Classical Economics & Free Trade Depend on 3 Invalid Presumptions—Now What?
The era of economic surrender is over, and the rebirth of American industry has begun.
~President Donald J Trump (2017)
President Trump says he’ll put America first when it comes to foreign trade. Many staunch conservatives agree with him: why should we let China sell its stuff in America but not vice versa? Won’t we lose jobs if our factories move to Mexico? These concerns are reasonable. They’re what got Trump elected.
Yet many libertarians, and establishment Republicans, are unwilling to take action. Congress has made it clear: no tariffs. They fear that by imposing tariffs, or simply enshrining reciprocity in our trade deals, we will start a trade war. Strong words. They claim that American exports, like beef and bourbon, will suffer if we tax Chinese semiconductors.
Beyond that, they argue international free trade is always good, reciting the tired mantra trade is not zero sum, everyone always wins. But reality is more complex than slogans. As it turns out, modern interdisciplinary scholarship from Michael Porter, Daniel Kahneman, Benoit Mandelbrot, and Nassim Taleb has completely debunked the presumptions underpinning classical, liberal economics.
In short: economics is dead.
In this article I’ll explain how three of the most important presumptions underpinning classical economics and free trade are no longer valid. The three presumptions I’ll debunk are (1) the myth of the rational consumer, (2) that the theory of comparative advantage applies internationally, and (3) that economic growth is caused by free trade.
1. Killing Homo Economicus & the Myth of the “Rational Consumer”
I’ve said it before and I’ll say it again: you’ll learn more about economics playing Settlers of Catan than you will in college—no I’m not joking. Think back to the last time you played. . .
It’s getting late. You’ve been playing Settlers of Catan for hours. And Joe is pissing you off.
He keeps moving the “knight” piece onto your tiles and stealing your resource cards. Not only that, but he’s been turning everyone else against you with his snide remarks.
Suddenly Joe presents you with a proposition: “trade me some clay and I’ll give you wheat”. It’s a good deal: you need clay just as much as Joe needs wheat, and trading will get both of you one step closer to winning the game. Trading with Joe is the rational decision—it makes economic sense. What do you do?
If you’re anything like me, you’ll tell Joe to take a hike: there’s no way you’re trading with a lowlife like him. You’d rather lose the game than trade with your nemesis!
Your response may not be all that rational, but it’s real. People aren’t computers that constantly weigh their options rationally, and then make the most reasonable choice based on the available evidence. People are animals. We’re emotional. We have instincts—or more accurately, we have decision-making heuristics (mental shortcuts) that are hardwired into our brain’s architecture. Basically, people aren’t rational.
The implications of this fact are of profound importance to the field of economics.
Behavioral Economics & the Anchoring and Adjustment Heuristic
Classical economic theory is based on the assumption that people behave rationally: we are rational consumers who weigh the relative utility of products before buying them. For example, economists assume that when presented with two different, but identical, items, people will invariably buy the cheaper one. Although this makes perfect sense in an abstract, theoretical sense, reality is messy.
People make irrational decisions all the time. In fact, behavioral psychologists like Daniel Kahneman (who won the Nobel Prize in economics for establishing “behavioral economics” as a field of study) thinks irrationality is the norm in the marketplace. This is echoed in the work of Richard Thaler, a law professor at Harvard University, and Benoit Mandelbrot, the mathematician who invented fractal geometry (and has since applied his research to the stock markets).
For example, Kahneman has shown that people are willing to pay more for a product if they are psychologically primed with completely unrelated high numbers than with low numbers (that is, if they were shown a sheet of paper with either high or low numbers on it a few minutes prior). This is because of something called the anchoring and adjustment heuristic, which is how the human brain interprets numbers.
Essentially, the brain will anchor to the last number with which it was primed, and then adjust down or up from that to arrive at a price. Say you ask ten people to estimate a price for a product—one that is fairly valued at $500. If they are primed with the number 1,000, their guesses will likely average around $550. However, if you primed a different group of people with the number 10, their guesses will likely average around $450.
There’s nothing rational about that, is there?
Behavioral psychologists have discovered many other heuristics that have big economic consequences, but the fact that even one exists is enough to undermine the foundation of classical economics. People just aren’t that rational.
Complexity & Emergent Properties
Economists often retort that while individuals are irrational, the law of averages smooths this out in the population as a whole. Unfortunately, the relatively new interdisciplinary field of emergent properties and complex systems puts the kaibosh on this.
