Circles and Squares

Asia Institute Seminar

 

“Free Trade and the Status of SMEs in the global economy

 

21^st April, 2012

 

Clyde Prestowitz

Founder and President of Economic Strategy Institute

Former counselor to the Secretary of Commerce  

  

On Free Trade

Emanuel Pastreich:

The proper relationship between market liberalization as part of larger trade liberalization efforts and the need to protect agricultural industry has become an enormous issue in Korea, debated at every level of society and it will be one focus of attention in the upcoming election.  As the issue is generally treated in a symbolic manner (concerns about mad cow disease rather than a debate on the concrete impact of market liberalization on the agricultural sector) there is much confusion as to what exactly is at stake. That said, there is a far wider consensus in Korea than is the case in other countries about the importance of trade to Korea’s economic growth. Most Koreans seem to believe that Korea has no choice but to trade.

Clyde Prestowitz:

When you say “there is a wide consensus,” what exactly do you mean? “Trade” implies a two-way street, that one should both buy and sell through trade and that both are good. Are you saying that there a consensus in Korea that Koreans need to buy or that they need to sell?

In my experience, I would say, most Asian countries, with one or two exceptions, focus on exports, on selling. They know that if they want to export, they sometimes have to buy something in return, but they don’t really want to buy things. So they enter into market opening agreements in which they agree to open their markets in return for overseas market access, but typically the Asian country’s market doesn’t open very much, even after the agreement is implemented. Asian nations feel a conflict because they know they should be buying because of the agreements, but they also know that buying is not their interest. I doubt there is a consensus in Korea about the value of trade, as opposed to the benefits of exports. Exports are something most everyone can agree is a good thing.

Emanuel Pastreich:

If you were a Korean, thinking from a Korean point of view, would you think that exports should be the focus? Or do you think that from a Korean perspective, imports would also be a great help and the whole problem is one of a misconception?

Clyde Prestowitz:

Well, franklyKorea is doing really well these days in an arrangement whereby their agricultural markets are protected and the farmers are can just be inefficient and maintain their picturesque farms in a beautiful countryside, so why change?  Just because the Americans say we want you to eat more beef?

Economists tend to put enormous emphasis on global efficiency, the proper allocation of resources and so on. We have heard all that before. But what economists do not explore, and what they are not that good at predicting, is the actual cost of adjustment—which are not just monetary. So let us take the case of agriculture. Let us suppose Korea just got rid of the protections for the Korean agricultural market. So that would mean a lot of farmers would be out of work, and so they would no longer maintain the land efficiently. Also, the tax base would fall, schools would deteriorate and the local economy would shrink. Ultimately, someone would have to step in to fix up the mess. That would be the cost of adjustment.

Typically economists take a very simplistic approach to those costs by just describing how many people lose their jobs and what there were earning. Such an approach ignores the secondary impact of all those changes, and so, when you actually sit down and consider the costs of adjustment, it is not clear that gains in efficiency, or the gains of sales through trade, are really worth all that much.

To come back to Korea, the domestic market for agricultural products is a relatively small market, in my opinion, and it’s not worth fighting for its protection, especially when it is not clear whether that fight produces all that big a gain for Korea.

Emanuel Pastreich:

Even among Koreans, although there may be consensus, for example, that Koreans are basically interested in exports, and not so much in trade, still there is quite a difference of opinion on the question of “Is it worth it” in terms of the costs?” There are many in South Korea who would say it is worth it. Whatever you may lose in terms of small agricultural production, you can buy that food elsewhere. But others say that it is a security issue: whether you use your own land and grown your own food.

Clyde Prestowitz:

It’s definitely not a security issue. Korea is dependent on the import of oil, on the import of all kinds of raw materials. So it’s nonsense to argue that you need to keep those rice farmers going for security reasons. There are probably a lot of Koreans who sympathize with the farmers for cultural reasons, but there are others in Korea who feel that they are getting ripped off by those farmers and would like to end that. The essential question is who are the people who feel they are being ripped off by the farmers and which industry do they work in? For example, let us take the telephone industry. Not many phones come into Korea from abroad. But how would those workers at communications companies in Korea feel if foreign phones flooded into the Korean market?

