Famous errors

Chapter 3: Advantage of one always disadvantage of the other?

Outline:

1st Introduction

2nd Specification of the basic thesis

3rd Five possible alternative behaviours

4th The role of the balance of trade in the justification of this thesis

5th What is the advantage of a positive trade balance?

6th Protectionism to achieve a positive trade balance

7th Long-term effect of a customs policy

8th The theory of comparative costs

1st Introduction

In this third chapter we want to deal with the basic conviction of mercantilism that in order to gain an economic advantage it is necessary for one state to cause economic damage to the other. Not the peaceful coexistence of individual nations, but mutual economic warfare was the normal case.

The term 'mercantilism' originally comes from Latin and is derived from the word 'mercari = trading'. Marquis de Mirabeau was probably the first to speak of mercantilism in 1763, referring to the prevailing economic theory of the time. Adam Smith, too, had always spoken of mercantilism when he opposed these doctrines. Later, this term was used in a general way to refer to the prevailing doctrine of the time; while at first only the critics of this doctrine (Mirabeau and Smith) spoke of mercantilism, this term was later also used by the supporters of this doctrine.

Mercantilism thus means the political exertion of influence of the state on trade and production in general and foreign trade in particular. Nowadays, this term is largely equated with state interventionism of any kind, which seeks to influence private economic entities, but above all enterprises.

Mercantilism, in the form in which Adam Smith fought it, was the economic doctrine of absolutism. Absolutism was the predominant state system from the end of the 16th to the 18th century and was particularly widespread in France, but also in a somewhat weaker form in England and in several small German states. Absolutism first emerged in France and reached its peak under the Sun King Louis XIV and King Louis XV. The way Louis XIV ruled and held court in Versailles soon became a model for the other rulers in Europe, especially for the Saxon King Augustus the Strong.

The absolutist king strove for sole reign in his dominion. Louis XIV is supposed to have once said: 'The state, that's me' (L'État, c'est moi). In the Middle Ages and the beginning of the modern era, the respective ruler had to share his power with the nobility and the clergy; he was controlled by the parliaments of estates, in which the nobility, clergy and citizens were represented.

The parliaments of the estates had the right to approve taxes. In this way they could significantly curtail the king's power. At the same time, the king was mainly dependent on the nobles, since all activities at court and in war were carried out by the nobles. On the one hand, the nobles were obliged to work for the king by providing mercenaries for the military campaigns of the kings apart from that they had to carry out the most diverse tasks at court, but on the other hand, the king himself depended on the willingness of the nobles to cooperate.

The absolutist rulers now sought to break this power of the estates. For this purpose, they created a standing army, so that warfare and its success no longer depended on how many able-bodied and trained mercenaries were made available by the nobles. At the same time, they built up a civil service with the help of which all the tasks at court could be carried out; the king was therefore no longer dependent on the services of the nobles at court.

In this way, the king could use his scarce resources much more efficiently than before. On the one hand, for each individual task, the most capable civil servants could be deployed. On the other hand, the fact that certain people were now always available for the same task increased their abilities even further.

2nd Specification of the basic thesis

Let us deal in more detail with this thesis, the advantage of one (country) turns into a disadvantage for the other (country). First of all, one could interpret this relationship from a moral point of view. One is entitled to strive for one's own advantage, even if in this way the respectively other suffers a disadvantage. According to Christian conviction, this may be considered amoral and therefore undesirable, since Christian morality draws a line for selfish striving where another person suffers harm as a result of one's own actions.

However, mercantilist philosophy goes a step further and interprets the statement: 'the advantage of one is the disadvantage of the other' not only from a moral point of view. It interprets this statement as an explicative statement in the sense that no other relationship is possible between two partners. Whenever an activity is to the advantage of one, another always suffers disadvantages. Either I harm the other or he harms me. No other alternative is seen at all. In this world, the natural law of 'eat or be eaten' also applies to interpersonal relationships.

Of course, it cannot be denied that in the past states have repeatedly attempted to enrich themselves at the expense of other countries and that they have very often been successful in these attempts. It is also hardly to be expected that in the near future states will completely renounce warlike conflicts. Incidentally, this basic attitude can also be found among individuals. Here, too, history is full of examples of how individuals harm others by murdering, stealing and lying and expect their own advantage from these actions.

