The U.S. Should Limit the Global Free Trade System

by: Ken Monahan

Whenever everybody in the US political sphere agrees on something, my instinct is to oppose it simply so there is opposition. The one thing the Bush and Obama administrations have in common (aside from their fondness for massive deficit spending) is their assertion that the maintenance of the global free trade system is essential for American prosperity. One of my favourite mantras from my time at the University of Chicago was: “If someone asserts it, deny it. If someone denies it, assert it.” So, I am going to deny the assertion that free trade is currently the optimal policy for the United States.

First, let’s remember the origin of the free trade system. Its original motivation was political/military rather than economic. World War II was a massive human tragedy which killed something like 3 % of the human population in just under ten years. For the American economy, however, this tragedy had a silver, or rather gold, lining: it was a war of annihilation between America’s main economic competitors. The war destroyed the industrial capacity of the Axis Powers and severely disrupted that of Central Europe and Soviet Russia. At the end of the war the United States was the only power in the world with an unimpaired industrial plant and as a result in 1945 the US accounted for nearly 50% of world GDP.

Despite its economic supremacy, America faced a severe political/military challenge from the Soviet Union. The Red Army had just crushed the Wermacht and was positioned in the Center of Europe and invaded Northern China near the end of the war. Americas grand strategy was to contain the Soviet Union with a ring of alliances that stretched around the periphery of the Russian empire. Unfortunately the allies who composed this ring were the battered former Axis powers and the supine allied European states.

America needed to revive the economies of the Western Alliance if the containment strategy were to succeed so it came up with a global economic plan with several features. The first was a massive influx of aid in the form of the now famous Marshall Plan. The second was the establishment of a stable foreign exchange regime which would simplify trade through the Bretton Woods agreements. Finally was the establishment of a trade liberalization regime under the General Agreement on Tariffs and Trade, or GATT, which became what we now know as the WTO. The first round held in Geneva in 1947 eliminated or reduced 45,000 tariffs. Subsequent rounds made great strides in bringing down tariff barriers all over the world. While the GATT was a multilateral organization, the fact that America was the only intact market on the planet meant that it’s most salient feature was granting more or less open access to the American consumer for our allies in the struggle against the Soviet Union.

The plan worked like a charm. Between 1948 and 1953 world trade grew by 40%. By 1963 the total volume of world trade was three times what it was before the war and twice its previous all time high. By 1971 it was six times what it had been in 1935. This is an extremely important point, the creation of the GATT system ended the generally mercantilist regime that predated the World Wars and international trade exploded as never before in human history. This channelled massive amounts of wealth to the various trading partners that would not have been possible without it and enabled a rapid recovery from the devastation of the war.

By the end of the Cold War in 1989, Germany had the same share of world GDP that it had before the war and Japan had twice as large a share. America and its allies presented an economic, military, and political challenge to the Soviet Union that it could not overcome and it collapsed after a failed coup attempt in 1991. Mission accomplished, well and truly.

After its victory America, confident in its permanent supremacy, kept the global free trade regime open. Indeed it expanded it, bringing in its erstwhile opponents Russia in 1993 and China in 2001. The maintenance of this free trade regime after the end of the cold war has arguably had an even greater effect on the world than it did during the cold war itself. By enabling China and India to access the US consumer on a level playing field the global free trade system has helped to bring 400 million people out of poverty in the last 20 years. This is a reduction of human misery that has been without precedent. It has made the world economy as a whole more efficient and raised world GDP by a substantial amount. The huge American trade deficits have been a massive subsidy to the rest of the world particularly China.

To get a sense of how important this is to China, you have to look through the numbers a little. In 2006 the Chinese trade surplus with the US was around $250 billion and Chinese nominal GDP was around $3 trillion (I use nominal rather than PPP because we are talking about international trade rather than domestic consumption.) So the Chinese trade surplus with the US in 2006 was 12% of the entire Chinese economy.

This overstates the case somewhat because China has trade deficits with countries which supply it with raw materials but in turn those deficits are driven by and more than financed by the surplus with America. Considering that an additional 40% of the Chinese economy is investment which is largely export oriented the impact of the global free trade regime accounts for nearly half of the Chinese economy. These are just numbers, what this has meant in the quality of life for hundreds of millions of people cannot be overstated or really understood unless you go to China and see if for yourself. It is truly mind boggling.

So how has it been working out for the country at the center of the system? This is a complicated question and it comes with a complicated answer. From the perspective of the American consumer this has been awesome. The global economy is much more efficient and the increasing globalization and the addition of hundreds of millions of new workers to the global trading system has kept down the prices of labor intensive products. In the immediate post-war era Americans got used to consuming at a level commensurate with a country which was producing 50% of the worlds GDP. As America’s share of GDP has declined the American people have been reluctant to reduce their consumption. And they haven’t had to because America’s trading partners have been willing to lend their surpluses back to America in order to finance yet more consumption. Yep, from the perspective of the consumer it seems like a good deal all around.

So how is it working out for the American worker? This is kind of a mixed bag. From the perspective of the American knowledge worker it’s working out quite nicely. People in the intellectual capital intensive businesses can farm out of the labor intensive aspects of their business to China for manufacturing or to India for services where the labor costs are much lower. For unskilled and semi-skilled Americans this has been a disaster. They are now forced to compete with the 400 million other semi-skilled workers in the global trading system and this has been pushing wages down. Here in the future the global market clearing price for a year of work in a factory as a semi-skilled worker is somewhere in the neighbourhood of $8,000 per year. Naturally this is not enough to sustain an American lifestyle which is why, as mentioned above, the American lifestyle is increasingly debt financed.

