Unit 12: Finance, Trade, and Globalization

Jim’s Guide

So far in this course we’ve looked at micro-economics, the behavior and decision-making of individuals and firms, and at macro-economics, the behavior, dynamics, and policy options for the whole economy.  Now we turn our attention to some particular social issues in the remaining units.  Each of these issues has aspects that some consider “micro-oriented” and aspects that are “macro-oriented”.  Up first in this unit are questions of international relationships and the economy, particularly trade, globalization, and international finance.

picture of economist Henry GeorgeFree trade consists simply in letting people buy and sell as they want to buy and sell. Protective tariffs are as much applications of force as are blockading squadrons, and their objective is the same to prevent trade. The difference between the two is that blockading squadrons are a means whereby nations seek to prevent their enemies from trading; protective tariffs are a means whereby nations attempt to prevent their own people from trading.

Henry George,
Protection or Free Trade 1886

What we’re discussing and analyzing in this unit is trade that occurs between people in different countries. Such trade includes,for example, when a Japanese auto company manufactures a car in Japan but ships it and sells it to a buyer in the United States. Or when a Hollywood movie studio produces a movie but sells to broadcasters in a European or Middle-Eastern nation. Or when a company in Latin America stitches together clothing and sells it U.S. retailers such as Wal-Mart. Economists typically (and not surprisingly) call such transactions “International” trade.

International trade has always been a hot topic in politics. But, international trade is often mis-understood and perceived as being different from ordinary all-inside-this-country trading. Unfortunately, the language used by politicians and news reporters describes international trade in terms of one country trading with another country.But it’s not really this way.Actually, private households and firms in one country make deals with private households and firms in another country. Each nation, as represented by its government, is not doing the trading. In other words, America doesn’t trade with Japan, instead individual Americans make deals with Japanese individuals.

International trade is simply trade between people who live in different countries or nations. Looked at this way, we can understand the motivation to trade and the benefits from trade. It’s just like any other form of trade. Trade happens when two people negotiate an exchange that makes both of them better off. Trade is mutually beneficial (assuming the traders are acting voluntarily).

The same principle that governs trade locally governs trade internationally — comparative advantage. (if the concept of comparative advantage seems only vaguely familiar at this point, I suggest you go refer to Unit 3 for a refresher!). Economic theory teaches us that international trade is a win-win proposition – both the buyer and seller will benefit. Therefore, if we observe trade happening between people in two different countries, the people in both countries will benefit. It doesn’t matter if one country is “rich” and the other “poor”. Both benefit. Granted, one may benefit more than the other depending upon the terms of trade negotiated, but both still benefit.

What is “Free Trade”?

Economists use the term “free trade” to describe the unrestricted ability to make transactions between private parties in different countries. In other words, free trade is just the existence of a free market between people in different countries. As we saw in Unit 3, a free market and trade is based on comparative advantage and voluntary transactions — it’s simply supply and demand. Free markets coordinate the profit-seeking production of firms with the utility-maximizing needs of consumers. Of course markets perform this coordination function very efficiently through the use of prices and price changes.

Economists are generally very supportive of free trade. They support free trade not just because the theory says people benefit in countries, but also because experience validates the theory. The economic history of most countries supports the idea that free trade is, in general, a very good thing. In Europe in the 19th century, those nations that encouraged free trade with the fewest trade barriers grew the fastest. Many economic historians attribute much of the economic success of the United States in the last 220 years to America being a giant free-trade zone (the U.S. Constitution prohibits trade barriers between the states). Further evidence is attested by the Great Depression of the 1920′s and 1930′s. In The Great Depression, the economies of the large Western industrialized economies shrunk and unemployment jumped to 33% or higher. A major cause of the The Great Depression was the collapse of the world trading system in World War I with governments raising tariffs, quotas, and other barriers to trade.

Despite the track record of free trade policies, governments have historically attempted to severely restrict the ability of their people to trade with people of other countries.

Barriers to Trade: Government and Special Interests Strike Back With Tariffs and Quotas

Unfortunately, the concept of trade as being mutually beneficial is sometimes lost when the proposed exchange takes place with people in some other country rather than our own community. Because of this misunderstanding, some people oppose or try to stop international trade. We will study the arguments they use in this chapter and try to evaluate them economically. The two most common tools to restrict trade are tariffs (taxes) and quotas (quantity restrictions).

