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Comparative Disadvantage

The heart of Samuel Gregg’s case against economic nationalism is an abiding faith in the theory of comparative advantage. So well does this theory guide national economic development on behalf of the national interest that interventions by policymakers can only make matters worse. His faith is misplaced.

“In the first place,” writes Gregg, “economic nationalism makes it harder for individuals, regions, and nations to discover their comparative advantage.” As an example, he suggests that “Israel may be able to produce more manufacturing goods and technology than Australia. It’s still, however, the case that Israel can obtain more manufactured goods from Australia by specializing in technology and trading some of that output for imported manufactured goods.”

This description is the “A” answer on an introductory economics exam. Comparative advantage allows trading partners, whether individuals or nations, to specialize where each has the lower opportunity cost, increasing total output and, through mutually beneficial exchange, leaving both with more to consume. The sooner that each side “discovers” its advantage and specializes accordingly, the sooner benefits can flow. By contrast, Gregg argues, a protectionist policy that interferes with trade in a free-market international economy, “gradually dulls a nation’s awareness of its comparative advantages.”

But the description bears no resemblance to how the international economy operates. Even the stylized example raises more questions than it answers. Israel is indeed an international technology powerhouse. But why? Is it simply in the nature of small, socialist agricultural communities founded by refugees and beset constantly by war and terrorism to become centers of innovation? Is it something about the Mediterranean winds, perhaps? Or, as the World Bank suggests, has it “been the Israeli government’s explicit goal to position Israel at the core of the knowledge economy.… There is broad agreement as to the significant role played by the government in the emergence and development of Israel’s vibrant and dynamic high-tech sector.”

Australia, for its part, might appear sensible to specialize in manufactured goods. The example conveniently provides only the desirable-seeming technology and manufacturing industries as candidates for specialization. What about kangaroo meat? Would Australia be wise to outsource all its technological needs to Israel so that it can focus on its own comparative advantage in marsupial herding? The theory assures us that, in year one, the Aussies will enjoy a greater bounty of software and ‘Roo-ribs than if it tried to develop software itself. But what sort of economic trajectory would the nation then travel?

The idyllic conception of an international economy in which countries all benefit from specializing in their discovered comparative advantages fails both because comparative advantage is not discovered and because specialization can backfire.

Comparative Advantage Is Created, Not “Discovered”

The conventional concept of comparative advantage emerged in the early 19th century when trade consisted primarily of agricultural commodities and natural resources, sometimes between nations with wildly different economic conditions and productivity levels. Comparative advantage, typically a function of geography, was exogenous to the economic activity—it was a fact of life to be discovered and pursued. That specialization made sense and could benefit both parties was an important insight.

Economists have long understood that the basic model describes poorly the modern international economy. For example, one crucial driver of comparative advantage is scale. The things which one makes a lot of, one is likely to make more efficiently. Thus, rather than a nation focusing where it has comparative advantage, it has comparative advantage where it focuses. In technical terms, the advantage is endogenous—it emerges from the behavior of the participants. Paul Krugman won his Nobel Prize in part for advancing this theory.

Likewise, a nation’s public policies exert a strong influence on its place in the global marketplace. Does its legal system provide for the predictable rule of law and enforceable contract and property rights? Does its education system produce a large supply of high-quality engineers? Does its labor regulation allow workers to exert power or leave them ripe for exploitation? Does its trade policy make domestic production a condition of access to its consumer market? Does it offer generous subsidies to producers? Answers to these questions—not any traditional, discovered comparative advantage—best explain the decisions of the international financiers and multinational corporations whose very visible hands move capital around the globe.

Analysts casually assert that some countries make more sense as manufacturing centers because they have “cheap labor.” But hourly wages say nothing about a market’s attractiveness. If workers are paid the marginal product of their labor, then employing someone at $1 per hour to produce $1 per hour of value is no more or less attractive than employing someone at $40 per hour to produce $40 per hour of value. A “cheap labor” country is not attractive because the wage is $1 per hour, but rather because the worker is generating far more than the $1 per hour of value that he is able to capture for himself. While much closer to the truth, “it is efficient for corporations to move operations to developing countries because the legal and cultural regimes there allow for more profitable exploitation of labor,” rather softens the narrative’s appeal.

If comparative advantage is created rather than discovered, and if nations understand this and develop their economic strategies accordingly, then a nation refusing to participate in the game will find itself left with the comparative advantage that no one else wants. Gregg contrasts the possibility that American industries have suffered from “unfair foreign competition” with what he sees as the “far more likely” explanation of “shifts in comparative advantage.” Those are two ways of saying the same thing.

