betazed
Seeking...
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- May 9, 2003
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From time to time, threads pop up on CFC OT which brings up the topic of trade between nations directly or indirectly. On reading those posts and threads I see that some people harbor concepts which seem to me to be incorrect. Either that or I do not really understand the macroeconomic concepts of global trade. So I thought I will write down my thoughts on trade in general and global trade in particular. This IMO will serve two purposes. (a) It will provide at least some insight (hopefully) to some people who have not been introduced to the issue (b) clarify misconceptions of mine and others through discussion.
This post will necessarily be long since we are talking about a complex topic. In some parts of this post I will probably end up harping on some concepts that many of you may find obvious. I do so only to be complete and coherent. So please bear with me. If you feel so inclined, just skip those sections; OTOH, although apparently they may seem obvious to you, reading them you might find that there are things that were not so obvious before. I have tried to keep the sections as independent as possible but maximum coherence is attained on reading them in order.
Three economists and the origin of trade
If I have to guess the origin of trade, I will venture that it must have been somewhere near Uruk – and definitely before the city was founded – when two people realized that they can be both better off by collaborating. Although they did not formalize the concepts of comparative advantage and related concept of specialization, I will consider them the world’s first economists. They figured out (long before Adam Smith, who starts with this concept in the very first line of his treatise The Wealth of Nations ) that instead of making everything they need themselves, if they together make everything they need, each one making only a subset of the whole, while both of them combined make the whole, then they will end up making more than the could individually. It may sound obvious and trivial to us now – to the extent that most of us do not even think about this anymore – but it is a great conceptual leap.
Surely, the first traders must have bartered and that must have been the greatest impediment to trade for a long time; to find a person who produces the exact thing you require and who requires the exact thing that you produce. So our next great economist must be the person (or most likely a group of persons) who invented a medium of exchange: a currency. Trade suddenly changed from a bilateral mode to a multilateral mode and also must have increased considerably.
(It is interesting to think these things through. This single event in history led to the necessity of writing and then arithmetic and mathematics. We owe a great deal to our first economists)
Yet, there still must have been problems. One group may not agree with another group of what their currency was. Thus multilateral trade must have been restricted to only those people who agreed on a common currency. So our third great economist must be the king, chief or the warlord who insisted and made sure (most probably through the might of his sword) that everyone agree on what he thinks is currency and hence invented the concept of Fiat currency . In doing so, unknowingly without doubt, he also laid down the first stirrings of budget deficit, inflation and government debt. This last concept of Fiat currency will be very important to us later on.
The fourth economist and the purpose of trade
So as explained in the previous section one purpose of trade must be its original purpose, the mutual increase of wealth. But is increasing wealth be the sole purpose of trade? It can be argued that it must have been so for some time. However, soon after the first trades in goods someone must have figured out another concept. Trade does not need to be restricted to physical goods. You can also trade services. Having nothing else to barter for (or having no currency) that person may have offered his labor or maybe himself or most probably herself. I like to think of that person as our fourth great economist. In doing so, he/she provided another purpose to trade.
Trade which was originally used to increase wealth once it exists can now be used to create wealth where none exists. Trade perhaps provides the closest thing there is to free lunch.
Seen another way, trade brings value to something (and hence brings it under the umbrella of wealth) which did not have any value to begin with. Perhaps, this is the place to introduce a thought. Next time you see arguements about how people are exploited in Chinese sweatshops which grease the gears of China-US trade ask them what value their labor had before the sweatshops were there. Trade provided a value to their labor; a value that was non-existent. This does not necessarily condone the work conditions of sweatshops but points out that the solution is not in boycotting trade or introducing tariffs which will eliminate the value altogether by taking the sweatshops away but changing work conditions through some other way (perhaps political perhaps social). Anyway, I digress.
This purpose (and I like to think a much more important purpose socially speaking) is not met – at least to the extent it should be – in our current global trade scenario. I will dwell more on that later.
