10/28/2016 02:36 pm ET Updated Oct 29, 2017

Why Free Traders Have It All Wrong

I participated in a panel on free trade at the Free Market Forum in Atlanta last week, and got to debate the topic with Prof. Don Boudreaux of George Mason University. With his permission, here's a copy of his remarks (unedited except for mechanics) with my responses inline.

As the reader will see, free traders a) simply ignore huge facts of economic history, and b) love to make arguments that are internally consistent but ask the wrong questions. Publicizing these facts, and forcing them to ask the right questions, is therefore the key to refuting them.

Prof. Boudreaux said,

The core of Adam Smith's still-relevant 1776 volume, An Inquiry Into the Nature and Causes of the Wealth of Nations, is an exhaustive and brilliant analysis of the mercantilist case for protectionism. Smith famously found it to be deeply flawed. Smith showed that mercantilism is built on questionable premises, that it employs flawed logic, and that it corresponds very poorly with political and economic reality.

Granted, if you define mercantilism as simply a narrow obsession with a nation accumulating as much gold as possible, then yes, mercantilism is silly. (Though not completely without point, in a world where gold was money and there was therefore no other way to expand the money supply, an appropriate move under some circumstances then as now.)

But if you understand mercantilism correctly, as the old name for what today we would call "developmentalism," i.e. a broad-based push to develop the national economy from the Third World to the First, then mercantilism has in fact been the basis of every single developed nation in the modern world. Starting with Holland in the 17th century, and including nations like China today, all countries that have successfully made this transition have done it with massive efforts by the state. This includes the U.S., by the way, laissez faire mythology notwithstanding. (The books to look at here are How Rich Countries Got Rich, by Erik Reinert, for the history, and Concrete Economics, by Cohen and DeLong, for the American story.)

And protectionism is a part of the mercantilist package. Not blind protectionism, and nations can certain screw up this policy (like any policy!), but protectionism is a legitimate tool.

In the 240 years since the publication of this great book launched what is today the modern discipline of economics, no topic has been pondered and researched more thoroughly by economists than has the economics of international trade.

I see. It's just a settled question. Nothing to see here, folks. Sorry, but for a start, it's just not true that the economics of international trade is a stable and completed part of the discipline of economics. Even if you're only looking at the most widely accepted parts of the discipline, you have to deal with facts like economies of scale - the basis of every modern industry - only being incorporated into models of trade in the 1980s. The 1980s, for heaven's sake! That's what Paul Krugman won the Nobel for, and it hardly suggests a discipline in stable consensus. And then we have Gomory and Baumol's work on multiple equilibria, which is what happens when economies of scale get into rivalry with each other, and this work only appeared around 2000, and has yet to be fully digested. So no, free trade is not a settled question of economics, and saying that it is suggests that Prof. Boudreaux, whatever his scholarly credentials, is engaging in advocacy here, not scholarship.

It is, therefore, futile for me to pretend to offer any new or unique insights on this subject: there are none left - at least not ones that a pedestrian economist such as myself can be expected to offer. And yet, despite the massive amounts of research on trade - and despite the fact that this research has led economists, regardless of their many disagreements on other policy issues, to overwhelmingly support free trade - the general public still does not get it. Members of the general public - and, hence, political leaders who inevitably and unquestioningly follow public opinion - remain deeply confused about trade.

Judging from the pronouncements of Donald Trump, Hillary Clinton, Bernie Sanders, and any number of randomly selected candidates for seats in the United States Congress, the public understanding of trade is today no better than it was in that long-ago year of 1776.

This is a repeated assertion from free traders: the question is settled beyond reasonable dispute, so the only real question is why the public and the politicians somehow never got the memo. My answer is, because there's no memo to get.

Now I do agree with Prof. Boudreaux on one thing here: the public and the politicians are often confused about trade. I deal with this all the time, even with people who take my side. But being confused about the technicalities isn't the same as reaching the wrong conclusions. The public's broad conclusion about trade, per current polls, seems to me correct: trade is good, but free trade under present circumstances is not.

In what follows I will say a few words about why the general public remains ignorant of the most basic economics of trade. I will then offer up some suggestions, admittedly idiosyncratic, of how economists might better contribute to improved public understanding of trade. The economics of trade are straightforward.

