America's Flawed, Outdated, Trade Policy

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Over the last several decades, the character of international trade has changed dramatically. Drastic advances in communication and information technologies have allowed businesses to slice the production process into pieces which are then located in their most efficient locations. Supply chains are formed that stretch across the globe, and individual parts, components, and even tasks, are traded from one country to another within these chains.

In his State of the Union Address, President Obama condemned this practice, saying, "It's time to stop rewarding businesses that ship jobs overseas, and start rewarding companies that create jobs right here in America." More specifically, he wants to conduct industrial targeting, namely he will favor American companies, the manufacturing industry, and particularly high-tech manufacturing.

First, it makes no sense to favor American companies over foreign companies. These are the types of policies that will drive plants for Toyota, BMW, Hyundai, Volkswagen, and Honda out of the American South.

Second, punishing companies for locating segments of the production chain in other countries makes those industries less efficient. This point requires a brief invocation of trade theory.

In 1817, David Ricardo noted that England could produce cloth quite efficiently, and Portugal was an adept producer of wine. Ricardo argued that each country could consume more of each if it specialized in its respective strong suit and traded. The case for free trade was born.

Ricardo's ideas still apply to a world of global supply chains, but our policy-makers do not seem to understand. Consider an alternative history where England specializes in oranges instead of cloth, the Portuguese still all become vintners, and the two nations trade. Each nation ends up with more oranges and wine, which the tired workers promptly mix together and down as sangria.

Trade in parts, oranges and wine, allowed each country to consume more of the final product -- sangria. While this example has not made it into the textbooks yet, it is extremely relevant in today's world. It means that punishing industries for taking part in global supply chains will make them less competitive.

Third, targeting industries for special treatment, like high-tech manufacturing, relies on outdated arguments for industrial policy. Some prominent economists from the 20th century, including Alfred Marshall and Paul Krugman, built a case for government protection or subsidy of key industries. Although intellectually defensible at the time, it has been largely undermined by the growth of supply chains.

The argument for industrial subsidies was based on the reality that some industries tend to cluster geographically. These clusters occur when industries share workers or inputs, or because knowledge spillovers occur between firms. Hollywood shares actors, Manhattan banks share securities lawyers, and tech geeks from different firms gather in Palo Alto bars to discuss CPUs, SEO, jar, and Python over beers. When an industry clusters for these reasons, economies of scale are created, and twice as many products can be produced for less than twice the money.

Moreover, these clusters can be quite arbitrary and dependent on historical whim. In 1541, John Calvin banned jewelry in Switzerland. As a result, Swiss jewelers started making watches, and they are still at it nearly 500 years later.

Could another country have been a more efficient watch capital? In the past, even if it could have, the industry would most likely not have moved. Since the economies of scale only work when the industry grows large, a bank would have had to finance the move of an entire industry to a new location and wait to reap future financial rewards. There's not a bank big enough.

Those who would advocate for an industrial policy of government intervention -- through subsidies or import protection -- presume that banks would be incapable of financing the relocation of an industry. However, studies of industrial policy throughout history have found few successes. The main reason for failure seems to be that policy-makers just pick the wrong industries. They misapply the theory, pander to special interests, or lack the technical know-how to identify the industries that form cluster based on economies of scale. Krugman also has recognized these difficulties.

Globalized supply chains make the hard task of picking industries to support near impossible. Industrial clusters are becoming less prominent and less valuable. As business coordination costs fall due to improved communication technologies, the sub industries, like the manufacture of parts and components, are separating geographically from the headquarters, R&D, and distribution. A hollowed-out industry is not worth as large of a subsidy, and the proper industries to target will be harder to identify.

What's more, as industries break down into their sub-industries, it is more likely that a new firm will play a larger role in a sub-industry. Specialized workers and inputs will cluster around that firm, and knowledge spillovers will begin to occur across departments. While no bank is big enough to move an entire industry to a more efficient location, it might be able to move a sub-industry. Where capital markets work, governments should not meddle.

No one can predict the future. The next communication or transportation revolutions will likely change the world as much as the internet revolution has, and policy-makers should not waste money predicting which industries will be valuable, and which will still cluster.

The policies that President Obama outlined in his State of the Union Address undermine the strength of America's economy, and are the wrong way to react to the changing nature of trade. Action is necessary, but it should focus on preparing future generations to compete in a global marketplace through education reform and retraining current workers who lose their jobs due to trade. The best policy advice is always to put the band aid where the cut is.



Matthew Jensen is an economic researcher at the American Enterprise Institute (AEI). 

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