Free Trade Under Fire

by ed dolan

ed dolan is the creator of Ed Dolan's Econ Blog and is the author of the textbook Introduction to Economics, now in its sixth edition.

Illustrations by Dan Page

Published October 19, 2016

Free trade has taken some major hits this election season.

In the Republican primaries, Donald Trump's forthright protectionism helped him defeat the few rivals who stuck by the traditional Republican free trade line. Those who retreated to the intentionally ill-defined middle ground of "free but fair" did no better. On the Democratic side, Bernie Sanders' attacks on Nafta and the pending Trans-Pacific Partnership raised his popularity with rank-and-file voters, helped to propel him from fringe candidate to a real contender for the nomination and effectively killed the TPP's prospects for ratification in the current Congress.

Trade promises to be even more central in the general election campaign. Taking a leaf from protectionists who preached economic isolation during the Great Depression, Trump is doubling down on his promises to reverse globalization. Speaking in June in western Pennsylvania, he said:

Our politicians have aggressively pursued a policy of globalization — moving our jobs, our wealth and our factories to Mexico and overseas. … Globalization has made the financial elite who donate to politicians very wealthy. But it has left millions of our workers with nothing but poverty and heartache. … It doesn't have to be this way. We can turn it all around — and we can turn it around fast.

Under pressure from right and left, Hillary Clinton has rapidly backed away from support for trade agreements that she formerly praised as first lady and secretary of state. Interestingly, the "issues" section of her official campaign website, which covers nearly every other topic, does not include a specific heading on globalization or trade. The "manufacturing" section, however, provides the following goal statement, which is hardly a ringing endorsement of free trade:

Level the global playing field for American workers and manufacturers by aggressively combating trade violations. Establish and empower a new chief trade prosecutor reporting directly to the president, triple the number of trade enforcement officers, stand up to Chinese abuses and crack down on currency manipulation that hurts American workers.

Mainstream economists have supported free trade since David Ricardo outlined the theory of comparative advantage in the early 19th century. However, dissent has increasingly begun to appear. Robert Reich, a professor at the University of California, Berkeley, who was secretary of labor in the Bill Clinton administration, wrote last year:

I used to believe in trade agreements. That was before the wages of most Americans stagnated and a relative few at the top captured just about all the economic gains.

Paul Krugman, the Nobel Prize-winning economist, who, as a New York Times columnist, is arguably the most influential left-center economist in the country, acknowledges the many benefits of trade. But he notes:

[N]ot all free-trade advocates are paragons of intellectual honesty. In fact, the elite case for ever-freer trade, the one that the public hears, is largely a scam. … What you hear, all too often, are claims that trade is an engine of job creation, that trade agreements will have big payoffs in terms of economic growth and that they are good for everyone. … Yet what the models of international trade used by real experts say is that, in general, agreements that lead to more trade neither create nor destroy jobs; that they usually make countries more efficient and richer, but that the numbers aren't huge; and that they can easily produce losers as well as winners.

So who's right here, the protectionists or the free traders? Free traders are mostly right to say that trade promotes economic growth and efficiency, but wrong to think that efficiency is everything. Anti-traders are right to say that economists should pay more attention to the reality that trade produces losers as well as winners, but wrong to think that protectionism is the cure for what ails. Both sides need to be open to ideas for managing trade policy to minimize the social costs.

Deficits are also a reflection of the fact that, more often than not, foreigners seek to store their wealth in dollar-denominated U.S. securities, both government and private, because they are seen as the safest in the world.
Trade Fallacies

Opponents of free trade have achieved considerable political success, but not because they make a good case. Many of the arguments published on blogs or heard in stump speeches reveal a regrettable ignorance of basic economics. Some examples:

Trade deficits imply that we are losers collectively. One of the oldest arguments against free trade is the claim that countries running trade deficits are like spendthrifts eating the seed corn. In the case of the United States, there are a host of reasons that deficits don't imply economic weakness. Start with the most fundamental, though least intuitive. If more is invested in the U.S. economy than American households and companies are willing to set aside in savings, the difference must be reflected, dollar for dollar, in the trade deficit as foreigners make up the difference.

Actually, pretty much all the reasons for rejecting the equivalence of trade deficits with economic mismanagement are unintuitive. Deficits are also a reflection of the fact that, more often than not, foreigners seek to store their wealth in dollar-denominated U.S. securities, both government and private, because they are seen as the safest in the world. And they are partly due to the status of the dollar as the world's reserve currency; as a matter of convenience and safety, governments and global businesses typically hold their cash reserves in dollars, creating a chronic net demand for dollars that must be offset by U.S. current account deficits. Protectionist measures would do little to change any of this, except, perhaps, to undermine the reputation of America as a country willing to compete aggressively in global markets and worthy of ongoing investment by foreigners.

