Economists aren't finding easy answers for the new era of free trade

The challenge for the economics profession is to find a way to reduce payment imbalances without resorting to unbridled protectionism that would invite retaliation.

One area in which economists typically speak with one voice is international trade. They have been staunch advocates of free trade dating back to Adam Smith and David Ricardo.

Throughout the post-war era, their guiding principle has been that the gains from trade outweigh the costs. But some prominent economists are reconsidering this premise in light of problems that arose after developing economies liberalized their trading systems and became integrated into the global economy.

According to economic historian Douglas Irwin, the period of 1985-1995 achieved “the greatest reduction in global trade barriers in world history.” During that span, developing countries in Latin America and South Asia slashed import restrictions. The collapse of communism led Eastern European countries to integrate with Western Europe, and China and Vietnam opened their economies to the world.  

Irwin’s take is that the principal factor behind this shift was the influence of economists in high-ranking policy positions who viewed import restrictions and overvalued exchange rates as impeding economic development.

One unforeseen development was the Asian financial crisis in 1997-1998 that resulted in China and other Asian countries stockpiling dollar reserves. As massive amounts of capital flowed into the U.S. from official sources, the U.S. ran record current account deficits in the ensuing decade when China joined the World Trade Organization. Ben Bernanke referred to it as a “Global Savings Glut.”

Robert Aliber, emeritus professor of international economics and finance at the University of Chicago’s Graduate School of Business, has long been critical of China and other countries that run persistent large current account surpluses. In an interview a decade ago, he argued that these countries had adopted “predatory trading and currency policies” by maintaining high levels of tariffs and low values for their currencies. He saw these practices as contributing to substantial job losses in U.S. manufacturing.

Aliber contended the solution was an orderly reduction in China’s bilateral trade surplus with the U.S. The instruments to achieve this included appreciating China's currency, reducing China’s import tariffs and requiring China to source more of its supplies from U.S. firms. Absent a satisfactory agreement, he favored imposing duties of 10 percent on imports from China, which would be increased until the trade surplus declined.

A criticism of those who favor “fair trade” is that free trade advocates are primarily concerned with economic efficiency rather than social justice. Nobel laureate Angus Deaton of Princeton writes in a recent commentary for the International Monetary Fund “When efficiency comes with upward wealth redistribution, [economists'] recommendations frequently become little more than a license for plunder.”

Deaton is more skeptical of the benefits of free trade to American workers than he was before, in light of what has happened to blue-collar workers. While economic theory asserts that workers who lose their jobs can be compensated by those who gain from trade, Deaton observes that this redistribution never happens in practice.

A study by David Autor, David Dorn and Gordon Hansen titled “China Shock: The Final Chapter” provides support for Aliber and Deaton's views. It found that trade with China eliminated about 1.5 million U.S. manufacturing jobs, or about one-quarter of all manufacturing jobs lost between 1990 and 2007. These losses were heavily concentrated in small- and medium-sized communities in America’s heartland, and workers who were displaced struggled to find other work.

A follow-up study for the period from 2000 to 2019 concluded that the China shock was basically over by 2010. Yet American communities never recovered from the evisceration of their industries. The reason: Politicians on both sides failed to create effective policies to help workers cope with their pain through trade adjustment assistance and job retraining programs.

More recently, national security considerations have taken precedence over economic considerations in setting trade policy. In a 2023 speech, National Security Advisor Jake Sullivan argued that the “Washington consensus” that favored free trade and globalization should be replaced with a new consensus that “invests in the sources of our own economic and technological strength.”  

Industrial policy has been the basis for the Biden administration to keep in place duties that Donald Trump initiated in 2018-2019, as well as to supplement them with additional duties on Chinese EVs and lithium batteries.

Mario Draghi, former head of the European Central Bank, said that Europe also needed to develop an industrial policy of its own in a recent speech. The goal would be to increase EU productivity by making research and innovation a collective priority and creating incentives to close an investment gap of more than $293 billion a year. Draghi believes the EU should also press China to play by global trading rules, and, failing that, should not be afraid of imposing tariffs and using subsidies of its own.

Finally, while some economists are receptive to using tariffs to tackle trade disputes, it is not apparent that increased duties will achieve their objectives. Paul Krugman contends that the dirty little secret is tariffs of 10 percent have relatively little impact on the U.S. economy.

Donald Trump took even stronger action against China in 2018 and 2019 when he increased tariffs on Chinese goods by 25 percent. Yet, these actions did not have the intended effect partly because China did not honor its pledge to increase imports from the U.S. by $200 billion.

Consequently, Trump is now threatening to boost tariffs on Chinese goods by 60 percent, as well as to increase duties on Chinese goods shipped through Mexico. Accordingly, we could find out what effect more substantial trade barriers would have if Trump is elected president.

The challenge for the economics profession, therefore, is to find a way to reduce payment imbalances without resorting to unbridled protectionism that would invite retaliation.

Nicholas Sargen, Ph.D., is an economic consultant for Fort Washington Investment Advisors and is affiliated with the University of Virginia’s Darden School of Business. He has authored three books including "Global Shocks: An Investment Guide for Turbulent Markets."