Keynote speech - Dr David Gruen - Collective animosities or cooperation?

Keynote speech - Dr David Gruen - Collective animosities or cooperation?

Thursday, 06 December 2018

Dr David Gruen

Symposium discussing ‘Asia’s Response to the Trade War’, Tokyo, Japan

6 December 2018

(Further information available here)

Image of Dr David Gruen

Thank you very much for inviting me here.

Last Friday and Saturday, I was in Buenos Aires for the G20 Leaders summit. Perhaps because we are so used to bad international news, many seemed to have missed the important respect in which the summit was a success.

Leaders recognised the role the multilateral trading system has played in global growth and committed to improving the rules-based international order. Most clearly and importantly Leaders for the first time recognised the need for WTO reform and said they would review progress at their next Summit, in Osaka in late June 2019.

Of course, reform of the WTO means different things to different people and so there is obviously lots of work ahead.  Nevertheless, we should be seeing this as opening up an opportunity and as a positive sign for global economic cooperation.

We should not take such cooperation for granted.

When re-reading Keynes’, ‘the economic consequences of the peace’, written in the aftermath of the First World War, I came across this quote.

“In a regime of Free Trade and free economic intercourse it would be of little consequence that iron lay on one side of a political frontier, and labor, coal, and blast furnaces on the other. But as it is, men have devised ways to impoverish themselves and one another; and prefer collective animosities to individual happiness.

Today I want to briefly outline some of the underlying economic reasons ‘why’ trade cooperation is so difficult.

I will avoid geo-political musing, and stick instead to the implications of standard economic reasoning.

Some of the recent tension over trade is a consequence of the strong and sustained economic growth in our region.

Let me elaborate.

As economies in our region have grown and moved up the value-added chain, they have increasingly competed with more entrenched, influential and valuable industries in advanced countries.

In his last published paper, Paul Samuelson pointed out that a positive technology shock in an industry in one country can sometimes lead to overall harm to another country that earns income from that industry. This is probably contrary to the intuitions of most economists.

I consider Professor Samuelson’s paper is clearly a warning against the complacency of economists thinking that productivity improvements are always beneficial.   But the extent of which the paper provides an accurate analysis of recent events depends on income effects.

The positive income effect from the productivity shock in the first country will also act to raise the national income of other countries. While some advanced country industries have undoubtedly been harmed by a rising Asia-Pacific, a rising Asia-Pacific has also meant more demand for other goods and services from advanced countries.

Rather than an overall fall in national income, trade and technology are more likely to change the income distribution of advanced countries. Given the relative scarcity of factors, more income flows to capital owners and highly skilled workers, while some lower skilled workers real incomes have stagnated or fallen. Autor, Hanson and Dorn found that the ‘China shock’ resulted in a long-lived loss of 2 million workers from the labour market of the US mid West. But it is important to recognise that paper is not saying the United States is worse off overall from trade. Their analysis is silent on the additional jobs Chinese demand and supply of business inputs created in other parts of the country and for other workers.

Such disruption is likely to continue as technology makes it easier to trade services across borders and economies in the Asia-Pacific become increasingly sophisticated. Some of these newly threatened advanced-economy jobs rely on intellectual property or skills premiums, providing an economic rent worth protecting. It is no surprise that the generally open trade stance of those in places like Silicon Valley sits alongside a demand for strong enforcement of intellectual property rights.

Now let me be clear that I think advanced countries are better off overall with free trade – Australia included. But as technology continues to bring down trade barriers in sectors previously considered ‘nontradeable’ - most notably in the services sector - politically influential opposition to free and open trade is likely to continue.

Let me turn to a second implication of the profound economic transformation of the Asia-Pacific.  It makes less sense for the largest economy in the world to bear the costs of maintaining an open trading system as its economy becomes a relatively smaller share of global output. Free trade is a public good – we all benefit from it, but each country has an incentive to shift the cost of maintaining it to others. The United States shouldered that burden when it was the world’s largest economy. When you are half the global economy you tend to benefit wherever in the world trade is occurring.

