This time it's (really not) different, Part I.

A trade deficit does not mean you are losing!

My dissertation predicted it.

I’ve been wanting to discuss these thoughts ever since I first wrote them in my university dissertation in 2010. My dissertation was about how the ‘pinnacle’ of economic theory was arguably Adam Smith’s Wealth of Nations in 1776. As well as being quite the work of philosophy, it also extoled the virtues of free international trade, not protectionist measures aimed at driving exports and limiting imports. And this new free trade mentality seemed to underlay the field of economics ever since.

Even though periodically, there were strong movements back to protectionism, every time, they were either reversed in later years due to the damage they inflicted, or failed to get enacted in the first place.

Every protectionist period thought ‘this time is different’. This time we don’t have to follow the ancient wisdom of Adam Smith’s free trade theory because circumstances are different now. Free trade doesn’t work anymore.

Well, circumstances have indeed changed a lot since 1776. Specifically, my dissertation looked at three periods since 1776 where protectionism made a resurgence in light of such changes, and the academics behind them:

·         Thomas Robert Malthus and the early 19^th Century ‘Corn Laws’ in Britain;

·         William James Ashley and the desire to protect manufacturing and other staple British industries in the late 19^th and early 20^th century; and

·         John Maynard Keynes in the interwar period and the Great Depression global protectionist movement.

But the overriding superiority of free trade compared to protectionism always seemed to eventually win out.

That was the focus of my dissertation. And I’ve wanted to discuss it openly ever since, but it never seemed particularly relevant to current events. And I thought it never would be, because I was sure the world had learnt its lessons from the trade wars of the past.

Silly me.

Well now, it’s very relevant. Only this time, it is Trump and Co. who believe ‘this time is different’. That ‘trade wars are good and easy to win’. That protectionism is once again the way to go.

So let’s take a walk through history.

Adam Smith discredited Mercantilism almost 250 years ago.

Let’s start with Trump’s constant claims that the US is ‘losing’ because of its massive trade deficits with China, supposedly justifying tariffs. The man is almost 250 years out of date!

The ‘Mercantilist’ school of thought used to believe trade is a zero-sum game of who can export the most and import the least. Historically, when countries operated on the Gold Standard of exchange rates, such policy resulted in trade surpluses and the accumulation of precious metals (gold). Now, running trade surpluses means accumulating the foreign currency that was used to pay for your country’s exports. So mercantilists argued that tariffs on imports could help achieve this end – hence the common use of tariffs before 1776.

But trade is not a zero-sum game and need not involve these kind of ‘beggar-thy-neighbour’ policies that often resulted in trade wars.

In fact, this Mercantilist view was discredited by Adam Smith’s Wealth of Nations in 1776! According to Smith, a country’s wealth is not based on its accumulation of precious metals, it’s based on its social division of labour – it’s ability to specialise in the activities in which it has a comparative advantage (a process facilitated by trade, not hindered). Both sides of trade benefits from the transaction, not just the exporter. This means that even a country that has an absolute advantage in every industry would still benefit from trade by specialising in the industries in which it has a comparative advantage – the things at which it is most superior.

Trump seems to think that the US importing from China represents a ‘loss’ for the US.

But Smith dismissed “the notion that imports are paid for by money which might otherwise be spent at home [as] the crudest of all popular fallacies” because if it were true, “Ireland … would long ago have been completely denuded of money [and] England must have spent its whole currency twice in six years without anyone’s noticing.”

This is not how trade works, Mr Trump!

Even before Adam Smith, the idea of trade as a zero-sum game was under threat.

In fact, even before Adam Smith, Thomas Mun (1571-1641), as Director of the East India Company, was accused of undermining Britain’s prosperity by exporting gold to acquire cheaper foreign raw materials. But Mun saw the advantage of being able to use these cheap raw materials domestically to create elaborately transformed manufacturers that could be then sold for far more (and would employ a great number more hands) than could be achieved by simply exporting raw materials and reducing imports. And while he used this as a reason to argue in favour of protectionism for the manufacturing industry, and still supported the running of trade surpluses, it does represent a progression away from the zero-sum game of simply exporting more than importing. It represents a move towards exporting, importing and domestic production, of producing things more valuable than their inputs, regardless of where they were sold – over 100 years before Adam Smith.

