Lecture on Globalization and the Issue of Free Trade
Recent arguments over the existence and effects of greater globalization have
centered on (1) whether or not the world is more interconnected now than in the
past; (2) whether increased free trade in goods and services can be harmful
overall to certain countries; (3) whether groups or owners of factors of
production within a country that are harmed by globalization can and will be
properly compensated; (5) whether increased international capital flows and
financial interconnectedness have made the world’s economy more unstable, and
(6) whether technology has changed the structure of economies so much that all
of the old arguments in favor of free trade (e.g. comparative advantage) no
longer hold true.
Nearly all arguments about the desirability of free trade, versus the advisedness
of protection, can be sorted into one of these broad categories above. The basic
question is an old one – are there lasting and equitable gains from free and open
trade in goods and services. If so, then an open door policy should be pursued
and perhaps even forced on countries. If not, then the open door should be at
least partially closed either by laws, regulations, tariffs, or quotas.
One problem with trying to systematically unpack these issues is that the losses
and gains often cannot be adequately monetized and therefore remain highly
subjective, value-laden, and abstract. Many of these losses include changes in
traditional culture and the elimination of entire ways of life for large groups of
people. They involve dislocations in livelihood and geography. The losses are
often psychologically unsettling, at least for periods measured in decades. For
example, the introduction of hypermarts (e.g., Carrefour) in Taiwan led to
substantial changes in shoppers’ habits away from traditional markets and small
stores. Taiwan has had to face its own form of Walmart-ization. The
resentment has run strong and deep, but consumers have had little to complain
about. Taiwan’s consumers have been given much greater choice. Instead of
consumer welfare, it has been concern over small scale domestic producers which
have been the focus of news stories and commentaries. These producers are
much smaller in number than their consumers and are therefore more
concentrated and unified in their opposition to free trade than their consumers
are to opening trade. This is a common problem for free trade. The benefits
are individually small and highly dispersed, whereas the costs are individually
large and highly concentrated. This makes it difficult to generate strong
political support for free trade, while opposition to free trade is easy to mobilize.
This is true, even though the overall gains from trade can be manifestly larger
than the collective costs.
This short lecture will try to answer the six questions above.
First we should answer whether or not the world is now more integrated than
before.
Consider the following graph
The data is taken from the UN data website
http://unstats.un.org/unsd/snaama/dnllist.asp
and the graph shows the total world trade (exports + imports) as a percentage of
total world GDP, with both numerator and denominator measured in current
USD.
Clearly there has been a steady increase in this measure of globalization
beginning in 1985. As of 2005, the ratio stood at around 57%. This measure
provides very strong evidence that globalization has been increasing and that the
world is becoming increasing integrated economically. The spike in 1980 may
have been due to the fact of the second oil crisis and the dramatic rise in the
price of oil.
The World Bank also makes estimates of trade to GDP ratios for the world and
various groupings of countries. Here is a sample
% Trade to GDP in current US Dollars
World
Low Income
Low and Middle Income
High Income
1990
32.3
23.6
32.5
32.3
2005
47.3
41.1
59.2
43.9
The World Bank has also estimated the percentage of services traded relative to
GDP in a similar way. It found that world traded services to GDP rose from
about 7% in 1990 to 11% in 2005. Obviously, trade in goods continues to
dominate overall trade.
In addition to trade flows, the world’s economies have become integrated
financially through greater foreign investment – both foreign direct investment
and foreign portfolio investment. Not only have private interests placed
investments abroad, central banks have increasingly taken an important role in
the holding of foreign assets.
Here is a summary of their findings on investment as a percentage of GDP.
Again it is clear that the overall trend in investment is towards greater
internationalization. This is especially true of high income countries involving
portfolio investment. FDI appears to be rising most quickly in low-middle
income countries.
The next question involves determining whether or not free trade is better than
protectionism.
This question goes all the way back to Adam Smith and the Wealth of Nations
(1776). Smith believed that the only way to increase the wealth of a country was
to increase productivity (he also recognized that if a greater percentage of the
population were to engage in labor then wealth would rise.) To increase
productivity, there must be a specialization of labor – something he called
division of labor. He then asked how that a country could enjoy a greater
degree of the division of labor. This he said depended on the size of the market.
A larger market would allow greater specialization. In order to increase the
size of the market, an increase in both exports and imports was needed.
Therefore, to have a richer country, free trade would be the best policy. Free
and balanced trade would always work to make both countries richer.
Smith ran into trouble however in trying to decide what products countries
should produce and trade. It seemed silly for a country to produce wheat and
import wheat at the same time, since clearly wheat would be roughly the same
regardless of where it was grown. If a country imported wheat, then it should
not produce sizable amounts of wheat. In short, Smith lacked a correct way of
describing the structure of trade – which products should be imported and which
should be exported.
David Ricardo and John Stuart Mill were given the task of explaining the
structure of trade. Ricardo presented his theory of comparative advantage,
which has now become a common place concept in international trade classes,
and indeed is part of general economic theory (not only trade). However,
Ricardo was rather blind to the aspects of demand. It was up to Mill to provide
a clearer statement of the solution. Comparative advantage based on relative
labor productivities would be the basis for geographic specialization, and
respective demands would help to determine international relative prices, the
actual quantities exported and imported, as well as the quantities consumed
domestically.
Would countries be unambiguously better off if there were free trade based on
productivity-inspired comparative advantage and relative demands? Here it
was clear that some people would be hurt after trade and some people would be
helped. It was thought that those who were hurt would simply adjust to their
new circumstances. The destruction of an industry due to cheap imports was to
be accepted as part of the game. In the long run, all would be better. This was
the accepted view for many years, although there was a suspicion that the pains
of adjustment might be too great for a government to accept. Protection was
always a welcome expedient.
We can see how that trade is beneficial by considering two countries (A and B)
and two goods (X and Y). Note the diagram on the next page. Country A is
small compared to country B. One could think of Taiwan = Country A and US
= Country B. If there is no trade, each country consumes at point C on its
production possibilities frontier. If there is specialization and trade, the
counties move to producing at points P and consuming at C’. A will export
good Y and import good X, while B will export good X and import good Y. By
trading both countries must be better off since they have more of each good.
The only question here is one of distribution. Note that there is no discussion of
how that enlarging the market causes greater wealth and prosperity.
Smith’s
original idea of linking free trade and the division of labor is not present in this
analysis. This is Ricardo’s theory. By the way, the diagram shows that it is not
necessary that both countries geographically specialize. Also, the diagram
assumes that imports equal exports and therefore there is balanced trade.
-------------------------------------------------We should point out here that recently, question number two above was
considered again by none other than Paul Samuelson in an article in the Journal
of Economic Perspectives 2004. The title of this article was “When Ricardo and
Mill Rebut and Confirm Arguments of Mainstream Economists Supporting
Globalization”. Let’s take a moment and consider this article closely…later we
can look at his critics (e.g., G . Mankiw) and Samuelson’s own reply to his critics.
Samuelson uses the method of a parable involving two countries which he calls
the US and China. The paper is very simple and abstract. There is no capital
flows and there are only two goods. Labor is homogeneous and is divided in
both countries between the two industries. The parable is very much in the
spirit of the above Ricardian analysis of two countries – two goods.
Here are the assumptions and the analysis of Samuelson’s paper showing the
movement from autarky to free trade.
Autarky
US: (here we use upper case letters)
Assume
Q1
2
L1
Q2 1

