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Why Most Economists Support Free Trade Rather than Balanced Trade

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The following article was submitted by W. Raymond Mills

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Why Most Economists Support Free Trade Rather than Balanced Trade

The above question will be addressed in this paper, but the answer provided will be a beginning rather than an ending.  The short, beginning answer is “They haven’t thought about it”.

They haven’t thought about it because: a) Popular textbooks ignore the main disadvantage of supporting free trade; b) Ben Bernanke  said that forces outside the U.S. created the U.S. trade deficit; c) Thomas Sowell articulates the common belief  that all intellectual issues surrounding free trade have been examined and settled long ago: d) Paul Lazerfield persuaded a generation of economists that ideas must be expressed in mathematical form if they are to be precise and his last (2004) model dealing with foreign trade assumed full employment and balanced trade.

And if they were to think about free trade versus balanced trade they will find precious little guidance in their Journals and papers accepted for publication.

This paper will argue that Paul Krugman made a mistake in his 1994 textbook International Economics when he limited his discussion of the consequences of the trade deficit to the second half of his book (financial issues).  Ben Bernanke made a mistake in his 2005 speech when he blamed a Global Savings Glut for the U.S. Current Account deficit.  Thomas Sowell made a mistake when he argued, in his 2004 book Basic Economics, that all the intellectual issues related to free trade had been discussed and settled by previous economists.  The model Paul Samuelson used in his article in the Summer 2004 edition of Journal of Economic Perspective is not a mistake if you want to talk about a world with full employment and balanced trade but it is definitely a mistake if you want to apply the findings of this model to real world events.

These mistakes have a common origin – an unwillingness of deal with the undesirable consequences of the yearly trade deficit experienced by the U.S. in the 36 years between 1976 and 2012.

This paper will begin with a discussion of the components of Gross Domestic product.  Then it will review the alleged mistakes.

The impetus to produce this paper came from some comments that appeared on the Blog Trade Reform early in Jan. 2013.  The writers agreed that U.S. public and leadership should abandon Free Trade as a goal or ideal and substitute Balanced Trade instead.  Balanced trade would distribute the benefits of trade among more nations and would create a more sustainable global trading system.  Academic economists are seen as opposed to that change for no good reason – therefore as irrational.

Gross Domestic Product – U.S. Year 2004.

The formula for Gross Domestic Product can be rewritten as:

GDP – Consumption (Public and Private)  =  Investment (Public and Private) + Trade Balance.  The numbers (in billions) for 2004 are:  11,853 – 10,132 = 2,341 – 619.  Both sides of this equation are equal – 1,721 & 1722.  This is identified as Savings as calculated from the components of GDP.  Gross Savings as reported by BEA in NAPA Table 5.1 line 1 is 1,739 – essentially the same.

If we magically could eliminate the trade balance (bring it to zero)  and Consumption and Investment remained the same, both sides of this equation would gain 619 billion dollars, bringing GDP to 12,472 billion, a growth of 5.2% in GDP.  This assumes that spending is not increased by the availability of imports.  That assumption is probably wrong.  Another assumption that is probably wrong at the other extreme is to assume that Consumption decreases by half of 619 (309.5 Billion) and that GDP increases by 309.5 Billion, resulting in an increase of 619 on the left side of the equation to balance the increase of 619 on the right side.  In that case, GDP would increase by 2.6%.   I believe the correct answer would fall between these two extremes.

If the assumption is accepted that spending in the U.S. will decrease by less than half the size of the previous trade deficit, if imports could be made equal to exports, we can agree that the U. S. economy will get a significant boost from moving towards balanced trade.  The benefits come each year, so long as trade is balanced between imports and exports.

Additional arguments are: when manufactured goods are imported into the U.S. this must reduce output in factories located in the U.S.  The U.S. was the leading manufacturing nation in the world after WW II.  Manufacturing share of GDP in the U.S. now is around 12%.  For Germany and Japan, the share is around 16%.  That spread of around 4% has existed for at least the last decade.  I attribute that difference to the fact that Germany and Japan both have developed and maintained for many years a sizeable excess of exports sold to imports purchased (for goods).  England is like the U.S. in share of GDP in manufacturing and in having a long-term trade deficit in goods.  More than 85% of the goods trade deficit in the U.S. in the U.S. in the year 2012 consists of manufactured goods.  The loss of manufacturing jobs in the U.S. in recent years has many causes – shift to a service economy, automation – but the trade deficit in goods is an important part of the picture.  The glory days for U.S. manufacturing in the modern period occurred during 1994-1998 when manufacturing employment actually increased.  The trade deficit in goods remained constant during that period (as measured by the percentage of imports paid for by exports).

