Wharton's Mauro Guillen, HEC's Olivier Chatain and John Kirton of the G7 Research Group discuss the recent G7 summit.

Guillen bookThe acrimonious nature of the recent G7 summit did nothing to quiet fears of an impending global trade war. After leaving the forum early, U.S. President Donald Trump declined to sign on to a consensus statement that highlighted the need for “free, fair and mutually beneficial” trade and the importance of fighting protectionism.

The disputes at the G7 highlight many of the issues addressed in a new book by Wharton management professor Mauro Guillen. In this excerpt from Rude Awakening: Threats to the Global Liberal Order, Guillen discusses the controversy over free trade and its real and perceived winners and losers. He also appeared on the Knowledge at Wharton show, which airs on SiriusXM channel 111 with John Kirton, director of the G7 Research Group and Olivier Chatain, a professor at HEC business school in Paris and a senior fellow at Wharton’s Mack Institute for Innovation Management, to discuss key takeaways from the G7. (Listen to the podcast using the player at the top of this page.)

The new actors onstage — from technocrats to nationalist and populist politicians — were given to making extreme claims about the origins of the problems afflicting citizens in their countries and how to address them. Chief among these was the controversy over free trade. Not far behind was the debate over the key element in version 2.0 of the global liberal order, namely, free capital flows. Immigration and technology were also presented as culprits.

Is Free Trade Such an Evil?

Free trade is frequently mentioned as a factor in the decline of manufacturing in Europe and the United States. During the 1950s and 1960s, American and European companies and their workers enjoyed the benefits of free trade both in terms of the jobs it created through greater specialization based on exports, and lower prices for consumers. In fact, the global liberal order version 1.0, based on Keynesian policies, was specifically geared toward enhancing the benefits for the working class of the market economy and free merchandise trade. French workers, for instance, could export manufactured goods to Spain while the latter sold them oranges. Charles de Gaulle famously asserted that such trade was mutually beneficial even when Spain was under a dictatorial regime, noting that he had never heard of “a fascist orange.” American and European companies, and their workers, made a fortune manufacturing goods for each other’s markets and for the developing world.

When the tables were turned, however, and economies in Southern Europe and, especially, East Asia started to churn cheap manufactured goods and sought to sell them in the developed markets of Europe and the United states, the reaction was timid at first, but resolutely hostile later, especially after the oil crises of the 1970s. Protectionism became the norm, especially toward Japan, adopting at times euphemistic forms, including “voluntary export restraints” or enhanced bureaucratic controls at the border.

“As usual, the realities surrounding NAFTA are far more complex than the simple equation ‘NAFTA = Job Migration to Mexico’ seems to suggest.”

According to economic theory, trade benefits every-one in the long term. The trouble with free trade is that its negative effects tend to manifest themselves in highly concentrated ways, undermining specific industries and local communities. Thus, Detroit or Birmingham suffered the brunt of it.

Meanwhile, other parts of the economy and of the developed world benefited from trade. Free trade always generates winners and losers, especially in the short run. The argument for free trade is about the balance of benefits and costs for the entire economy. Politically, it is always incumbent on the government and the community to look for ways to protect those negatively affected by it, and to provide them with the means to adapt. Free trade can be especially devastating to people above the age of 50, those with nontransferable skills, and those with limited geographical mobility due to cultural barriers, dual careers, or sunk costs (such as housing). What’s unfair about free trade is that it is not uniform in its effects.

Another legitimate argument against free trade is that production in some countries is competitive because of exploitatively low wages, dangerous working conditions and lax environmental regulations. These ills are commonly referred to as “social dumping.” The concept of “fair trade” seeks to address these issues by establishing boundaries to what counts as fair competition in global markets. The use of child labor is also conducive to unfair trade as well as to abuse. International labor conventions, such as those proposed by the international labor organization, and ratified by most countries in the world, seek to address these issues. Ratification, however, does not always lead to actual observance and enforcement.

Both the supporters of the global liberal order and opponents of free trade join in condemning unfair trade, although the former offer a narrower definition of what counts as unfair than the latter. At a time when liberalism is in retreat, adopting a broad definition would not only benefit workers but also rebuild popular support for free trade. Unfortunately, governments often fail to incorporate enough safeguards in trade agreements to protect workers. Evidence of this problem are the frequent consumer boycotts of brands that involve manufacturing in countries where child labor or poor working conditions occur.

“The trouble with free trade is that its negative effects tend to manifest themselves in highly concentrated ways, undermining specific industries and local communities.”

What Counts as an American-made Product?

A key concept in the nationalist-populist critique of the global liberal order is that of the “homemade product.” Without a clear definition, the critique becomes less incisive. The problem for protectionist arguments is that there appears no such thing as a 100% homemade product. There is always a certain proportion of a product’s final value that comes from abroad because some input, part, component, or treatment has a foreign origin.

The debate over trade protectionism in the United States has frequently run into this basic definitional problem. According to a recent study by the U.S. Department of Commerce, the manufacturing industries in the United States that use the least foreign inputs to generate their output are computers and electronics (12% foreign inputs), apparel (13%), wood (13%), food and beverages (14%), and chemicals (14%). By contrast, some industries need larger proportions of imported inputs, including automobiles (29%) and primary metals (25%).

The case of automobiles is especially important because of its impact on the economy and the frequency with which it gets discussed in the media and turned into an issue by politicians. According to the Made in America auto index calculated by the Kogod School of Business at American University, the models with the highest total domestic (i.e., American) content are the Chevrolet Traverse, the Buick Enclave, and the GMC Acadia, with 85.5%. Some foreign-branded cars have proportions as high as 78.5%, including the Honda CR-V, Ridgeline, and Pilot, and the Acura RDX, the Kia Optima, and the Toyota Camry. This means that even the most “American” automobiles have significant proportions of their value added through imported parts and components, something that would be expected from the international division of labor.

