Milton Friedman, Nobel Prize Winning Economist
April 27, 1978
Free Trade: Producer Versus Consumer
Thank you, President Acker and all of you on the platform. I observe from the tie which Dr. Flinchbaugh wears, and from several other things around here, that if I am going to be in Kansas State tradition, I must speak purple prose. I shall try to do so without offending you.
There's a standard cliche, which I am sure you have all heard, that if you have two economists in one room you are bound to have at least three opinions.
The subject I am going to talk about today, however, is one subject with respect to which that is not true. With respect to the area of international trade, with respect to the question whether it is desirable for a country to have free trade or to have tariffs and other restrictions on imports and exports, in that particular area economists have spoken with almost one voice for some two-hundred years. Ever since the father of modern economics, Adam Smith, published his great book, The Wealth of Nations, in 1776, the same year in which the Declaration of Independence was issued in this country; ever since then the economics profession has been almost unanimous on the subject of the desirability of free trade. Of course, complete unanimity is hardly ever possible, and every once in a while there have been some deviations from the straight and narrow path. Almost always those deviations have reflected not a disagreement with the fundamental message of Adam Smith, not a disagreement that in the good world free trade would be the best of all possible courses, but they have tended to reflect special circumstances of the time.
Perhaps the most famous such deviation was by the most noted and some would say notorious of modern economists, John Maynard Keynes, the English economist who gave his name to the Keynesian Revolution. In 1931 in the course of the depression, John Maynard Keynes, who had been a free trader all his life, came out in some articles in Britain in favor of departing from free trade and of introducing tariffs. He did so not because he thought that was in and of itself the best policy, but because he thought that the best policy was politically infeasible. In his view, the right policy for Britain at that time was to go off the gold standard, end a fixed exchange rate, allow the pound sterling to be a free market currency whose price would be determined in the market, as it now is, of course, in a world of floating exchange rates today. But Keynes, an economist, made the political judgment that it was not politically feasible for Britain to go off the gold standard. Tariffs can be an alternative to devaluation. If on the one hand the price of the pound sterling was changed from the four dollars and eighty some cents, which then was its price, to let's say four dollars, that would make British goods cheaper to foreigners; it would make foreign goods more expensive to British residents. In that way, it would redress the problem of the balance of payments they were facing. That's one way to do it and the best way. But Keynes thought that was politically infeasible and it comes to the same thing, to introduce a tariff on imports and a subsidy to exports. That's an indirect and concealed form of devaluation. And so Keynes came out for that concealed form.
His political judgment was like that of many economists, flawed. About three weeks after he came out for a tariff on these grounds, Britain went off the gold standard. I may say that this is not an isolated story. Time and again, economists, in my opinion, have erred when they have proposed second best solutions in the area where they are experts, namely economics, because of predictions they make about political feasibility in an area where they are not experts. At any rate, Keynes had a very flexible mind and one week after Britain went off the gold standard he retracted his support for tariffs. He published an article saying, now that we have gone off the gold standard, there's no longer any point to tariffs; I return to my free trade principles.
Later when he reprinted that retraction in a book of essays, he appended a footnote, which is a very revealing footnote because it shows how much damage can be done by the tendency for people to preach second best solutions. He said in his footnote, "Not all my free trade friends proved to be as prejudiced as I had thought, for after a tariff was no longer necessary, many of them were found voting for it." In other words, it's often easier to turn people in the wrong direction than it is to reverse that and get them back on the right line.
It's often argued that the reason we have bad economic policy is because the experts disagree; that, if only the experts would agree, if only all economists were of the same mind, we would have an excellent and fine economic policy. The case of free trade and the tariff is a clear counter example. Here is one case where economists have all agreed, or essentially so. As I say, you have the very minor deviations like Keynes, but very few others. Yet, except for the case of Great Britain from the repeal of the Corn Laws in 1846 to the First World War when, for nearly a century, Britain had complete free trade with no tariffs whatsoever on anything, tariffs have been widespread. The United States had tariffs throughout the nineteenth century. One of these measures, the infamous Smoot-Hawley Tariff Bill of 1930 which raised tariffs sharply, has been given some of the responsibility for the subsequent difficulties in the United States and the world.
