Economic View: “Comparative Advantage” Does Not Mean What You Think It Means

Economic View: “Comparative Advantage” Does Not Mean What You Think It Means

Free traders love to use the words “comparative advantage” to justify support for free trade. The phrase cropped up once again in an article by investment banker and former Obama advisor Steve Rattner in the New York Times. Rattner argued that President Biden’s new tariffs on Chinese electric vehicles (EVs) and other products violate the theory of comparative advantage which says that nations should specialize in the things they can produce most efficiently. 

Even though classical economist David Ricardo never used the phrase “comparative advantage,” he developed the concept in his classic 1817 book and free traders feel this gives it some sort of immortal relevance. 

But many of them, including Rattner, misunderstand what comparative advantage actually means. If, for example, Canada can produce aluminum more cheaply than the U.S., then that means Canada has an absolute advantage in aluminum production. If China can produce EVs more cheaply than we can in the U.S. (even if their cheapness is based on billions of dollars of subsidies of auto, battery, steel, and energy production) then China has an absolute advantage in EVs. 

In his Times article, Rattner repeatedly talked about comparative advantage when he meant absolute advantage.

So what is comparative advantage?

Comparative advantage occurs when the ratio of costs in one country differs from the ratio of costs in another. Here’s an example: imagine that Germany can produce automobiles priced at $50,000 and MRI machines for $200,000. The U.S. can produce cars for $75,000 and MRI machines for $100,000. Now imagine each country has $5 million worth of annual resources to devote to production of those two products. Germany’s ratio favors automobiles while America’s favors MRI machines. The U.S. should use its resources to produce 50 MRI machines (50x$100k=$5M) and Germany should produce 100 automobiles (100x$50k=$5M). The two countries should then trade so the U.S. can get the autos it needs and Germany the MRI machines. 

By each country specializing in what it does best, the total output is larger and when they trade with each other, each country should get more MRI machines AND autos than if each country made both goods. That’s comparative advantage. (1)

And it follows from such examples that every country always has a comparative advantage in something, because every country must make something with which it can purchase the other countries’ exports that it needs. In Ricardo’s world of the early 1800s, every country needed to export in order to import. You have to work to live, as my father used to say. 

But what if you don’t have to work? What if international lenders will lend you the money so you can buy as many imports as you like? Then if a nation has an absolute disadvantage in all major goods, it can run a persistent trade deficit, lose all its industries, and build up debts for years. 

This is the U.S. plight. In the age of hyperglobalization, where multinational corporations are determined to produce in low-cost, low-wage nations, and sell those products in high-wage nations, the U.S., one of the highest-income nations in the world, may have an absolute advantage in almost nothing. The U.S. may have a theoretical comparative advantage in certain goods, and we can calculate it mathematically, but this is entirely irrelevant because foreign nations will take our paper (Treasury bonds or equities) instead of demanding goods. 

We have had 48 consecutive years of trade deficit so far, reaching close to a trillion dollars a year now. But it could go on for another 48 years, and double to say $2 trillion, leading to further deindustrialization and job loss. The notion of “specializing in what we do best” does not apply in a world where what we do best is to consume more, fail to make exportable goods or services, and run up international debt, 

The solution to this problem is for prices to adjust. If U.S. prices fell, we might become internationally competitive in more goods and services. In the 19th century, a trade deficit in any country drove down prices in that country, as gold left the country, reducing the domestic money supply. In the 20th century, the solution has often been a depreciation of the exchange rate, making foreign goods more expensive. But the U.S. experiences neither of these things: our prices continue to rise at about 2% a year, except when they rise even faster. And our currency obstinately refuses to fall because of the demand of international investors for dollars. 

So comparative advantage is irrelevant for the U.S. As a rich nation, we have an absolute disadvantage in most manufactured goods and the problem just gets worse over time. In Rattner’s terms, when our workers leave the industries where they are less efficient, many of them do not go to other industries where they can generate higher output. Instead, they go to low-wage jobs in the service sector or they remain unemployed. A new study by economists from the Fed and Yale recently confirmed this fact, yet again. 

