Imagine a country where all resources (labor, land, capital) are used to produce goods and services for foreigners. Its residents, good patriots, import nothing and put all the money they earn from exports under their mattresses. Exports are 100% of GDP, there are no imports, and the trade surplus (in goods and services) is also 100% of GDP. Social nirvana?
Of course not. Our patriots would have nothing to eat and no house to live in. They would be well advised to use some of their export money to bid away from export industries some land and wood to grow food and build houses for themselves. If they go to the extreme, the country will end up in total autarky: no exports, no imports, and a trade deficit of zero.
The theory of comparative advantage demonstrates that our patriots could typically do better by exporting what they have a relative advantage in producing and importing the rest. They could have more of everything. Conceivably but not necessarily, depending on the configuration of comparative advantages, our patriots could choose to import all their goods and services from foreign countries, produce only for exports, and also have a zero trade deficit; both their exports and imports would be 100% of GDP–“total globalism,” as it were.
Our patriots would do even better, as far as their own consumption is concerned, if foreigners shipped them a bit more stuff—say 3% of GDP–for the same amount of exports. Our illustrative country would thus move to a trade deficit roughly the equivalent of the current US trade deficit. Assuming that there is such a thing as social nirvana, a trade deficit seems to be much closer to it than a trade surplus or a trade balance.
Thus, the trade deficit is a false problem. If anything, it looks more like an opportunity. As James Mill said in his Elements of Political Economy (1821), a country gains from its imports, not from its exports:
The benefit which is derived from exchanging one commodity for another, arises, in all cases, from the commodity received, not from the commodity given. When one country exchanges, in other words, when one country traffics with another, the whole of its advantage consists in the commodities imported. It benefits by importation, and by nothing else. … That country, or, more properly speaking, the people of that country, have certain commodities of their own, but these they are willing to give for certain commodities of other countries. They prefer having those other commodities. They are benefited, therefore, not by what they give away; that it would be absurd to say; but by what they receive.
I am grateful to Jorge Morales Meoqui (Vienna University of Economics and Business) for bringing to my attention the letter in which David Ricardo expresses to Mill his disagreement with the idea that “all advantage in trade is derived from the commodities received and not by those which are sent”, as Ricardo put it (The Works and Correspondence of David Ricardo, Volume IX, pp.127-128 and 130). He wrote:
It is the exchange which is beneficial. … I do not see how such a transaction can be separated into two parts and how it can be justly said that one part only is beneficial.
I am not persuaded that this is a substantial critique that changes the gist of Mill’s argument. If you give up an apple in exchange for an orange, the net benefit lies in the orange–in the increased utility that eating the orange brings you over and above the utility from eating the apple. The comparison between all exports of apples and all imports of oranges muddles the water because the exporters and the importers are typically not the same persons, but this is a difficulty inherent in aggregating individuals into collectives.
These problems are a bit more complicated than my stylized models suggest. Yet, a key to understanding the benefits of free trade is the idea that, for “a country,” if one wants to talk in these terms, exports are the cost and imports the benefit.
READER COMMENTS
Thaomas
Jan 24 2019 at 1:23pm
Whether a trade deficit is good or bad depends on the rate of return on what those resources are invested in vs the return to foreigners who supply the surplus resources. Arguably the US would have been better off with smaller fiscal and trade deficits over the last few decades.
Pierre Lemieux
Jan 24 2019 at 1:37pm
Thaomas: Can you be more explicit on what exactly are these two rates of return?
Benjamin Cole
Jan 24 2019 at 9:07pm
Well, there are different viewpoints on the results of chronic and large current account trade deficits. Which is the reality, and not the theory, of the US today.
The IMF posits that large US current-account trade deficits axiomatically incur large capital inflows, as Americans borrow or sell assets to pay for the imports.
These large capital inflows bloat asset values, until you get a Hyman Minsky moment—then the collapse in asset values can entail other risks, such as the collapse of the US financial system (as seen in 2008).