That last sentence says it all, frankly. The economics of very little is "straightforward." My personal 401(k) isn't straightforward! So why should we expect a global trading system containing hundreds of nations, hundreds of thousands of companies, and billions of people to be? If it's all simple, why do people get PhD's studying this stuff?

Probably because over-simplification enables free traders to say that because free markets are best most of the time - which they are - they must be best all of the time. Now watch as Prof. Boudreaux renders all sophisticated modeling of the economy superfluous with a little fable...

Mike values Molly's car more than he values whatever else he would have bought with the money that he spends to buy Molly's car, and Molly values whatever it is she will buy with the money that she receives from Mike more than she values the car that she sells to Mike. In short, Mike values Molly's car more than Molly values that car. So Mike and Molly trade. Each is made better off. In this simple example no one is made worse off. The world is a richer place simply because ownership rights to existing goods are transferred from those who value those goods less to those who value them more.

Yes, OK fine. I get it. Generically, people trading things is good for them. So we can say "trade is good." But that's only a very crude first approximation of reality. It's like one of those high-school physics problems where the teacher says, "ignore friction." But without friction, cars couldn't move in the first place. You have to pay attention to the details if you want an accurate description of reality.

Of course, human well-being can be improved only so much if we do nothing more than rearrange ownership rights to existing goods. Substantial economic growth - the sort that consistently and significantly raises the living standards not just of the elite but of the masses - requires that more and better goods and services be produced per capita. And to increase output per capita requires improvements in production techniques.

One of Adam Smith's key insights is that a main driver of improved production techniques is specialization, or what he called "the division of labor." As workers become more specialized, not only does each of them become better and faster at what he or she does, this specialization encourages the invention and use of machinery to replace human labor. And when an uncreative (but usually stronger, faster, and more durable) machine takes over a task once done by a creative human, that human becomes free to creatively perform other tasks that would be too costly to perform were the machine not available to perform the tasks once done by that worker. A larger quantity, as well as a larger variety, of goods and services are produced. The economic pie grows.

OK fine. I don't actually disagree with any of that.

Free trade is, as Smith correctly saw, an important driver of specialization. Here's the great Scot: "As it is the power of exchanging that gives occasion to the division of labor, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market." The greater the number of people who are part of the trading network, the greater is specialization. This reality is why large cities such as Atlanta and New York have highly specialized physicians, while small rural towns do not. (My favorite such physician is pediatric gastroenterologist, because one of these specialists near New York City literally saved my son's life many year ago.) Therefore, to artificially confine the extent of the market to the residents of a political unit is to artificially prevent specialization from deepening and, hence, to artificially prevent people from growing more prosperous.

Wait a minute. This only follows if you believe market size, and thus specialization (and related things like economies of scale) are the only factors at work here. Which isn't even remotely true. Free traders just love arguments that are narrowly true, but incomplete.

Next year - 2017 - will be the bicentenary of David Ricardo's extension of Smith's case for free trade - namely, Ricardo's explanation of the principle of comparative advantage. Yet while comparative advantage is an ingenious and important insight - and while it unquestionably bolsters the case for free trade - the case for free trade remains powerful even absent any understanding of this principle. Indeed, the case for free trade remains powerful even if the principle of comparative advantage did not apply in reality.

That case - let's call it the foundational economic case for free trade - is that political borders are economically meaningless. Or, put differently: political borders become economically meaningful only because they are treated by people - and, hence, by governments - has having an economic significance that they in fact do not have.

No, I'm sorry, but political borders are very far from being economically meaningless. They will remain meaningful as long as they remain relevant to the economic fates of the people who live within them. If you think where you live doesn't matter, you can try taking that nice job in Singapore the next time you're unemployed.

We think nothing of buying bread from the local bakery, fueling our automobiles at the local gasoline station, hiring neighborhood teenagers to mow our lawns, and having local dry cleaners clean our woolen suits and silk blouses. These exchanges are trade. We understand that we'd be poorer if we did these tasks ourselves. We know that we could buy the appropriate chemicals and then spend time dry cleaning our own clothing. Yet because the dry-cleaning establishment specializes in this task, it can perform this task at lower cost than can each of us. So we each specialize in our own jobs and then trade with the dry-cleaning specialist.

