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Nick Shaxson Entirely Misses The Point Of Comparative Advantage

Ricardo’s comparative advantage

Sure, we can forgive people for not grasping the point or detail of comparative advantage. It is, after all, the only non-trivial and non-obvious result in all of the social sciences (most of which is different ways of saying “People sure do some strange stuff”). It’s also rather difficult to grasp as is obvious given the number of people who don’t manage to.

However, those who would tell us who the entire socioeconomic system should be operated need to be held to a higher standard. This meaning that we both can and should castigate Shaxson for his failure to understand the point at issue here:

Study after study now finds a nonlinear relationship between the size of a country’s financial sector and its long-term economic growth. Every nation needs banking and finance, but only up to the point where it provides all the useful services the country needs: taking deposits, lending, handling business payments and so on. But once finance expands beyond this ideal size and the aforementioned roles – the City of London passed this point long ago – it turns nasty. It reduces economic growth, boosts inequality, distorts the economy and curbs entrepreneurialism and productivity (the UK’s is about 10% below France’s or Germany’s, according to the Organisation for Economic Co-operation and Development). A study by Sheffield University last year estimated that the UK had lost a cumulative £4.5tn in income between 1995 and 2015 due to the City’s bloated size.

The reasons for this “curse” are many but include a drain of talented people into highly paid City jobs from other parts of the economy and from government. People who might have devised cures for Alzheimer’s or led a dynamic, forward-looking political party into power instead get rich as wealth managers to Kazakh oligarchs.

As finance grows, its collective attention turns away from useful activities that help support the creation of wealth towards often more profitable activities extracting it – from other parts of the economy, from the environment and from foreigners. Oversized finance also delivers crippling financial crises.

Germany’s financial sector is notably smaller than the UK’s yet the German banking crisis was larger and more expensive than the British. That neatly deals with the financial crisis point.

But it’s the larger point that Shaxson is remarkably ignorant of. He talks of a financial sector which is adequate for the needs of the country in question. Which is to ignore that only interesting point from all of the social sciences – comparative advantage. And if you’re going to ignore that then this whole idea of international trade is going to be a bit of a mystery to you.

The point of trade at all – and don’t fall for the idea that such across national boundaries is any different from any other form – is to allow the division and specialisation of labour. The driving force behind the decision making being that comparative advantage. Who is better – or in the correct formulation, less bad – at doing whatever. Great, so, they do that, we’ll do what we’re least bad at and we’ll swap the resultant production. By doing this we’re all richer.

This is true of me writing the economics and you doing the financial trading, me waiting table (yes, I am good at it, very good at it) and you cooking (I’m terrible at it) and so on. It might not be true of a world in which we have Shaxson writing the economics.

For, imagine, one particular place is particularly good at doing something. Globally good, finest kind compared to near all other places. We call this a cluster and they exist in all sorts of things. Pharma research, Silicon Valley for computing, certain fields and valleys for wine, Bangladesh for ready made garments, Saudi Arabia for conventional oil production and yes, the City for financial services.

Quite why any place has the advantage doesn’t matter. Could be the vagaries of natural resource placement by the bloke God got in to do the work. Could be that happenstance of the lad who started the Bangladeshi RMG industry in the 70s with a few sewing machines in a couple of apartments and sold $20k overseas in his first year. Could be the glories of the English language and Common Law which means foreigners want us to manage their money, maybe just the realise that all belongs to Britannia, righteously.

But once such a comparative advantage exists we want people to exercise it. It’s also not just that we get to wax fat off doing what we’re good at – it’s that if everyone does this then we all gain more to consume. After all, if we get the competent – the most competent – doing the whatever then there’s more whatever being made. As all production is consumed therefore we have higher consumption possibilities, we’re richer.

Actually, we positively demand that people exercise such comparative advantage. We also insist that people do this, not just groups of them. If someone adds more value to the world – a useful guide being how much she gets paid to do it – by banking then we want them to be in banking. Not trying to cure Alzheimer’s. We do want those who are better at that to go do it, sure, but our sorting process is this very comparative advantage.

Although it is fun to think that the reason McDonnell is running the Labour Party’s economic policy is because all the competents went into The City instead. Hmm, not so much fun as revelatory in its explanatory power.

Shaxson is simply missing the most fundamental point about how we decide who gets to do what. If London’s good at finance then that’s what London should be doing. It makes us all richer that way.

Oh, and there is that other little point of detail, Britain’s domestic finance industry isn’t any larger than that in other rich countries. The only bit that is larger is that bit doing the international trading, selling finance to foreigners. Which brings us back neatly to Ricardo and comparative advantage. We’re supposed to be doing the stuff we do well and selling it to foreigners. That’s how we get to have the stuff they’re good at.

And as above, trying to decide how the world should be run without grasping comparative advantage and trade is unlikely to work well. But, you know, Shaxson….

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4 years ago

Moreover, Shaxson’s concept of banking (“taking deposits, lending, handling business payments and so on”) is as useless as viewing banking as teller lines, slips, and tickets. Banking is only superficially about guiding money from one customer’s hands to another, and it is often about building frameworks in which a customer, using someone else’s spare funds, can achieve; including finding holes in the customer’s planning. And ultimately the vital business of taking a non-functioning widget-maker and guiding it into the hands of a manager who can make it function. This profession is totally misunderstood (thanks for nothing, Mitt Romney) because it… Read more »

4 years ago

Sweden has a larger timber logging industry bigger than is needed for domestic needs, how DARE they! they must slash’n’burn their timber industry.

Our biggest export is “machinery”. The fact we’re exporting them demonstrates we’re making more than needed for domestic consumption, therefore we should, nay MUST, destroy this industry down the bare minimum for domestic need.

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