L2 2
L1  L 2  1 0 0
zero capital movements
1
W1L 1 W2 L 2  P1Q1  P2Q2  (2 P1 ) L 1 ( P2 ) L 2
2
which implies
W1
2
P1
and
W2 1

P2 2
Now, if there is competition in the product and factor markets, the real wages
adjust in both sectors so that
W1 W2

P* P*
where we assume the aggregate price level P* is equal to some number we will
discuss later. This combined with the two equations immediately preceding this
yields
P2
4
P1
Next, assume that the demands for good 1 and good 2 are such that
P1Q1 
1
(Nominal Income)
2
which implies
P1Q1  P2Q2
and therefore
L 1 L 2 50
Samuelson proceeds to measure real income by using the geometric mean of the
consumptions of good 1 and 2.
1
Q1Q2  (2L1 )( L2 )  L1L2  L12  L1  50
2
Real Income =
It follows that per capita real income in the US before trade is equal to
Real Income / Population
Note:
We can write
P2Q2  I / 2 .
It follows that
Thus,
Q1Q2
P1Q1  I / 2
Q1Q2 
=
50
 0.50
100
where I = nominal income.
1
I
I
( ( P1Q1 )( P2Q2 ) ) 
 *
P1P2
2 P1P2 2P
is a good measure of real income where
index to deflate nominal income.
It is also true that
P*
.
is the appropriate price
The only argument I have with what Samuelson has done is that
the measure appears to be only half the exact measure of real income.
to be the correct measure of real income.
That is,
2 Q1Q2
looks
This is not important to the main thrust of Samuelson’s
paper.
China: (here we use lower case letters)
Assume
q1
1

