The Great Flaw in the Free Trade Theory And Other Vain Beliefs, Hoaxes, and Follies

ilene's picture

As always, when Jesse discusses economic theory and politics, he clearly and concisely explains why the currently popular mind-numbing theories haven't worked, and will not work.  The time spent debating the existing models could be better spent constructing a new vision of how society can best be served by the government and the financial system - not the other way around. - Ilene  

The Great Flaw in the Free Trade Theory And Other Vain Beliefs, Hoaxes, and Follies

Courtesy of Jesse's Cafe Americain 

There are several economic models and political memes that rely on an underlying belief in the natural efficiency and goodness of 'free trade' and 'efficient markets.' One can question whether these ideas promoted certain behaviours, or if certain parties promoted these theories to serve as justification for their policy objectives. 

Whatever the case may be, let's take a look at the theories that seem to underpin the virtue of 'free trade,' meaning international commerce with very light national regulations and a centralized semi-autonomous authority as arbiter. 

One of the theories in favor of free trade is the idea of comparative advantage, that is, that one country might have a natural advantage which they can exploit for their own benefit and the general benefit of the world. I am sure we all learned this in business school. I myself was quite a fan of Michael Porter in my day.

This theory is a universalisation of the idea that the naturally gifted pottery maker, for example, has an inherent talent that can be exploited, and can create and exchange pots for food, let's say, from a farmer who has the advantage of owning suitable farm land and has the talent and tools to exploit it.

Makes common sense does it?  Everyone does what they do best, and through the free exchange of  products the aggregate good is increased.

But the fallacy that is repeated over and over by the non-scientific thinker (like too many economists and politicians for example) is that one can extend things that might make sense anecdotally into general principles writ large on the face real world, or more properly OVER the face of the real world, that at the end have little real fundamental connection with reality. 

This was Mandelbrot's great criticism of the neo-liberal school of economics, notably the Chicago School, for example. Their broad assumptions crushed the reality out of the math, and the application of their theory made the markets inherently unstable by miscalculating the risks which were allowed to grow to enormous levels, and then crash at the under-expected event, colloquially known as 'a black swan.'

There is some validity to this. Some nations, for example, are blessed with great natural resources such as coal and oil, and they can sell these items to other countries and regions in exchange for items like food, for example.

But like most efficiency arguments, most notably the efficient market hypothesis, these ripples in distribution or market anomalies are quickly exhausted, and in the classic impetus and peril of successful capitalism, the players start to create monopolies and other artificial advantages, such as frauds, which they can exploit more fully.

So for example, a nation such as China can devalue its currency substantially in the 1990's against the world's reserve currency, and thereby set up a set of artificial import barriers and export subsidies, simply by manipulating their currency.

By the way, this is basic math. There are plenty of people who were denying it, and most of them stood to benefit from this charade. But it is true. Anyone who travels internationally and changes money understands it. 

The underlying basis of the currency wars is the ability to artificially manipulate one's currency, or even establish a pseudo-monopoly, for the advantage of one to the disadvantage of the others.

There are other methods to accomplish this and they are usually lumped under the title of industrial policy or mercantilism. A country has a set of laws and regulations that foster a certain stance towards issues such as worker's rights, environmentalism, savings and consumption, wealth distribution and even human rights.

The more trade becomes independent of public policy and regulation, the greater the movement of all countries to the least common denominator of the broader policy stances of the mercantilist nations.

In a very real sense, if you control the issuance and terms of money, you care not who makes the laws locally. And the exchange of trade mechanism is a subset of the control of a medium of exchange, which is the trade system, both international and domestic, the who and how people can buy or sell.

This principle seems to be the basis of the inclusion of gold and silver in the money system essays written by my friend Hugo Salinas-Price, and the age old understanding of the balancing mechanism of a harder standard of exchange to manage the tendencies of various participants to 'cheat.'

Anyone who believes that believes that markets and society do not require clear laws and impartial referees because people are naturally inclined to know and do the 'right thing' has obviously never driven on a modern American freeway.

