A lesson in trade theory

“Every economic answer is a political question.”

Here then is a question for all you experts on international trade, taken directly from my Free Market Economics [pp. 248-249]. Picture two countries, A and C.

Suppose in Country A, in one hour it can produce either one car or 1000 shirts. [It’s also the same answer if Country A can produce ten cars and 10,000 shirts per hour!]

Meanwhile in Country C, in two hours it can produce either one car or 500 shirts.

According to the economic theory of comparative advantage, how many cars will Country A produce? OK, once you’ve worked that out, now tell me if you get the same answer using common sense. As chrisl said, “economic theory is all right in theory”. Personally, I’m not even sure of that, but you get the idea.

So here’s the thing. It is entirely possible that the US is tired of carrying most of the burden for the defence of the West and would like a bit of sharing the burden. It might also find some respite for itself in strengthening those parts of its economy which are more closely associated with its defence industries. And it might even wish for some kind of gratitude from others, supposedly on the same side, in trying to assist the US in resurrecting its strength. And then there are the straightforward economic issues, which are not the same as the political. So let us go to these.

And of course the issue economically is comparative advantage, and not pure let the most efficient producer produce each product. With comparative advantage, it is not always the most efficient low-cost producers who produce. If you don’t even understand that, you should keep right out of this debate.

Why encourage free trade:

  • competition is what drives improvement and growth – without competition most businesses would just coast along to the fullest extent they could
  • innovation is driven by competition – the way to take on an established business is to find a better way to do something
  • all other things being equal, free trade is best

Why “free trade” is not working for the US:

  • cheating is rife – try to sell an American car in Japan – not possible for all kinds of products in all kinds of countries
  • many countries subsidise exports while imposing non-tariff barriers to trade on imports along with tariffs themselves
  • currency manipulation – artificially holding exchange rate lower to discourage imports and encourage exports is not unknown
  • $US is world reserve currency it is unable to adjust to repair a balance of payments deficit
  • there are many forms of approved trade restrictions everywhere you look – the EU for example – such as:

Trading blocs

A regional trading bloc is a group of countries within a geographical region that protect themselves from imports from non-members. Trading blocs are a form of economic integration, and increasingly shape the pattern of world trade. There are several types of trading bloc:

Preferential Trade Area

Preferential Trade Areas (PTAs) exist when countries within a geographical region agree to reduce or eliminate tariff barriers on selected goods imported from other members of the area. This is often the first small step towards the creation of a trading bloc.

Free Trade Area

Free Trade Areas (FTAs) are created when two or more countries in a region agree to reduce or eliminate barriers to trade on all goods coming from other members.

Customs Union

A customs union involves the removal of tariff barriers between members, plus the acceptance of a common (unified) external tariff against non-members. This means that members may negotiate as a single bloc with 3rd parties, such as with other trading blocs, or with the WTO.

World Trade Organisation

There are then the WTO rules of trade engagement which are not designed to create a world where free trade is on the only answer. The rules were devised when the US economy was a lot more robust than it now is, and when the US was both willing and able to make sacrifices of all kinds to help others withstand the spread of communism. None of this is applicable today. The US is therefore no longer willing to watch others cheat their way into a stronger trade position, at the cost of its own national security, economic strength and domestic employment. Here is part of what the WTO is up to.

WTO Rules

1. Most-favoured-nation (MFN): treating other people equally Under the WTO agreements, countries cannot normally discriminate between their trading partners. Grant someone a special favour (such as a lower customs duty rate for one of their products) and you have to do the same for all other WTO members.

2. National treatment: Treating foreigners and locals equally Imported and locally-produced goods should be treated equally — at least after the foreign goods have entered the market. The same should apply to foreign and domestic services, and to foreign and local trademarks, copyrights and patents.

3. Developing countries have transition periods to adjust to the more unfamiliar and, perhaps, difficult WTO provisions — particularly so for the poorest, “least-developed” countries – so these basket case economies are allowed to whittle away at the economic strength of the developed world.

Meanwhile, economic ministers around the world increase unproductive public spending every chance they get, add new regulations on top of old, and increase business taxes at every turn, and then job on their chairs screaming, “Eek, a tariff!’

The quote at the top, by the way, is from Joan Robinson, who has quite a lot to say about free trade that ought to be read by the economic illiterates who populate the world, who are now found speaking on behalf of the status quo, as harmful as the status quo is to most of the lower half of the income distribution. Robinson was not just a Keynesian but also a big supporter of Mao, so I’d be very careful, but the above quote seems as accurate as anything else you are likely to hear about economics.

Beyond Economics 101

This post on Economics 101 reminds me yet again how useless modern economic theory is at working through almost any economic issue at all. It’s about the theory of comparative advantage, I think, and the role of free trade in creating a high standard of living. But let me go first to this question at Quora: What are 25 economics books that you would recommend (preferably classical and neoclassical)? My answer:

If you are seriously interested in understanding economics you need to understand classical economic theory, the economics of the period from the publication of Adam Smith’s Wealth of Nations in 1776 until the marginal revolution began about a hundred years later in the 1870s. And if you are interested in understanding classical economic theory, you should read the third edition of my own Free Market Economics: an Introduction for the General Reader.

Modern economic theory has fallen into very hard times since its classical period, and is now incapable of explaining almost anything that matters. My FME third edition is entirely supply-side, explaining how classical economists understood the operation of an economy which is how an economy actually does work.

