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Protectionists Refuted

Free Trade Benefits Developing Countries

Singapore city skyline. Photo: Wikipedia.

In a recent book, Professor Arvind Panagariya of Columbia presents a convincing case that free trade benefits developing nations. He refutes protectionists like Robert Wade and Ha-Joon Chang...

Ever since Adam Smith refuted protectionism in The Wealth of Nations, free trade has enjoyed wide support. His argument was persuasive: if it is cheaper to grow corn in Poland than in Portugal and also cheaper to grow wine in Portugal than in Poland, then the inhabitants of both countries benefit from trade between them. David Ricardo added to Smith’s argument the equally compelling idea of comparative advantage: even if the Czechs produce shirts more cheaply than the Indians, it benefits both nations that the Czechs produce something they know better than others how to make, for example exquisite glassware, and let the Indians produce the shirts. Everybody has something valuable to sell, also those who have nothing to provide but cheap labour. The reconstruction of the West after World War II included the return to free trade, vigorously promoted by leading economists such as Wilhelm Röpke in Germany, Luigi Einaudi in Italy and Gottfried von Haberler in various international associations. As David Rockefeller wrote in his memoirs Haberler had ‘a reputation as a staunch defender of free trade. His ideas were ignored in the 1930s when nations around the world gave in to the siren song of protectionism, but they would have a great impact after World War II when international trade expanded and world economic growth surged dramatically’.

The Asian Tigers: Against the Consensus

However, free trade became the exception rather than the rule in the developing countries many of which gained independence after World War II. The academic consensus, with only a few exceptions (like my old friend Lord Peter Bauer), was that the nascent industries in those countries had to be protected by high tariffs. But in the 1960s and 1970s three countries in Southeast Asia, Singapore, Taiwan, and South Korea, broke with the consensus and replaced import substitution by export promotion through free trade, while a fourth country in the region, Hong Kong, had maintained a free and open economy all the time. On the basis of their subsequent economic success, these countries were named the ‘Four Asian Tigers’. The consensus changed, and many other countries joined in rejecting the policy of import substitution, most spectacularly Chile in the 1970s, China in the 1980s and India in the 1990s. But the protectionism refuted by Adam Smith more than two centuries ago still has its academic adherents, of whom economist Ha-Joon Chang of Cambridge University and political scientist Robert Wade of the LSE are perhaps the most vocal. Recently, Professor Arvind Panagariya of Columbia University, an influential adviser to the Indian government during liberalisation, published Free Trade and Prosperity, a spirited restatement of the argument for free trade with special reference to developing countries, responding in detail to Chang, Wade, and kindred spirits.

Panagariya sets out clearly the traditional case for free trade, but his book is most valuable for its detailed discussion of the Four Asian Tigers on the one hand and the two giants which later joined them in opening up their economies, China and India. There is little disagreement that the success of Hong Kong and Singapore can be attributed to free trade, limited government and private property. (Today they have the two freest economies in the world, according to the Economic Freedom Index.) But free trade opponents like Wade and Chang focus on the fact that the situation in Taiwan and South Korea was more complicated. Even if these countries mostly turned away from import substitution in the 1960s and 1970s, their governments actively intervened in the economy before, during and after this change of course. This, Wade and Chang assert, shows that interventionism can sometimes produce economic growth. They also believe that in those countries selected infant industries were effectively protected. Panagariya goes however meticulously through Wade’s and Chang’s examples and shows them to be mostly spurious. Taiwan and South Korea were both different from Hong Kong and Singapore in that they inherited a relatively large public sector from the Japanese who had ruled these countries as colonies before World War II. They both managed to establish political and economic stability, under heavy challenges, and they both had a flexible labour market. The government interventions in these countries favouring some economic sectors at the cost of others often tended to cancel out one another so that the end result was not too different from what it would have been under free trade. Indeed, the success of these two countries seems to have been despite but not because of the interventions applauded by Wade and Change.