This article is not intended to deal with this general attitude of people, of course it cannot be denied that we find such behaviour and that indeed the harm of one has often brought advantages to another. Here in this article, we want to limit ourselves to the question of whether a state can gain economic advantages by deliberately causing harm to another nation, it is neither a question of whether acts of war are triggered for general political reasons nor whether individuals also act according to this maxim.

3rd Five possible alternative behaviours

In order to analyse this mercantilist fundamental conviction in more detail, let us start from a matrix that lists all conceivable alternatives that are available to a state in relation to the other states. If we take advantage and disadvantage as a criterion for classification, we can distinguish between five conceivable alternatives.

Alternatives 1 and 2: It is quite conceivable that certain open alternatives do not bring any advantage to the respective actor at all (alternative 1), and may even cause damage to the actor himself (alternative 2). Here, it is irrelevant how the situation of the partners changes: This can remain unaffected, bring advantages, but also damage. It is clear: a politician who tries to increase the benefit of his nation will not take such alternatives, nor will anyone give advice to take such alternatives.

Alternative 3: Further alternatives are conceivable, which bring advantages to the respective actor (or perhaps only hold out the prospect of such advantages), but without affecting the situation of the others. There will probably be no one who advises against such an alternative. Even politicians who respect the interests of the other states will generally accept this alternative as desirable.

Alternative 4: We now consider the alternatives that promise advantages to the acting state just as in alternative 3, but at the same time cause damage to any neighbouring states. It is clear that opinions differ here: While the mercantilist quite clearly regards such an alternative as justified and also desirable, a Christian-based morality comes to reject it. Of course, it is not rejected here either that such alternatives exist and that a large part of the states regards such alternatives as justified.

Alternative 5: Finally, those alternatives remain in which all parties involved gain advantages. It is clear that in these cases, from probably all points of view, such alternatives are considered highly desirable.

Of course, another alternative would also be conceivable, in which different effects on third parties can be observed in relation to the advantage of the actor: Some are damaged by the action, others also experience advantages, a third group remains unaffected. However, we can assign such possibilities to alternatives 3, 4 and 5 that we have already discussed. In this case, an action comprises several alternatives - with regard to the effects on others - and thus represents a mix of the other alternatives.

The essential difference between mercantilists and other doctrines, such as e.g. liberalism, is that mercantilism differs from other doctrines not only in how individual ways of acting are judged morally. In contrast to other schools of thought, mercantilism denies that there are any alternatives in the real world that do not belong to category 4. The advantage of one is (almost) always associated with a disadvantage of another. This means that, according to the mercantilist view, category 4 contains almost 100 per cent of the alternatives, while all other categories are almost empty.

4th The role of the balance of trade in the justification of this thesis

We must now ask ourselves which findings led mercantilism to this pessimistic view. Doesn't this conviction contradict our everyday experiences? Do we not notice in our lives that at least some of the possible alternatives benefit several people at the same time?

The answer to this question can be found by looking at the balance of trade. A balance of trade of a country compiles all revenues and expenditures that arise from trade with other economies. On the left-hand side of the balance sheet we enter all income from trade relations with other countries, while on the right-hand side we enter all expenditures arising from foreign trade relations.

Instead of the balance of trade, we could have chosen the current account balance or even the balance of payments. The current account balance is based on the trade balance and also includes the revenues and expenditures from the transfer of services and free services. In the balance of payments eventually, all payment flows from external relations are included in the analysis, i.e. proceeding from the current account balance, short- and long-term capital movements including foreign exchange trade are also taken into account. The fact that mercantilism was generally based on the balance of trade and not on the current account was simply due to the fact that service transactions were not yet of greater importance in international trade. Finally, the balance of payments is less suitable for our considerations, simply because a balance of payments is ex definitione always balanced.

In general, imports are paid from the foreign exchange earnings generated by the export of goods. If the value of exports and imports were equal, all imports could be paid from the foreign exchange earnings associated with exports.

