Back to basics – a few reflections on Heckscher-Ohlin

January 16, 2007

I used to have a very colourful blog where I mixed a lot of personal stuff with my preoccupations with the global economic world under a funny nom de plume, Ignatius. I “graduated” from this type of blogging, fortunately. However, I recently ran through the posts published there and fell upon one entitled somewhat pompously “is the heckscher-ohlin trade model still relevant in a global world? a critique of The Economist’s recent “Survey of the world economy”. It is on the fundamental economic model of international trade such as discussed by The Economist in its September 2006 Survey of the World Economy. The post was not meant to be a very technical discussion. I rather wanted it to be an explanation “for friends and family” of what the issues are. I will reproduce this post here, for your appreciation and hopefully some feedback and input. The underlying question is: what happens to the Heckscher-Ohlin model when the international economy starts showing signs of working like a single integrated one? I have no answer, but many questions. This is shown in that particular post, which I copied for you below:

“One of the articles in The Economist’s recent survey “The new titans. A survey of the world economy” (For a small overview, please consult this recent post) could almost have come out of a leftist anti-globalist and pro-unionist paper. Entitled “More pain than gain”, it tells us that there is increasing evidence that workers in rich countries “are missing out on the rewards of globalisation”. Contrary to your backward-looking trade-unionist or your naïve activist with the Che Guevara t-shirt and the dreadlocks, though, The Economist really knows what it is talking about. It extracts arguments and statistics coming from recent studies by the most eminent Ivy-league academics such as labour economist Richard Freeman from Harvard University or research institutes such as the Institute for International Economics, all with their “global-market-friendly” credentials. In this article, The Economist puts forward arguments which may lead the classic international trade model based on Ricardian comparative advantage to “need modifying”.

One first comment to begin with. Although, for the sake of simplicity, The Economist talks of the Ricardian model of comparative advantage, in fact it questions the so-called Heckscher-Ohlin-Stolper-Samuelson (HOSS) model. Ricardo in the early 19th century only said that when two countries start trading freely with each other, each country will specialize in the production it can achieve cheaper in “relative” – or “comparative” terms. The typical example is that of Portugal in its trade with Britain two centuries ago. Portugal might have produced cloth cheaper than Britain in absolute terms, but as it did Port wine even more efficiently, the wine industry would become more competitive compared to the textile industry which would be exposed to Britain’s impressive manufacturing force. Portugal’s workers would have to find new jobs in wineries and import cloth from Britain.

In the 20th Century, the Ricardian model was refined and rendered more operational for modern-day economics. It contends that trade is a substitution for the movement of factors of production. It is a model based on two countries, two goods, two factors of production (capital and labour) and tries to predict what happens when trade is opened between these countries. The country that is more endowed with capital than with labour has higher returns on capital. It will specialize in the products which require more capital than labour to be produced. Let us take the hypothetical example of medical equipment in the US and TV sets in Malaysia. When trade is freed up between the US and Malaysia, in the US, “investing” in capital will bring more returns, while in Malaysia, building factories employing hundreds of thousands of docile poor women will become even more lucrative. So: open trade between Malaysia and the US, you will see Malaysians invest more in TV equipment plants and Americans even more keenly in high-tech companies. You will also see US TV plants be closed and workers laid off, and attempts by smart Malaysians to produce medical equipment thwarted by US efficacy and laughed at by cynical anti-import-substitution economists. What both countries do not consume will be exported. Malaysians will import US medical machines, Americans will buy their TV sets from Malaysians. Everybody gains from this: returns are higher, production more efficient, products cheaper for the consumer. Welfare increases overall.

Events and research in the second half of the 20th century have constantly challenged this fundamental model. I fact, however, they have only refined and rendered it more sophisticated. Are the findings and arguments voiced by The Economist a real threat this time?

In order to discuss The Economist’s arguments, though, it is necessary to briefly introduce you to the variants of and addendums to the fundamental (HOSS) model. There have been challenges to the number of factors. One economist added a third factor – land, which in a sense explains why some parts of the world just persistently stick with exporting agricultural and other commodities and have had difficulties industrializing. Africa and Latin America are a case in point – a lot of land, not much labour, and not much capital. With China entering the world scene, any labour intensive industrial activity outside this huge country with an almost unlimited supply of cheap labour is set to have great difficulties. Other researchers found that there are two types of labour, skilled and non-skilled, and that in a free trade regime, rewards will be higher for skilled labour and skill-intensive activities. However, skilled labour can conceptually easily be added into the category “capital” – skills are “human capital”. This model tells us why in principle it is good to be a skilled worker in a rich country…. Another challenge to the model has been to its static nature. The Factor Price Equalization theorem enriched the current trade model by stating that in the long run, with open trade, the price of capital and labour will converge (…along with the respective economies, as classic economic theory predicts). The model has also been criticised for not taking into account capital mobility between the two trading countries and that it does not fit well into a world of FDI and portfolio investment, outsourcing or offshoring. Defendants of this model contend that these international investments and production shifts build on the existing comparative advantages. And why should not also services be included in this model? All this, once again, saves HOSS.

