Classical Champion of Free Trade

Photo: The Bettmann Archive.

David Ricardo is one of history's most influential economists. Born in England, Ricardo made a fortune on the London Stock Exchange. This wealth gave him the time to write and to serve in Parliament's House of Commons. His most famous work. Principles of Political Economy and Taxation (1817), marked him as the greatest spokesman for classical eco­nomics since Adam Smith.

Ricardo is especially famous in international economics for demonstrating the advantages of free trade.Free tradeis a policy in which tariffs and other barriers to trade between nations are removed. To prove his point, Ricardo developed a concept we now call the principle of compara­tive advantage. Comparative advantage enabled him to demonstrate that one nation might profitably import goods from another even though the importing country could produce that item for less than the exporter.

Ricardo's explanation of comparative advantage went as follows:

Portugal and England, both of whom produce wine and cloth, are considering the advantages of exchanging those products with one another.

Let's assume that:

· x barrels of wine are equal to (and therefore trade evenly for) y yards of cloth.

· In Portugal 80 workers can produce x barrels of wine in a year. It takes 120 English workers to produce that many barrels.

· 90 Portuguese workers can produce y yards of cloth in a year. It takes 100 English workers to produce y yards of cloth.

We can see, Ricardo continued, that even though Portugal can produce both wine and cloth more effi­ciently than England, it pays them to specialize in the production of wine and import English cloth. This is so because by trading with England, Portugal can obtain as much cloth for 80 worker-years as it would take 90 worker-years to produce themselves.

England will also benefit. By specializing in cloth, it will be able to obtain wine in exchange for 100 worker-years of labor rather than 120.

As a member of Parliament, Ricardo pressed the govern­ment to abandon its traditional policy of protection. Though he did not live to achieve that goal, his efforts bore fruit in the 1840's when England became the first industrial power to adopt a policy of free trade. There followed 70 years of economic growth during which the nation became the world's wealthiest industrial power.

The Barriers To International Trade

Despite the many advantages of trade between nations, most countries, including our own, often restrict that trade in a number of ways. Some of these ways are discussed below.

Tariffs. A tariff is a duty, or tax, on imports. There are two basic types of tariffs.Revenue Tariffs are levied as a way to raise money. Through most of its history (until 1910), the United States looked to the revenue tariff as its principal source of income.Protective Tariffs are levied to protect a domestic industry from foreign competition. The goal is to make the foreign product more expensive than a similar item produced m the United States. Then people will stop buying the foreign-made item and purchase its domestic counterpart.

Quotas. Restrictions on the numbers of certain specified goods that can enter the country from abroad are calledquotas. Like protective tariffs, quotas limit the amount of foreign competition a protected industry will have to face. In the 1980's, for example, the government protected the U.S. automobile industry by placing a quota on the number of automobiles that could be imported from Japan.

Other Tactics. There are a number of other devices that directly affect the free flow of trade among nations. One of these is theexport subsidy —a payment by a country to its exporters that enables them to sell their products abroad at a lower price ran they could sell them for at home. Selling the same product for a lower price abroad than at home is calleddumping.

Still another tactic that has been used to restrict foreign trade can be classified as "administrative red tape." This is the deliberate use of governmental rules and regulations to make it difficult to import goods from abroad.

Why Nations Restrict International Trade

The effect of tariffs, quotas, and other trade restrictions is to make imported goods and services more costly and therefore less available than they would be otherwise. With fewer goods and services to go around, living standards are reduced for many people. What arguments, then, could be used to impose restrictions on foreign trade?

Protect Industries That are Essential to the Nation's Defense. Certain industries are vital to the nation's security. If they were taken over by foreign competitors, they might not be available in time of war. For example, the United States subsidizes its merchant marine. Without those subsidies, shippers would use only foreign ships to transport their merchandise, and the American merchant fleet would go out of business. But shipping, it is argued, would be vital to our armed forces in time of war, and for that reason it is in the nation's interest to protect the merchant marine.

To Protect "Infant Industries." Nations that are beginning to industrialize often impose tariffs and create other trade restrictions to protect their "infant industries." The belief is that once the industry has had an opportunity to grow, it will be able to compete with its foreign counterpart, and the restric­tions can be lifted. In 1791 Alexander Hamilton used this argu­ment to support protective tariffs for America's new industries. Without that protection American manufacturers might not have been able to compete with the more efficient factories of Western Europe.

