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Free Trade Theory Known to be Wrong—Since 1817!

Economics / Economic Theory Mar 11, 2011 - 02:48 AM GMT

By: Ian_Fletcher

Economics

The economic argument for free trade is ultimately based on the theory of comparative advantage, invented by David Ricardo in 1817. Ricardo was a London stockbroker, self-made millionaire, and Member of Parliament who became a self-taught economist.


All the things we are told about why free trade is good for us are boiled down to hard economics and weighed against the costs by this single theory and its ramifications. If this theory is true, then no matter how high the costs of free trade, we can rely upon the fact that elsewhere in our economy, we are reaping benefits that exceed them.

But if it is false, we cannot.

This is why it is important to note that even Mr. Ricardo knew, when he expounded his theory to the world, that it suffered from enormous flaws—flaws sufficient to render it totally unreliable as a guide to real-world policy. Like many intellectual innovators, he was considerably smarter than a lot of his own followers, who tend to hear only what they want to.

For example, Ricardo knew perfectly well that his theory no longer holds if productive capital is mobile between nations. This is a problem we encounter today in, for example, the migration of America’s industrial base to China. As he explained it, using his favorite example of the trade in English cloth for Portuguese wine:

It would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances the wine and the cloth should both be made in Portugal, and therefore that the capital and labor of England employed in making cloth should be removed to Portugal for that purpose. [Principles of Political Economy and Taxation, p. 83]

But he does not say it would be advantageous to the workers of England! This is precisely the problem Americans experience today: when imports replace goods produced here, capitalists like the higher profits and consumers like the lower prices—but workers don’t like the lost jobs. Given that consumers and workers are ultimately the same people, this means they may lose more as workers than they gain as consumers.

Contrary to free-trade mythology, there is no theorem in economics which guarantees that workers’ gains will exceed their losses under these circumstances. Things can go either way, which means that free trade can be a losing move for them. Whether it will be a losing move is a complicated question that turns on a number of different variables, but the threat is real. The “win-win” guarantee that free traders believe in is pure fantasy.

Having observed that capital mobility would undo his theory, Ricardo then tried to argue why capital will not, in fact, be mobile—as he knew he had to prove for his theory to hold any water:

Experience, however, shows that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connections, and entrust himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.

So in the end, the inventor of the theoretical keystone of free trade had to rely upon government and instinctive economic localism in order to make his theory hold. Something has to anchor capital for it all to work!

Interestingly, the above paragraph hasn’t just become untrue in the modern globalized era. It was already untrue a few years after Ricardo wrote it, when billions of pounds began flowing out of Britain to finance railways and other investments around the world. British investors’ preference for building up other nations’ industries, rather than their own, exacted a heavy toll on the once-dominant British economy—a story repeated in the hemorrhage of American industry and know-how to China in the present day.

Sometimes, the hardest lesson to learn is the one you already knew.

Ian Fletcher is the author of the new book Free Trade Doesn’t Work: What Should Replace It and Why (USBIC, $24.95)  He is an Adjunct Fellow at the San Francisco office of the U.S. Business and Industry Council, a Washington think tank founded in 1933.  He was previously an economist in private practice, mostly serving hedge funds and private equity firms. He may be contacted at ian.fletcher@usbic.net.

© 2011 Copyright  Ian Fletcher - All Rights Reserved

Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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