Friday, February 22, 2008

“The Cost of Free Trade”

Recently the Island carried an article with the same title where the writer (a Kath Noble) goes on to explain the implications of the Indo-Lanka Free Trade Agreement (FTA). Now, I have seen worse articles on trade and economics in the Sri Lankan press, but it’s precisely the more reasonable guise of the article which makes it's errors more plausible.

Do read it in its entirety
. The following are the relevant excerpts where I think she (or he) has got it wrong.

[..]Trade between the two countries [India and Sri Lanka] has increased at least four-fold, and it is now worth well over $2 billion. India had cut its tariffs on Sri Lankan goods by 2003, and Sri Lanka is due to do away with all remaining taxes on Indian imports during 2008. Free trade has triumphed, apparently.
Unfortunately, the story isn’t so simple. Taking a closer look at what has happened in practice would prompt even the most ardent believer to question the undoubtedly beguiling theory of free trade
First of all, what pass these days as Free Trade Agreements, are not really “Free Trade” agreements. If they were, then that would require only a couple of pages long document with a place to sign. FTAs usually run into the hundreds of papers, precisely because the FTAs come with all sort of conditions and clauses on which products can be imported, the tariff levels, etc. They should be more accurately called Freer/Managed trade agreements. This makes them poor benchmarks to test the “theory of Free trade”, which can be done better by looking at say, domestic trade within a country where tariffs and other restrictions do not exist. There’s absolutely nothing special about International Trade that’s also not true about domestic trade, except for the fact that people have imposed barriers on International trade.

Now, I’ve met and seen many economists (ardent free-market kind) who think of FTAs, WTO, etc as being disruptive to real free trade. I think they have a point, which everyone should hear more often, but I support FTAs because they are the only politically feasible way of getting to a point where there are no (or virtually no) restrictions on trade.

The writer continues..
[..] Free trade is supposed to be about each country focusing on the goods that it can produce most efficiently, and then selling them to others and using the proceeds to buy whatever else it needs on a level playing field. However, this is clearly not the reality. [..]
Clearly not the reality? I wonder why. Her article certainly doesn’t offer a clue.

Perhaps she’s confused with what comparative advantage is, which according to some Economists is the most misunderstood concept in economics, here’s Brad Delong’s explanation:
“"Comparative advantage" holds that we should export not those commodities that we can make more efficiently than people in other countries can make them, but those commodities that we can make most efficiently relative to the efficiency with which we make the average good or service.” (Do read the whole thing)
But one has to keep in mind when we talk about trade between “two countries” we are really talking about people in those countries and comparative advantage is very much a reality. For example, if I’m the world’s greatest cricketer and also the world’s finest clerk. The law of comparative advantage says that I should play my Cricket instead of being a clerk although I do both better than anyone else on the planet. I do what I do best relative to whatever else I do and not just do everything I can do better than others. It works much the same way for aggregates of countries.

The Writer then goes into a lengthy explanation of fate of the vegetable oil industry, supposedly Sri Lanka’s major export under the FTA:

[..]Sri Lanka has been importing crude palm oil from Malaysia, putting it through a rather simple chemical process, and then exporting the end result as hydrogenated vegetable oil to India. Indian products have been undercut only because the Sri Lankan government has been imposing very little duty on crude palm oil, while India has been taxing such imports heavily.

[..]Indian manufacturers were understandably upset[..]and they began pressing the Indian government to protect them. India decided to forget the free trade agreement and simply put a stop to Sri Lankan imports. Factories stood idle for months while negotiations were underway to find a compromise solution, and everybody was relieved when the Indian government agreed to restart the trade with a fixed ceiling [..].

In fact, the dispute didn’t end there. The Indian government faced further demands from its industrialists, and it finally decided to reduce its import tariff on crude palm oil at the end of 2007. Sri Lankan products rather abruptly became no cheaper than those made in India.
[..]Sri Lankan workers are hardly going to celebrate having temporarily stolen a few jobs from their probably no better off Indian counterparts. Sri Lankan leaders will have to start worrying about the trade deficit again.

There are indeed great risks in export-dependant industries. Shift in policy can have major repercussions, especially on industries operating on negotiated policy advantages alone created by the particular trade agreement. I know a few economists who are very critical of export-led development. They criticize the strategy of “East Asian tigers” and china as being prone to bubbles and sudden shocks when the demand for their goods suddenly drops.

I’m puzzled though as to why “Sri Lankan leaders have to start worrying about the trade deficit”. Trade deficits (like the good people at Cafe Hayek often points out) are no longer a relevant statistic to “worry about”. I for example, have an increasing trade deficit with the Island Newspaper. I buy their product without ever having sold them anything. But to suggest that I’m somehow loosing out from this transaction is quite silly.

The writer then goes on to explain the plight of the pepper farmers in Kerala. The infamous problem of Farmer suicides, etc. She suggests that “Sri Lanka should be ashamed” if more and more pepper is exported to India.

Now as Nitin Pai and others have pointed out, there are major structural issues in India (some of which are common to Sri Lanka as well) which leads to the unfortunate plight Indian farmer’s face. It’s a sector where the market has not being allowed to properly operate. There are price controls, subsidies, lack of property rights, government interventions in the credit market and interventions and overall perverse incentives created by government policy (The increase of compensation for widows of suicides for example) Blaming this situation on the Free Trade Agreement is hardly prudent.

The writer concludes with some cautionary advice to India’s Minister of Commerce of the upcoming Comprehensive Economic Partnership which is bound to bring closer trade-ties, saying there is a cost to free trade.

Nobody denies there is a “cost” to trade, when two people trade a third can loose out. This is true for domestic trade as well as international, what free trade does is allows producers to increase their market potential and consumers to increase their range of choices by having access to cheaper goods at lower prices. It increases wealth in people and therefore countries. But there will be cost to some people, the writer will have to realize you can’t have the cake and eat it too.

Related Links : The Island Article, Paul Krugman on comparative advantage, Cris Lingle's lecture, Jagdish Bhagwati and more at Deaned on free trade.

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