Pundits no longer confidently assert that the massive US trade deficit is good for the economy, because it puts money in foreign hands to buy US exports and create jobs for Americans.
Some pundits are even beginning to realize that “lower-priced foreign goods” are not all that cheap when the price is the loss of high-paying US jobs.
But pundits still believe that free trade is somehow going to bail America out and create new industries and high-value-added jobs to replace the ones lost to offshore production and outsourcing (and, I should add, to competition from Japanese industrial policy).
Sooner or later pundits will have to face the fact that the conditions upon which the case for free trade is based simply no longer exist.
Free trade is based on the principle of comparative advantage. For comparative advantage to operate, two conditions are required: (1) a country’s factors of production must seek comparative advantage within the country and not move to absolute advantage abroad, and (2) countries must have different relative costs of producing different goods.
When free trade theory originated two centuries ago, climate and natural resources were important components of GDP. Climate and natural resources could not migrate, and countries’ different climates and resource endowments meant that relative costs varied among countries.
In today’s modern economies, production is based primarily on acquired knowledge. Modern production functions operate the same regardless of their location. There is no necessary reason for the relative costs of producing manufactured goods to vary from one country to another. Only the absolute costs vary, with the advantage going to countries with large excess supplies of labor.
Economists and pundits mistake offshore production and outsourcing for trade, whereas in fact they are merely the substitution of cheap foreign labor for expensive first world labor.
It is nonsense for economists and pundits to claim that the US benefits from the loss of jobs, capital and technology when economic theory tells us that all three are needed for economic development.
Economists need to catch up with their discipline. The latest work in trade theory is Global Trade and Conflicting National Interests, by Ralph E. Gomory and William J. Baumol, published by MIT Press in 2000.
Gomory and Baumol show that conflict is inherent in international trade. In some cases free trade can be mutually beneficial. In other cases, one country gains at the expense of another. In some cases trade is worse than no trade. The authors demonstrate that in no case can all trading countries achieve their individually best outcomes.
Many modern industries are characterized by increasing returns, which means that countries with industrial policies can target industries, wrest them away from free trading countries, achieve a monopoly and retain the industry indefinitely.
Gomory and Baumol remind us that the issue is not whether companies or individual consumers benefit from free trade, but whether the country overall benefits. Specific corporations and consumers can benefit from offshore production and outsourcing, while the country as a whole loses occupations, industries, production capability and GDP.
A country that produces a large share of the world’s goods “has much to consume and much to trade. It becomes a high-wage, high-consumption country. This beneficial effect of being the producer of a large proportion of the world’s tradable industries can be very substantial.” The greater the share of world income a country can achieve, the higher the wages of its workers.
A country whose policymakers are under the illusion that free trade is uniformly beneficial is likely to find itself blindsided in the competition for important industries and occupations.
In today’s world, the interest of multinational corporations can easily diverge from the interests of their home countries. When, in pursuit of lowest cost, multinationals move production for their home markets abroad, they move GDP abroad by turning domestic production into imports. A country that produces abroad for its home consumption will never close its trade deficit.
Perhaps Gomory and Baumol will wake up policymakers before the US becomes a mere low wage assembler of foreign made inputs.