The effective collapse of the Doha round of trade talks in Cancun in September has left the world trade scene in chaos, with an increase in protectionism likely. Free trade, beloved by economists, has only a modest worldwide political constituency, and severe practical defects in a world of floating exchange rates. And the world is turning toward the worst kind of protectionism. Instead of mere tariffs that are at least quantifiable, regulatable and revenue-producing, the world is adopting subsidies, quotas and non-tariff barriers, all less transparent and all more distorting of trade flows. The current world trade regulation system is thus both dangerous and unsatisfactory.

There is a trade structure that would better suit the world's needs, that would alleviate both the political and economic problems inherent in international trade, but not eliminate them (which would be impossible). Politically, the need is for an initiative similar to that of the Reagan Administration's tax reform of 1986: special interests need to give up their favored tax breaks and trade loopholes, replacing them with a modest general tariff. This would then build a system that satisfies the most important needs of all parties and, by its simplicity and efficiency, comes close to maximizing overall welfare.

Like most economic theories, the doctrine of comparative advantage rests on a number of theoretical assumptions that are often untrue in practice. In particular, the doctrine ignores the frictional costs of people losing their jobs and being forced to change their livelihoods. Thus, in cases where the advantage from free trade is modest and its disruption severe, free trade may not be wealth-maximizing, for the economy as a whole, when the time value of money is taken into account. Moreover, free trade involves inequality of sacrifice. In most cases, the benefits of free trade are hidden and accrue in small amounts to consumers all over the society. The costs, on the other hand, are highly visible, bearing particularly harshly on a relatively small group of people, generally of modest income and education. It has frequently been said that free trade is a mechanism to redistribute income from poor people in rich countries to rich people in poor countries; the history of blue-collar wage levels in the United States since 1973 tends to validate this thesis (although heavy immigration, a separate question, has exacerbated the problem by still further augmenting the supply of modestly skilled U.S. labor).

The benefits of freeing trade in an item do not in practice accrue in perpetuity; varying wage and other input costs and the inflow of new technology mean that cost differentials between production sources are quite unstable, occurring for only a few years, or at most a decade or two. Moreover, movements of exchange rates between currency blocs cause the comparative advantage between product sources to swing to and FRO, as respective currencies rise or fall. If we lived in a world of fixed parity gold-standard exchange rates and minimal technological advance, like Adam Smith's 18th century, then completely free trade would optimize the system over time--production factors would migrate to their nexus of greatest comparative advantage. But we have not lived in such a world since 1914 at the latest.

In the world of exchange rates that fluctuate against each other by substantial percentages (apparently in a rough long-term cycle), the optimization potential of comparative advantage does not work--even if you ignore technological changes. For example, from 1985-95, the deutschemark strengthened from DEM 3.17 = US$1 to DEM 1.42 = US$1, then weakened to the equivalent of DEM 2.38 = US$1 by 2002 (by which time it was of course subsumed in the euro). Inflation in both Germany and the United States was low and comparable throughout the period.

Consider manufacturers of equivalent products in Germany and the United States, whose products are primarily domestically manufactured but can be exported to the other country at a cost of 5 percent of their value. Suppose the products are closely equivalent, with the German product's manufacturing cost being DEM 200, and the U.S. product's manufacturing cost being $100. Then, at the deutschemark's nadir in 1985, the German company could export to the United States at a cost of $63.09, plus $3.15 freight, or $66.24 in the U.S. market, compared with the U.S. manufacturer's $100. The U.S. producer, facing such a huge cost differential, would be rapidly driven out of business.

Ten years later, the U.S. manufacturer could sell into Germany at a cost of DEM 142 plus DEM 7.10 freight, or DEM 149.10 total, compared with the German manufacturer's DEM 200. This time, it is the German manufacturer who would be driven out of business. By 2002, the German manufacturer again would have the advantage, selling in the United States for $84.03 plus $4.20 freight, or $88.23 total, with the U.S. manufacturer at a severe disadvantage.

