## Friday, February 25, 2011

### Countries compete for the gains from trade.

As a follow-up to my last post, I think there is yet another big problem with Greg Mankiw's column on trade and competition. His argument about trade, whether you believe it or not, doesn't really support his basic thesis - that "other nations are best viewed not as our competitors but as our trading partners." Why not? Because as soon as there are gains from trade to be had, countries can compete for those gains. Let me elaborate.

Suppose we grant Dr. Mankiw that each country really can be treated as a single person. Now let's examine what trade looks like when there are a bunch of countries. Mankiw uses the example of a kid (country 1) offering to shovel snow for his neighbor (country 2), so let's run with that example. If the world is just the kid and the neighbor, then yes, there's no rivalry or competition going on. But as soon as we bring in a third person/country, things look a little different, as Uwe Reinhardt explains:
Your driveway is covered in deep snow. Its removal is worth \$40 to you. The boy next door...would...shovel your driveway for \$20.
So if you pay him \$30 to shovel your driveway, you will both be better off by \$10...
[But] suppose...another boy from the neighborhood comes along and offers to shovel your driveway for \$10. Elated at this bargain, you pay him \$15. Now you are very much better off, and that other boy gains, too, because he would have done the job for \$10...
[But, the entry of the second boy is harmful to] the first boy, who is sorely miffed at losing out in this competition. He loses his anticipated profit... (emphasis mine)
Somewhat oddly, Reinhardt uses this example to make a point about distribution of the gains from trade within countries. But it also shows that gains from trade can be distributed unevenly between countries. Some countries are a lot better off from trade; some are only a little better off. And which is which can change over time, as trade patterns shift.

Notice that this is perfectly in line with the Econ 101 comparative-advantage theory of trade found in any Greg Mankiw textbook*. The more similar a country's cost structure is to that of other countries, the less comparative advantage that country has.

Consider Japan. In the late 1980s, most of the reliable fuel-efficient compact cars, portable consumer electronics, and high-end televisions were made in Japan; the country reaped huge gains from trade, because lots of other countries wanted these products. But with the entry of Korea, Taiwan, Finland, the U.S., and others into these high-end markets in the 1990s and 2000s, Japan was no longer the only kid on the block shoveling snow, so to speak. As a result, Japanese profits were squeezed.

So any trade regime with more than two players puts countries in competition for the gains from trade. But this is slightly different from countries competing, because for countries to "compete" implies that there is something countries can collectively do - in other words, some government policy - to protect their profit margins from the arrival of competitors. Are there such policies?

Of course there are. At the very least, there are things we should do in any case - improve public good provision, and decrease policies that needlessly increase costs**. We can improve education, rebuild our infrastructure, and spend more on research. We can reform our inefficient health care system. We can replace some of our corporate tax with personal income tax. (Side note: Reducing our reliance on corporate tax is something Greg Mankiw agrees we should do, and as a reason why, he tells us that other countries are outcompeting us on this front! Left hand, meet right hand.)

Naturally, these are things we should do in any situation, not just in the face of trade competition. But the political process is notoriously inefficient and sluggish; if trade competition can be used as a stick to force us to make the reforms we should be making anyway, then so much the better.

Now here's the strange part. President Obama's State of the Union speech, which is what Mankiw's column explicitly claims to rebut, was all about doing exactly these sort of things to improve our nation's trade position and increase our gains from trade. It was about education, infrastructure, R&D, etc. But somehow, Mankiw interpreted this as a call for trade protectionism! Where did he get that idea?

Bottom line: International competition does exist, and gains from trade are the prize for which we compete. Obama seems to understand this. Mankiw almost certainly understands it as well, but for some reason chooses to ignore it.

* The degree of competition is magnified if you allow for the existence of agglomeration economies - if one kid wins the competition for the snow-shoveling contract by even \$0.10, it can induce the neighborhood snow-shovel vendor to set up shop near that kid's house, and the neighborhood hot-chocolate vendor will then move nearby, and so on. A tiny difference in snow-shoveling advantage can multiply into a huge difference in overall economic growth.

** More controversial are "industrial policies." I won't rehash that debate here, and I'm pretty agnostic on the subject, but if you want to read a serious economist who actually thinks industrial policy can be a good thing, read Dani Rodrik. Also, some now argue that Germany has recently been having good success with this sort of policy.