May 21st 2005

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Articles from this issue:

COVER STORY: CANBERRA OBSERVED: Costello's latest budget - do the figures add up?

EDITORIAL: Australia's economy after the Budget

SCHOOLS: Our failure to provide good books for boys

DRUGS: How to crack down on illicit drugs

ABORTION: Public turning against late-term abortions

IN VITRO FERTILISATION: Why Abbott is right about IVF funding

TRADE: New Trade Theory challenges free trade

SUPERMARKETS: Big retailers set to hit farmers even harder

COMMUNISM: Remembering the Vietnamese exodus

ENVIRONMENT: Kyoto Protocol unleashes the friendly atom

Support, don't abort (letter)

Cheaper insurance for pro-lifers? (letter)

Australia's trade woes (letter)

Public inaction over illicit drugs (letter)

OBITUARY: Vale Hugh Slattery: tireless fighter

OBITUARY: Tribute to Sir Joh Bjelke-Petersen

THE SUPREMACISTS: The Tyranny of Judges and How To Stop It, by Phyllis Schlafly

THE PELOPONNESIAN WAR: Athens, Sparta and the Struggle for Greece, by Nigel Bagnall

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New Trade Theory challenges free trade

by Colin Teese

News Weekly, May 21, 2005
A so-called "New Trade Theory" has recently challenged the orthodoxy that proclaims that unrestricted free trade is universally beneficial to all countries in all circumstances, writes Colin Teese, former deputy secretary of the Department of Trade.

"First they ignore you, then they laugh at you, then they fight you, then you win." (A saying attributed to Mahatma Gandhi.)

Gandhi, in this famous saying, was talking about the political emancipation of India. But those struggling to overturn the commitment of policy-makers to the idea of undiluted free trade as universally beneficial to all, in all circumstances, can sympathise with Gandhi.

They too have been ignored, laughed at and fought. Is it now possible for them to hope for victory?

It is too early for such extremes of optimism, but the signs are, at least, encouraging - especially as we learn that academic and other circles are talking about what they call "New Trade Theory".

This rebuts most of the current orthodoxy concerning free trade - and, in particular, the assertion that the total removal of all barriers to trade will always benefit all economies in the same way, no matter what their stage of development or special circumstances.

Eminent supporters

Whatever else may be said about this new theory, it is certainly attracting attention. No less a figure than that most eminent of economists, Paul Samuelson, has spoken favourably about it.

Samuelson is now into his eighties; but is well remembered as the guiding light for more than a generation of economists trained in the period after the end of World War II. For decades, his was the pre-eminent textbook for universities throughout the English-speaking world and beyond. And, in 1970, Samuelson was the first American to be awarded the Nobel Prize for economics.

Samuelson's backing for the idea of a more critical attitude to current free-trade orthodoxy is both welcome and encouraging.

New Trade Theory is opening up a crack in what has been the solid wall of orthodoxy surrounding the idea of free trade. The new theory provides those in a position of influence with the tools needed to discredit the current orthodoxies being applied to the practice of free trade.

If it can dislodge the iron grip current orthodoxy has on the free-trade debate, it will, in the process, open the way for a more encouraging and realistic debate on trade policy. New Trade Theory has the potential to become an important new force.

At the very least, it is a recasting of classical economics away from the idea of comparative advantage, which is based on the idea of countries specialising in producing goods according to what they can do best. The old example of Britain selling cloth to Portugal in exchange for wine was said to be best for both countries.

New Trade Theory insists that, in the modern world, the conditions leading to comparative advantage are not solely derived from natural (e.g., geographical or climatic) differences, but can be created. If it is true that comparative advantage today is created not necessarily inherited, then we need to re-examine the ideas behind free trade.

Free trade - as currently described and practised - can only be justified if we accept that the old idea of comparative advantage still applies.

The reality is that a variety of influences - business as well as government-inspired - are always at work to frustrate the operation of perfectly competitive markets. For all of these reasons, free trade - as is currently advocated - cannot deliver what is being claimed for it.

That, however, does not mean that the case exists for the wholesale and universal application of protective measures against imports. Free trade - contrary to the claims of so many of its proponents - is not an absolute or an all-or-nothing proposition.

In practice, it becomes a matter of degree according to the special circumstances of each individual economy. And it has only been otherwise represented in the context of promoting globalisation. Obviously, globalisation can only make sense if all economies can respond in exactly the same way to the same economic stimuli.

New Trade Theory demonstrates that this is not so. Market imperfections preclude the possibility of total free trade. Realistically, the second best option is for individual countries to exempt as much of their imports from restriction as possible. How much is possible will depend on the circumstances and stage of development. Certainly, it will vary from country to country. Proponents of New Trade Theory, so-called, are at pains to point this out.

