TECHNICAL | FECB
Surfeit tension
Steve Adams
Why is it that only economists seem to understand the intricacies of international
trade and finance? Probably because it means abandoning ‘common sense’
esults from the recent Economics
R for Business (FECB) examinations
suggest that the topic of the “open
economy” remains the most problematic –
and not only for students. Paul Krugman, a
US economist, observed in 1996 that many
politicians, policy-makers and commenta-
tors seemed to have an understanding of
international trade and finance that was
rooted in a model of the world that econo-
mists thought had been abandoned nearly
two centuries ago1. So, what many people
claim to be common sense in the area of
international economic relations is seen by
economists as at best misleading and at
worst plain wrong.
John Keynes once castigated common
sense in economics as merely outdated
theory, leading to incorrect reasoning
and inappropriate conclusions – especially
about economic policy. So where exactly
does the common-sense understanding of
international trade part company with the
economists’ understanding of it? And in
what ways does the common-sense view of
international trade lead to conclusions that
are at odds with those of economic theory?
Some people seem to have great difficulty
coming to terms with the fact that the main
gains to a country’s economic welfare from
engaging in international trade come not
from exports, but from imports. This mis-
conception is often the result of trying to
understand the economy as whole as if it
were a business. This is misleading, because
a business’s profits are derived from the
income gained by selling goods and services
to other businesses and consumers. But
countries make profits and make their
economies gain not from selling goods
and services abroad, but from buying goods
and services from other countries.
This seemingly odd conclusion is derived
from two propositions. First, the ultimate
aim of all economic activity is the con-
sumption of goods and services. This
implies that, all other things being equal,
more consumption is better. Although this
proposition may raise issues about the
20 CIMA Insider December/January 2002/03
environment and sustainability, it is gener-
ally straightforward and not contentious.
Second, the law of comparative advantage,
which is a little more complicated, states
that a country can always gain from interna-
tional trade by exporting the commodities
in which it is most efficient – that is, in
which the opportunity costs of production
are lowest – and by importing those goods
that it’s least efficient at producing.
The UK can produce wine, for example,
but it is clearly more efficient at producing
financial services. So if a given bundle of
resources can produce 10 bottles of wine in
the UK, but could be used to produce a
volume of financial services that can be
exported to France in exchange for 15 bottles
of wine, it makes sense to engage in inter-
national trade. But note that the benefit
comes from the five extra bottles of wine that
have been imported. The function of the
exports is merely to provide the foreign
exchange to pay for the imports. The eco-
nomic benefit comes not from the exported
financial services, but from the imported
wine – and we can all drink to that.
So international trade, via imports,
allows us to acquire a wider variety and
larger quantity of goods and services that
would otherwise be the case. We pay for
these imports by earning foreign exchange
from our exports. There may even be extra
benefits from exporting – for example, if
there are economies of scale in the exporting
industries, trade reduces production costs.
But the main source of economic welfare
from international trade comes from
imports and, having established this general
principle, we can consider further issues.
The first of these is the question of whether
a trade surplus is good thing or a bad thing.
The common-sense view of international
trade is that a country should aim for a
trade surplus – ie, greater earnings from
exports than payments for imports. This
would appear as a net credit on the current
account of the balance of payments. But
economic theory cannot support this claim.
Remember that the real benefits of trade
come from imports, so a policy of aiming
for a trade surplus would imply reducing
imports and thus reducing the welfare
gains from trade. Moreover, what does a
country do with the trade surplus if it has
one? A surplus implies a net inflow of
foreign currency and this obviously cannot
be spent domestically – just try paying your
Saturday supermarket bill with a handful
of yen. So either it must be put into the
central banks’ reserves, where it will do
nothing; or it must be spent on paying for
imports. In the latter case the country
would have made good use of its export
earnings and would not, in effect, have a
surplus. This reinforces the belief that the
best use of export earnings is to pay for
imports of useful goods and services.
Of course, a nation could lend its surplus
foreign exchange to individuals and organ-
isations in other nations as an outflow of
capital. Here the country would be provid-
ing foreign exchange to enable another
country to import more goods and services
than its export earnings can finance – ie,
one country’s trade surplus is being used
to finance another country’s trade deficit.
In effect, this is what Japan and some
European nations have been doing for the
US for a long time. The US has had persis-
tent trade deficits that have been financed
by capital inflows from other countries.
