More than a gift from the gods
From Griffith REVIEW Edition 28: Still the Lucky Country?
© Copyright Griffith University & the author.
Written by Jonathan West
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Jonathan West's biography and other articles by this writer
The concept of comparative advantage is perhaps the single most powerful idea in economics. It is taught to every undergraduate and printed in every introductory textbook. It has all the hallmarks of a great theory: simple, non-obvious, logically irrefutable, with sweeping implications. And adherence to it promises a better world.
Never expressed better than by David Ricardo, its originator, the theory states that even if England is more efficient than Portugal at producing both textiles and wine, but Portugal is relatively better at producing wine than textiles, both countries would prosper if England produced all the textiles needed by the two countries and Portugal all the wine. The idea is to allow free markets to allocate resources to the sector(s) in which a nation has a relative productivity advantage and then trade freely to enjoy the benefits. In turn, free trade nudges the economy to concentrate on its comparative advantage.
Nowhere has this proposition had more impact than in Australia. Indeed, many would have it define the destiny of the nation. Comparative advantage stands today at the core of the free-trade ideology that dominates public discourse about the future. Applied to Australia, the theory proposes that this country stop trying to produce goods or services in which we lack a relative advantage – say, manufacturing and tradable services – and focus on exporting those in which we do, namely resources. And that's exactly what the Australian economy has been doing in recent years: narrowing, largely with the support of official policy.
Yet, in spite of its logical power and its promise of a painless path to superior economic performance, the idea of comparative advantage has always struggled for supremacy in Australia. Over the course of this country's economic development, comparative advantage has repeatedly been dethroned by another proposition: that, rather than narrow its focus to resources, Australia should broaden its economy, using its natural resource advantages as a platform from which to build other sectors.
Deliberate broadening appears to fly in the face of the prescriptions of comparative advantage and its companion, free trade. It implies protectionism and deliberate, government-directed industry policy. Today, these notions are almost universally rejected by economists and are even out of favour among political leaders of all stripes. Nevertheless, the impetus to broaden seems not to die, and every few years it re-emerges to shape the nation's view of its future. Indeed, the history of Australian economic policy can be seen as a century-long battle between these two propositions.
Why cannot such a great idea as comparative advantage – logical, simple and with the power to make everyone better off – achieve lasting dominance, particularly in Australia, which seems so obviously to be blessed by a compelling comparative advantage? How does such a seemingly discredited idea as protectionism keep reappearing? Put simply, why should the Portuguese (or Australians) exert extra effort to turn out five metres of woven cloth when, for the same amount of work, they could take advantage of their blissful climate and rich soil to produce six barrels of wine, trade three with England for perhaps ten metres of cloth and keep three barrels for their own enjoyment?
The answer is that as a guide to the economic future, and policy-making to shape the future, comparative advantage turns out to be fatally flawed. While as a snapshot fixed in time, and limited to the economic sphere, it is beyond reproach, looked at over time it ignores three vital dimensions of economic development: differential industry growth, technological improvement and the divergent social consequences of concentration in different types of economic activity. In fact, the theory of comparative advantage ignores economic development entirely – including the vital issue of the origins of comparative advantage itself. And therein lies its downfall, both as a concept and as a guide to good policy-making.
LET'S CONSIDER EACH of these three problems for comparative advantage. First, industries tend to grow at very different rates as societies become richer. Demand for meat grows faster than for rice, for automobiles faster than for bicycles, for televisions faster than for radios. This has an important implication for nations specialising in their comparative advantage. In Ricardo's illustration, for example, history shows that as Europe emerged from the centuries-long grip of poverty, demand for England's textiles grew much faster – by up to five times – than did demand for Portugal's wine. Clothing is much more ‘income elastic' than wine; as people break out of poverty they buy many more sets of clothes than they do casks of wine. The result was that by specialising in their respective comparative advantages, Portugal's economy stagnated, growing only as fast as population, but Britain's roared. It matters a great deal in which products your economy specialises and has comparative advantage. The East Asian nations that have improved so dramatically in recent decades have done so by specialising in fast-growing manufacturing sectors, not slow-growing traditional parts of the economy.
