The classical theory of comparative advantage has driven US trade policy for the past fifty years. That policy, in combination with technical innovations that have lowered costs of transportation and communication, has opened the global economy. Yet paradoxically, this opening has rendered classical trade theory obsolete. That in turn has left the US economically vulnerable because its trade policy remains stuck in the past and based on ideas that no longer hold.
The logic behind classical free trade is that all can benefit when countries specialize in producing those things in which they have comparative advantage. The necessary requirement is that the means of production (capital and technology) are internationally immobile and stuck in each country. That is what globalization has undone.
Several years ago Jack Welch, former CEO of General Electric, captured the new reality when he talked of ideally having “every plant you own on a bargeâ€. The economic logic was that factories should float between countries to take advantage of lowest costs, be they due to under-valued exchange rates, low taxes, subsidies, or a surfeit of cheap labor. Globalization has made Welch’s barge a reality. However, in doing so it has made capital mobility rather than country comparative advantage the engine of trade. And with that change, “free trade†increasingly trades jobs and promotes downward wage equalization.
The U.S. and European response to Welch’s barge has been competitiveness policy that advocates measures such as increased education spending to improve skills; lower corporate tax rates; and investment and R&D incentives. The thinking is increased competitiveness can make Europe and the US more attractive to businesses.
Unfortunately, competitiveness policy is not up to the task of anchoring the barge, and it can even be counter-productive. The core problem is corporations are globally mobile. Thus, government can subsidize R&D spending, but the resulting innovations may simply end up in new offshore factories. Moreover, competitiveness policy easily degenerates into a race to the bottom. For instance, if the US cuts corporation taxes, other countries may match to stay competitive. The result is no gain for the US, while profit taxes are lowered and tax burdens shifted on to wages, which widens income inequality.
Worse yet, capital mobility prompts countries to adopt unfair policies to increase their relative business attractiveness. These policies include disregard of environmental damage; suppression of labor to keep wages low; direct subsidies; and under-valued exchange rates. All are visible in China, which is the poster-child for such abuses.
A critical consequence of Welch’s barge is the creation of a “corporation versus country†divide. Previously, when corporations were nationally based, profit maximization by business contributed to national economic success by ensuring efficient resource use. Today, corporations still maximize profits, but they do so from the standpoint of their global operations. Consequently, what is good for corporations may not be good for country.
When companies raise profits by rearranging production according to global cost patterns, those shifts can lower country income. For instance, when Boeing transfers production to China, the US loses high value adding jobs and national income can fall. Moreover, though Boeing makes larger short-run profits on its Chinese production, even it may lose in the long run if it inadvertently creates a rival Chinese aircraft producer.
From an American worker perspective, the global economy has always had abundant supplies of cheap labor. In the past American workers were still able to compete and benefit from trade. The critical difference today is American corporations are taking their capital and technology offshore and equipping low-wage foreign workers. Those investments undermine American workers because that foreign production is intended for the US market.
The emergence of barge-like corporations has reduced the scope for effective competitiveness policy, increased the temptations for unfair policy, and created a wedge between corporate and national interests. This poses two critical policy challenges. First, there is need for rules against unfair competition, which is where exchange rate rules and labor and environment standards enter.
Second, there is need to close the wedge between corporation and country. In the U.S. that calls for such measures as ending preferential tax treatment of profits earned offshore; making it illegal for corporations to reincorporate outside the US to escape US tax laws; and new tax arrangements that encourage jobs and value creation within the US.
Addressing globalization’s challenges poses enormous analytical difficulties. Unfair competition must be prevented and companies re-anchored. But this must be done without losing the benefits of real trade based on comparative advantage or ending investment that fosters development.
These economic challenges are compounded by political difficulties. In Washington, elite policy thinking is funded and lobbied for by corporations. Consequently, corporations control trade policy at a time when corporate interests differ from the national interest. That is also increasingly true in Brussels. Fifty years ago what was good for GM may really have been good for the US. With Jack Welch’s barge, that may no longer hold.
