In 1817 David Ricardo formalized the Law of Comparative Advantage. Since then it has stood the test of time as one of the very few laws that an economist can point to and say, "this is indisputably true." It's because of this law that you can only rarely find an economist who doesn't believe in unrestricted free trade. But Ricardo added an important caveat when he discussed free trade and comparative advantage and it's one that most modern economists seem to have forgotten...

Let's quote straight from Ricardo:

In one and the same country, profits are, generally speaking, always on the same level; or differ only as the employment of capital may be more or less secure and agreeable. It is not so between different countries. If the profits of capital employed in Yorkshire, should exceed those of capital employed in London, capital would speedily move from London to Yorkshire, and an equality of profits would be effected; but if in consequence of the diminished rate of production in the lands of England, from the increase of capital and population, wages should rise, and profits fall, it would not follow that capital and population would necessarily move from England to Holland, or Spain, or Russia, where profits might be higher.

This is the Achilles heal of comparative advantage - the flaw in the foundation of free trade that causes outsourcing woes. Ricardo and those who say that the law of comparative advantage proves that free trade is good are absolutely right, but they've forgotten his caveat.

Because in Ricardo's world it was true that capital was not particularly mobile. It is not true in our world and it wasn't true in the Victorian world.

In a world where I can move my capital freely between locales, where I can also move my profits freely, and where I don't have to live where my capital is working, there is no reason to invest in any productive activity in my home country - I can make more money elsewhere.

The higher surplus locale is going to get as much free capital as it can soak up and is available.

The logic behind this is simple.

Let's say I have 1 million dollars to invest and I can invest it in two different locales. In one place I'll get 5% return, in another 10% return. In both locales I can take my profit and do what I want with it, and I can live in either locale and in both places my money is secure from being seized by the government or destroyed by violence. Obviously I'm going to put my money into the place with the higher returns.

And when I get those profits, I'm going to sink any reinvestment into the place with the higher returns again. It's a virtuous circle - if you're the place with the higher returns and it ends when returns even out or there is no more excess capacity.

If the higher return country has no more investment opportunities that pay higher than the low return country, it makes no sense to invest in it. What matters here is the marginal rate of return - that is the return on the next dollar of my investment. In principle there ought to be diminishing returns - people snap up the good opportunities and over time the opportunities get worse and worse until returns equalize. But that doesn't always happen - even in the long term - when we're all dead.

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Profit is just how much surplus you're you have. Let's say my workers are capable of producing $5 of goods for every hour they work and my costs are $3/hour for everything (property, taxes, capital costs and pay) - I'm making $2 an hour for every worker I have working for me.

If that's country A and in country B the average worker produces $10 an hour, but my costs are $9 - my surplus is $1 - half of country A, even though my workers are more productive.

And that's why US workers are more productive and people are shipping jobs to China and India. Costs in the US are higher for property, wages and taxation.

To stop the capital (and jobs) moving from Country B to Country A, you have to increase surplus. There are two ways to do that - you can reduce costs (most easily by cutting taxes or wages) or you can increase productivity. If the average worker produces one more dollar of goods while costs stays the same - and Country A's worker's productivity doesn't increase, then you're even.

Or Country A could increase wages, taxation or property costs and become less competitive.

In a world without mass capital flows there was another way. You could have lower capital costs. But right now having the Fed have lower capital costs than another country means little - borrow in the US, invest it where the ROI is higher.

More than that - money you can't use is, well, useless. Let's say you're investing in a factory in China but you want to live in Europe or the US - and Europe and the US won't let you use the money you have in China in their countries (or will only let a fraction back in) you're not likely to invest in China, are you? In addition, money that can't move is captive to political unrest and other such events - and that gives mature stable countries a big leg up. If moving money is hard or slow then you'd better be sure that where you have it is stable because if something goes wrong - kiss it goodbye.

A key problem right now is demand. Capital flows to low production cost, high surplus domiciles. But there's only so much demand for goods and only a limited amount of growth in demand for goods. So you've got your profits and you have to figure out what to do with them. You can't plow all of it back into productive investment, because you'd wind up with more productive capacity than there is ability to buy the goods. As a result the excess money has to go into nonproductive uses.

The money that does go into productive uses will go to the domiciles that produce the greatest surplus (profit). Many people have pointed out that the US hasn't lost jobs to outsourcing - that's only true in a technical sense. What has happened is that the new jobs have been mostly created overseas (in cases where they can be done overseas). Old jobs haven't (mostly) been moved because of sunk capital costs. Once you've paid 10 million dollars to create a factory, spending another 10 million dollars to relocate the factory usually doesn't make sense. But if you have to build a new factory anyway (either because you need more capacity or because the old factory would have to be replaced for some reason) then it makes sense to build it in the domicile with the higher surplus production. That's exactly what we've seen over the last few years: China and India getting the new jobs in non protected sectors. It's not rocket science, it's just ROI (Return on Investment).

But, since you can't put all the money back into production you've got to stick some of the money elsewhere. And what we have going is a nice reinforcing trend. Oldman has called it strip mining the US economy. The money is used to buy your customers' assets or leant to your customers. In exchange they put up as collateral either the full faith of their government (we'll see how good that is in a few years) or their assets - which in the current case means mortgage backed securities, bonds, and common shares in companies (which represent ownership of assets.) They then use that money to buy your goods and the cycle continues.

This vicious cycle (or virtuous if you're the one getting rich and you get out in time) results in excess productive capacity, a slow decline in employment in the low surplus domicile and an increase in debt in the low surplus domicile. It also pushes costs in the low surplus domicile lower (meaning wages and taxation, primarily.)

In the meantime, if the developed world (and specifically the US) were to stop borrowing to buy - the entire engine would collapse. This is not a sustainable development - if the US was to buy only what it could afford based on its own exports then there would be an economic shockwave not just in the US but in China, India and other high surplus, low cost domiciles. And right now the dynamic is being funded by taking money out of the US and other high cost domiciles - which must ultimately end in a reduction of demand. If the low cost domiciles which have been getting the capital investment are not capable of soaking up the excess capacity when the US's consumption comes in line with what the US can afford, then you will have a worldwide recession at the least - likely a depression.

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Economics views systems as moving towards equilibrium. But it's more useful to view systems as subject to multiple different tendencies. At any given time different tendencies may be stronger than other tendencies. What should be happening is that US costs should drop and developing country costs should rise. It is happening. It's not happening very fast, and where they meet is going to be somewhere a lot south of the current US standard of living. In the meantime the dynamic is the US shipping its capital and its growth in productive capacity to lower cost, higher surplus domiciles. That will continue until the conditions for it end - and not before. The conditions which can end it are increased shipping costs (favouring more localized production), surplus production evening out, a political decision to discourage either trade or capital flows or an unwillingness or inability of either the US to borrow or its creditors to lend. Until then capital will go to the higher returns and since the highest returns on production are mostly not in the US, capital that creates production jobs will flow disproportionately away from the US while asset bubbles form in the United States in order to pay for imports. (And the assets they have bought or allowed the US to borrow against are likely to crash in the final days of this system. A suckers game all around, but the only thing worse than playing is trying to stop playing.)

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