By emphasizing their empirical predictions with regard to the trade balance, explain how the neoclassical theory of international trade differs from the cost-of-production approach. Why does one key aspect of this debate hinge on the acceptance or rejection of the quantity theory of money, Say’s law, and a barter-based economy? Explain the Capital Controversy (or Capital Critique) and discuss how it challenges factor price equalization. A good essay should explain the implications of the neoclassical and political economy (which includes the cost-of-production and Capital Critique) approaches, respectively, for international trade imbalances and factor prices (wage and profit rates).
Drawing on David Ricardo as well as the Ha-Joon Chang and Fred Block readings, explain how these authors’ insights can be used to explain the persistence of trade imbalances in the cost-of-production perspective. How can Chang’s and Block’s analyses of real-world industrial development (capital accumulation) be related to the constitutional theory of money in an open economy?
Solution
FOREIGN TRADE
Trade has great economic relevance and significance because it is considered an instrument not only to realize economic objectives, but also a tool to implement political-economic agenda. Keynesian and neo-classical economists have different takes not only on the subject of trade but also on the subject of the free-trade agreement. Classical economists suggested that prime economic objectives, which included 1) economic expansion and 2) full employment (ignoring the natural rate of employment), can be efficiently achieved through trade and a trade agreement that is based on the notion of comparative advantage, permits countries in realizing their primary objectives.
However, free trade has associated it with other ideas, such as laissez-faire economy, Foreign Direct Investment, and small government. These associations suggest that trade is not only an economic subject, but also it is a political subject. As a political-economic subject, it is very controversial, as it has produced mixed results (Suranovic).
Before we discuss its results, it is imperative to discuss, in detail, its construction. Tariff-free trade is a Classical and Neoclassical concept, which is shaped by liberalism. As per this theory, an economy can realize its short and long-term objectives, only when economies implement liberal economic agenda. This agenda compels countries to allow Foreign Direct Investment and free trade. It is asserted that as the trade expands, based on comparative advantage, the economy expands and improves. It expands because of the increase in the size of exports, and it improves because of the better allocation of resources (a subcomponent of trade) (Suranovic). (Note: comparative advantage theory suggests that a country produces what it produces best when international trade is based on comparative advantage.)
However, this theory is flawed, and it was strongly contested by Keynes. For instance, statistics reveal that since the adoption of free-trade, economies around the world could not prosper or expand, as per projections. There are only very few examples of countries that benefited from free trade. These countries include China, India, and a few others. However, close study, of these economies, suggests that other factors, such as the cost of production (rather than comparative advantage) played a major part. The liberal theory of trade (free trade based on comparative advantage), suggests that it is priced that influence trade; however, evidence suggests that it is the cost of production that dictates trade and direction of trade. It is because in international markets, prices are stable and because of the competition (a large number of buyers and sellers), the emphasis is on reducing the cost of production (through optimization and innovation) rather than on exercising whatever influence a firm has on the market to increase prices (Suranovic).
Critique of Trade
Keynesian economists challenge the narrative about the alleged benefits of trade. Not only do they criticize it, but also these political-economists assert that global institutions have been hijacked by neo-classical economists. Keynes, who was dubbed as “pragmatic protectionist” questions the very premise of free trade and asserted that “when the economy is under-pressure, free trade aggravates economic conditions further.”Also, he also challenged the concept of comparative advantage, which seemed flawed to him (Edwards).
Ha-Joon Chang questions the logic of zero-tariffs, and he claims that the United States and then United Kingdom built their economies, during the developing stage, by adopting protectionist policies. In fact, since the adoption of free trade, both these economies did not excel exceptionally (Chang). However, economies, inclined towards protectionism (such as Germany and Japan), benefited without adopting a free trade policy (Cypher and Dietz).
