Does free capital mobility invalidate the basic comparative advantage argument for free trade in goods?

Question

In Herman Daly's article "Economics for a Full World", Daly states that international trade must be regulated because free capital mobility would invalidate the principle of comparative advantage (Daly, 2015, p.12). As a reference, he cites John Stuart Mill's "Principles of Political Economy" IV.VII.I. However, there doesn't seem to be a chapter 7 in book 4, so I cannot check what he is referring to.

I would greatly appreciate your help in understanding the argument made by Daly here!

References

Daly, H. (2015). Economics for a Full World. Great Transition Initiative.

Answer 1

Daly actually does explain further what he means by that in footnote 7 of his paper:

Capitalists are interested in maximizing absolute profits and therefore seek to minimize absolute costs. If capital is mobile between nations, it will move to the nation with lowest absolute costs. Only if capital is internationally immobile will capitalists bother to compare internal cost ratios of countries and choose to specialize in the domestic products having the lowest relative cost compared to other nations, and to trade that good (in which they have a comparative advantage) for other goods. In other words, comparative advantage is a second-best policy that capitalists will follow only when the first-best policy of following absolute advantage is blocked by international capital immobility. For more on this, see Chapter 18 in Herman Daly and Joshua Farley, Ecological Economics (Washington, DC: Island Press, 2004).

But IMHO, the absolute conclusion that international trade must be regulated as following from that seems silly. After all, one can regulate capital flows too negating that first-best policy (argument). In fact there are plenty of barriers to capital flow, some implicit and some explicit.

Having said that, I cannot quite find the ultimate conclusion stated in those absolute terms by Daly, although he does say (we should) "Move from free trade and free capital mobility to balanced and regulated international trade." Which is frankly pretty vague. I mean doesn't the WTO do at least some of the latter?

The whole writeup of Daly smacks of a certain social agenda. Later he says

Restore the US Full Employment Act of 1945 and its equivalent in other nations in order to make full employment once again the end, and economic growth the temporary means.

I think Bernie Sanders also said he wants something like that. Daly also says

Un/under-employment is the price we pay for growth from automation, off-shoring, deregulated trade, and a cheap-labor immigration policy.

And finally, Dally says (we should)

strengthen the original Bretton Woods vision of interdependent national economies, and resist the WTO vision of a single integrated global economy

That's basically a slogan in disguise, to put it diplomatically. You could just as well phrase it as "take back control of our economy/tariffs/borders/immigration". So his conclusions are more or less socio-political goals; it's hard to take them at face value as pure economic arguments. So there will undoubtedly be disagreement on such statements.

Perhaps to save his "ecological economics" creds Daly does say that in contrast

climate change and arms control require global institutions

To use a political science neologism, that's an ambivalox with demanding no world-wide regulatory institutions for any other economic issues, like trade.

---

But to come back to the more serious economic topic, glossing over Daly's black-and-white approach, capital mobility as partially substituting for goods exchange is hardly a new discovery. See Nadel (1971) for example.

It has long been recognized that commodity movements and factor movements [e.g. capital, my note] are, to a degree, substitutes for each other in international exchange [...] Yet, until recently, the dominant theory of international trade, the Heckscher-Ohlin model, had been rather thoroughly recognized under the rigid assumption of the immobility of factors. Only in 1957, with the publication of Robert Mundell's important article, was capital mobility in the H-O model explored.

(That important article being: Mundell, Robert, “International Trade and Factor Mobility,” American Economic Review 67 (1957):321–35. It has around 2800 citations in Google Scholar.)

What is somewhat novel (in ecology-related economics) is that under some models of pollution, capital movement is preferable to goods movement:

Using a Heckscher–Ohlin model, this paper re-examines Robert Mundell’s famous thesis that free trade and unimpeded capital mobility are perfect substitutes. Under very general conditions which, according to many economists, have caused international convergence of factor rewards,we show that in a polluted environment free trade is inferior to free international investment.This happens even though commodity prices and factor rewards are the same with both policies.The practical side of our thesis is that the world will be better off by reducing the volume of trade while removing all barriers to foreign direct investment that at present hamper the service industries.

That paper Batra and Belladi (2012) does also say that

Daly (1996), Batra (1992), and Batra et al. (1998) argue that transportation is highly pollution intensive, specially relative to production

That seems to be a cornerstone assumption of the model. It is [to me at least] an interesting separate question if economists outside of this narrow field of "ecological economics" agree with these premises.

Answer 2

Daly gets a lot wrong, including (in my view) the idea that capitalists pursue absolute profits in an economy that rests on fiat currencies and foreign exchange markets. Indeed, the very notion of opportunity cost implies that it is relative, not absolute, costs that matter most to the rational agent. Does the capitalist seek the lowest absolute cost, or the highest relative return, net relative tax rates, net relative currency risk, net relative geopolitical risk, etc. etc.?

