It’s Monday, and this week prudentbear.com ran the Hutchinson take on property rights and the brief and likely fatal joys of outsourcing.  The bearish nature of this message runs with the dissident grain and is a clever man’s way of introducing reasonable doubt into the conventional-thinking, mainstream mind.

GW

In a world in which information is an increasingly important commodity and intellect is the principal means of producing such information, David Ricardo’s 1817 Doctrine of Comparative Advantage may no longer be valid.  However the theory that free trade enriches all participants, central to modern globalization, depends crucially on Ricardo, with protectionists being denounced (sometimes correctly) by professional economists as economic illiterates.  What then is an economically literate framework for trade in a post-Ricardo world?

In his 1990 paper “Endogenous Technological Change” economist Paul Romer showed that economic growth is caused primarily by the spread and interaction of information, some but not all of which is “excludable” in that others can be prevented from using it once it’s created.  As an instance of information-driven technological change, he instanced Francis Cabot Lowell’s 1811 industrial espionage on British power looms, through which he created the U.S. textile industry.

From the Lowell example, it is immediately clear where the Doctrine of Comparative Advantage falls down.  Under the Doctrine, if the United States is able to produce textiles more cheaply than Britain because of its more advantageous factor costs, then the U.S. should specialize in textiles and Britain in other goods and this will be advantageous for both sides. However Lowell’s industrial espionage demonstrated a flaw in this argument: if British technological superiority consists of knowledge of how to run a textile mill, and can be suborned by an American spy, then the transfer of textile manufacture to the United States was disadvantageous to Britain. It produced new competition which drove down prices, removed the U.S. market (Lowell was instrumental in getting an 85% tariff enacted against imports of British textiles in 1816) and was highly damaging to British living standards.  By the process of technological piracy, the factors of comparative advantage were changed in the U.S. favor, with no compensating advantage to Britain.

The British government of 1810, economically highly literate, understood this well, and had legislation making it illegal to steal or even export British trade secrets. (This had been introduced following the case of Samuel Slater, a supervisor in Jedediah Strutt’s mill who had emigrated to the United States in 1789 with valuable spinning technology.)  Lowell, had he been caught, would have been hanged – you could be hanged at that time for stealing property of five shillings in value, and the secret of mechanized textile manufacture was clearly worth a lot more than five shillings.  Only later did Britain slip to a policy of wishy-washy unilateral free trade and lose its industrial dominance.

For the 19th and most of the 20th Century, the intellectual property exception to the Doctrine didn’t much matter. Most internationally traded goods were things you could drop on your foot.  Intellectual property could mostly be protected with patents, and when it couldn’t, it often formed only a small part of the value chain, so that mass production, mass marketing and distribution were also necessary to succeed.  A Lowell who in 1912 had stolen the secret of the self starter from General Motors’ Charles Kettering would have found himself owning the plans to a sub-assembly in a complex piece of equipment and needing to put together a large plant and sales force, with a market largely limited to GM and its immediate competitors. Thus if GM outsourced self-starter assembly to Mexico it knew what it was outsourcing; there was no chance that Mexico would swarm up the value chain and start manufacturing completed Buicks.

The modern economy is much more subject to intellectual piracy and outsourcee reverse-engineering.  If you outsource software to India, Indian software engineers acquire technical capabilities that enable them to manufacture software of the same or better functionality.  If you outsource chip design to China, Chinese chip designers acquire design skills that they can sell to your Chinese competitors.  In principle, services such as tourism, construction and personal services that can only be provided on-site are relatively invulnerable, but the advent of cheap travel and overwhelmed immigration bureaucracies have rendered even these services vulnerable to price competition driven by cheap labor.

Given that most intellectual property is portable and non-excludible, if the world economy is to consist largely of intellectual property, with physical goods being manufactured by robots and their design being far more important in their cost than human direct labor, then the world trading system is in deep trouble. Companies in rich countries that outsource intellectual property production to cheaper labor environments will soon find their trade secrets no longer secret and their outsourcees competing with them with an unbeatable wage cost advantage. 

U.S. and European top management that enters into outsourcing without proper thought, in the hope of boosting short term earnings, will find itself out of a job. Indian top management, like Indian labor, is much cheaper than its U.S. counterpart and pretty well as good – indeed U.S. bosses are today so overpaid that the cost differential is even greater at the top of the pyramid than at the bottom. The U.S. tycoons’ redundancies (with lavish retirement packages that are worth a lot less when their companies disappear) will seem poetic justice, but will be of little consolation to their former skilled U.S. workers and middle management, who will be greeting customers at WalMart.

From the point of view of a Third World country with a surplus of barely-employed labor and a deep hunger to enjoy the fruits of affluence, a world in which their citizens can enrich themselves from the intellectual capital of the West and thereby achieve Chinese or even Indian growth rates is very attractive. There are however two problems. 

