Free Trade Theory and Reality: An Economist’s Critique

The theory of free trade is so familiar and so often quoted, you might think there is ample evidence proving its accuracy.

But there isn’t. In fact, there is scarcely any evidence at all.

On the other hand, there is abundant evidence showing the theory is wrong. In an academic article recently published in the academic journal Real-World Economic Review (RWER), Free Trade Theory and Reality: How Economists Have Ignored Their Own Evidence for 100 Years, I showed how there is a century’s worth of evidence refuting the core principle behind free trade economics, the so-called “Law of Comparative Advantage.”

Why do economists still preach free trade while ignoring all the evidence that undermines the theory? It’s a good question. In this article I summarize the argument of my longer article, providing an explanation of where free trade theory goes wrong, and touch on why economists persistently ignore their own findings. (You can also read the full article, which has more detail on the evidence for job and income loss.)

The principle of comparative advantage says that if two nations begin to trade, both will achieve higher national incomes because each will specialize in production of the goods where it has a cost advantage. According to the principle, each nation abandons the industries where it is less efficient and moves workers and capital into the industries where it is more efficient. Trade would therefore be win-win.

The problem with this concept is it assumes that all workers are equally productive in any industry. The principle requires that equality to be true. So if a worker moves from one industry to another, free trade theory assumes that she still produces the same output per dollar of wages. In other words, labor markets must be highly competitive. If a worker is paid say $50,000 a year, her labor productivity (which must be higher than her wages) would be the same in any industry. To put it another way, if 1,000 steelworkers lose their jobs due to imports and they were earning an average of $50,000 a year, free trade theory expects, and requires, that they must all be able to move into other industries and earn at least the same wage (or more) and so generate the same value (or more) in their new employment in other industries. In free trade theory, from a financial perspective, all industries are the same.

The problem with the theory is that all industries are not the same. Some industries generate much higher-value output than others. And those industries that generate higher value tend to pay higher wages. In the RWER article, I cite many studies, stretching back a century and across multiple industries, regions, and nations, showing that some industries persistently pay higher wages than others. The industries that pay better tend to have higher profits. Many tend to enjoy oligopolistic positions in their industry, or unique products, or a valuable brand, or all three.

The irresistible conclusion from this is that, if imports take away jobs and production in a high-profit/high-wage industry, and resources move to a low-profit, low-wage industry, the nation’s national income will fall. A good example of the process is the loss of steel jobs and those workers moving to jobs in the low-wage, low-profit retail sector, as we saw in the 1980s and 1990s.

A series of studies on worker dislocation have documented that when manufacturing workers lose their jobs in mass-layoff events, if and when they find new jobs, those new jobs pay lower wages, on average some 20%-38% lower. There is no study of a layoff event I have been able to find showing that workers achieve the same average wage (let alone higher) at their subsequent jobs. Some of these dislocation studies tracked workers for 20 years, and still did not find the average worker getting back to their wage levels in the layoff-hit manufacturing industry.

The principle of comparative advantage is internally logically consistent, given the assumptions it starts with. But those assumptions are dramatically wrong. And the worst of its assumptions is that all industries generate the same value of output with equivalent inputs, and all workers get paid according to their skill level, which economists usually approximate with their age or years of work experience.

Once we abandon those erroneous assumptions, we find that increased trade can reduce national income.

“No Reality Please, We’re Economists”

Why do over 90% of economists (at least in the US and UK) refuse to acknowledge this giant flaw in their beloved principle of comparative advantage?

Economists have built a theoretical world of perfect competition, utility curves, production possibility frontiers, and other splendid theoretical, mathematical constructs. They enjoy teaching this imaginary world to students. Harvard economics professor Dani Rodrik described his pleasure in teaching trade economics to undergraduates, calling it “the joy of bringing the uninitiated into the fold.”[1]

Beginning after World War II with the passage of the Employment Act of 1946, successive administrations in Washington began to rely on economists for advice. To their amazement, economists found that if they lectured politicians and government officials with the same principles based on the imaginary mathematical world of perfect competition, the politicians would actually respond like students, listening and accepting this imaginary world as an accurate representation of the real world. The politicians would then follow economists’ advice, at least where it coincided with the interests of donors and lobbyists. Economists found it intoxicating to become respected counselors to the nation’s leaders, to be met at National Airport by congressional staffers, whisked to DC in chauffeured limousines, led into the White House or congressional hearings by fawning staffers, seated in the center of the room, and listened to with great respect, famous political leaders hanging on their every word. The financial rewards were not bad either.

So economists quickly learned to suppress their private knowledge that the whole imaginary world of perfect competition, free trade, identical risk-adjusted rates of return in every industry, and frictionless movement between jobs and industries was one giant fiction.

It is over 40 years ago, but I still remember in my undergraduate years, the day our young industrial organization professor began one class by telling us: “I won’t be here for next Wednesday’s lecture. I am going to Washington to testify in front of the Senate Commerce Committee.” The entire class stood up and applauded. Sharing the joke, the professor smiled and bowed.

Many economists have published empirical studies showing the loss of wages from plant closures and imports. But they have never allowed those studies to derail their outspoken confidence in their theoretical models, and its gravy train of government jobs, limousines, consulting contracts, and political power.

