Ideas and Policies fromHocking/McGuire

Trade Politics: Actors, Issues and Processes

Brian Hocking and Steven McGuire, eds.

Routledge, 1999

Chapter 4

Ideas and Policies

Bruce E. Moon

Lehigh University

Any explanation for the trade policies of nations must begin from the premise that each seeks to fashion a policy that will achieve its interests. It is the thesis of this chapter, however, that such interests are extraordinarily difficult to identify, even for the parties themselves. Trade produces such a welter of consequences through so many dynamic and complex causal processes, that preferences for trade policy are dominated by the relatively simple theoretical ideas used to interpret, calculate, and weigh the various interests of participants. Further, because these theoretical ideas are highly structured, the actual menu of choices available to policy advocates is relatively small and surprisingly universal. Consequently, the center of the trade policy debate has seldom strayed far from the basic division between the orthodox liberal trade theory which underlies strategies of (more or less) free trade and assorted ideas associated with mercantilist thought that inform strategies of managed trade. The choice can be illustrated with a comparison of the trade policy decisions of two of the leading actors in the contemporary global political economy, Japan and the United States.

Since the middle of the twentieth century, the United States has been the leading advocate of free trade. That position is rooted in an abiding faith in orthodox liberal theory, the basic parameters of which remain little changed from the principles of free market economics portrayed by Adam Smith in his classic eighteenth century work The Wealth of Nations.⁽¹⁾ Japan, on the other hand, has been more strongly influenced by a broader, but less systematic collection of ideas, ranging from Frederick List's nineteenth century critique of Smith, which helped codify mercantilism, to eclectic offshoots of liberal theory itself, such as strategic trade. Japanese practices of managed trade have attracted imitators, especially in Asia, and also strong opposition, especially in the United States. Partially in angry response to the Japanese challenge and partially in grudging admiration for the apparent Japanese success, many have advocated replacing the free trade ideal with the more ambiguous goal of fair trade.

To trace these ideas, we begin with a summary of the free trade doctrine and the liberal theory which gives it structure, citing U.S. trade initiatives that embody both the general approach and the specific policies to which it gives rise. We follow with a sampling of the theoretical critiques offered of liberal trade theory, ranging from List's infant industry arguments to strategic trade theory, illustrated with significant aspects of Japanese trade policy. We conclude by discussing American policies designed to achieve "fair trade."

The theory underlying the doctrine of free trade

The most powerful idea in shaping trade policy throughout the modern age is the liberal argument for free trade. It contends that global welfare is maximized if nations abandon self-sufficiency to specialize in those goods that they produce most efficiently. They may then export those goods in exchange for items produced more efficiently abroad, resulting in "gains from trade" manifested as increased global production and consumption. David Ricardo's remarkable theory of comparative advantage, a brilliant elaboration and extension of Smithian ideas, remains at the core of the liberal case for free trade. In his 1817 classic, The Principles of Political Economy and Taxation, Ricardo demonstrates the theoretical possibility that mutually beneficial trade may be conducted between a pair of nations, even when one is more efficient than the other in the production of all goods.

Table 1 is patterned after Ricardo's famous example of the gains to be achieved by trading British cloth for Portuguese wine.⁽²⁾ The analysis begins with production possibilities -- the output that could be produced by a worker in each country in each industry, together with the total labor force available. Here, an English worker in either industry can produce more than a Portuguese worker, signifying that England has an absolute advantage in both industries. To illustrate that trade between them would still be profitable to both, consider first the levels of production without specialization, assuming that both countries chose to produce equal quantities of cloth and wine. In England, 100 labor-hours devoted to the production of cloth and 200 hours to the production of wine would yield 600 yards of cloth and 600 gallons of wine. In Portugal, producing 400 units of each good would require that 400 labor-hours be devoted to cloth and only 200 to wine.

