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Clarifications on the Case for Free Trade

Mises Daily: Saturday, January 10, 2004 by

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Free trade has necessary conditions. Today these conditions are not met. This point has escaped Joe Salerno and George Reisman (both writing on Mises.org), as it has a vast number of other people.

The case for free trade is based on David Ricardo’s principle of comparative advantage. Ricardo addressed the question how trade could take place between country A and country B (England and Portugal in his example) if country B was more efficient in the production of tradable goods (cloth and wine in his example) than A.

In other words, if Portugal could produce both cloth and wine at lower cost than England, how could trade between the countries benefit each?

Ricardo found the answer in relative or comparative advantage. He said that if Portugal specialized in wine, where its absolute advantage was greatest, and England specialized in cloth, where its disadvantage was least, total output would be higher than if both countries achieved self-sufficiency by producing both products. The higher productivity from specialization would result in mutual gains from trade.

For comparative advantage to reign, two conditions are necessary:

One is that capital and labor must be mobile within each country so that the capital and labor employed in England in the production of wine can flow into the production of cloth, where England’s trade advantage lies. In Portugal capital and labor must be able to flow from cloth to wine where Portugal’s advantage is greatest.

The other necessary condition is that capital and labor (factors of production) cannot be internationally mobile. If the factors of production are internationally mobile, capital and labor would move from England to Portugal, where both commodities can be produced the cheapest. Both wine and cloth would be produced in Portugal. Portugal would gain and England would lose.

Ricardo makes it clear that for trade to make both countries better off, trade must be based on comparative advantage. Ricardo gives reasons why, in his time, factors of production are internationally immobile.

Since the time of Ricardo, the key assumption of trade theory remains, in the recent words of trade theorist Roy J. Ruffin, "the inability of factors to move from a country where productivity is low to another where productivity is higher." In a recent article in History of Political Economy (34:4, 2002, pp. 727-748), Ruffin shows that Ricardo’s claim over Robert Torrens as the discoverer of the principle of comparative advantage lies in Ricardo’s realization that comparative advantage, the basis of the case for free trade, lies in "factor immobility between countries." Ruffin notes that "of the 973 words Ricardo devoted to explaining the law of comparative advantage, 485 emphasized the importance of factor immobility."

If factors of production are as mobile as traded goods, the case for free trade--that it benefits all countries--collapses. There is no known case for free trade if factors of production are as mobile as traded goods.

For some time I have been pointing out that the collapse of world socialism and the advent of the Internet have made factors of production as mobile as traded goods. Indeed, factors of production are more mobile. Capital, technology, and ideas can move today with the speed of light, whereas goods have to be shipped.

The collapse of world socialism has made Asian countries, such as China and India, receptive to foreign capital, and it has made first world capital willing to migrate beyond first world countries. The Internet makes it possible for a country to hire knowledge workers anywhere on the globe.

The Internet and the international mobility of capital and technology have, in effect, made labor internationally mobile, especially labor that is paid less than the value of its marginal product or its contribution to output. The huge excess supplies of labor in countries such as China and India ensure that it will be many years before labor in those countries, both skilled and unskilled, will be paid the value of its marginal product.

The international mobility of factors of production is a new phenomenon. It permits first world businesses, seeking lower costs, greater profits, and a stronger competitive position, to substitute cheap foreign labor for the entire range of domestic labor involved in the creation of tradable goods and services. Only labor involved in non-traded goods and services is safe from foreign substitution. It is not yet possible to package hair cuts, surgical operations, dentistry or home repairs as internationally tradable services.

Many people confuse the workings of capitalism that lead to lower costs and greater profits with free trade. They overlook the necessary conditions for free trade to be mutually beneficial. The same people tend to confuse the free flow of factors of production with free trade. I have been amazed at the number of fierce adherents of free trade, even among economists, who have no idea of the necessary conditions on which the case for free trade rests.

Senator Schumer and I do not attack the doctrine of free trade. We accept it. We simply point out that the known necessary conditions for free trade to be mutually beneficial do not hold in today’s environment where factors of production are as mobile, if not more so, than traded goods. What we are witnessing, we think, is not trade based on comparative advantage but the flow of first world factors of production to cheap Asian labor where the productivity of capital and technology is highest.