None of us wants to be self-sufficient at the level of the individual or family. Nor is there any clamor for government to protect merchants who are located within our county's boundaries from the competition of merchants outside of those boundaries. Ditto for merchants who are in-state versus those who are out-of-state. We understand that trade across household boundaries, town boundaries, county boundaries, and state boundaries is perfectly natural and beneficial. There is nothing about crossing those boundaries that changes the nature of trade. Residents of Boston understand that buying a steak that comes from a steer slaughtered in eastern Nebraska is as legitimate and productive an economic act as is buying a steak from a steer slaughtered in western Massachusetts. But introduce national political boundaries into the discussion and people lose their wits.

This argument basically turns on the idea that if you hold position X in relation to question Y, you must hold position X in relation to question Z. Sorry, but there just isn't any principle of logic that says so. It's like saying "you don't expect there to be a traffic light at the end of your driveway. So why would you want one at the end of the street?"

Attitudes toward trade with foreigners are often the reverse of attitudes toward trade with fellow citizens. While we celebrate getting more for our money when we buy clothing or furniture from fellow citizens, when we buy these and other goods from foreigners we complain about getting more for our money. What, after all, is meant by the many laments about being 'flooded by low cost imports,' about foreigners selling their goods to us at excessively low prices, and about foreigners refusing to take more of our exports in exchange for their exports?

This is a straw-man argument. Nobody is upset over low prices of foreign imports per se. People are upset when a) there's cheating and subsidies involved, and b) when the aggregate effort of the former is a trade deficit on the part of the United States.

The continuing and, today, seemingly growing misunderstanding of international trade should be an embarrassment for me and my fellow economists. A truth known and prominent among scholars for nearly two-and-a-half centuries - and one that really isn't all that difficult to grasp - continues to elude popular understanding. Why?

This is a repeated pattern with free traders. They think that all the problems of international trade, which roil the politics of nations all over the world and have for centuries, are just collective hallucinations. Unlike in other areas of economics, where free-market types joyously defer to the right of individuals to judge wherein their self-interest consists, when it comes to trade, people mysteriously just don't know what's good for them! But there is an alternative hypothesis, which makes a lot more sense out of hundreds of years of economic history and present political discontents: international economic rivalry is real, not imagined, and trade is a part of it.

Before suggesting an answer to this question, let me note, with much regret, that almost none of my fellow economists are embarrassed by this widespread misunderstanding of trade. They should be embarrassed also by their non-embarrassment. While there continues to be among economists a consensus in favor of free trade, most economists do not see themselves as responsible for helping the general public to better understand trade.

I believe, although I cannot prove, that at least three reasons explain this attitude of aloofness that far too many economists have today. First, economists increasingly are expert mathematicians and statisticians. While they absorb at a superficial level the long-standing admiration that economists have for free trade, these economists don't understand the case deeply. Nor do they really care about it with any passion.

Second, many even of the economists who understand deeply the case for free trade, and who care about it, regard themselves as violating some sort of professional norm by publicly advocating in favor of free trade. These economists believe that such public advocacy compromises their credentials as scientists.

Third, most economists are poor communicators. This sad reality is partly due to the emphasis on learning and doing mathematics; partly it is due simply to a professional ethos that no longer values good, clear writing. So a substantial proportion of those relatively few economists who do try to communicate to the general public the lessons of the economics of trade are incapable of doing so. The result is that these economists become discouraged about any such communication effort.

Here's an idea, professor: if you repeatedly find you can't communicate idea X, maybe there's something wrong with the idea, not just your presentation of it. After all, as you said above, the economics of free trade is "simple," which rather suggests it shouldn't be hard to convey.

Whatever the cause, economists have utterly failed to teach more than the tiniest portion of the general public the economic case for free trade. To the extent that international trade has become more liberalized over the past 80 years - and it has - that liberalization is due to a happy invisible-hand feature of world politics: governments seeking to open foreign markets so that their domestic producers can export more are willing, in exchange, to open up their home markets to more imports.

Yet the very rationale of such trade deals reveals the danger of the public's ignorance of trade: with imports considered to be costs, while exports are considered to be benefits, politically powerful producer groups at home, and their political agents, have an easy time conning the ordinary people into sacrificing their purchasing power (in the form of import restrictions) and their tax dollars (in the form of export subsidies).

