lawsofeconomy

The law of the market is like the law of gravity
Olivio Dutra (1), minister of urban affairs in the present Brazilian government

The first step to a better trade policy is to clear our minds of the cobwebs of [Ricardo's theory of] comparative advantage.
Stephen A. Marglin (2), professor of economics at Harvard University

Ritual incantation

Senhor Dutra is one of the founder members of the Brazilian workers' party and of a major Brazilian trade union. Yet he is capable of talking like a University of Chicago economist. This is a curious phenomenon of our times: even left-wingers feel obliged, at least in public, to genuflect before the altar of the market. Let them kneel. I persist in believing that the market is not a sacrament.

Do the "laws" of the market really exist? According to libertarian economists, these "laws" are fixed laws of nature, like the principle of Archimedes. Our Brazilian friend's remark is simply a ritual incantation of a notion which, thanks to those economists' propaganda, has come to be very widely accepted. But all this is hardly new. Since economists first made their appearance in the 18th century, many of them have arrogantly insisted that their theories express absolute scientific laws like those of physics or mathematics.

Marx, for example, armed with his scientific theory of history, proclaimed (3) the inevitable implosion of capitalism: the fall of the bourgeoisie and the victory of the proletariat are equally inevitable. Ricardo, from the other side of the barricades, had already asserted (4) that the natural price of labour is that price which is necessary to enable the labourers, one with another, to subsist and to perpetuate their race, without either increase or diminution. This is known as the "iron law of wages": workers' pay always tends to sink to subsistence levels.

The economies that we actually know have clearly failed to obey either of those "laws". In reality, the "absolute laws" promulgated by certain economists are simply predictions of what may possibly happen if certain conditions are fulfilled.

What, in practice, is meant by those who assert that the economy behaves according to "laws of nature"? Let us look at three examples.

"Law" #1. With totally flexible wage rates, there would be no unemployment.

This is a well-known case of the theory of market equilibrium. The theory tells us that, in any market whatever, there is always a price which will bring supply and demand into balance. There is, therefore, always a rate of pay which will match up the supply and demand for any particular type of work. With these magic rates, there can be no unemployment! No problem, then, provided all rates of pay are fully flexible.

This theory is very popular with free-market economists, and with many employers, who argue that the opponents of flexibility are simply bloody-minded workers who refuse to move with the times, who are perversely determined to hang on to the fruits of historical trade-union victories. However, the theory depends on a mechanistic and unreal conception of the economy:

(i) It assumes that the demand for labour in each occupation, though variable, is nonetheless permanent. But business today is changing so fast that many occupations can disappear over quite short periods.

(ii) One might argue that (i) is not a real problem, since the workers in obsolete occupations can transfer to others. But in this case the theory requires that, if certain kinds of work are killed off by technical and commercial changes, they are quickly replaced by new jobs of other kinds. This is by no means certain. No economic law ensures that the creation of new kinds of work will keep pace with the disappearance of existing jobs.

(iii) The flexibilility of the ideal ultraliberal economy applies to prices as well as wages. It can therefore lead to deflation (falling prices). This phenomenon, observed in recent years in Japan, encourages everyone to postpone their purchases so as to buy cheaper later. Down this road we encounter general recession with widespread and persistent unemployment.

(iv) The theory ignores the psychological problem of prevalent pessimism. It is possible for a whole society to fall into a state of mind in which most people feel pessimistic about their future and therefore want to save rather than spend. This leads to economic slowdown and high unemployment.

(v) In a fully flexible labour market, wages for certain jobs may fall to seriously inadequate levels. In America, and increasingly today in Europe, there are workers who do not earn enough to pay for even the cheapest housing. Here is an unacceptable consequence of the free market.

"Law" #2. Unrestricted competition is the natural, and always the best, state of the economy.

Therefore, all restraints on competition are perverse, unnatural, even immoral. This belief is sacred to economic libertarians, those lovers of the mercilessly ferocious commercial jungle, though they themselves are often ensconced in secure academic posts. Let us examine some defects of this holy principle.

(i) In reality, unlimited competition is not natural. Competitors in any kind of business have a natural tendency to agree among themselves to avoid excessive competition. This has always been a basic objective of trade unions, professional associations, guilds and cartels. Their behaviour can be harmful, but they should not be presumed guilty without hard evidence.

(ii) One may argue that limitation of competition within one industry alone would be good for those who work or invest in that industry, but bad for the rest of society. However, it is possible both in theory and in practice for virtually everyone to belong to one or another of a range of unions, guilds, trade associations etc. In this case, everyone will benefit from the avoidance of excessive competition. We can all featherbed each other. Why not, unless you are allergic to feathers?

(iii) Excessive competition can reduce business profit margins to seriously inadequate levels; this is hardly conducive to a healthy economy. In recent decades, some major industries such as airlines, steel, bulk chemicals have been not just occasionally loss-making, but chronically unprofitable.

