US Mission - Geneva c/o Department of State Washington, D.C. 20521 November 13, 1997 Editor Wilson Quarterly Sir: We mysteriously began receiving the Wilson Quarterly when we arrived in Geneva 18 months ago. It stopped arriving in mid-summer. Why? I enjoy your magazine. A couple of years ago I heard Senator Sander Levin's participation on Super NBC, during which he made a number of astute observations regarding U.S. - Japanese Trade. He took considerable flack for his positions. An article in this morning's International Herald Tribune -- "Trade Bill's Fate Underlines Labor's Muscle", similarly takes Congressman Richard Gephardt to task for his opposition to Fast Track. As a retired U.S. Foreign Service Officer with thirty years experience in the trenches as a trade specialist, I am writing to express my full agreement with both Levins' and Gephardt's astute analysis of where the problem lies and my disagreement with the simple minded Johnny-one-note defense of Free Trade by the Trib writer.. The problem is not where the Trib and The White House have been telling us. As the whole world knows, we have undergone 35 separate negotiations with the Japanese regarding our mutual trade problem. Invariably they change Prime Ministers or otherwise obfuscate so that we're always starting over at ground zero. I forward a paper I wrote five years ago setting forward my own analysis of the problem -- and a proposed solution. I hope that you might find space for it in the Wilson Quarterly. The paper is, I think, based on sound economic arguments, if ones seldom voiced by the conventional media. And it's an argument that should be ventilated and debated. Seems to me that while we've been willing to step up to the plate with tin pot despots like Khaddafi, Saddam Hussein, and General Whoever in Haiti, we seem to be scared stiff we'd set off an international trade war if we actually implemented some reprisals on Japan. My paper includes some figures put together by Professor Paul Krugman suggesting that even a 100 per cent tariff imposed by each of the three main trade blocs, reducing imports by a high-side estimate of 50 per cent, would reduce world trade by less than 2.5 per cent -- less than 0.75 of world income (and only a third of this for the U.S.) The problem as I see it is that while we're used to dealing with formal trade barriers, and monopolies, we've never dealt with an industry-controlled monosony -- as in Japan. You know, and some others closely familiar with the Japanese system know, that Japanese production, distribution, and retail sales are vertically controlled by a small group of keiretsu effectively owned by the Japanese banks -- controlling capital of up to six times the size of the next largest banks in the UK, France, Germany, or the US. These groups have simply agreed to freeze out access to the retailing system for non-Japanese firms. And, it would appear, there's little formal Japanese Government involvement -- and, the Japanese co-participant in the NBC morning discussion insisted a couple of years ago, there is little the Japanese Government can do to help us with this problem. He was being disingenuous to say the least. Following WW-II, the Occupation agreements imposed by General Douglas MacArthur, in addition to providing for adoption of the present Japanese Constitution banning a national military force (which has itself been somewhat insidiously ignored), banned the pre-war zaibatsu -- the Japanese system of industrial cartels. As with Hitler's illegal re- occupation (and re-militarization) of the Rhineland in the early '30s, leading to WW II, the Japanese gradually permitted the re-emergence of the zaibatsu under the new form of keiretsu . And we've let them get away with it, while we've gone ahead with embargoing trade with Saddam for his failure fully to comply with the terms of the post-Gulf War settlement. Why so tough on Saddam and so permissive with regard to the Japanese? Seems to me the solution is to call the Japanese to task for ignoring the terms of the zaibatsu ban as rigorously as we've insisted on full compliance by Saddam. Why not hail the Japanese before the WTO? Or at least make a big case about their sneakiness in this regard with the world media -- reminding people of the outcome of letting Hitler get away with the Rhineland violation. Hoping to see something more of this major debate regarding the contemporary economic theory of the Second Best constrasted with simple minded, (and non-existent) Free Trade Theory, I remain, Very truly yours, D. B. Timmins, PhD (Harvard), FSO (ret.) Professor of Finance & Economics, Webster University - Geneva Enc: Paper on the Theory of Second Best and US Trade Policy THE THEORY OF SECOND BEST AND U.S. TRADE POLICY D. B. Timmins, PhD Some Theoretical Background Islam has its Seven Pillars of Wisdom, and Economics its Seven Marginal Conditions, constituting the respective Articles of Faith of the two confessions. Achievement of the Seven Marginal Conditions for the classically perfectly operating economy depends, among other things, on perfect competition among producers and sellers in the domestic market and upon free exchange of goods in international trade. Politicians have learned that the perfect is often the enemy of the good. We economists, being proprietors of a more exact science, seem unwilling merely to satisfice. We always wish to go for the brass ring, even though it is rarely obtainable in the real world. Economic intro-theory courses teach the beauty of the perfect competition model. It is not until later advanced theory courses that we acknowledge that the mythical seven marginal conditions do not obtain in the real world. Indeed, most of us seem to go on imagining that we are at, or near, the perfect competition model in making our