Who Gets the Gains of Trade

 Publication Information: Article Title: GATT Justice: Who Gets the Gains of Trade?. Contributors: Luke Lea - author. Journal Title: Challenge. Volume: 37. Issue: 5. Publication Year: 1994. Page Number: 11+. COPYRIGHT 1994 M.E. Sharpe, Inc.; COPYRIGHT 2002 Gale Group

GATT justice: who gets the gains of trade?

by Luke Lea

Without a practical and politically realistic formula to redistribute income from Capital to Labor, most Americans would be better off to reject free trade out of hand.

"I would never knowingly do anything to hurt the job market in America. . . . I ran for this job to alleviate the insecurity, the anxiety, the anger, the frustrations of ordinary Americans."

President Clinton, on the eve of last fall's NAFTA debate between Ross Perot and Vice-President Gore

In the aftermath of the Cold War, with communism having been relegated to the dust bin of history and the capitalist ideal triumphant everywhere, we awaken to find the West moving rapidly to embrace the idea of free trade in the new global economy. Last year's NAFTA, and this year's GATT, are but two milestones along the way. They lend substance to the idea that, not only will market economies soon blanket the earth, but a new golden age of laissez-faire is at hand--one whose watchwords will be free markets, free trade, and free mobility of capital around the world. "The tectonic forces of integration," waxed one bard on Wall Street, "have shifted irrevocably."

There are a number of reasons why this is happening. Opportunities to make money overseas are obviously not to be discounted, anymore than are the natural urges of statesmen to act on a grand scale. But one big reason is that economists have persuaded Western political leaders that free trade will lead to gains in the efficiency with which every country's economic resources are used--gains that, in theory at least, can make all citizens in every country better off than before, and that will greatly speed the development of the poorer parts of the globe. It sounds good, or even better than good, yet the ordinary citizen has no way of judging. Permit me, therefore--a simple gardener with no ax to grind (a voice of unorganized labor, if you will)--to take the reader on a cook's tour of contemporary trade theory in language the layman can understand. My purpose will be to see whether such claims are justified and, if so, under what circumstances and subject to what conditions. The results, I dare say, will surprise you.

Definition of terms

But first, following Voltaire, let us define our terms. By free trade, I mean the notion that nations are better off, on balance, not to tax or otherwise impede the flows of goods and services across their borders, with exceptions always being made for gun running, shipments of cocaine, child pornography, or the decampment of boatloads of illegal immigrants off the Jersey shore.

This is, of course, one of the oldest and most widely accepted axioms in economics. Adam Smith, for example, was already propounding the doctrine as early as 1776 in that annus mirabilis of the Scottish enlightenment, when The Wealth of Nations appeared alongside the Declaration of Independence. Smith's argument was, in essence, very simple. It boiled down to saying that voluntary exchange between individuals must, as a rule, be mutually beneficial, else the exchange would never take place. The mere fact that two individuals happened to reside in different countries could have no bearing on the matter. This had the ring of the self-evident and, doubtless, did much to shatter the mercantile prejudices of his age.

Forty years were to pass, however, before another amateur British economist of genius--this one a retired stock-exchange speculator named David Ricardo -- put trade theory on the map for good. He did it by extending Smith's original insight to cover the case of countries which aren't content merely to exchange the goods they already possess, but that deliberately set out to produce them for one another's markets. Ricardo's starting point was also rather simple. He noted that countries differ in the "relative efficiencies" with which they make various things. He measured efficiency here by the value of the inputs (in this case man-hours, since he subscribed to the labor theory of value) that it takes to produce a dollar's worth of output. Just as individuals differ in their talents, and are able to do some things best (relative to others), so it is too with countries. Ricardo ascribed these differences between nations to variations in climate, natural resources, and to the knowledge and skills that different groups of people bring to their tasks. The French, for example, have both the climate and the know-how to make wine. He then went on "to prove by algebra" that countries will be better off (will enjoy more of everything at lower prices) if they specialize in those things they do better than others. He showed this to be true, even if one country (owing to the superior talents of its people, let us say) was absolutely more efficient in every line of production than all the others. This insight--we can be better off by paying others to do things we know how to do better ourselves--(so counterintuitive on its face) is called the principle of comparative advantage, and it won economic immortality for Ricardo.