Emanuel Pastreich:

Korea has made enormous effort in terms of pursuing trade agreements with Europe, the United States, India and now China and Japan. There is a broad consensus on this policy, or else it would not go forward. There were some problems with the KORUS FTA, but the other agreements went through smoothly.

Clyde Prestowitz:

I am not really sure why Koreans are so agressive. I suppose that they are in part trying to assure continued access to large markets.  Perhaps in competition with Japan and China, they would like to guarantee some level of preferential access. But what is Korea thinking in terms of its own market? That is the real question. Is Korea seriously opening its markets, or are all these deals essentially “shams” in which Korea gains access to other markets while acting like it is opening its own markets, but then never actually implementing reforms. I am not sure about the true nature of these trade agreements.

Emanuel Pastreich:

That is the accusation that some people make about Korean trade policy. But we have to ask are selves, can the Koreans actually engage institutionally and culturally in such a strategy?

Clyde Prestowitz:

Well some countries can play this trade and diplomacy game well, and others cannot. The  United States simply cannot play this game effectively because the administrative system is simply too transparent, and the institutional culture is too fragmented. Foreign companies that are incorporated in the United States have the same rights as corporations and American corporations. They can use the United States court systems just like any American company. If the United States started playing games, the foreign companies would be filing suits in the United States that American courts would take seriously.

There is an example from back in the 1980s. At the time the Japanese were flooding the European Markets with inexpensive video tape recorders and the French got upset. So what did they do? They redirected customs for the import of all video tape recorders to the Port of Poitier.  The Port of Poitieris 150 miles inland and its custom inspectors only worked part-time. So the boats were backed up out into the sea and nothing moved. The French used this tactic very effectively and then they used the action as leverage to negotiate with the Japanese to limit imports.  You could never use that strategy in the United States. The American subsidiary of the of Japanese firm would just skip over to the courthouse, submit a complaint, receive a binding judgment and the whole thing would be over.

Japan is a major auto market, maybe the third biggest auto market in the world.  It has no tariffs on imported cars, and yet you do not see many foreign cars on the Japanese highways. Do you really think that if you signed a “free trade agreement” with Japan that suddenly you would see Korean cars running all over Japan’s roads? Hyundai is quite competitive globally but I believe that Hyundai actually just pulled out of Japan.

Emanuel Pastreich:

That approach we see being used in Japan and to some degree in Korea, that lack of transparency and of reciprocity in institutional agreements, do you think it is viable for those countries in the long term, or does it ultimately result in failure of transparency that has serious negative consequences?

Clyde Prestowitz:

I used to think that such approaches by Japan and Korea are not viable, but I have changed my mind. I believe that the strategy can be sustainable for two reasons. One is because the countries that have the more open markets, and take a more laissez faire approach to the economy, such as the United States, Australia and the United Kingdom, adopt laissez faire policies because their highest priority is not trade. These countries think more in terms of  geopolitics: the maintenance of bases globally, coming up with solutions to counter the military provocations of the North Koreans and Iranians, of the diplomatic initiatives of China and India. So such countries engage in trade agreements not for economic purposes, but as a demonstration of solidarity, of support for a broad range of political, diplomatic and security concerns.

One reason that countries like the United States engage in trade agreements is that their basic economic philosophy is that trade is win-win. There is a wide range of American economists who argue, in authoritative books, papers and editorials that whether it is potato chips or computer chips, It does not really matter what products you make or that you sell—in fact it does not really matter if you make things at all. By that logic, if your semiconductor industry gets wiped out by competition, don’t worry about it! You can always start up some other industry. So most American policy makers are rather unconcerned about the structure and health of an industry and its technological and manufacturing foundations. They simply have other priorities.

