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The Baguette Shop: A Parable About Trade

You own an artisanal bakery that makes the best $2 baguettes in town. Business is booming. In fact, business is so good that a German bakery opens up across the street. You’re not worried: their $3 baguettes are good, but not that good. You’re sure you can outcompete them in good ol’ American fashion—and let’s be honest, who’s ever heard of German baguettes?

A month later you notice baguette sales are down. Why? You walk across the street to compare sales with the German bakery, and you see a sign: “Baguettes Now $1.” How could they possibly afford to bake such cheap baguettes? The lederhosen-clad owner tells you that the government is now paying for his flour—that’s why his baguettes only cost $1. “That’s not fair!” you exclaim. He just shrugs and says, “What can I say?”

A few months pass. Baguette sales are down, and you’ve done everything you can to cut costs: you’ve switched flour providers, fired staff, and worked longer hours. But the cheapest baguette you can bake still costs $1.50—it’s cheap, but not that cheap. No matter what you do, you cannot compete with the German bakery. The government’s pockets are too deep. Reluctantly, you close shop.

A few months later you’re buying a baguette at the German bakery. You see a sign: “Baguette’s Now $3.” Excuse me, what happened to the cheap baguettes? The owner says that since there’s no competition, he can raise prices and make big profits.

Later that night you tell your family what happened over dinner. Your son, an economics student at Harvard, advises you to reopen your bakery. You wince—as if you hadn’t thought of that. “I can’t,” you say, “I don’t have enough savings to reopen the bakery. It’s too expensive to start from scratch.”

Your son smiles and shrugs, “That’s the free market, Pop. Don’t you know what’s good for you?”

The Butcher, the Baker, the State-Backed German Candlestick Maker
Like all good stories, this one has a moral—and no, it’s not something trite like the government should not pick winners and losers. In fact, it’s precisely the opposite: the American government has an economic, political, and moral duty to ensure American businesses triumph over foreign rivals.

In our story, you represent America’s businesses, who produce high-quality goods at reasonable prices—the best $2 baguettes in town, as well as the best cars, computers, and airplanes. In fact, data from the Brookings Institute show that America’s advanced industries (aeronautics, pharmaceuticals, information technologies, etc.) are the second most productive on earth, behind only Norway’s. Further, they are fully 50 to 70 percent more efficient than their primary competitors in Western Europe. This is important because these industries generate the majority of America’s economic growth.

The takeaway: America makes the best stuff at the best price.

Back to our story. You bake the best $2 baguette, while it costs the German bakery $3 to bake an equivalent baguette. In a fair world, you would outcompete the German bakery, and steal their customers. But life’s not fair. The government stepped in and bought the German baker’s flour, so he could make baguettes for $1. The government tipped the scales, making it impossible for you to compete. As a result, you were forced to close shop.

Essentially, this is what happens when America trades with foreign nations: American businesses compete against foreign, state-backed businesses and inevitably lose—regardless of whether they are more efficient or produce better products. Remember, efficient American factories are the ones moving to China, not relatively inefficient German factories.

Trade asymmetries destroy American industries. Consider that Chinese firms can operate in America, but American firms cannot generally operate in China unless they partner with a Chinese firm. This is exceedingly common in the IT industry, where American technology companies trade technology for access to Chinese consumers—only to face insurmountable competition from Chinese copycat companies months later. Tied to this is the fact that Chinese companies (with the government’s tacit blessing), steal more than $500 billion worth of American intellectual property every year.

How can American businesses compete against China’s monolithic government? They can’t. Those who demand free international trade must recognize that tariffs are not the only impediment—different legal structures, business models, and economic philosophies preclude free trade and guarantee that liberal “free traders” will get screwed.

The Ol’ Switcheroo
At the end of our story baguettes cost $3, and you cannot afford to reopen your bakery. Everyone loses—everyone except the German baker. There are two lessons worth mentioning here.

