Free trade theory fails to correspond to reality

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from Jeff Ferry 

For the last 90 years, the United States has pursued and advocated free trade. For the last 60 of those 90 years, American workers and other observers have watched America lose high-paying jobs to imports and asked: can this really be good for the American economy?

Professional economists have answered, virtually unanimously, that yes, it is good, due to something called the Law of Comparative Advantage.

They are wrong. Their free trade theory, based on the so-called Law of Comparative Advantage, does not work for the U.S. or for many other countries.  We know this because dozens of economists have published studies of the empirical results of import penetration showing that the Law of Comparative Advantage, and the modern economic theory built around it is outmoded and inapplicable to high wage nations like the U.S. Indeed, it can actually worsen the performance of high wage nations.

Economists advocate free trade theory less because they actually believe it than because of what Nobel laureate economist Paul Romer has called “a sense of academic group identity grounded in a common defense of [a] dogmatic position.”^[1] In other words, economists use this dogmatic theory as a weapon to win jobs, influence, and consulting contracts.

In fact, free trade theory fails to correspond to reality, as the evidence published by economists for at least 100 years has shown.

This is not an argument that free trade is insufficiently compassionate, or that it creates short-term problems. Rather, it is an argument that the theory itself is wrong because it is outdated and fails to recognize important features of modern high-wage economies. I should add that I consider myself a conventional economist. I consider the two greatest economists of the 20^th century to be John Maynard Keynes and Paul Samuelson. I believe if they were here today, they would agree with what follows.

First, a quick summary of what we mean by free trade. As first explained in 1817 by David Ricardo in his foundational text, Principles of Political Economy and Taxation^[2], a free trade event, such as the abolition of tariffs between two countries, should make all workers and capitalists better off in both countries as workers and companies take advantage of the cheaper imports to move to industries where they can be more productive. In modern economics, this was generalized and mathematicised to say much the same thing: each worker will increase her “marginal product” and wages by moving into higher-productivity industries as imports provide lower-productivity goods and services.

This view of an economy was reasonably accurate in David Ricardo’s time, because workers across Europe were paid at close to subsistence wages, with specialized craft workers earning slightly more.

But this wage structure has not been true since the rise of the Industrial Revolution in the late 1800s. It is even more inaccurate today, with devastating consequences for free trade theory.

The assumption that wages are independent of a worker’s industry and depend only on something called “marginal product” (which is in turn often proxied by years of experience) is a little-appreciated but critical assumption on which all free trade economics rests. The theory asserts, and requires, that when workers change industries their wages remain the same, or rise slightly because they are supposedly moving to a more productive industry.

There are reams of evidence disproving this assumption.  . . .   read more