Ironically, the US Federal Reserve, upon viewing bloating asset value, may actually trigger the Hyman Minsky moment. If it does not, the Fed is castigated for “blowing asset bubbles.”
The US Federal Reserve has also issued papers connecting large current account trade deficits to bloated house prices, not just in the US but other nations. Of course, higher higher costs drive lower living standards—as anyone trying to afford housing in Great Britain, New Zealand, Canada, or large parts of the US can attest.
David Ricardo never pondered a world of global capital flows (Ricardo considered capital domestically binded), nor of one in which several large economies could be defined as dirigiste, authoritarian and mercantilist states. Comparative advantages today are largely artifices of state action.
Such dirigiste economies eschew the price signal and profit-motive in order to maintain or expand market share and ensure domestic stability. Indeed, the Communist Party of China has issued several proclamations recently that it is moving to protect China employment.
If Beijing will move to protect market share, then one would be foolish to build an even more-efficient plant in the US. China will simply provide more subsidies to exporters. Who will finance a US plant under such circumstances? The China price may not be the best possible price, but it is the price we have.
Free-trade theory is a nice idea. But when sacralized, it become free-trade theology.
Add http to activate links.
//www.newyorkfed.org/medialibrary/media/research/staff_reports/sr541.pdf
//www.imf.org/en/Publications/ESR/Issues/2018/07/19/2018-external-sector-report
Pierre Lemieux
Jan 25 2019 at 3:42pm
@Benjamin: Your last sentence is very important. One must guard oneself against sacralizing a theory: even when logical and confirmed by multiple empirical facts over a long period of time, it must always remain questionable (which is what falsifiability means). I am certainly subject to the temptation, like any social (and other) scientist, and I welcome the warning. Come back and make it again.
There is however something worse, if that is possible. It is to sacralize a non-theory: to pile up random facts, to ignore the facts that have significance, and to oppose this intellectual blob to a scientific system carefully built by generations of analysts, without first understanding this system. If you want an interesting example of this, see Alexander Hamilton’s Continental Essay No. 5. If he had understood David Hume and Adam Smith, he could have avoided the blob. Better still, read anything that Peter Navarro wrote after 1984, noticing that, in this case, he did not have Hamilton’s excuse of having few economists discussing the trade deficit and such things before him. On this last point, you may want to read a recent Regulation article of mine, “Peter Navarro’s Conversion.”
Benjamin Cole
Jan 25 2019 at 9:21pm
Pierre L: Thanks for your reply.
In general, of course, I do not disagree with you. Theories can be sacralized, but skullduggery can be painted as virtue.
Pat Buchanan has said, “What starts out as a noble cause becomes part of political platform. Then it becomes a business. Then, a racket.”
So even such worthy causes as national security often sink to simple patronage or worse.
No doubt there are venal protectionists masquerading as patriots. And for the extraordinarily influential multinationals, the free-trade escutcheon is very convenient.
(Let me digress: We are often hear about “powerful” protectionist forces in the US. Who is kidding who? Apple, Wal-Mart, GM, BlackRock, Amazon? US foreign, trade and military policies are heavily hued by multinationals, not Joe’s Metal-Bending Shop.)
But back on point: The IMF, not me, raises central and important concerns about chronic and large US current-account trade deficits, and consequent bloated asset values. The IMF advises such deficits be corrected by expanding exports and “reducing labor costs.”
Well! The Trump Administration says it wants China to buy more. So, the Trump Administration (yes, a dubious group) may be doing something right, by IMF lights.
As for cutting labor costs in the US, I suppose we could have a payroll tax holiday, and look at any regulations that would help reduce costs.
Cutting wages? Has a ring to it. “To compete in world markets, the US needs to cut wages.”
Have I heard that before?
Waiting for the next Hyman Minsky moment? The Fed nearly got there in December, but seems to have backed off.
I assure you, here is an idea that will never get traction among conventional economists: “Did a Ballooning US Trade Deficit Trigger the 2008 Great Recession?”
Warren Platts
Jan 26 2019 at 5:54pm
“Did a Ballooning US Trade Deficit Trigger the 2008 Great Recession?”
