Regardless of who wins the presidential election in November, the 2016 campaign has already dramatically undermined a major pillar of post–World War II American economic and foreign policy—free trade.
Hillary Clinton’s current rejection of the same Trans-Pacific Partnership (TPP) free trade agreement that earlier she had called “the gold standard” of free trade deals is a far cry from her husband’s 1990s embrace of globalization as essentially the same thing as Americanization. Of course, her shift of position is a dramatic indication of how much she is feeling “the Bern,” since he rejects “all the crazy trade deals” of the past forty odd years.
Even more surprising is Donald Trump’s effective capture of the Republican presidential nomination on the basis of trashing the “terrible trade deals” and the free trade doctrine that have long been tenets of the conservative Republican faith. For all his bullying, narcissism, policy ignorance, and shameless self-contradictions, Trump is resonating with voters in significant part because of his willingness to break with the establishment elite on trade. Yes, his talk of slapping 45 percent tariffs on imports, forcing Apple to move iPhone assembly from China to America, and telling our allies to pay us for providing defense is uninformed and unrealistic. (Presidents don’t have the authority to set tariffs. IPhone assembly is low-pay work that won’t raise U.S. wages; we need to make the high-value-added parts. And allies might—and should—increase their own defense spending, but we can’t make them pay us directly.) The public, however, sees in Trump’s and also Sanders’s comments the articulation of a possibly larger truth and the revelation of a possible giant confidence job.
Of course, it’s possible that all this anti–free trade deal talk is just campaign hype and that orthodoxy will return to rule in Washington after the election. However, the fact that the top presidential candidates in both parties—conservative Senator Ted Cruz also opposes the TPP—have turned against policies upheld in bipartisan fashion since the end of World War II suggests otherwise. The public has spoken: polls show that opposition to current free trade arrangements is one of the few positions Democratic and Republican voters share.
How did we get to this point? The answer is twofold. For seventy years, leaders of both parties have pursued trade deals less to strengthen the American economy than to achieve geostrategic aims, from rewarding political-military allies to fostering development of emerging markets. And they’ve been encouraged in this pursuit by generations of economists who have argued that trade deals, no matter how one-sidedly generous to other nations, are also good for the American economy—which raises the second point. Globalization has changed conditions so dramatically that this orthodoxy is no longer true, if it ever was. With the public now in full rebellion and presidential candidates leading, or at least adjusting to, that revolt, change to our trade stance is coming. What we really need, however, and haven’t seen from any candidate, is a comprehensive strategy that can both strengthen the American economy and meet our geopolitical needs.
It is important to understand that from the early 1800s until about 1932, America specifically rejected free trade. Washington and Hamilton were protectionists, as was Lincoln. Teddy Roosevelt famously wrote, “Thank God I am not a free trader,” and Wilson squeezed the last penny out of Great Britain during World War I. So the United States got rich as a disciple of mercantilism.
The Great Depression, victory in World War II, and the outbreak of the Cold War led to a complete change of the American tune. The very high Smoot-Hawley tariffs introduced in 1930 during the Republican Hoover administration had been blamed for the outbreak of the Depression by free traders and the Democratic Party during the 1932 presidential election campaign. In fact, as the University of California, Berkeley, professor Barry Eichengreen has demonstrated, the tariff probably had a mildly expansionary impact on the U.S. economy. But the argument was about power, not facts, and after 1932 it became a given in any economic discussion that Smoot-Hawley had triggered the Depression and that “protectionism” was a wrongheaded policy.
Moreover, after the war American industry no longer needed protection; U.S. producers were the leaders in virtually every industry. Rather than protection, industrial leaders now asked for access to foreign markets. The great task was no longer for America to catch up, it was for America to help the rest of the world get up. The urgency of this was, of course, greatly heightened by the outbreak of the Cold War. The United States made the rebuilding of its ruined allies and their defense its top foreign policy objective. International economic policy was no longer so much about economics. It had become a major tool of geopolitics, and opening its markets for trade had become a major part of U.S. grand strategy.
