Trump and free trade

25 January, 2017 at 15:30 | Posted in Economics | 3 Comments

Dear President Trump,

Plenty of people will try to convince you that globalization and free trade could benefit everyone, if only the gains were more fairly shared …

trade-copyThis belief is shared by almost all politicians in both parties, and it’s an article of faith for the economics profession.

You are right to reject it …

It’s a fallacy based on a fantasy, and it has been ever since David Ricardo dreamed up the idea of “Comparative Advantage and the Gains from Trade” two centuries ago. The best way to prove that (apart from looking at the bitter experience of the millions of once-were-factory-workers who voted for you) is to apply real-world scepticism to the original argument in favour of free trade …

Ricardo’s model assumed that you could produce wine or cloth with only labour, but of course you can’t. You need machines as well, and machinery is specific to each industry. The essential machinery for making wine can’t be used to make anything else, if its use becomes unprofitable. It is either scrapped, sold at a large loss, or shipped overseas. Ditto a spinning jenny, or a steel mill: if making steel becomes unprofitable, the capital involved in its production is effectively destroyed …

Ricardo’s little shell and pea trick is therefore like most conventional economic theory: it’s neat, plausible, and wrong. It’s the product of armchair thinking by people who never put foot in the factories that their economic theories turned into rust buckets.

Steve Keen

As always with Keen — thought-provoking and interesting. But I think he misses the most powerful argument against the Ricardian paradigm — what counts to day is not comparative advantage, but absolute advantage.

In 1817 David Ricardo presented — in Principles — a theory that was meant to explain why countries trade and, based on the concept of opportunity cost, how the pattern of export and import is ruled by countries exporting goods in which they have comparative advantage and importing goods in which they have a comparative disadvantage.

Heckscher-Ohlin-HO-Modern-Theory-of-International-TradeRicardo’s theory of comparative advantage, however, didn’t explain why the comparative advantage was the way it was. In the beginning of the 20th century, two Swedish economists — Eli Heckscher and Bertil Ohlin — presented a theory/model/theorem according to which the comparative advantages arose from differences in factor endowments between countries. Countries have a comparative advantages in producing goods that use up production factors that are most abundant in the different countries. Countries would mostly export goods that used the abundant factors of production and import goods that mostly used factors of productions that were scarce.

The Heckscher-Ohlin theorem –as do the elaborations on in it by e.g. Vanek, Stolper and Samuelson — builds on a series of restrictive and unrealistic assumptions. The most critically important — beside the standard market clearing equilibrium assumptions — are

(1) Countries use identical production technologies.

(2) Production takes place with a constant returns to scale technology.

(3) Within countries the factor substitutability is more or less infinite.

(4) Factor-prices are equalised (the Stolper-Samuelson extension of the theorem).

These assumptions are, as almost all empirical testing of the theorem has shown, totally unrealistic. That is, they are empirically false.

That said, one could indeed wonder why on earth anyone should be interested in applying this theorem to real-world situations. As so many other mainstream mathematical models taught to economics students today, this theorem has very little to do  with the real world.

What has changed since Ricardo’s days is that the assumption of internationally immobile factors of production has been made totally untenable in our globalised world. When our modern corporations maximize their profits they do it by moving capital and technologies to where it is cheapest to produce.

So we’re actually in a situation today where absolute — not comparative — advantages rules the roost when it comes to free trade.

And in that world, what is good for corporations are not necessarily good for nations.

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3 Comments »

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  1. Not to keen on Keen’s chatter and I quibble with you. Its true that the post-Ricardian assumptions are unrealistic but they have actually been used to explain why trade is not necessarily beneficial to all. In sum, the assumptions don’t make the model as useless you claim. Also, if you look at the huge literature on trade, the supposed consensus is simply not there. Granted that a lot of the dissensus is “hidden” because much of it is about what happens when you relax certain assumptions or try to explain the data; nonetheless, the literature has recognized for a long time that win win images from trade are unrealistic.

  2. […] via Trump and free trade — LARS P. SYLL […]

  3. This misses one of the main problems with the so-called free trade agreements and that is the Investor States Dispute Settlements clauses (ISDS) or Chapter 11 in NAFTA allowing corporations to sue governments for lost imaginary profits and for that claim to be adjudicated without appeal by unelected appointed tribunals.


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