The Logic of Trade

Why trade to begin with? Why not produce what you need at home and preserve jobs in the process? There is an economic logic to trade, and that’s one of the reasons why it’s not all bad.

The idea that underpins international trade is the theory of comparative advantageThe theory that if people and states produce what they’re good at, and buy what they’re not, we’ll all be better off. It is the chief justification for free trade.. All of the arguments for global trade are based on this one theory. Like a lot of theories, there is evidence for it and evidence against it.

The most basic way to understand comparative advantage might be to put it this way: Make what you’re good at, and buy what you’re not good at. On a purely personal level, this should be easy to understand. We’re not all equally good at everything. Let’s say you major in accounting at college, and become proficient. You pass your CPA exam, and get a good job with a firm or even go out and start your own firm. One of things that will happen is that you will spend a lot of time at work as well as making a living wage. Your time is about to become more valuable. So, when you were a starving college student, perhaps you changed the oil in your car yourself because you could do it and save the money you would have spent at Minute Monkey or some other local oil change business. But, comparatively speaking, as a successful CPA, in some ways it makes more sense to pay a nearby mechanic to change your oil, because he’s better and faster at it than you are and your time is really better spent on a client’s tax return, or better spent just not working.

That’s comparative advantage: Do what you’re good at, and pay somebody else to do the other stuff. This translates to national economies as well. In the classic hypothetical situation, we have a two-person economy consisting of Bob and Carly.

Figure 10.2 [To Come] Comparative Advantage with Broccoli and Cabbage

This economy consists of two commodities: broccoli and cabbage. Now Bob can produce two broccoli and three cabbages in a given time period, whereas the ever-resourceful Carly can produce three broccoli and five cabbages. So, at first glance, things don’t look good for Bob. But under the theory of comparative advantage, Carly should make cabbages and Bob should produce broccoli. Why? Whereas Carly has an absolute advantage in both products, she stands to gain the most by making cabbages. She gives up more by producing broccoli. Bob thus should make broccoli, because he gives up less to do so. He thereby has a comparative advantage in broccoli.

There are clear examples where this is true. It would be possible to grow citrus fruit in Canada, perhaps in heavily climate-controlled greenhouses. But it would be very expensive fruit. Better for Canada to grow trees and produce lumber, and leave oranges to Florida, Mexico and Brazil. Nobody argues with this kind of comparative advantage, rooted as it is in geography and climate.

But in fact most trade is in similar kinds of goods, such as automobiles and parts, aircraft and parts, heavy equipment and raw materials. Rich nations trade with other more often than anybody trades with poor nations. Canada remains the United States’ biggest trading partner, and among the biggest category of what we trade with each other is automobiles and parts, which are produced in abundance on both sides of the border.

And even then, trade gets tricky. Softwood trees such as spruce, pine and hemlock grow well on both sides of the border, and despite their generally rosy relationship, the U.S. and Canada are frequently in dispute about softwood lumber exports. U.S. lumber producers argue that Canada’s low taxes on timber harvests constitute an unfair advantage. Canadian timber producers will argue that they need that tax break in order to compete with more productive forests south of the border. Both sides want to preserve jobs in the timber and wood products industries; both sides face lobbying pressure both from workers and business owners.

These kinds of trade disputes get even more complicated with more complicated products. Take commercial jetliners, for example. During World War II, the U.S. produced most of the Allies’ heavy bombers, which meant that U.S. firms left the war poised to seize a comparative advantage in producing large commercial aircraft. Some European firms attempted to build commercial jet transports, but they weren’t as good as the planes built by U.S. manufacturers such as Boeing, McDonnell Douglas and Lockheed. The DeHavilland Comet, the first commercial jet transport, tended to come apart in mid-air, which was not very popular with passengers or pilots.

Building commercial aircraft, however, was a point of national pride for the Europeans, as well as a potential source of jobs and a way to maintain technological and engineering skill. So firms from Great Britain, France, Germany and Spain joined to form what became known as Airbus. Airbus was heavily subsidized by the governments of the member firms—literally billions of dollars in “loans” that, apparently, will never be repaid—and Airbus was able to become competitive in the commercial jetliner market. Essentially, they pushed McDonnell Douglas and Lockheed out of that business, so that only Boeing and Airbus remained as dominant competitors in the large jetliner business. What’s important to understand here is that if you invest enough money, you can buy a comparative advantage. The theory of comparative advantage would have said that the Europeans shouldn’t build jets, and the Japanese shouldn’t build cars, and the Chinese shouldn’t be building anything. Theory, however, provides few jobs and pays no taxes.