In the 21st century, global trade will serve another crucial purpose. Trade which in the past has led nations to war will in the near future deter them from going to war. It will serve as a crucible of peace. When two nations are inter-dependent on each other’s trade they will think twice before going to war with each other. It is irrelevant to ask in such a scenario which of two trading partners is more dependent on each other e.g. whether US is more dependent on China or is China more dependent on the US. All that is necessary is that each is dependent enough on the other to resist it from going to war. Another example of this effect is India and Pakistan. Since their independence they have gone to war twice, and trade between them has been miniscule. Politicians on both sides resisted trading relations (much to the resentment of businessmen on both sides) because they knew that sufficient trading will ease relations. Only recently has trade been picking up; and no wonder relations are getting better and peace talks are getting more frequent. Also, is it any wonder that US-India relations are at a all time high when US-India trade is also at a all time high?
When is trade fair?
One of the references that I have provided below is a long Wikipedia article on Fair Trade. As the very beginning of the article will state this is a hotly contested concept. So, what exactly is fair trade? And who is it fair to? Common sense would tell us that trade should be fair to the two parties who are conducting the trade. As in most other cases, common sense would be wrong – or rather, in this case, incomplete. Trade to provide the maximum benefit to the trading parties should not only be fair to the two parties directly involved in the trade but also to other parties indirectly involved who may have nothing to do with the trade at the moment. Perhaps an example would clarify.
But before getting to the example, let us see naively what a fair trade will look like. A trade between A and B will be fair, if the prices that both pay to each other is a true reflection of their costs of production and some reasonable markup for profit. In fact, this is a sufficient condition for all trades to be a fair trade if and only if there are no trade barriers (i.e. everyone can trade with everyone) and all costs have been taken into account.
Unfortunately, neither of those two conditions are satisfied in the real world. There are trade barriers and all costs are not taken into account.
Let’s take the example of rice (or sugar, or shrimp, or cloth, or any of a long list of items). When a Japanese (or French) person buys a bag of rice at the local supermarket that trade can be idealized as a trade between that person and the Japanese rice farmer (basically think as if the retailer and all the other middlemen do not exist – this does not change our discussion). The price is a fair price in the sense that it is a true reflection of the cost of production to the Japanese farmer (with a caveat) and a certain reasonable profit margin. But is the trade fair? Absolutely not. Let’s apply our conditions. Are all costs taken into account in this trade? No. Japanese rice farmers get a huge subsidy from the Japanese government. This subsidy comes from taxes of the Japanese people. So our rice purchaser’s tax contribution to the subsidy should be added to the cost of the bag of rice. The moment that is done it is seen that the purchaser paid a higher price than what is reasonable. Hence the trade is not fair.
Is it fair to the rice producer? Once again common sense would say that the it is not only fair it is overly generous to the rice producer since he gets money from the end consumer twice (once as the direct price and once through his taxes). But there is a hidden cost to the rice producer in the long run. Were it not for the subsidies, in the long run, he would be out of the rice business (assuming that he could not maintain profitability on his own) and would have re-allocated his capital and labor to more productive endeavor till he made more money than what he makes in rice right now. This is precisely the problem in First world countries too. A farmer’s son who lives on subsidy has no reason to become anything else apart from a farmer unless there is a direct threat of losing his subsidy. So he will always be the inefficient farmer that he is. Although he may not know this, it is terribly unfair to him. There are other more direct harm to the farmer. Here is an example of a direct harm. So subsidy is a cost distorting and price distorting effect which tosses fair trade out the window.
What about the other condition? Is it fair to everyone else? Apart from being unfair to both buyer and seller parties directly, this trade is unfair to parties not involved in the trade directly. As mentioned before one of the purposes of trade is to alleviate poverty and create wealth for people who do not have wealth. Now, in this case, it so happens, that the Japanese rice buyer can purchase rice from a Phillipino rice producer at a cheaper price. Had the Japanese government allowed this then the Phillipino rice seller could have sold his rice and created wealth for himself. Now, instead of that he sells as much as he can in Philippines and the rest is either wasted or not produced to begin with and hence his opportunity to use his labor and capital is wasted.
Note though, that the Japanese buyer do not have to buy the rice at a high price for the Phillipino farmer to benefit. He just has to buy at any price which is a fair price; which is the cost of production to the Filipino farmer and some reasonable profit margin.
So why are trade subsidies perpetuated? Partly it is selfish, parochial politics. Partly it is a carry over from a old and out-dated concept of Mercantilism .