Historically, (as in long, long ago), international trade was primarily limited by the cost and inability to travel, communicate, and transport goods for long distances. For example, Marco Polo was willing to bring spices, spaghetti, and gunpowder back from China to Europe on the backs of camels and mules in the middle ages. Fresh fruits and large heavy goods couldn’t make the trip. Today, though, transport and communication is cheap, easy, and getting easier. What can economically be traded is growing. Yet, there are still often barriers to increased trade. Most of these barriers have been put in place by governments responding to the special interests and arguments of groups of people. As we saw in Units 8-11, most firms do not wish to compete. They would prefer monopoly or oligopoly to competition. Competition means lower prices and smaller economic profits. When the competition comes from firms in another country, firms often choose to lobby the government to simply restrict trade rather than try to compete.

Yet governments have also made some efforts to eliminate these barriers to trade. The most notable efforts to reduce trade barriers have the GATT and the World Trade Organization (WTO). You read about these carefully in the text.

The Nobel prize-winning economist George Stigler once remarked that the fact that tariffs and trade restrictions are still used by most countries is proof that economists have zero influence on actual policy-making. What Stigler referred to is the near-unanimous agreement among economists worldwide and of all political persuasions that trade restrictions are harmful. Unfortunately, while the elimination of all trade restrictions would undoubtedly improve the overall well-being every country that participated, it wouldn’t be a painless transition for some people. Often the people most likely to suffer immediate loss from reduced trade restrictions are the most vocal and most politically connected.

To understand the arguments for free trade better, imagine taking the arguments for & against trade restrictions and imagine them applied to trade between the United States. Imagine if each state had the power to legislate tariffs, quotas, and restrictions.California wine growers have clearly unfair advantage over the vineyards in Michigan. Maybe we should put a quota on California wines to protect the Michigan wine industry. Likewise, it would be easy to imagine Michigan implementing a protective tariff against Toyotas made in Kentucky or Nissans made in Tennessee because those states compete “unfairly” with non-union labor. It would be easy to then imagine Tennessee “retaliating” with a quota on the importation of Detroit-made vehicles. But it wouldn’t stop with cars. Tennessee would no doubt want to “punish” Michigan for attempting to keep out Tennessee vehicles and would then retaliate with a tariff or quota to restrict the sale of Michigan-made Kellogg’s cereals in Tennessee. Michigan would then retaliate with a prohibitive tariff on “imports” of country music or Jack Daniels whiskey. And on and on. The eventual outcome of such inter-state trade barriers would be to raise the prices and costs of production of most goods. It’s not even clear that there would be any more employment or more stable employment. What clearly would happen is that consumers in all states would fewer goods available and those goods would cost much more.

We Need Truth-in-Advertising for “Free” Trade

George Stigler believed economists have had no influence because trade policies don’t support what economists describe as free trade. Unfortunately, we have had a little, but not enough influence. It seems that most politicians these days want to be perceived as supporting “free trade”, whether they do or not. As a result, we have a very large number of new laws, treaties, and arrangements that are all usually called “free trade”. For example, the reduced tariff zone for the US, Mexico, and Canada is called NAFTA: the North American Free Trade Zone. And yet, NAFTA has added a large number of trade restrictions and costs to trading. In the U.S., Congress and the President often claim to be “promoting” free trade by eliminating tariffs on particular goods from particular countries, but often such “free trade agreements” also implement restrictive quotas for many goods in place of the tariffs. As usual, in politics it’s all about the “spin”, but real economic activity responds to actual legal restrictions, not political spin.

Take the Shirt (or Jeans) You Are Wearing: The Example of “Free Trade” Clothing

A good specific example is clothing. A large percentage of the everyday-clothing Americans buy and wear is assembled (sewn) in factories in Mexico, Central America, the Caribbean, or eastern Asia. These factories often use labor that is paid the equivalent of a few dollars a day. The factories are located in what are called “free trade zones” by both governments. In reality these “free trade zones” are simply factories where the local government agrees to not charge tariffs on cloth being imported from the US, as long as the stitched clothing is not charged a tariff going back to the US. An additional restriction is that the clothing made in these factories is not to be sold locally in the nations where it is being sewn. They can sew it, but they can’t buy it or wear it. US textile workers, of course, object to these arrangements since the superior productivity of US workers isn’t enough to fully overcome the difference in wages. In response to US workers’ objections (with the support of US stores & corporations), the US places quota limits on the imports of these clothing items.

The net effect of these so-called “free trade” arrangements is anything but true free trade. The quotas are always set below the quantities that US consumers buy. The same companies who produce in the US are the ones who also produce the ‘imported’ goods. In reality, the goods aren’t imports at all. They same company that shipped the cloth to Central America owned it the whole time and is the one bringing it back and selling it. The company didn’t trade with anyone. It simply opened a factory that doesn’t have to pay the same wages as it’s US factories. Yet, the company sells both the ‘imported’ and ‘US’ goods without any differentiation.

