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13 Jul 2020

We interrupt the regularly scheduled programming on growth with a quick lecture on the economics of free trade. Free trade refers to the unencumbered flow of goods and services between countries. Despite the academic consensus around its benefits, it is one of the most contested policy within the public sphere1 - and disappointingly, the Biden-Sanders Unity Task Force has recommended a “Buy American” trade strategy that could limit American imports. In order to figure out why there is this disparity, we will look at the Economics 101 model of trade, before addressing the three biggest concerns around international trade - exploitation of workers, undercutting domestic workers and trade deficits.

What is the Economics 101 of trade?

Economists see trade not as a zero-sum game but as positive-sum one, where people can gain without other people losing out. This is due to David Ricardo’s idea of comparative advantage - that is, when one’s opportunity cost of producing an item is less than another’s opportunity cost of producing that item. Suppose Harvey Specter is better at lawyering than I am, but he’s also better at mowing the lawn. He would earn $500 and$100 an hour for doing those two respectively, while I would earn $100 and$50 an hour.

If we both split our days 50/50 between the two, he’d make 12 * 500 + 12 * 100 = 7,200 and I’d make 12 * 100 + 12 * 50 = 1,800. By contrast, if he only lawyered and I only mowed lawns, he’d make 24 * 500 = 12,000 and I’d make 24 * 100 = 2,400 - that is, we both benefit from specialising in our comparative advantage. Society as a whole would have more lawyering services and mowed lawns too, compared to if we didn’t specialise. Despite him having an absolute advantage over me in both activities, it would make sense for him to focus on lawyering, because he has a comparative advantage there i.e. he’s much better at lawyering than me while only being somewhat better at mowing lawns than me.

In a similar vein, this would suggest that countries should specialise in what they’re good in and trade such that they can still access the other types of good and services, even if they could make it themselves. Because this is dependent on comparative rather than absolute advantage, countries can benefit even if they are worse at producing everything.

The validity of this comparative advantage model is confirmed empirically2. It is seen by a percentage point increase in the trade-to-GDP ratio being associated with per capita income rising by at least 0.5%3, which is corroborated as a causal effect of trade leading to growth across the 19th4 and 20th century5. This is to make no mention of the additional benefits from international trade, in terms of increasing the choices consumers have, accelerating the process of creative destruction and increasing competition6. Finally, free trade can lower the prices of imports relative to exports - by and large, this means people’s incomes go further due to their consumption basket being weighted towards imports, but this is by no means guaranteed.

The first objection to free trade is that it compels overseas workers to labour for exorbitantly low wages in sweatshops. Although it is true that conditions in low-wage factories are rarely glamorous, it is often a significant upgrade from the alternatives.

The misery of being exploited by capitalists is nothing compared to he misery of not being exploited at all.
- Joan Robinson

It is first worth recognising that these workers generally aren’t underpaid. The fact that in 2002, the average Chinese worker made 2.1% of what the average American worker made sounds shocking, until you notice that they were 2.7% as productive - indeed, this correlation between wages and productivity is incredibly strong across the world7.

These sweatshops actually often provide a huge amount of benefit to the developing world. This is because the entry of multinationals allows them to invest in machinery and equipment that brings up local productivity that raises wages, with a literature review finding that the wage premium associated with working for a MNC versus a local job being as high as 100%8.

This can bring up some of the most vulnerable in developing countries. For example, the proliferation of garment manufacturing in Bangladesh due to free trade improved the quality of life for young girls. Because sweatshops pay more than the alternatives and reward some level of education, it meant that compared to their peers, girls who lived close to garment factories were 38.6% more likely to become enrolled in school, 28% less likely to get married while in school and 29% less likely to get pregnant while in school 9.

Policies that attempt to restrict free trade by banning the imports of goods produced by child labour can be counterproductive. The 1992 Harkin Bill in the USA, which prohibited the import of products made by children under 15, caused garment employers in Bangladesh to dismiss 50,000 children, 75% of all children in the industry10. Though freed from the supposed shackles of sweatshops, they ended up trapped in a harsh environment with no skills, little to no education, and precious few alternatives. Schools were either inaccessible, useless or costly. Instead, they were forced to turn to stone-crushing, street hustling and prostitution - all of them more hazardous and exploitative than garment production. In several cases, the mothers of dismissed children also had to leave their jobs in order to look after their children, which meant even lower earnings and quality of life for the entire household.

