Ricardo’s Caveat
Ricardo
In 1817, David Ricardo formalized the Law of Comparative Advantage. Since then, it has stood the test of time as one of the very few laws that an economist can point to and say: “This is indisputably true.” It’s because of this law that you only rarely find an economist who doesn’t believe in unrestricted free trade. But Ricardo added an important caveat when he discussed free trade and comparative advantage and it’s one that most modern economists seem to have forgotten…
Let’s quote straight from Ricardo:
In one and the same country, profits are, generally speaking, always on the same level; or differ only as the employment of capital may be more or less secure and agreeable. It is not so between different countries. If the profits of capital employed in Yorkshire, should exceed those of capital employed in London, capital would speedily move from London to Yorkshire, and an equality of profits would be effected; but if in consequence of the diminished rate of production in the lands of England, from the increase of capital and population, wages should rise, and profits fall, it would not follow that capital and population would necessarily move from England to Holland, or Spain, or Russia, where profits might be higher.
This is the Achilles heal of comparative advantage–the flaw in the foundation of free trade that causes outsourcing woes. Those who say that the law of comparative advantage proves that free trade is good are absolutely right, but they’ve forgotten his caveat.
Because, in Ricardo’s world, it was true that capital was not particularly mobile. It is not true in our world and it wasn’t true in the Victorian world.
In a world in which I can move my capital freely between locales, in which I can also move my profits freely, and in which I don’t have to live where my capital is working, there is no reason to invest in any productive activity in my home country–I can make more money elsewhere.
The higher surplus locale is going to get as much free capital as it can soak up and as is available. The logic behind this is simple: Let’s say I have 1 million dollars to invest and I can invest it in two different locales. In one place, I’ll get 5% return, in another 10% return. In both locales, I can take my profit and do what I want with it and I can live in either locale and, in both places, my money is secure from being seized by the government or destroyed by violence. Obviously, I’m going to put my money into the place with the higher returns.
When I get those profits, I’m going to sink any reinvestment into the place with the higher returns again. It’s a virtuous circle–if you’re the place with the higher returns and it ends when returns even out or there is no more excess capacity.
If the higher-return country runs out of investment opportunities that pay higher than the low-return country, it makes no sense to invest in it. What matters here is the marginal rate of return–that is, the return on the next dollar of my investment. In principle, there ought to be diminishing returns; people snap up the good opportunities and, over time, the opportunities get worse and worse until returns equalize (this happens faster when currency values are decided independent of government intervention, but it doesn’t always happen–even in the long term–when we’re all dead).
Profit is just how much surplus you’re receiving. Let’s say my workers are capable of producing $5 of goods for every hour they work and my costs are $3/hour for everything (property, taxes, capital costs, and wages). I’m making $2 an hour for every worker I have working for me.
That’s country A. In country B, the average worker produces $10 an hour, but my costs are $9, so my surplus is $1. This is half the profit of country A, even though my workers are more productive.
That’s why US workers are more productive and people are shipping jobs to China and India. Costs in the US are higher for property, wages, and taxation.
To stop capital (and jobs) moving from Country B to Country A, you have to increase surplus. There are two ways to do that: You can reduce costs (most easily by cutting taxes or wages) or you can increase productivity. If the average worker produces one more dollar of goods while costs stays the same, and Country A’s worker’s productivity doesn’t increase, then you’re even.
Or Country A could increase wages, taxation, or property costs and become less competitive.
In a world without mass capital flows, there was another way. You could have lower capital costs. But having the Fed set lower capital costs than another country means little–borrow in the US, invest it where the ROI is higher.
More than that , money you can’t use is, well, useless. Let’s say you’re investing in a factory in China, but you want to live in Europe or the US–and Europe and the US won’t let you use the money you have in China in their countries (or will only let a fraction back in). In this scenario, you’re not likely to invest in China, are you? In addition, money that can’t move is captive to political unrest and other such events, which gives mature, stable countries a big leg up. If moving money is hard or slow, then you’d better be sure that where you have it is stable because if something goes wrong, you can kiss it goodbye.
A key problem right now is demand. Capital flows to low-production-cost/high-surplus domiciles. But there’s only so much demand for goods and only a limited amount of growth in demand for goods. So you’ve got your profits and you have to figure out what to do with them. You can’t plow all of it back into productive investment, because you’d wind up with more productive capacity than there is ability to buy the goods. As a result the excess money has to go into nonproductive uses.
The money that does go into productive uses will go to the domiciles that produce the greatest surplus (profit). Many people have pointed out that the US hasn’t lost jobs to outsourcing, that’s only true in a technical sense. What has happened is that the new jobs have been mostly created overseas (in cases where they can be done overseas). Old jobs haven’t (mostly) been moved because of sunk capital costs. Once you’ve paid ten million dollars to create a factory, spending another ten million dollars to relocate the factory usually doesn’t make sense. But if you have to build a new factory anyway (either because you need more capacity or because the old factory would have to be replaced for some reason), then it makes sense to build it in the domicile with the higher surplus production. That’s exactly what we’ve seen over the last few years: China and India getting the new jobs in non-protected sectors. It’s not rocket science, it’s just ROI (Return On Investment).
