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BA (Hons) Business – Thomas Galley NCN 307 Business in the Economic Environment: Critically evaluate if 'Free Trade' promotes growth and prosperity.

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Thomas Galley


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Thomas Galley


Critically evaluate if 'Free Trade' promotes growth and prosperity.

This essay will look at what 'Free Trade' is. The theoretical foundation for free trade will be considered as a starting point for the critical evaluation of its role in promoting growth and prosperity. How we define or measure growth and prosperity will also be addressed. The essay will consider the application of free trade policies and the formation of key organisations whose purpose is to promote them, as well as some context. The question of who benefits from free trade and whether the benefits are universal also lies within the remit of this essay. Some evaluation of the success of these policies will be conducted. The essay will take into account a variety of opinion on the subject of free trade. The concept of 'Free Trade' is derived from the theory of comparative advantage. David Ricardo introduces the concept at the beginning of the 19 th century (EconLib, 2010). His work examines the notion of economic scarcity (Oxford reference, 2010), in regard of goods traded internationally. This is key: the theory of comparative advantage describes how to make the most efficient use of scarce resources. The theory of comparative advantage states that '‌ countries specialize in producing and exporting the goods that they produce at a lower relative cost than other countries.' (Begg et al, 2008a). Whether this always occurs will be discussed later in this essay. However, for the sake of clarifying the theory: given that all other things are equal, countries that can produce a product (or service) the most efficiently will sell at a lower price. If Country A can produce one product at a comparitively cheaper price, it holds that Country B should buy that product from Country A, rather than produce the item themselves. This allows Country B to save money, and maximise the use of its own scarce resources to produce and export the product over which it holds advantage. The theory allows either country to maximise its production capability by shifting resources to products it can produce most efficiently. In this respect there are advantages to all nations of trading internationally. Theoretically, countries would see their production possibility frontier increase as a result of trading with each other. The outward movement of the production possibility curve, plotted on a graph is a visual representation of economic growth (Nellis & Parker, 2004). Therefore, the concept of comparative advantage indicates that trade between countries has a positive impact on growth, as both income and output are increased after the trading process. Begg et al (2008b) define economic growth as '... the rate of change of real income or real output.' Economists attempt to measure growth and compare data between countries, over time as a percentage change of gross domestic product. Many institutions including the Bank of England, the OECD and the IMF use the measure of GDP change to compare economic growth (BBC, 2010). Growth is just one way of measuring the economy. Others include inflation and unemployment. 'Prosperity' is less well defined. The Oxford English Dictionary in its definition talks about wealth, but also about less quantifiable terms like success and well-being Page 3

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(OED, 2010). To discuss the notion of prosperity in any detail is not within the scope of this essay with its foundation in economics. However, it is reasonable to suggest that other economic factors could be taken into account when evaluating the success of 'Free Trade'. For example, it could be argued that low employment means that production capability isn't being maximised or that high inflation reduces the impact of any economic growth. Grant (1999a) considers two schools of thought that recognise the importance of stable growth in economies. The discussion in this area comes from how stable growth is achieved. The Keynesian approach sees the economy left to its own devices as unstable. In an evaluation of free market policies, Stiglitz said that newly liberalised markets in developing countries were '...subject to both the rational and the irrational whims of the investor community, to their irrational exuberance and pessimism' (Stiglitz, 2002a). He asserts that markets can fail (and have failed) when governments do not provide an adequate regulatory environment. According to the IMF, '...instability can increase uncertainty and discourage investment, impede economic growth, and hurt living standards' (IMF, 2010). Economic stability is necessary to promote growth. In order to separate the influence of business cycles from the achievement of macroeconomic objectives, Keynesians argue that the government is required to intervene. According to Grant, '… Keynesians believe that the [intervention of the] government will encourage firms to invest and thereby increase the potential output of the economy...” (Grant, 1999). Conversely, monetarist theories that say '...business cycles are temporary and selfcorrecting...' (Nellis & Parker, 2004a). The market clears itself. Monetarists may argue that if governments provide '...an environment that is conducive to private enterprise, market transactions and wage and price flexibility' (Nellis & Parker, 2004a) rather than intervening with regulations and protectionist policies, the market will provide stable growth of its own accord. The monetarist argument often references Adam Smith, in particular his notion of the 'invisible hand'. Smith argues that: 'Freedom and self-interest need not produce chaos, but – as if guided by an ‘invisible hand’ – order and concord.' (Adam Smith Institute, 2010). Key to this argument is the idea that the market knows best. Left to function without interference, the market will find efficiency gains and act in the interests of all its participants. Enshrined in Smiths' theory is the idea of freedom. This has been interpreted as a requirement for governments to act in a style where trade is not hindered by excessive use of policy, restriction or taxation. Feldstein (2009) gives the examples of Margaret Thatcher and Ronald Reagan. In the USA and UK during the 1980's tax was reduced, industries were deregulated and government owned monopolies privatised in order to improve the economy. These two leaders aligned themselves with a school of thought that emphasises the private sector as wealth creator, and aims to reduce obstacles to that process.

