The Little Book of Economics

The best yardstick of this growing interdependence is in the remarkable expansion of global trade. Since 1950, global trade has outstripped world gross domestic product (GDP) growth by 6 percent to 4 percent, according to the World Trade Organization (WTO).² Exports account for more than 40 percent of China’s, Germany’s, and Israel’s GDP, and more than 80 percent of Ireland’s. Even in the United States, which depends less on trade because of its gigantic internal market, exports have risen from 5 percent of GDP in the 1960s to 11 percent in the 2000s. That number should head higher as U.S. firms seek their fortunes among the emerging markets’ nouveau riche consumers instead of hunkered down Americans.

We usually think the benefit of international trade is more exports. But that’s a blinkered view. Imports are just as important, perhaps more important, because they enrich consumers. Think of all the things you’d forsake if borders were closed: fresh fruit and tropical flowers in the dead of winter, British novelist J.K. Rowling’s Harry Potter novels, cheap oil from Saudi Arabia (okay, a mixed blessing), Hyundais.

Countries even benefit by importing something they could make themselves. Why do parents hire a nanny when they could stay home and raise the child themselves? Because it lets them earn the money to buy a nicer home and send the child to college. The same principle of comparative advantage is why rich countries buy toys and clothing from poor countries: so that their own workers can earn more building aircraft, conducting heart bypass operations, or making movies.

Yet, comparative advantage doesn’t explain why many countries export and import similar things. For example, why does France sells Renaults to Germany while Germany exports Volkswagens to France? Why don’t the French stick to buying Renaults and Germans to Volkswagens? Because consumers like choice. Just as your town has numerous pizzerias catering to different tastes in pizza, French and German consumers want to choose from more than just a few brands of car.

Giving consumers this much choice would be impossible without globalization. Cars require huge economies of scale to make cheaply and a single country’s market by itself can’t support more than a few brands. When global barriers come down, numerous small national markets become a big global market that numerous companies can now profitably serve. Singapore and Luxembourg are tiny countries but are among the richest because their companies and consumers are part of a global market. The competition inevitably improves the quality of the domestic product, such as when a flood of Japanese imports forced U.S. manufacturers to improve their own quality.

It’s Complicated

To economists, the benefits of both exports and imports are so obvious that it’s one of the few things this notoriously fractious profession agrees on. Yet, in recent years, trade has changed radically, rattling even normally stalwart supporters. Traditionally, we bought toys, clothing, and other things from poor countries that required more manual and less intellectual labor. We bought more advanced products like aircraft, software, and microprocessor chips from other rich countries.

But in recent decades, China, India, and Russia have joined the global workforce and now sell the sorts of advanced products we long thought were invulnerable to such competition. The collapsing cost of blasting megabytes of data across undersea cables makes it possible for foreigners to read Americans’ X-rays, take their hotel reservations, or report on town council meetings. Alan Blinder, a former vice-chairman of the Federal Reserve, has estimated that perhaps a quarter of U.S. jobs can now be done offshore.

This expansion of trade from things we drop on our foot to things we carry around in our brains terrifies many Americans who fear that even the most advanced jobs will disappear at the hands of foreign competition. Just consider the storm of criticism that greeted Gregory Mankiw, a Harvard professor who, while serving as chairman of George Bush’s Council of Economic Advisers in 2004, said outsourcing was just as beneficial as traditional trade. The Republican Speaker of the House, Dennis Hastert, accused Mankiw of failing a “basic test of real economics.”³

That so many Americans are fearful of outsourcing is understandable. Why, they might imagine, would anyone pay them (or a Japanese or British worker) more than a Chinese or Indian worker with the same university degree? The reason is that a U.S. worker’s productivity comes not just from her own education and skill but the social, economic, and political infrastructure around her: the advanced equipment she uses, the cables that transmit her telephone and Internet traffic free of static and brownouts across the country and back, highways that get her and her coworkers to the office and their products to market, trustworthy courts that enforce contracts and settle disputes with customers and suppliers.

Expanded trade in services plays to the United States’ strength—about one-third of our exports are already services from Hollywood films to engineering, architectural, and financial services. The Shanghai World Financial Center, which on completion in 2007 became China’s tallest skyscraper, was designed by Kohn Pedersen Fox, a New York-based architecture firm that gets 50 to 85 percent of its business outside the United States. Apple’s iPod is assembled in China, but much of the finished product’s designs, components, marketing and value were added elsewhere. Indeed, according to a study by the Personal Computing Industry Centre at the University of California, Irvine, just 2 percent of all the wages earned in the sale of an iPod are earned in China, while 70 percent are earned in the United States. When Apple sells an iPod in Germany, it shows up as an export from China, but most of the benefit flows back to the United States.

