Free to Take Exceptions to 'Free Trade'

Gregory Clark (Vice President, Akita International University)

The harsh treatment handed out to European Union ideals by French and Dutch voters this month was in part a reaction to excessive EU bureaucracy and expansionism. But it was also a gut rejection of so-called globalization -- the foolish effort to deny economic and social differences between nations. The idea, for example, that EU governments could be fined for not submitting to EU-imposed fiscal and free-trade policies was absurd from the start. Some nations need to protect economies and industries; some don't. Ironically, the same EU now threatens anti-free trade, protectionist fines to keep Chinese textiles at bay.

Conventional wisdoms come in cycles. Until the middle of the last century, it was taken for granted that societies should protect their economies and domestic industries from harmful foreign competition. Free trade was a bad word. Free traders were a despised minority.

But in the wake of World War II and as a reaction to the excessive protectionism and nationalism of the 1930s, a new wisdom took hold. This said that all trade and other national borders should be free. Protectionism became a bad word. The EU was one result.

The contortions needed to produce this 180-degree shift in economic theory were remarkable. I had to learn my economics from the free-trade textbooks of the 1960s. Amazingly, they relied heavily on the 19th-century concept of diminishing returns on scale. This said if a nation produced and exported something to excess its costs would rise. Trading partners could become competitive. Free trade would create economic balance.

In the real world, of course, it is almost always the exact opposite. The more you get in early to produce and export something in volume, the lower your costs become, and not just in one industry. Your entire economy becomes competitive via its stronger industrial base. Japan is a good example. Unless other nations take early protective action, many of their export- or import-competing industries will be wiped out.

The free-trade dogmatists then went on to say it did not matter even if a competitor lost certain industries. The labor and capital employed in defeated industries would be freed to move into higher grade industries. Workers and businessmen in, say, a bankrupted textile industry could overnight be transferred to create viable computer industries.

Even in advanced economies, this wisdom was doubtful; in developing economies, it was disastrous. From Morocco to Mozambique, we have seen the pathetic fallout as small-scale processing industries are wiped out by cheaper goods from more competitive economies, China and India especially. Far from creating balance, free-trade policies have imposed massive disequilibrium on the world economy. The strong get stronger and the weak get weaker.

The East Asian economies have long had a much more balanced approach. They protect weak industries seen as important for the future economy, encourage free trade for strong industries, and keep their currency undervalued for as long as possible. Helped by cheap labor and basic skills they were able to develop strong economies and highly competitive export industries, Japan especially.

In a significant 1980s' report, Tokyo tried hard to educate a free-trade dogmatic World Bank in these matters, but without much success.

Fortunately, there is a crude antidote to free-trade excesses -- and it is ignored by free-trade textbooks: They are changes in the exchange rate. Appreciation will choke off exports from strong economies. Devaluation can help protect industries in weak economies. In this way a kind of trade balance can be restored, though often not before key industries in weak nations have been heavily damaged, since laissez-faire, free-trade dogmatists often delay intervening in foreign exchange markets needed to restore balance.

Weak economies also face the risk that devaluation will cause severe currency flight, imported inflation and currency collapse. No amount of devaluation can then rescue the economy from its downward spiral.

Australia used to be a prime example of this laissez-faire free-trade dogmatism in action, with its free-trade theorists busily cutting tariffs even when the currency was grossly overvalued. It was lucky though. As its economy collapsed and its currency devalued, its producers could gain the massive exchange-rate protectionism needed for recovery before currency collapse evils could set in. (Later the theorists were to claim the recovery was due to those tariff cuts!)

Russia and the Latin Americans were not so lucky. Hit with antiprotectionist dogma, mainly from the IMF, World Bank and other U.S. advisers, their currencies and economies went into the downward spiral. They are only now recovering.

This column predicted more than two years ago that China's growing competitiveness demanded early currency appreciation. Only now are the U.S. and the EU dogmatists beginning to make the same point. China's response was reasonable enough. It promised some appreciation, though only at its own pace. In the meantime it imposed a tax on textile exports.

Compare this with Japan, which typically tries to mix free-trade dogma with an emotional protectionism. In 1982, when the yen was still heavily undervalued and trade surpluses booming, I found myself on a Finance Ministry committee to consider U.S. plans to impose high tariffs on Japanese exports, cars especially. Suggestions that something be done to encourage yen appreciation were dismissed out of hand.

Myself and another member, the economist Takashi Hosomi, then suggested Japan should at least get in first and impose export taxes. That way the income from the duties would go to Japan rather than the United States. But in those days the idea of a tax on car exports in Japan was like asking for a tax on motherhood. Besides, it was contrary to the rules of free trade we were told.

We ended up as a small paragraph in the final report. An impatient U.S. went on to force massive yen appreciation through the 1985 Plaza accords. Japan is still suffering.

(This article appeared in the June 15, 2005 issue of The Japan Times)