Clarifications on the Case for Free Trade

Free trade has necessary conditions. Today these conditions are not met. This point has escaped Joe Salerno and George Reisman (both writing on Mises.org), as it has a vast number of other people.

The case for free trade is based on David Ricardo’s principle of comparative advantage. Ricardo addressed the question how trade could take place between country A and country B (England and Portugal in his example) if country B was more efficient in the production of tradable goods (cloth and wine in his example) than A.

In other words, if Portugal could produce both cloth and wine at lower cost than England, how could trade between the countries benefit each?

Ricardo found the answer in relative or comparative advantage. He said that if Portugal specialized in wine, where its absolute advantage was greatest, and England specialized in cloth, where its disadvantage was least, total output would be higher than if both countries achieved self-sufficiency by producing both products. The higher productivity from specialization would result in mutual gains from trade.

For comparative advantage to reign, two conditions are necessary:

One is that capital and labor must be mobile within each country so that the capital and labor employed in England in the production of wine can flow into the production of cloth, where England’s trade advantage lies. In Portugal capital and labor must be able to flow from cloth to wine where Portugal’s advantage is greatest.

The other necessary condition is that capital and labor (factors of production) cannot be internationally mobile. If the factors of production are internationally mobile, capital and labor would move from England to Portugal, where both commodities can be produced the cheapest. Both wine and cloth would be produced in Portugal. Portugal would gain and England would lose.

Ricardo makes it clear that for trade to make both countries better off, trade must be based on comparative advantage. Ricardo gives reasons why, in his time, factors of production are internationally immobile.

Since the time of Ricardo, the key assumption of trade theory remains, in the recent words of trade theorist Roy J. Ruffin, "the inability of factors to move from a country where productivity is low to another where productivity is higher." In a recent article in History of Political Economy (34:4, 2002, pp. 727-748), Ruffin shows that Ricardo’s claim over Robert Torrens as the discoverer of the principle of comparative advantage lies in Ricardo’s realization that comparative advantage, the basis of the case for free trade, lies in "factor immobility between countries." Ruffin notes that "of the 973 words Ricardo devoted to explaining the law of comparative advantage, 485 emphasized the importance of factor immobility."

If factors of production are as mobile as traded goods, the case for free trade--that it benefits all countries--collapses. There is no known case for free trade if factors of production are as mobile as traded goods.

For some time I have been pointing out that the collapse of world socialism and the advent of the Internet have made factors of production as mobile as traded goods. Indeed, factors of production are more mobile. Capital, technology, and ideas can move today with the speed of light, whereas goods have to be shipped.

The collapse of world socialism has made Asian countries, such as China and India, receptive to foreign capital, and it has made first world capital willing to migrate beyond first world countries. The Internet makes it possible for a country to hire knowledge workers anywhere on the globe.

The Internet and the international mobility of capital and technology have, in effect, made labor internationally mobile, especially labor that is paid less than the value of its marginal product or its contribution to output. The huge excess supplies of labor in countries such as China and India ensure that it will be many years before labor in those countries, both skilled and unskilled, will be paid the value of its marginal product.

The international mobility of factors of production is a new phenomenon. It permits first world businesses, seeking lower costs, greater profits, and a stronger competitive position, to substitute cheap foreign labor for the entire range of domestic labor involved in the creation of tradable goods and services. Only labor involved in non-traded goods and services is safe from foreign substitution. It is not yet possible to package hair cuts, surgical operations, dentistry or home repairs as internationally tradable services.

Many people confuse the workings of capitalism that lead to lower costs and greater profits with free trade. They overlook the necessary conditions for free trade to be mutually beneficial. The same people tend to confuse the free flow of factors of production with free trade. I have been amazed at the number of fierce adherents of free trade, even among economists, who have no idea of the necessary conditions on which the case for free trade rests.

Senator Schumer and I do not attack the doctrine of free trade. We accept it. We simply point out that the known necessary conditions for free trade to be mutually beneficial do not hold in today’s environment where factors of production are as mobile, if not more so, than traded goods. What we are witnessing, we think, is not trade based on comparative advantage but the flow of first world factors of production to cheap Asian labor where the productivity of capital and technology is highest.

We do not dispute that global gains might exceed first world losses. Nevertheless, the flow of factors of production to absolute advantage in place of comparative advantage vitiates the case for free trade--that it produces mutual gains to the countries involved. What we may be witnessing is global capitalism destroying national sovereignties, leading to a global government, much as Marx described capitalism’s role in the overthrow of feudalism and the rise of the nation-state.

