Why Free Trade Doesn’t Work: an Allegory

Pocket

by Spencer P Morrison, NEE
free trade doesn't work, the baguette shop, an allegory

The Baguette Shop, or an economic parable on asymmetrical competition

You own an artisanal bakery that makes the best $2 baguettes in town—business is booming.  In fact, business is so good that a German bakery opens up across the street.  You’re not worried: their $3 baguettes are good, but not that good.  You’re sure you’ll be able to out-compete them in good ol’ American fashion—and let’s be honest, who’s ever heard of a German baguette?
A month later you notice that baguette sales are down.  Why, you ask?  You walk across the street to compare sales with the German bakery, and you see a sign: “Baguettes Now $1”.  How could they possibly afford to make such cheap baguettes?  You speak to the lederhosen-clad owner.  He tells you that the government is paying for his flour—that’s why his baguettes only cost $1.  “That’s not fair!” you exclaim.  “What can I say?” comes the reply.
 
A few more months pass.  Baguette sales are down, and you’ve done everything you can to cut costs: you’ve switched flour providers, you’ve fired staff, and you’re working longer hours.  But the cheapest baguette you can bake still costs $1.50—it’s cheap, but not that cheap.  No matter what you do, you cannot compete with the German bakery.  Uncle Sam’s pockets are too deep.  Reluctantly, you close shop.
A few months later you’re buying a baguette at the German bakery.  You see a sign: “Baguette’s Now $3.”  Excuse me, what happened to the cheap baguettes?  The owner says that since there’s no competition, he can raise prices and make big profits.
Later that night you tell your family what happened over dinner.  Your son, who’s studying economics at Harvard, advises you to reopen your bakery.  You wince—as if you hadn’t thought of that.  “I can’t,” you say, “I don’t have enough savings to reopen the bakery.  It’s too expensive to start from scratch.”
Your son smiles: “that’s the free market, Pa.  It’s for the best.”

the butcher, the baker, the state-backed German candlestick maker

Like all good stories, this one has a moral—and no, it’s not something trite like the government should not pick winners and losers.  In fact, it’s precisely the opposite: the American government has an economic, political, and moral duty to ensure American businesses triumph over their foreign rivals.
In our story, you represent America’s businesses, who produce high quality goods at reasonable prices—the best $2 baguettes in town, as well as the best cars, computers, and airplanes.  In fact, data from the Brookings Institute shows that America’s advanced industries (eg. aeronautics, pharmaceuticals, and information technologies) are the second most productive on earth, behind only Norway’s.  Even better news: America’s advanced industries are fully 50 to 70 percent more efficient than their primary competitors in Western Europe.
America makes the best stuff at the best price.
A digression: I focus on advanced industries because of the Pareto Principle.  Also known as the 80:20 Rule, Pareto stands for the idea that a minority of the input often causes the majority of the output—the relationship between cause and effect in a complex system is non-linear.  This is true when it comes to economic growth.  Consider that the majority of America’s economic growth over the last three decades either (i) occurred in America’s advanced industries, or was (ii) caused by spillover effects from said industries (for example, better computing technologies from IBM and Cisco improved productivity in grocery stores and gravel pits).  Because they generate new technology, advanced industries are the true engines of economic growth.
 
