Free Trade Doesn't Work

by Ian Fletcher

  Our industry dominates world markets...American labor can now produce so much more than low-priced foreign labor in a given day’s work that our workingmen need no longer fear, as they were justified in fearing in the past, the competition of foreign workers.479

  For 15 years or so, this was probably true. But our allies’ economies had recovered from WWII by 1960. And by the end of the 1960s, world Communism’s “We will bury you” threat to surpass us economically (which had genuinely worried rational people watching the USSR grow faster than the U.S. in the 1950s) had ceased to be credible.480 So the original rationales for America’s turn towards free trade had expired.

  In retrospect, the early 1960s were the time America should have turned back from free trade. We certainly could have. Unfortunately, we instead made the exact same mistake Britain had made a century before and mistook the short-term advantages of free trade, when viewed from the perspective of the leading economy of the day, for permanent benefits. In the early 1960s, it certainly seemed as if imports were only penetrating low-end industries, giving us foreign goods on the cheap while leaving our high-value industrial sectors unharmed. This appeared to vindicate the Ricardian notion that free trade would always operate in our favor. So we let a policy with a temporary and political origin harden into a permanent economic dogma. We started to indulge the delusion that the underlying economics really did work.

  FREE TRADE SOURS FOR AMERICA

  In retrospect, John F. Kennedy’s Trade Expansion Act of 1962 was America’s decisive wrong turn on trade.481 Quantitatively, the so-called Kennedy Round of tariff cuts was large enough to be noticed, but not earth-shaking: as this legislation was phased in, our average duty on dutiable imports fell from 14.3 percent in 1967 to 9.9 percent in 1972.482 But this was one of history’s small yet decisive turning points, occurring as it did at the same moment that America’s trading partners were getting into high gear economically and the 1944-71 Bretton Woods system of fixed exchange rates was beginning to falter. And tariff cuts were exceptionally steep on high technology goods, increasing their impact.483 Furthermore, the Trade Expansion Act should be evaluated not simply in terms of its before and after tariff levels, but contrasted with the alternative of turning back from free trade—which is what we should have done.

  There were certainly warnings at the time. The famous liberal economist John Kenneth Galbraith bluntly told President Johnson in 1964 that “If we are screwed on tariffs, this will have an enduringly adverse effect on the balance of payments. It will be a serious problem for years to come.”484 And, lo and behold, the first serious trade-related cracks in the American economy began to appear in the late 1960s. Black-and-white television production left for Japan. So did cameras, transistor radios, and toys. Our trade went into deficit in 1971. We have not run a surplus since 1975.485

  There has, of course, been a simmering revolt against free trade ever since. Organized labor, which had actually supported the Kennedy tariff cuts when proposed in 1962, turned against free trade by the end of the decade. In 1968, Senators Ernest Hollings (D-SC) and Norris Cotton (R-NH) managed to pass a protectionist trade bill in the Senate with 68 votes. President Johnson had it killed by House Ways and Means Committee chairman Wilbur Mills.486 1969 saw the first consideration, by Commerce Secretary Maurice Stans, of creating an American agency to coordinate industrial policy. Nixon abandoned the effort for lack of Congressional support.487 In 1971, a trade deficit of one-half of one percent of GDP (about a tenth of today’s level) was enough to frighten Nixon into imposing a temporary 10 percent surcharge tariff on all dutiable goods.488 In 1972, the AFL-CIO endorsed the Burke-Hartke bill, which would have imposed quotas on imports in threatened industries and restricted the export of capital by multinational corporations.489

  But free trade survived all these challenges. Fundamentally, protectionist forces in Congress fumbled the ball. In the words of one scholar describing the failure of the big protectionist push in the last days of the Nixon administration:

  Even in Congress, protectionist industries failed to utilize their potential resources. During negotiations over general trade bills in Congress, protectionists exerted weak influence because they lacked an umbrella association to represent them. Instead, protectionists were divided along industrial lines, each promoting its own distinct objectives….The logic of selective protectionism did not encourage industries to cooperate with each other, since the chances for congressional support increased if protectionist bills were narrowly constructed. In addition, protectionist industries did not cooperate with organized labor.490

  The failure of this protectionist effort carries important lessons for tactical thinking about free trade today. Sen. Hollings tried again under President Carter, but Carter preferred the Cold War priority of free trade. Ronald Reagan vetoed two protectionist trade bills, in 1985 and 1988. George H.W. Bush vetoed one, in 1990.

  Ronald Reagan viewed free trade as basically a good thing, but with exceptions, so he was willing to deviate from it occasionally for the sake of threatened industries and to protect the technology base needed to win the Cold War. He enacted the “voluntary” automobile agreement with Japan that Carter had negotiated and imposed a tariff on motorcycles to save American icon Harley Davidson.491 He protected steel, lumber, computer memory chips, and sundry other products.492 Unfortunately, his trade pragmatism, while preferable to the extremism of Bill Clinton and the two Bushes, was not guided by any thoroughgoing critique of the underlying economics of free trade—beyond the idea that it sometimes didn’t work in America’s favor. As a result, Reagan did not go beyond relatively narrow tactical interventions.

