The Costs and Benefits of Trade Agreements/Liberalization

This is from Krzysztof Pelc's review of Dani Rodrik's new book:

In the case of trade, one such wrinkle, long overlooked, comes from economic models’ focus on the “average citizen.” And while trade agreements may indeed be beneficial to the “average Canadian,” no such animal exists in the wild. There are Canadians who work in the finance sector in Toronto and eat organic yogurt, and there are Canadians who work in the dairy industry in Sainte-Anne-des-Plaines, say, and drive pick-up trucks. The first group will likely be better off after the TPP, while the second (which theory tells us should be smaller) may well be worse off, at least in the short term.

Just how short that short term is turns out to be the crux of the matter. On this question, a number of scholars have recently done that unusual thing of changing their minds in the face of new evidence, and I include myself among them. Until recently, the assumption was that while the dairy industry in Quebec may suffer from opening up to competition from organic dairy from Australia, those workers will swiftly find new work in another growing sector, and we’ll all end up better off. The term of art is a reallocation of resources, and the gains from trade rely on it. But what we’ve learned of late is that the reallocation is far from swift. A series of studies looking at the U.S. has shown that areas most exposed to trade competition from China, especially, have experienced decreased earnings, lower employment, and increased disability claims, even a decade later. The losses in the losing industries have not been offset by gains in winning industries nearly as fast as we thought, and the effects will be generational. You won’t be surprised to hear that such trade-exposed areas also disproportionately voted for Trump in the U.S., and Brexit in the U.K.

Which is to say that I’ve been chastened. When journalists ask me whether the TPP is “good for Canada,” I now have a more sheepish answer. I respond, “Which Canada?” Because whether or not such agreements are beneficial in any meaningful sense depends on our ability to redistribute some of the benefits, from the majority that gains to the minority that stands to lose. Canada happens to be quite good at this, given its strong social safety net. But it remains a massive looming policy challenge, especially with further labour market shocks, such as artificial intelligence, on the horizon. And it is not just a problem for individual countries: U.S. behaviour over the last year has been that of a country externalizing its domestic pains, rather than dealing with them domestically. Trump passes a tax reform bill that helps the wealthy, and then lashes out against NAFTA on the basis of its costing working-class jobs. Domestic troubles have a way of spilling over borders. The danger emerges when countries “putting their own economic houses in order” do so at the expense of the house next door.

It seems to me that when evaluating the costs and benefits of trade agreements and liberalization, you need to break down the analysis into two steps.

First, compare the overall costs to the overall benefits. On this measure, my sense is that almost all economists would agree that the benefits outweigh the costs (although no doubt they would argue about the precise numbers). This conclusion has been understood by economists for decades, the evidence hasn't changed, and no one has changed their mind about it. The "China shock" wasn't actually much of a shock, and followed the normal pattern. Trade liberalization allows for more specialization, and the opening up of trade will disrupt the existing production structure, which is what happened with China's rapid industrialization. I guess you can be surprised by the pace of China's industrialization, although Japan, South Korea and Taiwan provide a good precedent for fast development in that region, so perhaps this was more predictable than some people are suggesting.

Second, there is the question of how to compensate those who are harmed. Nobody thinks or thought that everyone would be better off. Trade liberalization will make society better off as a whole, but some will be hurt. People who work in the Canadian dairy industry might end up worse off, to take the example above.

So what kind of social safety net do you need for those harmed? Should there be a special safety net for trade, or just a general one that applies for all economic dislocation (e.g., the artificial intelligence Pelc mentions)? This is where the big debate should be taking place. Opinions vary, and some experimentation is probably needed.

The key point here is that trade liberalization is economically beneficial overall. There may be harm to specific people, but the best policy is still to liberalize, and that doesn't depend on redistribution. Even if there were no redistribution, liberalization would make society better off in terms of overall economic welfare. The adjustment period is important, but does not affect this conclusion. Adjustment may take a while in some cases, but that doesn't mean regulation to prevent trade with China or the development of new technologies is a good idea.

If you are skeptical of that conclusion, think about the alternative. We could have tariffs that impose economic harm on everyone, but with targeted benefits to the favored few. Under this policy, the costs will outweigh the benefits, making society worse off in terms of economic welfare. Going back to the Canadian dairy example, we can take from all Canadians and give to the dairy industry, but we reduce overall welfare by doing so. If someone asks, "Are tariffs good for Canada?", the right answer, in my view, is, "On balance, they are not, as they impose large costs throughout society, although some influential interest groups will benefit." (It's also worth noting that this is the right answer for any question about changes in economic policy: Overall the answer is X, but some groups are helped and others are hurt.)

This is the way I learned it all in the early 1990s, and as far as I can tell not much has changed. New evidence has come in, and it confirms what everybody already knew.

Now, you can complain about some of the rhetoric surrounding trade agreements. Krzysztof  says: "Ask a politician why Canada recently joined the Trans-Pacific Partnership (TPP), and you’re likely to get some well-rehearsed patter about growing Canadian jobs and expanding market access for our exporters." But that's just governments marketing trade agreements, not objective experts. In the world of economists, political scientists, and trade lawyers, the rationale for trade liberalization has always been about an overall weighing of costs and benefits.

Of course, there's always a small minority who wants to keep making the case that tariffs, in some circumstances, could lead to greater economic growth, and that debate will probably never end. And trade agreements have expanded into new areas, so we are not always talking about liberalization anymore. But if you are just thinking about the core issue of whether free trade or protection is the better policy, things haven't really changed much since the beginning. In this regard, check out the great new Doug Irwin book Clashing over Commerce, and you will quickly see that most of the arguments we are having today were all being made hundreds of years ago.