Economic Policy and Theory - International trade theory: from trailblazers to twentieth-century professionals

The British philosopher and economist John Stuart Mill (1806–1873) updated (and endorsed) much of Ricardo's analysis with his 1848 publication, Principles of Political Economy. The first to emphasize that allocation of resources and distribution of income are two somewhat distinct roles performed by modern market systems, Mill parted company with earlier classical economists by suggesting that policy could indeed shape the distribution of income. The late nineteenth-century (principally 1871–1877) analyses of William Stanley Jevons (1835–1882) in England, Karl Menger (1840–1921) in Austria, and Leon Walras (1834–1910) in Switzerland saw the emergence of the marginalist school of economic theory. Reorienting economic analysis away from theories of price determination that had relied exclusively upon supply-side factors or the costs of production, the marginalist school significantly updated the analyses of Smith and Ricardo and the classical economic theory built upon their writings. Beginning their theory of prices (and therefore of production and allocation as well) with consumer behavior and consumer choice, the marginalists moved economic theory closer to the consumercentered philosophy espoused, but never developed systematically or mathematically, by Smith. Walras would do this to great effect, for example, with his creation of demand functions, mathematical functions that for the first time expressed the quantities of a given product or service as they were determined collectively by consumer income, consumer preference or taste, product price, and product price relative to other related goods or services.

Until the assiduous efforts of Alfred Marshall (1842–1924) on behalf of the discipline and profession in England, however, economics was the vocation of few in academe, public policy was constructed with little or no professional economic advice, and international trade theory in particular had progressed only a little past its Smithian and Ricardian foundations. Academic chairs in political economy had been established early in the nineteenth century, but throughout much of that century most were either vacant or held as a secondary occupation. Jevons, Menger, and Walras, in fact, all worked in professions out-side of academe before being appointed to chairs in political economy at universities in England, Austria, and Switzerland. Jevons's government post as an assayer in Sydney, Australia, appears to have convinced him, in fact, that public officials required more—and more consistently offered—professional economic policy advice. Despite their later association with schools of free-market or even anti-government economic analyses, the progenitors of the marginalist revolution gravitated to economic theory out of concern for public policy, much of which centered on international affairs and international trade. Like Jevons, Menger, and Walras, the first professional economists found themselves holding academic chairs in political economy; the fledgling science and public policy were undeniably woven together. Until the twentieth century, however, the designation implied no distinct body of knowledge or craft. In Ireland, for example, it fell initially under the instruction of law, changing soon after into a course of study geared principally to business or industrial management.

Professor of political economy at the University of Cambridge from 1885 to 1908, Marshall began his teaching career in 1868 at St. John's College, Cambridge, as a lecturer in moral sciences. When he retired from teaching in 1908 to devote his final years to writing, he had succeeded in establishing a new honors examination (tripos) in economics and politics (1903) at Cambridge, had bequeathed to economic analysis the critical distinction between the short run and the long run (in what he called "period analysis"), and had established political economy as a distinct subject worthy of widespread study and generous public attention. The London School of Economics opened in 1895, and Oxford University offered its first diploma in economics in 1903, attesting to the rising popularity and increased relevance of economic study. Marshall's direct contribution to international trade theory was limited to his analysis of two-country trade with intersecting "offer curves" and its concomitant analysis of demand elasticity (how the increase of goods offered by one nation might affect the quantity of goods offered by a trading partner). The term "elasticity," so widely used by economists today to denote the ratio of change between dependent and independent variables, was Marshall's invention. More significantly, his attention to the professional standing of economists, his willingness to engage in policy debate and to observe real economic conditions and changes, and his conscious linking of modern economic analysis to classical foundations paved the way for the most significant twentieth-century breakthroughs in international trade theory.

Marshall's major work devoted to international trade issues, Industry and Trade, published in 1919, may well have lacked theoretical consistency or structure precisely because it considered so closely recent trends and activities in British and world trade networks. Indeed, his attention to the practical reach of modern economics led to the frequent inclusion in all of his writings of cautionary notes on what might or might not be successfully "impounded" in analytic assumptions about dynamic economic processes. These caveats remain significant today. For Marshall, any accurate depiction of dynamic economic processes required more information than was ever possible to obtain, an insight proved increasingly sound by the limitations and shortcomings of the newest and most ambitious computer-generated models.

