Eco Article - Surfeit Tension

TECHNICAL | FECB

Surfeit tension Steve Adams Why is it that only economists seem to understand the intricacies of international trade and finance? Probably because it means abandoning ‘common sense’

esults from the recent Economics for Business (FECB) examinations suggest that the topic of the “open economy” remains the most problematic – and not only for students. Paul Krugman, a US economist, observed in 1996 that many politicians, policy-makers and commentators seemed to have an understanding of international trade and finance that was rooted in a model of the world that economists thought had been abandoned nearly two centuries ago1. So, what many people claim to be common sense in the area of international economic relations is seen by economists as at best misleading and at worst plain wrong. John Keynes once castigated common sense in economics as merely outdated theory, leading to incorrect reasoning and inappropriate conclusions – especially about economic policy. So where exactly does the common-sense understanding of international trade part company with the economists’ understanding of it? And in what ways does the common-sense view of international trade lead to conclusions that are at odds with those of economic theory? Some people seem to have great difficulty coming to terms with the fact that the main gains to a country’s economic welfare from engaging in international trade come not from exports, but from imports. This misconception is often the result of trying to understand the economy as whole as if it were a business. This is misleading, because a business’s profits are derived from the income gained by selling goods and services to other businesses and consumers. But countries make profits and make their economies gain not from selling goods and services abroad, but from buying goods and services from other countries. This seemingly odd conclusion is derived from two propositions. First, the ultimate aim of all economic activity is the consumption of goods and services. This implies that, all other things being equal, more consumption is better. Although this proposition may raise issues about the

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environment and sustainability, it is generally straightforward and not contentious. Second, the law of comparative advantage, which is a little more complicated, states that a country can always gain from international trade by exporting the commodities in which it is most efficient – that is, in which the opportunity costs of production are lowest – and by importing those goods that it’s least efficient at producing. The UK can produce wine, for example, but it is clearly more efficient at producing financial services. So if a given bundle of resources can produce 10 bottles of wine in the UK, but could be used to produce a volume of financial services that can be exported to France in exchange for 15 bottles of wine, it makes sense to engage in international trade. But note that the benefit comes from the five extra bottles of wine that have been imported. The function of the exports is merely to provide the foreign exchange to pay for the imports. The economic benefit comes not from the exported financial services, but from the imported wine – and we can all drink to that. So international trade, via imports, allows us to acquire a wider variety and larger quantity of goods and services that would otherwise be the case. We pay for these imports by earning foreign exchange from our exports. There may even be extra benefits from exporting – for example, if there are economies of scale in the exporting industries, trade reduces production costs. But the main source of economic welfare from international trade comes from imports and, having established this general principle, we can consider further issues. The first of these is the question of whether a trade surplus is good thing or a bad thing. The common-sense view of international trade is that a country should aim for a trade surplus – ie, greater earnings from exports than payments for imports. This would appear as a net credit on the current account of the balance of payments. But economic theory cannot support this claim. Remember that the real benefits of trade

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come from imports, so a policy of aiming for a trade surplus would imply reducing imports and thus reducing the welfare gains from trade. Moreover, what does a country do with the trade surplus if it has one? A surplus implies a net inflow of foreign currency and this obviously cannot be spent domestically – just try paying your Saturday supermarket bill with a handful of yen. So either it must be put into the central banks’ reserves, where it will do nothing; or it must be spent on paying for imports. In the latter case the country would have made good use of its export earnings and would not, in effect, have a surplus. This reinforces the belief that the best use of export earnings is to pay for imports of useful goods and services. Of course, a nation could lend its surplus foreign exchange to individuals and organisations in other nations as an outflow of capital. Here the country would be providing foreign exchange to enable another country to import more goods and services than its export earnings can finance – ie, one country’s trade surplus is being used to finance another country’s trade deficit. In effect, this is what Japan and some European nations have been doing for the US for a long time. The US has had persistent trade deficits that have been financed by capital inflows from other countries. These have been financing a higher standard of living for US consumers than US export earnings would warrant. Does it really make sense to work hard to earn foreign exchange that is ultimately used to finance consumption in another country? Remember that the benefits of trade come from the consumption of imports. A country that has a trade surplus has used scarce resources to produce goods and services that it has exported in exchange not for useful consumer and investment goods, but for foreign exchange that simply piles up in the reserves of its central bank. There is simply no logic in doing this: if a trade surplus is seen as good, a bigger surplus is presumably better, so should a country aim to export as much as possible and import as little as possible? What would the outcome be then if a country exported all of its output of goods and services and imported none? A country in which no consumption occurs does not look a very attractive place. There is a strong belief that countries compete with others in international trade – ie, that different nations are rivals. In this view of the world, one country appears to gain at the expense of another. The erroneous belief that a trade surplus is desirable

