…An unbiased explanation of the trade policy options we face today…
Recently and specially during the 2016 presidential election cycle, there has been a great deal of discussion and criticism about both the U.S.’s free trade approach and also the free trade agreements that have either been enacted or are being currently negotiated. This public narrative seems to be based on the sentiment that free trade and free trade agreements are at the expense of American jobs ultimately negatively affecting the economy.
However, what would imply moving away from our current policy of free trade? How would our country change? Would the American people accept the type of changes that would be required to put in place a protectionist or mercantilist policy of trade? If the country moved ahead with a policy change such as this, would our current form of government be able to implement the types of programs needed to make the change from a free market economy to protectionism or mercantilism?
In order to properly answer these question, we must go back to understanding the basic principles and theories of economics under which the policy of free trade was originally conceptualized. We basically have to go back to the beginning.
Economics can be described as a social science that deals with the perpetual motion of wealth and income between firms and consumers. This process can be described as the circular flow of income occurring in society as producers and consumers interact. At its core, economics is the study of how people use resources in their attempt to create wealth.
Within this scientific discipline the theories of trading across national borders are among the most discussed and argued. These trade theories are comprised of seven distinct principals one of which dates back to Sir Thomas Mun’s work Treasure by Foreign Trade (1664) in which he described methods of international trade we know today and was described above as mercantilism.
The six theories that followed this protectionist and bullionist approach are as follows:
• Absolute Advantage
• Comparative Advantage
• Heckscher-Ohlin Theory
• The Product Life-Cycle Theory
• New Trade Theory
• National Competitive Advantage or Porter’s Diamond.
The combination of all of the above theories, even including Mercantilism are the basis for the U.S.’s policy of Free Trade, which points to the concept that any protectionist or inward-oriented approach to business will yield less than robust national economic outcomes. Today’s Free Trade policy is reinforced with an effort to create free trade agreements with those countries and regions that are deemed to offer commercial or geopolitical strategic advantages to the United States.
Out of the seven trade theories previously described, the two that most resonate as relevant to our current national discussion seem to be Mercantilism and New Trade. The reason for this is that mercantilism stands at the opposite end of the U.S.’s free trade policy, while new trade falls somewhere in between.
During the period of time between the 16th and the 18th century, mercantilism became a popular approach for European governments due to the promise that regulation of a nation’s economy would augment state power and wealth at the expense of rival national powers. In basic terms, Mercantilism aimed at accumulating monetary reserves in the form of precious metals through a positive balance of trade, especially as it related to finished goods. Today, these policies of market protection are viewed in a negative light as they often led to wars as well as motivated colonial expansion.
Some of the basic rules that mercantilist states followed were:
• forbidding colonies to trade with other nations
• monopolizing markets with staple ports
• banning the export of gold and silver, even for payments
• forbidding trade to be carried in foreign ships
• subsidies on exports
• promoting manufacturing through research or direct subsidies
• limiting wages
• maximizing the use of domestic resources
• restricting domestic consumption through non-tariff barriers to trade.
In simple terms, mercantilist countries limited imports by implementing tariffs, non-tariff barriers and subsidies to manufacturers in order to export more than they imported.
Absent the threat of war between colonial powers and the idea that countries should seek accumulation of gold and silver (bullionism), mercantilism today represents a different paradigm regarding the relationship between government and state. An economic liberal system, promotes a strict separation between the state and the private sector. On the other hand, mercantilism, aims for a partnership between the state and private business in which common objectives such as high employment rates, domestic economic growth, trade surplus and national power is attained.
Another major difference between economic liberalism and mercantilism lies in the importance attributed to consumers and producers by each of the system. In mercantilism, a strong production structure is paramount and consumption is strengthened by high employment levels with adequate wages. Ultimately, production, employment, and trade surpluses are more important than consumption and low prices.
With mercantilism trade becomes the means of supporting domestic production and employment, therefore creating policies that decrease imports and increase exports. This stands at a stark contrast with liberalism in which consumers are king, and low prices in goods and services are an absolute necessity even at the expense of trade deficits.
Today there are a fair amount of countries that use some form of mercantilist and protectionist approach to international trade. A few of these neomercantilist countries are:
Free Trade Policy
The policy of free trade is a policy followed by the U.S. as well as some other countries. It is a policy where the governments impose minimum restrictions on imports or exports. Free trade agreements are an integral part of free trade as exemplified by the North American Free Trade Agreement (NAFTA), the various other free trade agreements that the U.S. and a host of other countries have entered and by the European Economic Area which allows its members to trade freely with each other.
Most governments espousing free trade typically do impose some protectionist policies that are either intended to support some local employment such as food production, or attempt to limit exports of natural resources. Limits are also imposed on industries that are deemed crucial to national security. In spite of these restrictions on trade, economically liberal countries attempt to keep tariffs, non-tariff barriers, regulations and quotas as low as possible.
Typically, in these countries imports provide low prices and trade deficits are allowed to rise. Increasing household consumption becomes the ultimate goal and economic policies are geared toward creating a market environment that engenders competition, disruptiveness, and hyper retail activity.
The notion that free trade will yield greater benefits to the economy is grounded in David Ricardo’s theory of comparative advantage which posits that it is beneficial for a country to engage in international trade even when it buys products it is able to produce for itself. This theory claims that international trade allows a country to specialize in the manufacture and export of product it can produce efficiently. It can then import from other countries those products they that can be produced more efficiently.
Free traders also point to the impact a tariff or import quota can have on any given market. The chart below and its explanation from a Wikipedia article explains it best.
