Why Free Trade is Bad for the US

by John Kontolefa

1. The Good Points for Free Trade

Markets work. For the most part manufactured goods are cheaper now than ever before. Geezers like me have all had the experience of going into an Auto Parts store to buy say, brake rotors, and paying less in dollars than we did 25 years ago. Sporting goods, hand and power tools, even furniture are plentiful and cheap and have led to an age of abundance where the limitations on what many Americans buy is the space available to store things. (The items I mentioned above where specifically chosen as examples of goods where technological changes are not primarily responsible for cost decreases.)

This may partially be a short term result of China's industrialization where the peasant class provides a near inexhaustible supply of cheap labor for capital. Trade is also beginning to have severe impacts on the price of raw materials. However, it seems that while trade affects some segments of society negatively, overall most people benefit. If an asian company is able to import cars for $4K each, it might mean some highly paid auto workers will have to deliver pizza for a living. However, the rest of society (including guys already delivering pizza) would benefit from having almost everybody able to afford a new car.

Of course there is no free lunch. With the US adopting free trade to such an unprecedented extent, we have put our selves not only at the mercy of markets but at the mercy of countries who are organized to exert market power against the US. The case against free trade hinges on negative economic, governance, tax, and security effects.

2. Loss of Sovereignty

We obviously cannot legislate on acceptable means of production if production does not take place in the US. We must go to outside bodies to try to impact activities in foreign lands. Enforcement of agreements can also be problematic. On the other hand, we also expose our producers to foreign influence if they become dependent on outside markets.

An example where we lose influence is the case of trying to reduce dolphin deaths caused by tuna fishing. US tuna fisherman were required to take costly steps to save dolphins. As a result, tuna imports soared. The US tried to block imports of non "dolphin safe" tuna but was blocked by the WTO.

American agricultural producers are kept out of European markets by regulations regarding "genetically modified" food, even though most Americans believe they are safe. Specifically, use of genetically modified grains combined with "no till" weed control promises improved pollution and erosion control but is prevented from wide spread use because of foreign restrictions.

3. Loss of Economic Diversity

The last 40 years as seen an tremendous loss of industrial companies in the US. As an example, the entire machine tool industry has completely evaporated. Household names that used to be synonyms for the equipment they produced like Bridgeport, South Bend, Harding, and Clausing have ceased to exist. They were killed off by foreign competition and loss of market as industries shifted overseas. This loss is really unique. The European industry has shrunk, but places like Finland, Germany, England and Sweden still produce machine tools. The Japanese machine tool industry is doing well, mainly due to proximity to asian markets.

What a total embrace of Free Trade means is that a country will only be able to do what it does better than the rest of the world. If, due to local conditions, widgets are produced best and cheapest in Elbonia, all widgets in the US will come from Elbonia. (See Postscript 1 on the Krugman Nobel Prize.) For the US it appears that the few items that we produce for the rest of the world include AAA rated junk financial instruments (Yeaha! - get the foreigners to give no down payment house loans to Americans!), pharmaceuticals and entertainment. (See Postscript 2 below on the impact of trade and currency policies on the recent financial meltdown.)

This loss of diversity in economic activity makes the US like a one industry town. Any of the few industries that we rely on goes south (like the financial sector) and the US greatly suffers. For example, the US movie industry has had a setback in that digital media is so easy to copy. The industry has completely abandoned the market in Asia where pirate copies comprise greater than 99% of the US movie DVDs in circulation.

Loss of diversity also limits our opportunities for future innovation. Who knows where the next big break through in technology will come from? It may be in the area of metallurgy. Metallurgic processes may be developed to produce future items such as holographic displays or computer processing modules. However, if the metals business has completely died in the US, it means that whatever that innovation is - it won't be developed in the US!

4. National Security

You can't have a military-industrial complex if you have no industry.

With respect to infrastructure in particular, we would be at the mercy of foreign governments and companies should our infrastructure be the subject of any kind of attack. For instance, if terrorists were to attack transformers on the US bulk electric supply system, we would be dependent on foreign companies to ramp up production to replaced the damaged equipment.

5. Dependence on Foreign Markets for Strategic Materials

What is most annoying about the free trade advocates is the tone of inevitability that they apply to their arguments. They say "Those jobs are gone for good..." or "Globalization is an unstoppable force...". In reality, free trade hinges on a set of shaky treaties and agreements that are almost unenforceable, and that countries can back out of or subvert at will.

Many poor countries were told to improve the lot of their poor by opening up their markets to cheaper foreign food producers. With the run up in food prices, some producer countries have limited exports to keep prices low in their own countries. Some importer countries that followed the free traders' advise faced food shortages and unrest when commodity prices spiked.

