Robert Samuelson describes China's trade policies as "predatory" and "mercantilistic". Thomas Palley writes that "individual countries can strategically game the [international trading] system for their benefit at the expense of others. That is why the system needs rules and a spirit of cooperation... China has been admitted into the system but it is unwilling to play by the rules, in letter or spirit." I agree.

But. China's leadership has engineered the largest, fastest boom in all of human history, which has lifted hundreds of millions of people out of extreme poverty. They have retained legitimacy and control over a fractious, nearly ungovernable nation, despite capitalist-democratic triumphalism that loudly proclaimed their style of governance a relic. They have advanced China's national interest, and their own interest in clinging to power, brilliantly.

In doing so they have broken some rules. Well, knock me over with a feather. Nations play hardball with one another. When confronted with a choice — huge welfare gains for their citizens and huge personal benefits for themselves, or some genteel rules set by nations that have historically mistreated them — China's rulers opted to look out for number one. Incentives matter. What would an economist expect?

I dislike China's form of government, its authoritarianism, its brutality, its disrespect for liberty and free expression. But in terms of industrial and economic policy, the country is kicking ass and taking names. While it remains to be seen how sustainable its achievements are, China's leadership deserves admiration more than condemnation for its trade policy. They have not played nice. They have done what nations do, and done it well. They have acted in their own, and their citizens', self-interest.

The United States, on the other hand, has not acted admirably. Games, even the very high-stakes games played between nations, involve more than one player. It has been obvious for several years that China has been acting mercantilistically, that its government has been taxing workers to subsidize exports, undercutting American industry while buying political support in the US with easy credit and low, low prices. This has not been rocket science. Yet America has done nothing but mildly complain.

The United States needn't have stood helplessly by and watched China cheat. It might have acted. No, it is not rampant American consumerism or any other mushy cultural deficiency that is to blame. Consumers in the United States have been quite rational, buying artificially cheap products offered with very generous financing. Demand curves are downward sloping. But when individually rational behavior adds up to collectively poor results, it is the job of governments to change the incentives.

The US government has always had it in its power to bring trade into balance. It has the power enact tariffs, grant subsidies, and control the flow of foreign capital. America's central bank could "sterilize" all the excess credit provided by dollar-pegging exporters by selling US bonds and purchasing diversified portfolios of foreign debt. Even the credible threat of any of these policies might have persuaded China that it was more in its interest to "play by the rules" than to flout them. But the self-interest of the bought, combined with free trade as ideology, has prevented any of that from happening.

America's large deficits can't persist indefinitely. As Thomas Palley is right to note, America's choices are "pay now, or pay more later." Breaking America's China "addiction" (as Paul Krugman put it) will be difficult. But it does need to happen, "the sooner the better."

China is well on its way to becoming the world's largest economy, and its growing prosperity has been earned, not stolen. The US need not, and ought not, start a trade war with China. There is no need to single out China at all. The United States should simply take policy action to get its own house in order. It should force its trade into overall balance quickly, and endure whatever pain and dislocation that will entail. There are many workable policy choices. (I remain partial to Warren Buffett's proposal.)

In any hopeful future, the United States and China are both large, vibrant economies, and good friends. Culturally and commercially, China and the United States have a great deal to offer one another. China has played rough. So what. The US should congratulate China for its successes thus far, and wish it the best in the future. At the same time, policymakers should make clear that the rules of the game have changed, and that while America eagerly embraces globalization and interdependence, it will not accept asymmetrical relationships of dependence. Even if that means violating some rules of "free trade".

Thanks to Mark Thoma for calling attention to the Robert Samuelson and Paul Krugman pieces.

Economics has its founding fathers, like Adam Smith and David Ricardo. If list of greats were compiled for finance, Harry Markowitz would number among them. Markowitz helped invent Model Portfolio Theory, a mathematically elegant approach to optimizing investment portfolios that considers not only how well one expects investments to do, but also how certain one is of ones judgments, and the typical inter-relationships between "surprises" in different investments.

