2. Adam Smith on trade and trade policy

Adam Smith’s views on international trade have proved elusive, and, as Schumacher (Reference Schumacher2020) observes, have mainly been interpreted for us by later scholars seeking to purchase legitimacy for their own models by claiming lineage from the acclaimed master. Schumacher observes that Smith was focusing on the mechanical division of labour, not the territorial division of labour, which underpins most of our discussion of international trade; this focus partly explains why we find it so difficult to fit into our modern discourse.

This is not an area of scholarship in which a dilettante in the history of economic thought wishes to get caught, so I will confine myself to two observations which bear on contemporary debate; both are drawn from Schumacher. First, perhaps Smith’s best-known contribution is the division of labour—the pin factory. He identified that this gives rise to economies of scale and that this is limited by the extent of the market, which immediately introduces the relevance of international trade. Second, he believed that the volume of trade between countries is ‘in proportion to the wealth, population and proximity of the respective countries’, a statement which any trade scholar will recognise as the foundation of trade economists’ work-horse model, the gravity model. Moreover, Smith saw proximity as substantially a matter of transportation costs, which in modern usage has been generalised to trade costs.

Even if one cannot provide a fully articulated positive theory of international trade, however, one may still be able to contribute to the debate on trade policy in a meaningful way. Two hundred years ago, James Syme (Reference Syme1821) wrote (as quoted in Schumacher, Reference Schumacher2020) “Adam Smith knew little or nothing about the nature of trade or commerce, and, being conscious that he could not explain what he did not understand, he very wisely said ‘let trade be free’”.

But Smith did not just ‘say’, he argued, and, according to Irwin (Reference Irwin1996, p. 75) provided for the first time ‘a systematic, coherent framework for thinking about the economics of trade policy’. This section draws heavily on Irwin’s excellent book, and in order to avoid any underserved appearance of scholarship I refer the reader to Irwin rather than give original references for quotations below where they come from Irwin.

Adam Smith’s objective was to

That is, he seeks to assess policy against a national, rather than a sectoral, yardstick, coming very close to defining it in terms of Gross Domestic Product and National Income. Smith later re-enforced the message through an aphorism that should be nailed above every politician’s and every undergraduate’s desk

Smith’s next analytical building block was his famous ‘invisible hand’, whereby individuals trying to maximise the value of their own output, maximised that of society so long as they were free of distortions generated by governments or monopolies.Footnote ¹

We all want to maximise output and revenue, but how? Smith averred that, since a country’s stocks of capital and labour are fixed (what trade economists would 150 years later refer to as fixed endowments and full employment), there are necessarily trade-offs between sectors. He conceived these very directly in terms of opportunity costs:

and from here he concluded directly on trade policy, that

As Irwin notes, relative to the general policy statement in the preceding quotation which states that gain from intervention ‘is by no means certain’, Smith’s statement about trade policy is bold and definitive. It is immediately recognisable as a description of the current textbook general equilibrium analysis of trade restrictions, except for the fact that the latter spells out how intervention distorts prices to bring about the result.

Smith’s policy construct is one of resource allocation with a fixed stock of resources and is thus fundamentally static. But he also had dynamic arguments for preferring free trade (Irwin, p. 80): first, by enlarging the market, it permits a finer division of labour and hence increases productivity; second, the same force provides incentives to innovate, and third, and probably most important in Smith’s mind, international trade encourages the ‘mutual communication of knowledge’ about business practices and technologies.

Just as Smith was no ‘laissez faire zealot’, so he was also pragmatic about import restrictions. He admitted four exceptions to his general stance on free trade, two of principle and two of a tactical nature.

1. A. ‘When some particular sort of industry is necessary for the defence of the country’, which he justifies, after a long discussion of the UK Navigation Acts, on the grounds that ‘defence … is of much more importance than opulence’.

2. B. When domestic producers are subject to taxes, imports should be similarly taxed.

3. C. In retaliation when a partner impedes our exports, but only if there is a reasonable chance that retaliation will lead to the removal of the original restriction.

4. D. Where a reduction in an import tariff would cause ‘severe dislocation of domestic labour and capital’. Smith’s opinion is that this circumstance is much less common than commonly imagined, but if it does pertain, Smith concedes the need for gradual liberalisation.