None of the points raised by Mr. Salerno and Mr. Reisman touch on this analysis. They do not make a case for free trade based on the international flow of factors of production to absolute advantage. They do not show that the case for free trade does not rest on the principle of comparative advantage. They do not show that comparative advantage reigns supreme in today’s world of internationally mobile factors of production. Nothing they say touches in the slightest on what I said.

What can be done? Neither Senator Schumer nor I have solutions. Pressed for solutions by the New York Times editors, we said the solution was to restore the conditions necessary in order for free trade to produce mutual gains to the countries involved. But as we could not specify how factor immobility could be restored, the editors allowed us to present a problem without offering a solution.

All we have done is to ask people to think about the implications of the international mobility of factors of production in a world of nation-states. Our first success came on Wednesday, January 7, where a large and varied audience at the Brookings Institution acknowledged that we had identified a problem that deserved thought.

Other responses have been humorous. My free market friends ignored the content of the argument. Their only concern was that I was ruining myself by associating with Schumer. One indignantly declared: "The next thing you will be doing is coming out for gun control!" Schumer’s friends have responded similarly: "Why are you giving luster to that Reagan ideologue who only cares about the rich!"

Other responses have been disappointing. Mr. Reisman’s knee jerks. He mistakenly sees an attack on the doctrine of free trade and rushes to its defense, attributing to me statist motives that I never express and do not have. Reisman’s response is curious in another way. His "refutation" is based on assumptions that he cannot show to be operative.

Mr. Salerno raises a number of red herrings. As many libertarians are blinded by the same red herrings, I will address them and others that he does not mention.

Many people have noted that there is nothing new about the international mobility of capital. However, two crucial aspects of international capital mobility are new: (1) Until recently, capital mobility was limited to the first world, where labor cost differentials are not great. (2) Because labor costs do not greatly differ between first world economies, offshore production for home markets was not the reason for the capital flows. When Japanese and Germans invest in automobile plants in the US, it is to produce products for sale in US markets, not to displace car production in Japan and Germany by selling cars produced in the US in their home markets.

Another widely made error is to assume that US labor displaced by outsourcing, off shore production or the Internet moves into US export industries to meet increased demand for US goods from countries whose labor is made more productive by the inflow of US capital and technology. This model assumes that comparative advantage reigns. The model does not work if absolute advantage reigns.

The enormous and growing US trade deficit, reflecting our growing dependence on imported manufactured goods, the decline in US manufacturing, and the new, but rapid, loss of knowledge jobs, does not bear out the view that US labor displaced by factor mobility is re-employed in export industries. Certainly there is no empirical evidence for Salerno’s statement that US capital outflows are leading to "increased real demand for U.S. exports which raises prices and real wages in these industries." Isn’t Mr. Salerno aware that the dollar is declining in value and the prices of US exports are falling?

The theorizing offered by Mr. Reisman and Mr. Salerno is based on the assumption that comparative advantage reigns. If the necessary conditions for comparative advantage are not present, their theorizing does not hold.

Some try to avoid the issue of comparative advantage with an argument that we always benefit anytime we can acquire a good or service at a lower opportunity cost. This is true as partial equilibrium analysis. If 20,000 US workers involved in the production of brassieres lose their jobs to cheaper foreign producers, their loses will be outweighed by gains to 100 million American women. However, we cannot generalize this argument without the assumption of trade based on comparative advantage. If the full range of domestic labor involved in tradable goods and services can be replaced by cheaper foreign labor, the loss of incomes outweighs the lower prices. The lower prices themselves will be lost to currency devaluation.

Mr. Salerno also confuses the mobility of factors of production within a country with the international mobility of factors of production. The two things are entirely different. The flow of factors of production within the US from North to South or East to West is not comparable in the effects to international flows. To learn the difference, Mr. Salerno need only consult an international trade text.

Another common confusion comes from the misinterpretation of the inflow of foreign capital to the US. Many think that because the US is "a net importer, not exporter, of capital" we are staying ahead of the game. Just look at the huge amount of foreign capital that comes to the US, friends tell me, and the relative small amount of our capital that goes to China. How can we possibly be losing out when we get the lion’s share?

