WHEN EXPORTS ARE A COST AND IMPORTS ARE A BENEFIT: THE CONDITIONS UNDER
WHICH FREE TRADE IS BENEFICIAL*
Stephanie A. Bell
Department of Economics
University of Missouri, Kansas City and
The Center for Full Employment and Price Stability (firstname.lastname@example.org)
John F. Henry
Department of Economics
California State University, Sacramento (email@example.com)
There is perhaps no public policy issue on which economists are more likely to
agree than on the desirability of free trade.
[Yngve Ramstad, 1987, p. 6]
Proponents of what has come to be called globalization promote free trade as
one important part of the solution to poverty, economic volatility, and
inequality. The major institutional players on this side of the debate—the IMF,
World Bank and World Trade Organization—all emphasize the role played by a free
trade regime in addressing these issues.
Opponents of globalization take the opposite tack, arguing that free trade and
financial integration have exacerbated poverty, inequality and market
volatility. In Seattle, Quebec City, and in various venues throughout the world,
anti-globalizationists have taken their criticism into the streets with a
vigorous display of anti-corporate, anti-WTO sentiment: “Fair Trade not Free
problem, however, is that opponents have found it difficult to mount a sound
attack on free trade. The theoretical defense of this doctrine is highly
developed, is internally consistent within its own context, and it speaks
eloquently to the various watchwords of the modern era—efficiency, growth,
poverty-reduction, etc. Opponents have mainly nibbled at the edges of the
argument rather than attacking it at its center. In so doing, they have raised
issues such as the discrepancy between market prices and the true social costs
of production; differences in the income elasticity of demand for developed and
underdeveloped countries exports; Hecksher-Ohlin effects leading to greater
income inequalities within countries; market failures, etc. (Hahnel, 1999;
Gomoroy and Baumol, 2000).
The purpose of this essay is twofold. First, we
explain why the debate on the merits of free trade has not produced a definitive
statement as to the supposed benefits associated with the doctrine. Here, we are
inspired by Ramstad, who argued that, “for lack of a coherent alternative to the
framework provided by mainstream economic theory, opposition to the policy of
free trade has been supported by little more than ad hoc arguments” (1987, p.
26). Our objective is to specify an alternative framework from which a sound
theoretical attack against free trade can be launched. Specifically, we propose
Keynes’ monetary production framework, which accords with the actual economic
relations of a modern capitalist economy. Within the context of this framework,
it becomes clear that the intuition of the anti-free trade adherents is
correct. Having said that, our goal is not to defend import quotas or tariffs or
to otherwise restrict the free flow of trade. Nor are we concerned with
strategies designed to promote balanced trade. Instead, we specify the
institutional prerequisites that would allow the benefits of free trade to be
In a previous paper, we examined the necessary
conditions that had to be satisfied if money were to arise as an economic
institution. (Bell and Henry, 2001). In the course of our argument we touched on
the distinction between exchange-based views and monetary or debt-based views.
Here, we more carefully examine the neoclassical foundation of exchange that
leads to the equating of exchange with trade, and contrast this view with that
of theorists who examine the specific workings of a monetary economy where
exchange takes on a quite different role and generates quite different results
than those predicted by the neoclassical theory. Essentially, there is a
difference between trade and exchange, and while all exchange is a form of
trade, not all trade is exchange.
Trade and Exchange in the Neoclassical Framework
The standard, textbook argument on the benefits of free
trade follows from a particular view of the economy that is first found in the
work of Jean-Baptiste Say (though Adam Smith is usually cited as the point of
departure for the free trade position). Say expressed his basic postulate not as
“supply creates its own demand” (attributed to James Mill), but in more
trenchant terms, maintaining that “. . . products are always bought ultimately
with products” (Say, 1827 , 106). This statement represents a certain view
of the exchange relations of a market economy and gives rise to what would
eventually become neoclassical economic theory.
