U.S. Trade Policy and Declining Manufacturing: Where do we go from here?

U.S. Trade Policy and Declining Manufacturing: Where do we go from here?

Paul Crist, August 14, 2010

The U.S. economy and the manufacturing sector in particular, face both short-term and long-term challenges. There is debate about whether government can or should play a role in addressing those challenges, and if so, what are the fiscal, industrial, regulatory, and trade policies that would benefit the stakeholders, which essentially include all U.S. citizens in one way or another.

I should acknowledge at the outset a bias toward thoughtfully considered government interventions to guide the economy and trade in ways that benefit American workers and allow them to participate in the gains that accrue from their labor. There are economic reasons for my bias that have nothing to do with either socialist or altruistic impulse. That bias in no way means that I favor protectionism or a retreat from global trade, or that government intervention in the economy is always desirable, but there are, I believe, issues and stakeholders that get too little consideration and solutions to structural economic problems that are given short shrift in the name of conservative ideological orthodoxy.

There is ample evidence that without adequate and well-designed regulatory intervention in domestic and global markets, capital and political power tends to migrate upward and become concentrated at the top of the economic ladder. We see that phenomenon in country after country, most recently in the U.S. Concentrated wealth becomes problematic when it undermines social cohesion and a sense of shared purpose.

The wealth/income gap is at the core of social and political stress and instability in most developing countries, and the U.S. is now experiencing the pangs of disequilibrium once confined to so-called "poor" countries.

As inequality increases, it can begin to undermine demand for goods and services. The wealthy may consume a great deal, but there are simply not enough of them to maintain aggregate domestic or global demand. Further, at the extreme, even those at the top may suffer negative economic effects if insufficient demand results in their capital being inefficiently allocated to producing goods and services, assuming international markets are not soaking up domestic demand shortfalls.

Despite what conventional trade and economic theories suggest, there are benefits to large countries in maintaining a diverse economic base that includes a broad manufacturing sector. Not everyone in a large country is suited to higher education and high-skill employment. The alternatives for non-college-educated workers ought to go beyond low-paid service sector jobs. Comparative advantage theory may be great on paper, but societies have more complex goals that trade theory alone cannot address.

Comparative advantage may also have lost some of its relevance in a highly globalized world where the factors of production, labor, capital, goods, services, and information can cross national borders quickly and easily.

There are always losers and winners when countries move toward free trade. That part of the theory seems enduring. But decades of evidence worldwide make clear that the political will to compensate the losers rarely if ever exists, despite the fact that the gains to the winners are more than adequate to do so. Most economists acknowledge that trade has played a significant role in the increasing income inequality which has characterized the past two decades in the U.S.

Increasing "financialization,"[1] accompanied by declining industrial output in large, mature empire economies has also, I believe, played a historical role in their decline.

So there are political and economic factors that support arguments for thoughtful trade management and interventions, in order to preserve economic sustainability, diversity, and an efficient distribution of income and wealth that enhances a well-functioning capitalist system.

Finally, my firm opinion is that global trade, as practiced today, inadequately accounts for the power of large, multinational corporations whose allegiance is to shareholders (the owners of capital) regardless of where the headquarters office is domiciled. U.S. trade in particular is characterized by labor and environmental arbitrage by U.S.-based multinationals with no real national allegiance. Political leaders who routinely support globalization without questioning the motives of multinational players are either corrupted by their influence, or insufficiently versed in the current realities of international trade flows between the U.S. and its major trading partners.

On the question of government intervention in the economy, I take issue with so-called "free market conservatives"[2] who oppose what they see as government meddling in private sector investment, production, and decision making. "Free market" and small government ideology has dominated American policy for a generation. The resulted has been a broad retreat from worker and environmental protections and benefits; an enormous increase in the income gap; disastrous consequences in the financial sector that plunged the world into the worst economic recession since the 1930's; and a less diverse and more fragile economy than we had in the postwar era.

Domestic industrial production and employment has continued a long decline, even as industrial sector deregulation accelerated and unionization plummeted. Deregulation and lax oversight of the financial sector contributed to financialization of the U.S. economy in recent years. The development and trade in complex financial instruments helped the financial sector grow substantially as a percentage of GDP.[3] And in due course, the casino mentality on Wall Street, combined with monetary and housing sector policies that were furiously trying to prop up consumer spending as wage growth stagnated, resulted in the current deep economic downturn.

