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NEW MODEL OF ECONOMIC DEVELOPMENT AND INTERNATIONAL TRADE
Harmanjit S. Saini
October 09, 2017
India was a poor country while I was growing up in the 1960. I wondered why. The answer, of course, was that India was less technologically advanced than North America, Western European countries and Japan. Then I came to the USA in 1981 to pursue a PhD program in Marketing at the J.L. Kellogg Graduate School of Management at Northwestern University.
Soon after arriving in the USA, I began to notice the poor state of American manufacturing with American companies having exited one industry after another during the 1970s due to competition from Japanese and German firms. I felt that the problem was the so-called ‘free trade’ with all nations free to sell their products and services in the USA while blocking access to American goods and services as much as possible in their markets. I wondered why the U.S. government was allowing this to take place, as it was lowering the American standard of living while allowing the standard of living of other countries to rise at its expense.
During the Ph.D. program, in addition to attending the mandatory PhD seminars in marketing, I also took seminars in economics, econometrics (audited), quantitative methods of data analysis, international finance and management of international business.
I began to publicly speak out against the so-called 'free trade' that was wrecking the US economy and lowering the American standard of living. But this was contrary to what I was being taught in the International Economics and other international Business courses. It was also contrary to the views of 98% of the economists well entrenched in academia, national governments of developed countries, IMF and the World Bank. They all believed that free and unfettered trade benefited all nations.
The economists were able to justify their understanding of international trade by pointing out that American consumers were benefiting from free trade by importing products produced by low cost labor in developing countries. The same products would be more expensive if they had been manufactured in the USA. Everyone could see that.
But the American and British economies also provided much evidence to the contrary. Free trade was producing winners and losers and was destroying the U.S. economy. Free trade advocates did not take into account the fact that America and Britain were losing high paying jobs in manufacturing requiring sophisticated technology and related services, which was actually lowering the American standard of living. They also did not take into account the fact that the American dollar was a major reserve currency of the world. That’s why the US could continue to run massive trade deficits because nations would hold the dollars as currency reserves with their central banks. Other developed nations did not have that luxury. They needed to export in order to be able to pay for their imports.
This economic reality can be illustrated with a very simple example. Let’s say that prices for an average basket of goods for an average American family can be set at $100, and the income of the family at $120. Now suppose the father gets s high paying job in manufacturing, and the new income is at the level of $200. Now assume that the country decides to manufacture more products domestically. But since the labor costs are higher in America, the prices of the same average basket of goods rise to $150. In which situation is the family better off? Obviously in the second situation because the family is saving $50 as compared to the $20 in the first situation. Thus, even though the prices have risen by 50% because the country is now producing domestically and labor costs in America are higher, the average American family is still better off because of increase in the high paying jobs in the country. Rising standard of living should be a nation’s goal and not lower prices for consumers.
Another reality was that America and Britain were exiting one industry after another, even though they had invented most of the products initially. These industries were being lost to the Japanese and the Germans. That made absolutely no sense because the U.S. and Britain had as much skilled labor and knowledge workers as any of these countries. The U.S. had more scientists and engineers than Japan and Germany combined. Therefore, the U.S. should have been able to hold its own against any of these competitors in all industries and did not need to exit any industry. But American and the world’s leading economists were blinded by the fact that they could see American consumers paying lower prices than they would have to pay if all the products were manufactured in the USA.
Problems with the Theories of International Trade
I had started speaking out against the so-called ‘free trade’ in early 1983, but my campaign went nowhere. Most businesses agreed with my ideas, but government leaders who could take action were guided by economists who all believed in their theories of international trade. They generally ignored the pleas of business leaders for some sort of protection. Government leaders could themselves see that American consumers were paying lower prices. They blamed the business leaders for not being competitive and producing inferior quality products. The reliability of Japanese and German products, particularly automobiles, was much superior to American made products. To government leaders, the economists appeared to be right.
I finished my course work and obtained my Ph.D. candidacy with only my dissertation left. I began to review the business strategy and international marketing literature as I planned to do my dissertation in International Business strategies. I wondered why business leaders were at odds with economists to whom government leaders paid heed. Government leaders assumed that the economists knew best about how the economy functions. Business leaders appeared to be incompetent as they were producing products inferior to their Japanese and German competitors. But American workers were losing their high paying manufacturing jobs, and seeing their standard of living considerably lowered. Real wages (adjusted for inflation) had been falling since 1973.
I had taken courses in quantitative methods for data analysis and came to the realization that the problem with the analysis of economists lay in the misuse of mathematics in their econometric methods. Another major problem was that inebriated with their mathematical ability, leading economists had driven other economists who did not use sophisticated mathematics out of academia by labeling their analysis as unscientific, because mathematics is supposed to be precise. If anything can be ‘proved’ by mathematics, then all other analysis is inferior to it and worthy of disdain. So anyone who looked at economic reality and offered explanations for it, but not with econometrics using mathematical functions, his work was labeled as unscientific and he was quickly silenced.
The truth of the matter however, was that the results of international trade studies using econometric methods were intuitive and failed to explain the trade that was needed for raising or maintaining the high standard of living for a nation. Analyses showed that nations do indeed export products based on their resources which are a source of comparative advantage for them. For example, unskilled labor and land are sources of comparative advantage in agricultural products, and natural resources are sources of comparative advantage in natural resource products. [Bear in mind that this analysis was being performed in 1983 – 1985.] Therefore, the U.S. exports cereals because it has abundant land (but is an anomaly because the US has skilled labor and not unskilled labor unskilled labor as export of cereals is supposed to be correlated with unskilled labor. Only economists using high-level mathematics for analysis are blind and cannot see the obvious reasons why the U.S. exports cereals: abundant fertile land to grow grains cheaply due to high agricultural productivity due to use of farm machinery), and Sweden, Norway and Canada export forest products because they have abundant forest resources.
There was no earth-shattering revelation here. A country will export what a country has, which other countries want because they don’t have it. One does not need a theory using ‘sophisticated’ mathematics to explain it.
But the studies utterly failed to explain the trade among developed countries such as the USA, Europe, Germany and Japan in manufactured products requiring sophisticated technology such as in machinery, scientific instruments, automobiles and chemicals. This trade is also of maximum interest to developed countries because manufacture of these products generates high paying jobs, leading to a higher standard of living. It also constitutes well over half of world trade. The US and Britain were losing ground to Japan and Germany in precisely these industries which was lowering their standard of living during the 1980s.
Leamer (1995, p 33) stated that “the U.S. trade pattern in 1988 seems unsustainable, and we should expect a correction, probably in the machinery category,” but the correction never occurred in the 1990s, and the U.S. continued to have net imports of machinery and other manufactured products requiring sophisticated manufacturing. The theories failed to predict based on the factors used for analysis such as land, labor wages, natural resources and capital, which country would have comparative advantage in which manufactured product. This was a well-kept secret among international trade economists.
Politicians and other leaders in government were unaware of this sorry state of international trade theories. If anyone tried to criticize the work of international trade economists they were ridiculed as being unscientific because they did not back up their criticism with mathematics. Hence no one paid attention to them. Economics was ruled by tyrannical mathematicians.
The problems with the theories of international trade stemmed from their origins in the eighteenth and nineteenth centuries. The theories explained trade in those centuries because the trade and industries were based on differences in agricultural production which depended on differences in land, climate and other growing conditions; natural resources; production was more labor intensive and less skill-intensive, and technologies were similar. And most trade was related to basic human needs such as food, clothing and shelter. But as sophistication in technologies led to quality improvements and innovation, leading to product differentiation, the traditional factors of production such as land, labor, natural resources and capital were insufficient to explain the patterns of trade, particularly in manufactured products requiring a high degree of technological sophistication such as in automobiles, production machinery, machine tools, scientific instruments and chemicals. And as stated earlier, trade in goods requiring sophisticated technology was more than half the trade worldwide and between developed countries, and the most important for maintaining a high standard of living. Trade had changed considerably from meeting the basic human needs to sophisticated manufactured goods. Analysis of trade data using the best available mathematical econometric models actually provided strong evidence against the prevailing international trade theories.