Needless to say, driving manufacturers out of business in alternate countries once a decade is not optimal for anybody. In such a case, a low tariff, no more than 10 percent or so, imposed by each side on imports from the other, may help stabilize the system. Such a tariff is equivalent to raising shipping costs from 5 percent to 15 percent, thus making exporting more expensive. In the case above, the German product costs $72.86 in the U.S. market in 1985 and $97.11 in 2002, while the U.S. product costs DEM 164.01 in 1995. Since the extreme exchange rate values last for only a few months, with a reversion closer to the mean quite quickly, such a 10 percent tariff would probably be enough to prevent the bankruptcy of either manufacturer from exchange rate fluctuations alone.

The low tariff does not prevent truly substantial cost advantages from winning out. If the German company, instead of DEM 200 in manufacturing cost, had DEM 160, then its U.S. cost, even with the tariff, would be $58.29 in 1985 and $77.69 in 2002. This is enough of an advantage for it to gain dominance in the U.S. market, which it would maintain through most of the exchange rate cycle. The same analysis applies in the more complex case where there are several different manufacturers, each located in a different currency bloc.

In a completely free-trade system, temporary overvaluation of a particular currency against its trading partners causes bankruptcies and job losses that, taking into account the long term trend of exchange rates, are not justified. Experience has shown that currencies do not hover around their "purchasing power parity"; they fluctuate substantially beyond any rational estimation of their value, driven by speculative money flows and capital market transactions, far more than by trade.

Such an overvaluation of the dollar in 2002, combined with the political strength of the U.S. steel industry, caused President George W. Bush to impose high "anti-dumping" duties on many foreign steel imports. As the dollar dropped after the spring of 2002, the problems in the U.S. steel industry lessened, and the anti-dumping duties became superfluous, but they had already distorted trade by imposing a much higher tariff level than could have been justified in an open long term negotiation. At the same time, the United States faced retaliation: the EU, Japan and South Korea threatened to impose punitive tariffs of up to 30 percent on U.S. exports. Much better to have an overall low tariff on imports, openly negotiated and in place over the long term. It would be far less economically damaging to all parties than pre-emptive and unilateral impositions of high tariff rates, let alone quota systems.

When designing a free-trade agreement, one must look for areas in which the comparative advantage is large or the barriers being removed are high, because it is in those areas that the gains for free trade are greatest and most likely to outweigh the frictional costs of currency fluctuations. Reducing or removing tariffs that are already low produces only small gains (even proportional to the value of tariffs removed) and may well incur large costs.

Low tariffs may be beneficial in a world of floating exchange rates, but high tariffs, whether imposed overall as in many Third World countries, or in the form of anti-dumping duties as in the United States, are pernicious obstacles to economic optimization and should be outlawed in a well-designed tariff system. The high tariff rates between Third World countries are probably the greatest single economic obstacle that poorer countries face. Their removal by a strong World Trade Organization (WTO) would bring enormous gains--and all achieved entirely without participation by the wealthy West.

Not that tariffs are the worst form of protectionism: subsidies are more damaging because they cause huge distortions between the subsidized item and the rest of the economy, which is taxed rather than subsidized and must pay extra to provide the subsidy. Quotas are also more damaging than tariffs, as they provide a tariff that is effectively infinite at the margin, and hence allow the perpetuation of inefficient production, whatever the cost advantages of imports. Non-tariff barriers such as environmental or labor regulations are also more damaging than tariffs. They are not transparent, they impose costs often far beyond those of a simple tariff, and they are generally discriminatory in favor of Western suppliers and against less well established Third World producers.

Unlike broad-based tariffs that are negotiated through the WTO or previously through the General Agreement on Tariffs and Trade, subsidies, anti-dumping duties, quotas and non-tariff barriers are generally produced by a domestic political process. This not only allows non-economic factors to dominate the discussion, it is also a seed-bed of corruption.

