Does Free Trade Make Nations Wealthier?

The world economy is more interconnected than ever before. International commerce happens at the click of a button and multilateral trade agreements allow goods to move across national borders with limited barriers. Many politicians, economists, and corporations see liberalized trade between countries as a boon for national economies. While trade may be disruptive to some industries, in the long run the free exchange of goods across national borders benefits society. However, the shift to a more global economy is not without its detractors. Populist and left-wing political parties see liberalized trade laws as harmful to domestic industries,since it opens markets to international competition. Additionally, some contend that trade agreements can lead to a regulatory race-to-the-bottom, eroding domestic labor and quality protections to pad out multinational companies’ bottom lines.^[1] Recently these arguments have found a receptive audience in economically displaced voters whose livelihoods have been disrupted by trade-based economic restructuring.^[2]

In this case study, you will use data from the DemCap Analytics tool to adjudicate between the two perspectives described above. Does free trade generate more national wealth than protectionist economics? How can nations maximize the benefits of global competition while minimizing the harm caused by the economic changes it necessitates?  Considering these questions will give you a better understanding of the types of concerns and tradeoffs policymakers juggle when crafting trade policy.

A free trade agreement is “a pact between two or more nations to reduce barriers to imports and exports among them,” and usually entails a mutual reduction of tariffs and regulatory restrictions to promote international trade between countries involved in the agreement.^[3] These types of agreements are relatively new in the grand scheme of economic theory, as countries have historically created barriers to prevent importing international goods. Mercantilism, which was the dominant school of European economic thought until the 1800s, held that a country’s economic success depended on maintaining a positive balance of trade (i.e. maximizing exports while minimizing imports). Trade was seen as a zero-sum game, wherein nations were in direct competition with each other, and one country’s economic gain was another’s loss.

The mercantilist perspective fell out of favor in the 1800s. Building on the work of Adam Smith, economists of this era saw specialization as an economic benefit to all. If a country can produce a good at a lower cost than its peers, then it should produce that good and trade it to import other goods it needs for consumption. This way, all countries benefit from trade even if they do not have an absolute advantage in the production of a good. For the most part, this perspective on trade still predominates today. Economist Douglas Irwin argues that free trade “allows for more specialized inputs that help [firm’s] productivity,” and researchers Rosella Bardazzi and Leondardo Ghezzi argue global trade has “raised living standards in many countries by offering wider destination markets and potentially larger aggregate demand.”^{[4] [5]}

Having established what free trade is, this section details some benefits of free trade that might make lifting trade restrictions worthwhile. For one, while the effects of free trade vary considerably based on region and industry, on the whole free trade contributes to welfare gains that lift many people out of poverty. Though free trade can (and does) cause worker displacement in industries that can be easily outsourced, the loss of these jobs are offset by more efficient resource allocation to other industries. This leads to net welfare gains. Additionally, while most households benefit from these trade gains, welfare gains were especially pronounced in the lowest income decile, which experienced 57 percent larger welfare gains compared to the highest income decile.^[6]

Additionally, free trade agreements are especially beneficial for developing countries, who yield considerable welfare benefits from liberalized markets and stand to strengthen their position in global trade. A 2018 agreement among 44 member states of the African Union established the African Continental Free Trade Area (ACFTA), the largest free trade area since the World Trade Organization spanning 1.3 billion people. The agreement is expected to increase intra-African trade by 52%, and it will also provide an estimated welfare gain of $16.1 billion. These benefits will especially favor women, who currently manage 70% of cross-border trade. Developing nations who have historically been at the periphery of the global economy are already leveraging free trade to improve their economies and their citizens’ welfare.

