Journal of Policy Modeling 31 (2009) 593–599

Available online at www.sciencedirect.com

The challenges to the liberal trading system

Dominick Salvatore ∗Department of Economics, Fordham University, Bronx, NY, 10458, USA

Available online 6 June 2009

Abstract

Free trade has been a universally accepted economic tenet for almost two centuries. Despite challenges,Ricardo’s theory of comparative advantage has proven to be one of the most enduring of all economic laws.In recent decades, however, the liberal trading system has come under increasing attacks in the form ofstrategic trade and industrial policies, the deindustrialization in advanced countries, rapid globalization andoutsourcing, and others. This paper reviews each of these attacks and concludes that they do not justifyabandoning or moving away from the general preference of a liberal trading system.© 2009 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.

Keywords: Strategic trade and industrial policies; Deindustrialization; Globalization; Outsourcing; Labor and environ-mental standards; Regional trade arrangements; Global economic crisis

1. Introduction

Free trade has been a universally accepted economic tenet for almost two centuries. To be sure,there have been challenges from time to time, but the Ricardo’s theory of comparative advantagehas proven to be one of the most enduring of all economic laws. In recent decades, however, theliberal trading system has come under increasing attacks in the form of (1) strategic trade andindustrial policies, (2) the deindustrialization of advanced countries, (3) rapid globalization andoutsourcing, (4) demands by advanced countries for strict labor and environmental standards inemerging markets, (5) the proliferation of regional trade agreements, and (6) rising protectionismas most countries try to combat the present serious global economic crisis.

In this paper, I will briefly review each of these attacks on the free trading system and showthat they do not justify the call for a change in trade policies (read: move away from principle ofa liberal multilateral trading system).

∗ Tel.: +718 817 4045; fax: +1 914 337 3355.E-mail address: salvatore@fordham.edu.

0161-8938/$ – see front matter © 2009 Society for Policy Modeling. Published by Elsevier Inc. All rights reserved.doi:10.1016/j.jpolmod.2009.05.010

594 D. Salvatore / Journal of Policy Modeling 31 (2009) 593–599

Table 1Factors responsible for deindustrialization.

Industrial countries United States European Union Japan

Share of manufacturingEmployment (in percent)

1970 27.6 26.4 30.4 27.01994 18.0 16.0 20.2 23.2Change −9.6 −10.4 −10.2 −3.8

Percentage change due to:Productivity growth 65.6 65.4 59.8 157.9Investment 18.8 3.8 20.6 71.1Trade (−)2.1 9.6 (−)2.9 (−)30.0Other 17.7 21.2 22.5 (−)51.7Total 100.0 100.0 100.0 100.0

Source: International Monetary Fund (1997, p. 68), Scott (2007), and “Pain from Free Trade Spur Second Thoughts,”Wall Street Journal, March 28, 2008, p. A1.

2. Strategic trade and industrial policies

The most powerful theoretical argument advanced against free trade during the 1980s was thatthe traditional Ricardo’s theory of comparative advantage was entirely static in nature and not veryrelevant in today’s world characterized by imperfect competition, technological breakthroughs,product cycles, intra-industry trade, multinational corporations, and integrated capital markets.This was the case for strategic trade and industrial policies to create comparative advantage in newtechnologies, as contrasted with traditional comparative advantage based on inherited internationaldifferences in factor endowments across nations (see, Krugman, 1987; Tyson, 1992).

With the continued liberalization of international trade and rapid globalization of the worldeconomy during the 1990s, however, strategic trade theory became discredited. It became increas-ingly clear that a policy maker’s ability to identify industries of potential comparative advantageand actually create them by strategic trade and industrial policies was so difficult and fraught withdangers that even some of its original staunchest supporters (including Krugman) moved awayfrom it as a practical, real-world policy. In order words, free trade may be suboptimal in theory, butit is optimal in practice. Indeed, for every alleged success of strategic trade theory and industrialpolicy (such as semiconductors in Japan in the 1970s and 1980s), one could point to an equallyspectacular failure (such as the Concorde—a technological feat, but a commercial disaster).