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and a trade deficit undesirable is an example of this. Because a country can have a trade surplus (exports exceeding imports) only if some other country has a trade deficit (imports exceeding exports), the idea that countries are rivals and one can only gain at the expense of another is reinforced. The notion that countries compete arises directly from using a business analogy. In business terms companies clearly compete with other companies, including those in other countries. They do this in the pursuit of profit. Companies employ economic resources to produce output, and they sell this output in competition with other producers. If they are successful they earn profits for their shareholders. Countries are not like this for two reasons. First, they are both producers and consumers – indeed, countries consume most of the goods and services they produce. The point of economic activity is consumption rather than production, so it’s the consumption part that really matters, since this determines the standard of living. Second, countries cannot make profits. Profits are the reward to entrepreneurs for taking risks and this cannot apply to countries as a whole. Thus a country’s trade surplus is not a profit; it’s more akin to an person whose income exceeds his or her expenditure. I

may not spend all of my income on goods and services, but the money I don’t spend is not profit; it’s simply unspent income. The implication is that all countries can gain from international trade, and this is the most important conclusion to be derived from the theory of comparative advantage. For countries, international trade is a cooperative activity in which all can benefit. But if this is the case how do we explain why countries attempt to limit international trade through measures of trade protection? Recently the US government imposed import tariffs on steel. Why did it do this? The common-sense approach says that this will benefit the US economy, since its domestic steel industry will increase output and create more employment. But economic theory tells us that the whole point of economic activity is consumption, so American consumers of steel and steel products – both companies and individuals – will clearly suffer as a result. The purpose and effect of trade protection is to enable the domestic industry to charge higher prices for its products. The producer gains, but only at the expense of consumers. Also, overall productivity in the economy is reduced because resources such as labour and capital will be retained in the inefficient but protected domestic industry, rather

than moving to those sectors of the economy that are efficient by world standards. In this way the country as a whole loses out as a result of the protection granted to its steel industry. The reason for this apparently perverse decision by the US government must be rooted either in a failure to understand international trade and its benefits or in political considerations. Perhaps the best explanation in this case was that there were mid-term elections in the US in November and the governing party had unsafe seats in some major steel-producing regions. The whole country’s economic welfare was therefore sacrificed for votes. The possibility that the EU may impose retaliatory tariffs on certain US exports to Europe would compound the loss of economic welfare, since reduced imports from the US (from where principal trade gains are made) would reduce the standard of living for European consumers. Why would governments make such decisions? The standard explanation is that they respond to pressures. Some producers will lobby their governments to grant them protection from competing imports. This raises the profits of the protected industry but at the cost of reduced national economic welfare. So why doesn’t the rest of society, which will lose out from trade protection, lobby

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TECHNICAL | FECB

Reference 1 Paul Krugman, “Making sense of the competitiveness debate”, Oxford Review of Economic Policy, Vol 12, No 3, 1996. 22