Imports are always considered to be costs, a bad thing to be avoided, by the stupid public? No, I don't think that was what people thought at the time of the Arab Oil Embargo of 1973. People reasoned instead precisely as you would have them do: cheap imports are good, and the cheaper, the better.

Politically powerful producer groups at home? What groups, pray tell, and what century are you living in? Almost all the power on trade is in the hands of multinational companies who don't have any particular bias in favor of American production. There simply isn't a vast complex of powerful interests in favor of protectionism. If there was, we'd have the tariffs to prove it.

While I don't have a complete answer to the question "Why does the general public continue to thoroughly misunderstand the economics of trade?", I have some suggestions for why this sorry state of affairs persists. These suggestions can all be grouped under the heading "Misleading Language."

The economic historian and philosopher Deirdre McCloskey has convinced me that the way we talk - the words we use - matters mightily. With this reality in mind, I intend to show that the words we typically use when discussing international trade are highly misleading. We need a better approach to persuading members of the general public to improve their understanding of trade.

What's the most effect way to try to persuade the general public of the soundness of the case for free trade? An assistant professor of economics today is likely to answer "Show policy-makers and the public empirical studies that reveal a statistically significant positive correlation between freedom to trade and rates of economic growth or median household incomes. The data are there!" Indeed they are. They're dense and mountainous. Yet someone more seasoned will smile knowingly at this answer. The more-seasoned person understands that the public (and, hence, politicians) approach questions about trade with far more prejudices and priors than they approach questions about astronomy or about the Peloponnesian war. Therefore, disputes about trade are almost never settled by parades of raw facts and statistics.

A relatively small handful of people will take the time to listen attentively to the economist's theoretical analysis of trade. In an hour or two, these people can learn enough about comparative advantage, economies of scale and the extent of the market, the importance of competition, the fact that capital-accounts are the flip side of current-accounts, and some other economic points to better grasp, if not in all cases fully embrace, the standard case for free trade. But the vast majority of people will never learn even these rudiments.

So what to do? My answer: encourage the talk about trade to change so that it has more of a free-trade cast - or, at least, less of an economic-nationalism cast.

Imagine, for example, if the term "trade deficit" were replaced with "capital surplus" (or, more technically accurate if not as punchy, "capital-account surplus"). Imagine if every time news reporters, editorialists, politicians, bloggers, and television talking-heads start to say "trade deficit" they instead actually say "capital surplus." The latter term means exactly the same thing as the former. Yet "capital surplus" not only doesn't convey the sense of ominousness that is conveyed by "trade deficit," it sounds downright encouraging! A protectionist politician who bellows that "Our capital surplus gets bigger every month!" would not elicit as much dread in his audiences as he does when he says the same thing by bellowing that "Our trade deficit gets bigger every month!" Even audience members with no more than average curiosity would ask themselves - and perhaps ask even the bellowing politician - "What's wrong with a capital surplus?"

Looks like I have to explain one more time why trade deficits aren't free money. I did that in this article here, so let me suggest the reader just go have a look at it, if he or she is in any doubt on this point, so I can avoid making this present article any longer than it already is.

The bellowing politician asked this question would have to pause from his bellowing to supply an answer. If he supplies the correct answer - "Probably nothing is wrong with a capital surplus, as it means that foreigners are investing more in our country and thereby increasing our stock of capital" - the game is over: the trade deficit (or capital surplus) can no longer be used to confuse those audience members into believing that a trade deficit justifies trade restrictions. If instead (and as is much more likely) the politician supplies an incorrect answer, he is at least more exposed to being corrected by a rival or a talk-show host than he is when he bellows about "our trade deficit" in ways that suggest it to be calamitous.

Speaking of the so-called trade deficit, another helpful change would be to stop speaking of it as if it is an addition to debt. It's not. All or part of a trade deficit can become debt, but it need not become so. It is simply an error to talk of a trade deficit as necessarily casting the domestic population further into debt.

Yet again, another argument that's narrowly true, but broadly false. Granted, a trade deficit doesn't have to increase debt. But this is only the case if that deficit is financed by selling-off existing assets - which has the exact same effect of reducing the net worth of Americans.

