Trump Vs. Free Trade with Richard Epstein
2017-06-24 · Guest: Richard Epstein (Professor at NYU School of Law) · 17:29
Economic principles of foreign trade and mutual gain
Bob Zadek and Professor Richard Epstein discuss the economic principles of foreign trade, debunking common misconceptions about “fair trade” and trade deficits. They explore the concepts of mutual gain, specialization, and comparative advantage, explaining why free trade benefits all parties involved despite political rhetoric to the contrary.
Topics: Free Trade, Fair Trade, Comparative Advantage, Tariffs, Economics, International Trade, Donald Trump
Speakers: Bob Zadek, Richard Epstein
Introduction to Trade and Orwellian Rhetoric [00:30]
Bob Zadek: Well, with that stirring patriotic musical introduction, I’m happy to welcome you back to The Bob Zadek Show, the only live libertarian talk radio show on the air all weekend. I am, as always, your eponymous host, Bob Zadek. Thank you so much for listening on this summer Sunday morning.
George Orwell’s famous dystopian novel entitled 1984 brought to us all the phrase “War is peace, freedom is slavery, ignorance is strength.” Black is white, dark is light. Everything is upside down. Why do I mention that? This morning’s topic is one of the most important and least understood policy issues confronting America today. The problem has been compounded by some loose, inaccurate, misleading talk by our President Donald Trump. The subject is trade, foreign trade, buying and selling goods to and from manufacturers located outside of the US.
The trouble with discussing trade is that all the words, or the common phrases used in a discussion of trade, mean actually the opposite of what they sound. Bad words sound good, good words sound bad. I had to go to one of the wisest men that I know, Professor Richard Epstein at NYU School of Law, to help us sort out these really important concepts that will influence economic and social life in America for decades if they are profoundly changed. Richard has written over 15 books. He is the senior fellow at the Hoover Institution, a very important think tank here in California. He also has taught and is the professor of law emeritus and senior lecturer at the University of Chicago. I could go on, and perhaps I will later on in the show, but Richard, thank you so much for joining us this Sunday morning.
Richard Epstein: Well, thank you so much for that stirring introduction following the patriots.
Defining the Vocabulary of Trade [01:30]
Bob Zadek: Well, Richard, now, trade—trade with companies located outside the US and with countries other than the US—is of course of profound economic importance, not only in the US and within the entire planet. We saw that when the Smoot-Hawley Tariffs were imposed during the Great Depression. So help us understand. First of all, we have to have defined terms, and our friends out there will be able to follow the conversation if they understand some key defined terms and what they mean so when they hear the discourse in public, they can follow the conversation. So first, explain in a few words what foreign trade is, and then there are concepts like deficits, which sound terrible, and fair and unfair trade, which are co-opted by those people who have a specific point of view. So give us the important vocabulary of foreign trade so we can follow the conversation.
The Economic Logic of Mutual Gain [02:31]
Richard Epstein: Okay, well the first thing to do in understanding trade is not to worry about domestic markets or foreign markets, to take the geography out of it and look at the first simple observation: two people come together and one decides to sell and the other decides to buy services or goods. Now, one of the ways in which you could think about this transaction is as a quote-unquote “zero-sum game,” meaning in effect that after the transaction is finished, neither side is better off than it was before. At which point the whole thing becomes a complete puzzle, because why would people expend resources to put the trade together if they’re no better off afterwards than before? Indeed, the only thing they would have would be that resource loss, the transactions cost, as what they’re commonly called.
So to understand why free trade is so important, there has to be a gain. And the gain comes from the fact that the party who buys the goods values the goods more than the price that is paid for them, and the seller prefers to receive the money to the goods that he surrenders. Now, why is it that that is true? Well, as Adam Smith said a long time ago, there are enormous gains from trade through specialization. So that if I as a seller specialize in making some commodity, I can sell it to you. You, when you go on to your business, can take the thing pre-packaged from me and use it to get a set of outputs that you can then sell into the market where the same progression of gains from trade necessarily follows.
