Thursday, 26 May 2016

The Problem with Ever Freer Trade

Those who keep a keen eye on the news may have noticed recently that Donald Trump is doing very well in the US Presidential election. It has been suggested that part of the reason for his popularity is that he gains the support of those in the United States who feel displaced by the forces of globalisation; those people who lost their jobs or get lower wages due to competition from lower wage economies.

The standard defence of globalisation and free trade is that it means that everyone works where they add the most value and in sum everyone ends up better off. Total productivity of the world economy is higher because everyone concentrates on their specialisation. When I say 'defence', it is not really a defence as there is not really an attack on this theory - it is so standard and accepted by economists.

But the rise of Trump has prompted some very interesting challenges to the standard dogma. This one, by Daniel Altman, is particularly good. It points out that although globalisation may be good for everyone in general, giving cheaper goods and more choice, it is not good for everyone in particular. If your industry can be outsourced to China and most people in your city work in that industry, and further if you have 30 years experience in that industry and not that many transferable skills, globalisation is undoubtedly bad for you.

So the question becomes; if globalisation is better for everyone then why can't the people who do benefit the most share some of their proceeds with the biggest losers-out? Why are there not big retraining programmes and support for industry in areas that have been damaged? Well, this goes against the prevailing idea that the free market is the best arbiter. It also goes against the idea that if you tax people too much then they lose incentive. The beneficiaries would say that if we support the losers then we are distorting the free market, we are subsidising inefficient industry and this will end badly. We are actually doing them a favour by leaving them alone to find a new niche. And also I earned this money with my hard work, so why should I pay for others who aren't producing.

Free trade does bring down prices but also hugely increases competition for labour. It is arguable that although globalisation has indeed made us all richer, in the higher income countries it has particularly made shareholders richer because wages have stagnated relative to economic growth. This exacerbates inequality, and reduces demand in the economy. This is one reason why governments need to run such large deficits these days.

I think that the free market is an incredible thing. I think it has brought wonderful variety and happiness into people's lives. I am very much in favour of a free market - but only up to a certain point. The reason is that the free market is a very short term efficient arbiter - but it has no long term view.

And free trade, up to a point, is undoubtedly a wonderful thing that has brought great success to our economies. But being a great thing up to a certain point does not necessarily mean that more of it is even better. One steak for dinner is amazing. Two steaks are arguably better. But the marginal utility of the third steak is very likely negative. This is what I feel about free trade - it is a bit like having steak at dinner - one or maybe two are great. And that anyone arguing against free trade is laughed at like someone arguing against steak. This post, which develops a theme from my last post on Brexit, questions whether ever freer trade is indeed an ideal.

This post is not really about the question Altman brings up about distribution within a country of many industries such as the United States. It is more about the idea that an individual country is best off specialising in a small number of fields of major competitive advantage. I argue that completely free trade, without fiscal transfers to the countries that lose out, is not optimal. Altman makes the same argument but for people rather than countries.

To begin, I wish to show the graph that I put into an adendum to my last post; it is a graph of the real GDP growth of High Income countries vs that of EU countries. Now, if the freer trade provided by the EU has had the great economic benefit that most economists say it has, we would expect the EU countries to have grown more than their high income equivalents:
As can be seen from this graph the growth was pretty much exactly the same until 2008. That is to say that the freer trade from being a member of the EU either had no benefit or it was offset by something else. After 2008 we can see the EU lag the rest of the High Income world thanks to the impact of the Euro and policies associated with it.

This paper looks at the impact of tariffs on growth and finds that, while there is a statistically significant worsening of GDP for higher tariffs for richer countries, the size of the effect is pretty small - maybe in the order of 0.1 or 0.2% of GDP per year for pretty large changes in tariff levels. It actually finds that, if anything, poorer countries do better with higher tariffs but this is not as statistically significant.

The conclusion I reach here is that after a certain point, the benefits of even more free trade are not large enough that we should ignore all other consequences.

The next thing I wish to look at is what makes a desireable industry. Free trade forces specialisation and countries don't often get to choose what industry this is in. For example, a country with abundant natural resources will be forced to specialise in this because the sales of these resources raise their exchange rate and make other industries less competitive. In the UK, the location between Asia and the US, the laxer regulation, as well as the fact that English is the world language of finance, meant that the UK was, in a sense, forced to specialise in finance. If a country has a strong military, then defence companies from that country, boosted by contracts from their government, can gain a competitive advantage in that field. The historic tradition of fine watchmaking gives Switzerland a competitive advantage in that it can charge higher prices for its watches.

So what sort of industries would you ideally like your country to have? For a start, you would want those that are not too cyclical. Countries with natural resources are often described as having 'Dutch Disease' because the uncompetitiveness of their other industries mean that all investment goes into the natural resource extraction. When the economic cycle turns against these commodities, the country is left with loss-making businesses and no fall-back. Specialising in cyclical industries is not necessarily in the best interests of any country.

The sensible policy for a country with natural resources is to set up some kind of sovereign wealth fund. This has two benefits. The first is that you have built up claims on the future work of those in other countries. When your resources run out, or the cycle turns, then these can be cashed in - it provides stability. The second is that it keeps the currency lower meaning that other industries are not as uncompetitive.

