1.1.11 Mercantilism

What is called nowadays classical theory, Adam Smith, David Ricardo, Jean Baptiste Say, John Stuart Mill etc.. is most of all a refutation of mercantilism. (For a more detailed discussion about the term classic theory see classical theory.)

The mercantilists assumed that a country gets richer by accumulating money. At that time gold and silver being these metals a universal means of payement.

In order to accumulate money, gold at that time, following this theory a nation has to export as much as goods as possible and to import as less as possible. If the exports of a country exceeds the imports more money will flow into the country, because, thats obvious, the other countries don't pay with goods, but with money.

(A revaluation of the currencies is not possible, if gold is everywhere a means of payement. There are no inherent mecanisms that will stop this process. In the case of flexible exchange rates, we would have a devaluation of foreign currencies, it would become more and more expensive for foreign countries to buy goods in the country with the current account surplus and the process would be stopped sooner or later.)

This concept is typical for human thinking. We find it everywhere and even nowadays. People tend to draw conclusions from their own experience and tend to generalise these conclusions. We will see throughout this manual, that the classical theory falls in the same trap. The classical concept of saving for instance is due to the same error.

There is no doubt that an individual gets richer by accumulating money. Germany, although unconsciously, follows the same politics. However, what will happen if a whole nation sticks to this policy?

If a country exports more than it imports, they produce more than what they consume. It is obvious that they don't give away their products for free. They get money for the whole production, but only a part of it will be actually consumed. That means that the workers or the companies save money. The basic assumption of mercantilism is that a current account surplus promotes the wealth of a nation. In theory, this money could be invested in the country, but the consequence of the theory is, that the nation saves money.

If they can invest this money, there is not such a big problem. The question is whether it is possible to invest these saving. The foreign countries obviously have to earn money to pay with money. However, the basic idea of mercantilism is, that exports exceed imports. The other countries don't have a chance to get money.

Therefore, in the long run, there will be no profitable investments in the countries. No entrepreneur will invest if he or she can't sell more products. In other words, if all countries follow the mercantilism philosophy, that system can't work.

In other words, only balanced current accounts are stable or to put it otherwise, more in the sense of Jean-Baptiste Say, goods must be changed for goods.

The basic problem is not pure theory, as someone could believe. Germany (and China) for instance have a large current account surplus, they export much more than what they import. That leads to huge savings.

These savings end up in institutional investors, banks and insurance companies. They, in turn, find it more and more difficult to find investments, what they induced them to take more and more risks, invest for example in the housing sector.

(We are not going to discuss the topic here in detail. In theory, there are always opportunities for investments in foreign countries as well. However, this requires better-trained economists than what we actually have; see preliminaries.)

This risky investments are part of the problem we actually have. The financial crises that started in the US in 2008 with the mortgage-backed security, which was everything, but not backed by securities.

In chapter 23 of the General Theory of Employment, Interest and Money, Keynes argues in favour of mercantilism in a somehow sophisticated way. He interprets mercantilism from the perspective of his own theory. In his point of view, the mercantilists were the first to realise that money is not a mere veil, see balance of payements , but has a real impact on the economy and of the type of interests. The more money being circulated, the cheaper interests rates and the more investments are profitable and possible.

(Keynes sometimes likes kidding. There is no doubt that Keynes understood the failures of mercantilism. He describes the mechanism in The Economic Consequences of the Peace. Due to other jokes of this kind, some people believe that Keynes had wrong ideas about economics basics. These people don't understand that Keynes is an outstanding figure and the most important economist. He had no problems with economic basics.)

Unter the conditions in the 16th and 17th century, the only way to increase the amount of money was to import gold and silver because gold and silver were the only means of payment. From a modern perspective, the situation is completely different. There is no need to export goods to increase the amount of money because any central bank can print as much money as they want.

If we want to precise a little bit, the Keynesian argumentation in favour of mercantilism. We could say that Keynes only stressed the importance of money contradicting the classical idea that money is just a veil. Actually, mercantilism shares with classic theory- the same wrong idea that saving the increase in gold is the result of prior savings.

If people can spend the money buying things produced inside the country, there is a potential not already in use to satisfy the demand. Otherwise, the increase in gold would be balanced by a rise in prices. (That's what the classical theory assumes.) If this is the case, the increase in production could have been achieved as well with paper money. There is no prior saving needed.

