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?