Indeed, it is no understatement to say that, from Ricardo's day forward, enlightened opinion everywhere has subscribed to the idea of free trade, and that his principle of comparative advantage has been the chief weapon used to combat the claims of "special interests" everywhere who plead for high tariffs to protect their relatively less-efficient enterprises against foreign competition.

Winners and losers

Yet, as both Smith and Ricardo knew full well, these "special interests" are flies in the ointment of free trade. Because of them, one could not argue that free trade would automatically make everyone better off than before--at least not in the short run. Some groups could suffer immediate (and perhaps irremediable) harm. Workers employed in those enterprises which are no longer competitive, for example, would be thrown out of work; businessmen whose capital is employed in such enterprises could see the value of their investments shrivel to zero. Factories and skills that, on Monday, were serviceable enough, were providing livelihoods to ordinary hands, and were earning a decent rate of profit for their owners could turn out, on Friday, to be quite obsolete.

In short, free trade produced both winners and losers. On the positive side, there was no question that it would benefit those people who consume the articles that would, henceforth, be purchased more cheaply from abroad; they would experience the unalloyed pleasure that comes from a decline in their cost of living (call it the Wal-Mart effect). However, on the negative side, honesty required one to admit that free trade could also devastate the lives and fortunes of those people who formerly produced those articles in the home economy. And, of course, it often turns out, at least in our own day and age (though, interestingly enough, not in Ricardo's), that the people who consume and the people who produce are one and the same.

The way the classical economists chose to deal with this problem was, as we might expect, eminently sensible. They urged caution. They especially urged caution in the case of countries whose manufacturing industries had, for whatever reason, grown up behind high barriers to trade--whether because of a history of high tariffs, long-standing political hostilities abroad, or the mere absence of reliable transportation and communications facilities linking overseas markets. In such circumstances, they counseled, the barriers to trade should come down slowly and by degrees, so as to give the people whose livelihoods might be adversely affected a chance to adjust. For workers, this meant gradually leaving their old places of employment in declining industries, and finding new work and learning new skills in those industries which, because of their "comparative advantage" in the new international marketplace, would be expanding. It was the same for businessmen. Adjustment meant giving them time to depreciate their plant and equipment (by wearing it out). They would be allowed to redirect their capital into new lines of activity, instead of refurbishing existing factories. In this way (or so reasoned Smith, Ricardo, and, later, John Stuart Mill--the last of the great trio of classical British economists), it should be possible to minimize the harm done to the losers under free trade, and eventually to reach a point where everyone could benefit. Indeed, Adam Smith, in The Wealth of Nations, held, "It may be desirable to introduce freedom of trade by slow gradations." Thus would the general welfare of society be unmistakably improved.

I think most economists would accept this as a fair and accurate description of the classical doctrine of free trade. Moreover, I doubt many will accuse me of bias when I say that this is the form of the doctrine they first learned in school, and from which its immense intellectual prestige is derived. Indeed, with but minor modifications, it is in terms such as these that free trade is understood and approved by most educated opinion today. If you doubt it, look no further than to the countless editorials that were written in favor of NAFTA last fall; the ones in The New Republic and Nature were representative. Or take note of the current controversies surrounding GATT.

It may come as a surprise to most laypersons to learn, therefore, that this classical doctrine of free trade has almost nothing to do with the way modern economists think about trade. Indeed, classical free trade theory has about as much resemblance to modern trade theory as classical physics has to the modern theory of quantum electrodynamics.

The role of capital

If we were to point out the single thing that distinguishes modern trade theory from that of the classical economists, it would have to be capital--the role capital plays in production, how vast disparities in capital between nations can generate trade between them, and the effect such trade will have upon the distribution of income in society.

