There is nothing more practical than good theory

Merton Miller, the 1990 economics laureate, said those words, not me. Some of the best theory in economics is comparative advantage – a theory that Paul Samuelson once described as being both true and non-trivial.

It is unfortunate that comparative advantage is usually taught as part of international trade and not in the early stages of any economics subject. The point being that comparative advantage is not uniquely applicable to international trade, but rather it applies to all trade. Individuals should specialise in the production of those goods and services where they have an advantage and trade for those goods and services where they do not have an advantage.

Third party interference in that process means that the gains from trade are not fully exploited and that some people are worse off than they otherwise could have been.  I have almost never found anyone who disagrees with that sort of statement until I suggest that we imagine that two individuals want to trade across an international border and the third party interference is coming from a national government.

Then, all of a sudden, previously smart people become dumb people.

Apparently there are “special circumstances” that apply to international trade that make it entirely different to ordinary trade.

Economists have been exposed to these “special circumstances” arguments for centuries. Now these arguments vary in their sophistication and urgency but quite frankly they are rubbish. Just rubbish. Now the election of Donald Trump has not made these arguments any more sophisticated nor any more urgent. The argument that if only government imposed a tax on trade (or indeed anything else) the world would become a better place was just as invalid when Obama was president and remains just as invalid today.

It is well worth emphasising that arguments against free trade are always conspiracy theories. Evil foreigners are doing bad things to us. Normally those bad things involve them selling higher quality goods and services to willing buyers at lower prices. Or evil foreigners wanting to buy domestic assets for higher prices. As if somehow buying low and selling high was a bad thing.

Now we loathe the government telling us how to live our lives on the domestic front because we know it simply lacks the information and knowledge that we possess to pursue our own self-interest, yet some believe that once a foreigner comes into our lives that magically the government does possess the information and knowledge to maximise our interest.

The only interests that all Australians have in common, and with the government, is the maintenance of law and order, and national security.  Some people try to push the restrictions on trade are important for national security line. Senator Kim Carr of Victoria, for example, long maintained the argument that a domestic motor car industry was vital for national security. Something about car manufacturing skills and aeroplane manufacture – forgetting, perhaps, that modern fighters use jet engines and not the internal combustion engine.

Once you examine the arguments for trade restriction to bolster national security, they are quickly exposed as appeals to emotion and prejudice.  It was Milton Friedman who made the argument that restricting trade is something we do to our enemies in times of war, yet trade restriction is something we do to ourselves in times of peace.

Now I understand that often good economics doesn’t appear to be good politics. Yet good politicians always make good economics work for them.

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45 Responses to There is nothing more practical than good theory

  1. Entropy

    I don’t think it is evil foreigners doing the nasty. It’s venal politicians corrupting markets for tangental benefits for them and their mates.

    But yes, a worthwhile post to get things back on track from the Trump cheer squad.

  2. Arky

    Why didn’t you post my Jordan Peterson post you ratfink.

    [Sorry – forgot about that. Sinc]

  3. Yohan

    The gains from comparative advantage due to free trade are legitimate. What is not spoken about is the time taken for the equalisation and gains to occur. Economists pretend the gains for the overall economy are instantaneous, as it is in their math models. That’s not true to due to stickyness factors. For some segments of the economy the gains never occur, even after decades or generations.

    You can also have a situation where an advanced and well capitalised western economy is opened up to a cheap 3rd world labor force. The overall combined economy will see economic improvement due to comparative advantage. But what will be hidden is the modern western economy can see a lowered living standard due to the per head quota of capital having decreased when both economies joined.

    Like a bucket of water flowing into another there will be an equalization and the richer country can lose out for a certain period of time as benefits flow to the 3rd world country. This is what has been happening to the west for the last 20 years. There are legitimate gripes that Trump has tapped into.

  4. If absolute free trade is good, what has Australia to worry about? Aren’t we the free trade enlightened ones? Let the US implode and not worry about what happens across the Pond. After that we’ll have free trade everywhere, as we had before Trump came on the scene.

  5. Rafe Champion

    Another perspective.

    More finesse required from Trumpie.

  6. RobK

    Sinc,
    I wholly agree in principle, especially;
    “Individuals should specialise in the production of those goods and services where they have an advantage and trade for those goods and services where they do not have an advantage.”
    Seeing as western society sqawned from the industrial revolution, the Paris Agreement arrangements represent a massive disqualification of our comparitive advantage. We ought not turn our back on proven advantage of coal and nuclear power for an experiment in low energy density harvesting that is unsustainable without massive subsidies and exploitation by government mandate.
    Free-er trade please.