There is an inadequate sense of urgency to seek equitable solutions to the structural problems confronting the U.S. economy. The gutting and outsourcing of regulatory oversight in many U.S. economic sectors led to environmental degradation and worker exploitation (both of which have long-term costs not apparent on annual corporate balance sheets). A broken immigration policy has served the economic interests of politically influential business sectors while sewing social, economic, and cultural divisions. Tax, monetary, and trade policies have favored the richest and most politically powerful Americans, exacerbating the growing income and wealth gaps while putting middle class workers under increasing pressure (and this has in turn put more price pressure on multinational firms, forcing them to be peripatetic searchers of ever-cheaper labor, and further exacerbated already large trade imbalances). Political posturing on all these issues must give way to unified, strong lea dership.

Given this extensive list of complex economic and trade issues, what are the policy prescriptions that might best revitalize American capitalism? All of these issues are deeply interrelated, and it would take a book to adequately deal with all of the important questions. But it is possible to identify a few specific areas where change could have profound and lasting positive effects.

U.S. Trade Policies Have Failed American Workers and Led to Structural Imbalances in the Economy

Trade policy and trade agreements are rightly a prime target for criticism: manufacturing competition from low-wage, low-regulation countries is unfair to U.S. workers, exploitive of foreign workers and labor migrants, and injurious to the global and local environment.

Solutions to reviving the U.S. economy in ways that benefit working Americans and stimulate environmentally benign industrial production involve more than trade policy, but trade policy has played a central role in creating the problems we now face, and a refocusing of trade policies can also play a central role in renewal.

Growing trade deficits since the 1980's have been associated with declining real wages, especially for non-college educated Americans that make up nearly 2/3 of the workforce. Manufacturing sector workers have been shifting to lower-wage service sector jobs, in retail, healthcare, and other low-skilled services as manufacturing jobs migrated overseas.

To keep consumer demand buoyant as wages stagnated, ever greater downward pressure was put on prices, driving demands from U.S. multinationals for new bilateral and multilateral agreements that opened investment and trade access to low wage, low production cost countries. Initially, production offshoring was confined to low-skill, low technology sectors, but over time, more technology intensive manufacturing has followed the march overseas.

Of the top eight trade deficit industries, the second largest deficit after oil & natural gas is in motor vehicles and parts, which is not a low-technology industry by most measures. There are also large deficits in computers, office machines and parts; in steel and alloys; and in televisions and other electronic equipment. Only three of the top eight trade deficit industries (apparel, leather goods, and toys) are in categories usually considered by economists to be low-technology.

Meanwhile, the total surpluses produced in our top eight net surplus industries have on average amounted to less than half of the deficits of the top eight net deficit industries in recent years. And while most of our top eight surplus industries involve high technology production, three are in the (sometimes subsidized) commodity sector: agricultural grains, meat packing products, and cigarettes. These sectors do not generate many high-wage jobs.

In several of the net surplus industries that do involve high technology and high wage production (aircraft, chemicals, construction machinery, scientific instruments, and engines and turbines) there has not been sustained growth since the late 1990's. Further, the U.S. is also an importer in all of the high technology industries where we manage to maintain a surplus. Other countries are rapidly expanding their capabilities in these sectors. How long will the U.S. maintain surpluses even in high technology production without fundamental changes in policy?

The scale up in foreign countries of auto, aerospace, energy, biotechnology, and other high technology industries provide evidence of longer-term workforce benefits to maintaining low and medium-skilled manufacturing jobs. At least some of those workers will, over time, acquire the skill and training required for higher-skilled manufacturing jobs and engineering innovation.

Highly productive human capital is the result of many things, including an effective education system, good public health, and continuing skills development�the benefits usually associated with economic development. Thus, it may be no coincidence that even U.S. manufacturers in high technology sectors are increasingly relying on imported labor to meet U.S. based manufacturing workforce needs. After all, we've been exporting the low and medium skilled jobs that are the training ground required to meet the workforce demands of our own high technology sectors. And immigrant workers, even highly skilled, are often willing to work for lower wages in return for U.S. employment.