The classical economists (as I've already noted in the case of Ricardo) subscribed to the labor theory of value. For them, this meant that labor was the only recognized factor of production. Some goods cost more than others because different amounts of labor were required to produce them. The idea that capital (or tools)--together with a people's knowledge of how to use and make them--was also an important ingredient in production was alien to them. In fact, the very word "capital" (as used by the classical economists) usually referred to "corn"--meaning the surpluses of grain and other food stocks that had been accumulated from the previous year's harvest and that were thenceforth available to feed work crews to build roads, drain swamps, and undertake other such "capital" improvements. Of course, the classical economists were aware that there were novel forms of capital on the scene. The new steam engines, railroads, and textile machinery could hardly have escaped their notice. Yet they had no way of incorporating these novelties into their theory of exchange; they had no way of knowing (Ecclesiastes to the contrary notwithstanding) that vast accumulations of capital represented something fundamentally new under the sun.

The classical economists were also hobbled by another idea. They subscribed to the Malthusian notion of "the iron law of wages." This was the doctrine according to which the remuneration received by ordinary working people could never rise above the bare minimum needed to sustain life. According to Malthus, if wages rose above the subsistence level, the workers would breed until their numbers bid the price of labor back down. For this reason, it was impossible for them to conceive of a world in which the workers in one country would be paid many times more than the workers in another. The whole world was underdeveloped in those days, and the notion that some nations might grow rich (in the sense of their "laboring classes" being able to enjoy modest degrees of leisure and affluence) was simply more than their imaginations could comprehend. Incidentally, this is why the free trade debate in the last century was relatively little concerned with the welfare of ordinary working people; it was mostly about how free trade would benefit the small elites at the top of society--the landed aristocracy and the emerging bourgeoisie--who alone commanded the discretionary incomes necessary to purchase cheap foreign commodities. Not for nothing did economics become known as the dismal science.

A revolutionary thesis

But all this began to change in the last quarter of the nineteenth century. It was swept away by the undeniable progress of society (ordinary wages were going up) and by a revolution in the way economists looked at the process of production. For the first time, it was possible to understand the contribution that capital was making to wages. We call this revolution the "neoclassical" or "marginalist" revolution; it became, in effect, the quantum mechanics of all subsequent economic thinking.

At the heart of the neoclassical revolution was the recognition that labor, by itself, could produce little; but, when given tools and materials to work with, it could produce a great deal. Furthermore, it was realized that, the more tools a population had at its disposal, the more productive it would be--subject only to the law of diminishing returns. In short, tools were important, and more tools were better.

Nor was this all. When looked at from the other side, it turned out that the situation was exactly symmetrical with respect to capital. In other words, capital by itself could produce nothing. However, in the hands of labor, it could produce something. The more laborers there were for a given stock of capital, the more productive the capital would be--again subject to the same law of diminishing returns.

Economists put these two ideas together and called it "the law of variable proportions." Most important, they were able to show ("to prove by algebra" again) that, in a market economy, the rewards of labor and capital were set equal to their respective marginal productivities--as determined by their relative proportions. This law applied, not in any particular industry or place of employment, but throughout the society as a whole. Thus, the more capital a country had for a given population, the higher the wages would be, and the lower the profits. But the more workers there were for a given quantity of capital, the higher the profits would be, and the lower the wages. When wages went up, profits went down, and vice versa. The progress of wages could thus be explained by the fact that vast accumulations of capital were taking place in society, raising the average marginal productivity of labor.

Implications for trade

None of this had much to do with trade, of course, but it did raise an interesting question. If some countries were gradually growing wealthy while others remained poor, what prevented the capitalists from taking their capital out of the wealthy areas and investing it overseas, where the law of variable proportions would work to their favor?

As a matter of fact, a good deal of this did go on. But it was confined largely to western Europe and to the United States, for the simple reason that these were the only areas with all the institutions required to make markets work. Above all, they had strong central governments committed to making them work. England invested in Germany and vice versa. After all, let us remember that Engels owned a factory in Manchester. Moreover, both countries invested in the United States. Gradually, the whole West European cultural area grew rich. Meanwhile, such commercial goings-on--those that touched the relatively "backward" areas of Asia, Africa, and Latin America--were either rapacious in character (the slave trade, the East India Company, the opium wars), or else were intended to extract scarce raw materials and agricultural produce unavailable at home. These operations in foreign markets were concentrated around the peripheries, where harbors could be built. The interiors of these continents remained largely without roads, communications, or even the basic institutions needed to make individuals secure in their persons and property.