The logic of continuing to do so is now less compelling  The rules-based system, including the WTO, emerged at a time when the US was the dominant global superpower.

But it is worth reflecting on the incentives facing different sized countries in this system.

Small or medium-sized open economies with limited power in global markets – like Australia – are better off from free and open trade. This holds regardless of how protectionist other countries are. In that memorable phrase, ‘you shouldn’t put rocks in your harbour just because others are putting rocks in theirs’. It is Australian businesses and consumers who pay the costs of Australian tariffs. For countries like Australia, the WTO – indeed, any trade agreement - is a way of adding support from exporters to that of consumers in the domestic political debate.

But that analysis doesn’t always hold for large economies with significant market power. They can sometimes use tariffs to drive down their import prices, improving their terms of trade and forcing other countries to pay some of the tariff. Big countries can ‘pick the pockets’ of their trading partners. If they do so, smaller countries with little bargaining power are worse off and so is the global economy. The fear is that we can move to a system of managed trade replacing open trade, and the re-emergence of trading blocs. In such a world, miscalculations can sometimes spiral out of control –like when the US restricted Japan’s access to steel before the Second World War.

That is why the G20 statement calling for reform is significant. It represents the multi-polar world order seeking to step up.

Of course, it is not only sustained economic growth in our region that is underlying some current trade tensions. Some of it is also poor economic reasoning.

Standard economics teaches that trade deficits are not a measure of a country’s weakness or that it is being unfairly treated by other countries. The overall trade deficit (or more precisely, current account deficit) implies an economy investing more than its domestic savings can fund. Rather than financing imports by exports, a country finances them by selling assets or issuing debt to foreigners – to be redeemed by future net exports.

Nor can an overall trade deficit be ‘fixed’ by tariffs. For example, it is notable that the US trade balances did not increase in the 1930s despite the Smoot-Hawley Tariff Act raising import duties significantly. Bilateral trade deficits can shrink due to tariffs, but at the expense of higher cost imports from, and increasing bilateral trade deficits with, other countries.

There is more debate around intellectual property.  IP potentially stimulates investment by granting monopoly rights to IP owners. However, IP protection can also reduce investment and economic growth by requiring others to pay for using IP. Unlike cutting tariffs and reducing other barriers to trade which tend to make both countries better off, tighter IP rules are effectively an increased barrier to trade that can lead the country that has to pay for it being worse off. What kind of IP rules maximise global economic growth, rather than depress it, is still an open question. But it is a question requiring the help of economists – not just IP lawyers – to provide an answer. What is unquestionable is that countries should apply the rules they sign up for, and Australia benefits from the simplicity of harmonisation of rules through agreements like the TPP.

The appropriate rules for state owned enterprises are also not as simple as they seem. When SOEs are used to subsidise exports, consumers in other countries benefit while other domestic producers can be harmed. Distortions from subsidies risk cascading globally as efficient competing producers in other countries are harmed, and inefficient industries are allowed to flourish. This leads to worse global growth overall, ultimately hurting everyone. Still, the main beneficiary from restricting state-backed subsidies may be the countries providing the subsidies themselves.

Similarly, any movement towards restricting special and differential treatment for developing countries in the WTO is most likely to benefit those developing countries. There are often domestic political reasons for moving more slowly to meet the full requirements of the WTO, but your level of development is unlikely to be one of them. The fallacy that at lower levels of development, keeping your tariffs higher for longer is beneficial, is one that is causing continuing damage to emerging countries – and may be damaging the WTO itself.

Finally, let me conclude this tour of the standard economic implications of current trade policies by reflecting that, on these issues, Australia and Japan have much in common.

Like our G20 Leaders, I look forward to progress in the lead up to, and at the Summit in Osaka in June next year.