Saturday, November 21, 2009

Comparative Advantage and Finance

Tonight folks, I'm going to blog on the subject of comparative advantage, specifically, comparative advantage when considered at the national level. The idea is simple enough, it's that countries will end up producing the goods (or services) that they best suited to producing.

The comparative advantage argument is often invoked in defending the UK's finance industry with the suggestion that we have a comparative advantage in finance. This argument is, in my opinion, flawed.

When talking about comparative advantage I think it's necessary to make the distinction between what I'd call natural and artificial comparative advantages. A country can be considered to have a natural comparative advantage if that advantage arises from permanent natural factors. For example, a country with the right climate for growing grapes can be considered to have a comparative advantage in the production of wine.

An artifical comparative advantage is a bit different, it arises from factors that are not permanent and could be altered through policy decisions. An example of this could be a nations advantage in car production due to a well educated workforce. Another nation could achieve a similar advantage through policies aimed at encouraging education in mechanical engineering. In a developed economy almost all comparative advantage is artificial, this is because the areas where a nation might have a natural advantage, specifically agriculture and the production of raw materials are highly efficient and employ a small proportion of the workforce.

The upshot of all this is that with the exception of a few specific industries, there are no real limitations to what industries a nation can specialise in, and furthermore that specialisation is often shaped by the political decisions of governments. The UK's finance industry is a case in point, it developed as a result of the many measures introduced by the Thatcher government.

The problem I have with those who say we should not (over) regulate our finance industry is that they seem to be reading some kind of natural factor into our entirely artificial comparative advantage. To illustrate this, here's Anatole Kaletsky.
This is because Britain clearly has what economists call a comparative advantage in financial services; companies and workers based in Britain can generally earn more in this business than in most other industries. And the more Britain specialises in its areas of comparative advantage, the higher will its living standards rise.
If we were stuck in the situation where there was little choice over what comparative advantages we had, this argument would be valid. Since we actually have a bewlidering array of choices in front of us there is no particular reason why we should continue to specialise in one area over and above all others.

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