Friday, March 25, 2016

The One Thing Donald Trump is Right About: Foreign Trade & Economic Theory

Donald Trump is a buffoon, a narcissist, an egomaniac, and he has brought the boastful, childish culture of reality television to presidential elections. Nevertheless, there is one thing on which he is absolutely right, and most of his rivals are wrong: economic policy and foreign trade. In general, his rivals simply don’t understand the economics. Let me explain.

It’s widely believed that economic theory “proves” that free trade is always better for the nations that engage in trade. Those who criticize free trade usually say that what happens in practice is that those who lose their jobs because of import competition lack the right skills or are in the wrong locations to take other jobs. This makes the problem sound temporary. However, this line of argument is completely wrong—and economists have known it for 40 years.

The theory of free trade goes back to David Ricardo, classical economist and Portuguese-Jewish-British stockbroker who developed free trade theory in the years after the Napoleonic wars. Ricardo showed that if England produced wool and wine, and Portugal did the same, then if the two nations agreed to trade, England would concentrate on wool production and Portugal on wine. The result would be that total output would rise and both nations would benefit. That makes sense, right? Wool and sheep belong on England’s verdant fields, and vineyards on Portugal’s dry, rocky hillsides. And in the fifty years following Ricardo’s death in 1823, Britain rose to become the world’s number one economic power with free trade playing a leading role in its success.

But buried within Ricardo’s model are assumptions that don’t hold for modern industry.  In Ricardo’s model of a world of highly competitive agricultural goods, prices don’t change whether or not a country engages in trade. In the real world of modern industry, prices do change if a nation increases its trade. A simple example, which nobody disputes, is that smartphones are cheaper because most of them are assembled in China than they would be if they were assembled here in the U.S.  In 2004, Nobel-winning economist Paul Samuelson published an article (1) that demonstrated that if trade causes the price of goods in which the trading nation previously had a dominant position to fall, then that nation’s national income can and probably will fall. And that’s despite the benefit of being able to buy those goods at lower prices. Describing a case where China invents a product that competes directly with a product wherein the U.S. was previously dominant, Samuelson wrote: “this invention abroad that gives to China some of the comparative advantage that had belonged to the United States can induce for the United States permanent lost per capita real income…and mind well, this would not be a short run impact effect. Ceteris paribus it can be a permanent hurt.”  Samuelson called the Ricardian view that free trade is always beneficial for a nation a “popular polemical untruth.”  

And Samuelson found plenty of evidence of the phenomenon of falling national or regional income in history: “Economic history is replete with…examples, first insidiously and later decisively: in the United States, farming moved from east to west two centuries ago; textiles, shoes and manufacturers moved from New England to the low-wage South early in the last century; Victorian manufacturing hegemony became replaced by Yankee inroads after 1850.” In each case, the move of an industry to a new region had negative economic effects on the original region.  Samuelson claimed that he first put forth this analysis in his Nobel lecture in 1972. Unfortunately, few took any notice then.

Since today we are all encouraged to believe that television and social media are accurate portrayals of real life, I’ll add my own example: the TV series Mad Men showed how in the late 1950s and early 1960s New York’s Madison Avenue thrived because it was the center of the U.S. advertising industry. Pay was high and expense accounts were lavish.  The series went on to show that once consumer goods industries realized how important and expensive advertising services were, rival less-costly ad agencies began to spring up in cities like Detroit and Los Angeles. The effect (pretty obviously) was negative on New York’s regional income—men like Don Draper, if made unemployed in New York, could not find employment at similar pay levels in other industries. New York lost its quasi-monopoly position in advertising services and suffered economically. In fact there’s a double whammy: prices of the services fall due to competition, and the volume of the services produced within the region fall due to other regions taking significant market share.

New York could not and should not have “protected” itself against competition from Los Angeles—we are one nation. But the implications of an accurate appreciation of economic theory for trade and foreign competition are important. Most of the moves to expand world trade from 1945 to today’s Trans-Pacific Pact have been led and promoted by the U.S.  American support for free trade, like Britain’s support in the 19th century, was motivated partly by the conviction that our leadership in many industries was so unassailable that we would win in foreign markets with our complex technical goods like autos, airplanes, and later microchips and computers.