It doesn’t always work; the French once spent a lot of money trying to develop a domestic computer industry, without much success. However, the ability to buy a comparative advantage undercuts the entire theory, since making what I’m good at may depend on how much I’m willing to invest in becoming good at making it.

It should also be noted that virtually no nation has built its economic success on free trade. The U.S. and Europe built up their economies in the 1800s in large part via protectionism—limits on imports while trying to maximize exports to other countries, while protecting jobs and profits in domestic industries. The roaring success stories of the last half century—Japan, South Korea, Taiwan, Hong Kong and Singapore—pretty much did the same thing. To a lesser extent, China has practiced the same approach to trade and economic development.

Pro-free trade economists would argue that if other governments want to subsidize the heck out of their products, we should sit back and enjoy the lower prices. This, however, creates the Wal-Mart conundrum. Wal-Mart, which gets about 80 percent of what it sells from China, is in fact a very efficient firm that offers lower prices on many products. However, it also pays very low wages and offers few affordable benefits to the majority of its employees. Wal-Mart has even gone to so far as to coach their employees on how to apply for public assistance, because many of them earn so little they qualify for some kinds of welfare benefits. So, to some extent, the lower prices are offset by the low wages. Low prices are of limited consolation if you’re not making any money to begin with.

The Case Against Trade

There are a number of arguments against trade, not all of which make sense, but which are worth considering:

It promotes low wages. This is true domestically, since if a factory threatens to move overseas, it’s usually in pursuit of lower wages. However, while workers overseas are making less than their American or European counterparts, they’re probably making more than they were before, or they wouldn’t have taken those jobs. So in other countries it may force wages up. Meanwhile, workers in the countries which lost the jobs typically don’t make as much as they did in their old jobs.

It promotes poor working conditions. This much seems to be true. The wages in overseas factories in nations such as China are generally good by local standards. However the working conditions can be terrible—long hours, no overtime, dangerous conditions. In fact, it looks a lot like factory conditions in Europe and America in the late 19th and early 20th century, conditions that were only addressed through extraordinary political efforts that included legalizing unions and creating workplace safety laws. Chinese workers frequently are unionized, but like non-communist Chinese political parties, they are powerless.

It costs countries jobs. There’s certainly some truth to this. The United States lost more than 800 shoe factories between 1972 and 1992, and very little clothing is made in the U.S. anymore. These were not, on the whole, highly paid jobs, but if it was your job and it walked away, this couldn’t have been much fun.

The United States in particular has been slow to do anything about lost jobs. In the 1980s, the Reagan administration had a trade assistance program for people who lost their jobs due to trade, but it was nearly impossible to qualify for and helped very few people. Only recently has government stepped up to try to help people who need to be retrained for new work. Nonetheless, in general, the jobs that people find after trade displacement don’t pay as well as the jobs they lost. On the other hand, there’s also a structural problem that has little to do with trade: Manufacturing employment has been falling worldwide for decades—it simply takes fewer people to make a widget than it used to.

The infant industry argument: To get an industry going, it may be necessary to protect it from competition until it gets on its feet. The evidence is not good that this works, however; only Harley-Davidson, among major American companies, has successfully used protective measures to recover from a down period and become profitable again.

The strategic industry argument: Without protection of vital national industries, a nation may lose capacity in important sectors such as shipping and shipbuilding. For a nation that sees itself as having global interests, such as the United States, this has to be a serious concern.

Similarly, some economists argue that nations should not do so much to protect domestic agriculture, probably the most protected sector in the global economy. Much to the frustration of poorer countries whose economies are still heavily dependent on agriculture, richer nations still erect substantial barriers to trade in food and agricultural products. Part of that is because farmers are usually politically influential—farm-region and farm-state legislators tend to be cohesive and focused on farm issues, and basically nobody hates farmers. It’s hard to dislike someone whose job is growing food. But perhaps more importantly, a nation that couldn’t feed itself would be vulnerable to any kind of interruption in trade—either war or natural disaster. Allowing one’s food domestic food supply to wither away, strategically speaking, is pretty much like putting a gun to your own head.

