Unlearning false simplicities within mainstream Economics

Humans are not economic particles, resilience can trump efficiency, feedback effects matter.

So, I was reading a revealing comparative history—Victor Lieberman, Strange Parallels, Southeast Asia in Global Context, c.800-1830, Volume 2: Mainland Mirrors: Europe, Japan, China, South Asia and the Islands, Cambridge University Press, 2009—and came across:

External trade promoted flax and hemp exports from the northwest, favored urban growth, and provided Moscow with a persistent bullion surplus (up to 50 percent of its European imports) critical for domestic coinage. P.220.

In note 226: Muscovy imported bullion and cloth from Europe and textiles and horses from the Ottoman Empire and Persia, while supplying furs, hemp, and naval stores to Europe and textiles and silver to the Muslim world.

Trying to manage trade so that you could import bullion made complete sense if you did not control silver or gold mines enough for your monetary needs. In other words, in a society using bullion as money, trade surpluses were a sensible tool of policy. The previous volume—Victor Lieberman, Strange Parallels, Southeast Asia in Global Context, c.800-1830, Volume 1: Integration in the Mainland Mirrors, Cambridge University Press, 2003—had discussed how Dai Viet had persistent economic difficulties precisely because it had trouble attracting silver.

Gold ducats of Ivan III (r.1462-1505) from 1471-1485. Wikimedia commons.

Some of the medieval and early modern theorising about using trade surpluses to import bullion may have been overdone (Theory being overdone: I’m shocked, are you shocked?) but such policies made sense. This means that some of the subsequent attacks on “mercantilism” are a bit misconceived.

I very much dislike the term medium of exchange precisely because it encourages treating money as some weird, special thing. I much prefer the term exchange good because a good is subject to supply and demand. Exchange good also separates out using money in exchange for output (goods and services) from holding money as an asset. An economy with sufficient access to a useful exchange good will be larger—have more transactions—than one that does not.

By contrast, medium of account points to the role of money in setting (and settling) financial obligations. Yes, money is the hinge between output and assets; between obligations and payment; and between the current and future time periods, but it is preferable to use terms that do not encourage muddy thinking.

Trying to import more of exchange good(s)—or of the stuff from which the exchange good(s) are made—was a perfectly reasonable policy goal, if one lacked domestic sources of the same. Trade surpluses—exporting more than you imported, so that the balance was paid in bullion—could aid the operation of the state and encourage local commerce.

The point of money as an exchange good is precisely that it makes transacting so much easier, hence leads to more transacting. A monetised tax system, for example, has manifold advantages over a tax-in-kind system—less bulk, less storage, less wastage, cheaper administration, greater flexibility.

A surprising amount of economic activity can be done by various in-kind systems—as is discussed in this post—but, by their nature, they are information-intensive, so tend to be highly localised. Money scales far better than in-kind transactions because it economises on search, on information. In particular, it means you can readily transact with folk that you have little or no connections with.

Comparative advantage

Comparative advantage is one of the ornaments of Economics. It is both counter-intuitive and powerfully explanatory. A doctor may be better at cleaning than her cleaner, but it is a waste of her time to do the cleaning as she is much more productive being a doctor. The cleaner and the doctor can trade productively—that is, so they are both better off—even if the doctor is better at both doctoring and cleaning than the cleaner. That is the principle of comparative advantage.

It is a classic example of choice under constraint. The constraint in this case being the doctor can do one thing or the other, not both at the same time, and her time is limited.

There is a common view among economists that the principle of comparative advantage is “case closed” for free trade. There are, however, some extra difficulties. The US, UK and Australia all moved further towards free trade and away from protectionism in the 1970s and 80s. There was, however, a major difference. Unlike the US and the UK, Australia did not allow its shift to free trade to leave communities to rot. This likely has something to do with why there is currently no real pushback against free trade and globalisation in Australia.

Another reason is that Australia has managed migration better than the US and far better than the UK. That Australia did not suffer the Global Financial Crisis—because our banking regulation is superior—or the Great Recession, due to the success of Australian monetary policy, clearly also helps.

Connected resilience

The effects of free trade and immigration both raise issues about analysis operating as if folk are atomised individuals versus connected resilience. It is all very well to say free trade expands access to cheaper tradable goods and services (as it does). Nevertheless, free trade can make folk worse off if negative income, connection and wealth effects trump the cheaper consumption effects.

If people are knocked further down the production process—and so income sources—than they gain from cheaper goods and services, they are worse off. If their connections—their social capital—is eroded more than they gain from cheaper goods and services, they are worse off. If their other assets (e.g. the value of their houses) lose more value than they gain from cheaper goods and services, they are worse off.

It is entirely possible for free trade to make people worse off, even though the principle of comparative advantage operates. This is true even if the net gains for the economy as a whole are positive.

In the case of Australia, deliberate efforts were made during the transition away from protectionism to take those gains and to help the losers from free trade. This was Pareto improvement—a situation where, if you can tax the winners to compensate the losers, there is still a net gain overall—turned into policy.

In the case of the US and UK, Pareto improvement may have been invoked in the literature, but there was precious little of it done in policy practice.

It is all very well to say the point of production is consumption, but only if we remember that, in monetised economies, it is to enable us to afford such consumption. Even in subsistence foraging societies—where producing-to-consume is very direct—connections are an essential part of the process.

