Throughout the post-World War II era, the United States has been the world’s staunchest supporter of open trade. With our trade deficit topping $170 billion in 1986, however, it is not surprising that this support for open trade has ebbed and, indeed, turned into outright calls for protectionist measures. One need look no further than this journal for a recent expression of discontent about free trade doctrine.1

A dangerous imbalance between U.S. production and spending since 1981 has produced the mushrooming trade deficit; only a reversal of this imbalance can close the gap. How the United States chooses to accomplish this reversal is perhaps the most important economic policy matter facing our nation in the years just ahead.

Advocates of protection rest their case mainly on two premises. The first appeals to the commonsense notion that high-wage countries like the United States cannot compete with low-wage countries. If workers are paid $12 an hour in America and less than $2 in Korea, and both countries have access to world markets for capital and technology, Korean companies can always underprice U.S. companies. In free trade between such countries, workers in the high-wage economy face two disastrous options: unemployment or slave-level wages.

The second line of attack, the unlevel playing field argument, appeals to self-interest. The world is dominated by nationalistic economic policies; the competitive, open environment assumed by international trade economists simply doesn’t exist. While the United States plays by the rules of the free market, foreign governments support targeted industries with subsidies, selective procurement, and trade protection. The result is an “unlevel” playing field, and the ball inevitably bounces toward the U.S. goal.

The proper response to these problems seems clear: America should abandon the view that market forces dominate trade flows. It should act like other countries and manage trade to its advantage. Foreign imports should be strictly controlled with quotas until and unless foreign wage levels and industrial policies resemble those of the United States. Unless we protect our markets, the trade deficit will balloon even more and our manufacturing base will continue to shrink.

Fundamental truths

We share with the new protectionists a deep concern over the record trade deficit but firmly reject their diagnosis of America’s trade problems, on these grounds:

While our trade deficit mushroomed in the 1981 to 1985 period, the developing countries outside OPEC gained only slightly in their share of U.S. manufactured imports. Moreover, the United States now imports far less from low-wage countries than it did in 1960 (when Japan was in that category).

Since wage levels tend to reflect productivity levels, the truth is that the United States, like other high-wage countries, can compete with low-wage countries because its superior productivity compensates for higher wage rates. If developing countries had our skills, technology, and capital levels, their wages wouldn’t be so low.

The unlevel playing field argument evaporates before the facts: since 1981, when the United States last enjoyed a surplus in the trade of manufactured goods, the levels of protection have not changed much (except in the United States, where it has gone up). As for Japan, reputedly our most unfair trading partner, its proportion of the U.S. trade deficit hardly grew at all from 1981 to 1985.

Protectionists usually couch their claims in terms of saving particular industries from imports, as with shoes, lumber, and steel pipe. The facts show, however, that tariffs and quotas seldom save jobs for long or preserve the competitiveness of the industry to be “saved.” Meanwhile, of course, the consumer suffers through higher prices.

While subsidies, tariffs, and similar practices affect the mix of trade over the medium run, they do not affect the trade balance, which is driven by a nation’s spending and saving patterns. A country with investment opportunities exceeding its domestic savings will borrow from abroad and run a trade deficit even if its costs are relatively low, its home markets protected, and its exports subsidized. Conversely, a nation with high savings relative to investment will run a trade surplus even if its markets are open and its products sell poorly. The recent deterioration in the U.S. trade position resulted from the decline in net national saving when the growing budget deficit far outstripped any increase in net private saving.

It is unfortunate, if understandable, that these fundamental truths get little support in today’s environment. In this article we demonstrate the logic and empirical evidence behind them and expose other shaky arguments for protection offered over the years. Finally, we make policy suggestions for dealing with the trade deficit and the pressure for protection it spawns.

Those low-wage countries

From 1981 through 1985, the current-account balance (including both goods and services) declined from a positive $6 billion to a negative $118 billion. The drop in the manufactured goods trade balance over that period was almost as large: $118 billion. Since both the low-wage and the unlevel playing field arguments apply particularly to manufactured goods trade, let us examine U.S. trade performance in this area.