Porter (1990, p 12) noted that, “Comparative advantage based on factors of production [such as land, labor, natural resources, and capital] has intuitive appeal, and national differences in factor costs have certainly played a role in determining trade patterns in many industries. This view has informed much government policy toward competitiveness, because it has been recognized that governments can alter factor advantage either overall or in specific sectors through various forms of intervention. Governments have, rightly or wrongly, implemented various policies designed to improve comparative advantage in factor costs. Examples are reduction of interest rates, efforts to hold down wage costs, devaluation that seeks to affect comparative prices, subsidies, special depreciation allowances, and export financing addressed at particular sectors. Each in its own way, and over differing time horizons, these policies lower the relative costs of a nation’s firms compared to those of international rivals.”
I had begun my criticism of international trade theories in early 1983. I stated that the most important factors for trade in sophisticated manufactured goods were quality, continuous quality improvement (or rate of quality improvement), and innovation. These factors were not taken into account by economists in their models of international trade. Winning in the markets on the basis of these factors requires deliberate management actions by individual firms in the domestic market, and coordination by firms within an industry, often in collaboration with government, to win globally. Results of such management actions were not measured across industries and incorporated in models of international trade. Therefore, these models were unable to explain trade in manufactured goods requiring sophisticated technology.
It would be difficult to measure these factors for corporations. It would certainly be more difficult to measure these factors for nations to test models of international trade. Therefore, government intervention in factors of production used by economists in explaining international trade was not producing the intended results in competitiveness of American firms. Economists had tried to use ‘knowledge capital’ as a substitute, also known as intellectual capital as a factor in their empirical studies of international trade theories, but were aware of the unreliability of this resource data. (Leamer, 1984, p XVII). Knowledge capital for an organization is the know how that an organization develops from experience, knowledge of processes, organizational learning and employee skills.
Because of the far greater importance of management actions in improving quality and innovativeness, together with entrepreneurship in developing new businesses and industries to win in international trade, that did not depend on the factors of production used by economists, I advocated a managed approach to developing the nation’s economy. This approach is incorporated in my proposed model of economic development and international trade.
Stated in another way, economists tried to explain export data in manufactured products requiring sophisticated technology with factors of production such as land, labor, natural resources and capital. But winning in international trade in high-tech manufactured products did not depend on these factors of production, but depended rather on entrepreneurial and managerial decisions in launching new products and industries, and in innovation and continuous quality improvement. In other words, exports could not be changed much by changes in factors of production such as land, labor wages, capital through changes in interest rates, export financing, depreciation allowances etc. that government policy was trying to do. These changes would often be matched by other nations, thus, nullifying their effect. Changes in exports depended mainly on management decisions at the firm and industry level, and other forms of collaboration between government and industry, in managing the economy.
The problem with the use of econometrics in analyzing trade data can be stated in another way. Economists in studying an economy used factors such as land, labor, natural resources and capital as input into their mathematical models of international trade and tried to predict exports. Effectively, their analysis treated the economy as a black box into which the quantity of factors of production went in and expected them to correlate with exports as the output. Their mathematical analysis did capture reasonably well the output in terms of export of the products that factors of production would have naturally produced, such as what grows or comes out of the land. This would include grains, forest products and steel (in the case of Sweden because its iron ore deposits have a very low content of phosphorus impurities, resulting in higher quality steel).
But the models did not capture what actually went on inside the black box due to innovation, entrepreneurial and managerial decisions within businesses and industries to develop and manufacture new products and export them using what was naturally produced by the traditional factors of production as raw materials. These products would be those requiring sophisticated manufacturing processes developed through research and development. The reason the models failed to predict exports of such products is that the factors on which they were dependent such as innovation, research and development, entrepreneurship and management decisions simply could not be measured for the nation’s economy as a whole. Hence, they were not incorporated in the models. The measures of knowledge capital as a proxy for all the entrepreneurial and managerial decisions were tried but were very unreliable, and produced results that did not predict export performance.
Quantification of entrepreneurship and managerial skills would be very difficult even at the firm level. One would expect measurement of these factors at the national economy level to be almost impossible. But these are the most important factors that determine exports of sophisticated manufactured products. And these are not the only factors that can impact exports. Later I provide ways that nations used to defeat comparative and competitive advantage of American firms, which are also very important in determining export performance. These factors are also very difficult to measure for use in mathematical models. When the most important factors that determine export performance are not even incorporated in econometric models to explain international trade, one would expect the predictability of the models to be very poor. That is exactly what we find. Garbage in garbage out. Using inappropriate variables to explain international trade and labeling it as ‘scientific’ was a misuse of mathematics.
Lack of Understanding of Economic Development and its Links with Trade
To understand international trade, the distinction between the terms ‘comparative advantage’ and ‘competitive advantage’ should be understood. Porter (1990, p 11) discusses ‘comparative advantage’ in these terms:
“Adam Smith is credited with the notion of absolute advantage, in which a nation exports an item if it is the world’s low-cost producer. David Ricardo refined this notion to that of comparative advantage, recognizing that market forces will allocate a notion’s resources to those industries where it is relatively most productive. This means that a nation might still import a good where it could be the low-cost producer if it is even more productive in producing other goods…
“In Ricardo’s theory, trade was based on labor productivity differences between nations…” Today, “the dominant version of comparative advantage theory…is based on the idea that nations all have equivalent technology but differ in their endowments of so-called factors of production such as land, labor, natural resources, and capital. Factors are nothing more than the basic inputs necessary for production. Nations gain factor-based comparative advantage in industries that make intensive use of the factors they possess in abundance. They export these goods, and import those for which they have a comparative factor advantage.”
According to Michael Porter, a firm can gain “Competitive Advantage” in two ways over its rivals. Either it can provide comparable value to buyers at lower cost than competitors (gaining competitive advantage by charging lower price); or it can create more buyer value by differentiating its products from competitors in unique ways at comparable cost with rivals (gaining competitive advantage through product differentiation, which enables the firm to charge a premium price).
Therefore, a firm wins over rivals by either charging a lower price than competitors for products perceived by buyers to be of comparable value; or by differentiating its products from rivals which are perceived by buyers to be better in satisfying their needs, hence able to command a premium price.
The major concern I expressed was that the economists did not fully understand how economic development takes place, and the role international trade can play in it. Economic analysis was completely lacking in this perspective.
While continuous quality improvement and innovation were very important for gaining and maintaining competitive advantage in international trade, the most important factor in economic development (which does not have to be completely linked with international trade) was entrepreneurship. To increase a nation’s standard of living, entrepreneurship is the most important factor. To maintain a high standard of living, entrepreneurship, quality improvement and innovation in sophisticated technology products are required.
I discovered some flaws in the reasoning of economists about how to manage an economy which led me to develop a model of economic development, incorporating appropriate use of international trade. Here are some of the flaws I discovered:
1. Entrepreneurship is Most Important in Growing a Nation’s Economy
In the early 1980s when I was speaking out against economic analysis performed by leading economists in explaining the economy and how to grow it, the role of entrepreneurship was not at all obvious, because it was not considered as a factor in their analyses. But I kept hammering away at the idea for more than a decade that entrepreneurship was a key factor for economic development and growing the economy in all countries, developed or developing.
All human beings to survive must grow food, build some sort of shelters, produce and wear some sort of clothing. Beyond that, all economic activity requires entrepreneurship. The economy develops and grows through entrepreneurship.
In the 1980s, there was an adversarial relationship between government and business, particularly big business as it was considered greedy, interested only in becoming monopolies to be able to charge exorbitant prices for their products, not interested in maintaining the environment but only its bottom line. To obtain favorable legislation, big business was often perceived as ‘bribing’ legislators through its lobbying. Many legislators wanted to avoid this perception in the minds of their constituents by distancing themselves from big business, and sometimes to win points, deliberately opposed businesses. This adversarial relationship changed after I kept hammering away that business was not an enemy of the government and the people. The high standard of living and growth in the economy depended entirely on business. After fighting this battle single-handedly for 14 years, I was finally able to persuade the U.S. government to promote and facilitate entrepreneurship by existing and new businesses.
I believe this has been my greatest contribution to understanding of economic development, and the additional role international trade can play in it.
I also explained that the world economy is not a zero-sum game and new wealth can be created. Global economy can be expanded to make worldwide economic development possible. With the right international trade policies, the world economic pie can be increased so that all nations can have a better standard of living through international trade.
This was my second major contribution to understanding of economic development.
