Comparative advantage, economies of scale, and the cost of finance

Paul Krugman has an old paper titled How I Work which might be worth your time to read. I want to repeat a fragment of it here, for my own purposes. Krugman writes of his early days as an economist:

What had I found? The point of my trade models was not particularly startling once one thought about it: economies of scale could be an independent cause of international trade, even in the absence of comparative advantage. This was a new insight to me ...

"... within a few days," Krugman says, "I realized that I had hold of something that would form the core of my professional life." It was important to him, this little fragment which said not only comparative advantage, but also economies of scale drive international trade. It was important to him for personal reasons.

It is important to me because I read it this way:

not only comparative advantage, but other things also drive international trade.

It is important to me because it opens a door, the other things also door. And I know what I must bring through that door: the cost of finance.

That shouldn't surprise you. I always look at things in terms of the cost of finance.

Conservatives always gripe about the cost of labor. Liberals always grumble about profits. To my mind you need both wages and profits, if you are to have an economy. And, certainly, you also need finance.

But how much finance do you need? These days, we need a lot. Or, as I see it, we don't really need a lot of finance, but we sure do have a lot. And because we have a lot of finance, the cost of finance is high.

No, not just the rate of interest. Rather, the rate of interest applied to every dollar of debt. If there is not much debt, the cost of finance is low. If there is a lot of debt the cost of finance can be high, even when interest rates are low.

On the consumption side, the cost of finance reduces aggregate demand. On the production side, the cost of finance reduces profits and increases prices. A high cost of finance reduces demand and profits, both, and creates an economy in decline, the kind of decline we have endured now for decades. The cost of finance is a crucial consideration. That's why I talk about it all the time. But set all that aside.

In addition to reducing demand and reducing profits, the cost of finance also adds to the cost of products. It contributes to the increase of prices. (And this does not consider the effect finance has on the quantity of money, and the "inflation is always a monetary phenomenon" thing. But set that phenomenon aside.)

When the cost of finance is rising, it increases costs. It makes output more costly.


In Krugman's "How I Work" paper he says he doesn't worry that his assumptions might be unrealistic. He worries about not knowing what his assumptions are. There are some problems with that approach, but I'll go with it for now. I'll assume that the level of finance was at its best around 1955. You might think 1955 is an unrealistic date. I think it's not far off. But if it makes the reading easier, you can assume I picked a more reasonable date -- still decades ago, but not so many decades ago. That would make the latter 1950s a premonition of what was to come. I can live with that.

By "the level of finance was at its best" I mean that when finance was less, it hindered economic growth more, and that when finance was more it also hindered growth more. I imagine something like a "Laffer curve" for the optimum size of finance. If my Laffer curve comparison doesn't make sense to you, don't worry about it.

In 1960, looking back at the latter 1950s, Samuelson and Solow wrote:

... just by the time that cost-push was becoming discredited as a theory of inflation, we ran into the rather puzzling phenomenon of the 1955-58 upward creep of prices, which seemed to take place in the last part of the period despite growing overcapacity, slack labor markets, slow real growth, and no apparent great buoyancy in over-all demand.

In the end, Samuelson and Solow could not reject the cost-push explanation:

We have concluded that it is not possible on the basis of a priori reasoning to reject either the demand-pull or cost-push hypothesis ...

Ten years later, Federal Reserve Chairman Arthur Burns was pointing to the increases in employee compensation as the driver of inflation. Robert Hetzel quotes from the Board of Governors Minutes for November 1970, that Burns thought in terms of "cost-push inflation generated by union demands."

Perhaps by 1970 union demands were driving inflation. But in the latter 1950s? In the latter 1950s, the rising cost of finance was squeezing profits.

Growing financial cost got the inflation ball rolling. Union demands took the hit for it later, and perhaps rightly so. But union demands did not create the initial problem. The rising cost of finance got inflation going, and kept it going until a wage-price spiral emerged.

For domestic corporate business, financial cost increased faster than the compensation of employees:

Graph #1: Interest Costs Increased Faster Than Compensation of Employees

Consider the 1955-1958 period, the years that concerned Samuelson and Solow. For every dollar corporations paid out as employee compensation in 1955, they paid out five cents for interest costs. By 1958 that number was seven cents. For every dollar of employee compensation they paid out, corporate business spent two cents more on interest in 1958 than in 1955. Financial costs gained on labor costs.

Financial costs also gained on profits:

Graph #2: Interest Costs Increased Faster Than Corporate Profits

For domestic corporate business, financial costs increased faster than profits. Between 1955 and 1958, corporate interest costs rose from 15 cents to 25 cents per dollar of corporate profits: a ten-cent increase in interest costs, ten cents for every dollar of profit.


If financial costs had grown more slowly, if they had grown at the same rate as profits, say, how would the world have been different?

In 1955, corporate business interest paid totaled $7.3 billion, something less that 15% of profits. In 1958, interest paid came to $11.4 billion, something more than 25% of profits. Other things unchanged, if interest paid in 1958 remained at the 1955 percentage, the cost of interest would have been about $6.4 billion. This is $5 billion less than the actual 1958 cost of interest.

If this $5 billion expenditure had not happened, other things unchanged, corporate profits would have been $5 billion higher.

But I can't add that $5 billion to corporate profit, because it changes my interest-to-profit ratio. It throws the calculation off. In order to work thru the calculation cleanly, we cannot add the $5 billion of interest savings to corporate profits, nor to any corporate spending category. The only way to dispose of the $5 billion is to reduce gross corporate revenue by reducing the price of the corporate product.

