The Truth and Truthiness of Global Trade

What is the truth about trade and its benefits and costs? The International Observer takes a look at some long term data.

The Truth and Truthiness of Global Trade

Politicians have always lied, or, if you prefer, stretched the truth, in order to attract others to their point of view. In a well-functioning democracy there is nothing wrong with each side arguing their points and leaving out the arguments that help the opposing point of view; while leaving out important facts is intentionally misleading, when each side puts forward their best argument voters can decide whose case is stronger and where they would like to place their support.

Politicians have also lied in the past when they knew that the evidence needed to prove the falsehood of their statements was unavailable at the moment. A strong press corps has, at times, later proved those statements false. Nixon lied about Watergate, Vietnam, and supporting a coup in Chile; Reagan lied about Iran-Contra and US activities in El Salvador; Bill Clinton lied almost every time allegations of sexual impropriety were brought forward.

What has changed in recent years and the current Presidential election in particular is that politicians are now lying about things that are objective and easily verifiable as true or false. Since 2007 Politifact, run by the Tampa Bay Times, has independently fact checked statements made by public figures. This years’ Presidential Candidates have not exactly been defenders of the truth. Politifact rates 76% of Donald Trump’s statements as false and it is little comfort that only 28% of Hillary Clinton’s statements are similarly rated.

During the very first episode of The Colbert Report in 2005, Stephen Colbert foreshadowed this trend by introducing the word “Truthiness” to the English vernacular, with perfect parody:

“Now I’m sure some of the world police, the ‘wordinistas’ over at Webster’s are gonna say ‘Hey, that’s not a word.’ Well anyone that knows me, knows that I’m no fan of dictionaries or reference books. They are elitist. Constantly telling us what is or isn’t true or what did or didn’t happen. Who’s Britannica to tell me the Panama Canal was finished in 1914? If I want to say it happened in 1941 that’s my right. I don’t trust books. They’re all fact, no heart. And that’s exactly what’s pulling our country apart today. ‘Cause face it folks: we are a divided nation. Not between Democrats and Republicans or Conservatives and Liberals. Or tops and bottoms. No. We are divided between those who think with their head and those who know with their heart….That’s where the truth comes from ladies and gentleman, from the gut. Did you know you have more nerve endings in your gut than in your head? Look it up. Now, somebody’s gonna say ‘I did look that up and it’s wrong.’ Well, Mister that’s because you looked it up in a book. Next time try looking it up in your gut. I did. And my gut tells me that’s how our nervous system works. I know some of you may not trust your gut yet, but with my help you will. The ‘Truthiness’ is anyone can read the news to you. I promise to feel the news at you.”

“Truthiness” is well accepted today as feeling something to be true even if it is not objectively so and as the years pass what is “truthiness” seems to be replacing what is “true”. I think that discussions of trade may fall into the category of “truthiness” more than almost any other subject today.

Consider a few statements from various people:

“NAFTA, supported by the Secretary (Clinton), cost us 800,000 jobs nationwide.” – Bernie Sanders

“The Trans-Pacific Partnership was designed for China to come in, as they always do, through the back door and totally take advantage of everyone.” – Donald Trump

“Free trade agreements are trade agreements that don’t stick to trade….they colonize environmental labor, and consumer issues of grave concern.” – Ralph Nader

“It is not a free trade agreement. It has nothing to do with free trade. Virtually nothing.” – Noam Chomsky

“The World Trade Organization – a disaster for us.” – Donald Trump

Clearly, the issue of trade is not a left-right disagreement, but a populist-establishment battle that the establishment appears to be losing. Perhaps Mark Twain’s statement, “All you need in life is ignorance and confidence, and then success is sure” best sums up the current state of American politics, particularly in respect to trade.