Copyright Thomas I. Palley
[…] Thomas Palley, formerly of the AFL-CIO, just posted a very good piece on “The New Economics of Trade.” I do not think that he says anything I have not heard before, but he says it extremely well. […]
I think that while you list the consequences, there are the causes to consider too, and some are rather difficult to work around:
* Most of ex-communist and non aligned spheres has been merged with the rest of the global economy, and several large countries with lots of labour and short of capital have started to become accessible. As other people have noticed, the global amount of capital has hardly gone up, but the global amount of labour has nearly doubled. The relative leverage of labour and capital in the west is much weaker for labour and stronger for capital, and viceversa.
* The disappearance of a global political competitor which if only in words declaimed to be on the side of workers means that the ”home front” does not need to be taken care of anymore.
* Extraordinarily low interest rates have meant that for corporations the capital to build new plants and offices has been essentially free, and this has subsidised divesting in the west and move production abroad. To the point that many investments abroad are quite capital intensive, in countries where labour is very cheap.
* The demise of unions means that while wealthy individuals and corporations can sponsor large numbers of lawmakers, their opposition cannot afford to do so, which has resulted in the steady creation of rules favouring rentiers and corporations.
Overall the trends has been one of ”headquarterization” of the western economies; in countries like the USA and the UK used to have local and regional economies, with local and regional stock exchanges, company bases, and conversely large centers used to have production activities.
Now industry and production have largely left places like New York or Chicago (or London) for cheaper farther away places like the USA south, and viceversa corporate HQs have moved to financial centers.
The same is happening to whole countries: HQs are moving to them even from NDCs, while productive activities are moving from them to NDCs.
What to do? Well, I think the best tactics are to try and move employment patterns in the west towards HQ type jobs (largely services and ”courtier” style functions), and to attempt to revive unions as the aggregators of political action for workers, just as the Chambers of Commerce and industry associations are the sponsors of so much political force.
«From an American worker perspective, the global economy has always had abundant supplies of cheap labor.»
Not quite, because a couple billion people were behind impassable political barriers; and the others were either in countries with comparable capital/labour ratios (e.g. western europe, japan) or too improductive as they were in countries with scarce capital.
«making it illegal for corporations to reincorporate outside the US to escape US tax laws;»
Thats completely pointless, it is very easy to evade. it is much better to just tax corporations on their USA profits (or even better, sales) no matter where they are domiciled.
«In Washington, elite policy thinking is funded and lobbied for by corporations. Consequently, corporations control trade policy at a time when corporate interests differ from the national interest.»
The “national interest” is just a vacuous expression. And what is funded by the corporates and the rich is not “elite policy thinking” it is the campaign money, and this buys a lot of favourable legislation…
Really surprised to read such a chauvinistic analysis of foreign trade. There is one missing point: ownership of capital and intellectual property rights. If an american corporation makes more profits in China, the american citizens are receipients of those profits. If a chinese uses an american invention, the owner of the patent gets the benefits.
Welch wants american to continue being a factory while the globalization is changing american into a service economy. Factories require cheap labor and productivity is low comparing to information, electronic and know-how industries. Sorry, to read such poor analysis of the real world only to look pro workers!!!
“First, there is need for rules against unfair competition. . . . Second, there is need to close the wedge between corporation and country. . . These economic challenges are compounded by political difficulties. . . corporations control trade policy at a time when corporate interests differ from the national interest. That is also increasingly true in Brussels.”
As you suggest, political conflicts of interest (nationally) will prevent changes. Robert Reich says this is because political parties drink from the same trough.
[…] Via Mark Thoma we get Thomas Palley: "The logic behind classical free trade is that all can benefit when countries specialize in producing those things in which they have comparative advantage." […]
The discussion of comparative advantage begs one comment. Properly evaluated, comparative advantage assumes a level playing field on which the player nations gain advantage from local conditions. That level playing field has not existed with our Asian trading partners at least since the end of the Japanese occupation. American products are routinely denied access to Asian markets by manipulation of standards and procedures. In this context, exchange rates are only one of a myriad of tools used by Japan and Korea, and more recently China and India, to keep our products out while theirs are sold here.