Today, we have a widespread move for protection: pressures from the steel industry, I am sorry to say successful, to have the government take measures to restrict the imports of steel; so-called voluntary agreements to restrict the imports of TV sets from Japan, and of textiles from Hong Kong, Korea, and I know not where else; and of shoes from Italy. We have a growing pressure for quotas on imports of oil and of other products. We have widespread concern that somehow or other a weakening dollar, the decline in the price of the dollar in terms of the mark or in terms of the Swiss franc or the yen, that a weakening dollar in that respect, requires the government to impose restrictions on imports or to subsidize exports.
The interesting question, and the question I want to explore with you today, is why is it that interference with international trade has been so widespread, despite the almost uniform condemnation of such measures by economists? Why is it that you have the professional agreement on the one side, and observe practice on the other which departs so sharply from that agreement? The political reason is fairly straightforward. The political reason is that the interests that press for protection are concentrated. The people who are harmed by protection are spread and diffused. Indeed the very language shows the political pressure. We call a tariff a protective measure. It does protect; it protects the consumer very well against one thing. It protects the consumer against low prices. And yet we call it protection.
Each of us tends to produce a single product. We tend to buy a thousand and one products. If we impose a tariff on steel, or restrict imports of steel in other ways, the people who benefit are visible and clear and available and apparent. They have a very strong interest to press for restraints in that respect. The interests of the rest of us are very diffuse. Each of us will pay a few pennies more. We don't have the same interest to oppose it.
Let me take a much more extreme case that you may think does not come under the heading of protection but yet it does. We have a program of subsidizing the merchant marine, the maritime industry. That is really protection because what' we are doing is taking measures to prevent the use of foreign ships, that is, of importing the services for transporting goods. Those measures to benefit the merchant marine through ship building subsidies, through operating subsidies and so on, involve a total expenditure each year of roughly $600 million. That amounts to about $15,000 per year for each of the 40,000 people who are affected. You may be sure that they have every incentive to spend a lot of money on lobbying, on giving contributions to political candidates, and so on to see that continued. But $600 million with a population of two-hundred million people, that's three dollars apiece for each of us. Which one of us is going to go to Washington and lobby our congressman to avoid that extra three dollars of taxes?
While, on a superficial level, it's very easy to see why we have had tariffs and other restrictive measures such as the maritime subsidies, such as the recent import quotas, because producer interest is concentrated and consumer interest is diffused, that alone is not really a fully satisfactory answer. Let me take another example of exactly the same thing. Why have we had price supports of farm products to take up a subject of special interest here where there are special interests? (We're all of us special interests; it's only the other fellow who's a special interest.) Why have we had farm price supports? You will find it very hard to find any economists who will support farm price supports. This is another case in which the consumer is simply being protected against low prices. Why do we have them? Because the agricultural interest has been concentrated and the consumer interest diffused and widespread. Because you have a relatively small group of people who regard themselves as having much at stake and therefore they are able to be more effective politically than the diffused consumer interest.
We often think that this is a country in which we have a majority rule. That's true, it is a democracy. We do elect people to Congress. We do have majority rule. But it is a very special kind of majority. It's a majority that is formed by a coalition of minorities. If you want to get elected to Congress the way to do it is to find 3 percent of the people who will say to you, "If you vote for this, we'll vote for you whatever else you do." Then you find another 3 percent and another 3 percent, and you build up a 51 percent majority consisting of a coalition of special interests. And yet, that overstates the case. Because it's also true that special concentrated groups of that kind have never been able to get their way unless they could make a plausible case that it was in the general interest of the country as a whole to promote their special interest. The maritime interest could not have gotten their way unless they had been able to persuade at least a large fraction of the public that there was a genuine national security reason for maintaining a merchant marine. The agricultural interest, the farm price support proponents could never have gotten their way unless they had been able to establish a case that appeared plausible to a large fraction of the people that there was a national interest in preserving family farms or in some other aspect of agriculture.
So if we go below this superficial level to a deeper level, the question is, why is it that the economists have not been able to persuade the public of the virtues of free trade policy? After all, the argument for free trade is basically a very simple argument. Let me give you the argument which Adam Smith made two-hundred years ago. It's as persuasive now as it was then. And I quote, "In every country it always is and must be in the interest of the great body of the people to buy whatever they want of those who sell it cheapest. The proposition is so very manifest that it seems ridiculous to take any pains to prove it. Nor could it ever have been called in question had not the interested sophistry of merchants and manufacturers confounded the common sense of mankind. Their interest is in this respect, directly opposed to that of the great body of the people." That was the argument as he put it two-hundred years ago. And there is very little that needs to be added to it.
