Saturday, 23 February 2008

Attacking NAFTA? Don't Clinton and Obama have the guts to support Free Trade?

So both Hillary Clinton and Barack Obama are desperately struggling to portray themselves as opponents of NAFTA (the North American Free Trade Agreement). In Obama's case, he is (truthfully or otherwise) alleging that Hillary was once a strong supporter of NAFTA. The reasons for their desperate positioning are simple. The next phase of the Democratic primaries is moving to Ohio and Texas, big manufacturing states that have seen 3 million jobs move to cheaper Mexico.

They're pushing a protectionist agenda to win votes.

Well, I'm not running for US President, so I can proclaim, without fear of alienating voters, that I support NAFTA and other Free Trade agreements. My only complaint about Free Trade agreements is that they exclude countries not in their scope. I want to see a single global Free Trade agreement covering all the countries of the world. I want to see free movement of capital, goods and labour from surplus locations to deficit locations on demand, with the minimum of friction and irrational roadblocks.

Yes, Ohio and Texas lost 3 million jobs to Mexico. But that's the whole point! Jobs need to move to wherever they're done more efficiently. What we need in Texas and Ohio is not public lobbying to "change NAFTA" but people plunging into fresh training to equip themselves for jobs better done in the US. Attitude wanted: Good riddance to those manufacturing jobs! Let's now show the world what America can do!

I can understand that people cannot be reasonably expected to support an economic regime that causes them to lose their jobs, but statesmen must educate the public about the benefits of Free Trade. When you retrain yourself into a profession that your country does better at, you earn more, and you pay less for the goods and services that you need, because they're now produced by countries that do those jobs better and cheaper. Everybody is better off, but the process of adjustment and getting there may not be easy. It's highly personal (more on my personal experience in a moment), and it can hurt. It can also distort judgement and subvert sound economic policy.

Let me explain Ricardo's Law of Comparative Advantage, because it's something most people, even those who have studied economics at high school, probably don't really understand. And in this context, let me recommend this excellent book, "New Ideas from Dead Economists", by Todd G. Buchholz (Penguin Books).

Buchholz's chapter on David Ricardo provides a beautiful and counter-intuitive example to show why Free Trade is good.

Most people have a rather unsophisticated understanding of what Free Trade is about. Some may say that if country A is better at producing shoes than country B, and country B is better at producing butter than country A, then the two countries should specialise, with country A producing shoes exclusively and country B producing butter exclusively, and they should trade with each other.

That is correct, but there's actually more. Ask yourself, if country A is better than country B at producing shoes as well as butter, should it bother trading with country B at all?

The answer from Ricardo's Law of Comparative Advantage may surprise you. Yes, it should.

A little mathematics may make it clearer.

Let's say that country A makes a quantity of shoes for $10 million and a quantity of butter for $20 million. Let's also say that country B is less efficient at either, requiring $15 million to produce the same quantity of shoes and $45 million to produce the same quantity of butter.

Let's also say that country A has a budget of $2 billion, which it can spend on production. Country B has a budget of $3.6 billion.

Let's say that country A haughtily decides not to trade with its less efficient counterpart. Then with $2 billion split evenly between shoes and butter, country A would produce 100 units of shoes and 50 units of butter. Country B, splitting $3.6 billion equally between the two products, would produce 120 units of shoes and 40 units of butter. Together, the two countries would produce 220 units of shoes and 90 units of butter for a cost outlay of $5.6 billion.

But what if the countries had, against all conventional logic, decided to specialise and trade anyway? If country A specialised in butter, then it would produce 100 units of butter. Similarly, country B, specialising in shoes, would produce 240 units. In other words, the two countries would together produce 240 units of shoes and 100 units of butter for the same cost outlay of $5.6 billion.

That's an extra 20 units of shoes and 10 units of butter just because of specialisation and trade, even though country A was more efficient than country B in the production of both products!

Therein lies the genius of Ricardo's Law of Comparative Advantage. It shows why Free Trade is always better.

If you're flummoxed by this and suspect there's some mathematical sleight of hand here, the logic is actually quite simple. Country A is 1.5 times more efficient than country B in the production of shoes ($15 million to $10 million per unit), but 2.25 times more efficient than country B in the production of butter ($45 million to $20 million per unit). Therefore country A should concentrate on the production of the product in which they have a greater efficiency advantage, - in this case, butter. [Note that if the two countries had specialised differently, they would have produced only 200 units of shoes and 80 units of butter, worse than in the no-trade case. So it's not about Free Trade alone, but also Free Markets that decide where efficiencies lie.]

Let me once again inject a personal note into this debate. I was able to migrate to Australia because of a relatively free market in labour. Ironically, my job is under threat today from cheaper sources in my native country, India. You may say I straddle both sides of the Free Trade debate. On the one hand, I have benefited from Free Trade, because I have been able to move myself and my family to a country with a better standard of living (and many other attractive features). On the other, I am more threatened in terms of job security because of the same Free Trade regime. Now that I am an Australian citizen, should I turn around and vote for protectionist economic policies? (We're in now, shut the door!)

I know what it's like to lose one's job. I was unemployed (for a thankfully brief period of 6 weeks) when the dot-com crash occurred. So I will not gloss over the very real hardship that unemployment causes. My wife and I went through some pretty severe mental stress because of it, and can imagine the effects on our lifestyle had my unemployment continued. But I still say protectionism is a cure that is worse than the disease. For long-term global prosperity, there is no alternative to Free Trade - Free Trade in goods, capital and labour. Free Trade promises us all greater prosperity, but demands from us greater agility, - a willingness to adapt, learn and change.

It's a pity that neither Democratic candidate is willing to stand up for that. Instead of attacking NAFTA, they should be proposing schemes to help US citizens retrain themselves for other, better professions. Governments should protect citizens, not from competition, but from stagnation.

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