Wednesday, June 1, 2011

Absolutely zero comparative advantage

Free trade has its economic underpinning in the law of comparative advantage, first formulated by the English economist David Ricardo (1772-1823). Legions of economists have accepted this law unquestioningly, ignoring the context in which it was first written. Going back in time, the law of comparative advantage made its first appearance in 1817 in David Ricardo's book, On the Principles of Political Economy and Taxation. More important, it was written during the dawn of the Industrial Revolution which can be roughly dated to have begun in 1780.

It was in the 1780s decade that the fossil fuel mechanical engine began to mechanise industrial production with the improvement by James Watt from the to-and-fro movement of his steam engine into a rotary motion in 1781. Of course, credit for the engine lies with Thomas Newcomen who invented the unidirectional steam engine in 1712 and James Watt who added a condenser and turned the movement into a back and forth motion in 1774. But both these machines found their uses in the mines only. With the improved engines, Richard Arkwright began using them in his factories in 1783.

Of the three hallmarks of the Industrial Revolution, one of them was the dictating of the work pace by machines instead of humans. And the factory was the right setting for it. In the underground mine, the steam engines only pumped the water out, not set the rhythm of miners' work. Admittedly, in the factory, Richard Arkwright's water-powered spinning mill preceded the steam engines in 1771 but the water-powered machines were limited to areas with flowing streams. Also their operating months in winter were constrained by the frozen streams. Edmund Cartwright's invention broke the geographical and seasonal constraints, leaving production running uninterruptedly. As long as the factories were not far off from rivers, canals could always be built to move coal.

As a result of these innovations, the Industrial Revolution radically shifted the paradigm. Before, mankind always had to contend with inadequate production of agriculture and manufactured goods. After the Industrial Revolution, the periods of inadequate supply have alternated with periods of excess supply, each period succeeding the other in a predictable pattern.

The timing when one or the other prevails is important because it determines whether the economic condition is inflationary or deflationary. How can we know which one is dominant? Simple. Using 1780 as the starting point, you add 60 for every Kondratieff Wave. So you have 1840, 1900 and 1960 as the start points of the Second, Third and Fourth Waves. The Fifth and final wave will begin in 2020. For each wave, the first half or 30 years is the inflationary period and the subsequent 30 years is the deflationary period. The pattern is generally regular despite our perception that the rate of innovation has hastened in the last few decades. In fact, it's getting harder because as the start base becomes bigger, the leap needed to achieve the same level of incremental progress as before gets more difficult. If you begin with 10, a 10 percent increment needs only 1 but if you start with 100 you'll need 10.

Now if we view the situation that David Ricardo was in, the conditions then were at the beginning of a deflationary cycle. However, he would have grappled with the idea long before it was put on paper. Most likely, he would have known only life in an inflationary environment. Thus what Ricardo wrote was not wrong but it was right in the conditions that he was in. What the economists after him have failed to do is to reexamine the context. Had they done so, they would have restricted the applicability of the law of comparative advantage only to the first half of each Kondratieff Wave.

Let's analyse what the law is really about. Below is a hypothetical example of two countries, the USA and Australia, that produce two items, bolts and nuts. It just so happens that the US and the Aussie dollars are on a par with each other. So that makes it easier to focus on the workings of the law of comparative advantage itself. Later we'll see the impact of tweaking the exchange rate in order to spirit wealth away from one's trading partners.

In the above example, Australia's output for both items is higher than that of the US. For every bolt that the US produces, Australia can produce 1.16 bolts with the same input. For nuts, it's 1.20. As Australia has the edge in both items, it is said to have an absolute advantage. Assuming that each nut is priced at US$1 or A$1, the price of bolt in each country is different because of the different productivity level required to produce bolts relative to nuts. In reality, the relative prices are not determined solely by labour productivity. Land and capital have to be factored in and this complicates the matter. In our simplified example which calculates labour input only, the price of bolt in the US would be $1.05 while in Australia it's $1.09.

Assuming that each country produces both items, the total output for every two manhours of input is 205 bolts and 220 nuts, with one hour each spent on producing bolts and nuts, as shown in the top part of the table below.