Marshall also created a theoretical path that tended to consolidate and synthesize previous lines of economic analysis constructed upon a classical and orderly market-clearing conception of the economic world. As economic science matured and academic posts in political economy proliferated around the turn of the twentieth century, a classical consensus emerged, much of it constructed upon Marshall's edifice. With his Theory of International Trade, with Its Application to Commercial Policy, published in 1936, Gottfried Haberler introduced an expansive reformulation of this emerging consensus by fitting it with the dynamic language of general equilibrium analysis. The benefits of free trade could subsequently be viewed in terms of both direct and indirect effects, bringing free trade theory closer to real world phenomena. And though German historical economists and American institutional economists, such as Thorstein Veblen, pointed dramatically to the ways in which economic reality differed widely from the behavior predicted by classical economic theory, they offered no compelling theoretical substitute.

Only the economic dislocations of World War I and the onset of the Great Depression compelled economists to urge greater caution and to force the construction of new theoretical pathways, many of which highlighted and served questions of international trade. That levels of international trade had declined so precipitously during the Great Depression—by two-thirds in nominal dollar terms and by one-third in real, inflation-adjusted terms—made it virtually impossible to consider new economic ideas without an unwavering focus upon international trade.

The principal economists of this interwar period nudged theory onto different planes and punctured much of the prevailing orthodoxy regarding general economic adjustment, unemployment and investment, and the influence of money and interest rates. Free markets were judged increasingly as artifacts of the imagination and as abstractions toward which behavior was often inclined but seldom made manifest without significant gyrations, fits and starts, or failings of even the simplest economic prophecy. Free trade orthodoxy, however, proved to be something else; it depended in part upon a free market framework for much of its explanatory power, yet it also came to be viewed increasingly as a sphere of potentially unrestricted behavior existing atop a large assortment of thoroughly regulated or more artificially cultivated domestic economic affairs. In the face of rising skepticism toward the usefulness of the free market abstraction, and rising trade protectionism—the first significant departure from freer trade since the beginning of the nineteenth century—the tenets of the prevailing free trade orthodoxy emerged virtually unchanged.

In 1921 the American economist Frank Knight (1885–1972) published Risk, Uncertainty, and Profit, in which he distinguished between insurable risk that could be mostly ascertained and uninsurable uncertainty that proved impossible to predict. Almost ten years later the Swedish economist Gunnar Myrdal (1898–1987) published Monetary Equilibrium (1930), in which he introduced the terms "ex ante" and "ex post," underscoring both the distinction and the relation between expectations and outcomes and the unpredictable ways in which savings equaled investment. And in 1936 the British economist John Maynard Keynes, a former student of Alfred Marshall's, published The General Theory of Employment, Interest, and Money, in which he questioned both the microeconomic and the automatic and instantaneous market-clearing foundations of inherited classical theory.

Yet, despite increasingly numerous challenges of this kind, the implications and tendencies of inherited theory on questions of international trade remained virtually untouched. After extensive involvement with the German reparations question after World War I, as well as the debate surrounding the British return to the gold standard in 1924, Keynes had surely proven his interest in international affairs. Later in his career he looked increasingly to the United States for the most practical and noteworthy application of his increasingly refined economic principles. And Keynes's General Theory did carry implications for how nations might best effect freer trade and how domestic policy formulation should account for the dislocations and perturbations introduced by an increasingly open and free international trade network. But these implications were in no way an assault upon the general free trade consensus. Indeed, few direct theoretical challenges to free trade emerged in the late twentieth century, despite recurring offensives launched by politicians and various labor movements, and the relatively desperate reaction to economic recession.

From the General Agreement on Tariffs and Trade (GATT), signed in Geneva, Switzerland, on 1 January 1948, through the seven GATT revisions and negotiating rounds beginning in 1955 (and within World Trade Organization negotiations after 1994), free trade resumed its ascent in policy-making circles. Crafted as a means to expanded multilateral trade in the post–World War II era, GATT began with nine signatories (including Cuba) and expanded to include 128 by 1994; in 1995 it was subsumed under the newly formed World Trade Organization. Pausing only for the briefest moments during late twentieth-century recessions that paled in comparison with the calamity of the 1930s, free trade-centered theory found itself with fewer and fewer detractors and policy once again conformed generally to theory.

Implications of The General Theory Despite the perceptible ascendancy of Keynesian economics in the second half of the twentieth century, many of the questions raised by Keynes in The General Theory remain unsettled. His own followers, for example, continue to argue over whether Keynes described an economy that commonly achieved equilibrium—albeit at unacceptably low levels of output from time to time—or one characterized by continuous oscillations around a stable point or plateau. Few would argue, however, that Keynes did not describe an economy that converged on equilibrium—whether it could ever reach that point or not—by means of changes in income and output rather than through rapid and responsive price adjustments. Indeed, as Janos Kornai later explained, such tendencies may well be universal in modern, mass-production economies, whether capitalist or not. In Kornai's formulation, when confronted with underutilization and excess capacity, Western capitalist economies produced unemployment, whereas the command economies of the East, former and present, produced shortages of consumer goods. Under both schemes, price adjustments played no significant role. This may explain in part why officials in the People's Republic of China have in recent decades been so eager to learn Keynesian economics. Although Keynes left much of the explanation of sticky prices to his successors, he noticed the obvious way in which interest rates, wages, and commodity prices responded in Great Britain and abroad. And since they moved too slowly, haltingly, or imperceptibly to clear markets effectively enough to secure full employment, this led Keynes to his revolutionary conclusions regarding effective demand and the causes of economic stagnation or recession.

