(What’s Left of) Our Economy: A Big New Hit to Free Trade Theory

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Adam Smith, Bruce R. Scott, comparative advantage, David Ricardo, economics, economists, factors of production, free trade, Great Britain, machinery, manufacturing, Portugal, protectionism, Ralph E. Gomory, Steve Keen, technology, textiles, The Wealth of Nations, Trade, William J. Baumol, wine, {What's Left of) Our Economy

OK, time for some good news – at least if you’d like the economics community to come up with more realistic views of trade policy and its impact on the national and global economy. As made clearest by a (sadly overlooked) journal article by Steve Keen of Kingston University in London, some noted academic economists have identified fatal-looking flaws in comparative advantage theory – the 18^th century concept that ever since has anchored mainstream scholarly thinking about the entire discipline, along with justifying the virtues of the freest possible trade flows.

As Keen writes, comparative advantage identified benefits flowing from economic specialization, and was first advanced by British economist Adam Smith in his seminal The Wealth of Nations to explain the superiority of laissez-faire, free market practices within industries. His compatriot David Ricardo extended the concept to relationships between industries and countries. The core idea in its trade theory version is that all countries and their peoples will reap maximum gains if they limit themselves to those tasks that represent their own best efforts – even if they’re laggards by international standards in that particular sector.

I first encountered a compelling objection to comparative advantage in the early 1990s, in the form of a sharp observation by Harvard Business School professor Bruce R. Scott. As he noted, Portugal, one of two countries in Ricardo’s classic description of comparative advantage’s virtues, basically hewed to the Ricardian prescription, specialized in turning out relatively simple products (in this case, wine) – and remained a poor country for centuries. The second country was Great Britain. It specialized in higher value goods (epitomized, in that era, by textiles), and became the world’s greatest and richest empire.

More fundamentally, Portugal specialized in activity that could generate good levels of growth in the short-term, but whose long-term wealth creation potential was limited by low levels of productivity growth, capital and technology intensiveness, by limited potential for innovation, and by deficiencies in other closely related indicators of dynamism. Great Britain specialized in activity whose positive spinoffs were bound to be far greater.

Other major Ricardo blind spots have been pointed out since then – for example, his skepticism that capital would ever easily move across borders. But his central insights have continued commanding pervasive respect among professional economists. Just as important, they’re still revered by political leaders and opinion molders who find these theories convenient for portraying their often self-interested trade policy preferences as indisputable truths, or who learned in a freshman economics class that they’re gospel.

Keen’s big addition to comparative advantage critiques has to do with unfettered free trade’s likely effect on an economy’s diversity and growth potential. As he notes, Ricardo’s case for liberalizing trade flows hinges on a completely unrealistic assumption about its impact on a national productive base, and hence on national output and incomes. The assumption: that countries will wind up better on net if they abandon those activities that don’t meet the comparative advantage test, and refocus their efforts on activities that can pass it, and that such a transition is feasible in the first place.

In other words, Portugal would scrap all of its textile factories (and presumably all its other industries as well), and become for all intents and purposes a mono-economy devoted to wine. Great Britain would abandon whatever wine-making and other non-textile work it was engaged in, and turn into a big cloth-making facility. What of the other necessities of national and individual life, at least those that are in theory trade-able? They would be imported – and paid for by the earnings from exports of the national champions.

Simply articulating this scenario reveals how completely fanciful it is. For example, what about supplying needs before the envisioned transitions are completed? How long will they last? And even over decades under a free trade regime, could the global economy possibly be expected to turn into the kind of exquisitely complex but perfectly functioning mechanism that could enable a large number of mono-economies from securing the full range of traded goods and services that are either needed or simply wanted?