policy recommendations. Lipsey and Lancaster in their General Theory of the Second Best remind us however that "Despite the theoretical promise that true free markets will be perfectly efficient, the real world is not a textbook [and the seven marginal conditions to not obtain. The real world] is full of . . . . distortions, and piecemeal attempts to move closer to a pure market may make matters worse. Therefore we are not infrequently better off finding the best available 'second best' rather than looking for an unobtainable first best. The 1980s, alas, are replete with proofs of this theorem." (Emphasis supplied. And the precise two points of my own PhD dissertation written well before Lipsey and Lancaster, and the insights which earned my doctoral degree at Harvard). This is pretty well what happened to the U.S. TV and VCR industries -- and came close to happening with American car makers when the Japanese invaded our market. In such circumstances one can even experience the perverse situation in which an industry in one country which, under Free Trade would enjoy most comparative advantage, can be displaced, even destroyed, by one in a protected environment having less comparative advantage. Fortunately, the U.S. government assisted the American car companies by insisting that the Japanese adopt quotas (and by extending major financial help to the Chrysler Corporation) in time to save the automobile industry -- which has in consequence shown how a threatened industry can restructure and bounce back, given time to recognize its mistakes and react. Recognition of Imperfections in the Domestic Economy Following the period of rapid industrialization during and following the Civil War, politicians (economists catching up only after considerable delay) gradually came to realize that competition among producers and sellers in the domestic economy was anything but perfect. Without waiting for a theoretical explanation of these matters from economists, Congress stepped into the breach with a series of Anti-Trust, Child-Labor, Truth in Advertising, Postal Control, and Banking laws. Some fifty-five years ago Edward Chamberlain of Harvard University wrote his seminal study Monopolistic Competition which for the first time provided an explanation of how these apparent "imperfections" in the market were, in fact, just previously unrecognized aspects of market competition. In doing so, Chamberlain for the first time explained the phenomena of trademarks, style differences, advertising, and marketing strategy as elements of competition equally or more important than price competition -- which had been the only competitive element considered of importance in classical economic theory. Today, anti-trust law and the powerful advertising industry stand witness to the recognition among economists, businessmen, and government officials that perfect competition does not prevail naturally in the domestic economy and that, at times, government should and must intervene to right the scales of fairness and equity. Delayed Recognition of Imperfections in Foreign Trade Policy Yet economists and most businessmen, as well as almost all government officials, remain wedded to the conceptual correctness of Free Trade as the fount of all blessings in international trade. To be sure, the occasional industry or union spokesman may ask for transitional protection for his industry during a period of especially difficult competition from a foreign producer, and the occasional senator or congressman (e.g. Senator Gephardt), recognizing that all is not right, may call for an "Industrial Policy" for the United States; but perfect competition remains the lodestone of professional economists who continue to insist that Free Trade is the only way to go. Economic theory, like Classical Physics, holds true (or so essentially true that the variance from the real world can scarcely be measured) so long as we are considering relatively small distances and relatively large objects. But once distances are enlarged to inter-galactic scale or size is reduced to sub-atomic measure, scientists are compelled to resort to Einsteinian Relativity and Quantum Theory -- else both time and matter are found to behave in inexplicable ways and the stars are not quite where we expect them to be because of bending induced by gravitational waves. When the U.S. GNP was measured in a few hundreds of millions of dollars and foreign trade was less than five per cent of GNP, perhaps we could rely on the concept of idealistic Free Trade as a reasonable guide for policy, as we relied on reasonably precise Newtonian physics during the pre-space age. Particularly when the world was emerging from the greatest war ever known and the gross protectionism of the Great Depression which preceded it, it was perhaps right that the United States should have sought to show the way by adopting the most open borders any nation had hitherto ever permitted to encourage our trade partners and the newly industrializing nations to reciprocate in opening their own borders to the mighty engine of Free Trade. But with U.S. GNP now counted in the multiple trillions and foreign trade now accounting for a substantial portion of GNP, the erstwhile differences between the theoretical results of Free Trade and the actual results of the Imperfect Trade we are actually experiencing are no longer negligible and it is time the profession recognized this, as have so many intelligent lay people. To be sure, as East European economies emerge from the gross distortion of crude Marxism they have been compelled to operate under, even classical economic theory can lift them to heights of efficiency they haven't experienced in over seventy years. But the world has changed: we've learned a great deal since classical trade theory