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Nobel Laureates Abhijit Banerjee, Esther Duflo on free trade & growth from their forthcoming book- Good Economics for Hard Times

It is so rooted in our culture that we sometimes forget that the case for free trade is by no means self-evident.

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Updated: Oct 15, 2019, 01.41 PM IST
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By Abhijit V Banerjee & Esther Duflo

Many of the issues plaguing the world right now are particularly salient in the rich North, whereas we have spent our life studying poor people in poor countries.

It was obvious that we would have to immerse ourselves in many new literatures, and there was always a chance that we will miss something. It took us a while to convince ourselves that it was even worth trying.

We eventually decided to take the plunge, partly because we got tired of watching at a distance while the public conversation about core economic issues — immigration, trade, growth, inequality or the environment — goes more and more off-kilter.

But also because, as we thought about it, we realised that the problems facing the rich countries in the world were actually often eerily familiar to those used to studying the developing world — people left behind by development, ballooning inequality, lack of faith in government, fractured societies and polity, and so on.

We learnt a lot in the process and it did give us faith in what we, as economists, have learnt best to do, which is to be hard headed about the facts, sceptical of slick answers and magic bullets, modest and honest about what we know and understand, and perhaps most importantly, willing to try ideas and solutions and be wrong, as long as it takes us towards the ultimate goal of building a more humane world.

A woman hears from her doctor that she has only half a year to live. The doctor advises her to marry an economist and move to South Dakota. Woman: ‘Will this cure my illness?’ Doctor: ‘No, but the half year will seem pretty long.’

Why Whisky and Rum Don’t Mix
The idea that free trade is beneficial is one of the oldest propositions in modern economics. As the English stockbroker and MP David Ricardo, explained two centuries ago, since trade allows each country to specialise in what it does best, total income ought to go up everywhere when there is trade, and as a result, the gains to winners from trade must exceed the losses to losers. The last 200 years have given us a chance to refine this theory, but it is a rare economist who fails to be compelled by its essential logic. Indeed, it is so rooted in our culture that we sometimes forget that the case for free trade is by no means self-evident.

For one, the general public certainly does not think so. They are not blind to the advantages of being able to buy cheap abroad, but worry that at least for the direct victims of cheaper imports, the gains are swamped by the costs. In our survey, 42% of respondents thought that low-skilled workers are hurt when the US trades with China (21% thought that they are helped), and only 30% thought that everyone is helped by the fall in prices (and 27% said that they thought everyone was hurt). So, is the public simply ignorant, or might it have intuited something the economists have missed?

Stanislas Ulam was a Polish mathematician and physicist, one of the co-inventors of modern thermonuclear weapons. He had a low opinion of economics — perhaps because he underestimated economists’ capacity to blow up the world, albeit in their own way. Ulam challenged Paul Samuelson, our late colleague, and one of the great names in 20th century economics, to “name me one proposition in all of the social sciences which is both true and non-trivial”.

Samuelson came back with the idea of comparative advantage, the central idea in trade theory. “That this idea is logically true need not be argued before a mathematician; that it is not trivial is attested by the thousands of important and intelligent men who have never been able to grasp the doctrine for themselves or to believe it after it was explained to them.” Comparative advantage is the idea that countries should do what they are relatively best at doing. To understand how powerful the concept is, it is useful to contrast it to absolute advantage.

Absolute advantage is simple: grapes don’t grow in Scotland, and France does not have the peaty soil ideal for making scotch. Therefore, it makes sense that France should export wine to Scotland, and Scotland should export whisky to France. Where it gets confusing is when one country, like China today, looks like it’s pretty much better at producing everything than most other countries. Wouldn’t China simply swamp all markets with its products, leaving other countries with nothing to show for themselves?

Ricardo realised in 1817 that even if China (or, in his era, Portugal) was more productive at everything, it could not possibly sell everything, because then the buyer country would sell nothing and would have no money to buy anything from China. This proved that not all industries in 19th-century England would shrink. It was then evident that if any industry in England were to shrink because of international trade, it should be the ones that were the least productive.

Based on this argument, Ricardo concluded that even if Portugal was more productive than England at producing both wine and cloth, once trade between them opened up, they would nonetheless end up specialising in the product in which they have a comparative advantage (meaning where their productivity is high relative to their productivity in other sector: wine for Portugal, cloth for England).

