Posted on 16 May 2011.
One thing is for certain already: the present international trading order will not be here in ten years, and quite likely not in five. The unsustainable American trade deficit alone makes this a certainty.
Since the end of the Cold War, and accelerating after NAFTA in 1994, that order has consisted in ever-expanding “free” trade worldwide — which in reality is a curious mixture of genuinely free trade practiced by the United States and a few others with the technocratic mercantilism of surging East Asia and Germanic-Scandinavian Europe.
From America’s point of view, this order is free trade, at least on the import side of the equation, so it is as free trade that we must criticize it, prepare to celebrate its passing, and investigate what should replace it.
Our free trade policy is the answer to a question that currently has most mainstream economists scratching their heads: what killed the great American job machine? This policy has been partly responsible for increasing inequality in the United States and the gradual repudiation of our 200-year tradition of broadly shared middle-class prosperity. It is a major player in our rising indebtedness, community abandonment, and a weakening of the industrial sinews of our national security.
America’s economy today continues to struggle to emerge from recession because our trade deficit — fluctuating around $500 billion a year for a decade now — acts as a giant “reverse stimulus” to our economy. It causes a huge slice of domestic demand to flow not into domestic jobs, thus domestic wages and thus more demand, but into imports, therefore foreign wages, and therefore a boom in Guangdong, China; Seoul, South Korea; Yokohama, Japan; and even Munich — not Gary, Indiana; Fontana, California; and the other badlands of America’s industrial decline. Our response? Yet more stimulus, leading to an ever-increasing overhang of debt, both foreign and domestic, the cost of whose servicing then exerts its own drag on recovery.
The American economy has, in fact, entirely lost the ability to create jobs in tradable sectors. This cheery fact comes straight from the Commerce Department. All our net new jobs are in nontradeable services: a few heart surgeons and a legion of bus boys and security guards, most of them without health insurance or retirement benefits. These are dead-end jobs, and our economy as a whole is also being similarly squeezed into dead-end industries. The green jobs of the future? Gone to places like China where governments bid sweeter subsidies than Massachusetts can afford. Nanotechnology? Perhaps the first major technology in a century where America is not the leading innovator. Foreign subsidies are illegal under WTO rules, but no matter: who’s going to enforce them when corporate America is happily lapping at their very trough?
All the complaints just mentioned are familiar to the public, but they fly in the face of a sanctified myth that the superiority of free trade is a known truth of social science. Supposedly, it was proved long ago that protectionism is just a racket for the benefit of special interests at the expense of consumers.
Never mind that every developed nation, from England to South Korea, and including the United States, became a developed nation by means of this policy. That little piece of economic history is airbrushed out of the picture in favor of the Cold War myth of the absolute superiority of perfectly free markets. America never embraced this myth on its merits, merely as a tactical device to prop up the non-communist economies of the world and make them dependent upon us.
The cycle repeats: China today is reenacting this 400-year-old mercantilist playbook, which was born among the city-states of Renaissance Italy and never quite forgotten.
Economic theory will be sorted out eventually. Thanks to the work of a small, brave group of dissident economists — scholars like Ralph Gomory, William Baumol, Erik Reinert, and Ha-Joon Chang — the credibility of free trade as a theoretical doctrine is crumbling, and the discipline will eventually change its mind. But it will almost certainly be a lagging indicator, ready to vindicate policy forged in crisis well after the dust has settled. Academia is a superb rationalizer, and will doubtless find a way to avoid embarrassing questions about its own past positions when it teaches undergraduates twenty years from now that free trade is a delusion and a mistake.
What’s wrong with free trade? A whole host of problems, many of them long known to economists but assumed in recent decades to be unimportant.
The technical plot thickens here fast, but we can begin by noting that any serious discussion of free trade must confront David Ricardo’s celebrated 1817 theory of comparative advantage, whose tale of English cloth and Portuguese wine is familiar to generations of economics students. According to a myth accepted by both laypeople and far too many professional economists, this theory proves that free trade is best, always and everywhere, regardless of whether a nation’s trading partners reciprocate.
Unfortunately for free traders, this theory is riddled with dubious assumptions, some of which even Ricardo acknowledged. If they held true, the hypothesis would hold water. But because they often don’t, it is largely inapplicable in the real world. Here’s why:
Ricardo’s first dubious assumption is that trade is sustainable. But when a nation imports so much that it runs a trade deficit, this means it is either selling assets to foreign nations or going into debt to them. These processes, while elastic, aren’t infinitely so. This is precisely the situation the United States is in today: not only does it risk an eventual crash, but in the meantime, every dollar of assets it sells and every dollar of debt it assumes reduces the nation’s net worth.
