4FreeTrade,Unemployment,andEconomicPolicyAnwar M.ShaikhItisnowwidelyrecognizedthatacountrysabilitytocompeteeffec-tivelyintheworldmarketcanbevital toIts long-runprospects.Ufcourse, intheshortandmediumrunacountrycanprotectitselffrominternationalcompetitionthroughavarietyofdevices.Outrightprotec-tionintheformoftariffs,quotas,andevensubsidiescanhelpinsulateindividualindustriesorregions.Manipulationoftheexchangeratecanenhancethecompetitivenessofnationalindustriesvis&visthecorre-spondingworldsectors.Andmanipulationoftheinterestratecanin-duceforeigncapitalinflowsandthushelpcoveranyexistingtradedeficits.Butinthelongrun,itseems,theissueofinternationalcom-petitivenessmustbefacedsquarely.Crucialquestionsare:howdoesopeningupacountrytointema-tionalcompetitionthroughfreetradeaffectitslevelsofproductionandemployment?Doesfreetradeequalizecompetitiveadvantages,ordoesitworsenexistinginequalities?Islaissez-fairethebestwaytopartici-pateininternationaltrade,orissomedegreeofstatesupportandmanagementpreferable?Thequestionsareage-oldones,andtheyinvolveboththeoreticalandpolicyconsiderations.Toanswerthemadequately,wemustad-dresstheactualworkingsofthecapitalistworldmarket.Thismeansexaminingnotonlytheimmediateeffectsofinternationaltrade,butalSothelonger-termconsequences, theonesthatassertthemselvesthroughaslowandsteadyalterationoftheinitialeffects,orbygivingrisetounexpectedorevenunacceptablesideeffects.Successfulpolicytherefore requires astructuralanalysisofinternationalcompetitionand5960GLOBALUNEMPLOYMENTtheworldmarket.Inthisregard,theanalysisoftheexchangerateisofcriticalimportance,becauseitistheexchangeratethattranslateslocalcostsandpricesintotheinternationalarena(ChrystalandSedgwick,1989).Inwhatfollows,wewillexaminetheconventionalviewsoftheeffectsoffreetradeandinternationalcompetition.Wewillthenor&cize thesetheoriesandpresentanalternateframeworkbasedonastructuralapproachtointernationalcompetition.ConventionalAnalysesofInternationalCompetitionFREETRADE, UNEMPLOYMENT, AND ECONOMIC POLICY 61ducedinlower-costregions.Inotherwords,underunrestrictedtrade,high-cost regionswouldtendtohavedecliningexportsandrisingim-Ports relativetolower-costregions.Thisinturnimpliesthatifexistingtradebarrierswerereducedamongregions,thehigh-costregionswouldtendtosufferjoblossandadeclineinrealwages(duetobothuneulpluymcm andtop~ebbme tiornlower-wageregions).Theprecedingimplicationsareinherentintheverynotionofcom-Petitionandarecommontovirtuallyallschoolsofeconomictheory.But therearecertaincrucialrespectsinwhichconventionaltheorydivergesfromotherapproachesfromthispointonward.To beginwith,conventionaleconomictheoryassertsthatfullem-ploymentobtainswithineachcountry.Thus,increasedinterregionalcompetitionmerelyredistributesemploymentfromlesscompetitivetomorecompetitiveregions.Givenfullemployment,thepossibilityofoveralljoblossesisautomaticallyexcluded.Needlesstosay,theoriesthatdonotassumeautomaticfullemploymentyieldaverydifferentperspective.Theorthodoxtreatmentofcompetitionbetweencountries(i.e.,ofinternationaltrade)isevenmorecurious.Here,itisarguedthattheexistenceofseparatenationalcurrencieschangestheverynmre