But is this the only trade distortion? No. There is a much more invidious distortion. It is more invidious because unlike subsidy – which is at least heatedly discussed – this distortion is rarely discussed in international forums. Only recently are scientists bringing this up.
The criteria for a trade to be fair is that all costs must be taken into account including whatever hidden costs there might be. What if the hidden cost is pollution, or the depletion of a natural resource? Shouldn’t this cost be added to the price of the item? Because someone has to pay the cost. When the costs are not taken into account, someone who is not at all linked with the trade picks up these hidden costs. Here is an example, where a trade although apparently fair to both the seller and buyer is not fair to some third party who is not a direct participant in the process. A real life example of this is Japan’s fishing industry but since I have ranted against Japan already once before I will let you look up on this one. To see another example of this you may also do some research into mines in Montana or read Jared Diamonds latest book.
The function and importance of dollar in global trade
This is perhaps a section that everyone should read.
What is the essential difference between the dollar and any other currency. It is said that it is the reserve currency, but what does that mean? Remember, in our discussion earlier, what our third great economist did. He introduced a Fiat currency. A currency that all trading groups will agree on. Well dollar is the Fiat currency that all trading nations agree on. How it came about to be so, must be an essay for another occasion. So for now just assume that everyone agrees on the fiat.
So what effect does that have on US? Well, to put it in the mildest of terms it provides US at a order or magnitude advantage that any other country economically speaking. The basic laws of macro-economics that would apply to any other country does not apply to US. Let me explain a bit more.
Since, dollar is the fiat currency between the traders (who are nations in this case), they will all agree to accept (and in some case insist to accept) dollars for goods and services provided. So a buyer of goods must provide dollars to buy goods. However, when the buyer is not US, that nation must procure that dollar from another source. The only other source would be US or some other nation to which the buyer will sell something and get dollar in return using which it can proceed to buy the stuff it needs. So in the long run when you take US out of the equation any nation’s net external (buys – sells) in dollar terms must be zero. If it gets to be too far from zero then the nation gets into trouble. Exactly, this trouble happened to many countries (India and Argentina readily comes to mind).
But for US, there is another source for the dollar. The printing press. They simply print the dollar as much as they want and that’s it. So while other countries have to eventually trade goods/services for goods/services US can buy goods and services for paper. This is a great deal for US (at least apparently). Why should everyone else go with this? For two reasons. One is that as explained there is a benefit to everyone in having a fiat currency. It increases trade. The other is that every dollar note is basically a certificate of promise which states that the US will provide (in some time in the future) an equivalent amount of goods and services. Till date the US has kept its promise. But also, till date there were never too many dollars outside the US. Things have changed only recently.
Foreign countries hold a lot of dollars now. More than they ever held. If all of them suddenly asked the US for goods/services equivalent to those dollars US will not be able to meet that promise. The foreign countries use those dollars not to trade with each other but put the money back into interest accruing deposits with the US treasury. So US has to pay interest on those dollars. So instead of paying $1 worth of goods/services today it has to pay more than $1 worth of goods/services tomorrow. It need not have done that. It could as well have not taken those deposits and hence paid $1 worth of stuff later for $1 worth of stuff now. But owing to its profligacy (budget deficit) it has to borrow those dollars. But we are digressing away from trade issues now.
Dollar has other effects on world trade which we will dwell on later.
So what are the other problems today in global trade?
If I have to list the main problems of global trade, apart from the trade subsidy issue and the non-inclusions of cost issue (as pointed above), then I will list the following :-
Let’s talk about the first three points. They are all related. It is said that for the past decade or so the airplane of global economy used to run on the twin engines of Chinese production and US consumption. Unfortunately, the airplane analogy if taken further would mean that each of the engines are pointing, not in the direction in which the plane should fly, but in the some other direction (that direction being the ground). In a normal scenario long term trade between nations would have to be equal (as explained earlier). So production on the average should equal everywhere and so would consumption.
But owing to the fiat nature of the dollar, what happens is the following. You might want to work through the chain of events here a few times.
