One distortion embraced by elites is floating exchange rates, a flawed idea foisted on the world by Milton Friedman in the 1970s. If a builder hired you to construct a house using a one-foot ruler, then told you on day two that a foot was thirteen inches, and on day three that a foot was ten inches, and so on, the resulting house would be unsound and in danger of collapse. That’s how comparative advantage works under floating exchange rates. Currency hedges are generally unavailable more than one year forward; too short a time for capital commitments that have five- to ten-year horizons.
Floating exchange rates enrich currency traders and speculators, but add costs to commerce and impede capital flows. Exchange rates are ripe for manipulation. Champions of putative free trade based on comparative advantage need to consider the fixed exchange rate regime that prevailed from 1944 to 1971, a golden age of growth and higher real incomes. The elite herd favors free trade and floating exchange rates, a recipe for losing U.S. jobs to foreign manipulation.
The next deficiency in the free trade case is mobility of factors of production. Ricardo posited that factors of production were rooted in a home country. Markets work out comparative costs as a basis for trade. Today factors of production, especially capital, are not rooted, they’re mobile. Consider the case where China has more efficient labor (due to low costs), and the United States has more efficient capital (due to a deep, liquid financial system). If factors of production were immobile, the United States might have a comparative advantage in manufacturing even with more costly labor due to its lower capital costs. If cheap U.S. capital moves to China, and combines with cheap Chinese labor, then China gains both comparative and absolute advantage. This is not a hypothetical example; it is the quintessence of globalization. Ricardo’s theory fails in a world of mobile factors.
Another flaw in Ricardo involves intertemporal flux: the difference between static comparative advantage and dynamic comparative advantage. A country that does not have comparative advantage at the start of a decade may use protectionism to nurture infant industries and gain comparative advantage by decade’s end. Unfair trade practices are used by one country to undermine a trading partner’s comparative advantage. The cheater can join the free trade club after its advantage is secured.
A classic use of this method is the United States, which used protectionism from 1776 to 1944 to build the greatest industrial juggernaut the world had ever seen. Since the 1970s, the United States has been on the receiving end of protectionism from Japan, Korea, Taiwan, and China. Today the high-value jobs of the future are created in Asia. This is not due to an initial comparative advantage in Asia, but rather a created comparative advantage through the use of protectionism and currency manipulation.
Other defects in the theory of comparative advantage involve what are called externalities. These are hidden costs that do not enter into direct cost comparisons. China seems more efficient at mining than the United States because China dumps cyanide (used to extract metal from ore) into rivers. Should China be rewarded in terms of trade if the costs of cyanide poisoning are not included in the price of metal exports?
The greatest deficiency in the theory of comparative advantage is that it fails unless everyone plays by the rules. The thrust of the Bretton Woods General Agreement on Tariffs and Trade (1947) and its successor, the World Trade Organization (1995), was to force adherence to free trade by the signatories. Exceptions for agricultural subsidies, and cheating by China, leave the world far from the ideal. U.S. free trade policy is best understood as a poker game where the United States is the only participant not seeing the other players’ cards.
China’s trade policy today resembles U.K. policy in the eighteenth century, and U.S. policy in the nineteenth century. These prior policies involved protectionism, theft of intellectual property, and accumulation of gold. These mercantilist policies worked well for the United Kingdom and the United States. Great Britain was the dominant industrial and trading power until repeal of protectionist Corn Laws in 1846. It then began a seventy-year decline that culminated in near national bankruptcy in 1914. The United States was the dominant industrial and trading power until Bretton Woods in 1944. It began a seventy-year decline, culminating in crisis in 2008.
Decline is not the same as collapse. The United Kingdom enjoyed prosperity in the 1860s, as the United States enjoyed prosperity in the 1960s, after both embraced free trade. This prosperity is best seen as a seed-corn banquet. Both countries were living off the momentum of earlier mercantilism. When that momentum is not renewed it runs out.
Elite neoliberal free traders are relaxed about U.S. job losses because their mind-set lets them imagine jobs being created elsewhere in the economy where the United States retains comparative advantage. The United States leads the world in higher education and high tech. Yet total jobs in both fields are paltry compared with lost manufacturing jobs in recent decades. Even if one accepts that there will be winners and losers in a global trading system, what happens when the number of winners is few, and the losers are many? The answer is lower labor force participation, lower productivity, stagnant wage gains, and greater income inequality—exactly what the United States has experienced since the 1990s ascent of NAFTA and the WTO.
Even if jobs won and lost from trade are comparable in numbers (they’re not), all jobs are not created equal. Certain jobs persist yet go nowhere, and do not drive growth. A barista may have a steady job at decent wages, but that’s all. The barista will always work behind the counter, and nothing else will come of it because her exertions leave limited scope to apply new technology. Lego-style assembly jobs are not, without exogenous effects, a source of additional jobs.
Conversely, an entrepreneur using an improved manufacturing process creates new jobs directly, spins off intellectual property, and catalyzes upstream and downstream job growth in supply and distribution chains. High-value-added manufacturing jobs that support continual supply-chain improvements in materials, machine tools, and processes are the jobs America should support through policy. Dead-end jobs without positive externalities may safely be left to trading partners.
