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Home , New trade theory

Christoph Gelbhaar [email protected]

Sonderburger Straße 105, 68307 Mannheim, Germany 0049 176 528 29 180

Working Paper for the 23rd Annual Conference of the European Society for the History of Economic Thought

(University of Lille, 23-25th May 2019)

A tradition of conceptual confusion in the history of international theory

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<< If there were an Economist‘s creed, it would surely contain the affirmations “I understand the principle of ” and “I advocate .” >>

<< From the early nineteenth century until the late 1970s, theory was dominated almost entirely by the concept of comparative advantage(…). >>1

To explain and contextualize the achievements of their ‘New Trade Theory,’ like use statements like these. The history of scientific theory concerning international trade is divided in two parts, with their own theoretical contributions being the dividing event: From to the later 20th century, the whole theory of international trade was dominated by and built around the concept of comparative advantage. But this undue dominance has ended, they tell us. It ended when the ‘New Trade Theory’ gave us formal models of non-comparative advantage trade due to increasing .2

The premise of this account is hardly controversial; nor should it be. Economists have long been exaggerating the degree to which a mere understanding of the concept of comparative advantage, when combined with factual knowledge on the actual pattern of comparative advantages, had been enabling them to explain and predict the contents and directions of the flows of international trade. And they have certainly been exaggerating the degree to which the mere initiation into the concept of comparative advantage had to be equated with an introduction into an established truth concerning , that is, an insight into the superiority of free trade.

But what, precisely, has been the nature of this exaggeration?

Krugman sees it as a matter of omission and emphasis. In his account, economists had always understood that the impact of increasing returns to scale on trade was something that their models of comparative advantage had not fully captured. But since, originally, they weren’t able to model this other factor of influence on trade gains and trade patterns, they simply omitted it in their textbooks. They only incorporated what they could model: comparative advantage trade.

1 Krugman, Paul R.: Is Free Trade passé?, in: The Journal of Economic Perspectives 1 (1987), Nr. 2, p. 131-144, here: p. 131 and 132. 2 This is ‘work in progress,’ a conference working paper for the sole purpose of facilitating discussion of the author’s presentation at the ESHET gathering in Lille in May 2019. However, please feel invited to share your thoughts. Please feel free to contact the author using this address: [email protected]. The author would be especially interested in learning about ESHET members who are publishing on the same subject or related subjects in other languages. 2

So his account contains two hypotheses, one factual and one causal. Firstly, the exaggeration appears to be mainly a thing of the past that has been overcome, that has already been eliminated in modern textbooks. And secondly, it has supposedly been overcome by the same progress of scientific knowledge that created it: International trade theory has followed “the path of least mathematical resistance,” progressing naturally from the simpler models of comparative advantage to the New Trade Theory after the latter had been made possible by new models of ‘imperfect .’3

But the end result of this supposedly continual scientific evolution has been a change in political implications, though a rather limited one. Together with the accumulating knowledge on the of trade policy, the New Trade Theory is still providing a lot of weighty arguments against . But the status of free trade, according to Krugman, has “shifted from optimum to reasonable rule of thumb. There is still a case for free trade as a good policy, and as a useful target in the practical world of politics, but it can never again be asserted as the policy that economic theory tells us is always right.”4

By implication, the concept of comparative advantage should have lost most of its special status as well. For an ‘’s creed’ that equates initiation into this concept with an insight into the optimality of a certain policy is not in line with the state of professional knowledge anymore.

As a matter of course, the insight that survival in international competition does not necessarily depend on absolute cost advantages remains of the utmost importance. It still is, or rather could be and should be, a powerful pedagogical weapon against the most vulgar versions of protectionist demagoguery.

3 Krugman, Paul R.: Rethinking International Trade, Cambridge (Ma.) 1990, p. 3-4: „(…) [O]ne may wonder why it took so long for the new theory to emerge. The main answer is that while trade based on increasing returns is easy to talk about in a general sense, it is difficult to model formally. Since as practiced in the English-speaking world is strongly oriented toward mathematical models, any economic argument that has not been expressed in that form tends to remain invisible. While many economists no doubt understood that increasing returns could explain international trade even in the absence of comparative advantage, before 1980 there were no clean and simple models making the point. As a result this idea was often simply left out of textbooks and trade courses, and even good trade theorists often seemed unaware of the possibility. (…) The long dominance of Ricardo over Smith - of comparative advantage over increasing returns – was largely due to the belief that the alternative was necessarily a mess. In effect, the theory of international trade followed the perceived line of least mathematical resistance. Once it was clear that papers on noncomparative-advantage trade could be just as tight and clean as papers in the traditional mold, the field was ripe for rapid transformation.” 4 Krugman, Is Free Trade passé?, p. 132. 3

But the concept’s perceived status relative to less crude versions of protectionism should now basically equal the status of the concept of increasing returns. While generally considered to be a major reason for the mutual profitability of trade, increasing returns are also and have always been the key ingredient in sophisticated arguments for the potential desirability of protectionism under specific conditions. Comparative advantages can now be assigned to the same role.

