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How to Think Our Way Out of Our Trade Crisis

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Below is a long letter I and Marc Fasteau, a progressive banker in New York, wrote last year to one of the major organizations in this country which funds innovative economic research, suggesting ways to move the ball forward in terms of America’s thinking on trade.  They haven’t yet responded vigorously in this area of economics, so I’m publishing the letter to help clue the public in on what it will take for this country to think its way out of its current trade mess.

Dear XXXX:

The essential task in reforming trade economics is twofold: first, the breaking of new intellectual ground, and second, the forcing into broader academic and policy consciousness of ideas that already exist.  Without the latter, the former will mean little.  Conversely, novel academic research into trade provides an opportunity to shake up the field and draw the attention of both academics and the public.

With respect to existing critiques of free trade, there are, in fact, four levels of understanding in economics that must be addressed:

1.    The theories of academic specialists in trade economics.

2.    The consensus of academic economics as a whole, including the trade views of economists who do notspecialize in trade.  This determines what most undergraduates get taught about economics—the highest economics education 99.9% of the population ever receives.  It also determines the trade-related policy decisions of high-level policymakers in other areas of economics, like finance.

3.    The implied theoretical model of policy.  This concept refers to the fact that, whatever the purely theoretical views of top policymakers, there exists an (often quite different) theoretical model of the economy that is implied by their policy choices.

4.    The views of the mainstream news media, which closely track the views of the educated general public and Congress.

Failure to address all four levels will result in failure to fix America’s broken trade policy.  The first two levels will have little practical effect if they do not have an effect on the last two; the last two risk veering into populist nonsense if not informed by the first two.

Because mammoth U.S. trade deficits are not sustainable forever, a profound change in U.S. trade relations is inevitable during the next 3-8 years regardless of any coming policy decisions and independent of any particular economic theories. A transformative crisis, be it an acute shock like the 2008 financial crisis or a period of chronic turbulence like the stagflationary 1970s, is now basically inevitable on the trade front.

The better recognized are critiques of free trade when the probable crisis hits, the less likely is an uninformed policy response to crisis driven by a political firestorm. Addressing the issues completely and thoughtfully in advance will allow time for alternative analyses and policies to be developed and vetted.

It follows that whoever can “hear the distant hoof beats of approaching history” will be in a strong position to shape theoretical and practical responses to this coming breakdown of the existing order.  The intellectual high ground that confers dominance over this debate is currently wide open to any taker who understands the issues and has the resources to address them.  There thus exists an opportunity to shape U.S. trade policy and its intellectual underpinnings for a generation or more.

What kind of already-existing ideas on trade are languishing in undeserved obscurity with the public and the economics profession?

Let us consider only some obvious examples. Ricardo is known to be wrong, yet often treated as gospel. The Stolper-Samuelson theorem concerning income inequality and trade is familiar to mainstream economics—but its implications have not yet  been taken seriously.  Paul Krugman and others developed a theory of “strategic trade” starting in the late 1970s, but it has languished with respect to both theoretical fruition (above all, to incorporate dynamic as well as static effects) and policy application.  Bill Clinton’s economic advisor, Laura D’Andrea Tyson, and Barack Obama’s, Lawrence Summers, both did important academic work on the value of capturing global oligopoly industries, but no policy initiatives came of it.  Ralph Gomory and William Baumol of NYU have created a revolutionary new theory of trade based upon multiple equilibria, but it remains little known.

What kinds of ideas on trade could benefit from deepening by further purely academic research?

Ralph Gomory and William Baumol’s work in multiple-equilibrium trade theory is obviously pregnant with vast implications not yet drawn. Economists are increasingly aware that the all-important theory of comparative advantage is a static model which does not comprehend the dynamic relationships between trade and economic growth.  In economic history, insights both new and rediscovered are illuminating relationship between trade policy and economic development. And the profundity of the neomercantilist challenge to free trade emanating principally from East Asia, and its radical incompatibility with American laissez faire, remains poorly theorized in mainstream economics.

