07/16/2010 11:11 am ET Updated May 25, 2011

Compensated Free Trade

In my past eight weekly blogs I confined myself to criticizing the Anglo-American "mainstream" neoclassical economics. It is utopian in its assumptions and may be extremely dangerous if its conclusions are recommended for the real-world economy. They are recommended, with insistence and audacity, and we see the results.

For instance, a sure way to get into a crisis is to proceed from a paradigm that denies the very possibility of a crisis. If you assume that voluntary unemployment is practically impossible, you end up with "... one out of four Americans is unemployed or underemployed (working part-time, overqualified, or at a lower wage than before)" (Robert Reich).

I did not describe my own proposals, because I was afraid that economists, their debating skills honed in endless academic battles, would switch the topics and, instead of defending their position, would criticize mine.

Now it is time to start talking about what should be done. In this blog, I describe the first of my proposals, "compensated free trade" (for brevity, CFT).

Last week I diagnosed two main ills of this country as a cancerous tumor of the financial industry and the bleeding of factories, jobs, and money because of unbridled globalization. (My medical diagnosis was unexpectedly very soon confirmed by a second opinion. On July 12, Senator Alan Simpson, the co-chairman of President Obama's Debt and Deficit Commission, talked about fiscal cancer "that will destroy the country from within," unless checked by Washington. A cancer is a cancer is a cancer, irrespective whether it refers to financial deficit or financial industry. The patient dies, period. It does not matter if he has coughed or not before dying.)

Financial economics is not my field, so I have nothing to add here to a zillion of useful proposals made by many economists and financiers. Except for one consideration that holds true in general, rather than for finance only. Our corporate governance is badly off track. Corporations were conceived to protect investors. They became instead a means to protect the "agents," the corporate staff, from being responsible for their risky misbehavior. The answer may be the a change of the current approach to corporate governance: each large public corporation should have, above it, a holding company -- perhaps a partnership, where the assets of partners are held in escrow, to cover the possible losses, for the whole period of potential risks involved. Something like Lloyds of London.

I firmly believe, however, in one maxim: if a proposition is both simple and "kills many Goliaths by a single stone," it almost certainly is the proper policy. Tobin tax (for brevity, I will thus call a tax on all financial transactions, although its author has originally proposed it only for currency transactions) meets that condition perfectly: it is simple; it would cut to size the finance industry; it would severely decrease proprietary trading of banks, which is a legitimized highway robbery of small investors; it would sharply change the behavior of pension funds, these prime sources of leverage capital for banks and hedge funds; it would modify the short-term orientation of those "investors" who in reality are no more than speculators; last but maybe most important, it would substantially reduce the present urgent need to increase suicidal taxes on the middle class, therefore contributing to plugging the deficit and thus getting us out of the crisis.

Both Germany and France are already intensively pushing for financial transactions tax in the European Union, and they are pretty sure of success of that proposition. They consider the tax "both feasible and necessary." Germany has already included 6 billion euro of revenue from that tax into its four-year budget-consolidation package.

Of course, American politicians are in the pocket of the finance industry, and they will oppose the Tobin tax as long as they can. But I believe in the old truism - that nothing can resist an idea whose time has come. The time of financial transactions tax has come. If 300 plus million Americans would not insist on the tax being implemented, they fully deserve the consequences.

* * *

Now, what to do about the globalization bleeding?

I became aware of that problem after the 2004 TV speech of Gregory Mankiw, then heading the Council of Economic Advisors of the Bush's White House, where he praised transfer of American telephone customer service jobs to India as a normal outcome of free trade and therefore beneficial to the USA. (The "mainstream" economists extensively praised him for his courage in speaking unvarnished home truth to all those economically ignorant dunces.)

Frankly, I couldn't believe my ears. I started looking at the theory of international trade, and immediately discovered enormous holes in it and absurdity of its assumptions as applied to the real world (see my blog "The Myth of Comparative Advantage"}. For instance, all economics is based on comparison of costs and benefits. Why the "law of comparative advantage" takes into account only benefits - neither the social costs of causing unemployment, nor the costs of re-training, relocating, and readjusting the workers of the industry to be eliminated?

Shortly thereafter came the well-known article of Paul Samuelson in Journal of Economic Perspectives, which redoubled my concerns. As mentioned in my blog "America: Where We Are Today?" I was a proponent of balance-of-payment deficit constraints since the 1960s. Now I fortunately understood the additional need to specify this constraint by countries.

I came up with "compensated free trade" (for brevity, CFT) proposal. In short, it was as follows:

  • Congress sets annual limits (upper bounds) on the overall US trade deficit in consumer goods and undesirable capital goods (oil, gas, and other commodities are excluded as necessary).
  • The President of the United States allocates the allowed deficit for each of our trading counterparts -- countries or groups of countries.
  • A country may exceed its limit if its government pays the USA Treasury a stipulated percentage (up to the full amount) of the excess deficit, also approved for each country by the President of the USA. The President can cap the allowed amounts of such intergovernmental payments.