Chinese workers work in their factories, create goods cheaply and efficiently. They may or may not get fair wages for it (which is not a core problem here for the time being). However, they still manage to save some part of those wages and put the money in the bank. The bank eventually put the money in their Central bank which allows the Chinese government to fund their expenses and investments without dipping into their dollar reserves. The Chinese companies on the other hand sell those goods to Walmart for dollars, and once again deposits the dollars into the Chinese central banks. Walmart then goes on to sell the goods to the American buyer and the American government. However, neither of these two last entities have enough money to buy the stuff that Walmart (and companies like it sell). So they borrow. The US government borrows from the US Treasury and the normal people borrow from the credit card companies and other sundry banks who in turn borrow from the US Treasury indirectly or from Chinese banks directly. The US treasury in turn borrows from the Chinese central bank which accumulates the dollars from the Chinese companies and the chain is now complete.
So in this topsy-turvy world the pyramid stands on its head and the poor Chinese worker funds the US consumers Ferrari and the US governments war while himself staying in destitution like living conditions. Once you see the entire chain it should become obvious that this cannot go on. Unfortunately, not everyone sees the chain, least of all the Chinese saver and the US Ferrari buyer.
Now comes the fourth point, movement of labor. I will save this for the next section because it ties in another big problem of the world today.
Moving on to movement of capital. This is a major sticking point for most of the developed countries. The companies in developed countries have excess capital. Ideally, they would like to invest this capital and create more wealth. The place where this can be done is obviously the underdeveloped countries where the opportunity for growth and hence the rate of returns are the maximum. However, most of the underdeveloped countries do not allow free movement of capital for precisely the same reasons as the developed countries use subsidies. Old concepts of mercantilism, the fear of losing control, and the need to have at least one bargaining chip against wealthy first world nations. But on the whole where free movement of capital has been allowed it has been beneficial for both sides. Countries which have realized this, like China and India, actually compete with each other to attract more and more capital. But even in such cases there are barriers. For example, India does not provide full capital convertibility and only allows foreign investment in certain sectors. China also follows a similar approach.
Other problems with current global trade
Now about that fourth point above. As mentioned earlier, (I know I am repeating myself here – but the point it worth repeating) one of the purposes that trade can serve is that it can provide wealth to people who do not have anything. The person who does not have anything usually has at least one thing to sell. His/her physical labor (or some other service which does not require any other capital expenditure on his part). It is basically, trade of a factor of production. Unfortunately, the problem is that usually such persons find that the place where there labor is valuable is far from home and necessitates crossing of national boundaries. Thus forms the problem of immigration. Immigration problem is usually not seen as a trade problem, but fundamentally that is what it is. People do not immigrate to find “freedom”, “liberty” or any other such dubious concept. Neither do they immigrate to take advantage of the social safety net of first world countries. Instead what they do is that they readily trade in whatever they have which is usually their labor (and whatever “freedom” and “liberty” they had) for wealth in the hope that this wealth may uplift their life. There is a huge existing trade of this factor of production: Chinese workers in Taiwan, Philippino nurses in US, Mexican workers in California, South Indian workers in the Gulf, Indian software programmers in US; the list goes on.
So whenever you argue against immigration (for whatever reasons) remember you are also arguing against free trade. (I find this particular interesting since I have seen people who call themselves die-hard free traders also vociferously rail against immigration).
Fortunately, in our digital world there is a new trend that selling of your labor in another place does not need you to actually physically travel to that place. This new concept of off-shoring is a great boon. Unfortunately, only certain kinds of services are amenable to this process (although more and more services are coming under the umbrella). The other problem is that it has only touched a few million people (and almost all of them in India). I do not see this as a solution of creating wealth in Africa or Mexico.
Some references and links
Fair Trade – this is a proposal set up by a few western companies and activists. IMO, it is riddled with contradictions and conflicts of interest. But it offers insight into the problems of current trade.
Henry C K Liu: On trade in general – While this author’s writing might reek of anti-Americanism his writings hold water as far as trade in concerned. His proposals are intriguing to say the least and make an interesting read and he discusses the issues mentioned in this post thoroughly.
I had started this post with the desire to pen all of my thoughts on global trade. It seems I have not estimated my thoughts correctly. The post is already 19,785 chars and I have not even started talking about details of exchange rates, mercantilism, FTAs like NAFTA or CAFTA, WTO, and last but not least IMF among other things. Perhaps I will talk about them in another post.
