The Myths and Flaws of Free Trade

Questioning a Core Belief of Modern Economic Thinking - Article #113

In this 12-minute article, The X Project will answer these questions:

I. Why this article now?

II. Why has the economic theory of comparative advantage been widely accepted?

III. How has the United States' embrace of comparative advantage theory affected its economy?

IV. What are the fundamental flaws in the theory of comparative advantage?

V. How did historical American economic policies contrast with contemporary free-trade advocacy?

VI. Why do economists persistently advocate for comparative advantage despite its evident failures?

VII. What consequences have emerged from the economic community's reluctance to address the failures of free trade?

VIII. What approach should the United States take regarding trade and industrial policy?

IX. What does The X Project Guy have to say?

X. Why should you care?

Reminder for readers and listeners: nothing The X Project writes or says should be considered investment advice or recommendations to buy or sell securities or investment products. Everything written and said is for informational purposes only, and you should do your own research and due diligence. It would be best to discuss with an investment advisor before making any investments or changes to your investments based on any information provided by The X Project.

I. Why this article now?

I graduated from college after the fall semester in 1993. Had I finished college in four straight years, I would have graduated in the spring of 1992. However, after the first quarter of my junior year, struggling with my grades, my studies, and my motivations, I decided pre-medicine was not for me. So I withdrew from college to figure out what I wanted to study instead. I lived in Chicago and got a job on the floor of the Chicago Mercantile Exchange. I was a runner for one of the largest trading firms then, which was the beginning of the final heyday decade of the open outcry trading for commodity futures and options.

I was immediately hooked on the markets. Within a few months, I was going back to school part-time, pursuing my new degree in Economics. After a semester of part-time study, I transferred to a new school and took a full-time course load while still working full-time to pay for it all. I was motivated, thirsty to learn, and excelled in my studies. I graduated Summa Cum Laude and a member of Omnicron Delta Epsilon, the international honor society in economics in recognition of high scholastic achievement.

After graduating, I became a commodity futures broker and off-floor trader for five years before getting into information technology and IT networks after technology completely disrupted the retail brokerage and trading business. I have followed the markets and global macroeconomics passionately since then. However, I remember feeling somewhat unfulfilled intellectually after graduating, and that feeling has also festered and grown ever since. Only over the past decade did I slowly understand that the festering, unfulfilled feeling was based on the disconnect between academic economics and reality.

It has only been more recently that I have understood that this festering feeling was also based on some unquestionable economic dogmas, one of which is that free trade is not only always and everywhere good, and not even always better, but that free trade is supremely best and should be applied anywhere and everywhere.

I am writing this article now because this past week, I came across a podcast that led to an article that articulated very well some of my festering questions and concerns about the supremacy of our free trade doctrine. I will tell you more about the podcast and article in the last sections of this article, but first, let’s ask some questions that weren’t asked when I was initially studying economics.

II. Why has the economic theory of comparative advantage been widely accepted?

As articulated by David Ricardo in 1817, comparative advantage became the cornerstone for advocating free trade primarily because it supported geopolitical ambitions rather than purely economic logic. You may remember from your macroeconomics class Ricardo’s example involving Great Britain producing cloth more efficiently and Portugal producing wine more efficiently as the basis for why they should each only produce cloth and wine, respectively, and then trade with each other for what they shouldn’t produce. American economists revitalized this theory post-World War II, framing it as a universal economic truth to justify a U.S.-led global order to foster international interdependence. The theory's adoption was more politically expedient than economically rigorous, reflecting a conscious effort by economists to bolster America's geopolitical strategy.

Post-war economic policies championed tariff reductions, aligning closely with foreign policy objectives to establish peace and prevent future conflicts through economic interdependence. Economists like Paul Samuelson explicitly linked comparative advantage to these broader political agendas, downplaying critical caveats such as full employment prerequisites. Thus, comparative advantage's widespread acceptance was less about its intrinsic economic validity and more about serving as an ideological justification for U.S. global leadership.

The theory has persisted mainly due to entrenched institutional support and the discipline's reluctance to admit limitations, despite mounting evidence of adverse outcomes. Economists have shielded comparative advantage from critique by dismissing alternative views, thus maintaining its prominence as a political rather than purely economic doctrine.

