In previousdiaries, I described the concepts of “loss aversion”, and how this can affect the process of change. Basically, any change in the macroeconomic sense involves “winners” (those who gain something) and “losers” (those who lose something). Because of , where the winners are generally confused about their gains (because of the endowment effect), and the losers feel their losses very strongly due to loss aversion. These psychological concepts were developed by Nobel laureate Dan Kahneman, and are ingrained in us because of our evolutionary need for survival. If you understand these concepts, then you will proceed with incremental changes, and not radical reform. I had suggested that Bernie Sanders’ proposed revolution was doomed for this reason. Basically, the more radical your change, the louders the losers scream. Thus your ability to push that change depends on your ability to buy off the losers.
There is one very interesting example that illustrates this... that of free trade.
Let us first consider what trade does. Broadly speaking, there are 3 types of effects.
- Trade will open up certain sectors of the domestic (US) market to foreign competition. Thus, some jobs will be destroyed in “import-competing” sectors. Business owners who cater to these sectors will lose money.
- Trade opens up certain foreign markets to US companies. Thus, some jobs will be created in “export-oriented” sectors. Business owners who cater to those sectors will make more money.
- Less efficient sectors on both sides of the border are shuttered, and so the global economy becomes more efficient. As Adam Smith pointed out more than 2 centuries ago “All commerce that is carried on betwixt any two countries must necessarily he advantageous to both” Some of these benefits are passed on to consumers (via lower prices), some go to the capital holders (via increased profits), and some may be passed onto the labor (via higher wages). The savings accumulate over time, and can be invested elsewhere.
These were described by Prof. Douglas Irwin on NPR yesterday
IRWIN: Well, trade does destroy jobs in import-competing sectors, such as apparel and furniture. But so does technological change. And it also has to be pointed out that trade creates jobs in export-oriented sectors, such as aircraft and high-tech. So trade doesn't affect the number of jobs in the United States so much as it affects the composition of jobs. And unfortunately, some of those jobs are located in Ohio and Michigan, where heavy industry has traditionally been.
In the US, the “import-competing” jobs tend to be the lower paying jobs (such as apparel, certain auto parts etc.) and the export oriented jobs tend to be high paying (such as aircraft manufacturing). So, on the whole, trade has been good for the US.
But, trade does create losers, and this creates a two-fold problem
- Those who lose the low paying jobs cannot be immediately transitioned into a high paying job. As an example, someone who works in the apparel industry cannot be retrained to work as a machinist in an aircraft factory. Further, the person who loses a low paying job has likely accumulated less in savings, and is therefore less able to withstand extended unemployment.
- The job losses are often concentrated in certain regions (like Ohio and Michigan) that tend to be swing states. And there is never going to be a shortage of politicians (in either party) who will exploit that fact.
Let us go back to the interview with Prof Irwin
INSKEEP: Does it affect how much people can get paid? Are there higher-paying jobs being destroyed for lower-paying jobs?
IRWIN: Actually, it's sort of the opposite. A lot of the jobs that are being destroyed in apparel and furniture were low-paying jobs. And a lot of the jobs that are being created are in aircraft and high-tech - are high-paying jobs. But still that said, wages have been flat even though total compensation is up because health care costs are taking that wedge, that bite out of people's paycheck. So people don't think they've been getting a pay increase at all.
Free markets and comparative advantage
But it is more complicated than what Prof. Irwin just stated. When thinking about trade, it is good to start with Adam Smith, but it is also important to keep in mind Ricardo’s powerful insight.
- Adam Smith described an "obvious and simple system of natural liberty" in which individuals pursue their interests with the government providing the legal framework for the marketplace. In such a system, individuals would specialize at what they do best relative to the marketplace, and everyone would profit. Free trade is just this concept of specialization, when scaled up to the nation-state level.
- Ricardo added to Adam Smith’s work with a powerful insight on “comparative advantage”. Simply put, comparative advantage implies that it may be advantageous to import some goods, even if we can produce them more efficiently ourselves. This is where it gets dicey, so it is critical to understand this counter-intuitive concept. To understand comparative advantage, we have to understand that the costs that drive production are not the absolute costs, but the opportunity costs of not producing something else that may be even more advantageous.