So, comment on what I have said, or ask any questions that you might have and I will try to answer it to the best of my ability. It might take some time for me to get back with answers because now that I have wasted my morning, I actually have to earn my keep and do some actual work.
This post will necessarily be long since we are talking about a complex topic. In some parts of this post I will probably end up harping on some concepts that many of you may find obvious. I do so only to be complete and coherent. So please bear with me. If you feel so inclined, just skip those sections; OTOH, although apparently they may seem obvious to you, reading them you might find that there are things that were not so obvious before. I have tried to keep the sections as independent as possible but maximum coherence is attained on reading them in order.
Three economists and the origin of trade
If I have to guess the origin of trade, I will venture that it must have been somewhere near Uruk – and definitely before the city was founded – when two people realized that they can be both better off by collaborating. Although they did not formalize the concepts of comparative advantage and related concept of specialization, I will consider them the world’s first economists. They figured out (long before Adam Smith, who starts with this concept in the very first line of his treatise The Wealth of Nations ) that instead of making everything they need themselves, if they together make everything they need, each one making only a subset of the whole, while both of them combined make the whole, then they will end up making more than the could individually. It may sound obvious and trivial to us now – to the extent that most of us do not even think about this anymore – but it is a great conceptual leap.
Surely, the first traders must have bartered and that must have been the greatest impediment to trade for a long time; to find a person who produces the exact thing you require and who requires the exact thing that you produce. So our next great economist must be the person (or most likely a group of persons) who invented a medium of exchange: a currency. Trade suddenly changed from a bilateral mode to a multilateral mode and also must have increased considerably.
(It is interesting to think these things through. This single event in history led to the necessity of writing and then arithmetic and mathematics. We owe a great deal to our first economists)
Yet, there still must have been problems. One group may not agree with another group of what their currency was. Thus multilateral trade must have been restricted to only those people who agreed on a common currency. So our third great economist must be the king, chief or the warlord who insisted and made sure (most probably through the might of his sword) that everyone agree on what he thinks is currency and hence invented the concept of Fiat currency . In doing so, unknowingly without doubt, he also laid down the first stirrings of budget deficit, inflation and government debt. This last concept of Fiat currency will be very important to us later on.
The fourth economist and the purpose of trade
So as explained in the previous section one purpose of trade must be its original purpose, the mutual increase of wealth. But is increasing wealth be the sole purpose of trade? It can be argued that it must have been so for some time. However, soon after the first trades in goods someone must have figured out another concept. Trade does not need to be restricted to physical goods. You can also trade services. Having nothing else to barter for (or having no currency) that person may have offered his labor or maybe himself or most probably herself. I like to think of that person as our fourth great economist. In doing so, he/she provided another purpose to trade.
Trade which was originally used to increase wealth once it exists can now be used to create wealth where none exists. Trade perhaps provides the closest thing there is to free lunch.
Seen another way, trade brings value to something (and hence brings it under the umbrella of wealth) which did not have any value to begin with. Perhaps, this is the place to introduce a thought. Next time you see arguements about how people are exploited in Chinese sweatshops which grease the gears of China-US trade ask them what value their labor had before the sweatshops were there. Trade provided a value to their labor; a value that was non-existent. This does not necessarily condone the work conditions of sweatshops but points out that the solution is not in boycotting trade or introducing tariffs which will eliminate the value altogether by taking the sweatshops away but changing work conditions through some other way (perhaps political perhaps social). Anyway, I digress.
This purpose (and I like to think a much more important purpose socially speaking) is not met – at least to the extent it should be – in our current global trade scenario. I will dwell more on that later.
In the 21st century, global trade will serve another crucial purpose. Trade which in the past has led nations to war will in the near future deter them from going to war. It will serve as a crucible of peace. When two nations are inter-dependent on each other’s trade they will think twice before going to war with each other. It is irrelevant to ask in such a scenario which of two trading partners is more dependent on each other e.g. whether US is more dependent on China or is China more dependent on the US. All that is necessary is that each is dependent enough on the other to resist it from going to war. Another example of this effect is India and Pakistan. Since their independence they have gone to war twice, and trade between them has been miniscule. Politicians on both sides resisted trading relations (much to the resentment of businessmen on both sides) because they knew that sufficient trading will ease relations. Only recently has trade been picking up; and no wonder relations are getting better and peace talks are getting more frequent. Also, is it any wonder that US-India relations are at a all time high when US-India trade is also at a all time high?