However, foreign economic transactions can always be paid with gold, i.e. the official international currency of the time. Importers are forced to take this step if the foreign exchange earnings from exports are not sufficient to pay for all intended imports. In principle, the importer can always settle his imports with both forms of payment. Whether he pays with foreign exchange or gold depends solely on whether foreign exchange or gold achieve a lower price. Whenever less is exported than is imported, the exchange rate rises with the result that from a certain price onwards the purchase of gold becomes cheaper and it is worthwhile for the importer to pay with gold. This price of a foreign currency is therefore also called the gold point.

The import value sum in this case corresponds ex definitione to the sum of foreign exchange earnings plus the payment with gold, which must automatically lead to a gold export.

Conversely it applies that if the export value sum exceeds the import value sum, no longer merely foreign exchange is collected for the exports, but that exports partly lead to gold proceeds and thus to gold imports. Here too, in the case of an export surplus, the sum of foreign exchange earnings and gold imports equals the sum of export values. Both sides of the balance of payments are therefore also always - at any moment - balanced ex definitione if besides the proceeds from the transfer of goods, the transfer of gold is also included in the consideration.

Let us now also look at the trade balance of the countries that conduct foreign trade with us. Ex definitione, the import value sum of our economy corresponds to the export value sum of all our trading partners. This relationship simply results from the fact that the same goods that leave our country, i.e. that are exported, are imported by one of our trading partners, so that both value sums must correspond, since they refer to one and the same purchase act. Of course, the same applies mutatis mutandis to the export value sum of our country. For the same reasons, this also corresponds to the import value sum of the foreign economies with which we conduct foreign trade.

From these considerations follows now that an export surplus of our own country is always accompanied by an equally large import surplus of our trading partners. If we now strive for an export surplus, this is tantamount to saying that if these efforts are successful, the foreign country as a whole must automatically achieve an import surplus of equal size in relation to our national economy.

In general, we speak of an active trade balance of a national economy when it has an export surplus; conversely, a country has a passive trade balance when the import value sum exceeds the export value sum.

If we now assume that the welfare of an economy increases ceteris paribus, the higher the export surplus is, and correspondingly decreases, the higher the import surplus is, we can automatically derive the core theorem of mercantilism from this: it is desirable to achieve an active trade balance, but this automatically means that the foreign country achieves a passive trade balance in relation to our economy, which according to these ideas is equivalent to a welfare loss abroad.

5th What is the advantage of a positive trade balance?

We now only have to conclusively clarify why the mercantilists assumed that an active trade balance is always desirable for an economy. Doesn't this idea contradict all appearances? If we receive more imported goods from abroad than we export abroad, we increase our wealth; the more goods we receive for one unit of export, the better off we are, aren't we?

This view, however, would be too superficial. If foreign countries provide us with more goods than we deliver to them in exchange, we actually do not receive this surplus of goods as a gift, we have to pay for it with gold, and thus lose welfare through the export of gold.

The answer, of course, is that the absolutist ruler can only achieve his goals if the national economy flourishes. Indeed, as we will show in the next section, the goals of absolutism can only be realised if the state increases its revenues, i.e. can raise higher taxes, and of course the prospect of increased tax revenues increases in proportion to the growth of the national economy as a whole. According to the concept of the mercantilists, however, the growth of the national economy itself depends in turn on whether the national economy is supplied with sufficient money.

We had a gold currency at the time of absolutism and France was a country that did not have any major gold mines on its own at the time, so the quantity of gold could only be increased mainly because of an active balance of trade. We had already critically examined these monetary theory doctrines in the previous chapter. At this point, it is sufficient to have shown why, according to the mercantilist view, an active balance of trade is indispensable for the well-being of an economy and why, in this way, the advantage of one country is always accompanied by the disadvantage of one or more other countries.

In conclusion we want to state that mercantilism must be seen as a doctrine that sees the advantage of a nation as the result of conflicts between national economies. However, it should be noted that liberalism vehemently opposed this idea and defended the view that, on the contrary, harmonious relations exist between nations, provided that one is prepared to abandon the mercantilist regulation of foreign trade by the state and allow free trade, which is not hindered by any tariffs and other measures. The differences between the two world views are, however, somewhat more complicated than it was possible to characterise one world view (mercantilism) only as a conflict model and the other (liberalism) only as a harmony model.

