Clarifications on the Case for Free Trade

Ludwig von Mises Institute ^ | 4/12/04 | Paul Craig Roberts

[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.
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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.

[fooman]

But gov monies spent on science and tech (space, intel, and supercollider) end up benefitting us companies (boeing, other contractors)

[sinkspur]

Is that your Pastoral Response? Or your most intelligent one?

It's the truth, Niner.

[BfloGuy]

Roberts has answered his critics well, and he's honest enough to admit he doesn't have a solution.

But I think that by reigning in litigation costs, eliminating corporate taxes, and eliminating capital gains taxes we would go a long ways towards making the U.S. an attractive place to do business -- despite higher labor costs.

This would also eliminate the need to legislate where Americans can invest and would obviate the temptation to raise consumer prices through tariffs.

[Torie]

PCR lost his mind 20 years ago. I saw him on Firing Line as an interlocutor, and he was such an embarrassment, that Buckley had to declare his questions out of order, and he was never seen again on the program. PCR is a dyspeptic ideologue rather than a serious economist. That is my opinion.

[templar]

Let all these foreign countries develop technologies with their own money, not the money of American companies.

Actually, if you trace it back enough, most of that technology is/was developed originally by U.S Taxpayer money.

[schu]

This is a tough issue. There are a couple of givens, however:

1. The supply of cheap labor is for all intent unlimited for the foreseeable future. There are hundreds of millions if not billions of people in SE Asia waiting to enter the low skill labor market and work for $.50/day.

2. The short term benefits to the US consumer are enormous. Our standard of living is very high. It is unlikely we will be willing to pay $100 for a pair of jeans or $5,000 for a home PC.

3. The global companies, many which started in the US or are US based, are profit maximizers. They cannot accede to the idea of higher costs, the executives would be fired very quickly by their stockholders and replaced by those who will move to low cost countries.

Therefore, it seems to me we need to work to make the US the most competitive/productive economy in the world. For us, the cost excluding labor of doing business is very high and we need to work to reduce these costs. Litigation, regulation, etc must be brought under control while still maintaining the necessary protections.

[St.Chuck]

Good article. Thanks for posting it.

[MountainPatriot]

Comparative advantage is not the norm and we are failing to adapt. The norm today is absolute advantage. This is what the Chinese are practicing and we are losing. Absolute advantage: low-wage; no wage labor coupled with the appropriate technology and advancement. We can't compete against that.

The Chinese are marching toward a confrontation. Ten to fifteen years, tops and we're going to get caught watching the paint dry...

[Havoc]

.. why has it never been put to the test?.. .. Perhaps wiser heads have prevailed seeing the folly in Ricardo's theory.

I would venture to say it was never put to a test because the predicted outcome of it has been destablization causing a revolution due to class struggle brought on by the destruction of the middle class and a widening of the gulf between upper and lower classes.. essentially throwing us back for all intents and purposes to feudalism. The idea of this was warming to the hearts of the communists; but, deemed unwise as the scope would exceed the reach of those who might attempt to control it.

As the author above noted, if you want to destroy America's sovereignty and enslave us to a one world government, Free trade is a perfect mechanism. The president cannot by treaty subbordinate this nation to an outside government body. That cannot be done without a constitutional authority granted by the required majority of states. But, if they subvert the economy by devaluing our currency, and lowering our standard wage, our debt would seem to grow in proportion to our lack of ability to pay it - all the while, as noted above, our means of production are being outsourced on the one hand and bought up on the other. A two pronged attack that removes our means for production and thereby our means to mobilize for war. Our borders are not being dealt with; but, if you're going to make us just another state in a one world government, that no longer is a concern - no reason to gaurd the border. And if you need an internal army to garauntee takeover, there are 8 million illegal immigrants here. Add an outside invasion force of unknown origin and you don't know who to strike back at - especially if they arrive in american technology which has been outsourced..

Subverting our economy can and will wreck us as fast or faster than an armed invasion. And I didn't have to sweat over thinking this stuff up. It's all right there in front of us. Osama hit the trade towers for a reason. Same reason we had an arms race through the 80s. If you bankrupt a Country, you don't have to invade - it'll destroy itself for you and you can then just march in and mop up. Free trade isn't providing prosperity for anyone in the US but the businesses taking advantage of the "new slave labor" as I have called it. The one worlders believe that a one world government will mean prosperity for all. And if that's what they're driving at without seeking audience from us constitutionally, there's only one other way they're going to get it - by destroying this nation economically.

Is that what they're doing? Can't say. Nor will I say it's likely - you have to make up your own minds on that. But we're in a ready position in which it could easily happen. What would our forefathers have done to this government if it had gone so awry as to leave us this vulnerable? What will you do. Do you sit and talk or hold feet to the fire and threaten if need be to get our house back in order and put a stop to this nonsense before it can go any further. Their already giving away what we've taken hundreds of years to build up. How much of it has to go before we do something about it? How many more lives have to be ruined? Cause if ya'll haven't figured out the free traitors at this point, they think of you as cattle. Doesn't take long reading their comments to get a real good bead on things. It's rather odd to that Post Enron when the books are being scrutinized more carefully, they suddenly and for some reason have need of employing slave labor. And the feb 4 hearing on H1B and L1 visas is a real eye opener if you want to know some of the things they're actually doing out there. here it is in real audio.

Your politicians are doing what they do best - studying and debating while the ship drifts out to sea ablaze.