When is trade fair?
One of the references that I have provided below is a long Wikipedia article on Fair Trade. As the very beginning of the article will state this is a hotly contested concept. So, what exactly is fair trade? And who is it fair to? Common sense would tell us that trade should be fair to the two parties who are conducting the trade. As in most other cases, common sense would be wrong – or rather, in this case, incomplete. Trade to provide the maximum benefit to the trading parties should not only be fair to the two parties directly involved in the trade but also to other parties indirectly involved who may have nothing to do with the trade at the moment. Perhaps an example would clarify.
But before getting to the example, let us see naively what a fair trade will look like. A trade between A and B will be fair, if the prices that both pay to each other is a true reflection of their costs of production and some reasonable markup for profit. In fact, this is a sufficient condition for all trades to be a fair trade if and only if there are no trade barriers (i.e. everyone can trade with everyone) and all costs have been taken into account.
Unfortunately, neither of those two conditions are satisfied in the real world. There are trade barriers and all costs are not taken into account.
Let’s take the example of rice (or sugar, or shrimp, or cloth, or any of a long list of items). When a Japanese (or French) person buys a bag of rice at the local supermarket that trade can be idealized as a trade between that person and the Japanese rice farmer (basically think as if the retailer and all the other middlemen do not exist – this does not change our discussion). The price is a fair price in the sense that it is a true reflection of the cost of production to the Japanese farmer (with a caveat) and a certain reasonable profit margin. But is the trade fair? Absolutely not. Let’s apply our conditions. Are all costs taken into account in this trade? No. Japanese rice farmers get a huge subsidy from the Japanese government. This subsidy comes from taxes of the Japanese people. So our rice purchaser’s tax contribution to the subsidy should be added to the cost of the bag of rice. The moment that is done it is seen that the purchaser paid a higher price than what is reasonable. Hence the trade is not fair.
Is it fair to the rice producer? Once again common sense would say that the it is not only fair it is overly generous to the rice producer since he gets money from the end consumer twice (once as the direct price and once through his taxes). But there is a hidden cost to the rice producer in the long run. Were it not for the subsidies, in the long run, he would be out of the rice business (assuming that he could not maintain profitability on his own) and would have re-allocated his capital and labor to more productive endeavor till he made more money than what he makes in rice right now. This is precisely the problem in First world countries too. A farmer’s son who lives on subsidy has no reason to become anything else apart from a farmer unless there is a direct threat of losing his subsidy. So he will always be the inefficient farmer that he is. Although he may not know this, it is terribly unfair to him. There are other more direct harm to the farmer. Here is an example of a direct harm. So subsidy is a cost distorting and price distorting effect which tosses fair trade out the window.
What about the other condition? Is it fair to everyone else? Apart from being unfair to both buyer and seller parties directly, this trade is unfair to parties not involved in the trade directly. As mentioned before one of the purposes of trade is to alleviate poverty and create wealth for people who do not have wealth. Now, in this case, it so happens, that the Japanese rice buyer can purchase rice from a Phillipino rice producer at a cheaper price. Had the Japanese government allowed this then the Phillipino rice seller could have sold his rice and created wealth for himself. Now, instead of that he sells as much as he can in Philippines and the rest is either wasted or not produced to begin with and hence his opportunity to use his labor and capital is wasted.
Note though, that the Japanese buyer do not have to buy the rice at a high price for the Phillipino farmer to benefit. He just has to buy at any price which is a fair price; which is the cost of production to the Filipino farmer and some reasonable profit margin.
So why are trade subsidies perpetuated? Partly it is selfish, parochial politics. Partly it is a carry over from a old and out-dated concept of Mercantilism .
But is this the only trade distortion? No. There is a much more invidious distortion. It is more invidious because unlike subsidy – which is at least heatedly discussed – this distortion is rarely discussed in international forums. Only recently are scientists bringing this up.