Evidence, about the alleged benefits of free trade and laissez-faire economy, is apocryphal. Statistics reveal that only a few countries have benefited from the liberal economic model and economic conditions, even in developed countries, have deteriorated, instead of improving after the adoption of the liberal economic model (Block). Also, domestic consumption is considered an engine of growth; however, when exports grow drastically, they affect domestic consumption, as producers target foreign markets, causing smaller output for domestic consumers. It suggests that Industrial sector and industrial policy of an economy are strongly influenced by trade policy (Sheikh).
INDUSTRIAL POLICY
For both developed and developing countries, the industry has great significance and germaneness. It is because the industry has a very strong imprint on economic growth and it produces employment at large scale. The collapse of the Soviet Union (an economic anomaly, according to few) most of the developing economies, adopted the liberal economic model so that they might reshape their industrial sector and expand at an exceptional rate.
The Industrial policy, adopted by these fresh liberal economic systems, primarily based on trade and Foreign Direct Investment. Fresh liberal economies intended to expand the size of their economy and quality of their economy through Foreign Direct Investment. It was asserted by neo-classical economists that vertical and horizontal spill-over of Foreign Direct Investment matures economic institutions/corporate system, enforces innovation and puts downward pressure on prices. As the prices dwindle, as per theory, the consumer surplus increases and so do the real income, which positively affects overall consumption.
Trade, on the other hand, allows firms to operate in lucrative markets, where they can earn more profit in comparison to the local market. For instance, Chinese firms can operate in lucrative markets in the United States and Europe, where they can earn more profit. When the size of demand increases, output also increases, which generates employment at large scale, making it an endogenous phenomenon (Sheikh).
It makes it very apparent that the emphasis, of economies/states, is primarily on Foreign Direct Investment and trade to meet these objectives. However, most of the studies suggest that it is the domestic consumption, which is the true engine of growth. The question arises that if domestic consumption is the engine of growth and changes in its markets shape domestic markets, then why countries or economies are emphasizing on trade and foreign direct investment. The industrial changes are primarily a consequence of domestic consumption and changes in taste over the period. It implies that confidence, in trade and Foreign Direct Investment to evolve industrial sector, is quite misplaced (Chang).
Impact of Trade on Industry
To benefit the overall economy and its industrial and service sectors, modern economies sign various trade agreements. One of such agreements is North Atlantic Free Trade Agreement. When we study the consequences of this agreement, we learn that with the passage of time trade has imbalanced and titled in favor of Mexico, which is a signatory of the NAFTA agreement. It was believed that comparative advantage would benefit all trading countries (Canada, United States, and Mexico); however, statistics reveal that because of the free trade agreement, the United States has de-industrialized. Similarly, since China attained the status of Most Favored Nation, by the US, its penetration into US markets have increased, causing trade imbalance, which has led to foreign debt (Chang).
Money in an Open Economy
In the world of neo-classical economists, money are the most controversial subject, as neoclassical economists fail to understand its construction and role in an economy. It is considered a mere medium of exchange; however, in an open economy, where trade is an economic strategy, trade imbalance and interest rates affect the exchange rate of the currency, which in return impact consumption, production and export.Thus, the constitutional theory of money, proposed by classical and neo-classical economists are flawed(Suranovic).Therefore it can be said by the point of view of the constitutional money, fiscal or monetary actions or decisions taken by the public authorities are unable to fulfill the monetary needs of the economy and society, and it is all due to tentative characteristics of fiscal policy (Moudud).
The constitutional theory of money discusses nature, and it also discusses methodological and theoretical detail that provides the challenge to the heterodox and neoclassical economist. It is a political process of the final unit of account. Previously the unit of the account had not the ability to arise as well as establish it. From the activities of production, profit-making that requires the cost of input and prices of output comes from the same unit of account. By unit of account, that is, multiple is extremely challenging. The money that arises under this system can establish itself collectively at the center of politics to make sure the territory defense.
