Debunking trade myths

The U.S. does not economically “compete” with other nations

On February 24th, Barack Obama appeared before the Business Roundtable, an association of corporate CEOs, to give an address on what has now become a major talking point of his administration: competitiveness. In the president’s view, the main problem facing the U.S. is that other nations are catching up, they are making investments in education and infrastructure that have been unmatched by the United States, and as a consequence, American economic well-being has been eroded. The solution, he explained, is to renew America’s competitive edge with fresh investment, health care reform, stricter financial oversight, and closer integration between business and government to promote American exports abroad. In his own words, “Winning the competition means we need to export more of our goods and services to other nations.”

We’ve seen this type of rhetoric before, most notably when it was called by its proper name, “mercantilism,” but also in recent decades whenever a trade-imbalanced America hunts for scapegoats upon which to blame some new economic malaise. It is a popular argument; for many it seems obvious that, in the words of President Clinton, the United States is “like a big corporation competing in the global marketplace,” and that the problems our nation faces are essentially identical to the problems of Ford competing with Toyota.

At the core of this belief is the notion that there is a fixed amount of jobs and economic activity, and that unless we are more productive than our rivals, we will not capture our share of this activity and our economic well-being will decline. International trade, this idea posits, is very nearly (if not entirely) a zero-sum game, in which the winners are rewarded with economic growth and vitality, and the losers are punished with chronic unemployment and stagnation.

As persistently popular as this idea is, it is entirely false. It has virtually no basis in economic theory, zero supporting empirical evidence, and is so logically flawed that it has not been seriously considered in academic circles for nearly two centuries. Let us say it loud and clear right now: The national living standard of the United States is almost entirely independent of productivity growth in other nations, we do not economically compete with the world in any meaningful way, and none of our important economic problems can be attributed to a failure to compete.

The benefits of free trade are described by a very simple idea that laymen seem determined to avoid learning. It is called “comparative advantage.” Without trade (a condition we call “autarky”), a nation faces a trade-off in determining where its economic resources will go. If it adds a worker to, say, the computer industry, that means it must take that worker from somewhere else, say, the banana industry. Each decision of where to allocate scarce labor, capital, and other productive resources is sacrificing the output of one good or service for another.

Simplified, it is as if our economy were a machine that converted bananas into computers and vice-versa. The benefit from free trade is similar to one man with a two-bananas-for-one-computer machine coming across another man with a three-bananas-for-one-computer machine­ — if the first man produces computers and trades them to his compatriot for bananas at some ratio between 2-1 and 3-1, both men will be better off.

It is impossible for there to be losers from trade — if the first man asked for four bananas in exchange for one of his computers (a losing proposition for the man who could just stuff three bananas into his own machine), the second man would simply refuse — it would be as if you had tried to sell someone a four dollar banana when he is standing in a grocery aisle that offers the same banana for three dollars.

If you take any two multi-good economies, you will find that one of them is relatively better than the other at producing a subset of goods. Even if one of the two nations can produce every single good more efficiently than the other (what economists term absolute advantage), there will be room for mutually beneficial trade as one nation produces only the goods in which its productivity advantage is the greatest and the other produces the goods in which its productivity disadvantage is the least.

There is room for winners and smaller winners in trade. Remembering the example of the banana-to-computer machines, the two trading men could set the terms of trade anywhere between 2-1 and 3-1. If the first man were a truly magnificent negotiator, it would be possible for him to convince his friend to trade at three bananas for one computer and thereby capture all of the benefit of trade for himself.

In practice, terms of trade are not set through formal negotiation, but through the free market. At any given moment, the terms of trade are set proximately by the combination of exchange rates and relative good prices, and are set ultimately by whatever trade-off is occurring at the margin. The terms of trade for bananas and computers may be set by the relative productivity of a third good, dungarees, or the exchanges made between other trading partners. There is virtually no room for market power or bargaining to change the terms of trade — subsidies, tariffs, and currency manipulation will only prevent mutually beneficial trades from occurring and/or encourage trades that are not mutually beneficial (with the manipulating country on the losing end).

This said, it is possible for rising productivity in another nation to harm the United States. Thinking back to the example of the two men with banana-to-computer machines, what if the second man became better at producing computers such that his economic ‘machine’ changed into a 2.5-bananas-for-1-computer machine? Whereas before there was one banana of benefit to be split among the two men for each computer trade they made, now there would be only half a banana. As the pain is doled out, the second man will find that the gains from his added productivity outweigh the loss of this trade benefit, but the first man will be worse off. Thus, economists cannot unequivocally state that improvements in Chinese productivity will not harm the U.S.

At a glance, this may seem to confirm the competitiveness hypothesis that productivity gains in other nations will harm the United States, but let’s explore the problem a little bit more. Firstly, even with the deteriorating terms of trade, the first man is still better off than he was under autarky — he has not really been harmed by trade, it is merely that his potential gains from trade have been reduced as his partner’s economy becomes more similar to his own. Secondly, what if the other man had improved his productivity in bananas instead of computers? If the other man’s machine had changed into a 4-1 device, the gains from trade would have increased, not decreased. Unspecified productivity gains by a trade partner are just as likely to improve the United States’ well-being as they are to reduce it, and typically they do not change it much at all.

If we look at the data from the past fifty years, we find that by and large, changes in our terms of trade have not significantly impacted our well-being. As we would expect, our terms of trade have fluctuated randomly and mildly. The real wages of Americans are determined almost entirely by their own productivity gains and losses — when a typical worker can produce one computer per hour, he enjoys a standard of living and level of consumption equal to the value of forty computers per week, irregardless of how well or poorly Japan produces its own computers. When his productivity falls, his standard of living falls proportionately, and when it rises, he captures only the extra benefit that he himself has created.

It is dull to say that our economic well-being is determined by our own actions and is largely independent of how other economies perform, but it is the truth. Opposite what “competitiveness” advocates believe, free trade has a small and almost unambiguously positive impact on every economy that participates.

This is the first in a three part series on international trade.