  America’s last major attempt to create a full-blown industrial policy took place from 1983 to 1985 under Reagan’s Commerce Secretary Malcolm Baldrige, who proposed turning the Commerce Department into a Department of Trade and Industry analogous to Japan’s famed Ministry of International Trade and Industry (MITI). The proposal was killed by the ideological qualms of free-marketeers and by the efforts of the Office of the United States Trade Representative to defend its turf.493

  JAPAN’S PROTECTIONIST HISTORY

  In the 1980s, Japanese industrial policy was the object of intense American interest, which has since waned due to the misapprehension that Japan is in major economic decline.494 There was a flurry of books on the subject and for a while it seemed that America might acquire a serious industrial policy of its own (which never happened). But Japan remains much more relevant to America’s situation than China—which everyone is now obsessing about—simply because Japan has wages comparable to the U.S., while China competes largely on the basis of a low-wage policy that is impossible for any developed nation to emulate. So it is worth examining Japan’s trade history.

  The Japanese themselves certainly believe their economic success has been due to protectionism. No one in Japan of any standing in business, government, or academe believes that Japan’s success has been due to free trade. In the words of economic historian Kozo Yamamura:

  Protection from foreign competition was probably the most important incentive to domestic development that the Japanese government provided. The stronger the home market cushion...the smaller the risk and the more likely the Japanese competitor was to increase capacity boldly in anticipation of demand growth. This can give the firm a strategic as well as a cost advantage over a foreign competitor operating in a different environment who must be more cautious.495

  The cultural roots of Japan’s repudiation of free trade are extraordinarily deep—as deep, say, as the roots that make America a capitalist society. This was, after all, a nation which literally sealed itself off from the outside world for two centuries (1635-1853). This act is regarded by most Westerners as merely odd, but it was, in fact, profoundly consistent with the enduring character of Japanese civilization.

  Japan’s forcible opening to the modern world in 1853, when U.S. Commodore Matthew Perry sailed his famous “black ships” into Tokyo Bay demanding
trading rights, added a new element to Japan’s existing authoritarian social order: the need for economic and technological sophistication sufficient to defend its existence as an independent nation. Japan promptly set about engaging the modern world on terms congenial to its own political priorities—not those of outsiders. The key slogan of the day was fukoku kyohei, “rich country equals strong army.” Thus private economic interests have never, except perhaps for a brief liberal moment in the 1920s, been allowed to be the primary drivers of its national economy. Instead, private interests have been subordinated to the national economic interest under a system most succinctly describable as state capitalism. And protectionism is an innate part of that system.

  Japan in 1945 was economically crushed, its cities smoking ruins, its empire gone. It was poorer even than some African nations untouched by the B-29. It seemed so far behind the United States that there was no plausible way ever to catch up. It was widely expected that Japan would end up an economic also-ran like that neighboring island chain, the Philippines. And within the economic ideology America was promoting to Japan at the time, free trade according to comparative advantage, there seemed to be no way out, as Japan had comparative advantage only in low-value industries.

  History records a fascinating exchange on this topic, which encapsulates the entire postwar free trade debate. In 1955, when the U.S. and Japan were negotiating their first post-occupation trade agreement, the head of the American delegation, C. Thayer White, told the Japanese to cut their tariff on imported cars because, in his words: 496

  1. The United States industry is the largest and most efficient in the world.

  2. The industry is strongly in favor of expanding the opportunities for world trade.

  3. Its access to foreign markets in recent years has been limited by import controls.

  4. Although the United States Government appreciates that it is necessary for some countries to impose import restrictions for balance of payments reasons...it would be in Japan’s interest to import automobiles from the United States and export items in which Japan could excel.

  Upon Ricardian principles, White was, of course, 100 percent correct. But the Japanese trade negotiator, Kenichi Otabe, replied that:

  1. If the theory of international trade were pursued to its ultimate conclusion, the United States would specialize in the production of automobiles and Japan in the production of tuna.

  2. Such a division of labor does not take place...because each government encourages and protects those industries which it believes important for reasons of national policy.

  Needless to say, Japan did not choose to become a nation of fishing villages! Instead, its rulers drew the same conclusion that Alexander Hamilton had drawn 150 years earlier and Henry VII 300 years before that, opting for protectionism and industrial policy. They closed Japan’s markets to foreigners in industries they wished to enter, only welcoming foreign goods insofar as they helped build up Japan’s own industries. They applied administrative guidance to key industries and rigged Japan’s banking system and stock market to provide cheap capital to industry.497 Tokyo instead protected its then-fledgling automobile industry in the 1950s, limiting imports to $500,000 per year. (In the 1960s, prohibitive tariffs replaced this quota.) Japan only allowed foreign investment insofar as this transferred technology to its own manufacturers. Today, it produces over two-and-a-half times as many cars as the U.S., mostly for export.498

