The Trade Myths that refuse to die

I know I can't kill them, but I feel obligated to say my piece

Myth One: We don’t have a manufacturing sector any more

One myth is that American manufacturing has been devastated by trade. The evidence for this is the decline in the American work force engaged in manufacturing production work, from somewhere over 30 percent of American workers in the middle of the twentieth century to somewhere around 5 percent today.

But counting workers is the wrong metric. America is outstanding at food production. But in terms of employment, our agriculture industry is even more “devastated” than manufacturing. The majority of Americans 250 years ago were in farming. Now it is only about 2 or 3 percent.

Since 1980, American manufacturing output has doubled. Manufacturing has not been devastated. We are making more goods with fewer workers.

The key concept to understand is the Law of Relative Productivity Growth:

In the medium to long run, labor moves from sectors where productivity is rising faster than demand to where demand is rising faster than productivity.

This law follows from the definition of productivity. It describes the declining share of manufacturing employment. It is true for all advanced economies, including China.

Steady gains in productivity have given us higher incomes, and there is only so much stuff that we want to buy with those higher incomes. Instead of putting it all into more stuff, we spending much of our higher incomes on health care and education. In those sectors, productivity growth is not as fast as growth in demand.¹

Given the law of relative productivity growth, the only way to get manufacturing employment in America up to what it was 70 years ago is get manufacturing productivity down to what it was 70 years ago. That way, we would not have the surplus income to spend on education and health care, and we would have to keep more of our labor in manufacturing.

Of course, government can always choose to favor manufacturing relative to other sectors. Tariffs on imported goods will move in that direction, although I would predict that the effect will be small relative to the loss of consumer well-being that will result.

If you were to ask me how government can favor manufacturing, I would reduce government subsidies for other sectors—especially health care and education. My approach would help to reduce costly economic distortions, whereas tariffs increase them.

Myth two: Our trade deficit comes from other countries taking advantage of us

Every decent economist sees that this is a myth. I was reminded of this with Scott Sumner’s post.

Our trade balance is equal to domestic saving minus domestic investment. Once you understand what’s going on, it becomes easier to see what would be necessary to “solve the problem” of the trade deficit (which is not a problem at all.) One “solution” would be to reduce US investment, say by causing a big recession. And indeed, the US trade deficit often gets smaller during recessions.

A better solution might be to raise the level of domestic saving. But that’s much harder than it seems, as almost every possible solution is going to be painful. I’ve advocated reducing the federal budget deficit. But that would be unpopular (higher taxes and/or lower entitlement spending), and even that might not be enough

The trade deficit is the mirror image of our “capital account surplus,” part of which consists of foreign purchases of Treasury securities. But as Sumner and Kevin Erdmann point out, it also reflects differences in savings preferences.

Cautious German, Japanese and Chinese savers earn low returns by investing in our T-bonds, while we earn high returns from quite profitable multinational investments in other countries.

You can try to use tariffs to change saving preferences. But it would be better to focus on our own fiscal policy.

Don’t under-estimate mainstream economics regarding trade

The over-arching myth that is popular these days is that mainstream economists do not understand how trade works in the real world. I disagree with mainstream economists plenty. But on the issue of international trade I think that, if anything, mainstream economics under-estimates the benefits, and critics under-estimate the value of mainstream economics.

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Peter Navarro vs. Kevin Erdmann

1. “Productivity” is actually quite hard to measure in education and health care. But we can rely on our law to be confident that productivity is growing more slowly in those sectors than in manufacturing or agriculture.