Trade has been a part of the economic landscape throughout history and has expanded considerably with the passage of time; it has expanded greatly with the advent of better transportation technology over time. During the 19th century, trade liberalization began after the previous consensus of mercantilism, which seeks to maximize exports and minimize imports. From after World War 2, and especially in the last 40 years, trade has become much more open with the average global tariff rate at 2.59% in 2017, compared to around 40% a little before the inception of the General Agreement on Tariffs and Trade (not to mention the reduction in some non tariff barriers). Then and certainly now more than ever, there have been a great deal of misunderstandings about how trade fundamentally works, its distributional effects, as well as how it may differ from textbook models.

The Basic story

Trade in an international context (and even national context in a federal or confederated state) is the exchange of goods and services between economies. One could view immigration as the trade of labor, but that’s for a different post another time. The efficacy of and gains from trade largely hinge on the notion of comparative advantage; the idea of the a country being able to produce something at a lower opportunity cost than it’s foreign trade partner. This concept leads to the conclusion that countries ought to specialize in what they have a comparative advantage in to maximize the gains from trade. The gains from trade can be summarized as follows

• An indirect method of production, which can be more efficient than direct production
• Enlarges consumption possibilities and the variety of them

Primary Misconceptions

Equal mobility of factors

Many textbook models start with an assumption that capital and labor are equally mobile; in reality, capital is very mobile and labor isn’t (even under a world with unfettered immigration, you’d still encounter some frictions). What does this translate into? In many cases, it results in labor cost arbitrage (which isn’t inherently bad), which sometimes is predicated upon differences in environmental and safety regulations, as well as legal limitations on the ability of labor to organize.

The Pauper labor argument and exploitation

Just as much as labor cost arbitrage can be an issue, to prevent those in developing nations from trading at all because of some notion of “exploitation” would make them worse off and condemn them to be indigent if they were unable to export goods and services. Most people who push this argument use it as an excuse to push for protectionism of their favored industry.

The Trade deficit

This is easily the most widely abused term by politicians with respect to trade. At it’s core, it is a measure of the net savings vs investment of a country; part of this is reflected in intertemporal trade. The broader measure which the trade deficit is related directly to is the current account, which is the net exports and imports of goods and services plus payments to foreign investors and any other payments made to foreign entities. The trade deficit says nothing about the volume of trade, nor the contents. It also has no bearing on what the total quantity of jobs in an economy are. It does, however, have considerable impact on the composition of jobs in an economy; this is seen from the trade shocks faced by industries facing fierce import competition and the new jobs created are in export oriented industries primarily.

It should be noted that there there exists inherent trade-offs with respect to the level of the balance of payments (all of the economic transactions between all agents in an economy to the rest of the world). For example, the US Dollar currently enjoys the status of being the reserve currency in the world; this benefits the US as it’s able to borrow at lower interest rates than it may otherwise. This is because the dollar is stronger relative to other currencies, which keeps its demand as a reserve currency very high. A weaker dollar is better for exporters as goods are relatively cheaper for foreigners to purchase on the global market, but demand for the dollar as a reserve currency would decrease (as a side note, in would likely be in the best interest of the US and other countries to have some separate global reserve currency in place of the dollar, the euro, or any other currency currently used).

What is it actually caused by

Trade deficits are caused primarily by three things:

• Increased government spending if it leads to big budget deficits (I’ll explain more below)
• The currency exchange rate
• Economic growth, which leads to increased demand from higher incomes, so people purchase more imports

Trade policy doesn’t affect the trade deficit very much. To the degree that it does, there is a correlation between higher trade barriers and a larger current account deficit. To expand on the first point, a government that spends more money than it can finance through taxation must finance that spending somehow. Governments do this by borrowing from lenders on global capital markets. To this end, better fiscal discipline will reduce national borrowing, and thus the trade deficit. The 2017 Tax Cuts and Jobs Act increased the trade deficit significantly for example, because we required more borrowing from international lenders to finance the amount lost in tax revenue. National savings matter, but private savings can too; a tax code that shifts the incidence to consumption over income would encourage more savings and investment and would lower the trade deficit as long as such a reform raises aggregate private savings and has no adverse effects on the budget deficit.

