There has been a lot of debate recently about China’s international trade performance. This is not a new concern. The Chinese economy is once again running large and growing trade surpluses, as it did in the build up to the 2008 financial crisis and has done more or less since then. Its exports of sophisticated products like electric vehicles have been absorbing an increasing share of global demand. Authors such as Michael Pettis, a professor of finance at Peking University, have long argued that over the last couple of decades China’s economic policy has become a problem for the world. Briefly, its industrial policy has generated domestic imbalances which restrict consumption as a share of GDP. In aggregate, it is saving too much, and investing too much, and some of that investment has been poorly allocated. This is reflected in the fact that despite its enormous share of investment in GDP, the economy has been slowing steadily in recent years, and rapidly and unsustainably accumulating debt.
An article by Pettis in the FT from 28th May makes the point that China’s large trade surpluses are caused by weak domestic demand, and therefore a weak demand for imports, rather than by comparative advantage. China is not alone here. Other major economies, particularly Japan and Germany, have long run large trade surpluses while their overall GDP growth has been relatively weak.
The theory of comparative advantage, originated by the classical economist David Ricardo, is perhaps one of the most sacred theories in mainstream economics. Even distinguished economists whose work has questioned it, such as Paul Krugman, tend to support its implications for policy: countries both rich and poor have much to gain from free trade, and interfere with it at their peril.
The theory results in the argument that nations should specialise in the production and export of those goods and services in which they are relatively most efficient in producing. Even if they have no absolute advantage in producing anything compared with other countries, they should still gain from this. They can export goods in which their comparative costs of production are lowest, and then import goods and services of an equivalent value in order to maximise domestic income, consumption and welfare. I will come onto to some of the problems with this theory below.
There are alternative theories of international trade, which are critical of Ricardo. Anwar Shaikh, a professor of economics at the New School in New York, in his 2016 magnum opus Capitalism, has argued that a theory of absolute or competitive advantage, rather than one of comparative advantage, fits the facts much better. For Shaikh, trade takes place between trading firms rather than countries, and is regulated by real relative costs between them. These costs are largely determined by real wages and productivity, and all the factors that affect these two variables.
In the end, the key debate over all of these theories comes down to how economies adjust, or don’t, in order to maximise sustainable efficiency, production and consumption.
Questioning comparative advantage
The theory of comparative advantage adopts three major assumptions which are highly questionable empirically: first, it assumes that economies engaging in free trade are able to sustain full employment, and thus do not experience welfare losses during economic adjustments resulting from increasing openness to international trade; second, it assumes that trade imbalances, whether surplus or deficit, lead to an adjustment in the real exchange rate and from there the terms of trade; thirdly, it assumes that this adjustment will eliminate the trade imbalance. If a country is running a trade surplus, this will lead to a rise in the real exchange rate, through some combination of price increases and an appreciation in the exchange rate itself. This will make exports less competitive, and imports cheaper, so that the value of the former falls and that of the latter rises, eventually eliminating the surplus. The same mechanism is meant to occur in reverse for countries running a trade deficit.
The problem is that these tend not to occur. Episodes of persistent unemployment are widespread across the capitalist world; trade imbalances are also widespread and persistent, and often fail to be eliminated by changes in the exchange rate.
One might object that these adjustment mechanisms would work if only governments were to stop intervening in trade and adopt a completely liberal policy. But given that a huge range of policies impact trade and industry at both the micro and macro levels, from tax and spending to regulation, this is something of a utopian vision.
Economists have responded to empirical failure by modifying the comparative advantage model, introducing the possibility of ‘slow’ structural adjustments (though these can apparently take 70 years or more!) and a range of market imperfections such as oligopoly, economies of scale and strategic behaviour by firms. These kinds of models typically produce complex and indeterminate outcomes, with few unambiguous conclusions for policymakers. In the end, many orthodox economists still fall back on recommending free trade.
But for Shaikh, the historical record favours his own theory, whether free trade is present or not. He argues that the terms of trade will only change sustainably if the relative real costs of the leading exporters, and hence their prices, change. Countries where firms have the lowest cost of production relative to productivity, and hence are most competitive, will have an advantage in exporting, and will tend to run persistent trade surpluses. Those where firms have higher relative costs will tend to run a deficit. The determinants of competitive or absolute advantage, wages and productivity, are seen as structural, and both Adam Smith and Karl Marx favoured this theory, in contrast to Ricardo. A Keynesian income effect may affect the scale of the surplus or deficit, but according to Shaikh, this will only change the direction of the imbalance if it also changes the classical cost effect.
