10 Ways Free Trade Can Drive Prosperity

Over the past few months we have been doing some in-depth thinking about free trade agreements. Our fundamental belief is that trade between different countries increases people’s prosperity. However, certain basic conditions have to be met in order for free trade to actually lead to an improvement in people’s living conditions.

Our basic hypothesis: Free trade increases prosperity

Collaborative production processes have the advantage of enabling every producer to concentrate on the production of those goods and services that provide him with the greatest productivity benefits. By taking part in the collaborative process, all stakeholders can increase the number of goods and services available to them and thereby increase their material prosperity. This principle is also valid for collaboration between economies. An intensification of international trade therefore serves to increase the material prosperity of the participating countries.

Providing people with a high supply of goods and services, as well as, a high level of material living conditions are prerequisites for a high standard of living and for ensuring that every person is able to lead an independent life and participate fully in society within the context of his own personal freedom. The promotion of free trade between nations is to be welcomed because free trade positively affects economic growth, the fight against poverty and the opportunities available to people to participate in society.

Requirement #1: The removal of discriminatory trade restrictions

A key element underlying an intensification of international trade is the removal of barriers to the import of goods and services, when their sole purpose is to protect domestic suppliers. Such trade restrictions are termed discriminatory restrictions. A non-discriminatory trade restriction exists when, for example, both domestic and foreign firms are forbidden to sell meat treated with hormones. These trade barriers serve to protect domestic consumers from products that are harmful to health. In this case imports from abroad are not treated any differently to products offered on the domestic market, so there is no question of any discriminatory behavior. If, however, foreign firms are required to fulfill conditions that are not required of domestic providers, then this is classed as a discriminatory trade restriction.

The removal of discriminatory trade restrictions by no means implies that all requirements that are linked to the admissibility of an import can be eliminated in the context of a free trade agreement. If, for example, it is not guaranteed that medication imported from abroad has no harmful side effects, for reasons of consumer protection it is required that the exporter proves the quality of these products.

Requirement #2: Market transparency

Market transparency is an absolute prerequisite for the effective functioning of markets and at the same time also for a functioning free trade system. Only when consumers have information about all the advantages and disadvantages of a given product they can make the consumer decisions that best meet their needs. Hence the removal of trade restrictions in international trade must not result in a waiving of product specifications, which are necessary for consumers to make an optimal decision. The compulsory labeling of products giving information about those product properties which consumers might not immediately be aware of, should therefore be retained in the framework of free international trade as well.

Requirement #3: All participants in the market need to have the same level of information

A further prerequisite for the effective functioning of markets is that all the stakeholders involved have the same level of information about the quality of the products being traded. Inefficiencies in the markets occur as soon as there are any differences in information levels. Examples of this are insider trading in the sphere of financial markets, or the sale of a defective product to a consumer who is not aware of the defect and therefore pays too high a price for it. A functioning free trade system therefore requires the elimination of information asymmetries. If the description of certain properties on a product is necessary, then the relevant compulsory product labeling, such as technical descriptions for example, must be retained.

Requirement #4: Internalization of negative external effects

Negative external effects are present when the private costs of an economic decision are lower than the overall social costs of this decision. Self-interested economic parties only consider the private costs. As soon as the overall social costs are greater than the private ones this systematically leads to a market failure, because when a part of the total costs that are incurred are passed on to society as a whole, a self-interested individual will choose too great a level of activity. A standard example of this is a factory polluting a river. The private costs for the factory owner are low, the social costs however are high as for example fishermen can no longer fish in the river.

For international cooperation this means that free trade only leads to an improvement in the overall prosperity of society as a whole if consumers and producers bear all the costs related to international trade. A free trade system that improves prosperity therefore requires that all the stakeholders are held liable for their decisions and accept responsibility for all the consequences of those decisions. If the implementation of the principle of liability requires state interventions (e.g. taxes to increase the cost of CO₂ emissions), these interventions must not be seen as discriminatory trade restrictions.

Requirement #5: Free trade must take account of market boundaries

Alongside the negative external effects, there are also positive external effects. These occur when the private value of an economic decision is lower than its overall social value. Typical examples are education and culture, environmental protection and many healthcare services. Self-interested economic parties only take private advantages into account when making a decision, and therefore choose a level of activity that is too low when measured against the overall social advantages, because they bear the full costs of the decision but receive no monetary return for the benefits that other members of society accrue.

This type of market failure also requires state intervention that manifests itself particularly in the form of financial support by the state for relevant activities. Ideally in this situation the state should cover those costs that correspond to the level of the additional overall social advantages. Subsidies that support the internalization of positive external effects should therefore not be seen as a competition-distorting preference for domestic producers.

