Essay

More than a gift from the gods

THE CONCEPT OF comparative advantage is perhaps the single most powerful idea in economics. It is taught to every undergraduate and printed in every introductory textbook. It has all the hallmarks of a great theory: simple, non-obvious, logically irrefutable, with sweeping implications. And adherence to it promises a better world.

Never expressed better than by David Ricardo, its originator, the theory states that even if England is more efficient than Portugal at producing both textiles and wine, but Portugal is relatively better at producing wine than textiles, both countries would prosper if England produced all the textiles needed by the two countries and Portugal all the wine. The idea is to allow free markets to allocate resources to the sector(s) in which a nation has a relative productivity advantage and then trade freely to enjoy the benefits. In turn, free trade nudges the economy to concentrate on its comparative advantage.

Nowhere has this proposition had more impact than in Australia. Indeed, many would have it define the destiny of the nation. Comparative advantage stands today at the core of the free-trade ideology that dominates public discourse about the future. Applied to Australia, the theory proposes that this country stop trying to produce goods or services in which we lack a relative advantage – say, manufacturing and tradable services – and focus on exporting those in which we do, namely resources. And that's exactly what the Australian economy has been doing in recent years: narrowing, largely with the support of official policy.

Yet, in spite of its logical power and its promise of a painless path to superior economic performance, the idea of comparative advantage has always struggled for supremacy in Australia. Over the course of this country's economic development, comparative advantage has repeatedly been dethroned by another proposition: that, rather than narrow its focus to resources, Australia should broaden its economy, using its natural resource advantages as a platform from which to build other sectors.

Deliberate broadening appears to fly in the face of the prescriptions of comparative advantage and its companion, free trade. It implies protectionism and deliberate, government-directed industry policy. Today, these notions are almost universally rejected by economists and are even out of favour among political leaders of all stripes. Nevertheless, the impetus to broaden seems not to die, and every few years it re-emerges to shape the nation's view of its future. Indeed, the history of Australian economic policy can be seen as a century-long battle between these two propositions.

Why cannot such a great idea as comparative advantage – logical, simple and with the power to make everyone better off – achieve lasting dominance, particularly in Australia, which seems so obviously to be blessed by a compelling comparative advantage? How does such a seemingly discredited idea as protectionism keep reappearing? Put simply, why should the Portuguese (or Australians) exert extra effort to turn out five metres of woven cloth when, for the same amount of work, they could take advantage of their blissful climate and rich soil to produce six barrels of wine, trade three with England for perhaps ten metres of cloth and keep three barrels for their own enjoyment?

The answer is that as a guide to the economic future, and policy-making to shape the future, comparative advantage turns out to be fatally flawed. While as a snapshot fixed in time, and limited to the economic sphere, it is beyond reproach, looked at over time it ignores three vital dimensions of economic development: differential industry growth, technological improvement and the divergent social consequences of concentration in different types of economic activity. In fact, the theory of comparative advantage ignores economic development entirely – including the vital issue of the origins of comparative advantage itself. And therein lies its downfall, both as a concept and as a guide to good policy-making.

 

LET'S CONSIDER EACH of these three problems for comparative advantage. First, industries tend to grow at very different rates as societies become richer. Demand for meat grows faster than for rice, for automobiles faster than for bicycles, for televisions faster than for radios. This has an important implication for nations specialising in their comparative advantage. In Ricardo's illustration, for example, history shows that as Europe emerged from the centuries-long grip of poverty, demand for England's textiles grew much faster – by up to five times – than did demand for Portugal's wine. Clothing is much more ‘income elastic' than wine; as people break out of poverty they buy many more sets of clothes than they do casks of wine. The result was that by specialising in their respective comparative advantages, Portugal's economy stagnated, growing only as fast as population, but Britain's roared. It matters a great deal in which products your economy specialises and has comparative advantage. The East Asian nations that have improved so dramatically in recent decades have done so by specialising in fast-growing manufacturing sectors, not slow-growing traditional parts of the economy.