If it is considered that paper money is not backed by specie, then the issued paper may have absorbed for a future date in the form of tax. In the constitution money, the heart of future money is increasing demand for money and money possesses cash premium. So, in the constitutional theory of money, the political authority created legally unit of account to bring stability in the central monetary system. Such type of stability is like the basic of torts, contract, and property with the help of forces that are spontaneous in the absence of legal foundation. It also suggests that government has authority to dictate outcomes of a market (Moudud).
FOREIGN DEBT
Foreign debt is directly related to the trade deficit, which implies that imports have exceeded exports. As the deficit increases, so do the foreign debt, which puts pressure on successive/future generations. Foreign debt is becoming a serious challenge, as imports of developed countries are growing. As the Cost-of-Production of labor-intensive economies is less; therefore, in international markets firms from developing countries perform better. Furthermore, as technology is becoming universal, the quality of products is also becoming universal; therefore, the competitive advantage, of firms of developing countries, has reduced significantly.
Foreign debt is a serious challenge, which is associated with trade and industrial policy. Therefore, it is essential to address trade and industrial policy to resolve the issue of foreign debt, as it has an adverse impact on the economy(Edwards).
Neoclassical economists continue to ignore the deterioration in the health of the global economy because of liberal economic agenda that has been imposed through global institutions such World Bank and IMF. Also, there is no strong and unambiguous evidence, in any form, related to the benefits of trade. However, global institutions continue to enforce tariff-free trade on world economies. Despite the fact, all the developed countries had adopted protectionist policy/strategy during their development phase.
CONCLUSION
In any economy, the two prime objectives are 1) full employment and 2) economic growth. There are several instruments and policies to realize these objectives, which include fiscal policy, monetary policy, trade, foreign direct investment, etc. However, modern economies, which we can identify as liberal economies, emphasize on trade and foreign direct investment and industrial/service sector policies to realize these objectives. From the discussion, it is apparent Foreign Trade, Industrial Policy, and Foreign Debt are related. We also learn that there is very apocryphal evidence in favor of the free or tariff-free trade. The neo-classical relies more on theory than on evidence, when they advocate free trade.
Evidence of North Atlantic Free Trade Agreement (NAFTA) and World Trade Organization (WTO) suggest that comparative advantage is a flawed concept, as it undermines trust and ignores the free movement of capital (flight or landing of capital). Also, because of these trade agreements, the trade deficit of developing countries, such as the United States, has swelled and become the cause of high foreign debt. Furthermore, in the United States, NAFTA caused de-industrialization, in the US (as per some studies), causing unemployment, and low GDP growth. In contrast, countries that incline towards protectionism, their economies did well, which suggests that economic factors other than free trade and FDI played a more vital part in economic growth.
Work Cited
Block, Fred. “Swimming against the current: The rise of a hidden developmental state in the United States.” Politics and society XX.X (2008): 1-38.
Chang, Ha-Joon. “Kicking away the ladder: An unofficial history of capitalism, especially in Britain and the United States.” Challenge 45.5 (2002): 63-97. PDF.
Cypher, James M and James L Dietz. “Chapter 15 and 16.” The process of economic development. London and New York: 2008, Routledge. Book.
Edwards, Chris. “Chapter 2-The free-marketeers and the rise and fallof the Heckscher-Ohlin theory.” The Fragmented World: Competing Perspectives on Trade, Money and Crisis, London, England and New York. London and New York: Routledge, 1985. 17-32.
Moudud, Jamee K. “Analyzing the Constitutional Theory of Money: Governance, Power, and Instability.” Leiden Journal of International Law (2018): 1-25.
Sheikh, Anwar. “Chapter 3-Globalization and the myth of free trade.” Globalization and the Myths of Free Trade: History, Theory, and Empirical Evidence. Routledge, 2007. 50-58.
Suranovic, Steven M. “Chapter 60-The Heckscher-Ohlin (Factor Proportions) Model.” International trade theory and policy analysis. The International Economics Study Center, The George Washington University, 1997.
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