Why Economists Can’t Connect Free Trade and Low Prices to Economic Growth

Economists in the US are overwhelmingly in favor of free trade. But they continue to be frustrated that the public doesn’t buy their arguments. So frustrated are they that last May, one of the leading pro-free-trade think tanks, the Peterson Institute, invited highly respected economist Alan Blinder, now a Princeton professor and formerly Federal Reserve Vice Chairman to give a talk on why the public doesn’t buy the free trade gospel.

Professor Blinder titled his talk at Peterson Why, After 200 Years, Can’t Economists Sell Free Trade? It’s an accurate title. Blinder cited public opinion polls showing Americans highly skeptical of trade. One poll showed the public felt by a 48%-29% margin that trade with other countries leads to job losses at home rather than job gains. Another poll showed the public favored renegotiating trade agreements by a huge 64%-28% margin.  It’s clear that polls can vary widely: polls using language about jobs tend to get strong anti-free trade results while polls that ask for opinions on low priced imports will get a positive response to free trade. Blinder argued, like many pro-free trade economists, that the American public just doesn’t understand or appreciate the benefits of free trade, in particular the benefit of lower prices to consumers.

But there is another explanation for public opinion. It may not be that the public is too dumb or emotional to comprehend free trade—it may be that the public senses that free trade does not deliver long-term economic growth. And in that view the public would be right. It was conspicuous that in his Peterson talk, Blinder did not once mention long-term economic growth. Americans care of course about low prices. But in the bigger political and social picture, they care more about what they can expect for their jobs and their standard of living over the five or ten years to come. They also care about the prospects for their children. And those issues are linked to the rate of growth, not price levels. And the fact is that the economics of international trade has little to nothing to say about long-term economic growth.  

Noneconomists are often surprised by that statement. They imagine that economic theory embraces all economic forces, and so when economists argue that free trade is positive for the US economy, they mean it’s positive in the short and long term and for all major economic variables including the growth rate. But international trade economics is a division of microeconomics (the economics of prices and markets). It has nothing at all to say at the theoretical level about how free trade contributes to growth. It may be that low prices created by free trade contribute to economic growth by making goods cheap and enabling people to create new businesses. On the other hand, it may be that high prices and prosperity lead to growth by giving potential customers and investors more money in their pockets to fund new businesses. .

Perhaps the best example illustrating the disconnect between free trade and growth comes from David Ricardo, the British economist who first explained the theory of comparative advantage underlying free trade 200 years ago. Ricardo explained that whereas in the early 19^th century, Britain and Portugal each produced wool and wine, both economies could make themselves instantly better off by trading and specializing—Britain in wool and Portugal in wine, because the differing climates guaranteed higher productivity of wool in Britain and wine in Portugal. This analysis was precisely right, and Britain’s influence over the weak Portuguese monarchy enabled it to be largely fulfilled. But from a long-term growth perspective, this specialization was a boon for Britain and disastrous for Portugal. Britain specialized in one of the global boom industries of the 19^th century, textiles and apparel, while Portugal chose to specialize in an industry where profit margins were small and growth prospects dim, partly because other nearby countries produced far more wine from much better soil. Today, 200 years later, Portugal is still wrestling with the inheritance of this awful choice (exacerbated by a euro regime which enforces deflation on the country). Portugal would have done better 200 years ago to have rejected free trade and pursued a protectionist policy to build up its domestic industries partially sheltered from British competition (as France and the German states chose to do).

As far as I have been able to discover, there is only one economics textbook focused on the relationship between trade and growth, International Trade and Economic Growth, by Hendrik van den Berg and Joshua Lewer, published in 2007.  Van den Berg and Lewer point out as I have explained that there is no universal theoretical connection between free trade (or protectionism) and economic growth. They also point out that in the long term, growth is far more important than low prices.  “Estimates of the static gains from trade are very small, on the order of 1 to 2 percent of GDP. Such small gains suggest that free trade is just not very important…The largest gains from trade are the long-term dynamic gains derived from international trade’s positive effect on economic growth.” (Van den Berg and Lewer, pg. 250) This is a point that has, in a roundabout way, been endorsed by Paul Krugman, our foremost trade economist, who has said that “In the long-run, productivity is not quite everything, but almost everything.” Krugman was referring to labor productivity growth, a measure of long-term economic growth per employee and closely linked to the aggregate rate of long-term growth. Note that what Krugman did not say is that in the long-term (or the short-term), low prices are everything.