It was particularly attractive that this free trade approach was said by economists to be always and everywhere a win-win proposition. This idea was based primarily on the insights of the British banker David Ricardo and the Swedish economists Eli Heckscher and Bertil Gotthard Ohlin. In 1817, Ricardo developed the notion of “comparative advantage” by using the example of the production of cloth and wine in Britain and Portugal. He posited that in Britain, 100 hours of labor were needed to produce a unit of cloth and 120 to produce a unit of wine, while in Portugal it was only ninety hours for cloth and eighty for wine. So Portugal was the low-cost producer of both products, but it had a bigger cost advantage in wine than in cloth. If both countries specialized in what they did best and traded for the rest, the total amount produced of both products would be greater and each country would have more of both. Even if Britain refused to specialize, Portugal would still have more by doing so, and vice versa.
In the 1930s, Heckscher and Ohlin elaborated on this by adding capital and natural resources as factors of production to Ricardo’s labor. Whereas Ricardo had assumed that differences of technology within countries determine what they do best, Heckscher and Ohlin assumed that technology would spread rapidly and evenly to all players, and trade flows would be determined by endowments of land, labor, and capital.
A country rich in capital and with a high quotient of skilled versus unskilled labor would be expected to produce capital-intensive, high-technology products (computer chips, for example) and to export them in exchange for low-skill, labor-intensive, or naturally occurring products (apparel, toys, oil) from countries with a lot of unskilled labor or significant holdings of key natural resources.
It worked beautifully—at first. A succession of international economic deals slashed tariffs and provided capital and technology transfers that brought not only prosperity but also democracy to Europe and Japan while Communist expansion was checked in Europe and Asia. Exchange rates were fixed (per theory), international financial flows were relatively small, U.S. companies were happy with their expansion into Europe, and America ran a trade surplus and maintained full employment. It looked like all America had to do was keep the global peace and negotiate more free trade deals, which did seem always to be a win-win proposition, both economically and geopolitically.
Then things got more complicated. By the end of the 1960s, Europe and Japan had fully recovered. In 1971, the United States ran a trade deficit ($2 billion)—its first since 1888. That deficit rose in the 1970s. To stem it, President Richard Nixon traded in the fixed exchange rate system for a floating rate regime, but that didn’t stop “trade frictions” from starting to complicate important geopolitical relationships, especially with Japan. By 1980, the U.S. trade deficit was about $20 billion annually, and about half of it was with Japan.
In its drive for postwar recovery, Japan had ignored American advice to concentrate on production of labor-intensive goods. As an architect of the Japanese economic “miracle,” Naohiro Amaya, once explained, “We did the opposite of what the Americans told us.” The key elements of the miracle model included the protection of domestic markets, virtual prohibition of foreign investment, compulsory savings deposited into government-guided banks that directed lending to target industries, export-led growth, industrial policies aimed at developing domestic production in “strategic” industries (steel, shipbuilding, automaking, semiconductors, and so on), a currency that was undervalued against the dollar, technology transfer as a condition for foreign entrance into the market, and emphasis on building advanced infrastructure.
This was neither Adam Smith’s famous “unseen hand” nor the comparative advantage of Ricardo. It was “catch-up” industrial policy, and it worked so well that it was quickly imitated by Korea, Taiwan, Singapore, Malaysia, and others. It also gave rise to two conflicts: an external one between America and many of its trading partners, and an internal one pitting America’s trade agencies, some of its corporations, and many of its labor unions against its geopolitical agencies—the White House, the Departments of Defense and State, the National Security Council—and most professional economists. The problem was that free trade increasingly seemed to be less than win-win. The model had started to vary from the reality of an increasing number of Americans. Trade agreements slashing tariffs didn’t produce equally open markets. This was partly because U.S. negotiators wanting, say, a good deal from Japan or Germany for the use of military bases or support of a UN proposal would not insist on full reciprocity. But it was also because the mercantilism of important trading partners called into question the verity of free trade doctrine. An increasing loss of U.S. jobs and even whole companies in the textile, steel, consumer electronics, machine tool, auto, semiconductor, and other industries sparked a variety of reactions. Labor and many corporate executives called on Washington to do something about “unfair trade.” The U.S. Department of Commerce and the Office of the U.S. Trade Representative often sympathized with this request, but their proposals were usually overridden in the interagency process by the Departments of State, Defense, and Treasury and other foreign policy and economic agencies that were prepared to accept unreciprocal trade arrangements to obtain geopolitical objectives.