I think the answer is a big, fat yes. Trade deficits can be either good or bad. If you are a developing country, such as the USA during the 19th century, then you may have a genuine shortage of funding for needed and desired productive investment.
However, in 21st century America, there is a surfeit of funding and a dearth of productive investment opportunities. Thus foreign capital inflows only exacerbate an already existing problem. Only about a percent of all foreign capital inflows fund greenfield factories. The rest goes for either T-bills or speculative investments in stock market and real estate casino.
We get the asset bubbles, and when they burst, we get recessions that take a decade to recover from. Such divots in the growth curve cause a measurable slowdown in the average rate of real GDP growth. In the period from 1957 to 1987, GDP growth averaged 3.4%; in the subsequent 30 years–the free trade era–GDP growth rates only averaged 2.5%.
A 1 pp slowdown in real economic growth adds up to real money over 30 years. In such a situation, where are the gains from trade? There are some gains; owners of multinations have done very well for themselves. But I see no evidence that the nation as a whole has been made better off in terms of GDP growth because of the policy of mostly unilateral free trade.
Pierre Lemieux
Jan 31 2019 at 12:40am
By the way, in 2017, inflows of direct investment in the US amounted to $355 billion, which corresponds to 44% of the $799 billion of portfolio investment inflows. Of the latter, we can estimate that some $300 billion, or 38%, were borrowed by the federal government to finance its deficit. (This $300 is the only worrying aspect of the trade deficit, which is the reverse image of international financial transactions.) Main source: BEA.
Warren Platts
Feb 1 2019 at 5:55am
Hmm… Looking at selectUSA.gov/data I get a total inward FDI flow for 2017 of $277B. (Total outward FDI flow $300). However, the definition of FDI is rather arbitrary. That website defines it as merely owning 10% or more of the voting stock of a corporation. Thus it is basically just portfolio investment imo. FDI is advertised as this great source of new factories, but according to the website, in 2017, only $1.57B (0.57% of total FDI inflow) was spent on greenfield manufacturing. Of this, $1.13B (0.41%) was spent on expansion of existing facilities, and $0.43B (0.16%) was spent on construction of new establishments. Thus it appears to me that the vast majority of foreign investment is superfluous in terms of growing GDP. One is forced to wonder what purpose the open investment policy is really serving.
Warren Platts
Jan 26 2019 at 5:32pm
Hi Pierre, Thanks for the link to the Alexander Hamilton article. However, I think Hamilton understood Adam Smith better than a lot of modern free traders. From your link, Hamilton is clearly referring to Smith:
I think it is a big mistake to think that Adam Smith was some kind of radical, libertarian free trader in the mold of a modern Don Boudreaux. Smith after all was the Scottish Commissioner for Managing and Causing to be Levied and Collected His Majesty’s Customs, and Subsidies and other Duties in that part of Great Britain called Scotland, and also the Duties of Excise upon all Salt and Rock Salt Imported or to be Imported into that part of Great Britain called Scotland.
In other words, Smith worked for Leviathan. He was an organ of Leviathan. If he thought tariffs were the devil, then why would he take that job? By all accounts, he performed his duties with all due diligence. He did not sandbag. I know of no evidence that he lobbied parliament to end tariffs.
Smith didn’t even need the money. He had a pension for life from Lord Charles Townshend for 300 pounds per year, that was twice his former teacher’s salary, and he lived at his mom’s house at the time.
Moreover, Smith was a great student of ethics, having written the huge treatise on moral sentiments. Thus he would have to be a real moral hypocrite to take the Commissioner of Customs and Salt Duties job if he really thought that tariffs were an immoral theft by government thugs against free individuals freely exercising their natural right to trade with any other person on the planet.
Then there was the Wealth of Nations itself. I have been able to identify at least 5 positive arguments that Smith made for tariffs that would be justified all or part of the time:
National security: Smith thought the nation’s security trumped opulence. He would have been in favor of Section 232 tariffs, and would have argued that the Jones Act should be strengthened along the lines of the British Navigation Acts.