First, monopolies are bad for consumers because they increase prices. That’s why everyone except monopolists hates monopolies. We must remember, however, that monopolies are good for producers. In a domestic market, the harm to consumers often outweighs the benefits to producers—but this is not always true in a global context. Net-exporters of a product (whether good or service) unequivocally benefit from high prices.

For example, oil-exporting nations like Saudi Arabia benefit far more from high oil prices than their domestic consumers are hurt by them. As a result, it is in Saudi Arabia’s best interests to monopolize oil production as much as possible, so as to ensure prices are high. Likewise, high potash prices help Canadian potash producers far more than Canadian consumers are hurt by high potash prices—it all depends on the balance of trade. Because of this, monopolies are often desirable in global markets.

Once you understand this, China’s push to monopolize global semiconductor production makes sense: they don’t want to give the world cheap semiconductors, they want to monopolize the industry, and then leverage their market power into higher prices. They are likewise doing this in other high-value industries. Further, we have already seen China do this with various industries in South America and Africa: they kill domestic industries by dumping cheap products, then jack-up prices in the aftermath.

Our story’s second lesson is that once an industry is dead, it’s dead. In the same way that you cannot simply reopen your bakery, it is very difficult to rebuild an industry once it has been completely offshored. This flies in the face of what liberal economists and political parrots like Ben Shapiro claim. They say that magical “free market” will open the door for American competition if foreign monopolists raise prices too high. This simply isn’t true. There are three reasons why.

First, because economic development is path-dependent, nations often lose the human capital to resurrect an industry. Specifically, after about a decade (or less, depending on the industry), not enough skilled workers remain to rebuild the industry—and those who do will likely have outdated knowledge.

Can you imagine if all of America’s aerospace industry moved abroad? Do you really think that two decades from now we would be able to design and manufacture cutting-edge aircraft? Of course not. We’d become like Iran: at best we’d be able to build outdated aircraft, and we certainly wouldn’t be at the cutting edge of innovation. It takes decades, sometimes centuries to play catch-up. This is why it’s better never to leave the race—no matter how “inefficient” it seems at the time.

Second, building an industry from scratch is prohibitively expensive, and recreating the vanished supply lines is almost impossible. The economy is a complex system, much like a coral reef: just as removing the wrong coral may harm the whole reef, so too may offshoring the wrong industry harm the whole economy. We don’t know how all the pieces fit together, and we cannot assume that relocating a particular industry to China will not have adverse unforeseen consequences—how badly will ancillary industries be disrupted? Can they survive without their anchor industry?

The Brookings Institute notes that every advanced industrial job supports roughly two other jobs in an asymmetrical, yet symbiotic relationship. The advanced industry is the coral in our reef, upon which the anemones and fish (supply chains and the service sector) depend. Remove the coral, and the reef dies. So, too, with the anchor industries.

For example, offshoring America’s automobile factories (the anchor) will likely kill America’s automobile engine, tire, and windshield manufactures, too. All the service jobs that depended upon the industrial jobs would collapse as well. The ramifications would be felt by accountants, hairdressers, lawyers, artists—everyone. This is basically what happened in the Rustbelt, and the results have been disastrous: joblessness led to socialism, hopelessness led to drug addiction, poverty led to urban decay.

Re-building an industry from scratch is so difficult that the developmental economist Mehdi Shafaeddin notes that no country has ever industrialized without government investment or protection. The input costs are simply too high.

This ties into the third reason why American producers could be locked out of our own market: manufacturing is subject to increasing returns on investment, rather than diminishing returns. The more product a factory produces, the cheaper each unit of production becomes. This is the opposite of what many classical economic models assume, and it’s part of the reason that the Austrian School of economics is wrong about global free trade. Consider the ramifications: if China can outcompete American industries that are subject to increasing returns (manufacturing), then they need not jack-up prices to reap monopolist profits (although they could) since their profit margins will naturally improve as they grow in scale. This locks out new competitors, who lack the scale to compete with lower prices.

The free market is not God, and worshipping it will not make Americans prosperous. Instead, we need to abandon our ideological presumptions and re-examine the evidence with new eyes—only then will we be able to truly make America great again.