Portugal is said to have a comparative advantage in wine, because its workers can produce 2/3 as much wine but only 1/6 as much cloth as a worker in England. Suppose, then, that Portugal specializes completely in the production of wine while England shifts entirely to cloth. After specialization, Portugal could now produce 1200 units of wine while England could produce 1800 units of cloth, a substantial increase in global output over the 1000 units of each produced under conditions of self-sufficiency. If they were to trade 700 units of wine for 700 units of cloth, each nation could then consume more of each good than in the absence of specialization. The gains from trade consist of the increased consumption made possible by each producer allocating his resources in the most efficient way.

Key to the free trade policy implications of this argument is the contention that comparative advantage results from the intrinsic characteristics of the economies -- and requires no government action except to refrain from introducing trade barriers. Within the liberal tradition, the sources of comparative advantage have been best articulated by two Swedish economists of the 1920's, Eli Heckscher and Bertil Ohlin.⁽³⁾ They argue that a nation's comparative advantage lies in its factor endowments. For example, a capital abundant country (such as the United States) would have a natural cost advantage in the production of heavy manufactures like autos, which are dubbed "capital-intensive" because they require large quantities of expensive plant and equipment and advanced technology. Countries like Mexico, where unskilled labor is abundant (and therefore cheap), will naturally specialize in labor-intensive light manufactures that involve simple assembly.

This pattern is assumed to arise naturally through market processes if governments eliminate barriers to imports (such as tariffs and quotas) and inducements for exports (such as subsidies). Governments need play no role because entrepreneurs will naturally gravitate toward the production of goods in which they have a comparative advantage, since it is there that profit margins will be greatest. Thus, they follow Smith's famous dictum that the pursuit of maximum profit by each individual inevitably steers them -- as if guided by the so-called "invisible hand of self-interest" -- towards behavior which maximizes the benefit of the community as a whole:

As every individual ... endeavors as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it...[H]e intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was not part of it. By pursuing his own interest he frequently promotes that of society more effectually than when he intends to promote it.⁽⁴⁾

The free trade doctrine in American trade policy

For a variety of reasons, free trade doctrine has had special appeal in the United States and has come to dominate its foreign economic policy.⁽⁵⁾ The U.S. has sought to expand global trade in accord with liberal principles along two parallel tracks. First, it has liberalized its own trade policies, not only by eliminating most trade barriers, but also by minimizing government intervention in the economic processes that lead producers and consumers to initiate trade. For example, U.S. tariff rates have been reduced by more than 80% from their high-water mark after the Smoot-Hawley tariff of 1930 and subsidies, with the important exception of agriculture, have nearly disappeared.

Second, it has worked to move other nations toward free trade by creating a global economic system that facilitates that choice. While liberal theory argues forcefully that each nations stands to gain from lowering its own trade barriers regardless of what others may do, it remains that a policy of free trade produces the greatest benefits when open markets abroad enable each nation to take full advantage of its export specialization. The U.S. was a leading force in shaping the Bretton Woods institutions after World War II and has continued to play the greatest role in extending the liberalization process through the Uruguay Round of the General Agreements on Tariffs and Trade (GATT) that created the long-awaited World Trade Organization.

Liberal theory has played a central role in the evolution of American trade policy, not only because its center-piece, the Ricardian theory of comparative advantage, directly implies the free trade doctrine embodied in its unilateral and multilateral trade initiatives, but also because it has structured the debate over policy options. This school of thought contains more than a policy prescription, but rather a whole set of conceptual ideas that define the language used in the debate and the acceptable range of argumentation, together with a conventional interpretation of historical evidence that defines the "lessons" learned from various policy experiments.⁽⁶⁾ Some of these elements are highly controversial outside of the epistemic community of liberals who regard them as an article of faith, which explains how competing perspectives thrive despite liberalism's dominance of trade policy discourse in the U.S.⁽⁷⁾