People who argue this way implicitly assume that the foreign capital inflows are going to the construction of new plant and equipment, or at least into new businesses bringing new jobs. However, the facts are different. In recent years, the vast bulk, in some years almost 100%, of foreign capital inflows represent foreign acquisition of existing US assets. Foreign ownership of US stocks, bonds, and real estate is heavy and rising. Foreign ownership means that the current and future income streams produced by these assets belong to foreigners. We are paying for current consumption (imports) by giving up our wealth and future income flows. Being a net importer of capital in this case means that we are consuming wealth, not producing it.

In contrast, US capital flows to China are used to construct new plant and equipment, not to acquire existing Chinese assets.

It is trite to say that capital inflows and trade deficits are mirror images. The question is: which is driving the other? This can vary in time. I was able to refute the "twin deficits" theory advanced by Martin Feldstein and widely parroted by others during Reagan’s first term by showing that the US became a "net importer of capital" not because foreign capital had to rush in to finance "Reagan deficits," but because US capital outflows collapsed in response to the higher after-tax rate of return in the US due to the Reagan tax cuts. The capital stayed at home, and we financed our own deficit.

Today we are a net importer of capital because we are increasingly dependent on imported manufactured goods as a result of outsourcing and off shore production. Goods, and increasingly services, that US multinationals produce abroad for the US domestic market are driving up the trade deficit. Foreigners use the dollars we pay them to acquire ownership of our assets.

People also confuse themselves and others by comparing the large US investment stake in Europe with our small one in China. They overlook that our stake in Europe is a historical result of first world capital and technology being confined to the first world by world socialism. The global mobility of first world capital is new; thus, our stake in China is not as massive as our stake in Europe. Many commentators overlook that new developments are not contained in historical data. They also overlook that it takes large investments just to maintain the existing value of US investments in Europe. As it is extremely expensive to close a plant, adjustment to the new conditions cannot be instantaneous.

As a director of a global manufacturing firm, I am very much aware that outsourcing of high value-added products and jobs has begun to affect European countries. The difference is that, unlike Americans, Europeans are not blind to the reality.

Libertarians need to substitute their thinking caps for their knee-jerk reactions. A hidden agenda might be behind "globalism"--the international redistribution of first world income and wealth. It is a given that if factors of production are internationally mobile, domestic labor that is paid the value of its marginal product cannot compete with foreign labor in situations where excess supply prevents the foreign labor being paid the value of its contribution to output. If absolute advantage rules, capitalism itself will redistribute income and wealth from rich countries to poor ones.

Libertarians might say all to the good. But this overlooks that they live in a sovereign country. The downward adjustment in wages and salaries necessary to bring the US into equilibrium with the global labor market requires reductions that cannot be achieved. For example, try to imagine what must happen to existing mortgages and debts if US workers are to compete with Chinese and Indian workers employed by first world capital and technology. So many people forget that the reason that highly paid US workers could compete against lowly paid Asian workers is that the US workers were much more productive due to the immobility of capital and technology. The international mobility of factors of production has stripped away the productivity advantage of first world labor. Try to imagine the political instability in store for the US as the ladders of upward mobility collapse. The reality toward which we head is not a libertarian paradise.

Are libertarians going to allow their ideology to do their thinking? What good does it do for libertarians to go into denial and to call me, patronizingly, names?

The proper way to answer the argument that Schumer and I have made is to make a case that free trade is mutually advantageous in the absence of comparative advantage. Alternatively, make a convincing case that comparative advantage does not require at least some factors of production to be immobile. Anyone who can devise a new theory that proves free trade to be mutually advantageous in circumstances where factors of production are as mobile, if not more mobile, than traded goods will win a Nobel Prize.
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Paul Craig Roberts [send him mail] is John M. Olin Fellow at the Institute for Political Economy, Senior Research Fellow at the Hoover Institution, Stanford University, and Research Fellow at the Independent Institute.

What we need to do is develop a new computerized tarrif system which takes into account the actual cost of living in the country of manufacture. That way, if for example, the cost of living in a country is 50% of the cost in the US, the cost of the tariff would be 50%.

Getting tired of giving you math lessons, but here we go again.

If the cost of living in another country is 50% of the U.S. then I guess your point is their goods would cost 50% of our goods.

If you add a 50% tariff on a good that costs 50% you would only be adding 25%.

You meant to say a tariff of 100% would bring the price of their good up to the same level.

It's a good thing you're a chemistry and biology teacher and not a math teacher.

326 - "It's using a different method, but a legitimate one.
I didn't invent this. A CPA with a manufacturing firm invented it. As usual, they have 19 different ways to come up with the answer they want...
But if it's five steps at 15%/step, that seems to be 75% to me..."

