International Trade: Friend or Enemy

International Trade: Friend or Enemy?

by Donald R. Davis

Department of Economics

Harvard University

I. Introduction

It is always remarkable to see people who willingly come to listen to an economist. Are these the people who visit the dentist because they enjoy having their teeth pulled, or because of the prospect of seeing someone else’s teeth pulled?

I was reminded of this by a Sprint commercial from a year back. They were introducing a new rate structure. Now, for an advertising writer, a commercial about a new rate structure is the ultimate challenge. It’s like being asked to sell lint. How in the world can you make a new rate structure exciting? Of course, their spokeswoman is the mesmerizing Candace Bergen. But even this was not enough. They needed someone to set off her tender tidbits on telephone tariffs — in short, they needed contrast. Who, they wondered, could represent boredom itself? An ensign of ennui. A maestro of monotony. Who else? — a professor of economics!

I want you to know that I intend to uphold the standards of my profession. My talk tonight is on a serious subject: international trade policy. It affects our standard of living, equity in our society and in the world, the quality of our environment, and relations with friendly nations. Recently, the longstanding US commitment to move the world toward freer trade has come under strong political and intellectual challenge. I will outline a framework within which to think about these problems. And I will argue that the US will be well-served by maintaining its commitment to a freely trading world.

My talk will have two main sections. In the first, I will present the economic case for a freely trading world. In the second, I will consider a variety of concerns or challenges to these views.

II. The Economics of International Trade

If I want to think about the reasons that countries trade, I find this easiest when I think about what I do in my own life. I consume a remarkably broad array of goods. I have an apartment, a car, a couch, clothes, and the other accessories of everyday life. In a typical week, I will eat pizza, carrots, tofu, bagels, and so on. I use a computer, a phone, a fax machine, and many other items that we have come to rely on. Yet I produce virtually none of these. What I do produce is a single service — university teaching. In short, I am a generalist in consumption, but a specialist in production. As it is with individuals, so it is with countries. Most consume a broad variety of goods, but specialize in producing a smaller set. Trade makes up the difference.

It is plain enough why we are generalists in consumption: we could subsist on porridge alone, but it wouldn’t be much fun. But why do we specialize in production? One reason is that the distribution of resources or talents is not uniform across the globe. Brazil has mountains well suited to growing coffee; Boston does not. Boston has a work force very able to write computer software; Bolivia does not. If each specializes in those areas in which there is relatively high productivity, all can be better off through exchange. This is what economists call comparative advantage. Even where there is no natural difference, though, there may be advantages to focusing on a few activities, becoming very proficient at them, and exchanging for the remainder. This would be an example of (dynamic) increasing returns to scale. Together, comparative advantage and increasing returns to scale provide the two reasons that countries might gain from specializing in production, and trade.

So far, we have seen that countries, by specializing, can produce more of everything. Thus it is possible to make all countries better off. Is this guaranteed to happen? Unfortunately, no. The idea that trade makes both better off relies on an important assumption: that the prices we pay in the market reflect not only our private, but also the true social costs and benefits of our decisions. But this need not always be the case. Note two important exceptions. The first is if there is some monopoly power — like AT&T before its breakup. Exercise of the monopoly power introduces a wedge between the price and the true marginal costs of an activity. In such cases, we typically undertake too little of the associated activity. The second exception is if there are externalities. This occurs when the choice of one person affects the welfare of others directly, unmediated by the price mechanism. An example of a negative externality is pollution that darkens our skies, yet earns profits for the polluter. An example of a positive externality is when R&D investments by one firm produce knowledge that benefits other firms, even though they don’t have to pay for it. Our conclusion, then, is that trade typically yields mutual gains. But we also have to be aware of the potential exceptions of monopoly power and externalities, and consider what remedy, if any, is required.

Within the economics profession, one proposition would command a breadth of support attained by no other: the idea that individual countries and the world benefit from free trade. This might be surprising, given that I have just identified two reasons why laissez faire is inadequate. So further explanation is needed. First: free trade is not laissez faire. In principle, one can believe that monopoly power and externalities are pervasive, or that for reasons of equity the government should make major interventions, and still favor free trade. This relies on what economists call the Principle of Targeting: the least cost way to eliminate a distortion is to go directly to the source of the problem. The point is that trade interventions are typically the third or fourth best way to achieve a given objective, because something else is typically the source of the problem. For example, pollution is best addressed by taxing the act of polluting rather than taxing trade in goods produced with pollution as a byproduct.