The second reason why Korea can continue to use this approach is that they can effectively restructure the industries that interest them on a global level. As a result of the asymmetry in competition in industry between the United States and nations like Japan, China and Korea, countries that adopt a more strategic approach to the development of their economy—and therefore have a more controlled market, their companies start to dominate global markets. They then can drive the foreign competitors out of business, or buy the foreign competitors, or invest at a local level in building up a presence within the overseas market as the first step towards controlling the market. Over time the local competators in countries like the United States lose the ability to complain about adverse impact, or they simply disappear.

Actually in 1936, the Finance Minister of Japan Takahashi Korekiyo  made a very really insightful statement once. He said, “The consequences of economic defeat are far more difficult to reverse than those of a military defeat.” He was exactly right and that is perhaps why Asian countries put more emphasis on strategic trade and production and less on geopolitical positioning.  What is happening today is that the strategically trading countries are defeating the free trade countries in economic terms. The free trading countries are increasingly finding it impossible to reverse the consequences of this shift.

From the Korean point of view, free trade between Asian countries could result in a win-win situation. But with other countries, say with United States, where the auto markets are quite open, there is no win-win possible. Hyundai had a 5% market share of the US automobile market, nowadays it’s up to around 9%. That change means that companies like GM have a reduced market share at home and no increase overseas.

Emanuel Pastreich:

So do you have any ideas about how we can solve this problem?

Clyde Prestowitz:

Historically, there has never really been anything that can be called “free trade.” Let us look back to the 1850s, which is when England began to develop its textile and woolen industry on a large scale with foreign markets in mind.  The first country that advocated a “free trade” regime then was the United Kingdom, starting in 1846. The United Kingdom passed a law that essentially removed British tariffs on wheat and grain coming from the United States. The United States, however, did not adopt free trade. In general the United States was quite a protective trade nation until after the Second World War.

The European countries were all protectionists, apart from the United Kingdom, and that tradition is strong today. The UK practiced something resembling free trade from 1846 until 1914. During the First World War, the English became more protectionist. After the war they tried their hand at free trade for a while, but they were no longer an empire and it simply did not work, so they went back to protectionism. But the current idea of some sort of global free trade system, as represented by GATT, that approach has only been in existence since World War II. Let us remember that between 1945 and 1975, most of the major players were still recovering from the war. So although the United States spoke of “free trade” it was not encountering strong competition from its partners. So the real growth of free trade and global competition has been from 1975 until the present.

Economists have always argued that trade is win-win on an average, but they have to admit that there are some losers, and that some industries like agriculture or textiles—specifically the employees of these corporations, will lose. So, if the gain for the vast number of consumers is greater than the loss in these limited industry sectors, then what we should do is tax the winners and compensate the losers.

But although people talk about taxing the winners and compensating the losers, in fact that has never happened. In the 1950’s Japan began to develop textiles and that became the first industry for which American suppliers began to rely on offshore suppliers. Textile mills in the United States began to close and they were replaced by Japanese producers. Then, of course, the textile industry moved from Japan to Hong Kong, Korea andTaiwan. The American textile workers complained that they were being hurt by this trade system, but economists replied, “You are just a few textile workers. Don’t worry, we will take care of you.” But then, after textiles, it was steel that started moving overseas.  Japan, Korea and some other countries began build up a globally competitive steel industry. The steel workers in the US began to lose their jobs and they also complained loudly.  The answer was basically the same. Later on it was consumer electronics that followed textiles and steel to Asia. After a few decades, the pile of losers got pretty large, and nothing was being done to help them.  As a result, the political opposition to trade liberalization has grown and the public in general is wary of free trade.

Emanuel Pastreich:

Do you imagine there is an ideal state of free trade that we have not reached, but that we should strive for? Could such an ideal state actually be achieved?