There’s a caveat to this story, though. Trade does not make Americans collectively poorer, but it does alter the balance between winners and losers. In the case of the iPod, the winners, besides Americans who buy iPods, are clearly Steve Jobs and Apple’s employees. The people who sell the iPod in U.S. stores aren’t really affected. Their jobs don’t require high skills but they’re also relatively insulated from overseas competition. The losers are the people who may have assembled iPods in the United States but can’t compete with the low wages paid to factory workers in China. Trade can thus aggravate inequality, eroding wages for formerly middle-class workers while rewarding those at the top.

A Question of Balances: Trade Deficits and Surpluses

Trade has expanded over time because:

• Consumers around the world are getting more affluent and want more choices.

• The cost of getting stuff across the ocean has plummeted thanks to jet engines, the shipping container, and the fact that valuable things weigh less these days: some don’t weigh anything at all and can be zapped across fiber optic cables.

• Barriers to trade have fallen steadily.

Even as exports and imports grow over time, though, countries may swing from a trade surplus—that is, from exporting more than it imports—to a trade deficit and back, because of short-term influences, including:

• How Healthy a Country and Its Trading Partners Are. If European consumers are sickly and U.S. consumers are robust, the United States will import a lot from Europe but its exports to Europe will suffer, which will widen the U.S. trade deficit.

• The Terms of Trade. The relative prices of a country’s exports and imports also influence trade deficits. If you own an apartment in a neighborhood that suddenly becomes fashionable, you can raise the rent without investing a dime on renovations. Similarly, a country blessed with resources the rest of the world wants reaps a windfall. Russia’s trade surplus soared in the 2000s because soaring demand made its oil more valuable. The reverse is also true. Like a tenant whose rent doubles because his neighborhood has gentrified, the United States had to pay more for oil in the 2000s because it was so much in demand by other countries.

Some countries run deficits year after year while others run surpluses.

This reflects different saving and spending habits.

• Exchange Rate. A lower currency makes exports cheaper and imports more expensive, so shifts in the exchange rate have a big impact on trade deficits and surpluses. But the impact is fleeting if the lower currency sets off an inflationary spiral and exporters jack up prices, wiping out any competitive advantage.

Conversely, a stronger currency doesn’t spell the end of exports: companies can adjust by cutting their own costs or accepting thinner profit margins.

These factors can push exports and imports up or down in the short run yet some countries run deficits year after year while others run surpluses. Such persistent gaps reflect underlying differences in spending and saving. The United States persistently consumes and invests more than it produces because it has a shortage of saving. That extra consumption thus sucks in imports, leading to a trade deficit. Conversely, a country that always consumes less than it produces will have a trade surplus. Germany has chronically weak consumer spending, a reflection of its aging populations and a national obsession with saving. German stores don’t open on Sunday unless they’re in railway or gas stations and can only have sales on certain days of the year.

Meet Mr. Smoot and Mr. Hawley

Free trade is a tough sell because its benefits are less obvious than its costs. Imports make the majority of consumers better off, but they seldom know or care, whereas companies and workers that lose their livelihoods to imports are quick to let their representatives in Congress know. That’s why free trade politically is usually a loser. When John Edwards ran for president in 2004, he would rue the loss of textile factory jobs in North Carolina and lament that some families couldn’t afford winter coats for their children. Yet the imports that cost those textile workers their jobs are an important reason why children’s clothing cost almost 60 percent less in real terms than in 1980.

Given this political hostility, it’s remarkable that free trade has made so much progress. Before World War II, protectionism was the stated preference of Republican presidents, which is why Herbert Hoover signed into law the Smoot-Hawley Tariff Act in 1930. It raised tariffs on thousands of products and triggered outrage and, in some cases, retaliation from other countries. Global trade was already collapsing, but Smoot-Hawley accelerated the process.

Fear of a repeat has since helped free trade put down roots in the halls of power around the world. In 1934, Congress passed the Reciprocal Trade Agreements Act. It shifted responsibility for trade policy to the president who is less susceptible to narrow, protectionist interests and more likely to see trade agreements as a foreign policy bargaining chip. In 1947, the world signed onto global rules under the General Agreement on Tariffs and Trade (GATT). In 1995, GATT changed its name to the World Trade Organization (WTO). Visitors often ask the WTO’s chief, Pascal Lamy, if the two men whose pictures hang in his office are his relatives. He says they are Senator Reed Smoot and Representative Willis Hawley, the “true founders” of the WTO.

