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Capital Exports and Free Trade

January 29, 2004

Tags Free MarketsValue and Exchange

The benefits of the division of labor are widely acknowledged. Even the opponent of the market economy recognizes the fact that the coordination of productive efforts yields material benefits for all parties involved. But only the economists are intellectually consistent enough to draw all the necessary political implications from this insight. In particular, the case for free trade is squarely based on the fact that it makes all parties better off than they would have been without free trade.

Notice the nuance in the message. The point is not that free trade necessarily makes people better off than they have been so far. Rather, it makes them better off than they would be if trade were to be henceforth obstructed by government interventions, or by other violations of property rights.

This distinction has some importance in the present political context. For the first time in many decades, the United States might be confronted with the possibility of net capital exports. The consequence could be a relative impoverishment of the working population. But even if this were so, the case for free trade would stand unshaken. The stark fact is that the only logical alternative, government obstruction of international trade, would impoverish the population even more.

The Division of Labor

Joining forces entails material benefits. Two individuals working in isolation from one another produce less physical goods and services than if they coordinated their efforts. This is probably the most momentous fact of social life. All reflections on economic organization must start from here.

To illustrate the fact, consider the following example from a primitive island economy. John and Mike work in isolation from one another. They both spend their entire time plucking berries and hunting rabbits. John spends 8 hours per day hunting 1 rabbit, and another 2 hours plucking 3 ounces of berries. Mike spends 6 hours per day hunting 3 rabbits, and another 4 hours plucking 7 ounces of berries.

Now they get together and decide to coordinate their activities. They could then easily find a way to divide their tasks in a way that benefits both of them. For example, Mike could devote all of his time to hunting, while John devotes all of his time to berry plucking. The aggregate output of the island economy before and after the division of labor would look as follows:

Before: 4 rabbits,  10 ounces of berries

After:   5 rabbits, 15 ounces of berries

John and Mike have now have one rabbit and five ounces of berries more per day than they would have had if they had not joined their efforts. No matter how they divide the surplus, each of them will be better off than before. 

Notice that the division of labor is beneficial for all parties involved not only when each producer is superior to the other in some special field. It also holds true when one of them is more productive than the other in all fields. In our above example, Mike is better than John as a hunter, but he is also superior when it comes to plucking berries. For most noneconomists, this is certainly a surprising aspect of the division of labor.

Many people will be intuitively inclined to think that all-round superior producers such as John can draw no material benefits from cooperating with productive underlings such as Mike. If John deals with Mike at all, it is only out of courtesy and generosity. Such was indeed the social philosophy of the old European conservatives such as Carl-Ludwig Haller and Joseph de Maistre. As they say it, inferior producers could not possibly be the equal economic partners of superior ones. The only possible social relationship between them was one of subordination. The superior man granted favors, and in exchange he could expect obedience.

As we have just seen, this view of things is wrong. Economists do not of course exclude that favors be granted and obedience be due in certain cases. They merely point out that the bonds of favor and obedience are far from exhausting the reality of social cooperation. And these bonds certainly cannot compare in importance to the bonds that result from shared material benefits. The division of labor is a blessing for all people. Superior and inferior producers can be true social partners.

From Ricardo to Mises

It was the British economist David Ricardo who first highlighted this fact in his Principles of Economics and Taxation, in the context of an analysis of foreign trade. Ricardo did not truly grasp that he had hit a general economic law that applied to all cases of human cooperation. He merely claimed that free trade between nations was beneficial. Moreover, he emphasized that he assumed in his deduction that labor and capital were mobile factors only within the borders of each nation. In other words, he assumed that only raw materials and consumer products were traded across national borders. This trade, Ricardo stated, was beneficial.

Unfortunately, later writers have wrongly inferred that Ricardo's assumptions were also conditions for the validity of his argument. They reasoned as follows: "Ricardo proved that free trade was beneficial when capital and labor were immobile. Therefore, the case for free trade relies on these assumptions." The error in this argument is not difficult to see. Suppose someone said: "The physicist XY proved that the Law of Pythagoras held true for a triangle with a hypotenuse measuring 3 inches, within an error margin of plus-minus 0.001 inches. Therefore, the validity of that law is proven only for such triangles." Clearly, this is faulty reasoning. The Law of Pythagoras holds true for any right triangle; demonstrating that it holds true for a specific triangle must not be taken to mean that it only holds true for that triangle. And similarly, from the fact that Ricardo made the case for free trade under the assumption that capital and labor are immobile, it does not follow that free trade is beneficial only in this case.

The first economist who stressed the general validity of Ricardo's discovery was Ludwig von Mises. In two works from the late 1910s, the Austrian economist dropped Ricardo's assumptions and concluded that, in a world of free trade and universal capitalism, all factors of production would be allocated at the places that by virtue of their geological characteristics offered the highest marginal revenue for these factors. Capital would be exported to these places, and laborers would migrate there. Once all factors had found their right place, wage rates would be equal throughout the world, and so would interest rates.

