Understanding Free Trade: Definition, Pros, and Cons

Put simply, Free trade is international trade where there are no government policies restricting the import and export of goods and services. While economists consider this as the best approach to maintain a healthy global economy, this is more of a theoretical policy become some restrictions do exist.

• Free trade means importing and exporting without restrictions.
• Opposite of free trade is protectionism
• Most nations participate in free trade agreements (FTAs) where tariffs and other trade restrictions are regulated

Advantages of Free trade

There are several reasons why trade is considered good, several economists feel trade is good for the economy for the following reasons.

It results in specialization of companies thus producing better products/services, there is more competition which results in greater opportunities for innovation.

The less efficient firms are replaced with more efficient ones which means consumers get better quality products at lower prices.

In general, people also get more variety of products due to trade.

For the industry and the companies involved, it means there is economic efficiency, scale efficiency, longer production runs, and fewer market distortions.

Criticism of Free Trade

In economic theory, free trade – that is, trade unimpeded by government regulations and protection of domestic industries – improves the allocation of resources and therefore world economic growth.

The theory of comparative advantage explains why this is the case. However, the theory of comparative advantage is based on very restrictive assumptions about the way the world works, and in particular it ignores economic power relations. Yet, it has been an important back-up to the neoliberal position that growth will be highest when governments remove themselves from the allocation of resources and allow markets to work.

The modern push for increasing globalisation, free trade agreements, free trade blocks and the increasing integration of international financial markets are evidence of the success of this argument.

The Washington consensus – which argues for free trade, deregulation of industries, and privatisation of State’ assets – also derives from this neoliberal position on economic development. Often, developing countries have had to follow the Washington consensus to receive loans from the International Monetary Fund and World Bank.

It has been argued that this does not help to end poverty and encourage growth in developing economies but rather stacks trade in the favour of the rich countries. Ironically, the very countries arguing for free trade in developing economies earned their incredible wealth because they protected their industries.

Thus, free-trade agreements are said to lock developing countries into producing agricultural goods and other low value-added goods because they can’t protect and develop nascent industries. Because of the economic power of rich countries, free trade agreements often still allow these rich countries to protect their own agricultural industries and thus push down the price of the goods produced in developing economies.

Thus, the counterargument to the theory of comparative advantage is that free trade is really rigged trade in the favour of rich countries and will therefore not alleviate poverty and will have no impact on the incredible income inequality in the world.

Is the Current Trade System Outdated?

Over the last few decades, the trend in trade has been to move towards a barrier-less market where trading between countries is easier and beneficial to all the countries involved. While that may have worked well in the past, the current trade system seems to be inadequate to deal with current economic challenges, going by the several trade conflicts and propensity of countries to move towards protectionism.

As the economy faces a slowdown in most parts of the world, with increase in competition and free trade taking a toll on jobs/wages, trade wars seem to have become more common and with no immediate signs of resolution.

US-China trade war

The US-China trade war is the biggest trade conflict right now that threatens to affect the economic forecast of other countries as well.

Related: Read more on the US-China trade conflict

Several member states feel that the World Trade Organization (WTO) today is unable to effectively deal with certain economic issues. WTO happens to be the main body for setting rules of international trade, helps reduce trade barriers, and provides dispute resolution mechanism, and the institution has done a decent job in the last couple of decades.

However, of late there seems to be more disagreement among member states, especially over agricultural subsidies and intellectual property rights, and several countries are opting for regional free trade agreements to protect and advance their trade interests (McBride and Andrew Chatzky, 2019), or are opting to exit from previous free trades regions, such as the UK that decided to exit from the EU.

When it comes to the current trade practices, the general criticism is that there are winners and losers from free trades and that losers are not compensated adequately, farmers and labour groups fear that their incomes would get impacted and that bodies such as the WTO are biased towards corporate interests, environmentalists in general feel that not much is being done for the environment and fear that existing regulations could be scrapped to favour growth; environmentalists also are not in favour of WTO decisions concerning genetically modified foods.

The United States in particular has been extremely critical of the WTO because it feels that the institution has failed to efficiently handle Chinese excesses/abuses and it is unable to protect the wages of US workers due to unfair labour practices abroad (McBride and Andrew Chatzky, 2019).

Critics of international trade have been pointing to the fact that the gains are not evenly distributed among the people of a country leading to winners and losers (altman, 2013) and this is one of the reasons why not everybody is excited when they hear about the government planning a free trade agreement with some other country.

Trade agreements do reduce trade barriers but they are also extremely complex in nature and include several caveats which participating countries might misuse. While free trade does have its advantages and does create new jobs in new areas/segments, the fact that it has potential to impact weaker industries and cut jobs in certain industries worries many who feel there has to be a better solution to these problems.

Organizations today are more multinational than ever before, they have global supply chains and certain products use parts from all over the world. So, countries may not be able to successfully use traditional economic policy tools to control things, as they might have done in the past. So if the United States feel that a weaker dollar could boost export of certain products as those products will become cheaper for the other countries to buy, this logic may not really hold true because the product might be using parts from four or five different countries (Donnan and Leatherby, 2019).

These are the reasons why some countries (such as the US) are favoring protectionism by putting up trade barriers, while other countries are opting for freer trade and trying to reduce barriers.

However, studies indicate that imprudent trade practices is to be blamed that have caused considerable damage to the economy and it is not something that can be mitigated through monetary policies, such as changing interest rates (Frankel, 2018).

Are their losers from free trade?