To complete the picture, the trade deficit in manufactured goods happened because U.S. manufacturers lost competitiveness while manufacturers in Japan and Germany managed to find a niche where they could remain competitive.  Governmental actions to help create a trade surplus in goods in Japan and Germany are a large part of the reason for their success.

Evasion

a) Paul Krugman
Paul Krugman in his 1993 textbook did not examine the possible relationship between a trade deficit and reduction in GDP.  Perhaps his excuse could be that the U.S. trade deficit was extremely low in the latest data available to him.  Perhaps he discussed this issue in subsequent revisions.  He did talk about the Balance of Payments in the second part of the book when only financial issues were considered.  But the first part of the book, where actual interchange of goods and services were discussed, is devoid of discussion of the trade deficit.  His index has only one entry for the phrase “Trade Deficit”.  Here it is:” Like the problem of protectionism,  the balance of payments has become a central issue for the U.S. because the U.S. has run a huge trade deficit in every year since 1982”(Pg.6).   For him, the balance of payments is the only consequence of the trade deficit that is worth discussing.

The book has other problems.  It is filled with discussions of actions (such as tariffs) that deviate from ideal trade – Free Trade (absent government intervention).  Any deviation from free trade is deplored because it either reduces efficiencies of production or creates over or under consumption of specific goods.  These ideal efficiencies and ideal consumption possibilities are fictions because all international trade is contaminated by nations who create large trade surpluses by actions which violate free trade conditions.  The conclusions are logical, given the assumptions, but the assumptions are about a dream world rather than a real world.

His discussion of tariffs is shortsighted.  The only tariffs Krugman considers are tariffs which vary in size by individual product imported.  This kind of tariff is the only kind used historically, therefore the only kind discussed by Krugman.  Tariffs by product are Protectionism – the big no-no.  Tariffs that are of uniform size for all products coming from a specific country are beyond his imagining.  Such tariffs do not create the problems created by tariffs by product.  His criticisms of tariffs apply only to tariffs by product.

The only trade results that Krugman uses to measure the effect of trade on national welfare are change in the relative price of exports to imports (Terms of Trade).  This ignores the impact of the volume of exports and imports on national welfare.  The trade balance reflects changes in both prices and volume.  The trade balance is a better measure of the effects of trade on national welfare.  Mann shows, in her 1999 publication, Is the U.S. Trade Deficit Sustainable?, pg.103, that the Terms of Trade and Balance of Trade are inversely related (as one increases in size the other decreases).

Use of an incomplete measuring device leads to erroneous conclusions.  His measure shows that recent trade practices have a minimal impact on national welfare.  “The U.S. terms of trade in 1991 were only slightly worse than  in 1980; the downward slope over the whole period from 1967 to 1991, as shown in the figure, was only 0.7 percent.  A decline at that rate reduces U.S. growth by only about 0.07 percent annually”(p.98).

In the 5 years of 1982 to 1986, the goods exported from the U.S. each year was less than the amount exported in 1981.  By contrast, imports grew by 39% during that 5 years period.  The divergence between export and import growth resulted in export being only 3/4ths of value of goods imports in the years 1984 through 1987.  The goods trade deficit was around 3% of GDP during those years.  These events aroused legislators from manufacturing states.  “In 1985 Congress considered nearly 100 trade bills …that were protectionist in intent”(Mann, p.89).  The pro-free trade forces narrowly defeated those seeking legislative protection.

