The Hindu Business Line : What remains of the case for free trade

When economists sing the virtues of free trade they mean free trade according to the long run or dynamic comparative advantage. Free trade based on long run comparative advantage can potentially bring enormous gains to everyone. But it needs to be accompanied by a suitable compensation and redistribution mechanism to ensure that everyone actually ends up being better off, says Alok Ray.

MANY great economists since Adam Smith have been preaching the virtues of free trade. Yet, protectionism is rearing its head whenever there is an apprehension of significant job losses through freer trade. For instance, right now, there is stiff resistance in the US and Europe to the removal of agricultural subsidies or permitting outsourcing of service jobs to countries such as India. Does this mean that there is something seriously wrong with the economist's case for free trade?

A closer look. The case for free trade basically rests on the principle of comparative advantage. The principle says that if countries specialise and trade according to comparative (or relative) advantage, then all trading partners will gain. This is true even if a country, say, the US, is more efficient in the production of all goods relative to another country, say, India. In such a case, the US should specialise in the production of those goods in which it is relatively more efficient and India should specialise where its comparative disadvantage is less. So, except for the highly unlikely case where the difference in efficiency levels between US and India is exactly the same in all industries (like, say, the US is five times more efficient than India in all products), there would be a difference in comparative advantage and, hence, a scope for mutually-profitable trade between nations.

But, then, like all theories, this is based on assumptions. The most important assumptions are full employment and costless mobility of resources between sectors. So, if the Indian capital goods (CG) industry is less efficient and textiles industry is more efficient relative to the US, then resources in India should move out of capital goods and towards textiles production. In the process, jobs will be lost in the capital goods sector and more jobs would be created in the textiles sector. But this may take some time. It is possible (in fact, quite likely) that there will be immediate job losses in the capital goods industry as it cannot compete with cheaper imports, but the textile industry may not expand at a sufficiently high speed (it would need more investment, managerial resources, infrastructure) to absorb the surplus labour. Unemployment of resources would imply gains less than that postulated in theory. Similarly, the labour released from the capital goods industry may require a different type of skills in the textile industry. If so, then the cost of retraining has to be subtracted to get the net gains from free trade. It is, of course, possible that the net gains may be positive even after subtracting.

Similarly, given a sufficiently long time horizon, the people losing jobs in the capital goods sector would be eventually absorbed in the textile or some other sunrise industries. Historically, this is the way technological progress and productivity improvement have taken place. For instance, replacement of horse-driven cars by automobiles created temporary unemployment for coachmen, but eventually they found other jobs (including car driving after learning to drive autos).

The nations eventually became better off — very few would dispute that. The reabsorption time would be less for an economy which has a high rate of innovation and growth of new industries (like US), rather than a relatively stagnant economy (such as, say, Ethiopia). So, there will be short run adjustment costs for those who lose jobs (even if temporary). The society will have to take care of them by a suitable social safety net and direct compensation while easing the resource reallocation process through retraining and other facilities. Unless that is done, there will be justifiable opposition to free trade, however beneficial to the nation this may turn out to be in the longer run. Further, an aerospace engineer losing job and getting absorbed as hamburger flipper in McDonalds is not an ideal full employment situation.

A few other caveats. Comparative advantage does not remain fixed over time. It changes as an economy grows through investments in physical capital and in formation of new skills. The state may play an important role here. For instance, the successful development of world-class automobile industry in Japan and Korea is often attributed to the creation of comparative advantage in this industry by suitable government policies rather than free market forces. So, when economists sing the virtues of free trade they mean free trade according to the long run or dynamic comparative advantage. But to develop this comparative advantage may require temporary protection from free trade. Economists call this `infant industry' argument for temporary protection.

What happens if a country is not internationally cost-competitive in any product when it is exposed to free international trade? The economist's answer would be that, in such a case, it would temporarily import everything and export nothing. A big trade deficit and unemployment (as no industry is able to compete with imports) would result. But in a free market system, the wage rate in the country will fall and also the value of that country's currency will depreciate. Both would help the country gain cost-competitiveness in international markets in a sufficiently large number of products. But, again, these automatic adjustment mechanisms may not work if the wage rate is not allowed to fall, despite unemployment, and the exchange rate is kept fixed by government intervention. In such a case, the massive trade deficit and unemployment can continue indefinitely. Even otherwise, the process of adjustment may take a fairly long time, which a nation or its government may not find to their liking.

The gains from trade arise from the reallocation of resources from the relatively less-efficient to the more-efficient industries. The country then sells goods which fetch higher prices abroad and in exchange buys those which are cheaper. This increases the total availability of goods for the nation. But that does not mean that everyone ends up being better off. All that the economists say is that with a larger collection of goods, each and everyone can be made potentially better off. It is in this sense that the nation as a whole gains. But to the extent the losers (like resources in import competing industries) are not actually compensated by the gainers (like those working in export industries), some people will end up losers and would oppose free trade. It is small comfort for me to know that though I have lost my job, two other persons have gained jobs somewhere else.

There are some additional channels through which a nation benefits from trade. One, international trade increases product variety. Some varieties which have a small local demand (like say some exotic cheese or kiwi fruit or models of sports cars) may simply not be produced locally as it may not be profitable to produce on a very small scale.

The consumers can get these only through imports. Wider range of choice, in addition to cheaper goods, is a gain. Two, trade enables a country to produce a smaller range of goods (along with a wider range of choice for consumers) on bigger scales. The cost-reduction through scale economies means that all countries may get these goods at lower prices. Third, import competition and producing for the more competitive export markets force producers to improve quality, cut costs and upgrade technology on a continuing basis. This enforced efficiency effect is particularly evident in today's India. Finally, freer imports and direct foreign investment increase the range of capital goods, other inputs and technologies available to the nation. This increases the productive power of the economy.

Free trade based on long run comparative advantage can potentially bring enormous gains to everyone. But free trade needs to be accompanied by a suitable compensation and redistribution mechanism to ensure that everyone actually ends up being better off.

(The author is Professor of Economics, Indian Institute of Management Calcutta. He can be reached at alokr@iimcal.ac.in)