They felt justified in this because the majority of professional economists continued, despite having mostly no experience in trade, religiously preaching unilateral free trade. While they did admit that there might be some “costs of adjustment” in some industries and communities, they held these to be tiny in comparison to the benefits of low import prices for the vast body of consumers. The large number of winners, it was said, would compensate the small group of losers from free trade. The costs were never considered to be very high because full employment was assumed as part of the model. Thus the notion that trade could put overall downward pressure on wages was not considered. In any case, economists were confident that domestic economic stimulus would easily zero out unemployment.
It is important to emphasize here the significance of economists, whose role had become quite important in the wake of the Great Depression and who generally meant by the term “free trade” not the reciprocal market opening that the public generally understood it to be but the unilateral opening of the U.S. market regardless of the actions of trading partners. Thus a country might close its market to U.S. imports while engaging in illegal dumping (selling below the cost of production and/or below the home market price) into the U.S. market, and most economists would call that a gift to U.S. consumers. That the gift might be coming at the cost of otherwise competitive domestic producers and workers, or that it might result in the loss of substantial technological skills and capacity, was just never a significant consideration.
Amid these conflicts and debates, the fundamental founding myth of U.S. global economic policy—that America’s major trading partners were all dedicated in principle to free trade, and were all playing essentially the same game—was maintained. As a policy matter, no difference was recognized between the mercantilist catch-up strategy of a Japan and the largely laissez-faire strategy of a Great Britain. If there were problems, the cognoscenti were convinced that it had to be because all markets had not yet been sufficiently opened. Thus the recipe was to negotiate yet more free trade deals to tear down those hidden barriers. More deals were also seen as a way to strengthen U.S. alliances. This caused complications, because trade deals meant primarily to cement alliances had to be sold to Congress as aimed at opening foreign markets and creating good jobs for Americans. Consequently, the proposed new deals were always presented as the means to reduce trade deficits and create millions of jobs while checking the Soviet Union and China.
While orthodoxy reigned in the negotiating chambers, questions began to arise from some halls of academe around 1980. Young economists like Paul Krugman, James Brander, and Joseph Stiglitz noted that much of world trade was operating outside the theory. Krugman emphasized that this was because the theory rested on a host of now completely unrealistic assumptions—perfectly competitive markets (like commodities such as coffee or wheat), full employment, fixed exchange rates, no economies of scale, no cross-border flows of capital and technology, no costs for closing factories or switching to new industries, no government subsidies or industrial policies, and constantly balanced trade. He particularly focused on the fact that in reality economies of scale not only exist but are a driver of trade flows as or more important than land, labor, and capital in major industries such as aircraft, steel, and autos. For incorporating economies of scale into the standard trade model, Krugman was eventually awarded the Nobel Prize in economics.
Some expected that this “new trade theory” would change trade policies and negotiating strategies. For a while it appeared to rescue orthodox free trade doctrine from the inanity of false assumptions, but the incorporation of economies of scale also changed the theory from one of mathematical certainty to one of mere probability or possibility. Once falling unit costs are allowed among a few large producers, competition is imperfect—when an industry has only a few large producers, any one of them can affect the amount of total supply and the average market price—and comparative advantage depends not only on the cost and productivity of the factors (labor, land, capital) but also on the amount of production.
Under these conditions, comparative advantage can be created by mercantilist industrial and trade policies that will determine who wins and who loses, both between producers and between countries—which is what Japan’s Naohiro Amaya meant when he spoke about rejecting American advice.
It was on this basis that South Korean President Chung Hee Park directed the creation of the Korean steel, auto, petro-chemical, and electronics industries. As a member in good standing of the General Agreement on Tariffs and Trade (GATT) and later of its successor, the World Trade Organization (WTO), and without opposition from the United States, Korea, a country largely without the supposedly requisite capital and skilled labor, protected and subsidized these industries until they became world-class competitors. Korea seemed to prove that mercantilism works quite well, at least as long as your main trading partner embraces unilateral free trade and is more worried about having military bases on your soil and assuring your geopolitical allegiance than about trade results.