There is one type of case in which this is not correct — in which the tariff is the optimal instrument to raise national welfare. This occurs when a country uses tariffs to improve its terms of trade by exploiting national monopoly power in particular goods. However, an important point must be made: in this case, the gain to one country must come directly at the expense of another. Not only this, but the gainer gains less than the loser loses, leaving the world as a whole worse off. And this is the best case that we can make for use of the tariff! The case for trade intervention becomes worse when you think of the policies actually implemented. They represent a hodgepodge of special favors that lower our incomes, raise our prices and reduce the quality of the goods we purchase. An example is what is known as the Multi-Fibre Arrangement. This is a global system of quotas restricting the access of less developed countries to our market for textiles and apparel. The Institute for International Economics estimates that in 1990 this one intervention cost the typical family of four in the US $400, for a total of $24 billion. In the same year, quotas on the import of sugar cost consumers nearly $600 million — at the same time enriching a tiny number of US sugar producers. Where influence is for sale, you can expect that interventionist trade policies — however they may be peddled — will reflect money rather than the national interest.

Moreover, some policies defy reason. An example is “dumping.” This has become a very important instrument of trade policy in recent years, so is worth thinking about. “Dumping” is when foreigners charge us a price lower than we think they should. Now, you have to let that sink in. I have personally never complained about a merchant undercharging me. But with dumping, it is an offense to charge us too little for their goods, a crime if they give them away free, and an abomination if they pay us to take them. The punishment is that they have to raise their prices! — one that domestic producers, understandably, consider quite cozy. These have emphasized the costs associated with an individual country pursuing a protectionist trade policy. Perhaps more important, though, is the realization that as we close our markets to foreigners, they are likely to reply in kind. And both are likely to lose in the end. We would not think of cutting up our own country, so that goods are taxed as they cross state lines. Our Constitution prohibits it. It is no more sensible to cut the world up into little markets, ignoring the potential gains from specialization.

The economist’s case for free trade, then, can be summed up in a few lines. It yields higher incomes, lower prices, greater variety, and better quality. Actual trade policy is largely a sop to monied interests. Moreover, trade intervention is an aggressive act — it can raise one country’s welfare only by imposing a more than proportional loss to others. They are unlikely to accept this passively, and symmetric protection is likely to be worse for all. Finally, remember that the case for free trade is not the same thing as a call for laissez faire. One can believe that there are a lot of evils that require government intervention to correct. The point is that trade policy will virtually never be the appropriate way to address these problems.


III. Challenges to Free Trade

The picture that I have painted of free international trade is bound to strike you as excessively rosy. After all, trade is a national anxiety. When the trade deficit goes up, Laura Tyson frets, Mickey Kantor sweats, and Bill Clinton fails to re-elect. On Larry King Live!, Ross Perot shrills that Mexico is a mammoth void, sucking up native jobs. And if the trade deficit with Japan goes up, the professional worriers see an ambush, with the White-hatted Americans riding unarmed into a Kurosawa maelstrom. And this ignores the detrimental effects on wages, equity, the environment, and democracy itself!

So, am I here to tell you that all of these concerns are misplaced? No — only most of them. Let us start with the single statistic that you are most likely to hear recited on the nightly news — the trade deficit. Let me start with a heretical question: Are trade deficits bad? What exactly is a trade deficit? Simply enough, it is when we import more than we export, or equivalently, when we consume more than our income. Now, if the rest of the world would be so kind as to let us do this forever, then things really would be rosy! And the larger the deficits the better! But, of course, at some point they will not agree to continue letting us consume more than our income. And so, what is the penalty? Later on we will have to run trade surpluses (won’t that be grand!?) — that is, we will have to consume less than our income. In effect, we have things upside down: from the point of view of real consumption, the good times are when we are running deficits. This is not to say that trade deficits are never a cause for concern. It depends why the deficit is rising. If it is because private consumption is high, then we just have to trust that individuals can decide for themselves if they want to consume more now or later. If it is because investment at home is high, then this will have a payoff later in terms of increased output that will allow us easily to pay off our debts — no harm done. If it is because of increased government consumption that fails to raise productivity — increased military spending, for example — then we are just postponing paying the bill. A side of this discussion that is infrequently heard is that (absent government intervention) every trade deficit must have a matching capital inflow to finance it. So if you lose sleep at night over rising trade deficits, think of it instead as increases in our capital account surplus. What about the trade deficit with Japan? Is that something to lose sleep over? I, personally, am running huge deficits with my grocery store, somewhat smaller deficits with my bookstore, and again larger deficits with a certain coffee house. Luckily, I am running a huge surplus with my university. Should I go and insist that my grocery store hire me for a few lectures to narrow the deficit? Obviously, I shouldn’t expect that I will run balanced trade with all of my trading partners. And it is little different with countries. Given that there is no necessary cause for concern about aggregate trade deficits, there is even less reason to worry about imbalances with particular countries. This is not to say that we should be unconcerned if Japan or others erect barriers to our trade — this would hurt both us and them. But bilateral deficits alone are not sufficient reason to berate our trading partners.

