Economics essay 2: why global trade is going into reverse

Now for the second essay on economics that I wrote in 2008. The topic is trade, and it investigates the theory of trade between developed and developing nations. It turns out that standard trade theory, based on comparative advantage, works rather well here. But it contains a prediction that goes largely unremarked. Apart from Paul Samuelson (in 2004) I haven’t seen anybody else raise the point. And yet it does much to explain what is going on in the world now, especially between Britain and China.

The theory of comparative advantage is part of what Americans call “Economics 101”: basic first year economics. It explains how mutual trade can benefit economies even when one is manifestly more efficient than the other. But generally this wonderful piece of logic, made famous two centuries ago by David Ricardo, fails to advance much beyond Economics 101. Modern economists have not found ways of using it to make concrete predictions. Attempts to make the theory more specific, for example by relating it to availability of factors of production (like land, capital, etc.) have come to not much. Instead the idea is used to give a warm glow to the idea of trade being a Good Thing, and the basis of patronising comments to non-economists advocating protectionism, while economists get on with the day job without touching it.

That is a pity, because the theory repays more examination. Its central idea is that gains from trade are based on opportunity costs of the various products in an economy, or comparative advantage – that is how much of one product you have to forgo to produce a given quantity of another. The corollary is that where the differences in opportunity cost are minimal, the gains from trade are likewise minimal. As different economies converge, the less incentive there is to trade.

In fact trade does take place between similar economies, but it is driven by other factors, such as economies of scale, and is quite sensitive to transport costs. But the theory of comparative advantage does explain trade between developed and emerging economies rather well. These economies are self evidently very different from each other, and gains may be made between countries on opposite sides of the globe. But as emerging economies develop; they converge with developed economies. What happens then?

To explore this I created a simple mathematical model. I divided the economy into four sectors: agriculture, where productivity grows, but which is not traded; services, also not traded, but where no productivity changes happen; and two types of goods, high and low tech, which are tradable and where productivity changes at differing rates. I looked at three stages of development. The first, undeveloped stage has a huge and inefficient agriculture sector. In the second, intermediate, stage, low tech manufacturing has got going. In the final developed economy stage, productivity has advanced in all sectors apart from trade, but especially in high tech goods.

I then looked at how trade would work between the developed and undeveloped economy. There was no major impact, but the undeveloped economy would buy all its high tech goods from the developed one, in exchange for low tech goods.  The undeveloped economy’s currency traded at well below purchasing power parity. Next I considered what would happen if the undeveloped economy moved to the intermediate stage. Now trade becomes much more important to both economies; once again the intermediate economy buys all its high tech goods from the developed one, in exchange for low tech goods. But the developed economy imports a high proportion of its low tech goods. Both sides gain substantially.

But what happens as the economies converge further? The trade disappears; the developing economy supplies an increasing proportion of its high tech needs, and exports fewer low tech goods, substituting productivity gains for gains from trade. The developed economy has to supply its own low tech goods again, and loses gains from trade. It is worse off.

All this models what has been happening between Britain and China quite well. Nothing much at first, but as China’s agriculture became more efficient, and so its low tech manufacturing could grow, then trade ballooned, with gains to both sides. This took place in the 1990s and early 2000s. The price of manufactured goods in Britain dropped because of cheap imports, allowing other goods and services, and pay, to grow at a healthy 4% per annum or so, while keeping overall inflation at about 2%; the components of the inflation statistics became very revealing. A lot of the economic growth that took place in Britain in this period was surely driven by this, rather than advancing productivity.

But even in 2008 I could see that the party was coming to an end. Chinese costs were rising; they were moving increasingly into high tech areas. It has become harder for Britain to compete for high tech goods, but easier to repatriate lower tech manufacturing and services. This latter has been good for British jobs, but not for living standards, as what is being repatriated has lower productivity. Volumes of trade have fallen – though it is a complex affair so cause and effect are hard to prove.

Won’t China be replaced by other countries? Japan started the trend after all, to be replaced by the “Asian Tigers” (South Korea, Taiwan, etc.), before China entered the picture. There are emerging economies that are taking up some of the slack – Vietnam and Bangladesh, perhaps. Africa has huge scale. But not only are many of these economies slow to transition to the intermediate stage, with a strong export manufacturing base, but the sheer scale of China changes things. The emerging economies are as likely to trade with China (and India, whose emergence takes a different but parallel path) as they are with the developed world. And perhaps low tech is becoming more high tech too – making it hard for the newly emerging economies to find enough of scale where they have a comparative advantage.

And this is yet another reason why developed economies appear to be stagnating, and why much of the growth that took place before the crash of 2008 was unsustainable. Trade has a reverse gear that is nothing to do with protectionism and ignorance of economic theory. Economic theory predicts it.