Hunting is an activity with highly variable rate of success in any given day. So, food is shared within the foraging band to enable folk to eat whether or not they caught something that day. Indeed, unmarried males are significant contributors of protein to other families—including children unrelated to them—within the foraging band. This both “smoothes” their consumption and is a signal of their value as a risk-minimising provider, as protein and animal fat is difficult to acquire. This most often was a signal to parents, or other kin, of potential wives, as they were often the people who had to be convinced for a marriage to take place—courtship marriage is not even close to being a human universal.

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Anthropologists call personal connections relational wealth precisely because they are valuable assets. They definitely add to the resilience of individuals and networks—that is, they increase the ability to respond effectively to changes in circumstances.

Economists call such connections social capital, and then regularly ignore their significance. They are especially likely to ignore the significance of such connections based on locality. The willingness to let various communities rot was, at least in part, based on the idea that folk should just move; a claim that discounts the value of locality-based connections, rent-differentials and local wealth effects.

A trade surplus means that a country is exporting more than it is importing. Add in current financial payments, and that is the current account balance. If there is a current account surplus, that entails a capital account deficit. That is, the positive accumulation of assets and/or a fall in liabilities.

A trade deficit means that a country is importing more than it is exporting. If, after including current financial payments, there is a current account deficit overall, that entails a capital account surplus. That is, a continuing sale of assets, so an accumulation of liabilities.

Current account balance per head, (Cumulative 1980–2008, IMF). Wikimedia commons.

Such continual selling of assets—amassing more and more liabilities—only works as a net social gain if one is generating more assets than one sells. Otherwise, one is driving down national wealth, with liabilities increasing faster than assets. Building up productive assets generally adds to resilience—the ability to react to changes in circumstances—while building up liabilities generally detracts from resilience.

It is all very well to be impressed by the genuine explanatory power of comparative advantage. It is much less impressive if one further assumes that people are just atomised individuals, or should act as if they are.

Humans are not just economic particles in some social physics. If free trade means disruption of valued connections, drives people down the production scale, and increases liabilities more than assets, then lots of people are losing from free trade.

Yes, it might well be true—indeed, probably is true—that the net economic gain to an economy is greater than all those costs, but if the pattern of gains and losses are such that one group gets most of the gains and another group most of the losses, then free trade will be not only economically disruptive, it will be socially and politically disruptive as well.

Very similar points can be made about migration, except even more so, as the overwhelming majority of the benefits of migration go to the migrants and people can be disruptive—or simply complicating—in so many more ways than mere goods and services can. Treating migration as analogous to trade is a deeply silly simplification.

Much of the shrinking in manufacturing jobs in developed economies comes from automation and mechanisation—replicating the previous pattern in agriculture—but there can be, and have been, trade-shocks on the way. It is quite clear that the benefits of globalisation have been unequally distributed.

Wikimedia commons.

About financialisation

Moreover, even though there is a clear link between access to finance and economic growth and mass prosperity, there are also clear political economy negatives to the growth of financialisation in the US and UK economies that interact with the above complications.

First, if financialisation raises the value of the currency, it makes exporting harder and importing easier (the “Dutch disease” effect). Second, financialisation generates a lot of political donation money that is utterly uninterested in the problems of making things. The power of the financial industries of New York and London has much to do with why the US and the UK have let local communities rot.

Third, it fosters “one world” perspectives that tend to systematically discount local and national concerns. Fourth, it increases the pattern of liabilities and vulnerable assets that reduce the resilience of economies. Massively increasing local liabilities can be very profitable to financial industries, yet be very adverse to the resilience of the national economic, social and political order.

Free trade, but …

None of the above is an attack on free trade as such. Reducing transaction costs, increasing access to economies of scale and scope, forcing industries to be more adaptive and efficient—to be commercially successful rather than politically connected—are all good things. Thomas Sowell explains this with his normal clarity.

Nevertheless, a lot of the advocacy of free trade and financialisation engages in far too much simplistic self-congratulation. Such self-indulgent, simplistic, self-congratulation has a great deal to do with why support for free trade is weakening and why economists have lost at least some of their cachet as experts.

ADDENDA: On the decay of local connections point, if key local industries collapse due to a trade shock, then a community starts to decay. This is very obvious in rustbelt US and UK. In Australia, money was spent to help folk move to other industries. A trade shock is often a policy shock, where the policy “rules of the game” are suddenly changed.

References

George Borjas, ‘Immigration and the American Worker: A Review of the Academic Literature,’ Center for Immigration Studies, April 2013. https://cis.org/Report/Immigration-and-American-Worker

David Goodhart, The Road to Somewhere: The New Tribes Shaping British Politics, Penguin, 2017.

Victor Lieberman, Strange Parallels, Southeast Asia in Global Context, c.800-1830, Volume 1: Integration in the Mainland Mirrors, Cambridge University Press, 2003.

Victor Lieberman, Strange Parallels, Southeast Asia in Global Context, c.800-1830, Volume 2: Mainland Mirrors: Europe, Japan, China, South Asia and the Islands, Cambridge University Press, 2009.

Reserve Bank of Australia, Balance of Payments, Explainer, n.d.. https://www.rba.gov.au/education/resources/explainers/the-balance-of-payments.html