The Bear's Lair: Fallacious trade doctrine


WASHINGTON, March 15 (UPI) -- The argument over globalization has a tired quality to it, with primitive protectionists battling against dogmatic free traders, who cite the doctrine of comparative advantage and correctly term their opponents economically illiterate. Yet true economic understanding, not simply of the theory but of the second order effects that trade can produce, may not lie entirely on the free trade side.

The doctrine of comparative advantage, so beloved by free traders since it was propounded by David Ricardo in 1819, states that if two countries produce different goods with different cost structures, then output and wealth will be optimized by allowing each country to manufacture the good in which its comparative advantage is greatest. Thus if the United States produces aircraft for $20 million and toys for $20, while China can produce aircraft for $18 million and toys for $5, it makes sense for China to specialize in toys and the United States to specialize in aircraft (and, by all means, for China either to raise its wage rates somewhat or to strengthen its currency.)


Globalization of output, therefore, is justified by the comparative advantage doctrine. If relatively low skilled and low paid Indian workers can do the same telephone call center jobs as U.S. workers, then outsource telephone call centers to India, and allow the Indians to buy U.S. goods with their new found purchasing power. Not only is Indian wealth maximized, but U.S. wealth is maximized too; its benefit takes the form of a reduction in the cost of call center operations (assuming that more call center operations is an economic benefit to anybody, but that's a separate argument!)

There's just one flaw in this argument -- it assumes that the low paid, lower skill Indian and Chinese workers will remain low paid and lower skill. This was a very natural assumption for David Ricardo, writing in 1819 Britain; in the immortal words of Cecile Frances Alexander's hymn "All things bright and beautiful", verse 4 (which was always omitted at my annoyingly left-wing school in the 1960s):

"The rich man in his castle,

The poor man at his gate --

God made them high and lowly

And settled their estate."

But of course, modern societies don't work like this. The poor man doesn't regard his estate as "settled," he strives to improve it by all means possible, and quite right too. Certainly, in a modern society as distinct from a traditional peasant economy, an influx of greater affluence will lead to an increase in the education levels of young people, as they strive to get the qualifications that will entitle them to a share in the new possibilities. However, if the skill levels of the lower paid population increase, their ability to attract more skilled work and higher paying jobs will also increase, and the balance by which the original "comparative advantage" had taken place will be shifted. Since the static-world assumptions of the doctrine of comparative advantage have been violated, by the cheaper workforce using its extra income to improve its quality, its results also become invalid.


This is particularly important when considering India and China, countries with populations totaling 2.4 billion. Currently, the "advanced" economies with high "western" living standards of the United States, Canada, Europe, Japan, Australia and a few other countries in Asia have a population of roughly 800 million. By no means all of these are skilled; a barber in Boston is no more skilled than a barber in Bangalore, but he is able to command higher wages because he lives in a more affluent society. In any case, once the political and social barriers that have impeded India and China are broken down, and their entire population is able to compete, at whatever level, in the global economy, the number of highly skilled western-quality workers (whatever proportion of each workforce that subset represents) will be approximately quadrupled.

At that point, another iron law of economics kicks in, that of supply and demand. If the supply of something quadruples within a fairly short space of time, its price drops drastically. It doesn't drop by 75 percent, because the lower price itself increases demand. An econometric model could in principle calculate the price elasticity of skilled labor, and estimate how much its price would drop, but it would be useless -- such a huge increase in supply would change so many things that elasticity wouldn't remain constant. But it seems unlikely that the cost of skilled labor would drop by less than 40-50 percent; after all even a drop of 50 percent would double the total income being received by the skilled labor.


The world is thus no longer static, and while there remains a huge benefit from an increase in trade, more than 100 percent of this benefit may accrue to the poorer countries of India and China.

If this happens very slowly, it's not a problem. After all, if Gross World Product per capita quadruples, then the U.S. workforce can maintain or modestly increase its living standards, while the Indian and Chinese workforces can be brought up to Western levels. However, since GWP per capita is increasing by no more than 2 percent per annum, its quadrupling would require around 70 years, a very long time indeed in economic life. From the transition speeds seen in East Asia, it appears that the Indian and Chinese workforces will be fully competitive with the West far before 2074, probably by about 2025-2030. Thus GWP will be unable to keep up, and, if the world continues to globalize, U.S. living standards are set to decline sharply.

There is an additional problem with India and China's economic leap forward, and that is one of resources. If GWP doesn't quadruple until 2074, it is likely that the ordinary person's consumption will by then consist very largely of goods and services we have not thought of, such as nano-medical devices that enable us to live to 120. Such new goods are likely to be relatively small, and consume limited amounts of the world's resources. However, if India and China reach near-Western living standards with today's technology, there will be huge strains on resources from quadrupling the world's output of, for example automobiles or wood furniture. Inevitably resource costs would rise (further impoverishing the West) and environmental problems such as global warming would worsen.


The globalizers are insouciant about the risks from globalization to the U.S. workforce's living standards. At a lunch Thursday given by the Institute for International Economics, the Institute's senior fellow Catherine Mann looked in detail at developments in the last four years in information technology employment, two thirds of which is outside the traditional IT industry. She showed that in the United States in 1999-2002 143,250 data entry clerks, earning an average of $23,190 lost their jobs, 25,860 computer operators, earning an average of $31,640 lost their jobs, and 71,280 computer programmers, earning an average of $63,690 lost their jobs. However, 115,170 new computer software engineer jobs were created, paying an average of $74,615. (The total number of jobs in IT declined by 144,630, or about 2.6 percent of employment, but it is fair to note that these figures cover a general economic downturn.)

