Monday, February 13, 2012

Why does no one like free trade?

Most states engage in protectionism, and lots of it. Brazil, for example, just put up a significant tariff against Chinese imports, amidst fears of de-industrialization. And Obama, in his State of the Union, signaled that the U.S. isn't about to let its manufacturing jobs go either. 

The properly schooled free-trading economist is supposed to dismiss all these efforts as "politics" (or so I've been told); and sigh that their advice is once again ignored. But I think it's telling that time and time again, when push comes to shove, most governments are not willing to embrace free trade, even though almost all economic theory shows that the benefits of free trade clearly outweigh the costs in the aggregate and in the long run. Such a consistent pattern begs an explanation.

Whether a country pursues free trade policies or not depends on how it balances the resulting costs and benefits. Clearly, the people who bear the costs and benefits are often different—and this is dilemma that the political economy literature has seized upon to explain opposition to free trade. The way the explanation goes is that because the winners and the losers are different people, and particularly because the benefits are small and dispersed across the population, while the costs are concentrated for small sectors of the economy, politicians find it more expedient to cater to the losers (who put up an effective lobby, since they have much at stake) rather than to the winners (who only stand to gain a little at the margin, and so won't notice if they lose their gain from trade). So free trade is blocked.

This is a powerful explanation, and goes a long way towards explaining a lot of the resistance to free trade. But it makes it seem as if opposition to free trade is inevitable.

Here's an alternative explanation that gives some clear conditions for when individuals will choose to support free trade. It relies on turning the focus away from the distribution of costs and benefits across different individuals, and instead to the costs and benefits over time.

The costs of free trade are most often immediate: lost jobs, industries, careers, and livelihoods. The benefits—economic growth, cheaper and higher quality stuff—come much later. Economists know well that people discount future benefits—that is, people value future costs and benefits less than those in the present. So if the discount factor is large enough, the benefits may come too far in the future to offset present losses.

To illustrate the effect that discounting can have, consider the following numerical example. Suppose a voter is deciding whether to support free trade or not. If she supports it, she'll face a stream of costs and benefits. Denote them by  and . If she doesn't support it, then (in her mind) nothing changes and the net cost/benefit is zero. So it follows that if her valuation of the benefits is greater than her valuation of the costs, then she will support free trade.

Note that this is different than asking whether the benefits are greater than the costs for that individual. This question is given by:

whereas the inequality that the voter checks is instead the following:

where    is the discount rate. These sums can produce substantially different values. For example, the following seems to me to be a reasonable graph of the costs and benefits of trade over time.

The costs start very high, but fade quickly. The benefits increase significantly over time. I have set the cost and benefit values so that the sum of the benefits is approximately 3 times the sum of the costs (43 to 16). That, in itself, seems to be a strong argument in favor of free trade. But given a reasonable discount rate of 0.9, the present value of the benefit stream is only 9.5, compared to 15 for the costs! Rationality demands that the voter vote against free trade.

Within this framework, how would we get the individual to support free trade? There are three clear options:
  1. Mitigate costs in the present.
    Since the initial impact has such a strong effect, even small reductions in the initial cost can significantly alter the cost-benefit calculus.

  2. Accelerate the arrival of the benefits.
    The sooner they arrive, the more they are worth.

  3. Allow people the wherewithal be more patient.
    The easier it is for people to wait for future benefits, the more willing they will be to do so
These general principles, in turn, recommend specific policy prescriptions. Mitigating costs in the present often takes the form of a social safety net: unemployment insurance, compensation funds to those who lose their jobs, and the like. Accelerating the arrival of the benefits can mean something like including provisions in free trade agreements to require foreign investment to begin immediately. And a policy that would allow people to be more patient could include setting up a robust and ready job retraining program so that people know they have future benefits to look forward to. [Incidentally, ideology, control, and repression are also ways to make people more patient and more willing to support free trade, and unfortunately this is the way many countries (particularly in Latin America) have gone about it.]

Often I hear economists say that people oppose free trade because they are misguided, or stubborn, or selfish. But my point here is that people may oppose free trade, even if they know full well its implications, simply because the timing of the costs and benefits are unfavorable. The timing of some of those costs and benefits can't be changed—but a lot of them can, and that means there is a lot of scope for policy to shift the politics of free trade. Focusing on concrete policy steps to alter the cost / benefit calculus are likely to go much farther towards increasing trade than the 300 years of sermonizing that economists have been doing.

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