Simply put: groups follow different rules than individuals, these rules often differ according to the size of said group, and these rules could not be predicted given the individual characteristics. Given this, there is no reason to expect that purely rational consumers would make rational choices in the aggregate—never mind irrational consumers.
Groups have to be investigated on their own terms.
And of course, there is a large body of empirical evidence that shows aggregating people doesn’t magically make them rational—groups are just irrational in different ways.
For example, in his book The Hour Between Dog and Wolf, John Coates explains how stock markets vacillate between periods of irrational exuberance and panic across all time-horizons, be it minute-by-minute, hour-by-hour, or year-by-year. Emotions like hope and fear govern the market, not rational expectations.
Economic theory is based on the presumption that people are rational. This is a lie. There is no homo economicus—no rational consumer. There are just homo sapiens, and they’re irrational.
This fact has big implications: economists advocate in favor of global free trade based on the presumption that people (individual consumers, companies, and governments) behave fundamentally rationally. This isn’t true. Therefore, we should be skeptical of making grandiose claims about the benefits of free trade a priori, that is without first seeing the evidence.
I won’t go into the details here, but the preponderance of evidence suggests that global free trade has actually done enormous damage to America, but this has been largely ignored by academics because it does not conform to their theories. Theory must always take a backseat to reality.
2. The Limitations of David Ricardo’s Theory of Comparative Advantage
David Ricardo (d. 1823) redefined economics with his work On the Principles of Political Economy and Taxation. In it he outlines his big idea: the theory of comparative advantage. Comparative advantage underpins the global free trade movement (and has since the 1840s). In a sense, globalization is the house Ricardo built.
There’s just one tiny problem: comparative advantage doesn’t always work. The following critique assumes you’re familiar with Ricardo. If not, read this article on comparative advantage before proceeding.
Although I could make a very compelling case against comparative advantage by simply relying on exogenous critiques, I’ll limit my discussion to debunking the theory of comparative advantage using its internal logic.
Comparative advantage has two faulty premises.
Comparative Advantage’s 1st Faulty Premise: People Are Greedy
Ironically, the best critique of comparative advantage comes from David Ricardo himself. In his book, he acknowledges that his theory is domain-specific, meaning that it only applies when certain antecedent conditions are met.
In a way, the theory of comparative advantage contains the seeds of its own destruction. Ricardo writes:
…it would undoubtedly be advantageous to the capitalists [and consumers] of England… [that] the wine and cloth should both be made in Portugal [and that] the capital and labour of England employed in making cloth should be removed to Portugal for that purpose.
Ricardo explicitly states that, under his theory, it makes sense for England to import both cloth and wine from Portugal (since Portugal’s better at making both), and that England’s cloth-making industry should be offshored to Portugal.
Ricardo’s not a stupid man, and knows full well that this would be a losing strategy for England—if they imported everything and made nothing, they would have no economy.
Furthermore, they would be vulnerable to foreign suppliers, in the same way that the US depends upon Saudi Arabia, and other members of OPEC for its oil. This can have disastrous repercussions (recall the 1973 Oil Shock).
Therefore, Ricardo adds an intellectual buttress to ensure that the temple of trade will not collapse.
He argues that:
most men of property [will be] satisfied with a low rate of profits in their own country, rather than seek[ing] a more advantageous employment for their wealth in foreign nations
And there you have it.
There it is, Ricardo’s argument—the entire theory of comparative advantage, global free trade itself—is premised on the assumption that most people love their country more than money, and will invest domestically out of the goodness of their hearts.
Of course, this is not true. Gordon Gekko was right to note that “greed is good” is the name of their game.
Comparative Advantage’s 2nd Faulty Premise: Capital Is Mobile
Ricardo also used a more technical defence of comparative advantage from this obvious flaw. He argued that offshoring is impossible because capital is immobile—that is, England’s textile mills could not be moved to Portugal anyway.
This is the antecedent condition I mentioned before—comparative advantage is domain-specific because it only applies when capital is stuck and offshoring cannot occur (such as when trade happens within a nation, or when something prevents commerce from relocating).
To be fair, when Ricardo wrote his Principles, capital was indeed largely immobile. His theory of comparative advantage worked because, in the early 19th century, transportation was an order of magnitude more expensive, machinery could not legally be exported from Britain, tariffs on manufactured goods exceeded 50 percent, capital markets were undeveloped in most countries, and endemic warfare prevented a large-scale commodity trade. Therefore this hypothetical problem remained purely hypothetical for Ricardo. This is no longer true.
