While our dwindling manufacturing sector is not in the news like it used to be, given the current financial crisis, it’s gradual, (albeit often overstated), disappearance seems to be no mystery to anyone. Just pose the following question: “Why has the U.S. lost over 3 million manufacturing jobs in the last 15 years?” I’d bet good money that the answer would be free trade, or maybe, NAFTA. It’s just common knowledge. Duh. As paleoconservative Pat Buchanan puts it, “Between January 2002 and January 2007, the gargantuan U.S. trade deficit set five straight world records…If this is the fruit of a successful trade policy, what would a failed trade policy look like?” (1) Or Barack Obama, who agrees with Pat on approximately nothing, is actually in perfect harmony with him here. “It’s a game where trade deals like NAFTA ship jobs overseas and force parents to compete with their teenagers to work for minimum wage at Wal-Mart.” I’ve even heard Lou Dobbs isn’t a fan. I guess John McCain gave free trade some modest support while he was running for president, but rarely gave much of a rationale for it. That seems pretty standard these days. I mean, look at the embarrassing attempts the guy defending free trade makes in this debate. Countries like China have much lower wages, fewer labor protections and significantly less environmental regulations. Of course every company that could, would up and leave the United States if there were no trade barriers. It’s that simple.
Well, that’s a very solid argument. It has but one small caveat to it… it’s completely, utterly and unredeemably wrong. I’ll skip the heavy lifting and let renowned economist Henry Hazlitt do it for me. Suppose:
“An American exporter sells his goods to a British importer and is paid in British pounds sterling. But he cannot use British pounds to pay the wages of his workers, to buy his wife’s clothes or to buy theater tickets. For all these purposes he needs American dollars. Therefore his British pounds are of no use to him unless he either uses them himself to buy British goods or sells them to some American importer…” (2)
For all intents and purposes, the United States is the only country that uses the dollar.* Every dollar that leaves our country must eventually come back. Foreigners could buy up some manufacturing plants here but if they move those plants out of the country, any profits they get from the United States would still have to be spent in the United States.
There really shouldn’t ever be a trade deficit of any major significance. This may seem strange, but it shouldn’t. Exports pay for imports, so they must eventually balance out. Think of a bartering society. Let’s say we live in two different countries and I give you two goats and a rooster in exchange for five chickens, three sheep and one of those butter-churning thingamajigs (I just ripped you off by the way). In essence, my exports just paid for my imports. Add money into the mix and it simply adds another transaction. To stick with the previous example, I sell you my goats and rooster for cash and then turn around and use that money to buy your chickens, sheep and butter-churning thingamajig. My exports still paid for my imports. This works exactly the same for nations as it does for individuals.
Oh, but you’re saying there are trade deficits and the U.S. rocked one worth 568 billion dollars in 2008. Well two points need to be made, the first being general and the second specifically with regards to the United States.
In general, it’s obvious currencies don’t leave and come back instantaneously. There will be up and down cycles. It’s also hard to account for every economic transaction taking place between individuals, companies and governments in one country or another. This is especially true, given there are often large black markets in even the freest economies. And finally, well governments just lie sometimes. Shocking, I know. All of this becomes obvious when you look at the CIA Factbook for 2008, which says the world as a whole ran a $378 billion dollar trade surplus.** This is, of course, impossible.
Accounting issues only explain small discrepancies though. The United States is a very peculiar case. We just happen to hold the reserve currency for the world. To explain what this is and how it came about, we have to go back to the end of World War II. After the war, the Allied governments wanted to set up a system that would facilitate international trade and prevent the hyper-nationalistic protectionism of the 1930′s, which helped spur the Second World War. John Maynard Keynes and Harry Dexter White designed a system known as Bretton Woods, in which every country in the American sphere of influence, tied their currency to the U.S. dollar, at a fixed exchange rate and the dollar was in turn tied to gold at $35 per ounce.
Unfortunately, this system was doomed from the beginning; the problem was simple, it relied on a wise fiscal policy by U.S. politicians. In 1971, after a decade of paying for guns and butter (the Vietnam War and the Great Society) by inflating the dollar, the U.S. government could no longer justify the $35/ounce exchange rate. Foreign investors started requesting their gold and Nixon responded by closing the gold window (effectively declaring bankruptcy).