(iv) In the jungle of deregulated markets, the most aggressive and powerful enterprises gobble up the others; ultimately, too fierce competition leaves us with too few competitors.

(v) Unrestrained competition induces rapid and accelerating changes . But most people strongly dislike too much change. That is not just my personal opinion; the free-market economists themselves never stop complaining about the unwillingness of most people to accept ever faster change.

The economists continue nonetheless to try to force it down our throats; but this can have nasty consequences. In central Europe, voters are growing tired of the upheavals that have followed the fall of communism, replaced by Thatcherite free-market "shock therapy". Now those voters are turning to reactionary political movements.

"Law" #3. Every country or region should specialise in those industries where it has a clear comparative advantage over other countries or regions.

This is Ricardo's theory, mentioned at the head of this article. David Ricardo (1772 - 1823) was a London stockbroker who, when he was not busy making loads of money in the market, wrote about economics. He was particularly interested in the theory of international trade, and his arguments are still considered by most economists to be fundamentally and vitally important.

But his early nineteenth-century attitudes, not surprisingly, seem old-fashioned to us. He assumed that capital does not move readily from one country to another, because (5) most men of property are satisfied with a low rate of profits in their own country, rather than seek a more advantageous employment of their wealth in foreign nations.

Ricardo examined the arguments for producing wine and textiles in England and Portugal. He concluded that it makes sense for wine to be made in Portugal and not in England, since Portugal with its warmer climate has a major cost advantage. But he also argued that cloth should be made in England and not in Portugal, even if the Portuguese can make cloth more cheaply than the English.

At first sight, this seems puzzling. To explain: in Ricardo's example, the cost of making cloth in Portugal is 10% less than the cost in England, but the cost of making wine is 33% less in Portugal than in England. So it is rational for Portuguese capitalists to concentrate on making wine, where their advantage is big, leaving it to the English to make cloth, where their disadvantage is small. Then, the needs of both countries for cloth and wine can be met by trading between them.

This theory leads to the conclusion that, in order to minimise production costs and maximise profits, countries should be encouraged to specialise. To this end, barriers to free trade should be flattened. But there are problems in practice....

(i) By ruthlessly pursuing specialisation, a country may cease to have a healthy diversity of industries; it may become a narrowly-based economy, overdependent on foreign suppliers and customers. Portugal could lose its textile industry and become overdependent on the wine trade; dangerous in the event of an outbreak of phylloxera, or of prohibition! You never know; those American Baptists who don't want us to enjoy a drink are gaining ground.

In our own times, the pursuit of minimum costs has made Western countries overdependent on oil supplies from unstable and unfriendly sources. Some poor countries have become overdependent on export crops which they can produce cheaply; these countries are highly vulnerable to bad harvests and to sharp fluctuations in commodity prices.

(ii) Ricardo's theory works when capital does not move easily between countries. Englsh capitalists cannot invest in low-cost, highly-profitable Portuguese winemaking; so they stick to their clothmaking. But now suppose that the barriers to capital movements break down, as in fact is happening today. Then English clothmakers will delocalise their factories to Portugal, where costs are lower. This will cause serious unemployment in England.

Following the theory through, we assume that English wages are flexible, as Ricardo would insist they should be. So they will fall towards Portuguese levels, gradually cutting the costs of manufacturing in England. Meanwhile the Portuguese, by supplying the English with cloth as well as wine, will run up trade surpluses and accumulate reserves in sterling. In due course they will use these to invest in low-cost factories in England. Balance will be restored, but at wage levels nearer the subsistence level required by Ricardo's "iron law of wages".

So, free trade combined with free movement of capital causes wages to converge downwards. Today, it means that Western wages tend (unless trade unions stick to their guns) to sink towards Asian levels; not, of course, all the way to the bottom, since Asian wages are rising; still, there is a long way to fall. This may not worry professors of economics in Chicago, but it is a real problem for workers in Detroit.

(iii) Free-trade theory assumes that we must allow patterns of trade to reflect countries' existing "comparative advantages". Governments should in no way interfere. But in reality, most of these advantages are not simply natural phenomena or facts of geography. They reflect the historical strategies and investments of governments and business people.

Japan has long been renowned for its apparent advantages over other countries in industries such as electronics and motor manufacturing. But these advantages are not "natural", nor are they the result of laisser-faire government policies. They have been built up over many years by deliberate government strategies, and by the willingness of Japanese industrialists to work hard (not always for maximum short-term profits) to create their own advantages, under the protection of import restrictions and of limits on competition in their home market.

If the Japanese, during the twentieth century, had followed the advice of the free-market economists, they would not have acquired the advantages they have today.

We are not enslaved by economic "laws"

It is time to abandon the notion that we are subject to "economic laws" whose consequences are often objectionable. These laws are mainly imaginary. The success or failure of our economies depends on our behaviour, which does not follow rigid natural laws like those of physics. It follows wayward human nature, and it follows the rules and customs, or festers in the anarchy, that we choose to impose upon ourselves. We can do better than remain prisoners of our own defective structures and attitudes.

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