Monday, September 6, 2010

There goes the Stimulus Package on it's way to China.... the beginning of the end of the WTO.

Whenever everybody in the US political sphere agrees on something my instinct is to oppose it simply so there is opposition. The one thing the Bush and Obama administrations have in common (aside from their fondness for massive deficit spending) is their assertion that the maintenance of the global free trade system is essential for American prosperity. One of my favourite mantras from my time at the University of Chicago was: “If someone asserts it, deny it. If someone denies it, assert it.” So, I am going to deny the assertion that free trade is currently the optimal policy for the United States.

First, let’s remember the origin of the free trade system. Its original motivation was political/military rather than economic. The Second World War was a massive human tragedy which killed something like 3 % of the human population in just under ten years. For the American economy, however, this tragedy had a silver or rather gold lining: it was a war of annihilation between America’s main economic competitors. The war destroyed the industrial capacity of the Axis Powers and severely disrupted that of Central Europe and Soviet Russia. At the end of the war the United States was the only power in the world with an unimpaired industrial plant and as a result in 1945 the US accounted for nearly 50% of world GDP.

Despite its economic supremacy, America faced a severe political/military challenge from the Soviet Union. The Red Army had just crushed the Wermacht and was positioned in the Center of Europe and invaded Northern China near the end of the war. Americas grand strategy was to contain the Soviet Union with a ring of alliances that stretched around the periphery of the Russian empire. Unfortunately the allies who composed this ring were the battered former Axis powers and the supine allied European states.

America needed to revive the economies of the Western Alliance if the containment strategy were to succeed so it came up with a global economic plan with several features. The first was a massive influx of aid in the form of the now famous Marshall Plan. The second was the establishment of a stable foreign exchange regime which would simplify trade through the Bretton Woods agreements. Finally was the establishment of a trade liberalization regime under the General Agreement on Tariffs and Trade or GATT which became what we now know as the WTO. The first round held in Geneva in 1947 eliminated or reduced 45,000 tariffs. Subsequent rounds made great strides in bringing down tariff barriers all over the world. While the GATT was a multilateral organization, the fact that America was the only intact market on the planet meant that it’s most salient feature was granting more or less open access to the American consumer for our allies in the struggle against the Soviet Union.

The plan worked like a charm. Between 1948 and 1953 world trade grew by 40%. By 1963 the total volume of world trade was three times what it was before the war and twice its previous all time high. By 1971 it was six times what it had been in 1935. This is an extremely important point, the creation of the GATT system ended the generally mercantilist regime that predated the World Wars and international trade exploded as never before in human history. This channelled massive amounts of wealth to the various trading partners that would not have been possible without it and enabled a rapid recovery from the devastation of the war. By the end of the Cold War in 1989 Germany had the same share of world GDP that it had before the war and Japan had twice as large a share. America and its allies presented an economic, military, and political challenge to the Soviet Union that it could not overcome and it collapsed after a failed coup attempt in 1991. Mission accomplished, well and truly.

After its victory America, confident in its permanent supremacy, kept the global free trade regime open. Indeed it expanded it, bringing in its erstwhile opponents Russia in 1993 and China in 2001. The maintenance of this free trade regime after the end of the cold war has arguably had an even greater effect on the world than it did during the cold war itself. By enabling China and India to access the US consumer on a level playing field the global free trade system has helped to bring 400 million people out of poverty in the last 20 years. This is a reduction of human misery that has been without precedent. It has made the world economy as a whole more efficient and raised world GDP by a substantial amount. The huge American trade deficits have been a massive subsidy to the rest of the world particularly China.

To get a sense of how important this is to China you have to look through the numbers a little. In 2006 the Chinese trade surplus with the US was around $250 billion and Chinese nominal GDP was around $3 trillion (I use nominal rather than PPP because we are talking about international trade rather than domestic consumption.) So the Chinese trade surplus with the US in 2006 was 12% of the entire Chinese economy. This overstates the case somewhat because China has trade deficits with countries which supply it with raw materials but in turn those deficits are driven by and more than financed by the surplus with America. Considering that an additional 40% of the Chinese economy is investment which is largely export oriented the impact of the global free trade regime accounts for nearly half of the Chinese economy. These are just numbers, what this has meant in the quality of life for hundreds of millions of people cannot be overstated or really understood unless you go to China and see if for yourself. It is truly mind boggling.

