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Economic growth: trade, public finance, and the paradox of thrift

John Smithin

Keywords: balance of payments; classical economics; exchange rates; monetary mercantilism; fiscal policy; free trade; FTAs; growth; hard peg; investment; Keynes; savings; sectoral balances

The classical argument for free trade stressed the possibilities of economic growth by exploiting the gains from trade. A trade surplus per se was not the main objective; presumably the argument was that trade would be balanced at the new higher growth rate. Moreover, the arguments for free trade were made against the background of an assumed hard peg (the gold standard) which would enforce balance of payments equilibrium. This means that contemporary free trade agreements (FTAs), with floating exchange rates, cannot be defended on the traditional grounds.

With a floating exchange the appropriate policy advice for each individual jurisdiction is monetary mercantilism – the use of macroeconomic policy in an attempt to achieve a trade surplus as a percentage of GDP. If one partner pursues such a strategy alone, this will translate into a one-for-one increase in the growth rate, and potential regional hegemony for the first mover. To restore balance amongst the trade partners (not necessarily with the outside world) and yet still keep higher growth rates there would have to be a union-wide expansion. This need not be formally coordinated, but at least all the partners should be in broad agreement about the stance of policy.

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