At age 27, having devoured the Wealth of Nations while on holiday in Bath, David Ricardo found his calling in the emerging discipline of political economy. He believed govt interference in the economy messed up everything. Around 1810 there was a fierce debate about what was causing the rampant inflation in Britain (in 1812 it hit 11%). Ricardo wrote a series of letters to a newspaper criticising the BoE’s monetary policy (he argued it was printing too many notes).
What followed, On the Principles of Political Economy and Taxation, was the most influential text on economics published in the 75-year span between Smith's Wealth of Nations and John Stuart Mill’s Principles of Political Economy. Published in 1817, it’s not a great pleasure to read! In trying to make economics more scientific, Ricardo wrote in a dry style that lacked the flourish and colourful examples of Adam Smith.
Ricardo and other economists were obsessed with the concept of value. Ricardo proposed a “labour theory of value” that dominated his time and was later taken up by Marx. This led him towards the 3 things for which he is most famous today: theory of wages, theory of rent and “theory of comparative advantage”.?
Ricardo’s theory of comparative advantage states that each country should produce and trade what it is relatively least bad at. He used the examples of English cloth and Portuguese wine to explain the magic of international trade:
- Ricardo imagined that Portugal was better at producing both cloth and wine than England —it could produce both with less labour input than England.
- According to the Smithian approach, it would seemingly make sense for Portugal to import nothing from England.
- Ricardo’s logic takes a step further. If it takes 75 Portuguese labourers to produce wine and 85 to produce cloth, then it should export wine and import cloth since it is more efficient at producing wine than cloth, meaning Portugal would have to give up less cloth to make extra wine than England would.
- Thus, Portugal should export wine, and England cloth as it is relatively more efficient at weaving, though it isn’t an “absolute” advantage since Portugal can produce both cloth and wine with fewer workers.
This theory has been a standard item in basic economics textbooks and a prime justification for advocates of free trade. However, "free" trade is not "fair” trade.
When asked to identify one idea in the social sciences that was both true and non-trivial, Paul Samuelson replied: “Ricardo’s theory of comparative advantage”. But the truth in his reply “refers to the fact that Ricardo’s theory is mathematically correct, not that it is empirically valid”. Prof Charles Murdock of Loyola Univ Chicago goes a step further: Those who routinely parrot the notion that Ricardo's theory shows that foreign trade is beneficial to both countries have never read Ricardo and are unaware of the caveats he asserted. In summary, Ricardo’s theory doesn’t work in today’s globalised world.?
- Ricardo's proof of mutual benefit is conditioned upon the assumption that capital would be loyal to the country of origin and (akin to the gold standard) adjustments in the value of currencies would even out trade imbalances. This is no longer the case. We now have floating currencies that (supposedly) reflect the market demand for specific currencies. Since US has a substantial trade deficit with China, there should be a good demand for yuan to enable US firms to buy Chinese goods, which should increase the value of the yuan v/s the USD. The cost of Chinese exports would rise and that of US exports fall, thus bringing the China/US trade into balance. But, if China cleverly “manipulates its currency” v/s the USD, there will be no self-regulating mechanism to restore the balance of trade between the two nations.
- The movement of labour is scarcely mentioned by Ricardo. When capital is free to move around the world in search of the best return and when the conventional wisdom is that the purpose of a corporation is to maximize shareholder value, not worker well-being, international trade turns into labor arbitrage and jobs are shipped from the importing country to the exporting country. US has thus lost much of its manufacturing base. When one country is a net exporter and another a net importer, there is a transfer of wealth from the importing country to the exporting country.