3. The deindustrialization of advanced countries

Another argument advanced in favor of moving away from a free trading system was to counter-act deindustrialization in advanced countries, as reflected in their declining share of manufacturingemployment since the 1970s. But this is also an argument that should have been put to rest soonafter it was first advanced. Table 1 shows the relative importance of the different factors accountingfor deindustrialization in all industrial countries as a group, in the United States, in the EuropeanUnion, and in Japan. The table shows that from 1970 to 1994 manufacturing employment declinedby about 10 percentage points in all industrial countries, as a group, as well as in the United Statesand in the European Union, and by about 4 percentage points in Japan.

The table also shows, however, that most of this decline resulted from the growth of labor pro-ductivity (which made possible higher levels of output with less labor) as a result of the decline in

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the rate investments and other domestic forces. International trade actually resulted in an increasein industrial employment (the negative signs indicated the opposite of deindustrialization), exceptin the United States (where it led to 9.6 percentage point decline in manufacturing employment).This, however, does not take into consideration that the huge trade deficits that the United Statesincurred during the past decade led to many more job losses than gains.

But even if this were not the case, deindustrialization only reflects the change in comparativeadvantage in the world economy, whereby advanced countries moved toward greater specializationin services and leaving more of the manufacturing to emerging markets, in which the latter havebecome much more efficient. But this in no way justifies calling for new trade policies andindustrial protection in advanced countries.

4. Globalization and outsourcing

Since the turn of this century, the challenge to free trade seems to have re-emerged with avengeance as a result of the alleged rapid exporting of jobs from rich countries to emergingnations via outsourcing. The acceleration of the process of globalization of the world economythat has been taking place during the past decade is now leading to the transfer abroad not onlyof unskilled jobs, as part of the specialization in production engendered by traditional free tradetheory, but also of highly-skilled and high-paying jobs in the advanced sectors of rich nations.This problem has been brought forcefully to the forefront during the jobless recovery from theU.S. recession of 2001 and the present global economic crisis.

The reasoning goes as follows: if rapid globalization and international competitiveness leads –even requires – multinational corporations to send an increasing share of their investments of theirmost advanced technology to emerging markets, especially China, the comparative advantage (andwith it many high-paying jobs) will also be transferred from the advanced nations to the leadingemerging markets where capital and technology can earn higher returns. What does then remainin the rich countries to do?

Once, rich countries could rely on the greater availability of capital, more advanced technologyand higher skills to have a comparative advantage in high value-added and high-wage industries.But as capital and technology is transferred abroad ever more rapidly under the pressure ofintensifying international competition, an increasing share of the benefits of international tradeaccrues to the leading emerging markets in the form of rising wages and high-paying job at theexpense of today’s rich countries. At least, so the argument goes.

In short, the world seems to have turned up-side-down. In previous decades, it was the devel-oping countries that complained that the international economic system was biased againstthem, with most of the benefits from free international trade accruing to the rich countries.Now it is the rich countries that are starting to complain that an increasing share of the ben-efits from international trade and specialization go to emerging market economies, especiallyChina.

The only way for rich countries to retain more of the benefits of international specialization inproduction and trade now is to speed up the process of technological progress and hope to retainmore of its benefits, at least temporarily, as the United States (much more than continental Europe)seems to have been able to do during the past decade. Here, the old saying that nations need to runever faster in order not to fall behind seems pertinent. But, as Gomory and Baumol point out in thisissue, this may not help very much advanced countries because global corporations increasinglytransfer and use new technologies and more efficient productive techniques where they are mostefficient—and this often means in emerging markets. The question more vociferously being asked

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Table 2U.S. job loss rates by industry (percent).

Industry Overall Tradable Non-tradable

Manufacturing 12 12 17Information 4 4 15Financial services 4 3 12Professional & business services 4 6 3

Source: Bradword and Kletzer (2008).

today is “Does getting cheaper and/or better products and services from abroad justify sacrificingdomestic jobs?”.