There’s no such thing as a free market and there never has been. The question we need to ask is whether private restraints are better than government restraints. A sports contest without referees and rules devolves into a gang fight. Likewise, a market without rules devolves into a Mafia style oligopoly. “Free” markets exist in an unstable region between public and private oppression. Just as we must “wage peace” we must “wage freedom.” Freedom can increase by the addition of rules, and it can diminish by the removal of rules.
Classical economics implies that very large trade imbalances can’t exist. Yet there they are. Is economics wrong or is there something else at work here?
Asia runs big surpluses which tend to push up their currencies? Great! that means they can buy lots of foreign goods and increase their standard of living! Large forex reserves tend to be inflationary and drive up wages? Good! that’s what’s *supposed* to happen. That isn’t what’s happening? Don’t blame economics, it’s government meddling on behalf of politically powerful actors (who don’t work for wages, by the way).
There’s no reason a low wage country can’t trade with a high wage country. Europe seems to manage it. Immobile factors of production aren’t subject to enough arbitrage to equalize prices. Housing prices are higher here than in India, why shouldn’t wages be higher also?
Unbalanced trade is at the root of the problems we’re talking about and politics is at the root of unbalanced trade. Yes, global corporations don’t have our national interest at heart. Yes, there is no effective political voice for labor–but it’s more than that. There is no voice for the common interest of the nation and the world–only special interests. Economists are reluctant to admit that the sum of the special interests is not the common interest in many cases (nonlinear phobia?). There’s a fallacy of composition here which needs to be studied. Under which circumstances do we get this divergence? What structural changes can minimize it?
The ongoing upward income redistribution facilitated by profit gains from wage declines will eventually catch up with us. When you fire all your customers, eventually your sales will collapse. Joe Sixpack is putting everything on his Visa card for now, but he will eventually reach his credit limit and we will again be talking about “underconsumption” ala the 1930’s.
Let’s see, where to begin:
First, Unions are a Cartel of labor much like OPEC is a cartel of oil. Free trade destroys their labor pricing power by allowing an avenue to cut cartelized labor out-of-the-loop. Pardon me for not shedding a tear. This was inevitable, and is a good thing for the American consumer, it also forces labor to price their labor based on, you-know, value.
Second, US companies are only US companies by choice. They are not owned by, or otherwise beholden to the US. They ARE the property of the stockholders, wherever the stockholders are and their purpose in life is to provide to the stockholders, value. You are mixing your nationaliZm with the simple fact that a company must have a HQ somewhere and it is kind of scary. The way you cross over and back again speaking with regards to US BASED companies as if they were possessions of the US government or US people, most of who are NOT stockholders is frankly a little disturbing.
Lastly, If I am truly free, than what business is it of yours where I purchase the products I want? When I choose as a free citizen to purchase a car from a company based in Japan, what makes you think I should be beholden to someone from Detroit? Whether it is Sugar from India, Oranges from Brazil, or Cell Phones from Korea, as much as you feel compelled to *manage* the economy, with it you are managing my options and with it my freedom. Companies and workers in this country have an obligation to create products and services that are of the quality and type that I want to buy. From what I just read, you seem to feel that if I choose differently, I should be compelled to buy American products from American workers through the coercive power of trade tariffs and taxes.
Nice.
I don’t know where you get your Authoritarian bent, but keep your grubby paws off my freedom.
Your analysis is spot on, and highlights the deficiencies of classical free trade. Companies have a right to manage their affairs to their benefit, but so do countries. I find it hard to always know who looses in international trade, but it is easy to see that international companies benefit from the buy low / sell high.
[…] the question Thomas Palley asks as he reexamines “Free Trade” in the modern era… The classical theory of […]
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