The rest of this letter presents an analysis of what kinds of economic ideas your organization could fruitfully attempt to press into greater academic and policy recognition.  There are at least eight major potential projects that could fall into this category:

Research Area #1: Develop and disseminate the policy implications of  the hidden assumptions of David Ricardo’s Theory of Comparative Advantage.

Misuse of David Ricardo’s theory of comparative advantage is one of the most destructive patterns of reasoning in all of trade economics.  His reasoning is abused time and again in both the major media and in the pronouncements of high-level policymakers.  And yet the key problem here is well known: the theory depends upon hidden assumptions that are frequently false. To wit:

1.    Trade is sustainable. This refers to both trade deficits (unsustainable imports) and resource depletion (unsustainable exports.)

2. There are no externalities. This refers to both environmental damage (negative externalities) and spin-offs from technical innovation (positive externalities.)

3. Factors of production move easily between industries. This refers primarily to underemployment, which occurs when human capital cannot easily shift from declining to rising industries.

4. Trade does not raise income inequality. But in the U.S., free trade raises returns to the abundant factor of production (capital) and lowers returns to the scarce factor (labor).

5. Capital is not internationally mobile. It is; the larger question is mobility of all factors of production, but capital is the flashpoint.

6. Short-term efficiency causes long-term growth. It doesn’t, an issue addressed in greater detail in Research Area #2 below.

7. Trade does not induce adverse productivity growth abroad. It does, and while Ricardo shows (if his other assumptions hold) that free trade is advantageous in the short run, it doesn’t show that changes induced by free trade will make gains from trade go up, rather than down.

Although academic trade specialists are well aware of these problems, they remain de facto barely known to many non-trade economists, are omitted from many undergraduate treatments of economics, and are essentially unknown to journalists covering economic policy issues.  Their implications for trade policy should be examined, modeled quantitatively and widely disseminated.

Research Area #2: Develop and disseminate the policy implications of Erik Reinert’s work on the sources of economic growth.

Erik Reinert is a Norwegian scholar trained at Harvard Business School and Cornell and currently teaching at the University of Tallinn, Estonia.  His key work is the 2007 book How Rich Countries Got Rich and Why Poor Countries Stay Poor. The root of his theoretical innovations is his rediscovery of the relevance and sophistication of the mercantilist tradition that originated in the Renaissance, but his work extends far into modern economic conditions and theoretical constructs.

Much of Reinert’s work is neither absolutely original nor unique, as many of his ideas are already a part of the more sophisticated varieties of academic trade economics.  Nevertheless,  his attack on the crude economic ideas which inform much of policymaking is still uniquely valuable. Above all, his analyses are qualitative and thus within the intellectual reach of people without any background in mathematical economics. The three-step dissemination of ideas referred to earlier in this letter is far more likely to happen by way of compelling narrative “stories” which engage people’s  existing intuitions and ideological commitments than by way of mathematics, even if the mathematical version of the same ideas is the one considered canonical by academic economics.  Furthermore, his work provides valuable corroboration of these ideas.

Reinert identifies the following as the key flaws in the version of economics implied by the policymaking of recent years:

1.    Its inability to register qualitative differences between different industries, especially their different potentials to generate economic growth.

2.    Its inability to grasp the importance of synergies, linkages, and externalities.

3.    Its inability to comprehend innovation as intrinsic to economic activity itself, as opposed to an external event, unexplainable by economics.

Prof. Reinert argues that these ideas were well understood in the now almost forgotten German Historical School of economics, whose methods he would like to see revived. The salient differences between bad varieties of contemporary economics and this older school and related schools of thought, which he refers to as the “other canon,” are these:

·  Bad Contemporary Economics assumes and valorizes equilibrium / The other canon assumes and valorizes disequilibrium

·  Assumes perfect information and perfect foresight / Assumes learning and decision-making under uncertainty

·  Assumes a high level of abstraction desirable for its own sake / Chooses the level of abstraction according to the problem under consideration

·  Innovation impinges upon economics from outside, therefore unexplainable / Innovation is at the core of its economic model

·  Capital per se drives the economy / New knowledge creating a demand for capital drives the economy

·  Derives its metaphors from physics / Derives its metaphors from biology

·  Consumption is fundamental / Production is fundamental

·  Analysis is by comparative statics / Analysis focused on change

·  No cumulative causation, so history is unimportant / Cumulative causation key, so history is very important

·  Increasing returns (or their absence) is seen as a minor issue / Increasing returns (or their absence) is seen as a major issue

·  Precision (especially mathematical) regarded as the key virtue in analysis / Accepts a tradeoff between precision and relevance; math is just a tool.

