by Ian Fletcher
This problem is actually even more significant than explained here because it is also the foundation of an even more radical critique of free trade we will look at later, after we have developed some needed conceptual tools. This concerns the nightmare scenario that really haunts Americans: the idea that free trade can help other nations catch up with us in industrial sophistication, driving us out of our own most important industries.387
HOW MUCH OF THE THEORY STILL STANDS?
Given that the theory of comparative advantage has all of the above-described flaws, how much validity does it really have? Answer: some. It is a useful tool for analyzing trade in individual industries. Asking what industries a nation has comparative advantage in helps illuminate what kind of economy it has. And insofar as the theory’s assumptions do hold—to some extent, some of the time—it can give us some valid policy recommendations. Fairly open trade, most of the time, is a good thing. But the theory was never intended to be by its own inventor, and its innate logic will not support its being, a blank check that justifies 100 percent free trade with 100 percent of the world 100 percent of the time. It only justifies free trade when its assumptions hold true,388 and in present-day America, they quite clearly often do not.
One of the biggest insights remaining from the theory is that under free trade, a nation’s wages will be determined, other things being equal, by its productivity in those sectors of its economy that possess comparative advantage. That is to say, wages in America aren’t high because the productivity of barbers is higher here than in Ukraine. Wages are higher because the productivity of aircraft manufacturing workers is higher. This is true because a nation’s best industries tend to be those in which it has comparative advantage, and are thus the industries from which it exports. So under free trade, these industries will expand and suck in labor, bidding up labor’s price in other industries. This doesn’t mean export industries will pay more. They will pay the same as other industries requiring the same skill level, as they draw labor from the same pool. But these industries, not other industries, will be pushing the labor market up.389
The converse is that it’s a bad idea for a nation to lose its leading internationally traded industries. So all Americans, not just those working in these industries, have a stake in their health. Many Americans, especially those working in the 70 percent of our GDP that is in nontraded industries,390 are indifferent to the problems of our tradable sector because they think these problems will never affect them. Directly, as previously noted, indeed they won’t. But indirectly, they eventually will, as our wages are propped up, at the end of the day, by our ability to go work elsewhere if better money is offered. And this basically requires a strong export sector if we have free trade.391
MODERN DAY ELABORATIONS OF RICARDO
Of course, free trade is not considered justified by economists today simply on the strength of Ricardo’s original 1817 theory alone. His ideas have been considerably elaborated since then, and economists generally use sophisticated computable general equilibrium (CGE) computer models, built upon his work as the foundation, to assign actual dollar amounts to the purported benefits of free trade. These models are called “computable” because, unlike economic models that exist purely to prove theoretical points, it is possible to feed actual numbers into them and get numbers out the other end. They are called “general equilibrium” because they are based on the fundamental idea of free market economics: that the economy consists of a huge number of separate equilibria between supply and demand, and that all these markets clear, or match supply with demand, at once. So it’s worth looking at problems with these models a bit.
For a start, these models tend to make some rather implausible assumptions. For example, they often assume that government budget deficits and surpluses will not change due to the impact of trade, but will remain fixed at whatever they were in the starting year of the model. Worse, they assume that trade deficits or surpluses will be similarly stable, with exchange rates fluctuating to keep them constant. And they assume that a nation’s investment rate will equal its savings rate: every dollar saved will flow neatly into some productive investment. These assumptions are understandable, as devices to simplify the models enough to make them workable. They are, however, both clearly untrue and serious objects of controversy in their own right.392
That investment will equal savings is basically a form of Say’s Law, “supply creates its own demand,” named after the French economist Jean-Baptiste Say (1767-1832).393 This basically makes both underinvestment and unemployment theoretically impossible. Furthermore, these models often assume that nations enjoy magical macroeconomic stability: the business cycle has been mysteriously abolished. And their financial systems enjoy unruffled tranquility, without booms, busts, or bubbles. These assumptions are pre-Keynesian,394 and thus at least 70 years behind mainstream domestic economics. (This is a recurring problem in free trade economics: ideas long discarded in other areas of economics recur with alarming regularity.)
These models also generally leave out transition costs. These sound temporary, but such transitions can take decades: consider the pain experienced by the Midwestern manufacturing areas of the U.S. as their industries have gradually lost comparative advantage since the mid-sixties! Given that the world economy is not static, but constantly moving into new industries, there are always new transitions being generated, which means that transition costs go on forever, as an intrinsic cost of having a global economy based on shifting patterns of comparative advantage. Somebody will always be the rustbelt. (This does not of itself mean that economic change is a bad thing, but it does mean that these costs must be factored in to get an accurate accounting.)
