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Can Trade Wars Be Good for the Economy?

Can Trade Wars Be Good for the Economy?

With the world economic community focused on US President Donald Trump’s acrobatics of escalating and deescalating trade battles, the question naturally arises if there’s actually any truth to his two-part statement, or tweet, that “trade wars are good, and easy to win”.

Indeed, protectionism is an economic policy older than the science of Economics itself, but according to the classical theory of Smith and Ricardo it is just the oldest folly in the history of Economics. Modern neoclassical Economics incorporates and strongly validates the Smithian and Ricardian condemnation of protectionism, allowing deviations from it only in some exceptional and clearly specified situations. The explanation neoclassical Economics offers for the persistence of protectionism as a policy has changed however, replacing folly with a rational public choice theory of concentrated benefits for the beneficiaries and dispersed costs for those harmed. But is protectionism and its long history really just a folly? 

Forgotten lore 

In order to answer the question, one needs to take a second look at the work of a controversial and forgotten economist: Mihail Manoilescu. In his main work, “The Theory of Protectionism and International Exchange”, Manoilescu disputes the whole Ricardian theory in favor of free trade based on comparative advantage and argues – pretty much the same way John Maynard Keynes did with classical macroeconomics – that it is actually only a special case of a more general theory of trade, in which protectionism is an important and legitimate policy. According to Manoilescu’s perspective, protectionism is therefore neither a folly, nor an interest group rent, but a policy of economic growth and development. Yes, you read that correctly.

According to Manoilescu’s perspective, protectionism is therefore neither a folly, nor an interest group rent, but a policy of economic growth and development.

Manoilescu’s starting point for his reversal of classic trade theory is pretty similar to that of Paul Krugman’s New Growth Theory, only 50 years in advance. According to him, as well as according to Paul Krugman, comparative advantage – the products a country is more productive in manufacturing to be exchanged for products another country is more productive in manufacturing even if it can do both things just as well – is not a given, as the Riccardian theory latter developed by Bertil Ohlin and the Swedish School assumed on the basis of a theory of complementary natural endowments. In other words, the comparative advantage of the international division of labor is – at least in a large swath of the modern economy – usually man-made. And who or what makes a country more productive compared to another? New Growth Theory simply lists a lot of abnormal returns having to do with market imperfections in international exchange, such as increasing returns to scale, agglomeration economies, monopolies and duopolies, which are due either to geography or often just past policies such as investment in research, learning curves etc.

However, according to Manoilescu, as well as other more recent protectionist theorists such as Ja Joong-Chang and basically all protectionist theorists of one sort or another, an important policy by which a country becomes comparatively more productive than the other is actually the trade policy itself, hence the rehabilitation of protectionism as a legitimate policy. The free trade regime, contends Manoilescu, basically makes the comparatively more productive country even more productive while the less productive country – although not necessarily made worse off – maintains roughly the same distance with regards to the productivity frontier of the former. The protectionist regime, on the contrary, can reduce the distance in the productivity frontier between the more productive and the least productive country.

The protectionist policy and ideas have historically been the domain of the underdog countries engaged in competition with more advanced countries.

In short, it is about the rules of the game rather than the game itself, or in Donald Trump’s terms, it is about the good deal or the bad deal. The protectionist policy and ideas have historically been the domain of the underdog countries engaged in competition with more advanced countries: English protection of shipping against Dutch reign of the seas in the middle of the 17th century (or, earlier, of fabrics) later created the British Empire; French Colbertist protectionism in the 18th century against the new British industrial prodigy gave birth to a French state industry; German mid-19th century protectionism to catch-up with the industrial development of Britain and France as well as American protectionism against its former British rulers also played a role in these countries’ development. 

New spin 

Trump’s spin on this old protectionist tradition goes, however, in the opposite direction: that of the champion’s fear of decline in the face of a rising underdog instead of the underdog challenging the champion. This is evident in his Administration’s insistence on trade retaliation for China’s policies of technology transfer from American corporations wanting to enter the large Chinese market, which proved to be the only constant in the trade policy battles engaged so far. But why is technology so important with regard to trade anyway, national security concerns notwithstanding for a moment? Precisely because it is an important ingredient of productivity that makes up a country’s comparative advantage, as Manoilescu foresaw.

But why is technology so important with regard to trade anyway, national security concerns notwithstanding for a moment? Precisely because it is an important ingredient of productivity that makes up a country’s comparative advantage, as Manoilescu foresaw.

Let us go back to Ricardo’s statement of comparative advantage. The English sell clothes to the Portuguese and the Portuguese sell wine – oh, that Porto wine! – to the English. A mutual beneficial exchange, everyone is better off, Adam Smith would have said, shakes hands and goes home to enjoy the fruits of the trade. But upon closer inspection, one notices two things, very important with regard to the events of our time. First, late 18th century and early 19th century Britain and Portugal are allies. When Ricardo finished his book, the two countries had just won a war against Napoleon, the “ogre” according to his contemporary opponents, with the Duke of Wellington himself leading the British expedition in Lusitania before ending Napoleon Bonaparte’s career at Waterloo. From this observation of Ricardo’s original statement, one may conclude that a similar example of mutual beneficial trade with, say indigenous Indians or very dissimilar populations, maybe posed too many anthropological problems or simply that security is always somehow linked with trade. Secondly, and more importantly, notice that the British are selling a manufactured good, in fact the world’s premiere manufactured good of the time: textiles. In much the same way as today’s Apple iPhones, the British textiles of the era were a highly complex and innovative product, featuring:

