FREE TRADE...IS IT BAD FOR THE U.S. ECONOMY?

Of course not! Contrary to public opinion, free trade is a boon to the economy and a real benefit to consumers. It gives consumers more options in the goods and services they can purchase; it expands the markets within which businesses operate; and generally, it lowers prices to consumers too. In fact, free trade is the only issue on which virtually all economists agree.

But still you find some economists who oppose free trade. They very likely represent the vested interests of a narrow group of businesses, or perhaps a labor union trying to protect its workers from lower priced and more efficient foreign competition. Usually, what gets lost in all the discussion, are the benefits to all consumers. At this moment, in fact, the Senate is discussing passing a bill to grant President Obama "fast track authority" to make trade deals and those Senators objecting to the bill are liberals who are supporting narrow business interests.

Among consumers there is a lot of misguided and confused talk about foreign trade. On the one hand, many complain about all the foreign goods that are invading our shores and stores, and of the jobs we are losing to foreign competition. Today the complaints are mostly about China, but we should recall that a few years back the complaints were about Japan. On the other hand,  many of those consumers go cheerfully to those same stores to buy imported goods that are significantly lower-priced, and perhaps higher quality, than the alternatives made at home.

That which is seen, and that which is not seen

Frederic Bastiat - 1801-1850

About 165 years ago, the French economist Frederick Bastiat cleverly explained the reasons why many people oppose free trade. Bastiat put it in terms of what is seen and not seen. Upon opening borders to foreign competition some specific businesses may be forced to close and lay off workers, because they can't match that competition either in prices,  quality or both. This is what is seen- people observe that and immediately conclude that free trade is bad. We can all point out to examples, recent or not, where businesses have closed and workers became unemployed because of foreign competition. But those foreign products, at lower prices and/or better quality, can now be enjoyed by everybody. All consumers benefit from this, and this is what is not seen.

The important lesson from Bastiat, one that even some economists ignore today, is that when analyzing the economic impact of some action, we must look not only at the immediate, visible effects. We must look deeper at any subsequent, delayed effects that are not immediately apparent. In most cases, those delayed effects contradict and overwhelm the "seen" impact of the immediate effects.

What do the data reveal?
But first, let's take a look at some figures. As the rest of the world inevitably has become more industrialized and economically advanced, the U.S. global dominance in all economic matters has waned, naturally- this is seen as a reason for objecting to free trade. But in reality it is not a case of us losing ground; rather other countries are becoming more advanced and are gaining. But in the end we are all better off, much better off.
We only need to look at our imports and exports. The chart "U.S. Trade as a Percent of GDP" shows that while exports and imports were about 5% of GDP in 1969, today they are 13% and 17% of GDP, respectively. And the foreign trade share of GDP has grown in tandem with U.S. GDP growth. How can trade be a bad thing then?

This level of trade represent about three trillion dollars of foreign goods that we now have access to here in the U.S. For instance, while in the 50s or 60s we had only four choices of automobile companies (Ford, GM, Chrysler and American Motors- who remembers?), many of them offering cars of perhaps low quality, today we can choose from dozens of manufacturers coming from a multitude of countries. We have a multitude of choices in terms of types, quality, prices, etc.

What about the trade deficit?
But, you will say, we are running huge trade deficits, we are losing while countries like China are winning at our expense. This is not true- we are not losing and they are not winning. We are both voluntarily exchanging one thing for another. When we import goods or services from another country, say China, we give either dollars or IOUs in exchange. We get the cars, bicycles, or whatever we imported and they get pieces of paper. Are they richer and we poorer now? No, of course not. We have things now that we wanted more than those dollars, and they have the dollars or IOUs. But they can't eat those paper documents, they have to spend them either today or sometime in the future.
So, as long as they are willing to hold those IOUs (typically U.S. government debt, shares in U.S. companies, etc.) nothing happens. They are earning a modest rate of return on the IOUs and we only pay that interest due. This is what is called the "capital account" surplus.
If at some point in the future they decide to get rid of those IOUs, we will see an impact on the dollar exchange rate.

WHY DO WE IGNORE BUSINESS INVESTMENT?

Gross Domestic Product, or GDP, is commonly thought to reflect accurately the value of all goods and services provided in an economy. In the GDP model, the economy can be viewed simply as the result of adding the dollar value of five components, typically shown in the formula given below.

GDP = Consumption Spending + Investment + Government Spending + Exports - Imports

From this formula it follows that if we want to increase GDP, we only need to maneuver or increase one of its components. This explains why during and immediately after the 2008/09 recession there was a rush to increase government spending, on the misguided assumption that this would increase automatically GDP and get us out of the recession. President Obama, working with Congress, pushed through the so-called stimulus bill (the misleadingly named "American Recovery and Reinvestment Act") that called for spending of more than $800 billion by the Federal government. It was assumed that this boost in government spending would bring the economy rapidly out of the recession. The spending bill actually included several tax provisions too.