  7. Entropy

    It is about comparative advantage. The important thing is to not destroy your comparative advantage through excessive costs and regulation.

    It is possible to successfully trade your products where you have a comparative advantage and still have high wages if you keep just laws, minimise corruption, minimise red tape and keep other costs under control. And you don’t want to let those things get out of control because, well, there is a lot of ruin in a nation, and it is well nigh impossible to unpick.

    You can’t make up for bad performance in those areas by imposing tariffs. That just doubles the pain. Especially if you are mainly an exporter country anyway with a low population having a tiny domestic market.

  8. Confused Old Misfit

    Thank you Yohan! A point I’ve been unsuccessfully trying to make over three threads.
    The richer country looses out and ends up with a raft of social problems that don’t appear as externalizations in the economic theory but remain as empirical evidence of failure. Political failure? Economic failure? The two are not mutually exclusive.
    And apropos tariffs one is reminded of those imposed by Obama, BushII, Clinton et al.
    We will soon have the same “free trade everywhere, as we had before Trump came on the scene.”
    To do a Cathy Newman: “So what you’re saying is we should bend over and let ourselves be screwed because after we’ve been thoroughly screwed we’ll feel so virtuous that we won’t notice how poor we’ve become.”

  9. Entropy

    Hoban has a good point about stickiness
    , although it is about more than labour. That just the most visible bit.

  10. MPH

    There are so many assumptions underpinning this discussion that there are multiple PhDs to be had. One assumption appears to be that there is far more demand for goods than people available to produce them, hence the argument for specialisation based on efficiency. The problem is that availability of labour is not a true limiting factor any more, so there are surplus workers compared to actual labour demand. So when one nation produces something cheaper (not necessarily more efficiently) there is no way for the displaced worker to continue producing.

  11. DrBeauGan

    Third party interference in that process means that the gains from trade are not fully exploited and that some people are worse off than they otherwise could have been.

    Sounds good. So if any individual or company in China wants to buy something from some individual in the USA, or vice versa, government should not interfere at either end. Neither should any other party be empowered to interfere with a free trade between consenting adults. Is that your position, Sinc?

    Think hard about it before you agree.

  12. Pyrmonter

    Parenthetic comment:

    Is it the case that comparative advantage is usually taught in trade? Happy memories of Economics 1 are becoming a big dimmer with the passing decades, but I’m fairly sure comparative advantage was taught in the second or third weeks at Cambridge by the Torrens in the late 1980s, immediately after Opportunity Cost; surely the more overtly neoclassical and mathematical schools did the same?

  13. Tim Neilson

    I get the “free trade good-protectionism bad” mantra, but in and of itself it’s hopelessly incomplete as an analysis of the current situation.

    The unknown is exactly what Trump is trying to do here.

    Does Trump think that tariffs are somehow good per se?

    I doubt it.
    More likely, Trump sees three possible scenarios:
    (a) everyone trades free;
    (b) everyone uses tariffs or other protectionist measures to try to shut out foreigners’ goods and services, or other types of artificial distortions to try to gain advantage for their own production;
    (c ) the USA trades free and everyone else uses tariffs or other protectionist measures or other artificial distortions to try to gain advantage for their production over USA production – which it seems likely is what Trump sees as happening now.

    If so, the real questions for Trump are:
    First, is (c ) worse for the USA than (b) – if so, then if (c ) is really happening, then it’s time to slap on the tariffs.
    Second, even if (c ) is actually better than (b) for the USA or at least no worse, is (a) better still and if so can Trump use tariffs to negotiate a move away from (c ) and towards (a)?

    What Trump can negotiate is really a geopolitics question, but I’d be interested in the thoughts of Sinc and other economists on the other aspects of those two questions.

  14. It is well worth emphasising that arguments against free trade are always conspiracy theories. Evil foreigners are doing bad things to us.

    Evil foreigners are doing bad things to us. People were shitting their pants just a few months ago about Little Fat Kim and his nukes, but now he’s suddenly come to the negotiating table and wants to give them up. How the hell did that happen?

    China. Trump is using economic leverage on China in order to get them to act on North Korea. China enables North Korea – without them little Fats is screwed. So Trump is going after China and the only way to make them listen is economics. In case you haven’t noticed it’s called the art of the deal. The US military is there to back up the economic leverage. China respects this play, unlike the US foreign policy of the last 30 years.

