David Ricardo’s Theory of Comparative Advantage: Exploring the Hidden Historical Underside of Modern-Day Competitiveness Discourse

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Matthew Watson, Professor of Political Economy, University of Warwick

Matthew Watson, Professor of Political Economy, University of Warwick

David Ricardo’s status as the first really famous economist of the nineteenth century rests on two capacities: his ability to think in pure economic abstractions and his ability to harness economic theory to a liberal political worldview. They came together most famously in his theory of comparative advantage, through which countries are encouraged to specialise in producing the goods in which their workers are relatively most efficient. Despite being two hundred years old, Ricardo’s theory is still the mainstay of the orthodox economics justification of free trade and, at one stage removed, of modern-day competitiveness discourse too. This post by Matthew Watson looks behind the façade of the numbers that Ricardo used to illustrate his theory of comparative advantage, to show that they were anything but an innocent account of essential economic relationships. It therefore helps to place modern-day competitiveness discourse in a far from flattering intellectual light.

David Ricardo’s Theory of Comparative Advantage: Exploring the Hidden Historical Underside of Modern-Day Competitiveness Discourse

When faced with questions about competitiveness, most economists will reply with a polite, ‘aha, but don’t you actually mean something else?’ Paul Krugman’s well-known argument that the very concept of competitiveness is devoid of genuine economic meaning has left a lasting mark on the collective consciousness of his profession. The ‘something else’ that most economists have in mind when trying to deflect attention away from competitiveness concerns is comparative advantage theory. This theory will shortly celebrate an important anniversary, because it first appeared in David Ricardo’s Principles of Political Economy, which was published in 1817.

Ricardo’s insight is simply explained. He placed indicative numbers for underlying labour productivity in cloth and wine production on a hypothetical ‘England’ and ‘Portugal’. On the basis that each country should specialise in the production of the good for which it has the greatest relative labour productivity advantage, Ricardo showed that total production between the two countries would be expanded if each was prepared to trade its surplus production freely with the other. He also asserted that both ‘England’ and ‘Portugal’ would necessarily be better off as this trade increased living standards across the board.

Ricardo’s theory has been the totem of orthodox economists’ arguments for free trade ever since. The image he depicts is certainly an alluring one. His hypothetical ‘England’ gets richer by trading its surplus cloth with ‘Portugal’, whilst his hypothetical ‘Portugal’ gets richer by trading its surplus wine with ‘England’. What could there be to object to in this scenario, especially when Ricardo’s original two economy/two good model is extended into a genuinely global solution incorporating every country in the world? Everyone’s a winner, or so it seems.

This is certainly how all of the orthodox economics textbooks present Ricardo’s theory. It is unusual for any theory to survive for so long in pretty much its original form, but it is more unusual still for it to simultaneously attain the status where it becomes almost fundamentally unthinkable to challenge it. But this is what has happened to comparative advantage theory, on its journey from a few isolated thoughts scattered across ten pages of Ricardo’s Principles of Political Economy to the prime exemplar used to teach introductory students how to think like an academic economist. It is now a central part of the standard initiation process for all economics students. They are required to become conversant not only with what Ricardo’s numbers imply for the choices available to ‘England’ and ‘Portugal’ but also with what this means for imagining how to solve economic problems through market means. The competitive solution contained in Ricardo’s numerical example of comparative advantage becomes a precursor for competitive solutions that apply throughout the economy.

“Just as with Ricardo’s comparative advantage theory, the whole story embedded in competitiveness discourse is about how the economically strong subordinate the economically weak.”

This has become such a powerful argument for embracing the competitive solution whenever it is available because of the seemingly innocuous nature in which it is made. Economists will today very often tell you that there is no need to engage in any political controversies about competitiveness policy, because all that it is necessary to know is to be found in Ricardo’s original numbers. There is a strict mathematical logic in play, they say, and market forces should be left alone to ensure that that logic is allowed to flourish.