As we now know, and a few sage economists knew before, the much anticipated boost in GDP did not happen. Average GDP growth over the last six years, that is since 2009 when the stimulus spending bill was passed, has been a measly 1.4%. In contrast, the average growth of all previous economic recoveries since the end of the Second World War has been over 4.0%.
We have multiple examples, besides the recent U.S. experience, where boosting government spending has not resulted in a much heralded economic boom. Rather, the opposite has been the case, as in Japan where continuous bursts of government spending over the last 25 years have not pulled that country out of its dormant state.

Increased Government and Consumer Spending do not Lead to Growth

Given all this evidence disproving the presumably beneficial effect of government spending, it is mystifying why this approach continues to grab the attention of so many economists and businessmen.  Two plausible reasons appear to be self-interest and the burden of knowledge. Self-interest because of the benefit, direct or indirect, to those propounding government spending (the crony capitalism syndrome). Burden of knowledge because of the intellectual investment they may have in those theories and their reluctance to accept an alternative explanation of how a market economy works, thereby discarding their belief in incorrect theories.

As far as government spending goes, it's easily seen that what the government spends are funds not spent by consumers. When governments engage on additional spending, they are taking funds away from the public; either immediately in the form of taxes or in the long-run because of the new debt incurred to sustain that spending. Similarly, consumer spending does not lead to growth- at best it simply maintains the same level of goods flowing into the economy.

The Key to Growth: Savings and Business Investment

But the one element of the simplistic GDP formula above that is often neglected, investment, is the key to economic growth. It is only through investment, obtained from the savings of individuals and businesses, that real economic growth results. Most of us remember the example of Robinson Crusoe discussed in our first economics course. The purpose of bringing Crusoe to class was to explain how one day Crusoe decides not to consume all the berries he harvests (or whatever it was), and save some for a future day when the saved berries will allow him to spend his time developing a tool; a tool that will make it easier and more efficient for him to harvest berries in the future. This is the act of saving and investing that is so crucial for economic growth. But also this is the act that seems to have been forgotten in the efforts to generate growth without any effort.

There are many examples of the role investment plays in economic growth and development. We need to look no further than the Chinese economy to appreciate fully the value and impact of investment for economic growth. The phenomenal growth in the Chinese economy over the last 30 years did not result from spending by the Chinese government.  Yes, freeing up markets (to some extent) and allowing for investment to take place. This investment in capital good (facilities, machinery, etc.) is what trigger such spectacular growth. The savings came initially mostly from the Chinese diaspora in places such as Hong Kong, Singapore and Taiwan; most recently it's been from savings by Chinese nationals.

And in the U.S. investment has also historically been key in producing high economic growth. However, it also helps explain the slowdown in economic growth we have had since the beginning of the century. Although the chart "Gross Private Investment" shows what appears to be large and rising business investment in the country, except for the large dip around the 2008-09 recession, disaggregating it into its two main components helps explain that slowdown in growth, as shown below.

The two components are shown on the chart "Non-Residential Business Investment." They are investment for Replacement and Maintenance of the existing stock of capital goods, the ever rising line in red, and investment for New capital goods shown by the blue line on the top chart. At the bottom we display the ratio of New to Total investment where we can see that while in the sixties and seventies the proportion dedicated to New investment was roughly around a third of total investment, the ratio has been on a falling trend since the 1980s.

Naturally a question to ask is what is the significance of this declining trend?

Investment and GDP Growth
By plotting this ratio against GDP growth we can get a clear idea of the relationship, and the impact that New investment has on economic growth in general. To simplify the analysis, we have plotted on the chart "New Investment Ratio & GDP Growth" the five-year averages for both of these variables- GDP growth and the New Investment ratio. This averaging was done to smooth the data and get to the essence of the relationship.

We can see that up until the mid-1990s the New investment ratio was relatively flat, and also GDP growth was fairly robust. However, afterwards the investment ratio began to decline sharply, and so did GDP growth.

What does it all mean?
The emphasis on spending, whether it's government or consumer spending, has resulted in a neglect of business investment. Further, recent economic policies have tended to be adverse to investment, or even to discourage investment. At best, we have seen that the government officials give investment lip service, but they typically prefer direct spending since their effects are presumably more visible and immediate.
But one reason that despite these policies the U.S. economy still maintains some modicum of positive growth, is because the main alternative to investors is focus on one of the European countries. And we all know that the majority of those countries operate in an environment that is yet more punitive towards businesses than the U.S., making investments in those countries a not very attractive and more risky proposition.