…that finds it shocking that the following was written in the “leading trade theory textbook,”

When they were first proposed, market failure arguments for protection seemed to undermine much of the case for free trade. After all, who would want to argue that the real economies we live in are free from market failures? In poorer nations, in particular, market imperfections seem to be legion. For example, unemployment and massive differences between rural and urban wage rates are present in may less-developed countries.

— p. 227.

To be clear, this is part of a single paragraph, and by no means represents the entire book. The book is very good, and if you’re looking for a textbook introduction to trade theory and international monetary policy, I definitely recommend it. And, no, it’s not anti-free trade, although not everything would be found in a hypothetical analogous textbook by Mises or Rothbard (e.g. optimal tariff theory, market failure arguments for tariffs, et cetera — and my intention isn’t to disparage the latter two authors, especially since I’d mostly agree with them).

However, in my opinion, that’s a shocking statement. There are market failures. The market often fails to coordinate. But, to blame poverty and mass unemployment in the developing world on market failure seems disingenuous, and I mean that word with all of its implications. Many of these problems are caused by failures of those countries’ political institutions, and this shouldn’t be controversial. Economists have blamed bad policy on poor economic performance since the birth of the discipline. More formal and more recent research on institutions has expanded on our intuitions.  Market failure probably explains very little of poverty in the developing world. What those economies need are freer markets.

The title borrows from the term “immiserizing growth,” coined by Jagdish Bhagwati, but doesn’t have much to do with it.¹ Instead, my point here stems from a discussion on Jamaica, free trade, and the possibility that tariff reductions can damage, rather than help grow, small economies. I think they can, but that in the not-too-long-run the initial shock is worth it.

If we start out in a world where there are n countries and none of them trade with each other, the point of full employment equilibrium will correspond to the opportunity costs of the economic goods within each country. What this means is that economic goods in each separate economy will be allocated in a way that maximizes the attainment of ends, but in a way that only reflects each economy’s resource constraints and value scales. Over time, as countries begin trading with each other, assuming that the two options are “no trade” and “free trade,” resources will be re-allocated to reflect the broader range of values, factor endowments, and comparative advantages. In other words, trade requires a structural readjustment of economies that have to adapt to changes in the data — as Hayek liked to put it.

Suppose you are a small a country located only a few hundred miles away from an economy roughly 1,000 times larger than your own. Some time ago you were a colony of a distant empire and your indigenous population was put to work in gigantic sugarcane plantations, owned by wealthy imperial immigrants. Your society was bifurcated between wealthy landowners and the poor, a large fraction of them employed on the plantations, and this compressed caste system remains to this day. As the world passes you by in wealth and know-how, your country’s government decides to borrow on international capital markets — when you can get it, otherwise you borrow conditionally from the World Bank and International Monetary Fund — to fund investment. Much of this investment never materializes due to the inadequacy of your capital stock, or because of straightforward corruption, and your government buries itself beneath a growing pile of debt. The international community, led by your neighbor a few hundred miles away, offers your government an aid package, with the condition that it open itself to free trade.

With free trade comes even greater wealth, so the theory goes. As a free market oriented economist, I agree. But, benefits always come with costs. Your economy has one major industry: sugarcane. Uh-oh, as it turns out, there are already other countries — which now have access to your markets, as you do theirs — that produce sugarcane, and they do so while having the lowest global opportunity cost in sugarcane production. In other words, they have the comparative advantage. You also have a comparative advantage in something, but it’s in a good (or a set of goods) that your economy currently isn’t geared towards producing. Your economy must go through a period of structural readjustment. This is the equivalent of a “real” shock.