From the marginal revolution with its focus on marginal utility, through to the Keynesian Revolution of the 1930s with its introduction of aggregate demand, economic theory has looked at economies from the demand side. And while it has a superficial appeal, no economy is driven by demand. All economies are driven from its production side. People buy more where more is produced. If you want to understand what allows people to demand, you first have to understand what makes them capable of producing.

I will just add that if you try to read classical theory without some preparation for the changes in the terminology between economics today and economics then, you will miss the point. This is a paper you can find at SSRN which will help you get past what is a quite formidable barrier.

Classical Economics Explained: Understanding Economic Theory Before Keynes

Steven Kates


Since the publication of The General Theory, pre-Keynesian economics has been labelled “classical,” but what that classical economics actually consisted of is now virtually an unknown. There is, instead, a straw-man caricature most economists absorb through a form of academic osmosis but which is never specifically taught, not even as part of a course in the history of economics. The paper outlines the crucial features that differentiate modern macroeconomics from classical theory, with the emphasis on what an economist would have understood as The General Theory was being published. Based on the differences outlined, a model of classical economic theory is presented which explains how pre-Keynesian economists understood the operation of the economy, the causes of recession and why a public-spending stimulus was universally rejected by mainstream economists before 1936. The classical model presented is an amalgam of the final edition of John Stuart Mill’s 1848 Principles of Political Economy published in his lifetime and Henry Clay’s influential 1916 Economics: an Introduction for the General Reader, a text which was itself built from the economics of Mill.

Here’s the link to the paper.

Classical Economics Explained: Understanding Economic Theory Before Keynes

As for comparative advantage and free trade, if you’d like a very good explanation of its classical meaning, you won’t do better than my Free Market Economics, an analysis I have not changed a word of since the first edition. It is naturally taken from the economics of John Stuart Mill who had himself taken it from David Ricardo, who wrote it up in 1817. It’s a great first approximation for all those economic types who are actually addicted to mercantilism, whereby economies are driven from the demand side and economies grow by increasing their level of exports. I know, who could believe such a thing, but let us assume just for now that there really are morons who harbour such views. How did Mill and Ricardo explain what was wrong with such notions? By pointing out that the best way to improve one’s standard of living is to produce what one does best and exchange one’s own forms of supply for the goods and services produced by others. You know, goods buy goods. You know, Say’s Law. You know? Perhaps not.

But you know what was also current then? The gold standard. There are many ways this process of comparative advantage breaks down, but with the abandonment of the gold standard and fixed exchange rates, there are all kinds of ways to cheat in foreign trade relations that are not discussed as part of the basic theory. This is the definition of “currency manipulation” found at Google:

It occurs when a government or central bank buys or sells foreign currency in exchange for their own domestic currency, generally with the intention of influencing the exchange rate and trade policy outcomes.

“Influencing” as in making one’s own situation better at the expense of someone else. It can be done, and is done. And there’s more. For most economies, a devaluation occurs naturally with deficits but not with the $US which is the world’s reserve currency. And let me also add this, that there is no trade war imaginable unless others decide to retaliate. And why would they if the only damage of increased tariffs in the US is to its own economy? Let the US suffer for its actions, right? Why poke yourself in the eye if they want to poke themselves in the eye?

There is so much more that can be said but will leave it to some other time.

Self-interested economic advice for Japan from the US

I went to a seminar with an American trade negotiator today and what got to me was this incessant effort to get the Japanese to open their borders to American exports. I am not up on whatever passes for modern trade theory but even so it did seem a little self-serving. I therefore asked what was on my mind: since the point of comparative advantage is to show that both sides can benefit from free trade, who then is the loser if one of the parties doesn’t want to bother? Japan says it doesn’t want to lower its protection for its agricultural produce. OK, too bad for Japan. But what’s the difference to the US or Australia if they don’t want to buy food exports from us. Your bad luck. You’re the one missing out. We’ll go and trade around you ought to be the answer but somehow it isn’t. Given that everyone has a reasonable idea of their own self-interest, and given that self-interest is much more than just being able to buy more this year than last year, if the Japanese aren’t interested in cutting protection but the Americans (and Australians) really do want them to, just from this I can see there is something wrong with trade theory, or at least at that superficial level.

At the very minimum, the Japanese see no value in disrupting its rural sector. They manage to eat, no one is starving, they’re content with how things are, so why should we make a fuss? But of course we do because we want to sell because we think that’s good for us. From the nature of the conversation, and the persistence with which this is pursued, the Japanese would be doing us a favour in cutting tariffs and would be doing themselves harm. I’m very suspicious of arguments that are premised on this is for your own good.

While no one says it, I also think the Japanese are all too aware of – but much too polite to mention – the last time they took economic advice from the Americans. That was in 1993 just after Bill Clinton took over the White House. At the time, we were all coming out of the 1991-93 recessions. Clinton, because he wanted the Japanese to help the Americans with their own dull levels of activity, virtually demanded that the Japanese provided a stimulus to their economy. And so began the twenty year lost decade. Not that these sort of things happened to me often, but I happened to be sitting next to the Japanese Minister of Finance or something, when he was in Australia and being the economist was given the seat next to him. So I said to him that I thought it would be a mistake to try a Keynesian policy, and he said, “Don’t you care about the unemployed?” An exact quote which I have never forgotten. So off they went and did what they did but their economy has never recovered.

If you ask me, self-interested advice like that is something we can all do without.