Free Trade Doesn't Work

by Ian Fletcher

  Is this situation likely to improve? Unfortunately, it is almost certainly on track to get even worse in the next few years because the U.S., the great global underwriter of free trade, is now being forced by economic crisis into the same sorts of illegal subsidies that other nations have long employed. The 2008-2009 bailout of the U.S. auto industry, for example, was full of subsidies brazenly illegal under WTO rules.626 As a result, America is losing whatever standing it ever had to complain about such practices abroad. (Ironically, foreign subsidies were, of course, one of the things that got the U.S. auto industry into trouble in the first place.)

  The WTO-endorsed free trade loophole most harmful to the U.S. is probably Value-Added Tax or VAT. Every other major nation levies VAT, which resembles a state sales tax except that it is levied every time goods change hands on their journey from raw materials to consumer, not only when they are sold by the retailer. Because governments let businesses deduct VAT paid earlier in the supply chain, its cost is ultimately borne by the consumer. Governments rebate VAT on exported goods because their consumers are abroad and thus not the intended objects of taxation. Conversely, they levy VAT on imports because these goods have not already paid their share of the nation’s tax burden by passing through a domestic supply chain. This all makes sense, according to the logic of VAT, but it also means that when a country with VAT trades with a country without it, exports enjoy a subsidy and imports suffer a tariff. The average VAT worldwide is 15.7 percent (in the EU it averages 19.4 percent),627 so American goods face a net competitive disadvantage averaging over 30 percent. U.S. negotiators agreed to this system in 1955, when VAT was fairly rare and in the two to four percent range anyway.

  UNCLE SAM, GLOBAL SUCKER?

  If the trade agreements our government signs are so disadvantageous, why does it sign them in the first place? In large part, because it simply does not take their dangers seriously. Given its underlying assumptions about the universal benevolence of free trade, there is, of course, no reason for it to. Surprisingly, these assumptions rarely consist in outright intellectual fanaticism about the economics of free trade. That is easy enough to find in academia and the editorial pages, but quite rare in our trade negotiators and diplomatic service generally. Instead, there is a hazy sense that “economics says free trade is best” which renders our trade negotiators helpless in the face of corporate pressures for more trade agreements. This helplessness is worsened by inexperience and a lack of institutional memory about past negotiations.628 Indeed, our diplomats often have remarkably shallow knowledge of trade subjects: as Jeffrey Garten, Undersecretary of Commerce under Bill Clinton, noted in 1997, “The executive branch depends almost entirely on business for technical information regarding trade negotiations.”629

  Can business handle this role? No, because its interests do not align well with the interests of the U.S. economy as a whole. The interests of individual powerful corporations do not even align well with the interests of the U.S. business community as a whole, a fact exacerbated by the “every man for himself” mentality of American businesses abroad. (Contrast this with the notorious solidarity of, say, Japan, Inc., which plays as a team due to government pressure and financial ties between corporations.) American companies frequently bid against each other overseas, even over sensitive long-term issues such as technology transfer. Among other things, this makes them exceptionally easy for foreigners to manipulate. When, for example, Japanese companies form alliances with them, this tends to neutralize them as opponents of Japanese trade practices. In the words of distinguished former trade diplomat Clyde Prestowitz, “Once a company has got a deal with Hitachi, they become silent on those issues. Why attack your partner?”630 Similarly, American aircraft producers have been silenced about Airbus by complaints from their European customers.631

  Many of the largest American companies are now so dependent on their overseas operations, and thus so vulnerable to pressures by foreign governments, that they have become outright Trojan horses with respect to American trade policy. As former congressman Duncan Hunter (R-CA), for years one of the outstanding critics of trade giveaways in Congress, has put it, “For practical purposes, many of the multinational corporations have become Chinese corporations.”632

  When our trade negotiators work to open foreign markets, they usually do so willy-nilly, with no sense that some industries are more strategic than others. This assumption, too, is profoundly wrong, for reasons we will explore in the next chapter. Superficial attempts at hard bargaining occasionally reflect some well-organized industry that has managed to flag the attention of Congress, but are mainly just posturing. America’s trade bureaucrats have little sense of loyalty to American industry or understanding that their efforts must ultimately be judged by quantifiable success in America’s trade balances.633 One metric of our government’s sheer unseriousness about trade diplomacy is that between 1972 and 1990, fully half the American trade diplomats who left government service went to work for foreign nations.634 Imagine if this were happening with our military officers!

  America’s trade diplomacy thus leaves America naked in a world where other nations pursue the most sophisticated neomercantilist policies their bureaucrats can devise, backed up by disciplined diplomacy that puts economic objectives first. Our nakedness has, ironically, made us even more desperate in pushing for free trade: having disarmed ourselves by throwing open our markets, we desperately need to disarm everyone else by forcing their markets open, too. But we try to do this after having thrown away our principal leverage: access to our own market. We rationalize this implausible approach with the fantasy that the rest of the world “must” inevitably embrace our own laissez faire economic ideals, including free trade, due to their innate superiority, one day soon.