In 2017, the United States ran a $100 billion deficit in trade of Advanced Technology Products. We were, however, the world’s leading exporter of garbage. A nation indifferent to what it produces might be untroubled by such a development. If other nations are willing to trade us their advanced technology for our trash, perhaps they are the suckers. As Michael Boskin, chairman of George H.W. Bush’s Council of Economic Advisers supposedly said, “computer chips, potato chips, what’s the difference?”

That may be true if we concern ourselves with only a single point in time. But economic development is the ultimate repeated game. Our levels of investment in advanced technology and trash in 2017 have serious consequences for our opportunities in 2018, which in turn will influence investment throughout the 2020s. A nation heads down a dangerous path by specializing contentedly in sectors that are neither economically nor strategically important, that face declining demand and weak productivity growth, and that fail to provide opportunities for workers of widely varying aptitudes in widely varying places to support themselves and their families. .

Specialization Can Backfire

For an individual in a modern society, specialization is unavoidable. No one person can possibly develop the skills to produce more than a miniscule fraction of the goods and services he wishes to consume. For a small nation, the same logic might hold. It may grow most of its own food, provide its own financial services, even build its own infrastructure; it cannot design and produce all of its own pharmaceuticals, electronics, and airplanes.

But where possible, diversification has real benefits. “The products a country makes today,” explains The Economist, describing the work of Harvard professor Ricardo Hausmann and MIT professor César Hidalgo, “determine which products they will be able and likely to make tomorrow, through the evolution of their capabilities.” Whereas traditional economic theory suggests that specialization is key to prosperity, their research has shown the opposite to be true. The more diverse is the array of knowledge and capabilities within an economy, the stronger is its long-term health.

Especially in the most complex, technologically advanced industries—where productivity is often highest, and future growth likely to be strong—sophisticated supply-chains and engineering know-how are critical to the economy’s vitality. Writing in Businessweek in 2010, long-time Intel CEO Andy Grove explained Intel’s decision to invest heavily in chip fabrication and lamented that American firms no longer make such choices:

[Intel] was founded at a time when it was easier to scale domestically. For one thing, China wasn’t yet open for business. More importantly, the U.S. had not yet forgotten that scaling was crucial to its economic future. How could the U.S. have forgotten? … Consider this passage by Princeton University economist Alan S. Blinder: “The TV manufacturing industry really started here, and at one point employed many workers. But as TV sets became ‘just a commodity,’ their production moved offshore to locations with much lower wages. And nowadays the number of television sets manufactured in the U.S. is zero. A failure? No, a success.” I disagree. Not only did we lose an untold number of jobs, we broke the chain of experience that is so important in technological evolution. As happened with batteries, abandoning today’s “commodity” manufacturing can lock you out of tomorrow’s emerging industry.

Unlike in the nation of five million, the U.S. economy is large enough to support any and all domestic industries. Its failure to do so is not a result of having “discovered” a comparative advantage in soybeans (or having “discovered” that it can trade U.S. Treasury bonds for foreign goods rather than make anything at all), but its choice to abandon once-held advantages in infrastructure, engineering, and manufacturing.

The failure has become so grave as to now pose a substantial national security threat. In opposing economic nationalism, Gregg acknowledges an exception for “making the necessary provisions for national defense.” On the modern battlefield, those provisions can be quite extensive. Presumably they must extend to the domestic manufacturing capabilities necessary to smelt aluminum and steel, fabricate all manner of semiconductor, and maintain secure communications networks. If such activities are to be conducted efficiently and at the cutting edge, they will require scale.

The Drunk Donkey Problem

To observe that comparative advantage is created, and that a nation should care greatly about its economy’s industrial composition, is not to prove the validity of any particular policy. Indeed, one might use these arguments to advance any number of bad policies, from efforts by federal agencies at playing venture capitalist to wholesale nationalization of firms or industries. What these arguments do establish, however, is the potential for affirmative policy to improve upon the free market’s status quo.

Enamored of the idea that unfettered markets yield efficient and thus optimal outcomes, and the corollary that any political effort to improve upon them must backfire, market fundamentalists slip casually into the claim that the same holds true for the distribution of investment and production across industries. This is wrong—not only in the sense that one might disagree with it, but also in the sense that it lacks any substantive support. The social benefits that we expect from individuals pursuing their self-interest do not extend to macro-economic allocations.

This confusion is evident in Gregg’s lament that, “at the heart of industrial policy is the assumption that governments can often better identify which industries are more worthy of investment than others.” Note what’s missing from the sentence: governments can often better identify… than who? By what mechanism is the identification happening in the absence of an effort by policymakers? Certainly not individual investors or profit-seeking firms. That concern could not be further from their minds.

To the contrary, to quote Grove again, “Each company, ruggedly individualistic, does its best to expand efficiently and improve its own profitability. However, our pursuit of our individual businesses, which often involves transferring manufacturing and a great deal of engineering out of the country, has hindered our ability to bring innovations to scale at home. Without scaling, we don’t just lose jobs—we lose our hold on new technologies. Losing the ability to scale will ultimately damage our capacity to innovate.”