So how has it been working out for the country at the center of the system? This is a complicated question and it comes with a complicated answer. From the perspective of the American consumer this has been awesome. The global economy is much more efficient and the increasing globalization and the addition of hundreds of millions of new workers to the global trading system has kept down the prices of labor intensive products. In the immediate post-war era Americans got used to consuming at a level commensurate with a country which was producing 50% of the worlds GDP. As America’s share of GDP has declined the American people have been reluctant to reduce their consumption. And they haven’t had to because America’s trading partners have been willing to lend their surpluses back to America in order to finance yet more consumption. Yep, from the perspective of the consumer it seems like a good deal all around.

So how is it working out for the American worker? This is kind of a mixed bag. From the perspective of the American knowledge worker it’s working out quite nicely. People in the intellectual capital intensive businesses can farm out of the labor intensive aspects of their business to China for manufacturing or to India for services where the labor costs are much lower. For unskilled and semi-skilled Americans this has been a disaster. They are now forced to compete with the 400 million other semi-skilled workers in the global trading system and this has been pushing wages down. Here in the future the global market clearing price for a year of work in a factory as a semi-skilled worker is somewhere in the neighbourhood of $8,000 per year. Naturally this is not enough to sustain an American lifestyle which is why, as mentioned above, the American lifestyle is increasingly debt financed.

You can hear the echo of the global free trade system whenever Americans bemoan the problems with the economy. “Wages for working Americans have been stagnant for 20 years;” this is because American workers are competing with another 400 million people that were not in the system 20 years ago. “The divide between the rich and the poor is getting wider,” the rich benefit from lower prices and the ability to tap cheaper foreign labor which increases their earnings, the unskilled now have to compete with that foreign labor which decreases their earnings. “The post housing bubble unemployment seems to be structural not cyclical,” many semi-skilled workers who’s manufacturing jobs moved abroad went into construction, now that the housing boom is over there is not much manufacturing for them to return to so they are structurally unemployed. “The stimulus package is not working,” the stimulus package was designed to generate consumption; much of what we consume is produced abroad so much of the stimulus money was ultimately siphoned off by our trading partners. “This recovery is anaemic and not creating enough jobs,” Q2 GDP was revised down from 2.4% to 1.6% because of the trade deficit was larger than expected. 0.8% of American GDP is $110 billion or about as much GDP as would employ 1.1 million people. The recovery is creating jobs, but in our trading partners, not here. Yep, there it is beneath the surface, the global free trading system the US built up is causing serious problems for the US worker.

So given that so many of the problems which confront policymakers are linked directly or indirectly to American support for the free trade system why is protectionism not gaining more supporters. I think I know. It’s a unique psychosis that I will call “Smoot-o-phobia.” In 1930 partially as an attempt to raise revenue and partially in an effort to shield American workers from foreign competition Congress passed the Smoot-Hawley Tariff Act. This raised tariffs on imports to the highest level ever and touched off a trade war as our trading partners retaliated with tariffs of their own. World trade collapsed fell 40% from 1930-1933. The Smoot-o-phobes believe that the Smoot Hawley tariff caused this collapse in world trade and which deepened and lengthened the great depression and therefore they believe that the last thing we should do in the middle of a recession is tamper with the global trading system.

I think this argument is nonsense for two reasons. First, though I have a degree in economics I will be the first to agree with my friends from the physical sciences who called economics a social “science.” That is to say, it is not exact. It is very hard to separate causal and coincident factors in explaining a phenomenon. It may well be that the Smoot-o-phobes are onto something with their theory but I would argue that the collapse of the global banking system was a much more powerful factor. As evidence of this I point to the recent credit crisis. Between 1930 and 1931 in the immediate aftermath of Smoot world trade fell by about 28%, between 2008 and 2009 world trade fell by 24% without any additional trade restrictions. Could it be that the greater factor was the collapse of credit rather than the imposition of tariffs?

The second reason is that the position of America in the global trading system in 2010 is completely the opposite of what it was in 1930. The American position in 1930 was analogous to the position of China today, it was the source of most of the worlds spare industrial capacity and a net exporter both of finished goods and raw materials. As such it had a lot to fear from a trade war because its trade balance was a positive contributor to GDP so it really was a Congressional miscalculation (one of many I’m afraid) to pass the Smoot Hawley bill. Here in the future the US is not only not a net exporter, it is running the largest and most persistent trade deficit in the history of the world. If world trade were set to zero tomorrow the GDP would INCREASE, we LOSE money to world trade. I think the Smoot-o-phobia which infects American policymakers is purely psycho-somatic.