l1 20
q2 1

l2 5
l 1  l 2  1 0 0 0 zero capital movements
w1l 1 w2l 2  p1q1  p2 q2  (
1
1
p1 )l 1 ( p2 )l 2
20
5
which implies
w1 1

p1 20
w2 1

p2 5
and
Likewise, competition forces
p2 1

p1 4
Assume that the demands for good 1 and good 2 are such that
p1q1 
1
(Nominal Income)
2
which implies
p1q1  p2q2
and therefore
l 1 l 2 500
Again, Samuelson measures real income using the geometric mean of the
consumptions of good 1 and 2.
Real Income =
q1q2  (
1
1
1
1 2 1
l1 )( l2 ) 
l1l2 
l1  l1  50
20 5
10
10
10
It follows that per capita real income in China before trade is equal to
Real Income / Population
=
50
 0.05
1000
Free Trade
Now suppose that these two countries trade together freely. For the US, a unit
of good 1 requires a 1/2 unit of labor -- whereas a unit of good 2 requires 2 units
of labor.
In the US, good 1 is relatively cheaper.
By contrast, China’s
technology is such that a unit of good 1 requires 20 units of labor – whereas a
unit of good 2 only requires 5 units of labor. In China, good 2 is relatively
cheaper. This means that the US has a comparative advantage in good 1 and
China has a comparative advantage in good 2. The US should specialize in the
production of good 1 and China should specialize in the production of good 2.
The countries should then trade. If the US produces only good 1 it can produce
a total of 200 units of good 1. Similarly, if China produces only good 2, it can
produce a total of 200 units of good 2. The international terms of trade is
therefore given by
P2 p2

1
P1
p1
Real per capita income in the US and in China (after free trade) is now given by
Real per capita income US =
Q1Q2  1002 / 100  1.0
Real per capita income China =
q1q2  1002 / 1000  0.10
Clearly, both the US and China are better off than when they were in autarky.
This is the typical analysis of free trade found in most textbooks. No real
argument here, except some questions about the distribution of real income.
Now Samuelson asks a simple question. Suppose that China’s technology
q
1
changes so that the productivity in the good 1 industry rises from 1 
to
l1 20
q1 8
q
1

