TOPIC 11International Trade and the Balance of PaymentsClassical Trade TheoryThe Balance of Payments Accounts
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Trade among nations
has been a central concern of economists since the birth of the discipline
in the 18th century. Indeed, many of the practical policy issues which
prompted Adam Smith and his followers to inquire into the workings of the
economy had to do with controversies over how foreign trade should be handled
and how international flows of money were to be understood. Surprisingly,
these same issues exist today and after more than two centuries of refinement,
the economics of trade and international flows of payments continue to
be debated — with most economists lined up on one side of the debate and
a vociferous opposition (often using arguments the classical economists
thought they had refuted once and for all in the 19th century) on the other.
The prevailing wisdom on the subject of trade in the 18th century was that trade could be beneficial to a country if it were properly managed. Specifically, it was believed that a country could increase its wealth by allowing its merchants to sell goods to foreigners. If British merchants sold goods to Spanish consumers they would be paid in money, then defined in terms of precious metal. The amount of money in Britain would therefore increase. The Spanish would have more goods but less money. This seemed desirable to those inclined to equate money with the wealth it represented. But what if Spanish merchants were allowed to sell goods to buyers in Britain? This would reverse the process and the benefits of trade would be wiped out. The policy implication of this seemed self-evident: do everything possible to encourage exports (sales of domestically-produced goods abroad) and discourage imports (domestic purchases of foreign-produced goods). A substantial literature developed explaining how this kind of trade strategy should be organised. The central purpose of mercantilism, as this body of thought has come to be known, was succinctly stated by a British merchant, Thomas Mun, in a pamphlet England’s Treasure by Forraign Trade, published in 1664. For a nation to prosper, wrote Mun, "wee must ever observe this rule; to sell more to strangers yearly than wee consume of theirs in value." Adam Smith, in his Enquiry into the Nature and Causes of the Wealth of Nations, set out to refute this established view of trade. To Smith, it was evident that trade was trade, something is given up in exchange for something to be gained. Furthermore, as in all voluntary exchanges carried on through markets, there must be an equilibrium or balance between flows of real goods into and out of a country. There are also corresponding flows of payments which somehow also work to bring about this equilibrium. The nature of the gains to be realised from trade, or rather the actual source of these gains, remained unclear. If trade tended always to move toward a balance, what was the point of trading? One reason trade could be beneficial was simply that some countries lacked the ability to produce certain goods and had to trade for them or do without. A country in northern Europe could hardly, for reasons of climate, produce tropical spices. A country with few forests could not produce its own timber. Clearly there could be many opportunities for countries with such specific advantages or disadvantages to benefit from trade. This notion of absolute advantage is easy enough to grasp. Absolute advantage implies that the costs of production of certain goods may be quite different in different countries and that it therefore makes sense for countries able to produce a good cheaply (because of climate or particular resource endowments) to specialise in producing that good, trading it for goods it does not have such an advantage in producing. But the possible gains from trade are not limited to this simple case. As first set out by David Ricardo in the early 19th century, the possibilities of gain from trade are far greater than implied by the absolute advantage situation. Ricardo pointed out that a country should specialise in goods which can be produced at the least cost in terms of the other goods which might be produced using the same resources. Consider the case of a country with no absolute advantage in producing anything. That is, other countries can produce everything at lower cost than it can. What goods should it use its available scarce resources to produce? The answer is simple and intuitively appealing: it should produce those goods which it has the least disadvantage in producing. Or, what is the same thing, it should produce the goods it can produce most efficiently, not those it can produce less efficiently. But would there be any trade in such a case? Yes, because if other countries follow the same principle, specialising in those goods in which they have the greatest comparative (relative) advantage, they will provide a market for the goods being produced in the least advantaged country. A simplified example may help confirm the reasoning. Suppose the world economy consists of only two countries, Germany and France, and that they have become so highly specialised in their industries they produce only two goods which it is feasible to trade across their border. Let the goods be beer and bread. Assume too that under a European system of standards, the beer and bread produced in Germany and France are identical products. (Try to imagine that the beer produced in France is identical to the beer produced in Germany and that the bread produced in Germany is identical to the bread produced in France.) Also assume for the sake of simplicity that bread and beer are produced in both countries using only one factor of production. Following Ricardo, assume further that labour is the only factor of production. Assume too that labour does not move across the Franco-German border, that all the labour in each country is equally productive, and that labour can be used to produce either beer or bread interchangeably. Suppose that, in
the absence of trade, the cost in terms of resource inputs of producing
beer and bread in Germany and France is as follows and that these input
costs would remain constant over some range of different outputs to be
considered.