There is another type of industry that a country should preferably avoid, and this is an industry that accrues the benefits to a small number of people at the top. The reason for this is that it has a similar effect to running a current account deficit.

As a thought experiment, imagine I made an app that I licensed to an American company for £10bn per year. It all goes to me. What would happen? Well, for a start, I would get a lot of commendation for my helping UK exports. If I gave enough in donations I might get a knighthood for services to British industry.

But what does that £10bn do? It raises the £/$ exchange rate. This makes other industries less competitive. Think of the following identity: exports minus imports equals the trade balance. For simplicity let's assume no other flows and so that the trade balance and current account balance are the same. Now the current account balance would be unchanged, as the current account balance is equal to all the savings foreigners have put into the UK, and there is no reason for this to change. This means that my £10bn must be counteracted by £10bn of a combination of more imports and fewer exports.

Since I am unlikely to be able to spend much of the £10bn, the effect of this is similar to an extra £10bn of current account deficit. This means less demand in the UK economy, and unless counteracted by higher government deficits, more unemployment in the UK as a whole. An industry that gains exports but shares those gains between a few people who don't spend it in the economy is not a great help to the economy as a whole.

So the ideal industry is non-cyclical and shares the proceeds between a large number of employees. But there is one other target here; we do not want any industry to be too large - we would like a diversified industrial base.

A diversified industrial base means that as industries die or as economic cycles turn against them, there are other industries that can take the slack and provide support for those who have lost out. A specialised industrial base may well provide the highest overall return for the economy, but, like an undiversified share portfolio, will be a lot more volatile. And volatility for an economy is undoubtedly bad.

Central planning of an economy, deliberately putting resources to help certain industries, is much sneered at by those who believe in the free market. But in the end, the countries that don't plan their economies are left with the industries that those who do plan don't want.

With this in mind, we can look at how the economy in the EU with the freest trade has fared; by which I mean the UK. Well, by avoiding the Euro, it managed to avoid a particularly poisonous bullet that could have caused huge damage after 2008. It is a country of great variety of consumer choice. Living in Switzerland, a country with relatively high trade barriers, I now really appreciate how much choice there is in UK supermarkets and in terms of eating out and other entertainment. But I also see in the UK an economy where wages have been driven lower and lower relative to GDP and rentals higher and higher. 

I believe that of the problems in the UK are due to belief in the infallibility of the free market. That bad long-term economic decisions were taken but seen as good ones because private sector debt kept on rising and these problems were disguised by this hidden stimulus. Industries, like manufacturing,  made uncompetitive by a concentration on eg. finance were discarded as being not fit enough to survive. The South prospered, the North not so much. The owners of capital prospered, the workers not so much. But overall this idea held that we are all (as a whole) getting richer.

Is there merit in some sort of economic planning, some sort of help given to certain industries? In my opinion there is. Should tariffs be higher to protect them, maybe that is a good idea. I am not suggesting picking winners per se, maybe more just supporting industries that are almost there. My argument is that a country is better off with a diverse range of largely uncyclical industries, preferably those with a more even distribution of winnings. This is more desirable than the unplanned, short-term, profit maximising model that the UK has followed.


  1. yes great points,I agree 100 per cent.Although it is difficult to coordinate. Perhaps Government should just invest massively into R and D and innovation and science and technology,software energy facilitate industrial growth with a national investment bank (much like south east Asian tigers or Germany ),mild tariff protections.And allow the private sector to develop clustures of high tech firms in various different non cyclical sectors where the jobs created are high income (to ensure distributed earnings).

    Another point about German firms is that employees and local communities do not have to worry about off-shoring as a lot of the big firms are owned by local government.

    1. I agree, answers are not easy and I think you come up with good viable ideas. Overall, I think that it would help to acknowledge that in some cases the countries that planned got it right, and then study what they got right and why. I think we are too quick to brush off 'uncompetitive' ideas on principle, without empirically looking at results.

    2. There has bene plenty of offshoring by German companies, and industry as a % of GDP has declined heavily over the last few decades. Germany lives by exports and would collapse without them - thi only works while other countries are prepared to buy their goods - a serious dose of protectionism would break Germany swiftly, but they have the Eurozone where the terms of trade are heavily weighted in their favour

  2. "if globalisation is better for everyone then why can't the people who do benefit the most share some of their proceeds with the biggest losers-out?" If you loose your job because the production is outsourced to China I get cheaper products and benefit the most. I do accept a slight increase in taxes to fund your living after outsourcing. Sounds good enough to you?

  3. Anyone who is in favor of Globalization is an enemy of the United States. Anybody who is in favor of Globalization belongs in Guantanamo, along with the other enemies of the Untied States.

    The political reality is that the establishment consensus has failed, and President Trump will remove all of the Globalists from influence. They will all be transferred to the Montana field office, where they belong.

  4. "a country with abundant natural resources will be forced to specialise in this because the sales of these resources raise their exchange rate and make other industries less competitive"

    Great observation. As someone from a country reliant on the export of commodities I can relate.


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