The fixed exchange rate system was eventually replaced with floating exchange rates that had no gold backing. This allowed investors to set currency values by bidding on them in relation to each other. Now, this system works in principal, but unfortunately it opens up countries to currency attacks. If a government enacts poor policies, investors can leave that currency en masse. Or, as many leftists claim, powerful countries can simply de-fund weaker countries if they don’t like their policies; although whether this has ever actually happened is disputed. Regardless, it leaves countries vulnerable as illustrated by the most famous example of such currency implosions, the Asian Financial Crisis of 1997.
To avoid these crises (and store a “risk free” currency in case of other problems), governments started stockpiling dollars to act as a bulwark in case their own currency was attacked. While the dollar was the reserve currency under Bretton Woods, as well as in the ’70′s and ’80′s, government stockpiles really accelerated in the 1990′s and 2000′s when China started taking off and the fall of communism brought with it a whole host of new countries, who, lacking Soviet support, needed to start stockpiling dollars.
Hopefully you can see where this is going. The dollars are no longer returning to the United States, or at least, a sizable portion of them are not. We buy toys from China and oil from Saudi Arabia and cars from Japan and electronics from Taiwan and cocaine from Mexico and they turn around and stuff those dollars into their central banks. This does two things: first, companies no longer have to buy anything from the United States; they can simply outsource their factories and then sell the dollars they collect to the host country’s central bank, or other investors, and thus our manufacturing sector is hollowed out. Second, it gives the U.S. government a license to print an almost infinite amount of money without producing inflation. Or in other words, we pay for our imports with nothing more than thin, green pieces of paper.
Now we can have guns and butter, part deux, but without the inflation. How wonderful! Unfortunately, as Herb Stein once said, “things that can’t go on forever don’t.” The dollar currently makes up 63.8% of foreign reserves with the euro in distant second at 26.4%. This however, creates a very precarious situation. While the dollar is no longer sinking like a rock, many nations are very nervous about the massive number of bailouts and stimulus packages our government has been enacting. Foreign central banks are becoming so nervous they have started diversifying into the euro and other currencies. If we’re not careful, they will pull the plug and all those dollars will come rushing back to the United States. If this happens, the dollar will hyperinflate overnight.
Our manufacturing sector is being hollowed out and we may even be facing a monetary crisis to compliment our financial crisis. However, free trade has nothing to do with it. Anyways, we really don’t even have free trade; NAFTA and the WTO are managed trade agreements that have plenty of tariffs and subsidies stuck into them. As Milton Friedman said when Charlie Rose asked him about the proposed Central American version of NAFTA, “I discovered it was a thousand pages long and every page has exceptions to free trade. It’s not a free trade agreement.” (3) Still, what we have isn’t rampant protectionism either. But if we just throw up a bunch of tariffs right now, other countries would almost assuredly retaliate (or possibly sell off their dollars) and prices would rise without our manufacturing sector returning. It would be Smoot-Hawley all over again. It’s that simple.
Note: There are other reasons for the reduction in our manufacturing sector that would be too arduous to describe in detail here. Comparative advantage and the United States’ transition to a more service and technology oriented economy, have certainly played a part. They have not, however, played a part in our large trade deficits.
*There are technically 10 small countries that also use the dollar (usually secondary to another currency). However, since the dollar is usually secondary and the countries are small, this has an insignificant effect on trade balances. In addition, the fact that these countries use the dollar, is simply more evidence of the whole dollar hegemony problem.
**The CIA doesn’t have data on seven small countries and a few have old data. However, every country with old data has a deficit/surplus fewer than 100 million dollars. Similar estimations can be made for the seven exclusions, which include the likes of North Korea. These discrepancies certainly wouldn’t add up to anything close to 378 billion dollars.
(1) Patrick Buchanan, Day of Reckoning: How Hubris, Ideology, and Greed are Tearing America Apart, Pg. 203, Thomas Dunne Books, Copyright 2007
(2) Henry Hazlitt, Economics in One Lesson, Pg. 70, Laissez Faire Books, Copyright 1979
(3) Milton Friedman, An Hour with Nobel Prize-winning economist Milton Friedman, Charlie Rose, PBS, 12/26/2005