The Free Trade Fallacy
As longtime readers of this blog know, it's not uncommon for the essays I post here to go veering off on an assortment of tangents, and this week's post is going to be an addition to that already well-stocked list. Late last week, as the aftermath of the recent election was still spewing all over the media, I was mulling over one likely consequence of the way things turned out—the end of at least some of the free trade agreements that have played so large and dubious a role in recent economic history
One of the major currents underlying 2016's political turmoil in Europe and the United States, in fact, has been a sharp disagreement about the value of free trade. The political establishment throughout the modern industrial world insists that free trade policies, backed up by an ever-increasing network of trade agreements, are both inevitable and inevitably good. The movements that have risen up against the status quo—the Brexit campaign in Britain, the populist surge that just made Donald Trump the next US president, and an assortment of similar movements elsewhere—reject both these claims, and argue that free trade is an unwise policy that has a cascade of negative consequences.
It's important to be clear about what's under discussion here, since conversations about free trade very often get wrapped up in warm but vague generalities about open borders and the like. Under a system of free trade, goods and capital can pass freely across national borders; there are no tariffs to pay, no quotas to satisfy, no capital restrictions to keep money in one country or out of another. The so-called global economy, in which the consumer goods sold in a nation might be manufactured anywhere on the planet, with funds flowing freely to build a factory here and funnel profits back there, depends on free trade, and the promoters of free trade theory like to insist that this is always a good thing: abolishing trade barriers of all kinds, and allowing the free movement of goods and capital across national boundaries, is supposed to create prosperity for everyone.
That's the theory, at least. In practice? Well, not so much. It's not always remembered that there have been two great eras of free trade in modern history—the first from the 1860s to the beginning of the Great Depression, in which the United States never fully participated; the second from the 1980s to the present, with the United States at dead center—and neither one of them has ushered in a world of universal prosperity. Quite the contrary, both of them have yielded identical results: staggering profits for the rich, impoverishment and immiseration for the working classes, and cascading economic crises. The first such era ended in the Great Depression; the second, just at the moment, looks as though it could end the same way.
Economists—more precisely, the minority of economists who compare their theories to the evidence provided by the real world—like to insist that these unwelcome outcomes aren't the fault of free trade. As I hope to show, they're quite mistaken. An important factor has been left out of their analysis, and once that factor has been included, it becomes clear that free trade is bad policy that inevitably produces poverty and economic instability, not prosperity.
To see how this works, let's imagine a continent with many independent nations, all of which trade with one another. Some of the nations are richer than others; some have valuable natural resources, while others don't; standards of living and prevailing wages differ from country to country. Under normal conditions, trade barriers of various kinds limit the flow of goods and capital from one nation to another. Each nation adjusts its trade policy to further its own economic interests. One nation that's trying to build up a domestic steel industry, say, may use tariffs, quotas, and the like to shelter that industry from foreign competition. Another nation with an agricultural surplus may find it necessary to lower tariffs on other products to get neighboring countries to buy its grain.
Outside the two eras of free trade mentioned above, this has been the normal state of affairs, and it has had two reliable results. The first is that the movement of goods and capital between the nations tends toward a rough balance, because every nation uses its trade barriers to police hostile trade policy on the part of its neighbors. Imagine, for example, a nation that tries to monopolize steel production by "dumping"—that is, selling steel on the international market at rock-bottom prices to try to force all other nations' steel mills into bankruptcy. The other nations respond by slapping tariffs, quotas, or outright bans on imported steel from the dumping country, bringing the project to a screeching halt. Thus trade barriers tend to produce a relative equilibrium between national economies.
Notice that this is an equilibrium, not an equality. When trade barriers exist, it's usual for some nations to be rich and others to be poor, for a galaxy of reasons having nothing to do with international trade. At the same time, the difficulties this imposes on poor nations are balanced by a relative equilibrium, within nations, between wages and prices.
When the movement of goods and capital across national borders is restricted, the prices of consumer products in each nation will be linked via the law of supply and demand to the purchasing power of consumers in that nation, and thus to the wages paid by employers in that nation. Of course the usual cautions apply; wages and prices fluctuate for a galaxy of reasons, many of which have nothing to do with international trade. Even so, since the wages paid out by employers form the principal income stream that allows consumers to buy the employers' products, and consumers can have recourse to the political sphere if employers' attempts to drive down wages get out of hand, there's a significant pressure toward balance.