These free trade dysfunctions were recognized long ago. Joseph A. Schumpeter, in his 1942 classic, Capitalism, Socialism and Democracy, wrote, “Traditional theory . . . has since the time of Marshall and Edgeworth been discovering an increasing number of exceptions to the old propositions about perfect competition and . . . free trade, that have shaken that unqualified belief in its virtues cherished by the generation which flourished between Ricardo and Marshall. . . .”
Schumpeter wrote this in an analysis of how large-scale enterprises produce positive externalities that offset the perceived problems of bigness. Schumpeter’s point was that the entrepreneur is not as concerned about static competition as the dynamic forces he called “creative destruction.” The latter drives innovation. Modern analysts make the same point about the benefits of smart protectionist policy. American business is not really competing with foreigners, it’s competing with the future, and losing.
The issue is not that Ricardian theory is wrong; it’s that the theory relies on assumptions that don’t conform to the real world, and is therefore useless as a guide to policy. If comparative advantage is a chimera, and if putative free trade is a rigged game, why do elites insist upon it?
Elite support for so-called free trade is due to the fact that elites share a global perspective at odds with the best interests of the United States. Policies that produce world growth at U.S. expense are endorsed. Policies that benefit the United States while slowing world growth are rejected. Today globalization’s triumph over nationalism is energizing a nationalist revival as nations reassess their individual interests.
Certain global corporations profit enormously from the current flawed system. To illustrate this, consider two companies on opposite sides of the mercantilist divide—Apple Inc., the manufacturer of beloved iPhones, and Caterpillar Corporation, “Cat
,” the largest heavy equipment manufacturer in the world.
Apple exported capital to China, where the capital combined with cheap Chinese labor to produce both absolute and comparative advantage in the manufacture of iPhones. China facilitates this by maintaining a cheap currency, which increases the purchasing power of U.S. consumers relative to Chinese unit labor costs. The United States is by far the largest, richest consumer market in the world. China gains intellectual property, jobs, and hard currency reserves. Apple reaps enormous profits and defers U.S. taxes. Apple thrives, yet creates few jobs in the United States.
Caterpillar manufactures heavy equipment mainly in the United States and sells mainly abroad. Cat must overcome a full array of foreign mercantilist policies including protectionism, nontariff barriers, and cheap currencies. Mercantilism makes Japanese and Korean heavy equipment relatively more attractive to buyers in emerging markets. However, Cat creates high-paying, high-value-added jobs in its U.S. plants.
The divergent dynamics of Apple and Cat bear directly on economic debates about currency wars and the deflationary impact of the strong dollar. Economist Thomas I. Palley summarizes this divergence:
When U.S. companies produced domestically and looked to export, a weaker dollar was in their commercial interest, and they lobbied against dollar overvaluation. However, under the new model, U.S. corporations looked to produce offshore and import into the United States. This reversed their commercial interest, making them proponents of a strong dollar. This is because a strong dollar reduces the dollar costs of foreign production, raising the profit margins on their foreign production sold in the United States at U.S. prices.
This summary shows the irrelevance of comparative advantage. A small group of global corporations with mobile capital, hair-trigger ability to relocate plants, and political muscle to move exchange rates in the absence of a gold standard make a mockery of free trade. These companies create their own advantages and write their own rules. Manipulations are not limited to U.S.-based global companies. They are practiced with even more success by German, Japanese, and Chinese behemoths.
This comparison of the divergent interests of Apple and Cat demonstrates why free trade is a mirage. Mobile capital, technology transfer, protectionism, and manipulation of exchange rates are used to offset the comparative advantage America might once have had. When the transfer of input factors is complete, comparative advantage is lost forever. The United States is left with dead-end jobs or no jobs at all.
U.S. trade policy is mainly about opening doors for Cat abroad. Instead policy should be aimed at bringing Apple jobs back home. More of Apple’s value chain needs to reside in the United States. Those who claim this is inefficient under Ricardian theories should ask the following: If U.S. workers cannot get better jobs, and are hobbled by high debts, who will buy what global companies make? The United States should aggressively use tariffs and trade barriers to promote jobs that catalyze growth—exactly as Alexander Hamilton proposed in his Report on Manufactures presented to Congress in 1791.
The United States would benefit from an immediate 30 percent import duty on all goods from all sources. This could be made revenue neutral by pairing the tariff with a 10 percent cut in payroll taxes. An imported iPhone would be more expensive (unless Apple chose to reduce profit margins by lowering prices). But the payroll tax savings would help consumers pay for the phones, if that is their preference. The expected outcome is that Apple would relocate good jobs to the United States, where it could reap the combined benefits of lower tariffs and lower payroll taxes. The impact of this policy goes beyond Apple and iPhones to include all high-value-added imports.
The handmaiden of elite dominance is misinformed public opinion resulting from pro-trade propaganda by voices from the Council on Foreign Relations to The New York Times. This herd’s party line is that free trade is good and tariffs are bad. This is what reporters were taught in undergraduate economics classes ten or twenty years ago.