Extreme free traders also ignore the effect of tariffs in raising tax revenue. Of course, the economy is optimized if tariffs are zero, but it is equally optimized if tax rates are zero, and we are generally moving further away from rather than approaching that desirable state of affairs. Just as a tariff discriminates between domestic producers and importers, causing fewer goods to be imported than would be the case at a zero tariff rate, so an income tax discriminates between work and leisure, causing fewer goods to be produced than at a zero tax rate.

In the small-government societies before 1914, tariffs were often the major source of revenue for government. In late 19th-century America, the post-Civil War Republicans set tariff rates so high that the government generated a permanent excess of revenue, paying off Civil War debt and then accumulating a cash surplus. The 1880 Democratic presidential primary was fought on the slogan "Tariff for Revenue Only"--not for protectionism beyond the necessary level to fund government--producing the immortal Thomas Nast cartoon of their befuddled presidential candidate Winfield Scott Hancock inquiring "Who is Tariff, and why is he for Revenue Only?" Speaker "Czar" Thomas B. Reed, of the 1888 GOP Congress proclaimed in turn, "God help the Surplus." He then proceeded to spend it, an attitude not unknown in more recent years.

A "level playing field" tax system (of course, an unattainable ideal) that did not discriminate between consumption and production, nor between imports and exports, would have a tariff level lower than the income tax rate because income taxes are imposed on profits while tariffs are imposed on revenues. Since profit margins vary from item to item, a "level playing field" tariff would, in theory, be levied at a varied rate, with higher rates on high-margin items such as semiconductors and telecom equipment, and lower rates on low-margin items such as textiles. In this way, tariff rates on imports would be equilibrated approximately with taxes on incomes. All economic activity would be taxed to approximately the same extent.

This is not to advocate still a further increase in the size of government. Such a rational tariff system, to the extent it raised revenue, would allow for tax reductions in other areas. In the United States, taxes could usefully be reduced on corporate dividends, which remain subject to significant double taxation at overall rates that still exceed 50 percent, and on modest self-employment incomes, which, including doubled social security contributions, are also subject to high marginal tax rates.

In summary, a rational tariff system would allow modest protectionist tariffs to guard against exchange rate and weather driven disruption, but would not permit high tariffs, quotas, subsidies, non-tariff barriers or discrimination between sources of supply. It would allow for cuts in other government taxes. And it would need a credible world body policing it.

To see how such a system would work in practice, look at the three trade items that caused the most discord at Cancun: steel, textiles and agriculture. In a rational trade system, the United States and European steel industry would benefit from a low tariff of no more than 10 percent, which would provide American industry with modest assistance in periods such as early 2002 when the dollar was inordinately strong. However, the long-term lack of competitiveness of Big Steel (as distinct from the mini-mills) against cheaper labor and more efficient Asian competition would cause painful but necessary restructuring and downsizing in this industry. Costs of past mistakes, such as the excessive pension provisions in past union contracts, would not be subsidized by the American buyer of steel products. Whether they should be subsidized by the U.S. taxpayer as a way of easing the frictional costs of competition is outside the scope of this article (though I would be against doing so).

Similarly, U.S. and west European textile and garment industries are structurally uncompetitive with Asian imports because of their high labor costs. Specialty manufacturers, particularly producers of high-fashion apparel, can survive, but others must outsource most of the manufacturing process to cheap labor countries. (Sewing is particularly labor intensive, while cutting is largely automatable.) A modest overall tariff at the 10 percent level will not significantly slow the long-overdue migration of this industry to the Third World; the problem here is structural, not exchange-rate related. The Third World is right to be outraged by import quotas in textiles and by the inordinate delay to 2005 in removing them, as agreed by the Uruguay trade round in 1994.

