(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: Why Productivity Gains Won’t Save American Jobs, Either

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developing countries, factors of production, Global Imbalances, globalization, inequality, Jobs, multinational corporations, productivity, {What's Left of) Our Economy

The heated debate in the economics world about whether expanded trade and investment has worsened income inequality in wealthy countries like the United States often obscures the equally heated debate over globalization’s effects on developing countries. Many left-of-center critics of current U.S. policies in particular charge that current the current world trade regime has worsened the rich-poor gap within low-income economies and left entire third world countries behind.

The Economist magazine deserves credit for bringing this neglected debate to the mainstream media, and spotlighting new work from Nobelist Eric Maskin of Princeton University and Michael Kremer of Harvard University presenting a new explanation for this development, and for how it does or doesn’t fit into conventional trade theory. (Their paper itself, can be read here.) But actually, their findings tear a much bigger rent in the theoretical basis for the current version of globalization to an even greater extent than The Economist, most trade policy critics, and even the authors recognize.

As the magazine notes, worsening income inequality within developing countries and for much of the third world as a whole matters not only because it indicates that current world trade policies are exacting a major (and possibly needless) human toll, but because the prevailing economic wisdom tells us that exactly the opposite is supposed to happen.

Maskin and Kremer speculate that what’s been missed by the founding fathers of trade theory was how the explosion of global commerce was likely to foster what the authors call international worker “matching.” Today’s wide open global economy, they contend, enables higher-income economies to access relatively high-skill workers in developing countries by investing in new factories and labs their multinational companies build offshore. Therefore, they create unprecedented economic opportunities for those skilled workers while leaving their less-skilled compatriots up the creek.

As is clear to anyone who closely follows the globalization debate, Maskin and Kremer leave out another significant impact of this worker matching – how it harms relatively lower-skill workers in high income countries by plunging them into competition with much less expensive third world counterparts.

If they did discuss this unmistakable result of current U.S. trade policies and their foreign counterparts, they might have recognized how this relatively new form of worker matching strongly undercuts the uber claim of mainstream theory that trade liberalization is ultimately a winner for the entire world. First world corporate investment in high-value facilities and jobs in third world countries means nothing less than that productivity itself – assumed by mainstream economics to be what’s called a fixed factor of production – is actually mobile. Efficiency-creating knowhow can be transferred across borders as easily as goods and capital.

Not that this is exactly news. My book The Race to the Bottom and many other studies have extensively documented how it’s become routine for multinational corporations to engage in capital- and technology-intensive work in developing countries as well as in labor-intensive work.

One crucial implication of this finding is debunking the (still) widely accepted claim that liberalized trade threatens mainly low-skilled and poorly educated countries, and that this competitive heat should actually be welcomed because it encourages wealthier economies to get those disadvantaged portions of their populations up to speed, and move them into higher value industries and jobs. If this higher value work can be sent to much lower-cost countries just as easily as less advanced work, then reeducation and retraining claims become much less convincing.

But as the work of Maskin and Kremer underscores, high-value offshoring to low-income countries entails not just the export of industrial machinery and laboratory equipment. It also entails the export of technical expertise and corporate culture – of all the intangibles that produce corporate — and supposedly national competitive — success. As a result, it also entails the export of all of the social and cultural values and experiences – or at least their fruits – that over time have contributed to these intangible assets. In other words, it entails the export of productivity.

Supporters of the globalization status quo seem to assume that productivity can’t be exported, at least not readily. Indeed, despite the proliferation of high value offshoring, they seem confident that both its historically developed ingredients and its operational end product will remain uniquely American advantages, especially if government policies remain fundamentally supportive, and avoid creating unnecessary obstacles. But in their work on skill matching, Maskin and Kremer strongly (if inadvertently), suggest that even if public policy remains perfect, this confidence is misplaced.

But in addition to undercutting the theoretical case for current globalization policies, the factor mobility of productivity also undercuts the macroeconomic case. It greatly strengthens the idea that high-income countries – especially the United States – keep sending valuable production and employment to countries whose wages will long remain too low (largely because of their enormous populations) to permit them to consume and import remotely what they can produce and export. As long as these practices continue unabated, the U.S. and other high income governments will keep being tempted to fill the resulting income gaps for most of their people with cheap credit – and keep running the risk of reflating dangerous domestic and worldwide bubbles.

I’d feel a lot more confident that policymakers will promptly put this crucial two-and-two together if this challenge didn’t keep eluding prominent economists like Maskin and Kremer.