Second, as with growth rates, industries have very different technological potentials over time. England's textile producers spectacularly increased their output during the industrial revolution by introducing a string of new machines, driving productivity to hitherto unimagined heights; Portugal's wine makers, by contrast, were forced to continue growing grapes and pressing juice from them, with only marginal increases in output over time. This effect is even more marked today, with huge disparities among industries in average technology-driven productivity growth rates, particularly in the fields closest to the twin revolutions of computers and biotechnology.

Third, and perhaps most importantly, different industries have divergent social consequences. Which industries a society specialises in can exert important influence over the type of society that emerges: its relative equality, its social cohesion, its propensity to democracy, and even its sustenance or otherwise of such intangibles as personal self-respect and the arts. Some industries generate novel skills, and with them equality and self-reliance. The English textile industry created new classes of skilled workers, managers, fashion designers, equipment engineers and dye chemists, all of which were well rewarded for their skill and experience. The industry further supported a network of educational, technical and scientific institutions-which in turn spawned further technological advance. The textile industry also demanded increasingly sophisticated and complex machinery, which led to the birth of other industries, in a virtuous cycle. The Portuguese wine industry, with its time-honoured – and massively unequal – mix of peasants, winemakers and landowners, needed, and generated, little external support.

Indeed, it can be argued that the textile industry was important not only for creating the wealth that made England the richest country in the world in its day, but also for laying the foundations for the broadening of democracy to the majority of the population, and the flowering of science and the arts that was so apparent in eighteenth– and nineteenth-century Britain. Portugal's wine industry offered no such potential. In general, a society dominated by industries in which artisans and small enterprises are the natural form of economic organisation (textiles) can be expected to develop a very different character to one in which a single wealthy and powerful landowner employs the other members of society (Portuguese winemaking), or in which most people work for – or receive income without work from – the government.

Had the eighteenth-century Portuguese been able to divine the future, they would have been much better off ignoring Ricardo's advice and imposing a prohibitive tariff on English textile imports, giving their own textile industry a chance to survive and potentially even expand.

The proponents of comparative advantage and free trade would respond that Portugal's citizens would have seen their living standards lowered by any such decision, and that in any case England might retaliate with a tariff on wine. They would be right. Residents of Portugal would have had to put up with lower-quality and probably more expensive clothes, and would likely have sold less wine. But in Ricardo's example, there was no other way for Portugal to escape what became its fate over the next two centuries.

 

WITHOUT DELIBERATELY SETTING their sights on industries against their comparative advantage, Portugal could not develop. And indeed, no country has broken the grip of underdevelopment without ignoring the theory, at least as it is traditionally understood. The United States in the nineteenth century, Japan in the twentieth, Europe after World War II, East Asia in the 1980s and 1990s, and China today: all nations that have developed have done so contrary to the precepts of comparative advantage. Far from being a guide to good policy for aspiring nations, the theory has been a poverty trap.

In the principal industries that have driven economic development over the past two centuries – manufacturing and services – comparative advantage is not endowed by God but created, by human effort, ingenuity and organisation: comparative advantage can be brought into existence by deliberate investment and sustained commitment. This recognition makes all the difference. Because the theory is mute on the origins of comparative advantage and how it changes over time, it offers no guidance to how it can be constructed. Instead of insisting that nations stick to what they start with, we should ask how comparative advantage is created and what can be done to change a nation's destiny.

Actually, most economists, or at least those even slightly acquainted with history and the real economy, know this. They know that no nation has developed by applying the theory of comparative advantage, and they are aware that in the most important industries that advantage is deliberately created.

But they are reluctant to admit they know it. The real reason most economists espouse comparative advantage and free trade has nothing to do with economic theory. It stems from political judgement. Economists fear that conceding the possibility that comparative advantage might be created by the tools of government policy – tariffs, quotas, import prohibitions, low-interest loans, tax exemptions, subsidies, targeted education, government-funded research and development, military spin-offs, to name but a few – will open the floodgates to government-mandated protection for monopolies that have no hope of ever standing on their own feet. They worry that government will be captured by special interests, and industry policy will become merely a cloak for the kind of inefficient and expensive government-connected industries that are so common in the Third World. Economists commonly fear that democracies are especially prone to such capture, and that rather than building the industries of the future the slogans of ‘nation-building' will merely shelter dinosaurs.