Imagine a hypothetical peasant, petty-producing
economy in which all are small property owners. Since petty producers were not
jack’s-of-all-trades, they specialized in the production of a particular item,
which they trucked to the local trading venue for the purpose of conducting
trade. In Say’s hypothetical peasant economy, the output produced through
specialization enabled the varied wants of individual producers to be satisfied
through the process of barter. According to the textbook story, barter
transactions were conducted in markets, where, say, iron was traded for corn, so
that the demand for corn was determined by the amount of iron supplied. In an
n-market economy, all products trade for all other products and aggregate
demand is determined by aggregate supply. Disequilibrium relations, such as
excess demand or excess supply in any particular market, would be resolved
through changes in relative prices until all markets eventually clear.
At some point, producers/traders realize that
barter imposes significant (transaction) costs and money is invented as a medium
of exchange. However, the use of money opened up the possibility that selling
and buying might be temporally separated. Thus, as Mill argued:
Although he who
sells, really sells only to buy, he need not buy at the
same moment when he sells; and he does not therefore necessarily add
to the immediate demand for one commodity when he adds to the
of another (1844, p. 70).
For example, the iron producer might decide to save
a portion of his money income (instead of purchasing more corn). Within the
neoclassical framework, problems arising from the mismatch of supply and demand
are prevented by postulating a loanable funds market. Thus, an increase in
savings would bring “the” rate of interest down just enough to stimulate capital
production (in the corn industry) to the point where the additional saving would
be exactly exhausted by the additional demand for new investment. In an
international setting, this may require transferring those savings to foreign
markets (international capital flows), but the equality of aggregate supply and
demand would be ensured – internally, through domestic market forces, and
externally, through the price-specie-flow mechanism.
Thus, as trade relations evolve into the international arena, the efficiency
gains from trade are extended across national frontiers so that free trade is
beneficial to all.
Full employment is a necessary feature of such an
economy. Each petty producer determines how much effort to exert, and, thus, how
much output to produce, based on a calculation of the costs of that effort
relative to the quantity of consumption goods (income) his produce will command
in trade (supply creates its own demand). A “lazy” producer will clearly enjoy a
lower standard of living, but the decision to provide work-effort is an
individually determined one. As each individual is an independent producer with
access to her own means of production, there are no social or economic
constraints determining the amount of labor-time one can provide. Any perceived
unemployment, say a work-effort of only one-hour per day, is purely “voluntary”
and is determined solely by the cost-benefit calculation of the producer.
The framework that captures the neoclassical
gain-from-trade view of the economy is C- C’, where C and C’ represent produced goods with different use
iron and corn. When money is introduced, the relationship is modified to C-M-C’.
fundamental change occurs; money simply facilitates the exchange (trading)
process. As the purpose of production is to satisfy consumption, no general
overproduction is possible. As long as the use value contained in the product is
deemed satisfactory from a consumer’s perspective, buyers will always be found,
though prices may have to adjust to allow all output to eventually be exchanged.
The benefits of free trade are invariably
illustrated by comparing a hypothetical nation’s well being pre- and post-trade.
Internally, a nation maximizes its well being (i.e. its output) by producing
somewhere along its Production Possibilities Curve (PPC). Resources are fully
utilized at every point along the PPC and underutilized at every point below it.
As long as at least one country (in a two-country framework) has a comparative
advantage in the production of some good, both countries will benefit from
specialization and trade, since each will reach a point lying beyond its PPC (a
point previously unattainable due to resource and technological constraints).
In this view, trade is equated with exchange. And
if this view is accepted as the basis of the debate surrounding modern exchange
relations, it is impossible, given the assumptions, to undermine the doctrine of
free trade as beneficial. Free trade will promote output, will
promote efficiency, will promote income growth and poverty reduction.
Free trade is beneficial, and free trade detractors are imposing negative
consequences on those whom they claim to be defending—the poor in particular.
An Alternative Framework: Keynes’ Monetary Production Economy
In a monetary (or capitalist) economy, the proper
formulation expressing the exchange relationship is M-C-M’. In this framework,
money, not goods of different use values, is the object of exchange. Production
is undertaken on the belief that the quantity of money received at the end of
the production-exchange process (M’) will be greater than the amount of money
advanced at the outset (M). Capitalists borrow to purchase inputs, which are
used to produce output, which is sold to generate more money. If M’>M, debts can
be cleared and the process repeated. As Keynes explains:
The distinction between a
co-operative economy and an entrepreneur economy bears some relation to a
pregnant observation made by Karl Marx. . . . He pointed out that the nature of
production in the actual world is not, as economists seem often to suppose, a
case of C-M-C’. . . . That may be the standpoint of the private consumer. But it
is not the attitude of business, which is a case of M-C-M’, i.e. of
parting with money for commodity. . . in order to obtain more money (Keynes,
1979 , p. 81; emphasis in original).
