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The U.S. has been able to consume more than it produces and to borrow more than it saves because the dollar is the reserve currency. Other countries that get into such a situation either go broke and lose all access to credit or accept an International Monetary Fund austerity program that forces them to curtail consumption and to pay down debt. For the U.S., an IMF austerity program would mean a substantial reduction in living standards.

What can be done? As it would be very difficult for the U.S. to get its house in order if it were to lose the reserve currency role, the government should take immediate action to preserve this role. Preserving the dollar as reserve currency requires large reductions in trade and budget deficits, a tall order for the current weak state of the U.S. economy.

The U.S. could reduce the budget deficit by hundreds of billions of dollars by ending its pointless and illegal wars, by closing hundreds of overseas military bases, and by cutting an overstuffed military budget. This would require the U.S. to give up its goal of world hegemony, but now that America’s creditors have seen its aggressiveness, and this aggressiveness shows signs of turning toward China and Russia, creditors are unlikely to continue financing U.S. militarism. In the absence of foreign financing of U.S. deficits, or of insufficient foreign savings to cover annual U.S. budget deficits in excess of one trillion dollars, the Federal Reserve would have to monetize the U.S. deficit by purchasing the bond issues. Large scale debt monetization can result in high rates of inflation.

In traditional economic analysis, rising domestic unemployment curtails imports as consumers have less income to spend, thus reducing the trade deficit. The U.S. needs to do much more. U.S. manufacturing has declined so much that, should its creditors permit, the time is not far off when the U.S. trade deficit becomes as large a share of GDP as its manufacturing output.

Offshored production needs to be brought home. When corporations offshore their production for U.S. markets, they reduce U.S. GDP and increase the trade deficit, dollar for dollar.

The U.S. could bring home its offshored production by abolishing the corporate income tax and taxing corporations according to whether value is added to their products at home or abroad. Corporations that produce their products in the U.S. would have a low rate of tax; those that offshore their production would have a high rate of tax.

This change would take time to become effective, and in the near term it could anger creditors, such as China, a country where production for the U.S. market has raised employment and income. However, if the policy of bringing production home was seen as credible, the world would see a renewed prospect for the U.S. dollar as reserve currency.

Another helpful reform would be to overthrow performance pay for management based on short-term profits. Quarterly reporting and the cap on executive pay that is not performance based gives U.S. corporate executives a very short-time horizon compared to overseas competitors.

These suggestions would have to overcome powerful vested interests. Moreover, the hubris of American elites might outlast the window of opportunity that exists for the renewal of the U.S. economy.

Until recently, economists believed that the case for free trade was unassailable. Most economists still think that the case is secure. However, the two necessary conditions for David Ricardo’s 200-year-old theory are no longer present in the modern world. Moreover, the latest work in trade theory,
Global Trade and Conflicting National Interests
(MIT Press, 2000), by Ralph E. Gomory and William J. Baumol, shows that the case for free trade was incorrect from the beginning.

Let’s begin with the original case for free trade. It is based on the principle of comparative advantage. This principle says that it pays for countries to specialize and to trade even if one country can produce all tradable goods at a lower cost than the other country. This conclusion follows from countries having different “opportunity costs” of producing tradable goods. The opportunity cost of any good is the other goods that could have been produced by the same resources.

Ricardo uses as examples wine and wool. Portugal can produce both wine and wool cheaper than England, but Portugal has to give up more bottles of wine to gain a yard of woolen cloth than England. Thus, Portugal has a comparative advantage in producing wine, and England has a comparative advantage in producing wool. If each country specializes where it has comparative advantage, the total production of wine and wool will be greater than if each country produced both products. “The gains from trade” result from sharing the increase in total output by trading the two commodities on terms favorable to both countries. Therefore, specialization and trade will allow each country more consumption of both products than if each country were self-sufficient.

The different opportunity costs of one good in terms of another (the cost of wine in terms of wool) means that the trading partners have different relative price ratios for producing tradable goods. It is this difference that creates comparative advantage. In Ricardo’s time, unique national characteristics, climate, and geography were important determinants of relative costs. Today, however, most combinations of inputs that produce outputs are knowledge-based. The relative price ratios are the same in every country. Therefore, as opportunity costs do not differ across national boundaries, there is no basis for comparative advantage.

Ricardo’s other necessary condition for comparative advantage is that a country’s capital seeks its comparative advantage in its home country and does not seek more productive use abroad. Ricardo confronts the possibility that English capital might migrate to Portugal to take advantage of the lower costs of production, thus leaving the English workforce unemployed, or employed in less productive ways. He is able to dismiss this undermining of comparative advantage because of “the difficulty with which capital moves from one country to another” and because capital is insecure “when not under the immediate control of its owner.” This insecurity, “fancied or real,” together “with the natural disinclination which every man has to quit the country of his birth and connections, and entrust himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign lands.”

Today, these feelings have been weakened. Men of property have been replaced by corporations. Once the large excess supplies of Asian labor were available to American corporations, once Congress limited the tax deductibility of CEO pay that was not “performance related,” once Wall Street pressured corporations for higher shareholder returns, once Wal-Mart ordered its suppliers to meet “the Chinese price,” once hostile takeovers could be justified as improving shareholder returns by offshoring production, capital and jobs departed the country.

