The Great Game of trade

I was reading about the US-China trade war in Foreign Affairs, an article (The Unwinnable Trade War) strikingly awash with metaphors of conflict – blazing guns, cease fire, détente….) It sent me back to the excellent book by Rebecca and Jack Harding we just published in the Perspectives series, Gaming Trade: Win-Win strategies for the Digital Era. They (an economist and a political risk analyst) use game theory to analyse the interplay between the win-win economics of trade and the zero sum game of geopoltical power. States (and they mean the big blocs, the US, China, Russia, the EU) need to develop strategies simultaneously for military force, information/cyber warfare, and economic soft power. Trade policy is an important weapon in the complicated strategic game.

The book argues that the focus on old-fashioned trade wars is a distraction from the most important front at present (my goodness, impossible to avoid the military metaphors): control of cross-border flows of information, finance and intellectual property. The physical world  and control of material resources is of course still important; but the new frontier is the cyber frontier. Indeed a new column by the digital guru Andrew McAfee highlights the continuing dematerialization of the economy (as I wrote about in The Weightless World, and Danny Quah also back in the 1990s). Russia’s engagement on the cyber-front is all too obvious, with seemingly little effective counter-attack – or even connivance from the Trump family.

I was persuaded by the Hardings’ argument that the current global situation is very dangerous, threatening economic stability, environmental sustainability and peace. The slow growth or worse will encourage the trends toward populism and authoritarianism, and a spiral into more protectionism. If you consider the economic and political whirlwind associated with the collapse of trade in the 1930s, it’s worse now: the World Bank’s new annual World Development Report paints a vivid picture of the extraordinary economic interdependence of the world’s economies. Unravelling these value chains will be catastrophic (Brexit Britain seems to be offering itself as an early test case of the potential damage).

In the end, the book argues, we all lose unless the current great power conflicts – soft, cyber and potentially ‘hard’ – de-escalate. The strategic path from here to the sunlit uplands of a new era of multilateralism is far from obvious. But it does us a favour in drawing attention to the dangers, and to the need for clear strategies to get out of this situation.



The trade-investment-service-intellectual property nexus

I’ve managed to resist reviewing Richard Baldwin’s new book The Great Convergence: information technology, trade and the new globalization until now, and it has taken serious self-restraint as the book is so relevant to (among other things) the Brexit debate. I would for one thing force every Cabinet member to read it and not allow them to keep their jobs unless they could pass an exam based on it. Anyway, the book’s published on 14th November and now it’s November my self-denying ordinance can end.

The Great Convergence offers a compelling framework for thinking about how trade is organized and why and how it benefits whom. The first part is a historical overview of trade leading up to the first, the Old Globalization or the 19th century. This phenomenon, due to steam power reducing trading costs, industrialization and a context of relative global peace led to the Great Divergence: the major economies of Asia, which had been richer than the West, fell behind, dramatically so over the course of two centuries. The New Globalization, since the 1980s, driven by the new information and communication technologies, has taken the rich countries’ share of global output back to its 1914 level in little over two decades. China is the standout story, going from uncompetitive in 1970 to 2nd biggest in the world by 2010, but other rapidly industrializing nations in the New Globalization are Korea, India, Poland, Indonesia and Thailand (ie. a different group from the notorious BRICs).

However, as the book goes on to document, the New Globalization is a completely different kind. Trade over distance has three costs: the costs of moving goods, ideas and people. When moving goods got cheap, the first explosion of trade occurred, but ideas were costly to move so the innovations of the industrial revolution were not easily exported. The Old Globalization was the result of low shipping costs and high communication costs. ICTs have reduced the latter significantly, so industrial competitiveness is defined in terms of production networks, interlinked supply chains, that cross national borders. Knowledge has been offshored, and the rapid growth in a few previously poorer countries has come about because of their geographical location, close enough to G7 industrial centres that managers can travel there, sharing knowledge within the confines of the production network.

This means the New Globalization happens at the level of stages of production and occupations. This makes it harder to predict who will be affected – which jobs will be offshored, which areas most affected. “Nations are no longer the only natural unit of analysis”. Much of the book describes a new data set making it possible for economists to begin to explore the ‘value added’ pattern of trade created by the switch from trading finished goods toward trading components in global production chains. The picture is going to be utterly different – the famous example being the iPhone which is sourced conventionally as a Chinese export to the US but where the value added is concentrated in the American business and the Chinese import a lot of the components they assemble and re-export with not much value added at that stage.