Let me turn now to another major trade-related issue. When Vice President Gore and Ross Perot jousted over NAFTA in the presidential campaign, there was only one thing on which they agreed — that NAFTA was primarily about jobs. Gore promised that NAFTA would net us 200,000 jobs, while Perot warned of the now-famous “sucking sound.” Let me assure you that the one thing that NAFTA was surely not about was jobs. The link that each wanted to draw between the policy change and the level of employment runs through the trade deficit. Improvements in the trade deficit are presumed to create jobs, and a deterioration to destroy them. Does this make sense? If anything could convince you that this is nonsense, it is the experience of the last year. The US has been running record trade deficits, yet Alan Greenspan and the Fed were trying to contract demand. They worried that unemployment was getting so low that inflation would bite! The point is that the unemployment rate is a macroeconomic phenomenon, targeted by the Federal reserve, and that trade agreements can be expected to have no influence on their target level of unemployment.

While trade can be expected to have little or no impact on the aggregate level of employment, this does not exclude that some sectors may be adversely affected by imports, and so particular workers lose jobs. Should trade agreements include a special package of relief for those whose jobs are displaced? While such an argument is tempting, I believe that the answer is “no.” The creation and destruction of jobs in the US economy is one of the most noteworthy aspects of the labor market. While month to month movements in the unemployment rate — so net job changes — are small, the gross flows into and out of unemployment are huge. New firms rise, old ones die. A shift is added here and cut there. We do have a system of unemployment compensation designed to cushion the blows for affected individuals. Someone who loses their job in Massachusetts because market share is won by a firm in Mexico deserves assistance. But they are not more needy or deserving than if they had lost it because of expansion of a firm in New Mexico. If current unemployment benefits should be strengthened, so be it. But there is no case for special assistance when the job loss is due to trade. There are serious issues, though, that should concern us regarding the impact of international trade on workers in the United States. One is equity. Among the most serious developments in the US economy in recent decades is the rise in various indicators of inequality. For the least-skilled Americans, real wages have been nearly stagnant for twenty years. The growth in wages of highly skilled workers has thus introduced a widening gap in real wages. Measures of the concentration of wealth have shown a sharp rise in the same period. Various reasons have been suggested — including changes in tax policy; and technological change which has shifted demand relatively strongly toward skilled workers. It is reasonable to ask whether international trade has played an important role. My answer is one you never hear on McNeil-Lehrer: we just don’t know.

The conventional argument that countries enjoy gains from trade does not ensure that everyone gains. In fact, most models suggest that there typically will be losers. A simple way to think about it is to ask how trade will affect relative demand for the skills that you bring to the market. If you are unskilled in the US, then you are relatively rare, compared to the prevalence of unskilled workers in the world. It stands to reason that if the rest of the world’s unskilled workers also gain access to the US market via trade, that this may cause your wages to slip. Sensible as this is, it turns out to be difficult to confirm that this is actually what happened. There is a lively debate currently underway, and honest researchers can still disagree.

Let us suppose, for the sake of discussion, that in fact international trade does contribute to depressing relative wages of the unskilled in the US. Does equity then demand that we impose protection? I will argue “no” for two reasons. The first relates to what I previously called the Principle of Targeting. What we care about is distribution, not trade per se. The problem is that the amount redistributed via protection is very small relative to the total cost imposed. The Institute for International Economics estimates that the typical cost of saving one specific job in these sectors exceeds $170,000 per year. This is too high a price. I believe that the appropriate way to address this is that suggested by Labor Secretary Robert Reich. We should make a national commitment to raising the skills of our workforce. This is the only permanent guarantee of high and rising incomes. The second is an issue that rarely is noted in discussions of US trade policy. The same forces that may lead the wages of unskilled workers in the US to be depressed by trade will symmetrically tend to raise the wages of the unskilled in other countries. Protection in the US denies them access to our market, and so drives down their wages. Of course, poverty in the rest of the world is often much more severe than in the US. Thus, if one also cares about international equity, protection in the US again should be rejected.