Mercantilist ideas underlying managed trade

Outside of the U.S., a second vision, that of mercantilism, has competed on more equal terms, both in the academic arena of ideas and as an influence on policy.⁽⁸⁾ While liberalism contains an integrated body of precise premises, refined logical arguments, and universalistic policy conclusions, mercantilism has always consisted of fragmented practical wisdom derived from an eclectic mix of past policy successes, tactical judgements, and a smattering of theoretical ideas. In fact, it is awkward to identify the boundaries of mercantilism as a doctrine, because "mercantilism" is a name applied after the fact to a compilation of diverse arguments in defense of the various commercial (i.e. mercantile) policies widely practiced in Europe prior to the nineteenth century. That is why the best known text in the mercantilist tradition is Friedrich List's The National System of Political Economy, written in 1841, half a century after Smith's death, even though the practice of mercantilism it defends pre-dated liberalism by several centuries. Indeed, it was mercantilist practice in the form of the famous English Corn Laws that was the target of the critique by Smith and Ricardo, and thus the animating force in the formation of modern liberal thought. Mercantilist policies share little but the conviction that governments must manage trade in order for it to further the national interest. Because perceptions of that national interest have varied from time to time, from place to place, and from author to author -- after all, the "national interest" encompasses a multitude of imprecise and partially competing goals -- no universal policy advice is offered by mercantilism.

The asymmetry in form of these two perspectives elicits much confusion, distortion and frustration. Liberals, proceeding ahistorically in seeking the theoretical core of mercantilism, have mistakenly reduced it to naive protectionism and the pursuit of trade surpluses, a straw man easily defeated within liberalism's frame of reference, which does not even contain the language to express, let alone evaluate, the premises and goals which have historically motivated most mercantilist policy.⁽⁹⁾

Because of the breadth and diversity of the mercantilist ideas that inform the trade policy of most modern states (to one degree or another), this discussion is kept within space constraints by focusing on those most clearly manifested in the post-World War II Japanese policy of heavily managed trade. While most of these ideas are quite old -- often pre-dating liberalism -- they appear most coherent if developed as critiques of liberal theory.

The single most discordant element between liberalism and mercantilism concerns the goals meant to be satisfied by trade policy. While liberalism focuses almost exclusively on allocative efficiency in order to maximize aggregate consumption, mercantilism seeks a number of goals that compete with and sometimes outweigh that value.⁽¹⁰⁾ Classical mercantilism accorded special priority to promoting the power and autonomy of the state, often expressed in terms of maintaining self-sufficiency in industries relating to war or indispensable consumption (like food). Ironically, it is the liberal Adam Smith who gives clearest expression to this idea with his famous defense of the mercantilist Navigation Acts: "defense is of more importance than opulence."⁽¹¹⁾

States also seek to influence distributional patterns in income and wealth, often emphasizing the values of equality and stability over the liberal concern with aggregate living standards. Critics observe that the Ricardian argument fails to account for the short term dislocations required to move from the autarchic case to full specialization. The human costs implied by such a shift in employment are considerable, and so long as nations remain open to trade, changing global market conditions are likely to make them a permanent part of the social and political landscape.⁽¹²⁾ As Polanyi points out, security for workers is an important social value that is undermined by the self-regulating market envisioned by liberals, even if liberalism delivers on its promise to maximize aggregate consumption.⁽¹³⁾ Mercantilists also question whether the implicit assumption of full employment contained in Ricardian demonstrations of the gains from trade are realistic. Of course, these ideas may inspire either policies of managed trade or alternative strategies such as the growth of the welfare state.⁽¹⁴⁾

Finally, mercantilists often emphasize a favorable balance of trade. Under classical mercantilism, this was designed to produce an "inflow of treasure" that would enrich the state itself while guaranteeing an adequate money supply for the domestic economy. In the modern era, the motive is to avoid a trade deficit that would require a capital outflow to balance it, since this usually leads to external indebtedness. While liberals do not disapprove of moderate debt if it finances investment for long-term growth, mercantilists, emphasizing freedom of action for the state, tend to place greater emphasis on the leverage acquired by a lender and the dependence suffered by a debtor.