2. Jobs Lost in the Manufacturing Sector Can be Gained in the Services Sector
The thinking of economists in the USA and UK was that if a country loses comparative advantage in manufacturing, it will develop comparative advantage in other sectors such as services. As the USA lost comparative advantage in many manufacturing industries in the 1980s, it saw a shift in employment from 52% in services in 1948 to over 70% (more than 75% if the government sector is included) in the late 1980s (Friedman 1988, p 190). Manufacturing’s share of employment fell from 34% in 1950 to 27% in 1970 to 17% in 1990 and about 10.3% in 2012. The U.S. economy appeared to have made up its losses in manufacturing jobs by gains in jobs in the services sector. The economists appeared to be right.
The question is, can other countries do the same?
Before we can answer that question, we need to understand a few characteristics of service jobs. They are at two ends of the earnings spectrum. Professional jobs performed by lawyers, doctors, investment bankers, consultants etc. are at the high end of the earnings spectrum, whereas food services, retail and general labor are at the lowest end of the earnings spectrum. During the 1980s, most of the service job gains occurred at the low-end of the earnings spectrum. While any jobs would be good for the economy that leads to full employment, large gains in jobs at the high end of the earnings spectrum will lead to a higher standard of living. If high end manufacturing jobs are replaced by low end service sector jobs, it will lead to a lower standard of living for the country.
The other part of the story is how the U.S. made gains in the service sector jobs. One of the chief factors in the 1980s was the growth of the retail sector. The strong dollar made imports cheaper and the lower prices attractive to consumers, leading to a tremendous increase in retail activity. In addition, “More jobs in government, more jobs in the private sector defense industry, higher income supports for the unemployed, higher social security benefits for retirees, lower income taxes for individuals, lower profit taxes for corporations – the entire package added up to a massive injection of fiscal stimulus for an economy that was operating with plenty of unused resources to begin with. The American economy responded to this stimulus…The Reagan recovery was well under way” (Friedman 1988, p139).
Huge budget deficits have funded the increase in government jobs, non-profit sector social service jobs, health care and welfare sector jobs. The U.S. economy could not have created the service sector jobs to replace the lost high-paying manufacturing sector jobs without the huge budget deficits, and without the huge increase in cheap imports resulting in an increase in the retail sector employment. The U.S. still continues to do the same, ballooning the federal, state and local governments debt to above $23 trillion. This continually increasing bill will have to be paid by future generations.
The U.S. has also been in a unique position in its ability to import by paying with dollars, which other nations are willing to hold as foreign currency reserves to back up their currencies. That’s why the U.S. can continue to import all the products it wants with dollars. Most other nations don’t have that luxury. They first have to earn the dollars, or euros or the yen by exporting to the USA, EU countries or Japan before they can import as they will have to pay for them in the world’s major reserve currencies. If they lose manufacturing jobs, it has repercussions throughout the national economy.
To understand the repercussions of losing manufacturing jobs, one must first understand how service jobs are created. It is a myth that service jobs can exist in any economy without underlying economic activity to support them. Economists using sophisticated mathematics did not include this fact for their economic analysis to model the national economy. Service jobs in government cannot exist without taxes, and taxes are generally imposed on or paid with income generated through economic activity, except estate, property and certain other taxes. Other service jobs provide support services to other sectors, but mainly to manufacturing to produce, finance and market manufactured products.
In the traditional division, the economy can be divided into three sectors: primary, secondary and tertiary. The primary sector is engaged in extracting from the earth which includes extracting raw materials and agriculture. Activities in this sector include agriculture, mining, and quarrying. The level of activity and jobs in this sector depend on the level of natural resources a country is endowed with.
The secondary sector manufactures products from the raw materials produced in the primary sector. It includes all manufacturing, processing and construction activity. The raw materials do not have to be produced indigenously for a country to engage in these activities to increase employment in this sector. The raw materials can be imported.
The tertiary sector is what is known as the service industry. This sector provides services to commercialize the products produced by the secondary sector, as well as all services to any business enterprises, consumers and the general population. Examples of activities in this sector include finance, banking, insurance, marketing, sales, transportation and distribution of products, retail sales, food services, clerical support services, healthcare, law, media, government, and tourism.
In the tertiary sector, two distinctions between the kind of services can be made. One type of services includes high paying services such as managerial, consultancy, research and development functions. It is also known as the knowledge sector. Other kind of services are the lower paying services such as in retail, food service, clerical support. Employment in both types of services increases with the increase in activities in the primary and secondary sectors. Increase in the high paying jobs in the service sector create more jobs in the lower paying service jobs than increase in the lower paying service sector jobs would. This is a key fact to be considered in explaining the economy. Employment in the tertiary sector depends on employment in the primary and secondary sectors.
A further distinction needs to be made in the tertiary sector. Service industries in a country that earn foreign exchange function like the secondary sector and can further boost employment in the tertiary sector. Tourism catering mainly to foreign tourists is a prime example. Foreign exchange earned enables the country to import products that it does not manufacture (such as machinery and equipment) to increase entrepreneurial activity. Unlike the USA, most countries cannot import products by paying with their own currency. They must first earn foreign exchange before they can import products.
As the primary and secondary sectors grow due to entrepreneurship, more jobs will be created in the tertiary sector. This is called the economic multiplier effect. On the other hand, if there is a large reduction in jobs in the manufacturing sector, then via the reverse economic multiplier effect, jobs in the service sector will be reduced correspondingly, resulting in lower GDP and a lower standard of living. Loss of jobs in the service sector will be more severe if high-paying manufacturing jobs in sophisticated manufacturing and high-tech industries are lost. This seems obvious today, and should have been obvious in the 1980s, but it was not. Because of the Reagan Recovery due to deficit financing, the American industry continued to generate service jobs even though a large number of sophisticated manufacturing jobs were being lost in the millions. That’s why most economists were blinded to the linkage between manufacturing jobs in creating service sector jobs. But something had to give, and it did. The real earnings (adjusted for inflation) of American workers fell during this period.
I kept up my single-handed campaign for 14 years to convince the U.S. government that loss of manufacturing jobs was lowering the American standard of living, and that we are losing high paying service jobs as well as we lose more high-paying manufacturing jobs. That is how the linkage between manufacturing jobs and creation of service sector jobs began to be understood. That was the third major contribution I made in understanding economic development.
During this campaign, when I was not seeing any response from the U.S. government in taking steps to halt the slide in high paying manufacturing jobs, I started a campaign in 1990 to convince Americans to buy American cars and American made products. I even went to Detroit to discuss the matter with managers at General Motors, Ford and Chrysler. I did not get any encouraging response from them, but Americans began to respond to my campaign and started buying American cars and American made products. It led to the longest recovery and continuous expansion of the U.S. economy during the Clinton years. This was thus proof of the soundness of my idea that creation of service sector jobs is linked to manufacturing (or secondary sector of the economy) jobs, and that a high standard of living depends on high paying manufacturing jobs.
3. Every Nation Benefits from Free Trade
I started my campaign in early 1983 against the so called ‘free-trade’ because I saw the evidence in the lives of Americans that I came in contact with, and from the rising unemployment, that USA was not benefiting from free trade with Germany and Japan, whereas both nations were benefiting at the expense of the USA. Free-trade was lowering the American standard of living while raising the German and Japanese standard of living.
Industries requiring sophisticated manufacturing such as automobiles and machinery are more productive than industries manufacturing standardized, non-durable consumer products requiring simple, widely available technology such as for apparel manufacturing. If a nation exports products manufactured by high productivity industries, its standard of living will rise. On the other hand, if a nation loses position to foreign competitors in such industries, it will not be able to sustain its productivity growth. This will put a downward pressure on wages. If the process continues in industry after industry, it will lead to devaluation of the currency, raising the prices paid for imports. Both factors will lower the nation’s standard of living. In this case, the nation that loses position to competitors in high productivity industries will not benefit from trade. Thus all nations may not benefit from international trade.
Batra (1993, p 126) has shown that the U.S. lost out to foreign rivals in many industries, leading to a drop in real wages. He writes: “Unlike in most of its trading partners, the real wages in the U.S. have been tumbling since 1973, the first year of the country’s switch to laissez faire. The conclusion is unmistakable: every major trading partner except America has benefited from America’s adoption of free trade.”
4. Free Trade Benefits Consumers by Keeping Prices Low
The argument that free trade benefits consumers is based on the idea that only those goods will be imported that are cheaper than similar domestically produced goods. As a result, prices of such goods will come down and consumers will benefit from the lower prices. We see the evidence of this in America in retail stores where Americans buy clothing, small appliances, kitchen utensils and a host of other imported goods. If the same products were manufactured in America, and no imports were allowed, the cost to produce them in America would be higher due to much higher wage costs. So free trade does seem to benefit consumers by keeping prices low.