Trade policy is not just about import restrictions. Smith’s views about industrial policy may be inferred from the quote above starting ‘No regulation of commerce’—serious doubt—and he is much more acerbic about export subsidies:

3. UK trade policy through a Smithian lens

Smith was writing for a simpler world, without the advances in economic thinking of the last 250 years. Nonetheless, his framework and analysis provide a clear lens through which to observe several elements of contemporary UK trade policy. For several decades the UK had surrendered the management (‘sovereignty’ in some tellings) of its trade policy to the European Commission; not very much happened and even less attracted much attention in the UK. That all changed with the Brexit referendum of June 2016, and it is the period since then that I shall discuss.

Brexit was many things, but among the largest, it entailed a massive reconfiguration of UK international trade policy. Brexit threw up significant trade barriers between the UK and its geographically closest, economically largest, culturally most similar and most interconnected trading partner. As it left the EU Customs Union and Single Market, tariffs on goods remained at zero, but became subject to rules of origin and border formalities; UK and EU regulations became independent of each other so that any alignment between UK and EU standards had to be proven not presumed; and the standards enforced by regulations started to drift apart in the case of goods and were abruptly sundered in the case of many services—Ayele et al. (Reference Ayele, Gasiorek, Holmes, Jerzewska and Walmsley2021).

The final result of this separation is arguably yet to be seen, but by late 2022 UK imports of goods from the EU were 28 per cent lower than one might have expected on the basis of trade with non-EU partners; 18 per cent of goods exports to the EU paid tariffs (although aggregate exports had returned to expected levels), and the variety of UK exports to the EU had declined dramatically. Total exports (EU + non-EU) were 13 per cent down and import performance relative to pre-Brexit times was the worst in the G7.Footnote ²

Smith’s analysis suggests several arguments against this approach to foreign trade: the distortionary costs of new trade barriers, the loss of imports curtailing consumption, the associated loss of Gross Domestic Product (GDP) (e.g. Springford, Reference Springford2022), the reduced incentives to innovate through declining integration with firms in Europe, and the reduced extent of the market and hence of economies of scale. One might argue that with the sixth largest economy in the world and with trading links around the world, the UK should not be constrained by economies of scale. But they remain crucial in many service sectors, precisely those sectors in which the UK has most thoroughly detached itself from Europe by breaking regulatory alignment and for which negotiating access to other economies is so difficult. Dingel et al. (Reference Dingel, Gottlieb, Lozinski and Mourot2023) give a pertinent example of economies of scale in medical services in the USA.

As the Brexit referendum campaign proceeded, and even more strongly as Brexiteers tried to define the benefits they had won for the UK, the ability to strike its own trade agreements took centre stage. The UK Government rolled over nearly all the agreements it was party to through EU membership and has struck new agreements with Australia and New Zealand and has acceded to the Comprehensive and Progressive Trans-Pacific Partnership (CPTPP). It is renegotiating several of the roll-overs and hopes to sign an agreement with India by the end of 2023. The government’s own analysis suggests that the economic gains from these agreements are trivial, certainly compared with the losses associated with declining trade with the EU. Smith, as a proponent of gravity in trade, would not be surprised. He identified proximity as a key stimulus to trade, and it still is.

Independent, the UK now has the right to join plurilateral trade agreements on its own account. For example, it considered quite seriously joining the negotiations on the Agreement on Climate Change, Trade and Sustainability (ACCTS) but decided not to do so, because it wanted to keep fossil fuel subsidies and tariffs on some environmentally friendly goods and services back as bargaining chips in future negotiations Langtree (Reference Langtree2021). Such ‘negotiating tariffs’ are similar to Smith’s retaliatory tariffs and accordingly subject to Smith’s caveat that one needs to be confident that the immediate cost of higher tariffs and subsidies (economic or environmental) will be offset by future negotiating gains.

Trade policy comprises much more than just trade agreements—it involves a whole panoply of measures all of which the UK Government now has to decide on. Many of them are not named by Smith, because, as observed already, he wrote in a simpler era. Nonetheless, they are arguably subject to his general strictures on the role of trade. For example, the pursuit of UK-specific regulations in goods and services both creates additional costs for businesses trying to trade with the UK and tends to re-enforce any tendency towards Smith’s greatest bête noire, domestic monopoly. In particular, where regulatory approval, or even registration, is required for importing into the UK, overseas businesses may just not bother to supply the market. It is generally too early to tell whether such effects have come about, but potential concerns include the UK-specific approval and licencing system for medicines, (because meeting these will be a much lower priority for suppliers than gaining US or EU licences) and the need to seek UK-specific conformity assessment for products—the UKCA—which, after two welcome postponements, is due to be introduced in October 2023.