Americans are victims of currency manipulation. Another favorite tactic of protectionists is to emphasize currency manipulation — that is, foreign government intervention in currency markets to drive down the exchange value of their own currencies — as a source of trade imbalances. Both Trump and Clinton have indulged in this argument, pointing to China as the prime offender.

In fact, the Chinese have manipulated the value of the renminbi in the past, with the goal of making Chinese exports more competitive. But the charge is years out of date. Since 2014, China's foreign currency reserves have been falling, reflecting the central bank's efforts to strengthen — not weaken — the exchange rate. The strong currency policy partly reflects the government's pride in the renminbi's recent inclusion in the basket of currencies the IMF uses to calculate the relative value of its own proto-currency, called special drawing rights. It also reflects Beijing's current concern that a declining currency could touch off a wave of capital flight from China that would undermine growth.

Trading with poor countries always puts Americans at a disadvantage. During the primary campaign, Trump and Sanders both directed special opprobrium at trade with poor countries, where workers earn a tiny fraction of what their American counterparts take home. The implication is that trade with other high-wage countries is fair because it is a contest among equals, while trade with poor countries is unfair because American companies can compete only if they engage in a race to the bottom on wages, benefits and working conditions.

But that view reflects misunderstanding of the factors that determine a country's average wages and their producers' international competitiveness. The high wages of U.S. workers reflect the effects on labor productivity of a host of factors, including the efficiency of capital markets, the quality of technical education and a judicial system that enforces contracts.

Those institutions help American workers to remain competitive despite high wages — or rather, they make high wages competitive because they enhance productivity. But it's worth remembering that they do not affect all sectors equally. They make a comparatively large difference in sectors like pharmaceuticals, financial services and large-scale agriculture, allowing them to thrive as exporters. But they matter less in manufacturing — especially manufacturing that demands a lot of less-skilled labor. So, thanks to the flip side of comparative advantage, the United States imports most of its clothing, furniture, consumer electronics and the like.

Measures to make the United States self-sufficient in low- and middle-tech manufacturing would mean shifting labor and capital from sectors where the country's hard-won advantages make them more productive to sectors where they are less productive. Yes, that might create jobs – but only if it also depressed wages.

The Real Case Against Trade

If the protectionists' arguments are wrong on their face, why are they winning the political debate? Because there is a real downside to trade, one that free traders have long known about but often glossed over.

That downside lies in the fact that the benefits of trade in terms of higher wages, higher profits and lower prices are hardly shared equally. Suppose that I decide to switch from American-made tires for my car to Chinese-made tires. There are lots of winners here: I pay less, the importer makes a profit and the Chinese tire worker who makes the tires earns more.

However, the American plant that used to make my tires is now out of business. Joe the tire worker has lost his job. So has the guy at the food truck where Joe bought his lunch, maybe the teachers at the schools whose budget depended on taxes paid by the factory, and so on.

Economists have traditionally excused these losses by arguing that the overall gains from trade were large, while the losses were smaller, transitory and spread widely among the same people who benefit from cheaper tires. The tire example is not hypothetical. A study from the Peterson Institute for International Economics in Washington estimated that the gains to consumers from Chinese tire imports in the form of lower prices amounted to more than $800,000 for each job lost in the domestic tire industry. Moreover, when consumers spent the money they saved on other goods and services, they would create new jobs for the former tire workers. The study dismissed policies devised to protect the U.S. market from cheap tires as a highly inefficient way of preventing displacement or offsetting the consequences.

But what if the adjustment to trade shocks is not smooth? What if Joe, after losing his job at age 55, never finds steady work again? What if he has to get by on odd jobs, food stamps and Social Security? Or must uproot his family to move 1,000 miles to Texas to take a job at $12 an hour rather than the $30 he earned making tires? What if the consumers who saved on tires never spent a cent of the savings in Joe's old hometown?

If such displacement is permanent, or at least long-lasting, the net gains from trade in tires must be smaller, and the losses more concentrated on the directly affected industry and region, rather than spread widely via labor and product markets.

Recent research seems to suggest that worst-case outcomes for Joe and other displaced workers are more common than has generally been acknowledged. In an influential new paper, "The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade," the economists David Autor, David Dorn and Gordon Hanson reach several pessimistic conclusions:

    • The costs of trade shocks, including lower wages and loss of jobs, persist for years.
    • They are concentrated on workers in specific local labor markets. Labor mobility is not sufficient to ensure widespread sharing of losses by workers across all regions and industries of the economy.
    • When an increase in the overall trade deficit accompanies a trade shock (as was the case for the China shock), workers displaced by import competition do not quickly find comparable jobs in more competitive industries. Those who do find work often end up in service jobs that are a poor fit for their skills.
    • The enduring local effects of trade shocks include increases in unemployment claims, disability benefits, food stamps and other forms of government assistance.
    • Trade shocks disproportionately affect lower-wage workers.

