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Economic Nationalism as Political Realism

No market exists in a social vacuum, and hardly any market exists in a political vacuum. States are an all but ubiquitous context of modern life. They also provide the historical context in which sophisticated markets first developed: money, banks, stock exchanges, mass production, intellectual property, containerized shipping, the Internet, and most other institutions and features associated with market economies today arose within already existing political settings, and in many cases states themselves fostered these developments. But even when they did so, they no doubt also impeded many other market transactions desired by individuals. No state of any considerable significance has ever been just a night watchman.

Every market liberal should know this. Yet market liberals have a habit of arguing from unhistorical abstractions, as if the bare bones sketch of market operations that exists in textbook theory is directly applicable to real-world practice. This is as fundamentally misconceived as treating Plato’s Republic as a blueprint for a real polity.

Where economic nationalism is concerned, the abstraction against which tariffs and industrial policies are weighed is a pristine market in which there are no pre-existing distortions arising from political influence (or any other source). Market transactions are unimpeded expressions of individual preferences, and through all the processes that free markets involve—competition, creative destruction, peaceful satisfaction of ex ante preferences, etc.—optimal efficiency prevails.

Economic nationalism can only harm that optimal efficiency. As Samuel Gregg warns, it means that politicians or bureaucrats second-guess market processes, though they cannot possibly know enough to make decisions whose outcomes are better than those reached through the network logic of spontaneous order. Economic nationalism is therefore harmful to the market and to its participants overall (if not necessarily to every individual participant) and must be rejected as a policy prescription.

Self-Defense in Distorted Markets

In the real world, however, markets are not pristine and unmolested. Gregg acknowledges as much when he describes the mercantilist practices of Communist China—practices which distort any market in which China participates. Once such real-world detail enters the picture, the categorical case against economic nationalism becomes untenable.

Gregg admits the need to castigate China, but his preferred instrument for doing so, the World Trade Organization, has not proved adequate to the task. As he notes, China has only grown more abusive under Hu Jintao and now Xi Jinping, the two leaders who have come to power since China was admitted to the WTO. Stronger countermeasures are needed.

Market liberals cognizant of this have reason to make common cause with economic nationalists. Supporters of economic nationalism see U.S. tariffs against China as justified retaliation, and some see them as a means of achieving freer trade in the long run: by punishing trade violations with reprisals, the United States can pressure China into abandoning its bad behavior, which would then free the U.S. to re-liberalize its trade relations. Variations on this argument—that tariffs are a temporary means to the end of freer trade in the long run—are commonplace.

Yet some market liberals reject economic nationalism even in this light. Why worry if China just wants to sell us cheaper goods? That’s great for consumers. According to theory, if China is cheating, the market itself will sooner or later wreak vengeance: no one can sustain a diseconomical policy indefinitely, and when it eventually fails, creative destruction will clear the wreckage and establish a new equilibrium among trading partners.

The problem with this line of thinking is laid bare by a simple conceptual experiment. Consider two firms in competition in a given time and place. Both are retailers. One is an exemplary honest business—call it LawMart. The other is MafiaMart, which successfully undercuts LawMart’s prices every time because the goods sold at MarfiaMart “fell off the back of a truck.”

There’s nothing in economic theory that says the time horizon for LawMart’s survival has to be longer than the horizon for MafiaMart’s viability. The mafia might run out of goods to steal and sell at a discount eventually. But LawMart can be put of business long before then. And when LawMart goes under, if the managers of MafiaMart wish, they can raise their prices and scale back their dependence on looting—even to the point of accepting a “market price” in the context of a now established regional monopoly.

Consumers benefit from the cheap goods they can buy at MafiaMart while those goods are criminally discounted, but few market liberals would say that this benefit to consumers outweighs the harm done to LawMart and the victims of the mafia’s thefts. Indeed, if MafiaMart’s behavior is tolerated in the name of cheap consumer goods, perverse incentives are established for future LawMarts and MafiaMarts alike: the law-abiding will be discouraged from entering such markets in the first place, while criminals will be taught that crime does pay. It’s a formula for getting more crime and fewer honest businesses.

A market liberal who wants to prevent this scenario has to be prepared to support the policies necessary to stop the abuses, and in China’s case those include retaliatory tariffs and potentially other components of economic nationalism. Where markets have already been distorted, spontaneous order and the knowledge problem do not preclude defensive actions. No firm or nation can reasonably be expected to be indifferent to its fate in the understanding that come the Kingdom the righteous will be rewarded and the sinner punished by the gods of the market. Time matters, and firms, nations, and individuals within time are not interchangeable in the way that the actors in pure, timeless theory are.

