Capitalism and international free trade

Free trade is a foundation of capitalism not only at the national level but also at the international level. However, while locally it is easy to understand why free competition protects the capitalist system from capitalists who acquired a dominant position, when dealing with foreigners nationalist sentiments often win. For instance, it is common to find many arguments in favor of domestic producers using the infant industry argument, the notion of national champions or even a mercantilist ideology.

Yet, it is at the international level that societies may achieve better levels of specialization based on relative comparative advantage. This can be confirmed by looking at the link between exports and economic growth in the follow up to major reductions in international trade barriers.

The reduction of tariffs and non-tariff barriers started in 1947 with the signing in Geneva of the General Agreement on Trade and Tariffs (GATT). It continued through subsequent rounds of negotiations and played an important role in the extraordinary growth of international trade. For instance, between 1948-1968 the total volume of merchandise exports from non-communist countries grew 290 percent. Moreover, it outpaced the growth of world output. For example, from 1953 to 1963, trade in manufactured products increased by 83 percent, while manufacturing output rose by only 54 percent.

International trade liberalization was certainly a major driver of economic growth during the so-called Golden Age (1950-1973). Yet, although there are two virtuous circles associated with export-led growth (Marques-Mendes, 1988), one should not confuse the rising share of international trade in GDP as the direct cause of economic growth, because a faster rise in trade is not always associated with accelerating economic growth.

This can be easily confirmed by looking at two countries with high degrees of openness but significant differences in growth performance. For instance, Singapore and Hong Kong, classified ex aequo by ICC as the two most open economies in the world, were reported by the World Bank to have grown between 1966-2013, at market prices and 2005 $US, at an average annual rate of 7.8% and 5.8%, respectively. Meanwhile, during the same period their exports as a percentage of GDP rose 67 and 154 percentage points to reach 191% and 230%, respectively. That is, Hong Kong’s GDP grew less than Singapore’s despite a much faster growth in exports.

Likewise, the next two most open economies, Luxembourg and Belgium, grew in the same period at 3.7% and 2.5%, respectively, but their exports as a percentage of GDP grew 124 and 39 percentage points to reach 203% and 83%, respectively. Overall, in terms of economic growth over the past 47 year period Singapore outperformed Hong Kong by 162% and Luxembourg outpaced Belgium by 75%.

There are many factors explaining such disparate performances, including geography and sector specialization (both Singapore and Luxembourg are regional low tax financial centers) as well as demand factors (see Marques Mendes, 2011 and 2014, on why not all exports are the same), but the type of capitalism pursued is also a driving factor.

To understand the relation between exports and GDP it is useful to breakdown the latter in relation to the three identities used in GDP estimation – expenditure, income and production. For instance, the condition required for exports to exceed GDP under the expenditure approach is that the foreign trade balance (in ratio form) exceeds the ratio between domestic absorption (consumption and investment) and imports. This is more easily achieved in smaller countries and/or in countries where exports have a larger import content.

Likewise, using the income identity, we can see that the excess of exports over GDP requires that exports exceed wages by a factor equal to the wages/profits ratio. Thus, assuming a normal capital share of 40%, exports must exceed wages by 66% which is more easily achieved in low wage countries.

Finally, taking a production approach and splitting it into tradable and non-tradable we need exports to exceed non-tradable by a factor bigger than the tradable/non-tradable ratio. Since many non-tradable are produced in the non-capitalist sectors, it is easier for countries with a smaller state sector to achieve a high export/GDP ratio.

To understand the great advantage of capitalism in terms of capital accumulation and the deepening of the division of labor, one must bear in mind that the later can be achieved through rotation or specialization. These two distinct ways have substantial differences in terms of productivity impact as can be illustrated through a domestic example.

For example, my wife is much better than me at both cooking and doing the dishes, but her greatest advantage is in cooking. So, following the rule of relative comparative advantage she does the cooking and I do the dishes and we both gain by spending less time in the kitchen and having better meals. However, we could share the chores of preparing meals by alternating so that one day I would prepare dinner and she would do it the following day. This seems a more egalitarian division of labor but it would be much less efficient. For one, half of the week we would eat lousy food because it was me cooking. But I would also spend more time in the kitchen.

Obviously, capitalism relies on the division of labor through specialization and has a much greater scope in pursuing it through joint ownership, which facilitates accumulation and the unbundling of the production process.