 

THE FEAR IS valid. It may well be true that modern western democracies are no longer capable of sustaining commitment to future-oriented industrial development strategies, and that they will inevitably lapse back into pork-barrelling and special-interest protection. As western nations fragment into squabbling tribes, rancorously fighting over ever more hardened ideologies, perhaps we have lost the cohesion required to deliberate and to act. Certainly, the contemporary world offers plenty of evidence for such concern.

But if we accept this pessimistic view, it is important to be aware of the consequences. With the exception of a lucky few who do enjoy an insurmountable God-given comparative advantage, such a failure will likely doom western democracies to long-term economic decline. Successive waves of technological development rapidly supersede today's comparative advantage. If nations allow markets to narrow their bets to today's advantage and industries built in prior eras, they risk their industries being replaced as rapidly as the products they once made.

In this sense, all industries today are infant industries, the one exception allowed by the free-trade theorists. Technological change and targeted support from rivals can render a once healthy, grown-up industry a helpless infant within a few years. And along with these industries goes the service infrastructure that is intimately connected to them: banking, insurance, financial services, advertising and consulting. If assistance is denied to these industries, due to a fear of protectionism and in the face of competition from nations deliberately building new comparative advantage with every tool at their disposal, the overtaken industries will wither.

The overwhelming majority of Australia's manufacturing industry has already suffered this fate; much of North America's has gone down the same path. Failure to commit decisively to an alternative comparative advantage will lead inevitably to further narrowing towards our natural endowment in resources.

 

THE CONSEQUENCES WILL be not only economic but social and, for many, personal. Loss of the non-resource industries will transform our culture in as yet unimagined ways. But before we admit defeat, it is worth considering very seriously whether any other future is possible. Might we not be able to build a new comparative advantage? And what would be required?

One set of answers might come from our own past. The character of contemporary Australia, especially of its economy but also many of its social values, was forged more than a hundred years ago. In the decade following Federation, Australia's political parties negotiated an economic consensus that aimed to create the future desired by the population of the time.

This consensus survived largely intact until the late 1970s, and still underlies public assumptions about and expectations of government. The strategy was to draw upon the nation's natural comparative advantage in farming and resources to finance a shift to manufacturing. Key planks in the platform were tariff barriers to protect and promote manufacturing, racial and workforce insulation (the White Australia policy and the protection of wage workers from foreign competition went hand in hand), needs-based wages and judicially determined industrial relations, equalisation of revenues among the states, and a growing welfare role for the federal government.

These commitments were funded directly, through taxes on the resource and farming exporters, and indirectly, through tariffs and restrictive immigration. This ‘Federation settlement' took eight difficult years to agree upon, during which time Australia had three elections, nine minority governments and two failed efforts to fuse the non-Labor parties. Stability came only in 1909, with the merger of the non-Labor parties as a credible alternative to the Labor Party.

It was a deliberate, and successful, effort to build a particular type of economy that would shape a particular type of society – essentially, the one Australians live in today. The structure of the Australian economy was purposefully transformed, as investment and employment shifted from farming and mining into manufacturing. Farming and mining employment declined from 30 per cent of the workforce in 1901 to 12 per cent in 1968, while manufacturing employment rose over the same period from 12 per cent to 27 per cent. Services (termed ‘Other' in the statistics) remained largely stable, shifting only from 58 per cent to 61 per cent. To reiterate, this transformation was not a ‘natural' shift or a simple response to ‘market forces', but a consciously targeted and implemented political and social vision.

To succeed in the transformation, Australia's leadership had to understand comparative advantage in a novel way: not as an imperative to narrow the economy to a few advantaged sectors, which would export while the rest of the things the nation wanted to consume were imported; rather, as a source of finance to build the kind of economy that would support the liberal-democratic, diversified, middle-class nation in which Australians aspired to live.

WHAT WAS NOT undertaken, though, was the construction of a new comparative advantage. Australia's economic vision throughout most of the twentieth century was to continue exporting resources, while diversifying its economy into sectors that remained largely domestically focused and sheltered behind tariff walls. Unlike in other nations, tariffs were not employed as a means to construct infant industries that would ultimately prove to be export-capable. As the domestic economy diversified, Australia's export portfolio remained relatively unchanged.

