Europe in the World Economy: An Economic History

This power point presentation has been revised by Paul Sharp (Ph.D. student) on the basis of my slides.

What relevance does the world one hundred years ago have for me?

You probably have some stereotyped ideas about economics in the nineteenth century.

Great Hall, Bank of England

Surely the world has changed since then?

Of course, but maybe not in the way you expect!

What is the big economic buzzword today?

Globalization!

But the world was at least as globalized before the First World War as today!

Danmark i den globale økonomi logo (Danish government initiative)

Compare Keynes’ description of the world prior to WW1 with the world today

“What an extraordinary episode in the economic progress of man that age was which came to an end in August 1914! … The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could despatch his servant to the neighbouring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable. The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion, which were to play the serpent to this paradise, were little more than the amusements of his daily newspaper, and appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalisation of which was nearly complete in practice.”

Trade regimes in history

• Increasing trade is one of the cornerstones of globalization.• Is globalization a late twentieth century phenomenon?

Plan

1. A quick overview of the development of the comparative advantage argument for free trade.

2. Was 19th and 20th century trade determined by comparative advantage?

3. What happened to trade policy in1. The 19th century?2. The interwar period?3. The 20th century?

4. Is trade related to economic growth?

Is globalization a good thing?

• I will not attempt to answer that!• Here we focus on trade.• Many people are against free

trade…• … almost all economists are for

it!• To explain this you need to

understand the concept of “comparative advantage”.

• See Mankiw pp. 50-53.• Paul Samuelson: the best

example of an economic principle that is undeniably true yet not obvious to intelligent people.

Anti-globalization protests in Edinburgh

during the start of the 31st G8 summit.

Before the 19th century: Mercantilism

• Nations compete for wealth (gold and silver).• So nations should “hoard” wealth.• This can be done by exporting more than importing.• Trade surpluses “good”, trade deficits “bad”.• Justification for protectionism.• But not all nations can have a trade surplus!• Justification for war and colonialism.• Product of its time, when nations needed money to

fund military expenditures.• Now rejected by economists (although not all

politicians!).• A gradual process of enlightenment.

Ricardo (1817) and comparative advantage

Example:Two countries: Portugal and EnglandTwo goods: Cloth and wine (consumed by both).One input: Labour (can be used for production of cloth

or wine).Both countries have 1000 labourers each.

Portugal: Requires 90 labourers to produce 1 clothRequires 80 labourers to produce 1 wine

England: Requires 100 labourers to produce 1 cloth

Requires 120 labourers to produce 1 wine

N.B. Portugal has absolute advantage in producing both!

Opportunity costs of producing cloth

For every unit of cloth, Portugal could have produced 90/80=1.13 units of wine.

For every unit of cloth, England could have produced 100/120=0.83 units of wine.

Portugal’s opportunity cost of producing cloth is greater than that of England.

England has a comparative advantage in cloth. (Even though she has an absolute disadvantage!)

Portugal has a comparative advantage in wine production.

Autarky – both countries produce both goods

500 labourers to wine

500 labourers to cloth

Wine production: 500/80=6.25

Cloth production:

500/90=5.56

500 labourers to wine

500 labourers to cloth

Wine production:

500/120=4.17

Cloth production:

500/100=5

World Production (=consumption!):

Wine: 6.25 + 4.17 = 10.42

Cloth: 5.56 + 5 = 10.56

Trade

590 labourers to wine

410 labourers to cloth

Wine production: 590/80=7.38

Cloth production:

410/90=4.56

380 labourers to wine

620 labourers to cloth

Wine production:

380/120=3.17

Cloth production:

620/100=6.2

World Production (=consumption!):

Wine: 7.38 + 3.17 = 10.56 > 10.42

Cloth: 4.56 + 6.2 = 10.76 > 10.56

Portugal reduces cloth production by 1 unit, England reduces wine production by 1 unit

Lessons from comparative advantage

• World production increases when countries specialize in what they are good at, i.e. the good in which they have the lowest opportunity cost of producing.

• Because world production has increased it is possible to increase welfare in both countries by distributing the goods in such a way that both countries have more than in autarky.

• This will happen if each country exports the goods in which it has a comparative advantage.

So why do people oppose free trade?

• Free trade hurts some groups while helping others.• There are overall gains from trade, so the winners

could compensate the losers, whilst still leaving themselves better off than before free trade.