Although Australia has an absolute advantage, its comparative advantage lies in producing nuts because it can produce 1.20 nuts for every nut that the US produces compared to 1.16 for bolts. Suppose it focuses on nuts while the US on bolts, the total output now is 190 bolts and 240 nuts. Using $1 as the price of bolts and $1.0909, as the price of nuts, the specialisation has increased the economic return by $3.64.

But Ricardo's law has its fundamental flaw exposed when the economic conditions change as a result of technological advances. One major change brought about by modern technology is the almost limitless production capacity. Assuming that the cost remains constant, Australia can now produce both products for both countries. The US workforce can remain idle, which is what it is doing right now as China takes over the manufacturing of most stuff.

In our hypothetical example, can the US turn the table on Australia even if its labour productivity lags that of Australia? It can by devaluing its currency. Suppose it depreciates its currency by 50 percent, its 200 nuts would cost the same as Australia's 120 nuts. As for bolts, it's 190 to 110. The Australian workers would now be out of work. The US workers would get less pay since the currency is now worth half but it's a hundred times better than having no pay. Australia can nullify the US action by carrying a similar competitive devaluation. In our current real life situation, the US cannot devalue because China will match any US devaluation with one of its own, thus keeping the exchange rate stable.

If this one-sided trade is allowed to persist, it's the surplus accumulating country that would suffer a blowback. In international trade, each country's trade account must balance out for the long-term benefit of all nations. Surely, trade in this manner is inefficient since the cheapest goods may not be available to all. But more important than economic efficiency is social stability. In ecology, predator and prey cannot outwit one another all the time. They must achieve a stable relationship with one another or else an ecological collapse, disastrous for both parties, will set in. The root cause for the Middle East upheaval is the region's inability to produce stuff; the seeming demand for freedom is a symptom, now confused by many for causation.

What sort of blowback would hit China? The same one that hit Japan in the early 1990s for which until now Japan has not been able to recover from. In fact Japan's financial wave tsunami is insidious but more devastating than its tidal wave tsunami. A trade surplus country would naturally experience a rising currency as it holds more of the trade deficit country's currency. In relative terms, China's supply of yuan will increase at a slower rate than that of the US dollars (USD) as the US has to issue more dollars to finance its trade deficits. Simple mathematics will tell you that the yuan value must rise. China, infatuated with increasing the foreign currency amount in its vault, would have none of that. To sterilise its increased value, it must create more yuan, not through big government deficits as carried out by Obama, but by large scale private lending.

Since China does not buy as much imported goods as its exports, that money is chanelled internally towards a real estate frenzy. Everybody in China thinks property prices can only go up, that is, until he meets an American homeowner. In fact China's yuan value should move lower relative to that of the USD since total credit supply in the US has been static over the last two years. The only thing keeping its value high is the influx of speculative inflows hoping to cash in on the supposed China growth story. Certainly, the stratospheric property prices are never supported by matching rental income. When the owner-speculators could no longer flip the properties to suckers, the prices will crash to the bottom pulling the banks down with them. Money supply will vanish as the bank loans get written off. By then the yuan value will rise because its supply relative to that of the USD will decrease. That's the reason why the Japanese yen is stubbornly high even though its economy is in the doldrums. Similarly China's absolute advantage will turn full circle.

In the short term, this exchange rate setting mechanism is distorted by the hot speculative money. Actually politicians must not allow liberal currency movement because it negates their control of the economy and by extension politics. This also extends to trade, especially in the second half of the Kondratieff Wave. Notice that Ricardo's treatise is titled Political Economy. In the 18th and 19th centuries, economics did not stand alone but was studied with politics because the scholars then understood that economics undergirded politics. You split the two at the expense of the nation's stability. Now economics is being used to rigorously test mundane matters, of no importance to a nation well-being. That's why you find economists accepting the law of comparative advantage as the irrefutable truth. And politicians, clueless as ever, cling on to this dangerous notion without a hint of the tragedy that this blind adherence will inflict on the nation.

No comments:

Post a Comment