Thus, in a monetary economy,
the economic process is not directed toward the production of products
(use values) as in neoclassical theory. Rather, it is the production of profit
that is of concern. This requires the exchange of commodities so that the
potential income contained in the product can be realized in money form. The
economic process starts with debt (money) advanced to labor and the owners of
purchased inputs, prior to the creation of output. Use values are then created,
but these are useless in themselves to capitalists (or entrepreneurs, in Keynes’
terms). Use values must first be converted into money so that debts can be
cleared; these can then be used to satisfy the physical requirements of
consumption and further production (capital goods). In a very perceptive
analysis of The General Theory, Dudley Dillard observed: “Real goods
appear to the individual producer as an artificial form of wealth until they are
converted into money which appears as real wealth to the individual producer.”
(Dillard, 1954, pp. 28-29).
As Keynes explained, producers
acquire wealth by engaging in profitable investment opportunities. But the
investment decision is not passive (i.e. investment spending does not increase
passively with saving as is the case in the neoclassical framework), nor is
demand for firms’ output assured as it is in the C-M-C’ framework. Indeed,
Keynes emphasized the fact that investment decisions must be taken in the face
of an unknowable future, where the profits that might ultimately be forthcoming
cannot be known with any degree of certainty at the time the decision must be
made. Thus, decisions to acquire additional capital reflect the state of
long-term expectation. If individual investors are optimistic, their estimation
of the prospective yield of the investment will reflect this optimism.
Specifically, a favorable state of long-term expectation will be reflected in
the discount rate that equates the present value of the prospective revenue
stream with the supply price of the capital asset – i.e. the marginal efficiency
of capital. As Keynes explained, investment will be forthcoming only when the
marginal efficiency of capital – which reflects the degree of optimism – exceeds
the current rate of interest. Importantly, these “calculations” are made in the
face of genuine uncertainty:
[O]ur decisions to do something
positive, the full consequences of
which will be drawn out over many days to come,
can only be taken
as a result of animal spirits – of a spontaneous urge to action rather
than inaction, and not as the outcome of a weighted average of
quantitative benefits multiplied by quantitative probabilities (Keynes,
1964 , p. 161).
This insight goes to the heart of Keynes’ monetary theory
of production, where both consumption and saving are positive functions of the
level of current income; saving represents a leakage; there is no mechanism
(e.g. loanable funds market) to equilibrate ex ante saving and ex ante
investment; the rate of interest is determined by the interplay between the
stock demand for money – reflected by the degree of liquidity preference – and
its stock supply; investment depends on the relationship between the marginal
efficiency of capital and the current rate of interest; and the rate of interest
on money “plays a peculiar part in setting a limit to the level of employment”
(ibid., p. 222).
Thus, even in a closed economy, a host of purely
psychological variables – e.g. the marginal propensity to consume, the
marginal efficiency of capital and the state of liquidity preference – are
likely to take on values incompatible with full employment. If, for example,
private sector confidence is shaken, liquidity preference may increase and the
marginal efficiency of capital may fall. As interest rates rise – in response to
increased liquidity preference – fewer investment projects will be undertaken –
since the interest rate is rising and the marginal efficiency of capital
is falling. Declining investment spending will reduce aggregate output and
employment, and the situation will be exacerbated through the multiplier effect,
which is driven by the marginal propensity to consume.
The problems inherent in the closed-economy, M-C-M’
framework are not diminished by opening the economy to free trade,
a fact that was well-understood by Keynes’ contemporary, Abba P. Lerner:
We have examined the process by
which full employment may be
reached in a capitalist economy that is complete in itself – that is,
with no foreign trade – if the amount of money is given and the rate
of interest is permitted to adjust itself to it, equalizing the demand
money to hold with the amount of money available to be held. In
examining this process we noted a number of points at which it is
likely to be stalled. When we bring in the complications of foreign
trade we find there are still other difficulties in the way of the
automatic movement to and maintenance of full employment in
an uncontrolled capitalist economy” (Lerner, 1970, pp. 369-70).
