Ajit Ranade: The decline of trade orthodoxy and rise of anti-free-traders

The textbook economic answer is the importing country, despite its consistent trade deficit. This is because the consumption level of the importing country exceeds its productive capacity. Hence living standards are higher. Country A is not living beyond its means because it pays for the deficit with funds from abroad.

That country A has been America for more than four decades, it being the world’s largest importer. Country B was Japan in the 1980s and then China took over that role.

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What is illustrated in this simple two-country model can be reasonably extended to the more complex real world with multiple countries and a multitude of bilateral trade relations.

In the real world, all trade deficits are wiped out by surpluses in the aggregate. If country A has had a permanent trade deficit, who is funding that shortfall? That deficit is funded by finance pouring in from other countries. Or capital inflows. In a world with open economic borders, a trade deficit is identical to capital inflows at the individual country level.

In the case of America, its trade deficit is a structural problem and not due to low tariffs (till recently). It is also the flip side of the tremendous faith of global investors who have been pouring capital into the US. In recent times, much of its inbound capital has been funding its fiscal deficit, not necessarily new productive capacity. The Chinese pile of $4 trillion in accumulated dollar reserves has a large portion of US Treasury bonds. How China will ever encash that large pile of wealth in the midst of a geopolitical clash is anybody’s guess. What if the US decides to unilaterally devalue its foreign obligations? Or repudiate part of its foreign debt?

These were unthinkable situations, but in unprecedented times, such actions cannot be ruled out. The confiscation of Russian dollar assets as punishment for Russia’s invasion of Ukraine has already set a precedent. Many of the top foreign-exchange holders have started diversifying away from dollar assets into euro assets or gold. China is helping some dollar-indebted countries by paying off their debt in exchange for geopolitical leverage.

Back to the example of a country with a structural trade deficit. What did orthodox trade theorists say? When Milton Friedman was asked what America should do to exporting countries that subsidize exports to the US, he said it should send them a ‘thank you’ note.

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He was a strong proponent of unilateral tariff reduction and free trade. That is why economists trained in the free trade tradition never fully understood the need for anti-dumping duties against countries that export goods below their cost of production. If they are hurting themselves, and suffering a loss, why should an importer care? The importing country benefits from cheaper imports, higher quality and low inflation.

Friedman’s view was the orthodoxy that even his opponents like Paul Krugman concurred with. Economists of this tribe, including prominent names and Nobel laureates, were against tit-for-tat tariffs. Reciprocal tariffs were a bad idea among orthodox economists. Even the socially left-leaning anti-free-trader Joan Robinson said that just because your destination countries have rocky harbours (high tariffs), it does not mean that you throw rocks into your own harbour (i.e., raise your own tariffs).

But this orthodoxy has been in decline. The great Paul Samuelson, shortly before his death said that trade theory based on comparative advantage has limitations. This was based on the observation that China’s advantage of low-cost labour had evolved into an edge on high-end services and technology too.

Thus, the static theory of trade fails in a dynamic setting over time. The importing country erodes its manufacturing base, which then needs regeneration. This is the Trump strategy of reverting to protectionism.

The case against free trade was strongly articulated by left- wing economists and environmentalists Herman Daly, Ralph Nader and others back in 1993. But their objection was mainly based on their opposition to corporate interests, which they argued would maraud the environment and labour rights. Hence, they fiercely opposed the North American Free Trade Agreement between the US, Mexico and Canada. Their opposition found expression in the environmental safeguards and labour standards codified when the World Trade Organization (WTO) was born in 1995.

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The Trump regime’s opposition to free trade is not based on environmental concerns, but driven by the Chinese export juggernaut. The US contends that China abused the WTO system, did not respect intellectual property rights and indulged in currency manipulation, leading to America’s manufacturing sector getting hollowed out. This view has gained acceptance with the American public and even some economists who were once wedded to the earlier dogma.

As Oren Cass of Financial Times writes, “The collapse of the intellectual case for free trade, unfolding before us all in real time, reflects one of the most dramatic failures of elite consensus in decades." However, we have to be careful not to abandon the first principle of trade economics. The insights of Adam Smith and David Ricardo still hold. We just need to redesign the world trading system to reflect today’s geopolitical reality.

The author is Senior Fellow with Pune International Centre.