The "free trade" foundations of "comparative advantage" debunked--for all pracical purposes

by: Paul Rosenberg

Thu Jan 27, 2011 at 15:00

It was beyond surreal to hear President Barack Obama talk about the priority of creating U.S. jobs while saying nothing about on fixing our China trade debacle and calling on Congress to pass a NAFTA-style trade agreement with Korea that the government's own studies show will increase our trade deficit. The Korea pact is projected to cost another 159,000 U.S. jobs - with nine economic sectors, including high tech electronics, as losers.

There's a whole lot I could say in support of this observation--particularly since this sort of thing has been going on for decades now, with the same miserable results over and over again.  As far back as the late 1990s, I reviewed a book by a couple of economic experts from Business Week, The Judas Economy: The Triumph of Capital and the Betrayal of Work, that warned of the degree to which the US was already loosing middle-class, professional, high-tech jobs to Asian competitors.  Obama's response would have been incoherent and off-topic even way back then.

But rather than say more about Obama per se, I'd like to talk about a recent paper that goes after the underlying idea behind so-called "free trade" mania--the economic doctrine of comparative advantage.  As is often the case in economics, there's a simple yet powerful idea here--but reality is often a whole lot more complicated.  And when it is, reality suffers at the hands of economists.  It's much easier for them that way.

"Dubious assumptions of the theory of comparative advantage" by Ian Fletcher, from issue 55 of the real-world economics review.  First, he starts out explaining the basic logic of the theory, starting off with a more primitive idea--"absolute advantage"--and showing what's wrong with it, thus introducing us to the powerful logic of comparative advantage itself:

The concept of absolute advantage simply says that if some foreign nation is a more efficient producer of some product than we are, then free trade will cause us to import that product from them, and that this is good for both nations. It is good for us because we get the product for less money than it would have cost us to make it ourselves. It is good for the foreign nation because it gets a market for its goods. And it is good for the world economy as a whole because it causes production to come from the most efficient producer, maximizing world output.

Absolute advantage is thus a set of fairly obvious ideas. It is, unfortunately, also false. Under free trade, nations observably imports products of which they are the most efficient producer-which makes absolutely no sense by the standard of absolute advantage. This is why one must analyze trade in terms of not absolute but comparative advantage. Boiled down to its essence, the often-misunderstood theory simply says this:

Nations trade for the same reasons people do.

And the whole theory can be cracked open with one simple question:

Why don't pro football players mow their own lawns?

Why should this even be a question? Because the average footballer can almost certainly mow his lawn more efficiently than the average professional lawn mower. The average footballer is, after all, presumably stronger and more agile than the mediocre workforce attracted to a badly paid job like mowing lawns. Yet nobody finds it strange that he would "import" lawn-mowing services from a less efficient "producer." Why? Obviously, because he has better things to do with his time.

The theory says that it is advantageous for America, for example, to import some goods simply in order to free up its workforce to produce more-valuable goods instead.

Once you've had it explained like this, the logic seems fairly impeccable.  But that's where the realworld problems arise, and start teasing out the hidden assumptions invovled.  Fletcher analyzes seven of them.  I'm going to quote enough of his analysis to convey the essence of the proble for each of the first six.  I'll leave off the last, which is somewhat more technical. First is the problem of unsustainability, a personal favorite, as a life-long environmentalist (even though the issue goes far beyond the environment as commonly conceived):

Assumption #1: Trade is sustainable.

This problem divides into two parts: unsustainable imports and exports.

When America, for example, does not cover the value of its imports with the value of its exports, it must make up the difference by either selling assets or assuming debt. If either is happening, America is either gradually being sold off to foreigners or gradually sinking into debt to them. We are poorer simply because we own less and owe more.

And this situation is unsustainable. We have only so many existing assets we can sell off, and can afford to service only so much debt.4 By contrast, we can produce goods indefinitely. So deficit trade, if it goes on year after year, must eventually be curtailed-which will mean reducing our consumption one day. We get a decadent consumption binge today and pay the price tomorrow, but because mainstream economics doesn't traffic in concepts like "decadent," it doesn't see anything wrong.

The implied solution is to tax imports. And that is not free trade.

The other side of this problem, unsustainable exports, includes examples such as oil-exporting nations selling of their most valuable--and non-renewable--resource.  Again, the solution is to tax it (thus generating the basis for future economic activity), which also is not free trade.

Next is the problem of externalities--another favorite as a life-long environmentalist, which also has a broader application:

Assumption #2: There are no externalities.

