The Free Trade Fallacy

Robert Kuttner

[Reprinted from The New Republic, vol. 188, no. 12 (28 March 1983)]

In the firmament of American ideological convictions, no star burns brighter than the bipartisan devotion to free trade. The President's 1983 Economic Report, to no one's surprise, sternly admonished would-be protectionists. An editorial in The New York Times, midway through an otherwise sensibly Keynesian argument, paused to add ritually, "Protectionism might mean a few jobs for American auto workers, but it would depress the living standards of hundreds of millions of consumers and workers, here and abroad."

The Rising Tide of Protectionism has become an irresistible topic for a light news day. Before me is a thick sheaf of nearly interchangeable clips warning of impending trade war. With rare unanimity, the press has excoriated the United Auto Workers for its local content legislation. The Wall Street Journal's editorial ("Loco Content") and the Times's ("The Made-in-America Trap") were, if anything, a shade more charitable than Cockburn and Ridgeway in The Village Voice ("Jobs and Racism"). And when former Vice President Mondale began telling labor audiences that America should hold Japan to a single standard in trade, it signaled a chorus of shame-on-Fritz stories.

The standard trade war story goes like this: recession has prompted a spate of jingoistic and self-defeating demands to fence out superior foreign goods. These demands typically emanate from overpaid workers, loser industries, and their political toadies. Protectionism will breed stagnation, retaliation, and worldwide depression. Remember Smoot-Hawley!

Perhaps it is just the unnerving experience of seeing The Wall Street Journal and The Village Voice on the same side, but one is moved to further inquiry. Recall for a moment the classic theory of comparative advantage. As the English economist David Ricardo explained it in 1817, if you are more efficient at making wine and I am better at weaving cloth, then it would be silly for each of us to produce both goods. Far better to do what each does best, and to trade the excess. Obviously then, barriers to trade defeat potential efficiency gains. Add some algebra, and that is how trade theory continues to be taught today.

To bring Ricardo's homely illustration up to date, the economically sound way to deal with the Japanese menace is simply to buy their entire cornucopia - the cheaper the better. If they are superior at making autos, TVs, tape recorders, cameras, steel, machine tools, baseballs, semiconductors, computers, and other peculiarly Oriental products, it is irrational to shelter our own benighted industries. Far more sensible to buy their goods, let the bracing tonic of competition shake America from its torpor, and wait for the market to reveal our niche in the international division of labor.

But this formulation fails to describe the global economy as it actually works. The classical theory of free trade was based on what economists call "factor endowments" - a nation's natural advantages in climate, minerals, arable land, or plentiful labor. The theory doesn't fit a world of learning curves, economies of scale, and floating exchange rates. And it certainly doesn't deal with the fact that much "comparative advantage" today is created not by markets but by government action. If Boeing got a head start on the 707 from multibillion-dollar military contracts, is that a sin against free trade? Well, sort of. If the European Airbus responds with subsidized loans, is that worse? If only Western Electric (a U.S. supplier) can produce for Bell, is that protection? If Japan uses public capital, research subsidies, and market-sharing cartels to launch a highly competitive semiconductor industry, is that protection? Maybe so, maybe not.

Just fifty years ago, Keynes, having dissented from the nineteenth-century theory of free markets, began wondering about free trade as well. In a 1933 essay in the Yale Review called "National Self-Sufficiency," he noted that "most modern processes of mass production can be performed in most countries and climates with almost equal efficiency." He wondered whether the putative efficiencies of trade necessarily justified the loss of national autonomy. Today nearly half of world trade is conducted between units of multinational corporations. As Keynes predicted, most basic products (such as steel, plastics, microprocessors, textiles, and machine tools) can be manufactured almost anywhere, but by labor forces with vastly differing prevailing wages.

With dozens of countries trying to emulate Japan, the trend is toward worldwide excess capacity, shortened useful life of capital equipment, and downward pressure on wages. For in a world where technology is highly mobile and interchangeable, there is a real risk that comparative advantage comes to be defined as whose work force will work for the lowest wage.

