Thursday, June 4, 2009

Two Cheers for Free Trade

Everybody knows that trade benefits both parties. Otherwise, they wouldn’t take the trouble to do it. But that does not mean that free trade lifts all boats; it only lifts the boats of its participants. What happens next may be good or bad.

Let’s go back to Ricardo's example of comparative advantage. The Portuguese people benefit from the importation of English cloth because a bolt of cloth now costs them only $90 instead of $100. But what about the Portuguese cloth industry that was booming before the English showed up with their demand for wine and offer of “cheap” cloth?

I don’t mean that the displacement of workers is necessarily bad. Technology displaces buggy whip workers all the time, and there’s no reason trade shouldn’t displace them, too. But doesn’t it matter how many Portuguese were employed in the cloth industry? The theory supporting free trade is that capital and labor will move to the industries in which the local economy has a comparative advantage: Portuguese cloth workers will replant their cotton farms with vines to accommodate the British demand for Portuguese wine.

But whether that can happen in the real world depends on real-world phenomena. How much wine can be made in Portugal? How many people were employed making cloth? What happens if the Portuguese want more British cloth than the British want Portuguese wine? The British may be willing to lend the Portuguese the money they need to buy their cloth – economies of scale, what? But then, where will the displaced Portuguese cloth workers work? What will happen to the value of their homes? What about the businesses where they used to spend the money they are no longer making?

The Portuguese cloth worker in this example is not standing in for the workers in any one industry disadvantaged by an emerging trade opportunity. He is standing in for all of the workers displaced by free trade as our trade deficit grows. Because at the end of the day, the increase in the trade deficit is “funded” by the displacement of real workers in the deficit-running economy. It’s all well and good if these people can earn comparable incomes elsewhere, but there is no a priori reason to believe that such is the case. Historically, we’ve been able to cope with technological and trade-based displacement. But that’s not proof that it’s always possible, and we ought not to pretend that it is always possible.

The possibility that one trading partner will not be able to adjust to the displacements of trade is especially acute when the other partner’s comparative advantage lies in the lower standard of living of its workers. What that partner has to sell is not a product, but manufacturing itself. There aren’t many non-manufactured goods that a country can have a comparative advantage in. Natural resources, agriculture, software (including entertainment), engineering, and some others come to mind, but not enough to employ all the displaced workers. The displaced workers can take in each other’s wash, and as long as the partner with the cheap labor will lend its customers money with which to pay each other so that they can continue to buy from the manufacturing partner, the displacement may not seem as severe as it actually is.

But the borrowing does have to be supported by something, and eventually the non-manufacturing partner runs out of creditworthiness. First, unsecured private credit becomes hard to get. Then collateralized credit is tainted by bogus collateral (e.g., mortgages backed by over-appraised real estate), and the music stops. Only the national government is able to borrow. And even that credit becomes questionable over time.

The only way out of this mess may be for the manufacturing partner’s comparative advantage to be eliminated. There are only two ways to do that, and they are not mutually exclusive. One is to impose tariffs on manufactured goods. Plan B is to equalize the standards of living of the workers in the respective partners. And, of course, there are two ways to do Plan B, and they are not mutually exclusive either: improve the standard of living of workers in the exporting country or lower the standard of living of workers in the importing country.

Unfortunately, doing nothing is not an option. The system will equilibrate by forcing Plan B, and a lowered standard of living in the non-manufacturing country will feature prominently in the rebalancing. This natural equilibration has to be recognized and understood as the consequence of not imposing tariffs. So, when opponents of protectionism say that trade barriers will “lower our standard of living” by making imports more expensive and hurting our exports (which becomes less and less of a problem as the only thing we have comparative advantages in are things we have a virtual monopoly in), they will only have shown one side of the scale. The other side is the lowering in our standard of living that will result from not imposing tariffs. That side of the scale is harder to measure, but that does not mean it’s any less real or any less to be feared.

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