So if you really want to understand what’s wrong in the upside-down world, think of this: the Marxist definition of exploitation through market exchanges is in fact one of these Orwellian-type situations. Exploitation is appropriately used for theft where I take something from you without your consent. I’ll be a little better off and you’re a lot worse off. But if the world existed only through theft, it essentially is going to be solitary, poor, nasty, brutish, and short. So exploitation is not the correct term to use here. It is essentially mutual gains through beneficial transactions, which is the hallmark.
Then the question is, how do you put this in some kind of a geographical setting? And well, the easy case turns out to be you have a single sovereign. And what that sovereign does, binding both the buyer and the seller, is to say, “Look, I know you guys want to make this trade, and in fact it’s going to have mutual gains, but transactions are tricky. Often times they’re sequential. I have to pay for the goods before they’re delivered, or I have to deliver the goods before they’re paid for.” And if the state is essentially going to back both promises, what people can do is now trade along another dimension, which is time. So I can do something for you now and get paid for you later, or the reverse. And hence, therefore, government enforcement of contracts increases the possibility of gains for the party.
The Disappointed Competitor and Protectionism [04:31]
Richard Epstein: But then you will ask, what about the effects on third parties? And the answer to that question starts as follows: essentially, if I’m better off by selling and you’re better off by buying, what we will do is increase the opportunities for further trade at both ends of the transactions. I will buy more inputs and you will take your inputs and get more outputs from the particular transaction. So that the circle of beneficial situation will expand so long as you keep the transactions cost that are going into place working. And if everything is within a single jurisdiction and the state decides that it’s going to enforce these kinds of contracts, what you do is you get this virtuous circle in which each transaction is positive-sum, as I’ve just mentioned.
Now, what happens when you have two different jurisdictions? Well, before you get to the foreign case, which you wanted to talk about and rightly so, well, what you do is think about trade inside the United States. We do not have, fortunately, a mercantilist policy in which we try to protect our sellers by encouraging their exports and punishing any imports. Essentially, the United States is organized by and large as a free trade zone, so that anything that takes place in production in one state can now be sold in another. What this does in effect is it expands the possibility for gainful pairing between parties and accelerates the process of positive-gain transactions. And one of the great achievements of the United States Supreme Court is making sure that states cannot put up protectionist barriers to the movement of goods and services across state lines.
Take this argument one step further and now put it into the international context and ask yourself what’s going on here. Well, oddly enough, the transactions cost of working international trade arrangements will probably be a little bit more expensive given the distance and the change in culture than they are domestically, but the improvements in technology have reduced these kinds of financial barriers, and so the ability to get gains from trade given that different cultures have different resources and different skills and different abilities is even greater. So the same logic starts to apply. You want more and more of these transactions to take place.
Now, what’s the basically the bugaboo in this situation? It’s the question of the disappointed competitor. And so it turns out that domestically I buy from X at a price of 10, and now I go overseas and I buy from somebody else at a price of 8. The domestic guy says, “You’ve hurt me.” And so we get the Orwellian language that somebody who could no longer make a sale is allowed to treat himself as though he’s been beaten up in a back alley somewhere. Well, the answer is this is awfully good, not bad, because if I now can have my inputs at a lower price, I could expand the kinds of things that I can sell. And it turns out that the fellow who’s disappointed in one transaction has greater opportunities to move somewhere else in the market and improve the overall situation.
So the basic theorem of all trade, whether it be domestic or international, is disappointed competitors who lose out to superior products at lower prices should never be heard to demand they block in tradition. If you go into the Trump-like domestic policy or the Clinton-type domestic policies, what you will always see in particularly strongly unionized industries which have very high wage structures because of domestic monopolies are the first to complain about international trade. And that’s just a sign of their precarious position, and indeed you want the international trade to come in because what it does is it erodes the domestic power or the monopoly power of any local party. So gains from trade, which works between two people, works within a single jurisdiction, works across different states, and works across international relationships. So this is a real imperative. And to see both American parties, Republican and Democrat, deeply skeptical of this shows you that Bernie Sanders, one of the most ignorant men in public affairs and public life today, makes the same kind of mistakes as Donald Trump. Fortunately, now that Trump is in power, he’s backing off of this a little bit, and the more he backs off from his anti-free trade campaign, the better we will be.