Even “experts” can say drastically misleading statements. Consider the white paper that Peter Navarro and Wilbur Ross wrote on behalf of the Trump campaign called “Scoring the Trump Economic Plan: Trade, Regulatory, & Energy Policy Impacts.” Navarro is a Professor of Business at the University of California-Irvine and Ross a well-respected investor. With respect to trade, there are some reasonable suggestions – for instance a lowering the corporate tax rate and moving to a territorial system to make US companies more competitive – but also the bizarre and clearly fatuous suggestion that the value added taxes of other countries act as an export subsidiary and an unfair tax advantage. A value added tax behaves in many ways like a sales tax, it is just collected along the production cycle in order to avoid evasion and a lump sum collection at the time of the final retail sale. In the state of Ohio, where I live, the average sales tax is about 7%. Meanwhile, the state of Montana has no sales tax. Do Ohio manufactures receive an unfair advantage when they “export” products to Montana? Of course not. The fact that products made in both states have no sales tax when sold in Montana and a 7% sales tax when sold in Ohio means everyone is on the same playing field. It is astonishing that even experts can make such demonstrably stupid claims. (To be fair the candidate they support has also said that the real unemployment rate is 40% and that he would pay down the federal debt in 8 years.)

Criticizing the statements of others is pretty easy, though. How should we be thinking about trade and how should we judge potential trade agreements to be in our best interests or against them?

To do so, let’s consider a few broad topics:

  • · Why do countries trade with each other?
  • · A stylistic overview of the United States long-term trade patterns
  • · Is the trade deficit a bad thing?
  • · Why have there been so many free trade agreements in recent decades compared to the past?
  • · What’s in a free trade agreement?
  • · Is trade good for me?

Why do Countries Trade with Each Other? (A little academic, but you can handle it)

Any undergraduate student in economics is familiar with the concept of comparative advantage, but it is still extremely non-intuitive because it is determined by opportunity cost and not by accounting cost – meaning comparative advantage is not the same as absolute advantage. Just because country A can produce product X for $16.00 and country Y can produce product X for $17.00 does not mean that country A is the logical producer of the product. The real question is one of relative prices – what will each country be giving up by choosing to produce product X?

The International Economics text I used at Kent State (it was International Economics by Krugman and Obstfeld) probably explained the concept best through the example of Babe Ruth, who was both an excellent pitcher and hitter. Before Babe Ruth broke home run records, he was the best left handed pitcher in the American League. But, the question that mattered most was: relative to the other players in baseball at the time was he a more valuable pitcher or hitter? Similarly, a country could have an absolute advantage in every product in the world – but they would still benefit form trade through specialization. Babe Ruth may have been a better pitcher than the man who replaced him on the mound, but the team was better off by having him focus his energies on hitting. The opportunity cost of Babe Ruth pitching was not having him in the lineup every day hitting home runs.

The British philosopher John Stuart Mill built upon the idea of comparative advantage by thinking of trading in terms of “reciprocal demand” to develop a concept we now refer to as terms of trade. Most of the time our minds are trained to think in terms of production and consumption, supply and demand. But trade can often be thought of as reciprocal demand – a country’s imports are paid for with its exports. The terms of trade measures the relative prices of a country’s exports and imports or how much over time needs to be exported in order to pay for imports. Often times the most dramatic changes in the terms of trade occurs for commodity producing countries when their primary commodity increases or decreases in value. When oil prices rise, Saudi Arabia can afford to purchase far more imports than they could before.

Terms of trade for selected countries. 1960-2015. Source: Federal Reserve Bank of St. Louis

David Ricardo, the man who inserted comparative advantage into our vocabulary was primarily thinking of the opportunity cost of labor. In later years it became much better understood that the production process can be a complicated dance of land, resources, labor, and capital. Shortly after the First World War, Swedish economists Eli Heckscher and Bertil Ohlin proposed a new model of trade that retained the concept of comparative advantage but extended it to a production process that was a bundle of things in addition to labor input, including natural resources and capital.

The Heckscher-Olin model of trade makes some very specific predictions, particularly in regards to factor endowments. Countries that are capital abundant should be exporting capital intensive goods and importing labor intensive goods. That makes sense perfect sense, except a problem developed with the theory. During the 1950s when German economist Wassily Leontief took an empirical looked he found that the United States, which had more capital relative to labor than any country in the world, actually imported more capital intensive goods than it exported. How could that possibly be true? It came to be called the Leontief Paradox.

Leontief’s review of 1947 data found that imports to the United States were about 30% more capital intensive than exports. A 1971 paper by Robert Baldwin found a similar pattern (with a 25% gap in capital intensity).