Mann's solution to what she believes are transition problems of globalization is to institute a human capital investment tax credit, reimbursing companies for money spent on training their workers to higher skill levels. Not a bad idea as far as it goes, provided safeguards are included against subsidizing the training of foreign competitors. It could usefully replace the investment tax credit, a subsidy for capital spending that has helped produce huge amounts of wasted capital investment, lowering the capital productivity of the U.S. economy by 35 percent below its 1965 level.


Overall, however, Mann's optimism may be misplaced; if in the future the computer software engineer jobs also migrate to Bangalore, together with capable top management, then there may be no more rungs on the ladder for American workers to climb. As I said, you cannot assume that clever, capable Indian workers will be satisfied with an "estate" safely below the attractive job levels.

The depressing effect of worker competition on wages is demonstrated by the movements in U.S. wage rates since the great postwar boom ended around 1973. Whereas wage levels overall have grown by around 15 percent in real terms since 1973, the median earnings of males with a high school diploma or less dropped by 16 percent in the 28 year period 1973-2001. Increased competition for labor came from two sources: women entering the workforce, which presumably affected all educational levels equally, and resulted in the slow overall increase in wages, and immigration, small in 1973, but far larger since 1980 or so. Thus increased competition for a worker's services has the effect, not merely of reducing his relative income, but of rendering him poorer in absolute terms.

There is a huge difference between immigration and trade, and that is geographic separation. Immigrants are direct competitors for American workers; the immigrant barber in Boston competes with the domestic barber. But trade affects a much smaller section of the population. The barber in Bangalore does not compete directly with the barber in Boston; traditionally only products manufactured in Bangalore competed with those manufactured in Boston. Now there is suddenly competition in the service sector, but it is relatively limited; software can be written in India, and call centers staffed there, but most high level service industries still require the service provider to be geographically close to the customer. Air travel reduced some of these barriers, so that Saudi princes can get medical treatment in London, but that reduction happened several decades ago, and there is no sign of significant technological advances in the transportation industry that would intensify this type of competition.


In summary, globalization is a long term threat to U.S. living standards, but the extent of that threat depends on the sector. In most service sectors, only immigration is likely to drive down wage levels, which are otherwise set by supply and demand within the domestic economy. In other sectors, such as textiles, the traditional arguments for comparative advantage still hold; most traditional manufacturing industry can safely be allowed to migrate overseas, to the benefit of both the U.S. and foreign countries. Only in the highly skilled service sector is there a problem; here the migration of simple functions overseas in the long run produces a potential for the value chain to be hollowed out -- a process beneficial to the world as a whole, but highly detrimental to U.S. living standards.

The policy implications are clear. Traditional protectionism has the potential (quite severe, in a period of world economic difficulty) to produce world impoverishment similar to that of the 1930s, together with political moves towards extremism and hatred of the United States in those countries whose economic development is thwarted. On the other hand, high immigration intensifies the competition at the low end of the domestic wage scale, thus intensifying pressures on U.S. living standards that are already present. Temporary immigration of skilled workers, through H1B visas, is particularly pernicious -- by training them in the latest U.S. techniques and sending them home, the U.S. intensifies the upgrading of skills and capabilities in their home country, and the threat to U.S. living standards that this represents.


An appropriate trade and immigration policy would thus be open on trade, but very restrictive on immigration, both of skilled and unskilled workers. It would allow outsourcing of low-skill jobs with few restrictions, but would be much more protectionist on the transfer of high skill jobs, top management or entrepreneurial capability, and technological know-how. In essence, it would be very similar to Britain's trade policy under the 1783-1830 Tory governments of William Pitt and Robert, Lord Liverpool, that fostered the Industrial Revolution but imposed heavy sanctions against exporting the new techniques to the United States or France.

To minimize the long term costs of China and India's opening, the United States should pursue in international forums extreme anti-natalist policies, to encourage not only emerging markets' living standards but also their birth rates to approach European levels as soon as possible. The Italian birth rate of 1.3 children per mother, far below replacement level, is not properly seen an actuarial problem, solvable by a huge immigration that would destroy the unique Italian culture, it is a highly civilized response to the overpopulation that has gripped the world. It is clear that the world can support a western-living-standards population of 1 billion; it is not at all clear that it can support indefinitely such a population of 3.5 billion, let alone 6 or 9 billion. The Italian approach to reproduction, both in the emerging economies and in the United States itself, is thus in the long term an essential part of a thoughtful economic policy.


Both parties in the 2004 U.S. Presidential election campaign have so far got it wrong. The Democrats are applying a mixture of traditional protectionism together with liberal-elite laxity over immigration, both legal and illegal. The protectionism is highly dangerous to the health of the world economy, while high legal and illegal immigration is potentially devastating to U.S. living standards and employment, especially at the low end of the skill scale. In addition, the Democrats are likely to increase the cost of social programs, environmental regulations and trial lawyer shenanigans, all of which are sheer dead weight to the economy and will increase the temptation to outsource.

The Republicans, on the other hand, have spent too much time talking to the Chamber of Commerce. They favor large H1B visa programs, and are complacent about the long term dangers of outsourcing. Also, under president George W. Bush, they have extraordinarily come to favor amnesty for illegal immigrants, thus immiserating the lower half of the domestic labor force. Like the Democrats, they spend too much on government, but they also allow too many corporate chieftains to pump up their stock prices and loot their stockholders through excessive stock option grants and funny accounting. When India has top management costing one twentieth of U.S. top management's costs, a stock market that unlike Wall Street is not hopelessly overvalued, and accounting principles (Internationally Accepted Accounting Principles) superior to those in the United States, its competition is indeed to be reckoned with.


The doctrine of comparative advantage has outlived its usefulness; it needs to be replaced with the economics of the more complex world in which we actually live.

(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

Martin Hutchinson is the author of "Great Conservatives" (Academica press, April 2004) -- details can be found on the Web site

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