Business leaders do not, of course, live in an imaginary, mathematical world. They live in the real world. Many of them understood that whenever they could increase sales, and hire more workers at good wages, then they and their employees would spend more money in their local communities, and the local economy would benefit. And if that happened to many businesses across the nation, that would be good for the national economy. Conversely, if they lost market share to imports and had to lay off hundreds of workers, that would be bad for the national economy.

General Electric is perhaps the company that best illustrates the horrors inflicted on U.S. manufacturing industry by globalization. Founded by Thomas Edison in 1889, GE pioneered new products for lighting, electricity generation, and home appliances. In the 20th century it was famous and respected for treating its workers well. Management was acutely aware of its responsibilities to its workers and the communities it operated in. In 1980, Jack Welch took over, and put the new globalization philosophy into action. In a new book, The Man Who Broke Capitalism, author David Gelles tells the story well. Welch executed nearly 1,000 acquisitions and 408 divestitures (an average of more than one deal a week over 20 years), to turn GE into a mainly financial company with ever-rising quarterly profits. Manufacturing businesses were sold off, offshored, or shut down. Welch once expressed his enthusiasm for offshoring by saying: “ideally, you’d have every plant you own on a barge to move with currencies and changes in the economy.”[2]

But a business based on acquisitions, divestitures, and cost reduction has a finite lifespan. In 2000, Welch retired, a very rich and famous man. The business immediately started to go south. In 20 years, Welch had destroyed what Edison and his successors had spent a century building. In 2018, after losing half a trillion dollars in market value, GE was removed from the Dow Jones Industrial Average. GE Appliances is today owned by a Chinese company. GE Lighting is owned by a private equity firm, and recently did another round of layoffs in Ohio, saying it will import the needed parts from China. What remains of GE is now planning to break itself into three businesses. Jeff Immelt, the unfortunate CEO who inherited the utter chaos wrought by Jack Welch, tried in vain to save the company before being pushed out in disgrace in 2017. In a comment to author David Gelles, Immelt showed that he understood the fundamental flaw in globalization:

In a town like Erie, Pennsylvania, people don’t go from working at GE, making $36 an hour, to working at factory X making $30 an hour. They go from earning $36 an hour to earning $15 an hour. And that gap is a hugely negative impact. I get that.[3]

It is important to note that my argument is not the familiar plea about “adjustment,” that it takes time for workers to adjust to a “new world” or be “retrained” to reach the same income they once had. No. The evidence is simply overwhelming. In the U.S., imports destroy high-wage jobs and no amount of retraining will get those workers back to the same average wages they once enjoyed.

Globalization is regression to the global mean. It is wiping out our high-wage industries and relentlessly driving down average wages for the bottom 60% of America’s income distribution.

What is the Solution?

The federal government has an obligation to set the ground rules for the success of the U.S. economy, and to create an environment that facilitates broadly-based rising incomes for the majority of the population. If it does not do that, then globalization will drive U.S. incomes for the bottom half of our population to the point where we meet Mexico, China, and Bangladesh, whose wages are rising (slowly) from miserable poverty to something slightly better. Democracies do not cope very well with declining living standards.

The solution is to recognize that there are what I call the 4H industries: industries that can deliver high profits, high growth, high investment, and high wages. They must be supported and favored until they provide enough employment and prosperity for a critical mass of Americans and pull all the others along with them. This is exactly what happened in the American century of world-leading prosperity from 1870 to 1970. This is also what Singapore has done for the last 50 years. Today, Singapore’s economy has a manufacturing sector almost twice the size of the U.S., 21% of GDP vs. our 11%. Singapore’s GDP per person was $72,794 last year, 5% higher than in the U.S. Singapore surpassed the U.S. by focusing on carefully-targeted manufacturing industries that could deliver high-wage jobs to a significant share of its population.

It is important to recognize that high wages and high profits are closely related. Both are parts of the 4H principle. The nations that have succeeded in recent decades, like Singapore, South Korea, and Germany, have all recognized that workers and capitalists have shared interests in furthering certain industries. In contrast, incessant left-right political battles in the U.S. distract us from forging a consensus and a new set of non-partisan policies that would allow us to grow our economy and our living standards.

As for economic theory, much of it is today worse than useless. As the great economist Paul Samuelson often said, most economists work for “the applause of their peers.” Dani Rodrik has written that economists win respect “not by being right about the real world but by devising imaginative theoretical twists.”[4] Economists need an extended bath in the ice-cold swimming pool of reality. Until such time, it may be wise to consider banning them from Washington DC, just as in the Middle Ages, citizens of countries known to have the Black Plague were often banned from European capitals.

[1] Rodrik, Dani, The Globalization Paradox: Democracy and the Future of the World Economy, W.W. Norton & Co., 2011, pg. 55.

[2] Gelles, David, The Man Who Broke Capitalism: How Jack Welch Gutted the Heartland and Crushed the Soul of Corporate America, Simon & Schuster, 2022, pg. 46.

[3] Ibid, pg. 227.

[4] Rodrik, Dani, Straight Talk on Trade, Princeton University Press, 2017, pg. 145

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