  • outsourced supplies of raw materials from India (where, on top of that, the local textile industry was virtually destroyed when the British East India Company began colonization);
  • mass production by mechanized processing machines invented in Britain by brilliant engineers familiar with the Enlightenment’s greatest scientists along with new dyeing techniques;
  • a new professional full-time workforce as well as new management and organizational forms that gave birth to the factory – the quintessence of the industrial revolution landscape;
  • and an institutional system of contract, markets and credit which had been developing for hundreds of years before industrialization and was only matched by the Dutch.

The Portuguese, on the other hand, sell an agricultural good – one of the highly prized agricultural goods of the world, but an agricultural good nonetheless – wine, made according to ancestral customs and techniques near the sunny Lusitan vineyards that give it the famous sweet taste. From this second observation regarding Ricardo’s original formulation of comparative advantage one may identify a sociological difference underlying the exchange relation between the two countries as well as a qualitative difference in the type of goods exchanged.

In Manoilescu’s restatement of Ricardo’s theory of comparative advantage, the fact that Portugal sells wine to England and England sells cloth to Portugal is just one of several possible exchange relations given by the relative productivities of the two countries, but actually not the optimal one, as the neoclassical model of equalized returns assumes. This is due to the fact that the goods exchanged by Portugal and England are not equal in terms of their net product or value added. This productivity differential between the trading sectors of the two countries makes protectionism – or the lack of protectionism – a possibly welfare enhancing, or welfare reducing, policy in a more generalized theory of trade. The condition for protectionism to be economically justified can therefore be formally stated by the following equation:

 A p1,2 / I p1,2 < 1 × [(A2 - I2) / A2]

Where A is the ratio of export price p1 to internal price p2 in the agricultural or low value-added sector, I the ratio of export price p1 to the internal price p2 in the industrial or high value-added sector and (A2 - I2) / A2 the productivity differential between the employment of factors in the two sectors (see Bobulescu 2013; Cojanu 2002). 

Applications to Trumpism 

In practice, Manoilescu’s protectionist theory of trade based on productivity differentials of heterogeneous sectors was historically used to promote a policy of import-substitution industrialization, but – assuming that the Manoilescu condition holds – its use can be reversed for analyzing the Trump administration’s desire to promote a policy that can be accurately described as a policy of export-retention industrialization.

Could it be that this new postindustrial service sector constitutes a new iteration of Manoilescu’s low productivity agrarian sector?

The current American criticism of international free-trade regimes, directed primarily towards China – as epitomized by the writings and statements of noted China-hawk Peter Navarro, the Director of the US President’s National Trade Council – contends precisely that the opening up of the US market to foreign competition during the last decades has displaced American industry with deleterious consequences on employment and especially on wage growth and concomitant social spending burdens, along with intangible negative externalities. The displacement and disappearance of manufacturing jobs, which is only partly due to automatization (Autor et al, 2013), has been accompanied by the growth of service sector employment. According to the critics, the postindustrial service sector economy comes with more job insecurity and lower pay for the unskilled and less educated majority of the workforce as well as increased overall economic inequality, which must then be addressed through other distorting measures. Could it be that this new postindustrial service sector constitutes a new iteration of Manoilescu’s low productivity agrarian sector?

As already shown, productivity rather than the historical sociology of particular economic activities is at the essence of Manoilescu’s theory of protectionism, so much so that the second – more often reprinted – edition of his 1929 book bears the title “National Productive Forces and International Trade”. While the service sector is as old as the economy itself, its growth in the past decades particularly in developed economies has been nothing short of spectacular. Although it does not carry the stigma of the agricultural economy, on the contrary, the service economy is in its own way notoriously ridden with productivity issues (Baumol and Bowen 1966). The shift from the prevalence of a more productive sector to a less productive sector in the developed economies due to international trade competition can therefore, theoretically at least, justify an active trade policy of export-retention of the kind wanted by the Trump Administration and which Manoilescu formulated, with the exact opposite intention, for emerging economies almost a century ago. 

Conclusions and caveats 

There are good reasons to think that a reverse import-substitution policy of protection put in place to retain productive export industries will have to deal with a distinct, but rather similar, set of difficulties.

The hypothesis presented above does not validate the Trump Administration’s current or future trade policies but seeks to identify their rationale and a framework for analysis and comprehension. To paraphrase President Trump once more, trade wars can indeed sometimes be good, but – looking beyond the one-time battles – they are usually not that easy to win. The application of Manoilescu’s program of long-term protectionism for the promotion of import-substitution industrialization – which was actually pursued most consistently not in Romania, but in Brazil, beginning with the late 1930s and early 1940s and ending well into the 1980s – has had mixed results due to issues such as a lack of incentives absent foreign competition, problems with acquisition of know-how, human capital issues, widespread corruption and fragile institutions. There are good reasons to think that a reverse import-substitution policy of protection put in place to retain productive export industries will have to deal with a distinct, but rather similar, set of difficulties.

 
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