Domestic Market Distortions

Market liberals hostile to economic nationalism face another problem beyond the market distortions caused by bad actors abroad. Markets at home also deviate from the textbook ideal. The allocation of capital within the United States does not follow the unconstrained signals of any market. To give two examples of prime importance, spontaneous order did not create the Federal Reserve system, nor the U.S. banking system as a whole, and it did not create the system of intellectual property on which much of American business depends—from “new economy” companies like Facebook and Google to Disney, the pharmaceutical industry, and a host of “old economy” manufacturing firms.

In theory, the same arguments against “picking winners and losers” among firms and business sectors that are at the heart of the market liberal case against economic nationalism apply to the banking and IP dispensations. The same knowledge problem pertains. Yet only the most radical economists of the Austrian school make a thoroughgoing argument against the role of government in these architectonic areas of the economy. The Federal Reserve receives criticism from many directions, it’s true—but the uncompromising theoretical model of free-market banking goes much farther than just curtailing or even abolishing the Fed. For the radical Austrians, it goes so far as to question the very legitimacy of fractional-reserve banking.

In brief: the radicals hold that fractional-reserve banking is inherently fraudulent, and therefore impermissible in a lawful market, because banks cannot return all their deposits at any given moment—thus bank runs can happen, and sooner or later good-faith customers will lose their deposits. An argument against this view is that depositors do, in fact, know the risks when they deposit their money. Ergo, no fraud. But the reason the radicals insist that this must be fraudulent, and therefore not a “natural” part of the market, is that accepting the market validity of fractional-reserve banking means accepting the instability of the banking system as a legitimate feature of capitalism: and that instability inevitably invites demands for government intervention. A perfect, government-free market in an economy with modern banking would therefore be virtually impossible even in theory—all modern economies would have to be mixed economies.

Very few market liberals let the radical case against intellectual property or fractional-reserve banking trouble them, and most are prepared even to accept that central banks are compatible with a high degree of market freedom and prosperity. But the banking and IP regimes that are features of our economy are not just neutral rules—they shape entrepreneurial and investment behavior, and indeed they shape labor and consumer conditions in direct and indirect ways alike. They likewise influence the policies pursued by governments. Market liberals are often on the front lines of those demanding that government protect intellectual property, especially in foreign trade. When I pointed out in a debate last year that this is a form of protectionism, the trade policy expert with whom I was debating was left to insist that no, intellectual property is in fact (a close paraphrase here) “a government-granted monopoly to spur innovation.” A “government-granted monopoly” is, of course, precisely what the original and most extreme forms of protectionism were: “letters patent” granted a company exclusive right to trade or manufacture in a given sector. And they too were justified in terms of rule-setting and innovation.

And correctly so: Britain was a leading early industrial economy before it adopted free-trade in the mid-19th century. The contrast between Britain and, say, Portugal is striking. Did it matter if Britain specialized in wool and Portugal in wine? Did the logic of comparative advantage mean that Portugal was wise to stick with the low-tech business of winemaking, while Britain pursued the (as of the late 18th-century) comparatively high-tech woolen trade? (It was high-tech because of the manufacturing involved in processing wool, as well as the manufacturing necessary to make the components for the wool-related machinery.)

Like the United States, Germany, and Japan in the centuries that followed, Britain began its climb to economic eminence by actively pursuing industrial development and reaped vast rewards for doing so. And no, the fact that Japan’s economy has cooled off in the last 20 years does not negate the Japanese achievement of the preceding four decades—Japan is still the number 3 economy in the world, behind only the much larger states of the U.S. and China. And China has surpassed Japan only recently, and only by using much the same strategies that Japan had used to become an industrial superpower.

Comparative advantage is yet another reductive philosophical construct with little real-world application. Just consider what comparative advantage would mean at the individual level: if Joe is a computer programmer and Jack is a janitor, comparative advantage would say that Joe should spend all his time programming, and Jack should spend all his time taking out Joe’s trash. If Jack started to learn programming, he would initially be much worse at it than Joe, and Joe would be wasting time by taking out his own trash. Oh, the inefficiency! But such short-term inefficiency would lead to greater long-term prosperity if Jack succeeded in becoming a capable programmer. “Comparative advantage” only applies in a world of unalterably fixed skill levels. Needless to say, that is not the world in which we live.

