The traditional theory of free trade, in place for two centuries, no longer makes sense and must be replaced with a new model, given the radical changes that have taken place in the global economy over the past 30 years, argues Ralph Gomory, president of the Alfred P. Sloan Foundation.

Traditional trade theory has broken down because companies are no longer bound to the interests of their home countries. The link between a company’s motivation for after-tax profit and a nation’s desire to improve the wealth of its citizens by growing its GDP have been de-coupled. Companies can now make more profits by moving their production to other countries with cheap labor and subsidies and then exporting that output back to the United States. Most economists have not acknowledged this fundamental change and its implications on economic theory, says Gomory.

Multinational corporations are now highly profitable, but by shifting their production offshore, they are no longer adding to the nation’s GDP. “The country and companies are going off in two different directions,” says Gomory. “That is something that most people feel intuitively.”

Gomory, a mathematician and former head of research at IBM, has become a respected voice among those questioning current free trade policies and theory. His book on the subject with economist William Baumol entitled “Global Trade and Conflicting National Interests” published in 2000 continues to gain adherents, particularly as the trade deficit continues to remain so high.

The trade deficit is not a petty concern, Gomory notes. It is “dangerous,” he said in a recent interview with Manufacturing & Technology News. “We are going into debt to the tune of 6 percent of our GDP each year and we are not finding a way to pay it back. In truth, we are going into debt each year at a greater rate than the year before. A country cannot forever consume more value than it creates,” says Gomory. “This is an important issue: when you owe an amount that you cannot pay back, you will find that you are increasingly under the control of the lender. We must balance trade.

“If we really had a free market system out there, it would balance automatically. It shouldn’t be inherently difficult to balance trade because it’s something that should happen unless it’s screwed up. A starting point is to enforce agreements, but our negotiators really represent the interest of the multinational companies.”

Economic theory “says absolutely nothing that suggests that tearing down your own capability and building it abroad is good,” Gomory says. “That distinction is simply not presented.” Why, Gomory is asked? “Although there are many references in the economic literature to this distinction, most economists who understand the point are reluctant to discuss it because of their fear of protectionism.

“I’ve talked to a fair number of people on this,” he recounts. “If you want to do anything about the transfer of capabilities, you’re labeled as interfering with free trade. But it isn’t free trade.” Gomory argues that economic theory has no basis for saying it is good to shift a factory overseas. “In fact, it is almost certainly bad. But people just blindly mix that with trade. That piece of confusion is very hard to overcome.”

The Asian countries have figured it out. They are exploiting the divorce between a country’s GDP and its companies’ desires for profits. “They are saying, ‘If you want profits, come over here and we’ll give you tax breaks. You’ll get profits and we’ll get GDP. Your profits are only a small fraction of what you add to our GDP.’ ”

As production goes offshore, wages follow, as does the wealth of a nation. Americans have been told that this shift of production is inevitable and that it will only impact those workers involved in noncompetitive industries. “We are assured that it is bound to make us richer in the long run after the pain of change has been absorbed,” Gomory told a recent hearing of the House Science Committee. “…There is no basis for these claims. Analysis shows that the results can go either way, so the people of this country should not count on some long-range outcome that must inevitably make up for present pain. That day may never come.”

From this angst, rises protectionism, an unwelcome proposition. But if protectionism becomes a prevalent policy option, then the United States would forego the benefits of trade, Gomory argues.

There is a better answer. Gomory proposes changes to the U.S. corporate tax code to encourage companies to invest in high-value products and services made in the United States. If the United States wants GDP then it should provide companies that contribute most to GDP with a lower tax rate.

“If you measure the value added per hour of workers, you can take that whole value add of the company and divide it by the number of workers to set the corporate tax rate,” he says. This can be made revenue neutral: a low corporate income tax is assessed to companies with higher value-added per worker; a higher corporate income tax would be assessed for low value-added companies. “That is an inducement for companies to invest here,” he says. “Were not picking on any company. We’re not saying it’s R&D. What we’re saying is the companies that can figure out how to produce stuff in the country will be rewarded.”

In his book, Gomory suggests that it is important for countries to preserve their “retainable” industries. “Retention of an established position, as in the case of semiconductors, steel and automobiles, proved to be a task far less difficult than the creation of an equivalent industry from scratch,” he writes.

Gomory likes the fact that his views are gaining an audience. “For the first time, people are saying that there is something wrong and here is an explanation, plus something we can do about it,” he comments. “It’s a system problem, not an evil man problem; I know this because I’m one of the evil men.” He says this because he sits on the board of Lexmark, a printer company. “As a director, I look out for the profits of the shareholders,” he explains. “We have an incentive to make a profit. In Lexmark’s case, it meant moving production to lower-cost countries. It’s a system problem, and we need to change the system,” Gomory says. “At the moment there is no will. The people in our government still are treating the companies as if they represent the country, and they do not.”

As he and his co-author, well-known economist William Baumol, write in their book published by MIT Press: “A country that ends up producing little of value will have little to consume at home and little to trade abroad, and will have a low standard of living.”

To contact Richard McCormack:]