The basic reason I believe why economists have not been able to persuade the public is the one that I have already alluded to. It is suggested by the title of a famous essay which was written many years ago by a great economist, Wesley Mitchell. The title of his essay was "The Backward Art of Spending Money." And he asked, "Why is it that we are all of us so sophisticated about the activities in which we earn our living and tend to be so unsophisticated and backwards in the ways in which we spend our money?" And his answer was the one I have already mentioned: that each of us tends to be involved generally in only one kind of productive activity. We spend our working life, forty hours a week or sixty hours a week, whatever it may be, as a worker producing a product, as a merchant distributing a good, as a professor, well, forty hours a week teaching is a little long, but we're supposed to be putting in that much time on related ancillary activities and most of us do. On the other hand each of us buys a thousand and one things and it's perfectly understandable therefore that we devote far more attention and far more interest to the way we get our income than to the measures that affect how we spend it.
Unfortunately, this backward art of spending money leads to erroneous views in many directions and not only in the area of the tariff and of protection. For example, public discourse tends to be carried out in terms of jobs as if a great objective was to create jobs. That's not our objective at all. There's no problem about creating jobs. You can create any number of jobs by having people dig holes and fill them up again. Do we want jobs like that? No. Jobs are a price; we have to work to live, whereas if you listen to the terminology you would think that we live to work. Some of us do. There are workaholics, as there are alcoholics, and some of us do live to work. But in the main what we want are not jobs; we want productive jobs. We want jobs which will enable us to produce the goods and services we consume at a minimum expenditure of effort. In a way, the appropriate national objective is to have the fewest possible jobs, that is to say, the least amount of work for the greatest amount of product.
In the international trade area, the language is almost always about how we must export and what's really good is an industry that produces exports. If we buy from abroad and import, that's bad. But surely that's just upside down as well. What we send abroad we can't eat, we can't wear, we can't use for our houses. The goods and services we send abroad are goods and services not available to us. On the other hand, the goods and services we import provide us with TV sets we can watch, with automobiles we can drive, with all sorts of nice things for us to use. The gain from foreign trade is what we import. What we export is the cost of getting those imports. The proper objective for a nation, as Adam Smith put it, is to arrange things so we get as large a volume of imports as possible for as small a volume of exports as possible.
This carries over to the terminology we use. I have already referred to the misleading terminology of protection. But when people talk about a favorable balance of trade, what is that term taken to mean? It's taken to mean that we export more than we import. But from the point of view of our well-being that's an unfavorable balance. That means we are sending out more goods and getting fewer in. Each of you in your private household would know better than that. You don't regard it as a favorable balance when you have to send out more goods to get less coming in. It's favorable when you can get more by sending out less.
The tendency to concentrate on the productive side of our lives and to neglect the side of consumption is reinforced by the fact that even for the productive side of our lives the visible effects of tariffs are good, the invisible effects of tariffs are bad, even on the productive side. I have already referred to the steel case. It's perfectly clear that if you restrict the imports of steel, there are some workers in the steel industry who will have jobs they otherwise would not have. The beneficial effects for them of a tariff are perfectly clear. But if we import less steel, foreigners earn fewer dollars. They have fewer dollars to spend in this country. There are people around the country who will not have jobs, not have productive jobs because exports do not develop.
I should not have to spell this out in great detail here in Kansas. This is a great agricultural state. Agricultural products are one of our major exports. The harmful effects of restricting steel imports are to reduce jobs in agriculture. But that is invisible. The people who might have been producing goods to sell abroad don't know they might have had that job. So out of sight, out of mind. As a result, on both the side of consumption and the side of production you have the concentrated special interests versus the diffused general interests.
But then you will say to me, what's wrong with all these fine arguments I hear? What's wrong with the arguments by George Meany at the AFL-CIO convention: that the high-wage American workers are being unfairly competed against by the low-wage foreign workers; that we have to protect our American workers and their standard of living from the competition of foreigners in Japan, or Korea, or somewhere else who are willing to work for much less than the American worker? What's wrong with that argument? In the first place, what does a high wage and a low wage mean? The Japanese worker is paid in yen, the American worker is paid in dollars. How do I know how many dollars equal how many yen?
