The poverty of economics and trade

Content image - Phnom Penh Post
The diagram shows how economists understand the economy.

Recent articles published in The Post – Cambodia’s trade deficit to worsen to $2.3B per year with RCEP, says UNCTAD expert and Cambodia, ASEAN likely to teeter off balance with RCEP – raise a number of concerns about Cambodia’s possible membership of the free trade agreement. The commentary explores its effects throughout ASEAN, on the Cambodian economy, and debate about how to understand trade liberalisation. Discussion about Cambodia’s ongoing integration into the world economic system is certainly necessary; however, the articles overlooked some deeper issues about how mainstream economics shapes, and constrains a broader debate about public policy.

In the original report, RCEP: Goods Market Access Implications for ASEAN by Dr Rashmi Banga et al used World Integrated Trade Solutions (WITS)-SMART simulations and concluded that ASEAN nations would see their Balance of Trade, that is the difference in value between a country’s imports and exports, increase. For Cambodia, imports were likely to expand 13.4 per cent, and exports decline slightly. An
UNCTAD expert noted that there would be a loss of tariff revenue from membership of about $334.6 million per year and that this could employ many more nurses in the country, and so contribute to improving the health of the population. These concerns, while important, overlook the nature of market processes.

The diagram (pictured) shows how economists understand the economy. It is shown as a circular-flow model with flows of goods and money between two distinct parts; a market for goods and services, where households purchase goods and services from firms in exchange for money, and a market for factors of production; labour or capital, where firms purchase factors of production from households in exchange for money.

For economists the benefits of markets are clear, they ensure, when as free as possible and unrestrained by government intervention, an efficient allocation of resources. This desire for efficiency is concerned with an increase in production and return to investors.

There may be some costs, a decline in tax revenue, a reduction in public services, an increase in unemployment, and externalities; that is environmental costs that are not included in market transactions.

However, moving to an ideal economic state of rational self-interested actors operating in competitive markets, is an goal of public policy. This thinking is an outcome of how economists view economic development, but brings with it a number of problems.

In the case of trade liberalisation and how Cambodia might be effected, it’s important to note developed countries faith in free trade is in contrast to the strategies they pursued to obtain their levels of development.

From 1721 to 1846, Britain used infant industry protection, export subsidies, tariff rebates on inputs to promote exports, and quality control by the state to promote domestic industry. The US is a keen advocate of free trade today, yet between 1816 and the end of World War II they had one of the highest tariff rates on manufacturing imports in the world.

In Asia, the success of Japan, and more recently South Korea, and Taiwan have all been achieved in defiance of the free trade mantra. While it can easily be argued that these economies were open to the world in the areas of trade, technology and finance, the openness was different for specific sectors and according to industrial policy. Here the distinction between free trade and trade in the context of a coherent and country specific industrial development policy is paramount.

More recently, the success of China and India has confirmed, for the faithful, the virtues of free trade. While it is difficult to ignore their export growth in both cases, trade reforms took place after high levels of domestic
growth, internal reform, and restrictions on the import of foreign goods still apply. Ultimately a review of successful economies undermines the accepted wisdom that free trade is essential for development.

Economists that are dismissive of public concerns often fall back on their discipline’s theoretical rigor, but this only leads to more embarrassment. The theory of comparative advantage is often used in arguments to justify increased global economic integration.

Ricardo’s famous theory used the example of two countries – Portugal and England – to highlight how lifting restrictions on trade would increase production, and as a result increase wealth. In the model, Portugal was
absolutely more efficient at producing both wine and cloth than England, and relatively more efficient at producing wine than cloth within its own borders.

If restrictions on trade were lifted more wine and cloth could be produced with England specialising in cloth and Portugal in wine, and both countries trading increased surpluses.

Today the theory of comparative advantage is used to justify the move to free trade and confirmation that increasing global economic integration is not so much a policy option, but a standard that all countries should follow. Yet the theory suffers from a range of shortcomings that undermine its ability to serve as guide to policy. The theory ignores the specific nature of capital and labour. Capital cannot be converted to other uses
overnight, and people’s skills may become useless with changes in production. Yet the theory assumes both are infinitely flexible. These failings can lead to disastrous policy and a reduction in tariffs may lead to a
flooding of domestic markets, a decline in domestic capacity and an increase in unemployment, rather than spur new production.

In addition, it assumes that comparative advantage arises from a country’s natural endowments and fails to discuss or consider how economic success can be created. As a result, the theory cannot contribute to discussions surrounding the rise or decline of a country’s economy. Here the advocates of comparative advantage maintain fidelity to how they believe markets work, and ignore the reality of how they actually operate.

All theories make assumptions and the process of theorising is inevitably selective. However, the advocates of liberalisation use the theory of comparative advantage as a guide to economic policy making overlook its
limitations, and appear to celebrate it as an approximation of reality when this is clearly not the case.

Economists like to highlight the role of models in their work and use them to justify policy choices. Economic models are a simplified version of reality that aim to identify how specific variables interact with one another, and then from this understanding, make suggestions about policy.

The original report, ‘RCEP: Goods Market Access Implications for ASEAN’ by Dr Rashmi Banga et al used World Integrated Trade Solutions (WITS)-SMART simulations and suggested that the assumptions built into the general equilibrium models, for example, ‘perfect competition, full employment and balanced government budgets’ often used to assess trade liberalisation ensure that the outcomes are skewed in favour of liberalisation.

This concern with the reality of modeling is welcome, but further reveals the limitations of mainstream economics. The aim of economic growth through trade overlooks how such policies will contribute to greenhouse gases and exacerbate climate change. Economic growth simply cannot be separated from energy consumption. The belief that green growth, growth with declining use of energy and resources can in turn allow an economy to expand indefinitely is a fiction.

A 2019 report, ‘Decoupling debunked: Evidence and arguments against green growth as a sole strategy for sustainability, concluded that “. .. there [is] no empirical evidence supporting the existence of a decoupling of economic growth from environmental pressures on anywhere near the scale needed to deal with environmental breakdown...”

Here, one might like to reflect on an agreement that while it aims to promote the expansion of regional trade, investment and contribute to development, it will also contribute to climate change.

Compounding the problem is that current economic models used by the IPCC understate the damages that are likely to occur as the climate changes, and hence minimise the urgency for politicians to act. More realistic models highlight the need for urgent action, however mainstream economics is, as the diagram above shows, is wedded to the idea of an economy in isolation from the natural world.

Discussion about why Cambodia’s economic integration should be a focus of the country’s development agenda has to be understood in the context of today’s economics. Mainstream economics suffers from a market fundamentalism that recklessly celebrates its imagined workings while ignoring salient critiques of its theorising, economic history, and the physical world it operates in.

Cambodia is in the awkward position of being a developing country still trying to strengthen its institutions, while securing opportunities for a growing population.

In addition, decisions about Climate Change and what action developed countries should take are likely to be made in forums beyond its reach. In such a context there are no simple answers, but a more context specific approach to policy making in Cambodia would reveal options that the current ideology ignores.

Michael Powel is formerly a consultant on rural development and agriculture with local NGOs