The world in which we live is one in which there are more people than ever before, they are richer than ever before, and there is correspondingly greater demand than ever before for consumer products. This is a momentous business opportunity, but for reasons that have nothing to do with spontaneous order, the United States is not taking full advantage of it. Favored IP and financial interests reap easier returns than does manufacturing—which to be sure is not without its own political angles. Our leaders cherish the belief that IP will keep us at the top of the chain of production and that branding is of particularly high value. More capital put into technical IP and brands is better than capital assigned to production; hence, the best returns can be realized by offshoring production as long as the IP, including the brand, is protected.

But this calculation, which is rational in the short term for companies like Apple and Disney, is wrong in the long-term: technical IP can be copied even more easily than manufacturing plants and know-how can be relocated, and the value of brands is ephemeral. In the long term, the predictable outcome is that the technical IP and brand advantage of the U.S. will erode, and after that the U.S. will be neither a “knowledge economy” nor a manufacturing superpower. It will be as if 18th-century Britain had traded its woolen industries for winemaking. We will be an economic relic.

What is true of overinvestment in IP is also true for a knowledge economy that is overinvested in banking and finance. Here the U.S. advantage might endure for a longer time, but theory and history alike caution against betting everything on the banks. The structural and cultural biases that lead to the concentration of power and wealth in finance should be counteracted, or at least blunted, by policies designed to encourage production and trade in more than just financial services.

This message is never warmly received by people who think they are smart enough to get out of a Ponzi scheme just before it collapses—because until it collapses, a Ponzi scheme offers excellent returns. I will never forget the reaction a wealthy friend of mine who invests in real estate had when I told him that a publication I edited had predicted the Great Recession back in 2003. He said he would have been a fool to curtail his investment and speculation at that time—he would have missed four more years of profiting from the bubble. That kind of thinking is irrefutable at the private level; it’s also an obvious public hazard. And again the theoretical appeal to market correction and creative destruction does not save the day: the people with the money and influence to reap the biggest rewards from a bubble also have the money and influence to get themselves a bailout when the crisis comes.

Political Realism for a Real-World Economy

Market liberals are in the same difficult position that all ideologues and idealists occupy. When the world will never produce their first-choice theoretical optimum, they must pursue a second-best option, one that will by definition not have the purity and perfection of the model that inspires the idealist in the first place. But to get the closest you can in the real world to theoretical perfection requires—it absolutely necessitates—finding that difficult, compromised, sophisticated, and subtle second-best alternative. This is a lesson that neoconservatives and noninterventionists constantly have to re-learn in foreign policy, and it’s a lesson that market liberals must take to heart in economics. The economic nationalist, by contrast, cannot afford to be an idealist or perfectionist in the first place: he is a realist or he is nothing.

With that in mind, the economic nationalist is not arguing the opposite of the market liberal’s case. Tariffs are not always superior to freer trade, and the panoply of other policies in the economic nationalist’s arsenal—from manufacturing bounties to research support and industrial banks—may be used either wisely or not. This is not different from the risk and judgment involved in IP or financial policymaking. “Cronyism” is not a danger unique to industrial policy: all of our laws are strongly influenced by those with interests at stake. And while that has inherent drawbacks, the alternative—laws conceived by ideologues without “skin in the game”—has its downsides as well, including great difficulty in securing legitimacy among the public and interested institutions.

Market liberals would do well to revisit not only Alexander Hamilton but also James Madison. The political context that has made American freedom and prosperity possible is no easy fit for the philosophizing of idealists. Adam Smith himself warned of “the man of system” who is “so enamoured with the supposed beauty of his own ideal plan of government, that he cannot suffer the smallest deviation from any part of it” and attempts “to establish it completely and in all its parts, without any regard either to the great interests, or to the strong prejudices which may oppose it.”

Reader Discussion

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on January 22, 2020 at 13:20:25 pm

"Yet market liberals have a habit of arguing from unhistorical abstractions, as if the bare bones sketch of market operations that exists in textbook theory is directly applicable to real-world practice."

I've been a market liberal for about 10 years now, having studied and published on the market and liberalism for just about as long. No one has ever denied that the textbook abstraction is just that: an abstraction. Indeed, we go to long lengths to explain exactly that (see, for example, Ronald Coase's 1960 paper "The Problem of Social Cost" or his chapter 1 of "The Firm, The Market, and The Law." See also Hayek's many writings, but most of all "The Use of Knowledge in Society.")