To Diversify the Economy. This argument is similar to the "infant industry" argument. The economies of certain nations, particularly less-developed countries (LDC's), depend almost entirely on single crops or products. When a nation leans heavily on a single product, however, there is always the danger that a crop failure or a fall in price will bankrupt the nation. To prevent such a catastrophe some argue that the government should actively support (with tariffs and subsidies) the crea­tion of new industries to diversify its economy.

To Protect Us From the Competition of "Cheap Foreign Labor." This may be the most frequently heard argument in favor of protection in this country. Certain foreign countries, it is said, are able to undersell American goods in the United States because their workers are paid much less than American workers. As a result, American workers would either have to accept lower wages or lose their jobs to this unfair competi­tion. It is up to the government, therefore, to protect American workers by placing restrictions on the goods produced by "cheap foreign labor."

Reading for Enrichment

The Tariff Issue In American History

Should the United States impose a tax on foreign goods sold in this country? If so, at what level should import duties be set? These questions have generated much disagreement throughout the course of American history. Controversy over tariffs emerged at the Constitutional Convention in Philadelphia in 1787. Representatives from Northern and Middle states supported the idea of a tax on foreign products sold in the United States. Manufac­turers knew that a high tariff would raise the price of imported goods and force consumers to buy American goods instead. People in the nonindustrial South opposed a tax on imports, since they did not want to pay higher prices for goods. The North and South reached a compromise over tariffs at the Convention, but the issue was not permanently resolved.

The controversy flared again in 1828 when Congress passed a very high protective tariff. Southern leaders denounced the higher tax on imports as a "Tariff of Abominations." The dispute almost led to a civil war when South Carolina declared it would not adhere to the new law. Some Carolinians spoke of seceding from the Union. President Andrew Jackson was not willing to tolerate such defiance and was prepared to use troops to enforce federal law in South Carolina. The crisis ended without bloodshed when both sides accepted a new tariff which gradually decreased rates.

Congress approved high tariffs during the Civil War in order to protect American industry. Duties on imported goods rose even higher in 1890 with the McKinley Tariff, which effectively eliminated foreign competition. Progressives denounced those rates because they forced consumers to pay higher prices for manufactured goods. The Payne-Aldrich Tariff of 1909 lowered rates some­what, but the tax on most imported goods remained high.

Woodrow Wilson called for lower tariff when he was elected President in 1912. Wilson believed that by eliminating foreign competition, high tariffs created monopolies in the United States. Congress responded with the Underwood Tariff, the first real reduction in rates since the Civil War. But import duties rose again after World War I. Americans were isolationist-minded in the 1920's, and a return to protectionism met with little opposition. The Hawley-Smoot Act of 1930 introduced the highest tariff in American history. Indeed,

the rates were so high that some economists today cite Hawley-Smoot as a cause of the Great Depression. If it was not a root cause, it certainly made the depres­sion worse. For example, the increased duties prevented foreign countries from selling their goods in American markets. With their principal source of dollars cut off, those nations were unable to repay the money they had borrowed from Uncle Sam to fight the war. For their part, the nations of the world retaliated by raising their tariffs, thereby hurting American trade.

President Franklin D. Roosevelt tried to remedy the situ­ation by offering to reduce rates to any country that was willing to reciprocate. The Trade Agreement Act (or Reciprocal Trade Act) of 1934 contained a "most favored nation" clause, which offered any country the oppor­tunity to receive "most favored" treatment in any tariff agreement if it did the same for the United States. This legislation reduced import duties and greatly increased American trade with specific countries.

The trend toward reduced rates continued when Congress passed the Trade Expansion Act of 1962, giving the President greater power to lower import duties. This was accomplished in a series of negotia­tion rounds attended by the major industrial powers. During the Kennedy Round. (1963-67) tariffs were reduced to an average of 6.5 percent. These were further reduced at the Tokyo Round (1973-79) to 4.4 percent.

Protectionism, however, remains a sensitive issue. Foreign competition, particularly in the steel and automobile industries, has created some economic hard­ship in the United States. Manufacturers and workers in affected industries argue that it is necessary to restrict foreign competition. They feel that without such protec­tion, their products will be undersold, and they will be forced to go out of business.

