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Trade agreements: Theory and reality

LiveMint logoLiveMint 25-07-2017 Ajit Ranade

Ever since the days of David Ricardo in the early 19th century, it has been established, and remains unquestioned to date, that free trade is a win-win for everybody. The key word is “free”, meaning without coercion, fully voluntary. Ricardo’s clever insight was that trade between nations could be mutually beneficial, even if one nation was more efficient than the other in all commodities. This was his theory of comparative advantage. Most economists swear by this maxim. The simplest illustration is this: a lawyer may be a faster typist than her assistant, but her time should be spent in legal stuff, not in typing, which should be left to the assistant. The lawyer thus specializes in law, not in typing.

Countries specialize in goods and services in which they have a comparative advantage, and then free trade benefits everyone. It is not possible for one country to be unambiguously worse off due to free trade. But theory has clashed with reality, or its perception. Hence, in response to murmurs of disquiet, the free trade message was slightly modified thus. Sure, free trade might hurt some people, but it’s worth it, because in the end everyone is a winner. There are losers and winners, but the net gain to society is positive. The winners can compensate the losers and yet be ahead. The loss of American jobs is more than offset by getting cheap imported stuff at Walmart, which comes from low-wage countries. Unskilled workers in America may lose their jobs to low-cost labour overseas, but they can be redeployed in other sectors, in higher value-adding activity. All good in theory, and immensely seductive logic.

But in reality, the evidence is mixed. For instance, the North American Free Trade Agreement, that came into force in 1994, was supposed to create 200,000 new jobs due to exports to Mexico. But by 2010, the increased trade deficit with Mexico had eliminated close to 700,000 jobs, with job losses in every state. The US-Korea free trade agreement signed in 2010 was supposed to increase American exports, and jobs. But three years later the trade deficit had widened, US exports to Korea had fallen, and of course jobs were lost as well. Globalization, outsourcing, the rise of India and China and competition with low-cost labour have all been variously blamed for the stagnation in wages and productivity in the US. The economy grew steadily by 2% for many years, but median family incomes stagnated. No wonder public support for free trade is dipping. President Barack Obama fought an ultimately losing battle for a mega free trade pact with 12 countries, of which the US would have been the anchor. His successor Donald Trump has scrapped that pact. The rising protectionist sentiment under Trump is not surprising, considering the mixed evidence of gains from earlier free trade agreements. The US, which was traditionally the champion for free trade across the world, has ceded that position to a most unlikely new advocate, China.

India’s embrace of free trade became most visible with its aggressive trade liberalization since 1991. Not to forget, however, that India had been a founder member, since 1947, of Gatt (General Agreement on Tariffs and Trade), which eventually morphed into the World Trade Organization in 1995. India’s trade-to-GDP (gross domestic product) ratio climbed steeply from around 10% in the early 1990s to 50% now. India has always supported a multilateral approach to liberalizing trade. But the endless delay of the Doha round has led to India flirting with bilateral and regional free trade agreements (FTAs and RTAs). We are in the midst of the 19th round of negotiations seeking to seal the 16-nation Regional Comprehensive Economic Cooperation (RCEP) agreement. This is basically an RTA between Asean (Association of Southeast Asian Nations) plus six, accounting for half the world’s population and 30% of world’s GDP.

It is here that reality must confront theory, yet again. Here are four stylized facts. Firstly, in the last 10 years, India’s exports to non-RTA countries have grown at the same rate as RTA ones. So tariff elimination is not adding any fillip. Secondly, reduction in tariffs in RTAs doesn’t increase exports, as much as increase in incomes in destination countries. Thirdly, less than one-fifth of all exporters actually use the RTA route. Maybe they are deterred by the paperwork, procedures or corruption in the “stamping bureaucracy”. Fourthly, and most tellingly, India’s trade deficit with all the 10 Asean nations, Korea and Japan has more than doubled since the signing of the respective FTAs. So what has India gained in reality? Have jobs grown? Has manufacturing in India benefited? If anything, there is ample evidence of foreign manufactured goods rushing in through the FTA route. In services, where India hoped to gain, there’s not much to show.

In 2004, Paul Samuelson, the pre-eminent economist of the 20th century, cautioned that free trade can in fact leave workers worse off for long periods. He showed that through a simple analytical model. He especially pointed out the rise of India and China as a threat to American workers. The free trade fundamentalists pooh-poohed this, and said the old man had lost his marbles. But the old man’s caution has gained widespread support.

Most governments worry about job creation, not just growth in exports, when they sign up for free trade. Hence strategic policies like non-tariff barriers, local preference in public procurement are some examples of the sand in the wheels of global free trade. Thus, models and reality have to find a middle ground when it comes to free trade. India would do well to keep this in mind in its RCEP negotiations.

Ajit Ranade is chief economist at Aditya Birla Group.

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