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In Praise of Mercantilism (or Why Economic History Isn't Boring)

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Does economic history hold a giant clue for getting America out of its present trade mess? Yes, because it debunks the idea that free trade is how nations become prosperous. Instead, it shows that nations win at international trade by playing a 400-year-old game called mercantilism.

Let's look at England, for example.

The great Adam Smith, founder of modern economics, published his epoch-making free-trade tract The Wealth of Nations, the origin of endless subsequent delusions, in 1776. But he was a hypocrite, for Britain in 1776 was not a blank slate upon which free markets and free trade could work their magic. It was instead the beneficiary of several prior centuries of protectionism and industrial policy. In the words of British economist William Cunningham:

For a period of two hundred years [c. 1600-1800], the English nation knew very clearly what it wanted. Under all changes of dynasty and circumstances the object of building up national power was kept in view; and economics, though not yet admitted to the circle of the sciences, proved an excellent servant, and gave admirable suggestions as to the manner in which this aim might be accomplished.

England in this era was, in fact, a classic authoritarian (this is long before English democracy) developmentalist state: a Renaissance South Korea, with kings rather than the military dictators who ruled South Korea for most of the Cold War period. English industrialization must actually be traced 300 years prior to Adam Smith, to events like Henry VII's imposition of a tariff on woolen goods in 1489. King Henry's aim was to wrest the wool weaving trade, then the most technologically advanced major industry in Europe, away from Flanders (the Dutch half of present-day Belgium), where it had been thriving upon exports of English wool. Flemish producers were entrenched behind huge capital investments, which gave them economies of scale sufficient to outcompete fledgling entrants into the industry. So only government action could get England a toehold.

Even in the 15th century, there was an awareness that being an exporter of agricultural raw materials was a dead end--a problem impoverished African and Latin American nations wrestle with to this day. And there was an awareness that free trade will not lift a nation out of this predicament: you need some well-chosen protectionism. Henry VII created, in fact, the first national industrial policy of the modern era, long before the Industrial Revolution introduced artificial energy sources like steam power. A whole interlocking series of now-forgotten policy moves underlay the rise of English industry; what all these measures had in common was that protectionism was essential to making them work. In the words of economist John Culbertson of the University of Wisconsin and the Federal Reserve Board of Governors:

Step after step in the cumulative economic rise of England was directly caused by government action or depended upon supportive government action: the prohibition of importation of Spanish wool by Henry I, the revision of land-tenure arrangements to permit the development of large-scale sheep raising, Edward III's attracting of Flemish weavers to England and then prohibiting of the wearing of foreign cloth, the termination of the privileges in London of the Hanseatic League under Edward VI, the near-war between England under Elizabeth I and the Hanseatic League, which supported the rise of English shipping. And then there was the prohibition of export of English wool (which damaged the Flemish textile industry and stimulated that of England), the encouragement of production of dyed and finished cloth in England, the use of England's dominance in textile manufacture to push the Hanseatic League out of foreign markets for other products...

The aim of English policy was what would today be called "climbing the value chain": deliberately leveraging existing economic activity to break into more-sophisticated related activities. Henry VII's advisors got their economic ideas ultimately from the city-states of Renaissance Italy, where economics had been born as a component of Civic Humanism, their now-forgotten governing ideology.

The name for this forgotten developmentalist wisdom of early modern Europe that has stuck is "mercantilism." One of the great myths of contemporary economics is that mercantilism was an analytically vacuous bundle of gold-hoarding prejudices. It was, in fact, a remarkably sophisticated attempt, given the limited conceptual apparatus of the time, to advance national economic development by means that would be familiar and congenial to the technocrats of 21st-century Tokyo, Beijing, or Seoul. (And believe me, they're still using these techniques against us.) For 400 years, this is how former Third-World nations have become former Third World nations.

Mercantilists invented many economic concepts still in use today, such as the balance of payments, value added, and the embodied labor content of imports and exports. They championed the economic interests of the nation as a whole at a time when special interests (notably royal monopolies) were an even bigger problem than today. They began with obvious ideas like taxing foreign luxury goods. They progressed to the idea that exporting raw materials for foreigners to process was bad if the nation could process them itself. They understood that nations rose economically by imitating the industries of already rich nations (first the more primitive industries, then the more sophisticated) and that low relative wages were the key advantage of underdeveloped nations in this game. How little has changed!

Mercantilists saw free markets as a useful tool in economics, but not the sum total of economic wisdom. Even their much-mocked obsession with the accumulation of bullion was not as irrational as it is usually depicted as being, given that under a monetary system based on gold, accumulating it is the only way to expand the money supply and drive down interest rates, a boon to investment then as now. Mercantilism, in fact, created the modern European economy and thus made possible the colonial power that economically shaped much of the rest of the world. It is thus the foundation of modern capitalism itself.

Anyhow: Britain functioned on a mercantilist basis for centuries before its much misunderstood experiment with free trade began. Even as late as the beginning of the 19th century, Britain's average tariff on manufactured goods was roughly 50 percent--the highest of any major nation in Europe. And even after Britain embraced free trade in most goods, it continued to tightly regulate trade in strategic capital goods, such as the machinery for the mass production of textiles, in order to forestall its rivals. This was rational, as the win-win logic of free trade starts to break down if productive capital is mobile between nations or if free trade induces productivity growth abroad.

After Britain embraced free trade in the mid-19th century, its long economic decline, of course, began. Today, the United States is making the same mistake, having mistaken the temporary tactical advantages of free trade for a nation at the peak of its economic power for a fundamental strategic truth. Meanwhile, our rivals, especially but not only in the Far East, hold firm to the mercantilist principles that we ourselves employed for 150 years.

Mercantilism has somewhat different application in developed, rather than developing, nations, but its fundamentals still hold good. At the very least, we need to defend ourselves against mercantilist aggression against us, something we are not doing.