·  Perfect competition is the ideal / Imperfect competition is the ideal

·  Economic activities assumed identical as generators of economic growth / Economic growth is a product of some activities more than others.

·  Economic diversity is assumed unimportant / Economic diversity is seen as a key to growth

·  One-size-fits all policy recommendations / Theories and policies vary by time and place

·  Economy (tacitly) largely viewed as separate from society / Economy viewed as embedded in social context

·  Economy seen as self-regulating / Economies seen as inherently unstable and needing stabilization.

·  No important difference between the real and the financial economy / Conflicts between real and financial economy are normal and require regulation

Research Area #3: Deepen and develop the policy implications of Ralph Gomory and William Baumol’s multiple-equilibrium trade theory

Ralph Gomory and William Baumol are both professors at NYU’s Stern School of Business with distinguished careers behind them outside trade economics.

Their trade work centers on the fact that, in the presence of scale economies, the free market will not necessarily assign every industry to the nation most efficient at it. Instead, first-mover advantages will enable nations to entrench themselves in industries even if other nations might hypothetically have been better.

As a result, the international market does not give one (optimal) answer to the question of what goods should be produced in what nations; it gives many different answers (some suboptimal) depending upon historical accidents. So the Ricardian claim that free trade necessarily produces the most efficient outcome for the world economy and every individual nation is untenable.

Because all internationally traded oligopoly industries do involve scale economies, the Gomory-Baumol model explains the observed fact that strong positions in these industries are a key characteristic of economically successful nations.  In their model, comparative advantage remains a valid principle, but a nation’s best move is no longer, as in Ricardo, simply to trade according to the comparative advantage it already has.  It is to seek comparative advantage in the best industries. Ricardianism is about finding the best use for the comparative advantage one already has(mistaking this for the entire question); Gomory and Baumol are about what kind of comparative advantage it is bestto have.

What kind of comparative advantage is it best to have?  Ideally, advantage in industries that are large, strongly retainable, and with a long future potential for innovation, and many spin-off industries, ahead of it. As Michael Porter of Harvard Business School explains it, referring to such industries as “structurally attractive”:

Structurally attractive industries, with sustainable entry barriers in such areas as technology, specialized skills, channel access, and brand reputation, often involve high labor productivity and will earn more attractive returns to capital. Standard of living will depend importantly on the capacity of a nation’s firms to successfully penetrate structurally attractive industries. The attractiveness of an industry is not reliably indicated by size, rapid growth, or newness of technology, attributes often stressed by executives and by government planners. (Michael Porter, The Competitive Advantage of Nations, p. 36.)

Gomory and Baumol’s work successfully bridges the theoretical gap between the naive “international trade is always win-win” Ricardian view and the overly pessimistic “inter-national trade is war” view.  It is thus a theoretical framework that can accommodate economic reality as real-world economic actors actually experience it.  This makes it uniquely potent as a tool for changing the minds of the educated public on trade, and an excellent “bridge” between the educated non-academic understanding and more academic knowledge of the subject.

Their work, which has not received the scholarly attention it deserves, is also obviously pregnant with vast implications not yet drawn, which should be drawn out by further research. For more details, see their book Global Trade and Conflicting National Interests.

Research Area #4: Develop a national economic plan based on Michael Sekora’s research about how technological, rather than economic, logic is the key to economic growth.

Because many of the research agendas proposed in this document imply that active industrial policy is desirable, it is logical to include an example of what well-reasoned active industrial policy might look like.

Michael Sekora was the head of Project Socrates, a joint CIA-DIA effort at the end of the Reagan administration aimed at developing technology, industrial, and trade policies to win the Cold War.  He now runs a consulting company out of Austin, Texas that helps foreign nations develop economic policies.