In fact, this sort of bill has a secondary effect of causing manufacturing jobs to leave countries such as Ghana and Cambodia, which have labour-intensive factories. Instead, they move to wealthier places such as Malaysia, with capital-intensive factories that rely on machinery and automation. This results in an increased disparity within developing nations between the better-off developing countries and those condemned to perpetual poverty, because these policies have taken away their comparative advantage.

By contrast, a prime example of how sweatshops have allowed entire countries to give their citizens a better quality of life is Bangladesh. When it won its independence from Pakistan in 1971, it was far poorer than the country it left, with only 6% of its GDP coming from manufacturing compared to Pakistan’s 20%. Despite this, and despite the fact that its war for independence had left millions displaced, its infrastructure damaged and access to Pakistani funding gone, Bangladesh now boasts a GDP per capita 5% higher than Pakistan’s. Its industry accounts for 30% of GDP, and a country that was once struggling to clothe its people now exports more garments than India and Pakistan combined. More importantly, this wealth hasn’t been concentrated in the hands of wealthy factory owners – average incomes for the poorest 40% grew faster than for the country as a whole and absolute poverty has gone down by 65% since independence. That is 50 million Bangladeshis who are no longer starving and in absolute misery.

What about jobs at home that are lost?

The second main objection to free trade comes from the seemingly straightforward fear that foreign competition threatens living standards in advanced countries. If someone has learned to do something that used to be my speciality and are willing to work for a fraction of my wage, won’t I either be out of a job or have a lower standard of living? However, this is misleading - when world productivity increases as developing countries converge, average world living standards must rise. We can see how this occurs via examining some stylised models courtesy of Krugman11.

Suppose a world where there is only labour as a factor of production, and every country makes the same product. Wages would be determined by the productivity of labour, with chip prices being constant throughout the world due to arbitrage. That means the ratio of wages between different countries would equal the ratio of their productivity. If a country with previously low wages and low productivity increased its productivity, it would see its wage rates increase, with no effect on high wage countries.

Let’s now add three types of goods: high-tech, medium-tech and low-tech. Assume two countries called the North and the South. We have Northern labour being 10 times as productive than Southern labour in high-tech goods, 5 times in medium-tech and 2 times in low-tech. High-tech goods would likely be solely produced in the North and low-tech goods in South, while both competed in making medium-tech goods. Competition will mean that there is one wage within each country, as otherwise labourers would switch sectors. It will also ensure that ratio of wages between the North and South will be 5:1, the ratio of their productivity in the area where they compete.

Even though low-tech workers in the South are half as productive in low-tech, they’re being paid one-fifth as much. If Southern productivity increases in low-tech, the only effect is to make low-tech goods cheaper and raise real wages for everyone. If it rises in the medium-tech, Southern wages will rise - but because productivity has not risen in low-tech, those prices will rise and reduce real wages in the North. What this means is that the way Southern growth hurts the North is via rising export prices, not by undercutting workers. This ought to show up as a decline in the terms of trade, which is the ratio of export-to-import prices. However, this hasn’t happened, with advanced economies having seen terms of trade improve.

So does that mean trade is all positive?

The problem with the model of comparative advantage we began with and the ones we are using now is that they are full of simplifying assumptions. In particular, we’ve implicitly assumed that all labourers are identical and can swap between different industries frictionlessly and without difficulty. In reality, that is a process that takes time and doesn’t always occur.

Let’s include skilled and unskilled workers to demonstrate. If the North a higher skilled-to-unskilled ratio, it will naturally have a lower skilled-to-unskilled wages ratio. This means the North would be exporting skill-intensive goods in exchange for labour-intensive goods from the South. This makes skilled labour in the North scarcer and unskilled labour more abundant, which although unimportant on the overall wage rate, could lead to inequality between skilled and unskilled labour. This is a distributional cost from trade.

