How can nations get richer?
Source: US Mint
Ever since Adam Smith and David Ricardo, the path to national wealth was assumed to be specialization. Scotland should spin wool, and Portugal should make wine, Smith argued. Then they should trade, and everyone will be better off. It’s possible to grow wine grapes in Scotland, but the cost of doing so – in labor and materials – would make a Scottish winery far less productive than one in Portugal.
Ricardo expanded this notion to relative advantage. Economies can gain from specialization even if one country does everything better – or cheaper – by focusing on what they do best. That frees up resources, and trade allows the larger system to produce more goods and services with the same amount of labor. These are lessons that undergraduates learn in their basic economics classes.
But it turns out that reality is more complex. If nations just need wool and iron, Scotland and Portugal should specialize. But people require more than just a few commodities. And life is uncertain. Pests and blight can wipe out a crop. Markets go boom and bust. The way investors handle uncertainty is through diversification. And that’s not a bad approach for large economies as well.
Countries the hyper-specialize are far more vulnerable to external shocks than more diversified economies. In the 1960s Bulgarian central planners ran linear programming models that indicated the optimal crop for their economy would be sunflower seeds. So they duly assigned production quotas and produced endless fields of sunflowers.
Public Domain. Source: Wikipedia
Of course, the excess production caused the price of sunflower seeds to collapse. There was no corresponding increase in demand. The entire country’s economy suffered – a lesson in feedback loops and computer modeling. But the crop could have failed many other reasons: weather, insects, labor issues, and so on. Monocultures are vulnerable.
More diversified economies, like Brazil and Mexico, are inherently more stable than economies the focus on one or two things – like Venezuela. It’s not just the resource curse. It turns out that with economies – like people – diversity is strength.
Douglas R. Tengdin, CFA