In such a world, it is possible for industries to grow nominally more productive while the national economy grows poorer. How can that be? The factor left out of the simple Ricardo equation is idle capacity. If America's autos (or steel tubes, or machine tools) are manufactured more productively than a decade ago but less productively than in Japan (or Korea, or Brazil), and if we practice what we preach about open trade, then an immense share of U.S. purchasing power will go to provide jobs overseas. A growing segment of our productive resources will lie idle. American manufacturers, detecting soft markets and falling profits, will decline to invest. Steelmakers will buy oil companies. Consumer access to superior foreign products will not necessarily compensate for the decline in real income and the idle resources. Nor is there any guarantee that the new industrial countries will use their burgeoning income from American sales to buy American capital equipment (or computers, or even coal), for they are all striving to develop their own advanced, diversified economies.

Against this background of tidal change in the global economy, the conventional reverence for "free trade" is just not helpful. As an economic paradigm, it denies us a realistic appraisal of second bests. As a political principle, it leads liberals into a disastrous logic in which the main obstacle to a strong American economy is decent living: standards for the American work force. Worst of all, a simple-minded devotion to textbook free trade in a world of mercantilism assures that the form of protection we inevitably get will be purely defensive, and will not lead to constructive change in the protected industry.

The seductive fallacy that pervades the hand-wringing about protectionism is the premise that free trade is the norm and that successful foreign exporters must be playing by the rules. Even so canny a critic of political economy as Michael Kinsley wrote in these pages that "Very few American workers have lost their jobs because of unfair foreign trade practices, and it is demagogic for Mondale and company to suggest otherwise." But what is an unfair trade practice? The Common Market just filed a complaint alleging that the entire Japanese industrial system is one great unfair trade practice!

To the extent that the rules of liberal trade are codified, they repose in the General Agreement on Tariffs and Trade (stay awake, this will be brief). The GATT is one of those multilateral institutions created in the American image just after World War II, a splendid historical moment when we could commend free trade to our allies the way the biggest kid on the block calls for a fair fight.

The basic GATT treaty, ratified in 1947, requires that all member nations get the same tariff treatment (the "most favored nation" doctrine), and that tariffs, in theory at least, are the only permissible form of barrier. Governments are supposed to treat foreign goods exactly the same as domestic ones: no subsidies, tax preferences, cheap loans to home industries, no quotas, preferential procurement, or inspection gimmicks to exclude foreign ones. Nor can producers sell below cost (dumping) in foreign markets....

In classical free trade theory, the only permissible candidate for temporary protection is the "infant industry." But Japan and its imitators, not unreasonably, treat every emerging technology as an infant industry. Japan uses a highly sheltered domestic market as a laboratory, and as a shield behind which to launch one export winner after another. Seemingly, Japan should be paying a heavy price for its protectionism as its industry stagnates. Poor Japan! This is not the place for a detailed recapitulation of Japan, Inc., but keep in mind some essentials.

The Japanese government, in close collaboration with industry, targets sectors for development. It doesn't try to pick winners blindfolded; it creates them. It offers special equity loans, which need be repaid only if the venture turns a profit. It lends public capital through the Japan Development Bank, which signals private bankers to let funds flow. Where our government offers tax deductions to all businesses as an entitlement, Japan taxes ordinary business profits at stiff rates and saves its tax subsidies for targeted ventures. The government sometimes buys back outdated capital equipment to create markets for newer capital.

The famed Ministry of International Trade and Industry has pursued this essential strategy for better than twenty years, keeping foreign borrowers out of cheap Japanese capital markets, letting in foreign investors only on very restricted terms, moving Japan up the product ladder from cheap labor intensive goods in the 1950s to autos and steel in the 1960s, consumer electronics in the early 1970s, and computers, semiconductors, optical fibers, and just about everything else by 1980. The Japanese government also waives antimonopoly laws for development cartels, and organizes recession cartels when overcapacity is a problem. And far from defying the discipline of the market, Mm encourages fierce domestic competition before winnowing the field down to a few export champions....

The Japanese not only sin against the rules of market economics. They convert sin into productive virtue. By our own highest standards, they must be doing something right. The evident success of the Japanese model and the worldwide rush to emulate it create both a diplomatic crisis for American trade negotiators and a deeper ideological crisis for the free trade regime. As Berkeley professors John Zysman and Steven Cohen observed in a careful study for the Congressional Joint Economic Committee last December, America, as the main defender of the GATT philosophy, now faces an acute policy dilemma: "how to sustain the open trade system and promote the competitive position of American industry" at the same time.

Unfortunately, the dilemma is compounded by our ideological blinders. Americans believe so fervently in free markets, especially in trade, that we shun interventionist measures until an industry is in deep trouble. Then we build it half a bridge.

