The benefits of free trade — a fallacy based on a fantasy

25 April, 2017 at 08:29 | Posted in Economics | 10 Comments

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 … 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 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.

David_RicardoWhat 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 is not necessarily good for nations.

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10 Comments

  1. Keen’s point that you need machines as well as people to produce stuff is not exactly the revelation of the century: in fact it’s a statement of the obvious. Plus his point that when a country is suddenly exposed to free trade, various machines will need to be scrapped, sold or shipped overseas is equally obvious. I don’t see that those obvious points detract from Ricardo’s ideas on comparative advantage.

    Next, re the idea that absolute advantage rules the roost rather than comparative advantage, I’m fascinated. Suppose country A has absolute advantage in producing EVERYTHING. Employers will of course initially TRY TO shift production to it from country B. But that will ultimately cause B to run out of money, at which point A just won’t be able to sell anything to B. But before that disaster scenario, firms and labour in B will start to solve the problem by charging less for their output, either by cutting wages and/or by a depreciation of B’s currency. And that in turn will make it profitable to produce the stuff in B where B has comparative advantage.

    • I believe you misunderstood the point being made. It is not about the country having an absolute advantage but the corporations. They have an absolute advantage in negotiating low taxes and wages and the rest of the economic factors be damned. There may indeed be no other advantages to shifting the production. But if you can persuade governments to subsidize you and ignore the externalities (I prefer to call it collateral damages), then your corporation has an absolute advantage. Also where shareholder value matters more than anything else and is determined by the perceptions of stock and bond traders speculating on the profitability of the corporation, absolute advantage again goes to the corporation that handles the levers of political power.

  2. Ricardo’s assumption is unlikely to be a fact because he was well aware of Adam Smith’s LAND LABOR CAPITAL yields RENT WAGES AND INTEREST (OR DIVIDENDS) theory. I think the claim by Steve is unsubstantiated and if still current he should give a firmer explanation. When trade is restricted and limited by tariffs, less trade happens and the protected industries in the home country are unlikely to sell as much as if their workers were able to work in making something else.

    The lack of freedom for labor transfer is a political phenomena. Without it we would be able to enjoy cheaper goods and more of them. China has exported at a loss by “dumping” her produce due to a low exchange rate, but this practice is coming to an end. The huge sums in dollars that China has accumulated are useless until eventual exchange by which time inflation will have reduced their value. Free-trade immplies similar exchange both ways. Both dumping and tariffs are adverse.

    • Not sure that I agree with you. The US is going to impose tariffs on our softwood lumber in Canada. This has people all upset but, think about it. We have YUGE infrastructure needs in this country for housing especially on First Nations land where the lumber grows for the most part. Then those houses need new tables, chairs, dressers, furniture, etc. Why are we concerned about selling our softwood lumber elsewhere when we likely need a lot or all of it right here and both harvesting it and processing it would assist with our high unemployment problem? Because corporations have an absolute advantage they can dictate to our governments and manufacture the consent of the people to send our softwood lumber elsewhere for processing under the mythology of free trade.

  3. I hope I do not bother you to much with my frequent contrary comments, but you seem to have a grudge against David Ricardo based not on what he actually wrote but on the mainstream neoclassical (mis-)interpretation of his insights. I am just trying to draw your attention to the differences.

    Regarding “the most powerful argument against the Ricardian paradigm”, you might be surprised to read that he wrote the following:
    ‘The motive which determines us to import a commodity, is the discovery of its relative cheapness abroad: it is the comparison of its price abroad with its price at home’ (Vol. I, p. 170).

    His insights in the famous numerical example do not refute the notion that a foreign commodity must be cheaper than a domestic commodity of similar quality to get imported.

    Regarding international factor mobility, Ricardo stated the following:

    ‘It would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances, the wine and the cloth should both be made in Portugal, and therefore that the capital and labour of England employed in making cloth, should be removed to Portugal for that purpose. In that case, the relative value of these commodities would be regulated by the same principle, as if one were the produce of Yorkshire, and the other of London: and in every other case, if capital freely flowed towards those countries where it could be most profitably employed, there could be no difference in the rate of profit, and no other difference in the real or labour price of commodities, than the additional quantity of labour required to convey them to the various markets where they were to be sold’ (Vol. I, p. 136).

    Ricardo believed, thus, that if one day capital and workers could move as easily between countries as between the provinces of the same country, the relative value of commodities produced in different countries would be regulated by the same principle as if they were produced in the same country, namely by the amount of labour time required for their production and conveyance. Then, the most productive countries in the production of particular commodities would also be the cheapest producers.