Because you can’t put all the money back into production, you’ve got to stick some of the money elsewhere. And what we have going is a nice reinforcing trend. Oldman had called it strip mining the US economy. The money is used to buy your customers’ assets or lent to your customers. In exchange, they put up as collateral either the full faith of their government (we’ll see how good that is in a few years) or their assets, which in the current case means mortgage backed securities, bonds, and common shares in companies (which represent ownership of assets). They then use that money to buy your goods and the cycle continues.
This vicious cycle (or virtuous if you’re the one getting rich and you get out in time) results in excess productive capacity, a slow decline in employment in the low-surplus domicile, and an increase in debt in the low-surplus domicile. It also pushes costs in the low-surplus domicile lower (meaning wages and taxation, primarily).
In the meantime, if the developed world (and specifically the US) were to stop borrowing to buy, the entire engine would collapse. This is not a sustainable development; if the US were to buy only what it could afford, based on its own exports, there would be an economic shockwave–not just in the US, but in China, India, and other high-surplus/low-cost domiciles. And right now, the dynamic is being funded by taking money out of the US and other high-cost domiciles, which must ultimately end in a reduction of demand. If the low-cost domiciles, which have been getting the capital investment, are not capable of soaking up the excess capacity when the US’s consumption comes in line with what the US can afford, then you will have a worldwide recession at the least–and likely a depression.
Economics views systems as moving towards equilibrium. But it’s more useful to view systems as subject to multiple different tendencies. At any given time, different tendencies may be stronger than others. What should be happening is that US costs should drop and developing country costs should rise. It is happening, but it’s not happening very fast. Where these costs meet is going to be somewhere a lot south of the current US standard of living. In the meantime, the dynamic has the US shipping its capital and its growth in productive capacity to lower-cost/higher-surplus domiciles. This will continue until the conditions enabling it end and not before. The conditions which can end it are increased shipping costs (favouring more localized production), surplus production evening out, a political decision to discourage either trade or capital flows, or an unwillingness or inability of either the US to borrow or its creditors to lend (the end of the housing bubble strikes directly at this). Until then, capital will go to the higher returns and since the highest returns on production are mostly not in the US, capital that creates production jobs will flow disproportionately away from the US while asset bubbles form in the United States in order to pay for imports. (And the assets they have bought, or allowed the US to borrow against, are likely to crash in the final days of this system. A suckers game all around, but the only thing worse than playing is trying to stop playing.)
(Originally published years ago at BOP news, I put it back up here because this is what is at the heart of problems with globalization and why comparative advantage no longer works. April 25, 2015 —and back to the top again, in honor of the Trans-Pacific Partnership Trade Agreement.)
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Another oldie but goodie.
Henry C. K. Liu, Dollar Hegemony (April, 2002)
I worry about the “waste” of money: when the wealthy take capital out of corporations and put it into their own pockets. Being a layman, I don’t quite know where that wealth goes, but it strikes me that the wealth sits idle and eventually loses value. What work is wealth doing when it’s socked away in a Cayman Islands or Swiss bank? Are those organizations using the wealth for purposes that benefit anybody? What’s the gap between what that wealth could produce if a) distributed to workers as higher pay; b) re-invested it the originating company; c) actively invested in other companies, or; d) being squirreled away in some Swiss Bank until it’s paid out to the kids as inheritance? How much does hoarded wealth cost all of us?
My worry is that manufacturing, industry, and applied science are all keys to economic growth, technological development, and (over the longer term) increases in the standard of living. People who work with materials and technologies learn from them, they develop a mindset for building, investing, and tinkering that leads to innovations. By shipping so many of these jobs overseas, we’re losing the people and skills that lead to further innovations and growth. The future will be built by the producers of today, and while the US is still a manufacturing giant, we’ve slowed and reversed our growth in that area.
The future will not be built in the US, and while the economic picture outlined above is the cause, political decisions are to blame. We’ (or at least, our political class) have decided that high returns on capital outweigh investment in our material future.
The political class didn’t decide this. Their owners did.
This is a side issue (sort of) but I’m bothered by the line that “in the long run, we’re all dead.” Yes, I know what Keynes meant. And it’s certainly true that it can’t be all about the long run. We live in that shortest of runs called “now.”
It bothers me, though, because it’s not true. Or it better not be. Economists don’t really expect humanity to die out soon, do they? So what the phrase really means is, “In the long run, I’m dead, and forget everyone younger.”