Trade in services (AKA offshoring) is another sticking point. The root problem here is that this trade usually isn’t regulated the same way as trade in goods. Due to the fact that, prior to cheap long-distance telephony and the Internet, many services were rarely internationally traded, there are actually few outright tariffs or quotas on them. Instead, there is a crazy-quilt of hard-to-quantify barriers, ranging from licensing requirements to tacit local cartels and linguistic differences. As a result, when these barriers come down, they rarely come down in a neatly quantifiable way like reducing a tariff on cloth from 28 to 22 percent. So economists must basically guess how to quantify nonquantitative changes in order to model them. (The term for this is “tariff equivalent” numbers.) As a result, the conclusions generated by many models of trade in services are so dependent upon arbitrary guesses as to border on arbitrary themselves.
Another caveat: because all these models are predictions about the future, they are of necessity somewhat speculative under the best of circumstances and notoriously susceptible to deliberate manipulation. It is easy, for example, to generate inflated predictions of gains from trade by extrapolating calculations intended to apply only within certain limits with back-of-the-envelope calculations that go far beyond these limits. (These are known in the trade as “hockey stick” projections due to their shape when graphed.) So as Frank Ackerman of the Global Development and Environment Institute at Tufts University puts it:
The larger estimates still being reported from some studies reflect speculative extensions of standard models, and/or very simple, separate estimates of additional benefit categories, not the core results of established modeling methodologies.395
Similarly, the standard way for free traders to play down the damage done to the victims of free trade is to count only workers directly displaced from jobs as its losers.396 But, as Josh Bivens of the Economic Policy Institute, a think tank funded by organized labor, reminds us:
The largest cost from trade is the permanent and steady drag on the wages of all American workers whose education and skills resemble those displaced by trade. Waitresses, for example, do not generally lose their jobs due to trade, but their pay suffers as workers displaced from tradable goods industries crowd into their labor market and bid down wages. Not acknowledging these wage costs is a very g
ood way to minimize the total debit column in the balance sheet of globalization’s impact on American workers.397
Even if all statistical gamesmanship is removed and other reforms made, there is a deeper problem with CGE models: no such model can predict what choices of trade strategy a nation will make. For example, none of the models used in the 1950s predicted Japan’s ascent to economic superpower status. Quite probably, no model could have. Indeed, no model based upon purely free-market assumptions will ever readily predict the outcomes from such strategic choices, as free-market economics, with its insistence that it is always best to just do what the free market says, rules out a priori the possibility that most such deliberate economic strategies can even work.
IS BIG BUSINESS IN ON THE JOKE?
As we have seen, the theory of comparative advantage is considerably out of alignment with the real world. So we should, logically, expect this fact to affect the conduct of actual international businesses at some point. If the theory is wrong, that is, then surely they must deviate from it at some point simply in order to function profitably? A little investigation suffices to reveal that indeed they do: the business community is well aware of how problematic the theory is and generally avoids using it in practice. As Michael Porter of Harvard Business School puts it:
Comparative advantage based on factors of production is not sufficient to explain patterns of trade. Evidence hard to reconcile with factor comparative advantage is not difficult to find...More important, however, is that there has been a growing awareness that the assumptions underlying factor comparative advantage theories of trade are unrealistic in many industries…The theory also assumes that factors, such as skilled labor and capital, do not move among nations. All these assumptions bear little relation, in most industries, to actual competition.398
Nevertheless, the business community and its lobbyists in Washington use comparative advantage all the time in politics to lobby for more free trade. So to a huge extent, the American business community has been using, and broadcasting to the public through the media, economic ideas in which it does not itself believe and refuses to live by.
Chapter 6
The Deliberately Forgotten History of Trade
We saw in the previous chapter why the theory of comparative advantage, the key justification economics offers for free trade, is false most of the time. But if this is so, then economic history should reflect this fact. That is, successful economic powers should have prospered by defying this theory’s recommendations, not by following them. This indeed turns out to be the case. But while it is widely known that economically successful nations like China and Japan have little use for free trade even today, what is less well understood is that even the nations that have historically championed free trade—the most important being Britain and the United States—have not actually practiced it for most of their history. Instead, they have long, successful, but deliberately forgotten records as protectionists.
Standard economic history taught in the United States is distorted by ideology and has key facts airbrushed out. That history, largely a product of Cold War myth-mongering about the virtues of absolutely free markets, attributes world economic growth to the spread of free markets to one nation after another, aided by free trade between them. Not only do free traders believe in this history, but it pretty much has to be true if the economics of free trade is valid. But economic history actually reveals that no major developed nation got that way by practicing free trade. Every single one did it by way of protectionism and industrial policy.