Evidently France has an absolute advantage over Germany in producing both goods. In France it requires 20 units of labour to produce a unit of bread and only 10 units of labour to produce a unit of beer compared to Germany, where it takes 60 units of labour to produce bread and 15 units to produce beer. Can trade be beneficial under these circumstances? It is not difficult to show that it can, especially if the concept of opportunity cost is recalled. What are the opportunity costs (the quantity of one good that has to be given up to produce the other good) of producing these goods in each country? As shown in the table above, the opportunity cost of a unit of bread in France is 2 units of beer. The opportunity cost of a unit of bread in Germany is 4 units of beer. Alternatively, the opportunity cost of producing beer in France is half a unit of bread, whereas the opportunity cost of a unit of beer in Germany is only one quarter of a unit of bread. This suggests that both countries might gain by having France specialize in bread and Germany in beer, producing more of these goods than needed to satisfy domestic demand and trading the surplus for the other good. This would be advantageous
only within certain limits, however. France will require more than 2 units
of beer for a unit of bread, because in France it would be possible to
have 2 units of beer simply be switching some labour from bread to beer
production domestically. Similarly Germany will benefit only if it can
get more than one quarter of a unit of bread in exchange for a unit of
beer. Within these limits, trade could be advantageous to both countries.
Consider the following possibilities: France could export 4 units of bread
to obtain 12 units of beer (a ratio of 3 to 1 which is better than the
2 to 1 which would be attainable domestically). As shown in the table below
this requires that France reassign 80 units of labour from beer to bread
production (20 units of labour for each unit of bread for export). Note
that only changes in output and consumption are shown.
The cost of this is an 8 unit reduction in beer (10 units of labour per unit of beer), but the return is 12 units of beer obtained in trade, which is 4 more than was available in France before trade. The total amount of beer available for consumption in France increases by 4 units. Does French consumption of bread decline? No, it remains the same because the 4 units of bread exported will be produced by the additional labour transferred to the bread industry. The benefits to Germany, following the same reasoning, are 1 additional unit of bread than was available without trade, while consumption of beer remains as before trade was established. The particular trade ratio established in the example was chosen arbitrarily. In a more complex, more realistic example, it would be made to depend upon such things as the elasticities of demand for the products in the two countries, the nature of the production possibilities, and the negotiating strengths of the people or organisations involved in the process. A small country may, for example, find it very difficult to negotiate trade arrangements with a large country which controls substantial parts of total world trade in certain commodities. The existence of imperfect competition in many international product markets is a further complicating factor, as is the important role played by cartels and large multi-national firms which operate plants in several countries simultaneously. But despite these complications, the simple example serves to establish the general rule that underlies all international trade: gains from trade are possible at some ratio of exchange among products which will permit consumers in different countries to increase their consumption of some goods without reducing consumption of others. This will always be possible so long as there are differences in relative opportunity costs of producing different goods in different countries. In the rather unlikely event that two countries had the same alternative cost of production ratios among the goods they produce, there may or may not be possible gains from trade. If there were, it could be because of differences in consumer tastes in different countries. A country of vegetarians may find advantageous trade opportunities with a country of meat-eaters because of differences in consumption preferences rather than differences in production capabilities. Economies of scale may also provide a basis for advantageous trade. Even if production possibilities are similar in two countries, one may arbitrarily specialise in a particular line of production, achieving scale economies large enough to make it advantageous for the other country to specialise in some other industry and for the two to trade. It is also possible that a country may create a comparative advantage where none had previously existed. It would have been difficult to imagine that a country like Japan would acquire what appears to be a comparative advantage in the production of consumer electronics, but care must be taken to avoid the conclusion that engineering a comparative advantage is either easy or that the benefits to be realised will necessarily outweigh the cost of the capital and other resources which might have to be used up in the process. Note that in the simple example used above, both countries continue to produce both products even after trade. This is actually a very common phenomenon. Although trade is often thought of as involving movements of raw materials from less developed countries in exchange for finished goods produced in the more industrialised countries, most world trade today consists of exchanges of manufactured goods among developed countries. Both France and Germany manufacture automobiles, as does the UK, Sweden, the US, Canada, Japan. All these countries also produce a great range of finished goods and they also trade these goods. German automobiles move into markets throughout the world, as do those produced in other countries. Unlike the goods in the simple example used earlier, in which the goods produced in the two different countries were assumed to be identical, manufactured goods entering into real world trade are all differentiated to some degree. Because of such trade, consumers in all countries have access to a great variety of goods. Try to think of how many different makes and types of automobiles consumers have to choose among. How many types and brands of beer are on the market? One reason this profusion of choice is possible is that manufacturers producing for world markets can achieve economies of scale which would not be available if they were confined to their own much smaller domestic markets. A relatively small country like Canada, for example, would not be able to achieve economies of scale in auto making and offer a variety of makes and models if auto makers in Canada could produce only for the local market. But thanks to the automobile trade agreement with the US, Canadian auto makers can specialise in particular models which are then sold in the North American market, while plants in the US can also specialise, producing different models for sale in the same market. To Top