There is no better example of the lethal combination of protectionism plus market-capitalism-as-usual than the steel industry. Steel has enjoyed some import limitation since the late 1950s, initially through informal quotas. The industry is oligopolistic; it was very slow to modernize. By the mid-1970s, world demand for steel was leveling off just as aggressive new producers such as Japan, Korea, and Brazil were flooding world markets with cheap, state-of-the-art steel.

As the Carter Administration took office, the American steel industry was pursuing antidumping suits against foreign producers - an avenue that creates problems for American diplomacy. The new Administration had a better idea, more consistent with open markets and neighborly economic relations. It devised a "trigger price mechanism," a kind of floor price for foreign steel entering American markets. This was supposed to limit import penetration. The steelmakers withdrew their suits. Imports continued to increase.

So the Carter Administration moved with characteristic caution toward a minimalist industrial policy. Officials invented a kind of near-beer called the Steel Tripartite. Together, industry, labor, and government would devise a strategy for a competitive American steel industry. The eventual steel policy accepted the industry's own agenda: more protection, a softening of pollution control requirements, wage restraint, new tax incentives, and a gentlemen's agreement to phase out excess capacity. What the policy did not include was either an enforceable commitment or adequate capital to modernize the industry. By market standards, massive retooling was not a rational course, because the return on steel investment was well below prevailing yields on other investments. Moreover, government officials had neither the ideological mandate nor adequate information to tell the steel industry how to invest. "We would sit around and talk about rods versus plate versus specialty steel, and none of us in government had any knowledge of how the steel industry actually operates," confesses C. Fred Bergsten, who served as Treasury's top trade official under Carter. "There has never been a government study of what size and shape steel industry the country needs. If we're going to go down this road, we should do it right, rather than simply preserving the status quo."...

The argument that we should let "the market" ease us out of old-fashioned heavy industry in which newly industrialized countries have a comparative advantage quickly melts away once you realize that precisely the same nonmarket pressures are squeezing us out of the highest-tech industries as well. And the argument that blames the problem on overpaid American labor collapses when one understands that semiskilled labor overseas in several Asian nations is producing advanced products for the U.S. market at less than a dollar an hour. Who really thinks that we should lower American wages to that level in order to compete?

In theory, other nations' willingness to exploit their work forces in order to provide Americans with good, cheap products offers a deal we shouldn't refuse. But the fallacy in that logic is to measure the costs and benefits of a trade transaction only in terms of that transaction itself. Classical free-trade theory assumes full employment. When foreign, state-led competition drives us out of industry after industry, the costs to the economy as a whole can easily outweigh the benefits. As Wolfgang Hager, a consultant to the Common Market, has written, "The cheap [imported] shirt is paid for several times: once at the counter, then again in unemployment benefits. Secondary losses involve input industries... machinery, fibers, chemicals for dyeing and finishing products."

As it happens, Hager's metaphor, the textile industry, is a fairly successful example of managed trade, which combines a dose of protection with a dose of modernization. Essentially, textiles have been removed from the free-trade regime by an international market-sharing agreement. In the late 1950s, the American textile industry began suffering insurmountable competition from cheap imports. The United States first imposed quotas on imports of cotton fibers, then on synthetics, and eventually on most textiles and apparel as well. A so-called Multi-Fiber Arrangement eventually was negotiated with other nations, which shelters the textile industries of Europe and the United States from wholesale import penetration. Under M.F.A., import growth in textiles was limited to an average of 6 percent per year.

The consequences of this, in theory, should have been stagnation. But the result has been exactly the opposite. The degree of protection, and a climate of cooperation with the two major labor unions, encouraged the American textile industry to invest heavily in modernization. During the 1960s and 1970s, the average annual productivity growth in textiles has been about twice the U.S. industrial average, second only to electronics. According to a study done for the Common Market, productivity in the most efficient American weaving operations is 130,000 stitches per worker per hour - twice as high as France and three times as high as Britain. Textiles, surprisingly enough, have remained an export winner for the United States, with net exports regularly exceeding imports. (In 1982, a depressed year that saw renewed competition from China, Hong Kong, Korea, and Taiwan, exports just about equaled imports.)

But surely the American consumer pays the bill when the domestic market is sheltered from open foreign competition. Wrong again. Textile prices have risen at only about half the average rate of the producer price index, both before and after the introduction of the Multi-Fiber Arrangement.