As an example, consider the Swiss Clockmaking industry at the dawn of the era of the mechanical clock. The Swiss were very good at that, compared to the rest of the world. So there was a high demand for Swiss clocks ~ they could make a lot of money making and selling clocks. The Swiss are also good at making cheese, but other countries also knew how to make cheese. So Swiss cheese did not command such a premium, even though Swiss cheese is better than French cheese (let us ignore the protesting French for a second). In this case, the opportunity cost of making cheese was the profit that was commanded by Swiss clocks, which was very high… even though the absolute cost of making cheese was relatively low. Thus, it made sense for the Swiss to stop making cheese and to focus almost exclusively on clock making. In reality, the Swiss did not stop making cheese ~ this was because the farmers who were making cheese could not be repurposed into making clocks, despite Ricardo’s insight...and this holds an important lesson for free trade advocates.
The US finds itself in such a situation today. The productivity of the US worker is higher than the rest of the world ~this is true in almost every sector that you can think of. This means that the US worker can produce better products for the same absolute costs. But, because of comparative advantage, it makes sense for the US to import those products for which the opportunity costs are high, even when the absolute costs are low.
Let us see how this works for the US trade with China. The figure below shows the relative labor productivity of China vs US in several sectors, where the number 100 means that the Chinese productivity is the same as US productivity, and numbers less than 100 means that the Chinese productivity is less than US productivity. In all cases, the Chinese productivity is considerably lower than the US, both in 1980 and in 1997 ~ the US has a lower absolute cost. And yet, in 4 sectors (which are highlighted in yellow), the absolute advantage held by US workers is relatively small. In these 4 sectors, it makes sense for the US to buy products made by Chinese workers, who are paid less ~ China has a comparative advantage in those sectors. The US benefits by having those products at a lower price, and China benefits by having a customer for their product.
Clik here to view.
Losers are in sectors that are productive, but with higher opportunity costs
The politics of free trade gets complicated by comparative advantage in countries with high productivity (ie, in the US). In such countries, free trade will negatively impact sectors with low absolute costs (ie, with good productivity), but with high opportunity costs. At a personal level, the individual who is losing his/her job may be very good at what they do (ie, they are very productive), and is likely even better than the replacement.
This is a very difficult proposition to accept. For instance, in the next few days, as the primary season moves to Florida, you will likely hear stories about Disney employees who were laid off, and forced to train their replacements from India (who are said to be less qualified, but are also paid much less). And if you are a politician who is “for free trade” in this scenario, you are going to lose votes. There are no shortage of other politicians who will attack you on this issue, either because they don’t understand the benefits of free trade, or because they would rather demagogue the issue when convenient.
And there is no shortage of such politicians...in both parties.
INSKEEP: So we have a wide range of trade positions. Donald Trump has very loudly denounced NAFTA and other trade deals, has said the United States has done a terrible job of negotiating them. Bernie Sanders has a position on this. He's very skeptical of trade deals. Hillary Clinton favored the idea of the Trans-Pacific Partnership. But does not like the reality. We could go on for some time. What is the basic difference here as you follow the different campaigns? What are the sides?
IRWIN: Well, it's very interesting. Both parties have this division within them. Interestingly, public opinion polls suggest that Democrats support trade more than Republicans. But the Democratic candidates are speaking more to their union base in the party and opposing these trade agreements. Meanwhile, the Republicans traditionally have been, in recent decades, much more in favor of free trade. But the Republican base does not support trade as much. And now you see some candidates moving in that direction as well.
INSKEEP: What really is making trade such a potent issue in both parties?
IRWIN: Well, historically that's really been the case. We think back to 1992 when Pat Buchanan and Ross Perot ran on an anti-NAFTA platform. In 2008, Barack Obama ran against NAFTA - 2012, Mitt Romney raised issues with China. So trade has always been a sensitive issue in American politics because jobs are at stake.