Let me go at this a little more indirectly. You can see the fallacy in this argument I think most clearly by taking an extreme case. Let's take the most extreme case of all. Let's suppose that at the existing exchange rate, whatever it is, Japan, to take the example which is a favorite "whipping boy," could undersell us in everything, that the Japanese can produce whatever you name across the board from wheat and soybeans to television sets and automobiles more cheaply than we can. And let's see what would happen. We'd rush to buy them. The Japanese sellers would be paid for them in dollars. What would they do with the dollars? Nothing for them to buy in the United States, because by assumption everything is cheaper in Japan. What then would they do with the dollars?
If they would be willing to burn them up or to bury them in the Pacific Ocean, ah, that would be wonderful. After all, there is no product we can produce more cheaply than green pieces of paper. But of course, the Japanese are not going to do that. They are not going to work and produce goods and send them over here in order to get pieces of paper which they are going to burn up. They want to get goods and services and when they discover that there are no American goods and services that are cheaper than those in Japan, they will say, "Well, gee, I had better convert these dollars back into yen." But who is going to sell them yen? Why would anybody sell them yen? Because if I have yen I can buy the Japanese goods, by assumption, more cheaply, so nobody would be willing to sell yen.
Let's suppose, to begin with, that the rate of exchange between the dollar and the yen was, as it was for a long time, 360 yen to the dollar or one dollar would buy 360 yen. Then these people who had all these dollars that were useless to them would say, "If you'll sell me some yen, I'll give you a dollar for 300 yen." "No," says the owner of the yen, "even at 300 yen to the dollar American goods are too expensive. They're not worth it." "Okay, I'll give you a dollar for 200 yen." And you can see what would happen. The price of the yen would be bid up until what? Well, the fewer yen you get for a dollar, the more expensive Japanese goods are to Americans. The more dollars you get for a yen, the cheaper American goods are to Japanese. So the effect would be that the yen would rise in price until it was no longer true that all U.S. goods were more expensive than all Japanese goods. As the yen became more expensive, Japanese goods would become more expensive to U.S. citizens in dollars and American goods would become cheaper to Japanese in yen. That would continue until on the average the dollar value of the goods that the Japanese would buy in the United States would be roughly equal to the dollar value of the goods that the U.S. would sell. At that point, the price of the yen in terms of the dollar would be at an appropriate level.
I have simplified the story because over and above these bilateral transactions between the United States and Japan, of course, these flows of trade will take roundabout directions. The Japanese will spend some of their dollars in Brazil and the Brazilians in turn will spend their dollars in the U.S. and the dollars may flow in very roundabout circles. But the principle is the same. People want dollars not in order to have pieces of paper but in order to have U.S. or other goods. And again, the actual situation is complicated by the fact that, in addition to the flows of goods and services, there are also capital flows, also investments abroad. The United States throughout the nineteenth century, throughout the period when we were building up and getting to be the economically most developed country in the world, had a balance of payments trade deficit every single year almost. Why? Because the U.S. was a country in which foreigners wanted to invest capital. The British were producing goods and sending them over to us in return for pieces of paper, not those green pieces of paper but different pieces of paper, bonds, promising to pay back a sum of money at a later time plus interest on it. The British regarded that as a good investment and they regarded it therefore worth their while to send us goods in order to get those pieces of paper.
There was nothing wrong with that. On the contrary, we benefited by having foreign investment here that enabled us to develop more rapidly and the British benefited by getting a higher yield on their savings than they could have gotten any other way. In the twentieth century that was reversed. We had what was called a favorable balance of trade because the U.S. citizens were finding that they could get a higher return for their money by investing abroad than they could at home, and as a result we were sending goods abroad in return for those pieces of paper.
Again, in the post-World War II world under American foreign aid and Marshall Plan programs we were making gifts abroad. We were sending goods and services abroad as an expression of our belief that that was a contribution to a peaceful world.
So the situation is more complicated, but the fundamental point is the same. So long as you have a free exchange rate which is free to determine in the market the price of the dollar in terms of the yen, there is no balance of payments problem. There is no sense in which American industry is in danger of being undercut by foreign industries and destroyed.
