Current Commentary

Rethinking Free Trade

By William J. Dodwell    May 22, 2018


            Free trade purists have historically embraced the principle of comparative advantage which asserts that nations import what other nations can produce more economically because of substantially lower labor and materials costs, technological efficiencies or superior expertise.  But in practice other factors intervene in the international trade of goods and services.  Because of different political systems, macroeconomic factors and cultures, some foreign producers enjoy lower production costs derived from government subsidies and minimal regulation.  In addition, a country might manipulate (undervalue) its currency through central bank intervention to make its exports cheaper and thus more competitive, irrespective of production costs.  In the U.S., businesses are burdened by onerous labor and environmental regulations, comparatively high taxes, and higher wages resulting from a better standard of living, and in some cases from inflated union wage scales, all of which reduce global competitiveness.  To compensate, some companies import product.  Or, they lay off workers, move operations overseas, or choose to shut down altogether. 

Trade inequities

At issue are certain advantages U.S. trade partners enjoy because of longstanding accommodations in trade agreements.  In fact, the U.S. imposes a fraction of the tariffs levied by almost any other nation according to the World Bank.  Moreover, the U.S. largely ignores trade agreement violations.  President Trump has called for a re-examination of these heretofore largely unknown inequities in his quest for free trade but fair trade. 

Serious questions now arise.  Why should U.S. exports be subject to a 25% tariff while only a 10% tariff is charged on China imports?  Why should the U.S. pay a tariff on auto exports to the EU that is four times what that region pays on cars sold here?  Why should American companies be required to transfer technology to China, including patents, to get a deal?  Why does the U.S. allow trade agreements to be predicated on burdensome restrictions on U.S. foreign investment in China?  Why continue trade accommodations to Germany originally meant to help it recover from World War II?  And, of course, China, especially, flouts World Trade Organization (WTO) rules with impunity, and the U.S. gets little relief when it does appeal to that body.

Security considerations also come into play as China steals U.S. technology and sells it to enemy nations, such as Iran and North Korea, with little or no resistance.  In fact, Chinese moles infiltrate American corporations and universities and abscond with trade secrets putting future U.S. competiveness in jeopardy. Trump challenges technology theft and longstanding unfair concessions to trade partners in his effort to renegotiate trade agreements aimed at substantially reducing major chronic trade deficits.

Traditional free trade

            Traditional free trade advocates claim that trade deficits are not serious because U.S. capital expended on imports is invested back in U.S. stocks, bonds, real estate and other investments that support the economy.  This refers to the inverse relationship between the current account reflecting a trade deficit from net imports and the capital account showing a financial surplus from the sales proceeds of those net imports reinvested in dollar denominated assets.  Another reason trade deficits are benign is because imports give consumers the benefit of cheaper goods and greater selection, as well as possibly better quality as domestic producers scrimp to compensate for higher costs.  Indeed, the economic impact of domestic jobs lost from import competition pales in comparison to the gains to consumers who far outnumber displaced workers.  What’s more, free trade supporters are sensitive to artificial trade barriers because they can lead to retaliation that engenders a trade war that can seriously harm the world economy as it did in the Great Depression.

While this classic free trade thinking remains valid vis a´ vis the principle of comparative advantage, the other factors affecting U.S. trade agreements, including tariffs, quotas, regulation, subsidies and currency manipulation, have rendered them patently unfair in the excess.  This to the detriment of U.S. companies and their employees, investors and consumers because the inequities substantially squeeze profits by suppressing export revenue and increasing import costs.  As a consequence, lower profitability results in less tax revenue, thus adding to the budget deficit. In addition, large bilateral trade deficits may adversely depress the value of the dollar through the effect on the exchange rate.  While massive trade deficits reflect benign comparative advantage in part, they also reveal grossly unfair trade practices that need to be redressed.  President Trump has awakened the nation to this reality, including some dyed-in-the-wool free traders. 

Why has the U.S. been fleeced?

Over time the U.S. has drifted far from any semblance of basic comparative advantage.  Now President Trump has brought to light excessive concessions long imbedded in trade policies.  Why have past administrations allowed the country to be fleeced?  Special interests have lobbied for favorable provisions written into trade agreements, and into related legislation in exchange for political support.  Preferences could be in the form of extra tariffs on competing imports, such as Trump’s proposed levies on foreign steel and aluminum (partially for security reasons to help shore up an over-capacity domestic industry needed in war time).  Or, politically influential export sectors might be subject to lower tariffs offset by higher tariffs against exporters with less clout. 