For instance, suppose that the USA annually exports to some country goods and services totaling 7 billion dollars. If the deficit limit for that country is set at 3 billion, the country's exports to the USA may amount up to 10 billion. If the country wants to increase its exports to 12 billion, and the stipulated percentage is 80 percent, its government must pay to the USA Treasury 1.6 billion.

At the start of the system Congress may also approve, for instance, year-by-year mandatory minimal reductions of the trade deficit, as a percentage of GNP, to be applied until its size is acceptable. It may likewise set the rules of trade, such as: forbidding transshipping of goods between countries and similar techniques, aimed at bypassing the deficit limits; or demanding congressional approval for any substantial increase or decrease of the overall deficit limit.

Congress approves the budget and the debt limits now; similarly, it would approve the trade deficit limits, which may be no less important, although they do not deal with the "tax dollars." Also, the system uses to advantage the American separation of powers to limit arbitrariness of the limits, whenever one side, legislative or administrative, becomes too timid or too reckless.

Since the idea of CFT was to some degree evoked by the Samuelson's article, I sent to him its description. His assistant told me that Samuelson kept my letter on his desk for an unusually long time. Samuelson answered me that, on the one hand, he approves the idea; on the other hand, he would not help me in its publication or advancement. (He was called in Financial Times "an apostate" for his JEP article, so I completely understood him.)

As far as I know, CFT is fully in line with the real-world economic theory, and nobody has so far tried to disprove that. CFT extends to the global economy the Keynesian thesis of controlling and directing microeconomic activities at a higher level by a non-market entity (see my blog "In the Century of Black Swans"). It also automatically allocates the burden of economic adjustment between the surplus countries and the USA, which has been an important goal of Keynes. It imposes pigovian taxes on the balance-of-trade externalities (again, see "The Myth of Comparative Advantage" blog).

Surprisingly, it seems to be quite original in the multi-millennia history of international trade: an eminent trade economist Peter Morici stated that he did not "recall a similar proposal." (True, he also warned me "It will never fly politically." Sad, of course; but they say, "Never say 'never'." On the other hand, it is a nice compliment for a man who has been politically incorrect all his conscious life, under two radically different social orders, and is writing a book about politically incorrect economics.)

I have sent my articles describing CFT to several prominent economists, but not any one of them has provided a single theoretical argument against it. Paul Volcker disapproved the idea, but did not respond, when I asked for the reason.

* * *

Most important, however, CFT also meets the formulated above criterion for a good policy: it is both simple and "kills many Goliaths by a single stone." As a matter of fact, it has even more versatile crucial advantages than a Tobin tax. I will list here only several of them, those I consider the most important.

1. CFT fully corresponds to the international General Agreement on Tariffs & Trade (GATT): its Article XII declares that any country "in order to safeguard its external financial position and its balance of payments, may restrict the quantity or value of merchandise permitted to be imported." Accordingly, it cannot be canceled by WTO, which stems from GATT. Other measures, such as tariffs or quotas, almost certainly will be only temporary and will eventually be banned by that organization. CFT is equivalent to replacing our import tariffs by our trading partners' export tariffs, and export tariffs are not forbidden.

2. CFT is the only trade regulation system that would prevent trade wars: since it imposes constraints not on the USA import from a country per se, but rather on our trade deficit (that is, on the difference between the partner's export to the USA and the American export to that country), any attempt to decrease the latter would also automatically decrease the former. That will put to rest all ill-boding parallels with the Smoot-Hawley tariffs and their allegedly ominous consequences.

For instance, suppose that (as in the example above) our import from a country is 10 billion dollars, while our export to that country equals 7 billion. The deficit limit for the country is set at 3 billion. If the country adopts some measure that decreases our export to 6 billion, its allowed export to the USA would equal not 10, but rather 6 + 3 = 9 billion.

3. America faces an unpleasant choice: whether or not to take into account the externalities of Mother Nature. We are damned if we do and damned if we do not. If we do, that will require tremendous, long-term, extremely difficult centralized modeling effort of policy-making under radical uncertainty. Much worse, that will also increase production prices in our market. But if we do not, the planet Earth will punish us severely.

China, India, and other developing countries are in much worse environmental situation. They have greatly lower energy efficiency, both in their industry and in their consumption, and they do not intend to deny their citizens the blessing of having a car, air conditioning, or a refrigerator. So they will not take externalities into account. Their production prices will be much lower, and that will further aggravate the competitive position of American enterprises.

CTF would take care of both points. It would increase their export prices, and it would place on our partners the burden of deciding which prices to increase. (Also, determining deficit limits for different countries might be difficult from the geopolitical point of view, but it would take a very simple modeling.)