Like most ideas in economics, comparative advantage rests on a host of assumptions that don't play out perfectly in the real world. Many of these assumptions fail to hold if one looks at global trade. Possibly the most important: the assumption that agents are identical except in their production functions. In fact, geopolitical agents are diverse and varied - and most importantly, they have the power to impose arbitrary restrictions on trade.

Now, the real world is full of frictions, and I'm certainly not making an anti-regulation argument here. But I am suggesting that it is impossible to assert that whatever misallocations are occurring in global trade today can be put down to the freedom of capital, rather than the haystack of conflicting policies. The best of policymakers work with limited information, and I think it's fair to say that not all trade policy has global welfare in mind. The so-called "theory of second best" implies that any new rule that conflicts with the existing set of rules is likely to be overall welfare-decreasing.

So I would disagree that "capital mobility" invalidates comparative advantage, if for no other reason than that true capital mobility is an experiment we've never run. I would also disagree that if the present global trade paradigm is sub-optimal, additional regulation is guaranteed to be the answer. This is like suggesting that the needle will be easier to find if we dump more hay onto the haystack.

Answer 3

You're confusing footnote 6, which may reference a citation with a typo–but this references another issue—with footnote 7. It is in this footnote that he explains his claim,"...free capital mobility would invalidate the principle of comparative advantage."

In footnote 7 he writes, "Capitalists are interested in maximizing absolute profits and therefore seek to minimize absolute costs. If capital is mobile between nations, it will move to the nation with lowest absolute costs. Only if capital is internationally immobile will capitalists bother to compare internal cost ratios of countries and choose to specialize in the domestic products having the lowest relative cost compared to other nations, and to trade that good (in which they have a comparative advantage) for other goods. In other words, comparative advantage is a second-best policy that capitalists will follow only when the first-best policy of following absolute advantage is blocked by international capital immobility. For more on this, see Chapter 18 in Herman Daly and Joshua Farley, Ecological Economics (Washington, DC: Island Press, 2004)."

What Daly means is that given free factor movement, firms will not attempt to find comparative advantage domestically, but will instead move Kaptial* abroad to where costs are lowest in term of lower wages (resulting from a lower living standard), lower rents, and lower environmental and worker protection standards. This "race to the bottom" supersedes firms changing industries domestically to where, without free Kaptial mobility, their comparative advantage would otherwise lie.

Daly’s claim is largely correct: Kapital will move to where its production compliments are cheapest. This does not, however, necessarily result in comparative advantage being unrealized. Comparative advantage will be based on the new Kapital locations brought about by their being "sucked to the bottom" in terms of costs. Comparative advantage remains, but with free capital mobility, it is no longer the case that both trading partners will be necessarily left better off.

The reason for this is that absolute advantage changes with Kaptial mobilization, and this, despite comparative advantage being realized, can leave one trading partner worse off, because the effects of Kapital mobility can predominate any advantages found in realizing comparative advantage to either or both of the trading partners, free trade with Kapital mobility need not prevent comparative advantage from being realized to result in net derogatory effects to at least one of the countries.

For example, the U.S.A. might, say, have had an absolute advantage in toothbrush and toy production over China. Given that China has a comparative advantage in toothbrush production and the U.S. in toy production, If, in autarky, the U.S. could produce 100 toothbrushes or 10 toys and China 2 toothbrushes or 1 toy,** then, if, under Kaptial-mobile free trade, Kaptial for the production of both toothbrushes and toys moved to China such that China could produce 100 toothbrushes and 10 toys and the U.S. 2 toothbrushes or 1 toy, China produces toothbrushes and the U.S. toys, but given that the international price of a toy is now, say, 10 toothbrushes, the U.S. could now consume only 10 toothbrushes or 1 toy; if the international price were 2 two toothbrushes for 1 toy, the U.S. could now consume only 2 toothbrushes or 1 toy. Either way, under free-trade with Kapital mobility, comparative advantage exists, but one of the trading partners is made worse off.

Though and extreme example, the point is made: because absolute advantage is transferable under conditions of free Kapital mobility and free trade, it can change form one partner to the next, leaving the Kapital exporter worse off. Because Kaptial holders, as opposed to national leaders, are making the production decisions in a free-market economy, free trade under Kapital mobility conditions, at least where production costs vary, does not necessarily leave both trading partners better off and may leave one worse off. Theres is also the issue of increased environmental damage and ecological destruction form Kapital moving to countries where the market externalities that they produce are less sufficiently compensated in which they may leave one or both countries in the future, if not the present, worse off.

If all factors are mobile, comparative advantage cannot exist because comparative advantage is a function of at least some of these factors remaining stationary. Theoretically, if costs differed between countries, all factors would move such that no country had a comparative advantage because they would all be the same in terms of productive ability. All factors would have to be mobile such as human abilities (human Kaptial—agents are otherwise homogenous), climate, topography, and soil quality to name at least a few. The lack of mobility of some of these factors in the "real world" may make this seem irrelevant, but the point is, any comparative advantage is only a matter of Kaptial staticity.