Understanding Comparative Advantage [05:51]
Bob Zadek: Just to add a little bit of embellishment or color to it, you mentioned without identifying it the concept of comparative advantage when you talked about the foreign seller being able to sell goods in the US domestic market cheaper than a domestic manufacturer. Comparative advantage is a very important concept which provides a benefit to all buyers on the planet. Just explain in a few syllables if you can the concept of comparative advantage, because that goes such a long way to explaining why free trade is so important.
Richard Epstein: This is one of the most important developments. To understand why we use this funny trade “comparative advantage” is first of all what you have to think about is a situation in which there’s an absolute advantage, right? And so if I have an absolute advantage, what this means is I can do everything better than you can do. A comparative advantage is as follows: you make two things and I make two things, and what you can do is you can make thing number one at a cost of 5 and thing number two at a cost of 10, and I’m the reverse. So essentially, each of us as self-sustained would be okay, but if you specialize in making the thing that you do cheaper and I specialize in making the things that I can make cheaper, what happens is it turns out we’re both going to be better off because my comparative advantage, which is that I have slightly lower costs than you, is something that can spread itself out throughout the entire system.
So what international trade and what all trade does is what it tends to do is to move situations into a situation where they’re better. So if I’m better at you at two things, right? I can do A and B better than you, but you have resources. The trick is that you want to devote your resources to the case where your comparative advantage is greater. So if I’m twice as good at you at doing one thing and only 10% better than you at doing the other, I should specialize in the twice and you should specialize in the 10%. And this is a notion which goes back I guess to David Ricardo some 200 years ago, and what it does is it explains why it is that even if somebody is better at everything than somebody else, the guy who is inferior at everything will still find a place in the marketplace if he can produce goods at a cost below the price that they will demand inside the marketplace.
And comparative advantage is one of these things which actually drives market, and what Adam Smith said, which is still true: the bigger the market that you have, the more of these pairings that you can find. And so what happens is the benefits of comparative advantage take place because there’s now more sorts of people who can come in there and you can then organize the production of goods and services so that on relative terms, the low-price producer is in fact going to be the party who will command that. So do not think of a world in which I’m better at you than everything, Bob, which means in effect that you get to do nothing, which is one of the nightmarish themes that people have about international trade. What trade does is it blocks some possibilities by technological improvements, but it opens up others.
So to give you but one example: the United States for years had a situation in which we wouldn’t allow the export of refined or unrefined gasoline or oil overseas. And if you’d in effect kind of do things like that, what you’re doing in effect is you’re taking people who have a real comparative advantage in this country and making sure that they can’t reach foreign markets. And that means that somebody else is going to get a monopoly position—call that somebody Russia, call it Gazprom—and they’ll be able to charge higher prices because you will not be able, given the trade barriers, to exploit the comparative advantages that you have. So it’s absolutely vital that you lower your particular protective situations even if the other guys want to do something crazy, because as you make yourselves stronger, what will happen is you will command more resources, they will be deployed more efficiently, capital markets will work better, and in the end, free trade is a rosy story even if the other guy doesn’t want to practice it. What he’s going to do is to harm himself by preventing himself from getting the inputs that he needs. If he doesn’t get the inputs that he needs, he’s not going to have the capital necessary to create exports. So essentially, think of trade barriers as a self-inflicted harm by the nation that imposes them, ironically most savagely on itself.
Bob Zadek: And thank you. And one clear comparative advantage in the third world trading with the US is of course wages. If wage rates are lower in third world countries, then they have an advantage because they can provide labor at a cheaper cost. Now, they are not exploiting us, we are not exploiting them. They are using their comparative advantage in cheap labor to get our goods where we have a comparative advantage in manufacturing acumen and manufacturing skill. Both parties benefit, both parties will be better off, and both parties will grow accordingly. Now, another concept, Richard…
Richard Epstein: By the way, on that wage advantage, you know, it creates the following kind of dynamic. You have very low wages in a place called China, and then all of a sudden a lot of American…