Chapter Thirteen: The International Political Economy of Trade

Walk-through

States and Individuals in the International Economy

          Chapter 13 provides both an introduction to the economics of trade and finance and also an introduction to the political economy of trade and finance. Economists assume that all individuals are both producers and consumers. They care about the cost and quality of goods (their role as consumers), but the more important thing is the source of income that allows them to be consumers (that is, their role as producers). Political economists take this one step further. Individuals are both producers and consumers, as in economics, but they are also voters. As voters, individuals prefer candidates and policies that advance their own particular interests, which are derived from a combination of factors like the individual’s occupation, skills, and income.

This Walk-through explores the interests of states and individuals in the international economy. Why do states want--or not want--free trade? Who within a state benefits from free trade, and who suffers? How do states protect injured groups? What interests do groups and individuals have in exchange-rate policies? What is globalization? How has it changed over time? What effect does that have on states and individuals? You should read Chapter 13 before reading this.

Trade and Political Economy

Comparative advantage is the foundation of international trade. Countries are differentially endowed with factors of production--land, labor, and capital--and this allows some countries to be relatively more efficient producers of some goods and services than of others. Countries produce those goods in which they have a comparative advantage and trade their surplus production for goods in which they are less efficient producers. According to economists, then, all states should embrace free trade because their economies will specialize in producing goods in which they have a comparative advantage, and with specialization comes an expansion in the total amount of goods and services produced. To an economist, trade is good for everyone, and free trade is best, so states should shift to free trade even if no one else is doing it.

Political economists, on the other hand, recognize that free trade does not benefit all actors in a state equally. National income and production rises, but the rising tide does not raise leaky ships. Leaky ships--things in which the state is comparatively disadvantaged--sink. Individuals who are part of the comparatively disadvantaged group will be hurt by free trade, and leaders whose support depends on these groups may not want to antagonize them. The most preferred outcome for a state, according to a political economist’s point of view, would be to keep its own tariffs but have the other state remove its barriers: The first state gets the benefits of the other state’s specialization since the price of its goods will go down and more will be produced, but the first state doesn’t have to inflict political pain on supporters. Of course, the converse--the first state lowers its barriers but the other state does not--is the worst possible outcome. The first state would prefer mutual free trade (both states specialize and both accept political pain) over mutual protectionism, provided neither state cheats the other.

          Table 1 represents an economist’s view of free trade; Table 2 represents a political economist’s view of free trade. Solve these games. What is the outcome in each game? Do these games look familiar?

According to economists, the logic of free trade--that national income and production are improved by specialization--means that the outcome should be free trade, free trade (C, C). Each state has a dominant strategy to cooperate; free trade is thus a game of harmony. According to political economists, though, the outcome is tariffs, tariffs (D, D). The urge to minimize your own losses or costs while benefiting from the other’s reduction in tariffs changes the dominant strategy to defect; the game then becomes a prisoners’ dilemma. Free trade is not the equilibrium outcome for political economists because in the face of a dominant strategy to defect, states cannot credibly commit themselves to eliminate trade barriers.

Trade and Its Effects

          Specifying who benefits and who suffers requires us to break open the black box of the state and examine the inner workings of its economy. Factors of production are not equally distributed across states or across individuals within a state. Generally speaking, actors who use an abundant factor intensively benefit from trade. This is because their factor, which was abundant and so relatively cheap within the national economy, is now relatively less abundant (is more scarce) in the world market. The product is attractive and relatively cheap to foreign users. Demand for the product will rise, so the actors’ income will rise. Conversely, owners and intensive users of domestically scarce factors are hurt by international trade. Their domestic scarcity allowed them to demand a high price under a closed market, but international competition (particularly from places where their factor is abundant) will require them to lower their prices. This argument, derived from the basic principles of comparative advantage and supply and demand, is known as the Stolper-Samuelson theorem. When considered in light of factor ownership, this suggests that owners or users of the same factor should have similar political interests based on the country's overall factor distribution. In the face of trade, owners or users of the domestically scarce factor(s) will band together to press for protection.

          Another argument about the domestic political effects of trade is based on the Hecksher-Ohlin theorem. This theorem uses the same bases as Stolper-Samuelson--supply, demand, and comparative advantage--but instead argues that we should see similar political interests across all factors involved in a particular industry. In the face of increasing trade, labor and capital in industries that are comparatively disadvantaged will band together to press the government for protection.