nfcompetitionitself:whereasorthodoxeconomicsconcludesthatna-tionalcompetitionisruledbyabsolutecosts,ithasalwaysinsistedthatinternationaltradeisruledbycomparativecosts.Theargumentiswellknownandneedonlybesketchedhere.Con-siderthecaseoftwocountries,oneofwhichhashighercostsofproduction(duetolowerproductivityand/orhigherwages)atsomeinitialexchangerate.Nowimaginewhatwouldhappenifinternationaltradeisinitiatedbetweenthetwocountries.Inthecaseoffixedex-ch a n ger a t es , thecou n t r ywit h an in it ialabsu lu tGclisdvanlage (higherunitcosts)ininternationaltradewillsufferabalanceoftradedeficit,whichwillinturnleadtoamoneyoutflowtopayforthisdeficit.Orthodox economicsassumesthatthismoneyoutflowwilllowerthenationalpricelevelinthedeficitcountry.Aspricesfall,theindustrieswiththeleastinitialdisadvantage(i.e.,thecomparativeadvantage)willbethefirsttogetbackmtocompetition,andtheprocesswillcontinueuntilenoughofthecountrysindustriesbecomecompetitivetoensurethatoveralltradeisbalanced.Inthecaseofflexibleexchangerates,itistheexchangeratethatSuPPosedly doestheadjusting.Asbefore,theabsolutelydisadvantaged62GLOBALUNEMPLOYMENTcountryinitiallysuffersabalanceoftradedeficit.Butnowthisleadstothedepreciationofitscurrency,whichinturnlowerstheforeigncur-rencyequivalentsofitsproductprices.Theprocessisassumedtocontinueuntil,onceagain,enoughofthecountrysindustriesarecom-petitivetoensurethattradeisbalanced.1hetwocasesabovecanbesummarizedbyrrulirrg 11~1 iu eit h erscenario it is thereal exchange ratethatisassumedtomovein such awayastobalanceautomaticallythetradeofeverycountry,therebymakingallnationsequallycompetitiveininternationaltrade,re-gardlessofhowbackwardtheirtechnologyorhowhightheirwages(Officer,1976,pp.10-13; ArndtandRichardson,1987,pp.12-13).Moreover,sincefullemploymentisalwaysassumedtohold,therecanbenoquestionofnetjoblossforeithercountry.(Strictlyspeaking,itisswumedthatanydeclineinemploymentispurelyvoluntary,onthegroundsthatunderchangedcircumstancessomeworkersmayprefernottoworkandhencevoluntarilywithdrawfromthelabormarket,Nonetheless,marketsclear.)Ifitisassumedthatinternationalcompetitionrequiresproducersofthesamegoodtosellatroughlythesamepriceincommoncurrency,after a l l owi n gfor t r a n s p or t a t i on c os t s , t a xe s , a n d t a r i ffs , t h e n t h e c on ;ventionalargumentdepictedabovealsoimpliessomeversionofthe,theoryofPurchasingPowerParity(PPP):i.e.,thatpricelevelswilldroughlysimilarinallnationswhenexpressedincommoncurrencyISomeauthorsemphasizethegeneralpricelevel(Schumpeter,1954,pj1106), whileothersemphasizethepriceleveloftradablegoodsalon&(Hat-rod,1933,pp.53-63;Marston, 1987;Dornbusch,1988).SomeevenarguethatPPPtheocostsofproductionwillbeequalizedacrosscomaticmechanismsoffreetradeendupmakmgincompetition(Officer,1976,pp.1O-l2).Intheoreticalmodels,itisoftenassumedispreciselyatthetrade-balancinglevel.It is,anyactualbalancingprocesswouldtake timelevelthebasicexpectationoforthodoxintemati[eventhough]aneconomysinternationalcompetitivenessandfallovermedium-termperiods...onaverage, over a deebbsandflowsofcompetitiveadvantagetime and across economies. (Amdt and Richardson, 1987, p. 12)FREETRADE.UNEMPLOYMENT..I h D ECONQMZC POLl CY 63Atamoreconcretelevelofanalysis,orthodoxtheorytakesupthequestionofinternationalcapitalflowsandtheireffectontheexchangerate.Intheabsenceofcapitalflows,thebalanceoftradeisthesamething