Managing Trade's History


Against the Tide: An Intellectual History of Free Trade, by Douglas A. Irwin, Princeton, N.J.: Princeton University Press, 274 pages, $29.95

Ever since Pat Buchanan became the most prominent Republican favoring restricted trade, verbal fistfights have been breaking out between the adherents of free trade and the champions of the rather more amorphous "fair trade." From time to time, defenders of "managed trade" will also get their blows in, powered by the claim that someone, somewhere has "proven" free trade not to work. Most people, however, have only the vaguest notion of the intellectual history behind the trade theory battle, and many would be surprised to learn how the ideas of so many dead men underlie so many of our liveliest contemporary policy struggles.

Perhaps the greatest contribution by economists since Adam Smith's day has been to disentangle claims made about trade and its effects on material well-being from the very different ideas about what we should produce, ideas that are unrelated to economic growth. Pace Ross Perot, it usually doesn't matter whether a nation produces computer chips or potato chips. However, having asserted that trade usually makes both countries richer, the economist has no response to those who feel it would be better for the United States to grow at only 2 percent per year if the rest of the world (especially Europe and Japan) grows only at 1 percent per year, than to be in a world with U.S. growth at 4 percent per year while others grow at 6 percent per year.

Economists, and I suspect most readers of REASON, would say that the latter situation is self-evidently superior. But a preference for the former is a philosophical issue that economic theory is not designed to address. What economists have done well is to work out the technical conditions under which free trade promotes the general welfare, and on this issue the consensus for free trade is nearly unanimous.

Douglas Irwin, an associate professor of business economics at the University of Chicago and a scholar at the American Enterprise Institute, has produced a dense but lucid and carefully reasoned volume about the intellectual history of free trade and the recurring attempts to dislodge its place near the forefront of universally accepted economic wisdom. For many economists, an adherence to the general principle of free trade is the closest thing we have to Mom's apple pie. Since most experts' approbation for open-trading regimes has not been matched by a corresponding appreciation among the general public, there has always been a market for ideas that undermine or contradict the ideals of open trade.

By showing us that even the most pragmatic, up-to-the-minute trade struggles have their antecedents in more rarefied intellectual debates going back several centuries, Irwin demonstrates how robust the concept of free trade has been.

Irwin assumes some familiarity with the broad outlines of modern trade theory, and his book will not be an easy read for everyone. Still, by treating the evolution of trade theory in terms of conflicts between the leading academic theorists of the past 200 years, he makes the presentation lively.

First we observe ancient philosophers grappling with problems of commerce without a scientific standard by which to examine their judgments. There are bad ideas and brilliant insights, but no orderly economic framework to hold it all together. It is not until the English mercantilist writers and their rebuttal by Adam Smith that we come to the central debate that has lasted to the present day.

For the mercantilists, trade was war, with every winner having a corresponding loser. It was Smith who separated the politics of winning and losing from the problem of establishing the gains from trade. When trade is seen as voluntary exchange, the analogy to war becomes inappropriate and even destructive: Mutual exchange is mutually beneficial. Mercantilists worried about the loss of specie that accompanied trade deficits and disparaged the contribution of domestic industry. Smith understood that the wealth of the nation lay in the wealth of its citizens, and that the ability to produce and consume–not merely export–was at the heart of genuine prosperity.

The work of Smith and then David Ricardo established the modern subject of economics and made free trade the benchmark from which discussion proceeded. Over the next two centuries, various men tried to establish exceptions or raise objections to their framework but were invariably found to be inexact or to have employed highly specialized examples. Of course, exceptions have existed from the earliest work of Smith and Ricardo: Some markets were presumed to be imperfect, or else the author believed there was a noneconomic reason for overriding the market in a given instance.

More often than not, protectionists have simply noted that protecting group X or industry Y has helped X or Y, without asking how much the rest of the nation paid for the privilege of aiding them. It is easy to find the partial benefits of protectionism; it is much harder to establish that these benefits outweigh the considerable costs involved.

An important case worth pondering involves the current debate over managed trade and the role of strategic trade policy. The claim is that the peculiar characteristics of some industries–notably a winner-take-all race that favors the first entrant–justify intervention to insure industry dominance. Think about the European claims for Airbus or the 1980s flap over promoting high-definition TV.

Because so much of this material is highly technical, it is good to see Irwin place the debate in a broader perspective. These theoretical exceptions to free trade are quite limited and require a virtually all-knowing government, which most citizens are unlikely to accept (even if it were possible). Knowing that strategic industries might exist is one thing; finding out which real-world projects fit the theory is entirely another.

