Free trade | The yawning gap between free trade principle and practice

The yawning gap between free trade principle and practice

Reuven Brenner October 24, 2016 7:21 PM (UTC+8)
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After seven years of negotiations between Canada and the European Community, the free trade talks between them just collapsed on October 21, after the Belgian region of Wallonia rejected the negotiated deal. The same time, the Transatlantic Trade and Investment Partnership between the United States and the EU faces opposition, and the Congress refuses to ratify the Trans Pacific Partnership between the United States and 11 other Pacific Rim countries. Add to these Donald Trump’s promise to renegotiate NAFTA, and it appears that the idea of freer trade, widely thought to solve many problems after the fall of Iron and other dictatorial curtains, is now again questioned as being valid.

I am emphasizing the word “again” because about a century ago, there were serious debates too about its validity to bring overall benefits. In a much debated speech in Dublin, at the University College, titled “National Self-Sufficiency,” Keynes acknowledged that he changed his mind about his topic. He starts his speech stating that “I was brought up, like most Englishmen, to respect Free Trade not only as an economic doctrine which a rational and instructed person could not doubt, but almost as a part of moral law.” But he then explains that he changed his mind because political priorities became different for his times than they were for the 19th century Free Traders. Because of these changed priorities the benefits from an “ideal international division of labor” may be less – in some circumstances – than the gains of national self-sufficiency. Though, he does warn not to discard “too easily much of the value which the nineteenth century achieved.”

The 19th century free traders, as Keynes correctly points out, assumed that the whole world would soon be based on the principle of “freedom of private contract inviolably protected by the sanctions of law,” and the resulting free trade would solve “the problem of poverty, and solving it for the world as a whole.” That did not happen. Keynes then concludes that because of that the idea of the “Minister of Finance as the Chairman of a sort of joint-stock company has to be discarded. Now, if the functions and purposes of the State are to be thus enlarged, the decision as to what, broadly speaking, shall be produced within the nation and what shall be exchanged with abroad, must stand high amongst the objects of policy.”

Whereas Keynes emphasizes international politics and the state of capital markets at the time that forced him to more nuanced views about freer trade, the last few decades also remind us about the implicit assumptions about domestic institutions that must be in place for reaching the conclusion that freer trade is beneficial for all parties to the deal.

Let us start with the latter: even the most ardent free trader acknowledges that when tariffs are lowered, there are losers too and not only winners. But they assume that there are political institutions and mechanism that compensate the losers in various ways. These can be direct monetary distributions and retraining of employee, combined with gradual lowering of the tariffs, so as not to bring abrupt disruptions. These policies must be such that after compensating the losers, the gains to the winners (consumers benefiting from lower tariffs) still offer substantial benefits to the country.

Nobody disputes the facts that the fall of the Iron and other dictatorial curtains was the equivalent of a massive lowering of tariffs. Countries that were tightly closed to any trade with the US and Western Europe, were suddenly open. The same time, countries that pursued heavy tariff policies in the name of “self sufficiency” (such as India and others) lowered their tariffs too. The consequences in the US were that in a large number of sectors, American employees had to suddenly compete with hundreds of millions of equally qualified people around the world, working for much lower wages.

This drastic change coincided with drastic technological changes in the US that harmed this same group of – call it – “routine-type-work” employees. And in the last twenty years these two drastic changes also coincided with a third “force” – the demographic reality of Western, and to lesser extent US’ population, aging and expecting longer lives.

Neither the US, nor the West adjusted their fiscal, regulatory policies or various entitlements to these realities, though lately some countries increased the age of retirement and tried to mitigate the increasing health costs. They did not adjust the outdated patent laws either, that insured twenty years protection of patents – an entirely arbitrary number, drawing on political calculations, some from the 14th century, others from the 19th century. Congress first extended patent protection to 21 years in 1836. In 1861, the Senate wanted to return to a 14-year patent life; the House of Representatives wanted to stand pat. The result was a compromise, 17 years, which lasted until 1999, when 20 years became the standard world-wide.

Today, there is a belief that the 20-year life granted to patents in all industries fosters more patents, and that the number of patents granted implies much about a country’s ability to innovate or create wealth. Not really. As the University of Western Australia’s Tim Mazzarol correctly observed, “many companies today seem to be inventing patents rather than patenting innovations.” A bit like academics publishing plenty of nothings, but the universities measuring it as “contributions” to research. Meanwhile Jeff Bezos, among others, suggests the length of patents in software for example to be lowered to five years.

How are patent laws related to free trade?

The twenty-years patent gives great incentives to cheat for countries wanting to catch up, and with their lower employment costs, they can replicate most modern mass-production with relative ease. The US and Western countries could have negotiated far better deals for both their countries and the suddenly emerging ones the last twenty-thirty years by lowering the years that patents last. This would have lowered the prices of the patent-protected goods. But, at the same time, negotiators could have asked from these countries to move faster toward strengthening their own patent laws. Incentives to cheat around the world and undercut Western producers would have been diminished. The greatly expanded markets would have compensated to the lowered prices of the Western products. And possible some goodwill between the countries could have been created too.

The US could have put tariffs on imports from these countries, and lower them gradually as the suddenly-emerging countries would have introduced their own entitlements – or abilities to their employees to buy healthcare services and a range of instruments for their old age retirements, and thus increasing workers’ compensations. Such freer trade deals would have allowed the discrepancy between US employees and those in the countries emerging from once behind Iron curtains to be smaller, slowing down the abrupt impacts of the drastic lowering of effective tariffs as these curtains fell. Instead, the atavistic entitlement policies in the West stayed, keeping compensations relatively high – and inducing capital intensive innovations to substitute for them – aggravating the impact of the drastically lowered effective tariffs following the fall of those Iron curtains.

There are no theories, no models, and no data suggesting how slowly or how quickly adjustments to such drastic, unexpected political changes should be made so that societies on both sides of freer trade could benefit. The deals depend on negotiating powers of the moment. And there are no theories either how exactly political entrepreneurs manage to create such negotiating power: For these are not “given”: they must be created.

They are created by co-ordinating domestic fiscal, regulatory and institutional changes with international ones, those concerning a stable exchange regime in particular. Although to head in the beneficial direction of “freer trade” a 19th century principle must be solidly kept in mind. Namely: the domestic policy changes must be such that the goal is to eliminate obstacles that can easily change the value negotiated contracts. This can only be done both if the law protects such contracts and if exchange rates stay relatively stable. If not, the latter bring about financial and political instability, and a large expansion of the financial sector to mitigate (through complex and expensive hedging) what the monetary authorities – guided by political authorities – failed to do. Unfortunately, the idea that stable contracts are the basis of successful commercial societies is now nowhere in sight, and we are getting instead macro-strology’s gobbledygook

Reuven Brenner holds the Repap Chair at McGill University’s Desautels Faculty of Management. The article draws on his books, Force of Finance, Labyrinths of Prosperity and series of articles on patents and “macro-strology” (macro-economics as still called), some summarized on the pages of Asia Times.

Reuven Brenner
Dr. Reuven Brenner was appointed to the McGill Faculty of Management REPAP Chair in Economics in 1991. Brenner was the recipient of a Fulbright Fellowship, was awarded the Canada Council's prestigious Killam Fellowship Award in 1991, and is member of the Royal Society. In February 2013, he was awarded a Queen Elizabeth II Diamond Jubilee Medal for his contributions to his peers, his community, and to Canada.
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