Clyde Prestowitz:

No that ideal state cannot be achieved. There is a real problem in trade that is becoming increasingly apparent. To begin with, the concept of free trade is actually built on extremely limited theoretical foundations. We begin with Adam Smith and his concepts of  free margins, the “hidden hand” and comparative advantage. Later on, other economists elaborated on this theme, often without much sense of what Adam Smith was trying to articulate. Eventually, the theory that emerged holds that country should concentrate on making the products and services that it does best and then trade them to its own advantage with the rest of the world.

The argument goes that this sort of international trade will be win-win. It could be “win-win,” but only under the most limited and unique conditions. The assumption of this model is that you have perfect competition. That suggests that no single producer has an influence on the total amount of production for a product or service, or for its price. Let’s pick an example of a product that causes some international friction, say commercial aircraft. There are two producers for commercial aircraft, basically, Boeing and Airbus.  Both companies have a profound impact on the total amount of industry production and on the price set. The political, cultural and diplomatic factors are significant. The theory of free trade ignores that kind of competition, it suggests that in markets those factors don’t exist.

The second assumption is that there is no cross-border flow of technology, or no licensing of technology, no IPR issues, no concerns about the protection of patents and no cross-border flow of capital. All those messy factors are swept under the theoretical rug. The third assumption is that exchange rates are fixed and cannot be manipulated for advantage. Those rates reflect an ideal market that follows general principles like the law of gravity. Exchange rates are a perfect reflection of a natural system. Finally, there is an assumption that there will be full employment and full capacity utilization, and there will not be any secondary costs if you switch from making steel, for example, to making cell phones. If you accept all those assumptions, then yes Virginia, free trade is win-win.

There are few circumstances in which that logic works. But in most of the industries we are talking about, automobiles, semiconductors, cell phones, airplanes there is imperfect competition which are determined by economies of scale. There are no economies of scale in the looking-glass world of free trade.

To the degree that industries are characterized by economies of scale, by rapid technological progress, by other institutional and cultural barriers, then trade is zero sum. Most what goes on in world trade is ultimately zero sum: Somebody wins, somebody loses. That’s why governments are always so deeply involved in these deals.

Emanuel Pastreich:

But if you had zero sum equation, it still possible, in theory, to negotiate, to say you lose here, I lose there.

Clyde Prestowitz:

Maybe it’s possible theoretically, but in reality that does not happen.

Emanuel Pastreich:

Finally, there is a certain ambiguity in your description of the Asian approach to trade as to whether the problem is ultimately cultural or structural If Korea, China or Japan rose to the same level as the United States in a geopolitical sense, would they then, because of their new position adopt a free trade position? Or is the culture, the tradition, so fundamentally different from that of the West that such an approach would never be taken?

Clyde Prestowitz:

Well, even when Japan ran its own little empire, it never adopted a free trade ideology. The Free trade system is basically an Anglo American approach. It is not continental and it is not Asian. The lesson we should have learnt in the twentieth century is that less is more. Look at the rich countries today. Singapore for example, has no natural resources. It doesn’t have an empire, it does not have bases around the world, and yet it is rich. By contrast, the United States has natural resources, it has a big empire, but it is growing poorer and poorer.

The Status of SMEs

Emanuel Pastreich:

Another debate taking place in Korea today that is parallel to, but distinct from the debate on free trade is the question of the multinational corporation in relationship to the SME. There is much discussion about whether it’s important, or even effective, to protect smaller businesses from larger businesses domestically. The question for Koreans is whether the government should put in place barriers to give SMEs a chance to complete with large firms. Should the government keep, for example, large companies from using their resources to set up chains of bakeries, or fast food stores that complete unfairly with local businesses and exploit their advantages in terms of logistics and scale to put SMEs out of business, thereby reducing the diversity of businesses and ending local ownership?