The logical basis for trade which we have just investigated provides an intellectually respectable explanation of why trade should occur. Empirical evidence also abounds that trade must be advantageous, otherwise there would not be so much of it. It is, in fact, difficult to prevent people from trading, either domestically or internationally. Domestically, trade breaks out whenever people come together and discover mutual interests in exchanging things. What reason would there be to restrict such exchanges, except perhaps in the cases of certain commodities believed to be harmful? Even in these cases, note how difficult (and costly) it is to discourage people who want to trade from doing so. When it comes to international trade, however, many people seem to be ambivalent about its benefits. Nearly everyone enjoys consuming imported goods — as is evident from the huge domestic markets for foreign-made consumer items, ranging from cars to foodstuffs. Yet it is commonplace to hear these same consumers complaining that imports are taking jobs and money out of the domestic economy and that this should be prevented from happening. Such protectionist sentiment appears to be on the wane in the advanced industrial countries, as evidenced by the steady and by now very substantial reduction in tariffs and other impediments to trade which has been underway since the end of World War II. It flares up repeatedly, however, especially in times of recession. The case against trade cannot yet be relegated to the dustbin of history. The main instrument used to restrict trade is the tariff, a tax imposed on goods entering the country from abroad. The effect of a tariff, like any tax imposed on the production of a good results in a higher price consumers must pay to obtain the good. If there were no tariffs, consumers would pay the going world price for goods entering into international trade. In the presence of tariffs, they pay the world price plus the amount of the tariff. This higher price will mean that the quantity of such goods demanded will be reduced. The higher price also means, however, that domestic producers of these goods, if such there be, will be willing to produce larger quantities of them. What this means is that total consumption of a good which is subject to a tariff will be reduced relative to what would be consumed at the going world price, but a larger proportion of this consumption will be satisfied by domestic production, with the quantity imported declining. The implication of this for the efficiency with which resources are allocated among alternative uses is that there will be some loss of welfare to the society because output of this good will be lower than the economically optimum amount (given the existing supply and demand conditions). But the effects do not end there. Another consequence of the tariff is that some revenue will be generated for the government, just as would be the case when any tax is imposed. Whether this is good or bad can be debated, depending on whether one believes that this kind of taxation is a good or bad way for governments to raise the revenues they require. Yet another consequence is that domestic producers of the good will realise profits resulting from the higher domestic price of the good. Some income is in effect transferred from consumers of the good to the producers of it. Again, whether this is good or bad is debatable. Consumers are immediately worse off, producers realise some benefit. The net welfare effects of such a transfer are impossible to specify, although one may have an opinion about the likely consequences. Advocates of tariffs will point out that employment in domestic industries is likely to have been increased as a result of taxing imports. But when we remember that trade is trade, the question arises as to what happens to employment in other industries? The country or countries from which the imported good were coming will now be earning less from sales of goods to the country which imposed the tariff and will consequently be unable to buy as large a quantity of goods from that country as they could before. Somewhere this must turn up as a reduction in exports from the country imposing the tariff. Of course it is also to be expected that countries whose trading partners impose a tariff will retaliate by imposing tariffs themselves. This, it should be noted, is not likely to be a rational response because restricting trade harms both partners, but then, on the same grounds, it was not rational for the country imposing tariffs in the first instance to do so either. Another widely-used instrument for restricting trade is the quota. Imposing quotas on imports has much the same effect on domestic production and consumption as does imposing a tariff. The main difference is that a quota directly limits the quantity of imports. Quotas also differ from tariffs in that they generate no revenue for the government imposing them. Using quotas to limit imports typically entails issuing "import permits" which authorise domestic firms to import specific quantities of particular goods. Having such permits can be lucrative for those who have the political connections or whatever it is that qualifies them to be so rewarded. Having an import license is profitable in this situation because the importer is able to buy goods on the world market at a lower price than they can be sold for in the domestic market. Trying to win import quotas is an important form of "rent-seeking" behaviour — using time and other resources to obtain personal gain rather than to increase real total output. Since the effect of the quota on consumers and domestic producers is the same as the effect of the tariff, the main difference between the two methods of restricting trade is that, instead of the government receiving some revenue from the tariff, holders of import licenses pocket these revenues. Yet another type
of trade restriction which is very similar in its effects to a quota is
the voluntary export restraint, an arrangement by which the government
of an exporting country agrees to limit the quantity of a good it exports
to another country. A powerful country like the United States may be able
to protect one of its domestic industries, such as the auto industry, from
what it considers "excessive" imports of such goods as Japanese cars by
pressuring the Japanese government to impose export limits on its auto
companies. The effect on markets is much the same as in the case of a quota,
but instead of the difference between the world and the domestic price
being pocketed by the importer, as in the case of a quota, it goes to the
foreign exporter.