Right now, hybrid cars are the hot items in the auto market. The US companies are almost completely shut out of the market because they rely on Japanese producers of the high power electronic devices (junction-FETs, thyristors, etc.). These companies are part of Keritsus that also produce cars so they reserve their production capability for their own use. This situation can be traced all they way back to the Nixon administration decision (in the interest of global politics) to allow Japanese companies to dump consumer electronics into the US. Consumer electronics was then a small part of the electronics industry back then . However, when consumer electronics shifted to asia, other parts followed including the industrial electronics segment that produced high power devices for motor drives and other industrial uses. Now, that industry is not available in the US to produce drive electronics for hybrid cars.

6. Trade and the Business Cycle

One reason that anti-free trade arguments have not gained much traction is that trade does not usually result in a direct replacement of jobs. For example, when NAFTA was passed there was no "great sucking sound" caused by companies immediately moving jobs south of the border. (Ross Perot is an idiot.)

The creation and loss of jobs is based on the business cycle. The business cycle is mainly caused by the delays in increasing production to meet changes in demand. When there is a great demand for capital goods to increase production, that sector of the economy expands. When the demand is met it contracts, and typically drags the rest of the economy down.

With free trade in place, during periods of expansion increased demand is met by increasing imports or opening up new production in foreign countries. It is during the down turn in the economy that the US jobs are lost as the more expensive US production is shut down. The relationship between trade and job loss is masked by the fact that jobs are being lost all through the economy.

7. The US Tax Structure and Trade

Most European and many other countries rely on a Value Added Tax (VAT) for a large part of their tax revenues. They way it works is that producers of a good or service keep track of the items they buy to produce a product. The difference between the cost of inputs and the final price is the "value added" which is taxed at some rate. There are deductions, depending on the country, for items such as local taxes, employee benefits, etc. However, in order to re-capture some of the lost revenue for taxes that businesses pay, imports are taxed at the full VAT rate on their full value. In comparison exports are typically not subject to VAT at all.

The US relies on income taxes which basically tax profits. This actually provides an incentive for foreign imports. A foreign company can set up a car assembly factory owned by a US subsidiary. Then by paying inflated costs to the parts factories back home (i.e. to itself) can produce cars with little in country profit and avoid paying taxes in the US. This is referred to as profit shifting.

8. The History of Free Trade in the US

Some Free Trade advocates talk like Free Trade is as American as apple pie and is one reason why the US became such an industrial power house. The truth is actually the opposite. When the US was established, the entire federal budget was paid from an across the board 32% tax on all imported goods. During the Administration of Andrew Jackson, Congress raised the tax to 62%. (As a southerner, Jackson was opposed to the tax increase. However, when he heard that some South Carolina legislators started talking about secession, he threatened to march troops down the Charleston and "personally hang" any secessionist he could get his hands on. They apparently believed him.) If you where to quiz any Confederate soldier as to grievances against the union, the tariffs that forced him to buy shoddy "yankee made" goods would be at the top of his list.

The tax was kept in place through the westward expansion and the build up of industry in the US. Much of the build up was financed by foreigners who built factories in the US because they could not otherwise sell into the expanding US market. It was only after the US was industrialized with many of the industries controlled by robber baron monopolists that free trade was seen as a way to increase business and profits. The biggest pushes for free trade were after the world wars and during the Cold War.

9. What to do

If the US were to immediately cancel all trade agreements and institute the historical level of tariffs (62%) the US economy would probably collapse over night. (This does not even factor in the results of retaliation by trading partners.) What the US can do to restore our industries and provide a level of trade sanity would be as follows:

- Designate certain industries as of strategic importance and institute protective tariffs and subsidies.

- Institute a VAT and eliminate the corporate income tax.

- Institute local sourcing requirements for all governmental, military and infrastructure purchases. Nothing is as crazy as the hoops state and local governments make US suppliers go through (minority set asides, toxic waste reporting, labor rules, etc.) that foreign companies get to avoid by simply noting "N/A- Non-US Company".


1. Krugman Nobel Prize in Economics

Not long after I wrote the above, Princeton Economist and NY Times columnist Paul Krugman won the Nobel Prize for Economics. (Sort of - actually the Economics prize was added only recently and is financed by the Bank of Sweden rather than from the original Nobel endowment.) Reading some of the Times letters and other columnists, you would think that he won it for a vindication of socialist principles. Actually, he won it for work he did studying the export driven "Asian Tiger" economies back in the 80s and 90s. The work was financed by some of the governments of the countries he studied, and was vigorously plied in the halls of Congress by lobbying firms working for the same governments. The gist of it was that production shifted to these countries primarily because the size of their populations resulted in economies of scale. He also stated that even where these companies subsidized exports, industries would still survive in other countries due several factors including the desire of consumers for variety. It was as pro-free trade as anything written by Milton Friedman.