The effect of the quota hurts both US consumers and the foreign workers. Without the quota, the foreign workers’ wages would rise from the increased demand for their products. As it is, with a fixed limit on employment, workers must compete against each other for the limited jobs. Wages stay very low. In the US, consumers pay the price that is established by the marginal supply — in other words, we pay the price based on the cost of production in the US. US consumers get to pay the higher US-based price, but get the lower-cost goods in many cases. The foreign workers get to make the goods, but they don’t get paid fully for them. Where’s the difference between the lower cost and the higher price — that’s the profits that the manufacturers and stores make. Of course, persuading the politicians to implement the policies wasn’t cheap either, so they get some of it.

The bottom-line is: true free trade works in theory, and in the limited situations that meet the requirements of theory, it is a net benefit, for both rich countries and poor countries.

TIP: on a quiz or exam, you should answer according to the accepted theory of free trade!

Unfortunately, true free trade is nowhere near as common as the some believe. A significant indication of how “free trade” is actually the exception lies not only in the rules, tariffs, and treaties that governments have implemented, but also in a close look at the trading parties involved.  The reality in today’s “globalized” markets is that the majority of trade that crosses international borders is actually transactions between two corporate entities that are owned by the same corporate parent.  An example of this is an oil corporation in one country that sells crude oil to a refining company in another country, but the two companies are actually subsidiaries of the same parent global oil corporation.  Another example might be Ford Motor Company.  Ford Motor Canada makes and sells engines. It sells them to Ford Motor USA which installs them in new cars in the US. Both entities are sub-units owned and controlled by a single corporate parent: Ford Motor Co.  It is the parent company that controls quantities, prices, etc.  The apparent “trading partners” have no decision-making authority.

I believe that whether we help the world’s children should be the true litmus test of globalisation.
Gordon Brown, Chancellor of the Exchequer (now Prime Minister of the U.K.)Speech to UN General Assembly Special Session on Children 2002

What Causes Capital or Current Account Deficits/Surpluses?

A deficit in the current account will be matched by a surplus in the capital account, and vice-versa. So which one “causes” the other? Does the U.S. receive a surplus capital inflow because it chooses to buy more imports than exports? Or do we buy end up running a current account deficit (buy more imports) because we attract so much capital from overseas? Economists disagree. The reality is probably best described as the two are simultaneously determined. Current and capital account balances are driven partly by real economic factors: comparative advantage in producing goods, real productivity and resources available for production, and the opportunities for investment and growth. But there are also other significant short-term factors: interest rates, inflation, government budget deficits, national savings rates, currency exchange rates, and fear of economic/political uncertainty worldwide.

Currencies and Foreign Exchange Rates

Each nation creates and manages it’s own currency — its money (except for those who have joined a currency union like the Eurozone). As we studied in the last 3 units, the Federal Reserve System is ultimately responsible for how much U.S. money is available and circulating in the economy. Within an economy, this money is adequate for all transactions. Buyers pay with it and sellers accept it. But when we introduce international trade, we also introduce a difference in monies and the possibility that people will want to buy one currency with units of another currency (convert currency).

Let’s suppose an American and a German decide to conduct a trade. To be specific, the American wants to buy a car from Mercedes-Benz of Germany. The American has US dollars available to spend. But Daimler, the German company that makes the Mercedes, ultimately needs Euros, not dollars (they use the Euro in Germany). Daimler pays it’s suppliers in Euros. It pays it’s employees in Euros. And it wants it’s profits in Euros. The solution is to sell the car to the American and accept payment in US dollars. Then Daimler takes the US dollars and converts it to Euros in the international currency markets. This “currency conversion” is done in a market for currency called the foreign exchange markets, often called “forex” for short. In the foreign exchange markets, Daimler wants to “sell” the US dollars it now possesses to someone in return for Euros. It needs someone who has Euros that they want to use to buy dollars. Once this foreign exchange transaction is made, then Daimler will have the Euros it originally wanted and it can pay it’s suppliers, employees, and shareholders. The rate at which the US dollars were traded for Euros is called the foreign exchange rate, or currency conversion rate. The tutorial has a section on reading tables of foreign exchange rates.