The size of the short-term disturbance caused by free trade depends on the size of the economy and how diversified it is. A more competitive economy is not going to suffer as much as a smaller one, because the size of the sectors impacted by changes in the global data is comparatively smaller. But, the real world countries I have in mind — e.g. several Carribean nations — are small enough where this kind of issue may be important. I’m sure that this has occurred, or would occur, to several mid-sized nations with relatively small economies, like in Latin America and Africa. Because, not only are these economies relatively non-diversified, but they also suffer from major institutional burdens and inadequacies. In the former category are things like taxes, an extractive regime, violence, and corruption. The latter includes the all-important lack of property rights, where they are poorly defined and rarely enforced. These factors tend to exacerbate the pains of structural readjustments, by delaying them.

It’s not uncommon to come across pieces on small economies which opened themselves to trade and didn’t seem to benefit. Free trade often receives the blame. Maybe the critics aren’t wrong. Should this make us re-think free trade? I don’t think so. The benefit of an international division of labor is to maximize global efficiency, and free trade is the only way a global division of labor can come about. Small countries that have non-diversified economies, based on industries that are only profitable in closed, autarkic economies, might go through an initial shock that may be worsened by bad institutions, but after the structural readjustment their economies will be stronger, and their society will be able to consume more (in terms of value, that is subjectively) than they produce. There’s a caveat, though.

Where institutions are bad and entrenched, what comes first: free trade or institutional improvement? I’m inclined towards the second option. Institutional development and changes in wealth come hand-in-hand. As trade grows, the distribution of income will change and newly empowered people will begin acting to change the institutions in ways that allow them to participate in the political process. These marginal institutional improvements will tend to help improve economic conditions, which in turn continues to broaden the distribution of wealth. The processes of institutional improvement and market growth are reflexive. Now, imagine what happens when there major shocks to one or the other process. The dissolution of institutions of governance tend to force dramatic economic collapses. A large shock to markets can be socially devastating, especially if institutions are so bad that a readjustment becomes unbearably long. They can bring social upheaval and changes to institutions, but these aren’t guaranteed to work out in the right direction. They can worsen, achieving an outcome that is often even worse than the original, but better than the chaos of transition. Consider the real world case of Venezuela. My opinion is that we should allow countries to gradually come around to free trade, instead focusing on encouraging institutional advancements on the margin.

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1. A country’s international purchasing power can be defined by the ratio of average price of exports to average price of imports, such that the smaller the ratio becomes the less well-off the country is made through trade. An increase in exports may lead to a situation — although, whether this is possible in real life is disputed (that is, whether any country fits the conditions of the model) — where the average price of exports falls, and therefore a country’s terms of trade worsen.

I’ve been doing some research on tariff structures between nations of different income groups, and I decided to do a quick comparison between three highest income economies and three low income economies that also have access to interest-free, concessional loans from the World Bank. I just wanted to do a simple illustration of the consistent application of tariffs that characterizes low income tariff structures and the more discretionary tariff structure of developed nations. The logic is that lower income countries use tariffs as an easy method of accruing tax revenue, whereas wealthier governments can rely more in income taxes. The data is shown below. The average rates are “most favored nation” rates, which is the tariff rate which applies to all WTO trading partners.

The EU has relatively high tariff rates on agricultural products, but the pattern between the EU and the US is similar — they have their highest tariffs on certain products, which are usually labor-intensive and politically well-establish. Apart from “coffee and tea,” Israel doesn’t really fit this characterization. Before making a claim that may only apply to the EU and the US, I wanted to see why Israel has such high import duties placed against agricultural imports.

It turns out that Israel has been following a policy of agricultural autarky,

Israel’s initial years were characterized by chronic shortages of food. As the nascent State of Israel was absorbing hundreds of thousands of refugees from Arab lands, it faced a boycott from its Muslim neighbors. Domestic food production was inadequate, and proteins in particular were in short supply. Strict rationing of basic food supplies by the central government spawned a black market for a variety of staples. This period of collective hardship, known locally as the Tsenah, left an imprint on the national psyche. The residual effect of this trauma was a national commitment to agricultural self-reliance that has survived for fifty years.

— Tal, A. (2007). To Make a Desert Bloom: The Israeli Agricultural Adventure and the Quest for Sustainability. Agricultural History, 81(2), p. 239.