Thus, as imports represent
another form of “leakage”, bringing in foreign trade compounds the problem of
coordinating injections (I + G + X) with leakages (S + T + M). Moreover, since
output and employment are the adjusting variables in the Keynesian framework, a
trade deficit is likely to produce declining GDP and rising unemployment even
with domestic balance (i.e. I + G = S + T).
Since the balance of trade is a
determinant of national income (and, hence, employment) in this system, trade
surpluses are, almost by definition, desirable. Thus, one hears arguments in
favor of export led growth, competitive devaluation, protectionism, etc. Let us
now turn to an examination of the conditions under which these arguments are
When Free Trade is Detrimental
In chapter twenty-three of The General Theory,
Keynes considered the argument in favor of free trade. Although the
Mercantilists had been preoccupied with the balance of trade “for some two
hundred years”, Keynes believed that by the early 1900s, “almost all economic
theorists have held that anxiety concerning such matters is absolutely
groundless except on a very short view” (1964 , p. 333). Indeed, Keynes,
having been trained by Marshall, admits to sharing the view of the free-trade
So lately as 1923, as a faithful
pupil of the classical school who did not
at that time doubt what he had been taught and entertained on this matter
no reserves at all . . . As for earlier mercantilist theory, no intelligible
account was available; and we were brought up to believe that it was little
better than nonsense (ibid., p. 334-5).
Having said that, Keynes goes on to elucidate “what now
seems to me to be the element of truth in mercantilist doctrine” (ibid., p.
335). The purpose of this section is to consider this insight, which remains as
relevant today as it was almost one hundred years ago.
First, let us consider, from Keynes’ perspective, the
merits of the mercantilist doctrine. To see the argument through his eyes, we
must remember the core of his own argument:
social and political environment and the national characteristics
which determine the propensity to consume, the well-being of a
progressive state essentially depends, for the reasons we have already
explained, on the sufficiency of [inducements to new investment] (ibid.,
Thus, when the range of profitable investment
opportunities (i.e. projects on which the marginal efficiency of capital exceeds
the current rate of interest) is diminished, prosperity will be undermined.
Keynes rationalizes the mercantilist preoccupation with the balance of trade in
the following way. Effective demand (ED) is determined by aggregate investment;
aggregate investment (I) is the sum of home investment (IH) and
foreign investment (IF); home investment is a negative function of
the domestic rate of interest (iD); foreign investment is determined
by the favorable balance of trade (BOT); the domestic rate of interest (given
the state of liquidity preference) is a negative function of the quantity of
precious metals (SGOLD); and the quantity of precious metals is a
positive function of the balance of trade (BOT). These functional relations are
I = IH + IF
Thus, a favorable balance of trade directly
increases foreign investment and indirectly increases home investment,
both of which increase effective demand. In contrast, an unfavorable balance of
trade (i.e. a trade deficit) would lead to an outflow of gold, which would then
reduce home and foreign investment and, consequently, output and
employment. Under a gold standard, then, it was perfectly rational for a nation
to concern itself with the balance of trade.
But, as Keynes recognized, these problems are not peculiar
to nations operating under a gold standard; they emerge with any system
of fixed exchange rates. Thus, under a conventional fixed peg or a currency
board arrangement, countries face problems nearly identical to those faced by
nations operating under a gold standard.To see this, let us turn to an examination of the problems faced by
nations operating modern fixed exchange rate systems.