Standard of living scales with absolute productivity
So what is the point of having a higher absolute productivity if you will still lose out to other countries with lower wages and lower productivity ? A quick answer is that the average citizen’s standard of living scales with your productivity, averaged over all sectors of the economy. This applies even if you happen to get laid off as a result of a trade deal. However, the benefits are harder to explain. A good illustration of this can be had by comparing US and Japanese productivities, as shown in this chart.
Clik here to view.
The productivity of several Japanese sectors exceeds that in the US (everything above the blue line in the figure), but Japanese productivity is lower in several other sectors. Thus, the Japanese citizen has a slightly lower standard of living (as measured by per capita income) compared to the US.
In order to raise the Japanese standard of living, Japan needs to raise the productivity in the lagging sectors ~ it can do so by trading with other countries, and accepting cutbacks in sectors where it may have a comparative disadvantage. By opening up those lagging sectors to competition from foreign trade, Japan can raise the productivity of those sectors, and raise it’s per capita income. Ultimately, this benefits everyone...including the person who got laid off in the process (and who will hopefully be reemployed in a different sector at a higher wage).
Gains from free trade
Given all the complexities, and the politics associated with free trade, it is important to highlight the benefits of free trade. Roughly speaking, the gains can be divided into 3 categories, which were described by John Mills in The Principles of Political Economy
- Direct economical gains. This is the benefit that accrues from the concepts of specialization (described by Adam Smith) and comparative advantage (described by Ricardo). There are very few direct measurements that can help us quantify the direct economical gains associated with free trade, because there are very few instances where a country reverts from an absolute protectionist position to an absolute trading position. The examples that exist are the forced opening of the Japanese market (in 1859) and the economic embargo ordered by President Thomas Jefferson in 1807 (in response to French-British conflict). In both cases, the data suggests that free trade results in a 5% increase in economic output ~ which is a very sizeable increase. In a more realistic scenario, where a country moves to reduce barriers to trade, the policy changes are much more modest, and the gains are also much more modest ~ for the US, the modern trade agreements have been estimated to result in direct economic gains of about 0.1% of GDP. These benefits accrue from various mechanisms. (1) Economies of scale. An increase in market size that results from access to overseas markets can result in a small decrease in unit costs. This benefit is expected to be small ~ most firms take steps to minimize unit costs at all times; so unit costs in the absence of a trade agreement are also close to their optimal point (2) Benefits of competition. There is significant evidence that increased competition (e.g. from foreign vendors; but applicable to all sources) changes the behavior of domestic firms. Firms with market power tend to restrict output and raise prices ~ this increases their profits, which raises their stock price. In turn, they may declare larger dividends to their shareholders, and give out very large bonuses to their executives. With increase competition, firms are forced to alter this predatory behavior. Severalsurveys indicate that in every country studied, relatively high industry-wide exposure to foreign competition is associated with lower [price-cost] margins, and the effect is concentrated in larger plants. [As an aside, I should point out that the predatory Wall Street practices that Sen. Sanders complains about can be solved by effective competition as well; and not by imposing fines as he suggests]. (3) Exposure to new products. In this category, economists generally point to the consumers in Poland who saw bananas and other exotic fruits in the supermarket after the fall of communism. I consider these examples to be symbolic, and will provide one of my own. In my company, we were considering a new research direction 3 years back. That project required some optical instrumentation that costs about $50,000 from US vendors. The trade deals with China had newly enabled some Chinese vendors, who were selling an equivalent product (one that we were able to use) for about $1000. The difference was sizeable ~ and it meant that we were able to launch that research project 3 years back. That project will result in new products that we intend to sell in 2018.
- Indirect benefits — productivity gains. The 2nd type of benefit is an indirect increase in productivity that results from trade. As per John Mills, “A country which produces for a larger market than its own can introduce a more extended division of labour, and can make greater use of machinery, and is more Iikely to make inventions and improvements in the processes of production”. Foreign trade serves as a conduit to new technologies (one example of which I referred to above), which can enable new inventions. Foreign trade also forces domestic firms to become more efficient (and less predatory).