Capital is highly mobile in today’s economy. A factory can be relocated from the United States to China in short order, and transportation for bulk goods is incredibly (almost unbelievably) cheap. In fact, in the decades after Ricardo’s death in 1823, capital grew ever more mobile, and his hypothetical dilemma soon became real.
Throughout the 1800s there was a steady increase of capital outflows from Great Britain, as British investors built projects abroad seeking higher return. In 1815, £10 million was invested abroad. In 1825, this climbed to £100 million, and by 1870 it was £700 million. By 1914 (the peak) over 35 percent of Britain’s national wealth was held abroad—Britain suffered a severe, decades long shortfall in domestic investment.
Likewise, economic and industrial growth slowed to a crawl, as the British market was flooded with German and American products. The same thing is happening to America today: between 2000 and 2015 we invested almost $4 trillion abroad (in terms of Foreign Direct Investment, or FDI), and accumulated $10 trillion in trade deficits.
These two basic truths—people are greedy and capital is mobile—completely destroy comparative advantage by invalidating its underlying premise, and relegate it to the intellectual curiosity shop of history. Ricardo was a smart man who recognized his theory’s limits, and it’s too bad his ideas have been bastardized to justify global free trade in a world where his theory was never meant to apply—ironically, the same thing happened to Adam Smith, as my colleague Bob Calco has shown.
May Ricardo’s monster rest in peace.
Did Comparative Advantage Work Historically?
Perhaps the best way to end this section is to compare what happened to Ricardo’s hypothetical England and Portugal with what happened in the real countries. In his example, Portugal gets rich by maximizing its comparative advantage in wine, while England gets rich by doing so with cloth. Both countries trade, both benefit.
Reality is harsh. In 1703, the two countries signed the Treaty of Methuen, which, among other things, exempted English cloth from a Portuguese import-prohibition. In the following decades, cheap English imports destroyed Portugal’s textile industry, and Portugal indeed resorted to exporting wine.
Soon afterward, England gained a textile monopoly in Portugal, which allowed Britain to drive up prices above-market, expand her increasingly-advanced textile industry (this stimulated the mechanical and engineering breakthroughs that birthed the Industrial Revolution), and buy up Portugal’s vineyards, thereby securing both industries. As it turns out, not all industries are of equal value—cloth was more lucrative than wine. In the end, the Treaty of Methuen deal helped England industrialize and grow rich—at Portugal’s expense.
The story of Methuen contains two morals worth mentioning. First, we should be careful not to value our theories more than we value empirical evidence—often things look good on paper, but fail miserably in real life. This is emphatically the case with global free trade and classical (liberal) economics.
Second, we should endeavor to be like England, not Portugal. America’s trade policy should concentrate as much advanced industry in the nation as possible, even if that means imposing tariffs, or signing “unfair” deals with other countries. We need to stop thinking like economists, and think like businessmen.
3. How Does the Economy Grow? Exogeneity & Technology
The final presumption worth debunking deals with the big question: how do economies grow? As it turns out, classical economics is based on a faulty understanding of economic growth. Long run economic growth has nothing to do with free trade, immigration, or lower taxes—growth is a predicate of technology. Let’s look at the logic:
Economic growth occurs when—and only when—either more stuff is made or better stuff is made. For example, America’s economy grows when it produces more cars or bushels of wheat, or better cars and more nutritious wheat in the same time period. This applies to all products, whether goods or services. This point is rather obvious, and axiomatic.
Now the question becomes: how do we make more stuff? There are two options. First, we could work harder: want more wheat? Plant more fields. More legal research? Work overtime. More bobbleheads? Build another factory. This is the archaic growth paradigm, and it boils down to the maxim: more input, more output.
Historically, growth this way was fueled by conquest, slavery, or immigration. Why? Because economic and population growth were synonymous. The problem with archaic growth is for you to get rich, someone else must become poor. Profit is zero sum.
The second way to make more stuff is to increase productivity; that is, make more stuff in the same amount of time. This is the industrial growth paradigm. This is how countries get rich. Why? Because it snaps the link between population and production.
Take Britain at the dawn of the Industrial Revolution. In centuries prior, if Britain needed more cloth, it needed more weavers. It was that simple. But then something changed: in 1785 a man named Edmund Cartwright invented something called the power loom, which made British weavers 40-times more efficient. Within a few years, textile mills across Britain employed power looms, and churned out more cloth than the rest of Europe combined. This generated exponential economic growth and unprecedented material wealth.