These have been financing a higher stan-
dard of living for US consumers than US
export earnings would warrant. Does it
really make sense to work hard to earn
foreign exchange that is ultimately used to
finance consumption in another country?
Remember that the benefits of trade
come from the consumption of imports. A
country that has a trade surplus has used
scarce resources to produce goods and ser-
vices that it has exported in exchange not
for useful consumer and investment goods,
but for foreign exchange that simply piles
up in the reserves of its central bank. There
is simply no logic in doing this: if a trade
surplus is seen as good, a bigger surplus is
presumably better, so should a country aim
to export as much as possible and import as
little as possible? What would the outcome
be then if a country exported all of its output
of goods and services and imported none? A
country in which no consumption occurs
does not look a very attractive place.
There is a strong belief that countries
compete with others in international trade –
ie, that different nations are rivals. In this
view of the world, one country appears to
gain at the expense of another. The erro-
neous belief that a trade surplus is desirable

and a trade deficit undesirable is an exam-
ple of this. Because a country can have a
trade surplus (exports exceeding imports)
only if some other country has a trade deficit
(imports exceeding exports), the idea that
countries are rivals and one can only gain at
the expense of another is reinforced.
The notion that countries compete arises
directly from using a business analogy. In
business terms companies clearly compete
with other companies, including those in
other countries. They do this in the pursuit
of profit. Companies employ economic
resources to produce output, and they sell
this output in competition with other pro-
ducers. If they are successful they earn
profits for their shareholders.
Countries are not like this for two rea-
sons. First, they are both producers and
consumers – indeed, countries consume
most of the goods and services they produce.
The point of economic activity is consump-
tion rather than production, so it’s the con-
sumption part that really matters, since this
determines the standard of living. Second,
countries cannot make profits. Profits are
the reward to entrepreneurs for taking risks
and this cannot apply to countries as a
whole. Thus a country’s trade surplus is not
a profit; it’s more akin to an person whose
income exceeds his or her expenditure. I
may not spend all of my income on goods
and services, but the money I don’t spend is
not profit; it’s simply unspent income.
The implication is that all countries can
gain from international trade, and this is the
most important conclusion to be derived
from the theory of comparative advantage.
For countries, international trade is a co-
operative activity in which all can benefit.
But if this is the case how do we explain why
countries attempt to limit international
trade through measures of trade protection?
Recently the US government imposed
import tariffs on steel. Why did it do this?
The common-sense approach says that this
will benefit the US economy, since its
domestic steel industry will increase output
and create more employment. But econo-
mic theory tells us that the whole point
of economic activity is consumption, so
American consumers of steel and steel
products – both companies and individuals
– will clearly suffer as a result. The purpose
and effect of trade protection is to enable
the domestic industry to charge higher
prices for its products. The producer gains,
but only at the expense of consumers. Also,
overall productivity in the economy is
reduced because resources such as labour
and capital will be retained in the inefficient
but protected domestic industry, rather
December/January 2002/03 CIMA Insider
TECHNICAL | FECB
than moving to those sectors of the economy
that are efficient by world standards.
In this way the country as a whole loses
out as a result of the protection granted to
its steel industry. The reason for this
apparently perverse decision by the US
government must be rooted either in a
failure to understand international trade
and its benefits or in political considerations.
Perhaps the best explanation in this case was
that there were mid-term elections in the US
in November and the governing party had
unsafe seats in some major steel-producing
regions. The whole country’s economic wel-
fare was therefore sacrificed for votes.
The possibility that the EU may impose
retaliatory tariffs on certain US exports to
Europe would compound the loss of eco-
nomic welfare, since reduced imports from
the US (from where principal trade gains
are made) would reduce the standard of
living for European consumers. Why would
governments make such decisions? The
standard explanation is that they respond to
pressures. Some producers will lobby their
governments to grant them protection from
competing imports. This raises the profits of
the protected industry but at the cost of
reduced national economic welfare.
So why doesn’t the rest of society, which
will lose out from trade protection, lobby
21
TECHNICAL | FECB
governments to cut tariffs? There are two
reasons for this. First, producer groups tend
to be better organised informed about trade
protection than consumer groups. More
importantly, for producers the gains from
trade protection may be significant but for
individual consumers the loss is relatively
small, even if the total loss is large. Producers
therefore have a much greater incentive to
seek protection than individual consumers
have in preventing it.