asthebalanceofpayments,andsinceitisassumedthattherealexchange ratemovestoequalizetheformer,italsoautomaticallyequalizesthelatter.Oncecapitalflowsareconsidered,thesamerea-soning leadstotheconclusionthattherealexchangeratemovestoequilibrate theoverallbalanceofpayments.Inthefaceofexogenouscapital inflows,thisimpliesthattherealexchangeratewouldmovetoaccommodatetheseinflowsbygivingrisetoadeficitinthetradebalance,sothattheoverallpaymentsarebalanced(Rueff,1967,p.125; Krueger,1983,p.106).Buttheimportantpointhereisthatinso-farasthecapitalinflowsariseinresponsetorealinterestratedifferen-tialsbetweencountries,theywillservetoarbttrage thesedifferencesandhencetendtoeliminatethem-whichinturnwilleliminatetheneedforthecapitalflowsthemselves.Therefore,althoughexoge-nouslyinducedcapitalflowsmightdisturbtheprocessintheshortandmedium runs, it is expected that over the long run trade will bebalancedsothatthevalueofexportsequalsthevalueofimports(Demburg,1989,p.29).Inotherwords,inthelongruninternationaltradewilloperateasifnationsbarterexportsforimportsofequalvalue(Dombusch,1988,p.3).Insum,conventionaltheoryconcludesthatneithertechnologicalbackwardnessnorhighcostsareultimatelyadisadvantageinintema-tional trade.Realexchangerateswillalwaysmoveinsuchawayastomakealltradingpartnersequallycompetitive,sothatnocountrywillsufferpersistenttradedeficitsorenjoypersistenttradesurpluses.Thetrouble with ~11nf thisis that it has never fitted the facts. In thePostwarperiod,forinstance,neithercompetitiveadvantages,nortradebalances,norevenoverallpaymentbalanceshavebeentheleastbitrandomacrosstimeoracrosseconomies.Onthecontrary,internationaltradehasbeencharacterizedbypersistent,markedcompetitiveadvan-tagefor[countriessuchas]Japanandmarkedcompetitivedisadvan-t ageforcountries[suchas]theU~likxlStates,coupledwithPersistent,markedtradebalancesurplusesforJapananddeficitsforthe UnitedStates.Assomeorthodoxeconomiststhemselvesadmit,suchpatternshaveservedtoundermineconfidenceinthetraditionalarguments (AmdtandRichardson,1987,p.12).Forawhileitwasthoughtthatthefixed-exchange-ratesystemof64GLOBALUNEMPLOYMENTtheBretton Woodswastheexplanationforthismarkeddiscrepancybetweenconventionaltheoryandthefacts.Itwasthereforewidelyexpectedthattheswitchtoflexibleexchangeratesafter1973wouldfinallyconfirmthebasichypothesesoforthodoxtradetheory.Buttheresultshavebeenquitetheopposite.Notonlyhavepersistentinterna-t ion a limba la n ces fa iledt odis a ppea r , t h eyh a vea ct u a llyint ens ified.Moreover,ithasrapidlybecomeapparenttothebestpractitionersoforthodoxeconomicsthattheirtheoriesarenotabletoexplaintheob-servedmovementsinflexibleexchangerates.Dornbusch,whoisoneofthemostinfluentialvoicesinthefield,hasthistosay:Aftertwentyorthirtyyearsofexchangeratemodelling...weareleftwiththeuncomfortablerecognitionthatourunderstandingofexchangeratemovementsislessthansatisfactory.Mostmodelshavelosttheira bi li t y t o exp la i nwh a th a s h a ppcn cd, whencxch a n gcl a t cs mu v~dal o t ,as in the 1980s. (Dombusch, 