First, very rapid change is itself disruptive and does not affect all citizens equally. Thus a country may find itself with deep chasms between rich and poor, or between urban and rural citizens.  It is clear from Latin American and South African experience that a country with such deep chasms does not become wealthy.  Either the wealth remains concentrated in a tiny urban elite, and does not spread to the populace as a whole or, worse still, the electoral process (if the country is a democracy) throws up a series of governments hostile to business, who govern so corruptly and ineptly that economic growth goes into reverse. The democracies of Latin America, relatively well off in 1960, should today be much richer than the autocracies of East Asia; they’re not.

Second, the rapid industrialization of India and China, and the changes in consumption patterns that accompany industrialization, have put great strain on the world’s commodities markets and may also place great strain on the planet’s ecology as a whole.  Severe shortages of necessary commodities or a collapse in the world’s ecosystem would impose enormous costs on everybody, including poor countries.

In the pessimistic view of an information-ruled world, since both the world’s population and its growth are concentrated among the poor, as knowledge disseminates worldwide Western living standards will be averaged sharply downwards, particularly among the less intellectually gifted. Even if everybody in the West were to get degrees, the academic learning ability of the bottom half of the population is such that those degrees would add little value to a high school education.

There is however an optimistic view. If the benefits of higher education are spread to a greater proportion of the world, without a “dumbing down” in quality such as would accompany increasing university education in the West, then as Romer showed the creative fires of more people will be available for improving the world’s economic performance, and growth rates overall will increase. The problem with this is that there appear to be diminishing returns. Shakespeare and Newton appeared within a century, in a society of less than 5 million population; logically therefore the world should now see over 1,000 equals of Shakespeare and Newton, which it clearly doesn’t.

It’s clear what an optimal trading system for the new age would look like.  It would pour resources into Third World education, while minimizing the disruption from outsourcing and international migration. It would have very tight controls on immigration to the West, both at the low skill level (which impoverishes the unskilled domestic workforce) and at the high skill level (which hollows out Third World education systems.)  On the other hand it would allow mostly free trade, with modest tariff barriers but few non-tariff barriers or subsidies. It would impose only limited protection of intellectual property (which is impossible to protect in any case without providing excessive rents to successful innovators in software and pharmaceuticals).  Much foreign aid would take the form of offering bounties to companies inventing new cures for Third World diseases, which could then be distributed at near cost, without patent protection.

Since government needs to be financed somehow, there is no reason why a tariff cannot finance it as well as an income tax or why a tariff should be more economically distorting. It should be set at a more or less uniform rate, calculated roughly at 25-30% of the normal rate of income tax, thus imposing a similar rate of tax on the value added of imports as on direct incomes.  Conversely, all bounties and subsidies, which both distort trade and cost money, should be abolished. 

A low uniform tariff in Western countries would reduce the incentive to globalize, thus reducing the rate of economic disruption, but would allow globalization in cases where the benefit was greatest. This would moderate the pace of job loss in affected industries in the west, while maximizing the economic benefits that outsourcing brought (a substantial chunk of which benefits would be reaped by taxing governments, which would tax correspondingly less in other areas.)  The current system, with a few heavily protected areas in sunset industries and free trade elsewhere, prevents globalization where it would do most good and distorts the economy as a whole.

A low tariff, no subsidy or barrier system would also have the benefit of re-focusing the Third World on agriculture, in which it has a comparative advantage, thus providing jobs for those Third Worlders unable to get a university education. If we want to run automobiles on ethanol, it should be produced from tropical sugar cane, not Iowa corn.

Finally, the inexorable increase in world population needs to be reversed, in order that a Western standard of living can in a generation or two be enjoyed by everybody. Only by drastic population reduction can the world enjoy the fruits of globalization without impoverishing the West.  At a population of 1 billion, that pertaining at the start of the Industrial Revolution, the world can provide a good life for all without significant ecological and resource damage; at a population of 6.5 billion, let alone the 10 billion forecast for 2050, if all are equal, all must be poor. Adoption of civilized Italian and Japanese fertility standards, which halve population in 50 years, must be a goal for the world as a whole. Fortunately, as affluence increases fertility is likely to decline naturally, but every effort must be made to hasten the process or there won’t in the long run be any affluence.

The belief by the U.S. and European electorates that they are not enjoying growth in living standards is correct. Rising Gross Domestic Products are going to capital, government and speculators, leaving little or no increase in affluence for the rest of us. Globalization is immensely beneficial for competently governed poor countries; it benefits the rich West only to the extent that it proceeds at a moderate pace and with appropriate safeguards for Western living standards.

The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long ‘90s boom, the proportion of “sell” recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.

Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) - details can be found here