A Neoclassical Hole in Neoclassical Free Trade

Ian Fletcher (American Engineering Association, USA)

The myth reigns that, whatever may be said about the political case against free trade or its collateral damage, serious economics answered the economic case in its favor long ago. The interesting thing, from the point of view of post-autistic economics, is that if one knows where to look, this is not only not true, it is not true even within the neoclassical framework.

There are several known exceptions to the case that free trade is best. Let’s look at one in particular that is perhaps the most fundamental because, unlike many arguments against free trade, it does not touch upon thorny industrial policy questions or the debatable wisdom of government. The argument is not unknown – though grossly ignored relative to its significance – so we can find properly-mathematized versions of it in a number of places. Like in the paper “Factor Price Equalization in a Dynamic Economy,” published in 1970 by Joseph Stiglitz in the Journal of Political Economy (pp. 456-88)¹

Disclaimer: the argument presented below is a simplification, and in particular, the scenario described is only one of several possible outcomes that Stiglitz’s paper and others like it discover.

Begin a thought experiment with two wholly protectionist nations living side-by-side. Trade is forbidden. Make one a “decadent” nation that values short-term consumption over long-term. Make the other, a “miser” nation, the opposite.

The difference between them is, of course, time preference for consumption, conventionally designated in economics with the Greek letter rho (r.) Individuals have such a time preference and so do societies in aggregate.

Now lift their protectionist barriers so these nations can trade. And let them lend each other money so that if one wants to run a trade deficit with the other by buying more than it sells in return, it can, by borrowing the difference between what it spends on imports and what it earns by exports.

Then see what happens. The mathematical model runs out the various possible scenarios. The precise outcome depends on a number of variables not relevant to the present argument, but one scenario in particular is very interesting.

What happens in this scenario is that the decadent nation maximizes its short-term consumption by buying all the imports it can get. This means all it can afford to buy with the money it earns from exports plus all the money it can borrow from the miser nation.

The miser nation is delighted to lend the money because from its point of view, this lending is an investment in an interest-bearing asset and having its neighbor open up as a field of investment has expanded its range of investment opportunities. Within the ceteris paribus assumptions of the neoclassical model, this enables it to make better investments.

Because the decadent nation can now consume more in the short term, it is (for now) materially better off. In neoclassical terms, it has better maximized its utility. Its miser neighbor, too, enjoys a higher utility, because it can more efficiently eschew present consumption in favor of piling up for the future.

Within the neoclassical framework, everyone is now better off, and this conclusion agrees happily with the libertarian intuition underlying neoclassical economics: an increase in freedom makes people better able to better themselves.

So is free trade vindicated?

No, because then comes the denouement. The increased well-being of both nations (as they define it, remember, decadently or miserly, in terms of maximizing consumption in the short or the long term) depends upon the ability of the decadent to borrow. And one cannot borrow forever.

What happens is that the decadent nation slides deeper and deeper into debt, while the miser nation gets richer and richer as it accumulates wealth in the form of the money owed to it by the decadent one. So while both nations are indeed better off in the short run, in the long run one gets richer and richer, the other poorer and poorer.

And there’s a twist: what if the decadent nation enters into free trade at a time when it is much richer than the miser? This means that instead of borrowing money from the miser to pay for the difference between its imports and its exports, it can gradually sell off its existing assets. But this is just mortgaging the house to pay for groceries: it results in the same net transfer of ownership of wealth between the two nations.

Remember that, within the simplified two-nation model, the basic mechanics of balance-of-payments theory is not controversial. Trade policy is debatable, but it is axiomatic that a nation must pay for its imports in one of three ways:

1. by exports,

2. by borrowing money,

3. by selling existing assets.

This is a simple consequence of the fact that when citizens of one nation obtain goods from citizens of another, they must give something in return if they aren’t robbers. If one generalizes from a two-nation to a many-nation model, there can be round-robin trade or any complex network, but the fundamental principles don’t change.

Our little thought experiment makes clear the answer to the paradox that underlies all criticisms of free trade that take place within the libertarian intuitions that dominate neoclassical economics:

How can reducing people’s freedom make them better off?

The answer, obvious enough once one thinks about it in the way implied by our experiment, is this:

People are better off with less freedom when they would use that freedom to hurt themselves.

In the present experiment, this means that the citizens of the decadent country would be better off if their inability to trade with foreigners prevented them from being even more decadent than they already are. Protectionism for them is like a restriction on an heir’s squandering his inheritance. In this experiment, the “inheritance” is the entire accumulated wealth of the decadent nation that can be gradually sold off to pay for present imports. Plus its entire future debt-servicing capacity which can be used to float debt to pay for present imports.