We face what I call the Drunk Donkey Problem. Markets do some things very well, but when we attribute to them the power to do well things that they don’t do at all, we err by privileging a default outcome that deserves no such deference. Suppose that the allocation of investment across American industries were dictated each year by a drunk donkey stumbling across a grid. If that were the default, we would think that policymakers might improve upon it, even as we carefully weighed which tools would be appropriate to the effort and acknowledged the ways in which they would undoubtedly fall far short of anyone’s ideal. Gregg’s concern that “no one can know what will be the future growth businesses in any given nation. No one knows what technological innovation or entrepreneurial insight will upend the present economic landscape” would rightly seem irrelevant.

In some respects, a drunk donkey would improve upon the performance of our multinational corporations, who are not just oblivious to the national economy’s health but actively lured to act against its interest by foreign governments seeking to create their own comparative advantage. Gregg trusts that “accurate information” will allow “entrepreneurs, investors, and businesses to identify the most optimal economic path for each of them to follow—a process which constantly allows millions of piecemeal improvements to the overall economy.” Until that accurate information tells them they can create greater shareholder value by downsizing and offshoring, slashing investment and buying back shares. What then?

Reader Discussion

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on January 15, 2020 at 08:22:29 am

Unfortunately Mr. Cass has no idea what he’s talking about. Increasing productivity through technological advance and increased human capital is crucial for people within a country regardless of whether they trade internationally or not. Recognizing this does not refute the law of comparative advantage nor the economic benefits of free trade. Paul Krugman, whom he cites, refuted the arguments Cass makes several decades ago in his “Pop Internationalism.”

These critics of free trade don’t have much of an argument. Perhaps that’s why they so frequently refer to free trade proponents as driven by “faith” and “market fundamentalism.” It’s easier to for them pretend they are simply confronting mere ideologues than to actually confront theory and data.

In the “drunk donkey problem” Mr. Cass suggests government officials can identify some sort of national macro interests that mere “micro” entrepreneurs in the market cannot, and hence there’s a role for industrial policy; central planning lite. This is nonsense. Government officials have no ability to weigh benefits and costs apart from prices any more than entrepreneurs do. Of course, they can calculate their *own* interests and those of their patrons; whether it is what Cass, or Friederich List, or other proponents imagine, this is what their mercantilism is at heart, the nationalization of rent-seeking.

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Charles N. Steele
on January 15, 2020 at 11:00:37 am

Mr. Steele makes several important and valuable points.
Mr. Cass's case rests largely on this: "...confusion is evident in Gregg’s lament that, 'at the heart of industrial policy is the assumption that governments can often better identify which industries are more worthy of investment than others.' Note what’s missing from the sentence: governments can often better identify… than who? By what mechanism is the identification happening in the absence of an effort by policymakers? Certainly not individual investors or profit-seeking firms. That concern could not be further from their minds."
To think that investors or firms think not at all about synergies, knowledge spillovers, scale economies, or other forces that enable the "discovery of comparative advantage" betrays a profound ignorance about how financial markets allocate capital.
Further, as Mr. Steele notes, Mr. Cass 's case for economic nationalism entirely ignores the sordid and costly history of rent-seeking (or crony capitalism) that protectionism and industrial policy would invite. Voter beware.

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S. Walters
on January 15, 2020 at 13:20:49 pm

Mr. Cass uses some toy examples that I don't think support his points. However, in response to Mr. Steele, I believe there is "faith" in the support of absolutely free markets-- in particular, faith in lower-level economics theory such as the equilibrium concept and the convexity of aggregate production technology. Many simple economics theories are not supported by data. Another way of saying this is that absolute free marketeers have faith that their economic assumptions resemble the real world, and again, many empirical studies have shown the assumptions not to hold (not just constructed behavioral economics experiments). Modern research looks at the economy dynamically, which has been made possible by numerical analysis using computers, and a trend that emerges from much of this research is the presence of dynamic inefficiency.

Since we are talking about comparative advantage, I think we can also discuss how the processes generating comparative advantage are inefficient in our economy. Education (particularly the basics, K-12), innovation, and research are closely related, yet are underfunded based on the value they create through positive externalities, which is inefficient.

Pursuing or developing comparative advantage also takes time and forethought, which is aided by economic stability, and one control variable we can use for this is the fed's interest rate. Economic stability, the stated goal of this, helps everyone but speculators. Furthermore, by keeping inflation positive and close to a target, we can asymmetrically distribute new value with more to those beginning an enterprise, or taking out loans, and less to those already wealthy, or giving loans.

Finally we can think of projects like national infrastructure, and I'm not sure what research is available on this topic, but I don't think it would be well done by private markets.