  Our main method of getting the rest of the world to fold its cards has, of course, been bribing foreign nations to join our vision of a rules-based global trading system under the WTO (which enjoys fanatical American support despite its anti-American actions). Unfortunately, this bribe has mainly consisted in letting foreign nations run surpluses against us. We have thus become the global buyer of last resort and the subsidizer of a system that in theory needs no subsidy because it supposedly benefits everyone.635 One irony of this is that the U.S. has been diligently working to pry open foreign markets for Japan, China, and the other neomercantilist states. (As noted in Chapter Six, Britain had precisely this problem 100 years ago.)636

  We have not even applied the above misguided strategy with systematic discipline, as we have usually treated trade as a political issue first and an economic one second. (This is the reverse of most foreign nations.) China, for example, uses the prospect of large import orders as a wedge to break up solidarity between the U.S. and Europe regarding its human rights record, which might bring trade sanctions.637 By contrast, the first Bush administration bought, to take only one example, Turkey’s support in the Gulf War with, among other things, increases in that nation’s import quotas for apparel, fabric and yarn.638 Even in peacetime, American military bases abroad have given foreign nations leverage over U.S. trade policy. This has been quintessentially true of Japan, but has also been true of Spain, Portugal, and several other nations.639 As a report by the Senate Finance Committee once put it:

  Throughout most of the postwar era, U.S. trade policy has been the orphan of U.S. foreign policy. Too often the Executive has granted trade concessions to accomplish political objectives. Rather than conducting U.S. international economic relations on sound economic and commercial principles, the executive has set trade and monetary policy in a foreign aid context. An example has been the Executive’s unwillingness to enforce U.S. trade statutes in response to foreign unfair trade practices.640

  Today, the U.S. government spends billions trying to help other nations improve their trade performance. In 2008, the Office of the United States Trade Representative spent $2.3 billion on its Aid for Trade program, and it remains official U.S. policy to be “the largest si
ngle-country provider of trade-related assistance, including development of trade-related physical infrastructure.”641 The 9/11 attacks intensified this effort; apparently what Osama really wants is to export.

  American efforts to negotiate reasonable trade agreements are handicapped by the fact that some American politicians have an unrealistic idea of international law. International law is not like ordinary civil law because there exists no sovereign to compel the obedience of nations. Instead, it is analogous to the rules of a game of stickball being played by children on a vacant lot: its rules only mean anything insofar as they are enforced by the players upon themselves. Obviously, as in the case of stickball, the players will enforce certain rules, because that is the only way they can have a game at all. So international law is not a completely vacuous concept, as some cynics suggest. But the players also won’t enforce any rule grossly to the disadvantage of any particularly powerful player. This means that the Anglo-American legal framework Americans tend to take for granted simply does not exist internationally, and therefore that a trading model based upon neutral and consistent enforcement of legal obligations is not feasible. There is no way to take power politics out of trade, which means that there is no way to leave everything in the hands of a neutral and rational free market once we construct the right international legal machinery.

  Foreign nations sometimes seem genuinely puzzled why the U.S. does not grasp the game being played. So they occasionally make the U.S. offers which we logically would accept if we did understand, offers they expect would quiet down Uncle Sam and make his politicians stop uttering bizarre complaints about “unfair” trade.642 For example, Japan in 1990 offered a deal to limit its trade surpluses to two percent of its GDP if we would stop trying to reorder Japan’s economy to solve our trade difficulties. 643 We showed no interest. Japan’s 1990 surplus with the U.S. of $41 billion almost doubled over the next 10 years. It has remained at comparable levels ever since, dipping only with recession in 2009.644

  PART III

  THE SOLUTION

  Chapter 9

  Where Does Growth Really Come From?

  If we are serious about finding and justifying an alternative to free trade, we are ultimately going to need more than the long list of negative criticisms examined so far in this book. We are ultimately going to need an alternative positive explanation of economic growth, one that doesn’t turn on 100 percent pure free markets and thus free trade. We need an explanation not just of how free trade does economies harm, but of how protectionism does them good.

  In the free trade view, growth comes from nations integrating themselves ever more tightly with the wider world economy through unconstrained imports, exports, and capital flows, enabling them to ever-better exploit their comparative advantage. But even free traders admit, in unguarded moments, that they actually have little idea where growth really comes from. This is a fatal flaw. As the aggressively pro-free-trade magazine The Economist has written:

  Economists are interested in growth. The trouble is that, even by their standards, they have been terribly ignorant about it. The depth of the ignorance has long been their best-kept secret.645

  But if free market economics is bad at explaining growth and knows it, then we really shouldn’t be taking its recommendations on how to get growth so seriously—starting with free trade.

  Economic history contradicts free-trade economics at a number of points. For example, the all-important theory of comparative advantage promotes specialization as the path to growth. Supposedly, a nation’s best move is to concentrate its factors of production on the products in which it has comparative advantage and import most everything else. (Hewing to this, the World Bank has repeatedly advised heavily indebted Third World nations to specialize in one or two crops or raw materials for export.)