This is one insight the Brexiteers need to appreciate, although the Nissan letter suggests at least some members of the government realise the signficance. British businesses are woven into supply chains with our near neighbours: we aren’t importing prosecco and salami so much as gear boxes. Brexit threatens to tear apart these links. If the cost appears to be too high, the multinationals at the head of the supply chains will relocate chunks of their production networks, and won’t care if they’re exporting gear boxes to the Czech Republic rather than Britain.

The book adds: “Twenty-first century supply chains involve the whole trade-investment-service-intellectual property nexus, since bringing high quality, competitively priced goods to customers in a timely manner requires international coordination of production facilities via the continuous two-way flow of goods, people, ideas and investments. Threats to any of these flows become barriers to global value chain participation…” Baldwin adds that the movement of people is still a binding constraint on globalization, and face-to-face communication – and so distance – remain important. He argues that the improving quality of telepresence is changing this, but I think that remains to be seen.

Ultimately, trade policy today is not just about trade nor about nations. It involves deploying the nation’s productive resources through overseas connections. This is why 90% of the economics profession thought, and thinks, Brexit so damaging, and the idea that the UK has more economic self-determination outside the EU a delusion. The Great Convergence is not about Brexit – it ranges far wider. I can’t imagine a better and more accessible analysis of trade and globalization in the digital era.


(20 November: minor typos corrected)

Advice from David Hume

I delayed starting work this morning by re-reading my hero David Hume’s ‘Of the Balance of Trade’ from [amazon_link id=”0865970564″ target=”_blank” ]Essays, Moral, Political and Literary[/amazon_link].

“How is the balance kept in the provinces of every kingdom among themselves, but by the force of this principle, which makes it impossible for money to lose its level, and either to rise or sink beyond the proportion of the labour and the commodities which are in every province? Did not long experience make people easy on this head, what a fund of gloomy reflections might calculations afford to a melancholy Yorkshireman ……. Any man who travels over Europe at this day may see, by the prices of commodities, that money, in spite of the absurd jealousy of princes and states, has brought itself nearly to a level; and that the difference between one kingdom and another is not greater in this respect than it is often between the different provinces of the same kingdom.”

[amazon_image id=”0199540306″ link=”true” target=”_blank” size=”medium” ]Selected Essays (Oxford World’s Classics)[/amazon_image]

Think northern vs southern Italy, and Milan vs Munich.

What matters, Hume argues here, is the “art and industry” of every nation – or province. The equilibrating flows can be blocked – “as any body of water may be raised above the level of the surrounding element” – but real is real and balances balance. If there is a large and persistent trade surplus in one area, and no exchange rate adjustments, the capital account consequence is inevitable.

Still, we are in for a deal more “absurd jealousy” before the Eurozone saga is over.

I have this Hume essay in the Essays volume but also in one of those fantastic old Penguin modern economics readings collections, [amazon_link id=”B0086LN40I” target=”_blank” ]International Finance edited by R.N.Cooper[/amazon_link], published in 1969. The collection runs from Hume’s 1752 essay to 1967. There are tons of handbooks these days that aim to encapsulate the state of knowledge at the frontier (I say encapsulate but they are usually large tomes). It would be great to have the concise historical progressions once again – perhaps as web portals. Income distribution from Ricardo and Marx to Atkinson and Piketty. Financial bubbles from Jevons through Minsky to Farmer?

Vive l’exception culturelle

This morning brought reports that the French are prepared to torpedo EU-US trade talks to defend the l’exception culturelle. Almost all economists think the French insistence on protection in this domain is neanderthal mercantilism. The distinguished John Van Reenen of the LSE is one; he tweeted (@johnvanreenen) this morning: “EU must not capitulate to #French demands to block US trade talks if audio-visual not removed Yoghurt will be next”

I humbly disagree. This is an issue I wrote about in my 2002 book [amazon_link id=”1587991470″ target=”_blank” ]Sex, Drugs and Economics[/amazon_link] – the whole book is available as a download from my website or still available on Amazon and Abe. But the relevant chapter is pasted below.