Meanwhile, the economists too were busy trying to work out the implications of the neoclassical revolution for international trade, especially as it related to trade between rich countries and poor countries (or between populations that had lots of capital and populations that had little). It took them a long time. In fact, not until the first quarter of the twentieth century did two Swedes named Heckscher and Ohlin get the first glimpse of an answer. And it was not until mid-century that Paul Samuelson, the enfant terrible of American mathematical economists (and the man who wrote the textbook we all used in college), drew their insights to a logical conclusion. The results were theoretically surprising and (for workers in the West) ominous in the extreme--so surprising and ominous that, to this day, many economists are unable to believe them.

In essence, Samuelson found that it would make little difference whether capital were free to move between rich countries and poor. Trade alone could bring about much the same result. In other words, under free trade, wages could be expected to fall and profits to rise in the rich countries, just as would happen if large amounts of capital were shifted overseas. The way it worked was that low-wage countries would specialize in labor-intensive goods (because of comparative advantage), leaving the rich countries to specialize in goods that required little labor and much capital. The effect would be to lower the demand for labor and raise the demand for capital in the rich countries. That would cause wages to fall and profits to rise. This effect was limited only by the gap in wages between the two sets of countries (the bigger the gap the more wages could fall) and by whether complete specialization occurred.

In fact, Samuelson was able to prove (by algebra once again) that, as a rule, wages and profits would be equalized around the world at points somewhere between the rates that initially prevailed in the rich and poor countries before trading began. Indeed, the same result would accrue, if capital were completely mobile among them. The only difference was that, without capital mobility, wages and profits would both end up slightly lower, owing to the extra transportation costs incurred when trade is the only mechanism for bringing about equality. The name of this finding is "the factor-price equalization theorem," and it seems destined to become one of the most celebrated and controversial results in the whole history of economics, or certainly in this century.

But, of course, so long as there was relatively little trade in practice between the rich and poor countries (or little mobility of capital either, for that matter), the controversy was largely academic, and could be quietly confined to the economics departments of our leading universities. But all that changed in the years between 1987 and 1991. With the collapse of the Soviet Union, the West woke up one morning to discover that communism (its erstwhile ideological nemesis, and a political force to be reckoned with for over three generations) had unexpectedly disappeared. Virtually overnight, it seemed, Marxism had ceased to exist as an armed and credible creed in the world. This was true, not only in Russia and in the formerly captive nations of eastern Europe, but throughout Asia, Africa, and Latin America.

For their part, the leaders of dozens of former "second" and "third" world countries (now known collectively as the "developing world") could see the handwriting on the wall. They were busy getting over their hostility to the West and began to put aside any misgivings they might have formerly expressed about capitalism. Such feelings were henceforth to be dismissed as relics of the colonial and neo-colonial past. Portraits of Karl Marx were being torn down from their places in the public squares, even as neckties sporting Adam Smith's picture on them were appearing around the necks of their newly suited business classes. Most important of all, policies were changing. The poor countries were unilaterally slashing their tariffs, joining GATT, and unabashedly clamoring for western trade and investment. It soon became clear that they wished to ape the "export"-led growth strategies which had been pioneered by the little tigers of East Asia.

But these were no little tigers. Two of them--China and India--had a combined population of two billion people (twice the total population of the West) who were willing to work for less than a dollar per hour. In China's case, at least, it was apparent that a strong central government was in place that was absolutely committed to making markets work. Networks of roads, power stations, and wireless communications systems were springing up like crazy. A stock market was opened up (along with a high-fashion industry) and a central banking system was established. Theft and assault were made capital offenses. In short, all the barriers that formerly had prevented large-scale trade and investment with the West--political, institutional, technical, and economic--were giving way at once. It was as if the Hoover Dam had burst.