In 1958, the gross value added (GVA) to the economy by corporate business amounted to $256.9 billion. If we reduce the price of GVA by $5 billion, the reduced number is $251.9 billion. The reduced GVA number is 98% of the actual number. So, to make the calculation work we have to reduce the price of corporate output by 2%.

If corporate interest costs in 1958 remained in the same proportions as 1955, corporations could have reduced their prices by 2% without reducing their profits and without reducing the wages and benefits paid to their employees. Without reducing any of their spending, other than interest.

This is an exercise in "other things unchanged". Ceteris paribus. The assumption is not realistic. But the numbers tell an honest tale: The cost of interest increased faster than other corporate business costs, fast enough to push prices up 2% between 1955 and 1958.

This suggests a different conclusion for the Samuelson-Solow paper: identification of cost-push as the cause of the 1955-1958 inflation.


How did the rising cost of finance affect the economy?

In 1962, President Kennedy was "jawboning" the steel companies, trying to talk them out of raising prices. They raised prices anyway. In response then,

Kennedy launched investigations by the FTC and Justice Department into collusion and price rigging by the steel companies [and] threatened to break Pentagon contracts with U.S. Steel.

The steel companies acquiesced, rolling back the price hike. But they raised prices anyway the following year. This cannot have been simply

a tiny handful of steel executives whose pursuit of private power and profit exceeds their sense of public responsibility

as Kennedy claimed. The price increase was driven by financial cost pressures that Kennedy could not see. "Operating cost" pressures, according to encyclopedia.com:

Profits were being squeezed between rising operating costs and relatively stable prices, and in April 1962 U.S. Steel unexpectedly announced an across-the-board price increase ...

Kennedy was looking for a wage-price spiral. The steel price hike was not part of a wage-price spiral. In March of 1962 the Steelworkers accepted a contract that gave them no wage increase. In April, the price of steel increased 3.5%. The source of the cost pressure was not labor, but finance.


In 1965, on the last day of the year, in its renowned We Are All Keynesians Now article, Time magazine wrote:

First the U.S. economists embraced Keynesianism, then the public accepted its tenets. Now even businessmen, traditionally hostile to Government's role in the economy, have been won over—not only because Keynesianism works but because Lyndon Johnson knows how to make it palatable. They have begun to take for granted that the Government will intervene to head off recession or choke off inflation, no longer think that deficit spending is immoral. Nor, in perhaps the greatest change of all, do they believe that Government will ever fully pay off its debt, any more than General Motors or IBM find it advisable to pay off their long-term obligations; instead of demanding payment, creditors would rather continue collecting interest.

The "greatest change of all" was acceptance of the view that government would act more like business, rolling debt over rather than paying it off.

That change didn't last. Already in 1964, Ronald Reagan had spoken on behalf of Presidential candidate Barry Goldwater. Reagan:

Today, 37 cents of every dollar earned in this country is the tax collector's share, and yet our government continues to spend $17 million a day more than the government takes in. We haven't balanced our budget 28 out of the last 34 years. We have raised our debt limit three times in the last twelve months ...

In 1980, Reagan himself was elected President in a landslide. "We don’t have a trillion-dollar debt because we haven’t taxed enough," he said; "we have a trillion-dollar debt because we spend too much." By 1980, the greatest change of all was that people had come to believe the Federal debt must be reduced. So much for being all Keynesian.

But notice what was not a change in 1965: businesses did not "find it advisable to pay off their long-term obligations". Accumulating debt was standard practice. For the longest time, people thought it was okay if private debt increased. I guess that did finally change, about ten years back. But here's the thing: Corporate interest costs ran neck-and-neck with profits in 2003-2005. Other than that, interest costs were higher than corporate profits from 1980 to the crisis.

Corporate business interest costs were only 15% as much as profits in 1955. By 1980, interest costs were more than profits. The growth of financial cost, a trend visible in the late 1950s, continued to 1980 and continued on to the crisis.


By 1970 one could easily see that wage hikes were driving inflation, because employee compensation is a far larger number than the cost of interest. And by 1970, everyone was trying to catch up with everyone else. Inflation had become self-sustaining. But how, in the latter 1950s, with "no apparent great buoyancy in over-all demand", how is "the 1955-58 upward creep of prices" to be explained? And then in the early 1960s, the price of steel? These were not stories of demand-pull inflation. They were cost-push stories. But the driving force was not compensation of employees or union demands or wages. The driving force was rising financial cost.

"Comparative advantage" makes some domestic products an international bargain, and this, as Paul Krugman writes, is a "cause of international trade". But the point of Krugman's trade models was to show that economies of scale can also make some products a bargain in foreign markets. The lesson we learn from Paul Krugman is that costs affect trade: Low costs increase trade. High costs reduce it.

In the US we rely on credit. Credit has a cost. The use of credit in the productive sector raises the prices of US products. If we rely more on credit than other nations, our financial costs will be higher than theirs. Those costs are reflected in the higher prices of our products. High prices make our products less competitive in international markets.

Increasing financial costs, by raising prices, may be to blame for a significant share of US trade deficits going all the way back to the 1970s.

The point of this essay is not particularly startling once one thinks about it: Despite the best comparative advantage and the greatest economies of scale, high financial costs can be an impediment to the export trade.

// The Excel file