The Dangers of Trade Orthodoxy

From the orthodox view of trade, all nations win as markets spread tranquilly across borders. In reality, trade can often produce just the opposite: fierce market competition and worsening income inequality. Touted as a great employment generator, trade in fact cost a million factory jobs in four industrial U.S. states where angry voters cast ballots for President Donald Trump, according to a study by David Autor of the Massachusetts Institute of Technology and several co-authors. Now his trade war with China threatens to cut off business supply chains and spill into military rivalry.

In the developing world, meanwhile, trade has helped many poorer nations tap into world demand for exports. But there, too, it has caused harm. Even after Mexico’s “lost decade” in the 1980s, only 2 million Mexicans had crossed the U.S. border by 1990 seeking better lives as undocumented residents. But after the 1994 North American Free Trade Agreement (NAFTA), the numbers surged. By 2000, 4.8 million undocumented Mexicans, despairing of their future at home, were in the United States.

Orthodox thinking, it seems, has a problem. On its website, the World Trade Organization (WTO) still has emblazoned the original win-win model published by the British economist David Ricardo in 1817. If Britain uses less labor to make a yard of textiles than to make a gallon of wine, and Portugal uses less labor to make the wine than the textiles, Ricardo argued, they can each produce the good they make most efficiently, trade some of it for the other country’s good, and obtain more of both. Protectionist barriers are akin to throwing rocks in one’s own harbor.

The Ricardian model captures important insights, but its benefits are only fully realized if all its assumptions are met. Ricardo point-blank assumed away today’s fear that free trade allows factories to move abroad. Investors, he maintained, were generally “satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations,” he wrote, because they feared locating under “a strange government and new laws.”

His model, as well as modern variants of it, also assume that trade is balanced, both nations enjoy full employment, each nation has a single wage (income inequality is literally zero), and trade doesn’t affect the course of industrial development—all wild stretches. Of course, other models have delved into the issues the Ricardian model assumes away, but none has been so enshrined in contemporary thought.

In fact, Ricardo himself cared deeply about two of the issues his model writes off: income inequality and industrial development. The aristocracy was his particular bugbear. The idle rich monopolized agricultural land and drove up the price of wheat, the staple food of the working class, he argued. He fought against laws blocking grain imports in the hopes of reducing food prices, easing pressure on workers, and still leaving industrialists with higher profits. Since profits were nearly all invested (banking was still rudimentary), if they increased, Ricardo argued, they would spur development.

Beyond using it as an example in his model, Ricardo seems to have thought little about Portugal itself, but its unhappy situation also highlights development concerns that his schema can’t deal with. In 1703, the Royal Navy had sailed into Lisbon and forced Portugal to sign a now famous treaty to trade its wine for British textiles. Portugal never exported enough wine to balance this trade (the Brits, it seems, were insufficient lushes). In real life, to finance the textile trade, Portugal forced slaves to dig gold in Brazil and shipped perhaps 50,000 pounds’ worth every week on packet boats to England.

Demand for Britain’s textiles overseas, key to the early industrial revolution, supported its development. Demand for Portuguese gold supported, well, slaves digging gold. And Britain was not shy about passing acts requiring its colonies to buy more of its wares. “A great empire has been established,” Adam Smith complained, “for the sole purpose of raising up a nation of customers who should be obliged to buy from the shops of our different producers.”

U.S. Treasury Secretary Alexander Hamilton, having learned from that empire’s evident success, called for industrial policies—a national bank and infrastructure construction—and tariffs to shield American industry from foreign competition. Presidents George Washington and John Adams implemented some of these policies, the slaveholding Presidents Thomas Jefferson and Andrew Jackson undermined them (what need have slaveholders for industry?), and then ex-business lawyer Abraham Lincoln championed them.

From the Civil War to World War I, as the United States advanced from peripheral nation to global power, it maintained average tariffs of 40 to 50 percent, Ha-joon Chang of Cambridge University documents in Kicking Away the Ladder: Development Strategy in Historical Perspective. The Smoot-Hawley tariffs that were levied during the Depression—the ones economists never tire of lambasting—were only a bump up to the higher end of the range.

Essentially, all of the countries that we now think of as developed used domestic policies to promote industry and trade protection to shield it, Chang concludes. Modern China’s approach to export promotion and trade protection is just a free variation on Hamilton’s policies and Britain’s before them. Chinese government banks, including the four largest banks in the world, lend to support national manufacturing and booming infrastructure investment, often via state-owned firms. China manipulates its currency to make exports cheaper and imports more expensive, demands that government agencies at all levels buy local, and requires foreign investors to share intellectual property—or just outright appropriates it. “Not unlike the United States in the 19th century,” Wall Street financier Steven Rattner has written, gung-ho Chinese growth policies and lax law enforcement have “an unsavory wild West flavor.”