    I think you would agree that the above is not a realistic description of the world we are currently living, don’t you?

    As I have argued in my dissertation, the original classical case for free trade was not based on “comparative advantage”, nor on any fallacy or unrealistic assumption. See here:
    https://jorgemoralesmeoqui.academia.edu/research

    • Thanks for your comments Jorge.

      Actually, at least when it comes to the theory of comparative advantage, I don’t think we disagree. As your Ricardo quote shows (and I’ve used the same quote in my own History of Economic Thought books), Ricardo was quite aware (as was also Ohlin) of the assumption of international immobility of factors of production being a prerequisite for this theory to hold. Today we live in a world where the assumption is blatantly false, and so my grudge is against exponents of mainstream neoclassical economists (not Ricardo) who still today portray the theory of comparative advantage as being operative. it’s not!

      On the issue of the basic deductive-axiomatic approach of Ricardo, I (as did Keynes) think economics would have developed in a more relevant direction without it.

      • Thanks for your reply, Lars.

        I’m not sure that most readers of your blog get the impression that your criticism of the theory of comparative advantage is not meant to be directed towards Ricardo.

        Regarding the empirical validity of the theory, I think it was Einstein who said that whether you can observe a thing or not depends on the theory which you use. It is the theory which decides what can be observed.

        There is not a single theory of comparative advantage, but at least three: 1) Ricardo’s original theory; 2) the trade model in economic textbooks; and 3) Heckscher/Ohlin. The last two are wrong because they were developed based on specific misinterpretations of the original numerical example.

        Since a theory is a group of propositions, what are the propositions that Ricardo illustrated in the numerical example? 1) The amount of labor time does not regulate the relative value of commodities produced in different countries; and 2) and that it might be mutually beneficial if a country imports a commodity that can be produced with less labour internally.

        These propositions are not only empirically true but also easily observable nowadays. Don’t you think so? I certainly do.

        Regarding the deductive-axiomatic approach that you – apparently echoing Keynes – attribute to Ricardo, I don’t think it is an accurate description of Ricardo’s method.

        It was Ricardo’s close friend James Mill who recommended him to write his ideas down in the following way: first announce a proposition, then explained it and finally illustrate it with a numerical example. That is exactly how Ricardo proceeded in the chapter On Foreign Trade. I don’t know what is so problematic with this way of conveying an idea or proposition.

    • All that movement you are describing would create pollution and externalizes many of those and other costs not factored into the price of the goods and labour.

      • Comparative advantage is used within a single international corporation for allocating production resources with costs from different countries.
        .
        International corporations would certainly like to have free trades and less region regulations so that they can optimize production costs and maximize corporate profits based on each country advantages, but it is not necessarily good for each individual country.

  4. I do think Ricardo’s argument has an attraction for students of economics not unlike three-card Monte or a shell game. Everyone suspects a trick and thinks they can follow the shuffle closely enough to locate the pea — they will identify the key hidden assumption palmed by the dealer and the “real” game will be revealed.
    .
    On the fundamental question of whether we can always benefit mutually from specialization and trade, I think we can safely affirm that we can. Ricardo’s argument, excessively abstract as was his wont (this was his “vice”), does distinguish why alleged absolute advantage is irrelevant.
    .
    I cannot say I object to that fine analytic insight, nor to axiomatic-deductive analysis as a method. I do object to the excessive abstraction that fails to consider the full complement of necessary and sufficient elements that must attend production. And, I object to proving a theorem and then waving out the window as if one has described the world. No one doing geometry thinks proving a theorem surveys and maps a territory, but many economists demonstrate exactly that confusion.
    .
    I would not have to object, if taking the comparative advantage argument to heart, economists had attempted to determine the extent to which comparative advantage explains actual patterns of trade. Oh wait, H-O did that, as a recent Syll post reminded us, and . . . economists managed to learn very little from repeating the exercise hundreds if not thousands of times, always with a negative result: comparative advantage is not a powerful explanator. And, worse, in history we have many instances where trade seems to be immiserating at least some of the participants or even leaving some unable to produce anything of sufficient exchange value to keep them employed in the economy.
    .
    I also would not have to object, if having taken up deductive analysis, economists took responsibility for determining what are the necessary and sufficient elements of production. What is the economic theory of production? Keen is right to mention machinery, but that is scarcely beginning the task of building a complete list of necessary and sufficient elements. Management, finance, pollution, technological science — more obvious elements left aside in an analytic effort that fails to acknowledge or explore something as fundamental to economics as production.


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