Nevertheless, imagine that a washing machine is invented that reduced by 2/3 the time and skills needed to do the washing. Who would benefit? We could benefit both by, for example, me using half of the time saved to set the table a task previously done by my wife. But, what if I were a selfish person and insisted in doing only the dishes in exchange for the meal. Now my wife would have to consider to either forego the benefit of technical progress or to divorce me and find a more obliging husband.

Fortunately, in non-domestic activities we would not have such a dilemma because there would be many other suppliers competing to do the washing and those doing the cooking could play them to share on the gains from technical progress. That is why capitalist principles are better suited for non-family activities because one can contract and re-contract frequently.

So, to understand which are the most important drivers for international specialization and trade, one must examine the role played by each foundation of capitalism.

Starting with private property it is evident that the more this is protected the greater will be the level of private investment which accounts for the largest relative share of tradable goods and services. The profit motive is needed to increase the return on capital in a context of high wages. Free markets are indispensable to have a country specialization driven by dynamic comparative advantages needed to foster the benefits of export growth. Meanwhile, joint ownership and limited liability are needed to foster risk sharing and mitigation in international business. Yet, to prevent that these advantages are seized by protectionist interest groups, it is indispensable that the rule of law prevails.

The fundamental principle of the rule of law is that all be treated equal, regardless of sector of nationality. For instance, preference for national suppliers, price controls and distortionary taxes or subsidies are all in flagrant violation of the fair treatment principle required for a level playing field whether at the national or international level.

Subsistence economies and self-sufficiency

Many of the protectionist arguments against capitalism rely on the idea of self-sufficiency and independence as a safeguard for unforeseen events. This idea wrongly stems from confusing prudence with self-sufficiency and risk mitigation with protectionism.

It is normal that after being fustigated by so many natural and human-made calamities people seek safety in self-reliance. In the absence of markets for risk protection, subsistence economies may be seen as providing such safety. Yet, such safety is achieved at an enormous cost in terms of living standards.

I shall illustrate this through the personal experience of my ancestors. Before the 1930s, most of my ancestors lived for centuries in a remote village by cultivating small plots of land. They consumed almost all they produced except for the occasional goat that they would sell to buy clothing. If the wolves decimated part of the herd or the weather ruined the harvest they would have a rough year surviving on potatoes and without replacing their rags.

It was a tough life but they were self-sufficient and independent without a need to rely on others. The same happened with the other villagers, with the exception of the only specialized inhabitant (a carpenter) who had to walk to the neighboring villages to offer his services.

My family fortune changed only when, at the age of fifteen, my father and a friend migrated to Lisbon. He survived doing multiple jobs and later returned home to work in a textile mill in a neighboring village, where he also found jobs for his sister and two of his bothers. As a result I and my five sisters had the opportunity to study and to escape the self-sufficiency trap.

The problem with small self-sufficient communities is not that they do not know about division of labor. Indeed, for those with a romanticized view of such communities, my village had a well-developed communal way of herding, a communal bakery and a kind of labor exchange.

However, isolation and small scale prevented them from participating in trade with outsiders and achieve the necessary scale and specialization needed for capital accumulation.

However, the subsequent construction of roads and communication services did break isolation but it did not stop the village decline, why?

Because the lack of transport infrastructures is not the only obstacle to the development of remote areas. Unless they are a tourist hive or their inhabitants are writers or similar professionals able to work from home for a greater market, they will not be able to combine the profit motive with the joint ownership and limited liability needed to undertake risky ventures which are indispensable for the success of capitalism.

So for many millions trapped in small communities, like my ancestors were, the simplest way out is migration.

Yet, there are many still arguing for self-sufficiency or independence in large communities. They typically invoke the lack of scale and the need to safeguard the supply of goods and services considered essential, with an elastic definition that ranges from food, social services, environment and energy. Such calls for self-sufficiency contradict Ricardo’s law on comparative advantage, probably the only consensual law in economics formulated in 1817.

And, this law is not being ignored in non-capitalist societies alone, but also in Western countries at the core of capitalism. For instance, until recently the USA had a law banning the export of crude introduced in 1975 as a retaliation against the Arab oil embargo of 1973. Yet the ban was never lifted due to opposition from oil refineries and environmental groups. Only now, after a sharp increase in oil supply brought about by the new fracking technology and geopolitical considerations, did the refiners opposition eased and there is some hope for lifting the ban.

Obviously, whether to export crude or refined products should be a business decision not a political one. However, once a country tolerates special interest groups based on protectionism it becomes almost impossible to eradicate them. Thus the importance of free trade to control rent-seeking behaviour that undermines capitalism.