Free trade policy is not the optimal trade policy
16 November 2021
Countries and trading blocs such as the EU should be free to choose the trade policy they deem optimal. This requires a renunciation of the holy grail of free trade
image credit: unsplash.com/Pat Whelen
- An ultimate free trade policy is unlikely to be the optimal trade policy for any country.
- Countries should be free to pursue the trade policy they deem optimal for them, which implies abandoning current upper bounds for import tariffs.
- An actively designed, optimal trade policy is fully compatible with a rules-based system.
- Five basic principles for the design of the international trading system suffice to ensure that actively designed, optimal trade policies are not harmful to trading partners.
A fraying system
A recent issue of The Economist contains a highly interesting special report on world trade. This analyses frictions in the global trade order, describing it as a ‘fraying system’. The usual suspects are suggested as the factors explaining why the decade-long trend towards free trade has come to an end: geopolitical rivalries, overt violations of international trade rules by major trading powers and dysfunctional global value chains.
The optimal degree of trade openness
None of these explanations is questioned. What appears increasingly strange, however, is the portrayal of free trade as the ultimate goal of trade policy. True, dismantling trade barriers such as tariffs or quotas has helped many countries to kick-start their economies and to achieve higher living standards. But there are also numerous liberalisation failures. And above all, more is not always better and the extreme case of a free trade policy that aims to minimise trade barriers at any cost is a completely misguided target (we abstain here from the debate about the term ‘free trade’, which for many is a misnomer as free trade requires a set of agreed rules and therefore cannot be free from regulations). What should be aimed for instead is an optimal degree of trade openness (which we have discussed in detail here).
This optimal trade openness is necessarily country- and context-specific, with a greater product variety and enhanced scope to access foreign technologies on the upside, and issues such as adjustment costs (which are too often neglected) or differences in values (e.g. with regard to product safety or environmental degradation) across societies on the downside. Given this trade-off, the normal case for any country will be to maintain some trade barriers – to be interpreted in a broad sense, including regulatory measures and tariffs alike.
A case in point is the carbon tariffs that the EU intends to impose on selected, energy-intensive imports from countries that fail to introduce a domestic carbon pricing system. Carbon tariffs have a sound economic basis but are still a contentious issue. While some may point to ‘environmental protectionism’ in this context, carbon tariffs are backed by solid economic arguments (for example, see here). The same is true for many non-tariff measures (NTMs), including all sorts of standards (technical, health, environmental, etc.) or labelling requirements that are not only trade barriers but provide important information for consumers and firms.
Free trade adds to tensions in the world trading system
Why do so many economists and policy makers adhere to the free trade doctrine? The charm of the free trade mantra is its simplicity and the clear policy advice deducible from it: open up the economy with no caveats. But this simplicity is also its greatest weakness because markets are not functioning as smoothly and perfectly as one may wish. The world is full of market failures (environmental ones, for example) – in more and more industries we observe extreme market concentration, giving rise to ‘superstar firms’ with intimidating market power, and there are numerous political economy considerations (e.g. power asymmetries between trading partners) that can make free trade a sub-optimal policy.
Moreover, all these factors feed, in one way or another, into tensions in the global trading system. For example, the current supply shortages in some important international value chains (e.g. electronics) arise not so much from their complexity per se, but from the concentration of production of highly specific inputs in a few firms or places (in the case of semiconductors, the global market leader, TSMC, has a market share of more than 50%). In such environments, trade liberalisation will lead to a situation where the gains from trade accrue disproportionately to a few large firms, and will also leave supply chains prone to disruptions. Of course, trade policy is not the only lever to influence the distribution of the gains from trade; countries may prefer to use other tools, such as corporate taxes or competition law, to counteract these tendencies. But trade policy should certainly be one of the options that countries can use.
Principles for conducting optimal trade policies
What is needed is an international trading system that is predictable and at the same time allows countries to pursue trade policies that are coherent with their optimal degree of trade openness. In contrast to the simplistic free trade doctrine, there is no simple answer, let alone policy recommendation, as to exactly what such a policy should look like as it is necessarily context-specific. The general principle, however, is that countries must have the right to conduct a trade policy that is in line with their optimal degree of openness. Moreover, there is a set of further principles that could guide the design of an international trading system, which would keep potential negative consequences for trading partners to a minimum.
- Free choice of trade policy. All countries are entitled to freely choose their trade policy, including the level of tariffs, quotas and all other sorts of NTMs. This implies abandoning bound rates (tariff binding), which are the maximum permissible tariff rates under the General Agreement on Tariffs and Trade (GATT).
- Most-favoured nation principle. Although countries are free to choose the tariff levels they deem adequate, tariffs need to be applied in a non-discriminatory manner. In other words, the most-favoured nation (MFN) principle, enshrined by the World Trade Organisation (WTO) in the GATT, applies. This serves as a protection especially for smaller trading partners against unfair practices of more powerful trading nations. As is currently the case, countries can enter preferential trade agreements that contravene the MFN principle.
- Transparency. All new measures implemented need to be notified to trading partners. Sanctions are imposed in cases of repeated non-compliance with this notification obligation in order to avoid a situation similar to that prevailing under the WTO’s Agreement on Subsidies and Countervailing Measures (ASCM), with many member states notifying their subsidy measures only sporadically (if at all).
- Long planning horizons. Trade policy measures not only need to be transparent but must also be notified some four to five years in advance. This extremely long notification period serves two purposes. First, it provides predictability, thereby avoiding surprises for affected trading partners. Second, it rules out erratic trade policies that undermine a country’s own interests and only serves vested interests. This rule would not touch upon existing safeguard measures allowed under the GATT (e.g. when import surges jeopardise domestic industries).
- Reciprocity. Finally, while any country is obliged to accept (properly notified) trade measures by partner countries, it is entitled to match any action taken by partner countries within the same tariff line (that is, for the same product). This reciprocity rule would provide an exemption from the MFN principle. If such a matching is ineffective (e.g. because a negatively affected country does not import that kind of good, or only in negligible amounts), countries can take recourse to the existing trade defence measures (anti-dumping measures and countervailing duties).
Conclusion
Although these principles would constitute a significant change of the existing international trading order, they would allow countries and trading blocs such as the EU to freely choose the kind of trade policy they deem adequate in order to move towards their optimal degree of trade openness. If applied in an orderly manner, such policies are unlikely to hurt trading partners. On the contrary, they would help to ease some of the existing tensions in the trading system, which are to some extent the result of an overenthusiastic free trade policy. Such an extreme policy stance is rarely, if ever, an optimal trade policy.
References
Autor, D., D. Dorn, L.F. Katz, C. Patterson and J. Van Reenen (2020), ‘The Fall of the Labor Share and the Rise of Superstar Firms’, The Quarterly Journal of Economics, Vol. 135(2), pp. 645-709.
https://scholar.harvard.edu/files/lkatz/files/adkpv-superstars-qje-manuscript-final-20200123.pdf
The Economist, World Trade, Special Report, 9 October 2021.
https://www.economist.com/special-report/2021-10-09
Grübler, J. und R. Stöllinger (2018), „Die Evolution und Bedeutung ‚moderner‘ EU-Freihandelsabkommen“, FIW Policy Brief, Nr. 43, Dezember. https://www.fiw.ac.at/fileadmin/Documents/Publikationen/Policy_Briefs/43_FIW_Policy_Brief_Stoellinger_Gruebler.pdf.
Stöllinger, R. (2020), ‘Getting Serious About the European Green Deal with a Carbon Border Tax’, wiiw Policy Note/Policy Report, No. 39, The Vienna Institute for International Economic Studies, Vienna, August.