Trade is Hard

Why is free trade so hard to understand?

Source: Moeconomics Blog

The idea is simple: when everyone does what they do best, we’re all better off. Like a Mark Zuckerberg giving up coding to run Facebook. He knows how to code, by all reports he’s a good coder. But it wasn’t a productive use of his time. His time was better spent acting as Facebook’s CEO—managing his sector leaders, understanding where the business is moving, working out financial issues. So he gave up coding, even though he was good at it.

It’s the same with countries. One country may be better at everything they do than another. But it still makes sense for them to specialize in what they do best—leaving others to do what they do best—comparatively. This is called the “Law of Comparative Advantage,” and it was first articulated by Robert Torrens in 1808, when he suggested that if England traded cloth and lace with France—England’s mortal enemy—both countries would be better off. The idea was further developed by David Ricardo in 1817, in his book “On the Principles of Political Economy and Taxation.”

In this work, Ricardo considers an economy consisting of two countries that produce two goods of identical quality. But the relative costs of producing the two goods differ within each country. If each country specializes in the good for which it has a comparative advantage, global production increases—with no change in technology or labor. The mathematical logic improves conditions on both sides.

Yes, the world is more complicated than just having two countries produce two goods. And yes, the benefits of trade are not evenly distributed. David Ricardo himself discussed technological unemployment in the third edition of his book, published a few year later. But the general Ricardian equilibrium model—which accounts for thousands of goods and hundreds of countries—has been in place for decades, and a lot of folks still don’t get it.

Public Domain. Source: NOAA

Part of the reason is intellectual fashion. International trade isn’t cool—it seems to exploit sweatshop labor and cheap capital. Also, the very fact that free trade has been economic dogma for a long time counts against it. Another of the reason is xenophobia. We all prefer that which is familiar to that which is foreign. It’s why we see a home-bias in many investment portfolios, and grocery stores resist putting country-of-origin labels on their food. And part of the reason is that free trade is a harder idea than it first seems. It’s part of a matrix of concepts like efficient pricing, free exchange, flexible wages, and perfect information that aren’t always intuitive. Just because an idea has been around a long time doesn’t make it obvious.

Free trade rests on a mathematical foundation, and math can be challenging. Calculus was “discovered” centuries ago, but students still struggle with derivatives and integrals. But calculus proved essential to making the modern world. As is free trade.

Douglas R. Tengdin, CFA

Chief Investment Officer

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