In Shaikh’s own classical theory, in contrast to Ricardo’s, the quantity theory of money is rejected, and hence the mechanism by which a trade surplus automatically leads to a rise in the real exchange rate, and a deficit to it falling, until balance is achieved. For Shaikh, and following Marx, a trade surplus will tend to increase financial liquidity in the economy and to lower interest rates, which could either lead to increased capital exports, making the balance of payments ‘balance’, and preventing the real exchange rate from rising. A lower rate of interest could also under certain conditions stimulate domestic investment, which would reduce the surplus somewhat. For deficit countries, financial liquidity can fall, raising interest rates and attracting capital inflows to cover the deficit, while preventing the real exchange rate from falling. Higher interest rates could also reduce domestic investment, and hence reduce the deficit at the cost of slower economic growth.
Which theory of adjustment is correct?
Ricardo’s theory of comparative advantage is certainly questionable in both theory and practice. For Pettis, it would work if countries like China were to engineer faster wage growth relative to productivity. At some point this would make the least efficient exporters unable to compete internationally, and they would reduce production or fail, and their output would be replaced by more competitive imports. The higher wages would also strengthen domestic demand for domestic output and imports even as foreign demand for China’s less competitive exports weakened somewhat. This would reduce the country’s trade surplus and rebalance the economy in a way which served ordinary Chinese households in particular. It would harm exporters overall, but the most internationally competitive firms would likely still retain their advantage and continue to export. It would thus force a rebalancing and restructuring of the Chinese economy, which many feel is long overdue. Until this happens, its enormous trade surplus will continue to encourage global conflict over trade, and likely increase the trend towards greater protectionism from the likes of the US.
Viewed in this way, which links costs to demand in Keynesian fashion, there is some overlap between the comparative and competitive advantage theories. It all comes down to how economies adjust to global imbalances. But serious doubts must be cast on applying the doctrine of free trade to all countries, whether rich or poor. The history of international trade and development makes it clear that all of today’s rich countries used forms of selective trade and industrial policies to support infant industries which eventually created sufficient economic strength to enable benefits to be accrued from trading globally. In Shaikh’s theory, free trade benefits the strong and harms the weak when it comes to firms. At the urging of the rich world and institutions such as the IMF and World Bank, many poor countries have opened up to trade prematurely and seen whole sectors wiped out by international competition. In many cases the development record has subsequently been poor, leaving millions in poverty.
What are the policy implications?
Developing economies should be given the policy space to do what today’s rich countries did, and support emerging firms and industries in order to enable the accumulation of sufficient competitive capabilities to trade internationally. Success with such a strategy is never easy or straightforward, and policymakers need to pay attention to the political, economic and technological context.
As for the advanced or rich countries, where firms are closer to the technological frontier, trade and industrial policy generally needs to take a different form. In particular, there should be less emphasis on catching up to the frontier using already existing technologies, and more on advancing the frontier itself. Current US industrial policy is trying to do this, but is also engaged in attempting to rebuild US manufacturing capacity more broadly. To some extent this a second best policy compared with the kind of global rebalancing which would increase demand for US exports, and for manufactures in particular. But to the extent that this rebalancing must involve China and the other major surplus economies, it requires an increase in international cooperation and greater consensus on what must be done.
Ideas about trade and industrial policies, which tend to come under the microeconomics heading in economics textbooks, also have macroeconomic effects, as described above in the case of China. Large and persistent trade imbalances may be due to differences in competitive advantage, but the policies which go a long way towards creating these advantages need to be rethought if they eventually result in slower global growth, higher unemployment and debt, and conflict over trade.
Faster wage growth relative to productivity growth in China and the other major surplus economies would help to reduce the problem of underconsumption and excess savings. But even if the major economies could manage to negotiate agreements to achieve this, there remain strong vested interests which stand to lose out from the inevitable economic restructuring and are therefore likely to oppose such change. These include established capitalists with profits to protect, as well as wealthy rentiers and the financial sector. This is the case in China as well as the US, where global imbalances are reflected in the country’s large trade deficit, and the relatively diminished manufacturing sector.
A new Bretton Woods and reform of the international trade and payments system could go some way to creating a framework in which destabilising global imbalances are reduced in a more consensual way. But this would require not only agreement on economic theory and policy, but also sufficient political will and legitimacy. In today’s global economy, regional agreements may be a more realistic alternative.
The Political Economy of Development 