Requirement #6: Fair distribution of increases in income between the participating countries

The intensification of international free trade leads to a general growth in income. The distribution of these income gains between the countries concerned does not automatically mean, however, that there is an increase in material prosperity in every single country. It is conceivable that the increase in the exports of a country could lead to a reduction in prosperity. If in the wake of an intensification of international trade a country increases its exports, this increases the supply of goods on the world market. A greater supply of goods leads to a lowering of the world market price for the respective product. If there is a sufficiently steep drop in prices, this can lead to reduction in the export revenues despite the greater volume of exports, which in turn reduces the income at the disposal of the export country and thereby also lowers the standard of living in that country. This phenomenon is called “immiserizing growth”. This happens particularly in less developed economies that only export raw materials but not products that have undergone further processing.

In order to prevent the promotion of international trade from resulting in this negative effect, it would be helpful if, for example, all industrialized countries opened their markets for further processed products from developing countries without demanding that the developing countries do the same in return (because developing countries as a rule cannot compete on a level playing field with industrialized countries). In addition industrialized countries ought to reduce and even abolish their subsidies for traded agricultural products, so as to avoid the competition distortion in relation to those developing countries that are strongly dependent on agriculture.

Requirement #7: Fair distribution of increases in income within the participating countries

The abolition of trade restrictions for those sectors of industry that have been protected from competition from abroad by such trade barriers often results in sales losses and reductions in employment. In cases where a high level of protection exists, the immediate abolition of the trade barriers associated with it would result in serious disadvantages for the protected sectors and the people employed in them. To lessen the negative social effects linked to employee redundancy, one solution would be to gradually abolish non-tariff trade barriers over a longer period of time, in order to give strongly-protected sectors time to adjust to the new situation. Just as necessary are accompanying employment policy measures such as further and continuing vocational training measures, as well as transfer benefits to people who have lost their jobs. The underlying principle here is to compensate the disadvantages of those who have been disadvantaged by the abolition of trade barriers – a task of the tax-transfer system.

Requirement #8: Compensation for the loss of income in third countries

If free trade increases the material prosperity of the participating countries, the best solution would be a free trade system that operates worldwide. It is true that because negotiations for multilateral free trade have faltered, states are increasingly switching to bilateral or regional free trade agreements. However, such agreements only represent a second-best solution because they have negative effects for those economies that are not participants in the agreement. The intensification of free trade between two regions has the effect of increasing trade activity between these economies. This in turn means that that there is less need for these economies to import from other countries. For third countries this results in sales losses and a reduction in employment.

Particularly in less developed countries, which, as a rule, either do not have social security systems or have systems which only provide a low level of protection, this can lead to considerable social tensions. In this case a top priority to ensure fairness should be that those countries that profit from the intensification of free trade should contribute to the adaptation costs of those third countries that are negatively affected. Ultimately this compensation is also in the best interests of the countries that profit from a stronger free trade. For if there are negative effects for third countries as a result of the intensification of free trade, there is a danger that criticism of free trade could increase in these countries. This criticism could, amongst other things, find its expression in national isolationist tendencies (protectionism). This could threaten international cooperation and thereby affect the prosperity of all nations – but above all the prosperity of those countries that have a particularly high dependency on exports.

Requirement #9: Free trade must not be a “race to the bottom”

An intensification of international trade increases the pressure of worldwide competition. Companies must therefore constantly try to lower their production costs. Ideally they would do this by means of technological innovations, which would increase productivity and reduce production costs. If cost reduction cannot be achieved in this way, however, there is a danger of costs being reduced by, for example, increasing the actual number of working hours, as well as an intensification of the production processes. Further strategies to reduce costs include passing on those costs to the public as a whole – for example in the form of increasing environmental pollution.

To prevent a so-called “race to the bottom” it is necessary to have social and working standards that operate worldwide and ensure that individual countries do not mutually undercut each other in order to gain local advantages. This is relevant, for example, in relation to working time regulations, the ban on forced and child labor, health in the workplace, and environmental regulations. These protective rights must not be relinquished within the context of an intensification of worldwide trade. If it is politically impossible to implement protective standards worldwide, at least the developed industrialized nations should set a good example here and establish relevant protective rights.

Requirement #10: Participation in free trade presupposes corresponding production capacity

Participation in international trade presupposes that individual countries have the necessary production capacity for this. Alongside machines and buildings, this also refers to an appropriately qualified workforce, access to technologies, a public infrastructure as well as the possibility to finance all the investments linked to it, which means access to affordable credit. So that all countries can profit from the advantages of free trade, the developed industrialized nations are duty bound to offer their support. The economic advantages that they have gained from the free trade system to date also allow them to do this.

Summary

Overall, free trade between nations is fundamentally to be welcomed. The abolition of non-tariff trade restrictions however should not be equated with the demand to get rid of all the regulations that govern the production and trade of goods and services. Only when these regulations have the express aim of protecting domestic producers from competition from abroad should such regulations be considered as unnecessary and therefore as trade restrictions that should be abolished. To the extent, however, that these regulations are necessary for consumer protection, for employee protection, for environmental and climate protection, as well as in supporting the protection of privacy or the effective functioning of the markets (for example, the internalization of negative and positive external effects), then they are not an unnecessary trade restriction and should therefore be retained.