Impact on workers

Strangely, however, economists in the West were silent about the implications of this development for Western workers. They were urging none of the caution their classical forbears might have been expected to counsel in a similar situation. On the contrary, they seemed to be caught up in the same spirit of euphoria that was gripping the business and political elites. A perfect example of this was the highly influential letter sent to President Clinton last fall by 300 leading U.S. economists (including fourteen Nobel prize winners)--all of whom endorsed the North American Free Trade Agreement with Mexico. NAFTA, as the reader will recall, is designed to remove all trade and investment barriers with our poor and populous neighbor to the south. It was sold to Congress as a prelude to this year's GATT accords (encompassing both China and India) and to similar agreements to be negotiated in the near future with the rest of Latin America. After NAFTA would come AFTA--a truly all-American free trade zone stretching from north of the Arctic circle to the tip of Tierra Del Fuego.

What was most curious about the economists' letter to Clinton was its pretension to being a balanced appraisal--a weighing of "the costs against the benefits"--where the issue is free trade between a rich country and a poor country. Yet it opened with a standard piece of 19th century boilerplate ("an open trading relationship directly benefits all consumers"). It featured the observation that the gains to the winners would more than offset any losses to the losers. No mention was made of the fact that most consumers nowadays are workers too, and that the wages of the overwhelming majority of workers could be expected to fall even faster than prices. That is precisely what it means to say that real wages decline. In other words, the economists forgot to say that the Wal-Mart effect would be more than offset by the McJobs effect. Nor was it pointed out to the President that any gain in the nation's total output (and hence in the "average" American income) would be swamped by a wholesale redistribution of income between labor and capital. Typically, several dollars for every dollar of gain would be taken away from ordinary working people (the so-called low- and semi-skilled) and given to a privileged stratum at the top of society (composed of people with superior educations and significant capital holdings). It was as though Messrs. Heckscher and Ohlin had never been born.

Even more bizarre was a statement by Paul Samuelson himself--the king of the mathematical economists--delivered last October before an august assemblage in the East Room of the White House. Henry Kissinger was there along with President Clinton and six other Nobel laureates. They all supported NAFTA. Prof. Samuelson stepped to the microphone to opine that "protection had never resulted in a net increase in the number of high-paying jobs." This came from the same man who, fifty years earlier, had created a sensation in the economics profession by proving (in the celebrated Stolper-Samuelson theorem) that a tariff on labor-intensive goods imported from poor countries could prop up the wages of workers in a high-wage economy. That the good professor was being disingenuous, therefore, was the kindest thing one could say; it was enough to give his profession a bad name.

Clearly, something was going on here that cries out for explanation. Why would the world's leading economists choose to mislead the leader of a great democracy on an issue of such overriding importance to the majority of its citizens? Did they wish to bankrupt the welfare state and torpedo the liberal consensus that, since the days of Franklin Delano Roosevelt, had bound up the rift between labor and capital? Was it of no consequence to them that the bottom four-fifths of American families (who were already stretched in their ability to care for their children and old people, and whose wages had already been declining for more than two decades) should see their whole way of life unravel? How good could national health insurance be, if it were financed out of wages at a time when the wage-base was collapsing? Or were the people of the United States, having climbed from underdevelopment to a middle-class standard of living, to be consigned once more to the abyss?

Very few economists, I think, would answer this last question in the affirmative. Not even Milton Friedman at his most libertarian subscribes to what a recent letter-writer to The Wall Street Journal was pleased to call "the justice of the market place." Indeed, few flinty Presbyterians remain, even in the windy city of Chicago, who can take comfort in the words of St. Matthew, that "to them that hath shall be given, and from them that hath not shall be taken away, even the little that they hath."

A "value-free" objectivity

Was the problem that, nowadays, too many economists adopt the pretense of being scientists? Were they, in the name of objectivity--or what the Germans call being wertfrei ("value free")--enjoying the luxury of not having to make difficult judgments involving "interpersonal comparisons" between individuals? Certainly, many economists think this way. At least, they used to earlier in the century. For them the possibility that a skewing of the distribution of income might adversely affect the general welfare of society could be side-stepped, along with such quaint notions as a dollar being worth more to a poor man than a rich one. They could take cover behind a convenient agnosticism and be content to point out that, whenever total income goes up, at least the physical potential exists to make everyone better off than before. This has been their minimum (indeed only) criterion in such matters.