Markowitz's theory of investment and Ricardo's theory of trade are meant for very different domains, but the contrast between them is striking. Ricardo teaches that nations should determine their comparative advantage, and specialize in that, trading for what they do not produce most efficiently. Markowitz suggests that investors beware the temptation of specialization, and diversify even into apparently inferior investments to limit risk. Both are revered. What explains the difference?

Nations, after all, are investors, in the aggregate. Specializing in manufacturing or software or wine or cloth entail vastly different portfolios of fixed structures and human training. And investors, like nations, have comparative advantages. Consider a venture capitalist, or an "angel" investor. Each faces different investment opportunity sets, determined by who they know and the localities or domains in which they invest. Every investment has an opportunity cost (the expected return on other investments). Using return estimates alone, most investors would find that choosing one or a very few investments would uniquely maximize expected return, net the cost of foregone opportunities. The situation of a nation that can trade for what it does not produce is broadly similar to that of an investor, for whom a high return in a software venture yields specie that can be used to purchase food, shelter, and yachts. (The no-trade analogy would be an investor whose profits at a stocking factory would have to be taken in the form of inedible socks.)

So, should nations and investors both specialize? Or both diversify? Or should they behave differently, and if so why? From an investment perspective, the question would turn on two considerations, uncertainty and the optimal locus for diversification. Uncertainty is the easiest factor: An investor who can perfectly predict the real returns on investments should absolutely not diversify, even under Markowitz's theory. Ricardo took the comparative advantages — that is the relative investment returns — of nations as fixed and given. Under these circumstances, Markowitz would agree that specialization is the way to go. But how good are nations, really, at knowing their comparative advantages? And even when they choose correctly, how likely is it that changes in circumstance or random surprises render judgements inaccurate? The greater the uncertainty, either of estimation or environment, the greater the case that nations should diversify.

A second question hinges on who is best placed to diversify. In the 1960s, it became fashionable among corporations to form "conglomerates", large groups of unrelated businesses held under a single corporate umbrella. There were a bunch of rationales for this, including the ability of subsidiaries to raise capital internally, economies of scale in shared functions, and the market and political power associated with size. But one important motive for conglomeration was Markowitz' portfolio theory. It was argued that a diversified firm faced fewer risks than a specialized one, since when one industry was fairing poorly, other business units might do well to make up the difference.

Conglomerates are no longer fashionable. Investors rejected the case for corporate diversification, because they were perfectly capable of diversifying themselves. Why should MegaCorp include unrelated businesses A, B, and C, when an investor can divide her own portfolio between stock in A, B, and C? In fact, MegaCorp's diversification harms the investor, because the investor loses the opportunity to customize exposure to A, B, and C according to her own circumstance and expectations.

Unfortunately, most citizens can't hedge their exposure to nations in the way that investors can diversify investments in firms. This is a strong argument in favor of diversifying at the national level, even when it cuts against maximizing comparative advantage.

There are a several ways that nations may be different than investors that buttress the case for national specialization. Investors choose their investments according to flawed analytical processes, and make mistakes. When a capitalist economy specializes under open trade, it is a vast market that decides in which fields to specialize, what factories to build, what competences to educate. Perhaps owing to "the invisible hand", "the wisdom of crowds", or whatever, market economies make such better choices than private investors that there effectively is no uncertainty. The market always chooses correctly, so specialization is the optimal choice. I find this argument unpersuasive, both because I think markets can be short-sighted and mistaken, and because I believe in irreducible uncertainty that no predictive institution can overcome. Another difference between nations and ordinary investments is that national investment has dynamic effects. When a nation begins to specialize in, say, electronics manufacturing, economies of scale and network effects kick in that serve to magnify any original advantage the nation had in that field, and turn the investment into a kind of self-fulfilling prophecy. This, I think, is a quite reasonable point. But the difference between investors and nations can be drawn too starkly. A venture capitalist or angel investor also works, post-investment, to advise firms, to recruit good people, and to create connections between complementary firms. But these kinds of investors still do diversify.

If one buys the case that nations are like investors, and that investors ought diversify in an uncertain world, what does that mean in practical terms? It depends. It might mean nothing. Perhaps the ordinary functioning of national markets produce sufficiently diversified national portfolios on their own, in which case all is well and good. But it does suggest the possibility of market failure. If national investment is skewed or concentrated in some fashion whose future performance (relative to other possible portfolios) is uncertain, public action to promote diversification might be reasonable.

