Free trade has had its time

Come on. Does anyone really believe that the world will be okay if nations simply adhere to a belief that a nation should produce goods and exports in accordance to one's comparative advantage?

Or is international relations a bit more complex, thus requiring a bit more honesty about the limitations of recent policy trends?

In truth, there has never been a period where all nations adhered to free trade. Some did to a greater extent, others did not. In most recent times, one can note the protectionist barriers that have accompanied the rise of China to develop its manufacturing sector (and exports).

Even though most economists generally concur that true free trade erases inefficiencies and inequalities, the evidence indicates just how unfree international trade remains. While about 400 free trade agreements have emerged since the early 1990s, covering about a third of global trade, most had been 'nation-to-nation and, invariably, carry exemptions that protect domestic industries that politicians decided were vital'. For instance, as of 2008, all Canadian pacts protect Canada's milk, poultry and egg industries. Even the 15-year-old North American Free Trade Agreement had protectionist provisions given that 62.5 per cent of an automobile's total parts must be made within the three member states (Canada, the US and Mexico) before a car could cross a border. Further, agricultural subsidies by the US and European nations have 'paralyzed global trade talks since 2001'.

In Australia, where most tariffs are five per cent or less, considerable protectionist barriers remain. This includes bounties on the outputs of select industries; tax concessions on R&D; investment incentives/subsidies; and export assistance. There are also limitations placed on foreign acquisitions, and some regulation in key industries. For example, only a limited number of airlines are allowed on domestic routes and foreign banks in Australia must operate as a wholesale bank through an Australian branch or conduct business through an Australian-incorporated subsidiary.

Of course, there are good reasons why freer trade should be supported. For example, international food aid groups rightly blame agricultural subsidies - along with a conversion of farmland from food to bio-fuel - for increasing hunger across the developing world as local food producers give up growing crops that cannot compete against subsidised imports. Further, depriving poor nations their economic opportunities can lead to many more illegal immigrants or refugees, as suggested by Mexico's President Felipe Calderon of Mexico in 2008 when Obama vowed to renegotiate NAFTA to protect US workers.

But national policies never operate fully in accordance with an ideal. Each nation must make up its mind just what kind of policy mix is needed. There is no such thing as a magical policy solution in a world of competing nations still struggling for resources and the influence of certain ideas.

Truth is that Western leadership never had the complete answers. The US especially since the Second World War simply promoted freer trade as the best policy option to serve its national interest while promoting the growth of the international trade to encourage economic prosperity between nations.

The need to take account of national economic imperatives remains. Take the US decision in August 1971 to abandon ties between the value of its dollar to gold, and to abolish its capital controls in 1974. With a declining trade deficit and inflation reaching an unheard post-war high of 4.5 per cent in 1971, the US currency came under increased pressure because of declining international confidence that its value could be sustained. US financial dominance was also challenged by the expansion of private international finance, notably through the establishment of Eurocurrency and Eurobonds, where investors were able to avoid many of the national regulations governing the operation of domestic banks, especially in relation to national capital controls. With the US abolishing its capital controls, it was assumed that private market actors were more likely to hold their assets in American dollars in an open international financial environment because of its position as the world's largest economy.

In time, after the turmoil of the 1970s of high oil prices, unemployment and inflation, many Western governments gave policy support to floating exchange rates and the discipline of the market.

However, and despite many Western governments seeking to make their economies more competitive by lowering tariffs and promoting user-pay principles, although the degree varies between nations, Western nations became increasingly reliant upon debt (see Table 1). This includes Australia which, despite maintaining a relatively low level of government debt amongst developed nations, has experienced one of the greatest increases in household debt since 1990.

Table 1: Gross government and household debt as percentage of GDP

Some 2010 figures refer to 2009

So what are the answers? While they are difficult, the acceptance of recent policy trends is limited in the longer term, notwithstanding Australia's benefit from supplying raw materials to the fastest growing region in the world (especially China).

At present, Western governments desperately cling to a misguided hope that more and more debt is needed to save banks, boost share prices and somehow restore the magical days of economic growth. As the Bank for International Settlements declares,

...there is a clear linkage: high debt is bad for growth. When public debt is in a range of 85% of GDP, further increases in debt may begin to have a significant impact on growth: specifically, a further 10 percentage point increase reduces trend growth by more than one tenth of 1 percentage point. For corporate debt, the threshold is slightly lower, closer to 90%, and the impact is roughly half as big. Meanwhile for household debt, our best guess is that there is a threshold at something like 85% of GDP, but the estimate of the impact is extremely imprecise.