It would be an interesting analysis as to whether or not self-sufficiency is really the best means towards the end that Israel wants to achieve (being able to feed its people in times of siege). I also wonder on the welfare payoff of a greater consumer surplus by opening Israel to a competitive international market, weighed against the costs of food shortages during a state of war (multiplied by the probability of such a war ever occurring).

Edit: Another high income OECD member that doesn’t fit my rule is South Korea. They have a tariff structure that is similar to Israel’s. I’ve read that this is a product of a politically tensioned transition from an agricultural to an industrial economy during the past six decades.

[Over the next week I might be posting stuff on trade theory. In part, I think readers will find some aspects of it interesting, but this is also a form of "note taking" for me — it helps me better remember the specifics of the different models.]

The Heckscher–Ohlin model of international trade, named after the Swedish economists Eli Heckscher and Bertil Ohlin — the latter later received a Nobel prize for his work on trade theory —, is an equilibrium model that helps us understand the importance of relative factor endowments in deciding the pattern of international trade. It has been criticized for “poor predictive power,” meaning that some think it doesn’t explain the real world very well, but I think it’s still interesting to study it and its implications. One of the things it implies is that international trade might contribute to wealth gaps in a countries that are not abundant in unskilled labor.

The Heckscher–Ohlin theory can be modeled relatively easily if you simplify some of the assumptions. This is usually called the “2 × 2 × 2″ model: two outputs (bread [B] and cheese [C]), two factors of production (capital [K] and labor [L), and two countries (Home and Foreign, the latter denoted with an asterisk [*]). These factors are mobile in the long-run, meaning their rate of return will tend to equilibrate. This is an addition to the basic Ricardian model, which assumes that there is only one factor of production and that labor will specialize in the area it has a comparative advantage in.

First, we can see the effect of price changes on the distribution of factors of production in Home markets. Let’s establish some basic relationships and definitions,

• The mixture of factors of production to produce one unit of cheese ≡ Q_C (L, K); for bread ≡ Q_C (L, K);
• a_KC ≡ the amount of capital used to produce one unit of cheese;
• a_LC ≡ the amount of labor used to produce one unit of cheese;
• a_KB ≡ the amount of capital used to produce one unit of bread;
• a_LB ≡ the amount of labor used to produce one unit of bread;
• P_C & P_B ≡ the given prices of cheese and bread, respectively.

Let’s assume that cheese is a labor intensive industry and bread is capital intensive. Note, when we talk about intensity we’re talking about relative, not absolute, intensity. For example, suppose that each unit of bread requires two labor hours and six capital hours and that each unit of cheese uses five labor hours and ten capital hours. We see that cheese uses more of both goods, but bread is still capital intensive relative to cheese. This is more easily seen when we compare ratios of inputs: 1:3 for bread and 1:2 for cheese. This relationship between the two industries can be modeled algebraically: a_LC/a_KC > a_LB/a_KB (the relative amount of labor is greater in the production of cheese than it is in the production of bread).

In equilibrium the ratio of prices ( P_C/P_B ) is equal to the opportunity cost of the factors going towards the production of the two goods. The relationship between relative prices ( P_C/P_B ) and the production of the different outputs can be graphed abstractly on a production possibilities frontier (PPF). The point of production will have a slope of –P_C/P_B (the opportunity cost),

Another set of relationship we can graph are those between relative prices, relative returns to the factors of production (wages [w] for labor and rent [r] for capital), and the relative allocation of these factors in each industry,

The left hand panel (where a leftward movement along the abscissa [x-axis] represents increase) shows a hypothetical relationship between the relative price of cheese and the relative price of wages. It depicts relative wages increasing as does the relative price of cheese. Why is this? Remember that we said cheese is labor intensive and bread is capital intensive. An increase in the relative price of cheese will impact labor more than capital, because the change in relative prices is favoring a labor intensive industry.