The criteria for a trade to be fair is that all costs must be taken into account including whatever hidden costs there might be. What if the hidden cost is pollution, or the depletion of a natural resource? Shouldn’t this cost be added to the price of the item? Because someone has to pay the cost. When the costs are not taken into account, someone who is not at all linked with the trade picks up these hidden costs. Here is an example, where a trade although apparently fair to both the seller and buyer is not fair to some third party who is not a direct participant in the process. A real life example of this is Japan’s fishing industry but since I have ranted against Japan already once before I will let you look up on this one. To see another example of this you may also do some research into mines in Montana or read Jared Diamonds latest book.
The function and importance of dollar in global trade
This is perhaps a section that everyone should read.
What is the essential difference between the dollar and any other currency. It is said that it is the reserve currency, but what does that mean? Remember, in our discussion earlier, what our third great economist did. He introduced a Fiat currency. A currency that all trading groups will agree on. Well dollar is the Fiat currency that all trading nations agree on. How it came about to be so, must be an essay for another occasion. So for now just assume that everyone agrees on the fiat.
So what effect does that have on US? Well, to put it in the mildest of terms it provides US at a order or magnitude advantage that any other country economically speaking. The basic laws of macro-economics that would apply to any other country does not apply to US. Let me explain a bit more.
Since, dollar is the fiat currency between the traders (who are nations in this case), they will all agree to accept (and in some case insist to accept) dollars for goods and services provided. So a buyer of goods must provide dollars to buy goods. However, when the buyer is not US, that nation must procure that dollar from another source. The only other source would be US or some other nation to which the buyer will sell something and get dollar in return using which it can proceed to buy the stuff it needs. So in the long run when you take US out of the equation any nation’s net external (buys – sells) in dollar terms must be zero. If it gets to be too far from zero then the nation gets into trouble. Exactly, this trouble happened to many countries (India and Argentina readily comes to mind).
But for US, there is another source for the dollar. The printing press. They simply print the dollar as much as they want and that’s it. So while other countries have to eventually trade goods/services for goods/services US can buy goods and services for paper. This is a great deal for US (at least apparently). Why should everyone else go with this? For two reasons. One is that as explained there is a benefit to everyone in having a fiat currency. It increases trade. The other is that every dollar note is basically a certificate of promise which states that the US will provide (in some time in the future) an equivalent amount of goods and services. Till date the US has kept its promise. But also, till date there were never too many dollars outside the US. Things have changed only recently.
Foreign countries hold a lot of dollars now. More than they ever held. If all of them suddenly asked the US for goods/services equivalent to those dollars US will not be able to meet that promise. The foreign countries use those dollars not to trade with each other but put the money back into interest accruing deposits with the US treasury. So US has to pay interest on those dollars. So instead of paying $1 worth of goods/services today it has to pay more than $1 worth of goods/services tomorrow. It need not have done that. It could as well have not taken those deposits and hence paid $1 worth of stuff later for $1 worth of stuff now. But owing to its profligacy (budget deficit) it has to borrow those dollars. But we are digressing away from trade issues now.
Dollar has other effects on world trade which we will dwell on later.
So what are the other problems today in global trade?
If I have to list the main problems of global trade, apart from the trade subsidy issue and the non-inclusions of cost issue (as pointed above), then I will list the following :-
- Consumption is not equally distributed
- Production is not equally distributed
- Fiat Money
- Movement of labor, which is a tradable commodity and a factor of production, is restricted
- Movement of capital, another factor of production, is restricted.
Let’s talk about the first three points. They are all related. It is said that for the past decade or so the airplane of global economy used to run on the twin engines of Chinese production and US consumption. Unfortunately, the airplane analogy if taken further would mean that each of the engines are pointing, not in the direction in which the plane should fly, but in the some other direction (that direction being the ground). In a normal scenario long term trade between nations would have to be equal (as explained earlier). So production on the average should equal everywhere and so would consumption.
But owing to the fiat nature of the dollar, what happens is the following. You might want to work through the chain of events here a few times.
Chinese workers work in their factories, create goods cheaply and efficiently. They may or may not get fair wages for it (which is not a core problem here for the time being). However, they still manage to save some part of those wages and put the money in the bank. The bank eventually put the money in their Central bank which allows the Chinese government to fund their expenses and investments without dipping into their dollar reserves. The Chinese companies on the other hand sell those goods to Walmart for dollars, and once again deposits the dollars into the Chinese central banks. Walmart then goes on to sell the goods to the American buyer and the American government. However, neither of these two last entities have enough money to buy the stuff that Walmart (and companies like it sell). So they borrow. The US government borrows from the US Treasury and the normal people borrow from the credit card companies and other sundry banks who in turn borrow from the US Treasury indirectly or from Chinese banks directly. The US treasury in turn borrows from the Chinese central bank which accumulates the dollars from the Chinese companies and the chain is now complete.