Driving home the Ricardian message in the most general context, Mises emphasized that this geographical allocation of resources would be optimal from the point of view of consumer satisfaction. A few years later, in his book Socialism, Mises pointed out that the material benefits of the division of labor are a fundamental incentive for human cooperation. And in his mature work Human Action, he called the workings of these incentives the "law of association."

Notice that Mises did not say that the factors of production should move to the places that offer the highest remuneration. He said that as a matter of fact they would move to these places, and that this would in fact be beneficial from the standpoint of consumers. Notice further that Mises made in fact two contributions.

One, he digested the nub of Ricardo's argument and pointed out that it was universally valid.

Two, he applied this argument to a hypothetical world of global capitalism, in which no political obstacles would hamper the free movement of labor and capital – the exact opposite of the Ricardian world. In the period leading up to World War I, the Misesian hypothesis reflected to some extent the political conditions of the real world. The scenario that Mises analyzed could be observed in a good number of concrete cases, most notably, in the case of the British Empire. Capital and labor constantly left Great Britain and moved to overseas provinces such as Australia, India, and Canada, where they could be employed at greater returns.

The Economics of Capital Exports

Now this setting is of some relevance for the understanding of our present-day conditions. In the past twenty years or so, an increasing number of countries outside of the traditional western hemisphere have adopted free-market policies. Rather than seizing the assets of foreign capitalists, as they did before, they now protect the property rights of foreigners and allow them to re-export revenue to their home countries. Investments in some of these countries are now much more profitable than in the West. As a consequence, they attract western funds. Capitalists from the U.S., western Europe, and Japan have already invested considerable sums of money in these countries, and they are likely to increase these capital exports in the near future.

Thus we have a situation that in many respects resembles the British case of the 19th century. Great Britain constantly exported labor and capital. Now it is obvious that the exported factors of production earned higher revenue abroad than they would have earned at home. Thus for the owners of these factors (the workers and the capitalists), crossing the borders of the nation state was undoubtedly beneficial. But what about the factor owners who stayed at home?

The emigration of workers had the tendency to increase wage rates in Britain. Good news for the workers who stayed. Bad news for the capitalists, because they now had to pay higher wage rates—but who cares for the capitalists? Well, as usual they took care of themselves and exported their money overseas, to the places where the workers went and where higher returns could be earned on capital investments too.

Capital exports had the tendency to increase interest rates in Great Britain until they matched those of the colonies, which was of course precisely the reason why capital was being exported in the first place. Most importantly, the capital exports tended to decrease the wage rates of British workers, because wages can only be paid out of the available capital pool. They therefore had the tendency to impoverish people working for wages—more precisely they reduced wage rates below the level they could otherwise have reached.

Thus capital exports essentially entail a relative impoverishment of the wage earners. This is not the same thing as an absolute impoverishment. Wages are lower than they could have been, but they are not necessarily lower than before. For example, suppose the net increase of the capital stock is 15 percent. If two-thirds of that increase is exported, the capital invested at home still increases by 5 percent, thus entailing an absolute increase of wage payments.

It appears that in the British case, the decline in domestic wages was only relative, not absolute. Real wage rates in Great Britain constantly increased in the very period in which the country exported capital all over the world. But today things might be different. It cannot be excluded that the decline of wage rates will be absolute in the western countries, if capital exports to the less-developed world are allowed. Should this not be reason enough to revise the case for free trade? Some writers think so. They realize that capital exports will increase the wage rates and the productivity of foreign workers. They concede that this higher productivity of foreign workers might entail an indirect increase of real wage rates in our western countries. And they even accept that from an overall global point of view, capital exports are unobjectionable. However, they refuse to adopt any such global perspective. All they care about are domestic wage rates. As they see it, the case for free trade holds water only as long as international transactions do not diminish absolute wage rates for domestic workers. Yet they are wrong, as we will now proceed to show.

The Case For Free Trade

To see their error, we have to do above all one thing: We have to think in terms of alternatives; we have to adopt the economic point of view.

Let us therefore clearly define the question that is at stake. The question is not whether absolutely decreasing wage rates are good or bad from some aesthetic or ethical standpoint. Most economists will probably share the present writer's wish that all people in the U.S. and elsewhere shall constantly progress in prosperity. But this is beside the point. The question is not even whether it is likely that current capital exports will not only entail a relative, but also an absolute decline of wage rates in the western hemisphere.

We might for the sake of argument assume that the decline will be absolute—impoverishment of all people who depend on wage income. All of this cannot in the least affect the case for free trade. The only relevant question is how free trade stands up to its only logical alternative: government intervention. Can we make ourselves better off by letting government prevent capital from crossing borders? That is the only relevant question, and the answer is in the negative.