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The concept of 'Free Trade' was also an important part of Thatchers' decision to support UK entry into the European Union (Feldstein, 2009). The benefits of free trade, removal of tariff barriers and freedom of movement were seen as advantageous to growth. When the Thatcher government signed the Single European Act in 1986, along with the other signatories they were hoping to create an efficient single internal market (Europa, 2007). By eliminating trade boundaries between each other, EU member states would be in a position to make use of the efficiencies provided by the theory of comparative advantage. However, the EU can still erect trade barriers between itself and external countries. Since its formation, trade barriers continue to exist between the EU and others. Barysch (2008) illustrates this problem in light of EU-China trade. In this case there is a reluctance for either party to relax barriers before the other. The EU considers China as a threat and acts to protect its members interests, and China is in no rush to open up its markets. This highlights practical problems in implementing free trade. Conditions rarely allow the 'invisible hand' to work in the way Smith describes. Stiglitz (2003) offers a criticism of Adam Smiths' notion of the 'invisible hand'. Where Smith contended that an individual acting for his own benefit creates benefits for all Stiglitz said that often those in business are motivated by profit. His observations in relation to subsidies and government protection found that businesspeople 'oppose subsidies, for everyone, but themselves', were '...in favor of competition, in every sector but their own' and were '...in favor of openness and transparency, in every sector but their own' (Stiglitz, 2003a). As no market is perfect, businesses can attempt to extract competitive advantage by supporting government intervention. Free trade is therefore also political in nature; the benefits restricted by imperfect information and those with a vested self-interest. Durkin examined the case of Hong Kong, as a model example of free market ideas put into action. Durkin tells us of a city that '...reeks with confidence, ambition and dynamism.' (Durkin , 2010) and explains to the viewer, what he regards as the pivotal role of John Cowperthwaite in the cities transformation from a 'shanty town' to its modern incarnation as a world class commercial centre. By removing taxes and reducing income tax to a low level of 15%, Durkin argues that the individual in Hong Kong is incentivised to trade, and that the economy as a result has benefited from superior economic growth. The data certainly supports this argument. Hong Kong is ranked as having the 'freest' economy in the world (The Heritage Foundation, 2010) and over the last fifty years, Hong Kong has seen greater levels of economic growth annually than the UK, USA and Germany (World Bank Data, 2010). There is a clear correlation between economic growth and economic freedom. It could be argued that the correlation does not prove that the two variables are dependent on each other. As with all areas of economics, ceteris paribus rarely if ever occurs. Strong economic growth in Hong Kong may be attributed to a number of factors apart from low levels of government regulation. There are a number of organisations that act internationally to promote the free flow of trade. In its mission the World Trade Organization (WTO) says it '... provides a forum for negotiating agreements aimed at reducing obstacles to international trade Page 5