Industrial policy? That’s the deliberate manipulation of the domestic economy to help industries grow. Although this is a book about protectionism, from this point on we will not be able to ignore industrial policy entirely. Industrial policy is inextricably bound up with protectionism because these two policies are just the domestic and foreign expressions of the same underlying fact: 100 percent pure free markets are not best. So it is almost impossible for protectionism to be right without some kind of industrial policy being right, too. And because the mechanisms of effective protectionism are important largely for what they make happen inside the industries that make up an economy, understanding industrial policy helps illuminate what makes protectionism work.
One can, of course, always dismiss history as a guide to economic reality. In fact, this is precisely what contemporary economics, which is highly ahistorical, generally does.399 It is impossible to run real controlled experiments in economics, as one can in the physical sciences, because this would require re-running history with alternative policies. Therefore, one can always claim that nations which succeeded under protectionism would have succeeded without it. One can even claim that they succeeded in spite of, not because of, their protectionism, and that protectionism held them back.400 But such criticism is empty, as it makes any economic claim logically immune to historical evidence. One can only let the history below speak for itself, and see what looks like the least tendentious and most plausible interpretation of the generally agreed facts.
THE GREAT BRITISH FREE-TRADE MYTH
According to the creation myth of free trade, Great Britain is the original motherland of free markets, home of Adam Smith and David Ricardo both, the first nation to break free of the misguided gold-hoarding mercantilism that came before and consequently the industrial superpower of the 19th century, erector of a global empire upon free-trade principles. As Britain was indeed a free-trading state for most of this period, this myth has surface plausibility. Among other things, the British themselves believed in it during their mid-19th-century economic zenith, and some of them still do: the British newsmagazine The Economist was founded in 1843 specifically to agitate for free trade, and does so today from airport newsstands on six continents.401
Unfortunately, this whole story depends upon tricks of historical timing and starts to fall apart once one gets a few dates right. Adam Smith published his epoch-making free-trade tract, The Wealth of Nations, in 1776. But Britain in 1776 was not a blank slate upon which free markets and free trade could work their magic. It was the beneficiary of several prior centuries of protectionism and industrial policy.402 In the words of British economist William Cunningham:
For a period of two hundred years [c. 1600-1800], the English nation knew very clearly what it wanted. Under all changes of dynasty and circumstances the object of building up national power was kept in view; and economics, though not yet admitted to the circle of the sciences, proved an excellent servant, and gave admirable suggestions as to the manner in which this aim might be accomplished.403
England in this era was, in fact, a classic authoritarian (this is long before English democracy)404 developmentalist state: a Renaissance South Korea, with kings rather than the military dictators who ruled South Korea for most of the Cold War period. English industrialization must actually be traced 300 years prior to Adam Smith, to events like Henry VII’s imposition of a tariff on woolen goods in 1489.405 King Henry’s aim was to wrest the wool weaving trade, then the most technologically advanced major industry in Europe, away from Flanders (the Dutch half of present-day Belgium), where it had been thriving upon exports of English wool. Flemish producers were entrenched behind huge capital investments, which gave them economies of scale sufficient to outcompete fledgling entrants into the industry. So only government action could get England a toehold.
Even in the 15th century, there was an awareness that being an exporter of agricultural raw materials was a dead end—a problem African and Latin American nations wrestle with to this day. Henry VII created, in fact, the first national industrial policy of the modern era, long before the Industrial Revolution introduced artificial energy sources like steam power.406 A whole interlocking series of now-forgotten policy moves underlay the rise of English industry; what all these measures had in common was that protectionism was essential to making them work. In the words of economist John Culbertson of the University of Wisconsin and the Federal Reserve Board of Governors:
Step after step in the cumulative economic rise of England was directly caused by government action or depended upon supportive government action: the prohibition of importation of Spanish wool by Henry I, the revision of land-tenure arrangements to permit the development of large-scale sheep raising, Edward III’s attracting of Flemish weavers to England and then prohibiting of the wearing of foreign cloth, the termination of the privileges in London of the Hanseatic League under Edward VI, the near-war between England under Elizabeth I and the Hanseatic League, which supported the rise of English shipping. And then there was the prohibition of export of English wool (which damaged the Flemish textile industry and stimulated that of England), the encouragement of production of dyed and finished cloth in England, the use of England’s dominance in textile manufacture to push the Hanseatic League out of foreign markets for other products, the encouragement of fishing...407
The aim of English policy was what would today be called “climbing the value chain”: deliberately leveraging existing economic activity to break into more-sophisticated related activities. Fifteenth-century England was considerably more primitive than Bangladesh is today, so, among other things, it had not yet developed sophisticated financial markets capable of systematically identifying and exploiting business opportunities. Therefore it could not count on the free market to drive its industry into ever-more-advanced activities, but required the active intervention of the state to do so. (The free market does not spring into existence fully formed and functional automatically or overnight, a lesson most recently demonstrated in the chaos of post-Communist Russia.)