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The return of trade protectionism

The current consensus appears to favour trade sceptics over free-traders

In the unfolding presidential election campaign in the US, the issue of trade protectionism has taken centre stage at least among economic policy issues that the leading candidates are debating and making campaign pledges about.

Candidates as radically different as Republican Donald Trump and Democrat Bernie Sanders seem to be in agreement that a swell of cheap imports into the US, principally but not exclusively manufactured goods from China, has wreaked havoc with the living standards of poor and middle-class Americans. These are the voters that Trump, Sanders and the other candidates are assiduously wooing, in the hopes that they will help beat a path to the White House in January 2017.

A cry for protection by vote-seeking politicians when economic times are tough is hardly new; nor are protectionist policies themselves new. Indeed, one could argue that calls for protection often coincide with macroeconomic downturns or even macroeconomic and financial crises.

The stock market crash of 1929 led to a tit-for-tat “beggar thy neighbour" tariff war among the major trading economies that, as we now know, considerably worsened the Great Depression. And, as we also now know, that catastrophe blighted millions of lives in the 1930s and directly precipitated the rise of fascism and World War II.

In large measure as a direct result of the advanced economies’ disastrous experience with the tariff war of the 1930s, one of the multilateral institutions created out of the rubble of the war was the General Agreement on Tariffs and Trade—today the World Trade Organization (WTO)—which gave the world a rules-based, equitable trade regime.

(The other major institutions created around the same time were the World Bank and the International Monetary Fund, to manage international assistance and global monetary and exchange rate arrangements, respectively.)

Imperfect it may be, but the WTO system has indeed prevented any repetition of a 1930s experience of tit-for-tat tariff escalations among major trading nations. But it has not prevented what some economists call the problem of “creeping protectionism". This is a situation in which non-tariff trade barriers such as subsidies, quotas and other “beyond the border" measures such as domestic procurement requirements drift up during tough economic times, typically in response to economic populism by politicians.

The 1970s, which witnessed economic malaise in the US and other advanced economies following successive oil price shocks from the Organization of the Petroleum Exporting Countries (Opec) and the collapse of the Bretton Woods system of fixed exchange rates, were, indeed, a period of such an upward drift in protection. The end result was a system that was not exactly free trade nor exactly conventional protection, but what came to be called “managed trade".

The last major bout of protectionism in the US and other advanced economies was during the 1990s, again during a period of economic malaise and a business cycle downturn. Its high-water mark was during the 1992 US presidential campaign, when several candidates, most notably Democrat Bill Clinton and independent Ross Perot, blamed the depressed wages of American workers on cheap imports from Mexico and elsewhere, facilitated by major trade agreements, such as the recently agreed but not yet ratified North American Free Trade Agreement (Nafta).

Incumbent president, Republican George Bush, saw his early lead in the polls, built on the back of the popular and successful Gulf War, quickly evaporate. Clinton won in a landslide, despite the spoiler candidate Perot, and immediately surrounded himself with economists whose research and policy advocacy supported his tough views on trade, most notably Laura D’Andrea Tyson and future Nobel laureate Joseph Stiglitz, who were successive chairpersons of the president’s Council of Economic Advisors during his first term in office.

The protectionist urge waned during the economic boom of the late 1990s that continued, with minor hiccups, until the global financial crisis of 2007 and thereafter. During the immediate aftermath of the crisis, attention focused on its macroeconomic and financial dimensions, with trade issues on the back burner.

But now that the US, in particular, appears to be on the path of economic recovery, albeit a slow and shaky recovery, attention has once again shifted back to trade issues, especially as they affect American workers (and voters).

The “new protectionism" preached today by Trump, Sanders, and even to some extent by incumbent president, Democrat Barack Obama, and Democratic front-runner Hillary Clinton, harks back very directly to the debate in the early 1990s, in which I happened to be an interlocutor. An earlier Economics Express column outlined the contours of that debate.

In dense summary, that previous debate pitted supporters of the Bill Clinton view—that trade was indeed a major culprit in stagnating wages in the US—against the opponents of that view. The former group included, apart from the individuals already named, another future Nobel laureate, economist and columnist Paul Krugman. The latter group included economists such as Jagdish Bhagwati and myself.

In a 1993 conference paper, Bhagwati and I argued that it was inaccurate to blame the conventional trade channel of falling import prices feeding through into falling wages (in economic jargon, the “Stolper-Samuelson effect"). Rather, we argued, blame should be shared between technological change, which tends to favour capital and skilled workers over unskilled workers, and a new factor that we called “kaleidoscopic comparative advantage".

By the latter coinage, we meant that globalization, which was then a new phenomenon, was rendering margins of comparative advantage razor thin, so that industries, and the workers employed by them, would be footloose, and there would be greater churn in the economy—both domestically and globally.

In the intervening quarter century, the consensus among economists has shifted back and forth, originally favouring the Krugman-Stiglitz-Tyson view, then for a decade or more favouring the Bhagwati-Dehejia view, and, more recently, tilting back to the view that trade is, indeed, a major culprit in explaining stagnating proletarian and middle-class US wages—which is exactly the intellectual foundation for trade sceptics on the hustings today.

In my judgement, a key intellectual transition point to the current consensus, which increasingly appears to favour trade sceptics over ardent free traders, was an influential 2006 piece by economist Alan Blinder, published in Foreign Affairs. As it happens, Blinder was a member of Clinton’s Council of Economic Advisors when Tyson was its chair, and he remains influential in Democratic circles.

Picking up on our concept of kaleidoscopic comparative advantage, Blinder argued that globalization had rendered obsolete the old distinction between tradable and non-tradable goods and services, a staple of conventional trade economics. Rather, what was increasingly relevant, he argued, was a new distinction, one between goods which could be cheaply transported and services which could easily and without degradation of quality be outsourced through information technology on the one hand, and those which could not be so outsourced on the other.