Keen, however, identifies what he reasonably seems to view as a more fundamental problem: The sectors of the economy in which Ricardians want countries to specialize are relatively strong because they efficiently use various factors of production (chiefly, according to Keen, machinery). The Ricardian transition entails other parts of the economy switching to that strong sector (again, wine-making and textile-making in Portugal and Great Britain, respectively), and essentially becoming just as good as wine-making – largely because all the kinds of machinery used in that economy can easily, and indeed seamlessly be redeployed in the strong sector.

If this assumption was valid, as Keen observes, then it would be reasonable to suppose that each rejiggered national economy could produce even more output, and generate higher incomes for its population, than before. But as the author also observes, this outcome makes no sense because “machinery is specific to each industry, and the crucial machines in one industry cannot simply ‘move’ to another without loss of productivity.” And if you believe, as is the case with mainstream economics, that rising productivity is a key – and over the long run, the biggest key – to rising incomes, then you should recognize this Ricardian transition also as a recipe for worsening national impoverishment.

That is, in the kind of mono-economy Ricardo hoped would eventually comprise the global economy, most of the populace would be struggling with inappropriate capital stock and other assets to earn a living engaged in activity with which it boasted little, if any, experience.

Why did Ricardo overlook something so obvious? In Keen’s words, it’s an example of “a confusion of monetary capital (which Ricardo, as a stockbroker by trade, knew intimately) with the physical machinery in factories (about which he knew very little). Yes, monetary capital moves easily in search of a profit—today, even internationally. But machinery is specific to each industry….”

However, Keen continues, “The archetypal machines for cloth and wine manufacturing in Ricardo’s time included the spinning jenny and the wine press. It is stating the obvious that one cannot be turned into the other, but stating the obvious is necessary, because the easy conversion of one into the other was assumed by Ricardo, and has been assumed ever since by mainstream economic theory.”

Here’s another example of the same delusionality that will be familiar to everyone who’s followed the U.S. trade policy debate for the last few decades: the claim by supporters of current trade policies that trade-related production and job losses are no big deal because America’s real edge in the global economy going forward is, say, services. So the best response is to train all those displaced auto workers to become nurses (and, pace Keen, to use all that surplus auto production machinery to write software).

Just as interesting, Keen points to a small but growing body of research touting the advantages of industrial and other economic diversity – the opposite of Ricardo’s aim. A broad-based manufacturing and technology base has of course long been supported by critics of current trade policies for national security reasons (to ensure the ability to produce an adequate range of defense assets), and to avoid potentially dangerous dependence on foreign supplies of civilian goods as well.

Similarly, it’s been contended that too many linkages exist among manufacturing industries, and between manufacturing and many kinds of services, to assume that entire sectors can be lost without major collateral damage.

Keen’s piece, however, also spotlights evidence that the world’s least successful national economies tend to possess narrow – at best – productive bases and to generate a comparably narrow range of exports, and that the most successful turn out a wide variety of goods for both domestic and foreign markets.

Keen’s theoretical critique of Ricardo is by no means the only one that’s come from the ranks of economists themselves. In 2001, William J. Baumol (a former President of the American Economic Association no less) and Ralph E. Gomory, one of the nation’s leading technology authorities, produced this study purporting to show that explicitly promoting national industries and technologies via various forms of government intervention (including tariffs) can produce better results for individual countries that toeing the free trade line.

But the Baumol-Gomory case has (so far) failed to dent confidence in Ricardian trade theory notably. And certainly the Mainstream Media never displayed much interest. In that vein, of possible import is the appearance this week on Bloomberg.com of this follow-up of sorts to Keen-like analysis. More steps on a  journey of a thousand miles?

(What’s Left of) Our Economy: The Times’ History of Free Trade is Bunk

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Adam Smith, Binyamin Appelbaum, Donald Trump, Douglas A. Irwin, economics, economists, free trade, I.M. Destler, Jagdish Bhagwati, John Maynard Keynes, John Stuart Mill, mercantilism, protectionism, Republicans, Richard Nixon, Robert Torrens, Ronald Reagan, Smoot-Hawley Tariff, strategic trade theory, tariffs, The New York Times, Trade, {What's Left of) Our Economy

It’s easy to imagine the thought processes responsible for The New York Times running last week’s article describing Donald Trump’s views on trade policy as “Breaking with 200 Years of Economic Orthodoxy”:

“We are the newspaper of record.”