Consider a simple example. Americans increase by $1 million their cash purchases of Chinese-made electronics goods. The Chinese seller of these goods then uses the entire $1 million to buy shares of Microsoft stock. Because the $1 million increase in American imports is not offset by a $1 million increase in American exports, the result of this set of transactions is a $1 million increase in the size of America's trade deficit. And yet not one cent of additional American debt is created. No American is made indebted, or made further indebted, to any foreigner as a result of these transactions.

Yes, sure, but only because some foreigner, rather than some American, now owns that million dollars in Microsoft stock. So our net worth is lower.

The American buyers of the Chinese-made goods owe no additional debt to anyone as consequence of these transactions. The American sellers of the Microsoft stock owe no additional debt to anyone as a result of these transactions. And no other American owes any additional debt to anyone as a result of these transactions. Microsoft's shareholders owe no additional debt to anyone as result of these transactions. American consumers bought, using cash, $1 million worth of Chinese-made goods and the Chinese, in turn, used this $1 million to buy outright $1 million worth of equity in an American corporation.

Q.E.D. An increase in America's trade deficit does not necessarily increase Americans' indebtedness. Yet how much scarier are reports of rising U.S. trade deficits if they are - as they typically are - discussed as if they necessarily mean that Americans are thereby cast further into debt?

Regrettably, even some otherwise sensible economists mistakenly insist that a domestic trade deficit is necessarily an addition to citizens' indebtedness to foreigners - an indebtedness that, of course, eventually must be overcome by having the alleged debt repaid. A prominent example is Harvard's Martin Feldstein. He argues that "America will need trade surpluses" to repay today's trade deficits. Yet as the example above makes clear, this claim is simply untrue.

A closely related confusion in language is the often-made observation that a trade deficit - or, here more precisely, a current-account deficit - reflects the difference between a country's savings and its investments. This accounting reality is definitionally true. But it too easily suggests, wrongly, that the people of a country that runs a current-account deficit aren't saving enough.

This turns on the question of what "enough" means. If you mean "saving enough that we're not enjoying a consumption binge now at the price of diminished consumption in the future," then yes, we are indeed not saving enough. If you mean something else, then I have absolutely no idea.

Yet the people of a country are not a family, a firm, or a club. Just as there is no one 'correct' savings rate for the collection of all red-headed people, or for the collection of all people whose last names end with the letter "X," there is no one correct savings rate for that collection of people who are American citizens. Further, just as red-headed individual Sally can today save a great deal and then later enjoy the fruits of her saving even if red-headed person Sammy today saves nothing, the American Sally can today choose to save a great deal and then later enjoy the fruits of her saving even if the American Sammy today saves nothing. In neither case -despite being able, according to some criterion, to be classified as being in the same group as Sammy - is Sally's economic fate affected by Sammy's economic decisions any more than her fate is affected by the economic decisions of any other individual anywhere in the global economy.

This is just wordplay. If we're measuring the economic well-being of Americans as a group (which is the point here) then the savings behavior of Americans today does very much affect their consumption opportunities tomorrow. Because there's no free lunch if we borrow money and sell off assets to pay for imports.

What matters for economic growth is the total amount of savings that is available to finance what Deirdre McCloskey calls "market-tested betterment" - firms competing against each other for consumers' patronage in markets that are reasonably free. What does not matter is where this savings comes from.

False. If the savings come from an American, then an American owns that money and it's part of an American's net worth. If from somewhere else, then somebody else owns that wealth.

Just as the identities and nationalities of sellers of soap, steel, and sailboats are economically irrelevant, so too are the identities and nationalities of savers economically irrelevant. It should make no more difference to Mr. Jones of Atlanta that the factory he works in is financed by resources supplied by Mr. Smith of Birmingham, Alabama, or by Ms. Smith of Birmingham, England. In each case the savings of Smith help to improve the economic opportunities open to Mr. Jones in Atlanta.

Put differently, the only savings rate that matters for a country that keeps its borders open to goods, services, and capital is the global savings rate.

If this is true, then why does anyone save anything? After all, all that matters is the global savings rate. Let's all just consume and let somebody else do the saving!

Yet discussions of "the national" savings rate give the false impression to each American that if his or her fellow Americans are saving too little, then public policy must encourage them to save more. And when this false belief is combined with the affiliated error that a rise in a country's trade deficit is necessarily a rise in the indebtedness of that country's citizens - that a domestic trade deficit necessarily means the accumulation of debt for the nation's citizens - the path is well-paved for protectionists to win higher tariffs on the grounds that such tariffs will discourage imports and, thereby, protect us from irresponsible indebtedness.

