As a native Floridian who can never get enough of palm trees and beautiful beaches, I’ve been naturally drawn to the simple idyllic island textbook examples used to introduce the student of economics to the theory of free trade, otherwise known as the theory of comparative advantage (CA). Here we discover the island native as having a so called absolute advantage (i.e. is more efficient and produces more output) at collecting coconuts and catching fish. In other words, after 8 hours of labor the highly skilled native would have more coconuts and fish in his possession than the stranded mariner would. The magic of CA we are told is that if only the two would would simply get together and rearrange the work load (one fishes, one collects coconuts) and then trade, they would both better off! A simple calculation is usually included to show how this would obviously be true. So not only do we have a tropical paradise, but we also have an economic paradise. The surprising result is then used to make the case that if the entire world would only shuffle its industries around among nations, we’d all be better off.
But lets take a step back and ask what could be wrong with this trade wind laden fantasy. In short, there are at least two critical errors in this model. Note that there are only two producers. This is not a typical economy in which we have competitors and worker mobility. In other words, in the real world if the mariner was inefficiently producing coconuts and fish he would be put out of business by the native. The mariner would eventually be hired by the native and produce fish and coconuts using his methods. This is the normal path of industrial growth.
The second core defect in this model is that it does not use money in any form, in keeping with modern economics which treats money as an afterthought. But David Ricardo, the father of free trade theory, writing in the 1800s recognized that money had to be taken into account. As a result, he adopted Hume’s defective model of international gold flows to make the case for CA. Hume’s model is effectively what amounts to the Quantity Theory of Money (QTM) which I have dismantled and rejected in the earlier essay “Just Measure.” The implication for Ricardo is straight forward. He is forced to abandon the very heart of his economic theory–the labor theory of value–and replaces it with a supply-and-demand pricing model. Ricardo’s chapter “On Foreign Trade” contains the following powerful yet faulty observation: “The quantity of wine which she [Portugal] shall give in exchange for the cloth of England is not determined by the respective quantities of labour devoted to the production of each, as it would be if both commodities were manufactured in England, or both in Portugal.” (Ricardo. 1911. 82)
I consider this single sentence by Ricardo as a candidate for the most important sentence ever written in the history of economics, because it represents the intellectual fork in the road which a nation must choose to determine its final economic destiny. It either represents the rationale for utter economic destruction or glorious prosperity depending on your reading of it. Ultimately, our survival depends on it.
Let’s stick with Ricardo’s line of thinking and see where it leads us. What follows then is taken directly from my book.
Let’s modify our paradise to emulate an international model with competitive industries. Imagine, far away, in an emerald green sea a place where two cruise liners have dropped their passengers two decades earlier. Here we find the two respective parties split into two groups. Over the years, both marooned parties have achieved an identical standard of living (i.e. productivity), along with identical populations, tastes, and cultures. A visitor to either side of the island could not tell them apart, except for one thing: The prices of goods. Both parties have discovered different quantities of gold on the island and have chosen to use it as money. The East Shore (ES) party had very little gold and the West Shore (WS) party had roughly 10 times the amount of gold found on the ES. As a result, prices on the WS were 10 times higher in terms of gold than East Shore prices, because there is 10 times the labor needed to dig the gold out of the ground on ES. Note that East Shore has no way of knowing why there is a significant price differential. Perhaps the West Shore is only 1/ 10 as productive and requires ten times the labor to produce a product. In effect, these societies are small nations. Eventually, an earthquake brings the two parties together. As a result, the ES businesses see a fantastic opportunity to sell their product to the WS, since ES prices are 1/ 10 those on the WS. Afraid of other competitors in their own ranks, the ES producers keep a relatively small profit margin as they flood the WS with their goods. In no time at all, the WS industries are destroyed by the vastly cheaper imports from the ES, because the gold prices are radically different.
Wages won’t adjust because prices don’t drive wages, instead wages drive prices (the labor content of domestic gold set the domestic wage level). Because gold is gold, there no way to distinguish the labor content difference in ES gold verses WS gold. Thus in free trade the domestic nature of money is nothing but a mixed up measure. Note also, there has not been a significant loss of gold from the WS since the imports were radically cheaper. Businesses on the WS will therefore vanish under the price pressure from foreign competitors, with no one the wiser. During the decline, countless solutions ranging from improved education to tax reductions are proposed. Nothing works. Perplexing economic chaos eventually ensues due to mass unemployment in the manufacturing sector and related industries on the WS.
Except for the wage-unit tied to a quantity of gold, these societies were absolutely identical and yet one was ruined. Note also the ES industry sector sizes are now unnaturally distorted towards the export sector. What in the end did the ES gain, except more gold and less domestic buying power? Nothing. The ES labor force swapped gold for less purchasing power, because they could no longer purchase the total sum of their total output. A large portion of national output was not consumed but exported— pre-Civil War plantation economics in action (England’s forgotten subsistence wages of the 17-1800s). Transitioning to an export focused society, the ES actually got poorer in terms of consumption goods. The absolute price difference induced a form of trade which was absolutely pointless and destructive in two identical societies. To pretend this economic demolition would end happily is simple hand waving as I hope the story of the economic birth of the United States under the Articles of Confederation illustrated, because it could not lay tariffs.