Exhibit I shows that the deterioration in the American merchandise trade balance was evenly spread across capital goods, automotive products, and consumer goods. As Exhibit II demonstrates, the United States lost trade position with each major trading partner in the 1981 through 1985 period.

Exhibit I U.S. manufactured goods trade by selected categories Source: U.S. Department of Commerce, International Trade Association, United States Trade: Performance in 1985 and Outlook.

Exhibit II U.S. manufactured goods trade by region Source: U.S. Department of Commerce, International Trade Association, United States Trade: Performance in 1985 and Outlook.

If low wages abroad were driving the American trade deficit, the share of imports from developing countries should have risen dramatically in these five years. But as Exhibit II indicates, the share of U.S. manufactured imports from non-OPEC developing countries in 1985 (25.4%) was about the same as in 1981 (24.6%).

Indeed, the long-run evidence throws even greater doubt on the cheap-wage argument, which implies an inexorable rise in the share of imports from countries with low labor costs. In fact, statistics on U.S. manufactured imports show precisely the opposite: in 1960, two-thirds of these imports came from countries with less than half U.S. income (and wage) levels, whereas by 1985, the proportion had dropped to less than one-third. In 1960, of course, Japan and many European countries had cheap labor by this definition; today that is not the case. If cheap labor really determined trade deficits, the United States should have had a much larger deficit in the 1960s, when much more of the world had lower relative wages than it does today.

The progressive lowering of trade barriers between developed countries was connected not with any comparative wage rises in developed foreign countries but with a period of fast growth both here and abroad. Moreover, instead of staying at low levels, Europe’s and now Japan’s wages have converged to U.S. standards roughly in parallel with productivity levels in those countries.

Unfair trade practices

Virtually all countries, including the United States, maintain restrictions on imports. But unfair trade practices are not the driving force behind the recent rise in our trade deficit. Whatever the slope of the field, the trading system did not prevent the United States from attaining a growing surplus in manufactured goods trade from 1973 through 1981, including a huge $11.6 billion in dealings with the non-OPEC developing countries in 1981.

To account for the turnaround of the overall U.S. trade deficit, unfair foreign practices must suddenly and uniformly have had to change around 1981. Indeed, there must have been something close to a massive global conspiracy. Yet we know that protection is not much greater in the rest of the world today than in 1981; the Europeans have cut back on their industrial subsidies and the Japanese market is now somewhat more open (see Exhibit II). Actually, protection has probably risen more in the United States than in any other market. Since 1981, we have slapped tariffs, duties, or quotas on autos, lumber, machine tools, motorcycles, semiconductors, and steel, and have flirted in Congress with protection for shoes and wine, among other products.

Japan is still often singled out as having the most unfair practices among U.S. trading partners. Yet it is doubtful that such policies figured in much of the surge in Japan’s trade surplus with this country since 1981. Exhibit II indicates that the Japanese portion of the deficit growth is virtually proportional to its trade shares that year. In 1981, Japan accounted for 25.2% of U.S. manufactured imports and 6.1% of manufactured exports. Given the growth in total U.S. imports and exports since 1981, simply maintaining these proportions in 1985 would have entailed a rise in our trade deficit with Japan of $28.6 billion—an amount little different from the actual rise of $29.9 billion. These facts hardly support the unlevel playing field claim; Japan simply picked up its share of the action.

Japan’s behavior over many years also indicates that any protective steps it has taken are not causally related to its trade surplus position. From 1965 through 1973, Japan’s trade balance in goods and services (its current account) averaged 1.1% of gross domestic product. In the 1974 to 1984 period, it averaged 0.7%. This is scarcely a record of a chronic tendency toward surplus.

The real culprit

If low wages and unfair practices in other countries are not the culprits, what is? The pervasive character of the increase in the trade deficit—by trading partner and by product category—suggests that something macroeconomic is at work. That is so.

By definition, a nation’s trade balance represents the difference between its total spending and its production. A nation that spends more than it produces runs a trade deficit. The United States has been in such a net spending situation since 1981. From 1981 through 1985, total real U.S. spending on private consumption, investment, and government services increased by 23%, or 7.4 percentage points faster than the rise in production.