The paper has touched off a lively discussion among economists. Some say they were aware of the magnitude of the downside, but didn't dwell on it because the net benefits were still substantial. Others critiqued the paper's assumptions, methods and data sources, as good fellow professionals should. The question I find most interesting, though, is how policy should change, if the pessimistic conclusions that Autor and his colleagues made about slow adjustment to trade shocks are valid.

Speeding Adjustment

If slow adjustment to shocks undermines the gains from trade and amplifies the pain, we ought to be asking what can be done to speed adjustment. The traditional answer has been to offer a mix of temporary income support, retraining and help with job search and relocation to minimize the consequences for the most affected individuals and regions while ensuring that those who benefit from trade share the costs of adjustment. Those are the intended goals of the federal Trade Adjustment Assistance program.

But the TAA has a poor reputation. Some critics think the program is too narrow and inadequately funded; they urge expansion of TAA. Others point to studies that show the training offered has sometimes been poorly designed and ineffective. Whatever the reason, TAA clearly has not prevented the persistent adverse effects seen in the Autor study.

We need to recognize that the effectiveness of TAA is undermined by numerous policies that retard adjustment and increase the pain. What's more, the problem seems to be getting worse. Economists and policymakers need to more directly confront policies that throw sand in the wheels of labor market adjustment. A checklist:

Work disincentives in the social safety net. Autor et al. show that when a trade shock hits a region, total government benefits increase by a bit less than $60 for each $1,000 increase in trade; of this, TAA itself accounts for less than $4. Each of these social programs – unemployment insurance, food stamps, Social Security disability, etc. – helps cushion the pain of trade-related job loss, but together they create disincentives to finding new employment. Those disincentives arise from the way that benefits fall as family earnings rise. Indeed, a recent report from the Congressional Budget Office estimates that the combined effects of benefit reductions on food stamps, the earned-income tax credit, cost-sharing subsidies for health care and other programs can take back 60 percent or more of the income earned by low-income households.

Effective marginal tax rates are especially high for secondary earners in two-earner households. If we take child care, transportation and other work-related expenses into account, it may not pay at all for a second household member to take a job. That situation could easily fit a family in which one spouse lost a factory job because of import competition while the other retained a job as, say, a retail clerk.

This poses a dilemma. As research from the Center on Budget and Policy Priorities shows, conservative initiatives to restrict eligibility for safety net benefits have lowered the average effective marginal tax rates for low-income households. However, tighter eligibility limits increase the pain felt by displaced workers and thus could be expected to strengthen the political backlash against trade. Progressives push back against measures to narrow eligibility. But to the extent they are successful in easing the pain of displacement, they slow the speed of adjustment.

The way to resolve this situation would be through a broad-based reform of safety net programs, not through a constant tug of war over eligibility. A good first step would be to consolidate and cash out the numerous, overlapping programs now available to displaced workers, moving in the direction of a broadened earned-income tax credit or negative income tax. As I argued in an earlier article in the Review, a universal basic income might be an even better way to meet the basic needs of displaced workers while maintaining work incentives.

Portability of health care. Another reform that would speed adjustment is to move toward a system of universal health insurance that fully decoupled coverage from employment, income or place of residence. The Affordable Care Act has improved matters in one important respect, making it possible for people with pre-existing conditions to purchase individual health insurance when they lose coverage from their employers. However, the law left intact the central role of employer-provided insurance. As a result, displaced workers face, often for the first time, the task of choosing an insurance company and an insurance plan on a state or federal exchange. Furthermore, the cost and availability of coverage vary widely from state to state, making it more problematic for displaced workers to move in search of work.

Note, too, that ACA subsidies for individual policies that low-income families buy on the insurance exchanges are themselves subject to a substantial benefit reduction as household income rises, which increases the effective marginal tax rates faced by people who already receive benefits from other safety net programs. Premium support under the ACA extends further up the income scale than most other safety net programs; subsidies do not entirely phase out until a household reaches 400 percent of the poverty level. That makes them relevant to workers even in relatively high-paid jobs and two-earner families, categories into which many workers displaced by trade would fall.

The ownership bias in housing. Housing can be another important barrier to mobility for trade-displaced workers. As Autor's research shows, trade shocks do not hit individual workers at random; rather, they slam entire regions. Housing prices can fall catastrophically in areas affected by plant closings, a factor that makes it hard for displaced workers to move to localities with higher housing costs in search of new jobs.

The bias of U.S. housing policy toward ownership exacerbates this problem. Already, younger families are increasingly passing up the tax advantages of home ownership in favor of renting, in many cases because of the flexibility that renting affords. They expect to move repeatedly from job to job and city to city in a labor market that, by all forecasts, will remain volatile across their working lives. Tax policies that treat renters and homeowners equally, like those of Canada, Australia, Germany, Japan and other high-income countries, would ease labor mobility for trade-displaced workers.