When it comes to the current trade practices, the general criticism is that there are winners and losers from free trades and that losers are not compensated adequately, farmers and labour groups fear that their incomes would get impacted and that bodies such as the WTO are biased towards corporate interests, environmentalists in general feel that not much is being done for the environment and fear that existing regulations could be scrapped to favour growth; environmentalists also are not in favour of WTO decisions concerning genetically modified foods.

While there are advantages to free trade (Gould, D. et al, 1993), and countries that engage in trade do achieve gains, those gains may not be equally shared among its people, and that’s where you see the winners and the losers (altman, 2013). That is why, every once in a while, you will see farmers, workers turn up on the streets in various countries to protest the various free trade agreements.

The most common arguments for offering protection to local industries is that the domestic market is not yet ready to take on competition from the bigger foreign organizations; certain industries are in the infant stage and require protection until they mature. The losers from various free trade agreements are usually the domestic firms who are yet uncompetitive and are likely to lose out to cheaper imports, and workers who are likely to lose jobs in these uncompetitive industries.

Mahatma Gandhi once said that “India lives in its villages”, and even though the services sector in India has grown substantially over the past few decades, agriculture is still an important sector as there are close to 600,000 villages in India (Sharma, 2007), and over half of India’s population of 1.3 billion is dependent on agriculture for their livelihoods.

Also, compared to the farmers in the Western world, farmers in India have much smaller farms and have much smaller annual incomes. While farmers in India have an average land holding of one hectare, farmers in the United States have an average landholding of around 176 hectares (GRAIN, 2020).

This is true of farmers in most developing countries, and because there are losers from free trade, farmers in most developing countries get worried when they hear of free trade agreements involving their regions. Farmers in India are worried about the US-India free trade agreement that is expected to affect farmers, small-scale food producers and informal traders in India.

Agriculture in the US is heavily dependent on exports, and is controlled by large corporations, and they have been putting pressure on the US government to get India to open its markets to US farm goods. Over the past few years, the two countries have been having disagreements on various topics, including agricultural subsidies, which they have been trying to resolve at the World Trade Organisation (WTO) but without much progress.

While US agriculture is controller by big corporations, farmers in India operate on a much smaller scale. As a result, millions of small farmers in India engaged in dairy, poultry, soyabean production are likely to be severely impacted if they have to take on the giant American corporations once the market opens up (GRAIN, 2020).

Here’s another example.

Almost everyone in the US is excited about the U.S.-Mexico-Canada Agreement, also known as “USMCA” or “NAFTA 2.0.” and claiming it to be a political and economic victory for their respective parties (Long, 2019). This deal is an update to the 1994 North American Free Trade Agreement (NAFTA). However, experts say there are a few losers in this deal as well.

Long (2019) says the deal makes it difficult for companies in the auto industry to shift their factories from the US and Canada to Mexico (where labour is cheap) so it’s not great news for Mexico. Long (2019) says that this also means that car buyers in the US and Canada may have to shell out more for new cars as car makers cannot completely rely on Mexico for cheap labour and they will also have to incur higher compliance costs.

Another example is how America workers in certain industries were affected after China joined the World Trade Organization in 2001. Autor et al. (2014) observed that American workers who worked in industries with higher exposure to imports faced substantial cut in wages.

The losses were significant especially for workers who already had low wages. Autor et al. (2014) say that high-skilled workers in the same industries, on the other hand, were able to take their skills to other industries and as a result suffered lower income losses (many of them are able to find a new job with similar or better wages). Low-skilled workers unfortunately do not have the skills to move to another industry and being stuck in the same industry remained exposed to import competition.

So, while the advocates of free trade are quick to point out the several advantages of free trade, including a more efficient economy, there are many who still remain unconvinced. In fact, in many parts of the world, the trend is more towards protectionism.

So, the question that needs to be asked is what can be done to make free trade a less divisive issue.

Altman (2013) says one solution is to compensate the losers. He says because a country gets richer by opening its markets, the winners should ideally be able to able to compensate the losers so that there is bitterness among anybody; this redistribution of the gains should be a part of the process of opening markets rather than being an afterthought.

While it might be doable and the losers are compensated to some extent, Altman says more needs to be done on this aspect to get it right. However, there are some who feel that Altman’s solution is not practical. Lester (2013) says that there are people who can lose their jobs due to other reasons as well, such as changes in technology.

So, there is no need to compensate people for job losses when others who have lost jobs due to other reasons are not being compensated. Besides, in most countries, the government already administers social programs designed to help people during challenging economic situations.

Farmer (1970) points to the differences in the social attitudes and class positions of those who are against free trade, and says that those who are in favour of free trade are usually change-oriented and more cosmopolitan, whereas those who are against free trade tend to be inflexible and provincial, in which case economists should reach out to them via public relations and marketing to convince them.

In the earlier example, we also saw how workers who have the skills and the ability to cross industries and sectors are in a better position as they are less exposed to the hazards of trade exposure.

So, the government and industry bodies should focus more on upgrading the skills of the people working for the more vulnerable industries.

References

Altman (2013), Free Trade: You’re Doing It Wrong

Gould, D. et al. “The theory and practice of free trade.” Economic and Financial Policy Review (1993): 1-16.

Grain (2020), Perils of the US-India free trade agreement for Indian farmers

Lester (2013), Should We Compensate the Losers from Free Trade?

Long (2019), Winners and losers in the final USMCA deal

Sharma (2007), “Free” trade killing farmers in India