The difficulty of workers retraining and moving to another sector means there are also adjustment costs. For example, research has found that although the rise of China within the global trade system had no net negative effects on the USA, it did lead to concentrated job losses in certain areas which have persisted for over a decade, a testament to how immobile labour really is between different sectors and different parts of the country12.

So is free trade the reason for the economic stagnation in the Rust Belt?

Clearly it plays a role - but Autor et al. only show that the effects are persistent. 88% of the loss in manufacturing jobs can be accounted for by the increasing productivity of manufacturing workers, rather than free trade13. But where it does hit people, estimates suggest that impacts can vary. If mass layoffs from sectoral decline occur during good economic times, this wipes out what is equivalent to 1.4 years of pre-displacement earnings14. But if this occurs in bad times, that reaches 2.8 years of pre-displacement earnings.

In theory, this is a very tractable problem. Free trade provides a Kaldor-Hicks improvement - that is, those that are made better off could hypothetically compensate those that are made worse off and still be better off themselves. That means via redistribution, we could get a Pareto improvement, where everyone is either no worse off or better off. The government could tax those who received gains from trade and redistribute some of it to those harmed, by providing a safety net and retraining programs such that they can get a new job. In practice however, the political will and efficacy for programs such as the Trade Adjustment Assistance have been lackluster at best, causing some workers to suffer and to be unable to get back on their feet.

A third objection revolves around the balance of trade, exemplified by Trump’s narrative of trade deficits being bad. Here’s the thing - trade deficits simply mean that a country is importing more than it is exporting right now.

Let’s consider trade balance at an individual level - people run trade deficits with their supermarkets when they receive goods, but they simultaneously run a capital surplus, by paying money. They are able to do so, because they run a trade surplus at work where they export their labour and run a capital deficit by receiving wages. This suggests that bilateral trade deficits, like Trump’s concern about the US’s with China, is a non-issue.

Suppose someone takes out a loan to pay for books and supplies. They are running a trade deficit that is balanced a capital surplus, the loan. In the long-run, this trade deficit will eventually turn into a trade surplus when they get a job use the surplus earnings to pay back the loan. Although this limited their future consumption, borrowing was still a good idea. Trade deficits can be financed by a job, a loan or by selling assets.

In a similar fashion, Walmart buying towards from China increases the USA’s trade deficit. But Chinese toymakers have to do something with the US dollars they earn. Either they buy American computers, putting it back in trade balance, or they invest it in the USA, causing a capital surplus. Or they keep it, which means there are more US dollars in circulation and depreciating its value. If the US dollar is worth less, Americans will be able to buy less overseas, eliminating the trade deficit.

Because trade deficits are usually balanced by capital surpluses, an optimistic view suggests that this means the country is a good place to invest in, with these investments paying off in the future like the book loan above did. A more pessimistic view sees it representing low savings, where the country is consuming too much and borrowing unproductively. Consequently, the idea that a trade deficit is bad is not a truism, but rather very dependent of how one views the use of the capital coming in, and whether it is funding unproductive asset bubbles or investing for future developments.

Coda: what does this mean for trade policy?

1. Free trade primarily works by Ricardian efficiency gains. There can be other benefits from growth, choices, creative destruction, competition and prices - but these are more ambiguous may end up being a wash.
2. Sweatshops represent an uncomparative take on the choice developing countries face, and free trade can bring sizable benefits even if it seems exploitative.
3. Free trade can have adverse distributional and adjustment costs. These likely do not explain the demise of manufacturing, but they are important costs nonetheless due to their persistence. That is a good reason to redistribute and transform Kaldor-Hicks improvements into Pareto improvements.
4. Trade deficits don’t matter in themselves - the more relevant considerations are the savings rate and the productivity of investments.
5. Hence, trade policy should be about reducing barriers on the free exchange of goods and services across borders, while compensating those who get screwed. (Caveat: this doesn’t all apply if you are a developing country. I may do a post at some point about development and the messiness that arises.)