Here are some other simple but accurate changes in the way we talk about trade that, were they to become routine, would be salubrious.

Rather than describe tariffs and import quotas as actions taken against foreigners or against the inanimate objects that are imports, describe them instead as actions taken against fellow citizens. Call that tariff, not a penalty imposed "on Chinese tire makers" or "on Chinese-made tires" but, instead, a tax - or, better, a penalty - imposed on fellow citizens who buy Chinese-made tires. If the news announcer reports that "President Jones today raised the penalties inflicted on Americans who choose to spend their money on tires made in China," more people than otherwise would get a clearer sense of the unvarnished nature of tariffs. More people would see vividly that tariffs are not simply actions taken against foreigners, but are also restrictions upon the peaceful actions of fellow citizens.

You know, I actually think Americans understand that tariffs raise the price of imports. That's the whole point: to encourage consumption from domestic sources and bring our imports and exports into balance. It is indeed a trade-off.

And stop calling foreigners' (alleged) practice of occasionally selling to us goods at prices below cost "dumping." The word "dumping" gives the impression that we are involuntarily smothered and crushed under an avalanche of goods that we do not want. But, of course, it's not that at all. So called "dumped" goods are goods that we voluntarily purchase at prices that are (allegedly) so low that they fail to cover the sellers' costs. But access to such stupendous bargains is not a problem; it's a blessing.

Sure, it's a blessing, if you only look at the immediate act of consumption. We do indeed get cheaper stuff. But it's not a blessing when you look at the job loss, deindustrialization, increase in debt, and selling off of existing assets.

I suggest that, instead of calling alleged below-cost pricing of imports "dumping," that we call this practice "gifting." After all, when you voluntarily pay for a valuable good or service to be enjoyed by someone else, it's called a "gift." Why should not the same term be applied to goods and services bestowed on us in the same way by foreigners?

Because, as I've pointed out, there's no free lunch in this world. So it's not a "gift."

Here's yet another change in rhetoric that would be salutary: instead of saying "low-wage foreign workers" say "low-productivity foreign workers." Economics tells us that the two terms describe the same reality, if from different perspectives. Foreign workers whose wages are on average lower than the wages of domestic workers are on average less productive than are domestic workers. (If those low-wage workers were not less productive, then capital would pour into those low-wage countries in order to seize the profits to be had by employing workers at wages below the value of those workers' marginal products. Low-wage China rather than high-wage America would consistently run trade deficits - or, said better, capital surpluses.)

Sure, to a huge extent the low productivity of cheap foreign labor neutralizes it as a threat to American workers. But this assumes that America's high-productivity workers are exporting something in return for all these imports. And that equation is $500 billion a year out of kilter.

Calling workers in China, Mexico, Malaysia, and Bangladesh "low-wage workers" is to describe them by what they are paid; calling them "low-productivity workers" is to describe them by the value of what they produce in order to earn their pay. Each term is accurate, but the former is more misleading to an economically untutored general public because it conveys the mistaken impression that these workers have an absolute advantage over all workers in high-wage countries. Not so with the term "low-productivity foreign workers." A politician in the U.S. trying to drum up votes, or an industry lobbyist attempting to stir up support for higher tariffs, would not get very far if she warned that American-workers' cannot possibly compete successfully against all those low-productivity foreign workers. In addition to sounding alarmingly unpatriotic, such a warning would be recognized - even by the economically untutored - as economically questionable.

I conclude with an even more radical proposal for a change in the way we talk about trade - namely, stop - when talking about trade - using the pronoun "us" in contrast to "them"; stop saying "we" in contrast to "they"; avoid "our" as a contrast to "theirs." If the lesson on trade of Adam Smith and his intellectual progeny had to be summarized in a single sentence, that sentence would read something like this: "There is no 'us' and 'them'; there's just us, all of us on earth." (The reader will pardon me for constructing this sentence with a semi-colon!)

There's no us vs. them? OK fine, if you truly don't believe international economic rivalry exists, feel free to believe in free trade. Meanwhile, in the real world...