The West’s romance with Free Trade is ending. Why?

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Donald Trump is marching the US into a trade war with China.  Markets are rattled.  China is rattled.  American companies are rattled.  After 100 years of promoting free trade as a way of enriching everyone, the West is having a rethink: is free trade really that great?

This History Future Now article looks back at Western trading practices from the 1400s to the present day and sees a story ark that goes from mercantilism to free trade and back.  What is interesting is that free trade may have been an illusion all along.  Read on to find out why.

The origins of mercantilism

It is important to highlight that the Western system of trading has changed over time.  For most of the period from the 1400s the West employed a statist mercantilist system.    It only become a champion of free trade in the late 1800s.

In the 1400s merchants banded together to create joint stock companies that were frequently given special exclusive rights – monopolies-  over certain markets or regions by their governments, in return for a share of the profits being given to the state.   This enhanced the wealth and power of monarchs and made private individuals, generally merchants, wealthy. Early examples include the Bristol Society of Merchant Venturers, who paid for John Cabot (an Italian) to sail to Newfoundland in 1497, the Virginia Company (memorialised by the Disney cartoon Pocohantas) who had exclusive rights to large chunks of the eastern seaboard of North America, and the English East India Company, established in 1600, which had rights to trade in the Far East.  This latter company would eventually come to dominate India in the 1700s and precipitated the Opium Wars with China from 1839.  The French, Germans, Portuguese, Dutch, Russians, Spanish and Scandinavians all had similar companies.

What they all had in common was that they were anti-competitive and were violently opposed to any kind of free trade.  Going abroad was risky and expensive.  Once they got there and had established trading relations the last thing that they wanted to do was see new competitors come in and take market share.  These trading companies became increasingly militarised and had their own armed merchantmen to transport goods and private armies to protect their far-flung trading posts, called “factories”.   The state was fully behind this protectionist sentiment, which was not just confined to trading companies.  Europeans treated their colonies as sources of raw materials and, eventually, captive markets for their manufactured goods.  In the American colonies, for example, the Americans would ship raw materials to Britain and would receive value added manufactured goods in return.  Since the manufactured goods were more valuable than the raw materials sold the colonists supplemented their payments with gold and silver, which was then used by the British to buy other products from other countries or to increase their manufacturing capacity at home.  One of the key reasons for the American War of Independence was the fact all shipping to the North American colonies had to be transported by British ships (which included American ships as they were deemed British) and that the manufacture of many goods was banned in the colonies.  There are multiple letters between George Washington and his friends complaining about the high cost and low quality of goods delivered late and damaged from England.

The British only started advocating free trade after the American colonists successfully became independent from Britain in 1783, after the Treaty of Paris.  Adam Smith’s The Wealth of Nations was published in the 1776 (the same year as the Edward Gibbon’s Decline and Fall of the Roman Empire) and David Ricardo’s Principles of Political Economy and Taxation was published in 1817.  These books created the intellectual framework for free trade.  Smith and Ricardo argued that the mercantilist system of monopolistic trading companies and exclusive colonies was bad. Society would be much better off if all companies could compete anywhere they wanted. Ricardo even promoted the idea that certain countries would be better off sticking to producing low cost goods and buying high cost goods rather than trying to do everything themselves – this is the theory of comparative advantage.

And now things start to get really interesting.  If the West believed – and had empirical proof- that monopolistic trading companies and captive colonial markets was the best way to become rich and powerful, what persuaded them to think that the exact opposite, free competition and open markets, was better?  Surely it could not have been just because a Scottish intellectual, Adam Smith, and the son of a Portuguese refugee, David Ricardo, had written two books?   What else was going on?

The Industrial Revolution and the shift to free trade

The answer is the Industrial Revolution.  Britain’s mercantilist experience had created a huge amount of surplus wealth for Britain. By the late 1700s and the early 1800s this wealth was being used to back scientists and tinkerers in the developments of new labour saving machines.  Within a remarkably short period of time Britain, who led the Industrial Revolution, was able to produce goods that were cheaper, better and in far greater quantity than those produced by traditional home-based workshops.  If you can produce something that is cheaper, better and in greater quantities than anyone else you essentially have no competition.  And if you have no competition you are a monopoly.  So if Britain could compete, and win, against everyone else the only thing that stopped Britain from selling goods all over the world the was the fact that other countries restricted the imports of British goods.   That is why Britain shifted to being militantly pro free trade; free trade was nothing more than an extension of mercantilism. 

“..free trade was nothing more than an extension of mercantilism.”