David Hume’s (1711-76) Quantity Theory of Money also postulated than money is neutral in the long term, so a country’s wealth is not based on the accumulation of precious metals or currency, but in the quantity of goods and services and labour in the economy.

“Money is one of the wheels of trade … [but is irrelevant in the long run because] prices of commodities are always proportioned to the plenty of money”.

Therefore, the inflow of money resulting from a trade surplus would drive inflation (or the exchange rate if the country weren’t operating on a fixed [Gold Standard] exchange rate), reducing the country’s competitiveness, causing any surplus to naturally decline over time (see my previous blog about the inconsistency of Mercantilism and the Gold Standard). So if tariffs can’t maintain a trade surplus indefinitely because of the neutrality of money, free trade is preferable.

Hume also saw the potential for poorer countries to benefit from trade with wealthier countries via a “catch-up” or convergence effect due to the lower prices and wages that were generally inherent in poorer countries.

“Nature, by giving a diversity of geniuses, climates and soils, to different nations, has secured their natural intercourse and commerce”.

I know Trump is only interested in “America First”, but it’s worth noting the damage that a trade war can inflict on poorer countries.

So by the time we got to Adam Smith’s Wealth of Nations, trade was no longer seen as a zero-sum game. ‘Stealing’ from other countries by manipulating gold/currency flows with beggar-thy-neighbour trade policies was no longer seen as the optimal way to drive a country’s wealth. All countries could benefit from trade. Tariffs were in fact a hindrance.

Trade deficits do not represent ‘losing’.

A trade deficit with China simply means the US is buying stuff from China and selling its stuff elsewhere. China doesn’t have to buy the US’s stuff just because the US buys China’s stuff. That’s not how trade works. Should I get upset when I buy a burger from the corner store, just because the corner store didn’t buy something from me in return? Should this ‘trade deficit’ with the corner store make me angry? Of course not. Because that’s not how trade works. I’m exchanging the store’s burgers for my money, not my economics advice. This isn’t a bartering economy.

And even if you’re running a trade deficit with the entire world, it could just mean that your country has a lot of good investments locally in which the rest of the world is investing, and that trade deficit is largely returns on those investments paid to those foreign investors. You’re not losing! That is just international finance, and its actually facilitating your country’s wealth, not hindering it.

Paul Krugman argues there is one time when a trade deficit can be a bad thing – when there is mass unemployment, and the country really needs a lower exchange rate for exports to rise and imports to fall, thereby driving economic activity – like during the GFC, when the US claimed that China’s undervalued currency was stealing away part of the US’s recovery. But the US is near full employment now, and China is no longer undervaluing its currency (it actually had to be devalued a couple of times in recent years because it was overvalued), so the trade deficit is not a problem.

Once again, the US is not ‘losing’ just because it buys more from China than China buys from the US.

You can argue that China does not always play by the rules of international trade. Intellectual property laws are something that they arguably openly flout. But the way to deal with this is for the US to form a coalition of other countries to put pressure on China to play nicer. We could call it … a Trans Pacific Partnership, or TPP for short. Yes, that was a joke about how the TPP Trump abandoned was in fact designed to do just this – it was a trade deal that focused significantly on intellectual property rights, rather than actual trade of goods and services. The US had helped write a significant amount of provisions to this end, but as soon as Trump left the TPP, these provisions were largely dropped. This would have been the perfect way to get China on board, not unilaterally punishing them with steel and aluminium tariffs, in spite of the fact that China isn’t even a top-10 steel exporter to the US.

A trade deficit does not mean you are losing. And this kind of economic illiteracy at the highest levels of the largest economy on the planet has implications for us all.