Sekora’s theoretical work centers on  how economic growth derives from a technological logic that differs markedly from economic logic.  He maintains that although mainstream economists and business schools claim to understand and teach technology-based planning, they do not.  His work in trade economics is especially valuable because it directly addresses the concerns of executives running real businesses—a crucial constituency that must be persuaded to achieve lasting change in American trade policy.

In Sekora’s view, profit-driven economic logic is merely a way of harvesting growth, not,  as current economic theory mistakenly contends, its source. He believes that the focus since WWII on financial analysis and the elevation of people trained to focus on these metrics in US business, government and academia has obscured technology-driven business strategy and caused it to languish.

Sekora’s view is that competitive advantage, at the company or national level, ultimately comes from control and exploitation of key technologies.  He believes that strategic planning should start with a “techspace map” of all important technologies showing how the relate to each other and to present and anticipated market needs.  The business, academic and government entities where these technological capabilities reside form elements of this map.  (The map is small for a given company, large for an industry, larger for the United States, and all-inclusive for the world.) Strategy is then based upon this map in order to assure the availability, development, and symbiotic interaction of critical technologies—and to deny them to competitors.

Finance is a resource and a constraint on such strategy, but not its driver.  Maximizing financial returns is necessary, but must take place within a broad long term approach of achieving and maintaining technological dominance.

At the governmental level, this approach to economic strategy would inform such areas as:

1.    Trade policy, i.e. which markets are worth protecting and which are not.

2.    Education policy, i.e. which technologies should students be taught.

3.    Research funding policy.

4.    Which interdisciplinary business consortia to authorize and encourage.

This integrated technology based  strategy, in Sekora’s view, has been successfully employed by Japan, China and Germany, among others. In his words,

The foundation of every decision in technology-based planning is how to acquire and utilize technologymore effectively than the competition—to produce products or provide services that excel at satisfying the customer needs for a competitive advantage.

Once a competitive advantage is obtained, then the economics can be optimized to generate maximum profit.

Today, the United States must make the shift from economic-based planning back to technology-based planning to survive.

The Socrates Project developed the ability to generate a computer-based ‘techspace map.’ This tool provided a precise and detailed, real-time representation of current and emerging technologies in terms of their abilities to generate a competitive advantage. It was used to develop technology strategies for high-priority government programs in the 1980s, and it led to investments that resulted in the digital revolution of the 1990s.

Sekora’s key theoretical research into what the U.S. should do has already been done, and what is most needed at this point is the funding to write a comprehensive plan for American action.  He is already in exploratory discussions about this project with an agency of the U.S. government.

Research Area #5: Develop the policy implications of and disseminate Eamonn Fingleton’s work on the East Asian economic model

Eamonn Fingleton is a Tokyo-based Irish financial journalist whose principal contributions to trade economics are in his books In the Jaws of the Dragon (on China), Blindside (on Japan) and In Praise of Hard Industries (onmanufacturing).  His oeuvre constitutes perhaps the single most acute and far-ranging analysis of the contemporary East Asian economic model, both in terms of trade and its domestic industrial policies.

Fingleton’s ultimate conclusion is that free-market capitalism is only one variety of capitalism, far from the best-performing, and currently losing to a profoundly different version.  Insofar as an “East Asian Challenge” is widely perceived by the public and the political class as a serious problem America must confront, his work is among the most analytically profound ways of distilling serious economic understanding from this challenge, rather than the analytically empty responses mostly produced to date.

In Fingleton’s view, for example, Japan has done almost everything wrong by the lights of mainstream contemporary economics, yet remains the second-richest nation in the world. Its economy is highly regulated, centrally planned by the state, and often openly contemptuous of free markets. But it has thrived. (He contends that Japan has been doing very well lately, pace the vested interests that wish to depict it as an economic mess.)
In his view, Japan’s economy is something virtually impossible within the frame of reference of contemporaryeconomics: a non-socialist state-directed system. This is important not so much because America ought to imitate Japan per se, but because the Japanese system reveals that economic laws imagined to be fundamental by mainstream economics are nothing of the kind.  To give some key examples:

1.    It is assumed that capital is most productively employed when allowed to flow to its highest private return.

2.    It is assumed that cartels are eo ipso inefficient.

3.    It is assumed that economic rewards are the most efficient drivers of economic behavior.

4.    It is assumed that “flexible” hire-and-fire labor markets lead to the most efficient accumulation and deployment of human capital.

