/ 6 December 1996

New trade theory? Bah, humbug

Is there such a thing as international competitiveness? Paul Krugman thinks many of the arguments are bunk. Ben Laurance looks at his thesis

DEBATES about international trade are, Paul Krugman of the Massachusetts Institute of Technology suggests, “a study in confusion and misconceptions, in which the `experts’ are usually misinformed about the most basic facts and concepts”.

He goes on: “The idea that the economic success of a country depends on its international competitiveness took hold in the late 1970s. The World Economic Forum began issuing its World Competitiveness Report in 1980, and the rankings in that report soon became a major criterion by which national performance was judged. By the 1990s, the concept was no longer even controversial. Competitiveness was the key; the only question was how to achieve it.”

Krugman argues that people who use the term believe “nations compete for world markets in the same way that corporations do, that a nation which fails to match other nations in productivity or technology will face the same kind of crisis as a company that cannot match the costs of products of its rivals”.

In fact, says Krugman, the suggestion that countries compete like companies is a poor analogy. And within the muddle of the debate, he suggests, it is possible to discern four types of combatant: the Mercantilist, the Classicist, the Strategist, and the Realist.

l THE MERCANTILIST believes the purpose of trade is to generate exports, which create jobs; if he has any sympathy for free trade, it is because we can make a deal to accept other countries’ exports if they accept ours.

“The vast majority of those who use the term [competitiveness] are Mercantilists. Anyone who writes about trade as a global struggle or war; anyone who says that trade policy is about creating jobs; anyone who talks about `high value’ sectors: all of these people reveal themselves to be Mercantilists.

“Both the North American Free Trade Agreement and the Uruguay Round were sold politically not on the basis of economists’ estimates of the gains from trade, but with the claim that the extra exports thereby generated would add hundreds of thousands of jobs.”

l THE CLASSICIST, essentially a follower of the model postulated by David Ricardo and developed by John Stuart Mill: that the purpose of trade is imports, not exports. “An export is an indirect way to produce an import, which is worth doing because it is more efficient than producing our imports for ourselves. It is almost exactly the opposite of what Mercantilists believe.”

l THE STRATEGIST, in Krugman’s view, has an objection to the classical position “which can be summarised in two words: Silicon Valley”. The basic classical model assumes perfect competition. But there are industries in which economies of scale imply that only a few, perhaps highly profitable, firms dominate the market.

Says Krugman: “There are industries in which technological prowess seems to be generated by the mutual spill-overs of knowledge from national producers, and in which exports, therefore, may create comparative advantage, rather than the other way around.

* THE REALIST understands how the Classicists’ and Mercantilists’ views collide and how the qualifications to classical trade theory create new, more subtle, arguments for intervention.

“What distinguishes the Realist from the Strategist is two beliefs. First, the Realist has looked at the practical prospects for strategic trade policy and found them unimpressive: while markets are indeed imperfect, the potential gains from trying to exploit these imperfections are, he believes, essentially small change. Second, the Realist is cynical about the likelihood that subtle arguments for intervention can be translated into productive policies in the real world.”

Krugman, not surprisingly, declares himself a Realist. In too many cases, he says, reports and newspaper articles on competitiveness contain statements like these: growth of economies in Asia necessarily comes at the expense of the West; and if our foreign rivals become more productive than we are across the board, we will have nothing that we can produce competitively and our standard of living will collapse.

Such statements are silly, yet they attract nods of agreement, says Krugman. Why? Because too many observers fail to see that everything in the economy affects everything else in at least two ways.

“For example, the amateur pundit on international trade typically thinks of wages as a given, and so imagines that productivity growth in low-wage countries must always come at the expense of jobs elsewhere; or he thinks in terms of a world market of fixed size, in which one country’s increased output can come only by crowding out production and jobs in other countries.

“But if one understands even the simplest textbook model of comparative advantage, one already has a picture of a world in which wages, prices, the pattern of specialisation and production, and the size of the world market are all simultaneously and mutually determined; in which productivity growth will feed back to wages; in which output growth will feed back to demand.”

So having arrived at a defence of classicism, what has to be added to the mix to make up some of the so-called new trade theories?

According to the new theory: “Differences between countries are one reason for trade, but countries may trade because there are inherent advantages to specialisation. The economies of scale in aircraft manufacture are so large that the world market can accommodate at best only a few efficient- scale producers and thus only a few centres of production. “

So which country, in this case, becomes the aircraft producer? “In the new theory, an important element of arbitrariness is added to this story. Why are aircraft manufactured in Seattle? The logic of increasing returns mandates that aircraft production be concentrated somewhere, and Seattle just happens to be where the roulette wheel came to a stop.”

The new trade theory suggests that in export subsidies, temporary tariffs and other measures may shift world production in a way favourable to the protecting nation.

But, says Krugman, few of the new trade theorists can be described as Strategists, because the new trade theorists are generally Realists. The Realist “does not share the interventionist propensities of the Strategist.

`There is a big difference between knowing lots of facts and really knowing how a market works. And worse yet, if you should figure out aircraft, you will find that little of that knowledge generalises to computers, which are in turn utterly different from telecommunications, which do not at all resemble software.”

He continues: “Even if you think you understand an industry well enough to devise an activist policy, or are willing for the sake of argument to assume that your model is really good enough, estimates of the gains from strategic trade policies are almost always very small.”

Finally, Krugman suggests, there is a third reason why new trade theorists tend to be generally non-interventionist Realists: policymakers are unlikely to understand any of this. “Almost everyone who matters is a Mercantilist. What this means is that the Strategist who goes to politicians with clever ideas for strategic trade policies is kidding himself.

“He may imagine that they value the content of his ideas. In fact, they value him because what he says seems to confirm their Mercantilist views, and absolves them from the need to understand even classical, let alone `new’ trade theory.”

Krugman’s conclusion is clear and contemptuous: “Most of us would like to believe that great public debates are driven by serious intellectual concerns. We would therefore like to believe that if famed intellectuals and powerful politicians talk about competitiveness, they must have something meaningful in mind. It seems far too cynical to suggest that the debate is simply a matter of time-honoured fallacies about international trade dressed up in new and pretentious rhetoric.

“But it is.”

— Making Sense of the Competitiveness Debate, Paul Krugman, the Oxford Review of Economic Policy (OUP)