Given trade barriers, as a result, people who live in countries that pay low wages generally pay low prices for goods and services, while people who live in countries with high wages face correspondingly high prices when they go shopping. The low prices make life considerably easier for working people in poor countries, just as the tendency of wages to match prices makes life easier for working people in rich countries. Does this always work? Of course not—again, wages and prices fluctuate for countless reasons, and national economies are inherently unstable things—but the factors just enumerated push the economy in the direction of a rough balance between the needs and wants of consumers, on the one hand, and their ability to pay, on the other.
Now let's imagine that all of the nations we've imagined are convinced by a gaggle of neoliberal economists to enact a free trade zone, in which there are no barriers at all to the free movement of goods and capital. What happens?
When there are no trade barriers, the nation that can produce a given good or service at the lowest price will end up with the lion's share of the market for that good or service. Since labor costs make up so large a portion of the cost of producing goods, those nations with low wages will outbid those with high wages, resulting in high unemployment and decreasing wages in the formerly high-wage countries. The result is a race to the bottom in which wages everywhere decline toward those of the worst-paid labor force in the free trade zone.
When this happens in a single country, as already noted, the labor force can often respond to the economic downdraft by turning to the political sphere. In a free trade zone, though, employers faced with a political challenge to falling wages in one country can simply move elsewhere. It's the mismatch between economic union and political division that makes free trade unbalanced, and leads to problems we'll discuss shortly.
Now of course free trade advocates like to insist that jobs lost by wealthier nations to poorer ones will inevitably be replaced by new jobs. History doesn't support that claim—quite the contrary—and there are good reasons why the jobs that disappear will never be replaced. In a free trade system, it's more economical for startups in any labor-intensive industry to go straight to one of the countries with low wages; only those industries that are capital-intensive and thus employ comparatively few people have any reason to get under way in the high-wage countries. The computer industry is a classic example—and you'll notice, I trust, that just as soon as that industry started to become labor-intensive, it moved offshore. Still, there's another factor at work.
Since wages are a very large fraction of the cost of producing goods, the overall decrease in wages brings about an increase in profits. Thus one result of free trade is a transfer of wealth from the laboring majority, whose income comes from wages, to the affluent minority, whose income comes directly or indirectly from profits. That's the factor that's been left out of the picture by the proponents of free trade—its effect on income distribution. Free trade makes the rich richer and the poor poorer, by increasing profits while driving wages down. This no doubt explains why free trade is so popular among the affluent these days, just as it was in the Victorian era.
There's a worm in the bud, though, because a skewed income distribution imposes costs of its own, and those costs mount up over time in painfully familiar ways. The difficulty with making the rich richer and the poor poorer, as Henry Ford pointed out a long time ago, is that the wages you pay your employees are also the income stream they use to buy your products. As wages decline, purchasing power declines, and begins to exert downward pressure on returns on investment in every industry that relies on consumer purchases for its income.
Doesn't the increasing wealth of investors counterbalance the declining wealth of the wage-earning masses? No, because the rich spend a smaller proportion of their incomes on consumer goods than the poor, and divert the rest to investments. Divide a million dollars between a thousand working class family, and the money's going to be spent to improve the families' standard of living: better food, a bigger apartment, an extra toy or two around the Christmas tree, and so on. Give the same million to one rich family and it's a safe bet that much of it's going to be invested.
This, incidentally, is why the trickle-down economics beloved of Republican politicians of an earlier era simply doesn't work, and why the Obama administration's massive handouts of government money to banks in the wake of the 2008-9 financial panic did so little to improve the financial condition of most of the country. When it comes to consumption, the rich simply aren't as efficient as the poor. If you want to kickstart an economy with consumer expenditures, as a result, you need to make sure that poor and working class people have plenty of money to spend.
There's a broader principle here as well. Consumer expenditures and capital for investment are to an economy what sunlight and water are to a plant: you can't substitute one for the other. You need both. Since free trade policies funnel money away from expenditure toward investment by skewing the income distribution, it causes a shortage of the one and a surplus of the other. As the imbalance builds, it becomes harder for businesses to make a profit because consumers don't have the cash to buy their products; meanwhile the amount of money available for investment increases steadily. The result is a steady erosion in return on investment, as more and more money chases fewer and fewer worthwhile investment vehicles.