The GATT and WTO have been joined by proliferating bilateral and regional trade groups, like the European Union and the North American Free Trade Agreement. Still, like a virus, protectionism is always mutating, from the tariffs, quotas, and subsidies of old to preferential government procurement (“Buy American” or “Buy Chinese”), restrictive licensing requirements, local monopolies, and trumped-up health, safety, and environmental standards. For instance, for 90 years, Australia kept out New Zealand’s apples supposedly for sanitary reasons. Similarly, the United States has kept Mexican truckers off its roads claiming Mexican drivers are not safe, when in reality U.S. truckers just don’t want the competition. The next big wave of protectionism could be green, as countries whose companies buy permits to belch carbon slap tariffs on countries that don’t.

Into the Weeds

The benefits of trade are a matter of high-minded economics, but trade relations is a bare knuckle business. The president conducts trade policy through the U.S. trade representative. The trade representative is not there to debate the nuances of economic theory but to cajole and threaten other countries. The House of Representatives’ Committee on Ways and Means and the Senate Finance Committee oversee trade policy. The Senate must ratify treaties. Other countries are reluctant to sign a treaty that the Congress may amend before ratifying. To smooth the way, Congress sometimes give the president trade promotion authority, sometimes called Fast Track, which permits him to negotiate treaties that Congress can approve or reject, but not amend.

Individual legislators regularly take trade into their own hands, introducing bills that would punish other countries for protectionist behavior. The president usually stops them, but then uses them as leverage to extract concessions from the offending country. Dozens of bills, for example, in recent years aimed to hit China for keeping its currency artificially low. None have become law, but both George W. Bush and Barack Obama have used them as leverage to get China to let its currency rise.

Complaints about imports usually fall into one of three categories: subsidies, dumping, or surges. A subsidy is a government grant or some other favorable treatment that lowers the cost of the import. Dumping occurs when a foreign company sells its products abroad for less than it costs to make them, or for less than it charges at home. A surge is a sudden increase in imports.

Subsidy and dumping complaints are heard by the Import Administration, part of the Commerce Department. If the Import Administration agrees subsidies or dumping have occurred, as it does 95 percent of the time, it sends the complaint to the federal International Trade Commission (ITC), an independent, bipartisan panel, to determine if the subsidy or dumping actually hurt anyone in the United States. About 60 percent of the time it concludes that it did. In the case of subsidy it recommends a countervailing duty. In the case of dumping it recommends an antidumping duty. The president has little discretion here: if the ITC says injury has occurred, the Commerce Department generally has to impose the duty.

A company accused of causing a surge of imports hasn’t actually done anything wrong: it’s just making it hard for local competitors to survive. U.S. companies or unions can ask for a safeguard against the surge under one of two laws: Section 201, which applies to any country, or Section 421, which only applies to China. Safeguard cases are decided by the ITC. If it concludes that a safeguard is warranted, the president has the discretion to say no.

World trade is like hockey: fights are inevitable, but they’re more dangerous when the players leave the rink and settle matters in the parking lot. Like the referee who hands out the penalties and lets the game continue, the WTO gives countries an impartial venue to settle their trade disputes rather than mixing it up in the parking lot. In 2002, George W. Bush slapped tariffs on steel from numerous countries. Rather than strike back, the European Union complained to the WTO. The WTO ruled the tariffs illegal and gave the EU permission to retaliate. As the EU drew up a list of retaliatory moves, Bush backed down, and withdrew the tariffs. The EU declared victory and sheathed its sword.

Still, free trade is a tough sell at the best times, and won’t make much progress in coming years, if any. Prolonged high unemployment only makes people and their leaders more suspicious of competition. The global balance of power is also changing. For decades the United States let China and other poor countries get away with protectionism in the interests of letting them catch up. China is still poor but Americans now see it as a full-fledged economic and political rival and expect it to play by rich-country rules.

The Bottom Line

• Falling trade barriers, rising affluence, and the plunging cost of selling things across borders have fueled globalization. Able to buy from and sell to the entire world, even small countries can achieve exceptional levels of wealth.

• Trade makes the United States a whole richer. But the benefits are not shared equally. Especially as services trade grows, the biggest gainers will be the highest skilled workers while those with the least skills will see their wages eroded.

• Free trade is not politically popular and every country routinely indulges its protectionist impulses. Yet free trade survives because countries have also agreed to subject their actions to the rules of the World Trade Organization which keeps trade spats from becoming trade wars.

The Globalization Game Is Here Whether We’re Ready or Not

A Gravitational Pull from Afar

It’s Complicated

A Question of Balances: Trade Deficits and Surpluses

Meet Mr. Smoot and Mr. Hawley

Into the Weeds