Clyde Prestowitz:

I think that the emphasis on SMEs in Korean politics is somewhat misplaced. Koreans seem to think that because only a small group of Korean multinationals are engaged in global trade, therefore we need to help more SMEs get to the business of international trade through government subsidies and other support. There is a lot of support given to SMEs by the Korean government, but the bottom line is that in order to carry out global business in a meaningful manner you really have to have resources on a large scale that allow you to hire people who speak English and have your materials produced for an international audience. SMSs simply do not have the resources to do so, and it is unrealistic to expect that they would. So I think these calls in Korea to increase the amount of business that SMEs can do by increasing dramatically their role in international business is just nonsense and gives false expectations to companies that may lead them astray.

The bigger question that is suggested by your remarks is the problem of large multinationals leverage their scale of economy and other advantages in order to dominate in the local economy. But this question is not ultimately a question about SMEs. The essential question is about true competition and the limits of market forces. I strongly believe that effective competition policy in the domestic market, as well as meaningful anti-trust policy and anti-monopoly policy, is very important. Globalization and the advances in technology have not changed that fact. One might say that the failure to codify the response to monopolies in the case of Korea and Japan has been a serious weakness and the lack of laws to articulate this issue in Korea means that it is treated in an emotional, rather than rational, manner. The US has traditionally maintained a quite an effective anti-monopoly policy. In recent years, that all-important tradition in the United States has withered under attack from special interests. Nevertheless, Americans still understand what monopolies are and can identify them, and criticize them. The European Union has also been quite strong on anti-monopoly policy. Asia has a much weaker record.

Emanuel Pastreich:

On a practical basis, there is a nice coffee shop on the corner near my house. But that coffee shop is run by a large corporation, not a small business. There is a bakery next door that is run by a family. I like the family business, but let me be honest, I end up going to the well-lighted, attractive coffee short run by the larger corporation more often. So in that case, I can’t really help myself. Do you think that government has a role regulating this situation?

Clyde Prestowitz:

For this kind of issue, I don’t think government has much of a role. But I do think that there are serious distortions one finds at a higher level. Let us look at the automobile market in Japan. Look, why are there no foreign cars in Japan, or in Korea for that matter? If you ask that question to a Japanese, he will respond that the problem is simply cultural. “We don’t really like the design, the feel, of foreign cars. They are not that good in terms of quality and do not match well with our lifestyle.” So I respond, “Okay, I understand that maybe a Buick does not fit in that well in Japan. But what about Korean cars? They are of high quality, have excellent designs, perfect for use in a Japanese environment and lower in price than a Japanese car. Yet I don’t see any Korean cars driving around in Japan.”

The true story has nothing to do with aesthetics or the narrowness of Japanese streets. Simply put, in order to sell cars you have to have dealers who will sell them. What people fail to appreciate about the United States is that the automobile dealer is a fully independent business man and by law an automaker cannot control, or own the dealerships in the United States. That means that General Motors cannot tell a dealer not to sell Japanese or Korean cars.

Imagine what would have happened if when the first Japanese automaker tried to enter the United States market back in the 1960s, it was told that they would have to build a nationwide dealer network from scratch. That sort of a project would be hugely expensive and it would have taken years, decades. In fact, Japan would not have been able to do so at all. In fact, Japanese manufactures simply went to GM auto dealers and asked, “Please sell our cars too.” America is transparent and the powers of automobile companies are circumscribed, so Japan could get its toehold in the market. But things don’t work that way in Japan. The manufactures in Japan control the dealers. I think the situation is similar in Korea. If you can’t get the dealers to carry your cars, then it will be very difficult to sell the cars. Of course there are a few speciality shops in Korea or Japan that sell BMWs or Mercedes. But those are high-end products where they can make a sufficient profit selling few cars, so the manufactures don’t need lots of dealerships. But manufacturers interested in the average consumer have no way to break into that sort of a market.

Emanuel Pastreich:

Recently, the Korean government established laws that require Wal-Mart and other discount super stores, to take a holiday twice a month as a way to protect smaller merchants and grocery stores. What do you think of this policy?