Results from Robert Baldwin’s empirical research on the capital intensiveness of US imports and exports.

So, what’s really going on here? Well, the best explanation is probably that the word “capital” is far too narrow. The advantage the United States has always had is more in terms of human capital than physical capital. Many of our largest exports include aircraft, chemicals, pharmaceuticals, and financial services.

“New trade theory” eventually stepped in to not only shed some light on the paradox but also contribute a way of thinking about trade that is much more in-tune with the modern world. Previous trade theories had relied upon an assumption of constant returns to scale. This just means that as you increase inputs to a production process (capital and labor) you are going to get a proportionate increase in outputs. But this is not always the way the world works. Very often, there are increasing returns to scale as efficiencies are exploited. And understanding trade flows in these industries with increasing returns to scale is very important to understanding how economists think about trade today.

Think about the production of large jets. It’s incredibly complicated and without question exhibits increasing returns to scale (or you could simply say that a company like Boeing has a competitive advantage through economies of scale). Boeing and Airbus each have about 50% of the market for large commercial aircraft because of this. Other countries are capable of producing these airplanes, but because of gains from scale they will never be able to compete in wide-bodied aircraft and so they will import these goods.

How does a country come to be an exporter in an industry that requires enormous scale? There are certainly some random aspects to the equation, but domestic demand is a big factor that allows a firm to develop the requisite scale before competing internationally. Geography matters too. Production is biased to be closest to consumption in order to minimize transportation costs as well as to gain from special factors such as a developing base of skilled labor in a particular region or area. After a while a kind of gravity develops and concentrates certain trade activities.

I live near Akron, OH – a part of the United States now referred to as the rust belt that encompasses parts of New York, Pennsylvania, Michigan, West Virginia, and Indiana, but that at one time produced an astonishingly large amount of the world’s manufactured items. This area was nearby to large consumption centers, could transport relatively easily with the proximity of the Great Lakes. Over time a skilled labor force developed and gains from scale were achieved (the bombing of all competitors during the Second World War helped as well) and so increasing returns to scale and a gravity like pull of centralizing production processes made the Midwestern United States the industrial center of the world.

So, what are the key principles that should be gotten from academic discourse on trade? Comparative advantage still lies at the heart of explaining the benefits from trade but comparative advantage is understood much more deeply today and relies on factors beyond simple labor productivity to explain why trade occurs. But it is just as true today as in the 19th Century that trade can expand the sum total of production in the world. Modern (or “New”) trade theory expands some of those benefits from trade that can be received. One large benefit is added competition. You experience the benefits of this every time you purchase a car. But perhaps the biggest benefit in today’s world is that trade opens up the potential customers of a firm and in industries with increasing returns to scale can create efficiencies that would be absent in the presence of autarky. Those very benefits also are the reasons for a lot of the backlash against trade, though: the creation of huge, stateless, multi-national corporations that place profit above people. And if gains from trade are going to make them? The blue collar worker in Ohio who loses his job because China has a comparative advantage in manufacturing an item doesn’t enjoy them.

How the gains from trade are distributed is something that we will return to later. For now, it’s important to understand that there are gains from trade. Next, I want to take a look at some figures that can give us a sense for how trade has evolved within the United States and the World over time.

A Stylistic Overview of the United States Long-Term Trade Patterns

Trade as a percentage of GDP, World and U.S.A., 1870-2015. Source: World Bank.

Prior to the First World War international trade was on the up-swing, driven by trading within Europe and the British Empire. Trade collapsed with the war and did not return to comparable levels until the 1970s.

The breakdown in trade following WWI took decades to recover from. Source: World Bank.

Canada, China, Mexico, and Japan are the largest trading partners of the United States. Combined they represent about 44% of the United States’ trade with the rest of the world. As Donald Trump likes to make the world aware, the United States runs an enormous trade deficit with China at more than $300 billion. But contrary to what most would believe, the country that the United States has the next highest deficit with is Germany, with Mexico coming in at third.

U.S. top trading partners, 2014 and 2015. Amounts in millions of USD. Source: US Census Bureau.