In agriculture, most price fluctuations are caused neither by exchange rate movements nor relative labor costs, but by Mother Nature. Hence, in societies such as the United States where farming is highly capital intensive, governments must protect their farmers' investments against poor harvests or, more damagingly, against good harvests in other parts of the world that produce temporary gluts of produce and prices too low to cover the farmer's fixed costs. In the United States, Europe and Japan, the solution to this since the 1930s has been to subsidize the farmer, often paying him for acreage taken out of production or dumping exports on other countries at subsidized prices. This is incredibly wasteful, an unfair barrier to imports from the Third World and destabilizing to the incomes of Third World farmers. The objectives of farm subsidies (other than simply diverting wealth to the pockets of agribusiness) can be achieved much more elegantly by a mechanism that has been wrongly derided since it was abolished in 1846: the 1815 British Corn Laws, or rather their 1827-28 modification.

The central principle of the Corn Laws was that treatment of corn imports should vary with the market price of corn. Under George Canning's proposed version of 1827, the duty (paid by the foreign exporter) rose in rough proportion to the drop in the corn price and fell with the rise in price, with corn entering Britain free of duty when prices rose to high levels in times of scarcity. Farmers received protection against gluts and consequent drops in price, while consumers were protected against bad harvests. There were no subsidies, and the net cost to government was simply that of administration. In three respects, therefore, its lower cost to government, the lack of distortion to the domestic market (which rewarded the most efficient producers accordingly) and the lack of incentives to dump produce on the world market, the Corn Laws system was greatly superior to modern agriculture subsidies.

A modern Corn Law would apply to agricultural products in general and would work in the same way. It would replace subsidies, quotas (as in sugar) and above all export bounties, thus preventing the huge economic waste of over-production followed by export dumping (illegal under WTO rules in any sector other than agriculture). Ideally, it would be applied at equal levels in the United States, the EU and Japan.

The mechanism for negotiating trade agreements also needs to be modified. The current WTO, with its reliance on one country, one vote decision-making and a requirement for unanimity is, as demonstrated at Cancun, hopelessly open to subversion by anti-trade fanatics playing on the fears of the less sophisticated countries of the Third World. Equally, there are too many deals "stitched up" in advance of full WTO meetings between powerful trading blocs, which also tend to lock in negotiating positions and prevent progress being made.

A central difficulty in the WTO is its voting mechanism, which is based on a flawed analogy with democracy, and should instead be based much more soundly on a shareholder-type voting structure, with voting power proportional to the amount of trade a country enjoys. For example, voting rights could be allocated every five years according to the sum of a country's imports and exports of goods and services in the previous quinquennium. Countries with a great deal of trade in proportion to their GDP, such as Singapore, would be disproportionately weighted in the WTO, reflecting their disproportionate importance in the world trading system, whereas countries such as Brazil that maintained high trade barriers would be less heavily weighted. There would be a natural institutional bias toward free trade, proper in such a body.

Having established a voting system that truly represented the importance of each country in world trade, there would then be no need for unanimity. But a supermajority--maybe 75 percent--of votes would be required to pass tariff agreements. It could be that blocs of countries such as the EU would attempt to get together and form a blocking minority. But there is an obvious riposte. If they acted as a single entity in trade negotiations--as did the EU, for instance, at Cancun through Pascal Lamy--then their intra-regional trade would cease to be counted in determining their weighting, just as trade between Iowa and Kansas would not be used in determining the U.S. weighting. In addition, the problem of NGOs determining the atavistic reactions of small and unsophisticated Third World countries would go away. Such countries would represent only a small portion of world trade and so would have only a small WTO vote.

Naturally, countries that objected to the WTO's methodology would not be forced to join it; they would then not benefit from the access it negotiated to the major world markets. If they wanted such access, they would have to sign up to the WTO, thus both providing reciprocal access to their own market and subjecting themselves to the WTO's rules of the game in respect of subsidies, quotas and non-tariff barriers. Side deals, where a major WTO member granted preferential access to a non-member country without that country accepting the WTO's "fair-play" rules, would not be permitted. This reformed WTO would take decisions more effectively and would be mandated both to organize trade treaties between its members and, more importantly, to stamp out the protectionist growths that appear every time a country has an election coming up--namely, anti-dumping actions, new non-tariff barriers or the imposition of quota systems. Non-tariff barriers in the areas of labor and the environment should be permitted only if agreed by a 75 percent majority of the WTO. The principal function of the WTO would then be to act as a police court against election-driven special interest protectionism.