Level playing field: Smith argued that if import competing goods are taxes domestically, then letting in the same imported goods tariff-free would cause economic distortions. Thus he argued that tariffing the imported goods at the same rate that domestic goods are taxed would eliminate these distortions.
Import shocks: Smith was no Antoinette. He felt a great moral sympathy to his fellow citizen workmen. He was well aware of the misery that China Shock-style import surges can inflict on workers. Thus he argued that protections should be imposed in such cases, that they should be relaxed only very gradually.
Retaliation: If there was a good chance that retaliatory tariffs could open up a foreign market, then such tariffs should be tried. This is usually the only passage in favor of tariffs that free trade true believers will mention because that is also the only place in Wealth of Nations that Smith appears to argue that unilateral free trade is always the best policy. Smith said that if there was little chance the retaliatory tariff would open up the foreign market, then there was no point to punish home consumers for the sake of home producers. His point here is relative to retaliatory tariffs, however; the caveat does not obviate his other positive arguments for tariffs.
Revenue raising/protection: Smith argued (in his chapters on taxation) that tariffs especially on luxuries consumed by wealthy people, are a good way to raise tax revenue to fund government services (that he was not opposed to, if done correctly). He described a sort of Laffer curve where there was an optimal tariff rate that would maximize revenue raising (although I cannot find any evidence that Smith was aware of Torrens’ terms of trade argument). Moreover, Smith asserted that such optimal tariffs would provide much protection for home workmen; prohibitory tariffs are not necessary for adequate worker protection.
These arguments, taken together with the fact that he was the Commissioner of Customs and Salt Duties, clearly indicate imo (ymmv) that Adam Smith was a protectionist. He merely thought judicious protectionism should be done the right way. His critique of the “mercantile system” should be seen as a defense of 100% unilateral free trade 100% of the time. Rather, Smith was simply opposed to rampant crony capitalism and incompetent governmental management. Thus, Alexander Hamilton did indeed have a sophisticated understanding of Adam Smith’s work imo (ymmv).
Adamaria
Jan 31 2019 at 4:42pm
Warren Platts, i think you are right… at least in your analysis, but not necessarily in your labeling…
Adam Smith did favor those trade restrictions.
But that did not necessarily make Smith a protectionist, even if he did favored those specific protections.
If one defines free trade or protectionism as an on-off switch, than yes, Smith is not a 100% unconditional free trader, thus he is a protectionist.
But if one uses the more standard definition of protectionism and free trade, as the general means of wealth accumulation, then one can be a free trader even if he sees the benefits of some occasional tariffs contingent to specific situations, and as long as they are not a product of cronyism, which, as you correctly say, Smith strongly condemned.
Warren Platts
Feb 1 2019 at 3:52am
Adamaria, yes perhaps “protectionist” is too strong of a label to apply to Adam Smith, if we mean by that the Henry Clay-style of 19th-century American protectionism. If Smith was a protectionist, he was was a mild protectionist. At the same time, if Smith was a free trader, he was a mild free trader. There is certainly no support in WN that Smith favored 100% unilateral free trade 100% of the time, meaning no tariffs ever.
Smith’s main concern, in my reading, was to avoid economic distortions. He thought the economic ecosystem should evolve naturally, as much as possible. Let the invisible hand work its magic without interference.
The “mercantile system,” when not rank crony capitalism was misguided bullionism at best, was to be rejected because it introduced economic distortions. However, judicious use of tariffs could at times help to eliminate distortions. Hence Smith’s level playing field argument: taxation of domestic goods distorts their price relative to comparable foreign goods, thus a tariff on the foreign goods would restore balance. A corollary of this principle, it seems to me, is that Smith would favor countervailing tariffs where foreign subsidies lower the price of foreign goods relative to domestic goods: the foreign “bounty” introduces a distortion; a countervailing tariff would eliminate that distortion.