In the early 1990s, the former IBM chief scientist and Sloan Foundation president Ralph Gomory and the former American Economic Association president William Baumol developed a series of models that, in contrast to most, incorporated not only economies of scale but also rapid technological changes, sudden shifts in productivity, and large numbers of products and countries. What they found was that, contrary to orthodoxy, there is not one uniquely optimal pattern of win-win trade for all countries. Instead, there are many possible trading patterns, and none are optimal for all parties at any one time. In other words, rather than always being a win-win proposition, free trade is more frequently zero sum—I win, you lose. Consider, for example, Boeing and Airbus: a Boeing sale tends to be more of a gain for job and wealth creation in the United States than an Airbus sale, and vice versa.
Another key Gomory and Baumol conclusion is that whether a country achieves large-scale production, innovation, or major increases in productivity is largely unrelated to climate, geography, and national endowments such as capital, land, and labor. Sometimes the leap will be made by strategic choice (a la Korea) and sometimes by serendipity (a Portuguese entrepreneur may innovate the latest cloth fashion). The key point is that, once achieved, economies of scale and technology innovations become barriers to entry for newcomers, particularly so because normal market dynamics will reinforce the existing market structure. Because these positions yield extra profits and jobs, they are desirable to governments who try to shape policy to achieve them.
Despite these powerful critiques of orthodoxy, no one in either Republican or Democratic administrations or in the powerful foreign policy elite of Washington paid much attention. Partly this was because Krugman abjured the practical significance of what he had wrought, arguing that while a strategic trade policy might sound good in theory, it could not effectively be executed in practice, because of inevitable political tampering. Better the flaws of orthodoxy, he and his more orthodox cohorts said, than the risk of politically inspired management of trade. As for Gomory and Baumol, they were perceived as completely heretical and were quarantined by the economics establishment. So, too, were similar analyses by academics such as Chalmers Johnson and journalists like James Fallows and Robert Neff, who were reporting on the ground in Asia.
The fiction that trade is always and everywhere a win-win was necessary to the smooth functioning of U.S. geopolitical strategy. Thus, trade deals continued along the accustomed track and were sold and defended with the accustomed arguments that they would create economic growth and good jobs. The Tokyo Round of GATT negotiations was concluded in 1979, and was presented as having finally opened the Japanese market. In its wake, however, the U.S. trade deficit with Japan quadrupled and major U.S. industries like the semiconductor industry began to crumble in the face of protected and subsidized Japanese competitors benefiting from an undervalued currency. Between 1984 and 1986, Silicon Valley companies lost about $4 billion and 50,000 jobs.
In reaction to this, one leading Reagan administration economist was reported as having quipped, “Potato chips, computer chips. What’s the difference? They’re all chips.” Perhaps apocryphal, this comment nevertheless perfectly captures the attitude of the high priesthood of trade economists at the time. They thought almost exclusively in terms of today’s comparative advantage rather than of the significance of technology and economies of scale for what might become the comparative advantage of tomorrow.
To be sure, there were concessions to political and strategic reality. In response to job losses and corporate and labor lobbying, the Reagan administration pressured Japan into agreeing voluntarily to limit auto exports, to halt dumping of semiconductors, and to facilitate sales of U.S.-made semiconductors in Japan. There was also the so-called Plaza Agreement (named for New York’s Plaza Hotel, where the accord was signed) of 1985, which revalued the yen. But these measures were reactive and specific and did not change the flow of overall policy and negotiation as the trade deficit continued to rise to about $150 billion by the late 1980s.
The Uruguay Round of GATT negotiations, which established the WTO, was concluded at the end of 1993. Most of the leading think tanks forecast that it would create a boom in U.S. exports and new jobs, and it was presented to the U.S. Congress and public as a final solution that would completely open world markets to U.S. exports.
Before that could be proven, the North American Free Trade Agreement (NAFTA) was concluded in 1994. Negotiations had begun under the Reagan administration, which was chiefly interested in solving a geostrategic and political problem: stopping the flow of illegal immigrants by developing a Mexican economy that would provide sufficient domestic employment. But because it was a trade deal, it had to be sold to Congress and the public by both Republican and Democratic administrations as an agreement that would increase U.S. exports and create lots of good American jobs. This proved a difficult forecast to defend as illegal immigration continued throughout the 1990s and the 2000s and U.S. trade with Mexico switched from a surplus of about $2.5 billion in 1994 to a deficit of about $50 billion today. Illegal immigration did eventually level off after 2008, and it is probably true that NAFTA actually kept a lot of U.S. jobs from going to Asia because Mexican factories bought more parts and components from the United States than did the Asians. But that was no comfort to the working-class Americans who lost their jobs.