Globalization has accomplished the goal of lower consumer prices, but the long-term economic consequences of cheap imports and stagnant domestic wages in an increasingly service-oriented economy has begun to become clear. When wages eventually fail to sufficiently support domestic consumption, even in the face of cheaper prices, economic contraction is inevitable. Consumers can only use the equity in their homes as an ATM for so long. And if exchange rates and trade agreements hamper exports, the contraction in consumption coupled with trade deficits present a complex dilemma for policymakers.

To be sure, America has enjoyed substantial aggregate gains from growing trade. Overall, U.S. GDP growth has been moderate to strong right through mid 2008. And it may yet resume post recession. But the benefits of that growth have not been shared with American workers, and the current downturn has exposed deep structural challenges to our economy.

The time has come to re-think our approach to global trade and the economy on many levels. In some cases, renegotiation of key portions of existing agreements is called for. Fortunately, growing political pressure for change is limiting further expansion of trade policies that have cost an estimated 1 million manufacturing jobs during the past decade. There is an emerging consensus that the U.S. needs to take definitive steps to rebuild a domestic manufacturing base, to address the problem of wage disparities, and to take steps to level the global trade playing field.

Exchange Rates, Trade Barriers, and the Dollar as Global Reserve Currency

Exacerbating the challenges resulting from U.S. trade policies of the past several decades are complex trade barriers, export-led growth policies among key U.S. trading partners, and a global currency architecture that is unfavorable to U.S. exports.

There is little argument among economists that China manages renminbi exchange rates to promote exports and limit imports. But exchange rate controls are just one of many forms of non-tariff barriers to imports and export-led growth policies pursued by China. With China trade accounting for about three-quarters of the total U.S. non-oil goods trade deficit, China should be the primary focus for U.S. efforts to right trade imbalances. But progress will not be easy.

The Chinese government announced recently that it would allow its currency to fluctuate slightly, but there is no concrete evidence of progress. Between the June announcement and August 2010, the currency only appreciated by about 1 percent. Despite lack of progress, the U.S. Treasury Department declined to designate China as a currency manipulator. With the renminbi undervalued by as much as 40% according to some analysts, U.S. manufacturers and workers are paying a steep price for Chinese intransigence on this issue.

A number of bills to deal with Chinese currency manipulation are pending in congress, in the absence of firm action from the Obama administration. These include the Currency Exchange Rate Oversight Reform Act of 2010 in the Senate (18 cosponsors); and the Currency Reform for Fair Trade Act in the House (133 cosponsors). Both bills are in committee, with passage still uncertain. Many Members consider trade issues to be under the purview of the Executive, with Senate ratification of trade agreements. But several trade deals remain pending in the Senate, owing to growing anxiety over many trade issues including Chinese currency manipulation.

The large portfolio of U.S. government securities held by China complicate the relationship, but for the foreseeable future, China will rely on access to U.S. markets as much (and perhaps more) as the U.S. relies on China to buy U.S. debt. The relationship is not as asymmetrical as some fear. Chinese leaders have their own challenges with development, and rely on high rates of economic growth to maintain political support.

Chinese government control over economic resources and activities, particularly in the banking sector, have also helped China to pursue and export-led growth strategy. Where a banking system is controlled or heavily directed by the state, national savings can be assembled and funneled into development and infrastructure that either directly or indirectly supports an export led national policy.

China is not the first country to pursue growth using government control over banking and financial decision making. Germany pioneered the model in the late 19th century, and many of the East Asian countries have done the same thing in the 20th century. Over time, these other countries decided they needed to move beyond that model in order to promote economic diversification, and China may yet follow that same path over time. But for now, government control is an important driver of China's export led growth policy.

Related to, but quite different from, government control and decision-making is the issue of trade barriers driven by private sector exclusionary policies toward imports. Japan has its Keiretsu and South Korea has Chaebol. Both are systems of interwoven banking, business, and management relationships within different companies or subsidiaries. These are closed systems that favor transactions within and between members, keeping outsiders out even when outside players are competitive. Chinese private-sector business practices and trade policies, in many ways, are modeled on those of Japan and South Korea. But at its most extreme, the U.S.-Japan trade imbalance never exceeded a three-to-one ratio. U.S. imports from China exceed exports by five times.