"Industrial policy" is unfashionable, and it is of course true that political processes are flawed and corruptible. The case I've made opens the door for rent-seeking operators to seek government handouts in the form of "diversification subsidies". Any policy based on this argument would have to be designed with great care. Nevertheless, that chemotherapy is poisonous does not imply that cancer does not exist.

Note: While David Ricardo long ago joined Zeus on Mount Olympus, Harry Markowitz, whose work I much admire, is a living, active scholar. The views expressed in this essay are entirely my own, and if I seem to have put words in Harry Markowitz's (or David Ricardo's) mouth, I do apologize.

Though it may come as a surprise to some readers, my aesthetic predilection is towards libertarianism. My politics, alas, have moved beyond pure principle, and are now hostage to the messy business of outcomes, the management of which is, of course, anathema to perfect liberty. Nevertheless, I wish I could agree with this piece by Gabriel Mihalache. Gabriel writes an eloquent statement of the principled libertarian position. His candor is refreshing, about the philosophy, the politics, and the economics of trade. I don't agree with him. But reading the piece made me homesick. Here's a taste:

The knee-jerk, crypto-utilitarian reaction is to ask if [trade] improves the life (of the community?) on the net. (Isn’t it magical how “on the net” solves all conflicts between members of the same community?) But that’s not my thing. Any such calculus is philosophically suspect and highly conjectural at best.

A more robust alternative is to ask ourselves… by which interactions do these changes in welfare, the focus of so much debate, come about? And the answer is simple: by a “reshaping” of the decentralized, free trade pattern. Old contracts/associations are simply not renewed, new ones are created.

The “losers” from free trade lose because they can’t get the same trading terms they used to get. Others are no longer willing to associate with them under the previous terms. Is this legitimate? Yes. It’s the basic definition of the freedom of contract, which implies not only the freedom to draw and enter into contracts, but also to choose not to do so (anymore).

Hence, all trades and changes in trades/associations following the opening of borders are legitimate actions. There are no guilty parties. On the other hand, keeping borders closed is a direct violation of the freedom of association.

Innocent free men should not be subjected to coercion and persecution if they choose (not) to associate with foreigners and fellow countrymen alike. This is a basic political principle of any nation that calls itself free, at least in spirit, if not in letter also, but never in practice, it would seem.

Trade is a simple issue. Basic human decency, not to speak of the spirit, if not the letter, of contemporary constitutions demand it.

Is free trade without compensations Pareto inefficient, in the sense discussed here? Yes! But so is breaking up with your girlfriend, quitting your jobs or changing your favorite shop. So what? The Pareto & compensation criteria are at best dubious politics and at their worst, a cheap excuse to obfuscate and obstruct the issue of free trade.

There's a classic argument on the politics of trade that goes something like this: Free trade creates net wealth, but there are winners and losers. Unfortunately, the winners tend to be large, disorganized groups of people, each of whom gain just a little, while the losers are powerful, politically connected industries who face very serious disruption from overseas competition. Think of the automobile industry. International trade in automobiles has benefited consumers remarkably, but when the Japanese began to make inroads in the US market, domestic auto manufacturers put continual pressure on the government to keep foreign firms at a disadvantage. The public is easily misled — a consumer might like the fuel efficiency of her Corolla, but against thousands of autoworkers with families like hers, whose jobs are in jeopardy on her television, support at the ballot box for a large government subsidy to the local firm (what Chrysler got, in the form of below-market-rate credit) seems a small price to pay.

But arguments are not theorems. They must change with the times. Today, in the United States, who would be the biggest loser should, for example, the government enact restrictions designed to force trade towards overall balance? Diffuse, disorganized groups of consumers certainly would lose; imports would cost more and buyers could afford less. But do we know of anyone else who profits from consumers' enthusiasm for buying imported goods at "everyday low prices"? Walmart is, by any measure, a much larger company and much more powerful force in today's American economy than GM or any other import-competing titan.

