Book review: Free Trade Doesn’t Work

In April 2011, years before the problematic aspects of US trade policy had exploded into the national political conversation, I reviewed economist Ian Fletcher’s book laying out a powerful intellectual case against free trade. Given the timeliness of the topic and the very superficial level of most punditry on the trade question, I thought it might be useful to republish my review (slightly edited) below.

Everyone loves free trade. Economists, editorial boards, and politicians join in singing its praises. That free trade benefits all nations is an article of faith for America’s ruling elite. Protectionism is regarded as self-evidently stupid and evil; it is sufficient to call something “protectionist” to discredit it.

The belief in free trade is, in short, a sacred cow. It is unchallengeable in the realm of American politics and punditry because the economic case for it is considered airtight. Facts about industrial decline, job losses, and mounting debt are irrelevant. Common sense is irrelevant. Economic theory tells us that free trade benefits the US overall; therefore, no matter how high the costs of free trade, we can be sure that our economy is somehow reaping benefits that exceed the costs, and that any form of protectionism will necessarily do us more harm than good.

Ian Fletcher, Senior Economist of the Coalition for a Prosperous America, explains why this isn’t so. His book Free Trade Doesn’t Work: What Should Replace It and Why is a methodical dismantling of the assumptions, arguments, and popular beliefs that undergird free trade. In lucid prose that even an economic ignoramus (like me) can understand, Fletcher lays out the arguments against free trade and in favor of a flat tariff.

Dissecting Ricardo

The intellectual core of the case for free trade is, of course, David Ricardo’s 200-year-old theory of comparative advantage, which holds that (in Fletcher’s words): “If we could produce something more valuable with the resources we currently use to produce some product, then we should import that product, free up those resources, and produce that more valuable thing instead.” All well and good — but the theory depends on a host of dubious assumptions which simply do not hold true in the real world. Those assumptions are that:

  1. Trade is sustainable
  2. There are no externalities
  3. Factors of production move easily between industries
  4. Trade does not raise income inequality
  5. Capital is not internationally mobile
  6. Short-term efficiency causes long-term growth
  7. Trade does not induce adverse productivity growth abroad
  8. There are no scale economies

All of these assumptions are false at least some of the time. Assumption (2), for example, ignores both the negative externality of environmental damage and the positive externality of technological spillover (i.e. free trade wipes out industries that could have spawned new technologies and new industries). Assumption (5) is necessary for free trade to be a guaranteed win-win, rather than a potentially win-lose, proposition; the theory of comparative advantage says that market forces drive all factors of production to their best uses in the economy, but assumes that these factors cannot be driven right out of the economy to other countries. Of course, they can be. Capital is highly internationally mobile, and while this benefits the world economy as a whole, it certainly can hurt individual countries.

Assumption (1) falls apart when a “decadent” nation, which prefers short-term consumption, trades freely with a “miser” nation, which prefers long-term consumption. The decadent nation buys all the imports it can get, paying for them with a combination of exports, debt, and the sale of assets. The decadent nation is happy because it gets to consume more right now; the miser nation is happy because it gets to invest more and accumulate wealth. In the short run, both nations are “better off”; in economic terms, they have “maximized their utility.” Eventually, however, the decadent nation will exhaust its ability to assume debt and sell assets, leaving it poorer than it would have been without free trade. Trade restraints for this nation would be like restrictions on an heir’s squandering his inheritance.

And so on. Comparative advantage is, in short, a deeply flawed and inadequate picture of reality. Insofar as its assumptions hold true, it’s useful. “Fairly open trade, most of the time, is a good thing,” Fletcher concludes. But what about when it’s not?

Are tariffs the answer?

Neither the Ricardian view that free trade is always good, nor the pessimistic view that international trade is a zero-sum game, war by other means, is correct. The truth lies in some synthesis of these two extremes. The work of economists Ralph Gomory and William Baumol, set forth in their 2000 book Global Trade and Conflicting National Interests, tries to provide that synthesis. Gomory and Baumol observe that, contrary to Ricardo’s model, countries that get a head start in certain industries can lock other, potentially more-efficient, countries out of those industries due to the effects of economies of scale. Therefore, competition is imperfect and free trade outcomes are not always optimal.

Gomory and Baumol’s analysis suggests that international trade is sometimes win-win, and sometimes win-lose. Fletcher explains the policy implications of their work thusly: “Basically…a wise nation will willingly let other nations have their share of the world’s industrial base, but will try to grab the best industries for itself. Then it will sit back (here’s where laissez faire plays its legitimate role) and let the rest of the world compete…to produce for it the things it doesn’t want to produce at home.”