All textbook models are abstractions. They have to be. The real world is an incredibly complex place. But, as other market liberal Milton Freidman once said, what matters is not the realism of the model but rather its ability to make positive predictions. The simple textbook model does a very good job at predicting outcomes. Nobody thinks the model is literal. It's a tool, just like the physicist's model of gravity assuming away air resistance is a tool.

Of course social and political arrangements matter. They matter a whole lot. Adam Smith (market liberal) wrote two whole books on the matter (Theory of Moral Sentiments and The Wealth of Nations). More recently, Deidre McCloskey has a trilogy on exactly that. New Institutional School of Coase, Buchanan, Alchian, Stigler, Becker, etc etc., all emphasize the importance of social and political institutions. Indeed, one of Hayek's big arguments against the socialists during the Socialist Calculation Debate was that they ignored social and political arrangements. Bruno Leoni wrote lots on the importance of these arrangements. So has Elinor Ostrom.

I think you'll be hard-pressed to find a market liberal who acts as you describe. However, I know many folks who are illiberal who do act that way (Elizabeth Warren, for example).

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Jon Murphy
on January 22, 2020 at 13:58:23 pm

Your attempted justification of industrial policy and protectionism carried out in the name of economic nationalism fails on many fronts. But worst of all, perhaps, is your slaying of the straw man “market liberal” who supports free trade.

This “market liberal,” you tell us, argues for free trade from “unhistorical abstractions” because he naively believes that the “market exists in a social vacuum” as it is left “pristine” and undistorted by governments abroad and at home.

Yet other than Samuel Gregg – whose superb article inspired your essay, and whom you concede is aware that Beijing distorts the Chinese economy – you name not a single such “market liberal.” Not one. Where is this ignorant and foolish pedant?

The answer is nowhere. He doesn’t exist. And to prove it I’m willing to put my money where my mouth is.

Please join me in picking a panel of three judges: one chosen by you, one by me, and the third by the editor of Law & Liberty. I then challenge you to find in the works of scholars noted for strongly supporting a policy of free trade evidence of this mysterious and clueless “market liberal” about whom you write. You can submit evidence from as many works as you like – works on trade from scholars long ago such as Adam Smith, Frederic Bastiat, and William Graham Sumner, to more recent scholars such as Jagdish Bhagwati, Milton Friedman, Daniel Griswold, Daniel Ikenson, Douglas Irwin, Deirdre McCloskey, Arvind Panagariya, and Leland Yeager.

I will pay to you $100 for every passage that you find in such works, and that is agreed by two or more of the judges, to indeed reflect the belief of a serious advocate of free trade that markets exist in a social vacuum and that the case for free trade requires that markets be “pristine” and undistorted by state interference domestically and abroad.

My confidence that I’ll pay nothing is high. But if the judges do rule in your favor on any such passage, I will, after paying you, post that passage, along with its accompanying context, on my blog (Café Hayek) in order for the public to judge for itself if you truly did find evidence that your straw man is real.

Do we have a deal?

Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030

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Don Boudreaux
on January 22, 2020 at 18:07:42 pm

I'm not convinced by this article, but it's more well-written than most.

Two key flaws:
1. The notion that free market ideology fails in non-ideal conditions.
2. The notion that anti-free market policies solve the problem of bad actors.

In short, tariffs won't save LawMart.

That said, I am less critical of President Trump than many opponents of tariffs for two reasons.

1. I believe that he believes that he is using tariffs not as a permanent solution, but as a negotiating tactic. Even if this doesn't work, it's a good sign regarding his motives. But there's also a lot of evidence that the negotiating tactic WILL work, which would be even better. Far better this than a politician who hates free trade for its own sake.
2. President Trump's political rivals fail to remotely appreciate the threat to liberty posed by the Chinese government, which is disastrous in terms of human rights, economic policy, and aspirations of global domination. Failing to regard the Chinese government appropriately is a much bigger threat to liberty than a few tariffs. Given that the political alternative in the US is a party that dislikes free trade AND panders to China, it's obvious who we ought to prefer.

Argument #2 is the real pragmatic argument worth making, not "economic nationalism is good because the free market doesn't work in the real world."