The Chinese government has also been remarkably good at using pilot projects to speed development, and this, too has benefited its export industries. China is able to try laws and policies out in one city or to invest in an innovative manufacturing process in one place, and then pick what works for promotion elsewhere (often called "picking winners"). Few other political systems work in that way, but in China it is very easy to do. It has led to uneven development across China, but has allowed for rapid development and scale up from low and medium skill manufacturing to now competing globally in higher-technology sectors.[4]

China is not alone in its effective protectionism and use of non-tariff barriers to U.S. exports. Subsidizing domestic producers, minimum import pricing, advertising restrictions, import licensing requirements, rebates of domestic taxes to exporters, and many other barriers are added to the more obvious trade barriers engaged in by many countries. But China is the leader in promoting exports and blocking imports, especially in its trade relations with the U.S.

Returning to the general theme of currency valuations on trade competitiveness, the effects of a global currency architecture that keeps the dollar overvalued cannot be overestimated. As long as the U.S. dollar remains the global reserve currency, strong demand for dollars will keep the value at a level that makes U.S. exports uncompetitive on global markets. By most measures, the dollar is now at least 10% overvalued.

There are a number of potential ways to address exchange rates that negatively affect U.S. manufacturing (both over-valuation of the dollar and volatility). One option would be an orderly shift toward a new reserve currency system based on the IMF's special drawing rights (SDRs). SDRs are denominated in dollars, but the nominal value is based on a basket of major currencies, including Japanese yen, U.S. dollars, Euros, and British pounds. The concept could be expanded to include other currencies, not least the Chinese renminbi. The shift, implemented over time and in coordination with international partners, would be a positive long-term solution to excess global demand for U.S. dollars.

Such a shift would necessarily be measured and not without challenges. At present, SDRs make up only about 4%of global reserves, and to become the principal reserve asset, the supply would have to grow tremendously, to about $3 trillion. The IMF would have to take on the characteristics of a world central bank, which is sure to be controversial, especially in the U.S., which has veto power over SDR issuances, and will not be anxious to relinquish the prestige associated with the dollar as reserve currency.

Another option would be for the U.S. to adopt a more coordinated approach to exchange rate policy involving target zones, but retaliation by trading partners, intent on maintaining exchange rate advantage over the dollar might result in uncontrolled growth of money supply in multiple countries, kicking off an unacceptable period of high global inflation.

A tax on all cross-border currency flows would help dampen speculative currency movements, and could have the additional advantage of raising much-needed funds for global health and development initiatives. Such a tax would not be precluded by a move to an SDR-type reserve currency.

Fundamentally, the time has come to ask if there is a net benefit to the U.S. of having the dollar as the global reserve currency. We have to consider whether there are longer-term benefits to rebuilding a domestic manufacturing/industrial base and creating job growth in low- and mid-skill economic sectors that is being impeded by an overvalued dollar.

The McKinsey Global Institute (MGI) recently released a study examining the costs and benefits to the U.S. economy of the dollar as reserve currency. They found that the net financial benefit was between $40 billion and $70 billion�or 0.3% to 0.5% of U.S. GDP. In the first half of 2009, the dollar appreciated by about 10% due to its safe-haven role, and the cost-benefit became less positive to mildly negative. The estimated range was between a net benefit of $25 billion and a net cost of $5 billion.

The as the global reserve currency, U.S. is able to raise capital more cheaply owing to large purchases of U.S. Treasury securities by foreign governments and government agencies. Those purchases have reduced the U.S. borrowing rate over the past few years and are worth about $90 billion to the U.S. But without a yawning trade deficit, and with re-development of a vibrant manufacturing sector, it is likely that U.S. international borrowing needs could be reduced by more than the estimated net financial benefit.

So long as the dollar remains the reserve currency, it will be a magnet for official reserves and for global liquid assets, keeping it overvalued by between 5% and 10% according to MGI researchers. And that means that U.S. exports cost more on world markets while imports are too cheap in U.S. domestic markets. That has a short-term benefit for consumers, but represents a long term detriment for U.S.-based manufacturing, and for the U.S. fiscal position.

U.S. policymakers therefore need to ask, "Is it more important to the U.S. economy, and to U.S. manufacturers and workers, to be able to borrow cheaply, or to compete on world markets and create jobs?" MGI estimates that exporters and manufacturers are losing about $100 billion per year, and that employment in these sectors is reduced by nearly a million jobs.