Apart from differences over goals, mercantilists also question the wisdom of relying upon "the invisible hand of self-interest" to determine such an important facet of a nation's long-term development as its industrial structure. They fear that entrepreneurs motivated by a short-term profit calculus will be satisfied with existing comparative advantages and thus will fail to develop product specializations that offer greater long-term prospects for the nation as a whole. Advocates of managed trade contend that "it matters whether a nation specializes in potato chips or microchips", for example, because the latter offers spin-off effects in technology and human capital development that encourage growth in other industries, thereby strengthening everything from the nation's education to its national security.

In this connection, there is some doubt about the adequacy of the Heckscher-Ohlin (H-O) explanation for the sources of comparative advantage and, consequently, its implications for government policy. The liberal counsel that the state should avoid intervention in trade flows from H-O's assumption that the sole basis for comparative advantage lies in national endowments of land, labor, and capital -- which governments can do very little to affect. This account, mercantilists point out, ignores two additional considerations long appreciated by both governments and business -- a firm frequently gains an enormous advantage over its competitors by entering the market first and by operating at a larger scale.

The advantage of being first is the basis of the "infant industry argument" that dates to at least the seventeenth century: because mature firms have substantial advantages over new ones, "infants" must be protected by trade barriers or subsidies until they can compete successfully. Because this idea was central to the mercantilist policies that built England's economy prior to its nineteenth century liberalization, List argued, bitterly, that free trade is appropriate only for a nation with established firms. For all others, the state must identify those sectors in which it would be desirable to specialize -- today we call this "industrial policy" -- and then protect firms in those sectors through policies which manage trade⁽¹⁵⁾:

It is a vulgar rule of prudence for him who has reached the pinnacle of power to cast down the ladder by which he mounted that others may not follow. In this lies the secret of Adam Smith's theory, ... as well as all of his successors in the government of Great Britain. A nation which by protective duties and maritime restrictions has built up a manufacturing industry and a merchant marine to such a point of strength and power as not to fear the competition of any other, can pursue no safer policy than to thrust aside the means of elevation, to preach to other nations the advantages of free trade, and to utter loud expressions of repentance for having walked hitherto in the way of error, and for having come so lately to the knowledge of the truth.

Related to this is the advantage of being big. Micro-economic branches of liberal theory that study imperfect competition refer to this as "economies of scale", but until recently its implication for trade policy -- that it validates the strategy of managed trade associated with mercantilism -- was not recognized. In recent years this insight has given birth to a body of thought called "strategic trade theory" which explains the success of the Japanese mercantilist approach, especially its export promotion and industrial policies. Strategic trade theory breaks with liberal theory in providing a defense for two propositions which are antithetical to free trade canon. First, comparative advantage is not discovered by the savvy investor but actually created by a powerful state. Second, export promotion may be as essential to some infant industries as import protection, because in some sectors a firm cannot be sustained by the market of a single country. For both reasons, government intervention may be necessary to trade successfully, especially in the form of subsidies to firms with export potential.

Of course, government subsidies have always been capable of affording competitive advantage to firms in one nation over others, but such a policy was regarded as self-defeating for the economy as a whole because they require tax revenue to fund them. However, government intervention would be appropriate if comparative advantage rested on some factor that could be provided at no net cost only by the state. Strategic trade theory suggests at least three such candidates: very large scale capital, coordination among competing firms, and a credible commitment to aggressive export promotion policies. To be successful, though, all require the existence of economies of scale; that is, the unit cost of production must decline as the volume of production increases. Economies of scale arise in all products to some extent but in only a few do they persist at a volume that saturates the market, usually when the variable costs of production are low in relation to the fixed costs. For example, the major cost for firms that produce computer software -- paying programmers for the creative process of writing it -- is fixed regardless of how many copies are sold. Its variable costs -- buying blank disks to distribute the software -- are very small. Consequently, once a firm has sold enough copies to recoup their fixed costs, it can sell additional copies profitably at a price which cannot possibly be met by a new firm that produces a competing product at much smaller volumes.