So in this topsy-turvy world the pyramid stands on its head and the poor Chinese worker funds the US consumers Ferrari and the US governments war while himself staying in destitution like living conditions. Once you see the entire chain it should become obvious that this cannot go on. Unfortunately, not everyone sees the chain, least of all the Chinese saver and the US Ferrari buyer.
Now comes the fourth point, movement of labor. I will save this for the next section because it ties in another big problem of the world today.
Moving on to movement of capital. This is a major sticking point for most of the developed countries. The companies in developed countries have excess capital. Ideally, they would like to invest this capital and create more wealth. The place where this can be done is obviously the underdeveloped countries where the opportunity for growth and hence the rate of returns are the maximum. However, most of the underdeveloped countries do not allow free movement of capital for precisely the same reasons as the developed countries use subsidies. Old concepts of mercantilism, the fear of losing control, and the need to have at least one bargaining chip against wealthy first world nations. But on the whole where free movement of capital has been allowed it has been beneficial for both sides. Countries which have realized this, like China and India, actually compete with each other to attract more and more capital. But even in such cases there are barriers. For example, India does not provide full capital convertibility and only allows foreign investment in certain sectors. China also follows a similar approach.
Other problems with current global trade
Now about that fourth point above. As mentioned earlier, (I know I am repeating myself here – but the point it worth repeating) one of the purposes that trade can serve is that it can provide wealth to people who do not have anything. The person who does not have anything usually has at least one thing to sell. His/her physical labor (or some other service which does not require any other capital expenditure on his part). It is basically, trade of a factor of production. Unfortunately, the problem is that usually such persons find that the place where there labor is valuable is far from home and necessitates crossing of national boundaries. Thus forms the problem of immigration. Immigration problem is usually not seen as a trade problem, but fundamentally that is what it is. People do not immigrate to find “freedom”, “liberty” or any other such dubious concept. Neither do they immigrate to take advantage of the social safety net of first world countries. Instead what they do is that they readily trade in whatever they have which is usually their labor (and whatever “freedom” and “liberty” they had) for wealth in the hope that this wealth may uplift their life. There is a huge existing trade of this factor of production: Chinese workers in Taiwan, Philippino nurses in US, Mexican workers in California, South Indian workers in the Gulf, Indian software programmers in US; the list goes on.
So whenever you argue against immigration (for whatever reasons) remember you are also arguing against free trade. (I find this particular interesting since I have seen people who call themselves die-hard free traders also vociferously rail against immigration).
Fortunately, in our digital world there is a new trend that selling of your labor in another place does not need you to actually physically travel to that place. This new concept of off-shoring is a great boon. Unfortunately, only certain kinds of services are amenable to this process (although more and more services are coming under the umbrella). The other problem is that it has only touched a few million people (and almost all of them in India). I do not see this as a solution of creating wealth in Africa or Mexico.
Some references and links
Fair Trade – this is a proposal set up by a few western companies and activists. IMO, it is riddled with contradictions and conflicts of interest. But it offers insight into the problems of current trade.
Henry C K Liu: On trade in general – While this author’s writing might reek of anti-Americanism his writings hold water as far as trade in concerned. His proposals are intriguing to say the least and make an interesting read and he discusses the issues mentioned in this post thoroughly.
I had started this post with the desire to pen all of my thoughts on global trade. It seems I have not estimated my thoughts correctly. The post is already 19,785 chars and I have not even started talking about details of exchange rates, mercantilism, FTAs like NAFTA or CAFTA, WTO, and last but not least IMF among other things. Perhaps I will talk about them in another post.
So, comment on what I have said, or ask any questions that you might have and I will try to answer it to the best of my ability. It might take some time for me to get back with answers because now that I have wasted my morning, I actually have to earn my keep and do some actual work.
Thats what happens when you type out a long post in a hurry. I will correct this.