Under free trade, the natural temptation is for the present generation to maximize its consumption by having either past generations (who produced the existing wealth that can be sold off) or future ones (who will have to service debt it incurs) pay for it. It’s a wonder it doesn’t happen more often, and shows why it is false and dangerous to conceive of society as simply an aggregate of its present individuals, an assumption that easily creeps into social science and thus policy. There may be some value to Edmund Burke’s conception of society as a compact among generations, even if one rejects his political conclusion that this gives tradition a normative claim on the present generation.

Another point, which makes clear why globalism is wrong and nations do matter to economics: if the “decadents” in a society can only borrow from the “misers” in the same society, every borrower creates a lender in the same society, keeping the society as a whole in balance. But if they can borrow from foreigners, an entire society can “go decadent.” This can spiral out of control, given the self-reinforcing way in which the social and cultural validation of behavior within a society creates more behavior, then more validation, then more behavior and so on. So it does matter whether people engage in economic relations with compatriots they share a social system with, as opposed to foreigners with whom they do not.

This also means that, pace neoclassicism, people really can have better and worse preferences. Neoclassicism treats people’s preferences as “exogenous” to its model: they just want what they want and it is the job of economics to describe efficient and inefficient ways of getting it, not judge whether their wants make sense. That would be a value-judgment outside the scope of economics as an empirical social science, akin to a preference for pork vs. beef.

The problem with this is that the preference for long-term vs. short-term consumption is not a matter of indifference if one makes the strictly speaking dogmatic, but utterly reasonable in the real world, assumption that a nation wants to become more prosperous over time, not poorer. If one is genuinely agnostic about this question, then the whole argument here falls apart. But no sane person or nation is.

Neoclassicism tries to have it both ways: it demands public respect on the grounds of being an objective science aimed at a public good, economic efficiency, but it also claims, in the fine print, to be value-free. And the logically inescapable consequence of aiming at an efficiency that is agnostic about ends is the possibility of efficiently satisfying self-destructive preferences. Neoclassical economics tries to finesse this problem by tacitly assuming that nobody has such preferences, but as we have seen, they are clearly possible.

This explains, by the way, why this problem has been mostly ignored. Within the rigorously logical, though practically absurd, assumptions of neoclassical economics, it is merely a mathematical curiosity that free trade can make a nation worse off by seducing it into unsustainable debt-fueled pseudo-prosperity. That nation’s preference was for short-term consumption, and that’s what it got. Its utility was maximized. Maximum freedom produced maximized utility, so neoliberalism is confirmed once again.

In case you’re unaware of the quantitative data, the United States is the nation corresponding most closely to the decadent nation above. The archetypical miser nation is Japan, but includes a number of other nations whose public policy tends to bias their economic systems towards long-term over short-term consumption. The empirical facts are pretty much what our thought experiment would suggest: the USA maintains for now the world’s highest level of consumption, but is running a huge trade deficit and is the world’s largest debtor and biggest borrower.

The neoliberal retort to this problem is that it must self-correct eventually when the dollar collapses, pricing imports out of reach. True, but because America’s ability to assume debt and sell assets can postpone this collapse for years, it may not be the smooth correction that neoclassical models imply. Our thought experiment shows how the key is debt, because debt, confidence in which can collapse overnight, can turn this smooth adjustment into a volatile whipsaw. This insight oddly resembles Keynes’s attack on the classical model: credit is the joker in the deck that disturbs the celestial harmony of free markets. The dénouement may be a sudden collapse that comes after America’s industrial base has been ground down by years of cheap imports, resulting in a loss of entrenched industrial advantage that cannot be regained at feasible cost.

The potential perversity of rho, time preference for consumption, has implications beyond free trade and raises doubts about many other areas of economic policy over the last 25 years. For example, financial systems have been deregulated in many nations on the assumption, understandable within neoclassical assumptions, that this is efficient. But what if this just enables people to sink into debt more efficiently? It seems that many of the quaint old restraints on finance may have served, in a theoretically unrigorous way, to restrain the self-destructive tendencies of certain economic actors. It is no accident that the Bretton Woods system, which limited international capital flows, coincided with smaller trade deficits? If efficiency can be perverse, we can be better off inefficient.

Once one realizes how treacherous efficiency can be, and how important preferences are, it becomes clear that economics needs to focus less on the former and more on the latter. One surprising result of all this is a renewed respect for traditional bourgeois culture, or at least that aspect of it which inculcated people to save and not consume, i.e. have a long time preference for consumption. It seems those silly old Protestant misers had a point after all. One can even find it in the math, if one knows where to look.

Note

1. http://links.jstor.org/sici?sici=0022-3808%28197005%2F06%2978%3A3%3C456%3AFPEIAD%3E2.0.CO%3B2-N

Ian Fletcher is Vice-President for Government Relations of the American Engineering Association and may be contacted at ianfletcher@aea.org.

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SUGGESTED CITATION:
Ian Fletcher, “A Neoclassical Hole in Neoclassical Free Trade”, post-autistic economics review, issue no. 26, 2 August 2004, article 5, http://wwwpaecon.net/PAEReview/issue26/Fletcher26.htm