World Trade and the False Theory of Comparative Advantage

Some introductory remarks

This reply and the one that will follow should be seen as a continuation of my reply criticizing the view of economist Dean Baker that the U.S. dollar is “overvalued” and his claim that the U.S. trade deficit could easily be corrected and the U.S. unemployment crisis eased by simply lowering the exchange rate of the U.S. dollar against other currencies.

I had originally planned to continue the discussion of world trade and currency exchange rates the following month but the contrived U.S. government debt crisis in August forced a change of plans.

Reader Mike has made some interesting remarks about world trade and the dollar system—the foundation of the American empire, which has dominated the world politically, militarily as well as economically since World War II. To understand the growing threat of a renewed crisis barely two years after the official end of the “Great Recession” of 2007-09, it is important to understand both world trade and the dollar system. (1)

Discussing Baker’s arguments for a lower dollar, Mike wants to know if there is an objective basis for determining if currencies are “high” or “low” in relation to one another. Baker summarizes his argument as follows:

“[T]he U.S. pattern of spending more than it takes in is due to the fact that the dollar is too high. In a system of floating exchange rates, like the one we have, the price of currencies is supposed to fluctuate to bring trade into balance. This means that the trade deficit is caused by the over-valued dollar and a decline in the dollar is the predictable result.”

The obvious problem with the view that the U.S. dollar is “overvalued” is that ever since the end of the Bretton Woods system 40 years ago, the exchange rate of the U.S. dollar has shown a secular tendency to decline against other currencies. If the dollar was “too high” in the sense that there is a correct level of exchange rates that would end the U.S. trade deficit, why hasn’t the secular fall in the dollar brought the U.S. trade account into balance?

For 40 years, the dollar has been devalued against other currencies, and yet, until the “Great Recession” began in 2007, the U.S. trade balance has—with some ups and downs—grown ever larger. (2) It is true that the theory of international trade taught in the universities—the theory of comparative advantage, or comparative costs—predicts that under a system of floating paper currencies, exchange rates will align themselves over time in such a way that international trade will balance. Yet this has not happened.

(For an explanation of the theory of comparative advantage, see my reply from two months ago that dealt with Dean Baker’s claim that the U.S. dollar was “overvalued” and this main post.)

Understanding world trade, including the question of exchange rates between currencies, is not that inherently difficult. The main barrier to overcome is the fact that bourgeois political economy has mystified the subject of international trade more than any other in economics with the exception of the nature, origins and production of surplus value.

Just like we cannot understand the exploitation of the working class by the capitalist class without a correct theory of surplus value, we cannot understand the exploitation of one nation by another without a theory of world trade. And if we cannot understand the exploitation of one nation by another, we cannot understand the nature of imperialism. This is true even though understanding modern imperialism as the monopoly stage of capitalism involves more than—but includes—the exploitation of one nation by another.

In order to understand world trade, we have to carry out a radical critique of the theory of world trade that is taught in university economics departments—the so-called law of comparative advantage, sometimes called the theory of comparative costs. Indeed, we have to get the whole theory of comparative advantage out of our heads if we are to understand world trade, just like we have to get the marginalist theory that the “factors of production are compensated according to the value of their marginal product” out of our heads if we are to understand surplus value.

This is made all the more difficult because articles in the newspapers and other media that “explain” world trade and currency exchange rates are all based on “comparative advantage” even if the articles do not mention comparative advantage by name.

In this two-part reply, I will examine, first, the origins of the theory of comparative advantage, its development by bourgeois economists in the 19th century in the guise of the “currency school,” and Marx’s critique of the currency school in “Capital” and other works. Next month, I will examine the growing crisis of the dollar system that forms the financial foundation of the present-day American empire, which should shed light on how we can construct a correct theory of international trade and currency exchange rates based on Marx’s law of labor value and theory of money and price.

Ricardo and the origins of the theory of comparative advantage

The modern marginalist bourgeois economists take their theory of world trade, unlike the case for most of present-day bourgeois economic theory, directly from the great English classical economist David Ricardo. Since Ricardo brought bourgeois classical political economy to its highest point, doesn’t this mean that the modern bourgeois views on world trade and currency exchange rates, unlike other parts of modern bourgeois economics, rest on a solid foundation?