“Militantly” is not a figure of speech.  Britain used force to break into closed markets.  For example, China had restricted access by the British, and other European countries, to the Chinese market prior to the 1840s.  China was wary of European influences and had little interest in any products that the West had to offer, other than silver. As a result, European countries ran a massive trade deficit with China. Running permanent deficits was expensive and drained Britain of foreign exchange.  British searched for items that they could export to China. Eventually the British East India Company started growing poppies for opium production in India for export to China. This proved wildly successful commercially (it was also available and legal in Europe) but the Chinese government was furious about the impact the drug was having on its people. It banned the import but the British kept smuggling it into the country. In 1839 the Chinese confiscated over twenty thousand chests of opium produced by the East India Company.  The British retaliated by sending in the Royal Navy which destroyed a number of Chinese ships and ports and culminated in the Treaty of Nanking, which dramatically opened up China to British and eventually other Western powers.

Throughout the 1800s the British aggressively promoted free trade, confident that they were likely to win any competition.  After the First World War it was the Americans who pushed for open markets and free trade as they started to dominate sector after sector thanks to their large and expanding domestic market.  They actively encouraged European colonies to become independent, and open to American exports.

Free trade is great when you are winning

This American enthusiasm for free markets started to wane by the 1980s as West German and Japanese products – which were cheaper and better – started to be sold in the US.  Protectionist sentiments started to emerge.  It was revitalised after the collapse of the Soviet Union, in 1989, when Western companies rushed into former soviet block markets and quickly crushed the local competition.  There was another final burst of enthusiasm after 2001 when China joined the World Trade Organisation.  Western and Japanese companies swarmed into China, eager to replicate their successes in eastern Europe and Russia.  For a while they were successful and built factories not just for producing goods to be sold back to their home countries, making use of China’s low cost labour, but also for selling to the Chinese themselves.

For a brief period of time free trade appeared to be a win-win situation for everyone. The export of manufacturing jobs to places like China was being offset by the creation of new service industries in the West.  Low cost goods from China and other developing countries increased the spending power of Westerners, making them feel wealthier. And in the meantime millions of people in China were being employed making those goods for export. This brought them increased wealth and prosperity. This system of trade seemed to be text book Ricardian theory of comparative advantage – the West bought low value goods from China and sold it high value goods.  Fantastic.

However, by the early 2010s Western companies were starting to get alarmed.  Chinese companies, backed by the state, were proving to be remarkably successful in competing against Western companies. China was turning out to be a gigantic trap – Western companies had arrived in China, had trained the Chinese on how to build various products and had transferred decades worth of know how. Sometimes that knowledge transfer was voluntary, but it was frequently forced as the Chinese government insisted that Western companies set up joint ventures with Chinese companies and required them to transfer critical intellectual property to the joint venture.  Tempted by a huge Chinese market, Western companies agreed to these terms.  Finally, the Chinese engaged in industrial espionage and stole as much western technology as they could.

This industrial espionage has a historic echo. China once had monopolies on the global manufacture of silk, porcelain and tea. These monopolies were fiercely guarded state secrets and helped China create huge amounts of wealth via exports. China lost its monopoly on silk in 552AD when silk worms, hidden in rods of bamboo, were smuggled out of the country by Christian monks. It lost its porcelain monopoly in the early 1700s when a German based at Meissen, Ehernfried Walther von Tshirnhaus, managed to reverse engineer the formula for creating a very similar product that was white, very thin, light and extremely durable. Finally, a British botanist, Robert Fortune, smuggled 20,000 tea plants and seedlings out of China between 1848 and 1851, and planted tens of thousands of hectares of tea in the Darjeeling region of India, ushering in Britain’s love of the beverage.

Back to the present day; one by one Chinese local players emerged that were incredibly competitive and started to beat Western companies at their own game.  Western countries were not able to create new industries faster than the Chinese were able to dominate one manufacturing sector after another.  The theory of comparative advantage was starting to break down.  Not only was China able to produce low value goods, but it was also able to produce high value goods.  The Made in China 2025 policy, which provides significant government support for key next generation industries such as artificial intelligence, robots, autonomous electric vehicles and biotechnology, will push China even further up the value chain.

By 2018 China was the world’s largest manufacturer and the world’s largest exporter.  The Chinese economy increased from $305 billion in 1980 to $12.7 trillion in 2019; exports jumped from $21 billion in 1980 to $2.49 trillion in 2017 (well ahead of the US, in second place); and the economy has grown by an average of 10.2% between 1980 and 2016.  Its products have started to dominate market after market and have driven thousands of Western companies out of business.

All of a sudden free trade was starting to look significantly less attractive to Western companies and governments.  This explains why US President Trump has pushed for high tariffs on Chinese imports and Europe is starting to halt Chinese acquisitions of critical European technology companies.

 


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