Krugman ignores the possible impact of a trade deficit on GDP.  He also fails to provide a useful way to measure the costs and benefits of trade (deviation from a hypothetical ideal says nothing about happenings in the real world) and he uses an inadequate measure of the effects of trade on national welfare.

b)     Ben Bernanke
In an influential but controversial speech given on April 14, 2005, Ben Bernanke argued  that the large U.S. Current Account Deficit was created by other nations when they created the Global Savings Glut.  Bernanke provides data which showed that a group of developing nations had a Current Account Deficit almost as large as the U.S. in 1996 (90 Billion for the developing nations, 120 Billion for the U.S).  By 2004, the developing nations had reversed their Current Account Balance to a surplus of 326 Billion.  By that year (2004) the U.S. Current Account Deficit had grown to -400 Billion.

The conventional explanation for the shift by the developing nations is the Asian Financial Meltdown of 1998-1999.  When some developing nations could no longer pay their debts to international banks their credit disappeared, their economy shrank and the value of their currency declined.  But their recovery was swift.  They had no means to pay for imports except their exports.  Low currency value encouraged exports and discouraged imports.  They were determined to avoid the mistakes that devastated their economy.  Their shift from a trade deficit to a trade surplus nation was a natural response to the financial crisis of 1998-1999.

Bernanke presents a different view.  He prefers to look at these changes as a natural consequence of changes in the financial system of the world that led to a significant increase in the global supply of savings – a global savings glut.  “an important source of the global savings glut has been the remarkable reversal in the flow of credit to developing and emerging-market economies, a shift that has transformed these economies from borrowers on international capital markets to large net lenders”.

Bernanke has undertaken a heavy burden.  He must justify ignoring the actual interchange of goods and services for an alternative perspective which “focuses on savings, investment, and international financial flows”.  He says “the perspective one takes depends upon the particular analysis at hand”.   I disagree.  The perspective one takes should depend upon causal flows.  What caused the change in the trade balance experienced by the developing world?  If it was due to change in currency value and lack of credit experienced by these countries, the analysis should focus on these factors as they influence exports and imports.  If it was caused by a “precipitous decline in the U.S. national savings rate” then the analysis should focus on financial factors.

How does Bernake justify his perspective?  “most economists who have offered explanations for the high and rising level of the U.S. current account deficit …have emphasized investment-savings behavior rather than trade-related factors (and I will do the same today)”.  That is not a good reason, in my opinion.  What causes what should be the perspective chosen for analysis.

To justify an assertion of causation, one most show, at a minimum, priority (the cause preceded the event in time) and mechanism (the steps or paths whereby financial actions are translated into predictions of exports and imports).  Bernanke has not showed either priority or mechanisms.  He cannot provide these missing arguments because the Savings identified in the national accounts in any one year are themselves created simultaneously in time with the trade deficit.  The investments in year one are funded by savings from previous years, not current savings.  The size of that pool of savings must be large enough to fund investment.  In the U.S., in recent years, that pool has been much larger than is needed.  The decline is savings has not reduced the pool of assets available for investment below the demand for such funds.  Businesses have been buying their own shares with their undistributed earnings rather than investing because they do not see opportunities for good returns on investment in the U.S.  The decline in U.S. savings in the national accounts that Bernanke laments has no effect on the level of investment in the U.S. today.

What characteristic distinguishes a Saving Glut from a normal amount of savings?  Bernanke doesn’t say.  Since he has not defined how large a level of savings must be to constitute a glut, I think the word is vacuous – intended to create an impression rather than to convey a reality.

In addition, Savings is an endogenous variable in the Gross Domestic Product formula.  How can change in its level cause change in the level of the other variables in this equation?  It is the level of investment and the trade balance that controls the level of savings.  The level of investment in any one year in the U.S. is controlled by factors outside this equation, primarily the views of business executives concerning the prospects for a good return on an investment.  The level of the trade deficit is also controlled by factors outside this equation including governmental action both in the U.S. and abroad.

Financial activities can impact exports and imports via change in currency level.  But Bernanke has not shown how these activities are connected.  The mechanisms are not described – probably because a simple, universal relationship has not been documented.

c. Thomas Sowell
Thomas Sowell implies that all the possible objections to free trade have been examined by past writers and have been discarded.  His actual statement is more guarded.  The above sentence expresses my opinion of the impression he wants to leave.  On page 347 of the 2004 edition of Basic Economics he says: “many economists do not bother to answer either the special interests or those who oppose free trade for ideological reasons, since the arguments of both have essentially been refuted long ago and are now regarded in the economics profession as beneath contempt”.  This conveys the dogmatism that infects well trained economists, generally, while leaving open the possibility of critics arising who are not in either of the two categories who might have something important to say.

