Ptolemaic Trade Policy

More than four hundred years ago a Polish astronomer redrew the universe. Educated men throughout Europe believed in a spherical earth at the center of a collection of nested crystaline spheres, carrying along in their rotation sun, moon and planets. That picture, the Ptolemaic system, had been accepted since classical antiquity. Copernicus replaced it with the modern solar system: sun at the center, planets orbiting around it.

A little more than two centuries later two other brilliant men—a Scottish professor and a retired English speculator—produced a similar revolution in our picture of the world of trade. The old view—mercantilism—saw trade as a game of beggar your neighbor; the objective was to export more than you imported, take the difference in gold, and so grow rich. Since one country's imports are another's exports it was a game which pitted nations against each other, each trying to export more, import less.

What Adam Smith argued and David Ricardo later proved was that that picture was as much a fantasy as Ptolemy's crystal spheres. A nation that exports without importing is not making itself rich but subsidizing other nations—providing them automobiles, wheat, computers, while taking in exchange pieces of green paper. In Smith's day at least they got gold in exchange—but gold, although shinier than paper, is no better suited for food, clothing or housing. Nations get rich not by accumulating gold but by trading goods, each one exporting things it is relatively good at producing in exchange for the things it wants but is is relatively bad at producing.

Ptolemaic astronomy survives only in history books but Mercantilist economics is alive and well. The discussion of trade policy continues to be conducted in terms that have been obsolete for nearly two hundred years. It is as if editorials on the American space program warned that if we tried to launch a space probe beyond the moon’s orbit it would crash into the crystal sphere of the moon. The economic equivalent is talk about an "unfavorable balance of trade," the importance of remaining "competitive" or the need to "protect American workers from foreign competition."

The easiest way to explain trade as we now understand it—as we have understood it since Ricardo published The Principles of Political Economy in 1817—is to observe that the U.S. has two ways of manufacturing automobiles. We can build them in Detroit or we can grow them in Iowa. Everyone knows how we build automobiles in Detroit. To grow automobiles in Iowa, we start by growing the raw material they are made out of—wheat. We load the wheat on ships and send it out into the Pacific. The ships come back with Hondas on them.

Growing wheat and trading it for automobiles is just as much a way of producing automobiles—by American workers with American resources—as building them on an assembly line. If it costs fewer dollars in American resources and American labor to do it that way, we are better off growing our cars than building them. A tariff on automobiles is a way of forcing us to use the less efficient technology instead of the more efficient, to build automobiles when it is cheaper to grow them. It is a way of protecting American auto workers from the competition of American farmers.

A common worry in the U.S., probably in other countries as well, is that other countries will be better than we are at everything, that we will be "insufficently competitive," perhaps because we pay our workers more than people in India, or educate them less well than the Germans, or tax or regulate too much or too little—details vary with the political views of the worrier.

There are two ways to see why that is nonsense. The first is to imagine that India really is better than we are at everything—can produce cars, computers, wheat, rice, clothing cheaper than we can, and sell them all to us at prices our producers cannot match. What are the Indians getting in exchange? By assumption, nothing we produce is worth their buying. We are exporting dollars, which we can produce very cheaply, and living, free, on the bounty of India. A good deal for us but not one that Indian producers are likely to go along with.

The other way of seeing what is wrong with the idea is to note that in order to compare costs in India with costs in the U.S. we need a common unit. Indian costs are in rupees, American in dollars. To convert Indian costs from rupees to dollars requires an exchange rate—the price of dollars measured in rupees.

What determines that price? Like other prices it is determined by the forces of supply and demand. Dollars are supplied by Americans who want to sell them for rupees in order to buy things in India. Dollars are demanded by Indians who want to buy them with rupees in order to buy things in America. If everything were cheaper in India nobody in India would want to trade rupees for dollars, there would be no demand for dollars, and its price in rupees would fall. As it fell, American goods, bought with dollars, would get cheaper to Indians, who pay with rupees, and Indian goods more expensive to Americans. The price of the dollar would continue to fall until the number of dollars Indians wanted to buy reached the number Americans wanted to sell—which is to say, until Indians wanted to buy as much in America as Americans wanted to buy in India. The story is a little more complicated if we add in additional nations, but the essential logic does not change.

How, then, can it be that America is running a trade deficit, a fact lamented at intervals by American politicians? One answer is that foreigners sometimes buy dollars not to spend but to hoard. By doing so they give the U.S. an interest free loan, give us goods in exchange for paper which, in a world where inflation rates are rarely negative, will be worth less in the future when and if they bring it back for goods. The other answer is that goods bought by foreigners in America only count in the trade statistics if the buyers take them out of the country. Foreigners can use their dollars instead to invest in the U.S., buy stock in companies which can use them to build factories or develop new products. What the newspapers lament as a trade deficit is more accurately described as an inflow of capital. That is why the U.S. ran a trade deficit for a good deal of the nineteenth century. Europeans were selling us goods and using the money to build our railroads and canals.

For a country the size of the U.S., protectionism—tariffs to make us produce things directly at home instead of indirectly by trade—is a mistake but not a lethal one. The U.S. is big enough to be reasonably good at doing many things—growing wheat and building cars. Making trade more difficult, and so forcing us to produce goods ourselves that we could get more easily by trade, makes us poorer, but not a lot poorer. For smaller countries, protectionism is a much bigger mistake.