Each year, the United States runs a trade deficit in goods and a surplus in services. The category in which the United States has the largest surplus is in travel, followed by intellectual property royalties. Unsurprisingly, the largest deficits are in consumer goods (household appliances, cell phones, apparel, etc.), autos, and petroleum products. Consumer goods by itself is more than 80% of the trade deficit.

U.S. trade by category, 2015 and 2016. Source: U.S. Census Bureau.

Very obviously the United States buys more from the rest of the world than it sells and currently the trade deficit is somewhere in the range of $500 billion per year, equal to about 2.5% of GDP. No aspect of trade is more fraught with hand wringing and as evidence that the United States is getting ripped off than the trade deficit is. But, isn’t it a very bad thing that we send the rest of the world $500 billion more than they send us each year? Maybe, but not necessarily.

Is the Trade Deficit a Bad Thing?

The key to understanding a trade deficit is to understand the balance of payments. Think of the balance of payments as a massive accounting system that records a transaction each time someone in the United States and someone outside the United States transacts with each other. These transactions are divided into two accounts: the capital account and the current account. The current account includes the balance of trade along with income that Americans earn on foreign investments and transfer payments. The capital account records asset movements across borders, such as purchases or sales of financial assets or foreign direct investment. The capital account and the current account must balance each other out so long as the currency is freely floating.

I can remember many years ago Warren Buffett talking about the trade deficit and explaining why he was shorting the US dollar. I don’t think he misunderstood the economics, but I would be more sanguine than he is on the issue. Buffett explained the running a trade deficit was similar to a very rich family over-consuming each year and selling a small piece of their farm in order to consume. Slowly, the rich family’s wealth is transferred to those selling them what they are consuming. Another way of putting this is that the family is running a negative current account balance and offsetting that with a positive capital account balance.

People ought to have concerns about large imbalances in the world economy and a very large trade deficit in the United States would be a cause for caution. But, modest trade deficits are really nothing to be overly concerned with. Why? If you invert your thinking on the trade deficit by thinking of it not as an excess of consumption, but as a shortfall in investment funds you can begin understanding why.

Source: Federal Reserve Bank of St. Louis.

More funds are investment in the American economy than American’s save and this shortfall is filled by the current account deficit. So, yes it is true that as we run current account deficits other countries own a greater share of the country, but the investments that are recycled into the United States as a result of the trade deficit make the entire “pie” of America more valuable than it was before.

Arguing that the trade deficit is a bad thing is like saying a company issuing shares of stock is a bad thing. It’s not necessarily. Each year the United States sells a little bit of its stock to the rest of the world and uses the proceeds to invest in its “business”. There is nothing terrifying about that. People want to hold dollars and they want to invest in the United States. People should stop whining about that. They would find the opposite situation far less pleasant.

As we move on, let’s return somewhat to some of our original examination of trade over time and in particular the large increases in trade that occurred after the Second World War. This will help us understand the best way to think about recent proposed and enacted free trade agreements and whether they are or are not good for the country.

The GATT and the WTO

The General Agreement on Trade and Tariffs (GATT) was signed into existence in late 1947. For years afterwards, the countries that were parties to the agreements held rounds of discussions in order to find ways to eliminate barriers to trade, including tariffs. GATT was one of the aspects of the Bretton Woods System, intended to promote post-war stability, and included the creation of The World Bank and The International Monetary Fund. Whereas the GATT was a treaty that was periodically revised, the World Trade Organization is a functioning organization that can act as a forum for trade and disputes.

The key premise behind the GATT was the idea of most favored nation status and non-discrimination. In practice, this means that the United States should not give Canada a better set of tariffs than they would for Indonesia and the United States should not favor domestic producers over foreign producers exporting to the United States. Over time, tariff rates in the United States and the rest of the world fell ever lower.

Change in tariff rates for the USA and Internationally. Source: The United States in a Global Economy.

There was, however, a loophole in GATT that would allow one country to give preferential treatment to another: a regional or bilateral free trade accord. For many years, the United States and the rest of the world chose to primarily work with the GATT/WTO framework in order to break down trade barriers. Increasingly (and in some ways worryingly) focus has shifted to bilateral or regional trade agreements.

The first free trade agreement signed by the United States was with Israel in 1985. Part of the impetus for that deal was the fact that Israel had already enacted a similar agreement with the European Economic Community, which allowed Europe to take some market share from US exporters.