“The chart…analyzes the effect of the imposition of an import tariff on some imaginary good. Prior to the tariff, the price of the good in the world market (and hence in the domestic market) is Pworld. The tariff increases the domestic price to Ptariff. The higher price causes domestic production to increase from QS1 to QS2 and causes domestic consumption to decline from QC1 to QC2.
This has three main effects on societal welfare. Consumers are made worse off because the consumer surplus (green region) becomes smaller. Producers are better off because the producer surplus (yellow region) is made larger. The government also has additional tax revenue (blue region). However, the loss to consumers is greater than the gains by producers and the government. The magnitude of this societal loss is shown by the two pink triangles. Removing the tariff and having free trade would be a net gain for society”
What we can glean from the chart above, and what free trade proponents claim is that while there is a “concentration of harm” due to factories closing locally and moving their production overseas, leaving thousands out of work, there is an opposite effect of “diffusion of benefits” brought to society due to lower prices. Their claim is that high consuming, free trading economies generate more wealth than their high manufacturing protectionist counterparts.
These proponents also claim that lower prices benefit the poor and the middle class as they are able to afford products they would normally not be able to buy. This allows them to spend money on other items, eventually further benefiting the economy.
As previously stated, this idea that consumption yields greater benefits than production is at the crux of the argument between mercantilism and free trade.
New Trade Theory
New trade theory suggests that the ability of firms to gain economies of scale (unit cost reductions associated with a large scale output) can have important implications for international trade and for the local economy. New trade theorists argue that using protectionist measures to build up a huge industrial base in certain industries will then allow those sectors to dominate the world market.
This is particularly important for infant industries (new industries) which later can allow countries to begin a path to specialization and control over global segments. This model can create the national specialization-by-industry observed in the industrial world (movies in Hollywood, watches in Switzerland, etc.).
Some economists, such as Ha-Joon Chang, have argued that protectionist policies facilitated the development of the Japanese auto industries in the 1950s, when quotas and regulations prevented import competition. Japanese consumers suffered in the short term by being unable to buy superior vehicles produced by the world market, but eventually gained by having a local industry that could out-compete their international rivals.
These economies of scale can outweigh the more traditional theory of comparative advantage. In essence if a country specializes in a particular industry then it may gain economies of scale in that industry allowing for global dominance. This is especially important for firms who have the advantage of being an early entrant as they can become a dominant firm in the market.
Based on the assertion above, we can say that new trade theory suggests that governments have a role to play in promoting new industries and supporting the growth of key industries through strategic planning and investment.
A tactical approach in the usage of tariffs, subsidies and laws that prevent corporations from outsourcing crucial technologies could be needed to achieve the goal of economies of scale locally. (T. Pettinger — 2013)
The theory of New Trade seems to fall somewhere between a protectionist and a totally free market approach or economic liberalism.
Can the U.S. move away from a policy of free trade?
Moving away from free trade will not be an easy endeavor. Adopting a market or trade protectionist policy will bring about fundamental changes in government and in the market place that could be disruptive enough to create wide spread discontent.
The following points are a few of the policy and government changes that must first take place before the U.S. can shift away from free trade, and the subsequent market alterations that will occur.
- Increased tariffs will cause prices to increase. Inflation is a distinct possibility.
• Consumers will experience fewer product options.
• Available retail product options will sell at higher prices causing less volume. Some retail businesses will experience lower volumes and lower profits.
• Poor and middle class people will have to pay more for certain items. Conversely certain items will become unaffordable.
• Increased non-tariff barriers will increase bureaucracy.
• Retaliatory measures will decrease exports to some countries.
• World Trade Organization can approve trade sanction request against the U.S. from member countries affected by higher tariffs.
• Bringing manufacturing back could take several years.
• Companies forced to buy or bring back manufacturing equipment in order to restart U.S. manufacturing will be facing great financial burdens. For example, it could cost Apple hundreds of millions of dollars, perhaps even a billion dollars or more to build factories in the U.S. Even moving manufacturing from China to other countries with free trade agreements with the U.S. could be very expensive. Consumers will be paying for these changes in the form of higher prices.
• Government subsidies are inevitable for those industries that need help in staying competitive in world markets.
• Subsidies are against WTO rules and certain countries will seek to impose sanctions on the U.S. Affected industries to potentially file suit, could be automotive manufacturers, aircraft manufacturers, heavy equipment, etc.
• Subsidies requires the government to pick winners and losers. This could cause discontent within manufacturers of those industries that are not subsidized.
• In order to make proper determinations on subsidies, non-tariff trade barriers, tariffs, import regulations, a department of government will need to be created. The position of “Trade Tsar” would possibly have to be created.
• Any free trade agreement re-negotiations, such as NAFTA, CAFTA, etc., would have to be ratified by congress. The re-negotiation as well as the ratification of the new agreement could become contentious issues nationally as well as internationally.
The question is whether the U.S. consumer will be on board with these dramatic changes in product availability and prices. Industry will also have to change its mindset and allow for a more intrusive government that uses a more centrally planned approach to the market. Another important question is whether the government can micromanage something as complex as international trade successfully. Typically, neomercantilist regimes are more authoritarian than a democracy such as the United States. An example of this is China whose totalitarian approach to governance leaves little or no room for dissent.
Even the move to a new trade approach which is not quite as protectionist requires making and carrying out decisions that are centrally planned and could be considered as government overreach by some.
Can a developed country such as the U.S. be served well by protecting its markets. Traditionally, neomercantilism and protectionism has been within the realm of developing countries looking to grow their economies and maintain high levels of employment.
This is no easy decision for this country. One thing is for sure, even economists cannot agree on which will be the best approach for a country like the U.S.
One thing is for sure, this discussion will continue well beyond November 8th, 2016.