Why Foreign Exchange Rates Are Important

The rate at which two currencies exchange is of critical importance in determining international trade patterns. Let’s suppose a British manufacturer is selling their product in Britain for 55 Pounds (the British currency). At 52 Pounds, the firm makes a reasonable profit and can afford to do the business. Now they look at possibly exporting the product to the U.S. In the U.S., let’s suppose that a competitive U.S.-made product is selling for $100 USD. Can the British manufacturer afford to export to the U.S. and compete at the $100 U.S. price? Will U.S. customers be willing pay enough for the British product? The answer depends on the exchange rate. Suppose the exchange rate is $1USD will trade for 0.50 British Pounds. At this exchange rate, the British company could sell at the “market price” in the U.S. and receive $100 for each unit they sell. Then they convert the US dollars in Pounds in the foreign exchange markets. At the $1.00USD=0.50Pounds rate, the $100 US dollars becomes 50 pounds. It’s not enough for company to make a profit. But suppose, the exchange rate changed to $1.00USD=0.55 Pounds. At the new exchange rate, the US market price of $100 gets converted into 55 Pounds. Not only would the British firm be able to sell in the U.S. at this exchange rate, they would actually make more profit on their US sales than they would on British sales. Of course, instead of making “extra” profit on their U.S. sales, at the $1.00USD=0.55 Pounds exchange rate, the British firm could price their product at the $94.55 US dollars in the U.S. At this price the British firm would convert the $94.55 USD into 52 Pounds, the amount they were looking for, but they would also undercut the price of their U.S.-based competitors. As you can see, the volume of imports and exports a country has can easily be affected by the exchange rates between currencies.

The same holds true for consumers. Suppose you have $3000 USD to spend on a vacation (assuming you are in the US). Where will your money go the farthest? It depends on exchange rates. Let’s suppose that you researched and figured out that $3000 would buy you a decent vacation in Paris next summer (France, not Kentucky!). You save your money all year-long and when summer arrives, you’ve saved up your $3000. But suppose the interim while you were saving up for the vacation, the US dollar weakened. This means that the exchange rate of US dollars into Euros changed so that each US dollar buys fewer Euros and it takes more dollars to buy each Euro. Your $3000 won’t buy you the vacation in Paris. On the other hand, someone in France may well have found that the vacation to Disney World in Florida just became cheaper. International trade and capital flows depend on exchange rates.

How Are Foreign Exchange Rates Determined?

There are different ways of determining exchange rates. Each is a matter of policy and choice by the currency-officials of each nation.

One method used in the past was the gold standard. Each nation defined a fixed value of their currency in gold. Since each nation’s currency was pegged to a fixed amount of gold, the effect was to set a fixed exchange rate between currencies. The gold standard ruled international trade and currency transactions in the 19th and early 20th century. Despite the claims of some politicians today who wish a return to a gold standard, the gold standard was highly problematic from a macroeconomic perspective.  A gold standard largely eliminates the ability of the central bank to manage monetary policy effectively, including interest rates.  A gold standard forces a nation to tie the quantity of money in the economy, the growth of the money supply, and interest rates to the ability of a few scarce gold mines in the world to produce gold.  There is no reason why the growth of gold supply will match what the economy needs or wants to maintain full employment.  The history of the late 19th century and early 20th century confirms this. Today, virtually no nation has gold standard, but many currency traders still look at the price of gold bullion as an important trends indicator.

The second method is one of fixed exchange rates without using gold. Typically some particularly strong currency that is very widely used is set as the “reserve” currency. Other nations then “peg” the value of their currencies to this particular reserve currency. In the global financial system set-up after World War II at a conference in Bretton Woods, New Hampshire in 1946, the US dollar was established as the reserve currency to which other nations would peg or fix their currency exchange rates. In a fixed system like this, the central bank of a nation must be willing to buy or sell it’s currency as necessary in order to maintain the proper exchange rate. This type of system also requires that the rest of the world have enormous confidence in the stability and value of the reserve currency. In the post-World War II environment, the strength of the US economy and confidence in the Federal Reserve allowed the world to use the dollar as a reserve currency. To maintain such confidence, the US maintained that it would convert the US dollar into gold for foreign traders & central banks, if requested (US citizens were not allowed to convert dollars into gold). This system ended in 1972 when the US abandoned it’s commitment to convert dollars into gold. Today, there are still some nations in the world, particularly in smaller or developing nations, that continue to maintain a fixed rate to the US dollar.

In the 1970′s the world (or at least the major developed countries) attempted to move to a “floating rate regime”. In other words, exchange rates are set by market forces, supply-and-demand, in foreign exchange markets. If, on any given day the supply of dollars that people want to convert into Euros exceeds the demand for dollars by people who want to pay with Euros, then the dollar weakens — each Euro will bring a larger number of dollars and each dollar will bring fewer Euros. If the supply and demand are reversed, then the dollar strengthens and the Euro weakens.

