Understanding International Relations, Third Edition

Problems and perspectives
What difference does crossing a political border make to economic activity?
Consider a very basic situation – so basic in fact that, as we will see later, it
has now been superseded – wherein a firm in one country (A) produces
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goods bought by consumers in another (B). How is this different from
production and consumption taking place in the same country?
The first issue concerns money. The producer wishes to be paid in the
currency of A, while the consumer wishes to pay in currency B. Until 1914,
there were relatively few technical problems here, because virtually all cur-
rencies were convertible into precious metals, mainly gold, but sometimes
silver. The Victorian Londoner travelling to Paris could be confident that his
gold sovereigns would be readily convertible into gold francs – literally
convertible, since each coin was effectively a weight of a certain quality of
gold. And since paper money issued by the Bank of England was equally
convertible into gold (‘I promise to pay the bearer the sum of …’ is still,
meaninglessly, reprinted on British paper money) it also met few obstacles
abroad, although paper issued by lesser banks might be unacceptable. As
far as large-scale trading was concerned, bills of exchange issued by the
great merchant banking houses were widely accepted throughout Europe
and in the rest of the world.
A gold-based system was readily comprehensible, and required no special
mechanism to operate, but there was one feature of the system that poten-
tially posed political problems. If one country had firms that were more
successful at selling abroad than another, or consumers keener to buy foreign
goods, this might lead to a flow of gold in or out of the country. Ought this
to be a source of concern? In the seventeenth century, when for the first time
it became possible to measure gold flows, if not accurately then at least to
degrees of magnitude, the new proponents of ‘political arithmetic’, the
‘mercantilists’, argued that a positive, inward, flow of gold was good, a
negative, outward flow bad. In the eighteenth century David Hume, in
a splendidly concise essay, demonstrated that negative and positive flows
would be self-correcting – inward flows would raise price levels and make
exports more expensive, imports cheaper, and thus reverse the flow, and
vice versa with outward flows of gold – although his argument begs the
question whether governments would allow this mechanism to work
(Hume 1987).
In any event, since 1914 a different problem has emerged. Since that date,
most currencies most of the time have not been directly convertible into
gold, and thus domestic price levels are not directly affected by the flow of
precious metals, but this simply allows balance of payments crises to emerge
and persist more readily. Under the Bretton Woods System international
payments were still linked to the price of gold indirectly, but since 1973 this
has not been the case, and, in any event, an indirect link requires manage-
ment in a way that the old, self-regulating system did not. Once gold is no
longer the key, exchange rate policy is something that all states have to
have, and the essentially political problem of establishing a reliable medium
of exchange for international transactions becomes unavoidable.
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Assuming this problem can be solved, an international economy based
on a large-scale division of labour can emerge. In a system of uncontrolled
exchange, patterns of specialization will develop, with some countries
producing one range of goods, others another. Some countries may become
specialists in agricultural products, others in industrial goods. Does this
matter? Ought states to have positive policies to promote the production of
certain kinds of goods, or is this something where market forces can be
allowed to decide? Trade policy joins balance of payments policy and
exchange rate policy as areas where, like it or not, states must have a
position – and in this context not to have a position is itself a position, and
one with very considerable implications.
Two quite distinct orientations may be adopted towards these problems,
which can be termed liberal and nationalist – although, as we will see,
nationalist political economy can take widely different political and social
forms. Historically, the nationalist approach to international economic rela-
tions came first. As suggested above, following Hume, the mercantilist idea
that states should aim for a positive inflow of gold has been seen to be a self-
defeating policy because the effect on the trade balance of the consequent
changes in price level will reverse the trade flow, but the general idea that
the way one judges economic matters is in terms of the effect they have on
the nation’s position in the world and not from some other, less partial, per-
spective has never lost its appeal. Economic nationalism is still part of the
common rhetoric of the political life of most countries, as witnessed by the
universal desire of states to have a balance of payments surplus – impossible
for all to achieve, of course, since every surplus is someone else’s deficit.
Equally, no government minister ever returns from a trade negotiation to
announce with pride that a particular deal will increase the general welfare
even though, regrettably, it will have harmful effects at home; that the
universal expectation is that states will promote their own interests in such
negotiations illustrates the continuing salience of economic nationalism.
Still, if economic nationalism came first in history and is still in certain
respects politically dominant, economic liberalism has been the intellectu-
ally dominant position for most of the last two centuries. The basic liberal
proposition is that although in some areas a degree of regulation may be a
necessary evil, in general free market solutions to economic problems
maximize welfare in the system taken as a whole, and should be adopted.
There were three essential steps along the way to this conclusion, spread
over a century from the mid-eighteenth to the early nineteenth centuries.
The first was Hume’s demolition of the mercantilist love affair with gold,
noted above. The second was Adam Smith’s demonstration of the gains to
be had from an extended division of labour in The Wealth of Nations,
gains which are a function of the size of the market and therefore can, in
principle, be increased by foreign trade. The third and crucial step was
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David Ricardo’s ‘theory of comparative advantage’ which, although published
in 1817, remains in an amended form the basis of liberal trade theory and
the liberal international economic order (Ricardo 1971).
Ricardo’s achievement was to provide a logically sound, albeit counter-
intuitive, answer to one of the fundamental problems posed by interna-
tional trade. It is intuitively easy to see why trade takes place when two
countries have different kinds of resources, and thus produce different kinds
of products. Europe could produce bananas under glass, and the Windward
Islands could set up small-scale craft audio-visual and ‘white goods’ work-
shops, but it is not to difficult to see why, in fact, this does not happen and
the Windward Islands grow bananas and import televisions and refrigera-
tors from the industrial world. More generally, it is easy to see why two
similar countries that are efficient in the production of different products
would trade (although how they became efficient in different areas if they
are really similar is another issue). But what is very difficult to see is how
trade could be desirable and profitable in the quite common situation where
two countries produce the same products and one of them is more efficient
at producing everything than the other. Ricardo provides the answer, which
is that although one country may be more efficient at producing everything,
it will almost always be the case that the comparative costs of producing
different products will be different, and thus even the least efficient country
will have a comparative advantage in some product.
Ricardo’s demonstration of this proposition assumed a two-country, two-
commodity economy in which the costs of production are measured in
labour-time. Nowadays, this is, of course, much too simple and the modern
demonstration of Ricardo’s principle takes a chapter or more in the average
economics textbook – but the basic idea is of enormous significance and
underlies liberal economic thought to this day. What Ricardo demonstrated
was that under virtually all circumstances trade would be beneficial to both