Capital has become as mobile as traded goods. Indeed, capital can move with the speed of light, but traded goods have to move by ship or airplane. Economists would be hard-pressed to produce stories of American capital seeking comparative advantage in the 50 states. But they can easily show its flight abroad. Approximately half of U.S. imports from China are the offshored production of U.S. firms for the U.S. market.

Most economists, whom I have labeled “no-think economists,” learned in graduate school that to question free trade was to be a protectionist – a designation that could harm one’s career. I personally know many economists who are terrified to be anything but free traders, but who have no understanding of the theory on which free trade is based or of the theory’s many problems.

For most economists, free trade is a dictum like the Bush regime’s dictum that Saddam Hussein had “weapons of mass destruction.” The eight year, three trillion dollar war was pointless, just as is the de-industrialization of the United States by free trade.

I am not the only economist who takes issue with the free-trade dogma. A number of competent economists have criticized free-trade theory. For example, professors Herman E. Daly and John B. Cobb show the inadequacies of the theory in
For the Common Good
(1989). Professor James K. Galbraith puts the theory to rest in
The Predator State
(2008). Professor Robert E. Prasch, in a 1996 article in the
Review of Political Economy
, demonstrates fundamental problems with the theory. Professor Ron Baiman at DePaul University argues that Ricardo’s theory is “mathematically overdetermined and therefore generally unsolvable.” Professor Michael Hudson deconstructs free trade doctrine in
Trade, Development and Foreign Debt
(2009) and in
America’s Protectionist Takeoff 1815-1914
(2010). In 2004, America’s most famous economist, Paul Samuelson, wrote that an improvement in the productivity of one country can decrease the living standard of another. Thus, when U.S. corporations take their technology abroad and integrate it into the productive capability of a foreign country, they reduce the living standards in their home country.

This brings us to Gomory and Baumol. Samuelson’s 2004 article is a defense of the powerful new work in trade theory by these two authors. Gomory, one of America’s most distinguished mathematicians, and Baumol, a past president of the American Economics Association, show that free-trade theory has many problems because “the modern free-trade world is so different from the original historical setting of the free-trade models.”

Gomory and Baumol dismiss the alleged gains from offshoring production for home markets: “in almost all cases, most of the economic benefit stays where the value is added. Profits are usually only a small portion of the value added through economic activity, and most of the value added, such as wages, remains local. It matters to a country to be the site of an economic activity, whoever may own the company.”

Gomory and Baumol show that unlike Ricardo’s win-win outcome based on a simple arithmetical example, sophisticated mathematics proves that in most cases “the outcome [from trade] that is best for one country tends not to be good for another.” Gomory and Baumol re-establish the gains from trade (win-win situation) as a special case of limited applicability. They conclude that “free trade between nations is not always and automatically beneficial. It can yield many stable equilibria in which a country is worse off than it would be if it isolated itself from trade altogether.”

It will take the economics profession many years to come to terms with this new work. The myth that America’s economic success is based on free trade will be hard to dislodge.

R.W. Thompson, in his
History of Protective Tariff Laws
(1888), shows that protectionism is the father of economic development. Free trade has become an ideology. It once had a Ricardian basis, a basis no longer present in the real world. In the United States today, “free trade” is a shield for greed. Short-term gains for management and shareholders are maximized at the expense of the labor force and the economic welfare of the country. Jobs offshoring is dismantling the ladders of upward mobility that made America an opportunity society.

Offshoring’s proponents defend the practice on the grounds that it is free trade and thereby beneficial.

We saw in the previous section that free trade is not necessarily beneficial. Let’s now examine whether offshoring is trade.

In the traditional Ricardian free trade model, trade results from countries specializing in activities where they have comparative advantage and trading these products for the products of other countries doing likewise. In Ricardo’s example, England specializes in woolen cloth and Portugal specializes in wine.

In the Ricardian model,
trade is not competitive
. English wool is not competing against Portuguese wool, and Portuguese wine is not competing against English wine.

Somewhere along the historical way, free trade became identified with competition between countries producing the same products. American TV sets vs. Japanese TV sets. American cars vs. Japanese cars. This meaning of free trade diverged from the Ricardian meaning based on comparative advantage and came to mean innovation and improvements in design and performance driven by foreign competition. Free trade became divorced from comparative advantage without the creation of a new theoretical basis upon which to base the free trade doctrine.

Countries competing against one another in the same array of products and services is not covered by Ricardian trade theory.

Offshoring doesn’t fit the Ricardian or the competitive idea of free trade. In fact, offshoring is not trade.

Offshoring is the practice of a firm relocating its production of goods or services for its home market to a foreign country. When an American firm moves production offshore, US GDP declines by the amount of the offshored production, and foreign GDP increases by that amount. Employment and consumer income decline in the US and rise abroad. The US tax base shrinks, resulting in reductions in public services or in higher taxes or a switch from tax finance to bond finance and higher debt service cost.

When the offshored production comes back to the US to be marketed, the US trade deficit increases dollar for dollar. The trade deficit is financed by turning over to foreigners US assets and their future income streams. Profits, dividends, interest, capital gains, rents, and tolls from leased toll roads now flow from American pockets to foreign pockets, thus worsening the current account deficit as well.