June 27, 2011

What They Never Told You About "Comparative Advantage"

"If there were an Economist’s Creed, it would surely contain the affirmations 'I understand the Principle of Comparative Advantage' and 'I advocate Free Trade'."
-Paul Krugman
David Ricardo first articulated the concept of comparative advantage in 1817.  In a nutshell, it suggests a happy world where each country is better at producing some goods than others, and it pays for each country to specialize in producing goods in which it has the greatest comparative advantage.  In the classic example, Portgual can product both cloth and wine at 90 and 80 labor units, while England can produce them at 100 and 110 respectively.  Even though Portugal is the low-cost producer in both instances, there is more relative profit in wine (30) than in cloth (10), so collectively Portugal can trade wine for English cloth and both parties profit from the relationship.  How all of this magically balances out trade deficits and improves quality of life for everyone is an article of faith within the Economists' Creed.

A key assumption that Ricardo made is today ignored by modern economists:
" ... 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."
Guess what?  Capital flows freely around the world today, to every country, except oddballs like North Korea.  Mobile capital seeks cheap labor, cheap land, lax regulatory rules, and low taxes.  Therefore "comparative advantage" is now a race to the bottom for labor, environmental regulation, and progressive taxation.  With free capital, Portugal's low labor costs can now produce both wine and cloth and drive English businesses out entirely.

Modern economists look back upon the 19th century United States with disdain, a country that had booms and busts, no social safety net, little government economic intervention, and no central bank.  It was also strongly protectionist, starting with Alexander Hamilton and maintained by the Whig and later Republican parties.  This was known as the American System, which stood in contrast to the free trade-oriented British System.  These terms are quaint today, but the conflicting worldviews can still be identified in modern free trade debate.

Tariff rates bounced around from a low in 1857 of 18%, to 40-50% that was characteristic of the Gilded Age.  Abraham Lincoln raised tariffs to 49% during the US Civil War.  During the period 1865-1890, America experienced the most rapid growth of its entire existence, hitting 6.8% annual GDP growth and doubling its GDP during the 1880s.  By 1890, in but 100 years, America had eclipsed Great Britain as the world's largest industrial power.  Commitment to protectionism then began to falter, leading to conflict between free trade Democrats and protectionist Republicans.  Future President William McKinley said of this:
"Under free trade the trader is the master and the producer the slave. Protection is but the law of nature, the law of self-preservation, of self-development, of securing the highest and best destiny of the race of man. [It is said] that protection is immoral…. Why, if protection builds up and elevates 63,000,000 [the U.S. population] of people, the influence of those 63,000,000 of people elevates the rest of the world. We cannot take a step in the pathway of progress without benefiting mankind everywhere. Well, they say, ‘Buy where you can buy the cheapest'…. Of course, that applies to labor as to everything else. Let me give you a maxim that is a thousand times better than that, and it is the protection maxim: ‘Buy where you can pay the easiest.' And that spot of earth is where labor wins its highest rewards."
 McKinley successfully passed  through Congress a namesake tariff act in 1890.  To its critics in retrospect he commented:
"What has this Protective Tariff law of 1890 done? Why, it has increased factories all over the United States. It has built new ones, it has enlarged old ones.... [For example, we] used to buy our buttons made in Austria by the prison labor of Austria. We are buying our buttons today made by the free labor of America. We had 11 button factories before 1890; we have 85 now. We employed 500 men before 1890, at from $12 to $15 a week; we employ 8,000 men now, at from $18 to $35 a week."...|Well, but, they said, this tariff law of 1890 was going to increase the price of necessaries of life, and was going to diminish the wages of labor. It has done neither. The necessities of life are cheaper today than they were 18 months ago. The commodities that go into the household of every man and woman are cheaper today ... and the price of labor has increased to some extent."
Contrast this today with those who told us NAFTA and MFN status for China would create American jobs.  Do any pundits today set higher wages and lower product costs as a policy goal today?  No, we are told that higher wages leads to bad "price spiral" inflation, but higher product costs reflect more "quality", demand growth, and other positive things.

McKinley had this to say about land owenership:
``We must avoid in this country the holding of large tracts of land by non-resident owners for speculative purposes, and set our faces like flint against alien land-holding in small or large tracts. Our public domain must be re-dedicated to our own people, and neither foreign syndicates nor domestic corporations must be permitted to divert it from the hallowed purposes of actual settlement by real farmers."
You don't expect to hear Republicans talking like Marxist land reformers.  No doubt the Monsantos of the world are happy to keep this bit of US history dead.

Henry Carey, advisor to President Lincoln and a forgotten economist who promoted the American System, expressed some loftier goals for the battle between the American and British systems:
``Two systems are before the world; the one looks to increasing the proportion of persons and of capital engaged in trade and transportation, and therefore to diminishing the proportion engaged in producing commodities with which to trade, with necessarily diminished return to the labour of all; while the other looks to increasing the proportion engaged in the work of production, and diminishing that engaged in trade and transportation, with increased return to all, giving to the labourer good wages, and to the owner of capital good profits. One looks to increasing the quantity of raw materials to be exported, and diminishing the inducements to the import of men, thus impoverishing both farmer and planter by throwing on them the burden of freight; while the other looks to increasing the import of men, and diminishing the export of raw materials, thereby enriching both planter and farmer by relieving them from the payment of freight. One looks to compelling the farmers and planters of the Union to continue their contributions for the support of the fleets and armies, the paupers, the nobles and the sovereigns of Europe; the other to enabling ourselves to apply the same means to the moral and intellectual improvement of the sovereigns of America. One looks to the continuance of that bastard freedom of trade which denies the principle of protection, yet doles it out as revenue duties; the other to extending the area of legitimate free trade by the establishment of perfect protection, followed by the annexation of individuals and communities, and ultimately by the abolition of custom-houses. One looks to exporting men to occupy desert tracts, the sovereignty of which is obtained by aid of diplomacy or war; the other to increasing the value of an immense extent of vacant land by importing men by millions for their occupation. One looks to increasing the necessity for commerce; the other to increasing the power to maintain it. One looks to underworking the Hindoo [sic], and sinking the rest of the world to his level; the other to raising the standard of man throughout the world to our level. One looks to pauperism, ignorance, depopulation, and barbarism; the other in increasing wealth, comfort, intelligence, combination of action, and civilization. One looks towards universal war; the other towards universal peace. One is the English system; the other we may be proud to call the American system, for it is the only one ever devised the tendency of which was that of elevating while equalizing the condition of man throughout the world.
Once again we see Republicans calling for workers of the world to unite, even using rhetoric reminiscent of historical dialectics.  A far cry from modern Republicans, who have fully bought into the "British System".

Today China, Japan, South Korea, and other nations pursue protectionist trade policies, while US and many European tariffs remain low due to free trade theorists winning the public debate.  Not only is the comparative advantage theory obsolete in this age of global capital flows, but it has obviously unbalanced the distribution of wealth between labor and capital in the developed world.  These faux progressives who advocate free trade today run under a false flag--the capital class rewards them with academic accolades and media play in order to make the public believe that free trade is in their interest.

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