The Europeans seem to recognize the long-term downside of their currency becoming an alternative or secondary reserve currency. In a November 2009 interview with Le Monde, European Central Bank president Jean-Claude Trichet said that the euro was "not designed to be a global reserve currency."

Some economists see the renminbi as eventually supplanting the dollar as the global reserve currency, but that is unlikely to happen for many years, perhaps not before 2050. The renminbi is now plays only a minor role in international exchange, owing to liquidity and convertibility issues. If it were to play a larger role, it would appreciate, undercutting China's export-led growth policy.

If the world's two main reserve currency issuers increasingly see little national economic benefit to continuing that role, the time has come for a global summit to find an innovative solution such as adoption of SDR as a reserve currency. Failure to do so will result in a period in which an unmanageable global financial system is characterized by volatility and speculative capital flows. Such a period would be extremely difficult for businesses and national economies, with exchange rates frequently out of line with economic fundamentals. American workers will likely bear the brunt of global currency instability as credit becomes increasingly dear and business activity further contracts.

Policy Prescriptions to Rebalance Global Trade

Trade deficits, gains from trade, and exchange rate fluctuations only matter insofar as they affect real people, positively or negatively. U.S. workers have paid a steep price for U.S. globalization policies, while multinational businesses have been big winners. Thus, new approaches should be based on an analysis of how past and current approaches have failed U.S. workers. The outsize influence of business interests in trade policymaking bears significant responsibility. It is no coincidence that the Dow Jones Industrial Average of stock prices for the largest U.S. firms soared from the mid 1980's to 2000, as global trade flows dramatically increased. Even since 2000, and despite high volatility and the financial crisis that began in late 2008, stock prices have held up remarkably well and corporate profits in 2010 are at record levels while wages remain depressed and unemployment is unacceptably high. U.S. multinational corporations have clearly prospered under the curren t global trade regime.

U.S. trade policymaking has long been dominated by a powerful center-right coalition of corporate business interests. Republican business conservatives, supported by center-right Democrats have ensured that investor rights have received top priority, while workers, consumers protections, and the environment have been largely ignored. Through trade agreements like NAFTA, and WTO rulemaking, U.S. firms have been provided tremendous support for outsourcing labor abroad.

Just one example of how this has played out for U.S. manufacturers: Mexico now exports more vehicles (a high-technology sector) to the U.S. than the U.S. exports to the rest of the world. The number one Mexican exporter of vehicles is a U.S. firm: Chrysler. US multinationals initially used foreign plants to serve foreign markets, but over time, that has changed. Now those foreign plants largely serve the US market. U.S. firms export intermediary goods for assembly abroad, and re-import value-added finished goods in a purely labor arbitrage arrangement.

Trade agreements have promoted multinational business interests in many ways, including through limits on trade related investment measures,[5] intellectual property rights enforcement with binding dispute settlement mechanisms, and by bringing services trade into the WTO.

These and other business-favored trade rules have fostered tremendous growth in foreign investment that has accelerated the impact of trade on workers throughout the developed and developing worlds.

Globalization has also allowed U.S. multinationals to escape regulatory systems that were implemented after the 1930's. Those systems brought stability, environmental protections, and broadly shared prosperity in the U.S. and to a lesser extent globally. As globalization has proceeded, economic competition has become a race to the bottom in environmental protection, wages and labor standards, and consumer protections.

The time has come to build a new coalition for trade management that is center-left�giving more attention to workers, the environment, and consumers. Trade management and international trade agreements must focus on the following:

Priority must be given to a global trade environment that fosters a high and rising standard of living for all Americans, and for working people around the world. A domestic manufacturing base is an essential component of a diverse economy that achieves broadly shared high living standards. This is true for all countries, but the U.S., after decades of manufacturing-sector decline, should make this the top priority.

Domestic tax policies and a domestic industrial policy aimed at manufacturing jobs creation must be a part of this new approach. Most national governments intervene to affect the structure of national economies and affect outcomes. The U.S. has a long professed opposition to market interventions by government, but in fact, U.S. policies intervene in many ways, often benefitting the interests of influential multinational businesses. Active and coherent intervention, with input from management, labor, political leaders, and others, should be brought to bear in the promotion of specific industries in which high-wage jobs can be fostered and where the U.S. can compete internationally on a more level playing field. Attention should also be given to easing the challenges faced by workers, firms, and communities affected by structural economic change.