The UK also needs to develop its own rules on trade. These include customs procedures, which are now much more significant given that the half of UK goods imports that are from the EU now face ‘regular’ customs attention. They also include the rules for so-called trade remedies—temporary import restrictions where trade is deemed to be unfair or too disruptive. As the next sections show, the UK developed a reasonable scheme for this, but then gradually undermined it in an alarming way entirely contrary to Smith’s views of the needs of an economy.

A third example is how to integrate climate change and trade policy. The EU and the UK have an emissions trading scheme which charges energy-intensive sectors for the carbon dioxide they emit. The EU has committed to a Carbon Border Adjustment Mechanism (CBAM) which will be introduced from October 2023. It will impose costs—at the same rate—on importers for the emissions embedded in their imports of included goods as domestic producers face on their output of those goods through the EU’s Emissions Trading Scheme. This would presumably meet Smith’s approval, see exception (B) above:

[i.e. the CBAM would only impede those imports which displaced EU production that had been turned into less commercially profitable uses by the internal emissions charge, and hence restore a level playing field between imports and domestic producers.]

The UK is pondering whether to adopt the same policy and then, although it can barely admit to it, deciding whether to align the UK scheme so closely to the EU one that UK-EU trade could be carried out without any of the bureaucracy associated with imposing the CBAM on third party import sources.

The final example I shall mention is the World Trade Organization (WTO) in which the UK can now maintain wholly independent positions where previously it was constrained by the overall EU positions. Of course, Smith conceived of no such thing, but his views on trade touched on several of the issues dealt with under the WTO. First, the WTO, deriving from the General Agreement on Tariffs and Trade (GATT) has always admitted the dominance of national defence over trade policy. Article XXI allows members to break any WTO rule in the name of defence. The requirements for defence are left to the member itself to define and the only thing that has prevented the use of this Article from dissolving the trading system into anarchy has been self-restraint on the part of large players and ‘a quiet word in the ear’ of smaller players if they thought about exercising it. Self-restraint no longer appeals to Russia (which was accused of misusing the scope of this Article in 2016 by Ukraine whose transit through Russia to third markets had been impeded) or to President Trump’s USA (which cited national defence for several trade restrictions in 2019.) Neither case excites much sympathy among other members nor is the damage to the integrity of the WTO potentially massive. Nonetheless, I note that the justification of trade restrictions in the name of defence was accepted by Adam Smith.

A second link to Smith concerns retaliation against other countries’ trade policies. Smith admitted that this was an efficient economic policy if the retaliation achieved a reversal of policy and its cost did not exceed the original damage done. He opined that these conditions applied less commonly than often supposed, but that nevertheless retaliation is an extremely common response whenever a country is inconvenienced by another’s policies. The main sanction the WTO has against rule-breaking is to authorise the members adversely affected by a measure to retaliate against the offending member. The WTO’s key contribution is to define tight boundaries for such retaliation in order to prevent it spiralling out of control and to insist on due process before it is introduced. Over 70 years of the GATT and the WTO it has been pretty successful in this respect, but, as with Article XXI, the magic of voluntary adherence to WTO rules appears to be wearing thin now.

In neither of these cases has independence led the UK to take very active stances at the WTO. In a third case, on the other hand, which arises when a trade shock disturbs the local economy, the UK has consciously chosen to violate WTO rules. This, it turns out however, is but one instance of a general tendency of recent UK governments to ignore two other of Adam Smith’s dicta about how to properly run an economy—the ‘tolerable administration of justice’ and the need for sound institutions to provide some constrain on governments’ discretion to pursue political rather than economic objectives in determining commercial policy.

4. Institutions and the ‘tolerable administration of justice’

The first three books of Adam Smith’s Wealth of Nations establish his view that the key to a country’s economic success lies in ‘the productivity of its labour force, which in turn depends on specialisation and the division of labour driven by exchange (trade) and limited by the extent of the market’ (Irwin, Reference Irwin2020). Necessary to this desirable outcome, Smith argues, is the security of property rights which incentivises effort and also allows planning and facilitates investment in future economic activity. But what, in turn, delivers the security of property? Irwin (Reference Irwin2020) writes:

The operationalisation of these elements of justice requires institutions. While the ‘pop-version’ of Adam Smith focuses almost entirely on laissez-faire, any informed commentary recognises the critical importance that Smith placed on institutions as defining and preserving the rules of the game in which freedom of choice can flourish and which can channel individualist pursuits into the common good—see Nathan Rosenberg’s seminal article (Reference Rosenberg1960). Indeed, a substantial share of the Wealth of Nations is devoted to the analysis of how institutions may (or often may not) work to enhance the public good.