6th Protectionism to achieve a positive trade balance

The mercantilist state tried to achieve this goal of an active balance of trade primarily by imposing a tariff on the import of foreign goods. This instrument is certainly one of the most elaborate complexes of measures of mercantilism. This instrument serves here two purposes. On the one hand, the aim was to raise additional revenue for the state that could not be controlled by the parliaments of the estates. On the other hand, the state also wants to open up new markets for domestic enterprises. In this context, import duties serve to prevent domestic enterprises from being exposed to foreign competition. At the same time, the state facilitated access to foreign markets for domestic enterprises by granting export premiums, thereby enabling domestic enterprises to sell their goods abroad even below cost.

In this context, finished products are treated differently from raw materials. While the state endeavoured to reduce the import of goods by imposing import duties, it was also concerned to prevent the export of raw materials as far as possible by imposing export duties. France was one of the countries that had only a small quantity of raw materials domestically and, even during the heyday of mercantilism, did not have enough colonial states in Africa, America or Asia from which it could then obtain the raw materials it needed. They were therefore dependent on reserving the few available raw materials for domestic enterprises. This policy was complemented by the fact that premiums were granted by the state for the import of scarce raw materials, just as premiums were paid for the export of goods.

7th Long-term effect of a customs policy

Let us now ask ourselves to what extent the mercantilist state could actually achieve the goal of increasing the economic welfare of its own nation through its customs policy. This question was raised above all in the context of the discussion about the tariff optimum, although it was a discussion that was mainly confined to science. The starting point of this discussion was the observation that the trade equilibrium generally does not lie in the volume of trade and the terms of trade that guarantee a welfare maximum for the domestic state. With the help of the exchange curves developed by Alfred Marshall, it could be shown that the introduction of import tariffs up to a critical limit can improve the terms of trade and thus also domestic welfare, although the change in the terms of trade reduces the volume of trade.

Despite this observation, it could be shown in the framework of the continuation of these considerations that, in the long run, countries that want to increase their welfare by introducing import tariffs will even have to accept a loss of welfare in the long run. The reason for this is that hardly any country will accept that its export opportunities are reduced by tariffs imposed by other nations. In general, the states that are threatened in this manner will in turn introduce import tariffs on the imports of those states that have started this protectionist policy. This inevitably leads to a tariff war.

The fact that the other countries now also try to influence the terms of trade in their favour then leads to the terms of trade developing back to their original relationship with the consequence that the initial advantages of the state that started this tariff war are lost again. However, since every imposition of import tariffs ultimately reduces the volume of trade, in the end there is even a deterioration for the nation that was the first to introduce import tariffs. On the one hand, the terms of trade have not improved in favour of this nation; on the other hand, the imposition of tariffs by both domestic and foreign states has led to a reduction in the volume of trade and thus to a reduction in the international division of labour. Since productivity increases are associated with almost every division of labour, the reduction in the volume of trade has a negative impact on the welfare of all nations involved in international trade.

8th The theory of comparative costs

However, classical foreign trade theory has not only shown that a protectionist foreign trade policy harms the state that adopts it in the long run, it has also shown that and why refraining from a protectionist policy provides welfare gains to all nations involved in foreign trade by granting free trade. This evidence was made primarily in the theory of comparative costs developed by Davis Ricardo.

The basic thesis of the theory of comparative costs developed by David Ricardo states: In foreign trade, it is not the absolute but the comparative costs that determine the competitiveness of an economy. Comparative costs are defined as cost ratios (k₁/k₂). The comparative costs of the domestic market are related to those of the foreign market, whereby the domestic market has a comparative advantage in good x₁ if the following relationship applies:

(k₁/k₂) ^I < (k₁/k₂) ^A

k_n: unit costs I: domestic A: foreign

Accordingly, a country i has a comparative advantage with regard to good x₁ if the cost ratio of good x₁ to another good x₂ (k₁/k2₂) turns out to be lower at home than abroad.

The theory of comparative costs assumes that every economy has a comparative cost advantage in at least one good, even if the absolute costs for all goods are higher in the domestic market than abroad. The sole exception to this rule would only apply if the cost structures of all countries were identical.