Blinder’s new concept cut across old notions of tradable versus non-tradable goods and, perhaps as an unintended consequence, provided powerful new ammunition for putative protectionists. In the brave new globalized world, relatively few jobs would be safe from foreign competition—since many goods and services could now be cheaply purchased from, or easily outsourced to, China and elsewhere.

Crucially, jobs that would be essentially immune from foreign competition would be at the very low and at the very high end; meanwhile, most of the jobs, in the middle, would be vulnerable.

Thus, a factory worker and a radiologist would be equally vulnerable to their job being outsourced. Indeed, such jobs are already routinely being outsourced from the US, with the wages of those remaining in these fields falling or unemployment rising. But, a cab driver or construction worker, at one end, and a celebrity psychiatrist or high-powered financial adviser, at the other end, cannot be replaced by having the labour services they provide outsourced.

In the first case, this is because it is not cost-effective or is physically impossible to outsource cab driving and construction work, and it is at present too costly to replace such workers with robots.

In the second case, while it is possible to outsource psychiatry and financial advising, and this does happen at the lower value end of the market, ongoing personal contact with the service provider is a crucial prerequisite (and perquisite) of the package of services being offered at the upper value end. A billionaire is unlikely to invest her money through a mobile financial services app!

The logic of Blinder’s conception, if carried to its logical conclusion, suggests an apocalyptic vision of a world in which the bulk of American jobs are outsourced to China and elsewhere, or robotized, while an underclass of cab drivers and construction workers service a few celebrity psychiatrists and high-powered financial advisors. This is, indeed, the stuff of science fiction.

While this world has not yet arrived, there is some new evidence that intensified import competition, mainly from China, has, in fact, harmed American blue-collar workers more than has been widely acknowledged to date.

In a recent research paper, economists David Autor of the Massachusetts Institute of Technology (MIT), David Dorn of the University of Zurich and Gordon Hanson of University of California, San Diego, show that, due to very slow adjustment in local labour markets, wages and labour force participation remained low and unemployment remained high for more than a decade after what they term the “China shock", by which they mean the emergence of that country as a global trading powerhouse. Data that they present dates this emergence to the early 1990s, a little more than a decade after economic liberalization in China.

Autor, Dorn and Hanson argue, plausibly, that China’s emergence as a trading superpower has fundamentally transformed the structure of global production and trade, and has had knock-on effects on the US’s, and presumably other advanced nations’, labour markets of a comparably large magnitude. Their study, and other related research, makes clear that, contrary to the benign assumption of some free trade advocates, the distributional consequences of large-scale shifts in global trade patterns should not be assumed away or ignored.

But this is where a dose of economic theory must supplement the findings of empirical studies such as these. Economic theory does not suggest that free trade always benefits everyone; and no honest advocate for free trade has ever made that case. Rather, theory teaches us that, absent widespread market failures, freer trade raises aggregate economic welfare—let us say, as roughly measured by GDP.

Further, even though a nation as a whole is likely to benefit from freer trade, in any sensible trade model, there will be distributional impacts, such that some groups gain while others lose. It is true that, if there are distributional impacts in the presence of aggregate gain, it is possible for the losers to be compensated and the winners to remain better off than before (in economics jargon, a “Pareto improvement").

However, in the absence of a mechanism that accomplishes this—either through voluntary agreement or through redistributive taxes and transfers—the losers will, in fact, remain worse off, perhaps permanently or for a very long time.

The message, therefore, is that advocates for freer trade in advanced economies such as the US ought not to gloss over its potentially harmful distributive effects. Rather, if they are honest, they must concede that trade is likely to create losers just as it creates winners, even if the economy as a whole gains.

But, crucially, they must then pitch for sensible policy responses, such as adjustment assistance schemes and the like, which help mitigate, if not reverse, the losses, while also ensuring that such interventions do not cause the gains to dissipate.

The takeaway for developing economies such as India is, I would argue, more nuanced. In a still-poor economy, it is possible to make the conservative political economy case that aggregate gain trumps distributive consequences, if these latter are tolerably small in magnitude, and ameliorative policy measures, such as retraining schemes and adjustment assistance, are put in place to mitigate them to the extent possible.

The evidence to date, as persuasively argued by economist Arvind Panagariya in a 2008 lecture and elsewhere, suggests that developing economies such as India have gained enormously from the freeing of trade.

More broadly, as argued by Bhagwati, Panagariya and others, freer trade has been a crucial component, although by no means the only important one, of the Indian growth miracle and the concomitant reduction in poverty and other social ills (although not inequality, which is a debate for another time).

Such enormous aggregate gain ought not to be, one could argue, held hostage to the Utopian criterion that absolutely every last individual must be made better off. The stakes for the nation as a whole are, quite simply, too high.

To be somewhat provocative, one could argue further that the losers from the freeing of trade can, or should, be ignored in a poor and growing economy such as India. In terms of political economy, an economic policy which makes enough people (let us say, a majority, or large plurality), although not everyone, better off, probably makes economic and political good sense to pursue. This is true even though it would not pass the economic purist’s litmus test of “Pareto improvement" as discussed above.

But in an advanced economy such as the US, such an old-fashioned conservative argument for freer trade is most unlikely to find favour, and the answer to putative protectionists such as Trump and Sanders is not to brush away the uncomfortable fact that freer trade creates losers, but to tackle such losses head-on through government policy.

In a 2004 policy paper, economist James Dean and I, writing with co-authors, dubbed such an approach “optimal" liberalization, a liberalization which creates winners without losers.

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