No, trade surpluses aren’t caused by comparative advantage

Michael Pettis is a Beijing-based associate of the Carnegie Endowment for International Peace.

In a New York Times essay in the wake of Biden’s recent trade restrictions, former Obama administration official Steven Rattner made a plea for the return of the US to a global system of comparative advantage.

Tariffs and other trade policies, he argued, violate the principle of comparative advantage, and anyway Americans are better off if they can buy the cheapest foreign products available.

 As Rattner writes:

Every student in an introductory economics course learns about David Ricardo’s 200-year-old theory of comparative advantage: the idea that by specialising in the products that they can produce most efficiently and then trading with others, nations can be better off.

. . . Tariffs can be used to temporarily shelter nascent domestic industries — much as Alexander Hamilton proposed when he served as our first Treasury secretary. They can be used judiciously to address unfair trading practices. And they can be used when national security is genuinely at risk.

However, we also need to resume removing trade barriers, not increase them. Among other things, we need the World Trade Organization to function, but the Trump and Biden administrations have blocked all candidates for its appellate body and chosen to act unilaterally, rather than through the W.T.O.

I’m hoping that when the election dust settles, we can get back to what David Ricardo explained so clearly two centuries ago.

While many other economists and officials have made similar arguments, this only shows how poorly trade is understood. The global trading system has long diverged from one in which countries specialise in comparative advantage.

You can see this in the highly unbalanced trading environment of the past several decades. The theory of comparative advantage proposes that the global economy benefits when different countries specialise in products they can produce comparatively more efficiently, exchanging them in the global markets for products that other countries can produce more efficiently.

But “exchange” is the key word. To illustrate, let’s assume a world of two products, textiles and glass, and of two countries, Germany and Spain. In this world, even if Germany can produce both textiles and glass more cheaply than Spain, Germany wouldn’t have a comparative advantage in both.

If Germany’s price advantage in textiles is greater than it is in glass, this would mean that Germany’s comparative advantage will be in textiles and Spain’s in glass. In that case, if Germany produces textiles, and Spain glass, and each sells what it produces to obtain what it doesn’t produce, both countries will collectively produce more and be better off. David Ricardo famously showed why in his 1817 book, On the Principles of Political Economy and Taxation.

It’s often forgotten (even by economists) that the global benefits of trade under comparative advantage can’t be realised in their production. Only an balanced exchange of goods will express it.

So is it possible for Germany to sell both textiles and glass to Spain while running trade surpluses? Yes, but it turns out that this has nothing to do with comparative advantage, and everything to do with the domestic distribution of income.

If German workers receive a low enough share of what they produce — in the form of direct and indirect wages — German businesses will be able to produce both textiles and glass even more cheaply than Spanish businesses, but German households will not be able to consume or import in line with what they produce.

In that case, while Germany can expand production of both textiles and glass, and sell the part it cannot consume to Spain, its expansion will come at Spain’s expense. In other words, Germany will use its exports not to pay for imports from Spain, but rather to force the consequence of its weak domestic demand on to the Spanish economy. While this would leave German businesses better off, it would leave German and Spanish workers and Spanish businesses worse off.

Economists who argue that in this example Germany has a comparative advantage in both textiles and glass are confusing comparative advantage with weak domestic demand. To move to a system of comparative advantage would require enough of a rise in German wages that German demand would rise in line with and match German production. In that case Germany would still export, but its imports would increase relative to exports, and the problem of weak demand would be resolved.

In the discussion about Biden’s recent tariffs on Chinese goods, we have to make the same distinction between low Chinese prices associated with comparative advantage and low Chinese prices associated with weak domestic demand. Chinese workers are much less productive than American workers, so it’s to be expected that they earn lower wages. The problem is that even adjusting for differences in productivity, Chinese wages are low.

It is these relatively low wages — not comparative advantage — that explain China’s weak domestic demand as well as its low export prices across the board.

This would change if China were to raise its wages in line with its productivity, as it has been promising to do for nearly two decades. In that case it would still export products in which it had a comparative advantage, like electric vehicles, but because Chinese households would be able to consume more, it would import just as much as it exported, and so would contribute as much demand to the world economy as it absorbs. Americans would pay for their Chinese imports with exports to the world.

This isn’t what is happening. China exports far more than its population can afford to import. And so while most economists support free trade under comparative advantage because this maximises the value of goods and services produced by the economy, excess savings and persistent trade surpluses are not signs of comparative advantage.

This has important political implications. In a famous 1936 essay, Joan Robinson warned about a global trading system in which countries use trade to export weak domestic demand and domestic unemployment. This led to an explosion of trade conflict in the 1930s. No one should be surprised that it is leading to the same today.

Letter in response to this article:

Does Ricardian trade theory still apply? / From Professor Alejandro Cunat, Department of Economics, University of Vienna, Vienna, Austria