning of the battle with the American competitor on the global market.

This second case raises two objections.

First, with rare exceptions, such as, for example, the case of the countries that are part of the Organization of the Petroleum Exporting Countries (OPEC), there are few countries that have a significant monopoly position with respect to a sufficiently large number of goods to give practical importance to the exception to the rule of free trade.

Second, the other countries could resort, in turn, to retaliation against the “optimal” price. As a result, the possibility of exploiting a monopoly position to increase a country's welfare is questionable. Indeed, even those contemporary economists who have built their academic reputations by identifying theoretical cases in which oligopolistic markets allow governments to use import tariffs to increase national wealth, argue strongly against protectionist policies. Their argument is based primarily on the observation that governments rarely have the information they need to identify situations in which it is appropriate to apply tariffs.

(To be continued.)

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