The U.S. does not economically “compete” with other nations
On February 24th, Barack Obama appeared before the Business Roundtable, an association of corporate CEO’s, to give an address on what has now become a major talking point of his administration: competitiveness. In the President’s view, the main problem that the U.S. is facing is that other nations are catching up, they are making investments in education and infrastructure that have been unmatched by the United States, and as a consequence, American economic well-being has been eroded. The solution, he explained, is to renew America’s competitive edge with fresh investment, health care reform, stricter financial oversight, and closer integration between business and government to promote American exports abroad. In short and in his own words, “Winning the competition means we need to export more of our goods and services to other nations.”
We’ve seen this type of rhetoric before, most notably when it was called by its proper name, “mercantilism,” but also in recent decades whenever a trade-imbalanced America hunts for scapegoats upon which to blame some new economic malaise. It is a popular argument; for many it seems obvious that, in the words of President Clinton, the United States is “like a big corporation competing in the global marketplace,” and that the problems our nation faces are essentially identical to the problems of Ford competing with Toyota.
At the core of this belief is the notion that there is a fixed amount of jobs and economic activity, and that unless we are more productive than our rivals, we will not capture our share of this activity and our economic well-being will decline. International trade, this idea would posit, is very nearly (if not entirely) a zero-sum game, in which the winners are rewarded with economic growth and vitality, and the losers are punished with chronic unemployment and stagnation.
As persistently popular as this idea is, it is entirely false. It has virtually no basis in economic theory, zero supporting empirical evidence, and is so logically flawed that it has not been seriously considered in academic circles for nearly two centuries. Let us say it loud and clear right now: the national living standard of the United States is almost entirely independent of productivity growth in other nations, we do not economically compete with the world in any meaningful way, and none of our important economic problems can be attributed to a failure to compete.
The benefits of free trade are described by a very simple idea that laymen seem determined to avoid learning. It is called “comparative advantage.” Without trade (a condition we call “autarky”), a nation faces a trade-off in determining where its economic resources will go. If it adds a worker to, say, the computer industry, that means it must take that worker from somewhere else, say, the banana industry. Each decision of where to allocate scarce labor, capital, and other productive resources is sacrificing the output of one good or service for another. Simplified, it is as if our economy were a machine that converted bananas into computers and vice-versa. The benefit from free trade is similar to one man with a two-bananas-for-one-computer machine coming across another man with a three-bananas-for-one-computer machine– if the first man produces computers and trades them to his compatriot for bananas at some ratio between 2-1 and 3-1, both men will be better off. It is impossible for there to be losers from trade– if the first man asked for four bananas in exchange for one of his computers (a losing proposition for the man who could just stuff three bananas into his own machine), the second man would simply refuse– it would be as if you had tried to sell someone a four dollar banana when he is standing in a grocery aisle that offers the same banana for three dollars.
If you take any two multi-good economies, you will find that one of them is relatively better than the other at producing a subset of goods. Even if one of the two nations can produce every single good more efficiently than the other, there will be room for mutually beneficial trade as one nation produces those goods in which its productivity advantage is the greatest and the other produces those goods in which its productivity disadvantage is the least.
There is room for winners and smaller winners in trade. Remembering the example of the two men with banana-to-computer machines, the two men could set terms of trade anywhere between 2-1 and 3-1. If the first man were a truly magnificent negotiator, it would be possible for him to convince his friend to trade at three bananas for one computer and thereby capture all of the benefit of trade for himself.
In practice, terms of trade are not set through formal negotiation, but through the free market. At any given moment, the terms of trade are set proximately by the combination of exchange rates and relative good prices, and are set ultimately by whatever trade-off is occurring at the margin. The terms of trade for bananas and computers may be set by the relative productivity of a third good, dungarees, or the exchanges made between other trading partners. There is virtually no room for market power or bargaining to change the terms of trade– subsidies, tariffs, and currency manipulation will only prevent mutually beneficial trades from occurring and/or encourage trades that are not mutually beneficial (with the manipulating country on the losing end).
This said, it is possible for rising productivity in another nation to harm the United States. Thinking back to the example of the two men with banana-to-computer machines, what if the second man became better at producing computers such that his economic ‘machine’ changed into a 2.5-bananas-for-1-computer machine? Whereas before there was one banana of benefit to be split among the two men for each computer trade they made, now there would be only half a banana. As the pain is doled out, the second man will find that the gains from his added productivity outweigh the loss of this trade benefit, but the first man will be worse off. Thus, economists cannot unequivocally state that improvements in Chinese productivity will not harm the U.S.
