09/01/2011 08:16 pm ET Updated Nov 01, 2011

Free Trade is Making America the New Portugal

A columnist at the business magazine Forbes has agreed to that rarity of rarities: an actual debate on the merits of free trade! As the reader may have noticed, most free traders are so religiously committed to the doctrine that they can't even imagine the possibility that they might be wrong. (Believe me, as a former free trader, I'm familiar with this mentality.) And the rest? They seem to be well aware that their faith doesn't stand up very well to cross-examination, so they avoid debate.

My comments here are a response to this article by Tim Worstall.

Worstall is a Briton currently residing in Portugal. I find this a sublime irony, as economic history records that Britain and Portugal were, in fact, among the earliest and profoundest victims of free trade.

Let's consult the history.

Britain, prior to her adoption of free trade starting in the 1840s, was the world's leading economic power, birthplace of the industrial revolution and center of a worldwide empire. But she had attained this position not by practicing free trade, rather under a now-largely-forgotten protectionist policy that has come down to us under the name "mercantilism."

But after Britain embraced free trade beginning in 1846, this all began to fall apart, and Britain entered her long economic decline that has since reduced her to a minor economy heavily indebted to former colonies. In the words of one commentator,

The industries that formed the core of the British economy in the 19th century, textiles and steel, were developed during the period 1750-1840 -- before England abandoned mercantilism. Britain's lead in these fields held for roughly two decades after adopting free trade but eroded as other nations caught up. Britain then fell behind as new industries, using more advanced technology, emerged after 1870. These new industries were fostered by states that still practiced mercantilism, including protectionism.

The rising powers of this era? Protectionist nations like Germany, the United States, and later, Japan.

Economic history is an amazing solvent of the pretensions of theory. (Later, we can talk about fixing the theory so that it's actually true.)

Now for Portugal. Portugal's trade of wine for English textiles is, interestingly, the classic example of free trade given in economics textbooks. And therein lies a very revealing tale.

For in the era of England's rise to greatness, textiles were produced there with then-state-of-the-art technology, like steam engines. The textile industry thus nurtured a sophisticated machine tool industry to make the parts for these engines, which drove forward the general technological capabilities of the British economy and helped it break into related industries like locomotives and steamships. It was an industry fruitful for growth, a key industry to be in.

Wine, on the other hand, was made by methods that had not changed in centuries. So for hundreds of years, wine production contributed no technological advances to the Portuguese economy, no drivers of growth, no opportunities to raise economy-wide productivity. And its own productivity remained static: it did the same thing over and over again, year after year, decade after decade, century after century, because this was where Portugal's immediate comparative advantage lay.

Free trade may have been the cheapest move for Portuguese consumers in the short run, but it was a dead-end in the long run. This is why every single ex-Third World nation -- a category ranging from England 200 years ago to South Korea today -- has been protectionist.

What happened to Portugal?

In 1703, in the Treaty of Methuen, Portugal exempted England from its prohibition on the importation of woolen cloth, while England agreed to admit Portuguese wines at a tariff one-third less than that applied to competitors. This treaty merely switched suppliers for the English, who did not produce wine, but it admitted a deluge of cheap English cloth into Portugal, which wiped out its previously promising textile industry.

English capital eventually took control of Portugal's vineyards as their owners went into debt to London banks, and English influence sabotaged attempts at state policy that might have pushed Portugal back into textiles or other manufacturing industry. As textiles were (as they remain today) the first stepping stone to more-sophisticated industries, this all but prevented Portugal's further industrialization.

Not until the 1960s, under the Salazar dictatorship, did any Portuguese government make a serious attempt to dig itself out of this trap. Even today, Portugal has not yet recovered its 17th-century position relative to other European economies, and it remains the poorest country in Western Europe.

Today, free trade is similarly dangerous to poor and undeveloped nations because they tend, like Portugal, to have comparative advantage in industries that are economic dead ends. So despite being nominally free, free trade tends to lock them in place.

Is this just a problem for poor nations? No, because there's a flip side to the problem, one which affects the already developed. What if a developed country like the U.S. confronts a developing nation, like China, which has embraced the protectionist policies that made America rich in the first place? Well, that country had better not practice free trade in the face of this foreign mercantilism, or it will end up getting shoved aside -- just as the U.S. itself once did to Britain.

Trade isn't a zero-sum game, but it certainly has winners and losers.

America right now is being inexorably stripped of its most valuable industries by its naïve embrace of one-sided free trade. Here's the Harvard Business Review's list of industries we have already lost:

Fabless chips; compact fluorescent lighting; LCDs for monitors, TVs and handheld devices like mobile phones; electrophoretic displays; lithium ion, lithium polymer and NiMH batteries; advanced rechargeable batteries for hybrid vehicles; crystalline and polycrystalline silicon solar cells, inverters and power semiconductors for solar panels; desktop, notebook and netbook PCs; low-end servers; hard-disk drives; consumer networking gear such as routers, access points, and home set-top boxes; advanced composite used in sporting goods and other consumer gear; advanced ceramics and integrated circuit packaging.

Note that these are not the "junk" industries, like plastic toys, that free traders fantasize we are shedding to foreign nations that graciously acknowledge our divine right to skim the cream of the world economy while others do the donkey work. These are serious high-tech and thus high-wage industries, industries with a future. Without them, America is going to be increasingly shut out of the most lucrative and job-creating industries in the global economy. We are going to be the new Portugal.

Can a developed nation hang onto key industries in the face of cheap-labor foreign competition? Sure. Neither Japan nor Germany, nor their imitators from Taiwan to Switzerland, have suffered our chronic deindustrialization. Our unemployment rate right now is 9.2 percent; Germany's is 6.1 and Japan's is 4.7. General Motors went bankrupt, not Toyota or Mercedes.

The causes of these nations' industrial success are complex, but one thing they all have in common is that they do not actually practice free trade (whatever they may say in public to gull Uncle Sam). They practice managed trade by a dozen different means, starting with currency manipulation and deeply embedded in the behind-the-scenes understandings their corporations have with their banks, governments, and unions. Many of their trade barriers are not actual laws, and thus lurk below the surface to casual examination. For example, in the words of commentator William Greider:

In the European Union, supposedly liberalized by unifying fifteen national markets, the countries had more than seven hundred national restrictions on import quantities, many of which were converted to so-called voluntary restraints. The UK's Society of Motor Manufacturers and Traders maintained a long-standing 'gentlemen's agreement' with the Japanese Automobile Manufacturers Association that effectively limited Japanese cars to 11 percent of the British market. France and Italy had tougher restrictions. The EU periodically proclaimed its intention to eliminate such informal barriers but, meanwhile, it was tightening them. During the recessionary conditions in late 1993, Japanese auto imports to Europe were arbitrarily reduced by 18 percent.

This is the way the world of international trade really works.

America doesn't need to cut itself off from the world entirely, but it does need to get wise to the fact that the rest of the world views trade (correctly) as an arena of national rivalry, and start playing the game. We don't have to play it quite the same way they do -- there are plenty of ways to skin this cat -- but our own protectionist history from Independence to the start of the Cold War gives plenty of precedents for rational protectionism.

It's either that, or continuation of the inexorable national economic decline that anyone with eyes can see has already begun.