The continuing importance of trade liberalization.

A major initiative of the Clinton administration is to promote free trade. Renewing the President's authority to negotiate trade agreements on a "fast track " basis is an important step to achieve this goal. This paper demonstrates why we need fast track authority today and what are the benefits

The Basic Goals of the Clinton administration's economic policies are simple and uncontroversial: to secure rising living standards now and in the future, and to ensure that the benefits of a rising standard of living are extended to all Americans. To attain these ends, the administration's economic agenda has been based on three key policy initiatives: deficit reduction, investing in people through education and training, and opening markets worldwide to U.S. goods and services.

This third initiative -- promoting free and fair trade -- is the focus of this paper. From his first days in office, President Clinton has advocated an outward-looking, "internationalist" trade policy. During the first four years of the Clinton administration, over 200 trade agreements were ratified and implemented, some relatively large in scope, such as NAFTA and the Uruguay Round of GATT. Others were relatively small, but all were vital to our nation's competitive future. President Clinton intends to extend and build upon this record during the administration's next four years.

FAST TRACK AUTHORITY

The single most important next step in the administration's effort to open markets abroad and expand trade is for Congress to renew the President's authority to negotiate trade agreements on a "fast track" basis. The President recently announced his intention to send to Congress legislation that would renew his fast-track authority. This so-called "fast-track authority" allows the President to negotiate trade agreements with other countries, and then requires Congress to take an "up or down" vote on the entire agreement. Congress cannot in effect reopen negotiations by adding or deleting individual provisions of a trade agreement by amendment during Congressional debate. Instead, Congress must vote on the agreement as a whole. Of course, the final decision as to whether the trade agreement in its entirety is approved or disapproved is still in the hands of Congress. Fast-track authority simply allows the President to seek approval or disapproval for the agreement as a whole.

Every President since 1974 has gotten fast-track authority from Congress. Why is it so important? The answer is that fast track lends credibility to trade negotiations. Under fast track, the parties to a trade agreement know that any provisions that are agreed upon cannot later be renegotiated individually, nor can such renegotiation be threatened.

History tells us that fast-track negotiating authority is critical. In the early 1970s, Congress failed to ratify the Kennedy Round GATT agreement in its entirety, and as a result the Europeans refused to negotiate further trade agreements with the United States. For this reason, in 1974, Congress developed and passed legislation providing the President with fast-track negotiating authority, giving the President the credibility he needs to negotiate international trade agreements.

WHY IS FAST TRACK AUTHORITY NEEDED

So, why do we need fast track authority today? And, what would the Administration use it for? The Clinton Administration would focus on three key areas for its use.

The first use for fast-track negotiating authority would be to complete the agenda that was established in the Uruguay Round of GATT negotiations. At the end of the Uruguay Round negotiations, the United States, along with other countries, pushed for a timetable at which negotiations in different areas would resume. We did that, as did Europe and other countries, because we wanted more out of the Uruguay Round than we got. This year, we begin again the negotiations on government procurement; next year, we will begin intellectual property rights discussions; then we will begin talks on agriculture; then on services. Government procurement is a trillion-dollar market for the United States in Asia alone over the next decade; agriculture, a $600-billion market globally; services, $1.2 trillion market. The United States wants better access to those markets. And, we must have fast track authority before beginning discussions in these areas; otherwise, countries will not put meaningful offers for market access on the table.

The second major use for fast-track authority is to extend the information technology agreement (ITA). The recently concluded ITA will reduce to zero tariffs on a range of information technology products: semiconductors, computers, telecommunications equipment, faxes, phones, integrated circuits -- a huge array of products in which U.S. firms tend to be highly competitive. The U.S. tariff barriers in those areas are either very low or zero. Asia's tariffs in these areas averaged 30 percent. With the ITA, the United States agreed, together with forty-three other countries, that tariffs on information technology products should be brought to zero across the board in all countries, by roughly the year 2000. We already have agreement among our trading partners for an ITA-2, which would expand the scope of the products encompassed by this extremely ambitious initiative. And, fast-track authority would be needed to expand that arrangement.

We are also considering seeking similar kinds of agreements in a number of other individual sectors where the United States is very competitive but global barriers tend to be high -- areas such as environmental equipment and services, medical equipment and technology, and transportation equipment. In all of these areas, it would be necessary to have fast track authority to negotiate a reduction of trade barriers.

Finally, the third area where fast-track will be used is for more comprehensive market access agreements with individual countries. Thus far, Chile has been identified as the first and most likely country for this kind of arrangement. Today, every major economy in this hemisphere, except the United States, has a preferential trade agreement with Chile. In practice, this means that U.S. firms face tariffs in Chile that make their goods 11 percent more expensive than those of competing firms from other countries. This is a serious competitive disadvantage.