I do not fall in either of those categories and I have something important to say.

Comparative Advantage shows how two nations can both benefit from trade, even if one nation is more productive (efficient) in producing everything they trade.  The important and frequently overlooked assumption required for both nations to benefit is that the more efficient nation must be willing to accept what the less efficient nation produces so that the value of what is produced in each nation is equal.  Stated in contemporary terms, the less efficient nation must be able to sell on the international market enough of the goods they can produce to get enough dollars to pay for the exports from the more efficient nation.  Only those sales and purchases of two nations which produce equal returns to both nations can be cited as examples of when comparative advantage works as portrayed.  When one nation cannot sell enough exports to pay for their imports, comparative advantage does not describe what is happening.  Sowell says “Americans can get more chairs by producing television set and trading them with Canadians for chairs … .conversely, Canadians can get more television sets by producing chairs and trading them for American-made television sets”.  The operative word here is “can”.  But the condition required for producing the desired result is that the exchange must take place.  The exchange requires that the U.S. wants enough chairs to equal in value the television sets that Canadians want.  But direct exchange is not what happens in the real world.  Canadians buy television sets from global market.  Canadians sell chairs to the global market.  When purchases and sales of the two products are equal in both Canada and the U.S. can we say that that Comparative Advantage describes realty.  Because many nations have near equal trade with their trading partners, we can say that comparative advantage is a reality in some instances.  But we can also say that comparative advantage does not describe the situation when bilateral trade produces large surpluses and large deficits.  This argument has not been examined and refuted by previous economists,

To return to the question of whether all issues related to free trade have been previously discussed and resolved,  the U.S. has experienced 36 years of a continuous deficit in trade.  At no time in past history has the richest country in the world experienced anything like the continuous and sometime large trade deficit endured by the U.S.  This is a new phenomenon, never seen before – therefore never discussed before.  The alacrity with which U.S. economists avoid the subject makes is clear that no understanding of this kind of event has been created by previous economists.

Previous literature has not shown how Comparative Advantage can describe trade which produces sizable surpluses and deficits.  It has not explained how 36 years of a continuous trade deficit can increase national welfare in the U.S.  It has not justified the notion that the level of savings controls or in any way influences the level of the trade deficit as shown yearly in the national accounts.  It has not defended ignoring the impact of a trade deficit on the size of Gross Domestic Product in any one year.  It has not provided models of trade which assume large surpluses (and deficits) in a given period.

Economists are invited to join the rebels and reformers on the Blog Trade Reform as we discuss whether balanced trade is better than free trade (we are as biased on this question as most economists).  Actually, the discussion recently has focused on the relative merits of Import Certificates versus Targeted Tariffs as actions that will reduce the U.S. trade deficit most effectively.  We need some help to broaden the discussion of remedies.  We also need some certified economists with credentials to assure the public that free trade should be discarded.  To preserve their livelihood, we recommend that untenured professors ignore this invitation.  The only enticement we can offer to tenured professors is to note that models that assume balanced trade will be useful when trade is balanced.

One Response to “Why Most Economists Support Free Trade Rather than Balanced Trade”

  1. Bruce Bishop says:

    What people keep referring to as “free trade,” is NOT free trade.

    In Ian Fletcher’s book, “The Conservative Case Against Free Trade,” he states, on page 22, “Now the first thing to remember about this is that what we have today under the name `free trade’ isn’t free trade at all.”

    Paul Craig Roberts, in his book, “How The Economy Was Lost,” says: “The offshoring of American jobs is the ANTITHESIS (my emphasis) of free trade.” “Jobs offshoring is an activity in pursuit of the lowest factor cost–an activity that David Ricardo, the originator of free trade theory, described as the betrayal of one’s own country in pursuit of an ‘absolute advantage.’”

    Free trade would BE balanced trade. Shipping boatloads of freshly printed $100 bills to China in exchange for boatloads of stuff we could manufacture here is NOT comparative advantage and it is NOT free trade.

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