It’s used that way, too. Generally, it’s used to say, “Screw posterity,” and not to mean, “We need to balance short term and long term interests in a total least cost solution.” (Hmm. That sure wouldn’t make much of a bumpersticker.)
Just for the record, I’m old enough where I can trash posterity at no cost to me. But I don’t get it. If they don’t care about anyone else, don’t these people have grandchildren?
Off Topic. Have you seen this Ian? Just being reported at Al Jazeera. Commodity prices will short those at greatest risk.
http://english.aljazeera.net/news/europe/2010/08/20108514946473957.html
There is a third way to stop the flow of capital from higher cost areas to lower cost areas.
Abolish Free Trade and restore Protection.
(Everybody say it together)— Free Trade is the New Slavery. Protectionism is the New Abolition.
I don’t think Indians and Chinese are particularly happy about being dominated by foreign economic elites. “Shipping jobs overseas” is a bit like “he hit my fist with his face”.
I think the passivity of Americans is somewhat accounted for by the feeling of power they get from the idea that their own elites are keeping the ‘furriners down.
Yep,
I hope your analysis of the majority attitude in India/China/etc. is correct. Because if the majorities there can rise up and force the foreign elites to leave, perhaps the foreign elites will have nowhere to leave to but the countries they came from. Bringing “their” jobs ( OUR jobs) back with them.
“Yankee Go Home!! And take your jobs with you!!!” We should only be so lucky.
What about currencies and rates of exchange? It seems like it’s not just about the rate of return on an investment, but the probability of being able to spend that return in the currency you require. If you’re paying your bills in dollars, and earning your returns in reals, then a bad movement in the exchange rate could wipe out your “profits”. Yes?
Well, two weeks ago I finished listening to Walter Isaacson’s new book, The Innovators: How a Group of Inventors, Hackers, Geniuses, and Geeks Created the Digital Revolution. I think it provides two vivid examples which show that Ricardo’s theory is without basis in the real world.
Hungary should have been the world leaders in computers and computer science, and nuclear weaponry. Just look at a partial list of leading mathematicians and scientists born in Budapest at the turn of the 2oth century.
John von Neumann (born in Budapest, Hungary, December 28, 1903), Quantum Theory, Game theory a pioneer of digital computing and the key mathematician in the Manhattan Project.
Victor G. Szebehely (born in Budapest, Hungary, August 21, 1921) a key figure in the development and success of the Apollo moon program. His first book, The Theory of Orbits, is the definitive text on the restricted three-body problem as applicable to an Earth-Moon spacecraft system such as Apollo.
Zoltán Lajos Bay (July 24, 1900 in Gyulavári, Hungary) who developed microwave technology.
Imre Gyula Izsák (born in Zalaegerszeg, Hungary, February 21, 1929) determined the precise shape of the Earth.
Leó Szilárd (born in Budapest, February 11, 1898). He conceived the nuclear chain reaction in 1933, patented the idea of a nuclear reactor with Enrico Fermi, and in late 1939 wrote the letter for Albert Einstein’s signature that resulted in the Manhattan Project that built the atomic bomb.He also conceived the electron microscope.He conceived the linear accelerator and the cyclotron.[
Wigner Jenő Pál (born in Budapest, November 17, 1902), winner of 1963 Nobel Prize in Physics “for his contributions to the theory of the atomic nucleus and the elementary particles, particularly through the discovery and application of fundamental symmetry principles” Wigner is also important for his work in pure mathematics, having authored a number of theorems. In particular, Wigner’s theorem is a cornerstone in the mathematical formulation of quantum mechanics, which explains the inner workings of atoms.
Edward Teller (born in Budapest, January 15, 1908) known colloquially as “the father of the hydrogen bomb”.
John George Kemeny (born in Budapest, May 31, 1926) co-developer of the BASIC programming language in 1964 with Thomas E. Kurtz.
Charles Simonyi (born in Budapest September 10, 194) head of Microsoft’s application software group, oversaw the creation of Microsoft’s flagship Office suite of applications.
Theodore von Kármán (born in Budapest May 11, 1881) mathematician, aerospace engineer and physicist who was active primarily in the fields of aeronautics and astronautics. many key advances in aerodynamics, notably his work on supersonic and hypersonic airflow characterization.
With this extraordinary concentration of scientific genius and technological acumen, how is it that Hungary never emerged as a world center of computers, software, aeronautics, and nuclear weaponry? Of course there is the problem of anti-Semitism and pograms – many of these scientists and engineers were Jewish. I cannot see how Ricardo’s theory helps us at all in understanding this puzzle. But I can easily conceive of a reason – the power, patronage, and purse of the U.S. government completely derailed the “natural development” of Ricardo in these areas. In other words, deliberate actions and policies overwhelmingly can trump Ricardo’s theory. I.e., a “Hamiltonian” policy of nation building, which encourages scientific inquiry and technological innovation as the most noble of human mental endeavors. As different clue comments above: Abolish Free Trade and restore Protection.
