Why International Economics Theory Has Become Irrelevant

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With the US–China trade war and the Brexit dealings making headlines around the world, debates about international trade are at a high point. Unfortunately, those wishing to turn to the theory of international economics for support and enlightenment on these issues will find themselves disappointed. This field is perhaps the epitome of the much-despised “ivory tower economics,” as it is now severed from the reality of global markets. Dry, long-winded, and highly formalized, international economics is kept in a separate, pristine theoretical box, taught and used in a vacuum without much reference to other areas of economic science, and even less connected to the realities of global business. If connections are made by scholars, they are tenuous, unrealistic, or merely conjectural. Mainstream international trade theory explains only very little of international trade reality.

There are three reasons for this, which can be traced back to the methodological roots of international economic analysis, especially: 1) an exclusively macroeconomic approach, 2) the use of the classical dichotomy, and 3) the absence of the entrepreneur. Let me explain these in turn.

First, David Ricardo and John Stuart Mill drew a sharp line between domestic and international exchange, positing that international ‘value’ is different from domestic ‘value’, and thus that the two types of exchange, within and across borders, must be treated differently by economic analysis. This led, in turn, to international economics developing as an exclusively macroeconomic theoretical system, dealing with countries as units of analysis instead of seeing international exchange as a mere extension of domestic exchange, different in context and data, but not in kind. After 1871 and the Marginalist Revolution, neoclassical theories formalized, elaborated, or criticized the principle of comparative advantage, framing it within the new subjective paradigm, but kept the arbitrary idea of a nation’s borders as their unit of analysis.

In 1895, in an attempt to eliminate the labor theory of value from the principle of comparative advantage, Pareto created the first mathematical model of Ricardo’s principle—for two countries and two goods—in which relative costs were expressed in terms of marginal utility. In 1936, Gottfried Haberler then formulated the theory in terms of opportunity costs rather than hours of labor. Pareto and Haberler’s revisions opened the gate for mathematical models with multiple countries and multiple goods, and set the conceptual foundations for modern trade theory. The Swedish economist Bertil Ohlin, inspired by his professor Eli Heckscher, developed the theory of factor endowments in his 1933 treatise, Interregional and International Trade. Unlike Pareto and Haberler, Ohlin wished to discard Ricardo’s theory completely, and replace it with his own macroeconomic explanation of international trade. In this approach, given two factors of production, labor and capital, countries relatively more endowed in capital should produce and export capital-intensive goods, thus specializing in sectors that use the factor of production with which the country is relatively more endowed.

Second, classical economics has also introduced the “classical dichotomy” between the real and monetary sectors of the economy. This led to international economics growing into two separate branches: the pure theory of international trade, centered on the movements of goods and production factors, and international monetary theory, dealing with foreign exchange and the balance of payments equilibrium. The classical dichotomy not only survived the Marginalist Revolution, but later in the century was reinforced by a foundational shift from early neoclassical methods toward the Samuelsonian synthesis of Keynes’s theoretical system. During the 1980s and 1990s, this foundational shift led to an uprising against the neoclassical orthodoxy in international trade, which aimed at correcting previous errors like the perfect competition hypothesis, and extending trade models to incorporate more variables—such as technological development, scale economies, and product life-cycle theories. However, these extensions also operated with the classical dichotomy.

Third, the “unfortunate legacy” (Redlich 1966) of the British Classical school, i.e., the disregard for the role of entrepreneurship, was carried on after the Marginalist Revolution and the subsequent paradigm shift, and also significantly shaped the development of mainstream theories of international trade. Modern trade models, much like the theory of the firm model, became “an instrument of optimality analysis of well-defined problems which need no entrepreneur for their solution” (Baumol 2010). Since uncertainty had no meaning in a frictionless, predictable system—which postulated profit maximizing agents, production functions, and equilibrium prices—“the entrepreneur became a mere automaton, a passive onlooker with no real scope for individual decision-making” (Hébert and Link 2006, 326). International trade theories shared the evolutionary fate of mainstream economic analysis because Pareto, Ohlin, Samuelson, and Krugman developed their theories within the same non-entrepreneurial paradigm. Largely because of this, Ricardian and factor-endowments models have failed to develop beyond thinking of naturally-given productivities of land and homogeneous capital as sole causes of the international pattern of specialization (Dorobat and Topan 2015).

Finally, the best proof of the divorce between theory and reality in this field is displayed by the critical mass of economists declaring themselves in favor of free trade that are skeptical of or completely opposed to removing all tariffs and customs. As I explained before, “whichever side of the barricade commentators claim to be on, they all believe that increasing one’s own welfare can only be accomplished by decreasing the welfare of others—or, that the benefits of trade can only arise through reciprocal governmental agreements on mutual tariff concessions”—or, alternatively, through the escalation of political or economic conflict.

As we shall see in the next article, Mises built his analysis of international economics by avoiding each of these three pitfalls. This led to a coherent praxeological analysis of (monetary) exchange across national borders that is not only relevant today, but the only valid alternative to the body of modern trade theory and the best argument for a free trade policy.

[This article is an excerpt, edited for online publication, from Carmen Dorobăţ’s PhD thesis, “Cantillon Effects in International Trade: The Consequences of Fiat Money for Trade, Finance, and the International Distribution of Wealth.”]

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