  As Japan has historically been the economic leader for the whole of Confucian Asia499 (Japan, Korea, China, Taiwan, Vietnam, Hong Kong, and Singapore), its protectionist policies have been shared with nearby nations to a huge extent. The ultimate basis of these policies is an attitude towards economics that sees the economy not as an end in itself, but as an instrument of national power. (See the William Cunningham quote in Chapter 6 for a reminder of how this attitude used to be the norm even in the Western world.) As Harvard Asia specialists Roy Hofheinz and Kent Calder have written, “For more than a century, nationalist sentiments…have been a basic driving force underlying East Asian economic growth.”500 Even today, Chinese industry is 30 percent owned by the state.501 Over a dozen strategic industries have been slated to remain under outright government ownership and control, including information technology, telecommunications, shipping, civil aviation and steel.502 Laissez faire this is not.

  In relation to its neighbors, Japan has employed something called the “flying geese” strategy, christened thus by the Japanese economist Akamatsu Kaname in the 1930s.503 Japan breaks into an industry, wipes out existing Western competitors, then successively hands the industry down to less sophisticated neighboring economies such as Korea, Taiwan, Thailand, Malaysia, and Vietnam as they mature. This pattern has held for goods from garments to televisions for five decades. Japan’s withdrawal from labor-intensive goods in the 1970s opened up space for Taiwan, South Korea, Singapore, and Hong Kong, and their ongoing withdrawal from these goods is opening up space for China. Among other things, this nicely illustrates how rational protectionism is a dynamic, not a static, strategy, and does not consist in defending every job and every industry.

  Chapter 7

  The Negligible Benefits of Free Trade

  Having looked at the profound theoretical and historical reasons to doubt that free trade is the best policy, let’s try some quantification of what benefits America and other nations are really likely to get from the current agenda to relentlessly expand it. Because the surprising news here is that even the calculations of free traders themselves indicate that the benefits of expanding free trade (if they even are net benefits, which is precisely what is in dispute) are very small. Indeed, this is what Paul Krugman, a self-professed free trader despite his trenchant criticisms, has referred to as the “dirty little secret” of free trade.504 So even if we assume that the entire dubious edifice of free trade economics is true, there’s just not that much on the table for America—or anyone else.

  That the benefits of free trade are relatively modest should be intuitively comprehensible to anyone who thinks back to the economy America had in 1970.505 Then, imports were just over five percent of GDP, rather than the 17 percent they are now.506 Yet we somehow didn’t seem to need very many imports to have the world’s highest standard of living.507 Imports were mainly a matter of oil, natural products that don’t grow here like bananas, luxury goods like Swiss watches, and a few odds and ends like Volkswagens. This rather suggests that the benefits of free trade are at best a layer of icing on our economic cake, not a fundamental basis (let alone the fundamental basis, a ridiculous claim that gets made all the time) of our standard of living.

  The benefits of free trade are especially dubious in the long run because although we have become dependent upon many imported products and could not switch back to domestic production overnight, we could certainly do so over time. This is not some countercultural vision of the simple life or of voluntarily accepting a lower living standard: it just means going back to lower import levels. It does not mean the end of consumer society or anything like it. It does not even mean going back to the living standards of earlier decades, as our living standards without free trade (not without trade) would be much higher, due to economic and technological growth in the intervening years.

  Above all, the U.S. has virtually nothing to gain from pushing even further in the direction of free trade. Our government actually knows this perfectly well. The U.S. International Trade Commission periodically releases an official report, The Economic Effects of Significant U.S. Import Restraints, which recently put the gain from eliminating all remaining American trade barriers at $3.7 billion dollars.508 This is just over two one-hundredths of one percent of GDP—about what Americans spend on Halloween and Easter candy every year.509 That in itself is an irony, as about a quarter of these gains consist in cheaper sugar if the U.S. ends its (admittedly pointless) sugar import quota.510

  SMALL GAINS FOR THE REST OF THE WORLD

  Expanding free trade
doesn’t do much for the rest of the world, either. Generally accepted estimates of the likely benefits of further trade liberalization have, in fact, been going down for years as various criticisms of free-trade economics have started to tell.511 For example, in the run-up to the 2003 World Trade Organization negotiations in Cancun, Mexico, the most widely quoted figure for gains from further trade liberalization was $500 billion.512 And that was for the developing world alone, with more as gravy for the industrialized nations. But only two years later, at the next round of talks in Hong Kong, with revised economic models, there were few estimates over $100 billion: a drop of 75 percent!513 Many estimates were even lower. And 85 percent of the expected benefits to developed nations were slated to go to Europe, Japan, Korea, Taiwan, Hong Kong, and Singapore.514 The U.S. and Canada were destined for very small shares because their economies were already so open.

  The two most important models for generating these estimates are the Global Trade Analysis Project (GTAP) model, maintained at Purdue University in Indiana, and the LINKAGE model, maintained by the World Bank in Washington.515 The declining estimates generated by these models can be clearly seen in the table below: