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Trade Secrets

How economists kept their doubts about globalization quiet, and ushered in Trump.

Washington Monthly, January 2018

Clyde Prestowitz

Two decades ago, the Harvard political economist Dani Rodrik wrote a book, Has Globalization Gone Too Far?, in which he argued that global trade was creating dangerous fissures in developed nations between the better educated, who prosper under the new regimes, and the less educated, who do not. If not addressed, he warned, these fissures could lead to “social disintegration.” As is customary, Rodrik requested an endorsement for the book’s back cover from a well-known fellow economist. This person declined the request, not because of significant disagreement with the book’s analysis, but because he was worried that Rodrik’s book might “provide ammunition for the barbarians”—that is, protectionists, mercantilists, and other enemies of free trade.

 

Now, with the barbarians at least partway through the gates and in the act of taking over the helm of government, Rodrik has published another hard-hitting book, Straight Talk on Trade. In it, he relates the story above and blames his fellow professional economists for giving the barbarians their opening. He also predicts worse to come at both national and international levels if the professoriate doesn’t start playing straight with the masses. In public, the economists have stubbornly stuck to a theory of free trade and globalization, which holds that free trade (even if practiced unilaterally—meaning that I reduce tariffs to zero even if my trading partners don’t) is always and everywhere a win-win proposition.

Among themselves, however, economists admit that the theory is full of questionable assumptions and contingent conclusions and is not only a cause of growing income inequality and middle-class anxiety in many countries, but also the stimulator of rising international disharmony and of potential outright conflict. Yet they have persisted in publicly discounting the domestic costs of free trade, and wildly over-estimating the gains, in the face of mounting evidence that this consensus view is wrong.

When the North American Free Trade Agreement was being debated during the 1992 presidential campaign, candidate Ross Perot predicted that it would result in a “giant sucking sound” as jobs left the United States. Economists blasted Perot and asserted that the deal would, instead, generate rising American trade surpluses and thousands of new jobs. When the U.S. agreed to admit China to the World Trade Organization in 2001, economists foresaw a sharp decline in the $80 billion U.S. trade deficit with China. In the case of the U.S.-Korea Free Trade Agreement of 2007, economists predicted a dramatic decline in the $17 billion U.S. trade deficit with Korea as notorious Korean tariffs and trade barriers were removed.

In all of these cases, the facts turned out to be the complete opposite of the predictions. U.S. trade with Mexico went from a surplus to a $50 billion deficit. In the case of China, the deficit rose to over $400 billion. Rather than falling, the deficit with Korea about doubled. More importantly, Perot’s prediction turned out to be right. There was, in fact, a giant sucking sound—later confirmed by MIT economist David Autor—as jobs fled the U.S. There was also increased global tension, as much of Asia increasingly orbited China rather than the United States, and as China stole U.S. technology and openly spoke of its own system of “socialism with Chinese characteristics” as superior to America’s free market democracy model.

Rodrik wonders if economists were the underlying cause of Donald Trump’s election as president. He writes, “[E]ven if they may not have caused (or stopped) Trump, one thing is certain: economists would have had a greater—and much more positive—impact on the public debate had they stuck closer to their discipline’s teaching, instead of siding with globalization’s cheerleaders.”

For instance, the economist who turned down Rodrik’s blurb request worried that protectionists would seize on the book’s arguments about the downsides of globalization to justify their narrow, selfish agenda. But, points out Rodrik, many trade enthusiasts are no less motivated by their own narrow, selfish agendas. Pharmaceutical firms using free trade talks to obtain tougher patent rules and multinational firms seeking special arbitration tribunals have no greater regard for the public interest than do protectionists. Indeed, they seek protection in the name of free trade. So when economists shade their arguments, they are largely just favoring one set of barbarians over another.