III. How has the United States' embrace of comparative advantage theory affected its economy?

The United States' rigorous pursuit of free trade based on comparative advantage theory has substantially reshaped its economic landscape, often to its detriment. Over three decades, balanced trade in 1992 gave way to a massive deficit of over $900 billion by 2022. Critical sectors such as advanced technology experienced profound reversals, shifting from substantial surpluses to significant deficits, severely undermining America's industrial leadership.

This economic approach has led to the decline of traditional manufacturing bases and stagnation in productivity growth, notably evident in industries once dominated by U.S. innovation like aerospace, electronics, and the automotive sectors. The hollowing out of industrial capabilities has adversely impacted American innovation, employment prospects, and national security, illustrating significant flaws in the comparative advantage application.

Consequently, the broad acceptance of comparative advantage has failed to deliver promised prosperity and contributed to economic stagnation, job loss, and strategic vulnerabilities. The inability to scale manufacturing domestically further exacerbates these issues, highlighting the profound miscalculations of free trade policies applied to complex, modern economies.

IV. What are the fundamental flaws in the theory of comparative advantage?

Conceptually, the theory assumes equivalence in value among different industries, such as cloth and wine, but fails when applied to strategic sectors like semiconductors. The simplistic model overlooks the vital role manufacturing plays in a nation's innovation ecosystem, economic growth, and security.

Ricardo himself explicitly noted significant caveats to his theory of comparative advantage:

1. Capital Immobility: Ricardo acknowledged that the comparative advantage scenario relies fundamentally on the difficulty of capital moving from one country to another. If capital were easily mobile, production would relocate to the country that produces all goods most efficiently, undermining the benefits of specialization. He argued that the advantage only persisted because of practical limitations on capital mobility at the time.

2. National Attachment and Cultural Preferences: Ricardo emphasized the natural reluctance of individuals and capitalists to relocate from their home country. He believed this emotional and cultural attachment was a stabilizing factor preventing the wholesale movement of capital and labor that would negate comparative advantage.

3. Strategic Considerations: Ricardo implicitly recognized that certain goods or industries might carry strategic importance beyond economic efficiencies, which could justify deviations from strict comparative advantage principles. Although not explicitly termed by Ricardo, this caveat reflects the understanding that some sectors have strategic value influencing national decisions beyond pure economic efficiency.

Ricardo was conscious that his theory's applicability was contingent upon specific, restrictive conditions and human behavioral tendencies that limited capital flows and justified some form of economic nationalism.

Technically, his theory assumes balanced exchanges of goods for goods. However, trade today often involves exchanging goods for financial assets or real estate, given the easier flow of capital enabled by today’s international trading system. This is why we have such imbalances today, signified by the accumulated $15 trillion in trade debt since 1992. This fact alone fundamentally undermines the notion of sustainable economic benefit through unfettered free trade.

V. How did historical American economic policies contrast with contemporary free-trade advocacy?

Historically, the U.S. adhered to strong protectionist policies to nurture domestic industries, contradicting current free trade advocacy. Leaders like Alexander Hamilton, Abraham Lincoln, and Theodore Roosevelt promoted tariffs and industrial subsidies to secure economic independence and foster industrial growth. These policies significantly contributed to America’s industrial rise and economic prosperity.

SOURCE: Bureau of Economic Analysis, World Trade Historical Database, Measuring Worth, and authors’ calculations.

Historically, Protectionism enabled the U.S. to evolve from an agrarian economy into a leading industrial power by safeguarding nascent industries from foreign competition, stimulating domestic economic innovation, and infrastructure development. These historical precedents demonstrated the effectiveness of targeted economic policies in nurturing critical industries and maintaining national economic health.

Conversely, contemporary free-trade advocacy has often overlooked the historical success of protectionism, embracing open trade ideologically rather than empirically. This historical context underscores the need to critically reassess current U.S. trade policies, emphasizing strategic rather than doctrinal approaches to economic policymaking.

VI. Why do economists persistently advocate for comparative advantage despite its evident failures?

Economists continue advocating comparative advantage primarily due to ideological commitment, institutional inertia, and professional orthodoxy. This persistence arises partly from a reluctance to publicly acknowledge theoretical shortcomings, fearing such admissions might empower protectionist views considered politically regressive or economically naive.

