No Panacea, but free trade is still vital for poor nations’ prosperity

Yesterday, Mark Valladares published a post in which he argued that free trade would harm the economic development of the people of Vanuatu, and so undermine their already fairly basic standard of living.

I replied with a comment to the post in which I disagreed. Sadly, this comment has not made it onto Mark’s blog. I hope this is due to a technical error, or that Mark has been too busy to approve it. I would hate to think that a Liberal Democrat blogger was censoring the comments on his site because he disagreed with the content.

(UPDATE: Edis tells me that Mark is in the South Pacific as we speak, which might explain why he isn't poised in front of a PC, like I am. I bet he's jealous though. I wonder if he's wearing a plain shirt, as he tends to wear Hawaiian ones when in the cold, dank recesses of Blighty.)

The reason that this so concerns me is that Mark opened his post by saying “I know that our International Development spokeperson (sic.) reads this blog feed, so if you have a moment, Lynne…” My comment replied that I hoped Lynne had not read his comments yet, as I wanted to ensure that she read my response too. As my comments have been lost to the ether, I will attempt to reproduce them below, so as to explain why Mark is mistaken in arguing that Vanuatu should not enter into a free trade with the European Union.

Vanuatu is a small, pacific island nation of approximately a quarter of a million people, with a subsistence economy and 70% unemployment. Its government is currently negotiating a free trade deal with the European Union, and Mark questions whether the EU is acting in good faith, as he believes that the benefits will be rather one-sided. “Vanuatu’s economy is dominated by Australian companies” he tells us. “Whilst the tourism industry still has a significant element of indigenous providers, this is likely to change as international hotel chains move in. Tourism requires initial investment, which is hard to come by in a subsistence economy.”

Mark suggests that “free and fair trade” would best be achieved by “allowing such small nations free access to our markets, without reciprocity.” This, he suggests “would allow these comparative micro nations to support their inhabitants and reduce their dependence on overseas aid.”

In essence, this is the classic “Fair Trade” argument promoted by the Trade Justice Movement, and it is fundamentally flawed. There are two basic errors which undermine Mark’s argument, and which result in it being a recipe for stagnation and perpetual poverty rather than growth and enrichment.

The first error is the belief that the benefits of trade come from exports. Mark’s explains that Vanuatu produces little or nothing that we would want in Europe, so whereas the EU will have a new market for its companies, Vanuatu will be able to sell little or nothing back to us. This is a founding belief of Mercantilism, which argues that nations are enriched by a positive balance of trade (exporting more than they import). Basically, it boils down to “Exports good; imports bad.” Nothing could be further from the truth.

By far and away the greater benefit from trade comes from imports. Imports are only possible if a supplier can meet demand better than domestic producers, perhaps by selling goods more cheaply or of a higher quality. The result is that consumers (for which, read everybody) can increase their standard of living. This does of course put pressure on domestic producers to be more competitive, but that is healthy. Inefficient production is no more useful in Vanuatu than in Nottingham.

Milton Friedman made the point pretty well in Free to Choose, when he noted that "We cannot eat, wear, or enjoy the goods we send abroad. We eat bananas from Central America, wear Italian shoes, drive German automobiles, and enjoy programs we see on our Japanese TV sets. Our gain from foreign trade is what we import. Exports are the price we pay to get imports."

The second fallacy that underpins Mark’s concerns is the belief that because we can produce everything imaginable cheaper and more efficiently than the people of Vanuatu, we will undercut them in all things and destroy their home industry. In fact, as Ricardo made clear two centuries ago, it does not matter if one nation can produce everything more efficiently than another. What matters is that each concentrates on what they are best at and then exchanges goods.

To illustrate this, let us imagine two Vanuatu citizens, named (in traditional Polynesian manner) Andy and Bob. Andy is an excellent fisherman and a good boat maker. Bob is a fair boat-maker and a pretty lousy fisherman. By the logic of the Trade Justice Movement, Andy can out-produce Bob in both fish and boats, so Bob has nothing to gain by trading. However, as Ricardo demonstrated, it is far better for both parties if Andy concentrates of fishing while Bob makes boats. Andy is most efficient as a fisherman and Bob as a boat-maker, so if they both concentrate on what they are best at their combined yield is maximised, and they can then swap maritime equipment for fish in a mutually beneficial manner. Similarly with Vanuatu and the EU: as long as Vanuatu’s people produce what they are best at, it is worth the EU exchanging that for what the EU is best at – or rather, both make money selling what they produce best and buy what they are less good at producing.

In practice, the world is resplendent with examples of where this has worked. Vanuatu’s poverty is irrelevant: South Korea was as poor as Ghana half a century ago, but as it opened up its markets it has risen to become the world’s twelfth richest nation. Neither is size a problem: Hong Kong was a tiny, poverty stricken island colony after the war, but an aggressive policy of free trade and low taxes made it one of the world’s best place to do business, and prosperity followed. In this global electronic age, even distance is no longer a problem: Vanuatu could attract financial services companies with low business taxes and a light touch regulatory regime.

In fact, it is worth asking what Vanuatu has to lose from freer trade. If, as Mark suggests, most of the population are subsistence farmers and fishermen, then the worst that can happen is that they continue to be subsistence farmers and fishermen. On the other hand, if he is right that “Tourism requires initial investment, which is hard to come by in a subsistence economy”, then the influx of foreign capital will fund hotels that will bring jobs to some of those 70% that are unemployed. Foreign firms dominated Hong Kong, they poured in to soak up China’s cheap labour, and they are buying up UK “national champions” at a rate that some find alarming. The result has been prosperity for the recipients of this movement in capital, not some new colonialism.

If the EU is currently negotiating a free trade agreement, the current scenario must be one in which trade is not free. This has clearly not produced prosperity for Vanuatu’s population. But Mark is correct to doubt that both parties will benefit equally from a free trade deal. The European Union has little to gain from a tiny island nation with a small population. Vanuatu’s citizens, on the other hand, will reap enormous benefits from trading freely with the largest economic bloc in the world.

Free trade is no panacea, it is true. With free trade one also needs a stable society, good governance, strong property rights, democratic institutions, a liberal economy and the rule of law. But free trade remains a vital ingredient in generating prosperity across the world, be it in the high towers of global financial capital or the low beaches of a pacific island nation. Anything else requires governments to tell their citizens that they may not associate freely with whomever they wish: that buying and selling from some people is wrong, just because they are far away. It is an illiberal and misguided policy, which is why the Liberal and Liberal Democratic parties have always supported free trade. Long may we continue.