Don't Read the Guy Who Read the Guy. Read the Guy. The Case of David Ricardo

(6/11/2005)

NOTE TO READERS: Given the amount of stories written about US/China decoupling and industrial policy, I thought you might like to see this piece I wrote about David Ricardo’s real views on trade.

Several days ago while in London I had coffee with Patrick Lane who, besides being an interesting and thoughtful man, is Finance Editor of The Economist magazine. From the hundred things that Patrick and I talked about I want to pass along two.

First of all, Patrick advised me to read Fooled by Randomness, by Nakim Nicholas Taleb, which questions the mean-variance nonsense that Wall Street uses today to convince their customers they have risk under control. I will write more about the work my partners and I have been doing on a concept we call Intrinsic Risk later. For now, go out and buy the book. You will be glad you did.

Second, while Patrick and I were discussing my unorthodox views on trade he pointed out that High Grove, David Ricardo’s house in London is now occupied by the Prince of Wales, the most startling example of intellectual regression toward the mean I have ever encountered.

Ricardo (1772-1823) was a brilliant stock market investor who made his money by understanding that, from time to time, people get more frightened than warranted by the facts and drive security prices too low. Today he is most famous for his famous statement of the principle of comparative advantage.

Briefly, Ricardo’s example, as stated in The Principles of Political Economy and Taxation (1817), argued that England and Portugal would both experience an increase in overall income if each moved in the direction of specializing in the finished good–he used wine and cloth in his example–in which they were relatively most efficient.

Economists use Ricardo’s example today to argue for free trade. Ironically, if Ricardo were alive today he would not be making the argument–he was much too smart for that. He told the story the way he did because, in his day, people were tied to the land and capital was not tradable so the only thing there was to trade was finished goods.

One of my pet peeves is people who quote one guy talking about another guy. You need to read the original guy yourself if you want to know what he said. The following passage from his Chapter VII, On Foreign Trade shows that Ricardo understood the concept of capital flows, but believed that capital did not flow between countries.

In one and the same country, profits are, generally speaking, always on the same level; or differ only as the employment of capital may be more or less secure and agreeable. It is not so between different countries. If the profits on capital employed in Yorkshire should exceed those on capital employed in London, capital would speedily move from London to Yorkshire, and an equality of profits would be effected; but if in consequence of the diminished rate of production in the lands of England from the increase of capital and polulation wages should rise and profits fall, it would not follow that capital and population would necessarily move from England to Holland, or Spain, or Russia, where profits might be higher…Experience, however, shows that the fancied or real insecurity of capital, when not under the immediate control of its owner, together with the natural disinclination which every man has to quit the country of his birth and connections, and entrust himself, with all his habits fixed, to a strange government and new laws, check the emigration of capital. These feelings, which I would be sorry to see weakened, induce most men of property to be satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment for their wealth in foreign nations.

Today things are just the opposite. Physical goods are heavy; moving them is slow and expensive. In contrast, capital can be moved around the world at virtually no cost, undetected by governments, and professional service work travels over fiber-optic cable at the speed of light at zero incremental cost. In other words, today we trade capital rather than finished goods. This turns comparative advantage on its head. Where capital goes, productivity and paychecks go along with it. More about this later.

Dr. John