(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?

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Our So-Called Foreign Policy: When Things Went Wrong

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Cold War, foreign policy establishment, geopolitics, grand strategy, Great Britain, interventionism, nuclear weapons, Our So-Called Foreign Policy, U.S. foreign policy, Walter Lippmann, World War II

As winter, 2014-15 approaches, the United States finds itself

>struggling to avert another 9-11-type attack by fighting a half-hearted campaign in the Middle East that even hawks fear could last decades;

>slowly getting drawn into a potentially terrifying game of chicken in the skies over Europe with a nuclear-armed Russia:

>tying itself up in knots over protecting the public from an Africa-born disease;

>trapped in a strategy of fighting nuclear wars to defend protectionist Asian powers that have decimated its productive economy; and

>heavily reliant on foreign powers – friendly and otherwise – for everything from energy to industrial machinery to credit itself.

Nor are these predicaments at all exceptional over a period spanning decades. Both Democratic and Republican presidents have plunged the nation into military ventures in countries as far-flung and as poor and weak as Vietnam, Haiti, Somalia, and Bosnia, and fought proxy wars in equally peripheral Cental America and Angola. The United States has been so completely addicted to foreign, and therefore Middle East, oil for so long that it has preferred military intervention in this distant, politically dysfunctional, and deeply anti-American region rather than developing home-grown alternatives. Meanwhile, domestic and international deficits, along with debt-led growth, have been economic constants for the immensely wealthy American economy since the early 1970s.

Yet despite these vulnerabilities and dependencies, this same United States remains located thousands of miles from its greatest potential adversaries. As a result, it remains fully capable of deterring any form of attack on its own territory and of controlling its borders, and is still endowed with nearly all the human and material resources to prosper through its own efforts and devices.

Of course, any strategic disconnect this massive, costly, dangerous, and long-lasting owes to numerous culprits. But I’d like to add a name that’s probably found on few, if any lists: Walter Lippmann. I know that I’ve probably startled anyone who’s just read that sentence and knows a thing or two about modern U.S. foreign policy. The great journalist, philosopher, and advisor to presidents and numerous other leading politicians from the 1910s through his death in 1974 is usually regarded as a founding father of realist thinking in American diplomacy.

In so many ways Lippmann deserves this reputation. His main contribution to the cause of sound foreign policymaking was his observation that the indispensable ingredient for preserving security and other vital goals was bringing a nation’s power into a sustainable balance with its commitments, and maintaining this balance.

All the same, I also hold Lippmann uniquely responsible for the conviction held by of all wings of the nation’s foreign policy establishment that, despite the clearest lessons of geography and history, America is exquisitely sensitive to all manner of events all over the world. In his seminal 1943 book, U.S. Foreign Policy: Shield of the Republic, Lippmann told his countrymen that they were tragically and dangerously mistaken in viewing the United States as a continent-sized nation with game-changing advantages like multi-thousand mile wide ocean barriers and a treasure trove of minerals.

Instead, according to this supposedly quintessential diplomatic pragmatist, the United States is an island. And not just the United States. The entire Western Hemisphere is an island. It floats in “an immense oceanic lake of which the other great powers control the shores.” As a result, both North and South America are as totally at the mercy of potential aggressors from the rest of the world as other islands like the Philippines and Australia.

Lippmann argued that America’s potential enemies on the world lake shore enjoy an unbeatable combination of geographic advantage, boast combined military potential far greater than America’s, and in an age of long-range air power, are located much closer in strategic terms than his complacent countrymen realized.

Two related policy imperatives flowed from Lippmann’s analysis. First, Americans can not achieve adequate levels of security simply through a strategy of “passive defense” of the Western Hemisphere. In the new age of intercontinental air power in particular, they need to prevent the control by hostile or possibly hostile forces of “all the trans-oceanic lands from which an attack by sea or by air can be launched.” (Emphasis added.) Second, because the global power balance would always be so unfavorable, the nation needs “dependable” allies and must actively cooperate with them in creating and maintaining strategic parity or superiority.

In fairness to Lippmann, he did not portray America’s choice as either active global engagement or military defeat. The likeliest consequence of relying on passive defense, he seemed to believe, would be “remaining in an advanced stage of mobilization” similar to that toward which the nation was moving in the early post-Pearl Harbor years when he was writing. At the same time, the author made clear his grave doubts both on economic and military grounds that this approach could succeed for any significant stretch of time.

In fairness also, Lippmann can not be faulted for failing to foresee the creation of nuclear weapons and especially platforms with intercontinental range – which in sufficient numbers simply take off the table the threat of conventional attack on America. After all, how many minutes would an enemy invasion fleet be at sea – assuming it could even set sail – before it would be wiped out by U.S. nuclear-tipped missiles? And even before the atomic age, an airborne invasion force would have required enemies to control a hopelessly huge amount of airspace.

Nonetheless, there’s no sign that the advent of nuclear weapons changed Lippmann’s thinking significantly. Much more important, his fundamental island analysis not only survived, but unmistakably contained the seeds of the global containment strategy eventually adopted following World War II.

Why did the island analysis not only remain in favor, but become hugely more popular once the nuclear age arrived? My sense is that it’s for much the same reason that it occurred to Lippmann in the first place: the almost complete extent to which the overlapping American political, economic and social establishments in the first half of the 20^th century – and the national foreign policy establishment it spawned – identified with Britain.

It’s widely accepted that the perceived affinity with Britain – which in turn reflected numerous actual family ties as well as broader shared English heritage – was so intensely felt that it produced not only common political, cultural, and social values, but common views on foreign policy goals and global missions. But I suspect this affinity also shaped perceptions of America’s strategic circumstances.

That is, in those decisive early Cold War years, America’s foreign policy mandarins so closely identified with Britain that they considered their own gargantuan, naturally wealthy, remote country to be comparable geopolitically with a small, resource-poor nation located 20 miles from countries that had historically been deadly enemies. They were incapable of recognizing that if, in some technical sense, the Western Hemisphere is an island, it’s one that extends from pole to pole – and that, combined with the Atlantic and Pacific Oceans, it enjoys what some international relations scholars call existential security.

More recently, of course, the foreign policy establishment has become far more diverse in every conceivable way. Yet its members remain as instinctively interventionist as ever, differing at best on specific modes and tactics, not on the more fundamental need to engage and on the alleged impossibility of qualitative alternatives. These views, moreover, are wholeheartedly accepted by the media organizations that tightly control the nation’s foreign policy debate, and thus at least implicitly decide which ideas are acceptable and which are taboo.  As a result, the only reasonable forecast for U.S. foreign policy for the foreseeable future is more needless cost, danger, and dependence, and zero fresh thought from practitioners and even America’s most prominent strategists.