  But if this theory is true, it would imply that economies should concentrate on fewer industries as they become richer. Instead, the reverse is observed. In reality, economies starting out from a primitive state tend to expand the range of products they produce as they grow.646 They only start reconcentrating when they are well past the middle-income stage and start building entrenched positions in a few sophisticated high value-added industries.647 Narrow specialization is actually a hallmark of impoverished one-crop states, colonies managed for the benefit of distant rulers, and accidental raw materials-based economies like the Gulf oil producers.

  Successful nations diversify. This is an important clue that economic growth may actually be less about comparative advantage and more about something else. Economic history, in fact, suggests that development doesn’t come from increasing specialization, that is, from focusing ever more on what one already produces well, but from learning to produce entirely new things. But something new that a nation learns to produce is, by definition, not something in which it already had comparative advantage. So Ricardian thinking is not useful here. Even if comparative advantage applies after the fact, when a nation has mastered a new industry, it cannot tell a nation today what new industries it should try to break into tomorrow or how. Ireland didn’t have any comparative advantage in IT in 1970, but this industry has been a big driver of its later growth. Same for India. There is no way this industry made sense for either nation in advance based on Ricardo.

  There is an even larger lesson here: economic growth is, by definition, a disequilibrium event, in which an old equilibrium level of output is replaced by a new and higher level.648 So the economics of equilibria, which means most of free-market economics (whose supply and demand curves intersect in equilibrium), is of little use for understanding it. That is why the quote at the beginning of this chapter cuts so extremely deep. Among other things, equilibrium economics cannot explain entrepreneurship, whose profits represent the value of creatively upsetting the existing equilibrium in an industry. Equilibrium is a useful concept for examining how things stand once the dust has settled and the economy has reached a new stable state, but it is intrinsically weak at analyzing change. This is why, when confronted with entrepreneurship and innovation, mainstream economics tends to quietly give up and reach for concepts, such as the Austrian economist Joseph Schumpeter’s (1883-1950) idea of creative destruction, that are genuinely illuminating but lie outside the formal mathematical structures of mainstream economics. And as the logic of classic equilibrium-based economics still inescapably leads to Ricardo, this ad hoc patching doesn’t lead mainstream economics to the right conclusions about trade.

  COMPARATIVE ADVANTAGE VS. LADDER EXTERNALITIES

  But if specialization according to comparative advantage isn’t the key to growth, what is? What is that “something else” mentioned above?

  Let’s start with the common observation that real-world economic growth often seems to involve a virtuous cycle, in which the upgrading of one industry causes others to upgrade and so on. This has been seen time and again in nation after nation, industry after industry.649 For example, as one industry becomes a more sophisticated consumer of inputs, it may demand that its supplier industries become more sophisticated.650 Conversely, it may enable its downstream industries to increase the sophistication of their outputs. This process then ripples through the economy and repeats.

  Crucially, some industries are better at starting this process (or keeping it going if it has already started) than others. And the free market, and thus free trade, won’t optimize this process automatically. Why? Because the value of an industry for the next step in industrial growth is often an externality, from the point-of-view of today.

  We met externalities before, in dubious assumption #2 (there are no externalities) of Chapter Five. They occur when the profits of an industry do not reflect its full economic value. In this case, this means that the industry’s present owners will not see profits that reflect its long-term ability to help the economy upgrade or break into other industries. As a result, the industry will remain underdeveloped, relative to its long-term value to the national economy, and the free market w
ill not give the optimal answer for how much of this industry the economy should contain.

  When focusing on the technological aspects of this problem, economists have called these effects “location-specific technological externalities.”651 More generically and colloquially, they have been called “ladder” externalities.

  That such externalities exist is taken as obvious by governments from Utah to Uttar Pradesh. That is why they compete to attract industries—mainly high technology—which they believe will further their economic development in a way that they don’t get excited about somebody opening a chain of convenience stores employing just as many people.

  The existence of these externalities is also taken as a given by businesses in newly industrializing nations, which is why conglomerate-like structures like the Japanese keiretsus, the Korean chaebols, and the family networks of Taiwan and Italy have played such large roles there. These structures capture ladder externalities by taking positions in related and newly emerging industries, so their profits don’t just end up in the hands of someone else.652

  Even American managers are well aware of how one industry catalyzes another, though the short-termism imposed on them by the American financial system undermines their ability to exploit this fact strategically.653 In the words of former tech CEO Richard Elkus, who has been on the boards of over a dozen companies:

  Some markets are considered more strategic than others. By targeting strategic markets, an infrastructure can be built that ensures a solid basis for economic expansion. However, the leverage is not based simply on the importance of one market over another, but rather on the assumption that, as they develop, strategic markets will become interrelated and interdependent, with the whole becoming substantially larger than the sum of its parts...Every product becomes the basis for another, and every technology becomes the stepping-stone for the next.654