Table 2 shows that from 2003 to 2005 the percentage of jobs lost in U.S. manufacturing was threetimes higher than in U.S. service industries, but in all sectors (except professional and businessservices) job losses were much higher in the non-tradable sectors (and thus not caused by increasedimports, outsourcing or offshoring) than in the tradable sectors. As discussed in the case ofdeindustrialization above, most job losses in the United States resulted from technological changesthat raised labor productivity rather than from international trade, and it affected mostly low-skilled industrial workers. The fear today, however, is that the revolution in telecommunicationsand transportation is making possible the export of an increasing number of high-skill and high-paying jobs from advanced countries to emerging markets, not only in manufacturing, but also ina growing range of services that until recently were regarded as secure.

What can be made of all of this? First of all, and as pointed above, only a very small portion ofthe millions of new, high-paying jobs created by the new economy in advanced countries duringthe past decade actually went abroad through outsourcing. Secondly, some of the outsourced jobsare complementary with, and hence create, more domestic jobs in advanced countries. Thirdly,some companies from emerging markets also invest and create jobs in rich countries. Fourthly, asemerging markets grow and become more similar to advanced countries in terms of their factorendowments, their trade will become more intra- rather than inter-industry (i.e., like the tradeamong advanced countries) to the benefits of all countries involved.

The same arguments and reasons are valid against the claim that globalization and outsourcingis putting a great deal of pressures on real wages and workers’ income in advanced countries. Agreat deal of empirical evidence shows that stagnant wages for unskilled and semiskilled workersin advanced countries is more the result of technological change that of trade and outsourcing(see Bradword & Kletzer, 2008).

Thus, there is no reason to move away from the ideal of a liberal trading system. Shouldadvanced countries protect industries and jobs in sectors in which they have a comparative disad-vantage? How would or could this help them? All of this means that in today’s highly globalizedworld, more the gains from trade accrue to the leading emerging markets, particularly China, andrelatively less to advanced countries. As pointed out by Bhagwati in this issue, this is to someextent what Samuelson (2004) meant rather than supporting a move away from a liberal tradingsystem (as wrongly interpreted by some of his readers). In short, globalization is operating moreand more as the great equalizer in the world economy today.

5. Labor and environmental standards

To put an end to the process of deindustrialization, as well as to job losses and wage pressures inadvanced countries allegedly resulting from outsourcing and trading with emerging markets, the

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United States, France and other advanced countries have been demanding labor and environmentalstandards in developing nations or emerging markets in order to create a level-playing field.Labor standard are advocated not only to prohibit child labor but also for workers to receive“decent” wages and have “good” working conditions, thereby avoiding “social dumping”. Howcan a U.S. workers compete with a Chinese worker who receives a wage of only a dollar a day?And how can a steel plant in the United States compete with a steel plant in India if the latterdoes not require antipollution equipment that often costs half as much as that of the steel plantitself?

Although these may seem legitimate demands to many people in advanced countries, thesuspicion is that they are advocated more to protect domestic industries and labor than foraltruistic purposes out of concern with the wellbeing of foreign labor and the environment.Even if legitimate, there is a real danger that labor and environmental standards arguments willbe and can be easily captured by the protectionist elements in advanced countries and makethe further opening of international trade between advanced and emerging markets practicallyimpossible.

There is a more strictly economic reason for not trying to push labor and environmentalstandards on emerging markets. And that is that different nations have different tastes and itis wrong to try to impose uniform international standards on them. If emerging markets couldafford the same labor and environmental standards as advanced nations today, they would not beemerging or developing markets! The premature imposition of these standards would also takeaway most of their current absolute trade advantage. As emerging markets grow richer and moredeveloped, they will naturally begin to demand and impose more strict labor and environmentalstandards—exactly as it occurred in today’s advanced countries as they grew richer. Trying toimpose stricter labor and environmental standards on emerging markets today represent a formof protectionism and a serious stumbling block toward a more liberal multilateral trading system.