You can hear the echo of the global free trade system whenever Americans bemoan the problems with the economy.

  • “Wages for working Americans have been stagnant for 20 years;” this is because American workers are competing with another 400 million people that were not in the system 20 years ago.
  • “The divide between the rich and the poor is getting wider;” the rich benefit from lower prices and the ability to tap cheaper foreign labor which increases their earnings, the unskilled now have to compete with that foreign labor which decreases their earnings.
  • “The post housing bubble unemployment seems to be structural not cyclical;” many semi-skilled workers who’s manufacturing jobs moved abroad went into construction, now that the housing boom is over there is not much manufacturing for them to return to so they are structurally unemployed.
  • “The stimulus package is not working;” the stimulus package was designed to generate consumption; much of what we consume is produced abroad so much of the stimulus money was ultimately siphoned off by our trading partners.
  • “This recovery is anaemic and not creating enough jobs;” Q2 GDP was revised down from 2.4% to 1.6% because of the trade deficit was larger than expected. 0.8% of American GDP is $110 billion or about as much GDP as would employ 1.1 million people. The recovery is creating jobs, but in our trading partners, not here.

Yep, there it is beneath the surface, the global free trading system the US built up is causing serious problems for the US worker.

So given that so many of the problems which confront policymakers are linked directly or indirectly to American support for the free trade system why is protectionism not gaining more supporters. I think I know. It’s a unique psychosis that I will call “Smoot-o-phobia.” In 1930, partially as an attempt to raise revenue and partially in an effort to shield American workers from foreign competition, Congress passed the Smoot-Hawley Tariff Act. This raised tariffs on imports to the highest level ever and touched off a trade war as our trading partners retaliated with tariffs of their own. World trade collapsed fell 40% from 1930-1933. The Smoot-o-phobes believe that the Smoot Hawley tariff caused this collapse in world trade and which deepened and lengthened the great depression and therefore they believe that the last thing we should do in the middle of a recession is tamper with the global trading system.

I think this argument is nonsense for two reasons. First, though I have a degree in economics I will be the first to agree with my friends from the physical sciences who called economics a social “science.” That is to say, it is not exact. It is very hard to separate causal and coincident factors in explaining a phenomenon. It may well be that the Smoot-o-phobes are onto something with their theory but I would argue that the collapse of the global banking system was a much more powerful factor. As evidence of this I point to the recent credit crisis. Between 1930 and 1931 in the immediate aftermath of Smoot world trade fell by about 28%, between 2008 and 2009 world trade fell by 24% without any additional trade restrictions. Could it be that the greater factor was the collapse of credit rather than the imposition of tariffs?

The second reason is that the position of America in the global trading system in 2010 is completely the opposite of what it was in 1930. The American position in 1930 was analogous to the position of China today, it was the source of most of the worlds spare industrial capacity and a net exporter both of finished goods and raw materials. As such it had a lot to fear from a trade war because its trade balance was a positive contributor to GDP so it really was a Congressional miscalculation (one of many I’m afraid) to pass the Smoot Hawley bill. Here in the future the US is not only not a net exporter, it is running the largest and most persistent trade deficit in the history of the world. If world trade were set to zero tomorrow the GDP would INCREASE, we LOSE money to world trade. I think the Smoot-o-phobia which infects American policymakers is purely psycho-somatic.

Now that I have made my argument I think it is equally important for me to point out what I am not arguing. I am not arguing that limiting the global free trade system is the globally optimal solution. It is not. But it does not matter what is globally optimal, it matters what is optimal for the people who are in control of the largest consumption based economy in the world, namely: Americans. The only way for another country to limit American power over the trading system or to mitigate the effects of American protectism would be for that country to create a similarly consumption oriented economy, something which no one seems willing to do.

I am also not arguing that the limitation should be total. It should be just enough to mitigate or negate the labor cost advantage of the lower cost countries. Ordinarily this would happen over time with exchange rate adjustments but some of our trading partners are committed to maintaining a fixed exchange rate with the US dollar.

I am also not arguing that this would be costless. There would be increased inefficency in the US economy. The evaporation of our trading partners surpluses would also limit the avaliabilty of credit to the American consumer and the American government. I don't think this is bad thing because I think that is coming sooner or later. I simply think that the US would rather be in control of the timing and duration of that credit contraction rather than the bond vigilantes. Taking advance action like this would give the government the initiative.

What’s the cure for Smoot-o-phobia? That’s a complicated question but it comes with a simple answer: elections. The American consumer who benefits from the global free trade system and the American worker who is getting his head caved in by it are the same guys. At this stage of the game Americans need to do a lot more working and a lot less consuming in order to pay back all the money they borrowed over the past 30 years. In order to do this more effectively they need to negate the labor cost advantages of low cost countries which have enjoyed unfettered access to the American market for the past 20 years. To do that they need to place limits on the international trading system.

Lucky for them in addition to being the American consumer/workers these folks are also the American electorate and as such they are in control of the government most responsible for the maintenance of the international trading system. They can therefore vote in people who are in favour of limiting it. As the recession goes on and employment does not recover because the international trading system is limiting the capacity of traditional measures to revive the economy the Smoot-o-phobic arguments are going to fall on increasingly deaf ears and protectionist candidates will begin to win elections. You heard it here first.

Disclosure: No stocks mentioned