The Losses of Trade

09/28/2011 04:17 pm ET | Updated Nov 28, 2011

When you study economics 101 as a university freshman or, later, when you read about globalization and international trade after you have graduated and joined the work force, you constantly hear about the "gains of trade" -- the lower consumer prices and increased productivity that arise from specialization of production and trade between countries. What you never hear about is the possible existence of a downside and losses from trade.

Now, a new report on trade with China says that the adjustment costs like rising unemployment and the food stamps, declining tax receipts, reduced school budgets, and other expenses arising from trade with China wipe out up to two-thirds of the gains from trade and that doesn't include economic losses from people who lost their jobs. The full implication of the study is that, depending on circumstances, there may well often be no gains and perhaps even net losses from trade.

Done by MIT economist David Autor, U.C. San Diego economist Gordon Hanson, and David Dorn of Madrid's Center for Monetary and Financial Studies, the paper confirms earlier findings made by former Sloan Foundation President Ralph Gomory and former American Economic Association President William Baumol in a study of trade under conditions of imperfect competition and with less than full resource utilization.

Coming especially at a moment of economic crisis with high unemployment and declining median household income, these works hit directly at the main rationale for free trade. That has been the notion that free trade is always and everywhere a win-win proposition for the countries involved. Indeed, the argument has been that even if one trade partner is protectionist or mercantilist, the other is still better off sticking with free trade.

The conventional argument has always been based on restrictive assumptions including that all markets are perfectly competitive (no producer has market power), that there are no economies of scale and no cross border flows of investment or technology or people, that all resources (labor, equipment, land, etc.) are fully utilized, that there are no costs of adjustment in closing and opening factories or switching jobs and types of production, and that exchange rates are fixed. The conventional argument also does not say there will be no losers from trade. Rather it is careful to explain that some industries and workers might suffer temporary losses, but emphasizes that the gains of the winners will outweigh the losses of the losers and that the winners will therefore compensate those temporarily down on their luck.

Of course, a main difficulty over the years has been the fact that the winners have never compensated the losers adequately. But the new studies suggest that there may not be enough winners to do any compensating. The main problem is that the conventional assumptions obviously don't hold any longer if they ever did. Most markets are not perfectly competitive, investment does cross borders as does technology, economies of scale exist and are enormously important, and adjustment costs not only exist but can be very significant. Indeed, the new work indicates that the adjustment costs are huge.

In the past, the cost of worker adjustment has been estimated by adding up the number of workers who lost jobs due to imports, calculating how long they were out of work and the wage at which they returned to work, and multiplying all that times the days out of work. Then the resulting loss figure has been compared to the benefits to consumers purportedly arising from lower prices for a variety of goods and services. Since there are more consumers than affected workers, the result has always shown a balance of benefits under free trade.

But the new work goes much deeper into the cost side of things by looking at lost tax revenue, rising food stamp and other costs, and Gomory and Baumol also make the point that rising unemployment puts downward pressure on all wages that may more than offset the gains to consumers of lower import prices. In addition, there is the obvious fact that if huge benefits accrue to a small portion of a nation's population while the majority suffer losses, arithmetically the gains may offset the losses, but most people won't see or feel it that way.

A major point of the new work by the three economists is that China's advance into higher value added areas of production has been so fast that there has been no time for adequate adjustment on the part of U.S. and other countries' workers. Traditionally it has been presumed that poor countries like China would produce labor intensive products and trade them with countries like the United States for capital and knowledge intensive goods. But that kind of complementary, resource endowment based trade, is less and less what globalization is all about.

In his present job creation mode, maybe President Obama should think twice about calling for ratification of more free trade agreements and emphasize instead the importance of once again making America a producer country.