International trade: Separating fact and fiction

December 7, 2010, 12:41 pm By Andrew Page andrewpage

All disciplines are beset by various fallacies, but it's reasonable to say that economics suffers more than most.

All disciplines are beset by various fallacies, but it's reasonable to say that economics suffers more than most. The trouble in part stems from a general lack of basic economic literacy, but also due to the fact that, at its heart, economics is the study of human interaction. As with all social sciences, it is far from an exact science and divining fundamental truths isn't always straightforward.

Nevertheless, economists have made great progress over the years and it would be foolhardy to dismiss much of what they have to say, at least in terms of the structure and consequence of our commercial interactions (it's a different story when it comes to their forecasts) Yet regrettably it seems that is exactly what many of us do, including our most influential policy makers.

Take the example of international trade, a topic that often provokes heated debate. Yet the absence of any concrete understanding, from both proponents and critics, is quite stark. Most argument revolves around one of the biggest economic fallacies of all: that there is competition between trade partners. In point of fact, there is no such thing.

Trade is mutually beneficial

To understand why this is so, we need to appreciate that trade is, to borrow a phrase from Robert Nozick, "a capitalist act between consenting adults". In other words, trade is entirely voluntary: people, companies, and countries will only ever trade when both parties see the exchange as beneficial (otherwise they simply wouldn't trade). Under a system of voluntary exchange, it is incorrect to view trade between two parties as competitive; rather it is cooperative and mutually beneficial.

For example, when Australia sells iron ore to China, it is not competing with the tiger economy (it may be competing with another country that also wishes to sell ore to China, but there is no competition between China and Australia in this case). And the only reason we would sell our ore to China is if we get something in return. Specifically, Chinese products.

Currency exchange obscures this underlying fact, but at its heart international trade is an exchange of goods and services. We provide ore to China because they have something that we want in return (things like clothing, household goods etc). Yes, we could produce this stuff ourselves, just as China could choose to mine ore within its own borders (or buy it elsewhere), but both are happy to trade because it offers a benefit to both parties.

Making shorts by mining ore

Think of it this way, there are two ways for Australia to produce, say, clothing. We could make it domestically or alternatively we could dig up some iron ore, sell it to China and buy clothes with the proceeds. Either way we get what we want, it is just that one method may be much more efficient than the other. And indeed, although I have greatly simplified things, this is largely the case.

So when you think about it, from an economy wide perspective, Australian clothing manufacturers are not in direct competition with the Chinese; they are competing domestically with the minerals industry. If Chinese demand for ore continues to provide us with plenty of yuan, it will probably remain more efficient for us to obtain a lot of our products from China rather than to produce it ourselves.

Basically, if you don't like the idea that we are importing a lot of stuff from China, you should lobby the minerals industry to be less efficient, or to stop selling its wares to China. Alternatively, you could plead with Australian consumers to buy more expensive locally produced goods. In either case, you have a tough sell. Good luck.

Comparative advantage

It all comes down to focusing on the things you are comparatively good at, and out-sourcing things that you are comparatively weak at. If we are better at mining ore and China is better at making cloths, it stands to reason that we would benefit from trading with each other. Indeed there are huge efficiency gains to be made here, even though particular industries and individuals may suffer as a result of the arrangement. The point to note though is that, on a net basis, there is really no significant net loss of income; just a transfer to other areas of the economy. Certain industries may suffer, but only if others gain.

In our example, a loss of income in the clothing manufacturing sector is essentially offset by a gain in the minerals sector. You can argue for or against the trade relationship on that basis, but don't make the common mistake of thinking that the Chinese are "stealing our jobs". It is not just overly simplistic, it is downright wrong. In essence trading relationships may result in some economic restructuring, but they don't necessarily lead to a net loss of jobs. Indeed, trade can often lead to significant wealth creation opportunities. (This is why trade sanctions can be so disadvantageous).

Wages are too high

Another symptom of a narrow perspective on trade is that people will claim that lower wage rates and weaker corporate regulations in places like China gives them a competitive advantage. As such, they argue for a relaxation of standards in the name of international competitiveness, but in essence they are simply advocating a 'race to the bottom' for all involved.

As we have seen, within the scope of two trading nations, all competition is ultimately domestic. Just because Chinese factory workers are paid a pittance, doesn't mean that we are necessarily at a disadvantage by having much higher labour standards. Each worker operates within his or her own economy, and is paid in the local currency.

Yes, Australians receive better pay and conditions, but we must also live in an economy with higher prices (and of course we enjoy higher standards of living and far superior public services). Again, currency exchange rates are obscuring what is essentially going on: the mutually beneficial exchange of goods and services. Regardless of how a country produces its exports, whether that be through slavery or advanced robotics, it is the comparative differences that count. In other words, it's all about how things stack up relatively within each economy.

The role of currency

Of course although trade is essentially all about goods and services, we do not live in a barter economy: we use currency as an economic intermediary. However we must appreciate that the Australian dollar is useful for one thing and one thing only: to purchase Australian goods and services. (Note that foreign investment ultimately rests on this too; foreign entities that invest in Australian financial products receive a return in Australian dollars, and again this is of use only if you want Aussie goods and services, or if you can trade the currency to someone else who does).

Likewise the Chinese yuan is useful only for acquiring Chinese goods and services. Think of it like this; when the Chinese pay us for our ore, they do so by issuing a 'gift certificate', one that can only be redeemed in China.

So the demand for foreign currency is fundamentally driven by the demand for foreign goods and services. The relative exchange rate between trade partners will simply reflect this underlying fact. Of course things can quickly become complicated when you consider the network of global trade, but the fundamental principle is relatively straightforward.

A weaker dollar is better, or is it?

Note that such an understanding highlights another great economic fallacy; that a 'weak' currency is good for the economy. A lot of people are saying that the current value of the Aussie dollar is hurting our exporters, and they are right, but again they are forgetting that trade is a reciprocal act. Of course a weak currency is good for exporters, but it's equally bad for importers. If you like the kind of things that we tend to import, such as plasma TV's and iPhones, you might want to be careful what you wish for here.

Some may argue that you need to consider whether a country is a net exporter or importer, but again there is no such thing in the long term. A trade surplus or deficit is defined over specific intervals, but in either case Australia is either accumulating foreign currency or our trade partners are accumulating Aussie dollars. In the case of the latter, you can bet that our trade partners will wish to spend their Australian dollars at some stage (that is to redeem their Aussie 'gift certificates'), or trade them to some other country that does. And as I've pointed out, you can only spend Aussie dollars in one place on Earth.

As is often the case, it depends on your perspective (hence the heated argument between various interest groups), but the point is that broad statements over the relative exchange between countries are usually unhelpful, misleading and self serving. (It's the same thing with the notion that high interest rates are "bad"; depositors would strongly disagree).

So what?

So what is to be made of all of this? Of course we have considered things only from a very broad and fundamental perspective, but hopefully it has given you food for thought. Those trading currency would do well to take the time to understand the dominant factors that are the ultimate drivers of exchange rates.

For the rest of us, an understanding of the reality of international trade can help us better understand policy proposals, and help us cut through the mountain of misinformation and fallacious reasoning that dominates public debate.

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