If people spend this gold buying things in foreign countries, the amount of gold doesn't increase. In other words, money can activate a productive potential, but there is no need for it being the result of a prior saving.

If people don't spend the money at all, it's just stupid.

We will return to the topic in the chapter about Keynes.

If we follow the logic of mercantilism to its utmost consequences, the best thing to do is to remain at the level of subsistence and export everything. That seems to be strange at first glance, but that was the politics of China in the last 30 years. China accumulated three billions of foreign exchange reserves and right now, they have only three alternatives. a) They can burn all that money. b)They can buy a lot of foreign products. c) They can invest in foreign countries. What they actually do is c). Perhaps, it would be better for them to buy foreign technology and to use it in China.

The advantages of the free market, with no barriers to goods, services, labour and capital are easy to understand. The argument for the free market, at a national level, is the fact that in this case, there is a tendency to use the resources the best way possible, in other words, the (monetary) marginal product is the same in all uses, see natural price/market price. It is hard to see why that should not be true at an international level as well.

The example is not really relevant in real life, but illustrative. It is theoretically possible to produce oranges in Germany, although very expensive. It is as well possible to produce apples in Spain. However, the best thing is that oranges are produced in Spain and apples in Germany and then changed. A customs duty on apple and oranges would lead to a situation, if sufficiently high, that Germany starts to produce oranges and Spain produces apples. The price for both products would rise dramatically.

In other terms, everybody and every country should do what they can do best. We will return on the topic when talking about the comparative costs and David Ricardo.

It can hardly be denied that international trade is caused in part by exploitation. Nobody in the industrialised countries is really interested in knowing how the cheap clothes are produced. However, the only solution to the problem is to combine the advantages of underdeveloped countries, low wages, with an import of technology. That way, wages can rise and production becomes competitive.

Measuring the exact advantage of international trade is hard. One possibility is to evaluate all imported products with national prices. The difference between what has been actually paid and what would have to be paid for producing the products is the benefit of the consumers.

To get a total picture, it is a little bit more difficult. A national company pays taxes, employs people and has an impact on the economy as a whole because they have suppliers etc.

The effect on the consumer is not the total picture. It is possible that the industry of a country needs some protection for some time in order to become competitive.

However, if the government intervenes to protect the industry, it should be done in an intelligent way. It is, for instance, not very intelligent, as it is the case in Cuba, to put heavy customs duty on computers. Cuba will never produce computers; there is no competition with a national industry. However, if Cubans don't have computers, the whole economy is less efficient.

The earning of the exporting industry can be measured by a similar method. The exported goods must, therefore, be evaluated with the national price. They are obviously inferior. Otherwise, the products wouldn't have been exported, reducing what would have been earned by selling them on the national market.

There are therefore two effects. The first effect is that consumer can buy the product at a lower price and the second effect is that the companies can sell at a higher price

In case that the balance of goods and services is negative, a country imports more goods and services than it exports, the currency becomes devalued in the event of a flexible currency system. That means that foreign goods become more expensive for the consumer, and national companies became more competitive. The pressure on the currency will continue until the balance is balanced again.

In case that the balance of goods and services is positive, a country exports more good and services than it imports, the currency will become stronger. That means that foreign goods and services will become cheaper for the consumer and national companies became less competitive. The pressure on the currency will continue until it is balanced again.

This process will obviously not happen, as in the times of mercantilism, if the means of payment is the same all over the world: gold and silver. (The gold standard is something different. We will discuss the topic again later, see theory of money.

Another possibility to measure the effect of trades are the terms of trade.

If we only compare two products, the relationship between one imported good and one exported good, things are easy. If in 1984 a country must export 800 apples to get a computer and ten years later 900 apples, its situation has deteriorated.

If we compare several goods, we must compare baskets. Terms of trades measured in this case, the relationship of an exchange of a certain imported basket of goods with an exported basket of goods. If the relationship is observed for several years, it can be shown which country improved its situation and which is worse of than before.

sum of all products of the basket multiplied with their respective price of the imported goods
------------------------------------------------------------------------------------------------------------------------ = terms of trades
sum of all products of the basket multiplied with their respective price of the exported goods

We compare in this case, the value of the basket exported with the value of the basket imported. If we get more, the situation has improved, otherwise not. The term obviously only makes sense if the amount of the respective goods are fixed. Otherwise, it can happen that prices rise by 30 percent and the amount by 40 percent. The quotient would show a deterioration, but actually the situation would have improved.