In order to cater for the special needs of poor countries, should the WTO discriminate between countries according to their wealth, as measured by GDP per capita? Poor countries, while compelled to lower their overall tariff levels, particularly against each other, might be permitted to maintain higher tariffs in limited sensitive areas where they have a great deal of low-skill traditional labor. They might also be allowed, for example, to discriminate moderately against foreign financial institutions that have an undue advantage of lower funding costs in the local market since they carry a better credit risk derived from their Western parent. (Such discrimination would be most effective by means of a "funding cost tax" to equalize the foreign-owned bank's funding costs with that of its local competitors.) As countries graduated to middle-income status, or their credit ratings moved above Standard & Poor's BBB level, however, the WTO would compel them to phase out the additional protections over a period of, say, three years.

Intellectual property is a particularly difficult area. Governments and producers in Europe and the United States try to build support for intellectual property restrictions by focusing public opinion on life-saving drugs. But intellectual property also includes trashy movies and popular music. Property rights are a fuzzy concept, not an absolute. One can accept that, if intellectual property in pharmaceuticals is violated, research will be hampered. But allowing intellectual property in "gangsta" rap merely produces more "gangsta" rap.

As in trade generally, poor countries would not be subject to the full rigors of copyright and patent law until they reached a middle-income wealth level, and could be expected to produce copyrightable or patentable material (whether scientific or, as in the case of Japan's Manga comics, literary) of their own. If producers in poor countries produced "pirate" copies, then international trade in such copies could be prohibited by the WTO, thus providing additional protection to copyright holders' interest in Western markets.

In the meantime, as is happening with aids drugs, Western charitable and supranational organizations would provide funding for Western-produced pharmaceuticals for the Third World, thus avoiding the problem of local producers of low-quality generics flooding the market with untested and dangerous alternatives. There would be no such eleemosynary organizations for "gangsta rap" or Manga comics.

Absent a reformed trade regime of this kind, a partial return to protectionism seems likely, since the United States has moved considerably toward such a policy in recent years, and the EU as a body never left it. (The European value-added tax, generally levied at rates around 20 percent, is also discriminatory, since it is not levied on exports, thus providing European producers with a substantial subsidy for exports as against production for internal consumption.) And while new WTO members such as China and emerging WTO members such as India are strongly committed to free trade in principle, in practice they use every artifice they can to preserve their own protectionist structures. A weakened WTO will hardly be able to prevent them from doing so. Meanwhile, labor and environmental non-tariff barriers are both likely to blossom in the years ahead--the normal bureaucratic impulse to "compromise" with the pernicious agenda of the trade protesters will see to that.

The United States may mitigate some of the effects of this by forming bilateral trade agreements with favored nations, as will the EU in their hinterlands of eastern Europe, Central Asia, North Africa and the Middle East. In practice, this will increase the danger of the world becoming divided into a small number of autarkic trading blocs that have relatively free internal trade and high barriers against outsiders. Inevitably, this will tend to impoverish further those Third World countries that have little to offer economically, thus perpetuating their downtrodden status.

Without a trade body wielding real power to regulate protection, trade barriers will be raised by domestic political processes. Hence, they will pay little regard to comparative advantage, ossify economic structures and push the growth of gross world product far below its potential. The "have-nots", with their rapidly growing populations, will end by having even less.

This unpleasant fate can be avoided, but it will require trade negotiations to rise above both domestic electoral pressures and the unrealistic dogmas of frustrated trade economists. In trade, as in philosophy, the best should not be allowed to become the enemy of the good.