"Free Trade" Re-Examined

Stephen Roach is MorganStanley's global economist. The following is excerpted from his paper published at the MorganStanley economic forum. This is a slightly long read, but Roach proposes a carefully-balanced solution to a very significant problem--which is being ignored like The Man Behind the Tree by Congress.

While military success might be necessary to guarantee political freedom, cross-border economic battles are complicated by the co-dependencies of international trade and capital flows. One party’s defensive action can easily be viewed as an offensive threat by another - triggering a sequence of responses and counter-responses that can lead to trade wars and protectionism. Such is the case today, with the mounting tensions of globalization pushing the world uncomfortably close to the slippery slope of protectionism. What can be done to arrest this dangerous trend?

...In my opinion, this question can best be addressed through the lens of an increasingly precarious US-China trade relationship - quite possibly the most important bilateral economic relationship in the world. In essence, it boils down to today’s global hegemon versus what could well be the hegemon of the future.

...This simple contrast between supply- and demand-directed growth unlocks many of the important implications that have been key in driving a wedge between these two powerful economies.

That’s especially the case with respect to saving disparities. Lacking in support from self-sustaining internal demand - especially private consumption - China has the highest saving rate of any major economy in the world. Lacking in support from domestic income generation, America’s consumption binge has been accompanied by the lowest saving rate in the world. In 2005, China’s gross national saving rate was close to 50% - about four times the 13% rate in the US.

And, of course, the comparisons are even more worrisome when calculated in net terms - after stripping out the depreciation of worn-out capacity. On that basis, the US net national saving rate effectively fell to “zero” in the second half of 2005. Without any net saving, America has no choice other than to import surplus saving from abroad - and run massive current account and trade deficits to attract that capital.

What then is the mechanism by which macro tensions between China and the US are transmitted into the political arena? In my view, that’s where the global labor arbitrage comes into play. By our calculations, in 2004, average hourly compensation in Chinese manufacturing stood at only 3% of comparable pay rates in the US. And that’s after allowing for double-digit manufacturing wage inflation in China of about 12% per annum since 1999.

...It’s not just that a saving-short America is sourcing an increasing portion of demand from a low-wage Chinese economy. It’s that US real wages have been nearly stagnant for nearly a decade - rising at slightly less than a 1% average annual rate since 1995. Near-stagnation in real wages is an especially bitter pill to swallow in that it has occurred in the context of around 3% productivity growth over the same period. Consequently, the global labor arbitrage appears to be operating mainly through the price channel (real wages) rather than through quantities (hiring) - an outcome that tempers concerns over job security but heightens the angst over income insecurity.

(This also happens to be the principal source of angst over increases in health costs, gasoline prices, AND tax-burden in the United States.)

I’ve simplified the story a lot to get to the punch line - that the “win-win” theories of globalization are in real trouble. The basic conclusion of Ricardian comparative advantage that all economists are taught to worship from birth holds that trade liberalization not only brings poor workers from the developing world into the global economic equation (win #1), but workers in the developed world then benefit by buying low-cost, high-quality goods from the developing world (win #2).

The theory breaks down because of a new disruptive technology - in this case, the Internet - that dramatically accelerates both the speed and scope of worker displacement in the developed world.

...I had the honor of sharing the podium with two of the giants of modern trade theory - Paul Samuelson of MIT, who basically developed the modern-day version of the theory of comparative advantage, and William Baumol of NYU and Princeton, who led the way in exploring the ramifications of nontradable services.

Both of these gentlemen cautioned strongly against dismissing the plight of today’s generation of trade-displaced workers in the developed world. Samuelson stressed that in an earlier era of globalization, from 1880 to 1914, a comparable burst of innovation - in this case, the advent of the factory assembly line - lowered the standard of living for many workers in the US. “I am not here to be an optimist or a pessimist,” Samuelson stated matter-of-factly, “but a realist.” He concluded that it’s pretty clear a theory is in trouble when it fails the simplest of reality tests. “Displaced workers who have lost their jobs forever - be they blue or white-collar - draw no consolation from the theoretical conjecture of the win-win trap of the globalization advocates.”

In the spirit of a “Samuelson realist,” I would offer three basic guidelines to get the US-China relationship - and the globalization debate - back on track.

One, admit there is a problem - that courtesy of IT-enabled globalization, worker displacement and wage compression in the developed world is in uncharted territory. The rich industrialized economies need to respond by investing in human capital, educational reform, and basic research.

Two, the developing world needs to be engaged, not disenfranchised. Completion of the Doha round of trade liberalization is essential, as is compliance with new and rigorous standards of intellectual property protection - the residue of comparative advantage in the developed world.

Three, macro policies need to be realigned. The US must adopt a pro-saving policy - (it's time to look VERY hard at Paul Ryan's Social Security reform, --or reducing the "mortgage interest" deduction) facing up to structural budget deficits and the pro-consumption biases of the tax code and a bubble-prone central bank; such an approach would tilt national saving to the upside - reducing the risk of increasingly contentious current-account and trade deficits. China, for its part, must deliver on the pro-consumption intent of its newly enacted 11th Five-Year Plan; that approach would reduce its excess saving and temper the destabilizing impacts of its trade and current account surpluses.

...US-China trade tensions are a microcosm of what’s wrong with globalization. Neither side is facing up to the global ramifications of its economic aspirations. America’s excess consumption is placing an enormous burden on the rest of the world. China’s excess production is doing precisely the same. Painfully, history tells us that bilateral fixes cannot be imposed on a multilateral world. Economies that defend themselves on a bilateral basis ignore the darkest lessons of history at great peril.

The "peril" was likened to setting up a village at the foot of an active volcano, or in the path of an impending landslide.