The significance of the power loom cannot be overstated: not only did it usher in the industrial age, it also changed how people thought about economic growth. It switched the paradigm from one that was population-driven to one that was productivity-driven. This continues to be true today.
The question shifts for a final time: how do we improve productivity? In the short run there are many options. We could drink more coffee, organize our labor more efficiently (think Henry Ford), or we could trade with more efficient producers. These work, but only to a point: we can only do things so efficiently with our current technology before we hit a ceiling.
For example: no matter how freely the Dutch traded, their textile mills could not compete with Britain’s until they also used power looms. At this point it should be obvious: technology drives long-run productivity, and therefore economic growth.
Better technology is also how we make better stuff. Televisions are a good example. The first TVs were chunky boxes that emitted grainy, monochromatic pictures. Today, TVs are thin, elegant, and can produce more colors than we can imagine. Even if we were no faster at manufacturing TVs than we were in the 1930s, the improvement in quality would still have expanded our economy. Both quantity and quality are elements of economic growth.
The key takeaway here is that long-run economic growth is a predicate of technological growth—which is exogenous to economic models. It cannot be predicted, all we can do is increase the likelihood that innovation will take place.
This is the signal. Everything else—be it free trade or immigration—is noise.
Free Trade vs Protectionism
Given that long-term economic growth depends upon technological growth, it goes without saying that more inventive countries have distinct advantages—advantages that translate into wealth. History proves this: creativity is why the West dominated the global economy for centuries. It is why Britain ushered in the modern era. And it is why America became an economic powerhouse.
The data also confirm this: over the last few decades, almost all of America’s economic growth was generated by our advanced industries—technologically advanced manufacturing, information technologies, pharmaceuticals etc. Collectively, these industries employ just 9 percent of America’s workforce, but file 85 percent of all patents, provide 90 percent of private sector research dollars, and employ 80 percent of all engineers. This is where economic growth happens. It is easy to see why: the invention of the personal computer improved America’s economic efficiency across all industries.
My point: not all industries are of equal value. This is why free trade fails, and tariffs win.
Free trade theory lacks a time-horizon: it stipulates that if America can make more money today by exporting beef in exchange for cheap IT services from the Philippines, that’s a good deal. But it neglects a key fact: ranching is not a growth industry; IT services are. By offshoring our advanced industries, we forgo future growth.
A good example is trade with Mexico. After the North American Free Trade Agreement took effect in 1994, U.S. corn exports surged, as did our imports of automobiles. Trouble is, automobile manufacturing is much more likely to benefit from disruptive technology than is growing corn—under NAFTA, the preponderance of long-run benefits went to Mexico, not the United States.
Again, the hard data reflect this: in 2016 America ran an $83 billion trade deficit in advanced technology products. We offshored their production—along with the opportunity to generate new discoveries. As a result, we’ve increased the likelihood that the “next big thing” will be invented in Japan, China, or India, as opposed to the United States. Proof of this can be found in patent filings: America is filing fewer patents per capita, and fewer as a percentage of the world total, because we are now importing research from abroad.
A competent trade policy would prevent America’s cutting-edge industries from relocating to different countries, and concentrate advanced industries domestically. We must preserve, and sharpen, our cutting edge. Tariffs are the least-intrusive way to do this: they are a completely avoidable tax that create a strong incentive for businesses to build their new laboratory, factory, or industrial park in America. Not China. Not India. Not Mexico. America. This benefits everyone in the long run.
The End of Classical (Liberal) Economics, What Comes Next?
Classical economics has been dead for a while, and yet the majority of people have no idea. Why not? Classical economics is a powerful ideological tool: it justifies trade policies that benefit the rich and powerful at the expense of the poor. America’s middle class, and our industrial base have been completely hollowed out under the pretense of “good economics”. Who benefits?
The super rich who save a bundle offshoring their factories to Mexico, politicians who peddle in class struggle and depend on welfare recipients for votes, special interest groups who gain at America’s expense, and foreign countries who industrialize off our scraps. The list is large, but it is fundamentally outweighed by the millions of Americans who’ve lost their jobs, or who’ve seen their wages stagnate.
It’s time we took a historical approach to economics: we need to look at what worked in the past and simply copy that. A focus on historical precedent and contemporary data would change everything.