However, if a nation loses high paying jobs due to imports, a simplified example will illustrate that consumers will be worse off due to lower real earnings.
Suppose the population of the country is 100 and the number employed in various categories before free trade and after decades of free trade the population has grown to 130 and the real wages have increased for manufacturing and professional/Executive jobs while decreasing for service workers.
Before Free Trade After Free Trade
# Empld Pay/hr Earnings # Empld Pay/hr Earnings
Manufacturing 35 $25 $875 15 $28 $420
Prof/Executive 10 $50 500 10 55 550
Low-Pay Services 55 $10 550 105 9 945
________ _______ ________ _______ ______ ________
TOTAL 100 $1925 130 $1915
======= ====== ======= ====== ===== =======
Now suppose all products manufactured by the manufacturing sector are represented by cars and the total demand for cars before free trade is 100 at a cost of $10/car. Consumers will pay $1000 to buy these cars (as a proxy for all products manufactured by the manufacturing sector per our example). They will have $925 left over to purchase food, shelter and all other services, or $9.25 per capita.
After decades of free trade, even with a 30% increase in the population, the real total income of consumers has remained stagnant, and the per capita real income has gone down. Now suppose the demand for cars after free trade was allowed has gone up to 120 due to increase in population. Since import of cars has been allowed, assume the price of imported cars is $9.50/car. Due to productivity gains, the 15 workers still employed in manufacturing can now manufacture 50 cars domestically. Therefore 70 cars are being imported to meet the demand for cars. The cost to consumers to buy the 120 cars is $500 for the 50 domestically manufactured cars, and $665 for the 70 imported cars for a total cost of $1165. The consumers now have $750 left to purchase food, shelter and all other services, or $5.77 per capita. Average consumer is therefore worse off due to loss of high paying jobs, despite the lower cost of manufactured cars (or manufactured products).
Though the above example is very simplistic, it still illustrates the point that consumers in all nations are not better off due to lower prices with free unfettered trade.
The actual data shows that Americans were worse off due to free trade. Batra (1993, p 160) has shown that as a result of free trade since 1973, about 80% of the American workers have undergone a fall in real wages. Though not all these workers were employed in manufacturing, but as manufacturing jobs were lost, real wages in the service sector were also depressed because more workers were available. Real wages of non-supervisory workers dropped from $315 weekly in 1973 to $256 in 1991, a drop of 18.73%. The lower 80% of all workers saw a decline in family incomes whereas the top 20% saw their family income rise during the same period.
The effects of free trade can be gauged by comparison with other countries. All nations that have a large trade surplus with the U.S. have had their standard of living rise much faster than the U.S. With a fall in real wages, in fact, the U.S. standard of living has fallen whereas all our trading partners having a trade surplus with us have had their standard of living rise. Prime examples are Germany, and Japan earlier, and recently China. They have gained at our expense. This does not require rocket science level mathematics to analyze and figure out. It should have been obvious to Americans and government leaders, except that leading economists, many of them winders of the Nobel prize in Economics, had blinded them by characterizing all such economic analysis as unscientific as it did not use ‘high-level’ mathematics that only they understood. Thus, free trade may keep prices and inflation low, it can nevertheless lead to a falling standard of living in real terms.
5. Laissez Faire vs Managed Economy
Merriam-Webster’s dictionary defines laissez faire as “a doctrine opposing governmental interference in economic affairs beyond the minimum necessary for the maintenance of peace and property rights.” Or, “It is a capitalist precept that states that market economies function at optimal efficiency in the absence of government regulation.”
According to https://www.britannica.com/topic/laissez-faire, “Laissez-faire was a political as well as an economic doctrine. The pervading theory of the 19th century was that the individual, pursuing his own desired ends, would thereby achieve the best results for the society of which he was a part. The function of the state was to maintain order and security and to avoid interference with the initiative of the individual in pursuit of his own desired goals. But laissez-faire advocates nonetheless argued that government had an essential role in enforcing contracts as well as ensuring civil order.”
Acceptance of this doctrine reached its peak around 1870 as government felt the need for intervention due to business’ tendency to create monopolies, drive down labor wages, cut corners with worker safety, and pollute the environment in the absence of regulation. However, the doctrine was followed in international trade by Britain and America, allowing free and unfettered imports. Only Britain and America adhered most closely to the doctrine, whereas Japan did not. Japan benefited and America and Britain suffered economically. Germany also benefited because it had a disciplined population that bought only German made products and American companies manufactured in Germany rather than exporting to Germany.
My fourth major contribution to the debate was the recommendation that the USA and Britain adopt a managed approach to dealing with the economy and discard the laissez faire approach, particularly for international trade.
Here are the ways in which laissez faire destroyed American manufacturing and almost got us into the poor house. Only incredible American innovation in information technology with firms like Microsoft, IBM, Intel, Oracle, Google, Dell, HP and a host of others kept us from the poor house.
a) Allowing Access to U.S. Technology
After World War II, only the U.S. had its industrial capacity intact. Developed European countries and Japan lay in ruins. The U.S. helped Europeans rebuild their economies with the Marshall Plan and assisted Japan with liberal exports of technology, and continued to follow a policy of laissez faire in international trade and industrial policy. Other developed nations, particularly Japan took advantage of this situation to ‘raid’ U.S. firms for access to their technology. Three examples will illustrate the process.
The Japanese were determined to capture the computer mainframe market as they had done in consumer electronics and other mass market industries. They were investing heavily in research and development (R&D) to develop the fastest computer in the world. They also tried to gain access to IBM technology. In the early 1980s a Japanese national was caught trying to illegally gain access to IBM technology. The Japanese then changed their tactics.
Former IBM employees who were familiar with IBM technology had started Amdahl Corporation. The Japanese then gained access to that technology by acquiring Amdahl. IBM or any other American computer firm had no way to gain access to Japanese computer technology at Fujitsu or Hitachi as these firms would not employ Americans, or allow to be acquired by American firms. Under such circumstances it does not take a genius to figure out who will eventually gain the lead in technology. If my competitor knows everything I am doing and I have no idea about what R&D efforts my competitor is engaged in, it won’t be long before my competitor gains the lead in technology over me.
In a second example in Krugman (1986, p 99), Michael Bonus, Laura Tyson and John Zysman describe how the Japanese gained access to U.S. semiconductor technology:
“Thus, during the 1960s and the early 1970s the Japanese government, principally through MITI [Japanese Ministry of International Trade and Industry], sought to build a competitive semiconductor industry by limiting foreign competition in the domestic market and acquiring foreign technology and know-how. Foreign investment laws created after World War II required the Japanese government to review for approval all applications for foreign direct investment in Japan…
“The price to U.S. firms for limited access to the Japanese market was their licensing of advanced technology and know-how. Since MITI controlled access to the Japanese market…it required foreign firms to license all Japanese firms requesting access to a particular technology. It limited royalty payments by Japanese firms to a single rate on each deal, thereby preempting the competitive bidding up of royalty rates among Japanese firms…MITI also conditioned approval of certain deals on the willingness of the involved Japanese firms to diffuse their own technical developments through sublicense agreements to other Japanese firms. The total result of these policies was a controlled diffusion of advanced technology throughout the Japanese semiconductor industry. Tilton gives a convincing measure of the extent of Japanese firm dependence on the acquisition of U.S. technology: by the end of the 1960s Japanese IC producers were paying at least 10% of their semiconductor sales revenues as royalties to U.S. firms – 2% to Western Electric, 4.5% to Fairchild, and 3.5% to Texas Instruments.”
Japanese were also the most enterprising in acquiring the most advanced science and technology in the U.S. even before commercialization of the technology had been realized. However, the Japanese and other developed nations’ governments and firms did not allow similar access to their technology to U.S. firms. Thus, blind faith in laissez faire prevented the U.S. government and firms to act jointly to protect U.S. technology. Foreign rivals did not have any comparative or competitive advantage in these industries, but because of following the doctrine of laissez faire, the U.S. enabled them to create competitive advantage and destroy its own in the process.
The third example is the U.S. auto industry, and many other American industries. Instead of manufacturing all their products in the USA and exporting them, in the 1970s and 1980s, the U.S. firms set up manufacturing facilities in foreign countries through subsidiaries, particularly in Germany. These included General Motors, Ford, IBM, Exxon, Proctor & Gamble, Du Pont among others. In those decades, German companies did not have similar manufacturing operations in the USA. That also allowed access to U.S. technology to German firms because trained employees in U.S. subsidiaries with access to U.S. technology could simply seek employment with German competitors, or illegally pass on technology to them.