Modern Mercantilism and the Rate of Interest
Under an ordinary fixed
exchange rate system, the central bank must intervene to defend the official
exchange rate. In defending the peg, the central bank may be forced to buy or
sell large quantities of foreign assets. Under a currency board arrangement, no
such large-scale intervention is required; the currency board simply pledges to
convert the domestic currency and the reserve currency into one another at the
official (fixed) rate.However, both exchange rate systems bear important similarities to their
ancient predecessor – the gold standard – and, subsequently, carry similar
Let us illustrate the
argument by examining the mechanics under each type of fixed exchange rate
system, taking the conventional fixed exchange rate system first.Currently, Malaysia pegs the value of the domestic currency, the Malaysian
dollar, to the US dollar.Marginal holders of any Malaysian dollar (M$) bank deposit at any
Malaysian bank can:
(1)hold non-interest-bearing M$ clearing balances at the central bank
(2)exchange these non-interest-bearing M$ clearing balances for:
(a)an interest-bearing debt instrument issued by the Malaysian government
(b)US dollars at the official rate of exchange at the central bank
As banks earn no interest on M$ clearing balances, they
will ordinarily prefer to economize on these holdings. This means that they will
convert undesired clearing balances to domestic bonds or US dollars. The choice
will depend, in practice, on the expected rates of return on M$ versus US$
assets. If there is a widespread preference for dollar-denominated assets,
holders of Malaysian dollar clearing balances will predominantly prefer option
2(b). In satisfying the demand for US dollars, the central bank will lose US
Obviously, the central bank cannot tolerate a substantial
loss of foreign exchange, because it may undermine investors’ confidence in the
bank’s ability to defend the peg.
Thus, to stave off the outflow of US dollars, option 2(a) must be made more
appealing. This is accomplished by paying higher interest rates on Malaysian
government bonds. Under a conventional fixed exchange rate system, the domestic
interest rate becomes a positive function of the demand for the reserve currency
(relative to its supply). In other words, iD responds endogenously
to the conversion of domestic clearing balances to the reserve currency.
Comparing the conventional peg to the gold standard, we
discover that an outflow of the reserve asset (whether gold or US$) leads to a
rise in domestic rates, which can lead to all sorts of domestic problems (e.g.
rising debt-service burdens, banking crises, declining investment, unemployment,
Clearly, then, there are reasons to suspect that nations operating conventional
pegs would prefer a trade surplus to a trade deficit. By running a balance of
payments surplus, the country’s net holding of foreign reserves is increasing.
Thus, preoccupation with the balance of trade is as rational for a country on a
conventional peg as it was for a nation operating under the gold standard.
We now turn to the mechanics of the currency board. In
essence, a currency board is a fixed exchange rate with a twist. The twist
(usually) involves 100 percent backing of the domestic currency. In other words,
the Currency Board is usually required (by law) to hold enough of the foreign
reserve currency to convert the entire domestic monetary base.
Fully backing the monetary base is supposed to discourage market participants
from launching a speculative attack against the domestic currency. Below, we
illustrate the mechanics of the Bulgarian currency board.
Currently, the Hong Kong government fixes the value of its
currency, the Hong Kong dollar (HK$), to the US dollar. The convertible monetary
base exists as cash (HK$) and as HK$ balances at the monetary authority’s
designated bank. The convertible base can be:
(1)held as cash or as a non-interest clearing balance
(2)exchanged at the monetary authority for:
(a)HK dollar-denominated government bonds issued by the HK government
(b)US dollars at the official exchange rate
As before, undesired clearing balances will be
converted into something else (2a or 2b). Unlike before, conversion to
government bonds will not eliminate the undesired balance. This is because the
Hong Kong government does not have an account with the monetary authority. Thus,
bond sales will not reduce HK$ clearing balances; instead, the balances simply
move from one private bank to another. Because of this, option 2(a) does not compete with option 2(b). As a
result, clearing balances will be held willingly or they will be converted to US
dollars (i.e. option (1) competes with option 2(b) only).
But, since a currency board typically holds only
enough of the reserve currency to fully back the monetary base (M0 equivalent),
a widespread desire to convert domestic demand deposits (e.g. M1 equivalent) to
the reserve currency would require competition from 2(a) to stave off the
conversion. Thus, in the presence of widespread conversion, extremely high
interest rates are likely to result as the monetary authorities continue their
orders to defend the peg. As Davidson explained:
A currency board is
the modern equivalent of the gold standard
where U.S. dollars are the ‘gold’. The gold standard worked
when there were no bandwagon effects. It always failed when
was a bandwagon effect for a fast exit (Davidson, 1999, fn
Even when it has been possible for a country to harness the
bandwagon effect (i.e. to avoid going off the peg) by offering higher and higher
interest rates on domestic securities, the economy can be devastated in the
A currency board solution . . . is
the equivalent to the blood
letting prescribed by 17th century
doctors to cure a fever.
