Free Trade with a Hostile Mercantilist Empire?

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.

11 thoughts on “Free Trade with a Hostile Mercantilist Empire?”

  1. Regarding the proper measure of national well-being, economic growth, consumer consumption, etc, the guy at Political Calculations (a darned good econometrics blog) has been tinkering around with a different measure for GDP proposed by economist Irving Fisher called the National Dividend:

    “The national dividend or income consists solely of services as received by ultimate consumers, whether from their material or from their human environment. Thus, a Piano or an overcoat made for me this year is not a part of this year’s income, but an addition to capital. Only the services rendered to me during this year by these things are income”.

    Thus, according to Fisher, the national income of a country is determined by annual consumption. Suppose, a piano of the value of $20,000 was manufactgured in the year 2009, then according to Marshall and Pigou, the entire sum of $20,000 will be included in the national income of 2009. According to Fisher, only the money value of the actual consumption of the piano in 2009 will be $1,000. Therefore, according to Fisher, $1,000 only should be added to the national income of 2009, and not $20,000 as would be suggested by Marshall and Pigou.

    Fisher’s definition appears to be better and more scientific than that of either Marshall or of Pigou, because he includes in the national income of the country only the money value of the actual consuption of goods and services during the year.

    He found that over the years consumer expenditures as measured by the national dividend represented less and less share of GDP, indicating that economic growth was having less benefit on the quality of life of consumers.

    In terms of national dividend, the Great Recession lasted until the fall of 2015 for consumers:

    I’m not sure what the calculation of IM-EX has been over these years and decades, but whatever it was didn’t help typical American consumers, at least according to this metric.

  2. Rigged systems. Both countries have them.

    The US system is rigged to profit the corporate entities who often write the regulations involved.

    The Chinese system is not as simple but is engineered to advantage their strengths, to the end of increasing general welfare.

    Now one can argue about the above, especially the simplicity, but I think it’s true. What this produces now, for me, is a $49 multi-meter that compares very well with the best there are. More accurate than some Flukes. Faster than almost anything in several areas and very well made.

    Remember when people discovered Japanese cars? That is about to happen with almost everything.

  3. I don’t know much about macroeconomics. I’ll just note a couple of things:
    1. The Chinese Communist regime is evil. Period. Considering the size of their population and the length of time they’ve been in power, they’ve almost certainly be responsible for more human misery than any regime in the history of the world. I don’t see any reason we should have anything like free trade with them, and pretend that they’re morally equivalent to Germany, say. Trading with them is equivalent to trading with North Korea.
    2. I fully realize that one can calculate that there is a net national positive economic gain to closing down a huge percentage of our domestic manufacturing base (yes, I know this was happening regardless of our trade relationship with China) and importing all that stuff, given that a couple of million people lose their jobs but a couple hundred million can now buy cheaper stuff, etc., but I don’t recall any sort of vote on that proposition, and a drive across the country at the small towns that all look like a neutron bomb went off, and a look at the obituaries at the horrific situation in so many communities, indicate that this was a trade with pretty catastrophic social consequences.

  4. “they’ve almost certainly be responsible for more human misery than any regime in the history of the world”

    You have it upside down. China has raised in the last 70 years or so a billion people from near feudal conditions to middle class.

    They have done more to alleviate suffering that any other entity in the history of the world.

  5. What’s an Illinois Nazi, and who is Jake Blues?

    I think you may be confused about many things, but I’m open to helping with that.

  6. God help me, I think you’re both right.

    The Chicoms are savage murderers who have killed vast numbers- but lately they have also been stunningly successful at making China more powerful and prosperous. Of course, a whole lot of that success has simply come from ceasing to do stupid things- and from their good fortune of facing a chief rival in the form of a country that is ruled by fools- but still, they’ve been rather successful since circa 1990.

  7. Mercantilism had a certain logic when accounts were settled in gold. Prior to the Spanish conquest of the New World, the total wealth in the world was nearly constant as measured in gold, not much gold was mined in the Old World. With fiat currency this no longer applies. In actual practice, frequent panics and wars and ransoms kept thing interesting. More than one anti-Jewish pogrom was used to finance one or the other.

    China traded their excess dollars for securities that are ultimately exchangeable for more dollars. In the end, the only place that these dollars are worth anything is in the U.S. The equation for any Western currency is the same. Now, China seems intent on preventing any of these dollars from being exchanged for tangible assets in the name of capital conservation. This probably has more to do with preventing looters from off-shoring their loot than fiscal policy.

    At the same time, China has been trying to encourage trade in Yuan. So far, this seems to be happening in countries where international trade is conducted in dollars rather than the national currency. Imagine having to stop at a currency store on your way to buy the newest Iphone. The conversion would actually takes place in the background but the costs still still add up.

    China’s trillions in foreign reserves will disappear into inflation sooner or later. It will be a gift from the sweat shops to the rest of us. The chaos and dislocation when the sweat shops find this out will be deadly and, considering the Chinese nuclear capability, very interesting to watch from the sidelines.

    I often wonder if the first cargo of iron ore that will never be made into steel has already sailed, when the first ship to be scrapped without sailing will be laid down, how much steel is in stock piles where it will stay. The Chinese economy is deeply corrupt and opaque, most of all to Beijing. Almost any disturbance to trade will cause large numbers of workers to be sent into the streets, many without the pay that they have earned, let alone any sort of severance or unemployment cushion. I anticipate massive demonstrations repressed with ruthless force.

    The $49 meter along with the $30 smart phone is why neither Fluke or Apple will make much from the mirage of the Chinese consumer. Of course, the $300 Fluke is likely made at the same factory as the $49 one, just yellow and gray instead of green. You can also buy real Fluke for 1/2 -2/3 price if you will take Chinese packaging and manuals.

  8. 初めましてのコメントでおじゃまします。楽しいお誘いって急にやって来るのでお金がないと大変ですよね。



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