Problems:• How do you enforce compensation?• Is it always possible to compensate people for the

loss of their jobs? (i.e. is financial compensation enough?)

• In the absence of compensation, it is very easy for small disadvantaged groups to organize themselves and lobby for protectionism.

Hecksher-Ohlin (1933)

Basis for comparative advantage is relative cost differences dependent on factor endowments (labour, capital, land).

H-O theorem: Countries will export goods which use intensively the factors that are

relatively abundant.Based on the world at the end of the 19th century:

The US was abundant in land relative to labour, so she had a comparative advantage in goods that used a lot of land, e.g. grain.The UK was abundant in labour relative to land, so she had a comparative advantage in goods that used a lot of labour.

Stolper-Samuelson theorem (1941)

Owners of scarce (abundant) factors lose (win) when an economy opens up for trade and specializes.

Intuition: Goods which use the scarce factor intensively will be relatively expensive in autarky. With free trade, their price will fall. This results in a lower return for the scarce factor.

Example:In the 19th century, land abundant America started exporting

grain to land scarce Europe. This led to a fall in grain prices in Europe, and therefore a fall in the return to land.

So landowners in 19th century Europe should have opposed free trade, while landowners in the US should have been in favour. This was the case!

Does the H-O theory fit the data?

20th century trade

• Here we see a big difference between the 19th and 20th century worlds!

• See table 2: Most trade between industrialized countries.

• Maybe because trade is income-elastic.• Increasingly intra- rather than inter-industrial.• Sweden exports and imports cars.• Denmark exports and imports pharmaceuticals.

• How do we account for this?• Economies of scale / learning by doing.• Product differentiation.

Economies of scale / learning by doing

If there are economies of scale and/or imperfect competition, then trade patterns become less predictable. For example, Switzerland might have a comparative advantage in watches, even though new producers could potentially have lower costs.So history might be important for explaining trade patterns!Potentially gives reason for protection (infant industry protection)!

Price, cost (per watch)

Quantity of watches produced and demanded

D

SWISSAC

THAIAC

1Q

0C

1P1

2

Thailand cannot offer a price below C0 when starting production. Switzerland is the established producer, so has lower costs and can offer a lower price due to economies of scale.

Is there a role for H-O in the 20th century?

YES!Consider trade between China and Europe.Most trade between rich and poor countries is inter-industrial.Note: Developing nations increasingly export manufactured

goods.

Understanding Intra-industrial trade

If two economies trade mechanical engineering products with each other it is intra-industry trade and it is usually difficult to explain with reference two differences in factor endowments.

If two way trade is in close substitutes, Volvos and BMWs, trade might depend on product differentiation.

But the level of aggregation matters: two way trade in Trucks might reveal that one economy exploits economies in heavy trucks which are exported. The other economy might exploit economies of scale in producing light trucks.

Product differentiation and economies of scale at work

Grains from trade

• We have seen that welfare improves if countries trade according to their comparative advantages.

• This is not the same as saying that trade leads to a higher long-run growth rate.

• What determines growth?• Factor inputs (land, labour, capital, human capital).• Technology, institutions.

• If trade leads to the spread of technology, then it will lead to higher growth.

• But competition might harm investment in R&D.• Economists are still debating whether openness leads to

higher growth.• What does history tell us?

Early 19th century

Corn Laws (Early 19th century Britain)Tariff on foreign grain.Winners: Landowners (British aristocracy).Losers: Everyone else!Opposition: Anti-Corn Law League, The Economist

(1843).Debate split political parties, led to formation of

modern Conservative and Liberal Parties.Impact of Irish Potato Famine (1845-1849).Gradually relaxed through 1840s: started movement

to free trade in Europe and the beginning of “globalization”.

Consequence of protectionism?

Irish Potato Famine

First era of free trade

• 1860 Cobden-Chevalier treaty introduced Most Favoured Nation (MFN) principle between UK and France: trade concessions to third parties would be extended automatically to each other.

• Abolished most remaining UK tariffs.• 1850-75 was first free trade era in Europe.

• Insights from economics.• Political power moving to workers, industrialists.

• By early 20th century, historians could not understand the fuss about protectionism!

What would he have made of the CAP?!

