Cato’s Trade Report: Blinded by Ideology

On August 28 the Cato Institute in Washington DC published a report, “Thriving in a Global Economy: The Truth about US Manufacturing and Trade.” The report confuses a company’s offshored products with its import competition and wrongly concludes that US companies with the most import competition are the companies that are thriving.

The Cato report never mentions the practice of US corporations of offshoring their production for US markets. Consequently, the report conflates offshored inputs and final goods of US corporations with imports from competitive foreign firms. The report thus confuses corporations or industries that offshore their manufacturing with those most exposed to import competition.

This extraordinary mistake results in an incorrect conclusion. The Cato report finds that revenues, profits, and value added rose most for industries most exposed to import competition and mistakenly attributes this result to the beneficial workings of free trade.

In US trade statistics, offshored US production is counted as imports. Offshored production comprises a substantial percentage of manufacturing imports. Let’s rewrite Cato’s conclusion to take account of these facts: “Revenues, profits, output, and value added rose the most for industries that offshored manufacturing, and they rose the least for those industries that produced their output domestically.”

Obviously, corporations that arbitrage labor and replace their US employees with less expensive foreign labor are going to enjoy greater growth in profits and value added.

The Cato report did not set out to prove the benefits to corporations of offshoring. The goal of the report is to combat protectionist sentiments in Congress that might result in trade restrictions. Thus, a report that attributes the health of US manufacturing to import competition.

In January 2004 in the New York Times and at a televised Brookings Institution conference, Senator Charles Schumer and I attempted to create a new discussion around a new and unrecognized problem. The problem is that the collapse of world socialism and the rise of the high speed Internet made it possible for domestic corporations to arbitrage labor across national boundaries in pursuit of absolute advantage.

In the years since, I have written extensively on this issue. Labor arbitrage is not trade and does not meet the Ricardian conditions for comparative advantage upon which the case for free trade is based.

Few economists have bothered to think about the issue of offshoring, preferring to dismiss concerns about it as manifestations of the old protectionist fallacy. They learned in graduate school that free trade is always mutually beneficial and ceased to think when they passed their exams. This is especially true of “free market economists” who believe that economic freedom, which they identify with the freedom of capital, is always good. Thus, most economists mistakenly believe that offshoring is protected under the authority of free trade doctrine.

However, free trade doctrine is based on the assumption that domestic capital seeks its comparative advantage in its home economy, specializing where its comparative advantage is best and, thereby, increasing the general welfare in the home economy. David Ricardo, who explicated the case for free trade, rules out an economy’s capital seeking absolute advantage abroad instead of comparative advantage at home.

Jobs offshoring is not only a problem for displaced US manufacturing employees--displacement that Princeton economist and former Federal Reserve vice chairman Alan Blinder says will also impact 30 to 40 million high-end US service sector jobs as well-- but also a problem for economic theory.

Economic theory assumes that capitalists pursuing their individual interests are led to benefit the general welfare of their society by an invisible hand. But offshoring, or the pursuit of absolute advantage, breaks the connection between the profit motive and the general welfare. The beneficiaries of offshoring are the corporations’ shareholders and top executives and the foreign country, the GDP of which rises when its labor is substituted for the corporations’ home labor. Every time a corporation offshores its production, it converts domestic GDP into imports. The home economy loses GDP to the foreign country which gains it.

Recently, Ralph Gomory, co-author with William Baumol, of Global Trade and Conflicting National Interests the most important work in trade theory in 200 years, pointed out that traditional trade theory has broken down because companies are no longer bound to the interests of their home countries. Offshoring has de-coupled the link between a company’s motivation for profit and a nation’s desire to improve the wealth of its citizens. “Most economists,” Gomory observed, “have not acknowledged this fundamental change and its implications for economic theory.”

The Cato report shows no awareness of the problem for economic theory when the profit motive becomes disconnected from the general welfare, and the report does not appreciate the restraint placed on traditional protectionist legislation (tariffs and quotas) by manufacturers that offshore. The traditional purpose of trade protection is to shield domestic producers from foreign competition. Neither manufacturers that offshore production nor their trade associations favor any tariffs or quotas that would reduce their profits from offshoring by treating their offshored production as the products of foreign competitors. The Cato report is worried about a protectionist policy for which there is no organized constituency.

Congress and most economists are as confused about the issues as the Cato report. Today the profit motive causes capitalists to create job opportunities and GDP in low-wage foreign countries instead of their own. Every job that does not require a “hands-on” presence can be offshored. Charles McMillion and I have pointed out for years that the nonfarm payroll jobs data from the Bureau of Labor Statistics show that the US economy can only create net new jobs in domestic non-tradable services.

The Cato report does not acknowledge that the financial prosperity of US capital is at the expense of US labor. The report does not explain how an $800 billion trade deficit can be closed when domestic corporations face powerful incentives to offshore, and it shows no awareness of Susan Houseman’s findings that productivity gains and output growth that result from offshoring, and which occur abroad, are mistakenly being counted as US GDP and productivity growth. This phantom US output and productivity growth would explain the disconnect between rapid productivity growth and US real median family income, which is lagging far behind.

The financial prosperity that US corporations are enjoying from offshoring increases the US trade deficit and makes American consumers increasingly dependent on imports. In 2006 (the most recent annual data) the US trade deficit in manufactured consumer durable and nondurable goods was 3.4 times greater than the US trade deficit with OPEC. The US “superpower” has a massive trade deficit in consumer manufactured goods and even has a deficit in capital goods, including machinery, electric generating machinery, machine tools, computers, and telecommunications equipment.

In 2006 The US trade deficit with Europe was $142,538,000,000. With Canada the deficit was $75,085,000,000. With Latin America it was $112,579,000,000 (of which $67,303,000,000 was with Mexico). The deficit with Asia and Pacific was $409,765,000,000 (of which $233,087,000,000 was with China and $90,966,000,000 was with Japan). With the Middle East the deficit was $36,112,000,000, and with Africa the US trade deficit was $62,192,000,000. The trade deficit with OPEC was $106,260,000,000.

The more US corporations prosper by offshoring, the greater the US trade deficit will grow and the more unbearable the pressure will be on the dollar’s role as reserve currency.

At some point crisis will force Congress, economists and think tanks to deal with the real issues.

Paul Craig Roberts [email him] was Assistant Secretary of the Treasury in the Reagan Administration. He is the author of Supply-Side Revolution : An Insider's Account of Policymaking in Washington; Alienation and the Soviet Economy and Meltdown: Inside the Soviet Economy, and is the co-author with Lawrence M. Stratton of The Tyranny of Good Intentions : How Prosecutors and Bureaucrats Are Trampling the Constitution in the Name of Justice. Click here for Peter Brimelow’s Forbes Magazine interview with Roberts about the recent epidemic of prosecutorial misconduct.