Fingleton’s work has yet to be theorized within the conventionally accepted frameworks of economics.  Therefore, what would be called for in his case would be the translation of his qualitative insights into the formal models of contemporary economics, which would facilitate the promotion of his ideas so as to win them the academic and policy consideration they deserve.  This should be followed by analysis of what policies on America’s part constitute an appropriate response to his analysis, something that is presently clear only in a general, and largely negative, sense.

Research Area #5: Explore Ian Fletcher’s Hypothesis That a Natural Strategic Tariff Exists

Ian Fletcher is an adjunct fellow at the U.S. Business and Industry Council, a Washington-based think tank, and author of the 2010 book Free Trade Doesn’t Work: What Should Replace It and Why.  In Chapter 11 of this book, he analyzes why there may exist, in the case of the U.S., a relatively simple tariff policy that would, because of the complex interaction of the policy with the existing economy, have the sophisticated strategic effects America needs. This idea should be rigorously explored because, if correct, it would provide a simple but strategically sophisticatedsolution to many of America’s trade problems.  It would thus represent an extraordinarily attractive policy option for the U.S., removing at a stroke most of the vexing political-economy problems of administering a sophisticated trade policy with competence and honesty.

How might a natural strategic tariff work?

Take, for example, the likely fact that a flat 30 percent tariff on all imports would not be enough to relocate to the U.S. industries with a low value-added added per man-hour, like t-shirts or circuit board assembly, as the difference between foreign and domestic labor costs is too large for an industries whose production cost mainly consists of semiskilled labor.  But such a tariff would be enough to relocate industries like semiconductors, most of whose production cost is physical and intellectual capital and highly skilled labor.

Furthermore, a natural strategic tariff would have different effects on industries that were at different points on their cost curves, so it would have a bias towards stimulating nascent scale-economy industries.

In other words, the tariff would be self-targeting on precisely those industries America should want to target.

Although the economic literature contains any number of studies on the differential effects of simple tariffs applied to complex economies, a proposal similar to Fletcher’s has never, to the authors’ knowledge, been rigorously evaluated.

Research Area #7: Revisit and reconsider the economics underlying Bretton Woods

Since the collapse of the Bretton Woods system in 1971, the world has operated on the basis, supposedly, of more-or-less floating exchange rates.  But as evidence accumulating from Beijing to Berlin suggests, abolishing fixed exchange rates does not lead to floating rates, with the free-market efficiencies this implies, but to rates manipulated by neomercantilist governments.  This leads to unsustainable trade deficits in their trading partners, producing rising indebtedness and bubble-inducing overly cheap capital. Research in this area would aim to rediscover the largely forgotten economics underlying the Bretton Woods system.

The key virtue of Bretton Woods was that while floating exchange rates may be efficient, they are efficient at the wrong thing. They are driven by the total demand for a currency, that is, demand to buy not only a nation’s exports but also its debt and assets. As a result, demand for a nation’s currency is determined not only by its export prowess, but also by its willingness to sell off assets and assume debt. But this entails treating unsustainable demand (for assets and debt) the same as sustainable demand (for exports). So floating exchange rates will not necessarily find the level optimal for that part of the economy devoted to present production. But this is the only part of the economy that actually creates wealth, as opposed to shifting it forwards and backwards in time; it is no accident that we live in an age when the financial tail often seems to be wagging the dog of the real economy.

Of all the policies available to rebalance the world’s trade imbalances, fixed exchange rates are among the least intrusive. Changing a society’s time discount on consumption , the ultimate cause of trade deficits, is extremely hard: there is no lever directly attached to this variable, and most peacetime attempts to change it in the Western world have failed. (Only the authoritarian technocrats of East Asia have pulled it off, with policies no Western electorate would tolerate and that most Third World governments simply don’t have the administrative competence to pull off.)