The importance of growth can be illustrated by a simple mathematical exercise. Economists at the IMF and elsewhere generally agree that the US dollar is overvalued. An overvalued dollar helps to keep prices down but it also restrains economic growth by making US goods less competitive at home against imports and in foreign markets too. With colleagues at the Coalition for a Prosperous America, I’ve published a paper showing that the US dollar’s overvaluation can be estimated at about 25% today. Whenever we talk about reducing the dollar’s value, somebody is sure to protest that prices of imported goods will increase. But the benefits to growth, in terms of increased exports and reduced imports, that would flow from giving our exporters and domestic competitors a (huge) 25% boost in competitiveness are rarely considered. In Figure 1 we show the effects of dollar devaluation on both prices and economic growth. Case 1 shows the US economy chugging along at a stable 1.75% growth rate, more or less the growth rate we’ve seen recently. In Case 2, we look at the effects of a dollar devaluation that leads to faster growth. We assume that in 2018, we drive the value of the dollar down by 25%. Since imports account for about 15% of our economy, this would deliver a 4% increase in prices across the entire economy, so inflation reduces the real value of GDP to just 96 in 2019. But devaluation also adds 1 percentage point to the growth rate. This boost to the growth rate is very powerful: by 2025, seven years after the start of this policy, we’ve caught up to Case 1; by ten years out, Case 2 is 3% ahead; and 20 years out, Case 2 is 14% ahead. That’s a huge benefit in terms of standard of living, overwhelming the higher prices of imports through economic growth.

Figure 1: Dollar Devaluation Generates Faster Economic Growth

In their book, van den Berg and Lewer examine the many statistical studies on the relationship between growth and the two categories they call “open economies” and “closed economies.” There is clearly a correlation between faster economic growth and more openness over the last 40 years, although they point out the relationship is heavily influenced by the four economies known as the East Asian tigers (Hong Kong, Singapore, South Korea, Taiwan).  In my view, it is misleading to lump these four economies together with other so-called “open” (i.e. free trade) economies. A new category is needed for the tigers, and other similar economies, because they are not “open” in the same way that Britain or the US is open. Those four countries practice something better called “managed trade.” Managed trade economies focus on running a trade surplus as a path to growth. Singapore, which has the best growth record of pretty much any diversified economy in the world, has run a current account surplus (current account is a broader measure including the trade balance and a few other items) every year since 1988. In those 28 years, Singapore’s current account as a percent of its GDP has never fallen below the high level of 6.9% and last year came in at 19%, one of the highest levels in the world. Other countries that have chosen to run consistently large current account surpluses and delivered high long-term growth include Germany and China.

Van den Berg and Lewer divide economists’ theories of growth into two groups. One, associated with economist Robert Solow, attributes growth to technological innovation, and sees it as mostly random, i.e. driven by unpredictable scientific discoveries or inventions. Economist Robert Gordon follows the Solow school of thought and his recent book, The Rise and Fall of American Growth, argues that

Growth economist Robert Solow

the US has entered an age of lower growth because the pace of high-impact technological innovation has slowed down since the 1980s. He argues that the 200 years from the beginning of the First Industrial Revolution in Britain through the building of the railroads, the automobile, mass electrification, and related industries throughout the developed world generated a massive increase in the productivity of millions of workers, and that phenomenon is no longer in evidence today.

The second major group of growth theories could be called Schumpeterian. They derive from the work of Austrian-American economist Joseph Schumpeter. These theories also see technology as the most important driving force in long-term economic growth. But they argue that growth rates can be raised by the right forms of corporate organization and by a process Schumpeter christened “creative destruction.”  Schumpeterian growth theories look at issues like the level of research spending in the economy, and the freedom for new competitors to challenge existing players.

The important point to note is that neither of these growth theories include any systematic link to 

Economist Joseph Schumpeter (1883-1950)

trade policy: the rate of technological progress and long-term growth is not linked, in any consistent way to any particular form of trade, whether open, closed, or managed. Van den Berg and Lewer do point out that trade can be valuable when it brings knowledge into a country. But importing knowledge is very different from importing goods. They end their book with the wish that a link could be found between free trade and growth because that would strengthen the economists’ case for free trade: “Economic growth is a complex process that must be fully understood before economists can present the dynamic case for free trade to the public.” (pg. 253)

The theory of comparative advantage and free trade are among the “crown jewels” of academic economics, to quote Harvard Professor Dani Rodrik. It suits academic economists (and their colleagues in many Washington think tanks) to argue that free trade is a great policy and superior to a closed economy. In my view, this binary choice is an obsolete discussion and a hangover from the mid-20^th century. Economic developments since the watershed year of 1973 (when the US enacted a 90-day import tariff and stopped the free exchange of gold for dollars) have shown that we are in a different, more complex world. The US economy is incapable of balancing its trade—in other words we can only pay for all we import with loans from foreigners—and one day those loans will stop coming. The rise of Asian economies shows that managed trade as a strategy works.

But managed trade on its own is not enough. The most successful managed trade nations are the ones that target and favor the industries they view as offering high and rising productivity rates. In general, those are manufacturing industries. Free trade, as practiced in the Anglo-Saxon nations that are its greatest enthusiasts, is leading to an ever-greater shift from high-productivity manufacturing to low-productivity service industries. The small nations that practice managed trade, like Singapore and Hong Kong, have already surpassed most of the free trade enthusiasts in living standards per person. The larger managed trade nations, like South Korea and Germany, are on the way to doing so. It’s time for the US to wake up to the realities of trade and growth in the modern world.