Panagaraiya complains that free trade opponents such as Wade and Chang rarely state their own position with any precision. Of course, if government could swiftly produce prosperity with its policies, then many would abandon any ideology and embrace such policies. If this was only a question of pushing a green button, they would do it. But since when could bureaucrats pick winners in business? Where is the green button? Central economic planning was tried in the Soviet Union and China, and less comprehensively in India, and it did not work. Wade’s and Chang’s case for protectionism and other forms of interventionism consists in selecting some contingent features of the economies of Taiwan and South Korea, presenting them as causes of their undisputed success. They can play that game because in a dynamic economy at any time there are several different factors working in different directions, and because results in the short run may often differ from results in the long run. Panagaraiya concedes that occasionally judicious government intervention may have encouraged economic growth, especially under a solid infrastructure. But there are, he stresses, no examples of sustainable economic growth without an open economy. Free trade is a necessary condition of economic growth, although it may not be a sufficient condition. It is only by free trade that developing nations can break out of poverty. Panagyraiya describes how free trade does not provide a ‘trickle down’ effect on the poor: instead, it produces a ‘pull up’ effect, enabling them to escape poverty on their own. He cogently argues, moreover, that in developing countries poverty is the problem rather than income distribution. This is at least what ordinary people think: For example in India, they tend to move from poor states with relatively equal income distribution to more affluent states with a less equal income distribution.

Wade’s False Allegations about Iceland

It so happens that the Icelanders have some experience of the two interventionists, Wade and Chang, against whom Panagaraiya is arguing. They both immediately explained the 2008 Icelandic bank collapse as a failure of capitalism. They both came to Iceland and posed as prophets. Wade used the opportunity also for personal attacks on those whom he held responsible for the extensive liberal reforms implemented under Prime Minister David Oddsson in Iceland between 1991 and 2004. In New Left Review in 2010, he and an Icelandic co-author ridiculed me for having written in the Wall Street Journal: ‘Oddsson’s experiment with liberal policies is the greatest success story in the world.’ But although they put this sentence inside quotation marks, this was not what I had said. I had written: ‘Now, after a radical and comprehensive course of liberalization that mirrors similar reforms in Thatcher’s Britain, New Zealand and Chile, Iceland has emerged as one of the world’s most prosperous countries.’ Wade could easily have checked the quotation: the article was, and is, available online. When he and his co-author were contacted by my lawyers, they had to publish a retraction and an apology.

In their piece, Wade and his co-author made wild accusations against other Icelanders. They wrote, for example (p. 28): ‘Statistics Iceland, the public data agency, was notably cowed into suppressing information on soaring income and wealth inequality, and hardly dared to draw attention to unfavourable trends.’ When Wade published this, the astonished Director of Statistics Iceland immediately conducted an internal investigation which turned up no evidence of any attempt of suppressing information. Subsequently, he asked the authors to substantiate their allegations. They only referred him to articles by two Icelandic left-wing intellectuals. But in those articles there were no allegations to be found of any suppression of information. Those two intellectuals only complained that the bureau should have collected more data on inequality, although the truth of the matter was, and is, that Statistics Iceland coordinates its methods with the other Nordic statistical bureaus and with Eurostat: it strives to make its data comparable to those of its sister agencies. Upon receiving this answer, the Director asked Wade and his co-author to retract their allegation. He never received a reply, nor a retraction. The Director told me that he did not take the matter further because he did not want his agency to be embroiled in controversy.