I can support Mr. Cass's statement that "markets do some things very well" and some things not very well, although what those are, we really don't know due to the complexity of an accurate economic theory. We already have "central planning lite" and the US is a strong nation despite it (or because of it). I don't recommend industrial policy beyond protecting the safety of citizens, but I certainly recommend introducing subsidies for education and innovation and lowering the cost of necessities at the expense of protectionist regulation. (The last point, about necessities, is because when one lacks them one's preferences are lexicographic and economic theory falls apart.) What would result is a market system that rewards enterprise in general, rather than in a specific industry.

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xkz
on January 16, 2020 at 09:34:31 am

I noticed that in your critique, you mentioned confronting "theory and data" in that order.

I think that is revealing. You are going off David Ricardo's theory of comparative advantage, but fail to ask where comparative advantage comes from. In the modern economy, what matters most for the development of comparative advantage is the development of modern technology. Something that the theory of comparative advantage does not speak to at all.

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David Welker
on January 17, 2020 at 19:48:58 pm

No. Cass begins with theory, denying comparative advantage, and then (sort of) moves to empirical evidence (apparently he thinks trade creates net unemployment). You somehow suppose I don't understand the importance of technological advance. Your exegesis is wrong in both cases. My points are that trade is mutually beneficial rather than zero sum, and that bureaucrats and politicians have no competence and are usually destructive when it comes to planning an economy and picking winners.

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Charles N. Steele
on January 17, 2020 at 20:16:58 pm

xkz, your comments are mostly reasonable but beside the point. Our poor and probably worsening education system is indeed a problem (one of our most serious IMO) -- among other things, it hurts our future productivity. But that's true whether we have international trade or are completely isolated.

Bad monetary policy (and government deficits) are destructive, but again, this is true whether we trade or not and does nothing to support Cass' positions.

And yes, government provision of public goods (defense, some infrastructure, etc.) are important, but also not relevant to Cass' call for industrial policy and putting bureaucrats in charge of trade and the economy.

Where you are wrong:

1. What you are calling "lower-level economics theory" is (at least in this case, trade) better called the main effect; strategic trade policy is a secondary and empirically small effect -- that's according to Krugman. Similarly your complaint that "...the assumptions don't hold"doesn't matter -- that's true of every theory and model and beside the point. Equilibrium is a mere thought experiment, and as soon as you mention "inefficiency" you have accepted the thought experiment and even are using it as a standard. (And no, economics doesn't fall apart with lexicographic preferences. I can't imagine why you think that.)

2. You describe provision of public goods (infrastructure and national defense) as industrial policy. That's *not* industrial policy and not what Cass is discussing. We do not have central planning or "central planning lite" (my term for industrial policy) in which government planners sit and try to decide which industries, firms, goods should exist and which not. We do have regulation -- too much of it, IMO -- supposedly correcting externalities, but that's a different thing and not central planning.

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Charles N. Steele
on January 18, 2020 at 07:00:26 am

"But the description bears no resemblance to how the international economy operates."

Quite so, that's what the complaint is. It should be so, we can make it so, but because governments insist on interfering with tariffs and trade restrictions it is not so.

Thus we should do away with the state interference so that we can indeed gain that A grade.

Another way to make the same point, that government screws it up is not an argument for more government screwing up now, is it?

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Tim Worstall
on January 20, 2020 at 11:04:05 am

Bravo, Mr. Cass. Brave of you to bring down on yourself the calumny of those, like most of the commenting above, who insist that free trade is always, under any and all conceivable sets of circumstances, "mutually beneficial," but have never reflected on what "beneficial" means.

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djf
on January 20, 2020 at 15:52:33 pm

"His faith is misplaced".

It's not faith. You don't need faith when you have evidence. There is plenty of evidence that free markets (that is, distributed control over trade) are superior (that is, generates greater prosperity among the participants) to centrally-controlled (that is, government planned and regulated) markets. Even a small understanding of complexity theory will tell you that distributed computing (of value) is superior to centralized computing. That's why nobody makes single-processor computers anymore. The last of these was the Cray and it was obsoleted by multiprocessing forty years ago.

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Russell N Nelson
on January 20, 2020 at 15:59:24 pm

Why do people make absolutist statements easily disproved by a single example? "have never reflected" is easily disproved by finding a single example of an economist who has thought about and expounded on what "beneficial" means. Such people are EASY to find. "Beneficial" means "value to the individual", which is the resolution to the Diamond/Water paradox. It's not an obscure topic, but one which ever economist worth of the term understands.

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Russell N Nelson
on January 20, 2020 at 17:12:17 pm

I was talking about the people commenting here, not all economists. And simply accepting the economic profession's premise about what constitutes "benefit" does not qualify as reflection.

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djf

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.