Mises on the Ricardian Law of Association: The Flaws of Praxeology

I have already written a post criticising Misesian praxeology (“Mises’ Praxeology: A Critique,” October 1, 2010), but have recently been challenged to present specific examples of the unsound arguments in Mises’ praxeology which involve false stated or hidden assumptions (see “Apodictic Certainty of Praxeology”).

Mises’ discussion of the “Ricardian law of association” (or free trade by comparative advantage) is a perfect example of this, and is given in Mises’ Human Action: A Treatise on Economics (4th edn, 1996), pp. 159–164 (for discussion, see Murphy and Gabriel 2008: 65–66; Vaughn 1994: 78).

First, it is perfectly clear that even Mises admits some role for empirical evidence in praxeology. In fact, the alleged “apodictic certainty” for his praxeology claimed by some modern Austrians vanishes when we look carefully at a candid passage of Mises himself:

“Every theorem of praxeology is deduced by logical reasoning from the category of action. It partakes of the apodictic certainty provided by logical reasoning that starts from an a priori category. Into the chain of praxeological reasoning the praxeologist introduces certain assumptions concerning the conditions of the environment in which an action takes place. Then he tries to find out how these special conditions affect the result to which his reasoning must lead. The question whether or not the real conditions of the external world correspond to these assumptions is to be answered by experience. But if the answer is in the affirmative, all the conclusions drawn by logically correct praxeological reasoning strictly describe what is going on in reality” (Mises 1978 [1962]: 44).

An assumption about “real conditions of the external world” is a synthetic proposition. If the “question whether or not the real conditions of the external world correspond to these assumptions is to be answered by experience,” then we need empirical evidence.

And we can add to Mises’ last sentence: if the answer is in the negative, then the conclusions drawn even by valid praxeological reasoning do not describe what is going on in reality. They describe a non-existent, fantasy world.

Mises’ praxeological case for free trade is such an example. Mises’ argument is itself heavily dependent on Ricardo:

“Ricardo expounded the law of association in order to demonstrate what the consequences of the division of labor are when an individual or a group, more efficient in every regard, cooperates with an individual or a group less efficient in every regard. He investigated the effects of trade between two areas, unequally endowed by nature, under the assumption that the products, but not the workers and the accumulated factors of future production (capital goods), can freely move from each area into the other” (Mises 1996: 159).

“Ricardo, however, starts from the assumption that there is mobility of capital and labor only within each country, and not between the various countries …. Now, Ricardo’s assumptions by and large held good for his age. Later, in the course of the nineteenth century, conditions changed. The immobility of capital and labor gave way; international transfer of capital and labor became more and more common. Then came a reaction. Today capital and labor are again restricted in their mobility. Reality again corresponds to the Ricardian assumptions (Mises 1996: 164).

Mises correctly notes that there were certain assumptions made by Ricardo for his principle of comparative advantage to work. Mises was writing the original edition of Human Action before 1949, long before the era of globalization and liberalized capital markets that began from the 1970s.

The period from 1945 to 1973 was indeed a world where capital controls restricted foreign investment to some extent and labour mobility was more restricted than in the 19th century. Mises even concedes that by the late 19th century the conditions assumed by Ricardo did not necessarily hold.

What Mises completely misses is that, because of hidden assumptions in the argument for comparative advantage, it is highly doubtful whether his argument for comparative advantage works even for 1945–1973 period. Before we examine the hidden assumptions, however, it is useful to look at the stated assumptions.

Even neoclassical arguments for free trade rely on David Ricardo’s principle of comparative advantage, though of course modern neoclassical theory uses the more sophisticated Heckscher–Ohlin model as its defence of free trade. But this model has been increasingly challenged by modern critics (e.g., Gomory and Baumol 2000), and there are rival theories in mainstream economics like New Trade Theory (NTT), to which Paul Krugman has made contributions (for some other critical work on free trade, see Prasch 1996; Gomory and Baumol 2000; Reinert 2007; Fletcher 2008; Baiman 2010).

It should be noted that Ricardo wrote the book Principles of Political Economy and Taxation in 1817. This was at a time before the full effects of the industrial revolution were clear, a point which we will return to below.

Ricardo’s principle of comparative advantage requires two conditions to work properly, as follows:

(1) Domestic factors of production like capital goods and skilled labour are not internationally mobile, and instead will be re-employed in the sector/sectors in which the country’s comparative advantage lies;

(2) Workers are fungible, and will be re-trained easily and moved to the new sectors where comparative advantage lies (Prasch 1996: 39–40).

As is admitted even by Mises, by the late 19th century assumption (1) was questionable.

Today it is also the case that both capital goods themselves and investment money for production are very mobile, so that (1) is also not true. Proposition (2) is also questionable in many cases (Prasch 1996: 40–41).

Once capital becomes extremely mobile internationally, we no longer have comparative advantage, but absolute advantage. It is not at all clear that free trade under “absolute advantage” is beneficial to all nations. In Ricardo’s day, internationally mobile capital was not that significant. David Ricardo observed that the immobility of capital in his day prevented capital from seeking absolute advantage. He described it as

“the difficulty with which capital moves from one country to another, to seek a more profitable employment, and the … [ease] with which it invariably passes from one province to another in the same country” (Ricardo, On the Principles of Political Economy and Taxation, 7.18).