[fooman]

Good points , but reducing these costs are not the full solution.

[WilliamofCarmichael]

I wish he'd picked a respectable partner for his nyt piece, but..

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.

Why does one have to "think" it? Is this Alice in Wonderland? It is exactly what is happening. The question is IMO, Is it wrong in today's world? Ans: YES! When it's with a Communist country that murdered tens of millions of its own citizens!

the [nyt] editors allowed us to present a problem without offering a solution.

Uh, remove George Bush from the White House usually suffices.

Interesting that the reactions of people Mr. Roberts knows are exactly like "free" trade Freepers. Also interesting is he asks them to stop calling him names and prove their case. Which reminds me. Without waiting for the final post on this thread I will predict our "free" traders will post mostly drive-by invective.

Add absolute advantage to Mr. Stephen Roach's labor arbitrage, leakage, imported productivity, and more that I cannot remember.

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.

I say again, "free" trade is Kyoto except there's no energy use penalty and "free" trade hooks many Americans on cheap labor, cheap goods and cheap services. (Drool) Cheap labor.

[underbyte]

""""Litigation, regulation, etc must be brought under control while still maintaining the necessary protections""

fine eliminate all that and you are not going to gap the dollar an hour the chinese worker makes, you still have another $15 USD to go.

[Havoc]

HAH I wouldn't even admit to being a Republican in a room of Union Thugs...

Indiana largely votes republican on national level and democrat locally. They're my neighbors and friends even if they're from another party. And I have a lot of family in that bunch. I dared them to spit their tripe before a room of 10,000 UAW workers and warned them they'd need a police escort or an ambulance because these folks are not going to stand for the lip these free traitor creatures give us. They wouldn't stand for the insults to their intelligence. Nor would they stand for being told that it's in everyone's best interest for them to lose what they've worked hard for while we give their jobs to African pygmies at 52 cents a day. They evidently lack the courage of their convictions as long as they're not hiding behind a keyboard. And when they do say anything, one doesn't have to be a rocket scientist to see the level of deciet and warring against average people over their pet theory - a pet theory because it tacitly lets them create a new class of slave labor after all these years. This gonna get real ugly.

[Torie]

Hey, Roberts, explain to me how a nation prospers by producing that which it is less efficient at vis a vis the rest of the world, versus that which it is more efficient at? The horrors of the free mobility of production seem to assume a nation would be better off producing stuff that others can produce more efficiently given all the costs involved. That is ludicrous. What protects the American standard of living as numero uno is not protectionism, but the value added by the relative skill of American workers, and the efficiency of the macro economy. If America loses its edge, all the protectionism in the world will not protect the American worker from earning average world wages.

Which brings up another point: If the average world wage of those in the international market economy goes up, the floor goes up.

Another little detail, is that with technology and mobility, and improved information, a regime of protectionism is frankly near impossible to really enforce. And to the extent enforced, that improved information, will provoke ever more rapid retaliation.

What I suspect is really bothering Roberts, and Buchanan for that matter, is the collapse of the cosseted position of certain American workers, in certain industries that are dominated by folks that he can identify with, at the cost of the American consumer at large.

[neutrino]

Excellent article!

Bottom line - David Ricardo's free trade postion (as of 1823) has been invalidated because the advance in technology has invalidated the underlying assumptions!

Free trade - outdated thinking, and obsolete policy.

[schu]

We still have some advantages, freedom and minimal corruption versus China being one. We are also much more creative and information flows/availability in the US are far ahead of the rest of the world.

Many friends think like you folks, ultimately we are looking at significant wage and asset deflation. I do not share the same view, but it is hard to see how wages will be rising anytime soon for low or medium skill labor. We need to focus on our strengths and get much better at some core items like education and overhead costs.

Whatever the answer, high tariffs will not solve the problem.

[Torie]

Ya, it is not really economics and the American standard of living that really bothers you, is it? What is it that bothers you? What bothers you is America being emeshed and dependent on foreign trade relationships, like the rest of the world, but not the US until relatively recent times, since it was so far away from the other productive centers, and had such a large internal economy.

What you really want is a lower American standard of living overall, in exchange for some measure of American autarky, which you conflate with "sovereignty."

That is how I see it.

[neutrino]

Which brings up another point: If the average world wage of those in the international market economy goes up, the floor goes up.

Ahh, yes - free trade, the U.N. backed global welfare scheme funded by American taxpayers.

[Havoc]

Whatever the answer, high tariffs will not solve the problem.

They built s into a superpower along with our other factors for the protectionist society. Your comment flies in the face of reality and the facts on the table. This is a standard position taken by free traitors though. It's a lie; but, to admit the truth sinks their ability to convince you that ruining the lives uf US citizens, subverting our economy, putting our nation at risk of collapse and or war is all just illusory tinfoil hat speak.. and that they must be allowed to do all those things at any rate because their motive is pure - profit. Ethics and morality be damned, slave labor is in vogue again and profit once again is the motive. Either they haven't learned any lessons from history or they're counting on them for pernicious purposes. Greed is not what drives this nation. It drives them to the exclusion apparently of much anything else..

[Torie]

OK, I'll bite. Why is buying goods from the one willing to sell them at the lowest price a "welfare scheme" for the seller? Or do you have a new and novel and sui generis definition of "welfare," meaning "subsidization," rather than the alternative definition of "well being."