    The only interests that all Australians have in common, and with the government, is the maintenance of law and order, and national security.

    The two are intrinsically linked. Your precious economics does not exist in a bubble.

    Some people try to push the restrictions on trade are important for national security line. Senator Kim Carr of Victoria, for example, long maintained the argument that a domestic motor car industry was vital for national security. Something about car manufacturing skills and aeroplane manufacture – forgetting, perhaps, that modern fighters use jet engines and not the internal combustion engine.

    Germany’s tank industry prior to them being gifted Czechoslovakia was miserable. They had some of the worst tanks in the world. But getting the Czechs gave them access to the immense Skoda factory and their tank capabilities and quality were transformed in a matter of months.

    Now I understand that often good economics doesn’t appear to be good politics. Yet good politicians always make good economics work for them.

    Irony doesn’t get much better than this sentence. Trump is so far in front of you it’s not funny. You’re like a cat that has been moved halfway around the world and Trump is the owner. He’s not going to be bothered trying to explain to you where you are now located geographically. That’s impossible. He’s just going to get on with it.

  15. Yohan

    So when one nation produces something cheaper (not necessarily more efficiently) there is no way for the displaced worker to continue producing.

    Well we have seen it written many times that the displaced worker, usually older and trained in a factory, should just learn to code or go an die.

  16. Tim Neilson

    Very interesting reading of the situation Adam, I hadn’t thought of that angle.

  17. egg_

    Like a bucket of water flowing into another there will be an equalization and the richer country can lose out for a certain period of time as benefits flow to the 3rd world country. This is what has been happening to the west for the last 20 years. There are legitimate gripes that Trump has tapped into.

    Anything outside of a systems view is ridiculous simplification – and the more Countries and trading blocks involved, the more complex the real world situation.

  18. egg_

    It is about comparative advantage.

    Does it come as no surprise that mercury containing CFLs and radio-active RE mines are in China, with bugger all environmental laws?

  19. Yohan

    Comparative advantage also has problems not just with labor, but with capital. Imagine a rich economy of 20 million people. There are lots of infrastructure, power stations, bridges, factories, in other words it has a high amount of capital per head of population i.e its productive output is high, therefore the people in this country are rich.

    Imagine opening up this economy to 100 million 3rd world people, who are poor, have no capital, and are low skilled. What would happen? For the 3rd world country, and the entire new economy overall, there would be huge gains with the new access to capital, resources, and specialisation and comparative advantage.

    What would happen to the original 20 million? There would be a vastly decreased per head quota of capital. Only the same amount of bridges, factories, and capital will now service 120 million. So there will infrastructure pressures (which are highly sticky), shortages of many goods as the new buying power bids prices higher for scarcer resources, bidding up of fixed capital. So at the top end of the economy things will do very well, Woollies, Coles and Harvey Norman will do very well. Big business will see demand up and stock prices rising.

    But at the same time there will be a huge supply of low skilled labor, which will push down wages at the lower end service/manufacturing economy. So for people on the bottom half of society, they will see wage growth stop, while at the same time prices are rising for all their other expenses. So their real living standards will actually decline. This is the story of the western world since the 90’s.

  20. egg_

    Trump is using economic leverage on China in order to get them to act on North Korea. China enables North Korea – without them little Fats is screwed. So Trump is going after China and the only way to make them listen is economics. In case you haven’t noticed it’s called the art of the deal. The US military is there to back up the economic leverage. China respects this play, unlike the US foreign policy of the last 30 years.

    Trump has escalated to the boarding of ships acting outside of trade sanctions, bringing li’l Kim to the bargaining table.

  21. John Constantine

    Australia has no comparative advantage in refining transport fuels.

    Importing the fuel on a just in time supply chain is cheaper.

    If the supply chain is interrupted, we can simply ration the paltry buffer stocks we hold, so State departments can continue to function.

    Five days away from rationing in a worst case interruption event.

    What is the all in cost of importing vital non substitutable and time critical supplies?.

    Fertiliser, herbicide, fungicide, insecticide. All time critical cropping inputs, and all imported on a just in time supply chain.

    Because nothing ever goes oops.

    Our complete and utter dependence upon chicom goodwill is our strength.

    Comrades.

  22. John Constantine

    Men who made America had an episode on pay TV recently.

