Trade Truths for Turbulent Times

A Reply to Vladimir Masch

International trade has seen remarkable changes over recent decades. Transport costs have dropped, telecommunications have opened up trade in new sectors, and different countries have emerged as trading powers. The question raised by Vladimir Masch in an accompanying piece (see, 2/14/07, "A Radical Plan to Manage Globalization") is whether these changes are so drastic as to require new trade restraints that would shake the foundations of the modern trading system.

The future will undoubtedly differ from the past (or, at least, that's what we would think if we were willing to rely on history). The question is whether the changes will be so radical that no old lessons apply—in which case it's anyone's guess what to do—or whether some verities carry through.

Ricardo's Model

Economists have been studying trade for quite some time, both to see what it does for countries and for the people within. In the most basic model of comparative advantage, David Ricardo assumed there was only a single type of labor. Thus, all labor would either gain or lose from trade (they didn't lose). That model's main point about comparative advantage—countries can gain through specializing in the production of goods they produce relatively cheaply—is most useful in addressing the perpetual concern that a country might lose all its jobs to trade.

Later models, such as that of Eli Heckscher and Bertil Ohlin, did have winners and losers from trade liberalization. The winners could compensate the losers if they chose to and thereby make everyone better off, but there was some work to be done. More recent studies have quantified the extent of job loss, the duration of unemployment, and the pay cuts that displaced workers take after losing jobs to import competition.

Through all these studies, there is a central theme that emerges: Openness and economic integration have been prerequisites for economic growth and prosperity. Trade allows specialization, it increases the variety of products available to consumers, it spurs competition, and it helps spread technological innovation.

Stress-Test Economics

If one goes through trade theory selectively, it is easy to think that key points are being ignored. Economists stay gainfully employed, though, not by musing happily on the utopian virtues of a beloved model, but by stress-testing it. What happens if there are monopolies instead of small competitors? What if workers have skills that are particular to one sector of the economy and won't carry over to another? The only concealment of these discussions occurs when the results are couched in technical terms and published in journals.

Other mathematically-oriented disciplines "conceal" their findings the same way.

Even in sophisticated presentations, studies try to isolate the features of interest from other potentially confounding factors. Thus in most discussions of comparative advantage there is no mention of trade deficits. It is certainly possible to ask, though, whether gains from trade arguments would still apply in a world of unbalanced trade.

In dealing with trade deficits, it is essential to distinguish between bilateral and multilateral trade balances. We care only about the latter. Even if we had a world in which the value of United States imports equaled the value of its exports, there is no reason to think that trade could or should balance bilaterally. We could imagine a world in which the United States sells financial services to Chile; Chile sells copper to China; and China sells manufactured goods to the United States. Each country could have multilaterally balanced trade, but would have a bilateral deficit with one partner and an offsetting surplus with the other.

Relativity Theory of Savings

What happens if the bilateral surpluses don't offset the deficits and we have multilateral imbalances (as we almost always do)? Let's pretend the United States and China are the only two countries in the world—the only case in which that bilateral balance would mean anything. What would the Chinese accept in exchange for their goods if they didn't want any U.S. goods or services right now? They would take IOUs. We could call them "Treasury bonds." This is a form of borrowing on the part of the United States and lending on the part of China. IOUs only have value if you plan to cash them in at a later date.

Is such borrowing and lending a good idea? As with an individual's borrowing, it depends. It may be a very good idea to borrow to get a new house or launch a business. It may be a very bad idea to borrow to throw a wild party or to take a cruise. While we usually think of saving as virtuous, it may not be such a good idea for a poor country like China to save today if it will be substantially richer later on (it would probably value the goods more now in a time of relative scarcity).

One might be tempted to say that this is all well and good, but what happens when all American jobs go to China? There are theoretical reasons why this wouldn't happen, but U.S. experience is probably more persuasive. In each year since 1975, the United States has imported a greater value of goods and services from the world than it has exported. The current account, which adds in income and transfers, has been in deficit since 1991. In exchange for these net flows of goods and services, the United States has sent abroad IOUs in the form of financial instruments (currency, bonds, stocks or other forms of asset ownership).