Tariff, n. A scale of taxes on imports, designed to protect the domestic producer against the greed of his consumer. —Ambrose
Bierce (The Devil’s Dictionary)
The examples of voluntary
export restrictions and quotas just given demonstrate how protection can
result in financial benefits to particular groups, in one case recipients
of export licenses, in the other recipients of import licenses. More generally
it has been shown that all three types of restriction, including tariffs,
may benefit domestic producers who obtain profits as a result of the higher
price and larger share of domestic consumption the trade restriction gives
them. These gains are offset, of course, by the losses suffered by consumers
who must pay higher prices for goods than if there was free trade, and
who must do without some quantity of such goods because of these higher
prices. Elected governments which impose trade restrictions must, if they
behave rationally, be estimating that the votes lost by hurting large numbers
of consumers are more than offset by the votes gained by benefiting a relatively
small number of manufacturers, importers, and the people dependent on them
for employment. Is this possible? Apparently so. Business interests who
stand to gain from protection are likely to be well organised and well
positioned to exert pressure on government. Campaign contributions, political
party organisation, the "old boy" network, and other institutional features
of modern industrial democracies may add up to a degree of political influence
for the business community disproportionate to its size. It is also possible
that such organised interests may, through the media, be able to convince
consumers that it is actually in their interest to support trade restriction,
despite what some academic economists say to the contrary. It is also the
case that consumers are notoriously difficult to organise as a political
force. One explanation of the political appeal of protection is that the
benefits are substantial for the minority who gain, while the costs are
distributed very widely among the large mass of consumers, none of whom
bears a large portion of the total loss.
Judging from the treatment of the topic in virtually every standard economics textbook, the case for free trade appears to be solidly based in mainstream economics and the experience with trade liberalisation in the world economy since World War II suggests that the conventional logic of trade theory has found widespread acceptance among policy makers. But has it? Not only is there a vocal opposition in every country to free trade, typically reflecting the views of particular interest groups, but there is also a more broadly-based dissent which might appropriately be labelled "neo-mercantilist" because of its suggestion that the possible benefits of deliberate government intervention to "shape" trade in the interests of promoting national economic prosperity should be reconsidered. The revival of mercantilistic policy can be explained in part by the perception of some students of modern economic affairs that the traditional views of how world commerce is organised and conducted are outmoded. Although it has gone through many refinements, the traditional case for trade, like all the policy implications of mainstream theory, implies certain fundamental assumptions about both values and institutional arrangements. Again it is necessary to reiterate the point made earlier in this course that mainstream English-language economics is built on the assumption that the objective of all economic activity is to maximise the well-being of individuals. This individualistic bias, as noted earlier, leads to placing consumption at the centre of the stage of economic life. The objective is always to allocate resources so as to enable individual consumers to maximise their satisfaction of material wants. As far as the institutional arrangement of the economy is concerned, traditional theory, again as earlier reading has shown, not only assumes that competition exists, but that it should exist because it is beneficial (to the consumer, of course!) But what happens if these assumptions about values (individualism) and institutions (competition) are changed? What if it were assumed that the greatest social good would not be achieved by maximising benefits for individual consumers, but by maximising benefits for some larger group, even the community as a whole? And what if it could be argued that the facts of modern economic life suggest that competition is neither the norm, nor that it should be. Instead, perhaps it might be beneficial (to the nation) to have the government supervise and regulate the interactions that take place among firms so as to achieve some higher objective than merely satisfying the greatest possible number of possibly trivial consumer desires? This line of thinking is grounded in a tradition of economics having its roots in 19th century continental Europe. Unlike the English language economists of the 18th and early 19th centuries, a number of continental writers developed bodies of work based on the philosophical ideas of Hegel. Perhaps the best example is a German economist, Friederich List (1789-1846). List was the first professor of economics at the University of Tubingen. He was politically active (which got him exiled to the United States for more than a decade of his life), an enthusiastic supporter of economic union for the German states, and an advocate for active state involvement in making these states industrially more competitive. His ideas were most fully developed in his book, The National System of Political Economy (published in German in 1840, but not translated into English until 1904). List was convinced that no state could become successful unless individual investment activity was co-ordinated by government. Leaving individuals free to pursue their own selfish interests struck him as being clearly wasteful of resources. The lessons of history, he claimed, demonstrated that states which achieve economic maturity are not ones in which manufacturing and other industrial activities are left to develop by chance. For List it made sense to sacrifice the short-run benefits of consumers to the longer-run benefits which would be realised by promoting domestic industry. Rather than maximise current consumption, he advocated building up domestic industry. If this meant requiring consumers to subsidise domestic producers, so be it. What made a country strong was its ability to produce the goods it needed, not to buy goods from whatever foreign rivals could make them more cheaply. Unlike the English theoretical position which viewed trade as something which could be mutually beneficial to all parties combined, the German view was that trade, like war, was a contest in which there would be winners and losers. More
recently this approach to trade has been echoed in the largely successful
attempts by Japan and other countries of south-east Asia to build up their
industrial strength through deliberate government policies aimed at promoting
certain key industries and strictly limiting competition from foreign firms
in their domestic markets. This has led even some American commentators
to suggest that the US, and by implication other established industrial
democracies, should rethink their ideological commitment to free trade
and consider reverting to some form of industrial strategy to preserve
their international competitiveness.