In the UK the subsidies and protection
given to farming through the EU common
agricultural policy provides farmers with
about a third of all their income. British
farmers therefore recognise the clear benefits
to them of the government’s trade protection
measures. For the country’s 60 million
consumers the total cost of this protection is
enormous, but for individuals it’s relatively
small – about £10 per family a week.
The theory of comparative advantage
demonstrates that trade protection reduces
the economic welfare of the countries that
impose it. The general rule is that free trade,
unhampered by any restrictions, should be
preferable. Although there are many exam-
ples of state-imposed trade controls, there
are also cases where governments have
recognised the benefits of free trade and
have tried to lower the barriers to it. The first
example of this is the ongoing campaign of
the World Trade Organisation (WTO), to
reduce artificial barriers. The result is that,
for most members of the WTO, tariffs are no
longer a significant obstacle to trade, espe-
cially in manufactured goods.
The second example is the EU’s Single
European Market project, which has been
designed to eliminate all barriers to trade
within the EU. Although tariffs and quotas
were abandoned a long time ago, some
barriers remain – for example, different
national quality standards and unnecessary
red tape. The progressive elimination of
these is designed to encourage trade and
increase the economic welfare of the EU.
The final example arises from European
monetary integration. Most EU member
states have adopted the euro and the UK
must soon decide whether to follow suit.
This raises the question of the costs and ben-
efits of adopting the single currency. The
costs mainly relate to the loss of both an
independent monetary policy and the ability
Reference
1 Paul Krugman, “Making sense of
the competitiveness debate”,
Oxford Review of Economic Policy,
Vol 12, No 3, 1996.
22 CIMA Insider December/January 2002/03
Test your understanding
Question 1: To maximise its gains from trade, a country should
A try to maximise net exports;
B export products in which it has an absolute advantage;
C protect domestic producers from competition from cheap imports;
D export products in which it has a comparative advantage.
Question 2: International trade is best explained by the fact that
A all countries have an absolute advantage in the production of something;
B all countries have specialised in the production of certain goods and services;
C no country has an absolute advantage in the production of all goods and services;
D all countries have a comparative advantage in the production of something.
Question 3: All of the following are consequences of the imposition of trade
barriers by a country except one. Which is incorrect?
A Domestic prices tend to rise.
B Levels of imports tend to fall.
C Only the exporting country suffers a loss of economic welfare.
D Exports from the country imposing trade barriers tend to fall.
Question 4: A country can increase its benefits from trade in all of the following
ways except one. Which is incorrect?
A Reducing its tariffs on imports.
B Subsidising domestic producers to help them compete in international markets.
C Encouraging a reduction in trade barriers through negotiations in the WTO.
D Adopting free-trade policies even if its trading partners do not.
Question 5: The imposition of a tariff on imported goods will benefit
A domestic producers;
B domestic consumers;
C foreign producers;
Answers: 1D, 2D, 3C, 4B, 5A.
D none of the above.
to alter the country’s exchange rate. The ben- The danger is that, should the economies
efits have mainly been discussed in terms of of the US and other nations decline, they
the elimination of costs when buying and may try to shift unemployment to other
selling currency to finance international countries by imposing more import tariffs. If
transactions in the EU. But all the analysis of all countries were to try this, the result would
the benefits of the single currency shows that be a decline in world trade, output and
by far the biggest gains would arise from employment, which is what happened in the
increased trade within the EU. The existence great depression of the 1930s. The com-
of differing currencies acts as a barrier to parative advantage model of world trade is a
trade. Remove this barrier and both trade useful antidote to this danger. And it may
and economic welfare will increase. even help non-economists pass a few exams
The theory of comparative advantage in economics. Why not try the multiple-
and its related implications are not easy to choice questions (see panel) to find out? n
understand. But, once understood, they
provide a powerful analytical tool. That Steve Adams is examiner for Foundation
analysis points consistently in one direc- level Economics for Business. The
tion: free trade tends to increase economic Economics for Business Study System
welfare and the standard of living, whereas is a core text on the recommended
restrictions on trade tend to reduce it. reading list and
Nonetheless, government policy is based on is available from
a range of considerations, many of which CIMA Publishing.
are not economic. Trade restrictions are Telephone: +44 (0)20
often a popular device because they appear 8849 2229, or e-mail
to place burdens on other countries – even publishing.sales@
though this is not actually the case. cimaglobal.com