The Benefits of Open Markets and The Cost of Trade Protection

Executive Summary

The Administration’s recent failure to persuade Congress to grant “fast track” authority to negotiate trade agreements stems in part from a lack of understanding of the benefits of free trade for all consumers and for most workers. This study shows that free trade accelerates economic growth and investment, raises real wages, and enhances productivity growth. In addition, it shows that exposure to the world market has led to major improvements across a range of U.S. industries. Productivity in American plants that export is almost 40 percent higher on average for plants of all sizes, locations, and industries than for plants that produce only for the domestic U.S. market.

This study also concludes that economic sanctions-a tool used increasingly by the U.S. government to punish a country for its political views and actions by interfering with trade and foreign investment-usually do not work. In 1995 alone, U.S. economic sanctions against other nations reduced U.S. exports by up to $19 billion and deprived the U.S. economy of more than 200,000 relatively high-wage jobs.

Background

In recent years there has been a clear and marked trend in all regions of the world favoring the adoption of outwardly oriented economic policies. These policies entail opening domestic markets to imports and foreign investment and encouraging exports and investments overseas.

Outwardly oriented economic policies and globalization have combined in mutually supportive ways. Internationalization of business activities was made possible by two generations of trade and investment liberalization under GATT and OECD auspices, and pushed by successive American presidents. In turn, the desire of firms to have a global presence is the impetus behind new governmental efforts to further open markets to international competition. This synergy has led to a dramatic opening of the major economies of the world. In 1970, for example, U.S. exports and imports accounted for about 10.4 percent of U.S. GDP. By 1994, trade constituted 23.6 percent of U.S. GDP, an increase of 127 percent. This opening to international commerce has been mirrored around the world.

The Gains From Free Trade

American openness to international trade and investment enables the United States to have a stronger domestic economy than would otherwise be possible. Such gains from trade stem from the fact that not all economic activities can be performed with equal proficiency in every country and not all firms are equally competent in producing each line of goods and services. Trade and foreign investment allow specialization to flourish by permitting, or inducing, U.S. labor and capital to shift away from industries with low returns and into those with high returns. Through trade, American firms gain access to cheaper components and services from abroad. The result is more cost-competitive domestic production of both goods and services for the U.S. and international markets. By concentrating on the production of certain goods and services and trading for others, Americans can consume more of all products than would be possible without trade. This is what economists call the doctrine of comparative advantage.

  • U.S. Employment and Wages RiseExport-related employment in the United States accounted for 23 percent of new private-industry jobs between 1990 and 1994. Over the last decade, jobs supported by exports rose four times faster than overall private-industry job creation. As a result, 12 million Americans now owe their jobs to exports, out of a civilian labor force of 67 million people.At the level of the individual firm, jobs are created up to 18.5 percent faster in companies that export than in companies that have never exported or have stopped exporting. Moreover, exporting enterprises are less likely to go out of business. And being employed by an exporting firm is good for workers. A recent study found that both production and non-production workers received 14.4 percent higher pay at exporting plants, plus benefits that averaged 32.7 percent higher, than workers employed by firms that did not export. As a result, the communities where export workers live are better off. They enjoy growing tax bases and are less likely to face periodic business downturns, falling real estate prices, and cutbacks in community services.
  • Demand for Skilled Labor GrowsCritics of free trade often argue that competition with workers in low-wage countries is the reason wages in the United States have increased so slowly for the last decade and a half, and that trade is to blame for widening income inequality. Recent studies, however, suggest that imports account for only about 15 percent of the widening pay differential between skilled and unskilled workers. Most of the problem reflects the forces of technological change and immigration.This point is dramatically illustrated by Figure 1. Between 1967 and 1987, the ratio of less-educated workers to more-educated workers was cut in half, in both industries that must compete with imported products and export industries in the United States. In other words, over those two decades, there was a sharp decrease in demand for less-educated employees, relative to the demand for more educated workers. If this trend had occurred only in import-sensitive industries, it might suggest that foreign workers were taking jobs from low-skilled Americans. But since it occurred in both export- and import-sensitive industries, it is clearly a phenomenon driven by other economic forces that put a premium on skills. It is also clear that the demand for skilled labor has been the major force behind flat and falling wages for less-skilled American workers. There is, of course, only one appropriate public policy response to this trend: more intense education at all levels and lifetime training and retraining.

[Figure 1: Number of Less-Educated Workers Required for Each More-Educated Worker in Export and Import-Sensitive Industries]

Source: Baldwin and Cain (1995), Table 2, as cited by J. David Richardson and Karin Rindal, Why Exports Matter More! (Washington, D.C.: Institute for International Economics), 1996, p. 30.

