In my previous post, On UFOs, Unicorns, Bigfoot, and Comparative Advantage, I examined the real world outcomes of the free trade paradigm and its theoretical origin: David Ricardo’s theory of Comparative Advantage. The evidence showed that countries that talk “free trade” but actually combine aggressive trade with an active industrial policy win in the global economy. Nations like Japan, South Korea, and Taiwan targeted U.S. industries and focused on developing technology, acquiring capital, and building infrastructure. In dosing so they created new wealth and rapidly developed a thriving middle class. This is a good thing – when it isn’t used to support a totalitarian state.
Countries that actually drink the “free trade” Kool-Aid and open their markets and transfer their capital and technology to their competitors spiral downward economically and suffer from growing economic stratification – think post-Victorian Britain, and the U.S. and Canada today. This is not a good thing for anyone.
Now to be clear, I do not dispute the simple elegance of Ricardo’s theory. I teach it all the time and it is a brilliant little demonstration of a fundamental economic truth that Adam Smith originally outlined – specialization can benefit everyone. However, the real world is immensely more complex than Ricardo’s little two country, two product model allows for and the advantages of Comparative Advantage are easily overwhelmed by many other things that actual nations can do to each other in trade.
Let’s first consider the theory. There is some simple math, which you can find described nicely here if you are interested. It’s not difficult and I’ve found that even MBA students J can be trained to regurgitate it in fifteen minutes. However, I’ll try to explain it in English:
Firstly, some countries have an “Absolute Advantage” in the production of something. For instance, Saudi Arabia has absolute advantage in oil production – they have boatloads of high quality oil that is easily and cheaply extracted. The U.S. has absolute advantage in the production of foodstuffs – with vast tracts of flat land, water and sunshine. Not surprisingly, the Saudis sell us some oil and we sell them some corn.
Secondly, some countries don’t produce any important commodity at the absolute lowest price. Should they just give up and die? Of course not! They will have a “comparative advantage” in something. Let me explain that. While other countries out-produce them in several things those countries cannot do all these things at once. So the nation that is not best at anything still has a reason to do something, if only so that that the better endowed country can focus its people on its very most profitable output. This more blessed nation incurs an “opportunity cost” when making anything that is less profitable than its best product. That said having Absolute advantage sure doesn’t hurt and it does give a nation more options and higher relative income.
As an analogy, imagine you’re a Medical Doctor with a family practice in a small town. You have a nurse, a receptionist, an accountant, and a janitor. Now, frankly you’re perfectly capable of doing nursing better, answering the phone, doing your books, and even cleaning your own toilets. However, you happily pay less skilled folks to do these things in order to maximize your time spent doing your most profitable work – billing the hell out of insurance companies and Medicare. The janitor has a job because the opportunity cost of MDs cleaning toilets is too high. That said, the MD, with his absolute advantage, is will still always be the wealthiest.
The simple (too simple) trade example Ricardo chose was the production cost of English wool cloth and wine versus that of its trading partner Portugal. Portugal held absolute advantage in both due to the benefits of its climate and labor rates. However, Portugal’s opportunity cost of giving up wine production to make wool was higher than the profits from the wool. Wine was always more profitable. Meanwhile, England’s disadvantage in cloth production was much smaller than its disadvantage in wine. Consequently everyone was better off if Portugal gave up its Merino flocks and England abandoned its fog shrouded vineyards. English consumers benefited from cheaper Portuguese products, so England should drop all tariffs against imports from Portugal and wait for the market to respond. Portugal would wisely give up its sheep and send more cheap wine to English consumers! 
So where is the problem? There are several big holes and bad assumptions in Ricardo’s theory and my colleague at the Coalition for a Prosperous America, Ian Fletcher has nailed several of them in The Theory That’s Killing America’s Economy and several books including Free Trade Doesn’t Work. I’m going to focus on some points that are specific to China:
Scale and Excess Capacity. Ricardo’s theory is based on the assumption of opportunity cost –that a country must give up producing something in order to compete in production of another global commodity. China essentially has no opportunity cost in labor. Decades of horrible governance in China have left China with vast surplus capacity of labor. They have hundreds of millions of people working in medieval conditions. I’ve seen these folks literally pushing plows behind oxen, picking rice by hand, and separating grain with hand mills. U.S. farmers using GPS enabled super-combines, genetically engineered crops, and chemical fertilizers and pesticides and are thousands of times more efficient than their Chinese counterparts. Simply by advancing their feudal agricultural system a little bit at a time China has been able to move hundreds of millions more off the farms and into factories. Regardless of their heart-wrenching “one child” policy and talk about short-term labor costs, China can keep this up for a very long time.
China can make all the wool and all the wine or to update Ricardo they now make all the clothes and all the computers. And if we continue dumb trade, they will soon make all the cars and all the planes over the next decade or so. As their labor pool tightens they need only expropriate more of the production technology we developed to compete with them. We will not catch up in our lifetimes and by then it will too late for the West, anyhow.