Then came China’s entry into the WTO in 2001. The aim of the Clinton and Bush administration officials who negotiated and passed the agreement was, again, partly geostrategic. The pressures of entering a rule-bound international trading system would, the thinking went, encourage liberalization in China, while limiting challenges to existing security arrangements. For a while this bet seemed to be well founded, but more recently things seem to be moving in the opposite direction.
China’s WTO entry also had to be sold on economic grounds. The U.S. trade representative and other top government officials swore to Congress and the public that bringing China into the WTO would cut the then $80 billion U.S. bilateral deficit and create lots and lots of good American jobs. Superficially, this was a reasonable argument. China’s trade barriers were much higher then than America’s. It seemed logical that China would be opening to an America that was already open and that U.S. exports to China would therefore grow more rapidly than Chinese exports to the U.S. But instead of falling, the U.S. trade deficit with China rose, to about $360 billion today, and net U.S. manufacturing jobs lost topped two million.
How did the experts get the forecasts so wrong? The main error was to view these as trade agreements when they were actually investment arrangements. Of course, they all aimed at opening trade, but the real, if unintended, effect was to make Mexico and China safe for direct investment. This was mostly driven by shifting views among business executives. In the past, they had tended to fight to keep their U.S.-based operations and labor forces working. Now, they began to see the offshoring of their U.S. activities and the importation into America of their own offshore production from low-wage countries as the new road to high profits and became enthusiastic backers of the deals.
Prior to China’s entrance into the WTO, U.S. CEOs had often fought for maintaining U.S.-based production and for national competitiveness. Because Japan and Korea had never welcomed foreign investment and European costs were as high or higher than U.S. costs, the opportunity to move a lot of production offshore had not arisen. That changed when China became a WTO member in 2001. It had cheap labor and courted investment if the investors promised to export a lot of their production. Suddenly offshoring became the preferred American business model—consulting companies like McKinsey made a fortune advising U.S. producers how to move their operations to China while closing them at home. U.S. economists and trade negotiators alike had never imagined anything like this happening.
Just one example will tell the whole story. In 2011, GE CEO Jeff Immelt was chairman of President Obama’s Council on Jobs and Competitiveness. At the same time, GE announced that it was entering into a joint venture with China’s state-owned Aviation Industry Corporation (AVIC) to transfer much of its avionics production and development to China. “What?” Obama must have said. Avionics is what all the economic theories say America should be involved in—it’s high tech, and it’s not labor intensive. For trade negotiators, however, the decision was not surprising. China has made aviation a target industry for the future. It also has a large market for aircraft. GE wants to sell avionics to that market. So China is telling GE that if it wants the sale it will have to produce in China and transfer jobs and technology there. Of course, no one says it that directly. But that’s the game. It would be interesting to know if Immelt called Obama before making the announcement, or if Obama called him afterward.
The problem was and is that nothing in the orthodox trade model ever anticipated cross-border investment and offshoring of production. Indeed, Ricardo specifically said that his comparative advantage analysis would not apply under such circumstances.
None of this is meant to argue that international trade and globalization have been nothing but bad for Americans. No doubt the variety of goods available to consumers is greater, the quality better, and the prices lower as a result of increased trade and globalization. On the other hand, it may be the case that average wages and incomes are also lower. Whether free trade has resulted in a net loss of jobs and incomes is a matter of long and continuing debate. However, there does seem to be a growing consensus that it has definitely contributed to the widening gap between the incomes of the rich and everyone else.
Beyond this debate are two incontrovertible facts: the United States has a chronic trade deficit of about $500 billion, or 2.7 percent of GDP, and it has bilateral trade deficits with most major countries. This means Americans are consuming $500 billion a year more than they produce. The United States has become the global buyer of last resort and also the biggest global debtor.