In the long-run, a flexible market-driven system of floating exchange rates is superior – it will automatically balance out changes in economic conditions, inflations, interest rates, etc between countries. A flexible, floating exchange rate system also allows each nation to conduct the macroeconomic fiscal and monetary policies that best fit the needs of that nation.  Fixed rate systems are policy “straight-jackets”. But, in the short-run a system of floating exchange rates set in open markets can be disruptive. Exchange rates can suddenly move and move dramatically, disrupting firms’ and consumer’s plans. The floating rate system is also susceptible to excessive speculation which can drive exchange rates away from what they should be in the short-run. For this reason, the real system the world uses today is called a “managed float” system. In general, exchange rates are set by market forces, but central banks often enter the market in order to slow or even reverse rate changes.

What’s A Good Exchange Rate?

Some people make a big deal about which currency has the larger number. For example, for years when the Canadian dollar was trading at a rate where 1.00 CAD would bring much less than 1.00 USD (at times as low as 1 USD = 0.67 CND), many Canadians made fun of their own money, calling it “monopoly money” or “toy currency”. In fact, the actual numbers are largely irrelevant. For instance, $1.00 US dollar buys approximately 114 Japanese yen. The 1.00 to 114 ratio itself is meaningless. It simply means the US has a currency that uses fractional amounts ( such as 25 cents, which is 0.25 dollars) in it’s economy, while Japan chooses to only use whole units of it’s currency.

The “right” exchange rate in an economic sense is the one where the same product produced from the same materials, but sold in different countries, would yield the same amount of money no matter which currency it was converted into. This is called “purchasing power parity”. But what really matters is what the actual exchange rate is, not a theoretical number. And what matters most, is changes in that rate.

When exchange rates change, one of the currencies is described as “strengthening” or “appreciating”. The other currency gets “weaker” or “depreciates”. A stronger currency is one which will buy more units of the other currency than it did in the past. So for example, in 2003, the US dollar would buy approximately 1.50 Canadian dollars. We can re-state this in terms of the Canadian dollar. Each Canadian dollar would buy approximately $0.66 US dollars in 2003. Since 2003, the exchange rate has changed dramatically. In the fall of 2007, four years later, the two currencies reached “parity”, meaning they traded at 1-for-1. So in Fall 2007, one US dollar would only buy 1.00 Canadian dollar. Each US dollar was now buying fewer Canadian dollars. The US dollar had weakened. Of course from the Canadian perspective, each Canadian dollar would only buy 0.67 USD in 2003, but each Canadian dollar would buy 1.00 USD in 2007. The Canadian dollar had strengthened or “risen against the dollar”.

Winners and Losers in Exchange Rate Changes

Changes in exchange rates affect people differently, depending upon whether they are selling exports, buying imports, or travelling outside the country. In short, the following table summarizes who, in general, benefits and who is hurt by the changing value of a currency. This table is described in terms of Americans, foreigners, and the US dollar. But the same analysis holds for any currency – just substitute the other currency for dollar and replace “Americans’ with the people or firms of the nation that has the other currency.

If Dollar Strengthens If Dollar Weakens
Will benefit
(lower costs or more profits)
  • Foreign firms trying to sell in the US
  • Americans wanting to travel to other countries
  • Americans who buy imports
  • US firms trying to export
  • Foreigners wanting to travel to US
  • Foreigners who want to buy US goods
Will be hurt
(higher costs or lesser profits)
  • US firms trying to export
  • Foreigners wanting to travel to US
  • Foreigners who want to buy US goods
  • Foreign firms trying to sellin the US
  • Americans wanting to travel to other countries
  • Americans who buy import

Reading Guide – Assigned Readings

In addition to the Jim’s Guide (above), you should read and study in your Mandel Economics: The Basics textbook:

Chapter 13  – Financial Markets
Jim’s Comment: Pay the most attention to the primary narrative.  The graphs and illustrations are less important – if they help you understand, then great.  If they are confusing to you, don’t get too concerned.

Chapter 14  – International Trade
Jim’s Comment: Graph 14.3 is important.  The other graphs are less important.

Practice Quiz

Click here for the Unit 12 practice quiz.  The practice quiz will open in a new tab/window.


No worksheet for this unit.

Closer Look


What’s Next?

In the next unit we take a look at fairness and who gets the benefits of the economy.