Strategy. Ricardo’s theory is tactical and cross-sectional. It considers only what choices a country can make at a specific moment in time, given an unchangeable set of production possibilities. Consider the game of Blackjack. If you have a 15 and the dealer is showing a 4, you’re likely to “hold” and let the dealer draw a high card and bust. That’s the correct tactical response. However, if you’ve been watching the deck and know most of the face cards are buried you might do something very different. China is counting the cards. That’s strategy.
Ricardo assumed that absolute advantages were based on thing like climate and natural resources, things that were either not transferable or that no sane nation would sell to foreigners. Today, the most important sources of national competitive advantage are capital and intellectual property. American money has been flying across the Pacific ocean as fast as Wall Street can ship it. Our invaluable technologies, many developed through government funded R&D are being eagerly handed over by short sighted multinational corporations like General Electric or stolen by China’s legions of spies and hackers.
As to natural resources, smart countries like China never sell any of them while dumb countries like Canada are eagerly pitching their national treasures to China. Smart countries think strategically and longitudinally (over time). When America, Europe and Canada have been deindustrialized, China will recognize monopoly rents on just about everything.
Using our MD office analogy, imagine that the nurse you’re paying so well is using all of her paycheck to go to medical school with the specific plan of opening a competing practice across the street with the help of your accountant. Not such a good deal. That’s the difference between strategy and tactics. Strategy wins in the long.
Currency. Ricardo used a generic value of input, “labor”, though clearly he understood there was land, capital and other inputs into the mix. He also essentially presumed products were traded in this universal unit of pre-defined value. According to economist David Hume, currency prices should reflect the actual value of resources though an adjustment process he called the Gold Specie Flow Mechanism. In the real world, trade is conducted with pieces of paper that have no intrinsic value. If these pieces of paper are not traded at market prices – if the exchange rate is manipulated by one side to its favor – then Ricardo’s theory is sitting on shaky ground. It’s like tilting the whole trade playing field on its side. China knows this and Chinese leaders openly discuss adjusting manipulating Yuan/Dollar market to maintain jobs in China.
National Security. Being able to independently feed your people and provide energy for domestic industry has serious security implications, so the Saudis would be smart to maintain domestic food supplies and the U.S. has an interest in staying in the oil business. The second best option is to keep your supply chain of critical inputs politically diversified. Keeping the ability to make steel, motors, electronics, and airplanes is pretty important if your “trading partner” is conducting the biggest military build up since World War II. Enough said.
Human Ability and Social Bifurcation. Ricardo’s theory assumes all people are interchangeable cogs that can simply be diverted to the source of comparative advantage. Almost all human beings are capable of assembling an iPhone, very few of them could ever design one. Millions of American’s are not going to “gain new skills” and all start designing iPhones.
As I’ve mentioned many times in this blog the current trade regime increases the returns to capital invested abroad and represses the value of domestic labor. Consequently unemployment and under-employment are skyrocketing in the U.S. If we count unemployment the same way we used to, America is suffering with a rate well over 20%. If we add in the former factory foremen and engineers now working at Home Depot and Wal-Mart, our unemployment + underemployment rate is easily tipping 40%. That’s not even considering all those twenty-five year old community college students still living with mom and dad, our rapidly growing prison population, and unemployed illegal aliens. Eventually these millions of displaced folks are going to find a populist demagogue who promises to take care of them. Who cares if America get a “net benefit” from trade if the final result is either a permanent welfare state or civil unrest? The rulers of China know this is happening to America – wonder why they always smile?
Externalities and Resources. China also has lower opportunity costs in resources because they are willing to brutalize their environment to achieve short-term absolute advantages in extraction. Nobody in Zhongnanhai really cares if most of China’s GDP growth is lost to future pollution and health problems if they can put another nail in the coffin of a Western industry.
Further, they are rapidly expanding their resource pool by buying up resources around the world (though they NEVER sell any of their own.) This has allowed them to pollute Africa and exploit Africans Chinese style. Soon they will be using Brazil as a source of advantage over the U.S. and Europe. Ricardo never really considered that Portugal would sell Portugal to England. Today nations like Canada are transferring their sources of absolute advantage to China in exchange for short-term income – essentially selling out their children’s future to keep this generation’s party going.
The next time some amateur economist pulls out “Ricardo’s Theory of Comparative Advantage”, ask him to actually explain it. If he actually can, then please email him this post or buy him Ian’s books and then ask him to explain it again. If he still doesn’t get it, it is likely that he just doesn’t want to.
Please follow Greg on Facebook at: http://www.facebook.com/gregwautry
and sign up for email updates at: http://www.gregautry.us/updates
 However, in the more complex real world it is important to understand that the Saudi’s actually sell more of this oil to Europe and we buy more from Mexico and Canada. The Saudi Price, though, sets the global market and the availability of supply there keeps Canadian prices down regardless of where we get ours.