LOL, you are right - but ToddsNoTrader hasn't seemed to figure it out. And he uses spurious data to generate his proof.

As you know, There's another rule of thumb, that the end user sale price at high retail is about 500% of the cost of manufacture. And this is also accounts for the labor at each level. So, if you see something advertized for sale for $100, you can generally figure that it cost $20 to make. That's a total of 500% increase.

But look at toddsNoTrader's numbers, he has just one step adding $15 labor to a $100 item, and then being valued at $1000, that's a thousand percent increase, at one level only. ROTFL. He must be an Arab, Chinese or Indian trader.

And he can't seem to figure out that there is no way that is going to happen normally, at that level (4).

380 - And ToddsNoTrader, while he doesn't understand trade, can't even figure out what 'for example' means.

Ninenot, Since you are interested in trade:

It really gripes me, these people, who don't understand about trade, and disparage our opinions. I know things have changed a bit since I went to international trade school, and spent about 5 of my years as international Traffic Manager, building those petro-chem plants around the world. I shipped millions of tons of cargo, charterd ships, negotiated tariffs, wrangled with customs around the globe for years. It was very interesting.

The school was located in the World Trade Center in NYC, and got blown away in the massacre, but they are back in business. World Trade Centers around the world offer some courses, though this is one of the best, and it is now on the internet.

Check out some of the professional courses - you may be interested:

http://www.wti.pace.edu/SITC/course_descriptions.html

World Trade Institute, School of International Trade & Commerce

http://www.panynj.gov/pr/88-97.html
NEWS
World Trade Center
88-97: FOR IMMEDIATE RELEASE , July 1, 1997
The World Trade Institute, one of the nation’s leading schools specializing in international trade, transportation, taxes and language studies, has been purchased by Pace University.
The Institute will continue operating on the 55th floor of One World Trade Center in New York, where the Port Authority first opened it in 1970.

Cyborg, I told you I lived in NYC several times, and went to the above school on one of them. Since you are interested in other countries and have some experience, you might wish to check out the links. This is an interesting career and can pay pretty well, and good freight forwaders made 100k plus 20 years ago.

"Cost-of-Living" and "Gummint costs" are kind of a chicken/egg thing. One can easily argue that the cost of living is hyped by reg/tax costs--but that's only part of the story, as the labor cost for building apartments in Sudan is quite low, too.

However, we SHOULD agree that the West's understanding that the capital/labor equasion should be BALANCED is the nub of the argument here--IOW, that in a rightly-ordered society, neither Capital nor Labor should dominate, but that both should work together.

The offshoring phenomenon is Capital's revolt against the ideal.

So, if you see something advertized for sale for $100, you can generally figure that it cost $20 to make. That's a total of 500% increase.

Wow, you really don't understand math.

If something cost $20 to make and you sell it for $100 the $80 increase is an increase of 400%, not 500%.

And he can't seem to figure out that there is no way that is going to happen normally, at that level (4).

The numbers at any point are examples in no way meant to represent real products.

Value added

1st step $10 , $1.50 labor.

2nd step $20 , $3.00 labor.

3rd step $50 , $7.50 labor.

4th step $100 , $15.00 labor.

5th step $100 , $15.00 labor.

Final cost $280 , $42 labor

Plug any numbers you want for value added, labor still totals 15%.

IMHO, protectionism will NOT cause US to 'lose the edge,' and you only have to survey the last 100 years of industrial/technical progress to determine that.

Virtually all the technological development in that timeframe was done here. Major exceptions: BASIC rocketry, by Nazi Germany (perfected here;) the diesel engine, Germany; --there are others.

But manufacturing prowess: all invented here (some exported to Japan, then re-imported under duress...); electronics smarts, guidance systems, software for manufacturing, all done HERE.

Reason: we compete internally, all the time. You developed a specialty practice and compete against Big Downtown firms...right?

And "protectionism" is one thing--but maintaining a standard of living is another thing entirely. That calls for judicious, flexible tariffs, not cut-offs or shut-offs, EXCEPT in the case of war.

Another thread: (run FR search on "Losing China" Again by title) contains a thread-head article which proposes that Red China is more than a little bellicose toward the USA, although they are masking it for the time being. I think it deserves some serious consideration.

BTW, the article simply goes into further detail on what some of us have been saying for quite a while--that PRChina is deliberately and carefully stealing our industrial base for purposes that have very little to do with "empowering the masses" in China.