1988, pp. l-2)Thepersistentdiscrepanciesbetweenorthodoxtheoryandthehistoricalfactshavecreatedgreatdifficultiesforthetheoryofinter-nationaltrade.Inanefforttodealwiththis,twodifferenttendencieshaveemerged.Byfarthedominantonehasbeentoinsistthatthebasicresultsstillhold,butonlyinthelongrun.Theobserveddis-crepanciesbetweenthedataandthefundamentalssuggestedbytheoreticalmodelsoftheexchangerate(Dornbusch,1988,p.9)arethenaddressedasshort-ormedium-runphenomena.Thefourcom-petingexplanationsinthisveinarethemonetaryapproach,thenewclassicalapproach,theequilibriumapproach,andwhatDornbuschcallsthemacroeconomicapproach(ibid.,p. 10).AstheprecedingquotefromDornbuschmakesclear,heconcludesthatthesemodelsdonotworkwell.Theothermainreactiontotheempiricaldifficultiesoforthodoxtheoryhasbeentotrytomakecomparativecosttheorymorerealistic (Dosi,Pavitt,andSoete,1990,p.18)byrelocatingitwithinimperfectormonopolisticcompetitioninthecontextoftechno-logicaldiffcr cn ccs ,economics ofscale, diffcr cn t ia t ed pr odu ct s ,mu lt i-nationalcorporations,andsoon.However,certaincoreassumptionsconcerningthebehaviorofmaximizingagentsandtheautomaticclear-ingofallmarketsareretained,eventhoughtheyaredifficulttoacceptoneithertheoreticalorempiricalgrounds(ibid.,p.24).Mostimport-FRE.E TRADE,UNEMPLOYMENT.ANDECONOMICPOLICY65ant,thecentralassumptionthatinternationalparativecostsremainsunchallenged.trade i s regulated by com-TheImpactofTheoryTheCaseofNAFTAo n Policy:Giventhedifficultieswithorthodoxtradetheory,onewouldthinkthatempiricalstudiesandpolicyanalyseswouldbeundertakenwithinal-ternateframeworks.Buttheholdofthetheoryissogreatthatonefindsjusttheopposite:mostempiricalstudiestakethebasicpropositionsforgranted.ThedebatearoundNAFTAisagoodcaseinpoint.Itwaswidelyreportedthatthreehundredprominenteconomists,rangingfromcon-w r vat i ves t nl i ber al s, phl i rl y endorsedNAFTA.MoststudiesalsoconcludedthattheUnitedStates,Canada,andMexicowillallbenefitintermsofemployment,wages,andloweredprices(FauxandLee,1993,pp.24).Indeed,inOctober1993theWhiteHouseissuedastatementtotheeffectthat19of20comprehensivestudieshadconcludedthatNAFTAwouldbenefittheUnitedStates(JEC,1993,pp.v, xv).Butcloserexaminationofthesestudiesrevealsthattheysimplyassumethatlaboralwaysremainsfullyemployed,atleastintheUnitedStates(JEC, 1993b,p.12;Stanford,1993,pp.98-100).Thusjob loss is ruled out by assumption.This is, of course, a reflection ofabasictenetofconventionaleconomictheory.However,onecanquestionwhetheritisappropriatetobuildsuchanassumptionintoempiricalstudiesthatpurporttoguideeconomicpolicyinthepresent-dayworld.MoststudiesalsoassumethatnoinvestmentwillbedivertedfromtheUnitedStatestoMexico.This,too,derivesfromthebasictheory,sinceaswehaveseen,orthodoxtheoryassumesthatinthelongruntherewillbenonetcapitalflowsbetweencountries.Onceagain,itisdifficulttojustifysuchanassumptiononempiricalgrounds,giventhatthefundamentaleconomicpurposeofNAFTAistofacilitatetheshiftininvestmenttoMexico(FauxandLee,1993,p.11).WithinMexico,theopenlydeclaredofficialpositionisthattheagreementwillleadtoamassiveinflowofforeigninvestment.Manyinthebusinesscommu-nitylookuponthelowwagesandhighpotentialproductivityofMexi-canworkersasagreatincentiveforinvestment,particularlywhen66GLOBALUNEMPLOYMENTAnAlternateApproachtotheTheoryofInternationalCompetitionTheapproachpresentedhereisanextensionofearlierargument4(Shaikh,1980,1991).Ithasitsrootsintheclassicaltraditionandi$somerecentempiricallygroundedapproachesinthepost-Keynesidstructuralist,andhistoricaltraditions.Forinstance,AdamSmithbeFREE