Fletcher’s preferred policy is the Natural Strategic Tariff — a flat tariff of around 30% on all US imports. It is “strategic” because, due to the different sensitives and responses of industries to import competition, it tends to cause the relocation of “good” industries like high-tech manufacturing to the US, but not “bad” industries like textiles. It works — for the US, not for other countries — because it interacts with the existing competitive strengths of the US economy. It is relatively politics-proof because it does not single out any industries for protection. It is, overall, an elegant and pragmatic response to the problem of America’s free-trade-induced industrial decline.

An avoidable disaster

If you have any doubts as to the existence of the problem, consider:

  • US imports are 17% of GDP while the entire US manufacturing sector is only 11.5% — meaning the US could export its entire manufacturing sector and still not balance its trade.
  • The US has run a deficit in high technology since 2002.
  • Every few years there emerges an entire new industry which has no strong American players (e.g. hybrid cars).
  • The US invented photovoltaic cells, but is now fifth behind Japan, China, Germany, and Taiwan in their production.
  • In 2007, the US was a net importer of spacecraft.
  • American companies had 90% of the world market in semiconductors in 1980, but have less than 10% today.
  • The printed circuit board industry is on its last legs in the US. (From Manufacturing and Technology News: “There isn’t one single vertically-integrated North American shop that could independently supply a circuit board.”)

Says Fletcher: “Losing positions in key technologies means that whatever brilliant innovations Americans may dream up in small start-up companies in future, large-scale commercialization of those innovations will increasingly take place abroad.”

The more one looks at the actual history of trade, the more unnecessary and avoidable this outcome seems. Contrary to popular belief, American policy was basically protectionist from Independence until after World War II. All four presidents on Mount Rushmore were protectionists, as Fletcher points out. So was Alexander Hamilton, who worried that Britain’s lead in manufacturing would remain entrenched, relegating America to banana republic status, and proposed tariffs, import and export bans, and subsidies for exports and key innovations. From 1812 until 1846, America had high tariffs (up to 40%). A brief episode of free trade from 1846 to 1861 was followed by more tariffs. From 1865 to 1932 — when America’s economic performance surpassed the rest of the world by the greatest margin — tariffs remained high. The overwhelming consensus in favor of protectionism did not end until free trader Woodrow Wilson reduced tariffs in 1913. Then Congress pushed them back up, making the Roaring Twenties a tariff era. Under FDR in 1930s, tariffs came down again — and stayed down. JFK’s Trade Expansion Act of 1962 marked America’s decisive turn against protectionism; America has not run a trade surplus since 1975.

Tariffs, then, apparently worked for most of America’s history. But didn’t the Smoot-Hawley tariff of 1930 cause the Great Depression (and even World War II)? Nonsense, according to Fletcher. Smoot-Hawley applied to about one-third of America’s trade — a mere 1.3% of GDP. It increased duties, on average, from 44.6% to 53.2%. (“Tariffs as a percentage of imports were higher in almost every year from 1821 to 1914.”) And as for the myth of a death spiral of retaliation by foreign nations, the State Department reported in 1931 that “With the exception of discriminations in France, the extent of discrimination against American commerce is very slight.” Says Fletcher: “Smoot was a moderate and routine adjustment to America’s trade regime, not a major shock to the world trading system.”

Free trade doesn’t exist

So much for America. Is free trade good, at least, for the rest of the world? Not really, argues Fletcher. Opulent Japan and South Korea are highly protectionist. If industrial policy and neo-mercantilism are somehow crippling them, it’s hard to imagine what these countries would look like with free trade (the Jetsons, perhaps?). The developing world is not well-served by free trade either. Rapidly-growing China, whose government owns 30% of the country’s industry and systematically manipulates foreign trade to increase economic growth, arguably would not be better off embracing laissez-faire. Trade liberalization has either hurt or not helped most other developing nations.

Free trade tends to mean that the industrial sectors of developing nations either “make it to the big time” and become globally competitive, or else get killed off entirely by imports, leaving nothing but agriculture and raw materials extraction, dead-end sectors which tend not to grow very fast. Free trade eliminates the protected middle ground for economies, like Mongolia or Peru, which don’t have globally competitive industrial sectors but were still better off having such sectors, albeit inefficient ones, than not having them at all.

For all the scorn we heap upon it, protectionism works, a fact grasped by our more clear-sighted trading partners. That is why embracing free trade is not even an option for America. International trade is a rigged game, and if America refuses to protect its economic interests, US trade policy will simply be dictated by the governments of Beijing, Tokyo, Brussels, and so forth. Fortunately, the American public is starting to wake up to this reality and vote accordingly, and Fletcher predicts that the free trade consensus will fall apart over the next few years.

I’ve barely scratched the surface of Ian Fletcher’s important and hugely informative book. Anyone interested in trade policy, even (or especially) supporters of free trade, should check it out. Since I do not wish to be an example of the saying that a little knowledge is a dangerous thing, I welcome correction on any of the points made above.

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