How do modern economists manage to dig themselves out of this logical hole and imagine one with a happy ending if the simple gold model fails us? Their so called many-goods model simply assumes as long as one industry remains due to comparative advantage, it can provide the export good for all other imported goods to maintain a balanced trade. For example, we could cover the entire United States with hot houses, grow oranges, and literally import all our other needs in exchange for oranges. This magical result is based on the free trader’s belief of the power of flexible exchange rates, flexible prices, flexible wages, and comparative advantage.
Let’s give the free trader the benefit of the doubt and assume balanced trade has been achieved. Is it enough to save Ricardo’s model? To answer this question, let’s build another simple model. Assume country A has a population of 100 million and 1/ 10 the wages of country B which has a population of 10 million. Also assume Country A exports the equivalent of the annual output of 9 million workers at 1/ 10 the price of what Country B could produce it at. The imports in country B would appear as merely 9% of Country B’s GDP in dollar amounts. Keep in mind it therefore only takes 9% of the work force in Country B to produce the exports needed to balance trade in dollar amounts. How much harm if any could this do if trade is balanced? Astonishingly, Country B will have 90% unemployment (9 million workers) due to imports “price-masking” of the labor hours embedded the imported products. Suddenly, Ricardo’s comparative advantage price magic presents us with a tremendous problem for the very reason he flip flopped his logic: the embedded labor.
In spite of 90% unemployment in Country B and a mere 9% of GDP in terms of dollar amounts of imports, we have balanced trade. In other words, I’m suggesting balanced trade does not prevent fantastically high levels of unemployment and economic distortion, because an economy engaged in international trade can no longer track properly the embedded hours of labor. But is this necessarily the end of the story? No, we must consider the freed up labor which has resulted in Country B. We have to assume we have now freed up 90% of the work force to move into new employment due to the new purchasing power achieved through cheap imports. This first step is no different than cost savings achieved when a revolution in productivity takes place in a domestic industry except it suffers from an unnatural time distortion. Normally sectors grow and shift at the slow rate of productivity growth, while free-trade sector displacements amount to a brutal time machine which skips over this gentle movement forward. It can literally happen overnight as the tariffs are removed. Regardless, let’s ignore the brutality of the transition and recall if you saved money on a cost reduction in the clothing sector, you might spend the saved income on a new American-made TV in a closed economy. The TV industry therefore grows to make up for the new purchasing power. Unfortunately, this absolutely critical step cannot happen in a free-trade scenario where the foreign competitor has the cost advantage across all industries. Any industry which attempts to expand to take advantage of the increased purchasing power would be immediately smothered by the foreign competitor. In the closed economy scenario, the costs savings would be spent on a different domestic sector— emphasis on domestic sector. In the open economy the consumer savings are simply spent on more imports, assuming they still have a job (which they don’t). The entire adjustment dynamic of an economy is paralyzed.
I chose 10 to 1 to exaggerate the distortion taking place in an open economy, but as serendipity would have it a 10 to 1 price advantage when it comes to Asian surfboard imports is not so far fetched. When I first heard of this, and having grown up on the beaches of Florida, I immediately painted in my mind’s eye an image of five surfers sitting on the beach in the 1960s. One manufactured the sunglasses they all wore. The other the swim trunks, another the surfboard, and the other two the sun tan oil and flip flops. There is an honesty to this picture, and all earned good livings and employed many people. Then I imagined them all using and wearing imports because their industries have been destroyed and their standard of living standards radically reduced. This almost strikes me as something sinister. What would be the economist’s response? He would suggest that wages will drop like a rock in country B. Keep in mind QTM allows this fantasy to persist in economic models, a mechanism I reject in my “Just Measure” essay. Since our premise is that minimum wages must ultimately defined by decree in a modern money model we don’t expect this to happen.
It is interesting to consider that even if the foreign exporter reinvests his newly required dollars back in the USA, the damage is done. To appreciate this, consider a scenario where the foreign exporter has a 10 to 1 labor cost advantage. Now assume he has earned $ 100 million. This $ 100 million reflects $ 1 billion in displaced America labor due to labor content of the goods. Thus if he reinvests the $ 100 million, he has only repaired 10% of the damage he has created.
It may seem unreasonable to the reader that a low-wage nation would engage in trade at a 10 to 1 labor disadvantage. In other words, for every ten hours embedded in a manufactured product sent here, it only gets back one hour in say agricultural goods it purchases. Who would be that crazy, unless you are crazy like a fox ? The only reason someone would be shrewd enough to do such a thing is to drive corporations and know-how out of this country, and into the competing country. This allows the leap frogging of the 200-year process nations required to acquire technical skills. If you want to win an industrial war, you first have to take way the enemy’s economic guns. How do you take the enemy’s economic guns without having your own? You send over a very sweet and seductive offer in the form of cheap goods.
In the end, the Chinese have departed the island on a glorious ocean liner called S.S. Protectionism, while we are stuck collecting free trade coconuts.