One criticism protectionists might levy against free trade is that tariffs can be a substantial source of government revenue which, coupled with increased domestic production, offsets the decreased trade activity associated with the tax. However, in practice protectionism often blunts trade activity and decreases economic output. Indeed, Pablo Fajgelbaum and colleagues examine the short-run impact of President Trump’s 2018 import tariff hikes and find that, after accounting for tariff revenue and domestic production gains, the United States lost $7.2 billion dollars, or 0.04% of GDP because of the policy change.^[7]

While free trade has many potential benefits, some leftist and nationalist political parties adopt protectionist platforms that oppose free trade, because it subjects domestic industries to international competitors who can undercut their prices. While free trade may lead to an increase in wealth in absolute terms, its localized impact on industries and regions can vary wildly. For example, Lourdes Beneria and Luis Santiago find that after the Smith-Corona Corporation decided to relocate its manufacturing facility Cortland, New York to Tijuana, Mexico, its dislocated workers experienced “significant income losses and increasing wage inequality, even after receiving additional training.”^[8] While the economy as a whole may benefit from cheaper foreign manufacturing since it allows capital to be allocated more efficiently domestically, in the short-term these changes can be incredibly disruptive, and the policy response is not sufficient to offset that harm.

Many critics also worry that free trade will create a regulatory race to the bottom. Though classical economics teaches us that free exchange produces positive results for all parties involved, economist John Culbertson argues that this is only the case “when the exchange is an equal one that occurs within a common framework of laws, customs, rules, and regulations.”^[9] Different nations have a patchwork of regulatory and tax environments, and free trade forces these varied polities into direct competition with each other. In a competitive market, firms have an incentive to lower prices as much as possible to attract new customers. In international trade, these same incentives apply: countries will do whatever they can to make their goods more cost-competitive so their products are more appealing on the global market. This might compel them to remove regulations and taxes to drive down the cost of their goods in the international market. And after one country does this, others might need to follow their lead to keep their prices competitive, ultimately resulting in the erosion of worker and quality protections across the board.^[10]

^[1] Surowiecki, James. “The Corporate-Friendly World of the T.P.P.” The New Yorker. The New Yorker, October 6, 2015. https://www.newyorker.com/news/daily-comment/the-corporate-friendly-world-of-the-t-p-p?mbid=rss.

^[2] Jensen, J. Bradford, Dennis P. Quinn, and Stephen Weymouth. “Winners and losers in international trade: The effects on US presidential voting.” International Organization 71, no. 3 (2017): 423-457.

^[3] Barone, Adam. “Free Trade Agreement (FTA) Definition: How It Works, with Example.” Investopedia. Investopedia, January 18, 2023. https://www.investopedia.com/terms/f/free-trade.asp.

^[4] School, Columbia Business. “Why Trade Is Not a Zero-Sum Game.” Ideas & Insights. Chazen Global Insights, October 11, 2016. https://www8.gsb.columbia.edu/articles/chazen-global-insights/why-trade-not-zero-sum-game.

^[5] Bardazzi, Rossella, and Leonardo Ghezzi. “Large-scale multinational shocks and international trade: a non-zero-sum game.” Economic Systems Research 34, no. 4 (2022): 383-409.

^[6] Boudreaux, Donald J., and Nita Ghei. “The benefits of free trade: Addressing key myths.” Trade and Immigration| Policy Briefs| May 23 (2017): 2018.

^[7] Fajgelbaum, Pablo D., Pinelopi K. Goldberg, Patrick J. Kennedy, and Amit K. Khandelwal. “The return to protectionism.” The Quarterly Journal of Economics 135, no. 1 (2020): 1.

^[8] Beneria, Lourdes, and Luis E. Santiago. “The impact of industrial relocation on displaced workers: A case study of Cortland, New York.” Economic development quarterly 15, no. 1 (2001): 78-89.

^[9] Culbertson, John. “The Folly of Free Trade.” Harvard Business Review, August 1, 2014. https://hbr.org/1986/09/the-folly-of-free-trade.

^[10] Tonelson, Alan. The race to the bottom: Why a worldwide worker surplus and uncontrolled free trade are sinking American living standards. Westview Press, 2002.