A fixed exchange rate system, on the other hand, operates at the perimeter of an economy, leaving most of its internal mechanisms untouched. It violates few economic liberties. But even though it leaves flows of goodsuntouched, regulating the countervailing financial flows that must take place when goods are paid for imposes a balance just as effectively. If the pure free market won’t produce the best results on its own in trade and therefore must be regulated somewhere, it might as well be here.  Fixed exchange rates, plus the attendant capital controls, could, in fact, prevent many of the deleterious effects of free trade without requiring actual constraints on the flow of goods.

Research Area #8: Restore the centrality of economic history to the study of economics

The better an economist’s work is informed by economic history, the less likely that economist is to embrace free trade.  Most of the deceptive abstractions underlying free trade, while easy to accept in the context of mathematical modeling, are very hard to maintain in the face of serious historical study.  Most American BA, MA, and PhD programs in economics no longer require economic history; this should be changed.  (Simply exposing the paucity of economic history requirements would itself be a valuable step.)

A number of key lessons emerge from economic history that are very hard to learn from mathematical and statistical modeling of purely contemporary economic data.  The most obvious one, in the case of trade economics, is simply that neither the U.S., nor any other developed nation, became a developed nation by way of free trade abroad and laissez-faire at home.  All did so by way of protectionism and industrial policy.  Just correcting the mistaken belief among opinion leaders and policy makers that US economic growth coincided with and was driven by free trade would be a major step toward a more constructive trade policy.

The deeper lesson is the inescapability of economic diversity: different economies are non-trivially and usefully different.  Within a broadly capitalistic framework, successful economies differ widely, so there is no rational basis for the “one size fits all” policy solutions that have been favored by market fundamentalists.  The inevitability of national economic diversity is implied by the multiple-equilibrium thinking discussed in Research Area #3 above, as well as deeply rooted outside economics in national cultural, social, and political circumstances.  Therefore, national economies will not converge toward the Washington Consensus (or the Beijing consensus, for that matter).

The key policy implications of this are a) that any effective U.S. trade policy must recognize that other nations are unlikely play by the rules we are pressing on them, and b) that a borderless world economy, which presupposes homogeneity in all essentials, is all but impossible.

END OF LETTER

If American economists would start thinking along the lines suggested above, this country will have a fighting chance of reasoning its way out of its current trade mess before it is too late to do so at a reasonable cost.

Ian Fletcher is Senior Economist of the Coalition for a Prosperous America, a nationwide grass-roots organization dedicated to fixing America’s trade policies and comprising representatives from business, agriculture, and labor. He was previously Research Fellow at the U.S. Business and Industry Council, a Washington think tank, and before that, an economist in private practice serving mainly hedge funds and private equity firms. Educated at Columbia University and the University of Chicago, he lives in San Francisco. He is the author of Free Trade Doesn’t Work: What Should Replace It and Why.

2 Responses to “How to Think Our Way Out of Our Trade Crisis”

  1. L. Napoleon Cooper says:

    THE PARADIGM SHIFT IS TO RELOCATE JAPAN INC TO THE INDUSTRIAL HEARTLAND OF AMERICA!

    Not to dixiePublican land and not to California, but to the American industrial heartland that needs Japanese Manufacturing and for the great number of the Japanese people (and their “measurable” sums of Japan, Inc. investment capital looking for a safe harbor: The OBVIOUS choice is the United States of America.

    Nothing more need be said (KISS).

    AlxHamiltn@gmail.com
    Washington, D.C.

    Chop Chop, Trade Reform thinkers, Let’s Get It Done…

  2. Fred List says:

    Support 100%

    State governments can actually do a lot more than they have been doing to change procurement policies and levy sales taxes on imported products.

    Major policy transformations (abolition, women suffrage, temperance) in America’s past typically began at the state level. Organizing state referendums calling on voters to urge their elected officials to support industry and tariffs could be a useful mobilizing tool, especially in states such as Ohio & Michigan. A raft of referendums would also put this on the agenda of the national media.

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