FPIF Special Report
December 2003

Kicking Away the Ladder: The “Real” History of Free Trade

By Ha-Joon Chang

2. The “Official History of Capitalism” and Its Limitations

The “official history of capitalism,” which informs today's debate on trade policy, economic development, and globalization, goes like the following.

From the eighteenth century, Britain proved the superiority of free-market and free-trade policies by beating interventionist France, its main competitor at the time, and establishing itself as the supreme world economic power. Especially once it had abandoned its deplorable agricultural protection (the Corn Law) and other remnants of old mercantilist protectionist measures in 1846, it was able to play the role of the architect and dominant influence of a new “liberal” world economic order. This liberal world order, perfected around 1870, was based on laissez-faire industrial policies at home; low barriers to the international flows of goods, capital, and labor; and macroeconomic stability, both nationally and internationally, guaranteed by the Gold Standard and the principle of balanced budgets. A period of unprecedented prosperity followed.

Unfortunately, according to this story, things started to go wrong with the First World War. In response to the ensuing instability of the world economic and political system, countries started to erect trade barriers again. In 1930, the United States also abandoned free trade and raised tariffs with the infamous Smoot-Hawley tariff, which Jagdish Bhagwati called “the most visible and dramatic act of anti-trade folly” (Bhagwati, 1985, p. 22, footnote 10). The world free trade system finally ended in 1932, when Britain , hitherto the champion of free trade, succumbed to the temptation and re-introduced tariffs. The resulting contraction and instability in the world economy, and then finally the Second World War, destroyed the last remnants of the first liberal world order.

After the Second World War, so the story goes, some significant progress was made in trade liberalization through the early General Agreement on Trade and Tariffs (GATT) talks. However, unfortunately, dirigiste approaches to economic management dominated the policy-making scene until the 1970s in the developed world, and until the early 1980s in the developing world (and the Communist world until its collapse in 1989).

Fortunately, it is said, interventionist policies have been largely abandoned across the world since the 1980s with the rise of neoliberalism, which emphasized the virtues of small government, laissez-faire policies, and international openness. Especially in the developing world, by the late 1970s economic growth had begun to falter in most countries outside East and Southeast Asia, which were already pursuing “good” policies (of free market and free trade). This growth failure, which often manifested itself in economic crises of the early 1980s, exposed the limitations of old-style interventionism and protectionism. As a result, most developing countries have come to embrace “policy reform” in a neoliberal direction.

When combined with the establishment of new global governance institutions, represented by the World Trade Organization (WTO), these policy changes at the national level have created a new global economic system, comparable in its potential prosperity only to the earlier “golden age” of liberalism (1870–1914). Renato Ruggiero, the first director-general of the WTO, thus argues that, thanks to this new world order, we now have “the potential for eradicating global poverty in the early part of the next [twenty-first] century--a utopian notion even a few decades ago, but a real possibility today” (1998, p. 131).

As we shall see later, this story paints a fundamentally misleading picture, but no less a powerful one for it. And it should be accepted that there are some senses in which the late nineteenth century can indeed be described as a laissez-faire era.

To begin with, there was a period in the late-nineteenth century, albeit a brief one, when liberal trade regimes prevailed in large parts of the world economy. Between 1860 and 1880, many European countries reduced tariff protection substantially (see table 1). At the same time, most of the rest of the world was forced to practice free trade through colonialism and through unequal treaties in the cases of a few nominally “independent” countries (such as the Latin American countries, China, Thailand [then Siam], Iran [then Persia], and Turkey [then the Ottoman Empire], and even Japan until 1911). Of course, the obvious exception to this was the United States , which maintained very high tariff barriers even during this period (see table 1). However, given that the United States was still a relatively small part of the world economy, it may not be totally unreasonable to say that this is as close to free trade as the world has ever come.

More importantly, the scope of state intervention before the First World War was quite limited by modern standards. States had limited budgetary policy capability because there was no income tax in most countries and the balanced budget doctrine dominated. They also had limited monetary policy capability because many of them did not have a central bank, and the Gold Standard restricted their policy freedom. They also had limited command over investment resources, as they owned or regulated few financial institutions and industrial enterprises. One somewhat paradoxical consequence of all these limitations was that tariff protection was far more important as a policy tool in the nineteenth century than it is in our time.

Despite these limitations, as we shall soon see, virtually all of today's developed countries--or now-developed countries (henceforth NDCs)--actively used interventionist trade and industrial policies aimed at promoting, not simply “protecting,” it should be emphasized, infant industries during their catch-up periods.

Britain was the first country to introduce a permanent income tax, which happened in 1842. Denmark introduced income tax in 1903. In the United States , the income tax law of 1894 was overturned as “unconstitutional” by the Supreme Court. The Sixteenth Amendment, allowing federal income tax, was adopted only in 1913. In Belgium , income tax was introduced only in 1919. In Portugal , income tax was first introduced in 1922, but was abolished in 1928, and re-instated only in 1933. In Sweden , despite its later fame for the willingness to impose high rates of income tax, income tax was first introduced only in 1932. See Chang (2002, p. 101) for further details.

The Swedish Riksbank was nominally the first official central bank in the world (established in1688), but until the mid-nineteenth century, it could not function as a proper central bank because it did not have monopoly over note issue, which it acquired only in 1904. The first “real” central bank was the Bank of England, which was established in 1694, but became a full central bank in 1844. By the end of the nineteenth century, the central banks of France (1848), Belgium (1851), Spain (1874), and Portugal (1891) gained note issue monopoly, but it was only in the twentieth century that the central banks of Germany (1905), Switzerland (1907), and Italy (1926) gained it. The Swiss National Bank was formed only in 1907 by merging the four note-issue banks. The U.S. Federal Reserve System came into being only in 1913. Until 1915, however, only 30% of the banks (with 50% of all banking assets) were in the system, and even as late as 1929, 65% of the banks were still outside the system, although by this time they accounted for only 20% of total banking assets. See Chang (2002, pp. 94–97) for further details.

Moreover, when they reached the frontier, the NDCs used a range of policies in order to help themselves “pull away” from their existing and potential competitors. They used measures to control transfer of technology to its potential competitors (e.g., controls on skilled worker migration or machinery export) and made the less developed countries open up their markets by unequal treaties and colonization. However, the catch-up economies that were not formal or informal colonies did not simply sit down and accept these restrictive measures. They mobilized all kinds of different “legal” and “illegal” means to overcome the obstacles created by these restrictions, such as industrial espionage, poaching of workers, and smuggling of contraband machinery. See Chang (2002, pp. 51–9) for further details.

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