At a glance, this may seem to confirm the competitiveness hypothesis that productivity gains in other nations will harm the United States, but let’s explore the problem a little bit more. Firstly, even with the deteriorating terms of trade, the first man is still better off than he was under autarky– he has not really been harmed by trade, it is merely that his potential gains from trade have been reduced as his partner’s economy becomes more similar to his own. Secondly, what if the other man had improved his productivity in bananas instead of computers? If the other man’s machine had changed into a 4-1 device, the gains from trade would have increased, not decreased. Unspecified productivity gains by a trade partner are just as likely to improve the United States’ well-being as they are to reduce it, and typically they do not change it much at all.
If we look at the data from the past fifty years, we find that by and large, changes in our terms of trade have not significantly impacted our well-being. As we would expect, our terms of trade have fluctuated randomly and mildly. The real wages of Americans are determined almost entirely by their own productivity gains and losses– when a typical worker can produce a computer per hour, he enjoys a standard of living and level of consumption equal to the value of forty computers per week, irregardless of how well or poorly Japan produces its own computers. When his productivity falls, his standard of living falls proportionately, and when it rises, he captures only the extra benefit that he himself has created.
Our trade balance is a concern, but not a scorecard. When we run persistent trade deficits with China, it is not a sign of economic superiority or inferiority, but instead merely the effect of the United States consuming more than it produces and China producing more than it consumes. There are reasons to be worried that we are exchanging a higher standard of living later for a higher standard of living now, but we are not “losing” jobs or losing productivity any other such nonsense when we run a trade deficit.
It is worth repeating: a nation is NOT a corporation. For one, the effects of “trade” are far smaller for a nation than they are for its corporate analogue– Ford, after all, exports nearly 100% of its output, that is to say, the fraction of Ford vehicles consumed by Ford employees is vanishingly small. But most importantly, a nation cannot fail in the same sense that a corporation can. A corporation can vanish because its workers can migrate entirely to other companies. It ceases to exist because all of its “citizens” voluntarily decide to leave.
The United States does not face the same prospect– even if China were to grow at an extraordinary rate, even to the point where it had a higher per-capita income than the United States, most American citizens would still elect to remain in their own country. As other nations grow, we may lose political rank or watch the balance of military power shift, but otherwise our national standard of living will remain untouched. Because there will always be workers, a nation cannot “lose” like a business can– it may be dissatisfied with its own economic performance (which is in turn determined almost entirely by its own productivity), but there is no realistic way in which a country can go out of business– even if it did, and every last American citizen voluntarily decided to emigrate to another country, would we really consider that a loss, or even attribute the cause to economic factors? No competitiveness advocate is claiming we should bar our citizens from leaving the country; we would find it abhorrent to prevent our own citizens from finding greener pastures elsewhere.
It is important to remember that whenever we run a trade deficit, in effect what is really happening is that we are taking goods from other nations in exchange for scrip that we call “dollars.” Out in the rest of the world, the dollars may be used as a medium of exchange and become involved in transactions unrelated to the United States (ie. China may exchange the dollars to Europe in exchange for goods), but ultimately they are just paper and can only be redeemed for real, useful items by returning them to the United States.
The scrip that China has amassed, should we choose to honor it, entitles it to a (relatively small) fraction of our future output. Even if they chose to redeem their coupons for productive resources of the United States, such as factories and machines and other capital (this is the great fear of mercantilists), it would be relatively easy to reconstitute our capital stocks by shifting American workers from producing consumer good to producing capital goods. In fact, to the extent that such an outcome is likely, the free market is already allocating such workers– to the extent that we trust the free market hypothesis, our economy is already performing the adjustments necessary to start producing what we expect our trade partners to ask for on the timetable that they are expected to ask for it.
