The myth of comparative advantages
Should a country pursue industrial development only when the World Bank says so? Salah Al-Amrousi analyses the fundamental flaws in traditional approaches to economic development
For nearly a quarter of a century, the vast majority of developing nations have been suffering acutely sluggish economic growth rates -- industrial growth rates in particular. This same period proved sufficient in a few cases, such as in South Korea and Taiwan, to overcome many of the deficiencies of underdevelopment and significantly close the gap between them and advanced industrialised nations.
Suffice it to say that low and mid-income nations, under which categories most developing nations fall, had industrial growth rates -- which theoretically reflect what should be the most dynamic sector of the economy -- of less than 3.6 per cent through the 1980s and 1990s. Egypt hovered around the general average at 3.3 and 4.6 per cent in the two decades respectively. The enormity of the missed opportunities due to this bleak performance is made more palpable through comparison with the performance of the countries of Southeast Asia, which realised industrial growth rates ranging between 8.4 and 10.1 per cent in the same periods. The Chinese topped them all with the astounding industrial growth rates of 11.1 per cent for the 1980s and 13.1 per cent for 1990s.(All figures are taken from the World Development Indicators issued by the World Bank).
Naturally, this is not merely a quantitative issue. Those rates could never have been realised had there not been qualitative transformations in the domestic industries of these countries, whereby the acquisition of technological, scientific and know-how capacities was instrumental in the conversion of the industrial structure from light consumer manufactures to heavy industry, inclusive of the production of capital and intermediary products, such as tools and machinery. These latter industries are termed "base industries", because they enable domestic industry to stand on its own feet and develop autonomously. Simultaneously, one must be wary of overemphasising autonomous development. Those countries that followed this trend caused their domestic technology to lag further behind global technological developments. It is therefore essential to sustain a positive interaction with the advances of other industrialised nations, especially the most advanced and established. India, Brazil and Mexico followed this path and they have made important strides as emerging industrialised nations, if not quite as dramatically as the countries of Southeast Asia and China. Standing in stark contrast are the countries of the Arab world and Africa whose performance in the arena of industrial development is so dismal that it would be more appropriate to rank them in a class of their own: the "fourth world".
Contrary to the claims of classical economists, the World Bank and International Monetary Fund (IMF), impartial analysts are virtually unanimous in their assessment that the astounding performance of Southeast Asian countries in industrial development resides in the active intervention of the state in the domestic economy. They further maintain that the wretched performance record of "fourth world" countries is due to the withdrawal of the state from the helm of development, abandoning its fate to the vicissitudes of hidden market forces in accordance with the dictates of the "structural adjustment" programmes imposed by the World Bank and IMF on countries in the developing world. The underlying premise of these structural adjustment programmes is that free trade is the engine of development par excellence for all countries, industrialised or otherwise, and that the random mechanisms of the global market form the prime determinant of what role each country should play in the international division of labour. The theory of "comparative advantages" upon which this perception is based is the subject of this article, the purpose of which is to demonstrate that it is the inherent logic of this theory in practice, rather than purely practical considerations, that accounts for the failure of the majority of developing nations to achieve quantitative and qualitative development.
The theory of comparative advantages was originally formulated by the famous classical economist David Ricardo, but underwent various metamorphoses at the hands of later neoclassicists. To some, this theory with its subsequent modifications, embodies an incontrovertible truth, whereas in reality it is no more than a hypothesis. Indeed, it may be more accurate to say that it represents an ideological standpoint that tends to distort rather than depict the interrelations of reality in the service of the expanding interests of an advanced capitalism that aims to dominate the global economy. Confusion frequently arises between this theory and an older one that partially contradicts it. This is Adam Smith's theory of "absolute advantages". Although the theory of absolute advantages also advocates free trade as the engine of growth, apparently it was felt that it did not offer a strong enough justification for the hegemonic ambitions of the advocates of the Ricardo theory and its adjuncts.
The theory of absolute advantages holds that the theory of the value of labour applies as much to the global market as it does to the domestic market, and that consequently the global division of labour and international trade should function in accordance with the absolute superiority each country possesses in the production of a specific good. A country's absolute productive superiority in a specific item, which is to say its ability to elbow out all competitors in this item, is determined by free market forces. The resultant specialisation is mutually beneficial to all parties participating in the global market, so the theory goes, as each country will be able to allocate its time and energies with greater efficiency, which allows for higher rates of production and cheaper costs across the board.
The theory of absolute advantages is a static theory; it fails to take into account possible changes -- such as technological developments -- that could entirely alter the absolute or comparative advantages of each country. Nevertheless, what is important is that the theory appears to presume that the division of labour in global production takes place between equals, all being "superior" in their particular realm of production.