Wouldn’t Marx, who based so much of his own economic work on Ricardo, be pretty much in agreement with today’s bourgeois economists on international trade and currency exchange rate theories? As regards international trade, don’t Marx and the modern bourgeois economists share common Ricardian roots?

The simple answer to these questions is no.

Marx by no means accepted everything that Ricardo wrote. Marx did consider Ricardo’s attempt to develop a consistent theory of labor value a huge advance beyond the views on labor value developed by earlier (bourgeois) economists. True, Ricardo’s theory of (labor) value was not complete or without contradictions, some of which Ricardo himself acknowledged. It fell to Marx to complete Ricardo’s work on value theory and to resolve the contradictions that had stumped Ricardo.

However, it is hard to imagine Marx’s own work on (labor) value and surplus value without the work of Ricardo. Marx was able to see much further than Ricardo because he stood on the shoulders of a giant, David Ricardo.

Ricardo’s theory of value led to socialism

In contrast to Marx, modern bourgeois economists have, as is well known, completely rejected Ricardo’s work on (labor) value. The reason they do is that the concept of labor value even in its Ricardian form inevitably leads to the view that profit—surplus value—arises because a portion of the labor the workers perform is unpaid. Indeed, the entire early 19th-century pre-Marxist school of English socialism, also known as Ricardian socialism, based itself on the Ricardian labor theory of value.

Bourgeois political economy itself dared not go any further along the road that Ricardo had followed when it came to value theory. The beginnings of modern bourgeois marginalism can be traced back to the bourgeois opponents of Ricardo who, basing themselves on the very real contradictions within the Ricardian theory of value, decisively turned their backs on the theory.

Therefore, modern bourgeois economists reject the part of Ricardo’s work that Marx based himself on and further developed. But other parts of Ricardo’s work, which Marx rejected, bourgeois economists accept. Marx rejected Ricardo’s theory of world trade (now called comparative advantage, or comparative costs), the quantity theory of money (3) and Say’s Law, all of which were accepted by pre-Keynesian marginalist economists and are defended by neo-liberal economists to this day. (4)

Indeed, Ricardo’s claim that in a capitalist economy based on free trade, comparative rather than absolute advantage prevails depends explicitly on the quantity theory of money and implicitly on Say’s Law.

The quantity theory of money (5) holds that, assuming that the level of commodity production is given, changes in the quantity of money have no effect on real effective monetary demand, output and employment, but only affect nominal prices and wages. For example, the theory holds that if we reduced by one-half the money supply, the prices of commodities including the price of “labor”—actually labor power—would also fall by half, but real incomes, real effective demand, would be unchanged.

This view is called the “neutrality of money.” Essentially, the supporters of the quantity theory of money, which included Ricardo, see money as little more than a means of circulation. Marx, in contrast, strongly rejected the quantity theory of money—and in many places in his works comments that Ricardo’s theory of money was wrong. In Volume III of “Capital,” Marx explained—and provided statistics that proved it in practice—that a flow of money out of a country—Marx uses the example of Britain in the 1830s—caused by a deficit in the balance of trade strongly affects the rate of interest but has no effect on the general price level.

Second, and closely linked to his views on the quantity theory of money, Ricardo accepted Say’s Law. This is the view that a generalized overproduction of commodities is impossible. The supporters of Say’s Law see money as simply a device to overcome the technical difficulties of barter. They believe that in principle we can understand capitalism even if we abstract away money. Since the supporters of Say’s Law abstract away money, they hold that commodities are purchased by commodities. This they hold proves that a general overproduction of commodities is impossible. At most, only a partial overproduction of some commodities backed up by a shortage of other commodities is possible.

In modern terms, the quantity theory of money and Say’s Law, which are closely linked together, support the claim on the part of marginalist economists that a capitalist economy has a strong tendency toward “full employment.” Their view that both rich and poor countries benefit equally from free international trade is based precisely on the part of Ricardian theory that Marx rejected.