The economics profession has thus engaged in selective discourse, often ridiculing dissenting views and dismissing empirical evidence contrary to theoretical expectations. Prominent economists have actively discouraged rigorous internal critiques of globalization and comparative advantage, reinforcing dogmatic adherence to established beliefs.

Despite clear empirical challenges, this entrenched advocacy reflects broader tendencies toward ideological conformity within the discipline. Such intellectual rigidity risks further alienating the profession from meaningful policy discussions, diminishing its capacity to contribute constructively to future economic strategies.

VII. What consequences have emerged from the economic community's reluctance to address the failures of free trade?

The economics community's reluctance to engage substantively with the failures of free trade has contributed significantly to economic stagnation and public disenchantment. Economists have inadvertently promoted policies detrimental to national economic health, innovation, and social stability by ignoring empirical evidence and dismissing legitimate concerns.

Public skepticism toward economic expertise has intensified, driven by visible economic disruptions such as job losses, declining manufacturing sectors, and increasing inequality. Such skepticism fuels populist political movements that question economic policies and broader societal structures, threatening democratic stability and social cohesion.

This professional intransigence has further marginalized economists from pivotal policy debates, limiting their potential to guide the nation towards more balanced, empirically sound economic policies. Ultimately, this exclusion diminishes the role economists could effectively play in shaping future economic strategies, hindering their contribution to public policy.

VIII. What approach should the United States take regarding trade and industrial policy?

The United States should adopt a pragmatic, strategic trade policy emphasizing balanced economic interests and national security. Rather than strictly adhering to free trade doctrines, policy must integrate protections for critical industries, technological innovation, and economic resilience. Strategic tariffs, industrial subsidies, and domestic manufacturing incentives can effectively counteract economic vulnerabilities exposed by globalization.

Addressing the U.S. trade deficit requires policy recalibration to enhance domestic manufacturing, support technological innovation, and secure supply chains. This strategic recalibration would entail selective protectionist measures alongside global cooperation frameworks that promote equitable, sustainable trade.

Economists and policymakers must collaboratively reassess trade doctrines, recognizing the nuanced interplay between economic theory and geopolitical reality. This nuanced approach necessitates engaging deeply with empirical outcomes, adapting economic theories to contemporary realities, and realigning economic policy with broader national priorities to foster sustained economic health and strategic autonomy.

IX. What does The X Project Guy have to say?

I am a strong proponent of critical thinking, a multifaceted process of evaluating information, analyzing arguments, and forming judgments to reach well-reasoned conclusions. It involves actively questioning assumptions, exploring different perspectives, and using logic to assess the validity and reliability of information. Critical thinking goes beyond simply accepting information at face value and delves deeper to understand the underlying reasoning and evidence.

Exploring different perspectives is key to critical thinking. It involves considering perspectives that one might not normally or usually consider. I encourage everyone to step outside the “echo chambers” our modern mass media, news media, and social media tend to box us into.

This article primarily summarizes the views expressed by Oren Cass, the founder and chief economist of American Compass, in this podcast interview and in his article, “Free Trade’s Origin Myth,” published on January 2, 2024.

X. Why should you care?

If you can accept, or at least consider the possible validity of these views, then you may be able to accept, or at least consider the possible validity of the actions being taken by the Trump administration. And if you can do that, you may understand that we are going through a period of change that Trump or his administration is not causing. This period of change is based on unsustainable global economic imbalances that are on the verge of multiple breaking points, prompting all of these actions to be taken.

And if you can get to this point, you can consider that the investment themes that have worked well for the past several decades will probably not be the same ones that work for the next decade or two. Based on the generational changes that we are currently undergoing, these are the investment themes to which I subscribe:

1. Overweight cash and short-term U.S. T-bills for optionality, given expected INCREASING volatility related to the remaining list below.

2. Bullish gold and gold miner equities

3. Bullish Bitcoin

4. Bullish oil and oil-related equities

5. Bullish natural gas and related equities

6. Bullish uranium and related equities

7. Bullish industrial-associated commodities and equities

8. Bullish agricultural-associated commodities and equities

9. Bullish industrial and primarily electrical infrastructure equities

10. Bearish long-dated U.S. and other Western sovereign bonds

Remember, this is not investment advice nor recommendations to buy or sell securities or investment products. Everything written and said is for informational purposes only, and you should do your own research and due diligence. It would be best to discuss with an investment advisor before making any investments or changes to your investments based on any information provided by The X Project.

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