Overspecialization could leave a nation’s economy vulnerable to downturns in a particular sector. This has been especially true for nations that have relied on a particular industry, such as nations whose foreign earnings depend on sales raw materials, such as minerals such as tin or copper. If copper prices fall, you’re in trouble.

Nations who let their industries wander away to other countries also lose technological expertise and industrial infrastructure that makes it harder for them to participate in the next big thing, whatever that might be. As with food, disruptions in supply could then mean difficulty in acquiring products that people want.

Dumping: An exporting nation could engage in dumping—selling goods at below cost to drive competitors out of business. There’s some evidence that this happened with Japan and television sets in the United States. There’s less evidence in other industries, such as steel. What’s also apparent is that U.S. firms failed to build on their comparative advantage in many industries after World War II. They got greedy, and didn’t push their advantage with new technology and more innovative ways to pay workers to get wages to reflect actual costs and profits.

Environmental damage: This could be the single biggest argument against unfettered trade. For example, in the United States, the next bite of food you take traveled an average of 1,500 miles to get your plate. The pollution generated by transporting stuff around the world that could be produced closer to home—such as manhole covers from India to the West Coast of the U.S.—is one of the leading sources of greenhouse gases, which appear to be the main source of climate change. More about that later. Trade also can result in localized environmental degradation, such as cutting down tropical hardwood forests to produce chopsticks for the U.S. and Asia.

The Political Dimension of Trade

In terms of politics, nations are faced with conflicting demands. On the one hand, trade has helped economies grow and lifted more people around the world out of poverty. Domestic political interests push for both more trade—such as firms that export a lot—and for less trade, such as firms that must compete with foreign producers, and also labor groups who hope to see their members continue to have jobs.

This has led to an ongoing movement for fair tradeTrade, often involving commodities such as coffee, in which buyers agree to pay a higher price to support growers in other places., which usually means that the foreign producer has been fairly treated and paid. So, if you buy certified fair trade coffee, the grower in Burundi or Costa Rica is supposed to have been paid a better-than-market price for his crop. The market price is the price per pound currently being offered on world coffee markets, and markets don’t much care if you’re in the poorhouse or a millionaire. In commodities markets, such as wheat and coffee, the crop is worth what somebody is willing to pay for it, and not a dime more.

So governments around the world face conflicting demands when it comes to trade. To date, free trade advocates have been winning, despite widespread citizen protests against trade and globalization. Remember Sell’s First Law of Political Economy: The decision is made in the direction of the greatest value. Usually that’s money. So if increased trade makes somebody richer, the interest groups that represent those people will successful pressure government to keep trade barriers down. Governments have the idea of liberal commercialism on their side, so that makes it easier to accept the idea that more free trade will be better for everybody. And once free trade is established, the cost of reversing it gets added to the balance sheet. Limiting imports and thereby raising their prices won’t be any more popular than watching jobs get shipped overseas.

Trade Deficits and Currency Exchange

The one trade issue about which you shouldn’t lose any sleep is the trade deficit. If a nation exports more than it imports, it has a surplus. If it imports more than it exports, it has a deficit. The United States has run a trade deficit since the 1960s. If, personally, you had in essence spent more than you earned over the last 50 years, you would either be broke or heavily in debt, and maybe both. However the U.S. trade deficit is in fact a tiny portion of the U.S. economy and hence not a major issue.

For example, in 2010 the total size of the economy was $14.6 trillion. The total trade deficit was $497.9 billion. That’s about 3 percent of the total economy. We run a trade deficit in goods, which is partially offset by a surplus in services and by earnings of U.S. firms from overseas operations.

Left alone, this situation will resolve itself. Ultimately a U.S. trade deficit forces the value of the dollar down. Our trading partners end up holding more dollars than they know what to do with, and that surplus of dollars means they are worth less. Money is a commodity like any other. Meanwhile, the currency of the nation with the trade surplus gains in value, since there’s a higher demand for that currency from nations who want to buy that country’s goods and services. Those shifting currency values, by themselves, would address trade imbalances. For the nation with a weaker currency, imports become more expensive since it takes more dollars to acquire the equivalent amount of yen or euros. Exports, meanwhile, become cheaper for foreign buyers, since they need fewer euros to get the right amount of dollars. So exporting firms are helped, although consumers will see higher prices.

