The theory

Paul Krugman once wrote that if there were ever to be an Economists’ Creed, its first two points would be: (i) I believe in free trade and (ii) I understand the principle of comparative advantage. The latter supports the former. The theory predicts that countries are better off if they specialise in goods and services which they can produce efficiently because of the resources they are endowed with relative to other partners. The power of the theory is that it says that even if country A has more land, more skilled labour and more capital than country B, both countries would be better off if A specialised in goods and services that used resources it was particularly abundant in relative to B, and imported others from B, rather than trying to produce everything on its own.

One of the central insights of traditional trade theory is that it is always in a country’s own interests to remove barriers to trade, regardless of what others are doing. As the celebrated British economist (and by no means a free-market ideologue) Joan Robinson famously said when commenting on the pointlessness of raising tariffs in response to protectionism overseas: just because your trading partner throws boulders into their own harbour, it does not mean you need to throw boulders into yours. Indeed a group of prominent economists currently argues that post-Brexit the UK should abolish all tariffs and other import charges in respect of all imported goods.

The UK Government does not go as far as that, but it seems to have internalised the theory to the point where ministers, led by its Secretary for International Trade, have positioned the UK as a global champion of free trade. But if free trade is, to borrow from Jane Austen, a truth universally acknowledged, then why is trade in practice subject to many physical and procedural restrictions? And why do countries put their negotiators through the (often painfully slow) process of negotiating multilateral or preferential trade deals.

Two main reasons stand out. First, there are “political economy reasons”. These are principally that: (i) the benefits of free trade outweigh the costs, but the benefits tend to be diffuse (spread across many consumers and business sectors) while the costs fall on specific interest groups and are therefore more focused and politically visible. This concentration does however also make it easier to lobby against protectionism, and to capture the interest of politicians. (ii) in certain circumstances, very large economies that can affect world prices through consumption and production decisions can manipulate terms of trade in their favour through tariffs. This leads to “beggar-thy-neighbour” policies.

The second reason is that traditional trade theory applies mainly to measures at the border. Yet trade costs are affected by a plethora of other measures, notably domestic regulation. These non-tariff measures have become more important as traditional barriers have come down, and as cross-border value chains have emerged as the primary drivers of trade. Regulation responds (or it should) to cases of market failure, and good regulation is supported (or should be) by a calculus of the costs and benefits of intervention. Because of this, there is no automatic reason to think that reducing regulation, unlike reducing tariffs or quotas, will necessarily promote the welfare of citizens.

In the remainder of this piece we will consider trade “in the real world” in the light of these two sets of factors that affect trade policy, and see what it means for the UK’s aspirations in trade.

Trade in the real world

A few key points from the history of European trade demonstrate the potency of both sets of political economy arguments referred to in the introduction.

In the seventeenth century England and Holland fought bitter wars over the ambitions of both sides to dominate European trade. Trade was believed in those days to be a zero-sum game: if one side gained an advantage, the other side must perforce suffer a comparable disadvantage.

As part of the process of shoring up the UK’s economy after the Napoleonic Wars, the British Corn Laws imposed high tariffs on grain imports in order to protect the interests of the wealthy landed estates. They thereby impoverished the working population who needed to buy bread.

The Corn Laws caused much misery and were abolished in 1846, but at the end of the nineteenth century the so-called Tariff Reform Movement in the UK once again argued for the imposition of tariffs on goods imported from foreign sources, subject to exemptions or preferences for imports from the British Empire. That movement failed, but in response to the economic slump of the 1930s the UK did follow the United States and other major trading countries in imposing ruinous protective tariffs and other restrictions on international trade (in the UK case, subject again to preferences to protect imports from Empire sources), in the fallacious belief that this would protect and encourage domestic industries and jobs.

In consequence the volume of world trade declined during the 1930s by some 50%, impoverishing producers and populations all round the globe. The role this played in deepening the great depression was an essential reason why J.M. Keynes and others pushed for the creation of an International Trade Organisation, in parallel with the establishment of the World Bank and the International Monetary Fund. This movement gave rise to the creation in 1947 of the General Agreement on Tariffs and Trade (GATT), but was not fully realised until 1995 when the GATT was expanded into the World Trade Organisation.

Nowadays, trade policy makers have to pay regard to domestic sectoral and special interests which have political clout, and which therefore they feel compelled to encourage and protect. Traditionally these have been groups such as farmers, miners, textile producers or steelworkers. These days they extend increasingly to professionals such as teachers, lawyers, financial service providers or IT experts. On the wider policy level, consumers’ and workers’ interests and lobby groups concerned with health, animal welfare, gender and environmental issues exert increasing influence. Governments preparing for trade negotiations have to take this broad range of interests into account.

Negotiations for trade liberalisation are supposed to overcome deep-seated pockets of resistance to free trade by creating a coalition of interests between domestic producers seeking access to markets overseas, on one hand, and consumers and users of imports who benefit from more competition on the domestic market. Between 1948 and 1994 the GATT conducted a series of negotiating “rounds” which successfully reduced the incidence of tariffs and other restrictions on trade, as well as developing agreed disciplines over the different ways in which national governments intervene in trade (read about trade remedies here). In parallel countries also engaged in preferential trade negotiations, as a means of moving faster and further than what was possible on multilateral basis. This movement has been accentuated by the failure of the WTO’s Doha Development Agenda, initiated in 2001, to deliver a comprehensive package of agreements.

