Trade theory doesn’t always work

Surprise, surprise, surprise. Economists are finding that classical trade theory doesn’t seem to explain what is happening (or not happening, in this case). As a story in the Wall Street Journal, “Why Dollar Can’t Close Gap” explains:

Economists, puzzled that a weaker dollar hasn’t done more to shrink the U.S. trade deficit, think one reason may be the growing flow of goods moving between the foreign and U.S. divisions of large multinationals.
Forty-two percent of all U.S. trade in goods, $950 billion last year, occurs between arms of the same companies, including U.S.-based companies trading with their foreign divisions as well as foreign companies trading with their U.S. arms. Nearly 90% of U.S. imports from Ireland are such “related party” trade, as are 74.6% from Singapore, 62.1% from Germany and 61.1% from Mexico.
“When so much of trade is related-party moves, the determining driver is demand in the U.S., not shifts in exchange rates,” says Joseph Quinlan, chief market strategist of global wealth and investment at Bank of America.
. . .
Economic theory says that as the dollar declines, the trade balance should shift in the U.S.’s favor, usually with a delay of about 18 months after the currency starts moving downward. But it has been more than three years since the dollar started its slide, although it has recovered some ground recently, and there is little evidence of a significant impact on trade.
. . .
Gary Hufbauer, an economist at the Institute for International Economics, says companies with factories around the world, in theory, should be quicker to respond to shifting exchange rates because they see more immediately where it is cheap to produce and where the markets are strongest. But, in fact, he says, this isn’t how it works in practice.
One reason is that in large markets like the U.S., with many competitors, companies that import products are competing with domestic producers who don’t face the same pressure from the latest currency swings. As a result, importers are hesitant to raise prices to offset a falling dollar, because that would likely cut into market share, says Mr. Hufbauer. That, in turn, short-circuits one of the main ways in which a falling currency is supposed to curb imports.
Moreover, all producers face large fixed costs, regardless of where they build their plants, especially in industries such as autos and electronics that increasingly rely on advanced production technology and costly distribution systems. These companies are more inclined to choose production locations around the world and set prices according to competitive conditions in each market, rather than currency rates.

Seems like it isn’t your grandfather’s Ricardoian trade world any more.

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