    Bloke called Scott owned a railway, transporting oil from an oilfield to a cityfull of refineries for a bloke called Rockefeller.

    Scott defied Rockefeller, on the basis that without his railroad, the refineries would be unprofitable.

    Rockefeller shut the refineries and without their business, the railroad was crushed.

    Complete vulnerability to someone who would be happier with you replaced, that is now our strength.

    Keep the bribes coming, Comrade Maaaaates.

  23. jupes

    Some people try to push the restrictions on trade are important for national security line.

    They are.

    If China dumps enough subsidised steel in the US, then US steel manufacturers can’t compete and go out of business.

    American tanks will then have to rely on Chinese steel to get made. Hmmm …

  24. Texas Jack

    What Tim Neilson (6:13pm) and Adam (6:14pm) said.

    I reckon Cohn had been waiting for an exit opportunity. Given something, anything, he could claim to have “taken a stand” on. A point of principle to maybe get back into the Democrat tent somewhere down the track. I doubt it was for the principle of free trade theory since almost none of the US’ various partners trade freely. All the “free trade” agreements have retained big protectionist elements, and then there’s dirty FX floats. Cohn would know the US has been gamed for years – but couldn’t resist his exit meal-ticket.

  25. struth

    Thank you Adam.
    I’m getting so tire of these blinkered academics.

  26. Bob Dick

    “There is nothing more practical than good theory”

    Sounds as if Merton Miller may have been quoting Kurt Lewin, who reportedly said “There is nothing so practical as a good theory”.

  27. egg_

    Like a bucket of water flowing into another there will be an equalization and the richer country can lose out for a certain period of time as benefits flow to the 3rd world country. This is what has been happening to the west for the last 20 years. There are legitimate gripes that Trump has tapped into.

    Anything outside of a systems view is ridiculous simplification – and the more Countries and trading blocks involved, the more complex the real world situation.

    I.e. agree wholeheartedly.

  28. Yet another article by academic theorists which doesn’t address the real problem, just focuses on the tariff angle in a shallow way.

    Currencies were floated precisely to address trade imbalances.
    The US is in a unique situation because its currency is a reserve currency, meaning nobody has to spend US Dollars back in the US.
    This has caused the US to run unsustainable trade deficits. $800B to be precise, which is the equivalent of 4.5% of GDP.

    When Australian commodities rise in price, we have a trade surplus.
    The value of the Aussie dollar goes up.
    Imports become cheaper, exports become more expensive.
    Trade surplus reduces and in some instances we go into trade deficits.
    The value of the Aussie dollar reduces.
    Exports become cheaper, imports become more expensive.
    Rinse and repeat.

    When China, Japan and EU (They call it Quantitative Easing ffs) manipulate their currencies, they introduce artificial market distorting mechanisms.
    The US has no opportunity to benefit from the MARKET BASED fluctuations of its currency.
    Therefore the US ends up BLEEDING the equivalent of 4.5% of GDP (currently).

    No one, not Sinc, not Sloan has addressed this bleeding and how it’s good for the US economy.

  29. Sinclair Davidson

    Blah, blah, blah therefore free trade is bad.

    Yes, I know.

  30. Infidel Tiger 2.0 (Premium Content Subscribers Only)

    What if I told you the tariffs being put in place were nothing to do with trade whatsoever?

    Would I blow your fucking mind?

  31. Sinclair Davidson
    #2658300, posted on March 12, 2018 at 12:41 pm

    Blah, blah, blah therefore free trade is bad.

    Yes, I know.

    Who is that directed to?
    It can’t be me because I never ever said free trade was bad.
    Either you don’t read all comments, or you have no intelligible response to my last comment so you resort to an unhelpful drive by.

  32. struth

    Blah, blah, blah therefore free trade is bad.

    Yes, I know.

    Free trade is good.
    We all agree with this, I certainly do.
    Please tell me where it was occurring before the pro west Trump tariff was even mentioned?

    One pro western tariff by Trump and the socialists and their sympathisers go nuts.
    Sort of tells you without any further proof how needed it is.

