Wednesday, January 05, 2011

All About Industrial Policy, Part 2 - A Few Notes on Balance of Trade

Further to my first post on this subject, I wanted to get into the subject of why the global imbalances matter. To demonstrate this I'm going to start by considering two countries.

Country A: Is a wealthy well developed country, citizens of this country have high individual incomes. Due to the level of consumption in this country the country has a trade deficit with country B.

Country B: Is a developing country, citizens of this country have a far lower individual incomes. Consumption in this country is low, although it makes a large number of the high value goods consumed in Country A. As a result it has a trade surplus with country A.

As these two countries continue to trade with each other a problem will arise, because A is not producing enough goods to cover the value of the goods it buys from B there is a need to cover the difference. One way would be for B to either pay more or buy more goods from A. An alternative would be for B to build up a stock of country A's currency for use at a later date. This situation may continue for a number of years, however, at some point it's likely that B will no longer accept A's money at this time we have a problem.

A is now no longer able to buy it's usual quantity of goods from B, as a result B's firms have a problem since they are not able to sell the stock they are producing. In this theoretical example the problem could be solved quite easily B could use it's stock of A's cash to continue to buy from A and spend the spare cash on domestic goods produced in their homeland. In the real world however, it's not quite that simple, to demonstrate this I'm going to add a little more complexity to the model.

Firstly, it takes time for an economy to change and adapt, factories need to be built, old factories need to be closed down. An economy can't just change what it produces in an instant. Second, we need to consider how supply and demand match up, consumers living on Hawaii are unlikely to ever want snow ploughs, for example. Third, we need to consider the structure of firms, if a firm can't sell it's goods it's going to go into administration with all the consequences that entails.

Going back to the example, B's consumers are unable to take up the slack due to the vast difference in average income between the two countries. The goods that A's consumers buy are not affordable to the average consumer in B. It's at this point that the problems start to occur.

The Reckoning
In B there is now a problem of a massive drop in demand, much of the infrastructure will have developed with a view to producing goods for consumption in A. In A, problems also occur since much of the economic infrastructure will have been developed with a view to selling those goods produced in B. Inevitable conseuqnce of this is an economic downturn, with the accompanying unemployment and social unrest as well as a considerable amount of value being destroyed in both countries. In addition it will take several years of adjustment for the economies to correct themselves.

The issue of global imbalances seems to have become a far greater problem with the development of the financial system. Freely moving international capital seems to have increased the degree to which debtor nations can borrow before thing go wrong, as a result economies have developed further in the wrong direction and the size of the adjustment is greater.

One reason I'm in favour idea of industrial policy is that by actively seeking to improve the balance of trade we can play a part in making sure the economy remains more stable.

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