The pace with which preferential trade agreements are being negotiated between and among countries around the world is fast. The United States could easily be left behind through inaction. Since 1992, other countries have negotiated twenty preferential trade agreements in Latin America and Asia that exclude the United States. The European Union has begun a process that will culminate in a free trade agreement with Brazil, Argentina, and other MERCOSUR nations; President Chirac of France has even gone so far as to declare that the economic interests of Latin America "lie not with the United States, but with Europe." And within South America itself, the four MERCOSUR countries are attempting to extend their preferential trade arrangements to encompass the entire continent. Moreover, other countries are aggressively pursuing expanded foreign trade. For example, China has targeted a number of Latin American countries -- including Chile, Mexico and Brazil -- for increased bilateral trade.

BENEFITS OF FREE TRADE TO THE UNITED STATES

It is clear: now, more than ever, continued engagement with the global economy will require an active effort on the part of the United States. And, an extension of fast track authority must be an integral component of this effort. But, let's go back to a fundamental and important question: why is free trade so important? Why should we be concentrating so much effort in pushing for more open foreign markets, and how does freer trade contribute to the administration's goal of securing higher living standards for all Americans? In short, what are the benefits of free trade for the U.S. economy?

One of the benefits of free trade is not, as is sometimes supposed, an improved overall current account or trade balance. The administration's policies do indeed affect the current account, but it is its budget, saving, and investment policies, not its trade liberalization policies, that do so. The current account is a macroeconomic phenomenon that reflects the gap between what we as a nation invest and what we save. The large budget deficits of the 1980s and early 1990s reduced the amount of saving that was available to cover the nation's investment in plant and equipment (investment was choked off too, but not by as much), and this shortfall had to be filled by importing goods from abroad. In an important sense, the nation was overconsuming in the 1980s, financing its consumption binge by borrowing output from foreigners. The result was a large and persistent trade deficit,

Today, we still face a trade deficit, but for a very different reason. Reducing the government's budget deficit has left more room for investment in plant and equipment by the private sector. And invest it has: since 1993, real business fixed investment has grown nearly 9 percent per year on average, a much faster rate than that of the preceding ten years. This rate of investment is above the rate at which Americans save, even with the federal government dissaving less by virtue of its smaller budget deficit. So, once again the shortfall is made up for by borrowing output from abroad, with the result being a current account deficit. But there is a big difference between borrowing in order to invest, as the economy is doing now, and borrowing in order to consume, as we did in the 1980s. In fact, running a trade deficit in order to expand the nation's productive capacity is not new to American history. In the 1800s, we did much the same thing in order to build up the nation's infrastructure, most notably during the railroad construction boom a century ago.

So, it is not the gap between imports and exports that is relevant as far as trade policy is concerned. But the level of trade -- the "openness" of the U.S. economy -- does matter. In recent years, the United States has seen rapid growth in its degree of exposure to the world economy: real U.S. imports of goods and services grew at an average rate of 11 percent during the past four years, while real exports grew at an average rate of 10 percent per year. In the current recovery, export growth has been responsible for roughly a third of overall GDP growth. The United States now exports an amount equal to 13 percent of its GDP every year and imports an amount equal to 15 percent of GDP; to put these figures in perspective, the corresponding figures for the 1960s were 4 and 5 percent, respectively. The American economy is now more open than at any time in its history.

BENEFITS OF AN OPEN ECONOMY

What are the benefits of an open economy? Economists generally recognize two broad classes of benefits, the first being static, the second dynamic.

Static Benefits

Ever since the work of Adam Smith and David Ricardo, economists have recognized that trade helps an economy by allowing it to specialize in what it does best. Adam Smith argued that specialization -- the division of labor -- enhances productivity, but noted that the degree to which an individual or a nation could specialize depended critically on the extent of its market. We all know the story of Robinson Crusoe, who, alone and isolated, had to do everything for himself: farm, weave cloth, build shelter, and so on. But if a group of Robinson Crusoes can trade amongst themselves, each can specialize in the production of what he or she is best at doing, thus producing more than would be possible were their attentions divided among goods that they are less skilled at making. Then they each can trade with his or her neighbors for the goods that they in turn are good at producing.

It might even be the case that one individual (or country, to drop the Robinson Crusoe analogy) is better than anyone else at producing every good. Such an argument is often invoked in order to "prove" that the United States cannot benefit from trade with a country such as Mexico. But it turns out that the argument in favor of free trade still carries the day. All that is required is for a country to be relatively less skilled than another in the production of some good in order for it to benefit from trade. This is, of course, the doctrine of comparative advantage -- the fundamental (if perhaps counterintuitive) principle that underlies the theory of international trade.

This, in a nutshell, is the "classical" view of the benefits of free trade. It is important to note that the benefits from trade under the classical doctrine are primarily static in nature, i.e., they affect the level of output. Moving from a situation in which there is less trade (or no trade) to one in which trade is freer raises output, but this is more along the lines of a one-time increase (even though it might take a number of years for the benefits from trade to be fully felt). This is not to dismiss the significance of these static benefits: for example, some economic historians have argued that most of the economic growth that occurred in the classical world was rooted in the expansion of markets that took place as a result of increased sea trade around the Mediterranean.