was developed by Ricardo. And while we still use Ricardian examples and diagrams to explain grosso modo the concepts of comparative advantage and gains from trade, the discipline has gained new insights from Keynesian and post-Keynesian thought. The insistence of the United States on being the file leader in setting an example of trade liberalization in the postwar world (in which we've been lagged by virtually all our trade partners), while admittedly resulting as intended in a substantial increase in world trade to the advantage of all, has, as an insidious by-product, left us a lesser beneficiary than most of our less complying trade partners, and in some instances made us a clear loser, for reasons which will be elucidated in this paper. Estimated Cost of Imposing a Second Best Response to Trade Inequity The Washington Post National Weekly edition (Volt.7, No 21, p. 23) published an article by Paul Krugman entitled The Surprising Trade Offs of Trade Wars , in which Krugman calculated the cost of a 100 per cent tariff in each of three giant trading blocs, reducing imports by a high-side estimate of 50 per cent, at 2.5 per cent of world trade -- less than 0.75 per cent of world income. Krugman's calculations are supportive of a related argument I've been making in a series of papers I've submitted for publication over the past several years emerging from the doctoral dissertation I submitted at Harvard thirty years ago, which was highly praised by my committee at the time, and was later published by Universities Press, but which has had hard slogging among the more conventionally-minded when it comes to applying theory to real-world problems. The basic argument reaches back to the sixties when U.S. industry first began to respond to a two-pronged inducement to invest abroad. The first factor in this equation, a substantially overvalued dollar, was quickly grasped by the economic advisors to Charles DeGaulle, then President of France, who expressed concern that American businessmen were buying up French assets on the cheap. DeGaulle began the conversion of French holdings of U.S. Government bonds into gold to put pressure on Washington to devalue the dollar and put an end to Le Defi Americain . While it took awhile to accomplish his objective, in 1973 President Nixon was finally compelled to close the gold window to foreign holders of Treasury bonds and devalue the dollar, just as President Roosevelt had done for domestic holders in 1932. The second reason for the high level of U.S. investment abroad was not at that time readily understood; and, though it remains the principle reason for American companies to transfer operations overseas today, despite the fact that many now consider the dollar to be undervalued, is still not fully grasped. This is the "tilted scale" which, because of the excessive liberalization of U.S. trade and the protectionist measures a number of our principle trade partners, as well as most of the developing world, have retained or adopted (most not of a "classical" nature and thus not mentioned in text books), have artificially reduced or eliminated our natural comparative advantage in producing certain goods . In short, many of our trade partners have not responded positively to our good example (in part because we've been far less than Simon-pure in practice, thus leaving ourselves open to finger pointing and exposure as the butt of rationalization for the even less admirable behavior of others). As a result, a number of nations have achieved artificial "comparative advantages" which enable them to produce (and sell here) products which in a world of true Free Trade would have continued to be produced and consumed domestically, if not exported abroad (see last section, below). A preponderance of professional economists, because they are convinced they understand the theory of an article again presented without further nuance in an Economist magazine "Schools Brief" a year and a half ago, continue to argue that Free Trade is in the best interests of all, even where one partner insists on protecting its own market, have locked themselves into positions from which they are reluctant to budge. It would appear that the Economist 's writers, and indeed many professional economists, have never proceeded beyond crude classical trade theory, have never heard of the abuse of infant industry protection, don't understand the effect of such non-tariff barriers as Japanese keiretsu monopsony, and don't understand the theory of Second Best! As a matter of fact, even traditional trade theory tells us that in such circumstances, the disadvantaged partner can improve his situation by resorting to an "optimum tariff" (In a recent exchange with the Editor of the Economist, the author got a grudging admission of this fact, rebutted with the argument that the paper simply had more concern that the efforts of governments to offset such distortions would simply worsen existing distortions. As readers will see, this is no more than an argument of despair. Certainly most liberals of any stripe (and the Economist purports to be a liberal journal) have never hesitated to believe that governments can indeed ameliorate some of the negative aspects of market competition such as sweatshop and child labor, as mentioned above. The present paper, having more confidence in the ability of mankind to take steps towards solving its problems, boldly argues that in a distorted world economy, even with nominal Free Trade, the welfare of all countries would be improved by adopting, in lieu of such optimum tariff, other carefully considered Second Best measures to assure a return to a slightly (theoretically) sub-optimal (Second Best). Under such marginally modified conditions, the country which has been compelled to forfeit its natural