Consequently, as the burden of protection increased in the 1970s, with a long-term decline in resource and farm-based global commodity prices (relative to the price of imports), Australia's manufacturing and service industries were generally incapable of competing globally. They had not built a comparative advantage – unsurprisingly, since they were never intended to.

With the progressive removal of tariffs in the 1970s and 1980s, the trade-exposed portions of manufacturing and services shrank. Manufacturing declined as a share of gross domestic product, from a high of 28 per cent in 1956 to 11 per cent in 2007; and of employment, from a high in 1954 of 28 per cent to today's 10 per cent.

In recent years, the narrowing of Australia's economy, especially its export portfolio, has accelerated. Today the nation's exports are more dominated by resources than almost ever before. Minerals alone accounted for 59 per cent of merchandise exports in 2006 and 63 per cent in 2007, with iron ore and concentrates rising from $5.3 billion to $12.5 billion, and exports of coal from $10.9 billion to $24.4 billion. This concentration in resources is in marked contrast to any other developed country, even other resource-rich nations such as Canada that have broadened their economies and exports.

The implications of this narrowing focus, and the domination of public discussion of the nation's economic future by notions of nature-based comparative advantage and free trade, are likely to be profound. At the purely economic level, although primary production remains a small proportion of the overall economy (less than an eighth), the prosperity of the growing service sectors and of the remaining manufacturing sector – to say nothing of the finances of the Australian Government, which underwrites a substantial proportion of household income – depends greatly on the resource sector. Should that falter, for example due to a downturn in East Asia, Australia would rapidly encounter difficulty in servicing its mounting foreign debt. (Although there are frequent assertions to the contrary, Australia is one of the most foreign-indebted nations in the world, but the debt is private rather than government.)

 

OF PERHAPS EVEN greater concern are the long-term effects on the character of Australian society of an ever greater economic narrowing and resource focus. Resource-rich societies tend to come in two variants: either the resources are privately controlled, usually by a shrinking number of larger companies, or the government gains control, ‘redistributing' the wealth more or less widely. In the long run, even if successful – and there are many examples of failed resource-exporting nations – neither offers an attractive future. While privately controlled resource-rich nations can have high average incomes, the average almost always disguises a bifurcated population: a few rich who own or are employed by the resource-extraction industries, alongside many poor who don't, and little in between. The all-important middle class is absent, and with it the economic and social bulwark of democracy and opportunity.

Government is usually captured by the resource owners. And resource industries have traditionally proven to be weak multipliers of income and opportunity across society. In particular, they provide few opportunities for education– and skill-based advancement, and almost none for entrepreneurial achievement (outside of a very few exploration and service companies, usually critically dependent on connections with government and the large companies).

It is not an attractive picture. Fortunately, however, this is the least likely scenario. Most Australians would strenuously resist such an outcome, and the long-term strength of democratic institutions in Australia would almost certainly prevent the nation evolving into a kind of Saudi Arabia Down Under.

Much more probable, given Australia's history and social expectations, is that government will incrementally expand its control over the resource industries, seizing an ever expanding share of the proceeds. Indeed, around the world, from Russia and Brazil, through Norway and the Middle East, this is the model towards which resource-rich nations are gravitating. It is the one that fits best with the long-term Australian commitment to government as a guarantor of living standards, welfare and economic risk-bearing. In early 2010 it was reflected in new tax proposals under consideration by the federal government and at least two states.

But with fewer of the well-paid, skill-intensive jobs in manufacturing and non-resource-oriented areas, what would such a government-dominated society look like? As government is able to provide for its citizens more and more directly, its share of national economic activity would inexorably expand, and with it the dependence of the citizenry on government for economic wellbeing. The result would be a society in which the ability to undertake a task effectively is less important than getting along well with government, a society in which politics dominates self-reliance. It's ultimately a society in which the citizens are infantilised, as they remain lifelong mendicants of government. This can occur directly, with a growing proportion of the population dependent on government payments (in my home state of Tasmania, 34 per cent of households now have as their sole or primary source of income a Commonwealth Government payment), or indirectly, with a rising proportion of the population employed by government or government-owned entities.