The Germans had another advantage that the Japanese did not possess. Many Americans are of German descent. They helped German firms by clandestinely passing on the best and latest technology to the German firms. In addition, they helped German firms by buying German made products in the USA. That’s why the USA has had such huge trade deficits with Germany and continues to do so even today.
b) Strategies Used to Defeat Competitive Advantage of U.S. Firms
How can a nation’s firms tell if they have a comparative advantage in certain industries? This is how economists answer the question: “To put things in a nutshell, a nation’s producers can tell whether they have comparative advantage in the production of a certain commodity by seeing whether it is profitable for them to export it. If they can make a profit, they have comparative advantage.
A corollary to this reasoning is that if foreign competitors are beating the hell out of domestic manufacturing firms in your home market, then you are losing comparative advantage in those industries. That kind of thinking eased the guilt of American firms, government industrial policy makers and economists in exiting industry after industry at the expense of American workers and reduced military capability as no one can know which technology might prove critical in developing weapons of the future.
But foreign firms with the help of their governments can employ many strategies to defeat the competitive advantage of American firms. Here are examples of three strategies often used by foreign firms:
i) Variable Cost Pricing
Foreign firms have usually sold in the U.S. market at prices well below their domestic prices. They are able to do this because they cover their fixed manufacturing costs in their domestic market by selling at full price. Once fixed costs have been recovered, they can then sell in the U.S. market at variable costs plus profit and still make huge profits. Such foreign competitors can compete in the U.S. market on price alone and not because they have any comparative or competitive advantage in that industry. The following example illustrates how fixed costs and variable costs in manufacturing and marketing of products work.
Let’s take the example of manufacturing a TV for which the sales price the company can realize in its domestic country is $100. Assume that the initial investment in the plant to manufacture TVs is $100 million. Assume that this investment has to be recovered over 5 years in the form of depreciation, with $20 million to be recovered annually. To run the company, before any products can be produced and sold, the company will have to hire a CEO, and other administrative personnel. These costs have to be incurred annually, say to the tune of $4,000,000. These costs have to be incurred whether the company produces or sells any TVs. All these are called fixed costs, which in our example total $24 million annually. Now to manufacture each TV, the company incurs raw material and labor costs. The amount of labor and raw material used varies with the number of TVs produced. These are called variable costs. Suppose to manufacture each TV, it costs $20 in material costs and $20 in labor costs. Therefore, when a TV is sold for $100, it contributes $60 (i.e. Selling price of $100 minus the variable cost of manufacturing the unit at $40) towards covering the fixed costs and realizing a profit. Therefore, to break-even, meaning to realize no profit or loss by covering all its fixed costs and variable costs, the company must sell 400,000 TVs annually, which will enable it to cover its $24 million in fixed costs and $16 million in variable costs of manufacturing them at $40/TV. After breaking even, all the fixed costs have been recovered. Then any further sales contribute $60 to profits with the sale of each unit at $100.
Assume that a Japanese firm is the competitor for an American firm and the wage and material costs in both countries are similar. After the Japanese competitor has recovered its fixed costs in the Japanese market, it can continue selling TVs in the U.S. market at any price above $40 and still make a profit. It may even make it difficult for the U.S. firm to fully recover its fixed costs. The U.S. firm will then begin to incur losses and may be forced to exit the U.S. market eventually.
Now consider that the TV firm we are considering is in an Eastern European or a Latin American nation and the competing foreign firm is a Chinese firm. Since China has reached a higher standard of living, assume that it pays its workers 50% higher wages than wages in your country. To produce the same TV, China will incur $20 in material costs, but $30 in labor costs since it pays 50% higher wages. Its fixed administrative costs will also be higher at $6,000,000 instead of $4,000,000 in your country. Therefore, the annual fixed costs China must recover are $26 million instead of $24 million in your country. Since China’s production costs are higher, the contribution to covering its fixed costs and profits is only $50 instead of $60 in your country. To break even by covering all its fixed and variable costs, the Chinese company must sell 520,000 TVs at $100/TV whereas the firm in your country had to sell only 400,000 TVs to break-even.
But since China has a huge market, it is very easy for the Chinese firm to sell 520,000 TVs in China and a little harder for the firm in your country to sell 400,000 TVs in your country. After the Chinese firm has sold 520,000 TVs in China and recovered all its fixed costs, with the sale of each additional TV, the firm realizes $50 as profit (which is the sales price of $100, minus the variable price to manufacture each unit in China of $50.) This means that because of your country’s smaller population, while the TV manufacturing firm in your country is working hard to sell 400,000 TVs at $100 to break-even with no net profit, the Chinese firm can dump TVs in your market at $70, even after paying 50% more to its workers than your country’s firm can and realize a handsome profit of $20/TV. In fact, even if China paid its workers double of what your country’s firm pays and sells the TVs for $90, which is $10 lower than what your firm is selling them at just to break-even, Chinese firm can still realize a profit of $20 per TV sold. Thus, if your country’s workers are being paid $10/hr on the average and China pays its workers $20/hr, it can still make a huge profit by selling its TVs in your country, whereas your countries companies will struggle to break-even. They will eventually go bankrupt, allowing China to capture your market. That is how China can kill your manufacturing industries one-by-one with variable cost pricing.
ii) Targeting Industries
Foreign countries (particularly the Japanese) had targeted industries one by one to dominate worldwide in the 1970s and 1980s, but mainly in the biggest market in the world, the U.S. market. Japanese firms have not only had the firms’ own resources available to them, but also resources of financial institutions and the Japanese central, prefecture and local governments.
The government augmented the resources of the firms by subsidizing R&D expenditures, and also paid higher procurement prices by government administrations, utility, telecommunications and railway companies for the products of the targeted industries so that they could recover their fixed costs in the Japanese market itself, giving them flexibility in pricing their products in foreign markets. Financial institutions also added to the financial resources of the firms by taking equity stake in the firms and providing long term loans. These resources enabled the Japanese firms to sell below cost to capture foreign markets. This competition forced the nations’ own firms to exit the targeted industry. Then the Japanese firms could price their products at full pricing to rake in profits, maintain market share and move on to target other industries to take over with the freed financial resources available.
iii) Protectionism Against U.S. Firms
Even though American firms may have had competitive advantage in some industries, U.S. products were excluded from foreign markets through government or collective actions of an industry and government in the domestic market. Government actions included tariffs on imports, quotas, licensing requirements for imports, totally prohibiting import of products and allowing foreign firm entry only through joint ventures with domestic firms, imposition of unreasonable product quality standards, marketing restrictions through regulations such as not allowing retail outlets owned by foreign firms, and orderly marketing arrangements. Foreign diversified conglomerates also restrict their purchases in many cases to domestic firms, or from firms within the conglomerate.
Such barriers prevent U.S. firms from using variable cost pricing strategies to meet competition globally. For example, if a Japanese firm tries to sell its generators in the U.S. market by using variable cost based pricing, the U.S. competitor could do the same in the Japanese market to meet the competition by preventing the Japanese firm from recovering its fixed costs in the Japanese market.
The U.S. government took no action in the past to remove these barriers. Therefore, U.S. firms could not export in some cases; not because they did not have comparative or competitive advantage, but because they faced insurmountable barriers. On the other hand, they faced an onslaught of foreign competitors who were free to sell their products with variable cost pricing, or even below variable cost in order to capture large market share in the U.S., ultimately driving U.S. firms out of many industries altogether.
c) Maximization of Shareholder Wealth (MSW) Destroyed American Industries
Any basic textbook on Corporate Finance under the topic ‘Corporate Goals’ will state that ‘the goal of the firm is to maximize the wealth of its present owners (shareholders).’ Maximization of shareholder wealth implies the maximization of the net present value of income streams in the form of dividends and appreciation in the share price. Compensation packages of corporate executives in the 1980s were designed to ensure that they act in the best interests of the shareholders. If the executives did not act in the best interests of the shareholders, they could lose their jobs. If they did, they could enrich themselves fabulously.