comparative advantage in one or several product lines, can see this restored -- if not completely, at least in measure. To be sure, even then both countries remain slightly worse off than they would be under theoretically pure free trade, but they are both (all) measurably better off than under the existing Third Best conditions of the real (trade distorted) world. Reasons Nations May Prefer a World of Imperfect Trade The fact is, we are not operating in a Free Trade world and for the past fifteen years, at least, our efforts might better have been directed towards constructing a Second Best world in which U.S. industry could at least sub-optimize its performance rather than wasting our time preaching a will-o-the-wisp Free Trade gospel to Japan, India, and a dozen other obdurate nations which do not practice, and which may even have perfectly defensible reasons for not wishing to practice classical free trade. (I have published elsewhere a paper entitled The Theory of Social Product Differentiation [see Abstracts, SWEA Journal 1987 ]), applying Chamberlain's theory to explain why countries like Canada and Japan, to cite just two cogent examples, may prefer to operate less than fully efficient economies in order to preserve a desired national culture or lifestyle, just as some Americans, convinced that we live in a maximally efficient economy, may be willing to pay substantially more for branded designer jeans or branded breakfast cereal, the extra cost paying for the satisfaction this brings, just as a trip to Disney World or Yellowstone purchases, when all is said and done, only psychological fulfillment. Yet the profession has long understood these to be real products, whereas it has yet to understand national lifestyle as an economic commodity, just as product differentiation is Chamberlain's explanation for design differences and advertising. Why should this powerful explanatory tool not apply to desired differences in culture and the effects of this on international trade? A number of papers published in professional journals over the past ten years have attempted to extend the constituency of understanding for this important, but theoretically abstruse, policy point. The basic argument, however, is simple enough to be understood even by laymen. We are experiencing, it seems, a phenomenon reported by John Maynard Keynes, that political leaders have a habit of making policy based on the outdated economic analyses of a previous generation of academic scribblers under whom they were educated. But it seems Keynes had things wrong end about. It is professional economists who seem most wedded to out-of-date theory. When common sense thinkers like Senator Gephardt attempt to suggest something to rectify the situation, the messenger is attacked as being "protectionist", rather than attention being given to the causes of the message they're attempting to convey. Under political pressure, it is usually politicians who first get the message. And then, as with Chamberlain's belated explanation of market imperfections, an economist of a later generation finally gets around to explaining the economic logic of the programs applied by the politicians in their blind search for remedies to the problems long ago encountered by the business community. The Economist magazine in an article on this issue a year or two ago characterized this argument as "neo-protectionism". This is just one more tragic example of trained blindness. At worst, Second Best Theory might be identified with the Optimum Tariff Theory (extended to include non-tariff barriers); but, when fully and correctly understood, it is purely counter-protectionist , being an effort to offset protectionism through introducing carefully calculated measures to achieve a "Second Best" world trade position -- better than the distorted Third Best position we now endure. Indeed, it should even result in some economies by restoring, at least in part, the comparative advantage now lost to countries with less favorable basic conditions for distortion-free production, as previously noted. Taking these offsetting economies into account, the costs of standing up to Japan's "structural protectionism" might be even less than those calculated by Krugman. The Breadth and Insidiousness of Non-Tariff Barriers to Trade The real problem is not the countermeasures which might be undertaken by those offended against, it is the protectionism in conventionally unrecognized forms by others (an especially important example being Japan's monopsonistic distribution system, which is only now coming to be understood as the fundamental reason U.S. products, whatever their theoretical competitiveness, cannot find markets in Japan [see below for a recent example]). This deficiency in comprehension is understandable: the world has historically been troubled by monopoly, not monopsony, which perhaps has left us at a disadvantage both in recognizing and dealing with the Japanese challenge. The problem has been reinforced by U.S. pride; i.e. our unwillingness to compromise with principle by adopting countervailing measures to achieve a Second Best optimum in an imperfect world. In politics it is widely understood that "the perfect is the enemy of the good", and compromise is the order of the day. For some reason, perhaps because economists think that unlike Political Scientists they possess "hard theory" and can thus identify the "perfect" with some precision, we seem less willing to compromise in the interest of achieving the mere "good". Recognizing that our Post-WW-II role as idealistic schoolmaster for world-wide Free Trade has met with less than universal success is, in a way, it seems, as hard on our self-esteem as admitting forthrightly that we lost the Vietnam War. It has in any event been costly