If, for example, we were in a gold standard system for international trade, and the governance had allowed China and its multinational capitalist friends to game the system as they are doing now, eventually the flow of gold from the US to China would compel the US to devalue its currency against the Yuan, and thereby persuade China to release more of its reserves as gold back into the system by purchasing other things. If they used it to buy US debt for example, the dollar would continue to devalue in a cycle which would hamper and ultimately defeat the currency mercantilism.

It would have also restrained the US from manipulating the world by 'owning' the world's reserve currency and the 'exorbitant privilege' therein. It would have curtailed unfunded wars, and the exporting of jobs and production in favor of a 'service economy' that consists largely of pushing the reserve currency around the plate, and skimming the greatest portion for an elite group of policy leaders. No standard is perfect, and there are ways to subvert some external standard like gold, but it is more difficult to do, and it is more easily seen and exposed if the standard is resolute and robust.

We see a similar principle in action in the theory supporting efficient markets. On paper they sound good, but they are deeply flawed because of the nature of the assumptions they make about people and their rationality and selflessness.

As most gardeners can tell you, there is rarely such a thing as a naturally beautiful and weed free garden, especially the ones that look 'natural.' It takes a great deal of forethought, adjustment, and continual work to make anything sustainable in this world of ours. And so it is with markets, both local and international.

There are those, like former Fed Chairman Greenspan, who argue that the fiat regime of the Federal Reserve works if the Fed 'acts like a gold standard,' that is, with an unapproachable virtue.  A similar theory underpins the World Trade Organization's function in international trade.  But like all human systems, they tend to fall to the great truth observed by Lord Action some years ago, that "where you have the concentration of power in a few hands, all too frequently men with the mentality of gangsters get control. History has proven that."

I am not promoting a gold standard per se and understand the problems inherent with it, and do not wish to discuss that here. 

But what I am attempting to do is expose some of the fallacies of the zombie economic theories that have led the world to the place where it is today, with too much discretionary power concentrated in too few hands, with a propensity to act in secret and with an excess of latitude behind the cover of those artificial constructs known as 'corporations.'

This notion that government and regulation is the problem is true only to the extent that government has become weakened and corrupted by gross abuses. Effective government takes planning, continual hard work, and the adjustment of renewal and reform.

Human constructs, if not continually managed and repaired and occasionally renewed, tend inevitably into disruption, dysfunctionality, and corruption.

To say, let's just get rid of it and things will somehow become naturally good is to attempt to build a castle in the clouds. It will not and has never worked to promote a harmonious and productive society on a large scale, ever, in all of human history. It is the law of the jungle. But it has its continual appeal to sociopaths, misfits, the naive, the frustrated, and psychopaths.

It is a tool of the false dialectic of extremes, that argues that the choice is between no government and bad government, and that if government is not perfect it is inherently evil. Because they are driven to extremes, those who argue this cannot see the great middle ground, of an imperfect government that nevertheless is capable of maintaining justice and order within the context of freedom.  Failure is only certain at the extremes, of authoritarianism and anarchy, when by two different paths one turns society over to the wolves.

The longer this artificial construct of natural goodness and perfect rationality is maintained, the greater the forces against it will build, until countries and nations explode into revolution and wars, as a consequence of folly.  

The model in my forecast says that meaningful reform to the status quo will not be readily accepted by the power elite.  They will promote a 'new normal' which will span a leisurely 'five to ten years' for economic recovery, while they are comfortably standing above it all on other people's necks.  The ability to set oneself aside and apart, as separate and above, from the rest of humanity is served in many ways and by many things. It is a dangerous delusion to feel naturally privileged for whatever reason. It can only be maintained through power, and power is a deadly narcotic.

We can be thankful that other crackpot theories have not become mainstream, such as eugenics, or the marginalizing and then disposal of the weak, the disabled, and the different to serve the economic advancement of the state. Or groupthink, and profound belief in national or racial exceptionalism that tends to lead groups to quick utilitarian solutions and Pyrrhic ends. So there is some room for optimism.

Change may not come until the powerful are standing in ashes, and therein lies a tragedy yet to unfold. Let us work on with hope that reform comes well before then.