The 2018 Nobel Prize in economics has been awarded to William D. Nordhaus and Paul Romer. At a time when free trade has been maligned by some leaders, these economists’ observations on trade policy should be required reading for U.S. policymakers. Their views reaffirm the benefits of free trade, as noted in an NTU letter that was signed by over 1,000 economists, including 15 previous Nobel laureates.
People often use these national comparisons as if it’s a race where there’s winners and losers. I often tell my students, “Any time you’re thinking about rivalry between countries, reframe the question as rivalry between states in the United States.”
Would it upset us if we lived in Illinois and Intel was making microprocessors in California? Is it bad for us that Intel develops microprocessors? Of course not. We’re glad they make them and we’re happy to use them. We get the benefits from using them. Does it make people in Illinois any worse off if people in California grow richer or develop new technology? Absolutely not. People in Illinois are better off being able to trade with California and people in California are better off being able to trade with people in Illinois and New York and the rest of the country.
So this notion that there’s a kind of a rivalry with winners and losers when we think about nations, it’s really very misleading about the underlying economics. This, by the way, was one of the advantages the United States had in the early part of the twentieth century. We were already a big free trading block when a lot of the world was still relatively closed.
The most fundamental point is that trade – whether domestic or international – is mutually beneficial. The basic analysis was developed exactly 200 years ago by David Ricardo in his theory of comparative advantage (Ricardo 1817). Ricardo used the examples of Portuguese wine and English cloth. Today, the examples have changed but the principles are the same. By specialising in the production and export of goods that countries make relatively cheaply, and importing and consuming goods that the country makes relatively expensively, each country can improve its living standards.
If you look at a worker in a Nike factory in Vietnam, that worker is worse off and has a lower quality of life than a worker in the United States. That feels wrong to many of us, and that’s a reasonable kind of moral or ethical response. It’s sad that there are people who live lives that aren’t as nice as ours, but that’s not the question here.
The question is, did Nike’s coming in make the life of that person better off or worse off? The unambiguous answer is that Nike coming in really helps that person and helps many other people in that country.
Two hundred years ago, in the days of David Ricardo, it was largely true that goods were ‘made’ in one place. Such was standard during the ‘first wave of globalisation’, as has been described in the remarkable book on globalisation by Richard Baldwin (2016). Today, we have moved to the second wave. As with the iPhone … the production processes for cars, air conditioners, and airplanes have been sliced up very finely among different producers thanks to revolutionary declines in transport and communications costs. We live in the era of highly specialised global supply chains, which involve the increasingly intensive cross-border flows of goods, technology, investment, services, and workers.
If we trade with the entire world and we can take advantage of any new drug discovery anywhere in the world, we’re much more likely to come up with, say, a treatment for Alzheimer’s or some really valuable good than if we have to discover it ourselves. As more and more people are engaged in discovery, the odds of any particular discovery or the odds of valuable discoveries go up.
So we’d really do ourselves a disservice if we cut ourselves off and said, “Okay, California is big enough to trade with. We don’t need to trade with the rest of the world,” or “The United States is big enough to trade with. We don’t need to trade with the rest of the world.” But already important things are being discovered in other parts of the world, and we can take advantage of those if we engage in trade with people who discover those things.
An interesting example of the way foreigners save in the U.S. is the accumulation of dollar reserves by foreign central banks. These nest eggs (totalling $6 trillion owed by the US to foreign official agencies) are held by foreigners to protect against speculative attacks on their currencies. But the result of this accumulation of dollars by foreigners is that the exchange value of the dollar is higher and the US tends to run a larger trade deficit.
Another source of financial flows into the US is a portfolio effect. Foreigners own about $10 trillion of US debt securities. Just for simplicity of exposition, suppose this is a constant 10% of foreign portfolios. If the portfolios are growing at 3% a year, then foreigners will need to buy $300 billion of US debt each year to maintain the 10% share. This would have to be offset by a trade deficit.
Hence, the paradox is that the US trade deficit is big because its financial markets are so attractive, not because of lousy trade deals.