Marx on comparative advantage

Marx had intended to write a whole book on world trade and the world market where he would have presented a full-fledged critique of the Ricardian theory of world trade. It is here that Marx would probably have presented his theory of crisis as well. Therefore, the question of world trade and the claim that comparative advantage governs world trade under capitalism is actually closely related to crisis theory.

Marx wrote quite a bit against the currency school—which is closely linked to Ricardo’s theory of comparative advantage. As far as I know, Marx didn’t criticize comparative advantage as such only because the term “comparative advantage” was not current in Marx’s—or Ricardo’s—time. But in fact, Marx wrote a lot about the theory of comparative advantage in the guise of criticizing the currency school and the banking legislation that the currency school inspired—the English Bank Act of 1844.

Bank Act of 1844 and the currency school

Under the Bank Act of 1844, the Bank of England—then as now the British central bank—was divided into two departments: the Banking Department and the Issue Department. The Banking Department carried out commercial banking operations such as taking deposits from other commercial banks and some wealthy individuals, made loans and (re)discounted commercial paper. But the Banking Department, like modern commercial banks and unlike modern central banks, did not issue banknotes—or legal tender currency notes.

This job was reserved for the Issue Department. The Issue Department held the bank’s gold (and silver) reserves—actual money material—and it issued banknotes to the Banking Department—leaving aside a fixed fiduciary issue based on government bonds—only to the extent that it had gold (and silver) in its vaults. Under this system, which remained in effect until the outbreak of World War I, it was only the Issue Department of the Bank of England and not the Bank of England as a whole that functioned as Britain’s monetary authority.

If there was a drain of gold out of the Issue Department due to a negative balance of payments, the Issue Department would cancel some of the banknotes held by the Banking Department. (6) According to the quantity theory of money that formed the foundation of the currency school, the quantity of banknotes in circulation would then fall, which in turn would cause nominal prices and wages to immediately fall within Britain.

The currency school claimed that this fall in British prices would prevent the kind of gold drains that had played an important role during the economic crises of 1825 and 1837. Marx saw these two “commercial crises”—as they were called in the 19th century—as representing the first true cyclical crises of generalized overproduction of commodities that Marx expected to recur at periodic intervals until capitalism was transformed into socialism. According to Marx’s analysis, it was the general overproduction of commodities by all the countries then engaged in capitalist production on the world market as a whole that caused the crises of 1825 and 1837.

According to Marx, the imbalances in trade and payments among the capitalist nations that led to the British gold drains of 1825 and 1837 were merely a consequence of the global overproduction that was the real cause of these economic crises.

The supporters of Ricardo—the currency school—took the opposite point of view. As believers in Say’s Law, the currency school denied that a general overproduction was even possible. Therefore, following the logic of the currency school, a general overproduction of commodities on a world market-wide scale could not possibly have been the cause of the “commercial crises” of 1825 and 1837.

Instead, the currency school believed that these two “commercial crises” were simply the result of imbalances in world trade. If these imbalances among the capitalist nations could be “nipped in the bud” before they reached critical limits, “commercial crises” such of those of 1825 and 1837 would not recur in the future.

Therefore, the currency school reasoned that if the Bank of England experienced a major gold outflow that led to acute economic crises, this showed that British prices were too high relative to the prices in the rest of the world. These high prices then caused the balance of trade and payments to turn against Britain. According to the currency school, the high prices in Britain relative to world market prices were caused by the fact that too much money was circulating within Britain.

The currency school recognized two types of money: gold coins and banknotes. (7) The currency school claimed that in 1825 and 1837, since the Bank of England and other banknote-issuing commercial banks could issue banknotes that were not backed by gold, the British money supply failed to decline with the falling quantity of gold in the Bank of England vaults like it should have.