Not so for the theory of comparative advantages. This theory is primarily based on the premise that the global market, unlike the domestic market, is not subject to the theory of value due to the relative lack of fluidity of capital and labour. It also presumes that countries are not equal in their productive capacities; some are absolutely superior and others suffer absolute shortcomings. In other words, the division of global labour, or specialisation, should take into account the division between what we now term developed and underdeveloped nations. The theory in essence holds that underdeveloped nations can gain a competitive advantage in certain goods to the extent of excluding developed nations from the market in those goods, in spite of the fact that developed nations can produce them with greater efficiency and at less cost. How do its authors support this curious conclusion that seems to fly in the face of reality?
The argument is actually quite sophisticated. Ricardo devised a hypothetical model of two countries -- Portugal and Britain -- and two products -- wine and textiles. He posits that Portugal has absolute superiority over Britain in the production of the two products (that the reverse is true changes nothing), a disparity he measures in terms of units of labour time or its monetary value (which he calculates as 80 units for wine and 90 for textiles for Portugal versus 120 and 100 respectively for Britain). The comparative advantages are to be found in the disparities in the production capacities of the individual country, so that, for example, Portugal has a comparative advantage in the production of wine (80 unit costs versus 90) while the reverse is the case for Britain (100 versus 120). It can be said that Portugal has a comparative advantage in wine and Britain a comparative advantage in textiles, even if its production capacity is still lower than that of Portugal. It follows, according to the theory, that each country would be better off concentrating its efforts on that item for which it possesses a comparative advantage and abandon production of the second so as to invest the labour/cost spared to enhance production of the former. The resultant specialisation will enable the two countries to produce larger quantities of both products more cost effectively than they had been producing before, which in turn would reduce the end prices of both products.
To this happy ending, one can immediately counter that the model expresses the mutual benefits in a purely static situation and therefore offers no incentives to developing nations to develop technologically and explore other more comprehensive alternatives. But, even this static version is considerably suspect.
The process of realising global specialisation, with all the ostensible benefits that accrue, is not so straightforward. If the underdeveloped country -- Britain in our example above -- produces textiles at a higher cost than a more advanced nation (Portugal), then British producers need simply to offer their product at a cheaper price, thereby converting a productivity disadvantage to a pricing advantage. To demonstrate how this can occur, Ricardo abandons the value/ labour factor and turns to the cash flow theory in the process of exchange in the international market. To begin with, he suggests the advanced country (Portugal) exports both the products it excels in to the underdeveloped country (Britain). This generates a counter flow of cash from Britain to Portugal, which has an inflationary impact in the latter country and a deflationary impact in the former, until eventually British textiles become cheaper than their Portuguese counterparts, at which point Britain becomes the exporter of textiles to Portugal and equilibrium is reached with Britain specialising in textiles and Portugal in wine.
However, the hypothetical cash flow mechanism that supposedly enables a country with a new competitive advantage in production to acquire a competitive advantage in price is fundamentally flawed. It overlooks the fact that the cash moving from one country to another through foreign trade may not necessarily remain in circulation as a means of exchange. Sums can be siphoned off, for example, for conversion into savings or into investment capital, with the attendant possibility of obviating the inflationary/deflationary processes referred to above.
Of course, it is also possible for a low-productivity country to compete with a stronger one by lowering the level of wages. However, this would serve as no more than a stopgap, as the constant technological improvements needed to sustain growth in productivity ultimately cancel out the effect of wage reductions. That is unless wages are subjected to pressures sufficient to keep them below the costs of technological advancement, which is virtually impossible given that the expansion of industry is certain to generate labour demands for higher wages.
Neoclassicist economists such as Ohlin and Heckscher have made important modifications to Ricardo's theory. Whereas Ricardo presumes the existence of disparities between countries in technique and productivity, they presume that the disparities in technique exist between the goods, whatever country they are produced in. They also posited the existence of global differences in what they term production endowment factors. At any specific time, for example, different countries have different stocks of labour and capital. But through what they term the production function, it is possible to generate different combinations of labour or capital intensity. This is what forms the basis of comparative advantages. Therefore, developed nations with large reserves of capital and a limited labour supply would be expected to specialise in capital intensive industries, whereas underdeveloped nations with little capital and abundant labour would specialise in labour intensive industries. Various gradations between the two extremes could emerge. This permits for setting the processes of goods on the basis of the production costs in terms of labour and capital, and the "comparative advantages" of a particular country are attained through the adjustment of wages, prices and exchange rates. In this situation the exchange rate plays a similar role to Ricardo's cash flow mechanism. That is, modifying the exchange rate so as to reduce prices and enhance competitiveness is only a short term solution that does not necessarily contribute to changing production performance.
Contrary to the claims of its authors, this theory is static as well. In addition, it shares with the theory of "absolute advantages" the same theoretical shortcomings with regard to the quantities of cash available for enhancing competitiveness through lowering prices by altering the exchange rate. Finally, the production function itself is founded upon premises borrowed from the consumption function, which, however they may apply to consumption, are not applicable to production. Consequently, the capital for each unit of labour is viewed purely quantitatively, with no consideration for the qualitative dimensions of production that cannot be quantified. It further ignores the impossibility of separating labour and capital in the production process.