Rodrik argues that the unspoken rule that compels economists to champion free trade in public and not to dwell much on the fine print has produced a curious situation. “The standard models of trade . . . typically yield sharp distributional effects: income losses by certain groups of producers or workers are the flip side of the ‘gains from trade.’ And economists have long known that market failures—including poorly functioning labor markets, credit market imperfections, knowledge or environmental externalities, and monopolies—can interfere with reaping those gains.” By not listening to their critics, who warned about such things as currency manipulation, and by sticking to models that assumed away such things as trade-related unemployment and income inequality, economists lost the ability to argue effectively against many demagogic criticisms of free trade now enjoying popularity.

Rodrik thus offers this new book to show how a more honest narrative can be constructed and to outline ideas for creating better-functioning national economies as well as a healthier globalization. In doing so, he is following in the footsteps of none other than the great John Maynard Keynes, who wrote, “A favorable balance, provided it is not too large, will prove extremely stimulating; whilst an unfavorable balance may soon produce a state of persistent depression.”

Rodrik sees the key issue as that of “getting the balance right”—in this case, the balance between the difficult if not impossible to achieve globalization of the economists’ dreams and the loyalty that people everywhere persistently show to the nation-state, which, contrary to Davos Man and globalists everywhere, will long continue to be the only effective mechanism for providing the rules and institutional arrangements on which the markets they so adore must rely. Rodrik—who was born in Turkey but also carries a U.S. passport, teaches at Harvard, and roots for a European soccer team—would agree with British Prime Minister Theresa May: “If you believe you’re a citizen of the world, you’re a citizen of nowhere.”

Does this mean Rodrik is aligning with the barbarians and calling for a return to protectionist mercantilism? No. But it does mean that he in no way embraces the popular, early-twenty-first-century notion of a “flat world” in which mercantilism and authoritarianism automatically fade away in the face of a universal embrace of Anglo-American concepts of free trade and democracy. Unlike some free trade prophets who think of globalization as just another form of Americanization, Rodrik warns it could as easily turn out to be a form of Sinicization.

Indeed, he sees the global trading system, as currently constructed, as more likely to cause international crises than to stem them. The reason is that the main global trade institutions—the International Monetary Fund, the General Agreement on Tariffs and Trade, and the World Trade Organization—have evolved in a way that denies Keynes’s first principle of balance.

The original intent and assumption of the institutions was that no country would have chronic overall trade surpluses or deficits. With initial (1948) exchange rates fixed to a dollar that was itself indexed to gold, trade deficits would result in painful outflows of gold reserves. The International Monetary Fund would provide emergency lending to deficit states, but only on condition of following IMF economic policy dictates. Keynes also argued for penalties on countries accumulating chronic surpluses, which in his mind were as detrimental as chronic deficits. Lamentably, the U.S. (a surplus country in 1948) objected, and such penalties were never adopted.

After the United States began to accumulate balance-of-payments deficits and experience rising outflows of gold, President Nixon blew up the postwar international economic system by detaching the dollar from gold and allowing its value to be set entirely by the buying and selling of currencies on international markets. This floating exchange rate system removed all discipline from the United States, which, in effect, now printed the world’s money and could therefore accumulate trade deficits more or less indefinitely without apparent cost.

But, says Rodrik, there has, in fact, been a cost. The new system made mercantilism a sure bet for our trading partners. He emphasizes that the countries that experienced economic growth miracles—China, Taiwan, South Korea, Japan, Germany, and Singapore—all did so by specifically ignoring and not copying the economic policies and government-business relationships of the United States and to a lesser extent of Europe. Free trade doctrine assumes that there are no cross-border flows of capital, labor, and technology. It also assumes that there are no economies of scale (prices fall as output rises). The Nixonian system obviated the assumption of closed capital markets, and the international flow of capital accelerated an international flow of technology and even, to some extent, of labor. This, combined with the fact that economies of scale do indeed exist—especially in capital-intensive, traded goods such as steel, cars, and electronics—meant that mercantilist, national export-led growth strategies would in effect be rewarded, not penalized, by the new international trade system. Moreover, while the United States did not seem to experience an immediate cost and did benefit to some extent—by obtaining inexpensive imports and creating prosperous allies who would generally support its larger geostrategic and military objectives—it did ultimately pay a cost, in the form of lost jobs, lower wages, stolen technology, and the exacerbation of inequality.