Smith had little time for politicians (‘that insidious and crafty animal, vulgarly called a statesman or politician, whose councils are directed by the momentary fluctuation of affairs’ WN, BkIV, Ch II), nor officials (whom he saw, in Rosenberg’s words, as ‘a class of men peculiarly insulated not only from the ordinary pressures of the market but from any other compulsion which engages the pursuit of their selfish interests with the public welfare’—Rosenberg, Reference Rosenberg1960, p. 565). Hence, Smith saw sound institutions as necessary to guide/manage the behaviour not only of individuals and firms but also of government itself. The twenty-first century has moved on since the eighteenth in terms of a culture that recognises, if not always adheres to, the need for non-self-interested public administration. But institutional constraints have been an essential component of that progress, and one does not have to be a Public Choice zealot to notice that when such constraints are absent or ignored, policymaking can become distorted by the interests of politicians and their supporters.

In this section and the next, I argue that the UK’s ‘administration of justice’ has become less ‘tolerable’ over the last few years as constraints on the Executive behaviour have been eroded. This is evident both in issues of ‘high politics’ and in more day-to-day issues of administration: some involve the UK Government explicitly planning to act unlawfully and some are (possibly) unwitting. However, the bulk of the evidence lies in the cavalier way in which the government has undermined other branches of government by, for example, seeking to by-pass Parliament, neglecting to honour commitments to appear in front of Parliamentary Select Committees, ignoring the advice of formal advisory bodies, reducing the scope for the judicial review of government action and, most of all, in passing legislation which appropriates to itself the ability to change regulation by secondary legislation that had previously been determined by primary legislation. After listing a few instances of ‘high politics’, which are well known, I examine in detail a more day-to-day issue of international trade regulation which illustrates the way in which this erosion of standards of administration has occurred.

Brexit stressed UK politics and institutions nearly to breaking point. Among the symptoms, was the government’s growing intolerance of opposition from any quarter and this spilled over into several instances of activity that was unlawful or of highly dubious legality. Prime Minister Teresa May tried to exclude Parliament from key Brexit decisions, and when struck down by the Supreme Court made no effort to challenge a press campaign depicting judges as ‘the enemies of the people’. Boris Johnson prorogued Parliament when it would not pass his Brexit legislation and, again, was overruled by the Supreme Court. The government acknowledged that the Internal Market Bill of September 2020 broke international law by violating the Withdrawal Agreement with the EU. The Northern Ireland Protocol Bill of June 2022 was held by most to be unlawful and was dropped only after extensive EU-UK negotiations on a compromise deal on Northern Ireland—the Windsor Framework. Finally, the Home Secretary stated in March 2023 that she was ‘unable to make a statement that, in my view, the provisions of the Illegal Migration Bill are compatible with the [European Convention on Human Rights—of which the UK is a signatory]’.

International treaties are a form of contract and so, although he does not discuss the international dimension, the sort of behaviour outlined in the previous paragraph would fall short of Smith’s view of ‘tolerable administration’. In addition, the threats of unlawful behaviour have undermined the UK’s credibility in the community of nations, with clear potential economic costs. For example, Jacinda Ardern’s threat to block the UK’s access to the CPTPP because it did not respect ‘the rules-based order’ , and the EU’s refusal to admit the UK to the huge scientific programme Horizon Europe while it refused to honour the Northern Ireland Protocol. Although these specific issues have been resolved, they clearly weakened the UK’s hand in negotiations and it seems inevitable that there will continue to be reservations about the UK’s willingness to honour agreements and hence about the wisdom of entering cooperative arrangements with it.

5. The Trade Remedies Authority (TRA)

The UK Government’s weakening attachment to the rule of law is also present in less prominent areas of government than the previous examples, and in ways that are less likely to be undone in future. This section documents the breaking of the law and the subsequent ad hoc adjustment of the law to undermine an institution of economic governance: the TRA. Such behaviour violates the implicit contract with trading partners to behave fairly and also undermines property rights in the sense that investments in developing trading links with the UK might be undone by arbitrary UK action without due process.

