Free Trade vs. Balanced Trade

During the 2016 presidential campaign, trade has become a major economic and voting issue. For decades both political parties, in general, and Hillary Clinton in particular, have supported expansion of free trade through trade agreements that reduce tariff rates. In contrast, Donald Trump has upended that politics, seizing the Republican nomination with the promise to renegotiate trade agreements so that they balance trade.

As a result, the two alternatives in this year’s election are free trade vs. balanced trade. These are not necessary mutually exclusive. Indeed, there have been periods of world history in which trade has grown more free without getting out of balance. Especially notable were the 1840-1870 and the 1950-1997 periods. Those were the two golden ages of globalization in which tariff reductions around the world greatly benefited and integrated the world economy.

But the 1840-1870 period was followed by a period, much like the present, in which world trade became more and more unbalanced. The European countries were experiencing worsening trade deficits and eventually had to choose between free trade and balanced trade. Those that chose to balance their trade through tariffs resumed their economic growth, while those that stuck with free trade continued to stagnate. The United States faces a similar choice today.

The U.S. economic growth rate has followed the U.S. trade balance downward, as shown in the following graph:

The slow U.S. economic growth rate of the last 17 years is unprecedented. From 1999 through 2015, the average U.S. growth rate was just 2.1% per year, as compared with over 3% for almost every ten-year period during the previous five decades. And the first two quarters of 2016 (not shown on the chart) have been even lower -- just 0.8% and 1.1% growth. There are six primary reasons why trade deficits slow economic growth:

  1. They subtract from demand for American products. The negative trade balances since 1976, shown in blue in the graph above, have directly subtracted from each year’s GDP.
  2. Loss of manufacturing jobs. When imports exceed exports, there is a net loss of manufacturing jobs.
  3. Less investment in new factories. When foreign central banks manipulate exchange rates to keep the dollar’s exchange rate high and their exchange rates low, they reduce incentives to invest in American factories. 
  4. Less technological development. R&D is often related to current production and therefore needs to be near to factories. Also, “learning by doing” occurs in factories.
  5. Loss of economies of scale. As we lose factories, we lose economies of scale.
  6. Slower recoveries. Any stimulus leaks abroad as larger trade deficits.

The burden of the slower economic growth has fallen disproportionately upon America’s blue-collar middle class. They have lost highly-productive manufacturing jobs and have been forced to take less lucrative jobs in the service sector. This is a major reason why median U.S. family income, after subtracting for inflation, is lower today than it was in 1999.

The Problem of Mercantilism

Most of the problems of international trade are related to the fact that a number of countries have been running chronic trade surpluses which cause chronic trade deficits among their trading partners. They are following the mercantilist prescription of running trade surpluses in order to grow their economies more rapidly.

Almost all economists have decried mercantilism. For example, Adam Smith, the founder of modern economics called it a policy of “beggaring all their neighbors,” because mercantilists intend to grow at their trading partners’ expense.

The problem is that mercantilism works if trading partners tolerate it, as John Maynard Keynes, the founder of modern macro-economics pointed out in the chapter about mercantilism in his 1936 magnum opus The General Theory of Employment, Interest and Money:

[A] favorable [trade] balance, provided it is not too large, will prove extremely stimulating; whilst an unfavorable balance may soon produce a state of persistent depression. (p. 338)

China and several other Asian countries have successfully grown their economies at U.S. expense by following the classic recipe for mercantilism as laid out by University of Chicago economist Jacob Viner in 1948 and Chinese economist Heng-fu Zou in 1997.

Mercantilism gives faster economic growth and increased political power to the trade surplus countries, but gives trade deficits, slower economic growth, and reduced political power to their trade-deficit victims. The correlation between trade balances and changes in political power are striking, as we demonstrated statistically in a recent conference paper.

Unfortunately, the majority of the American economic profession has completely ignored the growing research about the destructive nature of chronic trade deficits and about ways to combat them. For example, in their popular international economics textbooks, now in their tenth and eleventh editions, Paul Krugman (with his co-authors) and Dominick Salvatore never consider the causes of chronic trade deficits, and never offer remedies to those trade deficits.

The Business Economists

Fortunately, there are a growing number of respected economists who have been addressing the problem. Most are business economists, and thus in close touch with business managers and the problems that they are facing.

One is Prof. Ralph Gomory, Research Professor at the Stern School of Business of New York University and former Director of Research at IBM. He now supports a system of import certificates to balance trade.

Another is Prof. Peter Morici at the Robert H. Smith School of Business of the University of Maryland and former director of the Office of Economics at the U.S. International Trade Commission. He now supports a dollar-yuan conversion tax that would be applied to Chinese imports into the United States at a rate that would be adjusted to the rate of Chinese currency market interventions.

Yet another is Donald Trump’s chief economic advisor, Prof. Peter Navarro at the Paul Merage School of Business of the University of California-Irvine. In his 2015 book Crouching Tiger he opposed Chinese currency manipulation and advocated countervailing duties against Chinese products.

In Navarro’s 2011 book Death by China, co-authored with Chinese dissident Greg Autry, he noted that China is singly responsible for about half of the total U.S. trade deficit and a half percent reduction in the U.S. growth rate. His estimate is in line with our own estimate, based upon the above graph, that current U.S. trade deficits are cutting the annual U.S. growth rate by about 1%. Specifically, he wrote:

As for the actual impact our Chinese import dependence has had on America’s growth and unemployment rates, this, too, is mind-boggling. Over the past decade, our trade deficit with China has typically shaved off close to a half a point of GDP growth a year. While that might not seem like a large sum, it translates into a cumulative impact of millions of jobs that the American economy failed to create. (p. 69)

The U.S. trade deficits have become an important political issue. The choice this election is between free trade and balanced trade. Trump, a businessman, and his chief economic advisor, a respected business economist, have put together a plan to balance trade.

If they succeed, they will significantly increase the U.S. annual economic growth rate, restore the blue-collar middle class, and begin the process of restoring U.S. economic and political power. If Hillary Clinton wins, the American economic decline, shown in red in the above graph, will likely continue.

Professor Emeritus Raymond Richman’s economics doctorate is from the University of Chicago. The Richmans co-authored the 2014 book Balanced Trade published by Lexington Books, and the 2008 book Trading Away Our Future published by Ideal Taxes Association.