Why Free Trade has not Created Jobs for American Workers

In 1994, Thomas I. Palley, then a Professor of Economics at the New School for Social Research, wrote:

From the standpoint of orthodox theory, increased international trade is an unambiguous good, so that lower international transactions costs and increased multinational production are both seen as major sources of gain. Orthodox economists have therefore persistently pushed for free trade and the elimination of tariffs, and these policies have reinforced the secular reduction in transactions costs.

However, the conventional approach to trade draws no distinctions between types of trade. Instead, all trade is good, and the greater the diversity of the trading partners, the greater the benefits to trade. Thus, Americans supposedly have the most to gain from trading with countries like China, Mexico, and the Phillipines. Nothing could be further from the truth; instead, the benefits to trade depend importantly on who one is trading with. Without doubt trade can be enormously beneficial, and these benefits include: (a) greater product diversity, (b) lower prices attributable to economies of scale associated with larger markets, (c) lower prices attributable to the fact that some countries have climatic and natural resource advantages in the production of certain commodities, and (d) lower prices due to increased market competition.

However, trade ceases to be a good when it rests exclusively on wage differentials: in this case, it becomes an implicit instrument for battering down wages and raising profits. This forces a reconsideration of trade policy: where countries have similar wage structures, employee protection laws, and environmental protection laws, then free trade is desirable; where countries differ in these regards, we need to be much more cautious. Free trade predicated exclusively on wage competition is entirely unacceptable, and represents a major threat to popular prosperity in America and Western Europe.

Professor Palley was too early with his prediction of disaster, as the Clinton years featured economic expansion here even as the trade deficit grew. But being too early is not being wrong: every President since Richard Nixon has been “too early” in calling for an end to our dependence on foreign oil, and they were all absolutely right. Nevertheless, it is an unfortunate trait of human beings that we tend to regard as intrinsically bad, and therefore as “discredited,” any advice whose time simply has not come.

In 1994, American capital was "all dressed up with no place to go." Enough jobs were moving off shore to alarm labor-oriented economists like Prof. Palley, but aggregate demand had not dropped enough to offset the benefits of lower prices, especially as other sectors of the economy (tech mostly) were growing. More productive capacity had to be created abroad before American capitalists could take full advantage of the low cost of accessing it. Prof. Palley may have underestimated how long it would take for that capacity to emerge, but disaster delayed is not disaster denied.

Cheap labor has always been an important part of our trade with less wealthy countries, but those countries have not historically been able to compete with us on so many different classes of goods. Quantity, they say, has a quality all its own. Whether cheap Chinese jeans are good for America or bad for America turns on whether there are also cheap Chinese cell phones and cheap Chinese TVs and cheap Chinese snow shovels and, and…. There’s a limit on the list of “other things” we can make, and even if we invent them here, we cannot make them here if our neighbors across the shrinking ocean can deliver them to us for less.

Certainly, cheap Chinese goods put extra money in consumers' pockets, which creates demand for more goods, which creates more jobs. But that demand may be offset by a reduction in demand from the loss of American jobs, and much of the alleged additional demand is for additional cheap Chinese goods, so many of those new jobs are also in China. And yet, every argument I read in support of free trade with China assumes both that (i) the loss of US jobs results in no net reduction in US demand, and (ii) the demand for more goods will create significantly more American jobs. Neither of these assumptions is ever necessarily true, and, more important, neither appears to be true now.

This is not to say that the US has done all it can to be as competitive as possible in the export market. But our competition in the export market is not China; it's Europe. The Eurozone is doing better at selling to China, India, and Brazil than we are. Despite their high labor rates, Germany, Holland, and Ireland are all running significant trade surpluses, and, in general, The Eurozone's trade balance seems to oscillate around zero, thanks not only to their exports but, of course, to their running a much lower oil bill than we do. The important point for Americans, however, is not that we must compete with the Europeans, but that we must compete with them for the global market in capital-intensive goods, a market that by definition creates few jobs and so wouldn't be satisfactory even if we had it all to ourselves. So, the fact that we are not competing well in that market is salt in our wounds, but it does not point to an opportunity for national prosperity.

Competitiveness with Europe - while certainly to be strived for - is not the answer to China's broad wage-based advantage. The obvious antidote to that ill is the imposition of tariffs. Prof. Palley put it this way:

Where there are conditions of domestic monopoly or where countries have a natural advantage in the production of goods, free trade is desirable…. However, where the only reasons for trade are poverty level wages, and lack of obligations regarding pollution abatement, worker safety standards, and health and social insurance costs, … free trade will end up promoting a decline in the wages of American workers as companies either transfer production overseas, or use the threat of doing so to extract wage concessions.

Moreover, to the extent that the system of social and environmental protections becomes viewed as a source of cost disadvantage and job loss, this will unleash political pressures for its repeal. In the realm of free trade, market forces promote the lowest common denominator.

Given this, free trade is appropriate where the requisite criteria are satisfied…. However, if the criteria are not met, countries should be subject to a "social" tariff designed to compensate for their exploitative economic conditions. As conditions in countries improve, this tariff can be lowered thereby providing an incentive mechanism for governments in under-developed countries to advance the welfare interests of workers. Moreover, the tariff proceeds could be used to provide aid for purchases of U.S. exports, thus helping both the U.S. economy and under-developed countries.

Leaving aside the welfare of foreign workers as a basis for U.S. trade policy (a slippery slope not to be tested in tough times), Prof. Palley’s proposal makes sense. Mobile capital will not come here or stay here if it can take advantage of “exploitative” wages and conditions elsewhere. So we must either immobilize the capital – not likely – or, for our own sake, end the exploitative conditions “enjoyed” by our trading partners. Prof. Palley’s tariff, which allows for competition on other bases – German and Japanese cars would be welcome – seems well-designed for that purpose.

Free-traders will doubtless object to the tariff proposal, citing the usual undifferentiated litany of horribles associated with tariffs and, of course, invoking the worship words “Smoot” and “Hawley.” We’ll be told that tariffs raise the cost of trade, thereby reducing its benefits, resulting in slower growth of wealth everywhere, and a delay in the development and transformation of the low-wage states. Some of these claims would be accurate, but they would not be persuasive.

A tariff would raise the cost of trade and so reduce its benefits. But only in the short term. If the cheap foreign labor is putting Americans out of work, aggregate demand will fall, and trade will not have created any benefits to reduce. The tariff sacrifices short-term gain for long-term prosperity. To treat the short-term sacrifice as the whole picture is simply wrong.

I don't know what effect a tariff regime that reflected wage differentials would have on Chinese development. Wages are rising in China, and the country is already trying to develop domestic demand. Either way, the world does not owe China a living, so Chinese development per se ought not to be an object of American trade policy. The Chinese need to consume as many consumer goods as they produce (whether the former are domestic or imported) and not expect the West be their dumping ground. A tariff will encourage them to do that, at whatever speed they choose.

As for Smoot-Hawley, which is remembered by many as the tariff that ate the 1930’s recovery, experts like Ben Bernanke will have to step up and explain the difference between a mercantilist tariff imposed by a trade surplus country (us, then) and one imposed by a trade deficit country under economic attack by underpaid workers (us, now). I can’t do everything…