Second, as with growth rates, industries have very different technological potentials over time. England's textile producers spectacularly increased their output during the industrial revolution by introducing a string of new machines, driving productivity to hitherto unimagined heights; Portugal's wine makers, by contrast, were forced to continue growing grapes and pressing juice from them, with only marginal increases in output over time. This effect is even more marked today, with huge disparities among industries in average technology-driven productivity growth rates, particularly in the fields closest to the twin revolutions of computers and biotechnology.
Third, and perhaps most importantly, different industries have divergent social consequences. Which industries a society specialises in can exert important influence over the type of society that emerges: its relative equality, its social cohesion, its propensity to democracy, and even its sustenance or otherwise of such intangibles as personal self-respect and the arts. Some industries generate novel skills, and with them equality and self-reliance. The English textile industry created new classes of skilled workers, managers, fashion designers, equipment engineers and dye chemists, all of which were well rewarded for their skill and experience. The industry further supported a network of educational, technical and scientific institutions-which in turn spawned further technological advance. The textile industry also demanded increasingly sophisticated and complex machinery, which led to the birth of other industries, in a virtuous cycle. The Portuguese wine industry, with its time-honoured – and massively unequal – mix of peasants, winemakers and landowners, needed, and generated, little external support.
Indeed, it can be argued that the textile industry was important not only for creating the wealth that made England the richest country in the world in its day, but also for laying the foundations for the broadening of democracy to the majority of the population, and the flowering of science and the arts that was so apparent in eighteenth– and nineteenth-century Britain. Portugal's wine industry offered no such potential. In general, a society dominated by industries in which artisans and small enterprises are the natural form of economic organisation (textiles) can be expected to develop a very different character to one in which a single wealthy and powerful landowner employs the other members of society (Portuguese winemaking), or in which most people work for – or receive income without work from – the government.
Had the eighteenth-century Portuguese been able to divine the future, they would have been much better off ignoring Ricardo's advice and imposing a prohibitive tariff on English textile imports, giving their own textile industry a chance to survive and potentially even expand.
The proponents of comparative advantage and free trade would respond that Portugal's citizens would have seen their living standards lowered by any such decision, and that in any case England might retaliate with a tariff on wine. They would be right. Residents of Portugal would have had to put up with lower-quality and probably more expensive clothes, and would likely have sold less wine. But in Ricardo's example, there was no other way for Portugal to escape what became its fate over the next two centuries.
WITHOUT DELIBERATELY SETTING their sights on industries against their comparative advantage, Portugal could not develop. And indeed, no country has broken the grip of underdevelopment without ignoring the theory, at least as it is traditionally understood. The United States in the nineteenth century, Japan in the twentieth, Europe after World War II, East Asia in the 1980s and 1990s, and China today: all nations that have developed have done so contrary to the precepts of comparative advantage. Far from being a guide to good policy for aspiring nations, the theory has been a poverty trap.
In the principal industries that have driven economic development over the past two centuries – manufacturing and services – comparative advantage is not endowed by God but created, by human effort, ingenuity and organisation: comparative advantage can be brought into existence by deliberate investment and sustained commitment. This recognition makes all the difference. Because the theory is mute on the origins of comparative advantage and how it changes over time, it offers no guidance to how it can be constructed. Instead of insisting that nations stick to what they start with, we should ask how comparative advantage is created and what can be done to change a nation's destiny.
Actually, most economists, or at least those even slightly acquainted with history and the real economy, know this. They know that no nation has developed by applying the theory of comparative advantage, and they are aware that in the most important industries that advantage is deliberately created.
But they are reluctant to admit they know it. The real reason most economists espouse comparative advantage and free trade has nothing to do with economic theory. It stems from political judgement. Economists fear that conceding the possibility that comparative advantage might be created by the tools of government policy – tariffs, quotas, import prohibitions, low-interest loans, tax exemptions, subsidies, targeted education, government-funded research and development, military spin-offs, to name but a few – will open the floodgates to government-mandated protection for monopolies that have no hope of ever standing on their own feet. They worry that government will be captured by special interests, and industry policy will become merely a cloak for the kind of inefficient and expensive government-connected industries that are so common in the Third World. Economists commonly fear that democracies are especially prone to such capture, and that rather than building the industries of the future the slogans of ‘nation-building' will merely shelter dinosaurs.