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and ensuring a level playing field for all, thus contributing to economic growth and development.' (WTO, 2010). The WTO makes a clear link here, between removing barriers to trade and improving economic growth. It is interesting that the mission mentions a 'level playing field for all'. Currently and historically economic conditions vary around the world, as do levels of development and existing trade barriers. Whether the level playing field is a realistic prospect for the future is open to debate. Convergence theory states that growth in poorer economies with lower output, increases faster than growth in rich countries (Grant, 2009b). It is fair to conclude that convergence theory supports the WTO case for market liberalisation in poorer countries. By reducing obstacles to free trade, the WTO aims to remove barriers to growth. However Nellis & Parker (2004b) question the validity of convergence theory and the lack of empirical evidence to support such an argument. Dicken (2003a) also questions international free trade policies more generally. He argues, 'The very poor developing countries, those at the bottom ‌ have benefited least from the globalization of economic activities'. If the point of free trade' is to promote growth and prosperity, Dicken would argue that the global proliferation of free trade policies and liberalised markets have failed developing countries in this respect. An alternative theory is offered. Conditional convergence theory states that the rate of convergence '...depends on [a countries] share of investment in GDP.' (Nellis & Parker, 2004c). That growth rate is not determined by the countries starting point, but also its attractiveness as a market. This could be an argument for free trade. By removing barriers to trade, lowering tax rates etc., countries may attract more investment and maximise the growth rate. However, this is dependant on market attractiveness being the only factor in deciding where foreign direct investment is allocated. The existence of the WTO testifies to this not being the case at the moment. When talking about 'Free Trade' it is important to consider what may hinder the flow of trade between countries, and the reasons why these barriers exist. Government policies that hinder the free flow of trade, whether directly or indirectly, are known as protectionist. Speaking at WTO talks in Davos, Prime Minister at the time Gordon Brown said of protectionism: '[it] protects no-one and least of all the poor' (Flanders, 2009). However correct or incorrect Mr Browns' assertion is, belies the fact that countries including the UK, and others that advocate free trade take part in protectionism. Nellis and Parker offer several arguments that support the use of protectionism in relation to growth. These include: the protection of infant industries, protection against unfair competition and the protection of industries in decline (Nellis & Parker, 2004d). In regard of protecting industries at either end of their life cycle, advocates of free trade would argue that government support reduces the incentive provided by the market for business to be more flexible and restructure. A Keynesian may argue that the opposite is the case and that support at an early stage acts as an insurance policy for businesses, lowering their costs and enabling them to take on risk, while Page 6

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reducing failure rate. Chang, in his analysis of the USA and its role as champion of free trade quotes former President Ulysses Grant who: 'In defiance of the British pressure on the USA to adopt free trade, he once remarked that “within 200 years, when America has gotten out of protection all that it can offer, it too will adopt free trade�' (Chang, 2010). This raises an issue. Is the time scale of transition an important consideration? Chakraborty (1999) talks about 'sequencing' as an important factor in creating successful liberalisation policies. For Chakraborty, the process of liberalisation is as important a consideration as the decision to open up a countries markets in the first place. Chakraborty looks at the liberalisation of markets in India, which had a planned economy up until reforms in 1991 (BBC, 1998). 'Although serious attempts had been made to reform the real sector and improve the efficiency of the allocation of resources, reform in the financial sector has been very cautious and slow. The government of India successfully steered the economy from experiencing volatile capital shocks'. It is implied that fast reform in the financial sector was avoided as this might have harmed growth if capital flows were allowed to get out of control. The key to India's successful growth is in liberalising the 'real' markets first. Only when this had occurred would the incentive be there for a 'sophisticated' financial sector to take shape that could handle exposure to the free market (Chakraborty, 1999). In conclusion, there is strong evidence to support the theory that free markets can improve growth and prosperity. There is also evidence to suggest that in some cases protectionism is a tool that helps nations develop their economies. To pursue free trade as a panacea is questionable. The notion of free trade as it stands, is charged with ideological and political implications. Some would consider the work of organisations that promote free trade to be flawed in their execution; and some nations that advocate free trade to have protectionist motives in their push for others to liberalise. In order to fulfil the promise of free trade and achieve sustainable growth, it should be argued that liberalisation be pursued gradually, alongside economic stability and fairness.

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Bibliography BIZED, 2010. Comparative and Absolute Advantage [online]. Available at: http://www.bized.co.uk/virtual/dc/trade/theory/th2.htm [accessed 18 November 2010]

