Sat Dec 12th, 2009 at 06:45:49 AM EST
Ricardo is one of those classical economists who is usually turned into a pagan idol - to be the subject either of worship or of purification rites, depending on one's political affiliation.
It will, I hope, be evident that this text is written with no such desire. Richardo was not a stupid man, nor, I believe, a uniquely wicked one. Those of his models that have passed into the modern (neo)classical synthesis were not stupid models, and they were not based on stupid assumptions. They have, however, suffered the unfortunate fate that most economic theory will eventually fall prey to: Events have overtaken several of the key assumptions underpinning them.
The best way to illustrate this will be with a little graph:
The image on the right illustrates the production possibility frontiers (PPF) of two countries, A and B, with equal population (for a thorough introduction to PPFs, see this diary by Migeru). Both countries produce microchips and ball bearings, but Country A is an industrial state, while Country B is a third-world country, as seen from the disparity in their production levels (recall that they have similar population).
Now imagine that we open up Ricardian free trade between these two countries. What happens?
The answer is "nothing at all." The PPFs of these countries have precisely the same shape, so there is no expansion in the aggregated PPF from Ricardian free trade.1
Suppose now that a well-meaning economist manages to convince Country A to enter into a bilateral trade agreement with Country B, modelled on the pattern of existing GATT/WTO treaties.
Promoted by afew
After one year, the picture looks like this:
Country A, as we see, is now poorer than it used to be (its PPF has been reduced). Country B is richer, granted, but the aggregated PPF has shrunk.
That was not supposed to happen.
So what went wrong here? Simple: The Ricardian analysis of trade is a (quasi)static analysis. It does not permit the production possibility frontiers to change - or at least it does not permit them to change due to trade.2
Now, why would the PPFs change due to trade? Simple: Modern "free trade" agreements permit free flow of capital - both in terms of financial assets and physical plant.
Microchips and ball bearings are both industries that require highly precise machine tools. A factory worker who is involved in the process of making ball bearings can not simply leave the factory and set up shop on his own, because he does not own any of the required machines (nevermind the intellectual property rights, long-term supply contracts and sundry other aspects of modern corporate management). So, if the capitalists who own the factory decide to shut it down and move the machines that permit production to another site, the worker is left with a more or less useless skill set, because he has no machines available with which to apply those skills.
But why would the capitalist decide to move it to a country where labour is less productive? This is also fairly simple, and can be summarised in two words: Rent seeking. Suppose, as in our example above, that the workers in Country B employ machines only 75 % as efficiently as the workers in Country A (due to lack of training, lack of proper infrastructure, etc.). But suppose that the workers in Country A are able to capture half of the value added in the industrial production, while the workers in Country B are only able to capture a quarter of the value added (due to differences in organisation, democratic accountability of the government, etc.).
The capitalist's return on his investment in Country A is then
[value added]x[fraction of value added captured by capitalist] = 100 % x 50 % = 50 %
His return on investment in Country B is
[value added]x[fraction of value added captured by capitalist] = 75 % x 75 % = 56.25 %.
In other words, from the point of view of the capitalist, the return on investment can be greater in the country with the lower productivity.
This seems like a pretty silly mistake to make, in our modern world. So why did I say that I didn't consider Ricardo a stupid man?
Well, Ricardo didn't live in our modern world. In Ricardo's world, the assumption that a country's capacity to produce was unrelated to whether it traded or not was not a stupid assumption. At Ricardo's time, production was almost exclusively craftsmanship and agriculture. The means of production were the skills of the workman and the quality of the soil he tilled. On a sunny day he might have a steam engine. The miller had a wind or water mill and the smith had a smithy. But these are not terribly mobile constructs at the best of times, and Ricardo's world did not have massive rail nets or intercontinental container shipping. So the means of production didn't move around much.
Modern economists have no similarly persuasive defence. Nevertheless, they do have two main excuses that are usually employed in defence of this bastardised Ricardian theory.3
The first is that the workmen in Country A are engaged in rent seeking behaviour, by using the collective bargaining power derived from labour unions to capture a greater share of the value added than that to which they would be entitled by the operation of market forces. The liberalisation of trade then eliminates the ability of labour unions to engage in such rent seeking behaviour.
The second excuse is that the reason the workmen of Country A capture a larger share of the value added is that they have better prospects for gainful employment elsewhere. This, by raising the opportunity cost of being employed in the microchip industry, increases the minimal wage that their fellow workmen are willing to accept, and thus improves the bargaining power of each individual workman. Therefore, the workman in Country A loses less by the movement of production to Country B than the workman in Country B gains.
It is easily recognised that both of these excuses presuppose a liquid, competitive labour market populated by small, independent, rational actors with fungible skills and equal access to information.4 They are, in other words, utter and complete garbage.
1I have tacitly assumed that the countries have the same relative demand for microchips and ball bearings. If they had different relative demand, Ricardian trade would expand their potential consumption.
2I owe a hat tip here to this excellent article which first started me down this line of thinking.
3Both by those who are caught up in the conventional wisdom and those who are being deliberately obtuse [8 of Spades].
4Proof is left as an exercise to the reader, as a discussion of the (neo)classical misconception of labour markets is beyond the scope of this diary.