[amazon_image id=”1587991470″ link=”true” target=”_blank” size=”medium” ]Sex, Drugs And Economics[/amazon_image]

Movies: Why subtitles need subsidies

The 2001 hit film Bridget Jones’s Diary was co-produced by three movie companies, Canal Plus of France, the independent UK-based Working Title and, representing Hollywood, Miramax. It was not typical of many commercial successes. The heroine was a then relatively unknown actress, nor were the two male leads the biggest stars around. Based on a book which was in turn based on an English newspaper column, there was almost nothing of the conventional Hollywood recipe about it. Oh, except for one thing. With a plot spanning two Christmases, it showed a wintry England blanketed in fluffy white snow. Reader, despite what the Christmas cards portray, it almost never snows in England at Christmas. The dominance of Hollywood values and American culture in the global film industry, even in a two-thirds European movie like Bridget Jones, helps explain why nothing delights a wannabe intellectual as much as art house movies. It’s a mark of free thinking and sophistication. Beautiful French actresses taking their clothes off – fantastic! Subtitles – even better!
The chasm between commercial Hollywood films and arty European ones is all too often
exaggerated, as the two traditions feed each other. Even so, successive French governments have time after time aggressively defended their right to protect French films, through measures such as minimum local content on television channels, on occasion even holding up all EU-US trade negotiations specifically to safeguard the one industry against the titans of Hollywood. The French call it the ‘cultural exception’. Can there possibly be an economic justification for a cultural exception to free trade, though? After all, the case for the mutual benefits of free trade is so fundamental in economics.
Audience preferences certainly seem to suggest this fundamental argument applies in the
movie industry, like any other. For the sad truth is that, despite the angst of the intellectuals, most French film-goers are almost as likely as those of any other nationality to prefer the popular Hollywood blockbusters to the obscure and arty home-grown alternatives. Likewise in Britain, the gritty social realism favoured by British directors does not do too well at the box office compared with the American hits. Drug addicts dying in stairwells on desolate northern British estates versus feel-good, glossy romance or big budget action? It’s no contest. Some local films do very well of course, but the people’s choice is definitely Hollywood.
In which case, you might well ask how European politicians justify special trade protection for their own cultural industries. Surely in culture too free trade will deliver the best outcomes in this as in any other industry, the widest choice for consumers at the lowest pricesFan as I am of free trade, I do however think there is something to the cultural exception. It is partly to do with culture, which is really just a non-economist’s description of a certain type of externality, and partly to do with economies of scale.
In classical trade theory the mutually beneficial effect of increased exchange depends on there not being any significant returns to production at a large scale and there not being high startup costs in industry. In the usual terminology, there are assumed to be diminishing returns to scale, meaning that extra units of output cost more, not less, to produce. In these circumstances market mechanisms mean that small is competitive, that small producers can produce more efficiently than large ones. There will be an equilibrium outcome – only one – in which the lowest-cost producers produce and nations specialize in particular industries. This was pretty realistic two centuries ago. Agriculture and basic commodities formed a high proportion of international trade. Farmers clearly used the best land first, so diminishing returns would set in as they put less fertile land to use, and similarly mines emptied the richest veins of ore before moving on to poorer ones. England could specialize in wool, Ireland in potatoes and France in wine. The same conditions also applied in many traditional manufacturing industries such as textiles and footwear.
However, the classical trade theorists like David Ricardo did not give much thought to Hollywood, or even the possibility of mass production and the assembly line in manufacturing. In the case of many manufactured goods there are substantial start-up costs and hence economies of scale. The research and development, design and set up costs for a new type of car or aircraft or a new medicine are extremely high. In such industries there are increasing returns to scale. They exist, too, in new industries where the marginal cost of producing additional units is tiny, such as the software business.
For the most part international trade now involves the exchange of manufactured goods
like cars or washing machines or pharmaceuticals between the developed countries. However, there is a fair degree of specialisation. Different countries lead in different sectors, especially in high-tech or advanced industries where you might expect large economies of scale, and tend to hang on to their lead. It is clear that historical accident has played a part in the specialisations that do exist, and that countries can develop industries despite lacking the obvious natural resources. For example, Japan is a significant producer of automobiles and steel, despite being naturally short on iron and energy, while the only reason the UK still makes any cars is because some of the key innovators in the early development of vehicles powered by the internal combustion engine were British.