          The key addition that produces this result is factor mobility, or the ease with which factors of production can be converted from one use to another. When factors can move easily and cheaply between uses, as Stolper-Samuelson assumes, comparative disadvantage simply means that the factor shifts to another (comparatively advantaged) industry. An example of highly mobile capital is a personal computer. Imagine that a firm in, say, the steel industry goes bankrupt and sells its assets. Few other industries would want to buy a large, used steel smelter. This is an example of immobile (or sector-specific) capital. On the other hand, the steel firm's computers from its accounting department and executive offices might be purchased by a local bakery, a hardware store, a medical practice, or a wide range of companies in other industries or sectors of the economy. Likewise, some labor is highly mobile. Unskilled labor, by definition, can move across sectors doing any task requiring unskilled labor. Secretarial, accounting, and information technology skills are generally also quite mobile. This generalizes to an argument that in countries or eras with high factor mobility, social cleavages (divisions) form along factor lines to produce class-based conflict. This is consistent with the Stolper-Samuelson theorem’s predictions. Conversely, when interindustry factor mobility is low, we expect to see social cleavages form along industry lines and for industry-based protectionist pressures to emerge. This is the main insight of the Hecksher-Ohlin theorem.

          Throughout most of history, the preferred form of protection was tariffs, or taxes placed on imports to raise their price to about the same level as domestically produced goods. Tariffs are a fairly obvious form of protection: Duties are imposed and collected at the border and appear in state revenues. Other forms of nontariff barriers (NTBs) are much more subtle, such as manipulating the value of the state currency or implementing health sand safety standards that discriminate against foreign producers. Because states use different currencies, the rate at which currencies can be exchanged for one another (the exchange rate) affects the relative attractiveness of foreign and domestic goods. When my currency buys a lot of a foreign currency, that is to say that my currency is appreciated or high in value, the same amount of currency can buy a more attractive foreign good than a domestic one. This encourages imports and depresses the domestic economy. When a currency is depreciated or relatively low in value, one unit of my currency buys fewer of the foreign currency. This means that imports are relatively expensive (my money will buy more of a domestic product than of a foreign one), so they are less attractive to consumers. Consumers will prefer to buy domestic goods rather than imports, thus spurring the domestic economy.

Money and Finance

          The logic of protection via currency values follows a similar logic to protection via tariffs. Firms that compete with imports prefer a low exchange rate because it discourages imports and makes their products relatively more attractive to consumers. Likewise, firms that produce goods and services for export also prefer a low exchange rate because this makes their products relatively attractive in foreign markets. If a state takes steps to keep the value of its currency artificially low, as the United States and the European Union allege China has done, it gives its exporters a substantial advantage by making their products relatively cheaper than comparable goods produced in the importing country.

          States have two ways to affect the values of their currencies, and the choice between the two depends on the state’s exchange rate regime--that is, its choice to have either a fixed exchange rate or a floating exchange rate. When a state has a fixed exchange rate, it pegs the value of its currency to the value of another currency or some precious metal.[1] When the rate is fixed, this means that the central bank[2] of a state guarantees that it will convert its currency into the other currency (or metal) at the specified rate for any holder of the currency, and that this rate will not change. If a state chooses a relatively low rate at which to peg its currency, its exporters are advantaged. This is the China case. Because it takes very few dollars to buy a certain amount of renmimbi,[3] Chinese-made products look cheap in the United States. Compared to a $100 stereo made in the United States, a $100 stereo made in China will be bigger or have more features or something like that. You get more stereo for the same amount of money if you buy a Chinese product compared to a U.S. product.

When a state has a fixed exchange rate, it can affect the value of its currency by changing the peg. Such a move is costly, though; the big advantage of a fixed rate is that it doesn’t change. Many developing countries find fixed exchange rates attractive for that reason: Their export industries--and the international investors who make these industries possible--prefer the stability of fixed rates. Doing this means, though, that the state must prioritize its external economic position over its domestic economic position. Even if the exchange rate is pegged, if the state still allows free movement of capital over its borders, the exchange rate will still feel pressure to move up or down. Defending the fixed rate requires the central bank to intervene in ways that are harmful to domestic economic interests, particularly the interests of labor and consumers. (More on this below.)

          On the other hand, if a state has chosen to have a floating exchange rate, it allows the market to set the price for the currency based on supply and demand. Demand for the currency is set by the level of domestic economic activity and also by international economic activity; foreigners who wish to buy goods from your country or who wish to invest in your country must first trade their currency for yours. The supply of the currency, on the other hand, is set by the state’s central bank. Most states that float their exchange rates do not have a “pure float” but instead use a “managed float” in which the currency is allowed to fluctuate based on market forces--but not too far. If the currency is fluctuating toward a level that the state does not like, the state has two choices for how it intervenes. First, the central bank could use monetary policy to reduce or increase the money supply.[4] If demand for the currency stays the same, reducing the money supply would push the exchange rate up, whereas increasing the money supply would push the exchange rate down. (Sketch a supply and demand graph to confirm this.) Second, the central bank could choose to intervene in the international currency markets by buying its own currency. If the money supply remains the same, this increases demand for the currency and pushes the exchange rate up. (Sketch a supply and demand graph to confirm this.)