We should also recognise that, even in the most favourable of circumstances, unrestrained market competition of the kind induced by free trade does not necessarily produce the best outcomes.

Competition in the context of free trade invariably is concentrated on price. And price competition quickly drives out the weaker producers. Meanwhile, the stronger survivors use their newly-won market power to protect themselves from the excesses of competition - even to the extent of recouping losses incurred in driving out weaker competitors.

As a matter of fact, the philosophy of cut-throat competition has never been a prime motivating force behind modern capitalism.

The preferred driving force for modern capitalism is not price competition, but innovation; the idea is not to join the race to produce the same product cheaper, but to make a different, more appealing product where price is not the consideration. To achieve this, funds are invested more in research and development than in marketing.

It's much easier to sell a new and different product. And, without competition, the producer to become a price-maker rather than a price-taker. It is also easier to export if there is no locally-made competition. And healthier and more reliable profits mean that funds can be set aside for further new product development. Thus the cycle of innovation is continued.

Price war

Price-takers, meanwhile, are left to fight a debilitating price war from which no winners emerge. Price-cutters, in their race to survive, can't hope to keep up quality.

That is not to say that innovating companies can completely avoid competitive pressures. But clearly they face competition of a less destructive kind. They must make the right product. Much of the competition is the company against itself, devising how to use research and develop skills to create a competitive advantage.

The benefits of the innovating companies don't only fall to the enterprise: the economy of the host nation also benefits. A nation whose enterprises are able to generate funds needed to sustain research programs gets the "spin-off" effect of higher quality and better-paid and more reliable jobs - and so do its workers.

As Peter Brain, one of our more imaginative economic analysts, likes to remind us, there is a qualitative difference between an industry producing micro-chips and one producing potato chips - even if, in money terms, they make the same contribution to GDP.

If those behind the push for what they call New Trade Theory are able to break the mindset of those currently influencing economic policy in Australia, away from what we might call the "potato chip" mentality, they will have done us a great service.

In re-examining current economic orthodoxy, the new theory compels orthodox free-traders to confront a number of uncomfortable realities. There is, it reminds us, no example of a country which has proceeded to economic pre-eminence by means of the free-trade path. All of the major economies have developed behind protective barriers: Britain, Germany, the United States and Japan are all examples.

Some, notably Britain and the United States, once pre-eminent, have perceived their best interests to be served by attempting to impose a free-trade régime on the rest of the world. They did so for what they perceived to be the best of self-interested reasons.

Once their most powerful companies had saturated domestic markets, these companies themselves began to press the advantages of free trade on their respective governments.

It made good commercial sense for them to enjoy unimpeded access to the markets of the rest of the world and, for un-differentiated products, to have them made at the cheapest possible source.

They found sympathetic ears within governments which then began to push for free trade. And in mounting that push, they have been advantaged in being able to draw on support from much of the economics profession committed to what they believed to be the benefits of free trade.

Now some, at least, of those countries have begun to have second thoughts. In the United States, concern over Chinese imports has forced the Bush Administration to acknowledge that the virtue of low-cost Chinese imports comes with a cost, and that cost is borne by US-based businesses and workers. The US is considering tariffs to discourage low-cost Chinese imports.

Implicitly, these possible actions suggest that free trade is no longer presumed as necessarily delivering undiluted benefits to the US. The New Trade Theorists would undoubtedly agree. Their theory accepts that benefits can flow from free trade - but it also argues that they don't always apply and, furthermore, that their value has been overstated.

As to the value of the benefits of free trade the New Trade Theorists, rather cleverly, rely on the 1986 work of an arch free-trader, Jagdish Bhagwati, for confirmation that free trade delivers benefits of around two to three per cent of GDP. And this is the raw benefit - that is, without adjustment for any adverse consequences such as re-distribution of income.

Suppose, for example, free trade adds 3 per cent to GDP, but, at the same time produces a 6 per cent redistribution of income away from employees and towards employers, then most of the population are worse off.

What has been outlined in this article cannot do justice to all of the arguments developed by the New Trade Theorists. Many of their more complicated, yet no less persuasive arguments, are left unconsidered. Mostly they are highly technical and some aspects are still being developed.

But already the new theory calls into question what is claimed for free trade in the public debate here in Australia. At the very least their opponents are entitled to expect proponents of free trade to respond.

If so, the opposition will have moved to what Gandhi called the "fight" stage, and, hopefully, be only one step away from winning.

  • Colin Teese was deputy secretary of the Department of Trade.

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