What happens, though, if this is not the case? How might we need to reappraise Ricardo’s comparative advantage theory and the economic foundations it provides for modern-day competitiveness discourse if his numbers are shown to be not so innocent after all?

The important point here is that Ricardo did not call the countries in his example ‘England’ and ‘Portugal’ by accident. If the only thing at stake in this instance was the straightforward elaboration of a universal mathematical logic then he could have named them any random collection of letters: say, ‘X’ and ‘Y’. Ricardo’s ‘England’ and ‘Portugal’ were of course named to provide more than a passing resemblance to the real England and the real Portugal.

The two coutries had been allies since the English king, Charles II, married the Portuguese princess, Catherine of Braganza in 1662. A number of commercial treaties between the two had been signed on the back of England providing Portugal with a series of military guarantees, with England generally receiving payback in the form of favourable trading terms in these treaties. The 1703 Methuen Treaty formally institutionalised extensive bilateral trade between the two goods that just so happened to reappear 114 years later in Ricardo’s numerical demonstration of comparative advantage. What he had to go on was a century and a half of historical studies which would have made him fully aware that the relationship worked decisively in favour of England’s cloth makers.

“This has become such a powerful argument for embracing the competitive solution whenever it is available because of the seemingly innocuous nature in which it is made. “

Not that you would have known from the numbers that he implanted in his example. Ricardo deliberately gave ‘Portugal’ an absolute advantage in the production of both wine and cloth. ‘England’ was depicted as the relatively backwards economy, with its labourers having to work 50% longer than their ‘Portuguese’ counterparts to produce exactly the same quantity of wine and 11% longer to produce exactly the same quantity of cloth. Despite these unfavourable starting conditions, though, Ricardo was able to show with a nifty bit of elementary arithmetic that total output would expand in this two economy/two good model if ‘England’ specialised in the production of cloth, ‘Portugal’ in wine, and each traded with the other in an unrestricted manner its surplus stocks.

There is a fairly easy objection to be made to the fact that Ricardo clearly started with the free trade solution as his ultimate objective, and selected some arbitrary numbers to help him make his argument. We know that this is the case because the absolute productivity advantage granted to ‘Portugal’ simply cannot be reconstructed using any available empirical data for the real Portugal. More importantly, though, there is nothing in Ricardo’s numbers – conveniently made up or otherwise – to support the further claim that he asserted on their behalf. On the back of being able to show that specialisation does indeed lead to an increase in total production in his model world, he then argued that this necessarily made every participant in the ensuing trade better off.

However, the extension of the argument relies on a very different economic principle to the argument itself. Whether or not comparative advantage is to be derived through specialisation is a matter of relative labour productivities: this is the whole basis of Ricardo’s argument. But whether or not gains are equitably shared to lift real incomes across all sides of the trading relationship is a different matter, which relates to the terms of trade. These two things are in no way the same, economically-speaking.

Surely it is not credible that an economist as sophisticated as Ricardo and as famed as he is for carefully working through economic theory from first principles would have conflated two such different economic theories. So we must seek some other explanation.

However tangential it might appear at first glance, the alternative explanation begins with the impotence of a Spanish king. When Carlos II died in 1700, he did so with no obvious blood-line successor. He had nominated a distant relative, Philippe, Duc d’Anjou, as his preferred choice, and because he was also related to the French king, Louis XIV, his claim quickly gained full Bourbon backing. As was common in those days, though, this was enough in itself for Philippe to be equally vigorously opposed by the Grand Alliance of England, Scotland, Ireland, the Netherlands, the Holy Roman Empire, Savoy and Aragon. When the Portuguese king, Pedro II, ignored the intermarriage of his own family and that of the English monarch to support the Bourbon claimant, this deprived the Grand Alliance of an Iberian stronghold from which to fight the War of Spanish Succession. As a consequence, the Methuen family, emissaries to Portugal and well known in the Lisbon court, were sent with what amounted to a blank cheque and their effortless politeness to try to get Pedro to change his mind.