Ironically, regarding trade among nations, Keynes had first overlooked this kind of adjustment. The Swedish economist Bertil Ohlin (1899–1979) did much to establish his reputation by disputing Keynes's rendering of the post–World War I German reparations problem, which Keynes had couched solely in terms of relative price changes. Although prejudiced somewhat by his belief that geographic endowments ordained Germany to lead the European economy, Keynes also believed that Germany faced a double burden under its requirement to pay reparations as determined under the armistice. First, it had to tax its citizens to pay for reparations, and second, it had to cheapen its export prices relative to its import prices by lowering wages at home (to effect export surpluses needed to transfer marks to foreign reparations creditors). Ohlin noted that the first burden would likely remove all necessity for the second; new German taxes sent abroad would simultaneously lower German demand and increase the demand of Germany's foreign creditors. And this would effect higher levels of German exports and lower levels of German imports without any relative change in the levels of German wages or export goods.

While Keynes eventually termed the debate "muddled" due to his insistence on the genuine possibility that creditor nations might entomb the German payments in hoarding or newly erected import barriers—a possibility largely ignored by Ohlin—the latter's argument had made its mark. Indeed, not long afterward, Keynes moved swiftly through a series of theoretical gyrations—building on and then dispensing with the quantity theory of money; finishing his Treatise on Money (1930) by reemphasizing in part his reparations policy argument and, at the same time, orienting himself more toward a general theory built upon a closed, static economy that underscored Ohlin's emphasis upon output or demand changes. Here, currency transfer and associated international trade problems diminished in importance and could be solved with less restricted currencies or special taxes on income from foreign lending. Free trade theory could march on not because it guaranteed the most efficient placement of all resources or global full employment, but because it only helped, and could largely be ignored if one could both loosen the "furtive Freudian cloak" of the gold standard-based, fixed exchange rate regime and focus instead on the stabilization of demand at home. Within a few years of the publication of the Treatise, Keynes encouraged President Franklin D. Roosevelt to make the currency and exchange policy of the United States "entirely subservient" to the aim of raising output and employment.

Heckscher-Ohlin, Factor-Price Equalization, and Real Free Trade Patterns If the abstract economic advantage of free trade had been well established by the late 1930s, the way in which free trade actually worked required additional explanation. Building upon "The Influence of Trade on the Distribution of Income," an article written in 1919 by his teacher, Eli Heckscher (1879–1952), Bertil Ohlin undertook analyses that would consolidate more completely the preeminence of the free trade persuasion in the process. Heckscher, under whom Ohlin had studied from 1917 to 1919 at the Stockholm School of Economics and Business Administration, and whom Ohlin succeeded in 1930, envisioned his article as a minor updating of classical Ricardian theory, which had, like Ricardo's Law of Comparative Advantage, done nothing to address the reasons for the existence of such advantage. Using both Heckscher's paper and his own graduate research, Ohlin staked out a theoretical position that began to explain the existence of comparative advantage, suggested the stringent real world requirements for the exploitation of free trade principles, and in part revived location theory, a substantial part of Adam Smith's cosmology that had been lost to most economists outside of the German historical school. Walter Isard's subsequent work in the economics of location and in regional economic studies, reflected principally in his 1956 publication Location and Space Economy, followed in part this theoretical pathway reopened chiefly by Bertil Ohlin.

As illustrated in Ohlin's Interregional and International Trade (1933)—for which he won the 1977 Nobel Prize—the Heckscher-Ohlin theorem explained how a nation will tend to have a relative advantage producing goods that require resources it holds in relative abundance (and an advantage importing those goods that require relatively scarce resources). If a nation possesses a relatively greater abundance of labor than its trading partners, for example, it will most frequently export products derived most intensively from labor, rather than capital, inputs.