As the buyer of last resort, America plays a valuable role in the international system by providing crucial demand when other countries cannot. This staves off global recessions, or lessens their impact, just as fiscal and monetary stimuli can do with domestic recessions. And, fortunately, the fact that the dollar is the world’s major reserve currency means that America can borrow in its own currency by simply printing T-bills that it sells at little immediate cost to China, Japan, and others. As long as they are willing to buy, the U.S. can continue consuming more than it produces, having a party for itself but also playing the crucial role of buyer of last resort. If, however, another currency, like the Chinese RMB, should emerge as an alternative, the party would be over; America would face a very steep bill and would have to dramatically cut consumption while increasing production.
Even if the dollar remains the world’s reserve currency, persistent trade deficits driven by the offshoring of American productive capacity are increasingly unsustainable economically, politically, and geopolitically. The push to offshore production and technology and the growing challenge from Beijing may well have changed the longtime calculus on trade and geopolitics.
At this point, it is clear that some of the most high-profile pro–free trade thought leaders have changed their minds. The über-globalist and New York Times columnist Tom Friedman has recently said that “free trade with China has hurt more people than originally thought.” Krugman has also acknowledged that he didn’t anticipate the extent of the impact of trade with China on the American workforce. And the longtime orthodox trade champion and former Treasury Secretary Larry Summers is now calling for “harmonization” rather than more “globalization.”
More important, the public has caught on. Trump and Bernie are resonating with the American people because many of them feel in their bones that their future is being stolen by a combination of inadequate trade deals and excessive care for allies at their expense. That feeling won’t pass with the election. The new president will have to redo the old trade-off. The days of unilateral American free trade for unilateral U.S. security guarantees may at long last be ending, but a new strategy is needed.
The first step toward a winning trade policy is to recognize that the game in our time is not trade. It’s globalization, a vastly more complex phenomenon that Harvard’s Robert Lawrence has aptly called “deep integration” of national economies rather than exchanges of goods and services between them. The game is about global power as well as economic welfare. Not all countries play it the same way, and existing rules and institutions are dated and inadequate.
The next president needs to recognize that globalization is deeply geopolitical and should pursue a new set of agreements over the rules of globalization. It needs to have as its central aim the replacement of the U.S.’s unilateral role as buyer of last resort with new arrangements that accomplish the same goal of providing demand, especially at moments when global recessions loom, but in a more equitable and sustainable way.
For its own long-term economic health, it would be nice if the United States could just decide to remove the dollar from being the key reserve currency. But it cannot and, even if it could, should not do so hastily. A better approach would be for countries such as Japan, China, Germany, and South Korea to keep promises they have repeatedly made to switch from investment- and export-led growth to internal consumption–led growth.
A weakness of the post–World War II trading system has always been that there was discipline on countries who ran chronic trade deficits but none on countries who ran chronic surpluses. What is needed now is for countries running chronic, large trade surpluses to be subject to the discipline of surcharges on their exports and limits on the accumulation of foreign assets.
There should also be surcharges for other beggar-thy-neighbor behavior that threatens the global economy. One of those is “dumping”—flooding world markets with products at below home market and/or-cost-of production prices, often as a result of overcapacity driven by export-led growth policies. At the moment, for example, China has more than enough steel production capacity to supply total global demand all by itself. This is ruining the steel industries of Europe, Japan, and the United States, which otherwise are perfectly competitive. Another behavior deserving sanctions is the practice of countries offering subsidies—tax holidays, free land, training of workers, capital grants, utilities at half price—to lure companies to their shores, companies that are competitive where they are. Government-supported hacking operations that steal corporate intellectual property also need to be reined in.
The question is how to bring such an agreement about. Countries will understandably be resistant to changing behaviors that have worked for them. The answer is that the United States should give them an incentive by using all available legal means to halt harmful trade. The White House has the authority to self-initiate anti-dumping actions rather than waiting for complaints from industry. It should do so. A “war chest” similar to that used in the 1980s and ’90s to stop direct export subsidies should be established to counter the investment incentives being proffered abroad. Currency manipulation should be met with counter-intervention in foreign exchange markets by Uncle Sam. These actions would not be ends in themselves, but means to the end of achieving a sustainable world financial order.
The next president will have a new stick to wave to bring other countries together around a new plan. That president can say, in all sincerity, that the American people have had enough. They are no longer willing to support globalization policies that strip the United States of its wealth-creating capacities, and they don’t mind throwing out of office leaders who do. Cut a deal with me, the next president can say, or rest assured the one after me will be worse.