We do not dispute that global gains might exceed first world losses. Nevertheless, the flow of factors of production to absolute advantage in place of comparative advantage vitiates the case for free trade--that it produces mutual gains to the countries involved. What we may be witnessing is global capitalism destroying national sovereignties, leading to a global government, much as Marx described capitalism’s role in the overthrow of feudalism and the rise of the nation-state.

None of the points raised by Mr. Salerno and Mr. Reisman touch on this analysis. They do not make a case for free trade based on the international flow of factors of production to absolute advantage. They do not show that the case for free trade does not rest on the principle of comparative advantage. They do not show that comparative advantage reigns supreme in today’s world of internationally mobile factors of production. Nothing they say touches in the slightest on what I said.

What can be done? Neither Senator Schumer nor I have solutions. Pressed for solutions by the New York Times editors, we said the solution was to restore the conditions necessary in order for free trade to produce mutual gains to the countries involved. But as we could not specify how factor immobility could be restored, the editors allowed us to present a problem without offering a solution.

All we have done is to ask people to think about the implications of the international mobility of factors of production in a world of nation-states. Our first success came on Wednesday, January 7, where a large and varied audience at the Brookings Institution acknowledged that we had identified a problem that deserved thought.

Other responses have been humorous. My free market friends ignored the content of the argument. Their only concern was that I was ruining myself by associating with Schumer. One indignantly declared: "The next thing you will be doing is coming out for gun control!" Schumer’s friends have responded similarly: "Why are you giving luster to that Reagan ideologue who only cares about the rich!"

Other responses have been disappointing. Mr. Reisman’s knee jerks. He mistakenly sees an attack on the doctrine of free trade and rushes to its defense, attributing to me statist motives that I never express and do not have. Reisman’s response is curious in another way. His "refutation" is based on assumptions that he cannot show to be operative.

Mr. Salerno raises a number of red herrings. As many libertarians are blinded by the same red herrings, I will address them and others that he does not mention.

Many people have noted that there is nothing new about the international mobility of capital. However, two crucial aspects of international capital mobility are new: (1) Until recently, capital mobility was limited to the first world, where labor cost differentials are not great. (2) Because labor costs do not greatly differ between first world economies, offshore production for home markets was not the reason for the capital flows. When Japanese and Germans invest in automobile plants in the US, it is to produce products for sale in US markets, not to displace car production in Japan and Germany by selling cars produced in the US in their home markets.

Another widely made error is to assume that US labor displaced by outsourcing, off shore production or the Internet moves into US export industries to meet increased demand for US goods from countries whose labor is made more productive by the inflow of US capital and technology. This model assumes that comparative advantage reigns. The model does not work if absolute advantage reigns.

The enormous and growing US trade deficit, reflecting our growing dependence on imported manufactured goods, the decline in US manufacturing, and the new, but rapid, loss of knowledge jobs, does not bear out the view that US labor displaced by factor mobility is re-employed in export industries. Certainly there is no empirical evidence for Salerno’s statement that US capital outflows are leading to "increased real demand for U.S. exports which raises prices and real wages in these industries." Isn’t Mr. Salerno aware that the dollar is declining in value and the prices of US exports are falling?

The theorizing offered by Mr. Reisman and Mr. Salerno is based on the assumption that comparative advantage reigns. If the necessary conditions for comparative advantage are not present, their theorizing does not hold.

Some try to avoid the issue of comparative advantage with an argument that we always benefit anytime we can acquire a good or service at a lower opportunity cost. This is true as partial equilibrium analysis. If 20,000 US workers involved in the production of brassieres lose their jobs to cheaper foreign producers, their loses will be outweighed by gains to 100 million American women. However, we cannot generalize this argument without the assumption of trade based on comparative advantage. If the full range of domestic labor involved in tradable goods and services can be replaced by cheaper foreign labor, the loss of incomes outweighs the lower prices. The lower prices themselves will be lost to currency devaluation.

Mr. Salerno also confuses the mobility of factors of production within a country with the international mobility of factors of production. The two things are entirely different. The flow of factors of production within the US from North to South or East to West is not comparable in the effects to international flows. To learn the difference, Mr. Salerno need only consult an international trade text.