Another issue Ricardo’s model assumes away—trade’s effect on employment—did not concern politicians until workers gained voting strength after World War I. In a 1937 essay, “Beggar-My-Neighbour Remedies For Unemployment,” the Cambridge University economist Joan Robinson presented win-lose models showing how a nation can use protectionism to run a trade surplus, sustain demand for its goods, and create jobs—all while pushing deficits and unemployment onto its trading partners. Modern economists rail against “beggar-thy neighbor” protectionism but rarely acknowledged her point: why a nation might use protectionism to support its economy to begin with.

Robinson’s concerns loomed large for the negotiators from the 44 Allied nations who met in Bretton Woods in 1944 to negotiate the post-World War II economic order. John Maynard Keynes, leader of the British delegation, had solicited Robinson’s ongoing advice in writing his own economic theory. Harry Dexter White, the U.S. leader, hewed to Keynes’ ideas, as did the overwhelming majority of other delegates. But they all understood Ricardo too.

Believing that trade war had contributed to the Depression and fascism in the 1930s, Keynes called for a global framework that would manage tensions, allow nations to trade peacefully, and sustain full employment. But he and his contemporaries at Bretton Woods did not seek to micromanage gazillions of individual trade rules—unlike Trump today, who believes he can use protectionism to decrease the U.S. trade deficit. The fact is that protectionism rarely affects overall trade deficits or surpluses. For example, throughout the post-World War II decades, Latin American nations such as Mexico, Brazil, and Argentina wielded high tariffs, often exceeding 50 percent, as well as setting fixed quotas on some imports—and still often racked up large trade deficits.

How can a nation with high tariffs run trade deficits? Tariffs regulate what is imported rather than how much. Postwar Latin American regimes would allow in industrial goods they couldn’t produce themselves but block consumer imports—a common development strategy. Overall, they still imported as much as they could borrow from abroad to pay for foreign goods. The United States did something similar after Trump’s tax cuts. Americans had more money in their pocket, but U.S. production couldn’t leap to match the demand, so goods poured in from abroad. The trade deficit swelled.

To prevent such outcomes, when the Bretton Woods negotiators set out to support trade but avoid large imbalances, they focused on financial flows across borders—IOUs nations accumulate in exchange for exports when they run trade surpluses or incur when the run trade deficits. The International Monetary Fund would monitor and control these flows.

The IMF would lend to deficit nations, but if they began borrowing too much, the fund would require them to cut government expenditures to reduce demand or otherwise slow imports. On the flip side, if a nation’s surplus began to rise, the IMF would start requiring measures to correct the problem. Before too long, the IMF would authorize deficit nations to completely halt exchange of the surplus nation’s currency, blocking its exports. Had the IMF operated as planned, China would have never had a chance to rack up its recent trade surpluses.

But the IMF faced immediate problems. After World War II, the administration of President Harry Truman—more economically conservative than the administration of President Franklin D. Roosevelt that had negotiated Bretton Woods—did not want to let any international agency interfere with U.S. trade surpluses. It starved the IMF of capital, personnel, and authority, quashing it for a decade. When the fund finally stirred back to life in the mid-1950s, it set about imposing harsh conditions on deficit nations in exchange for bridge loans. It hardly touched surplus nations.

By the 1960s, as some U.S. sectors went into trade deficit, IMF managing director Pierre-Paul Schweitzer, U.S. representatives to a fund meeting in 1967 in Rio de Janeiro, and other officials pushed to revive something like the original Bretton Woods system. But France, believing it would abet U.S. “hegemony,” opposed the idea, and Japan and Germany, having emerged as major surplus nations, dragged their feet.

Germany now learned to measure economic success not by “domestic well-being,” the economist Adam Tooze has lamented, but by “the scale of its trade surplus.” Though it escapes notice, Germany often runs surpluses in goods and services larger than China’s. Indeed, the financial IOUs Southern European nations signed over to German banks to cover their trade deficits set up the euro crisis.

All along, politicians never really seemed to believe Ricardo. Even U.S. President Bill Clinton, the consummate globalist, promoted NAFTA by promising that it would “create a million jobs in the first five years”—and well-paid jobs at that. Not only did they not materialize, the Ricardian model does not even promise them, but just assumes full employment from the start.

As the touchstone of trade orthodoxy, a position the pragmatic Ricardo himself would hardly have given it, the Ricardian model itself causes harm. By shoving the very idea of trade tensions under the table, it undermines coherent discussion of how to handle them. At best, the result is endless squabbling about dirty exceptions to an imagined world of perfect markets. At worst, the result is trade war, sometimes spilling into real war.

A contemporary revision of the IMF to handle trade tensions might be technically possible—it would first focus on correcting large currency undervaluations or overvaluations (causing sustained surpluses or deficits)—but nations won’t agree to it any time soon. In its absence, they will keep squabbling over trade at best, erupting in trade wars at worst. Global markets, spreading unregulated across national polities, will let capital apply pressure by seeking out cheaper locations to operate—NAFTA helped Mexico attract investment for a few years but soon saw much of it flee for lower-wage China—threatening an equitable income distribution, and on-and-off undermining full employment.