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The Real Issue

January 26, 2004

Posted from Paul Craig Roberts:

Many libertarians have misinterpreted what Senator Charles Schumer and I are saying about free trade, and they are misinterpreting or misapplying trade theory. I do not know why this is the case. Perhaps libertarians perceive a threat to one of their vital commitments and rush to its defense before they get their minds around the problem. Please accept my assurances that it is not I who threatens free trade. Free trade is threatened by new developments delivering results different from the promise of shared gains. Libertarians need to understand these new developments in order to have input into the resolution of the difficulty. Toward this end, I will again attempt to explain the new problem.

Begin with the realization that free trade is a policy, not a theory. The case for the policy is that it brings shared gains to the populations of the free trading countries. There will be winners and losers within each country, but on average the wins within each country outweigh the losses.

For there to be shared gains from free trade, countries must specialize and trade in goods in which they have comparative advantage. Comparative advantage comes from countries having different opportunity costs of producing traded goods. Those opportunity costs depend on factor endowments. Internationally mobile factors of production alter or obliterate the internal cost ratios that determine comparative advantage. Indeed, comparative advantage is irrelevant to the capitalists’ investment decision once capital is mobile between nations, because profit would be maximized by following absolute advantage.

Consider, for example, a trading country specializing according to comparative advantage. Now introduce new developments that create opportunity for capitalists to reallocate productive factors from comparative advantage at home to absolute advantage abroad. The result is a collapse in the conditions under which free trade produces mutual gains to trading countries.

It is possible to have a free trade policy based on absolute advantage. This free trade policy rests on the argument that world welfare is maximized at the expense of some countries. This is the free trade model that changed conditions have brought into operation. Changes in political and technological conditions have made it possible for first world capitalists producing for first world markets to substitute cheap foreign labor for expensive first world labor in their production functions. As daily announcements from US multinational corporations make clear, this dumping of first world labor is occurring across the entire range of tradable goods and services.

Offshoring platforms, both for manufacturing and for knowledge jobs, are now well developed in China and India. Because of the huge excess supplies of labor overhanging those labor markets, equally productive Asian labor can be hired for much less than first world labor. The high wage of first world labor is no longer protected by the confinement of first world capital and technology to the first world.

The displacements of first world labor are not occurring because of traditional import competition under conditions of comparative advantage. They are occurring because first world capital and technology are flowing abroad to the absolute advantage of equally productive but much cheaper labor.

We cannot dismiss this new development by arguing that factor-price equalization will restore equilibrium. Factor-price equalization is a result of a static model with many assumptions. Its point is to illustrate the insight that trade in goods is ultimately trade in the factors that produce the goods. Given the excess supply of Asian labor, it will be many years, decades, perhaps a half century, before the excess supply of labor is drawn down. In the meantime, US wages will rapidly fall to Asian levels. Business Week has already reported a case of top flight American software engineers being hired in the US at only a slight premium over Indian wages.

Another mechanism for bringing about adjustment is exchange rates. However, China pegs its currency to the dollar and resists pressures to appreciate its currency or allow a float. With the exchange rate unable to bring about an adjustment in the cost of Asian labor and in the prices in US currency of goods produced by US multinationals offshore for US markets, the US can lose in the meantime many millions of high value-added jobs as well as entire industries and occupations.

The economic and social dislocations and political instability can be severe. For example, the software engineers’ mortgages and debts will not be cut in half just because their salaries were. American voters will not be content that their sufferings are offset by gains in India and China.

One of my professors, Ronald Coase, advised that economists should occasionally emerge from their abstract models and look out the window. They might be surprised at what they see. This was Coase’s way of admonishing us to remember that theories and theorems are tools for understanding reality. We should always regard them as tools and not let them do our thinking for us. I have always tried to follow Coase’s advice.