There are no easy policy solutions out there, as reflected by the Swiss National Bank recently announcing moves to stem the flow of money into Swiss Francs in order to protect its exports.

For heavily indebted nations, there is likely to be painful reform, and this is why public dissent is increasing in many Western nations as governments struggle for answers.

Just recently, and following on from the Tea Party movement which aims to shrink the size of government and cut federal spending (with 60 of 435 US representatives now identifying themselves as party members), protests spread from Wall Street, New York to many cities around the world. In the US alone, signs, slogans and discussion focused on opposition to bank foreclosures, corporate influence in politics, the wars in Iraq and Afghanistan, insufficient job prospects, currency devaluation, affordable housing and universal health care, and fixing inner-city schools.

Dissent is hardly likely to go away. In the four years since the US recession began, the US civilian working-age population has grown by about 3 per cent yet the economy has 5 per cent fewer jobs (6.8 million jobs) with the real unemployment rate 15-20 per cent. With poverty levels rising recently to now affect 46.2 million Americans, the bottom fifth of households that made $20,000 or less in 2010 saw their incomes decline 3.8 per cent after inflation.

In countries like Greece, Ireland, Portugal and Spain, unemployment is already around 20 per cent (youth unemployment around 40-50 per cent) at a time when such economies have shrunk by 10-20 per cent.

Western societies are somehow expected to create employment and wealth at a time when domestic consumption already comprises 60-70 per cent of GDP.

As one critic notes, the US has to decide how much further it is prepared to go in terms of the balance between cheaper goods and enough wealth to boost domestic economic activity. With the average wage in developed economies about 10 times the average level in emerging economies with less environmental regulation and worker protection, the number of US manufacturing workers dropped by one-third over the past decade. In terms of output, manufacturing declined from 14.2 to 11 per cent of GDP from 2000 to 2009.

Solutions will also not come from authoritarian China, unless mercantilism is our inspiration and developing a rich class while exploiting the poor is the new policy role model for the world.

Yes, China' new confidence sees its lecture the West on what we debt-laden nations need to do while it calls for Western markets to be opened further to Chinese companies.

But China hardly created its wealth from new ideas about social and economic organisation. Rather, it benefited most since 2000 by policing capital crossing its border, and by curbing its currency to aid exports and buy US dollars and other foreign currencies, thus amassing $3.2 trillion of foreign-exchange reserves (about 54% of China's 2010 GDP). It is also estimated that China's headline debt to GDP ratio of 17 per cent could be above 100 per cent if debt from local government, state controlled banks, state owned enterprise, and other government supported debt are included.

Authoritarian China will aid many poor nations as it searches for more and more raw materials, but it will never inspire the world given its mercantilism, corruption, and authoritarian paranoia about its own population? Just recently, Michael Sata won the Zambian presidency because of opposition to China given the latter's drive to secure supplies of raw materials and the way its nationals treated local workers. While China has invested $6.1 billion into Zambia, many Zambians were outraged by Chinese managers who shot Zambian coalminers during a labour dispute.

In truth, unless Western nations are willing to destroy their social welfare systems simply to compete against lower cost economies, or to double infrastructure expenditure to China's level of 50 per cent of GDP, then greater protection may be needed.

As The Economist predicted in January 2010, while noting the importance of China helping the world economy through its own stimulus package and its imports growing faster than exports, protectionist pressures are likely to increase as China's rising share of world exports receives more attention. This will include further calls for China to revalue the yuan on the basis that this drains demand from other nations experiencing low growth.

The Economist notes that over the ten years to 2008 'China's exports grew by an annual average of 23 per cent in dollar terms, more than twice as fast as world trade'. If that rate was to continue, China would increase its share of world exports from 8 per cent in 2009 to about a quarter by 2020, a level higher than the 18 per cent share by the US in the early 1950s.

The answers are difficult, but time will show that recent policy trends cannot be sustained. There is only a set time that silly arguments advocate pure free trade or smashing working conditions can be tolerated.

Perhaps new tensions will emerge between nations as many developed nations recognise the difficulty of finding win-win economic situations for all involved in the international economy.

But we either change or increasingly accept that a greater proportion of Westerners will see their living conditions and wealth eroded, notwithstanding Australia's more fortunate position because of raw materials. The days of relying on debt are over, and the world now demands different policy solutions.