There is another argument for trade interventions that has attained a great deal of notoriety of late. These are the various proposals for strategic interventions, or promotion of high-tech industries. An important proponent of such policies, Laura Tyson, is now the President’s chief economic advisor. These have attained prominence, in part, because the economics profession in the last dozen years has paid greater attention to the role of imperfect competition and dynamic increasing returns to scale, and these are thought to invite greater intervention. Two distinct ideas are at work. The first returns to the idea I mentioned early on that in sectors where there is monopoly power, price is above marginal cost, giving rise to economic rents. If a government can help its firm achieve a larger share of the market in such industries, it can raise national income at the expense of the other country and its firms. The second idea is that if, in a certain good, your productivity tomorrow depends on your country’s output of that good today, then a country that grabs a larger market share today will gain an advantage that will cumulate over time. Tyson, in particular, has argued that the Japanese have systematically used these tools to wrest control of important industries from the US.

While the theoretical possibility of this occurring has been established, proponents of US intervention in these markets neglect the long list of qualifications required. The advantages to be gained depend very sensitively on fine details of market structure that, unfortunately, we are unlikely to know. Even if we could identify the appropriate conditions in one industry, we would have to be careful not to promote it at the expense of other industries that may enjoy even brighter prospects. Even if we could identify the right industries, the Principle of Targeting implies that the appropriate instruments would likely be subsidies to production or R&D, rather than trade subsidies. Finally, to promise to deliver subsidies is to invite a long line of petitioners. Unlike protection, this will create jobs — for lawyers, lobbyists, and Congressional campaign cadgers.

Recently discussions of international trade have begun to address environmental concerns. This is a complex subject, without simple answers ready for every case. I can but touch on a few issues. The first thing to note is that many environmental problems enter as classic externalities — the costs are not fully borne by the polluter, and affect others unmediated by the price mechanism. Thus there is a market failure that requires some intervention. The question is the nature of the intervention, and for our purposes, when trade interventions are appropriate.

Consider a real-life example. Suppose that old-growth trees are being harvested in the Northwest and exported as logs to Japan, where they are processed and turned into products. Suppose that excessive harvesting of these trees is causing damage to the ecosystem beyond that borne by the producer. Would it be an appropriate response to ban exports of unprocessed logs, as was proposed? The answer is “no.” The source of the problem is the harvesting of the logs, not their export unprocessed per se. An appropriate response would be to tax or restrict harvesting of the old-growth trees. Affecting the site at which the logs are processed is to raise the cost of the policy with no additional gain for the environment. It is not hard to see, though, why such a policy might be politically attractive. It raises demand for mills in the United States, while imposing the excess costs on the foreigners (who don’t vote). In effect, it buys the support of domestic producers — which may be savvy politics, but isn’t sound economics.

A contentious issue is whether taxes should be imposed on imports from countries with weaker environmental standards than our own. Two ideas seem to be behind this. The first is that the foreign country appears to be getting an unfair advantage in the industry if environmental regulations are less strict. A worry is that it may be harder to get domestic producers and workers to accept needed environmental regulation. The second concern is that firms will relocate to take advantage of the lax environmental regulation. How shall we analyze these? First, note that there is nothing inherently wrong in countries choosing different standards. It is rational for densely-settled Los Angeles to enforce stronger standards on auto emissions than would be acceptable in Nevada. This depends on absorptive capacity of the environment, and the perceived costs of reducing emissions. As well, the stringency of environmental regulation will sensibly vary with economic development. A rich country may find it quite tolerable to sacrifice economically to reduce pollution by a certain amount. A poor country may find the price too high to enact the same degree of protection. Shall we then insist that the poor country enact the stricter standards that we adopt or face tariffs that neutralize any implied cost advantage? The likely result will be to partially close our markets to the poor countries, tending to depress wages there as well. So long as the policies in the two countries reflect the concerns of the affected populations, there is no reason to intervene, either to levy taxes against countries with different regulations than our own, or to oppose firms moving from strictly-regulated regions.

IV. Conclusions

The title of this talk is: “International Trade: Friend or Enemy?” As I’m sure that you have guessed by now, my answer is “mostly friend.” Trade allows us to take advantage of specialization of production, reaping gains from comparative advantage and economies of scale. Barriers to trade typically lower our real income. They seldom reflect the national interest, but rather benefit a few at a greater cost to the many. Insofar as there is any opportunity to raise our income, it comes by imposing a more than proportional cost on foreign countries. This is likely to invite retaliation that leaves both worse off. However, this is not to say that there are no issues of serious concern. Trade may have a tendency to reinforce the rising wage gap between the skilled and less-skilled in the US. However, protection is a costly way to remedy this, and has the unfortunate consequence that it will tend to depress the wages of workers particularly in poorer countries. Our efforts for equity at home should come through a national commitment to raise the skills and productivity of the least advantaged. Only this can guarantee a continuing rise in the standard of living. The world needs a continued US commitment to maintaining a regime of open trade.

Source: THD

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