Those opposed to protectionism argue that as a result of the barriers, consumers must now pay more for automobiles and many other products. They also say that with less foreign competition to worry about, automobile and steel manufacturers are less inclined to improve productivity and the quality of their products.

Why Do Exchange Rates Change?

By 1971 so many dollars were held by foreigners that it was no longer possible for the United States to guarantee to redeem them in gold. At that point President Nixon announced that the dollar was no longer "convertible" into gold, and that its value would be determined by the laws of supply and demand. What the President had in mind was a system in which exchange rates would be determined in foreign exchange markets. A foreign exchange market is simply a place where foreign curren­cies are bought and sold.

If, for example, you were to take a trip to Mexico, you might choose to exchange some of your dollars for pesos at your local bank, or a currency exchange at the airport. Both those facili­ties are part of the foreign exchange market.

Following the United States' lead, most nations around the globe abandoned the old system in favor of what came to be called "flexible exchange rates." That is, they allowed the value of their currencies to be determined by the laws of supply and demand in foreign exchange markets rather than government agencies.

Exchange rates are flexible over time. Thus, the Mexican peso depreciated against the dollar. In 1975 a peso was worth 8 cents; in 1989 it was worth .0004 cents. To put it another way, in 1975 one dollar would buy 12.5 pesos; in 1989 one dollar bought 2,500 pesos. By contrast, the Swiss franc appreciated against the dollar, rising from a value of 23 cents in 1965 to a high of 64 cents in 1987.

The reason currencies fluctuate in value has to do with the laws of supply and demand. The demand for a nation's currency is usually a result of the demand for its goods and services. If people in the United States are buying an increasing number of goods and services from Canada, they will need additional Canadian dollars. This will tend to push up the price of the Canadian currency. Similarly, if people in the United States want fewer Austrian goods and services, the decreasing demand for the Austrian schilling will reduce the price of that currency.

The supply of foreign exchange increases and decreases as the citizens of a country use their currency to purchase curren­cies of the countries from which they wish to make purchases. For example, French importers seeking to buy U.S. goods will have to sell their francs in the foreign exchange markets to buy the dollars needed for the U.S. goods.

If, as a result of France's increased imports, the supply of francs in the foreign exchange markets is increased, the franc will tend to depreciate in value. When the opposite happens and the supply of French money in the markets declines, the franc will appreciate in value.

Exchange Rates Affect Us All. When the dollar appreciates against foreign currencies, U.S. importers, tourists, and anyone else in need of foreign currency will be able to buy more of it with their dollars. Consumers in this country will find that foreign-made goods are cheaper than they once were. U.S. exports, however, are likely to fall because the appreciation of the dollar against other currencies will make American goods more expensive to foreigners.

When the dollar depreciates against foreign currencies, just the opposite is likely to happen. Exports of U.S. goods will increase because foreigners will be able to buy more dollars with their currencies. At the same time, foreign-made imports will become more costly, and people in the United States will buy fewer of them.

Summary

Trade among nations takes place for the same reasons that it does within a nation: to obtain goods and services that a region could not produce itself, or to obtain them at a lower cost than they could be produced for at home. This is explained by the principle of comparative advantage, which states that as long as the opportunity costs to produce items differ between two nations, both will profit by specializing in those things that they produce most efficiently and exchanging their surpluses.

Despite the advantage of international trade, most nations have erected artificial barriers to that trade. These barriers are usually in the form of tariffs or quotas.

Imports must be paid for in a currency that is acceptable to the seller. In order to facilitate these transactions, there is a market for the currencies of all trading nations. The selling price of one nation’s currency in terms of the currencies of other nations is known as its "exchange rate." Exchange rates fluctuate in accordance with the laws of supply and demand.

When the value of a nation's currency is decreasing in terms of other currencies, its exports are likely to increase because they will be less expensive to people in foreign countries. Imports, in these circumstances, are likely to decrease because foreign goods will become more expensive. When a nation's currency is appreciating in terms of other currencies, the opposite is likely to occur.

The balance of payments summarizes the transactions that have taken place in international trade over a given period of time, usually one year. Economists look to the balance of payments for clues to future trends in the value of a nation's currency and other consequences of its foreign trade.