"Pareto optimality" is, of course, the technical term for this criterion. Economists use Pareto optimality to justify changes in the economy that can, in principle, make some people better off without making anyone else worse off. Changes that meet this criterion are said to increase the "efficiency" of the economy. The trouble is that Pareto optimality can theoretically be used to justify a change that leaves the entire product of the society in the hands of a single individual, with everyone else having nothing. Thus what was originally conceived to be a non-controversial (and, in some sense, "value free") criterion for advocating change turns out to be extraordinarily controversial.

But I doubt this ideal of the "value-free" explains the position of very many economists today--at least not those at the very top of their profession. Professors Samuelson and Solow, and the other Nobel laureates who showed up at the White House, strike one as altogether too liberal and humane. If they were so purely detached, why were they bothering to make policy recommendations at all?

Or is the problem that they care too much? Many economists, like many scientists, are internationalist at heart; they adopt what Columbia University trade theorist Jagdish Bhagwati refers to as "a cosmopolitan point of view." Their primary allegiance is to the well-being of all people everywhere, not to the members of any particular national group. Like God Himself, they care most about "global welfare." For them, it is enough that global welfare will go up under free trade, even if the welfare of the workers in certain rich countries goes down sharply. After all, is it a calamity when an American family is forced to go on food stamps and become much like the poor wretches who are starving on the streets of Calcutta or Mexico City?

Yet again, cosmopolitanism cannot really explain what needs to be explained, even though it helps. For one thing, it is simply dishonest to say that Americans will be better off under free trade, when what is meant is that most Americans will be worse off, even though a few Americans, along with many people overseas, will be better off. When advising a political leader, to confuse these two propositions is worse than dishonest; it is deceitful and borders on treachery. Indeed, in the long run, if it provokes a reaction, it might result in less free trade than a more candid assessment of the situation would allow. And it certainly it does not bode well for the long-run reputation of economists.

A better way?

We are left only with a vague but, so far, unarticulated feeling that there must be a better way. Indeed, Professor Samuelson implied as much at the end of his famous paper, "Protection and Real Wages," in which the Stolper-Samuelson theorem was first presented to the world. Having just demonstrated that tariffs could prop up the wages of workers in a rich country, he concluded that protection was, nonetheless, not the way to go. And why not? Because, under free trade, it would always be possible for the winners to compensate ("bribe") the losers out of their winnings, and leave everyone better off than before. Yet, as Mr. Samuelson also observed on a similar occasion, potentiality is not actuality. The mere fact that, under free trade, it may be theoretically possible to make everyone better off than before, if certain additional steps are taken, it is not at all the same as saying that those steps will (or can) be taken.

Make no mistake. What is required here is nothing less than a scheme to undo the redistributional effects of free trade itself. That means taking huge sums of money out of the pockets of the rich and the powerful and the politically well-connected, and giving it back to ordinary working people--not exactly the sort of proposal that's wildly popular in Congress these days.

My final conclusion is as inescapable as it is astonishing. Unless economists have up their sleeves a practical and politically realistic formula to redistribute income from the more to the less fortunate members of society--one that could operate on a grand scale, and not destroy the incentives to work and to enterprise--then they are blowing so much smoke. Without such a formula, it seems clear that the overwhelming majority of the American people would be better off if they rejected free trade out of hand. For them, the motto should be no liberalization without compensation. They would be better advised to turn to high tariffs and capital controls as the only means available to protect their livelihoods.

Mr. Samuelson, Mr. Friedman, Mr. Solow, Mr. Bhagwati: The ball is in your court.

LUKE LEA, a blue-collar intellectual, is a graduate of Reed College. He lives in Tennessee, where he earns his livelihood as a landscape gardener and part-time writer.

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