Dynamic Benefits

Recently, a new view of international trade has emerged, which argues that increased trade actually raises an economy's rate of growth. If this is in fact true, it makes the case for trade liberalization an even more compelling one. Raising the growth rate of the nation's economy, even by a few tenths of a percentage point per year, has vastly more significance for long-run living standards than even a relatively large one-off increase in the level of output. The reason, of course, is that a small increase in the economy's rate of growth cumulates over time to yield large gains.

What is the rationale behind the new trade theory, i.e., what is the source of the "dynamic" benefits from trade? Well, we know that economic growth has two sources: either we can increase the amount of inputs (capital, labor, and raw materials) that we feed into the productive process, or we can make those inputs more productive, through innovations in technology, better education and training, and so on. (In fact, this latter factor is necessary if the economy is to grow in per-capita terms in the long run, as sooner or later simply accumulating more inputs will run up against the law of diminishing returns.) The static benefits of trade represent a one-off increase in this latter factor: specialization lets us allocate labor and capital to the production of goods that we are relatively good at producing, making a given amount of labor and capital more productive in a manner that is not unlike an improvement in managerial technique.

The new view of international trade also focuses on this second factor, but argues that international trade can actually increase the rate of innovation and technological change. One economist has summarized the argument with the following catena:

- International trade leads to greater competition;

- Competition induces greater innovation; and,

- Innovation (i.e., technological change) drives economic growth.

(It's a simple notion once you think about it, although it will probably win the economists who thought it out a Nobel prize some day.)

In a sense, the emphasis of the new trade theory on the dynamic benefits of international trade comes full circle to Adam Smith. Although Smith's contribution to trade theory is generally seen as providing an argument in favor of free trade that highlighted the role of specialization in raising productivity, he also pointed out that specialization, by acquainting workers with a specific productive process, could give them insight into how such processes might be improved, thus fostering innovation. New trade theory also incorporates elements of Joseph Schumpeter's theory of "creative destruction," in which the competition that is a fundamental feature of a capitalist economy serves as a motive force for the economy's progress.

The new view of international trade represents a valuable contribution to academic economics, But theory alone cannot provide an airtight argument in favor of trade liberalization. There is, however, a large body of empirical literature that attempts to determine what drives economic growth across countries. Unsurprisingly, investment in physical capital -- plant and equipment -- and investment in human capital -- education, for instance -- are two factors that have a profound influence on economic growth. But these same studies also found that an economy's degree of openness (as proxied, say, by the amount that it imports and exports relative to its overall output) has an effect on its rate of growth.

CONCLUSION

In an ideal world -- the world in which economists live -- free trade unambiguously benefits the economy taken as a whole. This is true in the real world as well, although the ideal case masks the fact that some will gain from freer trade, but others may lose, even though on net the winners could compensate the losers and still have something left over. In practice, increased globalization will induce reallocations of labor and capital across sectors as the focus of American industry moves to the production of those goods and services that we are relatively good at producing. Because our economy is not frictionless, these adjustments sometimes involve lengthy periods of dislocation until the reallocation of labor and capital across industries is complete.

Policymakers advocating freer trade must be aware of this fact, and the Clinton Administration has realized from the beginning that it is the government's duty to minimize the impact of this dislocation by speeding up the adjustment process however it can. For example, one of the key provisions of NAFTA involved monitoring those industries that were in danger of being adversely affected by the free trade agreement, and the Administration committed itself early on to providing for dislocated workers through retraining programs. And, more generally, the Administration's commitment to investing in people through education and training serves as a strong complement to its policy of trade liberalization; because freer trade tends to benefit skilled workers most, the United States enjoys greater benefits from trade to the extent that more of its workers are highly skilled. In the end, though, those who would point to the short-term adverse effects of trade liberalization should not lose sight of an important point: Trade liberalization might adversely affect a small fraction of American workers in their role as producers, but it benefits all workers in their role as consumers.

The bottom line is that the benefits of increased openness and increased international trade are wide ranging: more efficient utilization of resources, faster productivity growth, higher quality goods, and lower prices, all of which raise living standards.

Finally, I have said nothing of the benefits of trade that arise simply from the fact that it links the economic interests of nations more closely. John Maynard Keynes once argued that the greatest tragedy visited upon Europe by the First World War was the disruption of the system of international trade that was a hallmark of the European economy before 1914. The eventual breakdown in the world trading system and resulting deterioration of Europe's economy was a proximate cause of the Second World War, and kept living standards in Europe and the United States much lower for much longer than was necessary by prolonging the Great Depression. It is only in recent years that the scope of international trade has returned to the level seen before the First World War.

The United States is now more closely tied to the rest of the world by trade than at any other time in its history. How the U.S. economy performs relative to the economies of other nations will depend critically on how we promote our commercial interests abroad. Aggressive pursuit of trade liberalization, for which fast track authority is a prerequisite, is the best way to ensure that the United States maintains its position as the strongest and most innovative economy in the world.

Janet L. Yellen is Chair, Council of Economic Advisers, Washington, DC. This paper was given at the 39th Annual Meeting of NABE, New Orleans, LA, September 14-17, 1997.