In Ricardo’s day, capital mobility did not happen on a large scale because capital and technology were more difficult to transfer. But it never occurred to Ricardo that, in a world of mobile capital and easily transferable technology, capital would seek absolute advantage in a destructive way to its home country.

The neoclassical and Misesian argument for free trade is dependent on the capital of one country remaining in that country and being put to work in some other productive domestic industry, where comparative advantage lies. This is not what happens today, where capital from Western countries seeks absolute advantage in the developing countries. Movement of capital to a place where it has absolute advantage simply causes de-industrialization in Western countries, as capital moves to nations with the lowest unit labour costs, and higher wage countries experience falling wages and high unemployment (Holt 2007: 103). Moreover, the large-scale movement of service industries overseas (often called “outsourcing”) is just as damaging.

With the collapse of manufacturing and other production, nations suffer higher unemployment and higher trade deficits. Capital does not simply move from one domestic sector to another where comparative advantage lies, because of international capital mobility and the drive for lower wages and higher profits. Thus the changes in domestic investment that would happen under the assumptions of Ricardo do not happen.

But, even if all the assumptions stated above are true, there are still devastating hidden assumptions underlying the whole argument of Ricardo and Mises. These hidden assumptions are precisely the type of synthetic propositions I have referred to in my earlier post on praxeology.

The hidden assumptions are as follows:

(1) it does not matter what you produce (e.g., you could produce pottery), as long as you do it in a way that gives you comparative advantage;

(2) technology is unchanging and uniform; and

(3) there are no returns to scale (Galbraith 2008: 68; Chang 2003: 292).

These hidden assumptions are utterly absurd. First, it does matter what you produce. Reliance on primary commodity exports whose prices are subject to volatility is not a successful strategy for economic development in most countries; in fact, such countries reliant on primary commodities and service industries are usually poor developing nations.

Moreover, as Galbraith as noted:

“Comparative advantage operates on the assumption of unchanged technology and constant returns to scale. There are no economies of scale, no learning curve, no improvements in productivity as output increases. The only requirement is that conditions of production differ, so that one good—in terms of the other—is relatively more expensive in one country and relatively less so in the other. The only efficiency gained from trade stems from the reorganization of production and the reallocation of factors—labor, capital, land—to their best uses in the new, larger, common market … But the argument does not generalize to the real world. Given three countries and three commodities, it is not obvious that each country will always be the relatively most efficient producer of exactly one good. And then what? Does the country that has no comparative advantage produce nothing? Does it refuse to trade? If its “comparative advantage” lies in exporting labour and closing up shop, is this acceptable? The textbooks do not say. The actual world has some 220 countries and thousands of distinct commodities. In this world—the one where we actually live—the calculation of comparative advantage is intractable, and the doctrine says nothing about who should specialize in what, still less that specialization will exactly reproduce full employment in each place ... Further, comparative advantage is based on the concept of constant returns: the idea that you can double or tripe the output of any good simply by doubling or tripling the inputs. But this is not generally the case. For manufactured products, increasing returns, learning, and technical change are the rule, not the exception: the cost of production falls with experience. With increasing returns, the lowest cost will be incurred by the country that starts the earliest and moves fastest on any particular product line … For most other commodities, where land or ecology places limits on the expansion of capacity, the opposite condition—diminishing returns—is the rule. In this situation, there can be no guarantee that an advantage of relative cost will persist once specialization and the resulting expansion of production take place” (Galbraith 2008: 68).

In the real world, production in high-value-added sectors like manufacturing leads to innovation, advancement of technology, increasing returns to scale, synergies, and strong economic growth. That is why manufacturing drives industrialization and makes nations rich. The basis of a modern first world economy is manufacturing and high-value added industries. Writing in 1817, Ricardo did not understand the full implications of the industrial revolution for economic development.

As is shown brilliantly by Erik S. Reinert in How Rich Countries Got Rich, and Why Poor Countries Stay Poor (Carroll & Graf, New York, 2007, p. 301ff.), a developing nation can follow rules of comparative advantage to the letter, and still remain mired in poverty and stagnation, with low-valued-added production and decreasing returns to scale.

A catastrophic example of the effects of comparative advantage was seen in Mongolia’s economy in the 1990s. Mongolia, under advice from the World Bank, implemented free trade, which caused its manufacturing sector to collapse, and it shifted to raising livestock (where its comparative advantage lay, according to classical trade theory). The result was a halving of per capita GDP and ecological disaster, as increasing livestock production led to diminishing returns, overgrazing, and desertification (Reinert 2004: 157–214).

Such free trade by comparative advantage is not a successful path to economic development.

In a world where a developing nation specialises in primary commodities, often according to the dictates of comparative advantage, it is normally cheaper to buy manufactured goods from overseas. But, under such circumstances, a Third World country will not industrialize. It will be permanently mired in poverty, commodity exports or service industries (the typical type of third world economy). There are sound reasons for violating free trade theory and creating your own high-value added industries, where the home market has sufficient demand for the products of those industries, through targeted infant industry protectionism or modern import substitution industrialization (Chang 2002, 2003, 2007; see also “Industrial Policy: A Brief Comment,” June 21, 2010)

The alleged economic advantages of free trade claimed by Misesian praxeology and by Ricardo are simply false, because of the false hidden premises in the argument.

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