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Clarifications on the Case for Free Trade
Ludwig von Mises Institute ^ | 4/12/04 | Paul Craig Roberts

Posted on 04/12/2004 6:50:44 PM PDT by ninenot

Clarifications on the Case for Free Trade

by Paul Craig Roberts

[Posted January 10, 2004]

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.
-----

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.


TOPICS: Business/Economy; Constitution/Conservatism; Culture/Society; Front Page News; Government; News/Current Events
KEYWORDS: assclown; compadvantage; economics; fairtrade; freetrade; leftwingactivists; paulcraigroberts; ricardo; trade
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To: Cronos
If someone supports protectionism and other commie style tactics (a la North Korea and Cuba), THEY are being traitors to what we stand for.

I'm with you!!! Havoc and XBob also want de facto government control over corporations that don't "benefit" society to their satisfaction.

201 posted on 04/13/2004 7:36:34 AM PDT by Toddsterpatriot (Quit yer whining)
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To: dimk
.....People can talk all they want about closing down borders and such. But the truth is Genie is out of the bottle. Since technology exists to produce more efficiently(cheaper) outside companies will do it. If government gets involved, it will be bribed, corrupted etc until restrictions are meaningless.....

Great point. whatever we do we do not want too much big governemnt.

202 posted on 04/13/2004 7:37:34 AM PDT by fooman (Get real with Kim Jung Mentally Ill about proliferation)
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To: Cronos
If you accept the theory that PRChina is at war with the USA (and I agree with this, mutatis mutandis) then you will have a hard time convincing us that the PRChinese gummint will accede to "demands" from unarmed peasants for "more democracy."

"More human rights" demands don't get too far over there, either.

What changed?
203 posted on 04/13/2004 7:55:18 AM PDT by ninenot (Minister of Membership, TomasTorquemadaGentlemen'sClub)
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To: ninenot; Cronos; meadsjn; johnboy; XBob; Havoc; fooman
From the WSJ this AM.

Record Imports Drive China's Trade Deficit To $540 Million in March

A WALL STREET JOURNAL ONLINE NEWS ROUNDUP April 12, 2004 12:50 p.m.

BEIJING -- Driven by record imports, China's trade deficit swelled to $540 million in March, widening its total deficit for the first three months of the year to $8.4 billion, state-controlled media said Monday.

Both imports and exports recorded monthly historical highs with imports in March up 42.8% to $46.4 billion, while exports were up 42.9% to $45.8 billion, the reports said.

Customs officials said the sharp rise in imports was driven by "the country's sustained need for raw materials and energy" for its booming economy, according to the Web site of the Communist Party newspaper People's Daily.

Is it perfect? Life seldom is.

204 posted on 04/13/2004 7:56:39 AM PDT by schu
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To: ninenot; swarthyguy
Immediate repeal of MFN for all countries which do NOT have Western human rights standards. (That takes out India and China right off the top.)

Wrong again, that takes out only China, India has got a western style democracy with the same Western human rights standards. In case you missed it they're having an election now, with half a billion voters and they've been having elections continuously since their independence.
205 posted on 04/13/2004 7:57:06 AM PDT by Cronos (W2K4!)
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To: Cronos
Ahhh-look a little further. India's non-metropolitan areas are damn near Wild West. Lotsa people getting killed over there, principally Muslim/Hindu/Christian conflicts.

Personally, I'm not as concerned with India as with PRChina.
206 posted on 04/13/2004 8:02:34 AM PDT by ninenot (Minister of Membership, TomasTorquemadaGentlemen'sClub)
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To: ninenot
You think that the economies of European nations from 1900-1939 were TOTALLY separated? definitely more separated than now.
207 posted on 04/13/2004 8:09:16 AM PDT by Cronos (W2K4!)
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To: ninenot
If you accept the theory that PRChina is at war with the USA (and I agree with this, mutatis mutandis) then you will have a hard time convincing us that the PRChinese gummint will accede to "demands" from unarmed peasants for "more democracy."
I don't believe the PRC will support political reform any more than the KMT supported it in Taiwan or the S Korean govt did but it WILL have to happen, as chinese folks get richer
208 posted on 04/13/2004 8:12:14 AM PDT by Cronos (W2K4!)
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To: ninenot
Ahhh-look a little further. India's non-metropolitan areas are damn near Wild West. Lotsa people getting killed over there, principally Muslim/Hindu/Christian conflicts.

Well, the country has a free press and human rights (national and international) agencies are given free reign to investigate and make changes. Those conflicts were sporadic, I dont' think I've heard of any things like that recently, unless you consider the slammie terrorist attacks on that country as freedom fighters not jihadis....
209 posted on 04/13/2004 8:15:16 AM PDT by Cronos (W2K4!)
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To: underbyte
...No Lie, the commerce dept called me when WJC was in office and asked me if it was OK to give a couple of my patents to a Chinese delegation they had coming to town.

Pigs, I always wonder actually how much and what, they gave our enemies ...

Wow. This is why we have to carefull in allowing government involvement.