Since the quantity of money did not contract, or did not contract enough, the currency school held, British prices stayed high and the “comparative advantage” mechanism “discovered” by Ricardo was paralyzed by a faulty monetary policy. Eventually, however, the gold in the Bank of England—and other note-issuing commercial banks—fell to such critically low levels that the British gold standard was brought to the brink of collapse—and many note-issuing commercial banks failed. The Bank of England was finally forced to sharply raise its discount rate curtailing its loans and discounts in order to save what was left of its gold, leading to a violent adjustment in the form of the “commercial crises” of 1825 and 1837.

The key to avoiding a repeat of the “commercial crises,” according to the currency school, was to in the future strictly tie the quantity of banknotes in circulation to the gold reserves in the vaults of the central bank—the Bank of England. In this way, as soon as the balance of payments turned against Britain, prices and wages would quickly drop, correcting the deficit and halting the gold drain well before it reached such proportions that a financial crash—commercial crisis—would occur. The British banking legislation of 1844 was designed, therefore, to reform the British monetary system so that Ricardo’s theory of comparative advantage would operate in the way that Ricardo had predicted it would.

In line with this thinking, the Bank Act phased out the right of commercial banks other than the Bank of England to issue banknotes. The commercial banking operations of the Bank of England were then strictly separated from the issuing of banknotes. These measures were to ensure that the quantity of banknotes in Britain would fluctuate according to the fluctuations of the gold in the vaults of the Issue Department. Comparative advantage, to use the modern terminology, would finally come into its own, and “commercial crises” would vanish.

The currency school—which was the reigning orthodoxy in Britain between 1844 and 1914—claimed that if these “rules of the game”—tying the quantity of banknotes in a country to the quantity of gold in its banks—were followed by all trading nations, both rich and poor countries would benefit equally from free trade. Any world trade imbalances that would arise would be automatically and painlessly corrected before they could lead to a “commercial crisis.”

When the “marginalist revolution” occurred in the late 19th century, the views of the currency school on world trade and comparative advantage, or costs, was integrated into the now-dominant marginalist orthodoxy, where it remains entrenched to this day—even if the currency school itself vanished with the decline and demise of the international gold standard.

What really happened?

Under the Bank Act when gold began to flow out of the Issue Department of the Bank of England, the rate of interest rose in Britain while prices and wages were unaffected. Contrary to the predictions of the currency school, trade imbalances that caused the gold outflow were not corrected. Instead, higher interest rates in Britain attracted “hot money” from abroad seeking higher interest rates, and gold flowed back into the Issue Department. If there was an underlying trade deficit, it was not corrected at that point.

Eventually, when the worldwide industrial cycle reached its peak, global credit grew “tight.” (8) Due to the global monetary shortage, which was simply the flip side of global overproduction, Britain could no longer attract “hot money”—borrow money to cover its trade deficit—like before. Only then would Britain’s balance of trade deficit cause gold to flow out of the Issue Department leading to a contraction in the quantity of banknotes available to the Banking Department.

The gold outflow would cause the Banking Department to raise its discount rate and restrict its loans and (re)discounting of commercial paper. However, prices and wages only fell when the crisis broke out and effective monetary demand contracted. As Britain’s domestic economy fell into recession, imports would fall faster than exports, and the trade deficit would be corrected.

But just as in 1825 and 1837, the trade balance would be corrected not through a painless adjustment of purely nominal prices and wages but through slumping real output—recession—leading to partial or complete factory shutdowns, business bankruptcies and “short time” or complete unemployment for factory and other workers.

Not only did the 1844 bank legislation fail to prevent new “commercial crises,” they actually made the crises that followed in 1847, 1857 and 1866 worse than they would otherwise have been. As realization became widespread that the “Bank” could not under the existing laws issue additional banknotes to meet the sudden increase in demand for banknotes as a means of payment, a run would develop on British commercial banks as customers attempted to convert their deposits into banknotes before the supply ran out.

Therefore, under this “ingenious” banking legislation, not only could commercial banks run out of banknotes and go bankrupt, but the Banking Department of the Bank of England itself could run out as well. Thanks to the 1844 currency school/comparative advantage-inspired law, the Bank of England could under conditions of panic actually run out of its own notes even if a considerable amount of gold remained in the vaults of the Issue Department.