Smith favored the use of judicious tariffs for raising revenue. In that case, the tariff must be implemented all the time. Thus, Smith’s concern was that such tariffs should be engineered so as to distort the economy as little as possible. Thus, he strongly favored tariffing imported luxuries as opposed to the necessities of life. The former tariffs would be progressive, falling mainly on the rich, but perhaps more importantly, they would not raise the overall price level in the same way a tariff on the necessities of life.
It is interesting to speculate what advice Adam Smith would give to President Trump if Smith were Trump’s economic adviser. If we accept WN at face value, one bit of advice would be to strengthen the Jones Act along the lines of the old British Navigation Acts and thus grant a near-monopoly to American ship builders and shipping lines for all maritime trade with the United States. Now that would be something!
Smith would probably also recommend revenue raising tariffs on the order of 25% to 30% on imported luxury items like BMW and Mercedes Benz autos. The hard part would be determining what are the necessities of life these days. Are flat screen TVs necessities of life? I suspect Smith would say yes!
Pierre Lemieux
Feb 1 2019 at 9:27pm
Two hundred and fifty years of Smith scholarship as well as the opinions of Smith’s contemporaries attest to Smith being a strong free trader and an opponent to protectionism. It is true that he had the national defense objection (but taxes are not the exception you suggest they are, as they meant excise taxes on things sold in the country). Although he proposed a gradual abolition of tariffs, I don’t recall him proposing tariffs to deal with any shock. He was a classical liberal, not a radical libertarian, and was a bit too trustful of Leviathan. Recall also that he missed a few tools of economic analysis that we now have.
Here are a few quotes (from The Wealth of Nations) that leave little doubt on the strong anti-protectionism and defense of economic freedom that we see all over his work:
“We trust with perfect security that the freedom of trade, without any attention of government, will always supply us with the wine which we have occasion for: and we may trust with equal security that it will always supply us with all the gold and silver which we can afford to purchase or to employ.”
“In every country it always is and must be the interest of the great body of the people to buy whatever they want of those who sell the cheapest. The proposition is so very manifest, that it seems ridiculous to take any pains to prove it; nor could it ever have been called in question, had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind.”
“The trades, it is to be observed, which are carried on by means of bounties [subsidies], are the only ones which can be carried on between two nations for any considerable time together, in such a manner as that one of them shall always and regularly lose.”
“Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration of justice; all the rest being brought about by the natural course of things. All governments which thwart this natural course, which force things into another channel, or which endeavour to arrest the progress of society at a particular point, are unnatural, and to support themselves are obliged to be oppressive and tyrannical.”
He also argued that concern with the balance of trade was a “most insignificant object of modern policy.” And recall that he opposed all imperial protectionist measures that were imposed to America (Chapter 7 of Book IV).
Benjamin Cole
Jan 25 2019 at 4:54am
I wish Pierre Lemieux had married my first wife.
She also believed that imports of goods and services into our household (or into or onto her body) was the big positive in life, and the more it exceeded the value of services and goods we (I) provided to the market at large, the rosier her cheeks got.
We were winning, baby!
Pierre Lemieux
Jan 25 2019 at 1:18pm
If she better understood what Humes, Smith, Mill, Say, or Ricardo meant, or the fact that a free society is not a family with children but a collection of millions of families, I wonder too: perhaps I should have married her.
Matthias Goergens
Jan 26 2019 at 4:58am
In the long enough run your wife was exactly right.
(I suspect you are suggesting that the pattern was not sustainable.)
Benjamin Cole
Jan 27 2019 at 2:13am
Open Letter to Pierre L:
In the past I have stated reservations about free-trade theory in the modern context. You often refer me to the great thinkers, and they are great thinkers, such as David Hume.
But, in a nutshell, here are three reservations.
Suppose a world of two nations. Nation’s A comparative advantage is that it steals IP from Nation B. What should Nation B do?
Morever, suppose Nation A has a policy of maintaining market share and meeting challengers by increasing subsidies on exports. Then, it would be foolish to finance construction of even better, more-efficient factories in Nation B. No one will extend financing on such factories anyway. What should Nation B do?
