When Does Theory Say Free Trade is a Good Thing?

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Dani Rodrik, if he thought it wasn’t beneath him, deserves an op-ed column at a well respected paper. He has managed to foment a good deal of lively debate among Serious Economists (the blogs involved include his, Brad DeLong’s, Mark Thoma’s, and Greg Mankiw’s) on the question of trade economics. For the most part, Dani has poked holes in certain elements of the orthodoxy, which has produced some heated reactions. And what is interesting is that Dani is most certainly not against free trade, but any questioning of the party line is treated (at least by some) as heresy.

His latest act of public service is to remind his peers of the theoretical conditions under which free trade produces better economic outcomes. As you will see, the conditions are rather restrictive:

So here is a straightforward economics question: under what conditions will trade liberalization enhance economic performance?

If you answered “under any and all,” you flunk. Here is the correct answer (adapted from here):

* The liberalization must be complete or else the reduction in import restrictions must take into account the potentially quite complicated structure of substitutability and complementarity across restricted commodities.
* There must be no externalities or microeconomic market imperfections other than the trade restrictions in question, or if there are some, the second-best interactions that are entailed must not be adverse.
* There must not be any increasing returns to scale, or else activities with scale economies must expand “on average.”
* The home economy must be “small” in world markets, or else the liberalization must not put the economy on the wrong side of the “optimum tariff.”
* The economy must be in reasonably full employment, or if not, the monetary and fiscal authorities must have effective tools of demand management at their disposal.
* The income-redistributive effects of the liberalization should not be judged undesirable by society at large, or if they are, there must be compensatory tax-transfer schemes with low enough excess burden.
* There must be no adverse effects on the fiscal balance, or if there are, there must be alternative and expedient ways of making up for the lost fiscal revenues.
* The economy must not have a trade deficit that is already “too large,” or else nominal wages or the exchange rate must adjust to compensate.
* The liberalization must be politically sustainable and hence credible so that economic agents do not fear or anticipate a reversal.

I could expand the list, but you get the point. And all of this is needed just to ensure static benefits. If you want dynamic (growth) benefits, we would have to add an even larger number of other prerequisites. (And just to be absolutely clear, the list above is no argument in favor of trade restrictions either.)

The point is that unconditional supporters of free trade take a whole lot for granted. Our professional training prepares us to be analysts who can make contingent statements. Policy A is good if conditions X, Y, and Z are in place. Rule-of-thumb economists sweep all the caveats under the rug, and in the end, are not true to their training.

(I can see the next line of objections coming: Forget theory, some people will say. Look at the real world. Countries that follow open trade policies do so much better than those that don’t. Well, not so fast actually. But that has to wait for a later post.)

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