 

COULD AUSTRALIA USE its comparative advantage to avoid – rather than fall into – this fate? It did in the past, through tariffs and domestically focused manufacturing. But that will not work in the future. With vastly improved freight to reduce import costs, and dramatically cheaper manufacturing in China and elsewhere, the cost gap of any attempt to resurrect the Federation settlement and manufacture most items in Australia would be prohibitive. That path is, in practical terms, blocked. Any simple-minded reintroduction of tariff protection won't achieve the aim of building comparative advantage in desirable industries. It will breed non-capable industries, possessed of comparative disadvantage, sheltered behind ever more expensive walls.

Two other alternatives are possible. Both focus on building new human-derived comparative advantage on the back of natural advantage, and both test themselves in global competition. One looks to value-adding in resources, by employing the income flows from minerals and energy to support massive new infrastructure and capital equipment investment. The other seeks to build on traditional strengths in industries in which the product is low-technology, such as food, by adding science and know-how to provide safer, more environmentally sustainable solutions.

But neither will be achieved by market forces alone, or by following comparative advantage as conceived by the economists. Economics is the study of markets: interactions and transactions among individuals and organisations. Why some individuals, organisations, regions or nations come to be better than others at performing the tasks that matter in market transactions is seen by most economists as being outside the scope of economic theory, a matter for historians, business analysts or organisation theorists. Yet, at its heart, comparative advantage is about just such economic capability: the ability to meet human wants better than rivals can.

Unfortunately, media coverage of economic issues rarely focuses on capability. It tends to dwell instead on eye-catching stories of managerial blunders or power struggles, mergers, acquisitions, business cycles, currency exchange and interest rates, taxes, fluctuations in energy prices. But none of these is fundamental. They can at best be thought of as contributing to shallow capability: short-term pricing and cost issues. Shifts in exchange rates, tax levels and interest rates might buffet companies' business and financial performance, inflating or deflating earnings for a year or two, but they are surface phenomena. Underlying the dramas that surround these topics are the permanent or enduring factors that determine sustainable prosperity.

Because the media focuses on the shallow factors, so too often do political leaders, ignoring the deep capabilities that develop more gradually and last longer. These include accumulations of strategic resources and proprietary knowledge, which demand for their realisation organisational routines and employee commitment, and in turn enable superior problem-solving. Deep capabilities are thus those aspects of the economy that are difficult for others to emulate and that support ongoing gains in competitiveness. To develop new capabilities – comparative advantage – we need to move from a static to a dynamic perspective. In the contemporary economy, deep capabilities are created more by human effort, skill, and organisational and institutional effectiveness than gifted from God. In reality, countries mostly make their own ‘luck'.

 

THREE CHARACTERISTICS OF economic capability are of particular interest when considering the construction of comparative advantage. First, in their traded sectors, economies tend to specialise according to their comparative advantage. That is, they concentrate in the fields in which they have acquired or built deep capability. Products and services from these sectors in a particular geography can generally out-compete those from others. While all developed economies include large and relatively similar proportions of largely non-trade-exposed sectors – health, education, community services, security, home-building, retail, personal services – in their traded sectors economies can be remarkably concentrated. And the traded sector is especially important for two reasons: first, non-traded sectors generally grow only roughly in line with population and per capita income, whereas traded sectors can generate far greater expansion as they tap distant and overseas markets. In a modern economy, especially a small one, many of the goods and services citizens want can be obtained only from afar; generating the income to pay for these imports depends on what the community can sell to the world. The economic fate of relatively small communities, such as Australia, can thus rest on a surprisingly narrow base of capability in very few fields. Ensuring the long-term strength of these sectors ought to be a high priority for any community and its government.

Capability is commonly geographically concentrated. Successful industries show a marked tendency to cluster in quite small regions. Such clusters include famous names like Silicon Valley in technology and the City of London and Manhattan in finance, but also such less-known locations as Aalsmeer, twenty kilometres south-west of Amsterdam, the global cut-flower trading capital (with 60 per cent of the global trade), and Surat, in the Indian state of Gujarat, which cuts 92 per cent of the world's diamonds. Capability concentrates regionally because much of the basis for capability within firms exists and is maintained outside firms, in educational and research institutions, finance, local industry and community bodies, support and allied service industries, and community memory. The combination of these elements can be thought of as the local capability platform, and the health of these platforms is of vital interest to the future of these communities.