Now, it is possible to perform some algebraic manipulations and show how much lower textile prices would have been without any protection. One such computation places the cost of each protected textile job at several hundred thousand dollars. But these static calculations are essentially useless as practical policy guides, for they leave out the value over time of maintaining a textile industry in the United States. The benefits include not only jobs, but contributions to G.N.P., to the balance of payments, and the fact that investing in this generation's technology is the ticket of admission to the next.

Why didn't the textile industry stagnate? Why didn't protectionism lead to higher prices? Largely because the textile industry is quite competitive domestically. The top five manufacturers have less than 20 percent of the market. The industry still operates under a 1968 Federal Trade Commission consent order prohibiting any company with sales of more than $100 million from acquiring one with sales exceeding $10 million. If an industry competes vigorously domestically, it can innovate and keep prices low, despite being sheltered from ultra- low-wage foreign competition - or rather, thanks to the shelter. In fact, students of the nature of modern managed capitalism should hardly be surprised that market stability and new investment go hand in hand.

The textile case also suggests that the sunrise industry/sunset industry distinction is so much nonsense. Most of America's major industries can be winners or losers, depending on whether they get sufficient capital investment. And it turns out that many U.S. industries such as textiles and shoes, which conventionally seem destined for lower-wage countries, can survive and modernize given a reasonable degree of, well, protection.

What, then, is to be done? First, we should acknowledge the realities of international trade. Our competitors, increasingly, are not free marketeers in our own mold. It is absurd to let foreign mercantilist enterprise overrun U.S. industry in the name of free trade. The alternative is not jingoist protectionism. It is managed trade, on the model of the Multi-Fiber Arrangement. If domestic industries are assured some limits to import growth, then it becomes rational for them to keep retooling and modernizing.

It is not necessary to protect every industry, nor do we want an American MITT. But surely it is reasonable to fashion plans for particular key sectors like steel, autos, machine tools, and semiconductors. The idea is not to close U.S. markets, but to limit the rate of import growth in key industries. In exchange, the domestic industry must invest heavily in modernization. And as part of the bargain, workers deserve a degree of job security and job retraining opportunities.

Far from being just another euphemism for beggar-thy-neighbor, a more stable trade system generally can be in the interest of producing countries. Universal excess capacity does no country much of a favor. When rapid penetration of the U.S. color TV market by Korean suppliers became intolerable, we slammed shut an open door. Overnight, Korean color TV production shrank to 20 percent of capacity. Predictable, if more gradual, growth in sales would have been preferable for us and for the Koreans.

Second, we should understand the interrelationship of managed trade, industrial policies, and economic recovery. Without a degree of industrial planning, limiting imports leads indeed to stagnation. Without restored world economic growth, managed trade becomes a nasty battle over shares of a shrinking pie, instead of allocation of a growing one. And without some limitation on imports, the Keynesian pump leaks. One reason big deficits fail to ignite recoveries is that so much of the growth in demand goes to purchase imported goods.

Third, we should train more economists to study industries in the particular. Most economists dwell in the best of all possible worlds, where markets equilibrate, firms optimize, the idle resources re-employ themselves. "Microeconomics" is seldom the study of actual industries; it is most often a branch of arcane mathematics. The issue of whether governments can sometimes improve on markets is not a fit subject for empirical inquiry, for the paradigm begins with the assumption that they cannot. The highly practical question of when a little protection is justified is ruled out ex ante, since neoclassical economics assumes that less protection is always better than more.

Because applied industrial economics is not a mainstream concern of the economics profession, the people who study it tend to come from the fields of management, industrial and labor relations, planning, and law. They are not invited to professional gatherings of economists, who thus continue to avoid the most pressing practical questions. One economist whom I otherwise admire told me he found it "seedy" that high-wage autoworkers would ask consumers to subsidize their pay. Surely it is seedier for an $800-a-week tenured economist to lecture a $400-a-week autoworker on job security; if the Japanese have a genuine comparative advantage in anything, it is in applied economics.

Fourth, we should stop viewing high wages as a liability. After World War II, Western Europe and North America evolved a social contract unique in the history of industrial capitalism. Unionism was encouraged, workers got a fair share in the fruits of production, and a measure of job security. The transformation of a crude industrial production machine into something approximating social citizenship is an immense achievement, not to be sacrificed lightly on the altar of "free trade." It took one depression to show that wage cuts are no route to recovery. Will it take another to show they are a poor formula for competitiveness? Well-paid workers, after all, are consumers.