The basis of this theory in its original form lies in the classical labour theory of value: the relative prices in the long run are determined only by supply, and specifically by the average costs. The demand, on the other hand, only influences the price level in the short term. All costs can be traced back to a homogeneous factor of labour and thus to a certain number of working hours within the framework of the labour theory of value.

The rent is a consequence of price increases, so it cannot be the cause of the long-term price level. The cost of capital (interest costs) increases all prices proportionally, so it cannot be a determinant of price ratios. A prerequisite for this statement is, however, that the useful life is the same for all capital goods. The structure of the individual labour qualities is determined technically, so that different labour hours can be converted into a standard quantity. The technology thus seems to clearly determine the level of average costs; most importantly, there is no dependence on the output quantity.

Ricardo tried to prove that an increase in world production is achieved when each country specialises in the goods in which it has a comparative cost advantage.

The spreadsheet compares the production ratios before and after specialisation through foreign trade. The domestic market has a comparative advantage in good x₁ and will therefore specialise in this good after the start of foreign trade, while the foreign market has comparative advantages in good x₂ and will therefore specialise in this good. As the spreadsheet shows, more goods are produced by both good x₁ and good x₂ after specialisation.

Before specialisation, the domestic sector produced 10 units of good x₁ at a cost of 4 labour hours per unit, so that a total of 40 cost units were spent on the production of good x₁. In contrast, the domestic sector produced 12 units of good x₂ at a cost of 5 labour hours, so 60 cost units were spent on good x₂. A total of 100 cost units were therefore available for both goods.

After specialisation, all 100 cost units are used in the domestic sector for production x₁, since the comparative advantage of the domestic sector lies in this good. Thus, a total of 100/4 = 25 units can be produced.

For the foreign country it is now assumed that both products have lower costs in absolute terms, 3 cost units for the production of good x₁ and only 1 cost unit for the production of good x₂. Previously, the foreign country produced 10 units of good x₁ and 12 units of good x₂. Since the foreign country has its comparative advantage with good x₂, it now specialises in this good and with its 42 cost units it can also produce 42 * 1 = 42 quantity units.

Thus, for both countries together, 25 units of good x₁ and 42 units of good x₂ are now produced. Previously, only 20 units were produced from good x₁ and 24 units from good x₂. Consequently, after specialisation, more units can be produced from both goods.

Here, there is a tendency towards complete specialisation, since the costs and thus also the cost ratios do not change after foreign trade has commenced. If we follow the specialisation process step by step, it is true for each performed extent of specialisation that both countries respectively have a clear cost advantage in one good and that therefore an expansion of specialisation remains advantageous until full specialisation is finally achieved.

No statement is made either about how the foreign trade gain is distributed between the two countries. The new equilibrium price lies - depending on the balance of power - between the previous comparative costs of both countries.

Now how does this specialisation come about? First, the country with the absolutely lower costs (in our example, the foreign country [red]) exports both goods. This country therefore initially achieves a positive current account balance. The home country pays for its imports with gold, so gold flows abroad while the domestic country loses gold. In accordance with the practice of the central banks, the money supply is reduced domestically, resulting in general price reductions, while abroad the money supply in circulation rises and with it the general price level. The price ratios converge. Finally, the exporting country (in our example, the foreign country) is only absolutely cheaper in the good that also has the lower comparative costs. The domestic market thus offers the good with the comparative cost advantages (x₁) also at an absolutely lower price, both goods are exchanged and the balance of the foreign exchange balances can be reduced again.

These conclusions apply analogously in regimes of floating exchange rates; here it is not the export or import of gold, but revaluations or devaluations of the exchange rates that ultimately lead to the shown result.

Even if the original theory of comparative costs was based on simplified and not always realistic assumptions, the further development of this theory by Gustav Haberler and J. Meade has shown that the basic statements of the theory of comparative costs could also be maintained in a further developed theory. Even if we abandon the labour value theory of the classical theory and include the fact that unit costs change with the change in the output quantity itself, the statement remains that foreign trade that is not hindered by protectionist policies brings generally welfare gains to all nations involved in foreign trade. And that thus the mercantilist thesis, according to which a country can only gain an advantage by causing damage to the foreign country, is clearly wrong.