Why it can be good in some circumstances

Borrowing on international markets has increased capital investment opportunities and lowered interest rates relative to what they would be in the counterfactual scenario without borrowing. An excessive surplus in a country’s capital account can lead to asset bubbles if there aren’t any productive investment opportunities, so it’s of profound importance to have prudent financial regulation to ensure that capital flows to the most productive investments. Another salient point is that there is a correlation between economic recessions and lower trade deficits, due to people facing income reductions and consuming less as a result.

All people gain from trade

Even the textbook definition doesn’t assert that trade is Pareto efficient; it is more aptly characterized as a Kaldor-Hicks improvement, which means the net gains from trade are such that if the winners of trade and globalization (the so called super star firms and earners) compensate the losers (mainly through progressive taxation to fund robust social insurance, active labor market policies, and accessible education/retraining for displaced workers). In practice, this hasn’t happened much in the United States, though other countries have pursued such policies with great success.

The trade industrial complex

All too often, certain politicians assume that any trade deal is good and liberalizes trade, but is usually only the case in name. Particularly as of late, many trade deals have less to do with lowering barriers to trade as much as they have to do with regulatory harmonization. This can potentially be a good thing, but it often manifests itself in protectionist non tariff trade barriers. For example, the new USMCA substantially increased local content requirements for automobiles and imposed an even more draconian patent protection regime. Moreover, there is a high degree of protectionism in high paying sectors like healthcare and law that hasn’t been dealt with seriously by any member of congress. The USMCA is hardly a fluke in this respect; the original TPP had terrible intellectual property provisions that would have greatly bolstered the profit of large pharmaceutical manufacturers by extending data exclusivity as well as patent and copyright protections (luckily, most of this was dealt with in the subsequent CPTPP).

It makes perfect sense to shield nascent industries

This argument typically stems from the fact that many major world economies engaged in heavy economic protectionism whilst their economies were still young and developing. The issue of making an industry flourish is one of ensuring that they can be competitive; protectionism hardly guarantees this. Instead, what must be focused on is whether firms are able to “learn in production”. To the extent that there are market failures that exist with emerging industries (such as capital constraints with venture capital firms that may fund a long run, capital intensive project, but just don’t have the funds or lack the incentives to invest in R&D), some government intervention is warranted, but not necessarily with respect to erecting a bunch of trade barriers. Irwin(2000) investigates the efficacy of high import tariffs in the US during the late 19th century, which finds that the tariffs didn’t benefit the US on net.

Domestic firms facing international competition will only face negative ramifications

It is true that there can be considerable labor market shocks due to increased import competition. For example, the United States began Permanent Normal Trade Relations with China (PNTR) in the year 2000. It had a larger labor market impact than a number of economists thought, leading to around 2 million jobs being lost due to reduced demand for domestic domestic industries between 1995-2011 (see Feenstra, Sasahara 2017). However, during the same period, 6.6 million jobs were created from growth in US exports; around 4.1 million of these were from the service sector and a third of those were from intermediate demand from goods exports. In fact, the China shock increased the net labor demand in the United States. There is also strong evidence that import competition from China forced US manufacturers to become more efficient and the average total factor productivity rose in manufacturing, due to the closing of more unproductive plants and the opening of more efficient ones (Davis, et all 2013).

The pain felt by workers in the manufacturing sector was real and cannot be ignored. Their suffering was due to a lackluster public policy response; the US did not make any necessary adjustments in becoming a more open economy as some other small open economies did. Some of specific steps I think need to be taken were touched on above with respect to my comments on the misnomer that everyone gains from trade, but I’ll go into greater detail in a future post. Trade will always make consumers better off, but not necessarily workers in firms in industries that are hit hard by import competition.

A final point that has been especially underscored in the latest bout of protectionism in the form of Trump’s capricious tariffs is that often times, domestic manufacturing firms make use of intermediate inputs made from abroad and the availability of those cheaper inputs allows them to be more competitive with other foreign firms they directly compete with. The productivity gains of firms in economies that have reduced trade barriers on inputs is substantial and notably larger than that seen from the reduction in output tariffs (Amiti, Konings 2007).

Moving forward

I intend on making another post about the state of trade policy throughout US history and necessary improvements that must be made. Trade has the potential to be a boon to all people, but our current trade regime isn’t conducive to making that happen and reform must happen to quell the red tide of rancor and anti-globalization populism.