Test your understanding

Question 1: To maximise its gains from trade, a country should A try to maximise net exports; B export products in which it has an absolute advantage; C protect domestic producers from competition from cheap imports; D export products in which it has a comparative advantage. Question 2: International trade is best explained by the fact that A all countries have an absolute advantage in the production of something; B all countries have specialised in the production of certain goods and services; C no country has an absolute advantage in the production of all goods and services; D all countries have a comparative advantage in the production of something. Question 3: All of the following are consequences of the imposition of trade barriers by a country except one. Which is incorrect? A Domestic prices tend to rise. B Levels of imports tend to fall. C Only the exporting country suffers a loss of economic welfare. D Exports from the country imposing trade barriers tend to fall. Question 4: A country can increase its benefits from trade in all of the following ways except one. Which is incorrect? A Reducing its tariffs on imports. B Subsidising domestic producers to help them compete in international markets. C Encouraging a reduction in trade barriers through negotiations in the WTO. D Adopting free-trade policies even if its trading partners do not. Question 5: The imposition of a tariff on imported goods will benefit A domestic producers; B domestic consumers; C foreign producers; D none of the above.

Answers: 1D, 2D, 3C, 4B, 5A.

governments to cut tariffs? There are two reasons for this. First, producer groups tend to be better organised informed about trade protection than consumer groups. More importantly, for producers the gains from trade protection may be significant but for individual consumers the loss is relatively small, even if the total loss is large. Producers therefore have a much greater incentive to seek protection than individual consumers have in preventing it. In the UK the subsidies and protection given to farming through the EU common agricultural policy provides farmers with about a third of all their income. British farmers therefore recognise the clear benefits to them of the government’s trade protection measures. For the country’s 60 million consumers the total cost of this protection is enormous, but for individuals it’s relatively small – about £10 per family a week. The theory of comparative advantage demonstrates that trade protection reduces the economic welfare of the countries that impose it. The general rule is that free trade, unhampered by any restrictions, should be preferable. Although there are many examples of state-imposed trade controls, there are also cases where governments have recognised the benefits of free trade and have tried to lower the barriers to it. The first example of this is the ongoing campaign of the World Trade Organisation (WTO), to reduce artificial barriers. The result is that, for most members of the WTO, tariffs are no longer a significant obstacle to trade, especially in manufactured goods. The second example is the EU’s Single European Market project, which has been designed to eliminate all barriers to trade within the EU. Although tariffs and quotas were abandoned a long time ago, some barriers remain – for example, different national quality standards and unnecessary red tape. The progressive elimination of these is designed to encourage trade and increase the economic welfare of the EU. The final example arises from European monetary integration. Most EU member states have adopted the euro and the UK must soon decide whether to follow suit. This raises the question of the costs and benefits of adopting the single currency. The costs mainly relate to the loss of both an independent monetary policy and the ability

to alter the country’s exchange rate. The benefits have mainly been discussed in terms of the elimination of costs when buying and selling currency to finance international transactions in the EU. But all the analysis of the benefits of the single currency shows that by far the biggest gains would arise from increased trade within the EU. The existence of differing currencies acts as a barrier to trade. Remove this barrier and both trade and economic welfare will increase. The theory of comparative advantage and its related implications are not easy to understand. But, once understood, they provide a powerful analytical tool. That analysis points consistently in one direction: free trade tends to increase economic welfare and the standard of living, whereas restrictions on trade tend to reduce it. Nonetheless, government policy is based on a range of considerations, many of which are not economic. Trade restrictions are often a popular device because they appear to place burdens on other countries – even though this is not actually the case.

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The danger is that, should the economies of the US and other nations decline, they may try to shift unemployment to other countries by imposing more import tariffs. If all countries were to try this, the result would be a decline in world trade, output and employment, which is what happened in the great depression of the 1930s. The comparative advantage model of world trade is a useful antidote to this danger. And it may even help non-economists pass a few exams in economics. Why not try the multiplechoice questions (see panel) to find out? n Steve Adams is examiner for Foundation level Economics for Business. The Economics for Business Study System is a core text on the recommended reading list and is available from CIMA Publishing. Telephone: +44 (0)20 8849 2229, or e-mail publishing.sales@ cimaglobal.com