One needn’t look far to discover what lies behind the spending-production imbalance. As Exhibit III shows, from 1980 through 1985 the government sector (federal, state, and local combined) increased its annual borrowing by about $100 billion. Borrowing by the federal government alone exploded, growing from $64 billion in 1981 to $198 billion in 1985. The private sector failed to boost its saving to balance the government’s binge. In fact, net private savings and investment actually declined.

Exhibit III Relative changes in national financial elements 1980–1985

Shaky arguments

Protection is usually advanced as a cure for the problems suffered by particular industries rather than a way of reducing the overall trade deficit. The three principal justifications for industry-specific protection all rest on misguided logical and empirical foundations.

Saving jobs

Proponents of protection often claim that it is needed to preserve jobs in particular industries. But this is a very expensive means of saving jobs—it raises consumers’ costs for both imported goods and the domestically produced goods with which they compete. The consumer cost in 1980 per job saved for quotas on imported TV sets was estimated at $74,155; for tariffs and quotas on footwear, $77,155; and for tariffs and quotas on carbon steel, $85,272.2 In 1984, American consumers paid an estimated $53 billion in higher prices because of the import restrictions levied that year.3

As high as they are, estimates of the costs for each job saved actually exaggerate the efficacy of protectionist measures in achieving employment objectives. Protection advocates are usually more interested in saving the jobs of those already working in a certain industry than in preserving industrywide employment generally. But quotas do not save specific jobs. Protectionists tend to believe that by diverting demand to domestic corporations, quotas will improve their profitability and prevent plant closures. Better prospects for profitability that attract investment, however, may induce a change in plant location or the purchase of more automated machinery. To the extent that protection encourages such a response, it can exacerbate dislocation and reduce employment.

In fact, we found that of 16 major U.S. industries receiving some type of shelter since 1950, only one—the bicycle industry—expanded after the protection lapsed. And even in this instance, protection failed to save many of the jobs existing when it was granted. Although the bicycle industry’s production and employment grew after it gained protection in 1955, the three largest bike manufacturers closed plants and moved in the next five years.

Moreover, while trade shelters may temporarily slow the shrinkage of a particular industry, it can lead to fewer jobs for those distributing protected goods as well as those using such goods in their own manufacture. This is especially true for “linkage” industries. By raising domestic prices for steel, for example, quota protection undermines the competitiveness of the car and machinery industries, heavy users of steel.

So protection is an extremely costly, unpredictable, and inefficient device for saving jobs. Indeed, by encouraging relocation and automation, by screening domestic producers from competition, and by raising production costs, it may actually reduce the number of jobs in some industries. And even if protection temporarily preserves jobs, the effects wane with time while workers elsewhere in the economy may actually be harmed.

Rejuvenating industries

Government, one argument goes, should be free to invoke protection in its desire to “pick a winner”—that is, allow a new industry to grow enough to become a healthy international competitor. Because the U.S. economy is so well developed, the infant industry argument is rarely invoked. But protectionists often lobby their cause with the objective of gaining import-damaged industries a breathing period in which to recuperate and modernize.

This line of argument raises an important question: If an industry can be profitable once it has attained enough capacity or experience (in the case of the infant industry) or when it has reequipped itself (in the case of the recuperating industry), what prevents it from entering the capital market to get the finances to tide itself over until it is profitable? Why can’t private participants in the capital market recognize these opportunities? The industry rejuvenation rationale for special trade assistance implies a serious failure in the capital market.

The United States, however, has the world’s best developed capital market. With so many suppliers of capital and such a sophisticated system of financial intermediaries to channel their funds to capital users, there is no reason why the market should systematically fail to recognize and underwrite industries that seem to have a future in the international market-place.

Those who want the government to help rejuvenate industries often claim that the recovery of single companies would help the entire industry. In the case of underdeveloped countries with primitive capital markets, this argument might be valid. But even then, the best approach would be direct capital subsidies instead of tariffs or quotas that add to the consumer’s costs. When an industry producing a standardized product loses its comparative advantage, far more than the passage of time is required to regain competitiveness.