TRADE,UNEMPLOYMENT.ANDECONOMICPOLICY67lievedthatinternationaltradewouldoperateinessentiallythesamemannerasnationaltrade:i.e.,thatitwouldberegulatedbytheabsolutecheapnessoftheproductsinvolved,asdeterminedbynaturalorac-quiredadvantages(Allen,1967,pp.5356;Dosi,Pavitt,andSoete,1990,pp.29-30). Thisisbasicallythelawofabsolutecosts.ItisRicardo whosubstitutedthelawotcomparativecosts,althoughhedidretaintheideathatthereexistpersistenttechnologicaldifferencesbe-tweennations.Inmorerecenttimes,theassumptionofdifferenttech-nologicalconditionsreappearswithintheworkofDornbusch,Fisher,Samuelson,Posner,Vernon,andmanyothers(Dosi,Pavitt,andSoete,1990,pp.21-22,25-26).Finally,itisawidespreadassumptionintheclassical,marxian, andneoricardianliteraturethatrealwagesarepri-marilydeterminedbyforceswithinacountry,andthatthefullemploy-mentoflaborisnotanautomaticoutcome(Emmanuel,1972,rh 3)Togroundtheargumentdevelopedhere,wereturntothetheoryofcomparativecosts.Webeginwiththefamiliarsituationoffixedex-changerates,inwhichthecountrywithlessefficienttechnologyand/orrelativelyhigherwagessuffersanabsolutedisadvantageinintema-tionaltrade.Itthereforeexperiencesapersistentdeficitinthebalanceoftrade,withacnrrespnnding persistentoutflowofmoneytopayforthistradedeficit.Accordingtoconventionalanalysis,theoutflowofmoneywilllowerthepricelevelinthecountry,therebymakingitmorecompetitiveininternationaltrade,untilthepointisreachedwhereitissufficientlycompetitivetoachievebalancedtrade.Allofthisissupposedtobeautomatic.Intheend,highdomesticcostsarenorealhandicapininternationaltrade(Feldstein,1993,p.4).Manyauthorsrejectthemonetaristfoundation,whichisthecruciallinkintheprecedingargument(Moore,1988;Wray,1990).Forin-stnncc, Har~ud arguesthattheprimaryeffectotamoneyouttlowistomaketheeconomylessliquid,whichinturntendstoraiseinterestratesabovetheinternationallevel.Insofarasinvestmentisatallsensitivetotheinterestrate,outputandemploymentmayfall,ratherthanprices(Harrod, 1933,p.53;Keynes,1936,p.348).Inanycase,theresultingdiscrepancyininternationalinterestrateswilltendtoattractshort-termcapitalintothecountry,thuscoveringupthestructuraltradeimbalancewithinternationalborrowing.Thisisevidentlyalimitedsolution,sinceitmerelytransformsthestructuraltradeproblemintooneofrisingutternational indebtedness,withallitsattendantdifficultiesandlimits.Ofcourse,ifthegovernmentactstopreventinterestratesfromrising,68GLOBALUNEMPLOYMENTitmustthensupportthecurrencybyrunningdownreserves(devalua-tionisaddressedbelow),ordirectlyintervenebyrestrictingimportsandstimulatingexports,orseeklong-termcapitalinflowsand/orfor-eignassistancetofinancethetradedeficit.Butaslongastherootcause,therelativelyhighunitcostsofnationalindustry,arenotaltered,theproblemwill~t -a ppt ;~ wl~15u cl1d cvi ccs a r ccxh a u st cd .Standardtheoryalsotellsusthatbalancedtradecanberestoredbydevaluingthecurrency(inthecaseoffixedexchangerates)orallow-ingittodepreciate(inthecaseofflexibleexchangerates).Butthewell-knowndifficultieswiththisapproachareequallysevere.Firstofall,insofarasdevaluationordepreciationissuccessfulinloweringtheforeigncurrencyequivalentofexportprices(i.e.,incausingthetermsoftradetofall),thislowersexportrevenuesandhenceworsensthebalanceoftradeatanygivenlevelofexportsandimports.Tooffsetthiseffect,exportlevelsmustriseand/orimportlevelsmustfallb