Of course, information is imperfect (much like the free market hypothesis) and it is possible for the markets to misjudge when and for what the rest of the world will demand from the United States. This could make the reorientation of our economy sudden and unexpected– what economists like to call a “hard landing.” It is valid to concern ourselves with the size of our trade deficit because of this potential risk, and there are some serious economists who would advocate taking measures to mitigate this risk– but this is fundamentally a different argument than what competitiveness advocates are claiming, and even on its face is not especially compelling. If we consider the free market incapable of properly assessing the future demand of Chinese consumers, why then would we trust it to properly assess the future demand of American consumers? In some sense, the argument that we need active government intervention to mitigate the risk of a hard trade landing is similar to the argument that the government should actively manage markets for, say, hotdogs, lest hotdog companies underestimate the future American appetite for hotdogs and are later forced to make wild and undignified expansions in their hotdog producing capacity.
It has been common for economists to tolerate the blather of competitiveness, not only because there are practical difficulties with trying to educate non-economists on comparative advantage and the mechanics of free markets, but also because it is commonly believed that such rhetoric can be harnessed in support of good policies. If I am worried about the large negative externalities posed by global warming, and believe it is in the U.S. or the world’s best interest for America to invest in public energy research, then what harm is there if others believe that such expenditures are necessary to “win” against China?
To quote Paul Krugman, “a government wedded to the ideology of competitiveness is as unlikely to make good economic policy as a government committed to creationism is to make good science policy, even in areas that have no direct relationship to the theory of evolution.” Adherents to the competitiveness doctrine are suffering from a fundamental misunderstanding of economics. It is inevitable that there will come a day when flawed thinking comes home to roost, and when it does, it is likely that more will suffer than just trade policy.
For now, let us consider the most likely victim of the competitiveness doctrine, free trade, and to illustrate the threat, let us take the production of solar panels as an example. China, due to the labor intensity of cell and module assemblage, produces nearly all of the world’s commercial solar panels. Clueless pundits such as Thomas Friedman claim that this is evidence that the U.S. is “losing” in some great race to a green economy. The Chinese, we are told, are the pinnacle of savvy– while we blunder about with our boneheaded Detroit automakers, those crafty Asians are eating our lunch with their green manufacturing. Unless we get serious about investing in green energy, our opponents will gain an everlasting edge and relegate our children to serfdom.
Thus is the argument for a range of green policies– increased research spending, production subsidies, feed-in-tariffs, and so on. Perhaps these policies make sense on their own– we could construct some argument (maybe not a convincing one) that such expenditures will raise our productivity or mitigate environmental damage or some such. But justifying these moves on the basis of competitiveness is illogical. The Chinese do not install many solar panels of their own (it turns out that they are an incredibly expensive and impractical method of generating electricity). Instead, the only reason they have built a solar cell industry is because the United States and Europe have created a demand for solar cells through massive subsidies. Were we to end our subsidies, the Chinese workshops would go back to making something else, like plastic toys and electric irons– mundane items that wouldn’t get so many pundits worked up.
If it is so important that we not let our rivals beat us in whatever competition it is presumed we are playing, then we have two realistic options in the face of this solar panel evidence. One is to cut our subsidies for green power until we deem that American industry is strong enough to duke it out with a cheap labor China. But if green investment really does make sense, this would mean sacrificing a good policy to avoid some imagined bad outcome. The other alternative is to treat American solar panel manufacturers as an infant industry in need of protectionist trade policy– we might continue to offer subsidies, but only American-manufactured panels could receive them, or we would handicap our rivals with large import tariffs.
The competitiveness advocates claim that they want us to win the trade game, not abandon it, but suppose it becomes obvious that we cannot “win?” Accepting the competitiveness rhetoric, despite whatever the pronouncements of support for free trade that come with it, is to invite protectionists into the debate.
As the Obama administration shifts to populist mode, it is likely that it will be rewarded for preaching the competitiveness doctrine. It is much easier to tell a struggling working class that “They took our jobs,” than to try and explain that economic performance is a nuanced problem without simple fixes. The rhetoric will also win him many friends among the CEO’s at the Business Roundtable– businessmen are comforted by the notion that national economies operate on the same principles as corporations, it lets them believe that their life experience entitles them to debate international economics on the same plane as actual economists. But for those of us who understand comparative advantage, it is time to stand up and put Washington on notice. At best, the president playing with fire. At worst, he actually believes what he is reading from his teleprompter.
There could not be a worse time for us to substitute sound economic thinking with voodoo recipes. So let’s start telling the truth: American living standards are determined almost wholly by American productivity, the Chinese are not stealing your job, and our obsession with competitiveness is both dangerous and wrong.