Polarization effect, descriptive explanation

Here, I will try to explain why the Comparative Advantage Theory not works, when the number of goods are lower than the number of countries. Let’s see the simplest comparative advantage model as it was presented by David Ricardo (British economist from the beginning of XIXth century, models used today are more sophisticated, but they are still based on David Ricardo assumptions and premises).

Let’s assume that we have two countries: Antigua (A) and Barbuda (B), which produce and trade two goods: avocado (A) and bananas (B). On Antigua prices are high: banana costs 100 $ and an avocado 200 $ (not mentioning olive). On Barbuda prices are lover: an avocado costs 100 $ and a banana costs 10 $. Moreover, let’s assume (as Ricardo did) that prices are money-neutral, so we can use relative prices (i.e. not nominal - in dollars - but we will measure the price of one good using the number pieces of another good, you can buy for it - this is a very dangerous assumption, scroll down for explanation). On Antigua we can buy one avocado for two bananas (avocado is relatively cheap, bananas are relatively costly). And on Barbuda we can buy one avocado for ten bananas (avocado is relatively costly and bananas are relatively cheap).

A merchant from Antigua who have one avocado can buy 2 bananas here on Antigua but also can go to Barbuda, and sell the same avocado for 10 bananas, then go back to Antigua, and sell bananas to buy 5 avocados, then go to Barbuda again...

Comparative advantage at work

The merchant goes richer and richer, and everything started from one avocado. Moreover, citizens of Antigua will consume more bananas and citizens of Barbuda will consume more avocado than without a trade. Everybody is happy, and the most important observation: international trade is profitable, even if prices of both goods are much higher on Antigua than on Barbuda.  And that was Ricardo’s point.

Now let see, what will happen if we add a third country - Montserrat (M) - but we do not add a third good that can be traded (there is no mango). On Montserrat island prices are medium (intermediate): an avocado costs 160 $ and a banana 40 $ (we can buy 1 avocado for 4 bananas).

And what our merchant with one avocado will do this time? Will he go to Montserrat to buy 4 bananas and go back to Antigua to sell these bananas for 2 avocados? Or will he go straight to Barbuda, where the relative prices are better? The same is true for a merchant from Barbuda. She will not try to sell bananas on Montserrat, if she can get better prices on Antigua.

A country eliminated from international trade

As you can see, when the number of traded goods is lower than the number of countries, it is pretty possible that a country with intermediate relative prices will be completely excluded from international trade. I did not write that the country will be always excluded, because there are at least two little exceptions here. See frames below.

What is the polarization effect?

Usually the number of traded goods is much more higher than the number of countries. But when the global economy shrinks, every country take some protectionist measures to make its comparative advantage (relative prices) better. It is unavoidable, because every country has some debts - money borrowed when the global economy was growing - that have to be repaid (see also virtual money).

Rich countries take efforts to make the export of capital-intensive goods (or the capital, which is an important element of their export) relatively more profitable and try to make import of labour-intensive goods less profitable. Poor countries take the opposite strategy: promote the export of labour-intensive goods and try to protect its economies against the import capital-intensive goods. Middle-income countries have these times very serious problems, because their export rapidly shrinks. Moreover, middle income country couldn’t take any of those two strategies described above, because right-winged GPIs (groups of political interests), which are interested in “capital-intensive” strategy have almost the same political strength like left-winged GPIs, which are interested in “labour-intensive” strategy.

Middle-income countries have a privileged position. The reason is all traded goods usually have the normal distribution (statistic term) - i.e. the group of medium goods (with more or less the same costs of labour and capital used to produce them) is most numerous.

And here is another picture, this time showing the “polarization effect”. Now traded goods forms two large “mountains”, and the number of medium goods rapidly shrinks. Number of traded goods do not decrease but they form two groups (capital-intensive and labour-intensive) and the effect is more or less the same as we had only two traded goods - so middle income countries suffer.

The most typical protectionistic measures taken, are:

• The increase of interest rates (for rich countries to increase the income from capital) 
• The devaluation of national currency (for poor countries to increase the income from labor-intensive goods) 

Again, middle-income countries have problem to chose the right protectionist strategy, because supporters of right-winged strategy (high interest rates, strong national currency, low taxes, reduction of government spendings, especially social spendings) and supporters of left-winged strategy (devaluation of national currency, expansive fiscal economic policy, protection of social spendings) have almost equal political strength. When crisis lasts for a few years, debt of middle-income country increases because of export problems. Eventually we can observe very serious crisis like Argentina collapse (of course institutional weaknesses, and corruption inside government mattered too).

But there are many other protectionistic measures possible: trade duties, more intensive exploitation of labour workers, etc. Moreover there are many variants of the polarization effect. When the top of the mountain (normal distribution of goods) is little shifted - i.e. is over capital-intensive goods or labour intensive goods (not over medium goods) - then the polarization crisis, and protectionistic measures taken may be different. And the crisis may affect middle income countries at different times, depending on their position on X (horizontal) axis. This explains (for example) different variants of oppressive populistic systems that evolved in Italy, Japan, Spain, Germany, Poland and other Central European or Latin America countries between 1919 and 1939.

Major flaw of the Comparative Advantage Theory

Please look carefully at the first (“Ricardo”) example. We actually have really three goods here: avocado, bananas and money. If you look closely, you will find that Antigua really have the comparative advantage in money - money are cheap and fruits (avocado and bananas) are costly. On the other hand, on Barbuda money are costly and fruits are cheap. No one merchant will be so stupid to transport avocados bought on Antigua for 200$ and try to sell these avocados for 100$ on Barbuda, if he could simply buy avocados for 100$ on Barbuda, and sell for 200$ on Antigua. As you can see, Barbuda will export both kind of fruits and Antigua will export the third good - money.