“The public needs vital context to make intelligent decisions.”

“We can flaunt our matchless knowledge of history.”

What a shame, then, that economic correspondent Binyamin Appelbaum’s piece failed so badly on so many counts.

Let’s be charitable and start off by accentuating the positive. Appelbaum deserves credit for characterizing trade concerns as “among his oldest and steadiest public positions.” That’s a healthy corrective to media-wide reporting portraying the Republican presidential front-runner as motivated solely or mainly by – nativist and even racist – hostility to immigration.

It was also encouraging that Appelbaum acknowledged (though in an excessively narrow way, as will be demonstrated below) that “economists have oversold their case.” And he helpfully quoting a leading voice in the profession as noting not only that foreign protectionist practices are all too common, but that “It might be that the threat of tariffs or other trade sanctions could cause American trading partners to open up their markets or drop their barriers to trade.”

Unfortunately, nothing else Appelbaum wrote met standards of current or historic accuracy. First, although he correctly described mercantilism’s focus on amassing trade surpluses, he never pointed to a Trump statement endorsing such a goal. Conversely, the author errs when he contends that the orthodoxy calls for maximizing international trade flows. Instead, it calls for permitting global trade to reflect patterns of comparative advantage to the greatest extent possible.

As for Appelbaum’s brief history of American trade politics, it omits crucial facts. Specifically, he quotes as gospel the view of the University of Maryland’s I.M. Destler that “For most of the last century…skepticism about trade had been relegated to the fringes of the Republican Party.” But no significant Republican shift toward trade liberalization took place until after World War II. Indeed, legislators Reed Smoot and Willis Hawley, sponsors of the 1930 tariff, were both Republicans.

And even after most of the party warmed toward freer trade positions, major tariffs were imposed in 1971 by President Richard M. Nixon and throughout the 1980s by President Ronald Reagan – hardly fringe figures.

Finally, Appelbaum also seriously distorts the economics profession’s position on trade liberalization. Why, for example, didn’t he point out that, like one of the contemporary he cited, Adam Smith himself endorsed the threat and use of tariffs to open foreign markets. He also left out all the major loopholes in standard free trade theory pointed out by some of the biggest names in economic history. This history of the idea of free trade by Dartmouth’s Douglas A. Irwin makes clear how significant they have been. Here’s a summary drawn from my (New York Times) review of Irwin’s 1996 study – which unfortunately has not been digitized:

“Robert Torrens and John Stuart Mill explained how countries could use tariffs to enhance national wealth by stimulating the production of more profitable exports. Mill showed that tariffs protecting ‘infant’ industries could help them survive competition with more established rivals and eventually become self-supporting — without exacting larger costs from that country’s consumers or other economic sectors.

“During the 1920’s, Frank Graham of Princeton theorized that tariffs could provide permanent help for national economies by encouraging a shift from agriculture into manufacturing, thereby increasing a country’s total wealth. In the wake of the Great Depression, John Maynard Keynes insisted that free trade policies could impoverish individual countries during periods of already high unemployment, deflation and fixed exchange rates, particularly when the deflation was caused by a central bank’s determination to keep interest rates up. And in the 1980’s, a school of ”strategic trade” theorists contended that the special characteristics of certain industries (particularly those dominated by a few producers) could allow governments in some instances to use export subsidies to create national advantage.”

Irwin was correct in noting that “these arguments simply represent exceptions to a still-enthroned free trade rule — not new rules themselves (my paraphrase).” But it’s also true that these exceptions are so substantial that they call the theory’s validity into question.