In fact, how can Ricardo’s theory explain anything about the development and deployment of new scientific and technological knowledge, and its application to economic processes? As I have argued before, it is exactly the development of science and technology that is the most important economic activity any society undertakes. It is new scientific and technological knowledge which allows a society to avoid the “limits to growth” imposed by natural resources at one particular point in the economic development of a society. From this perspective, it should be easy to see that Ricardo’s corpus of thought and work, like all of the work done by the British oligarchy, fails to deal with the most important aspect of human existence because it does not understand, nor celebrate, the creative powers of human mentation. It is oligarchical, and all it can comprehend is a finite world of fixed rules and strict hierarchy.
I want to mention one person discussed by Isaacson, Herman Goldstine, a mathematician at the University of Michigan who became a captain in the U.S. Army during World War Two, and supervised calculations of ballistic trajectories at the Ballistic Research Laboratory (BRL) at Aberdeen Proving Ground, Maryland. It was Captain Herman Goldstine who, in June 1943, recruited and directed John Mauchly to design and build ENIAC at Moore School of Electrical Engineering at the University of Pennsylvania. It was Goldstine who a few months later recruited and directed John von Neumann as von Neumann visited universities, companies, and military facilities around the country, gathering all the information he could on the problem of building a computer. Goldstine wrote to his Army superior, “We propose a centralized porgramming device in which the program routine is stored in coded form in the same type storage devices suggested above.” It was Goldstine who decided to openly distribute 24 copies of von Neumann’s report “First Draft of a Report on the EDVAC” in June 1945. This report became the foundation of computer development for the next decade and a half.
Or another example: How does Ricardo’s theory explain why Britain did not also emerge as a world leader in computers and computer science? It was British mathematican Alan Turing who wrote the crucial 1936 theoretical paper, “On Computable Numbers, with an Application to the Entscheidungsproblem” proving that a machine could be built to solve all mathematical problems. It remains a fundamental paper in computer sciences today. And the British had designed, built, and operated computers arguably better than ENIAC and EDVAC at the National Codes Centre at Bletchley Park and later the Manchester Mark 1, one of the earliest stored-program computers.
And just to erase any doubt that the policies which led the United States to dominate computerwere deliberate, look up the Moore School Lectures.. In July-August 1946, the Office of Naval Research and Army Ordnance Dept. sponsored a seminar now known as the Moore School Lectures. The formal title of the seminar was “Theory and Technique for the Design of Electronic Digital Computers.” Physicist John Mauchly, designer of ENIAC, made it clear to the participants that the purpose of the seminar “Purpose of course was to instruct and give background for design of new machines, not to learn operation of any machine already built,” according to participant Paul Gard. In other words, the Navy and Army intended the seminar not as a review of already existing programs, but as a free diffusion of scientific and technical knowledge to assist others in pushing forward the development of computers.
As Von Neumann explained a few years later, “I certainly intended to do my part to keep as much of this field in the public domain as I can.” He later explained that he had two goals: “to contribute to clarifying and coordinating the thinking of the group working on the EDVAC” and “to further the development of the art of building high speed computers.”
The “jobs” aren’t dropped on mere mortals by American billionaires like mannah from Heaven, people have skills that they can put to use or sell to an employer. Without the foreign “job creators”, they’d become “job creators” themselves or go to work for local “job creators” who would be much more amenable to local political pressure than remote overlords.
Really it’s the fear of the latter happening among the USA ruling class that drives the ferocity of the outsourcing push. India and China are each taken alone nearly 2X larger by population than the entire Euro-American world. There’s no way for that world’s elites to avoid being muscled aside by Asian upstarts other than to institute a neo-Raj.
[c’td]
Japan’s economic rise in the 1980s put enough of a scare into the Western ruling class for them to push through the Plaza Accords. India and China together have roughly 20x Japans population and aren’t military dependencies the way it was, so rather more frightening methods have been deployed.
Yep,
We don’t have to muscle them aside. We just could have stopped them from serving the International Free Trade Conspirators who plotted to muscle us aside inside our own countries.
That’s what Protectionism would be crudely about. That’s what Forced Equity of Trade would be about in a more fine-grained manner.
Why are all our knives, spoons and forks made outside the country at exploitive wages and conditions? Is it because Americans are too dumm to make a spoon or a knife or a fork? I think not.
Let’s go back to Equal Protectionism for All. Let China make all the silverware for China. Let India make all the silverware for India. And let America make all the silverware for America.
Capitalism in One! Country! For EVery country! Over and over again. And if the necessary evil of trade must be permitted between any of those countries, let it be under rigid restrictions designed to force Forced Equity of Trade.