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Remembering Ricardo

Amidst a looming trade war, it's worth recalling the principles of classical economics

Remembering Ricardo

David Ricardo (1772-1823), born to Abraham Ricardo, was the third of 17 children. His father was a successful stockbroker. David started working with his father at the age of 14, but a marriage without parental approval led to his estrangement with the family. He set up on his own and at the age of 43 made 'upwards of a million sterling' by stock market manipulation around news of the outcome of the Battle of Waterloo. He purchased a seat in Parliament and used his term to pursue a reform agenda.

Ricardo became interested in economics after reading Adam Smith's Wealth of Nations. His own contributions were towards free trade, and among the seminal ideas with which he is credited are 'comparative advantage' of international trade and 'Ricardian equivalence' between issuing debt or running a deficit. Both these ideas are of importance during current times - none more so than free trade.

Simple idea, complex outcome
Ricardo's idea of comparative advantage seems deceptively simple. The theory simply states that even if country A is better at producing everything compared to country B, both countries would still gain from specialising in producing what they do best. A simplistic example at an individual level can be specialisation of labour - a brain surgeon could possibly repair his dripping faucet but is better off using his time in surgery and calling a plumber.

The comparative-advantage theory works as follows:

Let us assume that there are only two products - cheese and computer - and two countries - A and B - that can produce both. Assume that there is no trade. Country A can produce 1,500 units of cheese or 750 computers. Country B can produce 750 units of cheese or 500 units of computers. Obviously, both can produce some combination of products and that is what they would do when no trade is allowed. For country A, it is possible to think in terms of an 'opportunity cost' - every one unit of computer foregone allows two units of cheese to be produced. For country B, this would be 1.5 units of cheese for every computer.

Let us take a case where the production is as per the table below:

Remembering Ricardo

Without trade, the world could produce 1,375 units of cheese and 500 computers. With trade and despite the fact that A is better at producing both compared to B, it makes sense for A to produce cheese and for B to specialise in computers, since the overall production is higher! The essential point that is illustrated in this simple model is that it is comparative advantage rather than absolute advantage that determines trades and specialisation. Country A above has higher productivity than country B in both products. But between cheese and computer, its productivity is higher in cheese. Hence when it focuses on cheese, both countries gain from trade.

A common argument against this theory is the 'pauper labour' argument - foreign competition is unfair when it is based on low wages. One of the outcomes of this theory is that labour rates are a function of productivity. If country B is less efficient as compared to A, it will also have lower wages. What is important is that relative to its own wages, country A is better off producing cheese and importing computers (incidentally, do not get confused by the use of computer and cheese in the example; it could be rice and airplane as well. There is no technology superiority implied in the example).

A corollary of this argument is that country B is running a sweat shop - where labourers are being exploited to produce items for export to country A. While it may seem iniquitous, the reality is that without trade, the labour rates in B would actually be lower. While comparison between labour rates between A and B may seem exploitative, without trade, labour in B may actually starve.

So why protectionism?
If the case for free trade is so compelling, why is it that we have a clamour for protection against imports across countries. The single biggest issue with the model is that it does not take into account income distribution within countries. Transitions can be painful and while removing trade barriers can increase overall economic growth of a country, there will be sections that will lose out heavily - those that are losing protection. In most cases, lobbying by these sectors forces government action in the form of import tariffs. Take the case of India. The government, under the guise of its Make in India policy, has increased tariff barriers across many items - steel and tyres are examples. While this benefits both - government gets higher taxes and producers receive higher profits, it penalises all user industries - and finally the consumer. Users of automobiles, trucks, air-conditioners, homes and offices - in fact all of us - are paying a 'steel tax' by stealth, as also a tyre tax, etc. Since the beneficiaries are fewer than the consumers, this eventually worsens the overall economic outcome.

The recent steps by the US government to increase tariffs on imports into the US can potentially have a similar deleterious effect. Obviously, trade partners are not likely to take it lying down and a trade 'war' is a distinct possibility. The existence of WTO softens the blow somewhat since it is not possible to take unilateral action without inviting action under WTO rules. Despite that, a worsening global economic-trade climate cannot be ruled out. While still a long way away, it may be a good time to dust up and re-read history and outcome of the Smoot Hawley tariffs - often blamed for worsening the Great Depression. One of the key legs for equity-market rally earlier this year was expectation of higher global growth. That assumption will now be tested.

Anand Tandon is an independent analyst.