Now that I have made my argument I think it is equally important for me to point out what I am not arguing. I am not arguing that limiting the global free trade system is the globally optimal solution. It is not. But it does not matter what is globally optimal, it matters what is optimal for the people who are in control of the largest consumption based economy in the world, namely: Americans. The only way for another country to limit American power over the trading system or to mitigate the effects of American protectism would be for that country to create a similarly consumption oriented economy, something which no one seems willing to do.

I am also not arguing that the limitation should be total. It should be just enough to mitigate or negate the labor cost advantage of the lower cost countries. Ordinarily this would happen over time with exchange rate adjustments but some of our trading partners are committed to maintaining a fixed exchange rate with the US dollar.

I am also not arguing that this would be costless. There would be increased inefficency in the US economy. The evaporation of our trading partners surpluses would also limit the avaliabilty of credit to the American consumer and the American government. I don't think this is bad thing because I think that is coming sooner or later. I simply think that the US would rather be in control of the timing and duration of that credit contraction rather than the bond vigilantes. Taking advance action like this would give the government the initiative.

What’s the cure for Smoot-o-phobia? That’s a complicated question but it comes with a simple answer: elections. The American consumer who benefits from the global free trade system and the American worker who is getting his head caved in by it are the same guys. At this stage of the game Americans need to do a lot more working and a lot less consuming in order to pay back all the money they borrowed over the past 30 years. In order to do this more effectively they need to negate the labor cost advantages of low cost countries which have enjoyed unfettered access to the American market for the past 20 years. To do that they need to place limits on the international trading system.

Lucky for them in addition to being the American consumer/workers these folks are also the American electorate and as such they are in control of the government most responsible for the maintenance of the international trading system. They can therefore vote in people who are in favour of limiting it. As the recession goes on and employment does not recover because the international trading system is limiting the capacity of traditional measures to revive the economy the Smoot-o-phobic arguments are going to fall on increasingly deaf ears and protectionist candidates will begin to win elections. You heard it here first.


Anonymous said...

I think you've made some excellent points, but I also think the political economy of trade needs to be discussed more openly. Most of the arguments in favor of free trade tend to involve larger pie arguments: that increased trade leads to a larger pie for everyone. In theory, government should be able to tax the winners enough to compensate the losers for their losses, and everyone ends up happier. Even with the higher taxes, everybody wins.

The political economy, though, is likely the exact opposite. With the short term benefits of free trade concentrated in a small group of beneficiaries and the (very long term) losses to trade spread throughout the population, you have a classic political economy dysfunction. Decreases in tariffs have never been accompanied by targeted tax increases to beneficiaries. Certainly none one would talk about them now with tax rates already scheduled to climb. At this point, almost 20 years after NAFTA and almost ten after China WTO, the recapture of these gains would be impossible.

ironically, Brad DeLong in 2006 tried to argue that American consumers should show more gratitude to China for providing cheap finance for their expensive CA homes:

A tax on the foreign reserve bank holdings of UST securities as a form of negative interest rates makes the most sense as a way to attack the RNB peg, but the alternative is a nice trade battle. In the meantime, we're like a Depression-era economy on the Gold Standard. As Reed Smoot said in 1932: "To hold the Government tariff policy, or any other policy of our government, responsible for this gigantic deflationary move is only to display ignorance of its universal character. The world is paying for its ruthless destruction of life and property in the World War, and for its failure to adjust purchasing power to productive capacity during the industrial revolution of the decade following the war."

Kevin said...

Fantastic post Ken. I have wondered why this possibility has been ignored and agree with your analysis that the economic argument for free trade is not as bulletproof as is generally assumed. And in a world that is extremely vulnerable to political pressures and in which logic is only one of many factors that influence policy, it is a mistake to assume a broad consensus in developed markets will continue to support unfettered free trade. It is also perhaps the biggest threat to the continued rise of EM, and a threat those markets are completely ignoring.

Abu 'Arqala said...


Thought provoking piece.

I recall reading somewhere that economics is neither art nor science but a religion. And that I think pretty much sums up the state of affairs.

Each school has its single explanation for events and its single magic bullet sacrament which if only applied will lead to the happy outcome.

