Friday, July 10, 2009

International Trade, Comparative Advantage and Protectionism, part 1

The latest attack of economic propaganda came out of the G8 meeting in Italy today, extolling the virtues of free trade and vowing to fight protectionism. The classic formula -- "the Great Depression was made worse by protectionism" – continues to get ground into our collective mindset until it becomes an unquestioned axiom of thought. Heck, I used to believe it myself, until I actually starting analyzing it.

Here is the short-form rebuttal: in the 1920's, the US was the world’s number 1 exporter and creditor. Today, the US is the world's number 1 importer and debtor. The case against protectionism, for America, does not apply. Less developed countries have understood for centuries that domestic industries often need protection to stand a chance of getting off the ground against larger and richer foreign competition. From colonial America to post-war Japan, nurturing of domestic industry has always been practiced.

But what about today? Have we passed the point where national protectionism is not necessary, that it does more harm than good? In fact, it is the opposite. Our economic world today, more than any other time in history, calls for a certain amount of protectionism. I am not making this claim based on nationalism or some theory of social justice, either (although those arguments have their own merits). I am saying protectionism is justified solely on economic grounds.

In free-trade theory, when a domestic job is displaced due to foreign competition, a new job is supposed to open up somewhere in the economy because of the money saved, based on the efficiencies of comparative advantage in production. The idea is that a foreigner can produce something more efficiently, thus lowering overall costs, thereby freeing up more money, which will create a job somewhere else.

Comparative advantage is a powerful economic theory, and it has much truth to it. In order to understand why it doesn't it apply to certain aspects of international trade today, we have to understand why it does apply to some situations. Only by understanding its truth and correct application, can we understand when it is used falsely and incorrectly applied.

Comparative advantage is mainly rooted in geological and environmental factors. For example, people on grassland plains have a comparative advantage raising cattle, people on the coasts have a comparative advantage catching fish, and people in the mountains have a comparative advantage raising timber. In a primitive economy, people have to raise their own meat, catch their own fish, and build their own houses out of local resources. However, trading freely and widely allows them to specialize in what they have an advantage in, thereby benefitting everyone.

Another aspect of comparative advantage comes from relative location. Thus, a factory close to a source of materials has a comparative advantage over a factory far away. An oil field with easily extracted crude has a comparative advantage over a location with deeper, harder to access oil. A power plant close to its fuel source has a comparative advantage over one farther away, and so on.

All comparative advantage is rooted in the efficient use of scare resources. The rule is: less resources in, cheaper products out. We all get richer, meaning more output in less time using less resources, when everyone is operating at maximum efficiency. Healthy systems of domestic and international trade incorporate those efficiencies. For example, oil from the Middle East is more easily accessed than domestic sources, while coffee and bananas cannot be grown in America. These are exactly the kind of comparative advantages that lie at the heart of healthy trade, making us all wealthier by encouraging us to do what we have a natural efficiency doing.

The problem with comparative advantage in global trade today is that it is not based on real comparative advantage, but only on the illusion of advantage created by money. Thus, the dominant source of comparative advantage today is found in taking advantage of low wage labor in countries with cheap currencies and low standards of living. We are so accustomed to operating in the nominal terms of dollars that we are blinded to the real effects of such wage arbitrage.

Real comparative advantage takes advantage of real efficiencies to increase overall wealth. Exporting jobs to low wage countries decreases real wealth by working against natural efficiencies and increasing input and transportation costs. The problem is thinking in dollar terms, not in real terms. In real terms, what happens when an industry is off-shored? That domestic factory grew up at a natural nexus of efficiency related to labor, materials, markets, and transport. Moving that factory disrupts that natural efficiency and introduces massive inefficiencies. In dollar terms, it seems like a good idea, but in resource terms, it is not.

The comparatively cheap labor rate in dollars is papering over big losses of real wealth as resources are squandered to make factories from scratch in far distant locations. The distant location of the new factory also increases the loss of resources that results from transporting raw material and finished goods to a location that is far removed from either primary resources or consumer markets.

In short, from a purely macro-economic perspective, off-shoring decreases overall wealth. After off-shoring, production is transferred to a new location which takes greater time and uses greater resources. This is the opposite of comparative advantage, which is based on less time and less resources. After off-shoring, the real cost of production, measured in time and resources, has risen.

Meanwhile, at home, the factory is shuttered, meaning capital is destroyed, and the labor is idled, meaning skills and training (human capital) are wasted. Theoretically, these workers are going to find something else to do, but by definition, anything else they do will be less economically efficient, since they have already spent years training, mastering their specific economic role. Anything they do after layoffs will be an economic loss overall, unless they are immediately transferred into some high-value added endeavor.

Off-shoring means that local production networks based on real comparative advantages are tossed aside, throwing away those advantages for the sake of illusory dollar profits. Because no real efficiency is gain, we are actually getting poorer, because there is less overall wealth circulating in the economy.

Most people get stuck on this point, so it bears repeating until it is fully understood: When a production job is outsourced, no real wealth is created. Rather, real wealth is lost as comparative advantages, fixed capital, and labor skills are thrown away. We are actually getting poorer as wealth is thrown away and efficiencies lost. Corporations gain an advantage at the expense of domestic workers because of the illusion of dollar savings, but our collective standard of living falls.

The only hope, the leap of faith in trade theory, is that those displaced workers find a more efficient economic activity. From a macro-economic perspective, that new economic activity has to be more efficient and productive than the previous activity, or the economy has suffered a net loss.

But, should we take that leap of free trade faith? Is it possible for that laid-off worker to find a more productive activity? If they can’t find a more productive activity, their layoff is not economically justified.

Notice the macro perspective I am adopting here. From the macro economic perspective, replacing one worker with another only makes sense if it introduces a real efficiency into the process. Remember, giving a production job to a worker in China, who was previously unemployed, is economically neutral if it merely causes a worker in Detroit to be unemployed. That fact that the new Chinese factory is far away from sources, trade networks, and markets, means that the off-shoring starts out as an economically backward idea, since it consumes greater resources. Moving production to some far-away locale costs more, so it must be justified by a greater efficiency introduced elsewhere, or we have just gotten poorer (since we are using more resources to produce the same goods)!

From the individual corporation’s perspective, laying off the worker for a lower-wage worker increases profits. But that is exactly the illusion created by looking at the situation through the nominal dollar lens. The company is saving money, but by doing so, they are introducing inefficiencies into the economic system. The inefficiencies of off-shoring are only worth it if the displaced workers move into a more efficient occupation.

Notice that the off-shoring company does not care about the displaced worker. They company’s only concern is with their own higher corporate profits. This is the paradox of modern industrial economic policy planning. What saves money for individual companies is often bad for the economy as a whole.

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