One might argue that the U.S. economy is better off if more consumers purchase goods with a greater proportion of Made in America value, but it is clear that at least some American workers benefit from the purchases of goods with a lower proportion. Thus, it is always the case that if a consumer switches from one product to another, there will be some American firms and workers that benefit while others do not. If Toyota sells more cars in the U.S. market, that will benefit workers in Tennessee, where some of their models are assembled. If BMW’s sales increase, employment in South Carolina may increase. Or if Ford’s sales go up, Michigan workers might benefit. Given how complex the U.S. and global economies have become, there are always winners and losers.

“At a time when liberalism is in retreat, adopting a broad definition would not only benefit workers but also rebuild popular support for free trade.”

Has NAFTA Undermined American Economic Well-being?

This analysis becomes even more complicated when considering the effects of trade blocs. Most of the debate in the United States about the North American Free Trade Agreement (NAFTA) has focused on job losses, given the large decline in manufacturing jobs that took place in the 1990s. But has NAFTA actually contributed significantly to that outcome? It seems accurate to maintain that around 800,000 jobs may have moved south of the border to Mexico, a country with lower base wages and less stringent business and environmental regulations. The conventional wisdom is that these job losses make NAFTA an agreement contrary to the national interests of the United States and to those of the American working class.

As usual, the realities surrounding NAFTA are far more complex than the simple equation “NAFTA = Job Migration to Mexico” seems to suggest. This trade bloc has also created jobs in the United States: Anywhere between two and four million jobs depend on trade with Mexico. Indeed, what most politicians, analysts and commentators forget is that NAFTA has created tens of thousands of high-paying jobs in the United States at the expense of workers in countries like Germany, Japan and South Korea. Companies from these countries used to ship their goods to the U.S. market but now make them here. A little-known fact about NAFTA is that, while the agreement provides for free trade among its three signatories, it is a protectionist trade pact relative to the rest of the world.

Take the example of automobiles. Before NAFTA came into effect at the beginning of 1994, exports of automobiles from the above-mentioned countries were literally flooding the U.S. market. But NAFTA made it more expensive for European and East Asian automobile companies to export because the North American local content requirement was raised from 50% to 62.5%. This meant that in order to avoid tariffs, a vehicle sold in the United States (or Canada or Mexico for that matter) had to incorporate more value in its components originating from within the NAFTA zone. At the same time, the rules under NAFTA as to how that local content requirement is calculated became more stringent.

Automobile companies responded to NAFTA’s protectionist stance swiftly. Within months, the Japanese, South Korean, and German makers were drawing plans to shift production away from their respective home countries and set up assembly facilities in the United States. Toyota established new manufacturing capacity in Indiana (starting production in 1990), BMW in South Carolina (1994), Mercedes-Benz in Alabama (1997), Honda in Alabama (2001), Hyundai in Alabama (2005), Kia in Georgia (2008), and Volkswagen in Tennessee (2011). Each of these assembly plants required the co-location of hundreds of suppliers. if there are about 800,000 U.S. workers engaged in automobile assembly and component manufacturing, a bit more than a third work for foreign-owned companies. Many of those jobs would, without NAFTA, be located in Europe or East Asia.

“The problem for protectionist arguments is that there appears no such thing as a 100% homemade product.”

The political aspects of NAFTA’s protectionism should not be overlooked. President Trump campaigned on a platform that leaned heavily on the narrative of Midwestern unemployment. This is only part of the story, however. Investments by European and East Asian firms have benefited workers and their communities in the United States — but not necessarily in the Rust Belt. Instead, they preferred regions with weaker unions and more favorable tax treatment, available in states like Alabama, Georgia, South Carolina, or Tennessee. In addition, the original intention behind the protectionist treatment of foreign-made automobiles was to help the Big Three — General Motors, Ford and Chrysler. Yet NAFTA has largely failed to benefit American auto companies, which increasingly found it difficult to compete. In some cases it actually had the opposite effect, shifting production offshore (including to Mexico), and focusing on trucks, minivans and SUVs, for which they had, at least temporarily, a competitive advantage.

In more ways than one, agreements such as NAFTA brought about a reconfiguration of the international division of labor, shifting jobs from the United States to Mexico, and from Europe and Asia toward the United States. In addition, it created millions of jobs on both sides of the U.S.-Mexico border. What appears to be clear is that the traditional unionized labor strongholds of the Midwest lost to the southern and southwestern states, with the labor movement losing strength. Eventually, these changes led to a tectonic shift in political alignments and electoral outcomes.

Unlike some of the talk coming out of the Trump administration and some segments of the Democratic Party, however, the solution to job losses is not to fall back on protectionism. In fact, such policies will ultimately hurt consumers, make companies lazy, reduce the incentives for innovation, and encourage interest groups who benefit from the protections to lobby so that they remain in place. The solution must instead be to take care of those who are negatively affected and help them adapt to the changing economy. Neither a revived global liberal order nor its polar opposite will bring manufacturing jobs back. In the United States, there has been a generalized failure to take care of workers displaced by technological change. Spending on so-called active labor market policies — worker retraining, job-search assistance, employment incentives, direct employment, etc. — has declined in the United States from 0.26% of GDP in 1985 to 0.12% by 2015. Among OECD countries, only Mexico and Chile spend less. At the high end of the spectrum, Sweden and Denmark spend more than 10 times as much.