Having taken responsibility for its trade policy from the European Commission, the UK Government immediately faced the question of the institutional and legal framework under which it would exercise that responsibility. One aspect concerned how to manage trade remedies—the imposition of temporary restrictions on imports in the face of unfair trade (resulting from dumping or subsidies) or unforeseen shocks which cause injury to UK producers (where governments can introduce temporary trade restrictions known as safeguards). There was effectively no discussion of whether to have a trade remedies regime. The EU had one, which had long been pretty active, and nearly all major economies also had such regimes.

To try to ensure that trade remedies responded to real needs rather than just meeting politically convenient requests for protection, WTO rules impose (mild) technical and procedural requirements on their introduction, but the details are determined by national governments and are written into national law. In the main economies of the world, the technical and procedural tests are carried out by arms-length bodies or largely autonomous branches of government, which then make recommendations to the ministries governing trade politically. The recommendations always refer to very precisely defined commodities rather than general issues of trade policy. While most administrations give ministers the right to override trade-remedy recommendations on ‘public interest’ (political) grounds, this is usually made rather public and inconvenient to discourage it from being done casually. This is the case in the UK.

Economists generally dislike the administrative structures that manage trade remedies. These involve extensive investigation of the case for imposing restrictions on a specific import, and thus inevitably pit the import-competing sector, which would get protection against its customers which would face higher prices. Investigations are almost always initiated in response to requests from the potential beneficiaries of the restrictions and are detailed and costly and thus place small firms and consumers at a disadvantage. Large firms and those that would gain heavily from protection can afford the resources to operate the system in their favour by collecting and presenting evidence and employing smart lawyers. Small firms lack resources and individual consumers lack the incentive to oppose any particular import restriction because it has only a miniscule effect on their budgets. But policies add up over products and there are millions of small firms and consumers, so in terms of aggregate interest, the latter groups are greatly under-represented in trade remedy decisions.

On the other hand, trade remedies are often seen as a necessary political evil, because permitting occasional trade restrictions in the name of fairness or compassion is seen as an important safety net which allows import-competing interests to agree to general trade liberalisation on the grounds that if it gets too uncomfortable, relief is possible—Bhagwati (Reference Bhagwati1988).

A leading critic of trade remedies was Michael Finger—starting from Finger et al. (Reference Finger, Hall and Nelson1982). Trade remedies create winners and losers and Finger argued that delegating much of the decision-making analysis to arms-length bodies and making it highly elaborate were designed to offer politicians a partial shield against lobbying and to take the political sting out of granting petitioners the protection they sought (or not). He demonstrated that, as noted above, most systems were heavily biased towards large producer interests. Eventually, however, with his co-authors, Finger concluded that the system does have one virtue—Baracat et al. (Reference Baracat, Finger, Thorne and Nogues2015): by codifying and making public the process of making one-off protection decisions, it can help to avoid political ad hocery and its eventual descent into favouritism, clientelism and chaos.

It is not clear that a Smithian trade policy would include anti-dumping or anti-subsidy actions: he believed that if foreign producers were more competitive than domestic ones, one should import, and he also abhorred any system that facilitated the ‘monopolisation’ of trade as anti-dumping duties are often said to do—Messerlin (Reference Messerlin1990). We can, on the other hand, find a parallel with safeguards in his comments on the occasional need for choosing gradual liberalisation. Independent of such detail, though, Smith’s broader comments seem to suggest providing a policy environment that offers predictability, security and robust defences against political interference.

The UK Government started off along this Smithian line: it consulted widely on trade remedies and eventually came up with a regime that was explicitly WTO-compatible, provided procedural limits on the introduction of import restrictions and established a credible appeals process. It required investigation of a case for introducing a trade remedy against stated criteria, including an Economic Interest Test (EIT) which attempts to balance the benefits to the protected sector against the costs to users/consumers and the wider effects of the remedy—Serwicka et al. (Reference Serwicka, Chapman and Tyler2023). The regime was initially embodied in the Trade Remedies Investigations Directorate (TRID) of the Department of International Trade and eventually, from 1 June 2021, in the independent non-departmental public body, the TRA, when the Trade Act was finally passed in 2021. The TRID’s and TRA’s powers and operating rules were defined by Statutory Instrument 2019/449 (Department for International Trade, 2019) under the Taxation (Cross-border Trade) Act of 2018. The undermining of the TRA began within a month of its formal entry into operation!