    See we are all now having a discussion about this, and the common man is waking up to what the top end of town are doing to them.
    Nothing like talking about a subject.
    This blog for one, has seen the heads explode of all the theorists here, when they actually get challenged,
    They come up well short, and cannot answer.
    And you get this , above.
    Academics or anyone claiming theory are the last people you should ask for a common sense general appraisal of anything.
    Theory is just theory.
    It doesn’t apply to all scenarios, as a fix all, because this theory of yours doesn’t take into account many factors, and as you have admitted, doesn’t recognise (like you) that there are bad people and bad countries out there.
    You are really coming up short here Sinclair.
    I’m just an ex tradesman, driver, small business owner, and now taking a break as a musician, producing SFA.
    Not worried about becoming wealthy and not investing anymore in this nation.
    Thanks to theorists.
    If I was to say, never listen to a theorist, that’s my theory.
    Therefore using your theory there is nothing more practical than my theory.
    Theories cannot be applied to all situations.
    Especially when you are dealing with corruption.
    Surely this is basic logic and not too hard to grapple with.

  33. Stimpson J. Cat

    It is well worth emphasising that arguments against free trade are always conspiracy theories.

    Yes but how can you prove definitively that the trade is actually free?
    Always is a rather definitive position.

  34. From the link mh put up…

    “Hey GOP, unfair trade practices are hurting me!”

    “Shut up, economic illiterate! There’s no problem. You’re imagining it. Shut up.”

    Sinclair couldn’t have hand waved better.

  35. Tel

    It was Milton Friedman who made the argument that restricting trade is something we do to our enemies in times of war, yet trade restriction is something we do to ourselves in times of peace.

    Actually it came from Henry George:

    Protective tariffs are as much applications of force as are blockading squadrons, and their object is the same—to prevent trade. The difference between the two is that blockading squadrons are a means whereby nations seek to prevent their enemies from trading; protective tariffs are a means whereby nations attempt to prevent their own people from trading. What protection teaches us, is to do to ourselves in time of peace what enemies seek to do to us in time of war.

    This is presuming that a 25% tariff is equivalent in effect to a military blockade… which I find doubtful.

    If you want to compare with domestic division of labour, the typical worker faces approx 25% income tax, plus 10% GST, plus 9% payroll tax, and 9% compulsory Super, plus a bunch of taxes on fuel, electricity, land, etc. If Trump’s tariff is equivalent to a military blockade then tell me what Australian workers are up against?!? Worse than military action apparently, and that’s just attempting to work a job.

  36. struth

    Protective tariffs are as much applications of force as are blockading squadrons, and their object is the same—to prevent trade. The difference between the two is that blockading squadrons are a means whereby nations seek to prevent their enemies from trading; protective tariffs are a means whereby nations attempt to prevent their own people from trading. What protection teaches us, is to do to ourselves in time of peace what enemies seek to do to us in time of war.

    Again, why quote this?

    Was he around when the United Nations were telling his country you can’t use the steam engine, but your trading partner can?

    What is it with you dunderheads that you can’t understand that trade has a lot more effecting it these days than just tariffs.

    Please stop quoting people prior to global corruption by the likes of the U.N.

  37. Tel

    Again, why quote this?

    Because that’s where the idea came from, and we don’t want the kiddies going home thinking that Milton Friedman came up with it.

  38. Tel

    Please stop quoting people prior to global corruption by the likes of the U.N.

    So stop quoting anyone prior to when I broke my pencil last week. The entire world changed after my pencil broke. The old rules no longer apply. This time is different. Forget the wisdom you once thought you knew and bravely move forward into a world without pencils!!

  39. I’m a big fan of Milton Friedman. Have watched hours and hours of his presentations and listen to his answers to questions (even one from a very young socialist Michael Moore).

    The thing that Milton emphasised regarding free trade was that countries like Japan (the dominant trading partner at the time) couldn’t use those surplus US dollars gained (due to trade manipulations) in their domestic economy, thus they’d have to spend or invest those dollars back with the US.
    Japan was just subsidising US consumers with Japanese taxpayers money. Bad for Japanese taxpayers, good for US consumers. This is true BUUUUTTTT……

    The thing Milton didn’t consider at the time was that the US dollar became a global reserve currency, meaning Japan didn’t have to spend US $ with the US. They could spend them with the Arabs for oil, or Aussies for ore etc and they did. They all do now.
    That’s why the US is suffering an annual $800B trade deficit.

    I’m certain Milton would change his stance today given the wealth bleeding from the US.

  40. struth

    Was he around when the United Nations were telling his country you can’t use the steam engine, but your trading partner can?

    Answer that Tel.

  41. Bruce

    The most restrictive trade practises occurred in WW2 . The US economy did pretty well during that period.

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