In 1922, Ohlin had submitted a paper to Francis Edgeworth (1845–1926), Drummond professor of political economy at Oxford and Keynes's coeditor of the Economic Journal, in which he introduced the mathematical outlines of what would become the Heckscher-Ohlin theorem. Though Keynes responded to Edgeworth's request for comment with a curt "This amounts to nothing and should be refused," it was one of Keynes's foremost American disciples, Paul Samuelson, who further refined the Heckscher-Ohlin theorem. It soon became a staple of virtually all general economics texts, including Samuelson's own best-selling work, first published in 1948.

Samuelson's Economic Journal article, "International Trade and the Equalization of Factor Prices," also published in 1948, underscored and refined Ohlin's theoretical work. In this article, Samuelson exploited Heckscher-Ohlin to provide a polished mathematical explanation for how free trade might well serve as a substitute for the free mobility of capital and labor. He extended the theorem to reveal how the change in price of an internationally traded commodity effects a similar change in the income of the factor (labor or capital) used most intensively in producing it. From this followed what he termed the factor-price equalization theorem: as free trade narrows differences in commodity prices between nations, it must also, under the same conditions, narrow differences in income accruing to the factors of production. Thus, free trade naturally lessens the differences and resulting imbalances introduced by immobile or relatively immobile workers, factories, or natural resources.

By dropping one modifying assumption of Ohlin's theory after another (zero transportation costs and import duties, flexible exchange rates, immobile capital, etc.), Samuelson revealed both the positive force and efficiency of a hypothetical free trade regime and the stringent conditions necessary to carry out such a regime. Indeed, as the empirical work of Wassily Leontief revealed, Heckscher-Ohlin did not always fit the real world. Building on his groundbreaking work in input-output studies, Leontief noted in his "Domestic Production and Foreign Trade: The American Capital Position Re-Examined" (1954) that American exports tend to be labor intensive while American imports are mostly capital intensive, results in direct opposition to those suggested by the Heckscher-Ohlin theorem. Likewise, when put to the test, the purchasing power parity theory—developed principally by another of Ohlin's Swedish professors, Gustav Cassel (1866–1945)—appears to have equal difficulty fitting real world conditions. Relating free trade flows to international currency matters, purchasing power parity suggests that the purchasing powers of currencies in equilibrium would be equivalent at that rate of exchange. The exchange rate between any two national currencies should, in other words, adjust to reflect differences in price levels in the two nations.

The chief factors that account for the breakdown of purchasing power parity—currency speculation in foreign exchange markets, an abundance of goods and services that are not traded internationally, the extensive trading of financial assets, and the difficulty with which both general domestic and comparable international price levels are determined—also account in part for the potential invalidity of the Heckscher-Ohlin theorem. That Leontief found an apparent contradiction in the U.S. example may only suggest that its economy is both more varied and complex than that of most other nations, and that its behavior consistent with the Heckscher-Ohlin pattern may simply be more readily found within its regional, as opposed to international, trading networks.

Such theoretical insights proved to make Samuelson a virtually indispensable economic policy adviser. Indeed, as chairman of the task force advising president-elect Kennedy in 1960–1961 on economic policy (and Kennedy's first choice for chairman of the Council of Economic Advisers), Samuelson may well claim paternity of Kennedy's efforts on behalf of free trade. The Trade Expansion Act (TEA) of 1962, the first significant American legislative sponsorship of free trade since the 1934 Reciprocal Trade Agreements Act, bore the stamp of Samuelson's theoretical work and policy advice. Well aware of the elusive conditions under which an ideal free trade regime might be enacted, Samuelson provided a sound theoretical footing for the pragmatic approach reflected in the TEA, one of President Kennedy's few major legislative victories. Giving rise to the so-called Kennedy Round of GATT negotiations, which reduced import duties on industrial goods worldwide by approximately 35 percent (and by a remarkable 64 percent for American-produced goods), the TEA also included new restrictions on textile imports. A historic mile-post on the road to greater trade liberalization, the TEA nonetheless reflected a pragmatic appraisal of real-world economic conditions and policy limitations. Trade liberalization for manufactured goods was likely impossible without the textile industry protections.

Lingering Theoretical Challenges Appointed to teach international economics at the London School of Economics in 1947, James Edward Meade (1907–1995) launched a book project to help him better grasp the ideas he hoped to convey to his new students. The resulting Theory of International Economic Policy, published in two volumes ( The Balance of Payments in 1951; Trade and Welfare in 1955), attempted to integrate domestic and international policy, pre-Keynesian price effects with Keynesian income effects, and abstract free trade patterns with real world tendencies that often included or necessitated trade control. Recognizing and underscoring the notion that legitimate government assistance (international market research, for example) is often difficult to distinguish from subsidized trade protection, Meade discovered the "theory of second best." In Meade's formulation, abstract free trade models may well produce less than optimum outcomes, given real world conditions or tendencies. His theory of the second best revealed how a free trade regime might countenance alternative policies that diverged from absolute free trade principles, protecting the authentic gains from freer trade in the process. Subsequent to Meade's discovery, few criticisms of free trade outcomes found anything but a loose theoretical foothold, especially so if the free trade regime itself became the object of criticism. After Meade, few of these criticisms represented broad theoretical challenges to the growing free trade orthodoxy but were, instead, reminders that imperfect conditions and irrational economic behavior had to be accommodated—or isolated and marginalized— within the prevailing regime.