Some U.S. corporations acquiesce to high tariffs because selling to certain foreign markets is still quite profitable and holds much promise for their future growth.  Other deficit inducing allowances might veil payments to other nations in exchange for political favors.  In addition, trade giveaways might constitute wealth redistribution, or stealth foreign aid, to other nations in accordance with some hidden agenda.  To some extent trade policy accommodates foreign policy.  What’s more, certain concessions may be altruistic, such as agreeing to a higher tariff so not to threaten an importing nation’s domestic industry.

According to stalwart free stalwart Steve Forbes of Forbes Magazine, the U.S. sells its prescription drugs to foreign government agencies at subsidized prices that do not cover the cost of research and development, thus leaving American consumers to bear the burden in higher prices.  Why is this?  Some concession to impoverished areas are justified on humanitarian grounds, but what about the developed world?  Forbes says that market should pay full price to lower costs to U.S. consumers, or do without American made drugs.  

What can be done?

            There is some leeway for renegotiating extreme trade terms.  For example, U.S. trade partners could lower tariffs on American goods and services, increase purchases, and relax restrictions on U.S. investments in their markets.  In the process, the U.S. could exercise some brinkmanship to get partners to cooperate without precipitating a trade war.  After all, they are very dependent on selling in U.S. markets and in many cases have huge advantages built into trade agreements that could be reduced without much sacrifice.  For this reason temporary protracted logjams are more likely than all out trade wars.  But a failure to achieve U.S. relief goals must not degenerate into a series of retaliatory actions that nonetheless hampers trade flows to serious detriment of the U.S. and world economy.

            Presently, the Trump administration, under the leadership of Trade Representative Robert Lighthizer, Treasury Secretary Steven Mnuchin, Commerce Secretary Wilbur Ross, and even Trump himself, is or will be renegotiating trade agreements with China, Japan, the EU, as well as Mexico and Canada in a recrafting of The North American Free Trade Agreement (Nafta).  In that spirit, Trump withdrew from the potential regional entanglements of the Trans-Pacific Partnership (TPP) with eleven other nations in favor of more manageable bilateral deals.  As a result, the president hopes to reduce major longstanding bilateral trade deficits, especially the more than $300 billion annual shortfall with China, mainly through foreign tariff reductions and significant increases in purchases of U.S. goods and services. 

Additionally, Trump tries to encourage U.S businesses overseas to move production back to the U.S. to create jobs and lessen reliance on imports, thus reducing trade deficits.  To that end, the recent tax cuts have caused Apple and Foxconn to commit to U.S. investments of $350 billion and $10 billion respectively. Another negotiating point with U.S. trade partners concerns relief from restrictions on cross-border direct investment taking into account legitimate U.S. security considerations.

But the line between free trade and fair trade becomes blurred when Trump insists on a minimum wage in Mexico, proposed tariffs (“border adjustment tax”) on the importation of certain U.S. goods produced overseas, and specified U.S. content requirements imposed on American manufacturers - all to protect relatively few American workers at the expense of far more consumers.  Also undermining fair trade are longstanding U.S. government farm subsidies, especially to sugar growers.  As a consequence, American businesses in need of agricultural inputs for their production have to grossly overpay at the expense of profits and hiring, while consumers suffer artificially high prices.  As usual, politics rears its ugly head.

            Many variables come into play in the calculus for correcting unfair trade imbalances.  As mentioned, they include, import purchase levels, tariffs, quotas, subsidies, technology transfers, and foreign investment that can be bargaining chips, both carrots and sticks, for more economical deals.  But, again, there are limits to resolving one-sided excesses with trade partners because of intrinsic differences in political regimes that determine the mix of government intervention and economic freedom.  Standards of living vary among nations as to affect the affordability of imports.  Macroeconomic measures, such as savings, employment, income and capital investment levels have a direct impact on trade flows.  In addition, economically free nations require protection from cheap government subsidized imports (dumping).  Inertia also takes its toll as U.S. trade partners have been spoiled for so long they are reluctant to change.