Because comparative advantage in such industries resides wherever large-scale production is initiated, an industrial policy that subsidizes start-up may be beneficial to initial firms and absolutely essential to later ones. Subsidies need not cause a loss of consumer welfare but only a postponement of it, because the mature firm should eventually generate employment, profits, and tax revenue which repay the state for its initial support. If so, a mercantilist industrial policy may itself be a source of comparative advantage. That is especially true when economies of scale accrue outside the firm itself, but inside the nation in which it is located. For example, the concentration of chip makers and computer industries in the Silicon Valley of California makes it profitable for similar firms to locate in the same area, taking advantage of the skilled technicians and the research expertise of those already employed there. Because the original companies produce advantages enjoyed by later ones, it may not pay private investors to initiate a dynamic industry, even though it would benefit the economy of the nation. In cases of "market failure" like this -- that is, when the private market fails to provide adequate capital because of "externalities" -- the state can play a pivotal role.

Furthermore, a state with an activist industrial policy can bestow sources of comparative advantage that no private market can provide, such as subsidies for pure research or relief from onerous laws and regulations (like anti-trust). But the most formidable weapon of strategic trade policy is the reputation of the state itself for aggressively supporting an industry and ruthlessly competing with rivals. The promise to subsidize firms (or benefit them in other ways) well beyond the capacity of an un-subsidized firm to respond can intimidate potential competitors in other countries. Indeed, if the intimidation is great enough, neither the initial advantage nor the economies of scale need be especially large.

Mercantilism in Japanese trade policy

All of these ideas find expression in Japan's policy of managed trade, which became the focal point of a far-reaching industrial policy through which the state re-shaped Japan's post-war economy. Autarchic development was impossible because Japan was very poorly endowed in key natural resources. Since it had to maintain a significant level of imports, export revenues were needed to pay for them, yet Japanese industry lagged behind their North American and European counterparts. Thus, Japan used mercantilist-inspired managed trade to develop globally competitive firms in a few well-chosen sectors that promised long-term growth. The methods combined initial import protection motivated by infant industry arguments with vigorous export promotion programs consistent with strategic trade theory. A complex set of policies coordinated by the Ministry of International Trade and Industry (MITI) controlled credit and imports, permitted monopolies, and granted favored firms direct subsidies, tax relief, and other public support. The unusually close connection between the government and private industry and the unusually prominent position of MITI within the government gave rise to the term "Japan, Inc." to describe the total social mobilization undertaken in support of these fledgling export industries. This reputation discouraged some American firms from even competing in sectors such as consumer electronics because they were convinced that the commitment of the Japanese government to capturing the American market would make their efforts futile and costly. Meanwhile, Japanese rice production was heavily protected by import barriers.

Under the influence of these mercantilist policies, the Japanese economy in general -- and several specific export industries in particular -- achieved great technical sophistication and market success. Specifically, Japanese firms achieved global dominance in textiles in the 1950's, electronics in the 1960's, and autos in the 1970's and 1980's. Japan's trade surplus became the largest in the world, bringing an inflow of capital that permitted aggressive foreign investment, not least in the form of purchasing more than 100 billion dollars of U.S. Treasury bonds. This gave Japanese investors considerable leverage in affecting the American economy, which partially offset Japanese military weakness whenever the relative power of these two states became an issue in foreign policy.