That’s all true if currency values are allowed to float on open markets. An issue between China and the rest of the world is that China has tended to assign its currency at a fixed exchange rate relative to the dollar and the euro, for example. As China has been running a trade surplus, the yuan would normally be rising in value against the dollar and the euro, making Chinese exports more expensive but lowering the price of imports for Chinese consumers. Why are they doing this? Because the Chinese Communist Party maintains legitimacy in part through providing continuing economic growth, and a slowdown in its export-driven economy would mean higher unemployment and more civil unrest. So the U.S. and Europe continue to push China to let the yuan float, and the Chinese keep holding back. As serious as this issue sounds, you should keep in mind that if the yuan did float, it would only address about 3 percent of the U.S. trade deficit with China.

Trade Policy Options

Presuming that we might be most concerned about the jobs issue, what should be done about trade? For much of modern history, the usual answer was tariffsA tax on imports into a country that is paid for buy consumers in that country and effectively raises the price of the imported goods., which are simply taxes on imported goods. Tariffs raise the price of imports, and make domestic goods more cost-competitive. The GATT and the WTO have largely done away with tariffs, which isn’t necessarily a good thing. When, as in the 1800s, tariffs were up to 50 percent of the price of a good, they did indeed reward inefficiency among domestic producers and make it difficult for foreign firms to compete. However a low tariff, say 2–3 percent, wouldn’t penalize or reward anybody too much, and the money could be used to help people who lost their jobs because of trade.

Truly protective tariffs, which would make imports unaffordable, are expensive. They cost a lot of money, hundreds of thousands of dollars per job for jobs, such as those at textile mills, that don’t actually pay all that well. Unfortunately, tariffs have been replaced by non-tariff barriersRegulations such as quotas and environmental and safety regulations that may restrict the quantity of goods imported into a given country., which still make products more expensive but don’t produce any revenue. In short, they leave consumers holding the bill.

Non-tariff barriers include quotas, which are limits on the number of units that can be shipped into the importing country. U.S. steel firms, which emerged from World War II with a comparative advantage over the rest of the world, failed then to invest in new products and processes and so fell behind Europe and Japan. Producers in Europe and Japan, having been destroyed by the war, were forced to build new mills with the latest technology. U.S. firms responded by getting quotas on steel imports. Foreign steel makers responded by moving into specialty steel, where U.S. firms had previously held an advantage, and so they lost that business too. American steel manufacturers have limped into the 21st century after dominating the 20th.

Another form of non-tariff barriers include health and safety requirements. The Japanese protected that country’s tiny and nearly sacred apple industry safe from competition with U.S. apples by barring imports for fear of an infestation of the coddling moth, which can in fact devastate orchards. It wasn’t until U.S. producers shipped apples packed in nitrogen gas—so that no pests could live—that the Japanese finally opened up that market. The Japanese did the same with various arcane measurements on automobiles, contending that U.S. cars were not safe. Of course, it didn’t help that Japan is a right-hand drive market, and U.S. cars exported to Japan still had the steering wheel on the left side.

A nation also could simply devalue its currency, declaring a low official exchange rate to raise the price of imports and lower the price of its own exports. This in effect is what China has done. Nations also engage in export subsidies: using various financial means to make buying your products cheaper for foreign customers. The U.S. uses the Export-Import Bank to make loans to buyers of U.S. products, particularly Boeing aircraft. Finally, nations rely on domestic content legislation: Laws that dictate that a given product will have so much “domestic content,” that is material or parts that come from the importing nation. Sometimes also called offset agreements—we’ll buy your jets if you buy enough parts from us—these are supposed to be outlawed under the WTO. And if you believe this, I’d like to sell you your neighbor’s car. He said it would be OK. Honest.

In fact, the WTO is supposed to address all these kinds of barriers, but as we’ve seen, nations have all kinds of strategic and domestic political reasons for resisting free trade when it comes to imports but being all for it when it comes to exports. For example, WTO-style free also makes it more difficult for a nation such as the U.S. to bar imports of fish that are captured in an unsustainable way. It is these kinds of environmental issues that may create the biggest political challenges of the current century.