Why has global trade become so controversial? Does free trade deserve its bad reputation? Here, Douglas Irwin sweeps aside the misconceptions that litter the debate over trade and gives the reader a clear understanding of the issues involved. Finely argued, this book makes a vast body of economic learning accessible to nonspecialists. It is an essential primer for anyone who wants to understand one of the most burning controversies of our time.

Free Trade Under Fire

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By Douglas A. Irwin

Princeton University Press

Copyright © 2003 Douglas A. Irwin
All right reserved.
ISBN: 0691116342

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Chapter One

The United States in a New Global Economy?

International trade has become an integral part of the U.S. economy over the past few decades. The United States imports toys from China, clothing from Costa Rica, and steel from Korea, and exports aircraft from Washington, wheat from Kansas, and machinery from Illinois. There is hardly a sector of the economy or a region of the country that is unaffected by international markets. As the twenty-first century begins, the United States may even have achieved a historically unprecedented degree of economic integration with the rest of the world. Perhaps it is not surprising, therefore, that the rapid growth of trade has been accompanied by a intensified debate over U.S. trade policy. To establish a context in which we can later examine current trade policy, this chapter briefly looks at the role of trade in the U.S. economy.

______The Increasing Importance of Trade

How important is trade to the U.S. economy? The simplest way to answer this question is to look at its share in gross domestic product (GDP). In 2000, for example, merchandise exports amounted to about $773 billion, about 7.8 percent of GDP. At the same time, merchandise imports were about $1,223 billion, about 12.3 percent of GDP.

By looking at these numbers in a historical perspective, we can determine whether they are high or low. Figure 1.1 presents U.S. merchandise exports and imports as a share of GDP from 1869 to 2000. As the figure shows, merchandise trade was fairly stable at about 7 percent of GDP in the period just after the Civil War until the outbreak of World War I in 1914. Exports surged during the war, but the trade shares declined sharply during the interwar period from 1919 to 1939 and on through World War II. Between the world wars, many countries pursued inward-looking economic policies, including protectionist trade policies, restrictions on international labor migration, and limitations on international capital flows. These policies substantially reduced world economic integration. Many of these restrictions were relaxed after World War II, and thus in some sense the United States has gone back to the future, returning to the degree of integration that prevailed before World War I. Exports and imports were higher after World War II than before the war, but were then stable until they began to rise steadily in the early 1970s.

Economists have interpreted these data in two conflicting ways. One interpretation, that trade is about as important now as it was a century ago (the "fin de sihcle dij` vu" view) points out that merchandise exports stood at about 7 percent of GDP in the late nineteenth century and are about 8 percent now, hardly a dramatic difference. A second interpretation (the "new global economy" view) stresses that the rapid rise in trade's share of GDP since the mid-1970s has put trade at a level unprecedented in recent history. Further evidence will suggest that this second interpretation better identifies the crucial trends in trade.

Will the current trend toward a higher trade share continue? There is certainly no law in economics that dictates an inexorable rise in the ratio of trade to GDP over time. In fact, many economists, from Robert Torrens in the early nineteenth century to Dennis Robertson in the mid-twentieth century, have expounded a "law of diminishing international trade." They believed that the spread of industrial technology around the world would result in smaller differences in industrial efficiency across countries. Each country would eventually come to produce manufactured goods just as efficiently as any other, and so international trade would diminish. But this theory has been proven false: over time, the division of labor in manufacturing and in other sectors has become more refined, increasing trade even between those countries with similar technology. For example, the spread of industrial technology has enabled an increasing number of countries to produce automobiles. Rather than reducing international trade in cars, this development has increased trade in automobiles, especially in parts and components.

