Is free trade beneficial or detrimental for developing states?

The discussion about the benefits and harms of free trade is one that has divided economists and

politicians ever since its theoretical inception in the 19th century. Free trade plays an especially

important role in the debate over the most suitable and effective policies for developing countries to

implement in order to facilitate growth and eliminate poverty. Trade liberalization has been

forcefully advocated by institutions such as the International Monetary Fund (IMF) and the World

Bank as part of the so-called “Washington Consensus”, with often mixed results for developing

countries. This essay will explain the origin of the concept of free trade in the work of economist

David Ricardo, before briefly discussing further arguments that have been developed in support of

this theory. By examining the historical development of different countries with varying degrees of

trade liberalization and in particular contrasting the paths of presently developed countries with the

measures they now advocate, it will attempt to establish whether there is a link between free trade

and growth and discuss the effects of present trade regimes on the developmental capabilities of

developing countries.

The principle of comparative advantage as set out by Ricardo (Mankiw and Taylor 2006, ch.3) lays the

theoretical foundation for the espousal of free trade and can be explained by assuming, for example,

two economies A and B that each produces cars and computers. It is normally assumed that these

countries ought only to trade goods if each country is better than the other at producing a certain

good. However, through comparative advantage it can be shown that countries ought to trade, even

if one country is better at producing both goods than the other. This is because the two countries

have limited resources that have to be allocated in order to produce differing combinations of the

two goods. The costs for country A to produce cars are the resources it takes to produce computers

and vice versa. If the costs of cars are higher than those of computers, then it is better for A to

produce more computers at the expense of allocating resources to produce cars, which it can instead

import from country B. By focusing on producing cars, B can gain an advantage through specialization

and import computers in exchange for cars. Because of specialization, both countries will be able to

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produce an overall greater amount of cars and computers than would have been the case without

trade amongst the two.

This example demonstrates the classic economic argument in support of free trade, as thereby it can

be shown how it is of mutual benefit to all countries participating. However, this simple model

cannot readily be applied to reality, because markets have to be perfect for it to hold, meaning that

producers as well as consumers are to have perfect information about all aspects of the market. As in

reality this is clearly not the case, other arguments have been brought forward (McCulloch 1993):

Even if government intervention in markets could raise welfare levels, this would in practise be

difficult to implement and highly susceptible to being abused by special interest groups, thereby

leading to an actual reduction of welfare. Therefore free trade is to be preferred as the safer choice.

Furthermore, free trade is said to enlarge markets by including many countries, thereby benefiting

consumers through a more efficient allocation of resources and greater division of labour through

economies of scale and the increased competition amongst producers. Similarly, technical knowledge

within one industry is said to possess “spillover” effects, i.e. it will benefit other industries as well: If

an corporation decides to set up a manufacturing plant in a country with cheap labour, the skills and

knowledge of the technological process will be passed on to the workers, who will through their

increased technical proficiency be able to set up their own businesses and be more attractive to

other potential investors. Some economists conclude therefore that trade liberalization is an

essential strategy to be adopted by developing countries on their quest for growth. International

institutions such as the IMF and the World Bank have used these arguments in order to force

developing countries to liberalize their markets and open up their economies to foreign investors

(Stiglitz pp.32).

Many studies have been conducted in the aim of analyzing the effects of free trade and have shown

no conclusive relationship between free trade and growth. In the course of history and also recently,

countries have achieved growth despite employing protectionist instruments and intervening in the

operation of markets. On the other hand, countries have lowered trade barriers and liberalized their
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markets without reaping any of the promised benefits. Stiglitz and Charlton (2005, p. 22) describe the

case of Mexico, which joined the North American Free Trade Agreement (NAFTA) in 1994 and

embarked on a substantial liberalization of markets together with the United States and Canada.

Whilst Mexico has experienced a growth in exports and Foreign Direct Investment (FDI), its growth

rate in the decade following the agreement to NAFTA has been lower than in previous decades.

Inequality grew, as real wage rates decreased and low-income earners were made poorer through

subsidized American products flooding the markets and driving down the price of Mexican

agricultural products. The example of Haiti (Malhotra et al 2003, p. 28) further dents the claim that

market liberalization leads to growth. After undertaking extensive reforms in 1994-1995, it

experienced no increase in growth rates or improvements in social injustices. Many Latin American

and African countries that have eased trade restrictions in order to better supply their natural

resources to the world market and exploit their “comparative advantage” in agriculture have not

experienced any gains in technology or knowledge, leaving them stuck in the role of commodity

supplier to the rich countries of the world. The rapid liberalization of Latin America and various

Carribean countries did not increase growth rates, but rather reduced them in comparison to pre-

liberalization years (Gallagher 2008).

On the other hand, many Asian states chose to play a more interventionist role in the development

of their economies (Stiglitz and Charlton 2005). Japan for example protected industries that were not

deemed ready to compete internationally and promoted those that were. The government issued

easier credit to such companies via banks, curtailed foreign imports and restricted international as

well as domestic competition. Japan and many other Asian countries experienced some of the

highest growth rates in history and challenged the consensus-view that anything short of a total

committal to free trade would have negative effects on a countries economy. The cases of China and

India (Rodrik and Subramanian 2005) further demonstrate that growth can be achieved without

resorting to trade liberalizing measures. These countries achieved high growth rates a decade before

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lifting trade restrictions by adopting measures that were business-friendly without exposing them

too much to aggressive foreign competition.