- Ricardo's example of cloth and wine didn’t involve dual-use technologies that have both industrial and military uses. One basis for comparative advantage that US enjoys is technological superiority, much of which is dual-use. However, some of its trading partners, like China, not only don’t enforce the patent and copyright laws that protect this advantage, but also engage in piracy, as well as demand technological transfer as a pre-requisite to entering its markets. Thus, the merits of foreign trade are eroded by the misfeasance and malfeasance of foreign govts…activities that were beyond imagination during Ricardo’s time. This is a consistent pattern but not one that is consistent with free trade principles! US considers the security risk of letting in Chinese cars as too great, since EVs are easily tracked and monitored. From a national security angle, can US rely upon either products that originate in, or supply chains that pass through, a potential adversary?
- Often nations shape their comparative advantage to influence what they specialize in, say, with govt policies that promote certain sectors. This extension of Ricardo’s model? has been developed by Paul Krugman (“new trade theory”) who won the Nobel Prize for the dynamic theory of trade. Although economists welcome cheap imports, politicians can fight back if they worry that an influx would hurt specific industries and towns. The recent EV tariffs are targeted at voters who are economically tied to the US auto industry in the swing states of Michigan, Wisconsin, Ohio, and Georgia. A virtual ban on Chinese EVs builds on Biden’s promises to support the US auto industry.
- Ricardo’s notion of comparative advantage did not envisage an export-oriented govt that would eliminate other countries’ competitive advantage by subsidizing exports at the expense of its own citizens via ultra-lax worker health and safety measures far below global norms.?
US Senator Marco Rubio’s Made in China 2025 Report recognized that markets cannot function without rules and so the govt should ensure that the rules provide for "strong families and decent wages for average people."? The Report asserted that the drive to maximize shareholder value, rather than for all American workers, can lead to catastrophic results.
Can US blindly ignore the realities of the situation and rely abstractly on the notion that the market solves all problems? While comparative advantage is a compelling theory, it isn’t clear it does much to explain the real world as the "assured mutual benefits of global trade" seem illusory. The underpinnings upon which Ricardo based his theory do not exist today.
For Ricardo, facts are for wimps. It almost didn’t matter if facts appeared to disprove his theories; if the theories had progressed logically from first principles then they were necessarily true. Today’s economists call this the “Ricardian vice”. Ricardo’s writings are deeply theoretical and abstract — so much so that decades later Alfred Marshall would spend many happy hours converting Ricardo’s arguments into mathematical equations.
In light of the above, isn’t the US justified to adopt an industrial policy that will safeguard its national security and rebuild manufacturing capability, especially in the industries of the future?
What then are the prospects for US in using the protection of tariffs to develop a competitive EV industry?
- In the past, nations have resorted to protectionism effectively in the auto sector to give their “infant industries” time to grow before being exposed to global competition. Post WWII, Japan protected its own fledgling auto market when it restricted foreign currency allocations to imported vehicles and imposed high tariffs on imported passenger vehicles and engines. It delayed liberalizing its auto market until after 1964 when the imminent threat of global competition spurred Japan to turn competitive very quickly. S. Korea used protections to give its Hyundai, Daewoo, and Kia a chance to catch up. Today, the Hyundai-Kia group is the 3rd largest auto maker in the world and the 2nd biggest EV seller in the US after Tesla.
- Biden faces the twin dilemmas of China and inflation. The solution he has chosen to face off China (tariffs) may hurt him when it comes to inflation. By definition, tariffs stifle competition, limit consumer choice and raise prices. So while a tough trade policy towards China might help Biden politically in industrial swing states, he may pay a high price (no pun intended!) on the issue of inflation that is frequently raised by voters as their biggest headache.
Huawei has shown that companies can find workarounds. Chinese EV firms may ramp up production in Mexico. Trade chiefs are already eyeing that loophole, suggesting this will turn into a game of Whac-a-Mole. Moreover, the auto industry is global. Swedish sedans (Volvo S60s) owned by a Chinese firm making cars in Ridgeville, South Carolina is par for the course.
Two centuries ago, Napoleon warned, “Let China sleep; when she wakes, she will shake the world." Today China has awakened, and the world is beginning to shake.
Higher tariffs may not be the last word on the US-China auto war yet.