In any event, to counter the charge of staticity, some neoclassicist theorists introduced a dynamic element in the form of the "stages approach to comparative advantages". They cited Japan as an example of a country that made the transition from non-skilled labour intensive exports to skilled-labour and capital intensive exports, and then to an expansion in technology intensive exports. Naturally, global market forces were the "hidden hand" that determined the transition from one phase to the next. Critics of the stages approach argue that the notion is only dynamic when considered over time, but remains just as rigid when measuring comparative advantages at any given period.
More significantly, we note that the above-mentioned transitions in the Japanese example focused solely on a superficial aspect of the Japanese economy -- its export structure -- rather than on the underlying industrial structure and how this developed in a manner that was ultimately reflected in the changing export structure. Firstly, it was not hidden market forces that changed the Japanese industrial structure, but the visible hand of the state. Secondly, industrial development did not follow the sequential step-by-step logic described. According to this logic, the industrial structure conforms to the fixed comparative advantages of each stage, only making the transition to a subsequent stage in response to some random change in the configuration of availability or scarcity of the factors of production (labour and capital). In fact, however, contrary to this passive or reflexive model, the Japanese Ministry of Trade and Industry was very proactive. Following World War II, Japanese industry and exports were founded primarily on textiles and light manufactures. At the same time there was still an abundance of inexpensive labour. According to the comparative advantages theory, Japan should have continued in this manner until the factors of production shifted from surplus labour to surplus capital. In the opinion of the Ministry of Trade and Industry, that industrial structure was not viable in the long run and it decided that the time was right to establish capital and technology intensive industries. And, in spite of the abundance of labour, there sprang up the very successful steel, automotive, petrochemical, aviation, industrial machinery, electronics and computer industries. Moreover, contrary to the claim that only labour intensive industries can create a sufficient number of jobs, the Japanese experience demonstrated that textiles and light industries alone could never have created jobs for a hundred million people and raised their standard of living to that of Europe and the US. Indeed, it demonstrated that the strategic capital and technology intensive industries were crucial to this transformation. These strategic industries, with their high productivity, stimulated rising rates in savings and increased investment and industrial expansion, even in light industries, which in turn enhanced the capacity of the industrial base as a whole to create jobs.
South Korea followed the same logic in its industrialisation policy. In the 1970s, at a time of surplus labour, it too decided to break the "comparative advantages" law and start up heavy industries in steel and other metals, petrochemicals, shipping, electronics and machinery. The programme was heavily subsidised by the government, which retained ownership of some of the strategic industries upon which the South Korean industrial revolution was based. Moreover, the same programme met with stiff resistance from international monetary agencies, which operate in accordance with the dictates of the neoclassical school. The World Bank and the Consortium of European Enterprises refused to help finance the South Korean national steel industry, for which purpose the government had founded the POSCO Company. According to World Bank officials at the time, the project was "immature and economically unfeasible". By the beginning of the 1990s, POSCO became the third largest steel company in the world and the first ranking in terms of profitability. In spite of this astounding success, the World Bank described the South Korean industrial policy as a failure in its 1991 report. In so doing, the international financial institution had simply taken advantage of the disruptions caused to the South Korean economy by the rise in petroleum prices that had ricocheted throughout the global economy. Later, in its 1993 report on the Asian miracle, the World Bank remained skeptical, claiming that the industrial policy had met with only partial success and that, moreover, it had caused grave disruptions, leaving one to wonder how Korea could have made such a historical transformation in its industrial structure without causing ripples in the economy. Indeed, the only way to avoid that prospect is to abandon the ambition to industrialise, which is precisely one of the guiding tenets behind the structural adjustment reforms through which developing nations are meant to resolve their budgetary imbalances at the expense of growth and at the cost of perpetual stagnation. This is the case of Egypt and most other developing nations that have been given this prescription.
Critics of the neoclassicist economists and the practices of the IMF and World Bank maintain that comparative advantages are not givens, but rather are made, and that this requires the intervention of the state. After all, who, on the basis of the natural endowment factor, would have ever predicted that Japan, South Korea, Taiwan and even China could have achieved such competitive capacities in the manufacture of cars, ships, electronics and computers, among other things?
It would thus seem that the World Bank and IMF prescription resides behind the failure of most of the developing world countries to industrialise and that the theory of comparative advantages is intended to perpetuate their underdevelopment. Indeed, it is possible that the same policy and the same theoretical foundations could work to de- industrialise developing nations, which is to say not merely to prevent progress towards industrialisation, but to destroy what has already been attained. This is a sobering thought for those who remain unconvinced that developing nations must develop a proactive industrialisation policy, one that refuses to follow the logic of structural adjustment and subscribe to the myth of "comparative advantages".
