1,000,000 economists can be wrong: The free trade fallacies

Not only did the global financial crisis catch the vast majority of economists completely unawares, they instead expected tranquil and even buoyant times just as the biggest economic crisis since the Great Depression began. My favourite such observation is from the OECD's Economic Outlook for June 2007-in which the Chief Economist suggested that, "the current economic situation is in many ways better than what we have experienced in years . . . Our central forecast remains indeed quite benign." But there are countless other such utterly wrong prognostications about the economy, from the profession that is supposed to be the font of wisdom on the economy.

Those "in the know" understand that this is not an isolated failing. The Neoclassical model that dominates economics today is riven with logical and empirical fallacies. If economics were a real science, it would have long ago been overthrown and replaced by something more realistic.

Yet at least 90% of academic economists believe in this model, as do almost all economists working in government and private industry. Left to their own devices, they will continue thinking that this model does describe the economy as the real economy falls deeper and deeper into a crisis, even though their model says that this can't even happen.

Since economics has failed to clean out its own intellectual stable, it will be the public that finally forces reform upon it - as once-supporters like Anatole Kaletsky of The Times calls for "a revolution in economic thought" and George Soros funds an Institute for New Economic Thinking. With luck, in a decade or two, a more realistic approach to economics might emerge. But in the meantime, here's a simple guide for the public: Anything the vast majority of economists believe is likely to be wrong.

Which brings me to "Free Trade." The belief in Free Trade is one of the hallmarks not just of the Neoclassical school which began in the 1870s, but also of the original Classical school which began with Smith in 1776. It argues that almost everyone's material welfare will be increased if all countries specialise in what they are good at-a proposition that on the surface seems plausible, and a formidable body of mathematical economic theory has been erected to support it.

Unfortunately, like so much else in economics the model of Free Trade is, to quote the humorist H.L. Mencken, "neat, plausible, and wrong." The theoretical fallacies at its core have been there since David Ricardo first coined his model of comparative advantage during the political battle to repeal the "Corn Laws," which restricted the importing of cereal crops into England.

The arguments in favour of the Corn Laws included the belief that if trade were unregulated, English industry-in particular its agriculture-might be wiped out by foreign competition. Ricardo, in a brilliant debating ploy, conceded his opponents' case that a rival country (Portugal, which was then one of Britain's major rivals) was better at both agriculture and manufacturing than England and then preceded to "prove" that England would still benefit from Free Trade.

He assumed that in Portugal 80 men could produce a quantity of wine (say, 1000 gallons), whereas England would need 120 men to produce the same amount and that Portugal was more efficient too at producing cloth-needing 90 men to produce a quantity of cloth (say, 100 square yards of cotton) whereas England needed 100.

Without trade, both countries would have to produce both goods for themselves so that per 1,000 workers, Portugal would produce some combination lying between the extremes of 12,500 gallons of wine and 1,100 yards of cotton, while England would produce a combination lying between 8,333 gallons of wine and 1,000 yards of cloth.

If however Portugal specialised only in wine and England specialised only in cloth, the total output would be 12,500 gallons of wine and 1,000 yards of cloth. This is more than the total output of the two countries in the absence of trade. With Free Trade, they could specialise in their comparative advantages and welfare in both countries would be higher.

This argument was so clever that it aided the campaign to repeal the Corn Laws and it has seduced almost all economists ever since.

But there is an obvious fallacy to this neat and plausible argument: To effect specialisation, England has to shift labour and capital from wine to cloth (and Portugal has to do the opposite). Arguably labour can be retrained-a vigneron can become a machinist-but how do you convert wine press into a spinning jenny?