But the actions of executives may not be in the best interests of the employees or the nation. Executives will usually not take actions that will hurt quarterly profits, or that will cause the share price to decline. For example, if sales of some products begin to decline for some reason such as low-priced imports, managers will take whatever actions necessary to prevent overall corporate profits from declining. These actions may include reducing advertising costs (thus eroding product image and market share further), cut R&D costs and investment in new processes and machinery which will affect product quality. The executives may ultimately decide to exit unprofitable segments of the market, and concentrate all efforts only on profitable segments. If however, losses continue to depress overall corporate profits, the firm may decide to quit the industry altogether. Many U.S. firms did precisely that during the 1970s and 80s. It seems to be of no concern to the firm that employees will lose high paying jobs, never to be regained by quitting an industry altogether and letting foreign rivals take over, or that the technology and products of the industry may be critical for military purposes or for other industries, and will make the nation dependent on foreign firms or nations who are friends today, but may be enemies tomorrow.
Relentless pursuit of MSW has spawned other destructive behaviors by U.S. firms. Mergers and acquisitions of the 1980s were pursued with the aim of MSW. Shareholders sold their stock at high prices and increased their wealth. But the acquiring corporations piled up huge amounts of debt, servicing of which forced them to sell parts of the acquired corporations, cut expenditures in R&D and capital investment necessary for upgrading technology and improving product quality. This affected growth in productivity, leading to a decline in competitiveness against foreign rivals.
Thus, MSW has given U.S. firms a very short-term perspective, CEOs, COOs and CFOs don’t seem to realize that loss of high-paying jobs means a smaller domestic market for their products, leading to smaller profits for them in the long run. Some industries were not lost due to loss of competitive advantage, but to relentless pursuit of MSW. High priced management consultants also helped CEOs feel no qualms about leaving many industries in control of foreign rivals.
There is no denying the fact that laissez faire has been a disastrous doctrine for the USA. Two countries that have followed the approach of managing the economy and have benefitted tremendously at the expense of the USA are Japan and recently China. I recommended the managed approach for the economy for both developed and developing nations. I proposed a new model of economic development and international trade with recommendations for both developed and developing countries.
A New Model of Economic Development and International Trade
The key to developing a model of economic development that would benefit all nations is to understand how wealth is created through entrepreneurial activity.
It is also important to understand that the world economy is not a zero-sum game game, and additional wealth can be created in a nation’s economy and globally. Global economy can be expanded to make worldwide economic development possible. With the right international trade policies, the world economic pie can be increased so that all nations can have a better standard of living through international trade.
For a nation to have a healthy economy and the highest standard of living possible, it is essential to keep the maximum number of high paying jobs within the country, and as much as possible, maintain full employment.
National leaders must also understand that jobs in the service sectors are created to provide services to other sectors such as manufacturing. These jobs are supported primarily by other sectors. The service sector cannot stand on its own.
Finally, international trade has to be managed for economic development to take place in all nations. Otherwise international trade will produce winners and losers. In other words, a laissez faire approach to the economy and international trade will produce winners and losers, which will not benefit all nations.
With these axioms in mind, I proposed the following model of economic development and international trade.
Initially, wealth is created from the natural resources of the earth. Basic needs of human beings are food, clothing and shelter. These needs must be satisfied first. Remember, when a nation or tribe starts out, most families are engaged in subsistence farming to satisfy their family’s basic needs. That’s why initially in developing countries (DCs), most of the population was engaged in subsistence farming. Further economic development takes place from the surplus (this is the earnings left over after satisfying the family’s basic needs) created by the farmers. All further economic activity takes place through entrepreneurship.
A part of the surplus is taken by the government in the form of taxes which is used to create government jobs. The remaining surplus is sold by the farmers in exchange for other products and services, thus creating jobs in the manufacturing and service sectors, through entrepreneurship. This demand creates wealth.
Increases in productivity (meaning producing more with less manpower increases per capita income. For this purpose, machinery is invented to produce more with less manpower, which will then require capital investment to manufacture the machinery. Then better ways of doing things and newer machinery will continue to increase productivity) in the farming sector take place through entrepreneurship to increase the surplus, which can then be exchanged for more manufactured products and services. This economic activity further creates wealth. This is evident from the high percentage of the population in less developed countries engaged in producing goods to satisfy the basic needs of food, clothing and shelter, as compared to those in highly developed countries. The drive to increase in productivity leads to specialization, which increases domestic trade.
To manufacture the products demanded by the population, growth in economic activity in the primary sectors of mining and exploitation of other natural resource takes place, increasing employment in these sectors. Along with agriculture, these sectors were identified as the primary sector, and employment in this sector depends on the resources a country is endowed with. Use of technology in this sector increases productivity, leading to a higher surplus, which leads to growth in the secondary sector which consists of manufacturing, processing and construction activities. This growth in the secondary sector further creates wealth.
Increases in productivity in the secondary sector depend on technological advances, and higher productivity leads to wage and earnings growth (because with the help of machinery, fewer workers are producing more), leading to greater wealth creation. Technological advances occur due to a quest for continuous quality improvement, and invention of new products that consumers will be willing to buy with their increased disposable incomes.
Economic activity in the secondary sector increases the demand for services which is the tertiary sector. This demand increases employment in the tertiary sector. In the tertiary sector, one part is known as the knowledge sector provides services to the secondary sector and creates high-paying jobs such as in managerial, consultancy, and research and development functions.
Other part of the services sector provides services to businesses as well as the general population. As economic activity and employment in the primary, secondary and knowledge sectors increase, employment in the other services sector (which include finance, banking, insurance, marketing, sales, transportation and distribution of products, retail sales, food services, clerical support services, healthcare, law, media, government, and tourism) also increases.
Increases in employment in the services sector due to increases in economic activity in the primary and secondary sectors is known as the economic multiplier effect. The economic multiplier effect can work in both ways. Increases in jobs, particularly high-paying jobs can increase employment in the services sector, thus boosting the GDP. On the other hand, decreases in economic activity and employment in the primary and secondary sectors can decrease employment in the services sector and reduction in GDP.
Thus beyond the simplest form of agriculture and animal husbandry using one’s hands, every other improvement requires entrepreneurship. This takes the form of tools to increase productivity to realize a high surplus to be able to buy other desired products produced by others. New technologies to improve productivity, quality, and invention, production and marketing of new products all require entrepreneurship. Therefore, entrepreneurship is the key to economic development.
The link between taxation and household savings should also be understood. Household spending creates demand which increases economic activity through entrepreneurship to meet that demand. Greater the percentage of household income spent to buy goods and services, the greater the boost to economic activity. The more household income taxed or saved, the less would be available for spending which would curtail economic activity.
Government taxation is needed to meet the necessary functions the government should provide, which include maintaining law and order (without which economic activity would be greatly impeded), meet expenditures on transportation, communications and educational infrastructure without which gains in productivity would suffer. Household savings are needed to provide the capital needed for investment in entrepreneurial activity. So, there is a tradeoff between spending, taxation, and household savings.
The important question then is, what is the optimal level of household taxation, and household savings? My view is that income tax on household incomes should be about 20%, with an additional 3% for social welfare programs. Corporate taxation should also be around 20% to provide the infrastructure that would be used mainly by businesses such as scientific institutions, transportation, communications and health care. Looking at the data on household savings in various nations, the optimal percentage appears to be around 10%.
These recommendations, however, would need to be modified in the case of undiversified economies. For example, the Gulf state economies are primarily oil revenue based. They need to maintain higher savings rates as prices of commodities can fluctuate widely.
The fact that capital can cross international borders should also be considered. If a country’s economy can earn enough foreign exchange through export of products and services or tourism, then it will have the ability to service foreign held debt. Then a higher household savings rate may not be critical in providing the capital needed for investment in entrepreneurial activity. Foreign loans may be a substitute.
An additional note on wealth and wealth creation. The Merriam-Webster dictionary defines wealth as “all property or all material objects that have a money value or an exchangeable value (economic utility).” This definition of wealth implies the value of all we own (liquid assets such as cash and non-liquid assets such as houses, property etc.). However, as the term is generally used, by wealth creation we mean additional income generated by spending. This is what helps the economy to grow, meaning leads to a rise in the nation’s GDP. This is known as the multiplier effect in economics.
Without going into how this multiplier effect works in an economy, the concept can be illustrated with a simple example.
Suppose, a farming family, after satisfying the family’s basic needs with what it has produced, earns $100 in income by selling its surplus and spends $80 of it and saves $20. That $80 spent is income for other families generated through the products and services they provided to the original family. If these families also save 20% and spend 80% or $64, that is income for other families. This process goes on. Thus, the initial $100 in income earned by the farming family by selling its produce and spending a part of it has generated more income throughout the economy. This is known as the multiplier effect. It represents the increase in final income generated by any new injection of spending.