Clyde Prestowitz:

It is not going to help.The small shops are not able going to be able to compete with Wal-Mart even with such policies in place. If people are willing to spend a little bit more money for the special services of smaller stories, or if they are willing to put up with slightly less quality for the price because they like to have the friendly neighborhood shops, they’ll keep going to those stores anyway. But the primary reason that many smaller stores cannot compete is because consumers simply prefer to go to Wal-Mart. The prices are lower and  quality and services are more consistent. That change is driven by a deep transformation of the economy that cannot be so readily be constrained by a law.

Emanuel Pastreich:

So if we compare the services offered by Wal-Mart with those offered by the small stores, the small stores cannot hold their own?

Clyde Prestowitz:

Sometimes a small firm can hold its own because it offers some form personal service: they owner knows your name and customizes his stock to meet your needs. Some customers like that service and they will prefer to patronize the store even if it is not competitive in terms of price.

Emanuel Pastreich:

In Korea, visiting the supermarket has become a weekly ritual for many families. Now so many housewives are working that it is rather difficult to run down to the local store to buy daily. Easier to buy en masse on the weekend.

Clyde Prestowitz:

Well, when I was a little boy the milkman came to the door everyday with milk and the bread man followed with the bread. I liked that service as a child. But let us fact the facts, such a system could not have been preserved. Some changes cannot be held back by laws.

Emanuel Pastreich:

So you really do not believe that programs that force big stores to take holidays cannot make a difference to smaller firms?

Clyde Prestowitz:

Well, I am not a Korea expert, but I seriously doubt that such band-aid policies can do much of anything to change the inevitable. The domestic market is changing and the little guys are at a disadvantage regardless of what is done. After all, nobody is forcing the customer to shop at Wal-Mart; they are choosing to shop there. If customers prefer to go to Wal-Mart, what realistic means does the government have to force them to go to the smaller shops? Any such a response is likely to create all manner of unintended distortions that do not help the small store or the consumer.

For example, Starbucks is found everywhere in the United States, and in Korea now. I see them all over my neighborhood in the United States. Now there are a couple of small independent coffee shops in my neighborhood as well. Even though the price there is higher, I still go there because of extra personal service that they offer. I like the environment and that is part of the experience. But I know that eventually those stores will go. There aren’t enough people like me to keep them going.

Emanuel Pastreich:

Now you did suggest that regulation of monopolies is important. If you were not talking about small firms competing with larger firms, what exactly were you referring to?

Clyde Prestowitz:

Well anti-trust, anti-monopoly regulation takes place at another level in the economy and is not about sentimental attachments to mom and pop stores. I am talking about cases like Microsoft’s introduction of Internet Explorer. Long ago, but not that long ago,Netscape was the first browser for the internet. All of us were introduced to the Internet originally by Netscape. But there is no Netscape today.

Why did that happen? Because Microsoft tied a new search engine Internet Explorer to Windows. That is to say that Microsoft used its monopoly over all computer operating systems through its control of Windows to force consumers to use Internet Explorer. So, in my view, Microsoft used its monopoly position to kill a very competent Netscape and then took over that Market. The result was a loss in terms of competition in the market and in terms of available expertise in the United States.

I think the U.S. government should have filed an anti-trust case against Microsoft at the time.   You can see the consequences of that failure today. There is no real meaningful competition in browsers. They have become parts of larger companies, Microsoft and Google, and there is not much innovation going on.

Emanuel Pastreich:

Well, it sounds as if you are saying that anti-monopoly laws can be taken advantage of by corporations, but that for the little guys, it does not really make much difference. Does not sound all that fair.

Clyde Prestowitz:

I think we have to be clear about what monopoly activity is and not let sentimental feelings about mom and pop stores cloud our vision. In the case of Wal-Mart competing with a small shop, Wal-Mart isn’t telling a customer what to do. Walmart does not say to the consumer: if you want to buy my dress, you also have to buy my shoes. But that is exactly what  Microsoft did. Microsoft told the consumer, if you buy my operating system, you also have to buy my browser. Of course the signs of abuse of monopolies are not always black and white. I always look for some clear sign of collusion, some element of obvious misuse of market power.