5 July 2017

The most surprising idea in economics

by Matt Ridley

Originally published by The Conservative.

Two hundred years ago, a successful London broker named David Ricardo published a book containing a counterintuitive insight – the economic equivalent of a free lunch, a magic rope trick and a perpetual motion machine. Building on Adam Smith’s theory of the division of labour, it explains much of the prosperity of the modern world. If people are free to exchange, they will specialise and become more productive and efficient, and if they specialise they will find more value in exchange, resulting in a spiral of accelerating prosperity through gains from trade.

The insight goes under the name of the principle of comparative advantage. It was once wickedly described by the economist Paul Samuelson as the only proposition in the whole of social science that is both true and surprising. What is surprising about it, and what Ricardo adds to Smith, is the demonstration that there is no such thing as a loser from free exchange.

Trade benefits inefficient people and countries as much as it benefits efficient ones. Even if you are better at doing everything than everybody else in the world it still pays you to specialise and trade with others; even if you are worse than everybody in the world at everything, there will still be goods and services people will want you to buy from you.

It is the gains from individual exchange between people that are most obviously explained by Ricardo – and with them the striking and central fact about the modern world, that when prosperity increases people become more and more specialised as producers so that they can become more and more diversified as consumers. It was free trade between countries that Ricardo was thinking about, however. Here is how he explained the idea, using the example of England trading cloth for Portuguese wine:

England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it in her interest to import wine, and to purchase it by the exportation of cloth. To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England.

Ricardo was of Portuguese Jewish extraction, one of 17 children of a financier who emigrated to Britain from Holland. Cut off by his father for marrying a gentile, David became a successful stockbroker, specializing in arbitrage opportunities in government debt. In 1815 he gambled and won big. On 14 June, just four days before the Battle of Waterloo, the government raised its biggest ever loan of £36 million at a time when bond prices were depressed by anxiety at the new threat from Napoleon’s army. Of the four bidders for the loan contract, Ricardo’s firm won. Early rumours of Wellington’s defeat drove the prices even lower, but Ricardo held on, refusing to sell (though his friend Robert Malthus lost his nerve and sold). When the news came through of the victory at Waterloo, he was able to realise a huge profit, over £1 million.

He would later be accused of having inside information, perhaps from semaphore informants, that the battle was already won while giving pessimistic signals to others who were still waiting for news so he could buy even more bonds. But no convincing evidence to substantiate this has emerged and it seems unlikely. With the profits he bought Gatcombe Park in Gloucestershire.

That same year he wrote an impassioned pamphlet arguing for the repeal of the Corn Laws. Between 1660 and 1846, in a vain attempt to control food prices by prescription, the British government had enacted no fewer than 127 Corn Laws to impede the trade in grain – imposing not just tariffs but rules about the storage, sale, import, export and quality of grain and bread. In 1815, after the war ended, to protect landowners as grain prices fell, the government banned the import of all grain if the price fell below 80 shillings a quarter. Ricardo could see that this punished the poor and rewarded the rich.

When he got into Parliament in 1819, he again took up the cause of repeal of the Corn Laws, making himself unpopular with agricultural interests. As Hansard reported one of his speeches,

He conceived the duty of government to be, to give the greatest possible development to industry. This they could only do by removing the obstacles which had been created ... If government interfered, they would do mischief and no good.

He argued in vain, however, and the Corn Laws persisted for another 25 years.

Ricardo became a close friend of Thomas Robert Malthus, but disagreed with him on many things, including free trade. Their correspondence is one of the most fascinating in the early history of economics. Watching local farmers struggle with bad harvests in the 1810s, however, he did agree with Malthus that corn yields must stagnate, because the best land was already in cultivation. He did not see the effect of technology.

Ricardo’s labour theory of value proved even more influential than his theory of comparative advantage, being taken up by Karl Marx. He also gave Marx the mistaken notion that mechanisation would leave an army of unemployed workers for the capitalist to exploit.

In the summer of 1823, Ricardo was at Gatcombe, where, according to the History of Parliament online,

He took satisfaction in the ‘more liberal spirit than heretofore’ which had been shown in Parliament and hoped that further progress would be made towards ‘getting rid of some of the absurd regulations which fetter commerce, till all shackles are removed’.

He composed a paper detailing his plan for the establishment of a national bank, ‘with a view to prove that the nation would lose nothing in profits by abolishing the Bank of England’.

The chance to see through such reforms was to be denied him. On 11 September he died from an infection that had started in his ear. He was only 51. An anonymous obituary called him “a great loss both to the country and to government. The extreme candour and fairness of his mind and conduct contrasted very strikingly with the extravagance of his political opinions”.