Primer on Trade

Primer on Trade

If you follow the money, trade generates economic efficiencies, driving down prices, benefiting consumers

and increasing real wages.

By Mark Brandly

In the broad sense, international trade is any commerce that occurs across political borders. Any trade between people in different countries is international trade.

Balance of payments: The balance of paymentsis the government's attempt to measure all international trade activity. The major accounts in the balance of payments are exports, imports, capital inflows and capital outflows. Exports and imports are goods and services sold to and purchased from foreign interests, respectively. It's important to remember that generally these goods and services are exchanged for currency. When exported and imported goods cross a political border in one direction, currency crosses the border in another direction.

Capital flows: In addition to exports and imports, much of the trade in the world involves situations where no assets leave or enter a country. These exchanges are called capital flows. Capital inflows occur when foreign interests acquire assets in this country. Examples include the purchase of stocks, bonds, real estate and businesses. Most capital inflows can be thought of as investments, individuals from one country are investing in another country. Conversely, capital outflows occur when domestic interests acquire assets in another country. Just as one country's imports are another country's exports, a capital inflow for one country is another country's capital outflow.

Trade surplus, deficit: When the dollar value of a country's imports exceeds the dollar value of its exports, the country has a trade deficit. If the country is exporting more than it imports, it has a trade surplus. A trade deficit implies that due to the trade of goods and services, more currency is flowing out of the country than into the country. This net currency outflow is generally associated with a net capital inflow. Similarly, a trade surplus is associated with a net capital outflow.

Free trade: If a government allows its citizens to engage in these commercial transactions without any restriction of any kind, this is free trade.

Protection: Protection is any policy that restricts trade to protect a domestic industry from foreign competition. Protectionist policies include tariffs (taxes on imports), quotas (limits on the quantity of imports) and non-tariff trade barriers, such as mandates on the quality or the content of imported goods. Protection increases the price of imported goods, reducing the amount of imports, thus protecting some domestic industry from foreign competition. A tariff on imported trinkets, for example, raises the price of imported trinkets making it easier for the domestic trinket industry to gain market share.

It's important to note that consumers are the main beneficiaries of trade and the main victims of protection. Trade drives down prices allowing consumers to buy more goods and protection increases prices.

Pro and Contra Trade

Now consider the cases for and against trade. The classic argument that provides us with the primary economic justification for free trade is called the law of comparative advantage. According to this argument, a country will profit by specializing in the production of goods in which it has a comparative advantage and trading for goods in which it does not have a comparative advantage. Free trade will result in a better use of a country's resources.

Under free trade, a country will use its resources more efficiently. It will increase the goods available for consumption and production. It will tend to specialize by producing goods that it can produce using fewer resources than its trading partners. This specialization generates the benefits of trade.

A key to understanding this law is realizing that there are two ways for a country to acquire a good. The country can produce the good, cars for example, directly by using its own resources, or it can produce a different good, say wheat, export the wheat and in return receive imported cars. Foreign trade is simply a way of producing cars by using domestic resources to produce wheat and then trade converts the wheat into cars.

The point is that trade allows the country to use its resources more efficiently. Free trade leads to greater wealth and prosperity. Trade restrictions waste resources.

What's not to understand?

Given the airtight case for free trade, the question arises: Why do governments intervene in international trade? Why do governments restrict international commerce? If free trade is in the public interest and protection is detrimental to the economy, why is there so much protection?

One answer is that government officials often tendto enact policies that have concentrated benefits for special interests and disperse the costs of the policies around to a large part of the population. Policies that are harmful to the country overall often generate votes and monetary contributions to political candidates. So while this doesn't makes sense from the point of view of the country overall, government officials have an incentive to enact destructive policies.In the case of protection, the costs are dispersed to consumers in general in the form of higher prices, but generate political support from the protected industry.

Cheap Labor?

Another argument for protection is cheap foreign labor. Here, the case is made that trade with countries with cheap labor will decrease domestic wages and jobs will be lost to these countries. Protection will increase the price of imports, preventing this loss of jobs and propping up domestic wages.

The problem with this argument is that it ignores which industries suffer from trade. Yes, under free trade, jobs will be lost in certain industries, industries where the country is at a competitive disadvantage. However, jobs will be gained in industries where the country has a comparative advantage.

Under free trade, workers tend to be in jobs where they have a comparative advantage. Marginal productivity increases. Wages increase. Therefore, workers, as a whole, have higher wages under free trade than they do with protectionist policies.

Also, the real value of workers' wage rates is determined by the prices of the goods the workers want to consume. Protection increases consumer prices, reducing real wages. Free trade keeps prices low, increasing real wage rates. Workers, as consumers, are the beneficiaries of free trade.

The trade deficit

Another pro-protectionist argument is the anti-trade deficit argument. Eliminating a trade deficit would imply either increasing exports or decreasing imports. This would either benefit exporting industries or it would benefit the domestic competitors of foreign imports. In both cases, wages would tend to increase in these domestic industries. So, trade deficits are economically harmful, and protection that is used to eliminate a trade deficit benefits the country overall.

To see the fallacy in this argument, follow the money. A trade deficit implies that more currency is flowing out of the country to pay for imports than is entering the country as payment for exports. This implies one of two situations. Either this currency stays out of the country or it flows back into the country in terms of capital inflows. In the former case, dollars are flowing out of the country and are being held by foreign interests. Foreign agents are trading goods and services that required valuable resources to produce in return for dollars that cost little, in terms of resources, to produce. Not only are such exchanges profitable, the currency outflow reduces the amount of currency within the domestic country, benefiting consumers by reducing prices within the country.

In the latter case, the trade deficit is associated with a net capital inflow. The currency outflow due to the trade deficit is offset by a currency inflow as foreign interests acquire assets within the country. These capital inflows tend to be investments. Foreign interests increase capital formation, they buy bonds and stocks, they build businesses, they create jobs and drive up wages, and they put their money in banks, reducing interest rates.

A country that attracts foreign investment, in other words a country with a healthy economy, will tend to have a net capital inflow and this will be associated with a trade deficit. There is every reason to see the benefits of such a situation. Both the acquisition of imports and the foreign investment are good for the country. Trade deficits do not justify protectionist policies.

In short, the case for free trade is unassailable, and the arguments for trade restrictions are flawed. Trade restrictions harm consumers and efficient firms at the expense of less competent firms. Trade generates economic efficiencies, driving down prices, benefiting consumers, and increasing real wages.

Mark Brandly teaches economics at Patrick Henry College.