Moreover, when quotas are applied to imports, protection may actually help foreign competitors more than the domestic industry. The “voluntary” export restraints imposed on Japanese cars, for example, raised car prices throughout the American market. U.S. car manufacturers enjoyed an increase in profits, but so did their major foreign competitors—which may have enabled those companies to perpetuate, if not widen, their cost advantage over American producers.

Supporting ‘basic’ industries

By harming certain key domestic industries, trade can allegedly impair a nation’s defense. But trade protection is a very inefficient means of preserving the production capacity of an industry deemed essential to national defense. A far cheaper way is to pay for the capacity and such stockpiles of products as are necessary to defend the nation directly out of the federal budget.

Protectionists have justified special government treatment by asserting a need to shelter and support certain “basic” industries, like steel, that are considered to be essential to the performance of other industries.4 The government, they argue, must deflect import competition from input producers, or even subsidize them, to prevent the American industries relying on them from becoming vulnerable to price hikes or supply disruptions.

The first problem with this line of argument is that it applies only, if at all, to those products for which international competition is weak, like crude oil in the 1970s when the OPEC cartel controlled world prices. When competition among foreign producers is brisk, American purchasers have no reason to fear that domestic suppliers will be driven out of business or forced to shrink capacity because of predatory practices or foreign producers’ more efficient operations. Indeed, American business would suffer if the government misguidedly imposed a tariff or quota on the importation of inputs, which would only raise their price and thereby reduce or destroy any competitive advantage U.S. manufacturers of finished goods enjoy in the international marketplace.

A second flaw in the basic industries rationale is the impossibility of distinguishing what is basic. Many industries produce inputs for other industries—lumber for wood products, copper for finished metal products, cotton for textiles, and so on. Why should only one or two of these sectors get subsidies or protection from imports?

Pragmatic policies

As we have argued, the U.S. trade deficit will not shrink much unless the imbalance between American spending and production is corrected. Clearly, given the magnitude of the imbalance—reflected in the $170 billion-plus merchandise trade deficit recorded in 1986—this will not be easy. And it cannot be accomplished overnight. For this reason, an effective trade policy must not only reverse national overspending but also hold protectionist pressures at bay during the difficult transition.

Shifting spending patterns

The imbalance between national spending and production can be corrected in any one, or a combination, of three ways. The first option, reducing private investment, is the least desirable. At a time when U.S. business is facing severe competitive pressures, America must, if anything, raise its rate of investment.

The second course, increasing private saving, is far more desirable but not readily susceptible to changes in government policy. After decades of empirical studies, it remains unclear whether savings patterns are sensitive to changes in interest rates and, if so, in what direction. Moreover, higher private saving, a main advertised benefit of the 1981 “supply side” cut in personal income tax rates, has failed to materialize. That year, net personal saving stood at 7.5% of disposable income. By 1985, the rate had fallen to 4.6%, the lowest level since 1949!

The third option, sharp reduction of the government deficit—in particular, the federal budget deficit—is by far the most feasible, if politically difficult. Although macroeconomists disagree about the desirability of actually eliminating the deficit, there is a broad consensus that it must be brought down from the range of $150 billion to $200 billion to something on the order of $50 billion. There is also a consensus in the policymaking community that deficit reduction should take place gradually and, if the economy slides into recession, be temporarily halted or even reversed.

Exchange rate adjustment would be the principal channel through which budget deficit reduction would improve the trade balance. Just as a run-up in federal borrowing pushed up interest rates domestically—which in turn pushed up the value of the dollar by attracting capital from abroad—a significant reduction in the federal budget deficit would depress interest rates and the value of the dollar, making U.S. goods less expensive abroad while raising the cost of imports. True, the dollar had fallen roughly 20% by March 1987 since its peak in the first quarter of 1985. But to return to its 1981 level, the dollar must recede by another 15% to 20% on a weighted average basis in respect to other currencies. It must fall by an even larger amount to enable the United States to compensate for the interest it has to pay on the more than $500 billion in borrowings from foreign investors between 1981 and the end of the decade.