Using the above example, economists refer to the decision of the family to spend 80% of its income as the marginal propensity to consume (mpc), which is 0.8. The marginal propensity to save (mps) then is 0.2.
The general formula to calculate the multiplier using marginal propensities, is:
Multiplier = 1/(1-mpc) = 1/mps
Using our example, if consumers spend 0.8 and save 0.2 of every $1 of extra income, the multiplier will be:
1/(1-0.8) = 1/0.2 = 5
Therefore, the multiplier in the economy is 5, which means that every $1 of new income generates $5 of extra income. In other words, every $1 increase on new income of which $0.8 is spent by consumers will lead to a rise in GDP of $5.
Initially, the farmers bringing their surplus into the market and selling it starts the process. The income so generated then via the multiplier effect generates more income. This is wealth creation. In addition to farmers actually engaged in farming, the same process applies to all those engaged in satisfying the basic human needs of food, clothing and shelter, such as those manufacturing tools and implements and transportation products to increase productivity. But the process continues beyond satisfying the basic human needs of food, clothing and shelter to even leisure and entertainment activities when consumers have left over disposable income to spend on these activities.
Earlier I used the term ‘economic multiplier effect’ to refer to the effect of economic activity in the primary and secondary sectors of the economy to generate jobs and incomes in the tertiary, or the service sector, of the economy. The ‘economic multiplier effect’ is really a subset of the term ‘multiplier effect’ used by economists, because the effects of imports and exports can be incorporated in calculating the multiplier effect.
The illustration of the multiplier effect would apply mainly to a simple economy. However, in a complex economy, the calculation of the multiplier effect can be modified by using additional terms that describe the withdrawal of additional income which would not be spent by consumers. These terms are the marginal tax rate (or mrt, which is the amount of tax paid on an additional dollar of income) and marginal propensity to import (or mpm, which is the increase or decrease in imports resulting from an increase or decrease in income). Taken together, marginal propensity to save (mps), mrt and mpm represent withdrawals of income that is not spent, which is termed as the marginal propensity to withdraw (mpw).
The multiplier effect now can be calculated as:
Multiplier effect = 1/(mps+mrt+mpm) = 1/mpw = 1/(1-mpc)While spending on imports represents withdrawal or leakage of income from the domestic economy (as the income is earned by those foreign countries manufacturing the imported products), increase in exports represents additional income for the domestic economy (as the income generated by manufacturing products and exporting them is earned by domestic employees) and will increase the nation’s GDP via the multiplier effect. In the same way, foreign exchange earned from foreign tourists functions the same way as income from exports and benefits the nation via the multiplier effect.
With these linkages between taxation, household savings, consumer spending and entrepreneurial activity being understood, we can describe the new model of economic development and international trade.
Model of Economic Development
Economic development takes place through entrepreneurial activity. Beyond subsistence farming and construction of rudimentary shelters and basic homespun clothing, all further development takes place through gains in productivity made by entrepreneurs in satisfying the basic needs of food, clothing and shelter. Entrepreneurs will improve agriculture, animal husbandry and cloth manufacturing making gains in productivity. This will enable them to earn higher incomes, specialize to make further gains in productivity. They will also have higher surplus, which they can spend to buy desired products to further stimulate the economy. With further gains in productivity, less household income will be required to meet the basic needs of food, shelter and clothing, making more income available for luxury items, comfort, convenience, entertainment, tourism, and spending on items for personal productivity improvement such as computers, smart phones etc. to save time which can be used to spend on leisure, entertainment, or educate and guide children. Government tax revenues will rise to make more government spending possible to better perform the functions the government needs to perform to boost entrepreneurial activity, and via the economic multiplier effect, need for services will rise, boosting employment in the services sector.
Thus, entrepreneurship creates wealth. If a country wants to develop economically, it must encourage entrepreneurial activity in the primary and secondary sectors. Every possible support must be given to entrepreneurs who create wealth. This would require investment in infrastructure; things such as a good education system to train manpower required for business enterprises, good transportation and telecommunication facilities.
Government must also encourage free and fair competition among entrepreneurs who create wealth. That requires adequate good laws, properly enforced through a good law enforcement and justice system to deter unfair competition that would otherwise lead to creation of monopolies and inefficiencies.
A major hindrance to entrepreneurial activity is acquisitive leadership. In many countries, the political leadership is interested only in getting wealthy by appropriating the income from the nation’s natural resources for personal use, inventing ways to steal from entrepreneurs if they have full control over state power, or take bribes to allow monopolies to develop which inhibit rapid economic growth. In such an atmosphere, entrepreneurs have to fritter away their energies in fighting government leaders in trying to protect and keep most of their earnings. They will try their best to pay as little taxes as possible. Bribing government leaders will leave less capital for investment in the business enterprises. The government will then not have sufficient revenues to develop the infrastructure necessary for supporting entrepreneurial activity. If national leaders have absolute power, and have no qualms about using it to benefit themselves only, they will hinder entrepreneurial activity so much, that it will lead to impoverishing the nation. An example is Robert Mugabe of Zimbabwe. On the other hand, if the political leadership encourages entrepreneurial activity, and imposes only reasonable taxes to run government for the benefit of the nation, the country can get on the road to economic development.
Policy Guidelines for Developed Countries
No nation is endowed with all the natural resources it needs. Therefore, trade among nations is essential. Trade can increase productivity through specialization and consumer welfare around the world. However, totally free and unfettered trade can produce winners and losers, as some nations will not follow the rules of free trade. There can be winners and losers even if nations follow the rules of free trade. It is possible that there can be many losers and only a few winners. That is no comfort to losing nations. Totally free trade for them is not a viable alternative. When a nation realizes that it is ending up being a loser, it’s an obligation on the part of the nation’s leaders to their citizens to get out of a losing situation and begin to manage their trade to avoid becoming a loser. Batra (1993, p 241) states it quite clearly: “when trade stimulates manufacturing, it enriches a country; when trade retards manufacturing, it hurts a nation.”
Kolko (1988, p 225) also writes: “In the end we are all nation states and the prime responsibility of nation states is towards their own people, not to the abstract ideal of free trade,” the British trade secretary Edmund Dell warned the Japanese. In Europe the president of the EC said in late 1982, “At a time when the unemployed in the community run into millions, no government can afford to be guided by theoretical models of…free trade at any price.”
The USA and British Commonwealth nations, therefore. should discard laissez faire and follow a managed approach to the economy. Japan has never followed laissez faire, and benefited tremendously from a managed approach to its economy. China is using the same strategy, though it duplicitously has begun preaching about ‘free trade.’
1. The goal of the nation should be full employment with the maximum percent of the population employed in the highest possible paying jobs in the primary sector (in which the employment depends on the nation’s natural resource endowment) and the secondary sector. Then via the economic multiplier effect, more jobs will be created in the service sector. Therefore, USA and Britain should maintain manufacturing employment in the highest paying jobs at the maximum level. When the USA begins to lose such jobs to foreign competition, restrictions should be imposed to redress the imbalance.
2. If the U.S. wants to remain a superpower, it must remain militarily and economically strong. To remain militarily strong, it must remain at the cutting edge of all technologies because it is difficult to predict which technology would be required for military weapons at any time. Therefore, the U.S. cannot afford to exit any high-tech industry.
3. The USA needs to guard its technology. Since World War II, the U.S. has liberally shared its technology with other developed nations. When Japan became a direct competitor, it was able to easily raid U.S. firms for the most advanced technology by various strategies such as restricting imports and not allowing entry into Japan by U.S. firms unless they licensed their most advanced technology to Japanese firms, or by acquiring U.S. firms. The U.S. should cooperate by sharing technology only with those nations that are willing to share their most advanced technology on an equal basis. Licensing of sensitive technology by U.S. firms should be strictly controlled.
4. The USA should require reciprocation from countries that have a trade surplus with the USA. After helping Japan and Germany recover, the U.S. and Britain have helped Korea, Taiwan, Singapore and Hong Kong develop, and continues to help in the development of many other countries such as Thailand, Malaysia, Indonesia and others. India exports $100 billion worth of IT services annually to the USA and British Commonwealth nations. This help in economic development should be used as leverage to export American products and services to these countries by requiring reciprocity in trade.