Back to our story.  You bake the best $2 baguette, while the German bakery can only make an equivalent baguette for $3.  In a fair world, you would outcompete the German bakery, and steal their customers.  But life’s not fair.  Uncle Sam stepped in and bought the German baker’s flour, so that he could make baguettes for $1.  The government tipped the scales, making it impossible for you to compete.  As a result, you were forced to close shop.
This is essentially what happens when America trades with foreign nations: American businesses compete with foreign, government-subsidized businesses, and our businesses inevitably lose—regardless of whether or not they were more efficient or produced better products.  Remember, efficient American factories are the ones moving to China, not relatively inefficient German factories.  Likewise, American, not Japanese, IT firms are moving to India.
Asymmetrical trade kills American businesses and makes us poor.  Consider that Chinese firms can operate in America, but American firms cannot generally operate in China.  Those American firms that are granted market access can only do so by entering into joint-ownership or profit-sharing agreements with Chinese entities.
This is exceedingly common in the IT industry, where American technology companies trade technology for access to Chinese consumers—only to face insurmountable competition from Chinese copy-cat companies months later.  Tied to this is the fact that Chinese companies (with the government’s tacit blessing), steal over $500 billion worth of American intellectual property every year.Bobbins, Not Gold- book on mercantilism and economic growth by Spencer P Morrison
How can American businesses compete against China’s monolithic government?  They can’t.  Nor can they compete with Germany’s feudal-industrial system, nor Japan’s keiretsus.  Those who demand free international trade must recognize that tariffs are not the only impediment—different legal structures and business models preclude free trade, and guarantee that “free traders” will get screwed.
This is axiomatic, and it explains why all successful historical economies adopted economic nationalism, as opposed to liberalism, as their modus operandi.
In fact, history shows us that any time a nation embraced free trade as its policy, said nation was plundered by foreign nations.  For example, free-trading Britain was flooded with artificially cheap German goods at the end of the nineteenth century.  This undermined British businesses, and deprived them of the capital they needed to expand.  British industry starved, economic growth plummeted, unemployment increased, and Britain lost her status as the first among nations.  What is currently happening to America is eerily similar, and it’s no mere coincidence.
In the end, President James Monroe said it best:
. . .whatever may be the abstract doctrine in favor of unrestricted commerce, [the necessary conditions of reciprocity and international peace] have never occurred and can not be expected. . . [reality] imposes on us the obligation to cherish and sustain our manufactures [through tariff protection].
History may not repeat, but it does rhyme.

the ol’ switcheroo

At the end of our story baguettes cost $3, and you cannot afford to reopen your bakery.  Everyone loses—everyone except the German baker.  There are two lessons worth mentioning here.
First, monopolies are bad for consumers because they increase prices.  This is why everyone hates monopolies.  However, we must remember that monopolies are good for producers.  In a domestic market, the harm to consumers often outweighs the benefits to producers—but this is not always true in a global context.  Net-exporters of a product (whether good or service) unequivocally benefit from high prices.
For example, oil-exporting nations like Saudi Arabia benefit far more from high oil prices than their domestic consumers are hurt by them.  As a result, it is in Saudi Arabia’s best interests to monopolize oil production as much as possible, so as to ensure prices are high.  Likewise, high potash prices Canadian potash producers far more than Canadian consumers are hurt by high potash prices—it all depends on the balance of trade.  Because of this, monopolies are desirablein global markets.
Once you understand this, China’s push to monopolize global semiconductor production makes sense: they don’t want to give the world cheap semiconductors, they want to monopolize the industry, and then leverage this market power into higher prices.  They are likewise doing this is other high-value industries.  Furthermore, we have already seen China do this with various industries in South America and Africa: they kill domestic industries by dumping cheap products, then jack-up prices in the aftermath.
Our story’s second lesson is that once an industry is dead, it’s dead.  That is, it is very difficult to rebuild an industry once it has been completely offshored.  There are two reasons for this.  First, because economic development is path-dependant, nations often lose the human capital to resurrect an industry.  That is, after a roughly decade (or less, depending upon the industry) not enough skilled workers remain to rebuild the industry—and those who do will likely have outdated knowledge.
Tying into this is the fact that building an industry from scratch is prohibitively expensive, and recreating the vanished supply lines is almost impossible.  The economy is a complex system, much like a coral reef: removing one industry will cause a cascade effect, which may destroy many others.  And because of the complexity, we may not know exactly which industries will be impacted.
The Brookings Institute notes that every advanced industrial job supports roughly two other jobs in a symbiotic relationship—offshoring one will necessarily disrupt the others, and offshoring the anchor industry will destroy the predicate industries.  For example, offshoring America’s automobile factories (the anchor industry) will kill America’s automobile engine, tire, and windshield manufactures too.  Furthermore, all the service jobs that depended upon the industrial jobs will collapse: ramifications will be felt by accountants, hairdressers, lawyers, artists—everyone.  Once the anchor industry dies, so too does the broader economy.  This is what happened in the rustbelt, and the results have been disastrous: joblessness led to socialism, hopelessness led to drug addiction, poverty led to urban decay.
It is so difficult and expensive to build a new industry from scratch that the developmental economist Mehdi Shafaeddin notes that no country has everindustrialized without government investment or protection.  The input costs are simply too high, especially when you consider that many industries (particularly manufacturing) are subject to increasing returns—the bigger they are, the cheaper they can produce products, and the easier they can outcompete start-ups.
As bad as this sounds, my assessment is not fatalistic.  America’s industrial base is large and diverse enough to recover, if only our government was as willing to build tariff walls as it is physical ones.

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