Calls for government intervention into the economy usually focus on some supposed deviation in the free market system: currency manipulation, tariffs by trading partners, taxation, etc. As the argument goes, because these things deviate from the ideal assumptions of the model, some government intervention (usually in the form of retaliatory or punitive actions against their citizens) becomes necessary.
However, this form of argumentation represents a fundamental misunderstanding on what free trade is and is not, and more importantly the uses of economic models. This post is an effort to clear up these misconceptions.
Free Trade is Not a Policy
The language surrounding is misleading, both by its advocates and its opponents. Both coach free trade in terms of policy: “Government needs to do laissez-faire!” or “Government needs to reign in free trade!” or something like that. Free trade, however, is not a policy. One does not implement free trade. A government can take action to promote free trade (reducing tariffs, cutting regulations, etc), but it cannot adopt a free trade policy per se.
Free trade is nothing more than allowing peaceful interactions between consenting individuals. It requires no active government policy. In a free trade society, any governmental role would be naturally be limited to a passive role of enforcing contracts and protecting rights (what Jim Buchanan calls the “Protective State“).
Furthermore, since free trade is no policy, it is not dependent upon the assumptions of the economic models to function (I will return to this point in the next section). None of the arguments for free trade require perfect information, identical principles between buyers and sellers, known utility functions and universal preferences, etc. Free trade is robust to deviations from the ideal; the system still works because it is a process, not a policy. Deviations from the ideal, movements away from equilibrium, present opportunities for entrepreneurs to correct issues; the many plan for the many and do not require the guiding hand of government to correct for deviations.
Models as Analysis and as Policy Tools
Models serve two roles: first as a means of analysis and second as a means of directing policy. In these two roles, the characteristics of the model matter.
An analytical model, which is the proper use of economic models, involve simplifying assumptions in order to explore (or “analyze”) a particular question. By way of example, let’s look at minimum wage. The question is: “What effects will minimum wage have?” Through a set of assumptions contained in the supply and demand price theory model, we can make a pattern prediction: a binding minimum wage will cause a surplus of labor in the market. We can make this pattern prediction because our model reasonably reflects reality, even though it has many simplifying assumptions which are, to be frank, unrealistic (for example, the model contains the assumption of “all else held equal,” a condition which never happens). Our analytical models give us the tools to analyze.
Where the problem comes in is using an analytical model to guide policy (both free-market supporters and opponents make this mistake). To guide policy, you need a descriptive model, not an analytical model. In other words, you need a model that is descrptive of reality, not one that reflects reality. When attempting to guide policy, this is where the assumptions of the model become important. To impose an “optimal tariff,” you need to know the demand and supply curves (something which is unknowable), you need to know indifference curves and von Neumann-Morgenstern utility functions (which are unknowable), true relative prices and equilibrium, etc etc. To paraphrase Hayek, to use these models to guide policy, you need to assume knowledge that the price system alone can actually give you! When using models to guide policy, deviations from the model’s assumptions become critical!
Any good scientist needs to know the limitations of the tools he uses. Price theory models are extremely helpful in providing a lens through which to analyze the world. They allow us to make pattern predictions and conduct analysis. What they do not allow us to do is to make point predictions and guide policy with any level of accuracy needed. Anyone who pretends otherwise is operating under the pretense of knowledge; he is not acting as a scientist, but rather as a charlatan or a fool: a charlatan if he deliberately knows the limits of his models but pretends they are more accurate than they are and a fool is he believes his own models give him the ability to shape policy.