Chronic U.S. trade deficits must be addressed, particularly deficits related to trade with China, Japan, Mexico, and Europe. Trade deficits are the effect of policies that have encouraged the offshoring of U.S. manufacturing and negatively affected U.S. workers. The structural causes of these deficits vary among trading partners, and the solutions will vary somewhat in each case. The deficit with Europe is mostly a factor of slow growth on the continent that will have to be dealt with mainly by European leaders. The problems with China and Japan are more complex, and involve exchange rate manipulation (addressed earlier� consideration should be given to adoption of a new global currency reserve regime based on the IMF SDR model); and systematic discrimination against U.S. imports (negotiations should work to remove non-tariff barriers, using a carrot and stick approach). The deficit with Mexico stems from wage and consumer demand differentials, and proximity to the U.S. market. A regional "Marshall Plan" to assist economic development in Mexico and the Western Hemisphere is long overdue. Economic development and poverty reduction in Latin America would address the twin problems of resistance to labor and environmental standards, and over-reliance on U.S. consumers as the market of first and last resort.[6]

The U.S., in coordination with other advanced economies, must gradually reduce the value of the dollar. As noted earlier, the surest, most sustainable way to do this is to gradually replace the dollar as the world's reserve currency.

Advanced economies must develop new incentives for developing countries to raise labor and environmental standards, and to adopt alternatives to export-led growth. Too many countries are competing for access to the only open market in the world, and the U.S. can no longer afford to be the market of first and last resort.

For the global marketplace to benefit the broadest possible number of stakeholders, cooperation and coordination among global policymakers, business, and workers is essential. The genie is out of the bottle, so to speak, and retreat from globalization is neither an option nor desirable. The market has outgrown the bounds of the domestic regulatory state in important ways. Issues that are causing significant frictions, imbalances, and inequities must be resolved soon, and the way forward must be based on inclusion and broad participation in decision making, implementation, and benefits.

[1] Financialization can be defined as an economy that increasingly depends on financial transactions to support GDP growth, while manufacturing and industry moves to low-cost overseas markets. The British Empire in the second half of the 19th century is a prime example. London became increasingly a financial and trading center, while manufacturing moved increasingly to the British co lonies. By the early 20th century, the empire was substantially weakened.

[2] A misnomer, since our economy is by no means free and unfettered, but is in fact skewed to support the owners of capital in subtle and profound ways.

[3] Financial sector profits accounted for 25% of all corporate profits, even in the recession year of 2009. In 2008, finance, insurance, real estate, rental, and leasing accounted for 21% of the entire private economy. Some would argue that these percentages are too high for an economic sector that "doesn't really make anything except money." That may be an unfair mischaracterization of the financial sector, but it bears considering what percentage of the economy we think ought to be centered on finance and financial services.

[4] "Picking winners" has long been opposed by U.S. political leaders, who believe that the market can better allocate resources to the most competitive technology innovations, but there is evidence that in capital-intensive, high technology industries, it can lead to long-term economic benefits. The European aerospace consortium that builds Airbus commercial airliners grew from a conscious decision to enter the market and subsidize the industry until it became profitable.

[5] The measures adopted by governments to attract and regulate foreign investment, including fiscal incentives, tax rebates and the provision of land and other services on preferential terms. In addition, governments impose conditions to encourage or compel the use of investment according to certain national priorities. Local content requirements, which require the investor to undertake to utilize a certain amount of local inputs in production, are an example of such conditions. Export performance requirements are another example; they compel the investor to undertake to export a certain proportion of its output. Such conditions, which can have adverse effects on trade, are known as trade-related investment measures or TRIMs.

[6] Such a plan would involve development aid targeting key institutional capacity building, debt relief where called for, and would require meeting benchmarks in key social standards. Japan and China could do the same in Asia, and Africa would need broad, multilateral assistance. A U.S.-led hemispheric "Marshall Plan" would foster regional integration, stimulating demand for high-wage, high-skilled exports from North America, which can be used to help the rest of the hemisphere grow develop more rapidly. U.S. policy must foster global growth, because slow global growth will pull imports to the U.S. while reducing demand for U.S. exports.