In recent weeks, the financial markets have been shaken by Donald Trump’s tariff announcement on April 2. The markets’ reaction came as no surprise as free trade and globalization have been key drivers of global growth since 1990.
Why free trade?
Division of labour, specialization and the subsequent exchange of goods and services via markets are the nucleus of prosperity in countries with market economies. Free trade means allowing the advantages of the division of labor and specialization at an international level.
The microeconomic findings on the advantages of the international division of labor led to comprehensive trade liberalization in the second half of the 20th century. Trade barriers between countries were deliberately dismantled by politicians in order to facilitate the free movement of goods, services and – to a lesser extent – labor. If the individual economic players are free in their decisions, prosperity is maximized because the economic resources flow to where they generate the greatest benefit or develop the highest productivity. The invisible hand (Adam Smith) ensures the economically efficient allocation of resources and thus maximum prosperity.
At the beginning of the 1990s, the idea of free trade received a decisive boost: the end of the political East-West-conflict, the associated victory of the market economy system over the centrally planned economy and the enormous progress in the field of information and communication technology, together with trade liberalization, created a dynamic that led to a veritable wave of globalization.
The theory was impressively confirmed by reality: globalization brought strong economic growth to the world economy, resulting in a drastic reduction in extreme poverty, particularly in Asia.
The dark side of globalization
Even if globalization is a success story overall, it has also had some downsides. There is a fundamental problem of the division of labor and specialization: dependencies arise between the trading partners. This in turn results in vulnerabilities, as the coronavirus crisis revealed at the latest. When supply chains broke, the supply of important goods, which until then had been assumed to be always available, was at risk. The Russia-Ukraine war revealed renewed risks to supply security. “Friendshoring”, in which supply chains are relocated to politically and economically friendly countries, and “nearshoring”, in which production and supply chains are relocated closer to home, became a trend.
For the Trump administration, potential dependence on China plays a particularly important role in the current trade conflict. This apparently applies to both direct and indirect dependencies, as American trading partners could take the wrong side in the event of a crisis due to their dependence on China. Dealing with political rival China has a decisive influence on US trade policy.
Globalization does not always proceed as smoothly as in the economic textbook. The gains from globalization are very unevenly distributed. A look at American income distribution shows that since the 1970s, the top 20% of the income pyramid in particular have benefited – and especially the top one percent. By contrast, incomes in the lower half have barely budged (inflation adjusted).
Globalization is also accelerating structural change. There are winners and losers. The structural change triggered by globalization (deindustrialization) has hit entire regions in the USA hard (“Rust Belt”). In comparison to European-style welfare states, the losers of structural change in the USA are hardly compensated, but are largely left alone with their problems. This creates the basis for social and cultural tensions.
Conclusion
Free trade does not have to be abolished in order to eliminate the downsides or negative side effects of globalization. With regard to the issue of distribution, the first step is to shape structural change in such a way that it is bearable for everyone involved – including the losers. Europe, and Germany in particular, has the right answer with its social market economy. The losers of structural change do not fall into the abyss here. They are socially protected and often receive state offers to gain further qualifications and thus adapt to the new labor market requirements (“activating welfare state”).