De-constructing Ricardian

David Ricardo. "Yes, have heard the name", informs one. Nudge a bit further and say, theory of comparative advantage. "Absolutley", heard collectively. If someone reading this piece still is unsure about what we are discussing then chances are that the person might have just come out from a long seclusion, cut out from this fast-paced interconnected world. After our country opened its market in last decade of 20th century, I reckon, his name must have got more space than any other economist in academic journals or magazines or even in the newsprint, whenever the print was serious enough to discuss.

About David Ricardo

Okay for the uniformed, David Ricardo introduced theory of comparative advantage in 1821 in his Principles of Political Economy and Taxation. Ricardo proved his theory of comparative advantage using a two country, static model of the world, in which Portugal is assumed to be a more efficient producer of both wine and cloth than England, but with greatest superiority in wine production. Ricardo demonstrated that, in his created world, both Portugal and England would gain by an international division of labor in which each produced the good in which it had the greatest relative or comparative advantage. Thus, even though England’s production efficiency was inferior to that of Portugal in both goods, the logic of free trade would lead Portugal to concentrate on wine production and England on cloth production, with the resulting trade between them generating maximum benefits for both countries.

Present world

Predominantly, arguments promoting free trade generally rest on the theory of comparative advantage. And is there any reason to question the validity of this claim? Well reading Ricardian made me to question this premise. I feel the free-trade supporting policy recommendations that flow from the theory of comparative advantage rest on a series of very dubious assumptions, rarely discussed outside the academic cirlces.

In fact, it is commonly misunderstood to assert the obvious, that countries have or can create different comparative advantages or that trade can be helpful. In fact, it supports a very specific policy conclusion: a country’s best economic policy is to allow unregulated international market activity to determine its comparative advantage and national patterns of production.

Conditions for the theory

But just like all theories, the theory of comparative advantage (and its conclusion) is based on a number of assumptions. Among the most important ones are that a country’s external trade should always be in balance and that a country’s gains from trade should be captured by those living in the country and spent locally. Morever, the theory also seeks perfect competition between firms, and asks for maintaining full employment of all factors of production. Finally, labour and capital should be perfectly mobile within a country and not moving across national borders.

Misinterpretation and fallacy of the theory

A quick consideration of the above assumptions reveals that they are extensive, utopian and unrealistic. The above conditions are never practised on any part of the globe (including Cuba). So i say that, if they are not satisfied, there is no basis for accepting the theory’s conclusion that free-market policies will promote international well being.

Moreover, think a bit more and we see that there is reason to challenge the assumption that external trade will remain in balance. This assumption depends on another, that exchange rate movements will automatically and quickly correct trade imbalances. However, exchange rates can easily be influenced by speculative financial activity, or by the rather smart role played by hedge funds (sort that triggered the collapse of the British pound in 1992 orchestrated by the would-be-turning billionare, George Soros).

In addition, as trade increasingly takes place through transnational corporate controlled production networks, it seems far less likely that exchange rate movements will generate the desired new production patterns. To the extent that exchange rate movements fail to produce the necessary trade adjustments in a reasonably short period, imports will have to be reduced (and consequenlty, the trade balance has to be restored) through a forced reduction in aggregate demand, and perhaps recession.

Also worthy of challenge is the assumption that capital is not highly mobile across national borders. If capital is highly mobile, then free-market/free-trade policies could produce capital flight leading to de-industrialisation, unbalanced trade, unemployment, finally leading to, yes you guessed it correctly, economic crisis.

So am I trying to disapprove the theory? Obviously not. Being a non-economics student myself, I question the theory for more refined answers.