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The Economics of Trade Agreements

December 11, 2018

Portrait: Timothy Kehoe

Portrait: Timothy Kehoe
Professor Timothy Kehoe, Department of Economics
For nearly three generations, the United States and scores of other nations have prospered through trade governed by international rules. But in the last couple of years, University of Minnesota economist Tim Kehoe has watched with alarm as global trade pacts have come under attack by the Trump Administration. In a recent interview, Kehoe outlined the risks of a new era of America First trade policies.

Q. For 70 years after World War 2, trade became easier and cheaper.  Thanks to multi-lateral agreements, ranging from the 1950s Common Market to the 1990s North American Free Trade [NAFTA] agreement. How has that trend changed in recent years?

A. The Allies, during the Second World War, started calling themselves the United Nations. They wanted to prevent the frictions that were partially responsible for leading to the war. How did Hitler rise in Germany? What were the tensions in Japan? All this kind of stuff. The 1930s was a period of very active trade wars.

This is what the Trump Administration seems to want to do, which is to have minor trade wars.

Q. Aren’t trade wars avoidable?

A. The United Nations held the Bretton Woods Conference in 1944 to set up a new way of running the world to avoid another world war.  They intended to set up something called International Trade Organization (ITO). It was intended to foster multilateral trade liberalization, which is the best way to go.  The process started with the GATT (the General Agreement on Tariffs and Trade), but the ITO never got off the ground. …We finally set up the WTO in 1994 (It started operations in 1995). Unfortunately, the trade liberalization through the WTO has stalled mostly because of lack of agreement over liberalization of trade in agriculture. 

Given that multilateral trade liberalization, in the form of the WTO, is stalled, we are doing the best that we can do with regional trade agreements.

Q. With multi-national agreements that encouraged movement of people and goods stagnating, what are the risks of unilateral agreements that represent the alternative path?

A. All our growth in trade recently – we [the United States] don’t trade much with Europe at all given how big it is – is centered on Canada, Mexico and China. Those three are where all of our trade growth is concentrated and that’s where we have trade wars starting now.

Q. What about the Chinese?

A. When U.S. companies want to get into the Chinese market, they are forced, de facto, to have a Chinese partner. They force them [U.S. partners] to turn over a big chunk of their intellectual property – designs, trade secrets and all that kind of stuff. What’s the right way to handle that? In my view, it’s to work through the WTO with our traditional allies, Canada, Mexico and Europe, to force China to keep with their commitments. That’s not what we’re doing.

Q. You’ve concluded that trade deficits, at most, contributed maybe to 15 percent of the decline in U.S. manufacturing employment. What are the other forces at work and why does trade get so much of the blame?

A. It’s not popular to say that there’s a big structural problem in the United States, which is that there’s not enough technical education and training. It’s much easier to say that the foreigners are at fault…Bernie Sanders and Donald Trump would agree on this. They’re both wrong.

That being said, 15 percent [decline in manufacturing jobs] was a big number. A loss of 2 million jobs. But the United States does pretty well in exporting services. We’re by far the biggest services exporter in the world. When Trump and his advisers talk about trade deficits, they’re always focused on merchandise. They miss out on the huge surpluses that we have in service trade. That is really difficult, if not impossible, to break down on a bilateral basis. Those 2 million lost jobs [in manufacturing] were made up in jobs in high-paid services.

We want people investing in our country. The Chinese, yeah, they didn’t buy our goods. Canadians and Mexicans buy our goods, right? But the Chinese buy our bonds. That keeps our interest rates low. The U.S. economy depends on that. We do well out of our trade with the Chinese.

Even though we’re the biggest, most-powerful economy in the world, we’re even bigger proportionately as headquarters for multinational corporations. We export the management services, the design services, insurance services and so forth. A car that’s made in Mexico is designed in the United States.

Q. Was NAFTA in need of renegotiation?

A. The financial system has changed so much in the last 25 years that we should have new rules. That being said, overall, the “new NAFTA” represents almost no changes. …The Trump Administration had wanted “sunset clauses” that expire after five or six years. Now they’re set at 16 years and can be renewed after 16 years. That’s a long way off. That’s good because, as every economist will tell you, a free trade agreement gives investors some certainty.

[Canadian Prime Minister Justin] Trudeau opposed sunset clauses in the new NAFTA. He had some very good economists around him, unlike President Trump.

Q. What did the U.S. get out of the new NAFTA?

A. Some minor concessions on cars. But German manufacturers who don’t meet the new parts and labor thresholds can simply pay the 2.5 percent tariff. For them, it’s not much of a penalty. It’s not a big deal at least if we live up to our WTO commitment to have a maximum tariff of 2.5 percent on automobiles.

The Canadians agreed to buy more U.S. cheese and other dairy products. But not this: the Canadians already had agreed to buy even more under the Trans-Pacific Trade Partnership that Trump withdrew the United States from.

The big thing the new NAFTA rules on [cross-border] dairy sales were meant to be was a slap in the face of Mr. Trudeau. To just embarrass him with the dairy lobby, which is pretty important in Canada, and to get nothing in return for Canada’s concessions.

Q. Your work seems to suggest the U.S. economy’s position is precarious.

A. That’s 100 percent right. In spite of President Trump’s claims at his rallies that our economy has never done better than we’re doing now, it’s just not true. We’ve never really recovered from the global recession that started in 2008. We grew [after 2009] at a normal rate, not the [far-faster recovery rate of 4 percent or more] typical after a recession. We are 10 percent below where we would have been [without being hit by a recession]. The danger is that we never get that back, that it’s just lost. We’ve gone through a period that’s unprecedented for being below where our trend growth was. The 3-to-4 percent growth the Trump Administration is crowing about is average. It’s only average.

I don’t want to fact check President Trump on everything because almost everything he says is a little bit of a lie, and some are major lies.

China has really slowed down in its growth. Europe is doing worse than North America. The whole world’s fragile. Trade wars are not what we need now. No one wins trade wars. Everybody suffers.

Trump likes to be unpredictable. In a trade war, can’t the other side be the same?

Let me tell you what I’m nervous about. Yes, we’ve backed off a trade war with Europe. We’ve avoided all-out trade war with Canada and Mexico. But we seem committed to have a fight to the end, a trade war, with China. We have them in a corner where they cannot graciously back out. That’s not the way their government works. This could end up having bad consequences in both countries and either the Trump Administration or the Chinese government are going to be hurt by this. Creating political instability in China is not going to be good. This is a bad situation.

Q. What are the consequences of dropping out of pacts, like the Trans-Pacific Partnership?

A. The TPP was a strategic move to restrict the influence of China. I think the people in the Trump Administration just simply didn’t understand that. They could connect [former Secretary of State Hillary] Clinton to that agreement. They just wanted to demonize that. In retrospect, I think they realized that was a big mistake.

When the United States dropped out of the TPP, people were speculating that the whole thing would collapse. It didn’t. Now I’ve heard the Trump Administration may want back in. It is best for the United States if we are the leader in the world economy. The renunciation of our leadership role in liberalizing trade and foreign investment is just a big mistake. That’s what we’re doing.

Q. Will the mistake be corrected?

A. Yes, I think it will. This is the first protectionist president we’ve had since the end of the Second World War. I anticipate it will be the last for quite a while. Because of the consequences. We’re not going to get anything out of the trade war but we’re going to suffer. It’s going to hurt U.S. workers, U.S. consumers. It’s too simplistic to blame trading partners for problems we have here in the United States.

The Heller-Hurwicz Q&A series shares exciting preliminary research findings from University of Minnesota economists. The text has been edited for clarity and length.