The panel on the right (where a rightward movement along the abscissa represents increase) shows the relationship for each output between the ratio of labor to capital (L/K). The CC curve shows different L/K ratios corresponding to different w/r ratios for the cheese industry, and BB for the bread industry. Note that curve CC is to the right of curve BB. We know this because we assumed that cheese is the labor intensive industry — this condition will always be true: L_C/K_C > L_B/K_B (it’s the same as saying a_LC/a_KC > a_LB/a_KB). An increase in relative wages will induce producers to increase the employment of capital relative to labor, which makes sense if you think of a demand curve for labor: the higher the price of labor the less of its quantity will be demanded.

There is an interesting implication of the model relevant to the subject of economic inequality. An increase in relative wages means that the return to labor will rise and the return to capital will fall. Remember that wages are equal to marginal product in equilibrium. A fall in L/K implies an increase in the marginal product of labor. This is because the capital intensity of that industry is rising. Since this is true for both industries, we see that capitalists (capital owners) lose and laborers gain purchasing power in terms of both goods.

Second, how does all of this relate to international trade. Take a look at the following graph,

This graph may be a little difficult to follow at first, because relative supply and demand curves are not customary. The logic is that as the relative price of cheese falls, the relative quantity of cheese demanded rises. Think about like this: if the price of cheese (the numerator) falls, all else equal quantity demanded will increase. If the price of bread rises, all else equal the quantity demanded for bread will fall — there is only one other good, so people substitute bread with cheese. Think of relative supply in similar terms. This graph assumes that relative demand in both countries is the same, and that foreign (RS*) is better endowed in capital than home. This means that, all else equal, at any price ratio home will produce more of the labor intensive good than foreign. This follows from our previous explanation of the relationship between relative prices and resource allocation: countries will tend to produce goods that use factors of production they’re relatively well endowed with.

The main takeaway, though, is that relative prices will tend to converge with trade — it has to do with the equalization of the rate of profits. People will take advantage of price differences until prices are the same. Following the graph, we see that the relative price of cheese in foreign falls (they can buy it for relatively cheaper prices from Home) and it rises at Home (they can sell cheese for higher prices at Foreign). How does this impact the distribution of income at Home? Well, we know from the previous graphs that a rise in P_C/P_B will, all else equal, raise relative wages: laborers gain at the expense of capitalists. In Foreign the opposite is true: capitalists gain at the expense of laborers.

This version of the Heckscher–Ohlin model predicts that laborers in capital abundant countries will suffer as a result of international trade, and capitalists will gain. That is, there will be a bifurcation of income. If we think about skilled labor versus unskilled labor, as opposed to capital versus labor, then unskilled labor in countries well endowed with skilled labor will suffer from international trade. To put this in the context of the real world, it means that unskilled labor in the United States (a capital intensive economy) will be hurt by globalization that lowers the prices of the goods unskilled labor produces (if countries like, say, China are relatively abundant in unskilled labor). In other words, this model predicts that trade will contribute to a growing inequality gap.

My challenge to this prediction is that it ignores the fact that the use of “skilled” and “unskilled” is often relative, not absolute. For example, let’s say that a U.S. farmer represents unskilled labor, and a U.S. computer engineer represents skilled labor. The same is true in Mexico: farmers are unskilled labor and computer engineers are skilled labor. But, farming in the U.S. is still much more capital intensive than farming in Mexico. U.S. farmers have better equipment. The same is probably true of U.S. computer engineers. Another way of saying the same thing is that the U.S. benefits from better technology. So, it doesn’t follow that skilled/unskilled labor in the U.S. are analogous to their counterparts in Mexico.

If we assume that the skills gap will continue to exist with trade, but that these gaps are somewhat incomparable between countries, then what we’d see is an increase in the domain of goods being manufactured. Both nations still gain: unskilled labor in countries where it’s abundant gain from an increase in demand for their products, and skilled labor in countries well endowed with it gain from an increased demand for their products. Note that if P_C/P_B converge internationally, then so will w/r. In other words, labor will tend to allocate where the returns are highest. It’s important to remember, though, that demand for a particular skill is dependent on the profitability of producing goods which use this skill. It also depends on the fact that the skill can be employed given certain endowments. This suggests that increases in skill follow increases in capital accumulation, which is consistent with the observation that different countries tend to have different absolute capital endowments.