When economists reply to me that offshore production in China makes Chinese more wealthy with the result that they buy more of our goods and cause more employment in our export industries, they overlook that Chinese wages are too low to replace via imports the domestic purchasing power lost in the US due to offshoring. These economists are not looking out the window. The US economy is 25 months into a recovery. By previous experience the economy would have created millions of new jobs by now. Charles McMillion, president of MBG Information Services in Washington, DC, says that his analyses show that 25 months after the trough in the average business cycle, the economy normally adds about 6% to its jobs total. Since November 2001, 7.85 million new jobs should have been created. Instead, the economy has lost almost another million private sector jobs during two years of recovery.

This is unprecedented, doubly so considering the extraordinary ease of monetary and fiscal policy. We are pumping $500 billion annually into other country’s markets for goods and services, and there is no sign of it coming back to us in employment growth in tradable goods and services. The only jobs that the economy has been able to create during two years of recovery are in low pay non-tradable services.

Economists have offered a running apology, but no explanation. I offered an explanation. The US economy is creating jobs for foreigners. The US is creating jobs for foreigners by running up debt, which foreigners are converting into ownership of our assets and the future income streams that they produce. This is not a picture of shared gains from trade based on comparative advantage.

Stephen Roach at Morgan Stanley and others, who pay closer attention to the matter than I do, have reported that upwards of 65% of our “imports” from China represent offshore production. The dislocations caused by these “imports” are a product of US labor being substituted out of US production functions. They are not a product of competitive trade. Economists need to address precisely what is being traded when a US multinational discharges its US employees and hires foreign ones.

Many have informed me that there is nothing new about capital mobility, that foreign investment has been taking place for a long time. They overlook the fundamental difference between traditional foreign investment and offshoring. Historically, the world has experienced protection, not free trade. Foreign investment was motivated by desire to enter foreign markets in the face of prohibitive tariffs. It was not, as in the case of offshoring, motivated by seeking absolute advantage in low cost labor abroad. Moreover, foreign investment was confined to the first world, except for some investments in extractive industries. Many of these investments, such as Chilean copper, were confiscated, reminding capitalists of Adam Smith’s and David Ricardo’s admonitions to keep their capital at home.

When factors of production flow from comparative advantage at home to absolute advantage abroad, the shared gains case for free trade breaks down. That is what Senator Schumer and I pointed out The challenge is to restore conditions under which free trade produces shared gains.

Some libertarians believe that globalism is a new force that is smashing states and establishing a stateless world of free markets. This is a nice dream, but nevertheless a dream. The more likely effect of US decline, absolute or relative, and rising success and confidence in Asia will be challenges and conflicts. Libertarian nirvana will never be. Libertarians should understand that they can affect things only on the margin. The issue is a little more freedom or a little less. Libertarians deprive themselves of policy input when they refuse to settle for anything but the perfection of abstract models. They deprive themselves of an audience when they declare themselves for free trade regardless of what it may do to their country.

Two final points. Yes, my mother told me that you are judged by the company that you keep. No doubt, Charles Schumer’s mother told him the same thing. My company looks as damning to his side as his looks to mine. We both ignored our mothers’ strictures in order to focus thought on an issue prior to the time that panic sets in. What will be the response if the economy continues to lose jobs after three years of recovery? At what point will job loss from offshoring cause GDP growth to stop? To decline? What happens to people with stagnant or falling wages when China is forced off the dollar peg and Wal-Mart’s prices rise?

Critics may say that this will never happen. But two years ago the same people would have denied that two years of economic recovery would produce a net loss of almost one million jobs.

In conclusion, people who resort to ad hominen attacks have weak arguments. Unable to deal intellectually with an argument, they fall back on name-calling. They try to discredit an argument they cannot answer by discrediting the person.

Although I had a graduate education with the finest economists extant at the University of Virginia, University of California at Berkeley, and at Oxford University, I can make mistakes just like the next man. If I turn out to be mistaken in my diagnosis of the job-loss recovery and the rise of free trade based on absolute instead of comparative advantage, so be it. I did my duty and offered an explanation in place of excuses. I am a person of good will. I will listen to a better explanation.

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