So, the comparative advantage theory is actually no more than a David Ricardo’s mistake. I feel little ashamed that I haven’t spot that before (i.e. before 23 Aug 2003), and knowledge that for nearly 200 years no one of thousands economists found that, doesn’t help.

Of course rich countries still can export goods to poor countries, but the reasons for that are different (i.e. export is not the effect of comparative advantage as classic model describes it):

• rich countries are exporting “bare” money, like precious metals
• rich countries are exporting capital
• rich countries are exporting goods that could not be manufactured in other countries because of the lover technology level (like advanced software)
• rich countries could export trade and financial services (like insurance, transport, etc.)
• rich country could export “international currency service” (like USA exporting dollars)
  
• If the prices are not much higher, goods could be exported to the country where the prices are little lower, because without the international trade local market in the second country could be dominated by some local monopoly (and thus without the trade, prices here would be higher, not lower).
  

Taking all these reservations into account I have to say that the real mechanism of the polarization effect is little more complicated than presented above. But the real mechanism is not very different. The most important thing to remember is that in case of very rich income countries, raising of interest rates could be a way to protect their trade balance.

Comparative Advantage in money - consequences

Knowing that a very rich country have a comparative advantage in money - not in any “normal” good - wwe have to make three reservations about economic models derived from the Comparative Advantage Theory:

1. When analyzing trade exchange in a model with two goods we can’t use relative prices and have to use absolute prices.
2. Model with relative prices and two goods will be applicable only for analysis of natural trade exchange (i.e. before the invention of money).
3. Or one of two analyzed goods (when we consider relative prices) have to be money.

These precautions apply to all economic models explaining the trade. For example to the Edgeworth box - when analyzing a trade exchange between two countries that trade two different goods, we have to use three-dimensional Edgeworth box (one dimension for each of two goods and one for money). Moreover, even the three-dimensional Edgeworth box will not give us unambiguous answer when there are more than two countries!

Rich country usually exports money in one of three forms:

• As the pure money - rich country has a negative trade balancce (its supplies of precious metals or currency reserves will shrink)
• As the capital - country lends some money to governments or firms from abroad, gaining some extra income from interest rates.
• As the international currency service (like US Dollars today, British Pound in XIXth century, Florence or Venetia coins in Renaissance), gaining this way some extra income.

We can formulate a quick-and-dirty law:

• When a income from exporting capital and international currency service is higher than an outflow of pure money, a very rich country will promote (even using military ways) a free trade.
• When a income from exporting capital and international currency service is lower than an outflow of pure money, a very rich country will take some protectionist measures (duties, subsidies, increase of interest rates, etc.).

Increase of interest rates have two effects:

• Increases the income from exporting capital
• Increases the costs of capital-intensive goods production. So, it works against all countries which are specialized in exporting capital-intensive goods and importing capital - i.e. some middle-income countries (like Argentina 1997-2001).
  

Devaluation of national currencies launched by poor countries will have a similar, but not exactly symmetric effect (like polarization picture above may suggest).

Of course, these effects appear only when a very rich country is so important supplier of capital, so can enforce (dictate) the prices of capital  - i.e. interest rates. Moreover, we have to remember that some times interest rates are increased because of some actions taken by countries borrowing capital (like nationalization of property of foreign investors), or simply because of falls on world stock markets (when overproduction crisis comes). These times effects mentioned above are simply side-effects and increase of interest rates is not intended to be a tool of a protectionist trade policy.

As you can see, free trade is not always profitable for every player in international market. This is mostly because of diffusion powers (reason for protectionism in rich countries) and because of political factors (trade policy that is best for the country is not always the best choice for ruling GPI - i.e. ruling group of political interests). But generally we can assume that free trade is rationale in times of prosperity, and protectionism may be rationale policy in times of global economic crisis.

Polarization effect, quick summary:

Variant in liberal periods:

1. When the overproduction crisis comes (i.e. after the series of falls on world stock markets, usually starting from emerging markets), rich countries increase interest rates to protect their income from abroad investments.
2. When the price of capital increases, poor countries devaluate their currencies to increase income from exporting labour-intensive goods, and this way compensate higher costs of credit.
3. Therefore middle-income countries (which imports capital and specialize in exporting labour-intensive goods to rich countries and capital-intensive goods to poor countries) face serious problems with their trade balance. It is the reason for fierce political conflicts between left-winged GPIs and right-winged GPI, especially in populistic countries.

This is true when world economy is in a free trade phase. Polarization crisis for a protectionist economy will be little different. Mechanism of crisis is not exactly symmetric, because economy of capital is little different than economy of labour. Although some protectionist strategies may look similar: ex. nationalization of foreign capital investments in countries exporting labour-intensive goods and deportation of immigrants in countries exporting of capital. Capital usually has a privileged position because it have to be accumulated again and again (I will explain this in The World History Rewritten section).

And a final note: probably I should completely rewritten that page when I found the major mistake in the comparative advantage theory, and make text under the horizontal line an integral part of this explanation, but science develops thorough mistakes and only half-true answers, so I decided to present you one of mines. Both elements mentioned here (problem of trade when the number of goods is smaller than the number of countries and comparative advantage at money) are important when we try to understand periodical trade problems of middle-income countries (ex. Argentina collapse 2001).

Warsaw, 17 July 2003
text  under the horizontal line: 18 November 2003
last revision: March-April 2006
Slawomir Dzieniszewski