The Many Causes of Job Loss

The evidence shows that there's not much correlation between trade deficits and the things we really care about—prosperity and jobs. Updating an example offered by Ben Bernanke when he was a mere governor of the Federal Reserve, in 1960 the United States ran a small trade surplus and enjoyed an unemployment rate of 5.5 percent; there were just over 65 million civilian jobs. In 2005, the United States ran a large trade deficit and enjoyed an unemployment rate of 5.1 percent. There were over 140 million civilian jobs. Over the same time span, imports grew from 4.3 percent of gross domestic product to 16 percent of GDP. Per capita income rose from roughly $15,600 per year to just over $42,000 per year (in 2005 dollars).

This is not to argue that growing imports and trade deficits were the sole cause of U.S. prosperity. Many other factors contributed to this performance. It would be absurd to pretend that these other factors—such as education, regulation, tax policy, or monetary policy—played no role.

In the same way, it is unreasonable to suppose that all job losses, or even all manufacturing job losses, are attributable to imports. People lose jobs for a number of reasons. Their factory or firm may close because of competition from abroad, or it may close because of competition from a neighboring state. One of the biggest culprits in manufacturing sector job loss is technological change. The steady fall in manufacturing employment has not been matched by an equivalent fall in output; the sector is using less labor to make each unit of output.

Offshoring Is No Catastrophe

It is also worth disentangling gross and net job losses. In 2005, 55 million Americans left jobs (gross job loss). In the same year, 57 million Americans were hired (a net job gain of 2 million). In such a dynamic labor market these gross figures dwarf estimates of gross job losses due to trade. In fact, this distinction between gross and net losses is made by Alan Blinder in his recent discussion of potential job losses to offshoring. He also concludes:

"…we should not view the coming wave of offshoring as an impending catastrophe. Nor should we try to stop it.

The normal gains from trade mean that the world as a whole cannot lose from increases in productivity, and the United States and other industrial countries have not only weathered but also benefited from comparable changes in the past."

One reason trade economists set aside questions about the unemployment rate is that it is largely determined by monetary policy and by how well the labor market functions. The 2005 unemployment rate of 5.1 percent corresponds to roughly 7.6 million unemployed people. Even if one were to develop a plan to block trade and somehow employ a substantial fraction of these individuals, the resulting plunge in the unemployment rate would cause the Federal Reserve to fret about looming inflation and boost interest rates until the labor market appeared less overheated.

The Trouble with Quotas

We do need a Federal Reserve to oversee monetary affairs, just as the government needs to provide a range of public goods. This is quite different from a centralized decision that steel production should exceed a set number of tons each year, or that the bilateral trade balance with China should be zero. With a centrally-planned allocation of bilateral trade balances, as Masch proposes, inflation would be the least of our worries. Right now, neither the President nor the Congress nor the Federal Reserve sets trade balances, whether bilateral or multilateral ones. These balances are the net outcome of all the buying and selling, borrowing and lending that occur across the vast range of goods, services, and financial markets.

The scheme to fix bilateral balances could only be achieved through a new system of comprehensive trade quotas. Even then, the very technology that poses the new challenges makes the imposition of limits extraordinarily difficult. How do you tax or subsidize the telephone call from New York to London in which an investment banker advises a CFO on financial strategy? Yet compensation for that service enters into each country's trade balance.

Under such a plan, the United States would not only lose in the classical trade sense (this is the equivalent of encouraging our trading partners to apply heavy tariffs against us), but the country would experience macroeconomic agony as our existing economic relationships unraveled. The job losses from skyrocketing interest rates, withdrawn foreign investment, and suspicions about U.S. economic policy would easily save the Fed from any concerns about labor market over-heating. Be careful what you wish for.

See the Debate Room discussion on free trade here;).

Philip Levy studies international trade and development at the American Enterprise Institute. Before joining AEI, he was a senior economist for trade on the President's Council of Economic Advisers and a member of the policy planning staff at the State Department. An economist by training, Levy has experience in many international trade and development policy issues.

Before it's here, it's on the Bloomberg Terminal.