Posted by Kevin Villani on March 14th, 2017 (All posts by Kevin Villani)
2017 marks the 200 year anniversary of David Ricardo’s publication on the theory of comparative advantage that underlies the economic case for free trade. Several years later Frederic Bastiat wrote the satirical Candle Maker’s Petition debunking the arguments in favor of protectionism. This was an ironic choice, as candle makers were politically protected by the Founding Fathers as necessary for the Revolutionary War. These protections lasted several centuries, and in 2016 Senator Chuck Schumer sought it re-instated on grounds of unfair competition from China.
President Trump’s trade representative economist Peter Navarro is making both the political and economic case against free trade with China, which he considers a mercantilist trader with military ambitions hostile to the U.S.
Navarro’s political case is an update of that faced by the Founders regarding candle making. China is viewed as pursuing a trading strategy to accumulate wealth and technical know-how to challenge the U.S. militarily in the South China Sea and globally. China’s mercantilist trade practices result in huge export surpluses with the U.S. He argues that China uses this advantage to weaken America’s industrial base and future defensive capability.
While economists can’t reject this political concern out of hand, it does seem several decades premature given the relative size of the two countries’ navies. At present the US could quickly secure sources of supply for military purposes, and protectionism tends to linger for decades or even centuries.
The second case against free trade with a mercantilist trader relates mostly to the loss of jobs due to “unfair” competition, i.e., not due to inherent comparative economic advantages as much as political subsidies, in China’s case a purportedly cheapened currency and weak labor and environmental protections. The standard argument is that such trade generally benefits consumers at the expense of high cost producers, resulting in a less political more fair distribution of consumption as well as a higher overall level.
In theory winners can afford to compensate losers whether the comparative advantage is “fair” or not. But Ricardo was a short term commodity speculator. The benefits of comparative advantage come after labor and capital has adjusted, which sometimes can take generations due to the sunk costs of capital and the skill and location of labor. Middle aged workers often don’t adjust and re-integrate into the labor force. A mercantilist trader acting as 19th century “robber barons” selling below cost in the short run to wipe out industries and pave the way for future exploitation should be resisted,but protectionism isn’t easily reversed.
But Navarro makes a different argument, that trade with mercantilist countries hurts economic growth and hence the general welfare. Economists since Keynes have treated gross national product (GNP) – what things cost – as a proxy for what they are worth to the public. Keynes convert its components into several categories of final goods C (consumption), I (investment), G (government spending) and (Ex) (exports) minus Im (imports), postulating the familiar accounting identity C+I+G+(Ex-Im)=GNP as both a measure of national well being and a model for improving it through economic growth.
Navarro argues for export subsidies because they increase Ex, assuming all else constant and negative consumption a virtue, thereby increasing GNP. He then makes the same argument for tariffs against imports. Milton Friedman argued that this is perverse: Im-Ex was the proper measure of consumer consumption, hence their economic welfare.
Macro-economists since Keynes have argued for increasing government spending (G) to grow the economy. This is particularly problematic as a measure of economic welfare. Government spending, represents taxation and debt forcibly incurred: fascist governments are inherently militaristic, hence fare particularly well by this measure.
Bastiat, a century before Keynes, highlighted the flaws in using this identity as a policy tool for economic growth, arguing that economics is the study of the unseen as well as the seen – the unseen changing intermediate goods and hence the components of GNP in various ways. Raising final consumer (C) or government (G) consumption lowers (I) investment and hence future economic growth.
Exports should enhance growth by promoting foreign direct investment, but Navarro opposes what Warren Buffett called the “conquest by purchase” popularized in the 1980s when prognosticators warned that the US would be owned by Japan, Inc. due to the U.S. trade deficit and capital inflows. That didn’t turn out to be correct. In fact the U.S. grew fastest during the 19th century by continually running trade deficits (largely with mercantilists) and importing capital that was productively employed, raising real wages and domestic consumption. This was so successful that wealthy Americans ultimately re-purchased their capital stock and started investing abroad.
What was different this time? China invested the proceeds from massive trade surpluses mostly in U.S government debt, investing well over a trillion dollars each in U.S. government agency mortgage securities and Treasury securities. Only about $1 in $7 invested in agency securities reflected real capital investments-the rest just contributed to the housing price bubble – and the direct investment in government securities paid only for current expenditures (some euphemistically called “investments” in human capital). China was an enabler of U.S. fiscal profligacy.
Had U.S. policy encouraged household savings to remain constant at around 10% (instead of dropping to and hovering around zero, net of defaults) and had the U.S. Government and the agencies not increased supply in response to foreign demand, resulting in the domestic liquidation of government debt in favor of business investment, U.S. growth may well have benefited from trade deficit, generating more high paying jobs than those lost to trade, however unfair. But in spite of record low interest rates, business investment has barely covered depreciation. Instead business used non-earning cash and cheap debt to buy back trillions of dollars of their stock, most likely reflecting an uncertain and discouraging political environment for domestic investment.
Ironically, former Federal Reserve Chairman Ben Bernanke blamed China’s savings glut for enabling the U.S. sub-prime lending bubble and by inference U.S. profligacy generally. But when China subsequently sold agency securities, as Fed Chairman he fought to keep the U.S. housing market inflated. His low rate policy was also intended to inflate stocks to boost GNP by stimulating consumption expenditures due to the illusory wealth effect (but few were fooled). The short term focus on stimulating C and G came at the expense of I, resulting in economic stagnation (virtually no growth per capita after the recession bounce back).
The Fed could enable fiscal profligacy because it has no opportunity cost of funds (it “prints” money), whereas the Chinese bear the risk of the Fed inflating away the value of Chinese bond holdings, something it has been attempting to do for a decade without much success. But the Chinese also had a very low opportunity cost as they may well experience huge losses on their excessive domestic state-driven investments. In any event their holdings are relatively short term and they have been winding down their portfolio while increasing gold stocks.
“We have met the enemy and he is us “(Pogo, 1970).
Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates. He has held senior government positions, been affiliated with nine universities, and served as CFO and director of several companies. He recently published Occupy Pennsylvania Avenue on the political origins of the sub-prime lending bubble and aftermath.