But why didn’t the economists and their econometric models pick up on all this?

This is where Rodrik shreds his fellow economists. Essentially, he says they are not at all the scientists they pretend to be. Unlike the natural sciences, he points out, economics does not deal with objective laws, but with often unquantifiable human behavior in social and institutional contexts. Because these are infinitely complex, economists must make simplifying assumptions and can never be sure that a particular type of situation will be indefinitely repeatable.

Take the proposed Trans-Pacific Partnership free trade agreement, which President Trump has vetoed. Trump has been roundly criticized by economists who argue that the deal would have brought substantial benefits to the United States. Rodrik notes, however, that these claims are mostly based on the results of what is known as the Petri/Plummer trade model, which predicted that the deal would increase real incomes for all the participating countries by 2025, with only a relatively insignificant cost to trade-sensitive industries. On the basis of this rosy forecast, President Obama and most of the American foreign policy elite worked to complete the deal. But, notes Rodrik, the model assumed sufficiently flexible labor markets that job losses in some parts of the economy would be compensated by job gains elsewhere. Thus, the possibility that the deal might result in some increase in unemployment or decrease in wages or both is ruled out from the start by the very assumptions of the model.

A competing analytic tool, the Capaldo/Izurieta model, used different assumptions and came to quite different conclusions, predicting wage cuts and increased unemployment in many areas, as well as declining income in the U.S. and Japan. But the Capaldo/Izurieta results tended to be discounted by the trade/foreign policy community, in part because they were at odds with the conventional economic consensus. Yet, as noted above, real-world outcomes over the past thirty years don’t seem to line up very well with the assumptions underpinning Petri/Plummer.

As Rodrik explains, underneath these numbers and the missed forecasts is a fundamental clash of two ways of thinking about trade. The Anglo-American free trade concept is based on the thinking of Adam Smith and the notion that the “unseen hand of the market” should be allowed to perform wonders without government interference. Consumers are king, and the ultimate objective is to increase the consumption potential of households. The alternative way of thinking is mercantilism, which offers a corporatist vision in which the government and private business are allies in pursuit of societal economic welfare and national power. Liberal free traders emphasize consumption, while mercantilists emphasize production. Although America has been a champion of the Smithian free trade approach for the past seventy-odd years, it got rich as a mercantilist power in the nineteenth century and the first fifty years of the twentieth. Indeed, all countries that have gotten rich, including the Great Britain of the eighteenth and early nineteenth centuries, did so while practicing mercantilism.

While not calling for a new mercantilism, Rodrik emphasizes the need for a more “balanced” American way of thinking about and adopting policies for dealing with globalization. He doesn’t go into a lot of detail, but a starting point would be the conscious adoption of a policy of long-term trade balance for the United States. An important step would be taking measures to prevent the tendency of the past sixty years for the dollar to be overvalued, thus making American exports artificially expensive and imports artificially inexpensive. Another step would be to copy virtually all other advanced economies by imposing a value-added tax on all goods and services sold in the United States, but which is rebated on exports.

In addition, Washington could match foreign investment subsidies. Countries like Singapore and China seek to induce the offshoring of factories and R&D facilities to their shores from America by offering free land, tax exemptions, and investment grants. These deals mean that goods that could and should be competitively produced and exported from the U.S. are actually increasingly being produced abroad and imported back into the country. An American war chest to match such offers along with an initiative to impose World Trade Organization disciplines on this practice would go a long way toward restoring long-term American trade balance.

There are many other options, but Rodrik’s main point is that where there is a will, there is a way. What he is calling for is a newfound American will.

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