Is the US moving on from free trade? Industrial policy comes full circle

In the 77 years since the end of World War II, both U.S. political parties, American economists, Wall Street and the Business Roundtable have preached free markets, free trade and globalization. Indeed, as counselor to the secretary of commerce in the Reagan administration, I was directed by the Secretary and the White House to negotiate a halt to “Japan’s unfair industrial policies and mercantilist trade practices” such as subsidization of its semiconductor industry.

Yet Japan was only imitating an earlier United States.

Jefferson vs. Hamilton

At America’s birth, a great debate began between Thomas Jefferson, who foresaw a free-trading nation of yeoman farmers, and Alexander Hamilton, who, being keenly aware of the gathering industrial revolution in Britain, foresaw a nation of workers in wealth-producing factories fueled by advancing technology.

America’s near loss of the War of 1812 with Britain, for want of ability to make the equipment of war, changed Jefferson’s mind. “Experience has taught me that manufactures are as necessary to our independence as to our comfort,” he said.

In the wake of this change of heart, America went mercantilist with high tariffs on imports and industrial policies that granted subsidies to industrial development such as Eli Whitney’s interchangeable parts for mass-production lines, Robert Fulton’s steamship, and the telegraph of Samuel Morse.

In the middle of the Civil War, Abraham Lincoln raised tariffs to record levels on imported steel from then global low-cost producer Great Britain. In response to critics, Lincoln said: “I don’t know much about tariffs, but I do know that when we buy steel abroad, the foreigner gets the money and we get the steel, but when we buy steel made in America, we get the steel and the money too.” Soon afterward, America became the low-cost producer by dint of the declining costs that often accompany rising production.

During World War II, the U.S. government simply told major corporations like General Motors to stop making autos (or whatever they had been making) and start making airplanes and tanks. The wartime economy was the ultimate industrial policy, and it both reduced production costs dramatically and resulted in heretofore unimagined technological advances.

Of course, the war had been preceded by the Great Depression, which itself had been preceded by the eye-watering Smoot-Hawley tariff, on which most leading economists blamed the Depression and even the war.

Policy reversal

After the war, America emerged as the dominant global producer in virtually every industry. The need was no longer for a more competitive U.S., but for one that would buy from and invest in reconstructing the rest of the world. The junction of this need with the rising role of professional economists, in dealing first with the Great Depression and then with the restructuring of the postwar world, led to an about-face of U.S. policy from its historical mercantilism to free trade and globalization.

The rationale for free trade was first defined by British banker David Ricardo in 1817 when he introduced the notion of comparative advantage. He demonstrated that even if Britain produced wine and cloth less efficiently than Portugal, both countries would still be better off with Britain making all the cloth and Portugal making all the wine because Britain was less bad at making cloth than wine. The concept was the same as that of the doctor who is a better typist than her assistant but who concentrates on doctoring and has the assistant do the typing.

Under this comparative advantage concept, all seem to prosper more by concentrating on what they do best and trading for the rest. Thus, free trade appears to be a win-win proposition that logically should be embraced by all.

But key assumptions of the theory and the econometric models used to calculate the impacts of trade are questionable. For example, the standard Global Trade Analysis Project econometric model assumes perfect competition with no single producer having any measurable impact on market prices or costs. But that certainly isn’t true in such cases as Boeing and Airbus. The model also assumes that the unit cost of a product is the same whether you make one or a thousand units. In fact, mass production typically leads to falling costs.

The models also assume that wages are determined by the inherent skills of workers and not by the nature of the companies and industries in which they work. Thus, if you are making $50 an hour working for Ford, it is assumed that if Ford fires you, Walmart will hire you at the same $50 rate.

The only path

From 1945 until recently, these theories and assumptions have been the bible and the law governing how trade is taught at American universities, negotiated by the U.S. government and explained by the media. The U.S. economics establishment insisted that free trade, even unilateral free trade, was the only path to salvation.

Then, on March 1, 2018, the cover story of the Economist magazine, the pope of the free-trade church, said “How the West Got China Wrong.” Less than six months later, in August, the Trump administration imposed tariffs on some imports from China.

In 2021, many believed the new Biden administration would repeal them. Instead, it has been imitating Alexander Hamilton and Abraham Lincoln with policies like the Chips act.

In doing so, President Biden has revealed not only the inadequacies of the heretofore reigning trade doctrine, but new problems. Take supply-chain risk. Globalization’s long, complex supply chains inevitably entail much greater risk than shorter, simpler ones. The Covid pandemic has shown some of the costs of that risk. These were never incorporated into the econometric models or the financing calculations of the investments. The risk is especially large when supply chains link countries of vastly different political, legal and philosophical systems. If the risk was incorporated into the costs, much of the trade would halt.

Another example is greenhouse-gas emissions. Trade entails shipping that generates about 14% of total greenhouse gases. This cost is never incorporated into the price of the product or service. If it was, there would be much less trade and more domestic production.

Another unincorporated cost is that of coercion. Germany today is paying a high price for having made itself subject to coercion by Russia because of its reliance on Russian natural gas. Similarly, the Covid crisis showed America’s vulnerability to dependence on a China whose political and philosophical concepts are directly opposed to those of the free world.

Clearly, globalization based on neoclassical free-trade doctrine was and is the wrong bet. Hamilton had it right at the start.

Mr. Prestowitz is the founder and president of the Economic Strategy Institute. He served as counselor to the secretary of commerce in the Reagan Administration.