Another allegation made by Wade and his Icelandic co-author was even more libelous. In the hectic days in early October 2008 when the banks were collapsing, the CBI, Central Bank of Iceland, tried to restore some confidence and therefore made a currency offer in the interbank market. Wade and his co-author commented (pp. 21–22): ‘In conditions where the currency was already tumbling, the foreign exchange reserves were exhausted and there were no capital controls, the peg lasted for only a few trading hours; it was perhaps the shortest-lived currency peg ever. But it was long enough for cronies-in-the-know to spirit their money out of the króna at a much more favourable rate than they would get later. Inside sources indicate that billions fled the currency in these hours.’ I was a member of the CBI Board of Overseers at the time, and I found this allegation surprising. It is however easy to confirm its falsity. This sale of hard currency was an open-market operation, and only six million euros (786 million Icelandic crowns) were bought by the three main banks. The CBI had no information about or control over what the banks did with that money, so it is quite implausible that it would have been transferred to any ‘cronies’ of the three CBI governors. I asked Wade who his ‘inside sources’ were. He replied that they were three people who should all remain nameless: a member of the SIC, Special Investigation Commission on the bank collapse, and an Icelandic banker and an economist residing in the United Kingdom. There were only three members of the SIC, and when I contacted them, all three of them assured me in writing that in their investigation they had not encountered any such information, let alone provided it to Wade. Moreover, his two other ‘inside sources’ would hardly have had any privileged information about who bought the six million euros (a negligible sum anyway, even by Icelandic standards). Thus, Wade’s ‘inside sources’ did not exist. This was just malicious gossip. However, because of the bank collapse the CBI governors were driven out and the new leadership had no interest in refuting false allegations against them.

Chang’s Plain Errors about Iceland

Like Wade, Chang believes that the Icelandic 2008 bank collapse was a failed ‘neo-liberal’ experiment. In a 2010 book, 23 Things They Don’t Tell You About Capitalism, Chang wrote (p. 233): ‘Between 1998 and 2003, the country privatized state-owned banks and investment funds, while abolishing even the most basic regulations on their activities, such as reserve requirements for the banks.’ This is plainly wrong. One of the three main banks was already privatised in 1990, under a left-wing government. More importantly, the Icelandic government did not at all abolish ‘even the most basic regulations on their activities, such as reserve requirements for the banks’, as Chang asserts. Since 1994 Iceland has been a member of the EEA, European Economic Area, which meant that her economy was a part of the European internal market. Therefore the financial regulatory framework had to be the same in Iceland as in the other EEA member countries. The reserve requirements for the Icelandic banks were precisely the same as in other EEA countries, no more, no less. Wade and Chang are wrong in blaming the bank collapse on the preceding liberalisation of the Icelandic economy. Why then did banks in still freer economies like Singapore, Hong Kong and Switzerland not go under? And why then did banks like Danske Bank in Denmark and UBS in Switzerland not fail? The answer is that many banks, including Danske Bank and UBS, would indeed have collapsed if the Scandinavian and Swiss central banks had not been able to increase their liquidity temporarily by dollar swap deals with the U. S. Federal Reserve Board—deals which were however denied to Iceland. In a credit crunch, liquidity is crucial. The banking sector in Switzerland was 10 times the GDP, Gross Domestic Product, of Switzerland, and it got help from the U.S. Federal Reserve Board. To take another telling example, the banking sector in Scotland was 12 times the GDP of Scotland, but it got help from the Bank of England.

The 2008 bank collapse in Iceland was not because of the preceding economic liberalisation or because of the excessive size of the banking sector. It was caused by a combination of many factors, the most important of which was that both the U. S. Federal Reserve Board and the European Central Bank refused to provide the same liquidity to the Central Bank of Iceland as they did to central banks in other countries. Perhaps the best indication of the strength and success of the liberal reforms between 1991 and 2007 was nonetheless how quick Iceland was to recover. But why are Wade and Chang so notably less conscientious in writing about Iceland than in their reasonably scholarly, even if flawed, analysis of the Four Asian Tigers? One explanation might be that when they wrote about the Tigers, they knew that scholars like Panagaraiya would scrutinise their work, but they may have felt that they had a free hand when writing about Iceland. As Mencken put it: ‘Conscience is the inner voice that warns us somebody may be looking.’