Enough blood loss can, of course, always reduce
the fever but
often at a terrible cost to the body of the
patient. Similarly, a
currency board may douse the flames of a currency
the result will be a moribund economy (ibid., p.
The other big problem with a currency board arrangement is
that it prevents the monetary authority from “increasing or decreasing the
monetary base at its own discretion” (Hanke and Schuler, 2000, p. 25).
As Carbaugh notes:
A country that adopts a
currency board thus puts its monetary policy
on autopilot. It is as if the chairman of the Board of Governors of the
Federal Reserve System were replaced by a personal computer. When
the anchor currency flows in, the board issues more domestic currency
and interest rates fall; when the anchor currency flows out, interest
rates rise. The government sits back and watches, even if interest
rates skyrocket and a recession ensures (Carbaugh, 2000, p. 489).
Again, this form of monetary system makes preoccupation
with balance of trade a perfectly rational activity. Indeed, the easiest way for
a nation operating under a currency board to increase its money supply is by
running a current account surplus. Free trade, when it results in a trade
deficit, may lead to a balance of payments crisis, a speculative attack,
skyrocketing interest rates, and a bludgeoning of the domestic economy. Thus, in
the modern-day world, the mercantilist doctrine finds its rationale under the
monetary systems of conventional fixed exchange rates and currency board
The Conditions Under Which Free Trade is Beneficial
Keynes realized that a nation would be forced to worry
about its balance of trade whenever a fixed exchange rate of any kind
(gold standard, conventional peg or a currency board) was adopted:
[T]he City of London gradually devised the most
dangerous technique for the maintenance of equilibrium which can possibly be
imagined, namely, the technique of bank rate coupled with a rigid parity of the
foreign exchanges. For this meant that the objective of maintaining a domestic
rate of interest consistent with full employment was wholly ruled out. . .
instead of protecting the rate of interest, [London] sacrificed it to the
operation of blind forces. . . one can . . . hope that in Great Britain the
technique of bank rate will never be used again to protect the foreign balance
in conditions in which it is likely to cause unemployment at home
(Keynes, 1964 , p. 339).
In this section, we lay out the conditions under which a
preoccupation with the balance of payments becomes unnecessary. We begin by
recognizing that a nation cannot disregard its balance of payments when it
adopts a fixed exchange rate of any kind. Consequently, flexible exchange rates
are a necessary condition.
They are not sufficient, however, since the balance
of payments still impacts private sector well being. Perhaps the easiest way to
think about this is to think in accounting terms, relating the balance of
payments to the private sector surplus. The balance sheet identity that defines
these relations is given by:
This equation shows the (ex
post) conditions under which the private sector will be in surplus or
deficit. A private sector surplus is possible only if: (1) the public sector
runs a deficit that exceeds any balance of payments deficit; (2) the balance of
payments surplus is large enough to more than offset any public sector surplus;
or (3) the public sector runs a deficit and the balance of payments is in
surplus. If the public sector runs a surplus larger than the balance of payments
surplus or its deficit is too small to offset the balance of payments deficit,
the private sector must be in deficit.
This, as Figure 1 shows, has been the situation in the United States since 1998.
Here, one sees a sharp
deterioration in the private sector’s balance as the public sector surplus,
together with the balance of payments deficit, combined to produce record-level
private sector deficits from 1998-2002.
Indeed, as Godley (1999) explained, the private sector’s willingness to
drastically increase its spending relative to its income enabled the U.S. to
prosper for almost a decade, despite the fact that net exports were negative and
fiscal policy was highly restrictive throughout most of the expansion.
as Godley explained, this scenario was necessarily unsustainable. By the start
of 2000, the private sector had begun its inevitable retrenchment (Godley,
1999), attempting to bring its spending back in line with its income. But the
private sector has not regained its surplus position, since public sector
deficits remain too small to offset the relatively large balance of payments
deficits the U.S. runs today. Now, this does not mean that the U.S. must resort
to mercantilist tactics. Nor does it suggest that quotas, tariffs and other
barriers to trade are needed. And clearly it would be silly to argue against
trade of any kind, for as Keynes recognized, “[t]he advantages of the
international division of labour are real and substantial” (1964 , p.