I’m taking a class on international trade theory, and we’re going over a number of models that help us understand the globalized allocation of resources. The Krugman–Obstfeld–Melitz textbook we’re using — which is great, since I find it clearer than a lecture — starts with the gravity model, which graphically depicts some relationships between aggregates that we might expect, and then moves on to the Ricardian model of comparative advantage (henceforth referred to as RCA) before dipping into 20th century trade theory. I’m reading these early chapters on my own to inculcate the models into my memory. Now that I’m farther in my studies than I was four years ago, looking at RCA again really allows me to enjoy the characteristics of a great model. It’s no wonder that Ludwig von Mises held the “law of association” (the law of comparative advantage) in such high esteem.

What makes it so great in my eyes is that the RCA starts from a very simple premise that holds true empirically almost self-evidently and explains so much: the division of labor, also providing a basis to study how factors of production are allocated (the models that follow comparative advantage in an international trade theory textbook will usually further develop this relationship between input allocations, relative prices, and productivity). But most models aggregate their foundations in a way that requires homogeneity; the RCA is based on heterogeneity, and I think this is really one of its greatest attributes. These are probably the reasons why this model has persisted for so long and why it’s almost universally accepted: this is an excellent example of something that’s incredibly close to Mises’ a priori theorizing, and of the power of such theories.

If there’s one thing I’d add to the textbook exposition of the RCA it’d be to stress that it explains exchange between individuals — whether inside or outside a country’s national borders. Then the true power of the theory is made obvious, and it becomes easier for the student to conceptualize why it’s nonsense to treat trade with foreigners as different than trade with compatriots (except for whatever relevant political contingencies). What the RCA in the context of nations helps us look at is the globalization of the division of labor. A world where the RCA works best is a world where the nation, politically defined, is essentially irrelevant.

Posting has been slow, because I’ve been preoccupied with an assignment for my International Monetary Theory course. The prompt asks to explain the convergence of Eurozone yields on sovereign bonds,

I didn’t have as much time as I wanted, or should have taken, as the paper is due today. But, here is a skeleton of my rationale,

1. Capital market liberalization doesn’t have sufficient explanatory power, because it predicts that interest rates will converge at a point between the lowest and highest rates. Instead, what we see is that all rates fall to around 4 percent;
2. One caveat to the above rejection is the possibility of a German balance sheet recession between 2000–05 (Koo [2009]), where debt repayment led to an increase in savings, used to buy foreign assets. I argue that it’s unlikely that an increase in German savings alone accounts for the extent of the Eurozone-wide drop in sovereign bond yields;
3. I argue that the spread between the yields reflects differences in risk premiums. I focus mostly on Greece and Spain, noting that both have similar macroeconomic trajectories: economic booms between ~1950–70, and then stagnation, high inflation, and public debt accumulation between ~1975–1990;
4. The Maastricht Treaty, in 1992, imposed upon soon-to-be Eurozone members certain fiscal and monetary requirements. These, along with rapidly improving fundamentals in Spain and Greece, may have assuaged investors’ concerns;
5. Finally, the European Central Bank (ECB) accommodated German needs during their balance sheet recession, signalling to investors that the ECB is willing to intervene to support struggling markets. Recent experiences provide some evidence for this explanation, knowing that rates on PIIGS’ bonds skyrocketed when it was clear that the ECB would push for internal devaluation and fiscal austerity over monetary devaluation. Yet, when the ECB declares its “limitless” intentions to buy sovereign bonds from struggling markets, some of these countries experienced sudden reductions in borrowing costs.

In short, my explanation is that it’s all about the risk.