A more plausible version of the idea of diminishing international trade is that the trade share would fall as countries grew richer because the composition of demand would shift away from traded goods (such as food, clothing, and manufactures) toward nontraded goods (such as housing, health care, education, and other services). And to some extent, this has taken place in the United States: the share of personal consumption expenditures devoted to services has risen steadily in recent decades at the expense of expenditures on durable and nondurable goods. This evolution of demand has contributed to a shift in the composition of the U.S. economy away from the production of merchandise goods toward the production of services. (The more rapid productivity growth in goods-producing sectors, which has reduced the price of goods relative to services, has also contributed to this result.) As a result, the tradedgoods sectors of the economy-specifically, agriculture, mining, and manufacturing-have declined from 33.5 percent of current-dollar GDP in 1960 to 18.7 percent in 1999. Other mostly nontraded sectors of the economy, such as transportation and public utilities; wholesale and retail trade; finance, insurance, and real estate; and government have grown more rapidly than the traded-goods sectors.

Even though the merchandise goods share of the economy has fallen, the merchandise trade share has not. The gradual rise in the share of merchandise trade to GDP therefore masks the vastly increased importance of trade within the traded-goods sector. This is seen most strikingly by comparing merchandise exports as a share of merchandise production rather than merchandise exports to total GDP. As figure 1.2 indicates, merchandise exports as a share of merchandise production soared from about 15 percent in 1970 to nearly 40 percent in 1999, while the share relative to GDP has changed only modestly. This implies that the increase in the size of the nontraded sector can sharpen the degree to which countries specialize in the traded-goods sector and therefore increase trade. Thus, a close analysis of the merchandise trade figures indicates that trade is substantially more important now than in the recent past for those sectors engaged in trade.

The rise in trade relative to production is also evident in the case of specific commodities. Table 1.1 compares exports as a share of domestic output and imports as a share of total supply (domestic output plus imports minus exports) for selected commodities in 1960 and 1993. Both the share of domestic production shipped to other markets and the ratio of imports to domestic consumption are much more pronounced today than just a few decades ago, especially for perishable products, which only recently have become traded internationally.

Two final points should be made about U.S. merchandise trade. First, the composition of both exports and imports has shifted toward manufactured goods over the past few decades. Table 1.2 presents the commodity composition of these exports and imports. The United States is a net exporter of agricultural commodities and a net importer of fuels. But the overwhelming majority (about 80 percent) of both exports and imports are manufactured goods. Of course, they are different types of manufactured goods. The leading manufactured exports consist of machinery (electrical, general industrial, power generating, and scientific), office equipment, airplanes and parts, chemicals, and televisions and VCRs. The major types of manufactured imports also include machinery, televisions, and VCRs, but also clothing, iron and steel mill products, toys and sporting goods, and footwear.

Second, most of this trade in manufactured goods is not in final consumer goods, but rather in intermediate components and parts. The Department of Commerce provides a closer look at the imports when it attempts to classify them based on final actual use. Table 1.3 shows this end-use classification of U.S. imports for three categories: consumer goods, industrial supplies and materials, and capital goods. The most striking change is the rise of capital goods as a share of U.S. imports, especially since 1970. Capital goods include machinery, equipment, instruments, parts, and various other components to production. Over half of all imports are either intermediate components or raw materials. These imports are sold as inputs to domestic businesses rather than as goods consumed directly by households. As chapter 3 will explain, this fact has important implications for trade policy: protectionist policies will directly harm employment in other domestic industries by raising their production costs, in addition to forcing consumers to pay a higher price for the products they buy.

Though trade is more important than ever for the merchandise-producing sector, this is not necessarily the case for the overall economy. Production and employment have become much more based on nontraded services. In fact, only about 17 percent of American workers, those employed in agriculture, mining, and manufacturing, are directly exposed to international competition today, as opposed to 40 percent in 1960. This means that a smaller part of the U.S. economy, in terms of output and employment, is directly affected by fluctuations in world trade.