Remember, under the 19th-century British gold standard, Bank of England banknotes were promissory notes on the bank payable in full-weight gold coins to the bearer on demand. However, during the 19th-century crises, the owners of these banknotes within Britain made no attempt to exercise their right to convert them into gold. During these crises, the credit of the Bank of England was never shaken, and the central bank’s notes, not gold, were hoarded during panics. Therefore, though universal overproduction at periodic intervals made crises inevitable, the Bank Act of 1844 inspired by the currency school—or what comes to the same thing, the Ricardian theory of comparative advantage—made the crises of 1847, 1857 and 1866 worse than they they would otherwise have been.

Fortunately for British capitalism, the Bank Act of 1844 had an escape clause and could be suspended in a crisis. As soon as the Bank Act was suspended, hoarded Bank of England notes would return to the vaults of the commercial banks including the Banking Department of the Bank of England itself and the financial panic would end.

The underlying trade imbalance would be corrected not by the working of comparative advantage but rather by the business depression with its associated mass unemployment that followed the crisis. As we saw above, depression in Britain meant a drop in British demand for commodities—imports—while British industrial and commercial capitalists, unable to sell as many of their commodities at home as usual, would instead sell more commodities to foreign markets. The underlying balance of trade deficit would be corrected, though not by the painless mechanism of “comparative advantage” but rather through depression, unemployment and bankruptcies in Britain—and other capitalist countries as well.

Not only was the Bank Act a complete failure as a means of preventing “commercial crises” and their associated depressions and mass unemployment, but these crises showed that Ricardo’s claim that “comparative advantage” as opposed to absolute advantage would operate in world trade under the capitalist system was false.

Here, by the way, we see illustrated one of the functions of crisis: Crises periodically even out world trade. Countries that are running deficits before the crisis breaks out—the crisis tends to begin in countries that are running deficits—are now forced to balance their trade, more or less. The flip side of the coin is that countries that were running trade surpluses when the crisis broke out will now see their surpluses disappear. In the wake of the crisis, world trade will be more or less balanced out.

During the boom with its credit inflation—remember, the boom and its credit inflation develops on a world market scale—world trade tends to get more and more out of balance—with some countries borrowing more and more from countries that are running trade surpluses, and running up large trade deficits just as many individuals and businesses do when credit is easy to obtain. The contraction of credit that occurs during the crisis rebalances world trade—until the next boom with its easy credit causes world trade to become unbalanced once again and the cycle repeats.

Not all Marxists realize that “comparative advantage” is incompatible with either Marxist theory or reality. Marxists who are well educated in economics at the college and post-graduate level inevitably are taught just like other economics students the theory of “comparative advantage.” Since Marx doesn’t refer to the “theory of comparative advantage” or “comparative costs” as such, these Marxist students often don’t realize that the law of comparative advantage is incompatible with either Marxist theory or reality.

As is often the case, Professor Anwar Shaikh has a much deeper understanding of Marxist economic theory, including Marx’s views on world trade, than most other university-based and -educated Marxists. He understands that the law of comparative advantage—or comparative costs—is not compatible either with Marx’s economic theories or, much more importantly, with reality. On his Video Lectures page, he has a video in which he explains to an audience of Indian students in a way that does not require a background in either bourgeois political economy or the Marxist critique of bourgeois political economy that the “theory of comparative costs,” as Shaikh calls it in the video, is false. All readers should, if they can, take time to listen to Shaikh’s talk over the next month.

Next month I will continue my examination of world trade and take a look at the present-day dollar system.

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1 As we now see, the world and U.S. economies have, to say the least, not fully recovered from the 2007-09 downturn. U.S. GDP has yet to reach the level that prevailed at the beginning of the “Great Recession” in 2007. Now, there is growing alarm that the “Great Recession” is about to resume its downward course as the European sovereign debt crisis worsens and U.S. economic growth seems to be grinding to a complete halt.

2 If the dollar system continues, it seems likely that when the next full industrial cycle reaches its boom phase, the U.S. trade deficit will again break records.