Ricardo’s second dubious assumption is that the productive assets used to generate goods and services can easily be shifted from declining to rising industries. But laid-off autoworkers and abandoned automobile plants don’t generally transition easily to making helicopters. Assistance payments can blunt the pain, but these costs must be counted against the purported benefits of free trade, and they make free trade an enlarger of big government.
The third dubious assumption is that free trade doesn’t worsen income inequality. But, in reality, it squeezes the wages of ordinary Americans because it expands the world’s effective supply of labor, which can move from rice paddy to factory overnight, faster than its supply of capital, which takes decades to accumulate at prevailing savings rates. As a result, free trade strengthens the bargaining position of capital relative to labor. And there is no guarantee that ordinary people’s gains from cheaper imports will outweigh their losses from lowered wages.
The fourth dubious assumption is that capital isn’t internationally mobile. If it can’t move between nations, then free trade will (if the other assumptions hold true) steer it to the most productive use in our own economy. But if capital can move between nations, then free trade may reveal that it can be used better somewhere else. This will benefit the nation that the capital migrates to, and the world economy as a whole, but it won’t always benefit us.
The fifth dubious assumption is that free trade won’t turn benign trading partners into dangerous trading rivals. But free trade often does do this, as we see today in China, whose growth is massively dependent upon exports. This is especially likely when trading partners practice mercantilism, the 400-year-old strategy of deliberately gaming the world trading system by methods like currency manipulation and hidden tariffs.
The sixth dubious assumption is that short-term efficiency leads to long-term growth. But such growth has more to do with creative destruction, innovation, and capital accumulation than it does with short-term efficiency. All developed nations, including the United States, industrialized by means of protectionist policies that were inefficient in the short run.
What is the implication of all these loopholes in Ricardo’s theory? That trade is good for America, but free trade, which is not the same thing at all, is a very dicey proposition.
Beyond the holes in Ricardo, there is an entire new way of looking at trade growing up around the theoretical insights of Ralph Gomory and William Baumol of New York University. The details are technical, but the upshot is they have managed to bridge the gap between the Pollyannaish “international trade is always win-win” Ricardian view and the overly pessimistic “international trade is war” view. The former view is naive; the latter ignores the fact that economics precisely isn’t war because it is a positive-sum game in which goods are produced, not just divided, making mutual gains possible.
So at long last, someone has given us a theoretical framework that can accommodate economic reality as we actually experience it, not just lecture us on what “must” happen as Ricardianism does. It’s both a dog-eat-dog and a scratch-my-back-and-I’ll-scratch-yours world. Economics has finally given common sense permission to be true. Ironically, their sophisticated mathematical models are actually closer to the thinking of the man on the street than those they replaced.
There is an appropriate policy response. For starters, the United States should apply compensatory tariffs against imports subsidized by currency manipulation, an idea that originated with Kevin Kearns of the U.S. Business and Industry Council and was passed by the House of Representatives in the previous Congress. Also essential is a border tax to counter foreign export rebates implemented by means of foreign value-added taxes.
Perhaps even more important than the pure economics of free trade is its political economy (an older and more accurate term). For the fundamental reality of free trade is that it relieves corporate America from any substantial economic tie to the economic well-being of ordinary Americans. If corporate America can produce its products anywhere, and sell them anywhere, then it has no incentive to care about the capacity of Americans to produce or consume. Conversely, if it is tied to making a profit by selling goods made by Americans to Americans, then it has a natural incentive to care about American productivity and consumption.
Productivity and consumption are prosperity. The rest is details.
Right now, America is confronting any number of long- and short-term economic problems with one hand tied behind its back: corporate America is, increasingly, quietly indifferent to America’s economic success. This must change. While any proposals to end the K Street dictatorship in America’s public life are welcome, the reality is that mechanical reforms are less likely to touch on true fundamentals than realigning the economic incentives they reflect.
This is not a utopian project. In fact, it has already been accomplished, during the long 1790-1945 era of American protectionism. America wandered away from Founding Father Alexander Hamilton’s vision of a relatively self-contained American economy in order to win the Cold War. We threw our markets open to the world as a bribe not to go communist. If we fail to return to a policy of strategic, not unconditional, economic openness, we may lose the next Cold War — to a Confucian authoritarianism no less opposed to the idea of a free society than Marxism, and considerably more efficient.