The classic debate
over whether a country can enrich itself at the expense of its trading
partners by exporting more to them than it imports revolved around the
possibility of "unbalanced" trade. If some international adjustment mechanism
exists which keeps trade balanced (as the classical economists contended)
there would seem to be little point in worrying about the amounts of goods
and services a country exports and imports. Nevertheless, flows of exports
and imports are among the best recorded of national economic data and what
they tell us is that trade need not be "balanced" in the sense that the
value of country's exports must equal the value of its imports on an annual
or other periodic basis. Countries may for extended periods of time import
more than they export or vice versa. How can this be so? The answer lies
in the possibility of international lending or other financial transactions.
These, along with the transactions associated with the flows of goods and
services, are recorded in a broader set of statistics, the "balance of
payments accounts".
The Balance of Payments Accounts A country’s balance of payments comprise three subordinate sets of accounts: the current account, the capital account, and the official settlements account. All transactions a country has with the rest of the world during the accounting period (such as a year) are recorded in these accounts. The current account is divided into three components: the largest, net exports (the value of goods and services exported minus the value of goods and services imported); net interest payments (interest received from foreign investments minus payments of interest to foreigners on their investments in the domestic economy); and a relatively small catch-all category called "other transfers" (mainly gifts and foreign aid paid to and received from foreigners). The capital account records the amounts a country borrows from the rest of the world and the amounts loaned to the rest of the world. These borrowings and loans are both private and government. The official settlements account records changes in the government’s holdings of foreign exchange reserves (gold and assets denominated in foreign currencies). The balance of payments accounts always achieve an overall balance because any difference between the balance on current account and the balance on capital account results in a change in the official settlements account in whatever amount is necessary to bring the total of payments to the rest of the world equal to the total of payments received from the rest of the world. Thus, if a country has a deficit on current account of 20 billion dollars and a surplus on capital account of 18 billion dollars, the official reserves will drop by 2 billion dollars. Discussion of what determines whether or not there is a deficit or a surplus on these different accounts will be deferred until after the way the economy as a whole functions has been taken up later in the course. The value of a country’s currency, the rate at which it exchanges for other currencies, is determined in international asset markets. The most elementary theory of exchange rate determination looks simply at the forces governing the demand for and the supply of a country’s currency per se. Foreigners who want to buy goods from producers in Germany must obtain a supply of German marks with which to pay for them. Germans wanting to buy goods abroad must first exchange Deutschmarks for the necessary foreign currencies. Thus there is a flow of German marks as well as of other currencies into the international currency market. The exchange rate between any two currencies may then be thought of as the price of one currency in terms of another that would make the quantity supplied of any one currency equal to the quantity demanded. Modern treatments of exchange rate determination do not restrict the analysis to the supply of and demand for national currencies as such, but take into account the fact that what is actually being exchanged is a broad range of financial assets, including government and other bonds as well as the national currency. Modern theory (called portfolio theory) also focuses attention on the desire of purchasers of these assets to hold stocks of them, rather than on the changes in flows by which such changes in stocks are effected. To this point money and financial matters, whether in the domestic or international sphere, have been kept in the background as much as possible so as to emphasise the real aspects of economic life. Now it is time to introduce money and financial processes explicitly into the analysis. |
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