Krugman has been scathingly critical of "Worst President Ever" Bush his entire tenure at the Times - except with respect to trade. He only wrote two columns that I can remember on Bush trade policy. When Bush put in place emergency tariffs on dumped Chinese steel, he railed against the move saying it helped politically connected steel at the expense of other industries and that free trade is always good, as long as there are good social safety nets to catch all the unemployed workers.. When another temporary quota was put in place to protect undergarment manufacturers he stated it was just a sop to workers, globalization had wrought great benefits (especially to his wife's village back in China) and "Who wants to earn a living making bras anyway?"

During the emerging economy financial crises of the 90s (Mexico, Thailand, Indonesia, etc.) his advise to those countries was to not cut government spending but instead to build up reserves in their own banking systems rather than rely on volatile international credit markets. (Good advise - but why not here as well?)

2. Trade Policy and the Financial Meltdown.

By far the biggest economic hoopla since I wrote the above is the melt down of the credit markets. Much of the focus has been on US housing market issues - mainly because of the explosion of shared risk debt instruments and "sub-prime" mortgages. However, the resulting housing bubble has not been restricted to the US but has been even worse in places like Spain, Russia and Poland. This is a strong indication that issues of regulations, governance, "greed", or other hot button political issues are not what "caused" the meltdown.

Probably the most enlightening and fair coverage of the financial crises has been provided, from of all places, NPR's "This American Life" radio series. They provided one episode that focused on the housing mortgage crises, from the viewpoints of all involved - lenders, brokers, financial institutions and home buyers. After the credit crises spread to Wall Street, they did another episode on the companies that packaged the securities, who they sold to (foreigners - many of them with the assumption that all mortgages in the US were backed by the Government were the most enthusiastic buyers of those securities) and the government regulators. These episodes can be downloaded here and here.

To summarize, the "cause" of the explosion in debt, which fueled the creation of all kinds of new instruments for making, packaging and reselling home mortgages (and other loans) was the tremendous increase of liquid capital - i.e. cash savings. According to the statistics cited in the radio programs, between 2000 and 2006 the amount of money in the world saved up and needing a place to be deposited doubled. Banks, portfolio managers, and foreign governments needed somewhere to park all that money and get some kind of return. That is probably the reason why the US has been able to run massive deficits - and not have the kind of inflation that characterized the 60s and 70s. The US Treasury department never had an trouble selling all those Treasury Notes when there were so many new buyers.

Does "Free Trade" factor in to this crises at all? Well I think that there is a good case that bad US Trade Policy was a major contributor, if not the main cause of the financial problems. The "This American Life" story attributed the great increase in world savings to the increase of living standards, mainly in places like Asia and the former Communist Bloc. With increases in earnings, people could save and as a result there was more money to invest. I don't think it is as simple an answer. I don't think the typical worker or even businessman in those countries is saving money in institutions that are in a position to invest in US Mortgage Backed securities. I believe the biggest players in those markets were by far foreign National Banks. As an example, the largest holder after the US Treasury of "Fannie Mae" bonds, at $40B is the Bank of China. It is a fact that countries with export driven economies, such as China and India hoarded dollars to keep their own currencies low. With so many US dollars, where else could they invest but in the US?

Here is where market mechanisms failed to work properly. With the US buying so much more than it sold the rest of the world, what should have happened was that foreigners should have used the money to either buy US Goods and Services or their own currencies. With so many dollars, since they weren't buying US Goods (i.e. there was always a big trade deficit) the price of their own currencies in relation to dollars would go up. That would cause foreign goods to cost more and be less attractive in the US market until the value of goods imported is the same as goods and services exported. What happened instead was the foreign governments build up huge reserves of dollars to keep their goods cheap in the US. (Free marketeers would call this good for the US - foreigners subsidizing US consumption.) What's worse was the positive feedback effect of sending those dollars into US investment markets. More credit stimulated more consumption, which stimulated more imports, and so on.

Foreign countries couldn't be expected to accumulate dollars forever, and here is where their activities further contributed to the collapse. Foreign governments not only stopped hoarding dollars but started expenditures to increase living standards and improve infrastructure. First, the US economy not had to weather a cut of of credit infusion as governments stopped hoarding dollars. This alone probably caused the housing bubble to burst. In addition, with all the expenditures and the fall of the US dollar - commodity prices started to go through the roof. (Remember $167/barrel oil?)

Where will it end? Forty years of Free Trade has wrought tremendous changes to the US and world economies. I doubt the economic problems can fixed by a bailout or a revision of banking regulations.