August 28, 2012

Three things the American people don’t understand about trade

By: Logan Albright

In the post-recession environment of high unemployment and slow growth, there has been a lot of talk about the need to protect American jobs and to rein in the trade policies of other countries (read: China) that are viewed as “unfair.” It’s an understandable outgrowth of domestic frustration and worry, but it betrays a misunderstanding of how trade really works. The problem with the way trade is discussed in politics and the media can be boiled down to three common misconceptions that crop up again and again. It is the aim of this article to correct these and explain to the reader the ways in which free trade is the antidote to, rather than the cause of, our current economic troubles

Countries, unlike private companies, do not compete. If McDonald’s sells me a hamburger, Burger King loses out on the opportunity to get my money. McDonald’s wins, Burger King loses. So if China wins, that must mean America loses, right? Wrong.

We live in a world economy now, which means that every country’s success is to our benefit and every country’s failure affects us as well. This point should be obvious when we examine the case of Greece. If any country can be said to have “lost,” surely it’s Greece, but if that is the case then who has “won?” We are not better off for Greece’s failures; we are worse off.

This is why the demagoguery against China is misguided. China’s gain is our gain as well. Unlike in the hamburger example above, a job created in China does not mean a lost opportunity for a job in the U.S. Quite the contrary. Imagine the following scenario: a Chinese worker gets a job for which he earns a salary. He is now making more money than he was before, and spends some of it on various goods and services, which increases the income of other Chinese workers. Sooner or later, one of them will buy a ticket to an American movie, or eat at an American restaurant or invest in an American company. The income from that first Chinese job perpetuates and multiplies itself, until eventually it comes back to the U.S. where it helps create American jobs.

Money is different from other goods in that the act of spending it doesn’t leave one worse off, but better off. If I earn $20 which I then use to buy a shirt, I am still richer than I was because I have the shirt. Likewise, the shirt maker is richer than he was, because he makes a profit on his sale. Thus, as money is spent, wealth is multiplied. This is possible because every financial transaction is really just a trade in which both parties benefit. As income passes from person to person, more and more of these trades are made and the general level of well being increases for the whole country, and indeed the whole world.

The preceding point is often missed because people have a habit of thinking in terms of winners and losers. Michael Douglas’ famous (and fallacious) line about capitalism being a zero sum game rings instinctively true. But instincts can be deceiving, and the fact is that all trade relies on the idea of the mutually beneficial exchange. After all, who would agree to a trade that is not beneficial?

The way in which countries, and indeed individuals, can always benefit from trade can be demonstrated using a simple idea that is covered in every undergraduate economics course, and yet seems lost on many politicians and pundits alike: the concept of comparative advantage.

The basic concept is that countries have different costs to produce different goods, where “cost” is understood as signifying not just a dollar amount but the opportunities that must be given up. Any one allocation of resources will mean that alternative allocations are no longer possible, and this is counted as a cost of producing particular goods.

It is then a mathematical certainty that two countries with different costs will be able to benefit through the process of specialization and trade, even if one country is able to out-produce the other in absolute terms. The United States imports much of its cotton from Egypt despite the fact that American soil is very well suited to growing cotton in large quantities. We could grow all of our own cotton, but that would mean not being able to grow as much corn or other crops that we value more highly. Egypt, on the other hand, generates a great deal of revenue from its cotton exports and it is unlikely that a reallocation of resources would be desirable. A numerical example will be helpful.

Suppose that there are two countries, Country A and Country B, each of which can produce two goods, apples and oranges, in various combinations. If Country A devotes all its resources towards apples, it can produce 10 of them. If, on the other hand, it chooses to produce only oranges, it can produce just 5. Country B is less resourceful than Country A and can only produce either 9 apples or 3 oranges. Even though Country A has superior capabilities to Country B for both products, both countries can still benefit from trade.

Notice that for each orange it produces, Country A must give up the opportunity to produce 2 apples. In Country B, however, each orange requires the sacrifice of 3 apples. Thus the cost of oranges in Country A is lower than in Country B. Since it faces a lower cost, we will allow Country A to specialize and produce only oranges, whereas Country B will produce only apples. This leaves us with a world supply of 9 apples and 5 oranges.

Country A can then trade 2 oranges to Country B in exchange for 5 apples, leaving the distribution as follows:

Country A: 5 apples; 3 oranges

Country B: 4 apples; 2 oranges

If Country A had attempted to produce both goods itself, it could have only produced 4 apples and 3 oranges, so it is better off from having traded. Likewise, the best Country B could have done on its own would have been 3 apples and 2 oranges, so it too is better off as a result of free trade.

This brings us to the subject of the trade deficit and the entirely mistaken idea that imports are somehow bad while exports are good. From the preceding discussion it is clear that this is not the case. Country A is not worse off for having imported cotton and Country B is quite happy to be able to import corn. Indeed, there is no conclusive evidence in the economic literature that indicates that large trade deficits have a negative impact on the economy.

The reasons for the remarkable persistence of this misapprehension are purely cosmetic. The first of these is the name itself. Americans have learned to hate and fear the word “deficit” due to its application to the federal budget as well as its general negative connotation. A deficit signifies something lacking, and how can that be good? In reality, this is just unfortunate terminology that has no relation to the actual concepts involved, but is merely an artifact of government accounting practices.

This is related to the second reason that people tend to distrust the trade deficit, but unlike the first instance, this one tends to confuse trained economists more than the general public. It has to do with the way in which gross domestic product is calculated and subsequently presented to people who are interested in such things. There are actually several methods for this, but the most common is to add the total consumption expenditures of Americans to the total investment (here signifying spending on business capital and infrastructure,) then adding government expenditures and total exports and final subtracting total imports.

The reason that imports are subtracted is that consumption and investment spending that goes towards foreign goods and services is not part of our domestic product, but since these expenditures have already been counted in the first two terms, they must now be subtracted out. The optics of this practice are such that many people get the mistaken idea that when we import something from another country, it actually lowers the total income for our own country. This is simply not true.

The argument supposes that if money were not spent on imports, it would instead be spent in an exactly analogous way domestically, but there is no reason to think this is so. One of the main reasons we import goods is because of the low prices they allow us to pay. By purchasing an import at a low cost, not only does the consumer get what he wants, but the money he saves can be put to use elsewhere, supporting other industries as well. In the absence of this option, the consumer would have to pay considerably more for an analogous domestic good, and may opt not to buy at all, or to buy an inferior good at a lower price. In either case, the consumer is worse off than he would have otherwise been.

From the preceding points it should be clear that free and open trade is not a hindrance to wealth and job creation, but a tremendous boon. It is time for the American public to stop capitulating to the xenophobic fear mongering of politicians and realize that protectionist policies are short sighted and counterproductive and that the ultimate path towards global prosperity lies in free and open trade.

Logan Albright is a writer in Washington, D.C.

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