while 2 
.
l1 10
l2 5
What this means for China is that q1  4q2 , which is
exactly the same in the US. Thus, the US no longer has a comparative
advantage and there is no reason for trade. The technological advance has
eliminated the gains that can be obtained through trade. Samuelson’s point is
simply that technology can eliminate trade and that differences in productivity
and technology makes trade desirable. The view he is espousing is that China’s
growing skilled labor force and its rich technical advances may result in a loss of
comparative advantage for the US in the future. An open China may result in a
future diminished role for trade if China begins to resemble the US. As he
writes “..it is free trade’s own spontaneous killing off of all trade that does harm
to the United States.”
We will discuss Mankiw’s response to this.
We now turn to the third question which is whether winners will compensate
losers in free trade.
The great English economist Alfred Marshall weighed in on this question.
Instead of pursuing the welfare question and the gains from trade from the point
of view of Pareto (something that was not very practical), Marshall chose a
different tack. He claimed that even if there were those who might be hurt by
free trade, the rest of society who were helped by free trade could compensate
those who were hurt and still be better off than with no trade (called autarky).
The issue then became not whether gains offset losses, but whether those who
won at free trade would significantly compensate those who lost at free trade.
This compensation would be used to buy time for the economy to adjust to a new
structure of trade and industry. The US has had a program of compensation
for trade dislocation since 1974.
Here is what the US Department of Labor says about trade adjustment:
The Trade Adjustment Assistance (TAA) Program is a federal program established under
the Trade Act of 1974 that provides aid to workers who lose their jobs or whose hours of
work and wages are reduced as a result of increased imports.
The TAA program offers a variety of benefits and reemployment services to help
unemployed workers prepare for and obtain suitable employment. Workers may be eligible
for training, job search and relocation allowances, income support, and other reemployment
services.
A petition for TAA may be filed by a group of three or more workers, their union, or other
duly authorized representative.
The Trade Adjustment Assistance Reform Act of 2002 (TAA Reform Act) reauthorized the
TAA program through fiscal year 2007 and amended and added provisions to the program.
I will be discussing some of the other questions and G . Mankiw’s paper in class
next time.
By the way, here are some basic arguments for and against free trade.
wish to read these. There is nothing technical here.
You may
ARGUMENTS FOR AND AGAINST FREE TRADE
I. WHY IS FREE TRADE ADVANTAGEOUS ?
There is an increasing trend towards greater economic interdependence among
countries of the world. The US has concluded agreements with Canada and Mexico to
institute a free trade area known as NAFTA (the North American Free Trade Area).
Europe is similarly working to promote the EC (the European Community) in which
trade between its member countries will be much freer. Finally, there is a clear shift
towards cooperation in Asia with APEC (the Association of Pacific Rim Economic
Cooperation) and other similar organizations.
The first thing to note about free trade is that it is between two groups who
willingly undertake the exchange. If the trade did not benefit both of these groups, it
would not take place. Both the buyers and the sellers must be satisfied. This is always
true of voluntary exchange, and it is very different from when the government
purchases things. We should always keep it in mind that free exchange must make
both parties in the exchange better off.
Second, free trade promotes competition and efficiency. When a domestic firm
faces only domestic competition, it may not utilize its resources in the least costly
manner. It may decide to use its profits to pay dividends to stockholders, rather than
using the profits to modernize its factories and upgrade its research. Greater
competition places greater pressure on firms to find the least costly way to produce
their products. This will free resources which can then be used to manufacture other
products in the economy.
Third, free trade can promote development of the economy. Many countries must
borrow vast sums of foreign exchange or foreign money to purchase needed goods
such as food, medicine, and capital equipment. To get this foreign exchange, such
countries must have access to open markets which will allow them to export and earn
the foreign exchange. South Korea is a good example of a country which has used
foreign loans and a free US consumer market to build their economy into a
competitive force. Moreover, free trade allows the expansion of markets and the
specialization of industry. This increases the division of labor and increases
productivity.
Fourth, free trade can promote the diffusion of new technologies and ideas. Both
Japan and China suffered greatly when they closed their economies to foreign trade.
China is largely behind the world technologically because it refused to engage the rest
of the world in trade. It is now making impressive progress because of the opening of
its markets.
Finally, free trade promotes international harmony and peace. History is replete
with examples of countries going to war principally because they refused to trade
freely with each other. The US has recently decided to use free trade as a means to
encourage better relations with China. It has learned that nothing is accomplished by
forcing China to withdraw into itself. And, even when relations between the US and
Japan were at their post-war low in 1988, the two countries knew that trade was too
important to allow a serious break to develop between their two economies. Taiwan is
also learning that cooperating economically with Mainland China has its rewards.
II.
WHY IS FREE TRADE DISADVANTAGEOUS ?
While we have listed some of the good points in favor of free trade, we must
acknowledge that no country in world practices pure free trade. Every country in the
world engages in some sort of protectionism, although there is less pressure today
than before for these policies. But, why do countries seek to protect themselves from
foreign trade?
First, some industries are important for the national defense. Generally, most
economists agree that agriculture is a necessary industry for every country, since
importing food during war might not be feasible. The same argument might be made
for certain basic industries such as steel and chemicals. But, unfortunately, it is
difficult to classify industries in this way. Each industry believes that it is necessary to
the national defense.
Second, free trade can cause social dislocations and adverse structural changes in
the economy. For example, free trade in steel in the US nearly resulted in a
destruction of the steel industry. It was only when the US government provided
protection to US steel producers that the industry was saved. Today, the US steel
industry is doing much better. It is using a smaller workforce, producing more output,
and exporting more than before. However, many steelworkers lost their jobs and had
to move to other areas of the country. This caused a long period of readjustment and
social hardship.
Third, some people feel that free trade can only help resource and technology
rich countries. They feel that the US is championing free trade because it has the
greatest economic strength, and will therefore benefit the most. Countries which are
underdeveloped and do not possess the resources and technology of the US will not be
able to compete. Their economies will not be able to grow if US, European, and
Japanese products are allowed to be imported freely. Protection is necessary in order
to level the playing field.
Fourth, some people feel that traditional culture suffers when there is free trade.
If US pop culture can be imported freely into a country, it might disrupt the value
system of the young in that country. A generation gap might even appear between the
young and old. This is of great concern in Mainland China where the term "spiritual
pollution" has been used to describe this effect. In other countries it has been called
"cultural imperialism".
Finally, some people feel that free trade is a wonderful idea theoretically, but it is
impossible to enforce. There are simply too many subtle ways that a country can
restrict trade. Even if trade is free for a while, if a country feels that its national
interests are at stake, it will simply impose protection. In this sense, free trade can
never be a law, but can only be a principle -- and as we all know, principles can be
subjectively interpreted.