Sunday, April 23, 2017

Ingrid Harvold Kvangraven — 200 Years of Ricardian Trade Theory: How Is This Still A Thing?

On Saturday, April 19th 1817, David Ricardo published The Principles of Political Economy and Taxation, where he laid out the theory of comparative advantage, which since has become the foundation of neoclassical, ‘mainstream’ international trade theory. 200 years – and lots of theoretical and empirical criticism later – it’s appropriate to ask, how is this still a thing?

This week we saw lots of praise of Ricardo, by the likes of The Economist, CNN, Forbes and Vox. Mainstream economists today tend to see the rejections of free trade implicit in Trump and Brexit as populist nonsense by people who don’t understand the complicated theory of comparative advantage (“Ricardo’s Difficult Idea”, as Paul Krugman once called it in his explanation of why non-economists seem to not understand comparative advantage). However, there are fundamental problems with the assumptions embedded in Ricardo’s theory and there’s little evidence, if any, to back up the Ricardian claim that free trade leads to benefits for all. On this bicentenary, I therefore think it’s timely to revisit some of the fundamental assumptions behind Ricardo’s theory of comparative advantage, that should have led us to consider alternative trade theories a long time ago....
Good summary backgrounder. "It's more complicated than that," the "that" being what is assumed.

The following quote contains an important lesson about logic and epistemology.
Rather than accept that there is something wrong with the exchange rate theory itself, empirical discrepancies are explained by measurement problems and/or imperfections in the market because of currency ‘manipulation’ (see for example Eichengreen 2013 or Gagnon 2012). In fact, neoclassical trade theory is so highly regarded that economists, almost across the board, cannot imagine any reason for China’s trade surplus with the US other than the Chinese manipulating their exchange rate in order to stimulate their exports.
What has happened here is that the theoretical model become the criterion for assessing truth rather than a model to be compared with observation in measurement.

Take probability theory. Probability theory shows the outcome of a long run roll of a coin toss, regardless of whether it is an ensemble of 1000 coins tossed at once or a single coin tossed a 1000 times. If the outcome does not converge on 0.50, then the fairness of the coin becomes suspect and not the theory.

This is not necessarily the case with a scientific theory. In the case of an anomaly scientists check the experiment but after checking and finding no errors, the theory becomes suspect. Repeated failures result in re-thinking the theory.

Because it is difficult to impossible to run controlled experiments in economics in many cases, trade being one of them, the dominant theory is never questioned. It serves as a criterion of truth whose truth is privileged from question.

Developing Economics
200 Years of Ricardian Trade Theory: How Is This Still A Thing?
Ingrid Harvold Kvangraven | PhD student in Economics at the New School for Social Research

13 comments:

Matt Franko said...

Well if when US exporters came back to the US with CNY balances and the US Fed would agree to exchange the CNY balances obtained by US exporters for USD at 6 USD : 1 CNY for as much as the exporters would show up with then we would soon have balanced trade ...

Fed would just have to accrue CNY as foreign reserves... US real terms of trade would be reduced from current though....

Tom Hickey said...

Why wouldn't exporters based in the US just invoice in USD and let the foreign importers figure out how to get the $.

A BOP issue arises with US FDI in China where US firms operating in China operate in yuan. And the only issue is if they decide to repatriate their RMB earnings and want to get USD for them.

Matt Franko said...

They would invoice in the yuan in order to get the sale easier... you never want to make it hard for your customers to do business with you... so you work with them in their own currency over there knowing when you got back your own CB would change you out into USDs at a fixed exchange rate....

If the CB delegates that function to fiscal agents then those agents will have to exchange at varying rates as they have fixed capital (effectively) as compared to often high volatility asset prices between which they strive to maintain a fixed regulatory ratio...

So if the external deficit nation fiscal agent takes a hit in some other asset category (say loans) , they have to acquire deficit nation reserve assets so they offer MORE surplus nation reserves per unit deficit nation reserves (increase their bid for deficit nation currency) which decreases the exchange value of the surplus nations currency.... vice versa, etc...

Tom Hickey said...

1. Setting a fixed rate of exchange sounds like a gold standard without the gold.

2. So here there are two fixed rates. The first is the peg that China adopts and the second is the fixed rate that the Fed sets for currency exchange.

