[ExI] Fwd: The Theory That's Killing America's Economy -- and Why It's Wrong

Keith Henson hkeithhenson at gmail.com
Sun May 1 14:21:35 UTC 2011


The main point made here:

"The problem here is that the theory of comparative advantage pays no
attention to the long term. So it can quite easily recommend a trade
policy that gives us the highest possible living standard in the short
run -- but by way of selling off our country out from under us.

"This is what happens when a nation runs a trade deficit, which
necessarily means that it's either sinking into debt to foreigners or
selling off its existing assets to them.

"The theory of comparative advantage is blind to this problem because
it treats people's time horizons as a given. So if a nation wants a
short-term consumption binge followed by long-term decline, the theory
says "OK, no problem. You wanted it, you got it, what's not to like?"

Keith

http://www.huffingtonpost.com/ian-fletcher/the-theory-thats-killing-_b_846452.html
==========================================================

Ian Fletcher

Author, 'Free Trade Doesn't Work: What Should Replace It and Why'

The Theory That's Killing America's Economy -- and Why It's Wrong

Posted: 04/ 7/11 08:43 PM ET

I wrote in a previous article how America's disastrous embrace of free
trade is ultimately based on a false theory of how the global economy
works: the so-called Theory of Comparative Advantage. This is what
economists, from the government on down, believe in. This matters.

But I didn't explain why the theory is wrong -- which it is.
Understanding its flaws is the price of admission to serious criticism
of free trade, so it's well worth getting a grasp on them. Economic
theory can be a tough chew, but it's worth the effort, if only to gain
the intellectual confidence not to be intimidated by the so-called
experts. So... let's take a look at some of that machinery behind the
wizard's curtain, shall we?

The theory's flaws, which are fairly well known to economists but
mostly ignored, consist of a number of dubious assumptions upon which
the theory depends. To wit:

Dubious Assumption #1: Trade is sustainable.

The problem here is that the theory of comparative advantage pays no
attention to the long term. So it can quite easily recommend a trade
policy that gives us the highest possible living standard in the short
run -- but by way of selling off our country out from under us.

This is what happens when a nation runs a trade deficit, which
necessarily means that it's either sinking into debt to foreigners or
selling off its existing assets to them.

The theory of comparative advantage is blind to this problem because
it treats people's time horizons as a given. So if a nation wants a
short-term consumption binge followed by long-term decline, the theory
says "OK, no problem. You wanted it, you got it, what's not to like?"

A saner theory of trade (and of economics generally) would advise
people that it's not a good idea to engage in decadent binges,
regardless of how good it feels right now. It would recommend
protectionist restraints on imports to force trade into balance, not
free trade.

Dubious Assumption #2: There are no externalities.

An externality is a missing price tag. More precisely, it is the
economists' term for when the price of a product does not reflect its
true economic cost or value.

The classic negative externality is environmental damage, which
reduces the value of natural resources without raising the price of
the product that harmed them. The classic positive externality is
technological spillover, where one company's inventing a product
enables others to copy or build upon it, generating wealth that the
original company can't capture.

If prices are wrong due to positive or negative externalities, free
trade will produce suboptimal results.

For example, goods from a nation with lax pollution standards will be
too cheap. So its trading partners will import too much of them. And
the exporting nation will export too much of them, overconcentrating
its economy in industries that are not really as profitable as they
seem, due to ignoring pollution damage.

Positive externalities are also a problem. If an industry generates
technological spillovers for the rest of the economy, then free trade
can let that industry be wiped out by foreign competition because the
economy ignored its hidden value. Some industries spawn new
technologies, fertilize improvements in other industries, and drive
economy-wide technological advance; losing these industries means
losing all the industries that would have flowed from them in the
future.

Dubious Assumption #3: Productive resources move easily between industries.

As noted in my original article, the theory of comparative advantage
is about switching productive resources from less-valuable to
more-valuable uses. It's about putting our economy to its own best
use.

But this assumes that the productive resources used to produce one
product can switch to producing another. Because if they can't, then
imports won't push our economy into industries better suited to its
comparative advantage. Imports will just kill off our existing
industries and leave nothing in their place.

When workers, for example, can't move between industries--usually
because they don't have the right skills or don't live in the right
place--shifts in an economy's comparative advantage won't move them
into a more appropriate industry, but into unemployment.

In the United States, because of our relatively low minimum wage and
hire-and-fire labor laws, this problem tends to take the form of
underemployment, rather than unemployment per se. So $28 an hour
ex-autoworkers go work at the video rental store for eight dollars an
hour.

The same goes for other inflexible factors of production, like real
estate. That's why the shuttered factory rivals the unemployment line
as a visual image of trade problems.

Dubious Assumption #4: Trade does not raise income inequality.

Even if free trade expands the economy overall (dubious), it can tilt
the distribution of income so much that ordinary people see little or
none of the gains.

For example, suppose that opening up a nation to freer trade means
that it starts exporting more airplanes and importing more clothes
than before. Because the nation gets to expand an industry better
suited to its comparative advantage and contract one less suited, it
becomes more productive and its GDP goes up.

So far, so good.