Let me put the matter to you a little differently. Suppose on the average an American worker is roughly twice as productive as the average Japanese worker. That's roughly what the situation is. On the average the American worker takes home from his work as pay for his activities a sum of money which will buy about twice as large a basket of goods as his Japanese counterpart can buy. If that's the case, we cannot afford well that's a little exaggeration, we should not afford we should not use any American worker in an activity in which he is less than twice as efficient. This is what was dubbed 150 years ago, in the jargon of economics, the principle of comparative advantage. We may be more efficient in everything than the Japanese. That doesn't mean it pays us to produce everything at home. We should concentrate our efforts on those activities in which we are the most efficient.
Let me put it to you in a simple way. In a domestic illustration, I have a lawyer who is a very good typist. Does that mean he should dispense with his secretary and type his own letters? He may be a better typist than his secretary but if he's only one and one-half times as good a typist but five times as good a lawyer, both he and his secretary are better off if he concentrates on doing the law and she concentrates on typing the letters, or in this day and age I should say she concentrates on doing the law and he concentrates on typing the letters. (As it happens, I have a daughter who is an attorney, so that's personal as well as general.)
In the light of all this analysis, let us consider some current issues. Take the case of steel. What about the argument of steel that we need a steel industry for our national defense? You know there was a famous statement by, I think it was Emerson, that patriotism is the last resort of the scoundrel. I don't want to call the steel people scoundrels, they're not. They're perfectly decent human beings. They're like you and me and like you and me they know very well that what's good for them is good for the country. We are all sincere about that. The greatest human capacity we have is not to reason but to rationalize.
But what of the validity of that argument? Well, there are two things to be said about it. First, if we had complete free trade in steel, there is not the slightest chance in the world that the U.S. steel industry would disappear. The advantages of being close to sources of supply, to sources of fuel, and to the market would certainly guarantee that we would have a very large steel industry. It might be that foreign imports would amount to 15, 20, 30 percent of the total. But so far as our national defense needs are concerned, insofar as we cannot satisfy them by importing steel from abroad, we would always have a domestic steel industry. Second, ask a steel man whether before he builds a factory he gets estimates of the cost of building it. He'll look at you as if you're mad and say, "Of course, of course I get estimates." And I will say to him, well now tell me do you get estimates of building it just one way? "Oh no, we get estimates of building it in a variety of alternative ways and then pick the best." And my standard answer to the steel man who gives the national defense argument is to say that when the steel industry presents to this country cost estimates of alternative ways of providing for our national security I will believe that its argument is sincere and not simply an excuse for self-interest.
Because there are many ways. You can stockpile steel. It's the easiest thing in the world to stockpile. Some of it may rust but that's not a very serious problem. Aside from stockpiling it, you can maintain some steel plants in mothballs the way we maintain ships in mothballs, and so on. There are lots of alternatives. Have you ever seen a cost estimate by the steel industry of how much it would cost to protect our national security one way or the other?
The same thing has been true over the years of the continuous argument by the oil interests that we ought to have, at one point, an oil import quota, or percentage depletion, or all sorts of other things on national security grounds. I believe that is an excuse and not a reason.
What about the argument of unfair competition? What about the argument that the Japanese dump their goods below cost? As a consumer, all I can say is the more dumping the better. If the Japanese government is so ill-advised as to tax its taxpayers in order to send to us, at below cost, TV sets and other things, why should we as a nation refuse reverse foreign aid?
What about the problem of the price of the U.S. dollar, the weakening of the dollar abroad? It is an artificial problem to which we should pay no attention. The market will set a price, let it. So far as we as a nation are concerned, the important thing is to get our internal house in order. If we followed policies at home which would eliminate inflation, and provide the basis for sound and healthy economic growth, the price of the dollar in foreign exchange markets would take care of itself. If we follow policies as we have been that produce a steadily rising inflation, or unsteadily rising inflation, I should say, ups and downs, well then, of course, the dollar is going to become worth less at home and it will be worth less abroad than it otherwise would be.