Even the U.S. has structural limitations.  For example, Trump wants to reduce the deficit with China by increasing U.S. exports to that country by $200 billion annually.  But the U.S. lacks the industrial capacity to produce anywhere near that much additional output, especially given a full employment economy.  And saving and spending rates in China do not support commensurate demand.  What’s more, China’s Made in China 2025 campaign does not bode well for increasing imports. That program is dedicated to developing local high-end manufacturing, such as artificial intelligence products, as an alternative to its current focus on low-end consumer goods in order to elevate China’s status in the world economy.  

Shifting imports from China to other countries where possible does not change the aggregate trade deficit unless the terms are better.  Replacing imports with domestic production where feasible would relieve the deficit.  But, despite Trump’s admonishments, forced home grown product is restricted by significantly higher U.S. production costs and attendant market prices that can seriously curtail domestic and international demand and bankrupt companies causing an economic tailspin. 

So, while some artificial trade barriers may be negotiated away to lower the trade deficit, new ones imposed in retaliation could exacerbate it, as well as slow economic growth.  As such, some question the wisdom of Trump’s gambit to China in which he threatens $150 billion of tariffs if that country denies him his goal of reducing the bilateral trade deficit by $100 billion.  Is Trump calling bluff?  Treasury Secretary Mnuchin just announced a suspension of Trump’s tariff proposal pending consideration of a “framework” for a deal.  In addition, Trump was quick to grant multiple exemptions to his proposed steel and aluminum tariffs.  Perhaps he knows the danger of overplaying his hand.

Exceptions to the rule

Some considerations, such as national security, are legitimate exceptions to the purist trade and foreign direct investment model.  For example, the president has imposed sanctions on foreign companies that violate U.S. geopolitical interests.  As punishment he blocks international payment systems to prevent those firms from executing trade transactions in U.S. dollars in which a significant percentage of trade deals are denominated because of its status as a reserve currency.  This geopolitical act is an appropriate imposition on unfriendly trade partners where necessary.  Foreign acquisition of U.S companies, especially by Chinese companies, is also properly subject to special scrutiny and should be appropriately restricted on security grounds regarding technology transfer/theft and national defense.

But President Trump is currently considering sanctions relief as a negotiating point in response to President Xi Jinping’s personal appeal to Trump to save the collapse of ZTE, China’s largest telecommunications company. That demise was caused by U.S. retaliatory sanctions in reaction to the firm’s violation of pre-existing sanctions imposed on Iran and North Korea.  Critics warn about combining foreign policy and trade policy in employing sanctions relief as a bargaining chip because it can seriously undermine the effectiveness of such international interference as a national security tool.

Getting to fair trade

            We now know the U.S. extends excessive largesse to its trade partners that is unfair to exporters and importers throughout the country as to have substantial impact on economic growth.  The sensitivity of the U.S. stock market to trade agreement prospects attests to that linkage.  President Trump is attempting to redress this excess through comprehensive bilateral trade renegotiations, but he risks going too far with his protectionist impulses.  He should be supported to the extent he does not overly compromise the principle of competitive advantage in a retaliatory fit of pique.  At the same time, the seemingly extra-conciliatory posture of Treasury Secretary Mnuchin should be held in check.  In addition, new agreements should ensure effective compliance monitoring and enforcement given the history of trade partners cheating.  In any case, give President Trump credit for exposing waste and fraud in trade agreements long kept under wraps.

            Comparative advantage is still the gold standard for international trade.  But heavily one-sided tariffs and other impediments corrupt the principle.  Some adjustments to a pure free trade model may be justified because of structural differences between national economies.  However, if U.S. trade partners will not mitigate the excess, the U.S. must respond in kind to protect its economic interest.  It is likely such resistance would yield concessions to avoid a trade war which is in no one's interest.  U.S. acquiescence to grossly inequitable trade agreements is a fool’s errand.

                                                                                                    ©2018 William J. Dodwell

William J. Dodwell is a retired corporate executive, management consultant and financial writer in the financial-services industry with particular expertise in the capital markets.  Mr. Dodwell has written in professional journals, the trade press and corporate publications. He is a Certified Public Accountant (Inactive) licensed in the State of New York.