Institutionalists have thought about how best to strike a balance between the
costs and benefits of free trade, and we believe they are on the right path.
According to Wilber:
To soften the human suffering in
those cases of massive dislocation,
trade readjustment aid needs to be increased. Retraining programs
for displaced workers, relocation allowances, and subsidies will help the
impacted communities attract new businesses, in addition to helping
to reduce human suffering and increase economic efficiency by
providing access to new skills and encouraging mobility of resources.
And, clearly, full employment is necessary to make these policies work”
(Wilber, 1998, p. 470).
Posing a similar problem, Atkinson asks “[W]hat should the
role of public authority be as
the global economy continues to emerge?” (1999, p. 337). He concludes, following
Commons, that the state should set “the minimum level below which the struggle
for existence shall not be permitted” (ibid.). Summing up the institutionalist
position, Adams says:
[I]nstitutionalists … advocate …
cushioning the impact on genuinely
affected groups through labor retraining and relocation, thereby helping
to maintain full employment … There must be a national program that
can provide sufficient inducements and safeguards to affected people,
firms and regions … the affected individuals’ basic subsistence, health,
and pension benefits must be provided for when industries yield ground
to imports” (Adams, 1984, p. 278).
What this group of Institutionalists seems to support,
then, is a federal program designed to cushion social and economic well being
against the vagaries of free trade. The buffer stock employment programs,
supported by Mosler (1998), Wray (1998, 1999), Forstater (1999) and Mitchell
(1999) appear consistent with these calls.6 The Employer of Last
Resort (ELR) program supported by Mosler, Wray and Forstater and the Buffer
Stock Employment Program (BSE) put forward by Mitchell, would provide the kinds
of safeguards recommended by Wilber, Atkinson and Adams.
Both programs require the federal government to fund a job
guarantee program that would provide employment to anyone who is ready, willing
and able to work but who is unable to secure a job in the private sector. In
addition to protecting against job loss, both proposals also emphasize the
importance of retraining for displaced workers. As an added advantage,
supporters of the ELR plan have also recommended that the workers receive a
pension, health care and childcare as part of the program.
As Lerner succinctly put it, “[t]he most serious foreign
trade problems of the capitalist economy are connected with employment. (Lerner,
1970, pp. 369-70). That said, the benefits of free trade have been dampened the
world over by the harsh effects of globalization, particularly those that
accompany rising unemployment (i.e. widespread poverty, growing inequality and
indebtedness.) To best cope with these problems, we need to establish a
framework within which the benefits of free trade can be garnered without
disregarding human rights in the process. To capitalize on the benefits of free
trade, countries should adopt flexible exchange rates and implement a
buffer stock employment program. With this framework in place, exports will
become a cost and imports will be a benefit. Only then will preoccupation with
the balance of trade truly be unnecessary.
Proponents of free trade invariably adopt the C-M-C’ view
of the economy first elaborated by Jean Baptiste Say. When Ricardo’s principle
of comparative advantage is added to this theoretical perspective, it is easy to
demonstrate that free trade indeed promotes the advantages normally ascribed to
this program. However, Say’s (and Ricardo’s) economy assumes full employment—the
economy is already operating on the production possibilities curve. Any gains in
efficiency resulting from free trade then allow an outward shift in the PPC,
benefiting all trading partners (and their citizenry).
In an M-C-M’ (i.e. capitalist) world, the economy
(almost always) operates at some level below the production frontier, i.e., at
some level of unemployment. In this context, a trade surplus means reducing
the level of available consumption (exports must exceed imports) that is already
less than an economy is technologically capable of producing. Economies running
a trade deficit are advantaged given the logic of the export-import
relationship, but, obviously, not all economies can be in a deficit position. At
the world level, foreign trade must be a zero-sum game as to demand creation
(exports must equal imports). Thus, if economies begin the trade process with
some level of unemployment, there is nothing in the free trade argument to move
them to their production frontier. Indeed, if we begin the argument from a
position of unemployment, the tendency will be to move economies farther away
from the frontier: surplus countries face no pressure to increase their
production, while deficit countries will be under pressure to bring their
accounts into balance usually through domestic policies designed to reduce
imports through reducing consumption: i.e. recessionary policies.
