Imagine you and I are the only two people in the economy. I’m good at making shoes while you’re good at making baskets. Each of us needs both. Instead of us making our own stuff, we should trade one for the other. That way we can focus on our specialty, reduce the time we spend on things we don’t do well, and still enjoy the highest quality product available.
If you get that concept, then welcome to Adam Smith’s The Wealth of Nations. The 18th century Scot argued that trade among nations raises the standard of living for everyone. In this way, the quality of stuff goes up, prices go down, and everyone’s happy!
It’s a great theory, but in practice things get dicey.
One big issue is that nations don’t produce equally. A country good at making many different things would soon drive companies in the less efficient country out of business. The two nations would quickly develop a trade imbalance, where the efficient country took in a bunch of money, while the less efficient country paid out more than it received.
When imbalances occur, weaker producers are supposed to lower their costs to once again become competitive on the world market.
But that simple notion of lowering costs masks a very large point of pain – wages.
The biggest expense in most businesses is compensation. If you find your company competing with a low-cost producer from overseas, then Adam Smith’s logic would have you slashing wages.
That’s where the fight starts.
People don’t like it when their wages go down. They particularly hate it when this happens so that domestic consumers can save a few bucks by purchasing goods made overseas.
Never mind that this destructive process gives local consumers a slightly higher standard of living because those goods are cheaper or better. And never mind that it provides more income to the low-cost producer in another country. The fact remains that the local employees of the company selling less stuff will suffer with lower wages or, more likely, people will lose their jobs.
Which brings up the next problem – what are we supposed to do with excess labor?
Before the Industrial Revolution – in Adam Smith’s time – there wasn’t much surplus of anything. If an inefficient producer went out of business, its workers could just switch to another industry or work the land. Today, not so much.
Even if a local company does win foreign orders, it doesn’t necessarily need to increase headcount, at least not where it’s based. The domestic firm can meet demand by growing production at overseas facilities or through automation.
What is a country to do with thousands of unemployed people of various ages that have either lost their jobs or had their wages cut? This is a question without a good answer.
And then there’s currency.
When Adam Smith was writing, the basis of trade was either precious metals or the British pound, which, at the time, was minted from precious metal. Comparing prices on goods and services was simple.
Today, transactions happen in many currencies (though the U.S. dollar is the leading one), none of which are based on a metal or any other fixed commodity. Most currencies float, so the exchange rates among them are always changing. That means countries have the power to influence international trade by manipulating the value of their currency, like Japan is doing today.
When Japanese leaders thought their currency was overvalued, the Bank of Japan took several steps to drive it down. In U.S. dollar terms, it fell from 75 to the dollar at the end of 2012 to 122 two years later.
This increased the cost of imported items that were priced in dollars by more than 60%. The change in exchange rate not only hurt U.S. goods sold in Japan, but also made Japanese products cheaper on the world markets.
The change in competitiveness had nothing to do with the quality of Japanese products. It was simply a function of prices reacting to monetary policy and changing exchange rates.
Since every country is interested in its own prosperity first, it seems self-evident that governments pursue monetary and fiscal policies that increase their exports while limiting imports. And this doesn’t begin to address the myriad of government programs – such as low-cost government loans and nationalized supply chains – that exist to support specific, export-related industries around the world.
Still, there’s no denying that trade agreements bring cheaper, better, or simply different goods to foreign markets.
In the U.S. we enjoy thousands of products from other nations that undercut or displace American goods. In that sense, free trade works.
But while the broader population enjoys a higher standard of living, we can’t ignore the cost of lost employment in some industries.
As we contemplate the new Trans-Pacific Partnership among the U.S. and several Asian nations, we have to remember that free trade definitely isn’t free. Determining if it’s worth the loss of jobs probably depends on whether you are a consumer that will buy cheaper goods, or an employee of a company that will compete with those products.