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JD
on January 23, 2020 at 03:45:03 am

Ah, the old canard of "predatory pricing." this time dressed up as LawMart and MafiaMart. There are many economic papers disputing this scenario. The author should consider some real-world complexities here. Once MafiaMart has driven LawMart out of business, what is to stop NewMart from opening up and preventing MafiaMart from raising its prices to recoup its losses? Fine, MafiaMart is tough minded. It drives NewMart out of business too. Then comes NewNewMart. And so on. MafiaMart is never able to recoup its losses...making the whole scheme pointless. It is nearly impossible to charge an above-market clearing price for any extended period of time, unless competition is artificially constrained.
Ah, but what about foreign governments? There are many examples of businesses defeating unfair foreign rivals without government help. My favorite was brainstormed by the founder of Dow Chemical. He went bankrupt three times because French and British chemical makers took a loss to undercut him. His fourth time out, he got clever. He bought chemicals from his European predators via front companies at below-market prices and sold them at market prices. Eventually, the losses became too steep from the Europeans to endure and Dow became a global powerhouse. A certain GMU Econ prof, when called hoe to help the family supermarket business, did something similar when Walmart tried to sell food at below-market prices. Walmart lost.

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Richard Miniter
on January 23, 2020 at 06:53:17 am

A most thought- provoking article. Read in conjunction with Michael Lind’s book “The New Class War: Saving Democracy from the Managerial Elite” it makes this believer in the free market think twice. The three previous comments are note-worthy for their reflections that no one in the real world is a purist one way or the other. And tariffs as a short term tactic or targeted at a particular bad-acting nation are not necessarily indicative of a failure to appreciate the inherent value of the free market. Thanks for making me question my beliefs.

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Marc Myers
on January 23, 2020 at 09:47:06 am

"I believe that he believes that he is using tariffs not as a permanent solution, but as a negotiating tactic."

You need to read his thoughts on the subject going back to the 1980s. He's had backwards mercantilist fallacy dominating his thoughts on trade for as long as he's had opinions on the subject.

He honestly thinks that a trade deficit is a "loss" to the country that exhibits one! Worse, he surrounds himself with economic cranks the likes of Peter Navarro who still publicly claims that China is paying all the import taxes levied on American consumers by Trump.

That China's government is illiberal is no secret. How that illiberal government "threatens" any other country that trades with the Chinese people is a mystery as yet to be explained by warrior and "America First" groups...

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OH Anarcho-Capitalist
on January 23, 2020 at 09:49:18 am

"...it makes this believer in the free market think twice. "

Think some more. Freedom always produces better results than management by 3rd parties with no skin in the game, but a thumb on the scale...

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OH Anarcho-Capitalist
on January 23, 2020 at 13:50:08 pm

Among the justifications that Daniel McCarthy offers for protective tariffs is the claim that tariffs can be used to keep prices of goods over time lower. For example, if today’s low-priced U.S. imports bankrupt American firms, foreign firms tomorrow will gain monopoly power which they’ll then exploit to raise prices to monopolistically high levels. By preventing predatorily low prices today (the argument goes), tariffs protect us from monopolistically high prices tomorrow.

That tariffs might work in this way isn’t impossible. In this complex world of ours, almost anything is possible. But only a tiny fraction of possibilities are plausible, and an even smaller number are probable. And nothing is more improbable than governments using tariffs to keep tomorrow’s prices lower than they would otherwise be.

Economic theory reveals several reasons for the deep improbability of any such successful use of tariffs. These reasons include the fact that foreign firms aren’t a single entity: even if all American producers of, say, steel are driven out of business, there are hundreds of steel producers in dozens of different countries and, therefore, competition amongst these firms to sell their steel in America would ensure that prices here are kept at competitive levels. Importantly, this reality renders self-destructive the efforts of any government to bankrupt all American steel producers by subsidizing steel exports.

But still, Mr. McCarthy might ask, what’s the harm in allowing our government officials nevertheless to use tariffs in case they judge that today’s low prices will bring about higher prices tomorrow. The answer is that government officials are political creatures who, as such, dispense tariff protection in order to protect special-interest groups today rather than to protect the general welfare tomorrow. (For powerful evidence, I recommend to Mr. McCarthy and your readers Douglas Irwin’s definitive 2017 history of U.S. trade policy, Clashing Over Commerce.)

Mr. McCarthy rightly calls for political realism. It is, therefore, ironic that his case for protectionism rests on assumptions about trade and trade policy that are fantastically unrealistic.

Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University

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Don Boudreaux
on January 31, 2020 at 10:59:31 am

From at least 1703, the "Portuguese" wine industry was basically an English industry located in Portugal. This perhaps reduces the value of Ricardo's famous example.

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Joseph R. Stromber

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