Suppose, as a matter of prolonged empirical observation, the US runs large and chronic current-account trade deficits, and that the IMF says the deficits bloat US asset values (due to axiomatic capital inflows), which can pop in any pending Hyman Minsky moment. In 2008, this dragged down the US financial system too (which was heavily exposed to the asset real estate), and triggered the Great Global Financial Crisis. What should the US do about large and chronic current-account trade deficits, if they lead to bloated asset values?
And now to David Hume: Devising trade theories in the era of the gold standard, Hume chastised Great Britain for building gold reserves through mercantilism, which only led to domestic inflation and less global competitiveness.
This is far different picture than from today (or from that seen by David Ricardo). Capital flows offset trade deficits, as you know.
Today, a nation that runs a chronic trade deficits does not merely trade round lumps of yellow metal for real products and services. Today a nation running trade deficits sells assets, or goes deeper into debt to finance trade deficits.
If I can refer to the horse-and-buggy era, when I was in college we learned nations running trade deficits would see their currency depreciate, and that would fix the problem.
Later, in grad school (those hot Model T’s were on campus), I was warned by long-faced serious people that the “balance of payments” was a serious issue, though others said when OPEC sucked a few hundred billions of the out the US through a cartel, that was okay, as they bought stocks and bonds with the money, the so-called recycled petro-dollars. I wondered then if the people recycling (middlemen and brokers) the petro-dollars were the main proponents of this point of view. Oil cartels are good!
In any event, tackle points 1-3, if you would. I am re-reading Hume, and he is so smart—-but not relevant today, I am afraid.
Pierre Lemieux
Jan 30 2019 at 12:31am
Benjamin: Can you identify your three separate points? Do they correspond to the questions at the end of the first three paragraphs?
Warren Platts
Jan 30 2019 at 9:08am
Well I can tackle the 2nd one above: we can start by charging foreign investors the same tax rates we charge American investors. As things stand, non-resident aliens do not have to pay capital gains taxes. These people own 35% of all U.S. equities last time I checked. Thus, when Trump reduced the corporate taxes to 21%, not only did 35% of that benefit/decrease-in-tax-revenue slosh overseas, the foreign investors did not have to pay taxes on any resultant capital gains.
Pierre Lemieux
Jan 31 2019 at 12:54am
Benjamin: I think I answer many of your concerns with the trade deficit in my recent Regulation article, at https://object.cato.org/sites/cato.org/files/serials/files/regulation/2018/9/regulation-v41n3-1.pdf. Regarding your concern about the inflows of portfolio investment, note that nearly 40% of it is made of borrowing by the federal government to finance its deficit. The government is not nirvana; I think we should prefer economic freedom. One question that puts trade deficit issues in perspective is the following: Why aren’t we concerned about the probably very large trade deficit of NY vis-à-vis the rest of the US? Texas must also have a trade deficit.
Warren Platts
Jan 27 2019 at 4:05am
If you give up an apple in exchange for an orange, the net benefit lies in the orange–in the increased utility that eating the orange brings you over and above the utility from eating the apple.
I think I agree with Ricardo that the export/import value distinction is specious.
So you like oranges better than apples, but oranges won’t grow in your backyard, yet apples will.
So what ought to be more important to you, the apples or the oranges? A: the apples. The oranges aren’t your problem. Obtaining them is easy once you have the apples. The hard part is growing the apples. So in terms of your effort and attention paid, if you want oranges, you had better focus on apples.
This is what Friedrich List was getting at in his famous aphorism that the fruit tree is more valuable than the fruit. If you had a mutant goose that laid golden eggs, what should you focus on: all the wonderful items you can buy with all those golden eggs? Or would you be better served by focusing on keeping the darned goose alive as long as possible?
Pierre Lemieux
Jan 30 2019 at 10:50am
Yes, you can grow oranges with an apple tree. Trade is a technology for transforming what you produce into what you want. If you have an apple tree that produces apples to exchange for oranges, your apple tree is worth the value of the oranges you “produce” with it. Note that this does not totally answer Ricardo’s objection (the benefit is in the exchange itself and you can’t separate it in two parts), but it should answer yours.
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