Take, for example, the model of ‘External Economies and Specialization’ in Krugman’s and Obstfeld’s bestselling textbook. This model aims to explain a theoretically valid argument for protection: A fully established industry residing in a comparatively disadvantaged country can nevertheless survive, due simply to the early start that it enjoyed relative to its potential competitors, for the of localized in this industry will discourage any new individual investment in other countries that would otherwise be advantaged, be it absolutely or comparatively. But this means that, technically, unused comparative advantages can provide an additional argument for infant industry protection: According to the model, if the aim is to maximize both global and national welfare by redirecting international trade so that it will eventually conform to the pattern of comparative advantage, this aim might then call for a protectionist policy.

But as a matter of fact, economists still represent the introduction into the concept of comparative advantage as a provision of an insight into the wisdom of free trade, while assigning other textbook contents to the role of the qualifications. The concept’s special status remains intact.

And this shows why Krugman’s account of the history of the discipline should indeed be controversial, both with respect to the supposedly achieved elimination of international trade theory’s undue domination by the concept of comparative advantage and with respect to the factors that have ostensibly sustained and ended this domination.

And though criticism of the account is usually not explicit, neither is it rare. It usually takes the form of papers or statements criticizing the “theory of comparative advantage,” a theory that is supposedly the core of a textbook orthodoxy on the subject of international trade – a currently dominating orthodoxy, not one of the past. Although the theory is usually criticized without being precisely defined beforehand, it is clear enough what its content is thought to be: It is vaguely understood as the postulate that the contents and directions of the flows of

4 international trade are generally determined by the patterns of comparative advantage, and that this clearly points to free trade as an optimal economic policy.

In this alternative view, the traditional exaggeration has not yet been overcome. Its elimination is still to be achieved, which is precisely what the critics of the “theory” understand to be the purpose of their critical efforts.

And this “theory” is not just a straw man, put up by the critics of textbook orthodoxy to inflate the importance of their contribution. A “theory of comparative advantage” is actually mentioned in many of the criticized textbooks, as a theory that is generally valid and that has been proven by David Ricardo in 1817. Some even call it the “law of comparative advantage.” The description of that supposed law usually contains not more than an explanation of the concept of comparative advantage, plus sometimes a description of one of the mechanisms that can turn comparative cost advantages into absolute advantages. But the law is nevertheless presented as “one of the most important laws in economics” (as, for example, in Dominick Salvatore’s “. Trade and Finance”), and it is often explicitly presented not as an argument for, but as proof of the general desirability of free trade.

Most notably, Paul Krugman himself has continued to take note of the concept’s special status ever after his ‘New Trade Theory’ supposedly emancipated international trade theory from its dominance. For example, here is Krugman in 1993, writing 6 years after he proclaimed the end of that dominance in “Is Free Trade passé”:

“Why are economists free-traders? It is hard not to suspect that our professional commitment to free trade is a sociological phenomenon as well as an intellectual conviction, that is, that there is more to it than our altruistic desire to persuade society to avoid deadweight losses. After all, if social welfare were all that were at stake, we should as a profession be equally committed to, say, the use of the price mechanism to limit pollution and congestion. However, support for free trade is a badge of professional integrity in a way that support for other, equally worthy causes is not. By emphasizing the virtues of free trade, we also emphasize our intellectual superiority over the unenlightened who do not understand comparative advantage.”5

5 Krugman, Paul R.: The Narrow and Broad Arguments for Free Trade, in: The American Economic Review 83 (1993), No. 2, p.362-366, here: p. 362. Krugman has made many similar utterances throughout the decades that followed. For a particularly recent example, see Krugman, Paul R.: Killing the Pax Americana. Trump’s is about more than economics, in: New York Times, May 11, 2019: “Trump’s critics, while vastly more accurate than he is, also, I think, get a few things wrong, or at least overstate some risks while understating others. On one side, the short-run costs of trade war tend to be overstated. […]Maybe the larger point here is that there tends to be a certain amount of mysticism about trade policy, because the fact that it’s global and touches on one of the most famous insights 5

Evidently, then, the concept’s special status has not disappeared, and the ‘Economist’s creed’ built on it is very much alive.

And this means that we have to search for at least some complementary explanations for what has sustained it for so long. Economists are still exaggerating the degree to which a mere understanding of the concept of comparative advantage will lead to a correct representation of the actual flows of international trade. When this hasn’t been changed, neither by neat new models of ‘noncomparative-advantage trade’ nor by the empirical realization that much of modern international trade is, in fact, noncomparative-advantage trade, when the link between the concept of comparative advantage and free trade as “the policy that economic theory tells us is always right” has survived its theoretical falsification, then neither the beginning nor the end of this tradition can be explained as the products of analytical progress alone.

But where should we look for an alternative explanation? We should take up the hint given by the confused parlance of the textbook authors, who write of a ‘concept’ or a ‘theory’ or a ‘law of comparative advantage’ without ever explaining whether they see a difference between those or not. For, evidently, a concept is not the same thing as a scientific theory, and a scientific theory is not the same thing as a scientific law. What is needed, therefore, is an exercise in Begriffsgeschichte, in the history of concepts. To gain a better understanding of the history of the concept of comparative advantage and its special status within economics, we need a better understanding of the concept itself: We ought to analyze how the concept has been represented by economists, how it has been defined, how it should have been defined and how it has not been defined.

in economics, the theory of comparative advantage, gives it an amount of mind space somewhat disproportionate to its actual economic importance.” 6