Hmm.

Matt Franko said...

I'm not recommending it... I'm just pointing out what would happen...

I'd probably recommend fixed exchange at 1:1 so real terms would also soon also equalize then the decision to export or not would become less financial and more based on the real relationship between the nations... get the munnie zombies out of it....

Tom Hickey said...

The classical economists realized that money is a convenience for overcoming the issue of double coincidence of wants that inhibits barter exchange. They and the neoclassicals assumed that this was all there was to it. So they concluded that money is neutral in the long run.

Marx and Keynes demurred, observing that money is itself a good that is wanted for itself. Hence money is not the "hot potato" that Say's law assumes. Saving money and financial assets (banking and finance) affect that the economic cycle of production-distribuiton and consumption through demand leakage, for example.

Similarly with monetarism. Trade was conducted with the objective of accumulating gold and silver, which were used for military expenditure to acquire and project power.

Marxists also observed that financial wealth is also integral to class structure and class power.

Marxists tried to avoid these issues by abolishing private ownership of the means of production and monetary exchange, eliminating finance, but it didn't go so well.

Ideally, exchange would be essentially barter, but there is little prospect of getting away from a monetary production economy and the attendant significance of money, banking, finance and financial assets socially, politically and economically.

How to deal with this optimally is the underlying question. We are a long way from figuring this out.

Matt Franko said...

Well if you set he exchange rate at 1:1 and have the CB redeem at that ratio, it doesn't become barter but rather a gratuity between nations....might be a better system than present....

Laborers will labor as long as they are paid well so the needed stuff will surely get produced...

GLH said...

Free trade is still a thing because it benefits the financial interest that control the universities, the media and the government - better known as the deep state.

Neil Wilson said...

"Why wouldn't exporters based in the US just invoice in USD and let the foreign importers figure out how to get the $"

(i) Invoicing in local currency gets you the trade ahead of those that don't. Remember you're competing with the rest of the world.
(ii) If you invoice in your own currency, you're not the functional entity at the currency area edge. The functional entity at the currency area edge is the one that does the currency swap and stands the currency exchange risk - wherever they are physically located.

Forget about national borders. That's not always where the currency area edge is.

Neil Wilson said...

"they strive to maintain a fixed regulatory ratio... "

Isn't that the problem. The regulation is based upon an idea of financial exchange that is just false.

Change to the Mosler approach - where banks cannot hold foreign exchange as assets (since that is a loan to a foreign entity and is banned), but have access to liquidity overdrafts as long as they stay solvent.

Matthew Franko said...

Well I dont think they "want" to hold the assets Neil seems like that is just what they have to deal with to be a member institution... so they have to accept deposits and code them as liabilities on the right and reserve assets on the left... its their role as fiscal agents...

Look at Deutchbank over in Germany, the German economy is firing on all cylinders and yet DB has had a very hard time of it their stock is in the toilet... they are probably drowning in reserves coming in from all over the EZ with that huge trade surplus at negative yield and are circling the toilet bowl... this does not look attractive from the POV of an investor at least...

commentsongpe said...

I think it's important to keep in mind that the system is fundamentally global and not inter-national. We see this in global portfolio diversification, the nature of transnational corporations, supply chains, and so on.

This being the case, the entire subject of inter-national trade deficits strikes me as little more than a status-quo ideology serving to force workers into ever downward competition. It's immaterial to the diversified global oligarchy where production occurs for they get their profit regardless.

Far better to completely ignore trade deficits and focus only on what's important - assuring widespread prosperity everywhere. The best way to do that, using Germany / Greece as an example, would not be to push for ever more consumption in Germany or to relocate German business to Greece (what would then happen to German workers?), or to lower Greek wages. It would be to create enough money for use in Greece to bring the Greek people up. Trade deficits aren't remotely the problem - it's the lack of agency on the part of the global population.

Jim


MRW said...

The best way to do that, using Germany / Greece as an example, would not be to push for ever more consumption in Germany or to relocate German business to Greece (what would then happen to German workers?), or to lower Greek wages.

The best way, it seems to me, would be for Germany to buy Greek goods.