Monday, November 19, 2012

Foreign Trade and Investment are Beneficial

Noriko Hama, an economist and professor at Doshisha University Graduate School of Business writes in The Japan Times Online  HERE 
“Elusive 'wealth of nations' in a global economy”
When in doubt, resort to the classics. This is the advice that comes to mind. Accordingly, I looked into that mother of all classics in economic writing: Adam Smith's "An Enquiry into The Nature and Causes of The Wealth of Nations." Running to 2,000-odd pages, this is some inquiry indeed. Inquiring within the inquiry, I found the following enlightening passage. Here the founding father of economics is talking about the relationship between private individual decision-making and the public interest:
"He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention."
Readers please note that this is the place where Adam Smith's famous "invisible hand" makes an appearance. The one and only place. For all the attention that this expression has attracted over time, it is but one phrase in a great ocean of words. One wonders how the great man feels as he looks down from on high at all the fuss we are making of that nonrecurring phrase.
But I digress. What is really interesting about this passage is that the whole analysis presupposes complete identification between individual welfare and that of the whole nation. And that private individuals will always choose to give support to domestic industry rather than foreign ones. Given these assumptions, the invisible hand theory makes perfect sense. It is the only logical conclusion. In this type of world, there is no room for meddling by the visible hand. Heavy-handed attempts to dictate individual behavior toward the patriotic choice are totally uncalled for. Individuals will always end up making the patriotic choice anyway, as they pursue their own private gain.
This whole image is so enlightening because it is so different from the world in which we live at present. In the global age, there is no guarantee that individuals will always choose domestic industry over foreign counterparts. Very much to the contrary, today's individuals responsible for management will tend to do business with foreign partners if that is the less-costly choice. They will choose to relocate their production facilities overseas if that is the cheapest way. In such a world, increases in the wealth of the individual will no longer lead automatically to an increase in the wealth of the nation.
Does all this mean that in the global age, we have to start resorting to the visible hand of government to prevent the individual pursuit of wealth leading to a decline in the wealth of the nation? Surely not. But it might be a tempting idea for some beleaguered politicians looking for a quick fix and a quick boost in popularity. Perish the thought.
Noriko Hama has read a single passage in Wealth Of Nations and may have come to the wrong conclusions.  He may have to read the other 1,999 odd pages to see where and why he may be making a category error about Adam Smith’s message.  He is in good company, namely the majority of other members of our profession.
Even the few sentences he quotes make it clear it is about the merchant who is concerned about the security of his capital if he sent it abroad and, instead, invested it in “domestic industry, which had the unintended consequence that he promoted “an end which was no part of his intention”. But what is that that “end” specifically?  It is this simple point that most economists miss: Smith drew attention to how this merchant – and any others motivated by their insecurity for their capital - who chose instead to invest it at home, added their capital investments to the flow of total domestic investment.  In short, they increased the arithmetic sum of domestic investment, which in turn added to the country’s “annual revenue and employment”.  This addition followed the arithmetic rule that the whole is the sum of its parts.  Of course, this promoted the “pubic interest” in Smith’s general view.  Increasing revenue and employment were beneficial outcomes, much as growth was too – because much of the labouring poor were desperately poor and evenlow wages from any employment were beneficial for them in Smith's view.
 However, Professor Noriko Hama draws the other conclusions.  First that the economy in Smith’s days “presupposes’” the “complete identification between individual welfare and that of the whole nation”.   That outcome depends on many factors, which Smith discusses in the rest of that particular chapter. Secondly, in Smith’s day, as today, many merchants invested abroad significant amounts of their capital.  Not all of them preferred “domestic industry”.
Foreign trade and shipping were major sectors and foreign trade was an important source of Britain’s annual wealth, as it is today.  The corollary of the “invisible hand” chapter is that the capital sent abroad (to Europe and the North American colonies) reduced the amount of capital invested domestically, which was still beneficial to Britain’s welfare, as represented by its imports of foreign and colonial produce from where it made its capital investments.   None of this has changed today.  And Japan spent many decades in foreign investment – I remember consulting for successful Japanese businesses in South Africa in the 1990s.  Locating production abroad is not detrimental to domestic prosperity. The sentence that “private individuals will always choose to give support to domestic industry rather than foreign ones” is counter-factual.  They never did from the 14th century in Britain nor do they in all growing economies since the 19th.
Smith attachment to free trade and against tariffs and protection restraints on imports from abroad is well known from the rest of his long book.   
Lastly, the so-called “invisible hand” theory isn’t a theory and it does not “make perfect sense”.  A scroll through a few months of Lost Legacy would explain why I state this view.  Markets always work – can only work – by visible prices – and there is no ‘invisible hand”.


Blogger IJ said...

"in Smith’s day, as today, many merchants invested abroad significant amounts of their capital. Not all of them preferred “domestic industry”.

Signs of financial discipline this week. The IMF have opened the door to governments refusing investment from abroad on the basis the monies might play havoc with their national exchange rates.

Evolution. A nod in the direction of a politically sustainable global economy perhaps.

5:22 pm  

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