Thus, assume the U.S. government enacted clearly defined laws aiming to prevent capital exports; that these laws were effectively enforced; and that therefore no more nonauthorized export of capital would take place. What would be the consequences?

The first consequence would be of course that some capital that otherwise would have left the U.S. is now blocked at its borders. It would not necessarily be the case, however, that all of this money would be reinvested. Part of it might go into personal consumption; another part might be donated to political campaigns aiming at the reversal of the neo-protectionism. As soon as the government starts telling everyone what to do with their money, capitalists grow suspicious and ask themselves what might well come next. Reinvesting their money into any long-term venture would turn it into a sitting duck. It is therefore safe to assume that American capitalists would seek to invest only in rather liquid short-term projects or, better still, use the money for consumption expenditure while they still have it. The consequence would be a reduction of the overall capital fund and thus a decrease of wage rates in all but the consumer-goods industries.

But the intervention will not only incite greater consumption of existing capital. It will also curtail the formation of new capital. American citizens and residents would diminish their savings and indulge in greater consumption. Some of the savings are only made because of the prospect of interest returns that, at present, can only be realized on investments abroad. Preventing these investments means preventing the savings that are made in the first place. Again, the result would be decreasing wage rates.

Foreign capitalists would deal with their blocked U.S. investments in exactly the same way as their American fellows, and with the same consequences for U.S. wages. But most importantly, they would stop making any further investments in the U.S. There is no point in buying U.S. assets if it is impossible to re-export the revenue. It is clear to all informed readers that this alone weighs heavily against such interventions. No western country benefits more from capital imports than the U.S. Discouraging these foreign investments means reducing American wage rates.

Moreover, one should avoid conceiving of "capital exports" in too narrow terms. Just about any good can be capital. Capital export does not only take place when machines and other industrial equipment are sent abroad. It also happens when dollars are exchanged against other currencies, or when consumer goods are exported. A rigorous control of capital exports thus requires government control over the entire foreign exchanges and the entire trade of the nation. In short, it requires government control over all economic transactions involving residents and foreigners. It follows that foreign trade would be cut back to a fraction of what it is at present. It is a great error to assume that this intervention would affect only imports. As John Stuart Mill and many others have pointed out, you cannot cut back imports without cutting back your own exports. Thus, American wage rates would shrink in more or less all export-related industries.

In the light of these considerations, it is clear that a policy of blocking capital movements out of the U.S. would not automatically preserve the present stock of capital; and thus it would not automatically prevent a fall of U.S. wage rates. The policy entails strong tendencies that counteract its intentions. The only remaining question is whether the net effects are positive or negative. The answer is that the net effects will most certainly be negative in the long run; and that even in the short run they are more likely to be negative than positive.

In the long run, it is unavoidable that the unintended consequences of blocking capital movements become far greater than any short-run benefits. Preventing capital from moving to foreign places where it can be used at greater returns means to deprive Americans of cheaper products. It means depriving them of the benefits of a large-scale division of labor. Protectionism produces poverty.

Even in the very short run, the net effect is likely to be negative. In the light of our above analysis alone, it certainly cannot be excluded that they be negative. And so far we have assumed that the new policies would be effectively enforced! Yet it is naïve to expect that capital exports could be prevented, especially if high returns wait just behind the border. As in all similar cases, we would rather have to assume that a huge black market would develop rather quickly, and that in its wake corruption and organized crime would flourish.

Notice that these are purely practical considerations. Blocking capital movements just does not make much sense. It is bound to produce more of the evil it seeks to combat, and a host of other evils on top of that.

Conclusion: The Great Parenthesis

A few years ago, the French historian Jean Baechler remarked that the period from the onset of World War I until the demise of the Soviet empire in 1991 was a "great parenthesis" in western history. We might add: It was also a great parenthesis in international economic relations. During this period—a time of revolution and war in most other parts of the world—the United States offered virtually the only safe haven for capital investments. Many people realized this, and many brought their money to the U.S. American prosperity of the past eighty years was therefore to a large extent, and to an increasing extent, a borrowed prosperity. From all over the world, persecuted capitalists brought their money to the U.S. Among the beneficiaries of this somewhat artificial increase of the capital stock were the American wage earners.

Now this epoch is drawing to an end. The parenthesis is closing and things are returning to a more normal state of affairs. Capital begins to leave the developed capitalist countries and spreads into other regions of the world economy, certainly to the benefit of these areas, but ultimately to the benefit of all of mankind. It is possible—though by no means sure—that Americans might experience falling wage rates for a few years. But they would be ill advised to let fear outweigh their sober judgement. Free trade is not merely the policy that alone is worthy of a free nation. It is also from a narrow materialistic point of view far superior to its only logical alternative: letting government ruin trade and the worldwide division of labor.

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Jörg Guido Hülsmann (jgh@mises.org) is a senior fellow of the Mises Institute.


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