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Capital Flows and Ricardo's Law

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Tags Global EconomyMoney and BanksMoney and BankingValue and Exchange


As a presidential candidate, Donald Trump promised to renegotiate international trade agreements such as NAFTA and to withdraw from the Trans-Pacific Partnership. While Trump’s views on international trade are murky, two things seem clear.

One: Trump is in favor of trade deals that halt the migration of US factories to other countries and increase investments in the US. He argues that his policies would give domestic and foreign companies an incentive to invest capital in the US rather than overseas. In economic terms, he wants to increase US net capital flows (capital inflows minus capital outflows).

Two: Trump views the US trade deficit as a loss to the US economy. He sees the $502.3 billion trade deficit in goods and services in 2016 as spending that could create jobs in this country, spending that is forever lost.

How Trump Misunderstands the Trade Deficit and Capital Flows

The trade deficit means that the rest of the world sends us $500 billion more in goods and services than we send to the rest of the world. We get to consume $500 billion more than we produce and trade away. At first glance, this looks like a great deal for the US.

However Trump is focused on the dollar flows, not the goods and services that are being traded. We get to have $500 billion of goods and services but $500 billion flows out of the US. What happens to this $500 billion?

If the dollars would stay outside the US, that means we are sending the rest of the world $500 billion that costs us almost nothing to produce, almost no resources are needed to manufacture this money, and in return we get to have cars and clothes and food the production of which requires a massive quantity of resources. Even if that money never comes back, we are getting the better end of this deal. We are trading away something that costs us nothing and in return get to have goods that are costly to produce.

But for the most part that doesn’t happen. The money that flows out of the country does not stay outside the country, it comes back into the country in the form of capital inflows (e.g., foreign companies build factories in the US or foreigners loan us money to expand our businesses and build new houses). The spending on imports does not tend to lead to fewer dollars in the US. Foreigners invest this money into our country.

We Can’t Have it Both Ways

Note how Trump’s views are contradictory. He wants trade deals that increase US net capital flows and he wants to reduce the trade deficit. However, reducing the trade deficit would decrease net capital flows. If fewer dollars flow out of the country due to smaller trade deficits then fewer dollars will flow back into the country as capital inflows. He cannot have it both ways. If Trump is successful in negotiating trade deals that lead to greater capital inflows then those deals will tend to increase the trade deficit.

Understanding Ricardo’s Law of Comparative Advantage

But what about those free traders who criticize Trump’s protectionist policies by referring to David Ricardo’s Law of Comparative Advantage? They should be very careful in their attacks. While it is correct to say that free trade provides us with efficiency gains due to specialization, one of the underlying assumptions of the comparative advantage argument is that capital does not flow across international political borders.

Mises recognizes this point, saying “Ricardo assumes that there is no mobility of capital and labor,” however he concludes that the law of comparative advantage still holds because “the state of affairs is by and large the same as in the time of Ricardo. Note that this article was written in 1943 but not published until 1990.

At this time, though, capital is mobile and if capital is flowing into the country, there is more to the story than comparative advantage. It is correct to say that there are efficiency gains due to comparative advantage and that there are also benefits from having more capital inflows. If one wants to argue against Trump’s position, one must either claim that his policies will not increase the amount of capital in the US or make the case that the damage from his protectionist policies outweighs the gains from the increased capital accumulation.

For example: while not the only issue, a major problem with Trump’s case for protectionist policies to increase capital inflows is that importing capital for industries tends to lead to capital exportation for other industries. Increasing capital inflows are correlated with larger trade deficits. This will cause capital outflows in exporting industries.

Changing the structure of trade in one industry will tend to affect other industries that engage in international trade. Capital, for some industries, will flow into the country, and for other countries capital will flow out of the country. One cannot conclude that capital accumulation in one sector of the economy due to protectionist policies is an indication of overall capital accumulation. (Gottfried Haberler explains this more thoroughly in International Trade (pp. 273–8).

To be clear, I am not saying that Trump understands the economics of international trade, and I am not arguing that Trump’s protectionist policies will lead to economic growth due to an increase in US net capital inflows. I am just pointing out that this is Trump’s position and simply referring to Ricardo’s comparative advantage argument does not end the discussion.

Mark Brandly is a professor of economics at Ferris State University and an Associated Scholar of the Mises Institute.

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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