The idea and practice of "fair trade"

Japanese success in managing trade raise a venerable dilemma for U.S. policy: how to maintain a free trade doctrine when trading partners do not. If other nations practice extensive import restrictions, even a liberal nation may find it difficult to find export markets. While this "reciprocity" objection is a common feature of all debates over free trade, liberal economists are unanimous in finding it to be totally without merit because protection always hurts consumers by increasing the prices of imports. Thus, while Smith acknowledges that "revenge naturally dictates retaliation" he finds the policy unwise: "it seems a bad method of compensating the injury done to certain classes of our people to do another injury ourselves, not only to those classes, but to almost all the other classes."⁽¹⁶⁾ The sole exception to the principle that retaliation is self-defeating is the allowance that temporary measures designed to induce others to eliminate the objectionable barriers may be justified. On how far in this direction it may be safe to go, sage judgement cannot be found in the analytical ability of the economist, says Smith, but in "the skill of that insidious and crafty animal, vulgarly called a statesman or politician."

Statesmen in liberal nations frequently see great opportunities for such diplomacy to achieve "a level playing field" for its firms in competition with mercantilist ones. Because the methods such liberal states employ often borrow from the very managed trade policies to which they object, it is common for them to package these initiatives under the rubric of "fair trade" rather than "free trade". This is especially true in the U.S., where, ironically, the reaction came about the time the Japanese strategy was undergoing change anyway. Japan had become fully competitive in global markets by about 1975, and since then its trade policy has moved away from mercantilist extremes.⁽¹⁷⁾ However, the balance of trade deficits remain, and so do the political pressures on the U.S. government to defend American firms and workers from Japan's "unfair" trade practices.

Though the U.S. remains committed to a liberal international system, American policy has employed a range of defensive tools of managed trade to achieve "fair trade". Section 201 of the Trade Reform Act of 1974 charged the U.S. International Trade Commission (ITC) with investigating petitions for import relief and recommending action to the President. Between 1974 and 1986, 55 cases were investigated under Section 201 and relief was provided in 18 of them. GATT's Article VI, which permits "countervailing duties" to offset foreign subsidies, was implemented by Section 301, which authorizes retaliation against any foreign manufacturer found to be engaging in "unjustifiable, unreasonable or discriminatory" trading practices. Countervailing duties are used by the U.S. primarily to protect American industry from injury caused by the "dumping" of foreign manufacturers, which consists of either selling a product abroad for below its cost of production or below the price for which it is sold in the home market. The ITC has authorizing countervailing duties against many countries, but the most frequent target has been Japan. The "Super 301" provision of the 1988 Trade Act places pressure on the President to designate "priority foreign countries" who maintain "unfair" trading practices and to set a deadline for progress in correcting them. The major target again was clearly Japan, but both 301 and Super 301 have been broadly used in recent years. Such actions provide the teeth that encourage nations to seek bilateral negotiations with the U.S. over trade disputes.

As a result, it has become common for the U.S. to require competitors to "voluntarily" reduce exports through bilateral voluntary restraint agreements (VRA's). Of course, when the U.S. asks another nation to restrict their exports and threatens retaliation if they do not agree, the agreement is "voluntary" in exactly the same sense that one hands over one's wallet to a gun-toting mugger "voluntarily". The most notable of these arose from a conflict over automobiles which began in the 1970's and culminated in the early 1980's. In June of 1980, the U.S. Senate adopted -- by a vote of 90 to 4 -- a resolution calling on the Carter Administration to send a signal to Japan by reviewing American import policies. In 1981, a VRA was negotiated that limited sales of Japanese cars in the U.S. to 1.68 million units per year. This illustrates that "fair trade" really means managed trade, even if one of the parties would have preferred free trade.

Conclusion

Thus, we see that the venerable ideas of international trade theory continue to exert a profound influence on contemporary trade policies. Given the range of alternative values being sought by nations and the different priorities attached to them by various actors, it is hard to argue unequivocally that any of these trade strategies best achieve the interests of any nation. We can say, however, that the acceptance of some ideas and the rejection of others powerfully shapes the strategies employed by nations -- quite likely more than the interests themselves.