The sum of all heresies

Tim Duy weighs in on the industrial policy discussion touched off by Andy Grove's article in Business Week. His post is telling, because it gives voice, all at once, to all the nagging suspicions that are gnawing away at the guts of so many observers of current events. He writes:

Only one word describes the American labor market outcome of the last decade - abysmal. Not only is job growth well below trend, but the quality of jobs is in question. The jobs deficit is even more striking considering the supposed gains in productivity over the past 15 years. Job growth should not stagnate. Resources - including labor - released via higher productivity are supposed to be channeled into expanding sectors. Moreover, productivity growth is supposed to yield improved economic outcomes via higher real wages. Yet as spencer famously shows, labor's share of output has been steadily decreasing since the early 1980s...

Why has the American jobs machine failed so spectacularly? This should be the most pressing issue facing economists and policymakers. Are either up to the task?

Yves Smith directs us to an intriguing piece by Andy Grove, former CEO of Intel. Rajiv Sethi follows up and summarizes...I think the Yves-Sethi conversation is remarkably important, and should lead one to reexamine the importance of the manufacturing sector. I admit that in past years I tended to dismiss the manufacturing sector, seeing its relative decline as simply a transition to more productive knowledge-based work...

The loss of manufacturing capacity in the Groves scenario critically impacts the potential growth of the nation...

Note that a number of trends all begin in the 1980s. Absolute manufacturing declines, the rise of persistent trade deficits, the decline in labor's share of output, growing income inequality, and the Great Moderation. That the combination of these trends is coincidental seems unlikely...

If manufacturing is critically important to driving trends of national well being, an exploration of the decline of that sector is crucial. But that exploration almost always leads back to a very difficult place - international trade. And every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley. Therefore, the examination ends. Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

[The modern pro-free-trade orthodoxy] fails to acknowledge that while free trade produces net positive effects, that process can certainly be upset by the deliberate manipulation of currency values. And make no mistake, those values have been manipulated. There can be no other excuse for the massive buildup of official reserve assets in global central banks.

I don't think it is a coincidence that the absolute decline in manufacturing accelerated in the wake of the US strong Dollar policy, which provided the freedom for China to pursue an aggressively mercantilist economic strategy, perfecting what Japan's policymakers began in the 1980s. Thus I don't think the pernicious hollowing out of America's industrial base is simply the result of comparative advantage. I grow increasingly convinced that the disappointing economic outcomes of the last decade are the culmination of decades of industrial neglect...And I am increasingly convinced that these trends have been largely dismissed by the economics community because acknowledging them would cast doubt on value of free trade, failing to recognize that currency manipulation was turning free trade into a zero-sum game.

In short, I have become a heretic.

But what then is the appropriate policy response? Unfortunately, we are held captive by fears of a debilitating trade war...

Bottom Line: Something more than cyclical forces is weighing on the American jobs machine. Here I have tried to extend the Grove/Smith/Sethi discourse with additional focus on absolute declines in manufacturing jobs and distressing declines in capacity growth rates. These trends may be critically important in understanding the dismal performance of US labor markets. If they are in fact critical, they raise serious questions about US trade policy - questions that few in Washington want to address. Given the extent to which manufacturing capacity has already been offshored, those questions go far beyond the recently announced tiny shift in Chinese currency policy. Simply put, accepting the importance of manufacturing capacity and the possibility that offshoring has had a much more deleterious impact on the US economy than commonly accepted would requrie a significant paradigm shift in the thinking of US policymakers. If you scream "protectionist fool" in response, then you need to have a viable policy alternative that goes beyond the empty rhetoric of "we need to teach better creative thinking skills in schools." That answer is simply too little too late.

Tim Duy's post is not an economics paper, and it does not prove his case. But it tells a story (which is all most econ papers do anyway) that weaves together a number of disturbing threads - the decline of American manufacturing, Chinese mercantilism, rising inequality, stagnant real wages, and job insecurity. This is a story that is not supported by any economic model that I know of...but, given economists' ability to write down a model that supports any conclusion, and given the tendency of models that defy the free-trade orthodoxy to languish unread in third-rate journals, I'm inclined to give Duy a pass for now.

The fact is, many people instinctively believe that mercantilism can work if your trade partners don't fight back; that the export (or import-substituting) manufacturing sector is especially important for job growth and living standards; and that it is no coincidence that our inequality, stagnant living standards, and insecurity have worsened as our trade balance with China (and with the other Asian nations in China's supply chain) has worsened. These beliefs are considered heretical, but they just refuse to go away.

Now, many instinctive, heretical beliefs are actually totally false: for example, "young-Earth" theories, global warming denial, or disbelief in quantum mechanics. But in the case of the free trade orthodoxy, there is no hard evidence that free trade is always and everywhere the optimum policy. There is no fossil record, no climate record, no electron double-slit experiment that free-traders can hold up and say "Look, unbelievers! HERE'S THE PROOF YOU ARE WRONG!" Instead, economists have a bunch of models, all of which assume that free trade is good and proceed from there.

So instead or arguing from evidence, the free-trade orthodoxy relies on shouting down and insulting any who deny its precepts. I myself have participated in this, in the Introductory Macroeconomics course I TA for at the University of Michigan. We always include a lecture that pits pro-free-trade arguments against anti-free-trade arguments, and we make sure that the former always come out the "winner" at the end of the day. We use the very simplest models of trade, and we never mention industrial policy or the manufacturing sector or mercantilism. And another four hundred students tramps off to be America's next generation of businesspeople, lawyers, journalists, professors, and voters...

And yet the nagging little voice in the backs of our heads continues to whisper the things Tim Duy has dared to say in the light of day. It continues to tug and worry at the corners of our faith in free trade, crying "E pur, non e libero!"