But since the 1970s, it’s become clear that our lead is not unassailable. Asian nations have copied our technology, and in many cases innovated their own solutions, and taken market share from us. Political leaders have continued to support free trade, partly because of a blind belief in Ricardian theory, partly because they believe free trade wins us friends overseas, and partly because they think protectionism would just turn into “featherbedding” for unions trying to protect jobs. There’s a lot of validity in the second and third reasons. But what if unfettered foreign trade continues to have a negative effect on U.S. national income? What if globalization means just what it implies—that the wages of American workers will fall to meet the wages of Indian, Chinese, and Mexican workers? There are a lot more of them than there are of us, so anybody who understands how weighted averages work will instantly appreciate that our wages will fall faster than theirs will rise.

And what if well-managed foreign countries successfully target those industries where wages and profits are highest? Then other nations get the leftovers. This is exactly what has happened in the last couple of decades. Check out Figures 1 and 2, which show how U.S. manufacturing industry has declined since the year 2000, while the number of wait and bar staff has risen steadily. According to BLS figures, the average pay for a manufacturing worker is $25.58 an hour (and she works an average 41 hours a week), while a wait/barstaff person earns $13.20 an hour (working an average 25 hours a week). With those trends, it’s no wonder average incomes in the U.S. are not rising. It also won’t be long before wait/barstaff overtake manufacturing employees. We’ve heard about nations that succeeded and dominated the world as great military powers, great seafaring powers, or great manufacturing powers. I have not yet read of any that succeeded through their great bartending skills.

Figure 1: US Manufacturing Employment 2000-2016 (Source: BLS)

Figure 2: US Food & Drink Employment 2000-2016 (Source: BLS)

The great virtue of Donald Trump (despite his many failings) is that he is waking up the entire political establishment to this economic reality. In recent weeks, senior Democratic economic advisor Jared Bernstein has published an article entitled The Era of Free Trade Might Be Over. Hillary Clinton has flipped to now oppose the TPP—which was always based on the crazy idea that by opening up our markets even more extensively to ten Asian nations, we would win greater political and strategic support in Asia. Kind of like telling the guys in the tough gang at school that you’ll give them twice as much candy each day and in return you want them to like you more.

One final point: members of the educated classes are fond of labeling Trump a “populist” or “demagogue,” as if that dismisses him as a fool. In my mind there is a big difference between the two terms: a populist is a politician who appeals to the uneducated masses based on genuine policy prescriptions. A demagogue is someone who cynically uses his speechmaking skills to win popularity with no intention of carrying out any of his promises. Trump is a mixture of the two—there is sincerity along with cynicism, and probably (like Evita Peron) a healthy measure of self-delusion. But it’s worth remembering the achievement of the greatest populist in American history, William Jennings Bryan. He ran for the presidency in 1896, and was trounced by William McKinley. The heart of Bryan’s campaign was economic policy: he wanted the government to help out farmers by reversing the painful decline in farm prices through monetary expansion. His “cross of gold” speech is still one of the greatest speeches in U.S. political history. Sometimes the common people recognize a problem that the educated elite can’t or won’t see. Bryan and his common people were right, and not long after Bryan lost the election, the Federal Reserve was established and the federal government took control of the money supply and ultimately of price inflation. 

Like Trump, Bryan was a bit of a buffoon. But populists are like that.

(1) Paul A. Samuelson, Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization, Journal of Economic Perspectives, Vol. 18, No. 3, Summer 2004.


  1. Hi Jeff:
    An apparently devastating piece. But if "economists have known for 40 years" that Samuelson is right, why don't more of them say so? On the face of it they'd have much to gain by speaking up. Trump isn't the only presidential aspirant who might welcome cover for a protectionist tilt.

  2. Hi David,
    That's a good question. I checked with an MIT professor who is an authority on trade and he told me: "there's no major professional dispute about the validity of Samuelson's argument." I think the problem may lie in the fact that economists don't know what to conclude or recommend based on the fact that trade can be negative. There's no obvious policy response. Blanket protectionism is, it's generally agreed, not a good idea. Right now, liberal economists are generally focused on redistribution as the big policy idea, in all its forms: raising the minimum wage, changing taxes etc. But I think over the next few years we'll see more economists and policy ideas emerge because redistribution does not address the growth issue. Rgds, Jeff