References

ADAM SMITH INSTITUTE, 2010. Adam Smith [online]. Available at: http://www.adamsmith.org/adam-smith/ [accessed 29 November 2010] BARYSCH, K., 2008. The Threat of Protectionism: Trade barriers would only hurt Sino-European relations. [online]. Available at: http://online.wsj.com/article/SB122809278289767851.html [accessed 29 November 2010] BBC, 1998. India: the economy [online]. Available at: http://news.bbc.co.uk/1/hi/world/south_asia/55427.stm [accessed 30 November 2010] BBC, 2010. Q&A: What is GDP? [online]. Available at: http://news.bbc.co.uk/1/hi/88618.stm [accessed 17 November 2010] BEGG, D., FISCHER, S., and DORNBUSCH, R., 2008a. Economics. 9th edn. Maidenhead: McGraw-Hill. p.635. BEGG, D., FISCHER, S., and DORNBUSCH, R., 2008b. Economics. 9th edn. Maidenhead: McGraw-Hill. p.579. CHAKRABORTY, D., 1999. Macroeconomic conditions and opening up – Argentina, Chile and India. International Journal of Social Economics [online]' 26 (1/2/3). Available at: http://dx.doi.org/10.1108/03068299910229712 [accessed 18 November 2010] DICKEN, P., 2003a. Global Shift. 4th edn. London: Sage publications. p. 575. DURKIN, M., 2010. Britain's Trillion Pound Horror Story. TV. Directed by Martin Durkin. UK: Channel 4. ECONLIB, 2010. Comparative advantage [online]. Available at: http://www.econlib.org/library/Topics/Details/comparativeadvantage.html [accessed 18 November 2010] EUROPA, 2007. The Single European Act [online]. Available at: http://europa.eu/legislation_summaries/institutional_affairs/treaties/treaties_singleact Page 8

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_en.htm [accessed 25 November 2010] FELDSTEIN, M., 2009. Is the Reagan-Thatcher Revolution Over? [online]. Available at: http://www.project-syndicate.org/commentary/feldstein17/English [accessed 24 November 2010] FLANDERS, S., 2009. The pressure for protectionism [online]. Available at: http://www.bbc.co.uk/blogs/thereporters/stephanieflanders/2009/01/the_pressure_for _protectionism.html [accessed 18 November 2010] GRANT, S., 2009a. Economic Growth and Business Cycles. Oxford: Heinemann. pp. 68-72. GRANT, S., 2009b. Economic Growth and Business Cycles. Oxford: Heinemann. pp. 36-37. IMF, 2010. Factsheet: How the IMF Promotes Global Economic Stability [online]. Available at: http://www.imf.org/external/np/exr/facts/globstab.htm [accessed 29 November 2010] MANGAN, L., 2010. Last night's TV: Britain's Trillion Pound Horror Story and Misfits [online]. Available at: http://www.guardian.co.uk/tv-and-radio/2010/nov/12/britainstrillion-pound-horror-story-tv-review [accessed 30 November 2010] NELLIS, J., and PARKER, D., 2004. Principles of Macroeconomics. Harlow: Pearson Education Ltd. p. 11. NELLIS, J., and PARKER, D., 2004a. Principles of Macroeconomics. Harlow: Pearson Education Ltd. p. 423. NELLIS, J., and PARKER, D., 2004b. Principles of Macroeconomics. Harlow: Pearson Education Ltd. p. 228. NELLIS, J., and PARKER, D., 2004c. Principles of Macroeconomics. Harlow: Pearson Education Ltd. p. 238. NELLIS, J., and PARKER, D., 2004d. Principles of Macroeconomics. Harlow: Pearson Education Ltd. pp. 320-323. OED, 2010. Oxford English Dictionary: prosperity, n. [online]. Available at: http://dictionary.oed.com/cgi/entry/50190555? single=1&query_type=word&queryword=prosperity&first=1&max_to_show=10 [accessed 18 November 2010] OXFORD REFERENCE, 2010. scarcity: Oxford Reference Online [online]. Available at: http://www.oxfordreference.com/views/ENTRY.html?entry=t19.e2767 [accessed 18 November 2010] STIGLITZ, J., 2002a. Globalization and its discontents. London: Penguin. p.100.

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STIGLITZ, J., 2003a. The Roaring Nineties. London: Penguin. p. 106. THE HERITAGE FOUNDATION, 2010. Hong Kong [online]. Available at: http://www.heritage.org/index/Country/HongKong [accessed 30 November 2010] WORLD BANK DATA, 2010. Data: GDP growth (annual %) [online]. Available at: http://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG/countries/HK-GB-US-DE? display=graph [accessed 30 November 2010] WTO, 2010. About the WTO — a statement by the Director-General [online]. Available at: http://www.wto.org/english/thewto_e/whatis_e/wto_dg_stat_e.htm [accessed 24 November 2010]

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Econonomics - Free Trade