Capability also assumes different forms, and is created by different processes, in different sectors. If capability can be thought of as the ability to perform tasks that matter in competition, what matters in competition varies industry by industry.

These three observations lead to an important implication: the construction of comparative advantage implies geographic and sectoral decentralisation. To promote capability and comparative advantage effectively, government policy ought to focus on sectors in which the economy specialises, and be geographically specific. There can be no effective one-size-fits-all ‘best' economic policy.

How, then, might we navigate between the twin – but opposite – evils of, on the one hand, undesirably narrowing and potentially atrophying comparative advantage; and, on the other, coddling long-term state mendicants? We must expose candidates for strengthened comparative advantage to competition, while improving their ability to survive in that competition.

Consider coal and iron ore, Australia's most important exports. While a necessary precondition for the nation's prominent position in international trade in these sectors is a surplus of raw materials over domestic needs, that alone does not create global comparative advantage. In commodity competition, it is not sufficient simply to have been endowed with a surplus of the material in the ground. The tasks that matter in such commodities are the ability to deliver the right product (that is, with precisely the right specifications), to the right customer, in the right place, in the right quantity, at the right time – and all at the right price.

Achieving that requires far more than a mere surplus endowment. Otherwise, Africa would dominate almost every commodity sector. To be successful in the coal and iron ore sectors, Australia has had to develop a wide capability that ultimately comprises its comparative advantage, and much of its has been supported or provided by government and other non-firm institutions. To begin with, these industries require effective systems for financing and performing mineral exploration and discovery. Australia has built these.

It possesses the world's foremost risk-capital market for financing early stage mineral-discovery, with highly sophisticated market rules and governance for ensuring that potential investors can properly compare claims and evaluate risk in exploration ventures. The Australian Stock Exchange has invested in this capability over many years, and Australia leads the world in the field, with the result that the nation possesses the world's broadest and deepest markets for financing mineral exploration. The ASX includes hundreds of firms active in these fields – firms that must be able to tap a body of geological expertise and methodologies for engaging knowledge to create efficient search systems. Again, the country has invested in these, and leads the world in this field.

The rules for controlling ownership and access to raw materials must be designed and enforced without corruption. Australian government bodies are ahead in this area. Beyond discovery, highly complex and scale-intensive development projects must be financed. Australia's banks, financial institutions and resource companies lead the world in large-scale project finance and management. Logistics systems of great complexity must be designed, constructed, maintained and operated. Australia has built these. (To understand the scale of these systems, it is necessary only to note that more than half of all world trade, by weight, is in a single product: iron ore.)

Comparative advantage stems from the combination of all these organisational, institutional and individual capabilities, which must be deliberately nurtured and sustained, including often through downturn periods when markets don't yet want to pay for them, and whose interaction must be co-ordinated.

Australia has built similar, if not yet so obvious, comparative advantage in other fields. Consider wheat, humanity's most important food source. Wheat is grown on 500 million acres worldwide, taking more space than any other crop. Australia produces a surplus over domestic needs, and while it is not a major grower of wheat, it is able to be a major trader. Its farmers produce high yields. But comparative advantage in this case comes also from superior genetics – Australia is pre-eminent in wheat genetics and genomics, an unsung national treasure – along with superior logistics and trading.

 

THESE EXAMPLES ILLUSTRATE not only that comparative advantage in the modern world must reach far beyond natural endowment, even in areas that would appear most dependent on nature, but also that comparative advantage is continuously dynamic, changing all the time. Possession of comparative advantage must be deliberately led, to ensure that it stays abreast of the future.

This is not a matter of government planning and control, but of strategic investment to create the capabilities, incentives and rules through which private industry can succeed in competition. A vital part of government economic policy must be to consider which forms of comparative advantage the nation wants to build and sustain, and to help construct them; for that will shape the future.

Griffith Review