Elite opinion carriers disdain those who question free trade dogma. These pseudo-experts tell you Smoot-Hawley tariffs caused the Great Depression, an implausible view because the depression began earlier and was caused by Federal Reserve monetary policy blunders. The United States had average tariffs of 44.6 percent before Smoot-Hawley, and 53.2 percent after—not an extreme increase. Ian Fletcher points out that tariff increases in 1861, 1864, 1890, and 1922 did not produce depressions, while recessions occurred in 1873 and 1893 without tariff increases. The case for causality between tariffs and recessions is somewhere between weak and nonexistent. This comes as a surprise to most pundits.
A new U.S. tariff will leave certain dead-end assembly and agricultural jobs with our trading partners, yet create more high-value-added jobs in the United States. A tariff impedes the efforts of U.S. trading partners to capture the high-value-added jobs for themselves with their own battery of trade barriers, intellectual property theft, and local content requirements. America, the world’s largest consumer economy, needs this type of structural change to raise potential growth. The result is higher productivity and higher real wages, important steps toward debt sustainability.
There is a case for open markets and low tariffs, but it is a special case, not a general case, and the case is political, not economic. When your economy is intact, yet your trading partners are in ruins, exactly the relationship between the United States and Europe after the Second World War, it makes sense to provide open markets and cheap finance to the ruined party to restart the game. Free trade in the form of customs unions also makes good sense among nations with a history of warfare and destruction—exactly the case inside Europe at the same time.
A rare convergence of a special case to restart world trade with an imperative to prevent another war in the late 1940s made the Bretton Woods institutions not only useful, but necessary. Those special circumstances do not apply to China, India, and the rest of the world today. The United States is no longer helping its partners, it is hurting itself.
Empire of Debt
The elite worldview rests on the intellectual pillars of equilibrium models, monetarism, Keynesianism, floating exchange rates, free trade, globalization, and fiat money. Meanwhile, the real world is best understood through the lens of complexity theory, conditional probability, behavioral psychology, currency wars, neomercantilism, and gold. Cognitive dissonance between the elite worldview and real-world economics is taking its toll on elite self-confidence and control. The elites now divide into two types: those who are confused by lost credibility, and those who are quietly panicked because they understand their intellectual failure and its consequences.
The principal rebuttal to this critique of the elite consensus is the demonstrable global growth and prosperity since the end of the Second World War. The 1950s and 1960s witnessed exceptionally strong growth in the United States, Canada, Western Europe, and Japan, with low unemployment and little inflation. Of course, this growth emerged from a low baseline given the devastation caused by the war. There was ample space for utilization of factor inputs, especially abundant human capital, and finance capital supplied by the United States.
However, prevailing conditions in this period of initial prosperity do not conform to conditions today. The 1950s and 1960s were defined by fixed exchange rates, a gold standard, balanced budgets, tariffs, and trade preferences. All of these conditions are antithetical to the elite formula today.
The 1970s and 1980s were a transitional period for the postwar Bretton Woods institutions. Gold was abandoned as a monetary standard. Floating exchange rates emerged in the mid-1970s. Still, the demise of the gold standard was muted by the rise of a new dollar standard during the Reagan administration. King Dollar was finessed by Treasury Secretary James Baker through the Plaza Accord in 1985, and the Louvre Accord in 1987, which yielded broad agreement among major economies on acceptable exchange rates. King Dollar was not a fixed rate regime, but it was the next best thing,
bolstered by Paul Volcker’s success at achieving low inflation after the near-hyperinflationary episode of 1977 to 1981. Efforts at monetary convergence in Europe, albeit uneven and marked by occasional ruptures, served as a rough substitute for the gold standard.
The 1970s and 1980s were also a heyday of neo-Keynesianism and monetarism. Keynesianism justified persistent budget deficits, while monetarism disparaged fixed exchange rates and insisted that control of the fiat money stock produces maximum sustainable real growth without inflation. An intellectual battle between Hayek and Friedman on the one hand, and John Maynard Keynes on the other, was mooted, but both schools were now embedded in academia. What they shared was a thirst for government control; the only difference was whether control came from fiscal or monetary authorities. The neoliberal consensus favored both.
The ascent of globalized elites occurred after 1989, the dawn of a second age of globalization, a distant echo of the first age of globalization from 1870 to 1914. In 1989, the cold war ended, the Berlin Wall fell, and the Washington Consensus was announced in a seminal article by John Williamson, an English economist working in Washington, D.C. Williamson’s article summarized views that had been evolving since the 1970s. He condensed these views into a playbook for a newly globalized world. Williamson called for free trade, open capital accounts, direct foreign investment, and protection of intellectual property. He also called for fiscal discipline, yet in practice this was reserved for emerging markets, and not followed by developed economies themselves. The Washington Consensus was enforced ruthlessly throughout the 1990s by the IMF, urged on by Bob Rubin’s U.S. Treasury.
The Road to Ruin Page 24