5. Business leaders have an obligation to the nation and for public good rather than merely maximization of shareholder wealth. In the long-run, public good is best served when corporate goals are aligned with national goals (such as remaining competitive to retain the maximum number of high-paying jobs in the country, and remaining at the cutting edge of every technology because we don’t know what technology might be needed for military purposes). To help develop, monitor and coordinate the incorporation of national goals into corporate goals, industrial and international trade policies must be managed to retain the highest paying jobs within the country and to combat foreign competition.
6. The USA is the largest market in the world, and has a large population. It does not need to specialize, and should compete globally in all high-tech industries. The situation with other developed countries in Europe, however, is different. Countries in Europe with population less than 40 million are not in a position to be significant players in every industry. Therefore, international trade is essential for them to maintain a high standard of living, and they must specialize. They need access to the market in other countries so that they can reap the benefits of economies of scale where applicable. One way for them to gain access to a large market is to join in regional economic blocks or common markets which allow free trade among themselves on the pattern of the EC. However, they have to guard against unequal players such as Germany capturing markets. In my opinion, it makes more sense for smaller European nations to form an economic union that is a free market among themselves (minus the bigger nations such as Germany, France and Britain) so that they can compete effectively against bigger European nations such as Germany, France and Britain.
7. The USA is in a unique position in the world because of the U.S. dollar being the reserve currency of the world. There are only two ways a nation can obtain foreign currency to be able to pay for its imports: a) Through a positive trade balance in goods and services (which includes tourism), and b) Through foreign currency loans. But loans have to be repaid. So ultimately, the only way to obtain foreign currency is through a favorable trade balance in goods and services. Because the U.S. has an unfavorable trade balance with virtually every country, it puts dollars in the hands of foreign nations which can then hold them as foreign currency reserves to back their national currencies. For this reason, it is hard for the yen and the Yuan to become the primary reserve currencies of the world as Japan and China are both exporters with a favorable trade balance. In this way, it is advantageous for the world that the U.S. has a trade deficit with most nations. The U.S. should continue to play this role as it is benefitting global commerce. The stock of precious metals is not large enough (and precious metals have the disadvantage of costs of transporting them) to provide the liquidity that international commerce needs. One cannot beat the advantage of a medium of exchange, the dollar, that can be exchanged by a mere computer entry. However, the U.S. should guard against large trade surpluses with developed countries such as Germany, Japan and now China that lead to loss of high paying jobs in America. It is lowering the American standard of living.
8. China has been trying very hard for the last 5-7 years to make the yuan a world reserve currency. But China has already destroyed its credibility with most nations by selling products deliberately designed to harm and even poison populations, For example, in America, China has sold toys and other products for children coated with lead paint (which causes developmental delay, learning difficulties, irritability, weight loss, sluggishness and fatigue, hearing loss, seizures and other health problems); suspect seafood; half a million radial tires in which its Chinese manufacturer had discontinued a safety feature that prevented the tires from coming apart; toothpaste containing dangerous amounts of the poisonous chemical diethylene glycol; cosmetics with harmful levels of lead, beryllium, aluminum, mercury and bacteria; counterfeit medicines; contaminated drywall which has caused health problems, metal corrosion, and which may be responsible for a rotten egg smell in affected homes, blackened or corroded pipes, failure of air conditioners and other household appliances, and health problems such as asthma, coughing, headaches, sore throats, and irritated eyes; and contaminated pet food that caused renal failure in cats and dogs.
USA has the technical capability and resources to detect these harmful products and order their recall, but most other countries don’t. They will simply be inviting China to slowly poison their populations. Nations will be buying Chinese products at their own risk. With such a reputation, and other arbitrary decisions to interfere in the domestic Chinese market to restrict free and fair access for foreign products, nations simply cannot trust to do business with the Chinese. It will be difficult to inspire confidence in the yuan among nations to hold it as a reserve currency as China can arbitrarily manipulate exchange rates and the convertibility of the yuan into other currencies.Moreover, individuals and nations with yuan holdings will not have the avenue of investing them in China to obtain a higher return as they have with investing their dollar holdings in the American markets or real estate. China simply will not allow unfettered investment in Chinese companies, real estate and other assets.
9. The US economy is the engine that drives the world economy. Availability of more land in the USA allows the building of bigger houses, bigger facilities of all kinds, which means households can buy more goods. That’s why the USA has high per capita consumption of consumer goods. In addition, more agricultural and mineral wealth means that less food and raw materials need to be imported. Only a high consuming country can import more low-technology manufactured products from developing countries, thus acting as the engine for driving their economies. Japan and Germany cannot be the engines that drive the world’s economy because they themselves are dependent on the U.S. market for selling their produced by their high-tech and high-paying jobs manufacturing sectors. If the U.S. manufactures most of those products itself and imports less from Germany, Japan and Korea, it will have a much higher standard of living than Germany and Japan. Thus the U.S. economy is the engine that drives the world’s economy rather than Japan, Germany, and now China.
Japan, Germany and China can become the engines of the world economy only if they manufacture unique high-tech products that the U.S. must import from them in very large quantities. As long as the USA stays at par with them technologically, it will remain the engine that drives the world’s economy. The USA thus shoulders a great deal of responsibility in keeping the world economy growing and the standard of living of all nations rising. But it must always guard against Japan, Germany, China and other developed countries taking away most of the high-paying manufacturing jobs. The follies of the 1970s and 1980s should not be repeated.
10. It is incumbent on developed countries to refuse to buy products produced by child labor. Products then will cost a little more, but lower prices do not justify exploitation of children. If collective action is taken by all developed countries and the practice of using child labor is strictly monitored by an agency of the U.N. or some other human-rights international organization, this practice can be stopped so that children in developing countries can obtain an education and have a childhood.
11. Under free trade, there can be winners and losers. Does that imply that developing countries (DCs) that are not competitive should be left to their fate? Certainly not. Free trade should not be so ruthlessly pursued such that developed countries cannot make some allowance for likely losers. Some form of economic development programs should be formulated for each nation so that developed countries can set up some projects in those countries in exchange for being able to sell their own products to them. Since prices higher than world competitive prices would have to be supported, developed country government involvement may be necessary in the form of some aid programs.
Policy Guidelines for Developing Countries
1. If any time a DC realizes that it might be a loser under free trade, the responsible thing for its leadership to do is to manage trade and avoid being a loser. However, individual DCs may not have enough leverage. If it cannot produce the commodity, non-durable consumer good or standardized manufactured product at a lower price, it may lose out. Under such circumstances, the only leverage the country has is to control access to its market by developed countries. It should negotiate with developed countries for help in setting up manufacturing projects in the country which will help it to export and develop in exchange for buying products from the particular developed country.
2. Even if the DC has comparative advantage and can export successfully, it can speed up its economic development further by leveraging access to its market by developing countries. It can negotiate for more industrial projects geared for exports from particular developed countries in exchange for buying products from them. Allowing free access to its market to any developed country without getting anything in return is a waste of a valuable asset.
3. Individual DC market may not be large enough for industrial projects geared for domestic demand. To provide economies of scale for a manufacturing plant, DCs may have to set up common markets on the pattern of the EC. These common markets will tend to break up if the location of industrial projects becomes lopsided in favor of one or two countries in the block. If this problem can be avoided, the idea is basically sound and should be able to benefit all DCs in the common market.
4. A DC initially may not have the trained manpower and entrepreneurs to kick start economic activity. Under such circumstances, partnership with developed countries can help them kick start economic activity and develop entrepreneurial talent.
1. Batra, Ravi, “The Pooring of America: Competition and the Myth of Free Trade,” Collier Books, Macmillan Publishing Company, New York, 1993.
2. Friedman, Benjamin M., “Day of reckoning: The Consequences of American Economic Policy under Reagan and After,” Random House, New York, 1988.
3. Kolko, Joyce, “Restructuring the World Economy”, Pantheon Books, New York, 1988.
4. Krugman, Paul R., Editor, “Strategic Trade Policy and the New International Economics,” The MIT Press, Cambridge, MA, 1986.
5. Leamer, Edward E., “Sources of International Comparative Advantage, Theory and Evidence,” The MIT Press, Cambridge, MA, 1984.
6. Leamer, Edward E., “The Heckscher-Ohlin Model in Theory and Practice”, Princeton University, Princeton, NJ, 1995.
7. Porter, Michael E., “The Competitive Advantage of Nations”, The Free Press, New York, 1990.