It is particularly interesting to be reminded of Paul Krugman's evolution in matters of policy. As the most prominent trade theorist of his generation, and one of the founders of strategic trade theory, Krugman exerts a great deal of influence both in academia and in policy circles. From claiming in 1987 that "the case for free trade is currently more in doubt than at any time since the 1817 publication of Ricardo's Principles," Krugman in the 1990s arrived at a position of vocal advocacy of free trade. It has been interesting to observe how theoretical exceptionalism has been tempered by real-world political economy. Where once Krugman produced mathematical models that argued for the possibility of helpful trade intervention, he has come to emphasize how difficult it is to put such ideas into practice, and he has become sensitive to the use of his ideas by all sorts of people to justify indefensible trade policies. In his recent popular writing, Krugman, now the scourge of managed traders, sees the irony of so many writers abusing theoretical ideas to which he once contributed so much.

I would like to have seen Irwin discuss the 1988 paper by Richard Baldwin and Krugman in which a theoretical case is made for Japan's subsidizing its memory chip industry. This work has often been cited by managed trade advocates because it purports to show that, given certain assumptions, Japan might not have had a chip industry without government support. But no one bothered to mention that even under those hypothetical conditions, Japan as a whole would still have been better off without a chip industry and without paying those subsidies. If this was one of the best of the hypothetical examples in favor of managed trade, how much more difficult would it be to make a case for intervention in the real world?

The general reader may well wonder why, if free trade is so good, its adoption has been so exceptional. The short answer is politics. While Irwin's book is unimpeachable on the normative theory of trade–that is, a careful discussion of what state-of-the-art economic theory has to say for and against free trade–it is disappointing to see so little discussion of the politics of trade, particularly the work in public choice.

Few nations pursue free trade, and those that try often deviate from the theoretical ideal. Furthermore, as is now apparent, the most common forms of real-world protection do little to promote the general good. Modern public choice theory has abandoned the utopian assumption of an all-knowing, benevolent state seeking to maximize social benefit. It now studies policies as enacted by politicians responding to lobbying and the need to win elections. We need not assume corruption or venality. Rather, the incentives facing the typical politician are sufficiently skewed so that even the most well-meaning tend to promote the interests of the few at a cost to the many. We need to learn why governments that are subject to manipulation distort their domestic markets, and how persistent misinformation has ensured that even the educated classes remain ignorant of the most elementary notions of comparative economic advantage.

The gap between hypothetical instances when some protection may enhance the public good, and the policies actually implemented in the name of theory, is never more clear than in dealing with newer, "infant" industries. The claim is that newer companies competing with internationally established giants need time to develop behind tariff walls from which they will eventually emerge. In practice, protection merely encourages inefficient production, and in most cases temporary protections drag on indefinitely.

John Stuart Mill first made this idea widespread, but the strongest 19th-century advocate of the "infant industry" critique of free trade was the German Friedrich List, an inspiration to such modern-day nationalists as Buchanan. But even List never abandoned the goal of worldwide free trade, and he advocated protection only as a temporary measure for countries catching up with advanced industrial nations.

Yet more often than not, protectionism is used to protect not infant industries, but geriatric ones such as steel, textiles, and automobiles. List's name is also used to defend protections that contribute more to the stagnation than to the development of Third World nations, by keeping their industries bloated, technologically backward, and uncompetitive.

In the end, Irwin does us a great service in demonstrating that the theoretical argument against free trade boils down to the following three cases:

? First, those situations in which protection may be helpful if precisely targeted, such as temporarily aiding infant industries. (We would still be better off, however, keeping trade free and subsidizing such infant industries directly.)

? Second, situations involving industries with a large number of peculiar characteristics–such as significant returns to scale or huge spillover effects or winner-take-all effects–that may dictate counterintuitive strategies, such as selling at a loss for a very long time. The industries involved have to be so delicately poised that the first companies to enter a market reap all the rewards and no catch-up is feasible. Most important, one must assume ineffective capital markets that cannot foresee these problems, while postulating a government agency that can.

? Finally, purely political or distributional considerations that have little to do with promoting the nation's wealth. This case is the most intractable since the winners may well outnumber the losers, but the losers are so important to the government–or the public feels such sympathy for their plight–that political or emotional considerations about short-term job loss, or profit erosion, dominate the policy debate. But here too, free trade combined with direct assistance is a more efficient and humane policy.

For anyone familiar with the history of economic thought, it ought to be clear that free trade remains the best practical policy involving the fewest complications and the greatest overall gain. Hypothetical exceptions only strengthen the soundness of this fundamental prescription. So it is extremely useful to have at hand such a scrupulous and lucid guide to the history of modern thought on the subject. It is also worth bearing in mind that the theory will continue to evolve and that scholars will continue their debate, but that in the end any successful exceptions to the norm of free trade will depend on state authorities having penetrating insight, superior knowledge, and extraordinary benevolence. This, unfortunately, will rarely be the case, no matter now sophisticated our scientific knowledge becomes.