Now, let us go back to The Economist’s reasons to put our classic trade model in question. Its three main arguments are: first, in accordance with Freeman’s findings, the “sheer size of the emerging giants’ labour forces has shifted the global capital-labour ratio (which determines the relative rewards of capital and workers) massively against workers as a group. The entry of China, India and the former Soviet Union into market capitalism has, in effect, doubled the world supply of workers, from 1.5 billion to 3 billion. These new entrants brought little capital with them, so the global capital-labour ratio dropped sharply. According to economic theory, this should raise the global return to capital – which is exactly what has happened” (nb. aha. as if nobody knew this. it takes a lot of time for academia to accept what to the layman has been obvious for at least one to two decades….I grew up with this type of arguments). Second, skills levels in emerging markets have risen. So there is increased competition for skilled workers in established rich countries – which until now have been considered protected and rather on the winner side of globalization. Third, emerging markets increasingly produce capital and skill-intensive goods, which is a threat to those industries in rich countries.

The second and third arguments, in my opinion are not sufficient to lead to “the traditional theory” to “need modifying”, as The Economist puts it. With traditional economic theory you can explain most of what is happening. The Factor Price Equalization theorem and economic convergence models can also help. It also easy to contend that change in factor prices also to some extent reflect the changing nature of factor quality. You still pay more for a skilled worker than for an unskilled worker in India, even if in absolute terms this worker is cheaper than his/her counterpart in a rich country. Having emerging economies boasting better skills levels is only good news for everybody, and especially for those countries which really need them. Although HOSS is not really threated by these findings, they do point to the shortcomings of its fundamentally static nature (n.b.: yet we know that with capitalism nothing is set to ever remain the same: see post on Schumpeter)

The first argument, however, is in my view the real challenge to HOSS. There is an important problem with HOSS: its non consideration of factor mobility between countries. I don’t know how much the authors of The Economist’s report are aware of it, who describe capital and labour supply in global terms. Yet the traditional trade model conceptualises factor supply at country level. Who will reap the gains of free trade is determined by the ratio of capital to labour within a country. Now the figures and arguments The Economist takes from eminent labour economist Richard Freedman are placed on a non-national, global scale, as if there were a single global factor market. Indeed, we are not in a world were capital and labour stay nicely at home. Capital is extremely mobile, and migration is part of the current globalization process. Let us also be reminded that in the last big wave of globalization before 1914, rich countries not only exported their capital, but also massively their (poor) people. Today, the international market of capital (a pointer is the size of the global financial industry worth almost US$ 9 trillion, almost the value of world trade, which in 2005 was just above 10 trillion) is one of the most globalised and integrated. Let us not enter into the debates on how well and deeply, and how far it is the result of national policies. Let us just accept the fact that its impact on national economies cannot be ignored, and can be extremely important. The point here is that we indeed need to think in global-market terms to be able to better conceptualize what is currently happening on the world economic stage. To go back to the arguments above on foreign investment and outsourcing – they do not put into question the theory of comparative advantage. But comparative advantages also exist within single countries with totally integrated factor markets. Yet comparative advantages based on factor endowments within countries are not the object of Heckscher-Ohlin, for the precise reason that, within countries, workers and capital move freely, which leads to completely different patterns of production, trade, and economic con-/divergence.

The argument, now buttressed by increased empirical evidence, that globalisation has shifted the balance of power from labour to capital is quite compelling. In theory, the only way to re-balance all this would be: more labour mobility. When not only capital can exit countries and thus put pressure on workers – unskilled or, increasingly, skilled – but also labour put capital under pressure by voting with its feet, than the balance of power might well shift back more in favour of labour. But nowadays, despite perceived massive migration, there is a huge gap between how much capital is allowed to do world tours within seconds and labour to find a suitable place for itself in better countries. NAFTA is a case in point – free trade not only of goods and services, but also totally free movement of capital. Yet there is a huge fence trying to prevent Mexicans of entering the US. If there are exploited workers in rich countries, it is well the unprotected illegal immigrants having to work outside any legal protection. In rich countries, those immigrants are increasingly becoming the scapegoats of those workers who are feeling they are loosing out on globalisation.

So, yes, indeed, The Economist in this article rightly says that “it is time for a more honest debate about trade”. “The fact that many workers seem to be excluded from the spoils of globalisation is a big challenge to orthodox economics (nb. I do not agree, all what is happening is pretty predictable with your classic economic tools of analysis). Many of its practitioners refuse to come clean about the costs to workers of trade with emerging economies for fear of handing ammunition to protectionists. At the same time, protectionists exaggerate those costs and ignore the benefits.” One can’t disagree with this. The solution might well be towards more openness and mobility. But preparing rich country workers for this new world is a great political challenge. I find The Economist’s very “can-do” approach to solutions based on increased compensation, increased labour and product market liberalisation and education slightly blue-eyed, although they do point to the right direction. For example, on compensation: European countries are being criticised exaclty by publications such as The Economist for their generous and unsustainable unemployment benefits. But this is straying too far away from the actual topic of this post…

Finally, to reply to the question in this post’s title: Heckssher-Ohlin is far from dead. Its explanatory power is still very impressive. And the fundamental dynamics it points to are still very much alive. But it is necessary to relax the assumption of absence of factor mobility between countries and to think outside the fences of national borders to come to grips with the ever deepening forces of globalisation.”

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