Here’s a note to a long-time reader of Café Hayek.
Mr. B__:
Thanks for sending along Michael Pettis’s essay “Comparative advantage is not competitive advantage.” I must, however, be blunt: this essay is gobbledygook.
I have neither inclination nor time to deal with every error, but I’ll point out the most fundamental of these: Pettis mistakenly insists that international trade is guided by comparative advantage only if that trade is what Pettis calls “balanced trade” – meaning, no trade deficits or surpluses.
As best as I can figure – Pettis, being confused, writes confusingly – Pettis’s theory is that trade surpluses and deficits arise only when some governments subsidize production. The resulting excess production is then exported at prices below cost. The subsidized countries run trade surpluses that force other countries to run trade deficits. (Forget here that there’s absolutely no evidence to support Pettis’s empirical claim that trade-deficit countries suffer deindustrialization and reduced aggregate demand.)
To support his theoretical case, Pettis notes that trade is “balanced” in David Ricardo’s famous example of comparative advantage. Yet trade is balanced in that example only because Ricardo explicitly assumed away international capital flows. By assumption, therefore, countries exported only to import an equivalent amount. Once we allow for international capital flows, however, export earnings have two possible, alternative uses: to purchase imports or to be invested abroad.
In the real world in which cross-border investment is possible, some countries will have a comparative disadvantage over other countries at attracting capital. These countries will then run trade surpluses not because their governments arrange for them to produce excessively but, rather, because their governments have made investing at home less attractive than investing abroad. Residents of those countries will use some of their export earnings to invest abroad. Other governments that have relatively better economic and monetary policies will thus be net attractors of global capital.
Contrary to Pettis’s belief, the resulting trade surpluses and deficits reflect comparative advantage and belie his assertion that comparative advantage “can only be expressed in balanced trade.”
Let me close by highlighting a passage in Pettis’s essay that reveals just how feebly he grasps economics. He writes that “the whole point of Ricardo’s model was to make (and prove) the counterintuitive point that … the world benefits from balanced trade even when one country can produce everything more cheaply.”
Face palm.
The point of Ricardo’s model has nothing to do with proving the benefits of balanced trade. In Ricardo’s example, England would still have a comparative advantage over Portugal at producing cloth even if, for whatever reason, the Portuguese refused to import from England as much as England imports from Portugal.
Ricardo’s point instead was to explain that a foreign country does not necessarily produce some output – say, cloth – at a lower cost than cloth is produced at home just because cloth is produced in that foreign country using fewer inputs than are used at home to produce cloth. What matters is how much other output – say, wine – that other country sacrifices by producing cloth relative to how much wine the home country sacrifices by producing cloth.
Ricardo explained that if the amounts of these foregone outputs differ from country to country, only one of these countries is the low-cost producer of cloth while only the other is the low-cost producer of wine. The fact that Pettis supposes that the country that uses the fewest inputs to produce each product “can produce everything more cheaply” means that he fundamentally misunderstands comparative advantage.
If you want to understand international trade, read Doug Irwin. Read Anne Krueger. Read Leland Yeager. Read Fritz Machlup. Read Russ Roberts. Read Pierre Lemieux. Don’t read Michael Pettis
Sincerely,
Donald J. Boudreaux
Professor of Economics
and
Martha and Nelson Getchell Chair for the Study of Free Market Capitalism at the Mercatus Center
George Mason University
Fairfax, VA 22030