The history of free-trade eras is thus marked by frantic attempts to prop up returns on investment by any means necessary. The offshoring fad that stripped the United States of its manufacturing economy in the 1970s had its exact equivalent in the offshoring of fabric mills from Britain to India in the late Victorian era; in both cases, the move capitalized on remaining disparities in wages and prices between rich and poor areas in a free trade zone. In both cases, offshoring worsened the problem it was meant to fix, by increasing the downward pressure on wages in the richer countries and further decreasing returns on investment across the entire spectrum of consumer industries—then as now, the largest single share of the economy.
A gambit that as far as I know wasn't tried in the first era of free trade was the attempt to turn capital into ersatz income by convincing consumers to make purchases with borrowed money. That's been the keystone of economic policy in the United States for most of two decades now. The housing bubble was only the most exorbitant manifestation of a frantic attempt to get people to spend money they don't have, and then find some way to pay it all back with interest. It hasn't worked well, not least because all those interest payments put an additional downward pressure on consumer expenditures.
A variety of other, mostly self-defeating gimmicks have been put in play in both of the modern free trade eras to try to keep consumer expenditures high while wages decline. None of them work, because they don't address the actual problem—the fact that under free trade, the downward pressure on wages means that consumers can't afford to spend enough to keep the economy running at a level that will absorb the available investment capital—and so the final solution to the problem of declining returns on investment arrives on schedule: the diversion of capital from productive investment into speculation.
Any of my readers who don't know how this story ends should get up right now, and go find a copy of John Kenneth Galbraith's classic The Great Crash 1929. Speculative bubbles, while they last, produce abundant returns; when free trade has driven down wages, forced the consumer economy into stagnation or contraction, and decreased the returns on investment in productive industries to the point of "why bother," a speculative bubble is very often the only profitable game in town. What's more, since there are so few investments with decent returns in the late stages of a free trade scheme, there's a vast amount of money ready to flow into any investment vehicle that can show a decent return, and that's exactly the environment in which speculative bubbles breed most readily.
So the great free trade era that began tentatively with the repeal of the Corn Laws in 1846, and came into full flower with Gladstone's abolition of tariffs in 1869, ended in the stock market debacle of 1929 and the Great Depression. The road there was littered with plenty of other crises, too. The economic history of the late nineteenth and early twentieth centuries is a cratered moonscape of speculative busts and stock market crashes, culminating in the Big One in 1929. It resembles, in fact, nothing so much as the economic history of the late twentieth and early twenty-first centuries, which have had their own sequence of busts and crashes: the stock market crash of 1987, the emerging markets crash of 1994, the tech-stock debacle of 2000, the housing bust of 2008, and the beat goes on.
Thus free trade causes the impoverishment and immiseration of the labor force, and a cascading series of economic busts driven by the mismatch between insufficent consumption and excess investment. Those problems aren't accidental—they're hardwired into any free trade system—and the only way to stop them in their tracks is to abandon free trade as bad policy, and replace it with sensible trade barriers that ensure that most of the products consumed in each nation are made there.
It's probably necessary to stop here and point out a couple of things. First of all, the fact that free trade is bad policy doesn't mean that every kind of trade barrier is good policy. The habit of insisting that the only possible points along a spectrum are its two ends, common as it is, is an effective way to make really bad decisions; as in most things, there's a middle ground that yields better results than either of the two extremes. Finding that middle ground isn't necessarily easy, but the same thing's true of most economic and political issues.
Second, free trade isn't the only cause of economic dysfunction, nor is it the only thing that can cause skewed income distribution and the attendant problems that this brings with it. Plenty of factors can cause a national or global economy to run off the rails. What history shows with painful clarity is that free trade inevitably makes this happen. Getting rid of free trade and returning to a normal state of affairs, in which nations provide most of their own needs from within their own borders and trade with other nations to exchange surpluses or get products that aren't available at home readily, or at all, gets rid of one reliable cause of serious economic dysfunction. That's all, but arguably it's enough to make a movement away from free trade a good idea.
Finally, the points I've just made suggest that there may be unexpected benefits, even today, to a nation that extracts itself from free trade agreements and puts a well-planned set of trade restrictions in place. There are plenty of factors putting downward pressure on prosperity just now, but the reasoning I've just sketched out suggests that the destitution and immiseration so common in the world right now may have been made considerably worse than they would otherwise be by the mania for free trade that's been so pervasive in recent decades. A country that withdraws from free trade agreements and reorients its economy for the production of goods for domestic consumption might thus expect to see some improvement, not only in the prosperity of its working people, but in rates of return on investment.
That's the theory I propose. Given the stated policies of the incoming US administration, it's about to be put to the test—and the results should be apparent over the next few years.
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