Ricardo Dethroned and Debunked


To my fellow MBAs, armchair economists, and globalisation-watchers:  That cornerstone of our education, as unchallengeable as Adam Smith or Milton Friedman, is bunkum in the 21st Century, and this post lays out why.  Remember, you read it here first.

I first started thinking about this when I was in the United States.  It was reported there that 63% of Republican voters surveyed, felt that international trade was bad for the country!

I couldn’t believe it.  ‘How could they be so ignorant?’ I thought.  Then I started to think about the size of their domestic market, their ‘hollow corporation’ off-shoring, and the fact that I had grown up in a very small, very free-market country, where the domestic market is a pretty minimal consideration.  I realised that the US situation was quite different, and I realised why people could come to that conclusion.

Just to recap on Ricardo’s Theory of Comparative Advantage: Briefly, this theory states that free trade is a universal good.  In Portugal it is possible to produce both wine and cloth with less work than it takes in England. However the relative costs of producing those two goods are different in the two countries.

In England it is very hard to produce wine, and only moderately difficult to produce cloth.

In Portugal both are easy to produce. Therefore while it is cheaper to produce cloth in Portugal than England, it is cheaper still for Portugal to produce excess wine, and trade that for English cloth.

And conversely England benefits from this trade because its cost for producing cloth has not changed but it can now get wine at a cheaper cost, closer to the cost of cloth.

The conclusion drawn from this analysis is that a country should specialize in products and services in which it has a comparative advantage. It should trade with another country for products in which the other country has a comparative advantage. In this way both countries become better off and gain from trade.

Ricardo wrote this in 1817.  The conclusion, which governments have espoused ever since, is that countries should stick to their knitting, produce goods that they can produce most cheaply, (even if someone else can produce it more cheaply), and free trade is a universal good for everyone.

In actual fact, a number of countries take actions counter to this wonderful theory, and this is what all the wrangling at GATT is all about.  The US, for example, are considered trade hawks.  They have huge subsidies for farmers which they refuses to dismantle, for all the NAFTAs and other free trade agreements.  The US sugar industry is a protected industry, much to Australia’s chagrin.  China and Japan do similar things, and then there is the fascinating subject of Non-Tariff Barriers to Trade (NTB’s). 

One possibly apocryphal example was allegedly Spain, who deemed that all quality control of imported VCRs be done by a single government official in a small office in the Pyrenees, next to the French border.  No VCR could come into Spain unless approved by this man!  But the Spanish government had no trade restrictions on VCRs.

In 1990, and again in 2000, Michael Porter visited a number of countries at the invitation of their departments of Foreign Affairs and Trade, to produce a report called ‘The Porter Report,’ using his famous five-forces analysis to identify each country’s sources of sustainable competitive advantage.  He left having identified that New Zealand had a sustainable competitive advantage in Rugby Coaches, Electric Fencing, Racing Yacht Building, and Milk.

This fitted in well with the extreme free-market ethos in NZ government circles at the time.  For a while Gallagher’s Ltd, that revolutionary world-beater of electric fence production, was feted as the saviour of the economy.  NZ in the 1990’s was lauded by The Economist magazine and others as the most free market economy in the world.  This extended to selling all state assets, most State Owned Enterprises, and big chunks of land to offshore investors.

Ever since, the economy of NZ has slipped down the OECD table.  And how can this be, if Ricardo’s theory is to hold?  We are producing electric fences, rugby coaches and yacht designers at a faster and faster rate?

Well, let’s just take it apart piece by piece:

  1. The mobility of labour.  The recent gift of Robbie Deans to the Wallabies was accompanied by no country-to-country transaction.  We are good at producing them, then we give them away for free.  John O’Neill was reported to be doubled up with laughter.  Similarly, Tom Schnackenberg currently lives in Italy and designs yachts for the Alinghi syndicate.
  2. The mobility of capital.  There is no guarantee that any of our exported rugby coaches or racing yacht designers are keeping their wages domiciled in NZ.  Or that they are paying NZ tax on any of it.  Or that they intend to spend any of it in that country.
  3. The rise of services:  Services, rather than products, now dominate most developed economies in GDP terms.  This was not the case in 1817. 
  4. The cost of logistics: The logistics costs of co-ordinating, assembling and transporting products often is higher than the cost of producing them.  This is certainly true of our world-beating electric fences.  Arriving in Europe at twice the cost of competing Polish electric fencing wire.
  5. The theory only works if everyone believes in it.  Trade-hawk behaviour runs counter to it.  Coffee-drinking has taken off five-fold in developed countries in the last ten years.  This has done nothing at all for all those Arabica-producing countries of South America.
  6. Globalisation:  Most products are not produced in one place.
  7. The mobility of Intellectual Property.  Patents, products, copyrights, and companies can be bought.  And they can be listed on various stock exchanges around the world.  The life-long value, produced and sold to a ready market, is many orders of magnitude what the inventor could sell it for.

Welcome to the rough-and-tumble world of the 21st century.  Game On!

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