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The World according to Economist; Free Trade part 2

July 23rd, 2008 · No Comments

We continue (see here for part 1) the election platform which would attract the economist vote according to Greg Mankiw. Free trade features prominently in that platform. It’s also in rather significant difference with the population at large, which is considerably less enthusiastic about free trade in most places in the world.

One of the problem with free trade (and capitalism in general) is that it creates winners and losers, and as we discussed previously, the losers are usually much few in number and therefore have they have bigger incentive to organize and lobby, and there is also a bigger pay-off (as there are fewer to share the  spoils).

These problems are more manifest today because developments generally move a lot faster, there is a premium on the ability to shift resources (especially labour) fast from losing sectors to winning sectors. However, and here’s a real problem, many economies just don’t have that required level of flexibility, especially labour market flexibility is often lacking.

Without the ability to shift resources fast to where they are most productive, free trade would then cause the victims (the companies or sectors that can no longer compete with producers abroad) to linger.

Apart from being a waste of resources (a cardinal sin, according to economists), making these more scarce and hence more expensive, this also hamstrings those sectors that can compete abroad and need resources to expand.

Without swiftly re-employing resources from losing to winning companies and sectors, more resources are kept idle and this could very well cause a backlash against free trade and calls for protectionism from sectors that are losing against foreign competition.

Once some form of protectionism is granted, this puts a premium on lobbying the government.
This problem is known as ‘rent seeking behaviour‘, it is one of the big risks of protectionism.

Once companies realize that lobbying the government is just as important, if not more important, for their bottom line than good old-fashioned entrepreneurship, then a lot of creativity that would otherwise have been engaged in productive activities will be sapped away towards unproductive redistribution via lobbying.

Protectionism not only diverts energies from entrepreneurship towards rent seeking, it also
limits the forces of competition
. This makes life easier for domestic producers, it blunts incentives to improve and to be efficient and it increases prices for consumers.

The damage might not show up immediately, but over time, it can be severe. India had it’s own car industry even before the country opened up in the early 1990s under Rajiv Gandi, but by all accounts, the quality of those cars was rather poor.

Competition is a powerful incentive to improve, and blunting these is dangerous. If one goes back to the old Soviet economies to see what could happen.

Yes, competition creates losers, but the price of too much protection is just too high. Capitalims works, in the famous words of Joseph Schumpeter, as a process of creative destruction. Unfortunately, limiting the destruction will also limit the creation.

So an economy has to find a way to move resources pretty swiftly from declining to growing sectors, the sectors that compete abroad.

You might think that this would leave only a relatively rough ‘survival of the fittest’ type of capitalism (US style, although one could say, as we have done, that there is a form of state socialism for the rich practised there), but you would be wrong.

However, some of the Nordic countries (especially Denmark) who traditionally have big welfare states have embraced so called activating labour market policies that embrace the change.

The idea is not to let laid-off workers from losing companies and sectors linger in long-term unemployment (which has happened in many other European companies), but actively facilitate their retraining and cutting the time they can stay on relatively generous benefit packages, so increasing a sense of urgency to look for new jobs.

The European Union (EU) has more or less embraced this model and called it ‘flexicurity‘, combining the flexibility of the Anglo-Saxon labour markets with the security traditionally provided in many European economies.

However, the EU has little powers to intervene in national labour markets and to impose this kind of ‘flexicurity’, and labour markets are finely balanced social constructs which are difficult to reform. Once you start to alter a few pieces of the puzzle, the whole puzzle will rearrange, but this is perhaps a topic for another time..

Tags: The World according to Economics