for U.S. workers and U.S. industry despite our admirable record of having created as many new jobs in the past decade as all Europe and Japan combined and having kept the last expansion going for an unprecedented nine years. But whatever one chooses to call it, it remains rationalization when, deliberately or otherwise, one avoids recognition of the bad by emphasizing the undeniably good. Some Examples of Successful Second Best Policies With all his other faults, Charles DeGaulle, the ultimate realpolitician, when President of France, never hesitated to adopt the most extraordinarily unconventional measures to compel France's trade or security partners to rethink their policies when these adversely impacted France's interests. Cases in point: his willingness to renounce French sovereignty over Algeria after being brought to power by those seeking to retain it as an inalienable Departement of France (which it juridically was); his decision to give up participation in the NATO command structure to secure his independent force de frappe ; his willingness to reimburse NATO for the costs of constructing its oil pipeline across France to Germany as the price for getting NATO out of France; and his related decision to force NATO Headquarters, EUCOM, and constituent U.S. and Canadian bases, together with their substantial contribution to the French economy, to depart. (Americans are more popular in France today than when G.I.'s in uniform seemed to be everywhere, giving France the appearance of an occupied country). Who today can successfully maintain that DeGaulle's decision negatively affected NATO's contribution towards inducing the fall of the Soviet empire and the dissolution of the Warsaw Pact? One might on the contrary see his action as having set an example for Poland, Hungary, East Germany, and Lithuania's insistence on the withdrawal of Soviet troops from their borders when the appropriate moment arrived. Few Americans probably even remember these events, but I was Executive Assistant to the U.S. Ambassador of the day and will never forget the palpitations set off in Washington by DeGaulle's demand for a equal voice in NATO decisions or he would walk out. Or the daily rockets we received telling us we must change his mind or the world would surely come to an end. But Eastern Europe didn't forget. Europeans have a far longer time horizon than most Americans. A second instance: DeGaulle's decision to convert French dollar holdings to gold, compelling President Nixon to close the gold window to foreigners (as we had closed it to residents in 1932) and to devalue the dollar. In a day when the U.S. Treasury has been actively involved in forcing the dollar down against the Yen and Deutschemark to improve our trade stance, who would insist that the French did us a bad turn in compelling us to adopt realism as a policy guide in 1972. History tells us that major unconventional problems often require radically unconventional measures to resolve them. Historians credit Franklin D. Roosevelt with having saved America's free market economy, though he was pilloried at the time by Big Business as a crypto-socialist Distortions in Production Resulting from Distortions in Trade While world trade has been growing from strength to strength, there has, as already noted, been simultaneously occurring an unintended (and largely unrecognized) distortion in world production through induced displacement overseas of a number of goods in whose production we used to enjoy and should -- in a world without trade distortions -- possibly continue to enjoy, a relative comparative advantage. This has taken place under the shelter of lagging liberalization on the part of several of our traditional competitors, while the situation has been egregiously worsened by the adoption on the part of a number of emerging Less Developed Countries, notably those now characterized as the Newly Industrialized Countries -- Singapore, Taiwan, Korea, and Hong Kong -- of the "infant industry" strategy permitted by the GATT, and helpful to any number of developing nations in Africa, Latin America, and the Orient. The U.S. was similarly generously forbearing when somewhat equivalent strategies were adopted as temporary measures during the postwar recovery of Europe. Regrettably, some of our European partners have maintained for over forty five years some of the protective measures adopted at the end of the war -- principally with respect to insurance, films, and banking. We rather casually and routinely examine and reapprove the European controls in the OECD Invisibles Transactions Committee every year or two, but have never found a way to compel them to be abandoned (though the DISC and IET countermeasures we adopted in the late 60s illustrate the applicability and utility of the types of Second Best strategies outlined here). In the meantime, we have negatively "rewarded" the NICs for their success by removing them from the list of nations benefitting from our Preferential Tariff schedule, leaving some of them wondering if they'd not have been better off remaining somewhat under- developed. (In this connection I cannot forebear commenting that I think it would have been ever so much better policy to have offered them promotion into newly formed Pacific Basin and Latin American OECDs-Marks II and III in recognition of their success rather than unceremoniously booting them downstairs -- as if success were something to be penalized in the world of international trade and finance!). Professor Gottfried Habeler used regularly to warn his students that one of the major drawbacks to permitting the erection of such "temporary" shelters, essential as they may appear to gain a foothold in world markets, is that they are seldom if ever abandoned once the infant industry reaches