Not by co-incidence, X42, who will be remembered as the highest-ranking traitor in US history, was the single most significant proponent of "make nice" to PRChina, after Kissinger, whose motivations were always doubtful--that is to say, never clearly patriotic.

Man, you seem to think government can direct a command centralized economic protectionist regime "intelligently." The US has been free trade since trade became a significant factor in its overall economy. If non competitive industries are cosseted, in time, particularly since protectionism is so hard to really enforce, the US would be eaten alive economically in rather short order. The US needs a Darwinian testing to retain its muscle tone.

I don't worry much however about this issue. A serious protectionism regime will never be enacted in America, for any length of time. The negative consequences will so quickly manifest themselves, that the regime would collapse of its own weight. The debate is simply for public consumption during campaigns by those protectionist elements who think it might further their drive to power. That drive will fail too. I have confidence in the ultimate good judgment of the American voter on the basics.

Man, you seem to think government can direct a command centralized economic protectionist regime "intelligently."

Not really. But a few years of "whoa--let's look at this.." won't hurt too much.

The US has been free trade since trade became a significant factor in its overall economy.

I think your history is erroneous. Recent history: Ron Reagan, a conservative as you recall, discovered that the Japs were dumping both cars AND motorcycles in the USA and stopped them, cold.

But hey, Harley-Davidson is just buggywhips, right? Junk, right? Fat lazy managers and union types, right?

Not-so-recent history: we have ALWAYS maintained tariffs, just as we have ALWAYS subsidized certain export industries (principally agricultural.)

Where do you get this "free trade" stuff?

Ya, and the US bailed out Chrysler, and that was a mistake too. The current regime of tariffs is a minor factor, and has been for a long time. Let's get a bit more recent here. How did the Bush steel protectionism measure work out? First, it hurt industries that consume steel, and put Ohio manufacturing in a slump, and Ohio in play in the election, and then it was found to be a violation of various treaties by the world court, and our major trading nations were about to slap on retaliatory tariffs, and then Bush ran with his tail between his legs, which was a most intelligent cutting of his losses over a very stupid and counterproductive policy.

And there you have it.

Since I live in the Rust Belt and have a far more nuanced understanding of the steel tariff, please allow me:

I have no idea why GWB imposed the tariff--although I suspect it was for two reasons, both political: 1) to bail out the Big Steel boys who are a bit inefficient, although VERY necessary to the national defense (the mini-mills don't make steel from scratch--they only recycle..); and 2) the unions wanted Big Steel up and running to fund their pensions. (As you know, Bush also shoved through a defined-benefit pension rescue plan, altering the required contributions by re-indexing the actuarial numbers...)

Having said that,

The Administration F$%^&$d this up to a fare-thee-well, demonstrating (to your credit) that too many years at Harvard and Yale leave you educated FAR beyond your intelligence. Follow this carefully:

The Administration placed a tariff on raw steel, but NOT on fabricated steel. Thus, while US fabricators had to pay a gazillion dollars for raw materials, FOREIGN fabricators did not. Multi-nationals who operated both here and overseas merely moved their fab. operations to Canada, or Mexico, or wherever, and brought the steel in, free of US tariffs.

But small, or mid-sized US-only fabricators got screwed.

Had the Administration had an understanding of the real world, they would have slapped the tariff on ALL steel AND fabricated steel products, avoiding the dislocation.

(It had no noticeable effect on consumer product purchases, did it? You note that retail sales have hummed along quite well, regardless, do you not???)

In any case, the WTO boys railed and puffed, and GWB backed down. Had he some actual interest in the welfare of the citizens of THIS country, he could have told WTO to F%^^ themselves, cut side deals with our largest geopolitical ALLIES, and pissed on the WTO treaty as he shredded it for the cameras.

But no. He gave in. He's a wuss.

Ya a more comprehensive tariff would have made all US goods that used steel to be less competitive in the international market. It is good there was a workaround to limit the damage.

I must say that you are more knowledgeable than the normal Luddite protectionist. I enjoy chatting with you. You are worthy of my time. I mean that as a complement. Carry on.

Thanks, I guess.

When all the rest is said and done, it's critical to remember that the US does have enemies, and they are not just a bunch of ragtags in the Middle East.

BTW, you'll be interested to know that the new slander against us "Luddites/demi-Luddites" is that we're aided and abetted by George Soros--and conversely, aiding and abetting him.

Watch for further development of THAT theme. Should be thrown at PJBuchanan any day now.

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