At the same time, many previously nontraded services are now becoming more tradable. The major categories of services trade include shipping and tourism, royalties and fees (receipts from intellectual property rights, such as trademarks, patents, and copyrights), and military transfers. The most rapidly growing category of U.S. service exports are those listed as "other private services," which include education, finance, insurance, telecommunications, and business, professional, and technical services. In 2000, the value of these U.S. service exports (excluded from the merchandise trade figures considered so far) amounted to about $310 billion, nearly 40 percent of the value of merchandise exports. The United States is a large net exporter of services, having only imported $219 billion in 2000.

The addition of trade in services has raised the overall economic significance of trade. In 2000, the broader figure of exports of goods and services as a portion of GDP stood at 11.0 percent, of which merchandise exports were 7.9 percent and service exports were 3.1 percent. (In 1970, by contrast, service exports were only about 1 percent of GDP.) Also in that year, imports of goods and services stood at 14.7 percent of GDP, of which merchandise imports were 12.5 percent and service imports were 2.2 percent. As in the case of merchandise, service exports have risen as a share of services production. In 1960, the ratio of service exports to services value-added was 1.7 percent, but by 1999 that ratio had risen to 5.5 percent. While small in comparison to the merchandise sector, this ratio has been rising rapidly and portends even greater trade in services in the future.

Yet even services that are not subject to trade are increasingly subject to international competition. This is because direct investments enable U.S. firms to enter foreign markets directly and allow foreign service providers to compete in the U.S. market. U.S. direct investment abroad increased from 6 percent of GDP in 1960 to 20 percent in 1996, and much of this investment was in the service sector. For example, in the 1990s the University of Chicago's Graduate School of Business built small campuses in Barcelona and Singapore to bring education services directly to Europeans and Asians who are not able to come to Chicago. Similarly, foreign direct investment in the United States increased from 1 percent of GDP in 1960 to 16 percent in 1996. For example, many foreign banks have established a presence in the U.S. market to provide financial services. In addition, domestic service firms are increasingly the target of mergers and acquisitions as foreign firms seek entry into the U.S. market. As an indication of the increased foreign presence in the U.S. economy, the foreign-owned affiliates' share of gross product originating in private industry in the United States increased from 2.3 percent in 1977 to 6.3 percent in 1998.

As a result, firms have a choice in how they can sell products to foreign residents: either by exporting domestically produced goods, or by producing and selling directly in the foreign country. This gives us another way to look at international commerce. In 1998, U.S. companies sold $933 billion worth of goods to foreign consumers through exports and $2,810 billion through foreign affiliates. Meanwhile, foreign companies sold $1,100 billion to U.S. consumers through exports to the United States and $1,710 billion through sales by foreign-owned U.S. affiliates. Thus, worldwide sales by U.S. companies to foreign nationals exceeded sales by foreign companies to U.S. residents by $363 billion in that year.

______Trade and the Fragmentation of Production

Is the recent rise in the trade share misleading? The increased trade in intermediate components requires that we ask this question. Every time a component is shipped across a border, it gets recorded by customs officials as an export or an import. When components are repeatedly shipped across the border at different stages of production, the official recorded value of trade rises with each crossing, but there may be no more final goods output than before. Thus, the value of trade relative to production may be inflated if intermediate products cross national borders multiple times during the production process. For example, about 60 percent of U.S. auto exports to Canada are engines and parts, whereas 75 percent of U.S. auto imports from Canada are finished cars and trucks. The increase in automobile trade between the United States, Canada, and other countries does not itself indicate that more and more cars are being built; rather, various parts and components that used to be produced domestically are now produced in other countries and traded across international borders.

This phenomenon is known as vertical specialization. Vertical specialization refers to the fragmentation of the production process as intermediate goods and components become a greater part of world trade. According to one estimate, vertical specialization accounts for about a third of the increase in world trade since 1970.

As the Canadian example suggests, a nonnegligible portion of the value of U.S. imports is simply the value of U.S. exports of domestically produced components that are shipped abroad for further processing or assembly and then returned to the United States for additional work before sale or export. Imports that incorporate U.S.-



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