its majority (viz. Korea, Taiwan, Hong Kong, and Singapore -- not to mention Japan, or the countries of Western Europe which after restoring the performance of their prewar economies went on to form the European Common Market with its common external tariff to the advantage of member nations). With the passage of time, and as experience has been gained, many nations have learned superficially to satisfy U.S. GATT complaints by reducing their more visible tariff barriers while retaining more invidious, externally invisible non-tariff barriers (NTBs), based on such grounds as "quality control", "preservation of culture", and "protection of health and safety", not to mention Japan's unprecedented system of monopsonistic Trade Combines and distribution networks (keiretsu ). The Effect of Foreign Trade Shelters -- Mostly NTB's -- on U.S. Trade and Production Among American industries which have been negatively affected by our adhering to inadequately comprehensive economic theories and the defective policies based on them are television, VCRs (and any number of other electronic and high tech goods), lumber products, chemicals, and agriculture (especially citrus fruits, rice, and beef). For years we've tried to persuade our trade partners, especially Japan, to reduce their non-tariff barriers to give American producers equal market access, but with relatively little success. And most observers wisely did not holding their breath over former Japanese Prime Minister Kaifu's most recent promises or the likelihood of resolving these problems at the recently concluded Uruguay Round of GATT talks. It seems every time we seem to get halfway meaningful promises from one set of Japanese leaders, they change Prime Ministers and we must start over again. Indeed, since this paper was prepared for presentation in May, 1994, we've had another shift of Prime Ministers and are in the process of starting a new round of talks with Japan. Senator Gephart's example of a Plymouth automobile having to sell for $45,000 in Japan because of Japan's tight importer/wholesaler/retailer structure, while perhaps somewhat naive in its understanding of the underlying problems, is but one apposite case of Common Sense preceding theoretical understanding, as noted, a not uncommon event in the evolution of economic theory. A major phenomenon in the market attracting widespread public attention has often, if not usually, preceded the development of a theory to explain it: in this case The Theory of Second Best as applied to International Trade and Finance. Other examples of restraints on products in which the U.S. probably would still enjoy a comparative advantage in an undistorted free trade world include Europe's quotas on U.S. films and TV productions, and on banking and insurance operations; and Japan's restrictions on banking, participation in its securities market, and on the importation or sale of the agricultural products already mentioned. A Current Example of an NTB Meriting an Offsetting Second Best Measure The April 6. 1991 Washington Post reports the experience of an adept U.S. exporter who, after devising a way around market restrictions on the sale of U.S. beef by installing freezer-type vending machines in railroad stations in which a kilo of U.S. beef could be purchased by commuters at a savings of $23 over an identical weight of local beef, was abruptly informed just as sales were to commence that he had to obtain a license -- though no licenses are required for similar vending machines supplying local products. Nor could anyone tell our unfortunate American entrepreneur (entrepreneur in the truest sense of the word), just which license was required or to which agency he should apply. A solid, innovative American approach to doing business which would have benefitted both Japanese consumers and American suppliers, was again defeated by a peculiarly Japanese monopsonistic non-tariff barrier on the very day the Japanese Prime Minister was promising important liberalization measures. Voila , point made about the need in this period of major crisis in U.S. foreign trade for offsetting measures to achieve a Second Best optimum (or, ideally, compel a trading partner like Japan to rethink a policy adversely affecting the United States a la De Gaulle). We. Must Remain Constantly on Guard: There are no Permanent Solutions to Trade Questions -- or Any Other Economic Problems Anticipating such real world distortions, I used to tell my marketing students in Mexico, as an example of the operations of comparative advantage and the benefits of trade, that with President de la Madrid's entry into GATT they should be able to sell their first quality Sonoran beef, marketed locally at U.S. $1.75 a kilo, in Tokyo where equivalent beef sells for U.S. $34 per kilo, buying Japanese cars and televisions in exchange, to the benefit of both nations. As an example of the imperfections of the present international trading system, I cautioned that Mexico probably wouldn't realize these benefits (and they haven't) because of Japanese insistence on protecting their local beef producers for social and political purposes, defeating all the beautiful theories of Free Trade we were exploring on a theoretical basis -- something our American businessman has just discovered). I'd conclude by telling my young graduates they'd have plenty to occupy themselves with as future finance, economic, and trade officials of the Mexican government since the work of an economist is never definitively accomplished: businessmen are constantly devising new ways to circumvent government policies, tax policy must be thoroughly revised every ten or twelve years to overcome tax erosion, and nations are constantly inventing new ways to take advantage of trading partners (with the apparent exception