Why have free trade agreements taken on greater importance rather than a WTO process? Quite a few reasons, but perhaps the simplest is that it’s pretty hard to get a couple hundred countries to agree to anything and regional agreements can help cement strong relations between a set of countries.

From 1985 until today the United States has entered into free trade agreements with 21 countries. The proposed Trans-Pacific Partnership (TPP) would include 11 countries not counting the United States, but the United States already has free trade agreements with 6 of those 11 countries (Singapore, Chile, Australia, Peru, Mexico, and Canada). The proposed Trans-Atlantic Trade and Investment Partnership (T-TIP) would be a free trade agreement between the United States and the European Union.

List of U.S. Free Trade Agreements. Source: US Trade Representative.

What’s in a Free Trade Agreement

NAFTA included many provisions beyond just progressive tariff reduction. Non-tariff barriers to trade were reduced, health, safety, and industrial standards were established and supplemental agreements on labor and the environment were signed.

If you have time to kill, you can read the proposed TPP agreement here. It runs thirty chapters and includes a schedule of tariff reductions, processes for dispute resolution, determining rules of origin, agreements to bring customs enforcement agencies closer together, and agreements covering investment, intellectual property, labor rights, and the environment.

What is the argument against it? Some are simply ideologically opposed to free trade agreements because they believe it gives too much power to corporations and harms the labor movement. Elizabeth Warren has specifically cited the dispute resolution process as a reason to oppose it because it could give large corporations the ability to escape a legal process within the United States -a potentially valid concern. Hillary Clinton’s manufactured opposition to the deal is predicated on a lack of agreement on currency manipulation by trading partners.

The currency manipulation in Asian countries still exists to some extent, but less so than in the past. Additionally, when the United States exports goods and services to the rest of the world it pays an average tariff of between 6% and 7% versus a tariff close to 3% for goods entering the United States. So, in total the United States normally wins from tariff reductions.

Is Trade Good for Me?

Maybe. It depends who you are and how you earn income and consume goods and services. There are winners and losers from trade, but the United States and the World at large certainly is wealthier because there is more trade.

The U.S. International Trade Commission estimated that free trade agreements (not total trade with the rest of the world, but the trade agreements themselves) increased real wages by 0.3% on average, employment by 0.1%, and real GDP by +0.2%. At the median household income of about $56,000 per year that would equate to about an additional $170 per household, however that would not take into account benefits accrued from lower prices for many goods. Cheap imports (whether because of a specific free trade agreement or not) have created enormous increases in standards of living for many American consumers.

At the same time, it must be recognized that not everyone benefits from free trade. Some people lose. The biggest losers are those with low skills who must now compete with a larger pool of low-skilled workers in various parts of the world. Workers with a high school diploma now earn only about 55% what a worker with a college degree earns.

The puzzling thing about the TPP is that it is not primarily about reducing tariffs, which have already been brought to extremely low levels, but more about protecting intellectual property and raising labor and environmental standards. These would actually make American workers more competitive and the deal seems to be a positive one for the American car industry.

But, as a country we benefit from breaking down trade barriers and the gains from trade are not shared equally. It is entirely appropriate to create assistance programs for those who have been displaced by trade. These have always been promised, but rarely actually delivered for those unfortunate enough to be adversely impacted.

Truth over Truthiness

There can be no question that free trade is a positive for the world and there should be an avoidance of “truthiness” when it comes to trade – simply believing what feels right.

There are certainly many ways we can improve trade policies and the agreements we sign with other nations, but America should not turn its back on free trade just because it feels like the right thing to do. And by all means, stop lying to people and telling them things like the value added tax is an export subsidy.

Both sides of the political aisle are guilty of exploiting trade to their advantage. Workers should know that, for the most part, they have not lost their jobs because of trade and that trade has likely benefited them and that the trade deficit is not a scorecard of who is winning and losing. But advocates of free trade should be careful not to exaggerate the benefits of trade and be willing to provide assistance to those displaced by the policies that benefit the rest of us.

One Response to "The Truth and Truthiness of Global Trade"

  1. Pingback: NAFTA in the Crosshairs - The International Observer

You must be logged in to post a comment Login