THE FEAR IS valid. It may well be true that modern western democracies are no longer capable of sustaining commitment to future-oriented industrial development strategies, and that they will inevitably lapse back into pork-barrelling and special-interest protection. As western nations fragment into squabbling tribes, rancorously fighting over ever more hardened ideologies, perhaps we have lost the cohesion required to deliberate and to act. Certainly, the contemporary world offers plenty of evidence for such concern.
But if we accept this pessimistic view, it is important to be aware of the consequences. With the exception of a lucky few who do enjoy an insurmountable God-given comparative advantage, such a failure will likely doom western democracies to long-term economic decline. Successive waves of technological development rapidly supersede today's comparative advantage. If nations allow markets to narrow their bets to today's advantage and industries built in prior eras, they risk their industries being replaced as rapidly as the products they once made.
In this sense, all industries today are infant industries, the one exception allowed by the free-trade theorists. Technological change and targeted support from rivals can render a once healthy, grown-up industry a helpless infant within a few years. And along with these industries goes the service infrastructure that is intimately connected to them: banking, insurance, financial services, advertising and consulting. If assistance is denied to these industries, due to a fear of protectionism and in the face of competition from nations deliberately building new comparative advantage with every tool at their disposal, the overtaken industries will wither.
The overwhelming majority of Australia's manufacturing industry has already suffered this fate; much of North America's has gone down the same path. Failure to commit decisively to an alternative comparative advantage will lead inevitably to further narrowing towards our natural endowment in resources.
THE CONSEQUENCES WILL be not only economic but social and, for many, personal. Loss of the non-resource industries will transform our culture in as yet unimagined ways. But before we admit defeat, it is worth considering very seriously whether any other future is possible. Might we not be able to build a new comparative advantage? And what would be required?
One set of answers might come from our own past. The character of contemporary Australia, especially of its economy but also many of its social values, was forged more than a hundred years ago. In the decade following Federation, Australia's political parties negotiated an economic consensus that aimed to create the future desired by the population of the time.
This consensus survived largely intact until the late 1970s, and still underlies public assumptions about and expectations of government. The strategy was to draw upon the nation's natural comparative advantage in farming and resources to finance a shift to manufacturing. Key planks in the platform were tariff barriers to protect and promote manufacturing, racial and workforce insulation (the White Australia policy and the protection of wage workers from foreign competition went hand in hand), needs-based wages and judicially determined industrial relations, equalisation of revenues among the states, and a growing welfare role for the federal government.
These commitments were funded directly, through taxes on the resource and farming exporters, and indirectly, through tariffs and restrictive immigration. This ‘Federation settlement' took eight difficult years to agree upon, during which time Australia had three elections, nine minority governments and two failed efforts to fuse the non-Labor parties. Stability came only in 1909, with the merger of the non-Labor parties as a credible alternative to the Labor Party.
It was a deliberate, and successful, effort to build a particular type of economy that would shape a particular type of society – essentially, the one Australians live in today. The structure of the Australian economy was purposefully transformed, as investment and employment shifted from farming and mining into manufacturing. Farming and mining employment declined from 30 per cent of the workforce in 1901 to 12 per cent in 1968, while manufacturing employment rose over the same period from 12 per cent to 27 per cent. Services (termed ‘Other' in the statistics) remained largely stable, shifting only from 58 per cent to 61 per cent. To reiterate, this transformation was not a ‘natural' shift or a simple response to ‘market forces', but a consciously targeted and implemented political and social vision.
To succeed in the transformation, Australia's leadership had to understand comparative advantage in a novel way: not as an imperative to narrow the economy to a few advantaged sectors, which would export while the rest of the things the nation wanted to consume were imported; rather, as a source of finance to build the kind of economy that would support the liberal-democratic, diversified, middle-class nation in which Australians aspired to live.