of the naive and good-willed United States of America). An Example of American Policy Hard Ball Paying Off Some twenty years ago when I was Deputy Economic Advisor to the U.S. Mission to the OECD in Paris and co-delegate to the Economic Development and Policy Review Committee, we tried to persuade our EC partners to eliminate their rebate of VAT taxes on exports which the U.S. viewed as subsidies prohibited under the General Agreement on Tariffs and Trade. These subsidies amounted on average to 16 per cent, putting U.S. exporters at a substantial disadvantage. Being unsuccessful in our diplomatic endeavors, the Administration, in one of America's rare exhibitions of innovative policy thinking, introduced the Domestic International Sales Corporation (DISC) legislation which allowed U.S. exporters to postpone tax payments on exports, restoring in part their competitive position. At about the same time, and for related reasons, Congress passed the Interest Equalization Tax (IET) which established substantial parity between domestic borrowers and foreign borrowers in the U.S. capital markets.) Need For Similar Measures to Resolve Some of Today's Intractable Problems Taking into account our lack of success in trying to convince our trade partners by polite persuasion to eliminate or reduce barriers on films, TV productions, insurance and banking, and monopsonistic Japanese market distribution measures, perhaps the time has come to consider what Second Best, offsetting measures we might take to induce our crafty and less idealistic trade partners to open up, or in the absence of positive response, to impose a Second Best sub-optimum to improve the market position for American business. When others, e.g . Senator Gephardt, arguing perhaps without solid theoretical ground, have made such suggestions the reaction has more often than not been to express fear of retaliation -- as if our clever trade partners wouldn't recognize that a trade war would affect them far more adversely than us. Which brings the argument back to the calculations presented by Krugman in his Washington Post article that even a major three way trade war reducing trade by fully fifty per cent would reduce world GNP by less that three quarters of one per cent. And even less if, as I believe, such measures restored some of the world's true balance of comparative advantage. We were willing to pay the price of intervention in Panama to get a druglord. And the President confronted Gorbachev over Lithuanian independence, risking an important disarmament treaty. We bombed Khadafi, despite his possession of poison gas and his financing of terrorists around the globe. We pursued a full-scale war in the Gulf against the world's fourth largest military power -- equipped with tanks, missiles, poison gas, and, perhaps, concealed atomic weapons, to chastise Saddam Hussein for violating a UN dictum to restore Kuwaiti sovereignty; And have maintained a trade embargo against Iraq for years because of Saddam's refusal to comply fully with the terms of the agreement for ceasing hostilities. Why are we willing to assume such grave risks over political policy, but never to secure success of our economic policy on which is based our ability to pursue all other national goals and objectives? Why can't we stand firm against Japan until we see the actual results of their often promised but never delivered liberalization? Or hold Japan to the terms of General MacArthurs's occupation decree outlawing Japan's pre-war zaibatsu (the parallel of the current keiretsu which were gradually brought into being as U.S. attention was given elsewhere -- in much the same manner that Hitler found occasion to violate the demilitarization of the Rhineland -- leading to WW II. History teaches that important goals can seldom be attained entirely risk free. And in this case do not the results merit the minor risks involved? Where Do We Stand Today? The situation has finally gotten so bad, that Congress, through threatening import controls in concert with Trade Representative Mickey Kantor (independently of the theoretical arguments recounted above) seems to have made a sufficiently strong impression on the Japanese that we mean business that newly installed, Prime Minister Hatta has again made some promises and sent a delegation to reopen talks in Washington. And we may yet see progress. That is if we don't cave in at the last moment before the countermeasures proposed to ensure Japanese compliance are imposed. The purpose of this paper is to throw some additional light on the theory underlying the current debate in the White House, among Trade Representative Mickey Kantor and his associates, interested Congressional leadership, and, perhaps, the undogmatic few of my former E-Bureau associates in the State Department at a moment when the issue is hot and attention high. Nothing like an idea whose time has come (or more disillusioning than trying to push an idea no matter how important when attention is diverted elsewhere). Enlightenment arrives better late than never. The U.S. has very limited experience with Second Best measures. Presidents Reagan and Bush negotiated vigorously with the past five Prime Ministers of Japan with absolutely nothing to show for it. Indeed, their Structural Disparities Initiative seemed to add up to nothing more than asking the Japanese to be less competitive, not addressing the real problems of the Japanese monopsonistic market structure . A secondary, but no less important purpose of this paper is to add some additional stiffness to the backs of U.S. Congressmen in evaluating the results of the Uruguay talks before ratification, by reinforcing and adding to Mr. Krugman's argument that even if we have to push to the brink of a trade war, or beyond, the cost will be less