India and Trade Theory

Donald Trump has come and gone. The visit may yield some standalone benefits to both sides. But will the underlying fault lines change? To answer this, it’s necessary to revisit international trade theory.

After 1945 one of the most researched topics in economics used to be this. But in the 1970s the Americans lost interest in theorising, and took to imperial ways of gaining market access. So latter-day economists only make do with data analysis.

This has its uses, to be sure, especially for fine-tuning strategy and tactics, but it doesn’t quite explain trade patterns between countries and how they should view trade between themselves.

This is because while economic theories are based on logic, which is permanent, data is fleeting. Here today, gone tomorrow. So it’s not very clever to forget the lessons of theory.

There are a few theories that are particularly relevant in the context of India-US trade. And it is worth reminding readers about them because they set the limits within which India and the US — and indeed all countries — trade.

The first of the theories came from David Ricardo, who said that merely the existence of profitable and internationally competitive industries wasn’t enough. He then proposed that it was better to have only the most competitive industries — these were the ones with a technological edge — because in time the economic dislocation caused by closing profitable but less competitive industries would be more than made up by the medium-term gains from trade.

Although later economists have tried to refute this, by and large it still remains true because the key lies in accepting the political consequences of the unemployment caused by closure of several industries. Countries that accept these consequences — which the US used to till recently — do well. Those like India that don’t do badly.

Other theories

Then there was the famous proposition contained in the classic Heckscher-Ohlin Theorem. It extended Ricardo’s comparative advantage theory and said that countries exported products that used their abundant and cheap factors of production, and imported products that used the countries’ scarce factors.

This seems obvious but it depends for success completely on free-labour markets, which means hire-and-fire systems.

Electoral politics makes this hard. So does EU style welfarism.

Then in the early 1950s, Wassily Leontief tested the Heckscher-Ohlin theory and came up with his famous paradox. After analysing the export data, he found that the US, which was a labour-scarce and capital-abundant country, was exporting labour-intensive things.

There was a massive flutter in the economic dovecotes till someone came up with an explanation. This said that skilled labour is a form of capital. India exports a lot of it now to the US.

The third theory was put forth in 1941. It is called the Stolper-Samuelson theorem. It says that when the price of X in terms of Y increased, the real return to the factor used most intensively in the production of X would increase. The opposite also happens.

Some years later Paul Samuelson restated this theory as the factor price equalisation theorem, which basically says that if you have completely open borders, the prices of labour and capital will equalise. So you can see why politics prevents this from happening. Who wants Chinese barbers in the US? Or Indian software workers?

Samuelson was making the theoretical case that GATT should go beyond trade in goods and tariff reductions. This was seen as the best counter to the widespread appeal of communism.

As must be clear by now, the essence of all these theories is that countries export what they can make cheaply and import what they can’t. China’s trade success is a testimony to these theories as indeed is India’s failure.

Enter finance

So, now, what does the US produce most cheaply these days and which is used most intensively in any product? Yes, dollars.

Trading power has always been closely associated with abundant factors of production, provided a country is independent politically. So China has labour and the US has dollars and the technology these dollars enable to be produced, which is plain vanilla Ricardo. Together and separately they wield immense trading power.

What does India have in abundance? Broadly speaking, nothing actually.

Ninety-nine per cent of its vast pool of labour is semi-skilled or unskilled and therefore the abundance is irrelevant for trade. And the little highly skilled labour that it has it exports, which doesn’t yield much dollar income, nor therefore the ability to purchase technology.

It is in this sense that India violates every necessary condition for beneficial trade. That’s why it needs a refresher course in neoclassical trade theory to undo the effects of Left economics, which saw international trade as colonial exploitation.