The scourge of occupational licensing. In a recent book, the University of Minnesota economist Morris Kleiner found that occupational licensing has increasingly spread beyond high-skill professions like law and medicine to relatively low-skill occupations like florists and hair braiders. Nearly one in three jobs now requires some kind of government license, up from one in 10 in the 1970s. Kleiner compares occupational licensing to the medieval guild system, in that the goal is focused on protecting incumbent practitioners from competition rather than on protecting consumers from the risks of tastelessly arranged flowers or clumsily braided hair.

The fact that licensing requirements vary widely from state to state is a particular problem for displaced workers. Suppose, for example, that the family of a trade-displaced factory worker is now dependent on the income of a spouse who is a licensed interior designer, manicurist or pest control worker. Moving to a new state in search of a new factory job would mean loss of that second income during an extended, and often costly, process of requalification.

Three kinds of reform could reduce the adverse impact of occupational licensing on labor mobility. One would be to lift licensing requirements altogether for occupations where the risk of harm to customers is minimal – flower buyers beware. A second would be to make licensing requirements more uniform and transferable from state to state. A third would replace licensing with simpler certification systems that are less prone to abuse by incumbent practitioners.

Criminal records and background checks. According to the Brennan Center for Justice, some 70 million Americans have criminal records. That is as many as have college degrees, and far more than have served in the military. Criminal records represent a significant barrier to labor mobility, and not just for the 20 million who have felony convictions. Misdemeanors like possession of small amounts of marijuana, arrests for infractions like disorderly conduct that do not result in charges and even prosecutions that result in not-guilty verdicts are sufficient to make prospective employers think twice. The number of people with criminal records, like the number of people who are incarcerated, has grown steadily in recent years. Furthermore, online databases make it more likely that prospective employers will learn of even minor encounters with the criminal justice system.

Many people with criminal records do eventually manage to find some sort of work. However, it does not help that many licensed occupations are off limits to people with criminal records. What's more, if a job offer materializes in a distant city, a criminal record can make it harder to obtain a mortgage or rent an apartment.

Obviously, one policy change that would ease this burden on labor mobility would be to reduce incarceration rates. However, that would not help people who already have records. Another approach is that of the national "Ban the Box" campaign. Its aim is to reduce discrimination by removing the requirement that people notify prospective employers of criminal records on preliminary job applications. The campaign encourages employers to evaluate criminal records on a case-by-case basis after an applicant passes initial screening.

Why Protectionism is not the Answer

It's a fact we ignore at our collective peril: the changes brought by globalization have been painful to millions. However, a reversion to protectionism would be a terrible, self-defeating response. Withdrawing from trade agreements and imposing high tariffs on imports would not restore the imagined glories of American manufacturing or make the country great again.

One reason is that a sharp swing toward protectionism would itself be an enormous shock to labor markets. Tens of millions of American workers are employed in export industries that would face loss of business or outright retaliation from trading partners if the United States raised tariffs or withdrew from agreements. More millions are employed by companies that are inextricably tied to global supply chains or import finished goods for resale. Still others work in logistics or financial service operations that would be disrupted by a sharp reduction in imports.

Even if protectionist measures did open up new jobs in domestic industries, workers displaced by foreign retaliation or supply-chain problems would face the same barriers in moving to jobs that trade-displaced workers have faced in the past. The research by Autor and others suggests that it would take years for the consequences of such a shock to work its way through the economy and that some industries and regions would remain permanently depressed.

A second reason protectionism is not the answer is that trade is only one factor behind the transformation of American manufacturing. Automation and technological change have had an even greater impact. That is evident from the fact that the number of U.S. manufacturing jobs has been falling since the late 1970s, long before Nafta and the rise of China.

But even if high tariffs forced manufacturing operations back to the United States, there is no reason to believe that manufacturing jobs would return to previous levels. As the Harvard economist Dani Rodrik has meticulously documented, loss of manufacturing jobs is a worldwide phenomenon that has affected Europe, Latin America, Africa and the early industrializers of Asia. Manufacturing jobs appear to have peaked, even in China. Big operators like Foxconn Technology, which assembles iPhones, are laying off workers and replacing them with robots as wages rise. In short, the days when high-school-educated workers could find factory jobs at wages sufficient to sustain a middle-class living standard are not going to return – not in the United States or anywhere else.

It isn't beyond the ingenuity of good-willed people to create policies (at reasonable cost) that allow globalization to run its course without leaving successive waves of workers jobless or transforming them into itinerant laborers. But it isn't going to happen until policymakers and politicians recognize that the damage done by globalization is very real – and that the alternative to confronting the damage is to risk the rise of the demagogues and opportunists.

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