Current patterns of trade have created huge trade surpluses in several export-focused economies, which in turn have been lent back to the United States on very favorable terms. The US financial industry is booming despite a tepid overall economy, thanks to leveraged private equity deals and a hedge-fund boom that churns out billionaires like butter. What's the secret sauce? Ask any player, they'll tell you: Liquidity, abundant easy credit on terms that seem to make no sense, from the lender's perspective. Where is all this easy money coming from? From overseas trade surpluses. Who would lose if this flow of capital were to be curtailed? Again, there'd be some diffuse harm: Many Americans' 401-Ks would take a hit. But are there are maybe some large, politically-connected actors profiting from this firehose of foreign capital? Where was it that the United States' current treasury secretary was plucked from? Walgreens? No, that's not quite right.

Wall Street. Wal-Mart and Wall Street. Those are the diffuse, weak, politically inept actors benefiting from current trade arrangements. We'd better be very careful to be sure someone stands up for them. Don't forget the little guy.

This harangue is inspired by Tyler Cowen, who was kind enough to give interfluidity a plug yesterday. Interfluidity has been flowing all over Tyler and Marginal Revolution for years, in a good way. (We hope that's not too gross). For more on how trade flows get recycled into capital flows, read Brad Setser until your head explodes. In a good way. (Okay, we admit that's just a little bit gross.)

I was thrilled to see that Ben Bernanke's speech today (here, courtesy of Mark Thoma) addressed the trade deficit, and whether trade imbalance might bear upon the case for international trade:

Although many readily accept that balanced trade does not reduce aggregate employment, some might argue that the United States' current large trade deficit must mean that the number of U.S. jobs has been reduced on net. However, the existence of a trade deficit or surplus, by itself, does not have any evident effect on the level of employment. For example, across countries, trade deficits and unemployment rates show little correlation. Among our six Group of Seven partners (the world's leading industrial countries), three have trade surpluses (Canada, Germany, and Japan). However, based on the figures for February of this year, the unemployment rates in Canada (5.3 percent) and in Germany (9.0 percent) are significantly higher than the 4.5 percent rate in the United States; and Japan's unemployment rate, at 4.0 percent, is only a bit lower.⁷ Factors such as the degree of flexibility in the labor market, not trade, are the primary source of these cross-country variations in unemployment.

Though I found much to quibble over in Bernanke's very orthodox defense of trade, this one paragraph made the whole speech worthwhile. I do agree with it. There's no reason to think that unbalanced trade should have any effect on unemployment rates. But that's not why I was so pleased. I was excited just to see the question of imbalance addressed, to see America's huge trade balance actually grappled with in a major policy speech on trade. So often the fact of persistent imbalance is just ignored, maybe mentioned with a quick cough, but let's move on and pretend we are all living in some Ricardian paradise.

Perhaps in future speeches, Bernanke could address the trade imbalance and its effect on the character of domestic investment — that is, whether persistently unbalanced trade results in a skewing of physical and human capital out of tradable sectors. He might touch upon how these dynamic effects bear on the United States' future ability to repay its growing international debt with real goods or services. In his role as Fed chief, Bernanke could comment on whether managing the sizable debt associated with unbalanced trade might someday require a more accommodative monetary stance than would be expected under inflation targeting. (This would be a good opportunity to celebrate the US central bank's famous dual mandate!)

Bernanke could discuss housing and asset bubbles, and future price volatility should patterns of international capital flow change or Americans become more reluctant to increase their debt load. With respect to employment, Bernanke could muse on whether and to what degree unbalanced trade affects wages, if it does not affect unemployment rates. He might offer some insight on whether the combination of sluggish wage growth, low tradables prices, unusually easy credit, and booming financial markets — all related to current trade patterns! — have anything to do with declining labor force participation in the United States.

It could happen. A boy can dream, can't he?

So two cheers for Ben Bernanke, and his speech today on trade. May it be the first of many.

p.s. Bernanke deserves a full three cheers for a famous speech several years ago. His suggestion of a "global savings glut" was a profoundly useful contribution to the conversation on globalization and international trade. It'd be great to see a follow-up on why it is or ought to be the United States that does the world the service of accommodating that glut, and what if any limits there are or ought to be on America's willingness to borrow the world's copious savings.