6. Regional trade arrangements

A third alleged attack on the liberal trading system is provided by the rapid proliferation ofregional trade arrangements (RTAs). Bhagwati (2008) believes that RTAs are discriminatory andtheir proliferation represents a “stumbling block” and detracts from the effort toward free trade. Healso points out that trade controversies are also more dangerous in a world of RTAs, as they ofteninvolve continents rather than nations. Larger nations can also bully smaller ones into formingan RTA and extract most of the potential benefits from economic integration. Finally, Lee, Parkand Shin (2008) found that the current proliferations of overlapping or “spaghetti-bowl” RTAsmay not lead to freer trade. Indeed, the United States only started to favor and move toward RTAssince the late-1980s as a result of frustration with the slow progress in negotiating the UruguayRound.

The World Trade Organization (WTO), on the other hand, seems to believe (perhaps out ofnecessity) that RTAs represent “building blocks” toward a liberal multilateral trading system.To the WTO, RTAs represent a second best choice of partially moving toward free trade in apiecemeal fashion in view of the fact that the first-best choice of full world-wide free trade ispresently impossible to achieve. The WTO advocates policies to make RTAs function more likebuilding blocks than stumbling blocks by (1) the adoption of the lowest, rather than the average,tariff of the nations forming a RTA, (2) keep membership open (as the European Union does, forthe most part), and (3) negotiate multilateral reductions in averages rates of protection (as in theUruguay Round). Globalization also works as a force toward multilateralism and inclusion.

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So far, RTAs seem to have been complimentary and do not seem to have hindered multilater-alism, but as more overlapping RTAs come into existence the point may soon be reached wherethey will become stumbling blocks to a liberal multilateral trading system. As pointed out byBhagwati, even now, RTAs are basically discriminatory and they do detract from efforts towardmultilateralism.

7. The present economic crisis and protectionism

In 2008 and 2009, the world faced the most serious financial and economic crisis since theGreat Depression. The current crisis started in the U.S. subprime (high-risk) housing mortgagemarket in August 2007 and then spread to the entire financial and real sectors of the U.S. econ-omy in 2008, and from there to the rest of the world. Advanced nations faced deep recessionand emerging markets experienced sharply lower growth. The United States and other nationsresponded by rescuing banks and other financial institutions from bankruptcy, slashing interestrates, and introducing huge economic stimulus packages. These efforts, however, only succeededin preventing the economic recession in advanced countries and decline in economic growth inemerging markets from being deeper than otherwise.

In May 2009, the Organization for Economic Cooperation and Development (OECD, 2009)forecasted that the volume of world trade would shrink by has much as 13 percent from 2008levels. Despite warnings by most international institutions and pledges made at the G-8 and G-20meetings in fall 2008 and spring 2009 to avoid protectionist trade measures, many countries haveraised import duties or passed stimulus measures with “buy American” clauses and other trade-distorting subsidies in the vain attempt to protect domestic jobs. These retard recovery and leadto trade disputes that represent a serious setback from the effort to move the world toward a moreliberal multilateral trading system.

For example, the number of antidumping investigations increased from an 11-year low of 163in 2007 to 208 in 2008 and are expected to rise even more in 2009 (they were 306 in 2001, afterthe burst of the dot.com bubble). The largest number of antidumping cases (about a quarter ofthe total) were imposed by India, followed by Brazil and Turkey. The largest number were onsteel exports from China. Russia raised tariffs on imported cars, China tightened import standardson food, India banned Chinese toys, Argentina tightened licensing requirements on auto partsand textiles, and a dozen countries, or so, are subsidizing embattled automakers and car dealers.France’s President, Nicolas Sarchozy, in one of his pronouncements, stated that Europe wouldturn into an industrial wasteland if it did not prop up its manufacturers. Clearly, protectionismis raising its ugly head. Recession must be fought with monetary, fiscal and competitive policiesand not trade protection, which would be self-defeating and wrong.

8. Conclusions

Free trade is under unprecedented attack both theoretically and empirically. Protection has beenjustified on strategic trade and industrial policies, in order to reverse the process of deindustrial-ization in advanced countries, to protect jobs and wages from globalization and outsourcing, bydemands by advanced countries for strict labor and environmental standards in emerging marketsso as to establish a level-playing field in international trade and competition, from the prolifer-ation of overlapping regional trade agreements, and in order to mitigate the effects of the worldeconomic crisis. None of the above, however, justify changing trade policies and moving awayfrom the goal of a liberal multilateral trade system.

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