The theory of comparative advantage, like all theories of free market economics, is driven by prices, so if prices are wrong due to positive or negative externalities, it will recommend suboptimal policies.

For example, goods from a nation with lax pollution standards will be too cheap. As a result, its trading partners will import too much of them. And the exporting nation will export too much of them, overconcentrating its economy in industries that are not really as profitable as they seem, due to ignoring pollution damage. Free trade not only permits problems such as these, but positively encourages them, as skimping on pollution control is an easy way to grab a cost advantage.

Positive externalities are also a problem. If an industry generates technological spillovers for the rest of the economy, then free trade can let that industry be wiped out by foreign competition because the economy ignored its hidden value.

As if these aren't obvious problems once they're pointed out, the next one is even more obvious:

Assumption #3: Factors of production move easily between industries.

The theory of comparative advantage is about reshuffling factors of production from less-valuable to more-valuable uses. But this assumes that the factors of production used to produce one product can switch to producing another. Because if they can't, then imports won't push a nation's economy into industries better suited to its comparative advantage. Imports will just kill off its existing industries and leave nothing in their place.

Although this problem actually applies to all factors of production, we usually hear of it with regard to labor and real estate because people and buildings are the least mobile factors of production. When workers can't move between industries-usually because they don't have the right skills or don't live in the right place-shifts in an economy's comparative advantage won't move them into an industry with lower opportunity costs, but into unemployment.

This has only been obvious since about 1980 or so.  Has anyone in Versailles visited Michigan or Ohio lately?  No, of course not.  Silly me.

The next one is only slightly less obvious.  Or maybe not:

Assumption #4: Trade does not raise income inequality.

When the theory of comparative advantage promises gains from free trade, these gains are only promised to the economy as a whole, not to any particular individuals or groups thereof. So it is entirely possible that even if the economy as a whole gets bigger thanks to freer trade, many (or even most) of the people in it may lose income. This is not a trivial problem: it has been estimated that freeing up trade reshuffles five dollars of income between different groups of people domestically for every one dollar of net gain it brings to the economy as a whole.14

The next issue is a bit less obvious to the non-economist.  But not that hard to grasp, since we've seen it so brutally at work:

Assumption #5: Capital is not internationally mobile.

Despite its wide implications, the theory of comparative advantage is, at bottom, a very narrow theory. It is only about the best uses to which nations can put their factors of production. We have certain cards in hand, so to speak, the other players have certain cards, and the theory tells us the best way to play the hand we've been dealt. Or more precisely, it tells us to let the free market play our hand for us, so market forces can drive all our factors to their best uses in our economy.

Unfortunately, this all relies upon the impossibility of these same market forces driving these factors right out of our economy. If that happens, all bets are off about driving these factors to their most productive use in our economy. Their most productive use may well be in another country, and if they are internationally mobile, then free trade will cause them to migrate there. This will benefit the world economy as a whole, and the nation they migrate to, but it will not necessarily benefit us.

Of course, the theory also assumes that land is not internationally mobile--but that's actually true.  So not a problematic assumption.  Labor mobility is subject to law--which slows it down considerably in most cases.  So it really is capital mobility that stands out as the assumption that messes things up.

Next, another assumption that may not be immediately obvious to the layperson, unless, of course, they've heard any number of sayings, stories, proverbs, fables, etc. about the importance of thinking ahead:

Assumption #6: Short-term efficiency causes long-term growth.

The theory of comparative advantage is a case of static analysis. That is, it looks at the facts of a single instant in time and determines the best response to those facts at that instant. This is not an intrinsically invalid way of doing economics-balancing one's checkbook is an exercise in static analysis-but it is vulnerable to a key problem: it says nothing about dynamic facts. That is, it says nothing about how today's facts may change tomorrow. More importantly, it says nothing about how one might cause them to change in one's favor.

The problem here is that even if the theory of comparative advantage tells us our best move today, given our productivities and opportunity costs in various industries, it doesn't tell us the best way to raise those productivities tomorrow.

The last assumption is actually a bit more complicated, and because I'm trying to keep things simply here, I'm just going to name it and leave it at that:

Assumption #7: Trade does not induce adverse productivity growth abroad.

What this brief overview should show is that the theory of comparative advantage--the key theoretical underpinning for the ideology of international "free trade"--is only applicable to a very narrow set of circumstances, and in no way should function as a broad, unquestionable "rule of nature" to which we must mindlessly bow down.

When we have reams of data telling us that "free trade" has been bad for us, we should believe the data.  We should not believe the punditalkcrazy telling us to trust them and not our own lying eyes.

And we should not believe Obama, either.