In fact, Columbia University economist Jagdish Bhagwati, a leading free trade champion for decades, put it best when he observed, ”One cannot assert that free trade is ‘the policy that economic theory tells us is always right’ . . . certain developments make the case for free trade more robust whereas others make it less so . . . the latter are subject to many difficulties as one passes from the classroom to the corridors of policy making.”

I suppose that Appelbaum and The Times should be praised to trying to convey the idea that a high profile current campaign issue has deep roots in the past. But is it so unreasonable to hope that they could do the story anything close to justice?

(What’s Left of) Our Economy: The Exim Bank Fight is Much Ado About Very Little

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Adam Smith, conservatives, Exim, Export-Import Bank, exports, financing, manufacturing, Mitch McConnell, subsidies, Ted Cruz, The Race to the Bottom, Trade

The fight in Washington over resurrecting the Export-Import Bank has gotten so heated that it’s responsible for Texas Republican Senator (and presidential candidate) Ted Cruz calling his Kentucky colleague (and Senate leader) Mitch McConnell a liar, and has the nation’s major business groups lobbying furiously for reauthorization. For the life of me, I still can’t figure out what the big deal is.

In principle, I like the idea of the Bank – which has been forced to suspend most of its operations since its authorizing legislation ran out on June 30. It helps promote U.S. overseas sales by providing low-cost, taxpayer-backed financing for American businesses that want to do business with foreign customers that are sort of risky. The financing needed to clinch sales to these customers – in effect, a subsidy – enables the exporters to compete effectively with foreign rivals that receive similarly “attractive financing” from their governments.

It’s hardly free markets – but America faces a world of trade competitors that aggressively intervene to support their own firms and workers all the time. Matching this particular form of subsidy is simply a variation on Adam Smith’s maxim that an appropriate way to fight foreign trade barriers is to create bargaining chips by erecting your own.

At the same time, as I originally pointed out in my book The Race to the Bottom, by fostering trade with partners that aren’t terribly creditworthy, the Bank’s operations have reinforced the illusory claim that the supposedly “emerging markets” of the third world have become keys to future U.S. prosperity, and that reaching and cultivating these markets should trump other possible trade policy goals (like, say, recapturing the import-controlled portions of America’s home market). After all, if exports to a certain country need to be subsidized, that market probably isn’t very sustainable, and businesses should be wary of relying on them.

In addition, the share of U.S. exports aided by the Bank is miniscule. During fiscal year 2014, Exim says it supported $27.4 billion worth of these transactions. That works out to 1.68 percent of total goods exports. It’s true that, just as not all goods and services produced necessarily have the same long-term value to a national economy, not all exports are created equal. As I’ve repeatedly written, manufacturing plays a special role due to its heavy reliance on research and development, the high wages it pays, and its economy-leading productivity growth. Exim overwhelmingly works with manufacturers, but those $27.4 billion worth of 2014 fiscal year Bank-aided manufactures exports come to only 2.30 percent of the U.S. total that calendar year.

I’m kind of sympathetic to the argument that cutting smallish programs can create outsized political benefits by demonstrating will. In other words, how can politicians who can’t even agree on eliminating trifles ever hope to agree on meaningful spending reductions? In addition, the Bank has had a not-trivial scandal problem in recent years, reinforcing conservative charges that it embodies “crony capitalism.”

Yet the Bank has experienced only very low default rates on its loans, and largely as a result, it’s actually a net contributor to the U.S. Treasury. Its minor role makes clear that the Bank is anything but a game-changer – as its sometimes fevered corporate supporters often imply. (In fact, if they were really concerned about leveling the global playing field for domestic producers, they’d drop their opposition to unilateral U.S. sanctions on currency manipulation and other predatory foreign trade practices.) But Exim’s record adds force to supporters’ arguments that the nation’s economy is better off with its activities than without them.

By the same token, however, although conservatives are right to worry about official overreach and its dangers, Exim is anything but a poster child for government corruption or inefficiency. If their leaner government campaign is serious, Congressional Republican hardliners will target much more appropriate targets than the Export-Import Bank.