If we want to understand the complexity of the old system, we must look to the detailed records of the Customs. We must refer to that most interesting Blue-Book which gives the Customs tariffs of the United Kingdom from 1800 to 1897, the year of its publication. It is nearly one thousand pages in bulk – all facts and figures, no theories, no opinions. As an example of the old system, we shall find that the tariff in force from 1825-26 to 1832-33 occupies one hundred and fifty-one pages, and one of the pages is of prohibitions that include such varieties as beef and buttons, silk fringes and swine, mutton and band-strings. We must read to appreciate the details of the one hundred and fifty-one pages of these varied and complex duties. By way of contrast, if we look to the tariff after the great reform of 1860 we find it occupies only thirteen pages, and most of the duties are simply imposed to secure the productiveness of a very small number, whilst the only prohibition of importance is that of infected cattle.

The old system… is so utterly and ludicrously indefensible that the most ardent admirer of the past would not wish for a return to it. But we ought not to forget that at the time it seemed not only based on reasonable principles, but necessary.

– Nicholson (1904)

United Kingdom

Differing responses to American grain invasion

American grain invasion of Europe at end of 19th century.

• Increasing US exports of grain led to a fall in prices across Europe.

• Different countries reacted differently:• UK: Free trade, agriculture shrank dramatically.• Denmark: Free trade, diversified to meat and dairy

production.• Most others (France, Germany, Sweden etc.): Imposed

tariffs.

United States

In US, tariffs decreased until the Civil War, then increased afterwards.

Why was the US different?

• US had comparative advantage in land-intensive goods.

• Agricultural interests wanted free trade.• Manufacturing interests wanted “infant

industry” protection.• The agricultural South lost the Civil War.• High tariffs were also important for the

emerging state to raise income.

The interwar period (1919-38)

What happened?

• Growing protectionist sentiment even before WW1.• The Great Depression of 1929 (which we will discuss

in future lectures).• US real GDP fell by 27%, unemployment rose to

25%.

1. US demanded fewer imports.2. Export prices fell, especially for producers of food

and raw materials.3. Trade deficit, need to borrow money.4. But US financial institutions not willing to lend.5. Easiest solution to control trade through tariffs.

Lack of coordination to blame

• When one country imposed tariffs, e.g. US with Smoot-Hawley Act 1930, it became necessary for other countries to do the same.

• There was an alternative, but we return to this in a future lecture.

• The world divided itself into trading blocs:• British Commonwealth• German ASKI mark• Etc.

• Took until 1960s for trade to recover!

After WW2

• General agreement that trade liberalization was desirable.

• GATT rounds from 1947.• WTO from 1995.• Solve trade disputes, negotiate cuts:

coordination!• Kennedy round in 1960s.• Free trade and customs unions (e.g. EU).• Agriculture left out, still controversial.• Some “voluntary” export restrictions.• Still periodic trade disputes.

A contemporary trade debate

European Union “Bra Wars”.• January 1, 2005: System of world textile quotas

abolished.• Large orders of cheap clothes from China made by

European retailers.• EU enacts emergency quotas on clothes from China.• Mountains of clothes build up on EU’s borders.• Countries with large domestic textile industries want

quotas (e.g. France and Italy).• Countries without against (Northern Europe).• September 5: Agreement reached to allow clothes

into EU as part of new quotas. (But must be lifted by 2008 under WTO rules.)

• Similar story in US.

Tariffs and growth

• This section of the note is difficult!• But note the following important points:

• The empirical evidence is inconclusive (in contrast to the “Washington Consensus” of the 1990s).

• It is very difficult to isolate the effect of trade on growth from other factors.

• There is a distinction to be made between trade and openness.

• The interwar period is often considered to be the best example of the negative effect of protectionism on growth.

• In all likelihood, small tariffs have little impact on growth, while prohibitively high tariffs have a large negative impact on growth.

• This seems quite intuitive!• Late 19th century tariffs were small. In the 20th

century they were often prohibitive.

Some of the latest findings

References

Krugman, P.R. & Obstfeld, M. (2003) International Economics:Theory and Policy.

Mankiw, N.G. (2004) Principles of Economics.Persson, K.G. The evolution of the comparative advantage

argument for free trade and A Note on Trade, Tariffs and Growth. Available on the course homepage:www.econ.ku.dk/kgp

Rodríguez, F. (2006) Openness and Growth: What have we learned? Wesleyan Economics Working Papers No. 2006-011