And the fact that both countries make the goods that they are at least relatively good at making and buy the rest, instead of wasting resources producing the latter ineptly, must add to the gross national product (GNP), which is the total value of goods that people in each country can consume.

Ricardo’s insight underlines why there is no way to think of trade without thinking about all the markets together — China could win in any single market and yet, there is no way for it to win in every market.

Of course, the fact that GNP goes up (both in England and in Portugal) does not mean that there are no losers. In fact, one of Paul Samuelson’s most famous papers tells us exactly who they are. Ricardo’s entire discussion had assumed that production required only labour, and all workers were identical, so when the economy became richer, everyone benefited.

Once there is capital as well as labour, things are not that simple. But Samuelson, in a paper published in 1941, when he was just 25, set out the ideas that are still the basis of how we are taught to think about it. The logic, once you understand it — as is often the case with the best insights — is compellingly simple.

Some goods require relatively more labour than others to produce and relatively less capital — think of handmade carpets versus robotmade cars. If two countries have access to the same technologies of production for both goods, it should be obvious that the country that is relatively abundant in labour will have a comparative advantage in producing the labour-intensive product, the carpet if you like. We would therefore expect a labour-rich country to specialise in labour-intensive products and move out of capital-intensive ones.

This should raise the demand for labour compared to when there was no trade (or more restricted trade) and therefore wages. And, conversely, in a relatively capital-abundant country, we should expect instead that the price of capital goes up (and wages go down) when it trades with a more labour-abundant partner.

Since the labour-abundant countries tend to be poor, and labourers are usually poorer than their employers, this implies that freeing trade should help the poor in the poorer countries, and inequality should fall there. The opposite would be true in the rich countries. So, opening trade between the US and China should hurt US workers’ wages (and benefit Chinese workers). That does not mean that the workers in the US must necessarily end up worse off.

This is because, as Samuelson showed in a later paper, the fact that free trade raises GNP means that there is more to go around for everybody, and therefore, even the workers in the United States can be made better off if society taxes the winners from free trade and distributes that money to the losers. The problem is that this is a big ‘if ’, which leaves workers at the mercy of the political process.

When Trees are Seen as Shady
When a rickshaw-puller in Abhijit’s native Kolkata takes the afternoon off to spend with his lady love, GDP goes down, but how could welfare not be higher? When a tree gets cut down in Nairobi, GDP counts the labour used and the wood produced, but does not deduct the shade and the beauty that are lost. GDP values only those things that are priced and marketed.

This matters because growth is always measured in terms of GDP. 2004, the year when TFP (total factor productivity) growth, after jumpstarting in 1995, slowed down again, is when Facebook began to occupy the outsized role that it currently plays in our lives. Twitter would join in 2006, and Instagram in 2010. What is common to all these platforms is the fact that they are nominally free, cheap to run, and wildly popular. When, as is now done in GDP calculations, we judge the value of watching videos or updating online profiles by the price people pay — which is often zero — or even by what it costs to set up and operate Facebook, we might grossly underestimate its contribution to well-being.

Of course, if you are convinced that waiting anxiously for someone to like your latest post is no fun at all, but you are unable to kick the Facebook habit because all your friends are on it, GDP could also be overestimating well-being. Either way, the cost of running Facebook, which is how it is counted in GDP, has very little to do with the well-being (or ill-being) that it generates. The fact that the recent slowdown in measured productivity growth coincides with the explosion of social media, poses a problem, because it is entirely conceivable that the gap between what gets counted as GDP and what should be counted in well-being widened exactly at this time. Could it be that there was real productivity growth, in the sense that true well-being increased, but our GDP statistics are missing this entire story?

Edited extracts from Banerjee and Duflo’s forthcoming book, Good Economics for Hard Times: Better Answers to Our Biggest Problems, Juggernaut Books.

Banerjee is Ford Foundation International Professor of Economics, at Massachusetts Institute of Technology (MIT), US, and Duflo is Professor of Poverty Alleviation and Development Economics, MIT. Both are founders of the Abdul Latif Jameel Poverty Action Lab (J-PAL) with Duflo as its director. Along with Michael Kremer, Gates Professor of Developing Societies, Harvard University, they are recipients of the 2019 Nobel Prize for Economics.

(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
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