The chief ongoing quarrel with increased trade liberalization appears to be a criticism of theorists and policymakers who conflate international free trade with domestic free markets, or international trade with international capital flows. With the recent advent of policy initiatives such as Trade Related Investment Measures (TRIMs), it has become easier to make such a conflation. Promulgated by the World Trade Organization, TRIMs are measures that force nations to compensate foreign investors for rules imposed after their initial investment (such as minimum wage increases). But free trade need not imply a policy of strict noninterference on the part of national governments (or even international organizations); some, like Charles Kindleberger, have suggested that government-sponsored domestic prosperity may even be a prerequisite for the enlargement of free trade networks abroad. If such enlargement requires that one prosperous nation serve as a lender or buyer of last resort, and be willing to sacrifice parts of some internationally exposed markets in the process, then this may well be the case.

As free trade theory and policy burnished their standing among policymakers worldwide in the last quarter of the twentieth century, economic circumstances continued to raise nagging questions. The distributional effects of trade often appeared to undermine general prosperity; protectionist regimes often appeared beneficial if introduced skillfully enough to avoid retaliation; free trade appeared to undermine environmental protection in developing nations. The Prebisch-Singer theory arose directly in response to rising distributional problems, particularly those that surfaced in the southern hemisphere. Named for Raul Prebisch (1901–1986), professor of economics at the University of Buenos Aires and the first director-general of the UN Conference on Trade and Development, and Hans W. Singer, German-born UN economist who had trained under both Joseph Schumpeter and Keynes, the Prebisch-Singer theory suggested that international free trade reinforced harmful economic development practices in the developing and least developed countries. Because colonialism had produced unsustainable economic structures in these nations based on the encouragement of exports—most of which were inexpensive raw materials—Prebisch and Singer argued that trade protection and import substitution strategies were necessary if these developing nations were to strike out onto a sustainable path of growth and prosperity.

An agreement to set up a common raw materials price support fund of $750 million, after deliberations at the fourth UN Conference on Trade and Development, came as a direct result of Prebisch-Singer. Prebisch later suggested, however, that he was motivated primarily by the promise of industrialization, well suited to policies of import substitution but not, perhaps, to the labor surpluses so evident in the developing economies. Noticing later that increased wealth and increased demand for imports in developed nations might well improve the terms of trade for developing countries, Singer also modified his theoretical conclusions and policy recommendations. The slow maturation of the Latin American economies in the early post–World War II period, combined with rising American and European prosperity in the 1950s and 1960s (especially the latter decade), perhaps masked the ways in which protectionism and import substitution may have easily become self-defeating strategies. These developing nations matured and came to depend increasingly upon external markets and capital only a few years before the stagflation, oil price hikes, and higher interest rates of the 1970s obliterated gains on both sides.

The apparent success of East Asian protectionist regimes in the late twentieth century and the onslaught of developing world environmental crises also cast doubt upon the superiority and applicability of free trade theory. But here, as well, theorists have largely acknowledged that protectionist regimes can flourish only when foreign sources of prosperity offer forbearance and accommodation in place of retaliation or increasing autarky. Absent undemocratic political systems and regressive fiscal and monetary policies, most theorists have also inferred that global free trade need not prevent environmental stewardship, just as it need not prevent lessened inequality within or between nations. Most have concluded that it is economic growth itself and the associated capital intensity that bring pressure on the natural environment. Free trade has essentially been implicated, then, in environmental crises as little more than the handmaiden of economic growth. If free trade is not distinguished from the absolute free market, however, such theoretical conclusions often remain opaque and virtually incomprehensible. And since the theoretical gains from freer trade tend to be as regressive as the theoretical gains from economic growth in general, the conflation of free trade with laissez-faire only serves to make trade theory even more ambiguous. Linking trade theory to development and growth theory, Gunnar Myrdal and others urged deliberate policy initiatives, without which lessened inequality and growth would prove unattainable. Failing to make that distinction, they argued, would place "second best" policy and the progressive, compensatory measures it often required beyond reach and would render free trade incapable of fulfilling its modest theoretical promise.

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