A continuing decline in the dollar, of course, would cut American consumers’ purchasing power. But the day of reckoning due to the excess consumption enjoyed in the 1980s cannot be postponed forever. The only way our nation can compensate for an erosion in the value of the dollar is to raise productivity. It is encouraging that both political parties are concentrating on this issue and considering policies to bolster education and retraining as well as R&D spending, while moving away from blatant protectionism.

Resisting protectionism

Reversing overall trade patterns will be not only politically difficult but also time consuming. In the interim, even if the trade deficit drops to the $100 billion range, the political pressure to embrace protectionist measures will not let up. Indeed, despite its free trade rhetoric, the Reagan administration has resorted increasingly to protection in the worst way possible, by using quotas and sanctioning the creation of cartels.

Why has an administration so philosophically committed to free trade caved in to the clamor for protection? Because the two safety valves in our trade regime for absorbing protectionist pressures don’t work well.

The first, the so-called escape clause, allows domestic industries to receive a temporary haven from imports when they can prove to the U.S. International Trade Commission (ITC) that the imports cause them, or threaten to cause them, serious economic injury. Although this provision of U.S. law has been reasonably effective in screening out the domestic industries least meriting assistance—the ITC has denied relief to roughly 40% of applicants since the last revision of the law in 1974—it nevertheless has a fatal flaw. An industry can win its case before the ITC but still be denied relief by the president, which encourages it to run to Congress for permanent protection (as the shoe and copper industries have done in the last two years). In addition, the law has allowed the president to authorize temporary import relief in the form of quotas as well as tariffs; the latter distort trade flows less and, unlike quotas, also raise revenue for the government.

The second safety valve—trade adjustment assistance (TAA) for companies, workers, and communities hurt by import competition—has been rendered increasingly ineffective because of severe funding cutbacks over the past five years. Yet even in its heyday, TAA delayed adjustment, particularly for displaced workers, who were merely given extended unemployment compensation payments without encouragement to find other employment.

Modest changes in the escape clause and the TAA program would make them more useful:

1. Declining tariffs should be made the sole form of temporary relief for industries seriously damaged by import competition. This would make the escape clause more cost effective. In addition, all existing quotas and other quantitative restrictions should be converted to their tariff equivalents by auction; that is, rights to import products within quota ceilings would be sold to the highest bidders. Tariff rates would then be scheduled to decline over time. The revenue raised by these tariffs would be earmarked for workers affected by imports.

2. An affirmative injury finding by the International Trade Commission should cause liberalized standards to be invoked when the government is assessing proposed mergers of companies in beleaguered industries unprotected by quotas, as recently recommended by the Reagan administration. If the ITC judges an industry to be seriously damaged by imports, there is little worry that mergers will lead to imperfect competition.

3. Trade adjustment assistance should automatically be extended to displaced workers, but only in such a way that the benefits promote, not delay, adjustment. The primary TAA component should consist of insurance against loss of wages. That is, displaced workers should be compensated for some proportion of any wage reductions suffered in obtaining new jobs. This would encourage them to find and accept new employment quickly. Compensation could vary with the worker’s age and seniority in the lost job. A second component could provide extended unemployment compensation to workers living where the unemployment rate is much higher than the national average. Relocation allowances and help in retraining could also form part of this program. Federal loans for retraining would carry repayment obligations tied to future earnings and collected automatically through the income tax system.

Even under very conservative assumptions, conversion of existing quotas into declining tariffs would readily finance this program of trade adjustment assistance for at least a decade. As a result, there would be no financial pressures to impose new tariffs to fund the program, although the president would still be authorized to grant tariff remedies to domestic industries that could prove to the ITC that they merit relief.

4. A new insurance mechanism would ease the pain of economic dislocation in communities—a voluntary insurance system by which municipalities, counties, and states could protect themselves against sudden losses in their tax bases not produced by a reduction in tax rates. Under such a program, participating government entities would pay an insurance premium, much like the premiums in corporate unemployment compensation, for a policy that would compensate for losses in the tax base caused by plant closures or large layoffs.5

We will not be able to correct our trade imbalance until our national spending patterns change. But in the meantime, we must do a far better job of easing the difficult dislocations that this persistent imbalance has caused.