However, there is reason to suspect that the world economy is going through a series of partial industrial cycles like it did in the 1970s. If that is the case, it may be that a real recovery—a full industrial cycle as opposed to a 1970s-style partial cycle—will not occur until the dollar system is replaced by a different international monetary system where the U.S. dollar is no longer the medium in which internationally traded commodities are priced and world debts are denominated. Maybe we have finally reached the point where the U.S. cannot continue to increase its commodity imports relative to its exports. There is no doubt that such a limit exists. If we have indeed reached this limit—and this remains to be seen—we are now witnessing the death throes of the dollar system. More on this next month.

3 Ricardo was not the originator of the quantity theory of money. He was, however, a supporter of that theory as well as Say’s Law, with which it is closely linked. Without the quantity theory of money, Ricardo’s claim that comparative as opposed to absolute advantage prevails on the world market falls to the ground.

4 In his “General Theory,” Keynes also rejected many of the parts of Ricardo’s work that Marx did as well. However, Keynes also showed great hostility to the parts of Ricardo’s work that Marx accepted. Keynes even blamed Ricardo for spawning Marxism. There is, of course, an element of truth to Keynes’s claims in this regard. Here we see the huge gap that separates Marx and Keynes.

5 Since believers in the quantity theory of money basically see money as nothing more than a means of circulation, they fail to distinguish between metallic (real) money, token money and credit money. As I explained in the main posts here and here, the three forms of money obey quite different laws.

6 Under the gold standard that was then in effect in Britain, the Bank of England was obliged to exchange its banknotes on demand of the bearer for a given quantity of full-weight gold coin. When foreign capitalists exported commodities to Britain, they would accumulate pound-denominated bills of exchange—a form of commercial paper.

They had two choices. They could sell this pound-denominated commercial paper for local currency, or they could acquire pound-denominated Bank of England banknotes and demand gold sovereigns at the rate of one British sovereign for one pound. They could then ship the gold sovereigns back to their home countries, melt the sovereigns into bullion—money material—and present the bullion to the local mints for re-coining into their local currencies, or sell the bullion for the local banknotes denominated in the local currency.

Shipping gold across the oceans was not without expense and risk. First, there was the cost of changing the physical location of the gold, from Threadneedle Street in London, where the Bank of England is located, to your own country. Second, ships could sink, perhaps because of a storm at sea, or in event of war, the ship might be sunk or seized by an enemy of Britain. Therefore, in addition to paying the transportation costs, you had to insure the gold. These costs determined what was known as the “gold point.”

If the pound fell against your local currency, it was worth eating the exchange losses if the loss was less than or equal to the costs of shipping and insuring the gold. In this case, the pound was still within the gold point. If, however, the exchange loss was greater than the costs of shipping and insuring the gold—had fallen below the gold point—you would demand actual gold from the Bank of England—under the 1844 Bank Act, from the Bank’s Issue Department. Gold would then physically flow out of the Issue Department and a portion of the pound notes available to the Banking Department would be canceled.

7 Modern-day supporters of the quantity theory of money—such as Milton Friedman’s monetarist school—acknowledge that the currency school failed. They claim that it failed not because the quantity theory of money was fundamentally wrong but because the currency school’s economists incorrectly defined “money” as gold coins in circulation plus banknotes. The modern monetarists claim that money should have been defined as gold coins plus banknotes plus checkable bank deposits. Indeed, modern monetarists are continuously arguing exactly what kinds of bank deposits should be defined as money. Very often, the “money supply” defined one way moves in a radically different direction than the money supply defined in a different way. In these cases, the monetarists are at a loss in trying to decide exactly what version of the “money supply” will determine the changes in nominal prices and wages.

8 Keynesian and other bourgeois economists often blame crises on “tight money” or “tight credit.” If only “the Fed” hadn’t “tightened too much,” the recession would have been avoided, they claim. In reality, it is not “tight credit” or “tight money” that causes crises but rather overproduction, which manifests itself initially as “tight money” or “tight credit.” At a certain point, overproduction will cause credit to contract. The economists of the Keynesian and other bourgeois schools see the credit contraction as the cause of the crisis when in reality it is the result of the crisis.

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