Here's the rub: suppose that a million dollars' worth of clothes
production requires one white-collar worker and nine blue-collar
workers, while a million dollars of airplane production requires three
white-collar workers and seven blue-collar workers. So for every
million dollars' change in what gets produced, there is a demand for
two more white-collar workers and two fewer blue-collar workers.
Because demand for white-collar workers goes up and demand for
blue-collar workers goes down, the wages of white-collar workers go up
and those of blue-collar workers go down.

But most workers are blue-collar workers -- so free trade has lowered
wages for most workers in the economy!

This is not a trivial problem: Dani Rodrik of Harvard estimates that
freeing up trade reshuffles five dollars of income between different
groups of people domestically for every one dollar of net gain it
brings to the economy as a whole.

Dubious Assumption #5: Capital is not internationally mobile.

The theory of comparative advantage is about the best uses to which
America can put its productive resources, what economists call
"factors of production." We have certain cards in hand, so to speak,
the other players have certain cards, and the theory tells us the best
way to play the hand we've been dealt. Or more precisely, it tells us
to let the free market play our hand for us, so market forces can
drive all our factors to their best uses in our economy.

Unfortunately, this relies upon the impossibility of these same market
forces driving these factors right out of our economy. If that
happens, all bets are off about driving these factors to their most
productive use in our economy. Their most productive use may well be
in another country, and if they are internationally mobile, then free
trade will cause them to migrate there.

This will benefit the world economy as a whole, and the nation they
migrate to, but it will not necessarily benefit us.

This problem applies to all factors of production, but the crux of the
problem is capital. Capital mobility replaces comparative advantage,
which applies when capital is forced to choose between alternative
uses within a single national economy, with absolute advantage. And
absolute advantage contains no guarantees whatsoever about the results
being good for both trading partners.

Capital immobility doesn't have to be absolute, but it has to be
significant and as it melts away, trade shifts from a guarantee of
win-win relations to a possibility of win-lose relations.

David Ricardo, the British economist who invented the theory of
comparative advantage in 1817, actually knew about this problem
perfectly well, and wrote about it in his book on the subject. So
there's no excuse for modern economists to ignore it.

Dubious Assumption #6: Short-term efficiency causes long-term growth.

The theory of comparative advantage is what economists call "static"
analysis. That is, it looks at the facts of a single instant in time
and determines the best response to those facts at that instant. But
it says nothing about how today's facts may change tomorrow. More
importantly, it says nothing about how one might cause them to change
in one's favor.

So even if the theory of comparative advantage tells us our best move
today, given our productivities in various industries, it doesn't tell
us the best way to raise those productivities tomorrow. That, however,
is the essence of economic growth, and in the long run much more
important than squeezing every last drop of advantage from the
productivities we have today. Economic growth is ultimately less about
using one's factors of production than about transforming them--into
more productive factors tomorrow.

The theory of comparative advantage is not so much wrong about
long-term growth as simply silent.

Analogously, it is a valid application of personal comparative
advantage for someone with secretarial skills to work as a secretary
and someone with banking skills to work as a banker. In the short run,
it is efficient for them both, as it results in both being better paid
than if they tried to swap roles. (They would both be fired for
inability to do their jobs and earn zero.) But the path to personal
success doesn't consist in being the best possible secretary forever;
it consists in upgrading one's skills to better-paid occupations, like
banker. And there is very little about being the best possible
secretary that tells one how to do this.

Dubious Assumption #7: Trade does not induce adverse productivity growth abroad.

When we trade with a foreign nation, this will generally build up that
nation's industries, i.e. raise its productivity in them. Now it would
be nice to assume that this productivity growth in our trading
partners can only make them ever more efficient at supplying the
things we want, and we will just get ever cheaper foreign goods in
exchange for our own exports, right?

Wrong. Consider our present trade with China. Despite all the problems
this trade causes us, we do get compensation in the form of some very
cheap goods, thanks mainly to China's very cheap labor. The same goes
for other poor countries we import from. But labor is cheap in poor
countries because it has poor alternative employment opportunities.
What if these opportunities improve? Then this labor may cease to be
so cheap, and our supply of cheap goods may dry up.

This is actually what happened in Japan from the 1960s to the 1980s,
as Japan's economy transitioned from primitive to sophisticated
manufacturing and the cheap merchandise readers over 40 will remember
(the same things stamped "Made in China" today) disappeared from
America's stores. Did this reduce the pressure of cheap Japanese labor
on American workers? It did. But it also deprived us of some very
cheap goods we used to get.

And it's not like Japan stopped pressing us, either, as it moved
upmarket and started competing in more sophisticated industries.

Oops!

When Nobel laureate Paul Samuelson -- author of the best-selling
economics textbook in history -- reminded economists of this problem
in a (quite accessible) 2004 article , he drew scandalized gasps from
one end of the discipline to the other. But nobody was able to explain
why he was wrong.

They still haven't.

I don't expect most readers to get all the above analysis the first
time through. But I do hope that everyone who's read this far now
understands that there is no good reason -- regardless of what most
economists say -- to assume that free trade is necessarily best. The
economic logic of those who say it is, is riddled with enough holes to
sink a container ship.


Free Trade Doesn't Work: What Should Replace it and Why
by Ian Fletcher



Follow Ian Fletcher on Twitter: www.twitter.com/IanFletcher



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