210 posted on 04/13/2004 8:22:29 AM PDT by fooman (Get real with Kim Jung Mentally Ill about proliferation)
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To: ninenot
China sees herself as she has always seen herself - The Middle Kingdom, the center of her cosmos. The best modern demonstration of China's thinking was demonstrated when Clinton visited the city of Xian in 1999. The Chinese insisted that he enter the city through the "Barbarian Gate". This is the entrance by which foreigners traditionally entered in order to pay tribute to their hegemon. And they liked Clinton.

Barbarian attitudes relating to "human rights", "free trade" and "democracy" are of no real relevance to Chinese political thinking.
211 posted on 04/13/2004 8:30:59 AM PDT by InABunkerUnderSF (Where there is no vision the people perish.)
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To: ninenot
Good find, maybe econmists will begin to re-examine the concept of free-trade and the ramifications it has for our future.
212 posted on 04/13/2004 8:44:50 AM PDT by RockyMtnMan
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To: Cronos
Y'know it's hard to deal with people who seem analytically and politically blind, or wear ColdWar covered glasses, and treat India as the enemy.

Frankly, who cares, they're about as relevant as old Stalinists in Russia.

But Thanks to you for keeping on keeping on.
213 posted on 04/13/2004 10:10:16 AM PDT by swarthyguy
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To: XBob
Some good points

1.It is not that their code is bad by itself, some of it is but normally it is good enough. What they lack is good architects and designers with good understanding of business processes. This is just from my experience. Also overall organization on their projects is normally lacking. I have no doubt they will get better, but as they get better they will start charging more. In fact it is happening already.

2. I completely disagree about this. There are tons of new stuff being developed atm. Quality of the code and designs produced been improving steadily. One look at site like sourceforge.net (open source) shows how many new projects people are starting just for the heck of it. There are dozens of areas where lots of software development is needed.

3. This does happen alot. People who are being replaced with indians need to probably look at how to upgrade their skills to become more competitive again. I am trying to do this continuously, if I am not working on the project I try to learn new system, new approach etc

4. Well I already been in this race for a bit. To have the skills I can bring these people need to work as hard as me if they are as smart as me(some are some are not). In fact they keep me awake and not able to take stuff for granted that makes life more exciting.

Reason I waited to buy house is that I am saving money(nothing very risky just 4-5% annual return) as a backup for when I lose my job and need to have mortgage paid(I aim for 1 year of comfortable life). Also being a contractor it is a necessity, I am never totally employed sometimes I work 70hours a week sometimes I have nothing to do for a month. I am not sure that as I get older(more experienced too) the race will get harder. Senior people do get paid much more, until I retire I want to try and push up see how far up can I get. In current economy it is hard to stay in one spot, best to work in one spot for 2-3 years then move on to something else
214 posted on 04/13/2004 10:11:40 AM PDT by dimk
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To: Cronos
High tariffs would tie down this economy and make the country a basket case like the other closed economies in the world

We were doing fine up to the point this free trade crap kicked in. There is no basis on which to say what you're saying other that the free traitor dream of destructive profiteering. You guys will mutter anything if it convinces people to let you destroy people and our economy so you can further enrich yourselves. That's something our constitution and government are supposed to protect us from - it's called tyranny.

215 posted on 04/13/2004 10:33:43 AM PDT by Havoc ("The line must be drawn here. This far and no further!")
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To: Cronos
No, that's a lie. This country has historically grown due to it's own innovation, work ethic and standard trade with other nations. Free trade came about under Nafta. How could you be so ignorant or so decietful as to try and make such a statement? Oh, wait, forgot - modus operandi - lie until called on it but keep shovelling smoke in the hopes that someone will buy one of the lies.
216 posted on 04/13/2004 10:36:26 AM PDT by Havoc ("The line must be drawn here. This far and no further!")
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To: Cronos
PBS documentary if memory serves. I can't tell you the name of it, so guess you'll have to go do your homework and satisfy yourself - just as anyone else here can do. As far as my having gone to school with indian imigrants, the sentences may appear disjointed for the things I didn't say - like that one of them I knew quite well.. Spent a lot of time with her and her family. Suppose people never talk about life when they have such involvements - must just sit back and watch the simpsons or something huh.. lol.
217 posted on 04/13/2004 10:43:58 AM PDT by Havoc ("The line must be drawn here. This far and no further!")
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To: Cronos
I believe I posted a link earlier on the thread, did I not? Are you just a johnny come lately looking for something to throw a fit about because you didn't bother to read the exchange to date before charging? You might check, cause I know I posted that link on at least two occasions last night.
218 posted on 04/13/2004 10:46:11 AM PDT by Havoc ("The line must be drawn here. This far and no further!")
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To: Poohbah
Some may miss the ref to Atlas Shrugged here. It is very easy to fall down slippery slope of government intervention here.

219 posted on 04/13/2004 10:59:02 AM PDT by fooman (Get real with Kim Jung Mentally Ill about proliferation)
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To: BrucefromMtVernon
At the end of the day, we have tolerated the experimentation driven by dogmatic, doctrinaire, Libertarian purists, for far too long, and with far less than advertised net benefit. It is time to move on and to formally discredit said doctrine, and return to our true republican roots. The core values held by Wm. McKinley are an excellent baseline which we could use to resurrect the true, GOP spirit.
220 posted on 04/13/2004 11:13:54 AM PDT by GOP_1900AD (Un-PC even to "Conservatives!" - Right makes right)
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