One way to look at this problem is to say: is it possible to be a high-income island in a world of low-income nations? Especially when the multinational corporations of our own land and other nations are determined to move their production and their IP to low-wage locations? 

The answer is that if you wish to preserve high income, you must find a way to insulate yourself from the pressures of low-wage competition. The Republican politicians typically describe this competition as motivated by the evil Chinese Communist Party while Democrats call it the ruthless “race to the bottom” of heartless, unfeeling corporations and dictatorships. But evil motives are not necessary to understand the pressures on the U.S. economy. They are systemic:  the result of a transition from a system of insulated national prosperity that we enjoyed between 1807 and (roughly) 1990 to a system where all or most of our workers and small companies were in direct competition with a low-wage world. 

A currency that would adjust to force us to pay for all the goods we import would solve a large part of the problem. But the dollar refuses to come down. And one thing the Treasuries of Trump and Biden have in common is an obstinate refusal to manage our currency in the interests of national prosperity. Look up hubris in the dictionary and you will see a picture of Steve Mnuchin and Janet Yellen smiling happily atop a huge pile of Treasury bonds. 

Incidentally, Ricardo saw this problem too. Way back in 1817, he anticipated much of modern neoliberal “Washington Consensus” philosophy when, aware of the higher wages in England as compared to Portugal, he wrote:

“It would undoubtedly be advantageous to the capitalists of England, and to the consumers in both countries, that under such circumstances the wine and cloth should both be made in Portugal, and therefore that the capital and labour of England employed in making cloth be removed to Portugal for that purpose.” (2)

But Ricardo reassured himself and his readers that this was unlikely to happen:

“Experience however shows that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connections, and intrust himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I should be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.” (3)

It’s 207 years since Ricardo wrote those words and much has changed. Today capital will go anywhere if it can shave a nickel off the costs of production.

Industries Matter

But the problem is worse than that. Even if we balanced trade by devaluing the dollar (the necessary devaluation, we estimate, would be around 20% to 25%), which would make foreign imports more expensive, raise the U.S. savings rate, raise the investment rate, and lead more people to get off the sofa and find a job, even with all those positive effects of balanced trade, we would find that our economic growth rate and the U.S. income distribution, while improving from today, would still not reach the exceptionally good levels achieved in the 1960s. 

Our economy back then was dominated by a handful of manufacturing industries, led by the auto industry, which had three wonderful characteristics: relatively high, steady growth, the capacity to employ millions, and the propensity to pay relatively high wages, even to those without a college education. In the 1950s, every one of America’s top ten largest companies was either an auto company or a supplier of auto-related goods.

By 1970, that boom period reached its end. We can debate whether it was caused by the two oil crises of the 1970s, or the sudden arrival of international competition, or the failures of management to respond quickly enough to the new threats, or perhaps just the inability of century-old institutions to recognize the need for radical change. 

Today, devaluation on its own would not be sufficient, because even a 25% reduction in the value of the dollar would still leave us uncompetitive compared to, for example, microchips made in Taiwan or automobiles assembled in Mexico. 

So proactive industrial policy is needed. This is justified by both national security and economic grounds. I focus on the economic grounds because the arguments there are more interesting. The national security arguments are stunningly obvious. Can anybody really doubt that we should not rely on China for the rare earths used in the motors and actuators on the fighter jets in the U.S. Air Force? Can anybody doubt that we should not be dependent on China for the basic medicines that soldiers need in times of war?

The economic arguments are more ambitious. Can we return to the growth and egalitarian nature of our society before 1970? I think we can. It requires a modest amount of industrial policy, administered with a clear sense of purpose, and with a willingness to allow the private sector to build the companies and strive to achieve the objectives, because only private sector executives have the necessary experience. 

The Biden administration’s industrial policies have shown willingness to charge the private sector with the tasks. But the final objectives of the industrial policies are not clear. And the plans themselves are not ambitious enough in the context of a $27 trillion economy with 150 million employees. The CHIPS Act will lead to more than a dozen shiny new chipmaking fabs, but there is little thought for the ecosystem around chips which would enlarge their impact. A complete ecosystem would mean that final tech products could be made here, and that millions of people might be employed in tech industries instead of tens of thousands. 