Perhaps one of the best rules of waging a war is to transfer the military activities to the enemy's territory. CTF does exactly that.

4. In that respect, the July 1 article of Andrew Grove in Bloomberg Business Week makes the same point that I do: in a non-industrial service economy "scaling" of an enterprise (that is, "technology going from prototype to mass production") becomes extremely difficult. Invention may indeed be made in an American garage, but a factory to manufacture the product would be built in another country. "Today, manufacturing employment in the U.S. computer industry is about 166,000, lower than it was before the first PC ... was assembled in 1975. Meanwhile, a very effective computer manufacturing industry has emerged in Asia, employing about 1.5 million workers - factory employees, engineers, and managers." Accordingly, "the U.S. has become wildly inefficient in creating American tech jobs."

The same picture as in computers emerges in alternative energy and other industries of the future: invented here, manufactured there. Moreover, "With some technologies, both scaling and innovation take place overseas. ... That's the problem. A new industry needs an effective ecosystem in which technology knowhow accumulates, experience builds on experience, and close relationships develop between supplier and customer."

He continues: "Without scaling, we don't just lose jobs - we lose our hold on new technologies. Losing the ability to scale will ultimately damage our capacity to innovate."

Among other factors, Grove blames economists, who maintain, "the free market is the best of all economic systems - the freer the better." They created a system of wrong financial incentives; that system must be corrected. "Levy an extra tax on the product of offshored labor. (If the result is a trade war, treat it like other wars - fight to win.) ... If what I am suggesting is protectionism, so be it."

I am a protectionist, too. Anybody who is worth anything protects something. Andrew Grove protects our country. So do I, to the extent of my modest capabilities. (By the way, both he and I are immigrants.) What do the free market economists protect? Their ability to sell utopian fantasies under the trademark of economics?

5. De Vauvenargues, a French writer of the 18th century, said, "The wicked are always surprised that the good can be clever." At one simple stroke, CFT overcomes the sum total of any crafty combination of dirty trade tricks that may be used by our trade partners: currency manipulations, low wages, constraints and tariffs on our exports to that country, and so on. Moreover, CFT would stop predatory trading - any country will think twice about using dirty tricks under a threat of the next year's tightening of the CFT limit. At last, we would have a big stick and could stop to humiliating ourselves. In vain, too.

6. As the recent G20 and other meetings and negotiations have shown, any expectations of fair and binding international agreements with other countries are no more than the height of naiveté. The White House wants to sit on a fence, holding - at least in words - to such empty and "so nineteenth century" concepts as free trade. According to the Center for Economic Policy Research, other countries meanwhile imposed at least 443 mercantilist measures to block imports. The USA must act unilaterally. And both the Congress and the President can easily do it. It is just a matter of political will.

I've heard an objection: the other countries will not allow CFT. But the most China can do is to dump onto market its Treasuries holdings. That might indeed cause some crisis. (Other countries can do even less.) But factories will eventually return to the USA, and the country will survive and flourish. As for China, which for political stability needs American markets, that action will be as close to the regime's suicide as possible.

As a matter of fact, China must recognize that "Chimerica" is unsustainable; it will stop, one way or another, any moment now. China might even prefer gradual, orderly, mutually agreeable reduction of trade imbalances to uncertain (and possibly harmful) other ways of that reduction, such as appreciating the yuan or Congress-imposed tariffs. CFT may indeed provide a way to true cooperation, rather than to a conflict.

7. I will just mention some other economic benefits. They are:

  • Establishing the U.S. government control ("minding the store") over the currently open-accessed (and openly abused) common good, the current account of the country.
  • Making the profit motives of economic agents (industrial and service enterprises) consistent with goals and objectives of the USA;
  • Making every trading partner of the USA our ally in protecting itself from transshipment of goods, which might eat up that partner's deficit limit;
  • Imposing financial discipline on the USA as a whole -- on a Micawberish country that forgot the concept of "affordable";
  • Providing "precision bombing" of only the harmful areas of the global market -- in contrast to an indiscriminate impact of the sole usual control tool of the Fed (changing the interest rates), which may lead to damaging unintended consequences, and thus serving as an auxiliary tool in monetary and fiscal efforts of directing the economy.
  • Preventing economic and political blackmail of trading countries and corporations by countries with abundant currency reserves (again, see my "Myth" blog, issue (F).

There are many more economic advantages, but a round dozen is enough, for the moment.

8. I will mention here only two geopolitical advantages of CFT: It would serve to contain an adversary a la Kennan, as well as an effective tool of diplomacy (again, see my "Myth" blog). And it would be a superior risk management tool, both short-term and long-term.

In conclusion, I think that time has come for both the financial transactions tax and the "compensated free trade." I do not see any alternative measures that would provide equal advantages.