than conventionally argued and probably even less than Krugman's figure of 0.75 per cent of world GNP, as present distortions in production are reduced by introducing some carefully calculated Second Best, offsets (along the lines of the DISC and IET measures mentioned above). At least some of the loss in production of goods in which the U.S. would have a comparative advantage in an undistorted world might be restored, such goods being produced domestically even more cost-effectively than they are at present produced abroad (true costs being taken into consideration). Under such circumstances the world would actually climb from its current Third Best position, to a Second Best secondary peak. In this connection, one might reflect on the fact that the Japanese, apparently recognizing U.S. comparative advantage in many product lines while most U.S. economists and businessmen are still wringing their hands, have chosen to take advantage of this, investing major sums in U.S. businesses, including hotels, office buildings, movie companies and records producers, and, not least, the automotive industry, which some American analysts have all but written off. Almost forty per cent of Japanese cars sold in the U.S. will this year be manufactured here. But by Japanese companies, not American ones! Of course, if Japan, Africa, Latin America (and, yes, even the EC) begin to take us seriously and eliminate or substantially reduce current non-tariff barriers to U.S. levels, we might just conceivably be able to look across Jordan to the frontiers of the Land of Free Trade which economists have for a century been preaching is the best of all possible economic worlds. Why the U.S. seems to be prepared to accept more risk to accomplish political goals (Grenada, Panama, Kuwait) than we have in recent years been willing to assume in pursuit of bread and butter issues is matter for another analysis. It is sufficient here to note that the costs of threatening (or experiencing) a trade war may prove less than some feared, while the gains are likely to be even greater than even the brave dared hope. It will be interesting to see what President Clinton's Trade Czar Mickey Kantor does with the Second Best Super 301 ammunition Congress has given him. AmEmbassy - Bucharest APO AE 09213-1315 April 20, 1995 The Honorable Sander Levin United States Congress Washington, D.C. 20510 Dear Congressman Levin: I heard your participation regarding U.S. - Japanese Trade on Super NBC this morning. As a retired U.S. Foreign Service Officer with thirty years experience in the trenches as a trade specialist, I am writing to express my full agreement with your astute analysis of where the problem lies. As you know, we have undergone 32 separate negotiations with the Japanese regarding our mutual trade problem. Invariably they change Prime Ministers or otherwise obfuscate so that we're always starting over at ground zero. I'm writing to provide you with a paper I wrote four or five years ago setting forward my own analysis of the problem -- and a proposed solution. Seems to me that while we've been willing to step up to the plate with tin pot despots like Khaddafi, Saddam Hussein, and General Whoever in Haiti, we seem to be scared stiff we'd set off an international trade war if we actually implemented some reprisals on Japan. My paper includes some figures put together by Professor Paul Krugman suggesting that even a 100 per cent tariff imposed by each of the three main trade blocs, reducing imports by a high-side estimate of 50 per cent, would reduce world trade by less than 2.5 per cent -- less than 0.75 of world income (and only a third of this for the U.S.) The problem as I see it is that while we're used to dealing with formal trade barriers, and monopolies, we've never dealt with an industry-controlled monosony -- as in Japan. You know, and some others closely familiar with the Japanese system know, that Japanese production, distribution, and retail sales are vertically controlled by a small group of keiretsu effectively owned by the Japanese banks -- controlling capital of up to six times the size of the next largest banks in the UK, France, Germany, or the US. These groups have simply agreed to freeze out access to the retailing system for non-Japanese firms. And, it would appear, there's little formal Japanese Government involvement -- and, as your Japanese co-participant in the NBC morning discussion insisted, little the Japanese Government can do to help us with this problem. He was being disingenuous to say the least. Following WW-II, the Occupation agreements imposed by General Douglas MacArthur, in addition to providing for adoption of the present Japanese Constitution banning a national military force (which has itself been somewhat insidiously ignored), banned the pre-war zaibatsu -- the Japanese system of industrial cartels. As with Hitler's illegal re- occupation (and re-militarization) of the Rhineland in the early '30s, leading to WW II, the Japanese gradually permitted the re-emergence of the zaibatsu under the new form of keiretsu . And we've let them get away with it, while we've gone ahead with embargoing trade with Saddam for his failure fully to comply with the terms of the post-Gulf War settlement. Why so tough on Saddam and so permissive with regard to the Japs? Seems to me the solution is to call the Japanese to task for ignoring the terms of the zaibatsu ban as rigorously as we've insisted on full compliance by Saddam. Why not hail the Japanese before the UN? Or at least make a big case about their sneakiness in this regard with the world media -- reminding people of the outcome of letting Hitler get away with the Rhineland violation. With best wishes for your success in getting Mr. Kantor to be tougher in his dealings with the Japs..