The EV support is potentially broader in its impact, but at the end of the day, it is about replacing the 17 million gasoline-powered vehicles Americans buy now with 17 million EV vehicles, which can and will be built with a smaller labor force. 

We need more growth industries. We need more technological progress that can be embodied in new products that require millions to make them. We need the same hothouse approach to our economy we had in the century before 1970, when economic growth put the average worker on a rising income and career curve. 

Tariffs or some form of import restriction (insulation) are required, but are not enough on their own. The never-ending arguments over tariffs in the media today are really the arguments between those industries that gain from exports (finance, Internet/software, and branded pharmaceuticals) and those industries that employ and serve our domestic high-income economy (chiefly manufacturing). 

Rattner in the New York Times speaks for finance when he attacks tariffs. He makes the absurd claim that tariffs are self-defeating because they raise prices and U.S. buyers pay the full cost of tariffs. Since Trump first implemented the 2018 tariffs and economists began saying that the tariffs were 100% passed onto U.S. consumers, I have been asking economists I meet to name one product whose price rose by 25% following a 25% tariff. There are none. Even the prices that rose briefly after tariffs were imposed came back to earth quickly. See this article for the fascinating detail that over several years, washing machine prices actually rose more slowly than new automobile prices after the imposition of washing machine tariffs. The washing machine tariffs were one of the most outstandingly successful economic policy moves of recent years. (It says a lot about the teaching of economics in our universities that the best economic policies tend to be enacted by those with the least knowledge of textbook economics!)

Michael Pettis made a good point in a recent article that China’s excessive surplus and its restricted domestic consumption put pressure on other nations, especially the US, to consume more, run deficits, and deindustrialize. That’s true, and it provides excellent grounds for the US to take action against any country that runs persistent surpluses. Before 1945, the gold standard made the system self-regulating. It was impossible for a country to run sustained deficits (as it still is for many small countries).

Replacing the gold standard with what is effectively a dollar standard has left the U.S. in the awful position of supporting global trade and investment and foreign economic growth through our own indebtedness. Future generations will wonder why we ever agreed to do this. But even if we refused to trade with any nation with a persistent surplus, we would still find millions of jobs and entire industries moving to other nations, like Mexico. Mexico is not a persistent surplus nation. It is just a pseudo-democracy whose rulers are able to maintain conditions of low-wage semi-servitude for much of the population, including those making products for Americans. And, judging by the commentary in this year’s Mexican presidential election, Mexicans know it: they feel themselves poor, abused by their government, and the victims of relentless violent crime. Far from a win-win, NAFTA-USMCA is a lose-lose. By any objective standards, it is the trade pact from hell.

The solutions for the American economy today include: adjust the value of the dollar, balance trade, identify and target large-scale industries that can reignite growth, invest in them, set clear targets while handing the management over to those best qualified to achieve results, and launch a new century of entrepreneurial and bottoms-up growth. 

One final thought: many hours and millions of web pages and dead trees are devoted to debating the existence or not of climate change. The fact is, it doesn’t matter. In the 1960s, we spent billions getting to the moon. We got there in 1969. Now, 55 years later, the moon is still utterly useless to mankind. But the investment, the challenge, and the galvanizing power of the space program played a critical role in dozens of new technologies that energized our economy. We need new forces, similar but less divisive than climate change, to galvanize the nation.

  1.  For further discussion of comparative advantage and the two ratios, see the excellent summary by Andrea Maneschi, available here. For an interesting discussion of Ricardo’s development of the concept, including a description of Robert Torrens’ development of the concept at the same time, see David Ricardo’s Discovery of Comparative Advantage by Roy Ruffin, published 2002 in the journal History of Political Economy, full text available here.
  2. David Ricardo, The Principles of Political Economy and Taxation, Dover Publications editions, 2004 (1817), pg. 83.
  3.  Ibid.


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