The growing technological and political complexity of trade, has meant that the coverage of trade rules has extended well beyond traditional trade measures at the border to measures enforced deep behind the border, addressing matters of regulation, standards, market structure in services, and intellectual property protection.

The emergence among developed economies of global value chains as drivers of trade, and the growing importance of services in national GDP and trade, have placed a premium both on developing efficient regulation and on reducing regulatory fragmentation. Recent work by the OECD suggests for example, that even for countries (such as the UK) that have low levels of restrictions on trade in services, divergences in regulation, and the time and effort required to overcome them, can generate costs equivalent to tariffs of between 20 and 75%.

The interplay between trade rules and domestic policy, notably regulation, means that trade negotiators face the tricky challenge of striking a balance between reducing trade costs and preserving appropriate space to pursue domestically optimal regulation.

International disciplines on regulation and standards

At the international level, such pressures, engendered by growing public awareness of wider social and environmental issues, have led since the end of World War 2 to a proliferation of multilateral bodies, many of which operate under the aegis of the United Nations. These bodies negotiate and supervise internationally accepted standards in matters ranging from human, animal and plant health through labour standards, product standards and education and accountancy standards, to vehicle safety and telecommunications.

To take one example, The UN Economic Commission for Europe’s World Forum for the Harmonisation of Vehicle Regulations sounds as unglamorous as its title is unwieldy. Yet its work covers such detailed and essential issues as vehicle noise, and standards for brakes and running gear. It attempts to harmonise regulatory approaches to these in a bid to reduce trade barriers.

There is lively internal debate within these bodies and among their constituent governments about what their remits should be and about the standards which they devise and oversee, but no-one now seriously argues that such controls should not exist.

The central point is that even in a world without tariffs and other direct barriers to trade, the costs of trade would be affected by a slew of regulatory measures. A tariff may make a product harder to sell in a particular market because it increases the price; a health standard or performance requirement with complex technical requirements that impose high compliance costs may make it impossible to sell at all.

From a trade negotiation perspective, the challenge is to take regulatory issues that have evolved with national public goods in mind and translate them into frameworks that seek to reduce trade costs by reducing the costs to business of complying with these regulations while not jeopardising the overall public benefits which the regulations seek to deliver.

“Free” trade in the modern world – or rather, “open” trade

So what, in this context, can we actually mean when we talk about “free trade”? And given that the UK has positioned itself as a “champion of free trade” post-Brexit, what in practice does that mean for the direction of UK trade policy?

This present-day mass of regulation, whether directly or indirectly impinging on trade, reflects very specific aims and priorities of national and international populations. It is not going to go away. In this context totally “free” trade – shorn of any domestic policy intervention – is neither possible nor is it desirable.

The key issue therefore is to keep trade moving, to agree internationally on procedures which will facilitate and enhance economic exchange between nations, and to prohibit or discourage restrictive or discriminatory trade policies, while at the same time recognising the need to promote concerns for the public good. The system to which all these controls contribute must be clear; transparent; open on a fair and equal basis to all participants in international trade, whether developed or developing countries; and accepted and fairly administered by democratic governments and institutions. In each case governments and international regulatory bodies must devise and administer rules that are proportionate to the needs that are to be met. This international trade structure is anything but “free” in the simple sense of the word, but it aims to be as accessible and fair as possible to all who participate in it.

It is therefore preferable (and much more accurate) to talk about the “open” international trading system, rather than about “free” trade. Openness in this context means the ready, fair and equal access of all trading partners to a system based on agreed and accepted standards and rules – in effect, on the much-invoked “level playing field”.

How does this context affect UK ambitions, in the wake of Brexit, to negotiate new bilateral trade agreements on a worldwide basis?

One of the major arguments advanced in support of Brexit is that it will liberate the United Kingdom, once outside the European Union, to pursue its own vision and objective of promoting a world in which trade takes place freely, with a minimum of intervention by national governments. British ministers present the UK as a world leader in the policy and process of freeing up trade and aim to negotiate a structure of new bilateral trade agreements with individual countries.

In fact, most of the countries targeted by this national UK policy already have, or are negotiating for, some form of free or preferential trade agreements with the European Union, in which the UK participates, and from which it benefits, as an EU member state. The UK Government’s case is that it will be able to negotiate more favourable bilateral trade agreements on its own than as part of a customs union and a single market of half a billion people.

That remains to be seen. The aim in every such case will be to reduce barriers and to facilitate the flow of trade between the parties according to agreed standards and procedures. But prospective partners will have their own approaches to regulation, and moreover, if faced with a choice when it comes to aligning these regulations with foreign partners, are likely to choose to align them with larger partners as this may be more favourable to the development and operation of cross-border value chains. Thus for the UK, the challenge will be to avoid buying into superficial rhetoric about “cutting the shackles” and “getting rid of red tape”, and to think more closely about what good regulation looks like, and how to translate that into agreements that really do free up trade.