ysufficientamountssoastoimprovetheoveralltradebalance.ThisisthefamousMarshall-Lerner-Robinson-Metzlerelasticitiesproblemthathassobedeviledtheneoclassicalliterature.Atbest,itleavesuswiththeconclusionthattheeffectsofdevaluationanddepreciationarethenretically indeterminate.Butnosuchindeterminacyexistsintheempiricalrecord,sinceaswehavealreadynoted,theflexibilityofexchangeratesinthelatterhalfofthepostwarperiodhasnotledinanywaytobalancedtradeamongnations(Dombusch,1988).Considerationssuchasthesesuggestthatareexaminationofthetheoryofcomparativecostsmightprovefruitful.AformalmodelofanalternateapproachappearsinShaikh(1991)andistestedagainsttheempiricalexperienceoffive advancedindustrialcountries(UnitedStates,Canada,UnitedKingdom,Germany,Japan).Here,weonlyou llin t : 11~biZbiL: s t q m i l l t h ea lgu mcn t .First,itisanessentialfeatureofouranalysisthatproductioncondi-tionsandrealwagesareassumedtodifferacrosscountries.Neoclassi-caltheorytendstoassumethatproductionfunctionsaresimilaracrosscountries,andevenderivesafundamentaltheoremthatfactorprices(i.e.,wagesandinterestrates)willthereforebeequalized,throughinternationaltradealone,acrosscountries (Leontie&lYV5,p.37-/l.Yetnothingcouldbefurtherfromtheempiricalfacts.Productioncondi-tionsandrealwageshavealwaysvariedconsiderablyacrosscountriesthroughoutthehistoryofcapitalism.AlthoughthispointwasalreadyanessentialpartoftheclassicalFREETRADE.UNEMPLOYMENT.ANDECONOMICPOLICY69 tradition,ithasrecentlybeenemphasizedonceagain.Dollar,Wolff, and Baumol (1988) find that for any given industry, productivity varies substantially across countries, with an average variation of 100 percent (p.31,Table2.1).Foranygiveninternationalindustry,suchinterna-tionalproductivityvariationsarelargelyexplainedbycorresponding variationsinrealcapital-labor ratios.Moreover,countries withhigher productivityand/orcapital-laborratiosinoneindustrytendtohave highermeasures in allindustries(p.33, Table 2.3),and countries with higher productivity ina givenindustry tend toalsohavehigher wages inthesameindustry(p.42).On thisbasisweassumethat realwages andtechnologyaredeterminedlocallyineachnation.Ofcourse, money wagescan besticky intheshortrun.But itisexpected thatin thelongrunthekey determinantsof therealwagearefactorssuchas nationalproductivity, outputgrowth,levelof unemployment,and bal-ance uf forcesbetween workers and their employers.This alsoimplies that the realwageisnot necessarily a market-clearing variable,so that fullemployment of laborisnotpresumed--unlike conventionalmod-els,inwhichtherealwageisassumedtomoveinsuchawayasto maketradebalancedortobringaboutthefullemploymentof labor (Krueger,1983, pp.159-60; Dornbusch,1988; p.5). Second,itisassumedthatinternationalcompetitionbindstogether theprices of internationally traded commodities.Wewillcallthisthe Lawof CorrelatedPrices(LCP).Notethatthisdoesnotrequirean immediateandcompleteinternationalequalizationof thepricesof a commongood,asisoftenassumedintheconventionalnotionof the Law of One Price (LOP). For one thing, the existence of transfer costs (transport,insurance,etc.)andof tariffsandtaxesimpliesthatthere existsabandwithinwhichacountry'sproducersareinsulatedfrom internationalcompetitivepre!'