Under conditions of increasing returns to scale, market forces can take the world economy to many possible combinations of output, depending on such happenstance, because it is hard to dislodge a particular country from an early lead. And it cannot be confidently predicted that any particular outcome will be the most efficient possible. Increasing returns introduce the conclusion that it all depends – on which countries’ industries get to what size and when. In such a world – the real world – the conventional conclusions of trade theory will still usually apply. It will not be efficient for an industrialized country to produce almost everything it consumes itself, splitting the workforce between many different industries. What’s more, any country will benefit from its trading partners being equally successful in a wide range of industries because that will generate the prosperity necessary to create a big market for its own products. Poor, isolated countries do not make good trading partners; rich, integrated ones do. So there will continue to be gains from trade. In fact, there may be more potential for gains globally from trade precisely because there are increasing returns in many industries.
The hitch pointed out by theorists recently, as increasing returns to scale have become more characteristic in the advanced economies, is that in some cases trade need not be mutually beneficial. For if increasing returns benefit big producers, those producers will be located in particular countries. There might well be zones of conflict in which the success of one industry from one country actually damages other countries. It is likely that such conflicts arise between very similar developed countries or regions, like the EU and US. An obvious example is aircraft production, essentially a two-horse race between Boeing and Airbus.
Another is the movie industry. The economies of scale are slightly different. They do not arise in production; after all, there are plenty of low-budget movies around. The costs of moviemaking are still plummeting thanks to continuing technological innovation like Apple’s fantastic iMovie software or small and low-cost professional-quality HD cameras now available for the consumer market. Instead, the returns to scale occur in buying in superstar talent, and in marketing and distribution, as discussed earlier in the case of sport and music. Anybody can make a high-quality film at low cost, but few can translate their creative skill into box office success.
Now, I am highly sceptical of most industry lobby groups’ claims that theirs is a special case and they deserve protection from overseas competition. Even though there is a potential theoretical justification, I’m certain it does not operate in practice as often as special interest  groups would like us to believe. While exploiting economies of scale might sometimes offer greater efficiency and higher output in theory, the benefits from competition point the other way.
Figuring out whether a given industry is in a zone of conflict with trading partners is an empirical question, and one highly vulnerable to political manipulation by rich and powerful corporations and lobbyists. Some economists in the late 1980s started out enthusiastic about the idea of ‘managed trade’, based on figuring out which particular national industries needed government help to exploit economies of scale or protection against competitors able to exploit them, but retreated from their enthusiasm when it became obvious the argument had given the usual suspects fresh ammunition to operate against the public interest.
In the case of the movies, I’d nevertheless be inclined to give the European film industry the benefit of the doubt. It might just be an exception to the rule that freer trade is always better. It seems very likely that the big Hollywood studios have an important advantage over European competitors even in European markets because of extensive increasing returns to scale. Hollywood has got into this position because the US itself is the biggest single English language market in the world, whereas language fragments the European market even though moviemaking had a head-start there historically. Scale means Hollywood can always thrash British or French or Italian movies commercially. Yet the dominance of American films is not necessarily the most efficient and desirable outcome for the British or French or Italian economies – or cultures.
It is not as if movies account for a huge portion of international trade and GDP. However, the social benefits of having a domestic film industry probably outweigh the private benefits. The contribution to national culture exceeds the private return to moviegoers of watching pneumatic French starlets or scrawny Scottish junkies (especially the latter). In other words, there is a cultural externality, a gain unlikely to be realized by the operation of market forces.
It is with trepidation that an economist brings in a consideration as fuzzy and controversial as culture, even in the loosest sense, into the argument. Some economists would disagree altogether. However, I have put forward here the kind of argument you need to make to persuade other economists of the merits of special protection from completely free trade for European movies. In other words, it’s not enough to say the film industry is part of the nation’s cultural heritage, full stop. Defenders of subtitled films need to make a stronger case than that.
After all, in the advanced economies, culture, however defined, is an economic resource.
If an increasing share of GDP is generated by services like the creative industries, creativity and new ideas are important. It is impossible to say for sure where ideas come from, but a vibrant and distinctive culture is bound to play a part.
Personally, I feel that an afternoon spent watching something subtitled is as much hard
work as a few hours running regressions sitting at the computer. One thing’s for sure: Hollywood has the best special effects but it’s really not the place to look for the intellectual cutting edge.