They succeeded. This led to the signing of three bilateral treaties between England and Portugal in 1703. The first confirmed that Pedro now backed the Grand Alliance’s claimant to the Spanish throne, the Archduke Charles of Austria, whilst the second guaranteed Portugal English naval protection against expected Spanish retribution. The third had not been authorised beforehand by the English Parliament, and it resulted when John Methuen in effect went freelance to negotiate a purely commercial treaty. This third treaty, signed on December 27th 1703 and ratified by the English Parliament the following April, is now widely known as the Methuen Treaty.

The Methuens were themselves from a family of clothiers, so the fact that Ricardo had his hypothetical ‘England’ producing cloth for export to ‘Portugal’ is far from the innocuous example of pure market relationships that it is routinely presented as in economics textbooks today. John was trying to do a deal that would specifically privilege the early eighteenth-century wool interest in which his family’s business was deeply embedded. Wool traders such as the Methuens had become increasingly disenchanted with Portuguese sumptuary laws that prevented the wearing in public of foreign-made fabrics. John’s unilateral actions put together a deal whereby these restrictions on cloth exported from England would be dropped in return for privileged treatment of Portuguese wine exports. The English had already begun to invest in Portuguese vineyards as a potential substitute for French wines that England’s well-to-do imported so heavily that the country was running a large trade deficit with its historic enemy. Portuguese wine makers had already been paid to take cuttings back home from Bordeaux in an attempt to replicate the lighter clarets originating from within that region. Further impetus was then given to Portuguese wine exports to England through the clause in the Methuen Treaty which ensured that the tariffs paid on Portuguese wine would never be more than two-thirds those paid on French wine.

Moreover, the historical story obscured by the apparent banality of Ricardo’s numerical illustration of comparative advantage theory still has one twist to go. Given the relative social structures of consumption in existence in the two countries at the time, Portugal was never going to be able to export enough wine to England to pay for its cloth imports. A further mechanism therefore had to be activated to ward off an unsustainable trade imbalance. Without it the Methuen Treaty would have simply been inoperative. That additional mechanism arose from the discovery in Brazil, almost exactly contemporaneously with the signing of the Methuen Treaty, of previously undreamt of new gold reserves. Portugal paid off its deficit on cloth/wine trade by allowing England to appropriate massive amounts of Brazilian bullion which in turn enabled London to replace Amsterdam as the world’s leading financial centre. The gold mines were worked almost solely by African slaves who were redeployed when Brazilian sugar plantations suddenly began to lose their profitability. Ricardo’s hypothetical ‘England’ and ‘Portugal’ are clearly based on the real England and Portugal. As a consequence, the numerical example he used to illustrate his comparative advantage theory is looking less and less innocuous all the time, isn’t it?

“The numerical example he used to illustrate his comparative advantage theory is looking less and less innocuous all the time, isn’t it?”

There is a clear logical symmetry between comparative advantage theory and competitiveness discourse. Both are structured in the same way to suggest that if you get the institutional framework right and adopt policies to match, then the market will ensure that the best possible solution will follow for everyone. But neither should be believed on its own terms. Ricardo’s comparative advantage theory somewhat duplicitously airbrushes away the historical context of the Methuen Treaty. It therefore remains silent on the extent to which it was based on an oppressive political structure of everything from belligerent European royal houses to the African slave trade. The competitiveness discourse fares little better in comparison, because it too is founded on removing from view the political realities that make it work in practice. Just as with Ricardo’s comparative advantage theory, the whole story embedded in competitiveness discourse is about how the economically strong subordinate the economically weak.

Matthew Watson is Professor of Political Economy in the Department of Politics and International Studies at the University of Warwick and an Economic and Social Research Council Professorial Fellow.

See also his longer June 2015 paper entitled Following in John Methuen’s Early Eighteenth-Century Footsteps: Ricardo’s Comparative Advantage Theory and the False Foundations of the Competitiveness of Nations.

 

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