Hence, in the world we actually inhabit, free trade
is not the panacea its proponents propagate. If we are to advance the economic
interests of the bulk of the citizenry in a decent and humane fashion, we must
promote a full employment policy domestically, and couple this with a flexible
exchange rate regime internationally. With these institutions in place (on a
global scale), exports become a cost and imports a benefit, and the conditions
under which free trade is beneficial will have been established.
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A version of this paper was presented at the Association for
Institutionalist Thought, Las Vegas, NV, April 2003. Henry thanks the office
of the Dean, College of Social Sciences and Interdisciplinary Studies,
California State University, Sacramento for financial support. Bell thanks
the Center for Full Employment and Price Stability. The authors also thank
Jan Kregel for helpful comments.
For a fuller account of what follows, in particular the relation between
Say’s economy and his view of a just society, see Henry, 2003.
Countries with trade deficits would experience gold outflows, which would
reduce the domestic money supply and, hence, domestic prices. This, in turn,
would stimulate foreign demand for domestically produced goods, which would
reverse the flow of gold until equilibrium was reestablished at a position
of balanced trade.
Recall that in the C-M-C’ framework trade increases national well being
because nations are able to reach points lying outside their production
possibilities curves. However, when there are unemployed resources in the
home country, it makes no sense to specialize productive efforts and engage
in international trade, since it would be just as easy to increase domestic
well being by using home resources efficiently.
Having pointed out the
political and economic rationale forpolicies designed
to promote a favorable balance of trade, Keynes was careful to point out the
practical limitations of such policies. These limitations, which
derive from the potential impact on the wage-unit and the possibility of
capital flight, are not here germane. Interested readers can consult The
General Theory (1964 , pp. 336-7).
Today, forty-four countries
operate conventional fixed pegs and eight operate currency boards (Krugman,
Paul and Maurice Obstfeld, 2003, p.483).
Currency boards are usually
(legally) required to hold enough foreign reserves to fully back the
domestic monetary base (i.e. 100 percent reserve backing). This is supposed
to enhance the credibility of the peg and discourage speculative attacks.
The illustrations are based on
Mosler’s (1998) approach.
Most countries operating fixed exchange rate systems still peg to the US
dollar, however, since January 1, 1999, many countries have chosen to peg
their currencies to the Euro.
A loss of confidence in the
central bank’s ability to defend the peg can lead to a speculative attack on
the Malaysian dollar.
As an example of how bad things can get, consider the case of Russia, which
used to peg its currency to the US dollar. In the late 1990s, to stave off a
massive conversion of ruble balances to US$, interest rates on GKOs rose to
roughly 150%. Soon after, the Russian government suspended the peg and
adopted a floating exchange rate. (Mosler, 1998).
Domestic demand deposits are
not convertible at the Board. If holders of domestic demand deposits wish to
convert to the reserve currency, they must first convert their demand
deposit to the domestic currency (i.e. cash). The Board only holds enough
reserves to guarantee convertibility of the domestic base (i.e. the
equivalent of M0 in the United States).
Here, the accounting is somewhat tricky, so it helps to have a firm grasp of
money and banking principles.
This, of course, is only a “problem” for those who believe that the monetary
authority should have discretion in this regard. For many economists – e.g.
Hanke and Schuler – disempowering the monetary authority is an added benefit
of the currency board arrangement.
Note that this implies nothing
about causality. The conclusion follows merely from an ex post
The public sector’s balance is inverted so that surpluses appear in negative
territory and deficits are shown in positive territory. This standard
practice allows one to easily view the sum of the public sector deficit and
the balance of payments surplus as the private sector surplus.
Godley (1999) explains that the stance of fiscal policy is considered
neutral if the deficit is small and does not increase, as a share of GDP,
through time. According to this definition, the government’s fiscal position
has been restrictive since 1992.