  • Consumers and Businesses Benefit From TradeTrade stimulates economic growth and reduces prices, enabling consumers who earn more as workers to see their paychecks go further. While it is impossible to precisely estimate the consumer benefits from trade, it is roughly calculated that a 50 percent reduction in existing industrial tariffs would increase the global economy by $270 billion per year. A similar halving of agricultural protection would permit a $100 billion cut in the world’s food bill.Trade increases the variety of goods and services available to consumers. For example, forty years ago, during the long winter months, fresh strawberries and raspberries were an unattainable luxury. Their availability was limited to the “season,” a few months or weeks in the summer when local farmers brought in their harvests. Today, strawberries from Mexico and raspberries from Chile are available throughout the winter in all parts of the United States, thanks to a lively international trade in agricultural products.Business also benefits from trade because alternative sources of supply enhance competitive pressures on domestic firms, forcing them to improve their products and their methods of production to keep pace with the competition. Alternative sources also reduce the likelihood of supply bottlenecks in times of rapid economic growth or emergency. As a result, companies can avoid the costly and destructive boom-and-bust cycles of the past, when domestic production would be ratcheted up to meet a sudden increase in domestic demand, only to be cut back, with layoffs and idling of plant capacity, when domestic demand subsided. Now firms can meet spikes in domestic demand by importing products from abroad and can satisfy a sudden increase in foreign demand by exporting more. In this manner in the late 1980s, the computer industry satisfied a sudden demand for computer chips while new domestic capacity was coming in line.
  • Investment and Productivity IncreaseThe removal of impediments to trade and the resulting improvement in the efficiency of resource allocation throughout the economy naturally raises the rate of return on investment in tradable goods. The reduction of trade barriers on industrial products due to the Uruguay Round of international trade negotiations is expected to increase the real return to capital in the United States by 0.3 percent. There is likely to be a similar increase in the return on investment in Europe and Canada. In countries where the service sector has been highly protected-such as Japan-trade liberalization will similarly improve rates of return for industries such as financial services and insurance. The real return on capital in the Japanese service sector is expected to improve by 0.4 percent, thanks to the Uruguay Round. And the return on investment in nations such as Korea and Taiwan is likely to rise 0.3 percent. Since the tradable goods sector is generally capital intensive, a higher rate of return on investment there will lead to faster overall capital accumulation in the economy as a whole.Exposure to new production and management technologies and to new products due to international trade can foster productivity at both the industry and plant levels. For example, exposure to the world market is what transformed the U.S. auto industry from an aging dinosaur to an agile competitor. Facing little competition from abroad, U.S. automakers inefficiently produced lemons. Suddenly confronted with competition from well-built, efficiently produced, and thus competitively priced Japanese-built cars, the U.S. automakers were forced to clean up their act. The number of man-hours needed to build a car was cut from 24.1 in 1989 to 20 in 1994.
  • Costs of Economic SanctionsIn recent years, it has become increasingly popular for governments-especially the government of the United States-to interfere with trade and foreign investment as a means of punishing other countries for their political views and actions. By curtailing or banning trade with another nation or by sanctioning those who invest there, governments often hope to improve human rights in the target nation, or force it to stop developing dangerous weapons, or halt some other objectionable act. In U.S. political life, this hope can be traced back to President Woodrow Wilson, who believed that sanctions could bring a country “to its knees.” The most recent examples of all-out sanctions are the U.S. Helms-Burton law [Cuban Liberty and Democratic Solidarity (LIBERTAD) Act of 1996] that attempts to punish European, Asian, and Latin American firms for doing business with Cuba, and the Iran-Libya Sanctions Act of 1996 that attempts to punish firms that do business with those rogue states.
  • Sanctions Usually Fail to Achieve Political ObjectivesDespite the high-minded rhetoric that often accompanies the imposition of sanctions, history suggests they usually do not work. A recent study analyzing the effectiveness and costs of 100 cases of economic sanctions between 1915 and 1990 found that only 34 percent of such actions achieved their intended goals. Moreover, the success rate in the 1990s was lower than that in the 1980s, and the success rate in the 1980s was lower than that in the 1970s. In other words, while sanctions have been used more frequently, their success in achieving foreign policy objectives is less now than it was thirty years ago.
  • Sanctions Cost U.S. Jobs and Reduce GDP GrowthThis meager success rate comes at a high cost to the United States. As intended, trade sanctions reduce trade, both exports and imports. Financial sanctions may also reduce trade by denying investment, foreign exchange, or credit to the target country or by raising its cost of credit.Moreover, U.S. exports lost today may mean lower exports after sanctions are lifted, because U.S. firms will not be called on to supply replacement parts or related technologies. And foreign buyers may design out U.S. intermediate goods and technologies or decide against buying U.S.-made final products in the future because they have decided American firms are “unreliable suppliers.”In 1995 alone, U.S. economic sanctions against other nations may have reduced U.S. exports to 26 target nations by up to $19 billion. Unless there were offsetting increases in exports to other markets, these sanctions deprived the U.S. economy of more than 200,000 relatively high-wage export sector jobs and cost American families nearly $1 billion in higher wages.
  • A Better Approach to Foreign PolicyDomestic political pressure on a foreign policy issue can easily reach a level where U.S. policymakers feel the need to “do something.” Given this political reality, U.S. policymakers who find themselves considering the imposition of sanctions should adopt the following guidelines:-Recognize that sanctions alone-even very severe sanctions-stand a low probability of achieving most foreign policy objectives.-Limit the frequency of sanctions applications by insisting on multilateral measures. When multilateral cooperation cannot be achieved, sanctions are probably not the right tool.

    -Limit the collateral damage of sanctions, both to business interests at home and to powerless civilians abroad, by concentrating their force on punishing the elite. In other words, target sanctions on the leaders, not the populace at large.

Conclusion

Outwardly oriented trade policies-policies that open the U.S. market to foreign products and investment and that work to open foreign markets to U.S. goods, services, and investment-maximize economic benefits for American consumers, workers, businesses, and the economy at large. Efforts to impede trade come at a high cost. They can seldom be justified in economic or political terms.