          Some domestic groups prefer floating exchange rates. In particular, firms or individuals who produce primarily for the domestic economy prefer floating exchange rates.  If the exchange rate floats, the government can use monetary policy (interest rates) to affect domestic economic growth.  Since the domestic economy is the source of their income, they prefer that the government can take steps to prevent or mitigate economic downturns in the domestic economy.

          In contrast, states that have chosen to have fixed exchange rates and free movement of capital across their borders cannot use their monetary policy for such autonomous purposes. Instead, they must use their monetary policy to defend their pegged exchange rates. If international demand for their currency drops, the price will try to drop as well. With a fixed rate, the central bank must then raise its interest rates to attract more capital to its country; this increases demand for the currency and pushes the exchange rate back to where the peg is. (Sketch a supply and demand graph to confirm this. Pick a “price” for your currency and draw a horizontal line there. Draw a supply curve and a demand curve that produce the price you selected. Draw another demand curve somewhere else. Does it produce the same price as the first demand curve? What has to happen to supply to produce the desired price? Experiment with a few different curves.)

          This leads us to a very famous result in international economics. Free movement of capital, fixed exchange rates, and monetary policy autonomy are the Mundell-Fleming conditions, named after the two economists that formalized the argument. The trilemma, as these conditions are sometimes called, is that states can only have at most two of the three at the same time. Table 3 combines political economists’ insights about group preferences with economists’ insights about the effects of exchange rate levels and flexibility.

Trade, Globalization, and Economic Development

          The process of economic globalization is the result of the gradual reduction or elimination in the postwar period of most tariffs and nontariff barriers. Combined with advances in technology, particularly in communications and shipping, trade is easier and cheaper than ever. Trade increases national income as states begin to specialize in those products or sectors in which they have a comparative advantage, but not all groups within a country benefit equally from increased trade. Some groups are hurt. Importantly, though, opponents of globalization who claim that globalization exploits or injures labor in “poor” countries are missing a key element of the economics of trade. “Poor” countries are poor only in capital; they are quite rich in labor, and they are particularly well endowed in unskilled labor, which is quite scarce in the large economies of the developed (or “rich”) world. Because unskilled labor is abundant in the poor country's domestic economy, it is unable to command a high price (wages). Importing capital from rich countries increases demand for unskilled labor, allowing it to demand a higher price domestically than it previously did. This benefits all labor in the developing country, as well as benefiting capital from the developed country (which pays less in wages) and consumers in the developed country (who get the same product at a cheaper price).

          During the first wave of globalization, from about 1865 to 1913, the United States developed its domestic economy using largely this type of strategy. British capital funded U.S. railroads to connect the Great Plains with eastern seaports, and it funded cargo ships to transport the grain to European markets. Feeding Western Europe allowed the United States to capitalize on its comparative advantage in land and to begin amassing domestic capital. This domestic capital, from J.P. Morgan, Leland Stanford, Cornelius Vanderbilt, and others, then funded the construction of factories employing the masses of unskilled labor that emigrated from Europe starting in the 1880s. By this point, the two regions’ comparative advantages had shifted. The United States was scarce in labor, both to work the land and to work in factories. Europe was overpopulated, with more people than it could feed or employ. Europe’s largest comparative advantage at this point became labor: The great waves of U.S. immigration in the late 1800s and early 1900s were Europe exporting labor to the United States.

Modern developing countries must use a different tactic. Most developing countries are quite abundant in unskilled labor. Since the advent of immigration restrictions, though, they cannot export that labor directly in the same manner Western Europe did. By definition, a developing state is scarce in capital; without capital, they are unable to employ their labor effectively. Since they cannot export labor, they must import capital to build factories or other businesses, then export the value of the labor rather than the labor itself. Unlike the United States' strong commitment to laissez-faire economics[6] in the pre-World War II period, modern developing countries, particularly the successful ones, often have governments committed to developing the infrastructure (ports, railroads, and other transportation systems) needed for trade. Often, these governments are aided by loans and grants from the World Bank and other international financial and development institutions, and from foreign aid from developed countries.

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