I come again to the problem of farm policy here, agricultural policy. That is an area which has been very intimately related to foreign trade. You will remember some years back when there was a great scandal about the extent to which the American taxpayers subsidized the Soviet Union by selling agricultural products at a price below the domestic price. I have already expressed the view that there is no national interest whatsoever in farm price supports or in government attempts to manipulate the price of farm products anymore than there is in government attempts to manipulate the price of steel, or of any other product. But it's much more fundamental than that. Agriculture is one of our major export industries. It is an area in which we have been incredibly efficient, in which we can produce goods and out compete almost everybody in the rest of the world. There is nothing that would be in the greater self-interest of the agricultural producer than for the U.S. to have complete free trade. That would generate a greater supply of dollars abroad to produce a better market for U.S. products.
I submit to you that the movement toward having farm price supports is a very shortsighted movement. What will be its results? It can only have the effect of either destroying export markets or requiring the government once again to subsidize exports. If we have a high artificial price at home, which is above the world price, nobody in the world is going to buy American products unless somebody or other sells these to them at the world price. Hence, a system of artificially high domestic agricultural prices necessarily requires a system of government subsidies for the export of wheat abroad.
I submit to you that that's not in the interest of the American consumer, it's not in the interest of the American taxpayer, and in the longer run it is not in the interest of the American farmer.
What do we do from here? What's the answer? Suppose we could be as successful as the British were in the 1820's and 1830's and get a national crusade going to move toward free trade. What should we do? Many people say that what we should do is to try to engage in reciprocal tariff reductions. True enough, they will say, our tariffs hurt us. But look at what those foreign countries are doing. Japan has tariffs on imports. How can we compete without tariffs, while they restrict trade with tariffs? The answer to that is very straightforward. The Japanese, by imposing tariffs and other restraints on their international trade, hurt themselves; but they also hurt us. No doubt they diminish the efficiency of the international division of labor, they hurt us and themselves. But if we impose tariffs in return we only hurt them and ourselves still further.
It's hard for me to see any justification in harming ourselves in order to harm somebody else. That's not a very sensible policy. Moreover it doesn't work. We have been trying for many years to engage in reciprocal tariff reductions. Every now and then one comes through. But on the whole, it has been a very unsuccessful policy.
I believe that the right policy for us would be to act like the great nation we are, to say we are not going to determine what we do on the basis of what Hong Kong and Korea and Japan do. We are a great nation and we are unilaterally and on our own going to move to remove every barrier to international trade. We are not going to do it overnight. People have made plans on the basis of existing tariffs. Let's take a five-year period, or a ten-year period, that's less important. But let's each year reduce by one-fifth every tariff barrier, eliminate every subsidy to exports by one-fifth, and over a five-year period get to a period at which we have no tariffs and no subsidies to exports. We should do that and we should also completely stay out of the market of foreign exchange. Your government on your behalf has been speculating in the foreign exchange markets for the past seven years and has cost you, up until last year and not counting the speculation of this year, $550 million of losses on those transactions. Money down the drain. Let's stop that.
What is the chance that we shall follow these measures? Candidly, I think the chance is zero and yet hope springs eternal. If we know the ultimate direction we want to go in, then that will improve the chances that the separate steps we take will move in that direction rather than away from it. Moreover I go back to my mentor, Adam Smith. In 1776 when he wrote his great book, The Wealth of Nations, he wrote and I quote, "To expect, indeed, that the freedom of trade should ever be entirely restored in Great Britain, is as absurd as to expect that an Oceania or Utopia should ever be established in it. Not only the prejudices of the public, but what is even more unconquerable, the private interests of many individuals, irresistibly oppose it."
He wrote that in 1776, yet seventy years later Britain had complete free trade. What he had said was impossible and absurd had been accomplished. One of the few places in which he was wrong. That move toward complete free trade ushered in the great period of Britain's prosperity and glory. And ever since Britain has departed from free trade she has been declining in prosperity and glory. I don't mean to say that that is the only source of her decline; it certainly is not. But it is not an unimportant source.
In the same way, the U.S. has been a great nation and we have prospered despite the tariffs and despite the restrictions on trade. But we could set a great example to the world and benefit the world as a whole, contribute not only to prosperity but to peace around the world, by moving in the direction of free trade. Because once again, go back to the British experience, the century of free trade was also the century of the greatest international peace. Why? Because if you eliminate government from these matters you enable individuals to deal with one another. If you introduce protection, tariffs, restrictions on trade, they become matters for government-to-government wrangling and they are an enormous source of division. So in the name of both prosperity and world peace there are few steps that we could take which would contribute more than a complete move toward free trade. Thank you.