Another common confusion comes from the misinterpretation of the inflow of foreign capital to the US. Many think that because the US is "a net importer, not exporter, of capital" we are staying ahead of the game. Just look at the huge amount of foreign capital that comes to the US, friends tell me, and the relative small amount of our capital that goes to China. How can we possibly be losing out when we get the lion’s share?

People who argue this way implicitly assume that the foreign capital inflows are going to the construction of new plant and equipment, or at least into new businesses bringing new jobs. However, the facts are different. In recent years, the vast bulk, in some years almost 100%, of foreign capital inflows represent foreign acquisition of existing US assets. Foreign ownership of US stocks, bonds, and real estate is heavy and rising. Foreign ownership means that the current and future income streams produced by these assets belong to foreigners. We are paying for current consumption (imports) by giving up our wealth and future income flows. Being a net importer of capital in this case means that we are consuming wealth, not producing it.

In contrast, US capital flows to China are used to construct new plant and equipment, not to acquire existing Chinese assets.

It is trite to say that capital inflows and trade deficits are mirror images. The question is: which is driving the other? This can vary in time. I was able to refute the "twin deficits" theory advanced by Martin Feldstein and widely parroted by others during Reagan’s first term by showing that the US became a "net importer of capital" not because foreign capital had to rush in to finance "Reagan deficits," but because US capital outflows collapsed in response to the higher after-tax rate of return in the US due to the Reagan tax cuts. The capital stayed at home, and we financed our own deficit.

Today we are a net importer of capital because we are increasingly dependent on imported manufactured goods as a result of outsourcing and off shore production. Goods, and increasingly services, that US multinationals produce abroad for the US domestic market are driving up the trade deficit. Foreigners use the dollars we pay them to acquire ownership of our assets.

People also confuse themselves and others by comparing the large US investment stake in Europe with our small one in China. They overlook that our stake in Europe is a historical result of first world capital and technology being confined to the first world by world socialism. The global mobility of first world capital is new; thus, our stake in China is not as massive as our stake in Europe. Many commentators overlook that new developments are not contained in historical data. They also overlook that it takes large investments just to maintain the existing value of US investments in Europe. As it is extremely expensive to close a plant, adjustment to the new conditions cannot be instantaneous.

As a director of a global manufacturing firm, I am very much aware that outsourcing of high value-added products and jobs has begun to affect European countries. The difference is that, unlike Americans, Europeans are not blind to the reality.

Libertarians need to substitute their thinking caps for their knee-jerk reactions. A hidden agenda might be behind "globalism"--the international redistribution of first world income and wealth. It is a given that if factors of production are internationally mobile, domestic labor that is paid the value of its marginal product cannot compete with foreign labor in situations where excess supply prevents the foreign labor being paid the value of its contribution to output. If absolute advantage rules, capitalism itself will redistribute income and wealth from rich countries to poor ones.

Libertarians might say all to the good. But this overlooks that they live in a sovereign country. The downward adjustment in wages and salaries necessary to bring the US into equilibrium with the global labor market requires reductions that cannot be achieved. For example, try to imagine what must happen to existing mortgages and debts if US workers are to compete with Chinese and Indian workers employed by first world capital and technology. So many people forget that the reason that highly paid US workers could compete against lowly paid Asian workers is that the US workers were much more productive due to the immobility of capital and technology. The international mobility of factors of production has stripped away the productivity advantage of first world labor. Try to imagine the political instability in store for the US as the ladders of upward mobility collapse. The reality toward which we head is not a libertarian paradise.

Are libertarians going to allow their ideology to do their thinking? What good does it do for libertarians to go into denial and to call me, patronizingly, names?

The proper way to answer the argument that Schumer and I have made is to make a case that free trade is mutually advantageous in the absence of comparative advantage. Alternatively, make a convincing case that comparative advantage does not require at least some factors of production to be immobile. Anyone who can devise a new theory that proves free trade to be mutually advantageous in circumstances where factors of production are as mobile, if not more mobile, than traded goods will win a Nobel Prize.
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Paul Craig Roberts [send him mail] is John M. Olin Fellow at the Institute for Political Economy, Senior Research Fellow at the Hoover Institution, Stanford University, and Research Fellow at the Independent Institute. See also his final reply to critics.