Many of the problems that developing countries face when they take the necessary steps to

liberalize their markets are connected with the trade policies of developed countries and the

organization of institutions such as the World Trade Organization (WTO) (Wade 2003). Numerous

agreements that have been reached, which are often the result of intense lobbying on the part of

vested interests within developed countries, deprive developing countries of domestic instruments in

order to regulate foreign competition more stringently. These policy tools are important for

managing the economies of developing countries in order to address so-called “market failures”, in

which resources are not allocated efficiently and distort the functioning of the economy, along with

negative effects on the overall welfare of society. In order to remedy these failures, developing

countries often resort to interventionist measures in order to correct these distortions. As a result of

the Uruguay round, however, a swathe of such policy-space restricting measures were passed, such

as the Agreement on Trade-related Aspects of Intellectual Property Rights (TRIPS) which force

developing countries to pass laws that set a minimum standard of patent protection and strips them

of the ability to deny companies certain patents. Because of the unequal market for knowledge, with

developed countries registering a multiple of the amount of patents that developing countries do,

this benefits the large corporations of developed countries through larger earnings from royalties

and hampers the developing countries abilities to gain knowledge through imitation of advanced

technology, a measure that many developed countries employed in the early stages of their

development. The Agreement on Trade-related Investment Measures (TRIMS) bans “performance

requirements” on foreign firms, such as export requirements or the need to use local inputs in the

manufacturing process, while the General Agreement on Trade in Services (GATS) liberalizes the

markets for services by hindering developing countries from interfering in them. This results in the

service industries of developing countries being open to foreign firms, making it difficult for local

companies to establish themselves. If a developing country chooses to violate any of these

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agreements, it can be taken to the Dispute Settlement Mechanism within the WTO. Because of the

power of developed countries, even their accusation of distortion on the part of developing countries

is sufficient for them to win the case against the developing countries and thereby force open the

markets for their own corporations (Stiglitz 2003). Many of the measures that have been banned

under the new agreements have been used previously by countries on their paths to development

and have proved successful at fostering internationally competitive industries, such as in South

Korea, China and Taiwan. The policy protection of agricultural sectors further damages developing

countries by subsidizing farmer’s wages and enabling them to compete on the world market at much

lower prices than can be produced at in developing countries (Wade 2003).

The evidence for the benefits of free trade is therefore inconclusive at best, with no obvious

relationship between free trade and growth distinctly visible (Rodriguez and Rodrik 2001). As has

been noted by many economists, it appears that reaping the fruits of a successful fair trade policy is

contingent on a host of other internal factors. Stiglitz (2003) argues for a more cautious approach to

trade liberalization than has been pushed by international institutions in the past. He emphasizes the

need to tailor the recommended measures to the needs of the economy, in which the order and pace

of liberalization play a crucial part. Furthermore, many of the developed countries that now argue in

support of the benefits of free trade have themselves attained this developed stage through blatantly

protectionist measures. As Chang (2002) points out, state support and protection of new

manufacturing industries played a vital role in the development of these industries in Britain and the

United States at the end of the 19 th and beginning of the 20th centuries. The United States, for

example, had until the middle of the 20 th century the highest manufacturing tariffs in the world. It

therefore appears that trade is not an independent force for good in developing countries, but rather

needs to be restrained appropriately. Requiring foreign companies’ investments to be undertaken

jointly with local companies, that certain amounts of local suppliers be used or that technological

innovation directly benefit the host country are measure that have been instrumental in the

development of many countries today. Opening a developing economy to foreign corporations can

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lead to them crowding out the underdeveloped local manufactures without there being any

beneficial spillover effects for the local economy. This particularly is a problem that besets

developing countries if their largest sector is the agricultural one. Large investments there do not go

hand in hand with benefits to labourers, as the knowledge required on their part is quite low.

However, governmental intervention has to be undertaken with the utmost care that the right

industries are chosen to be protected; otherwise public resources are squandered on useless

projects.

As a result, free trade cannot definitely be said to benefit or harm developing countries. Whether

trade is good or bad depends on a number of other factors, such as the domestic policies, a sound

legal framework and macroeconomic stability. It is clear, however, from the historical experience of

developed countries, that a certain degree of protectionism and state intervention is beneficial, and

perhaps even necessary, for the development of effective industries that can successfully compete at

an international level. Unfortunately it is now the case that the agreements that are made in the

name of free trade at various trade rounds and the policies that are prescribed by international

institutions strip developing countries of the ability to impose effective regulations on their domestic

markets.. This limits their capacity to decide the course of development that they think most fitting

to the local circumstances. In order for developing countries to experience higher growth rates, it is

necessary for developed countries to change their attitudes towards such issues as the

appropriateness of market liberalization for less-developed countries trading with them and apply

their own policies of liberalization to agricultural and textile markets.

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