For some it is tax cuts. For others control over the money supply. For some the holy relic (gold). For others stimulus pump priming. For others a simple-minded belief in the power of the free market to self-regulate.

In many cases the acolytes of an economic cult are more orthodox than the original prophet. Or is that profit? It's said that after a meeting with American economists, Keynes (RAA) remarked, "I was the only non Kenynesian in the room".

Turning to another fundamental issue, there is a quote attributed I believe to Milton Friedman (AS) that there were more variables than equations in Economics and so it was necessary to plug one or more variables to arrive at a solution.

Assume away inflation and you get one set of outcomes.

Assume self adjusting markets and no unemployment (above that of the frictional and lazy) and you get another.

Assume stable equilibrium in markets ...

Abu 'Arqala said...

To the topic at hand:

The classical free trade argument (Ricardo) assumes
(a) full equivalence of the goods traded - Your Mouton Cadet is as good as my Thunderbird,
(b) that the factors of production are fully employed (or at least to the same level of employment) in the pre and post specialization scenarios,
(c) that the move to specialization does not have secondary impacts on other sectors of the economy and
(d) that the actual benefit takes place. That is, that the goods are actually traded in the quantities necessary to achieve the "gains from trade".

All of which are not necessarily true.

Finally, as was noted by Anonymous, the gains from trade are measured at the aggregate national level.

As a result, free trade can result in significant deterioration in the economic position of large segments of a nation. The impact this has -- the many secondary effects -- is not considered.

I would also not be so sanguine about the position of knowledge workers.

The Internet allows the offshoring of a lot of knowledge work to less expensive cost centers. There are many smart folks out there - now available due to the opening of formerly closed economic blocs: the PRC, the Soviet bloc, and India.

One firm I worked for started farming out basic IB analyst work to India. Number crunching, model building. And some financial analysis for research. As English language skills improve, more such work can be moved with just a few "editors" required in NY, London, or Hong Kong to refine the prose.

Back office functions for banks, funds, trusts.

Software development. Harware engineering.

Accounting services, tax return prep and review. There are lots of highly talented CPAs in the Philippines.

Reviews of X-rays, lab reports. Insurance claims.

And many more ...

sigismondo said...

Ken thank you, nice subject.
I agree with the analysis until the “mind boggling” remark, included :) but I disagree with the proposal at many levels. I think that you have thought it through from the short term economical standpoint, but not overall essentially I think that the effects would be as you predict, but that you have not looked beyond.

a- US economy: you will save many blue collar jobs from extinction, could also resuscitate some, but growth will slow down, in a big way, because the old supply chain was costlier and less dynamic than the new one. You will also diminish competition, then protect even more, …a highway to Yugoslavia J

b- World’s economy: yes you could semi-bankrupt your competitors and emerge with a bigger share of the world’s pie, but that pie will have shrunk, in a big way too (no, I cannot prove this), so the stimuli for you to grow later will not come from outside either ..Kossovo.

c- International politics: you can put China in serious trouble and eliminate, or retard, its emergence as a power with this type of policy, but will that really be beneficial? The lesson that you exposed so well about the post WWII is valid now, too, but in another way. If the economic ties are deep, they will love you or hate you, but will stay in bed with you., is like a girlfriend and shopping: you will always have great sex the night before a scheduled shopping spree. Try it.

..and above all: elections in the US (more than anywhere else) go the way of big business. Your electorate will go vote big business candidates and collect their unemployment checks the next day. So don’t worry about free trade, is there to stay.

sigismondo said...

PS: why do I read these articles before dinner? Now I am late again.

Two final remarks:
1- IMHO the way forward for the US is to keep enlarging the pie. You will say that this is failing. I say that has not been done enough. There are continents out there waiting for development (not aid, please: business). That will enlarge everybody’s pie *and* give long term political stability

2- The main issue in the US now is more political : America has changed, but americans do not realize it. The US economic policies are indistinguishable from europe’s (high taxes, high subsidies, protect the citizen from himself), but the rethorics and the self perception are still with the lonely ranger and Theodor Rooseevelt. This disconnect creates terrible decisions, bad compromises, totally kills any consistence in direction.

lillyput4u said...

Fantastic piece.
I came across a similar one this morning on the WSJ.
So, were you the first ... or were you the first? :)

Looking forward to many more posts!