- Intellectual and moral. The 3rd benefit from free trade is actually even more profound. Consider Afghanistan as an example. For centuries, Afghanistan was a critical crossroads in the Silk road. International trade had to flow through Afghanistan. As the traders moved back and forth, they brought with them new ideas. Largely as a result (in my view), Afghanistan during this era was very prosperous, and the Afghan people were the source of several empires that were established in neighboring countries. The founder of modern religion ~ Zoaraster (who invented God and the Devil, and the apocalypse) was also from that area. In fact, several great philosophers (Jesus, Mohammad...and of course Zoaraster) have been associated with those trade routes. The 3 wise men from the east were traders. In the modern era, the importance of the Silk roads have declined with the advent of container ships. The Silk roads have been effectively shuttered because of political conflict. Again, largely as a result (again, in my view), the Afghan people have suffered from the intellectual bankruptcy that results from being an isolated landlocked country. Political conflict ensues. In the last few years, President Obama has taken steps to restore trade with Cuba and Iran. I suspect he is doing this because he gets the intellectual and moral benefits of trade. Experts have suggested that “Restoring trade ties and expanding commerce would revolutionize the Cuban economy and transform Cuban society” into something that is much more open than what it is now, and President Obama is a truly global citizen with relatives all over the world (which means that he has likely experienced his own version of the Silk road)
Class divisions and nativism
An interesting fallout of free trade is that it reveals underlying class divisions. In the US, most of the jobs that have been affected by free trade (software, call centers, apparels, auto parts etc.) were jobs that were done by the “working class white” people, particularly if they reside in the industrial midwest. Blacks, Latinos, and Asians have been relatively unaffected, specially if they do not reside within the upper midwest. It is thus natural that the working class whites are the ones who are the most “angry” in this election cycle. Other demographic groups have not lost as much, and can see the gains. You can trace the voting preferences accordingly.
The politicians who are appealing to the white working class are tapping into this nativism.
The politics of free trade.
We can now discuss the politics of free trade agreements. The benefits of a free trade agreement are documented above, and so are the costs. How does it impact the democratic system ?
In a democratic setup, the Presidential elections are generally “high turnout” events in which the benefits of free trade can be discussed semi-rationally. The voice of the “free trade losers” is generally drowned out by the majority. But in the primaries, and in off-year elections, the turnouts are lower. In this setting, the voice of the loser can become paramount. Thus, a winning candidate must be able to navigate through the screaming of the losers in the primaries, and then be able to pivot to the benefits in the Presidential election.
I suspect that our founding fathers setup our system with this in mind.
A successful politician in the US must be able to address the fears, and the anger, felt by the free trade losers. They must do so, or else they do not survive the primary selection process (as an example, see Michigan, 3.8.2016). But they must also be able to pivot to the benefits of free trade, or else they will either lose the general election or not be able to deliver a higher standard of living for the people. They must understand the benefits of free trade.
This has been the case for all of our Presidents, dating back to Ronald Reagan (and probably before that… but I am not old enough to remember). Every elected President since Reagan has been elected in part on a promise to curb free trade (at least during the primaries), and has then pivoted to negotiate additional free trade agreements. Every elected President has compensated for this, in part, by launching a trade dispute. This is the only politically viable way to get elected, and to do the right thing after that.
As an example, Senator Obama campaigned vigorously against free trade ~ he hit Sen. Clinton hard on NAFTA, for instance. Once elected, President Obama pivoted to negotiating additional free trade agreements (the TPP, for instance), and also simultaneously initiated a trade dispute (by invoking anti-dumping clauses that are permitted under GATT… on automobile tires, if I recall correctly).
Final word
I understand that free trade is not very popular in this blog. While I have tried to be respectful to those who may hold a different opinion on this issue (~ my apologies in advance if I have failed on that front. Some of the terminology, which may appear inflammatory, are actually borrowed by Dan Kahneman’s book), I am a firm supporter of free trade. It is one of the reasons why I am supporting Secy Clinton in this cycle. And I have tried to describe my thoughts in a rational way. I hope I gave you something to think about...even if you continue to hold the same beliefs after reading this.
Peace.