Actually, terms of trade is a concept very similar to the concept of the real exchange rate. The real exchange rate measures the quantity of something we get when buying it in a foreign country or at home and they should always get the same amount. If we can get more of it in a foreign country, we would by it abroad until it becomes more expensive abroad as well.

The difference between the real exchange rate and the terms of trade is, that terms of trades consider two baskets, with different products, the real exchange rate considers the same product.

The concept of terms of trade is very popular, but actually, it only measures changes in the structure of the supply and demand. Nothing really new and nothing really complicated, although one can doubt that the concept is useful.

It is well possible that price for, let's say, clothes decreases. If Malaysia had to export in 1984, for instance, 10 kilos of clothes for 1 kilo of a drug and ten years later 12 kilos because the prices of clothes has fallen. Following the terms of trade logic, its situation has deteriorated. However, if they produce this clothes ten years later at half the costs because Malaysia has becomoe more productive, then the situation has improved. For half of the costs, or half of the labour if we want, they get the same amount of drugs. Actually, the concept of terms of trades is meaningless.

It makes more sense to compare the costs of production. The price on the world market can fall, but the costs can even fall more. In this case, the contributions margins rise, even if the prices fall.

At the other side even if the costs remains the same and the price fall, a country can improve its situation, if the amount of the products sold rise.

There are a lot of different effects, but these effects are similar to phenomenon we see in any kind of trade. If a country imposes for instance, a tariff on imported goods, we can get very different effects depending on the reaction. If the companies just add the tariff on top of the price before and the amount sold doesn't change, the whole effect is zero. The government gets more, but the tariff is paid by the customers.

If the foreign countries reduce the price in order that the price for customers remains the same, the government earns money, but in this case, the foreign companies lose money.

And of course, one can get any situation between these two extreme situations.

The existence of tariffs on trade are hard to understand and this is advantageous for the national producer. He gets rid of the competition of foreign competitors. It is also possible that the government earns money with that. (Directly, it gets the money collected through tariffs, and indirectly, less money must be spent for transfers to the non-competitive companies if they go bankrupt.) However, in any case, the national consumer will pay the bill.

Concrete data doesn't exist, but it is to presume that if the Germans were obliged to buy electronic devices, food and clothes from German companies, not much money would be left for them for other things produced by German companies. In other words, some sectors of the economy profit from trade tariffs, others are worse off. The last ones are competitive on an international level, but their possibilities to specialise more and be still more competitive is restricted by a lack of demand on the national market, if the consumer pays more for what he should pay, if trade were free.

If trade tariffs have the effect the government expect them to have, in other words increase the tax revenue, than the exporting countries earn less money. In the case of developping countries that has a fatal effect. If they earn less money, they by less high tech products. That not only make them less productive, but is a problem as well for the companies who export high tech products.

Last but not the least, trade tariffs lead to complicated systems and to a huge bureaucracy. It is not only useless and inefficient, but costs a lot of money.

To simplify the topic, what is true on a national level is true as well at an international level. If tariffs on trades don't make sense on a national level, they don't make sense at an international level. They are a hindrance to all the positive effects we normally expect from a free market economy.

- The possibility for more specialisation
- Optimal allocation of resources through prices
- Use of regional advantages
- Optimisation of logistics

The protection of national companies at the disadvantage of the national consumers only works if the system is intransparent or the impact on the millions of consumers is so low, that they don't care. If people knew the amount of tariff rates they pay for sugar, chocolate or coffee, it is very plausible that they would protest. However, they don't know it.

It can be argued that tariff rates must be considered as any other taxes. It's a way for the government to get the money they need. The argument is not very strong. Taxes that influences on the assignation of resources are more critical than taxes that don't have an impact on allocation of resources.

Another problem is the people involved in making this laws, mostly lawyers. These people are not trained to understand the economic effects of laws, but most employees working in ministries and most politicians are lawyers.

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