Economind Re-thinks: Is trade still our best buddy?

Trade has traditionally been thought of as the economic engine propeller, and as clearly stated by David Ricardo – a highly-esteemed British economist of the early 19th century – and I rephrase here: “Nations gain the most from producing their most labour-efficient products and trade with the others for the rest of their needs”.

In economics, this has already become a positive economic statement, meaning that it has already been widely accepted as if it were a fact. But, is it always the case?

To answer this question, it is worth visiting one of the most influential economic thought of the century, the Lucas Critique. Basically, Lucas Critique revolves around the idea that the economic structure and the underlying assumptions are not static and will change according to expectation of the public. Thus, it would be naïve to say that trade is oh-so-great based on historical data alone. In fact, the economic conditions might change considerably every decade or so that it should be not to anyone’s surprise if there exist nations in which the gain from trade is largely offset by the loss, a complete opposite of the economic claim years ago.

Simply put, rapid globalization is a new playground that we did not have until a couple of decades before. So, measuring the association between trade and economic outcomes using past data to shape future policy is not always a good idea.

China, as an example, has been growing at a rate never before experienced by any country as an exporter of various products covering a wide range of economic sectors. It has become a major trading partner for many countries in the world. In essence, this should imply that China is providing a huge benefit to itself as well as to the rest of the world. Yet, China has suffered from numerous problems ranging from its inability to convert its huge reserve of dollars (or else it would risk appreciating its own currency and thus lowering its exports) to one of the worst pollution issues in cities like Beijing (a result of cost-reduction oriented businesses). Then, another question arises. How about the other side of trade? Will trade with China always generate benefits greater than losses? Mainstream economics says absolutely yes.

But, it is worth looking deeper into the matter for the purpose of designing proper counter-measures (just in case). There have been studies by many economists that found significant loss associated with free trade in the medium run (particularly for the US and probably extendable to other big economies).

A paper by David Autor, David Dorn and Gordon H. Hanson – published in 2011 in the American Economic Reviews – challenged the mainstream economic thought (at least for the short- and medium-term economic effects of trade). Their finding was surprising and controversial but worth pondering over.

Based on empirical evidence, they found that free-trade actually produces losses about at least 2/3 of the gain in the medium run. Let me repeat that their research does not clash with the economic belief of the benefits of free-trade in the long-run but only for the medium run.

According to their findings, US counties highly exposed to Chinese import, particularly those with manufacturing outputs competing directly with the imported goods, saw considerable decline in wage and employment-to-population ratio in both the manufacturing sector and non-manufacturing sectors. The logic is simple. Cheaper Chinese goods swept through the market causing many manufacturing firms to shut down. The laid off manufacturing employees (usually low-skilled or with skill sets too specific) flooded the labour market leading to downward pressure on the overall wages. This subsequently led to lower aggregate income and demand within the local economy, and the impact soon spread through the entire labour market. Painful structural adjustment for workers (whose skills are not useful outside of their former industry) also adds up to the cost.

The effect rippled far and wide. As unemployment rose, unemployment insurance claims, food stamps, health care spending, and claims on other government benefits increased substantially. This further spelled two indirect consequences. First, taxes levied on people and passed on as transfers to the unemployed tend to lower the incentive to work for both parties. Second, the tax collection system is a leaky bucket. This simply means that $1 tax does not result in $1 transfer. A part of the tax collected is used for government administrative cost. Some got diverted to earmarked projects for the interest of some small groups (the downside of democratic process of budget allocation which tends to favour short-term gains through agenda of small special-interest groups). In essence, tax system is not an efficient system, and thus, income redistribution via tax almost always creates deadweight loss.

Be aware though that this is not an argument against free trade, but a warning to all policy makers that economics is not hard-science and should never be. While we should rejoice over the long-run prosperity, we are all living in the short run. The job loss hurts, and so does its multiplier effects. While it is true that the scope of the research is limited, the point it makes is not to be neglected, that is supporting free-trade purely on the basis of past research conclusions (even if consistent) over a few decades ago might be a fallacy in the present time. When it comes to free trade with the emerging economic powerhouse like China in particular, the impact has to be assessed separately. The reason is that we have never witnessed a country’s export surging so fast before (no historical data). The case of China is unprecedented and is often not properly accounted for in a lot of past economic studies.

The moral of the story is that when you think about trade, think beyond introductory economics (if you have read or learnt about it). This is exactly the case for large economies like the US. Sure, there is overall gain, but the damage done at regional/local level is too real to ignore. Sometimes, the blow leaves a huge scar to the local economy that can take decades to adjust (consider the case of Detroit as a consequence of the influx of Japanese car into the US market).

But, trade has been great for smaller economies, especially those who have seen their export sectors growing vigorously. Plus, trade remains our best buddy when we take into account of the overall gain in the world economy. After all, it has lifted hundreds of millions of people out of poverty. However, with regard to any one specific country or region (at micro level), though trading gain is real and even tangible, so is the loss and the human suffering. With this in mind, at a certain stage of growth of a nation, the cost and benefit of trade should be put forth as a serious subject of debate and study. Still, for tiny economies like ours (especially ASEAN), let’s stick to economics 101 for now.