Posted by: Dirk | January 26, 2010

Van Rompuy on Schumpeter

The President of the European Council has recently said the following:

For sure, Schumpeter spoke of the “creative destruction” of capitalism. Simply put: every closed factory ‘A’ would be replaced by a more innovative factory ‘B’. But Schumpeter never told us how long we are supposed to wait in between destruction and creation…

Personally, I believe the question is not how long we are supposed to wait but where in the world factory ‘B’ will be located. And that question has something to do with “fair” competition, which itself depends on exchange rate, wages, price levels and all kinds of external effects. The way industry location is determined in the 21st century should be clear: increasing returns to scale and transport costs.

In a nutshell, industry locates next to markets. This is because increasing returns to scale translate into advantages of being big. More output means a lower price, which is good. In order to exploit that competitive edge, products need to be shipped to consumers worldwide (or to as many consumers as possible). This depends on transport costs. Since these as well as communication costs have fallen in the last decades, global integration has seen Asia catching up with Europe and North America (source: Carpe Diem):

So, to attract industry it might be profitable to undercut competitors by dumping: lowering costs artificially to attract firms and to increase exports of existing firms until the agglomeration is big enough. Then, increasing returns to scale can be realized to keep costs low and lock-in the firms.

Economists like Michael Mussa have called foul on the fixed exchange rate between China and the US for a long time, but still many economists are in denial.



  1. “exchange rate, wages, price levels” are not “kinds of external effects”
    Each country, if politics does not get into the way, does what it does best, one mines gold because it has it in the soil, another manufactures labour-intensive products as it has cheaper labour, so much cheaper though, that it can offset higher distance/transport costs. That would be vulnerable to e.g. rising oil prices. The “comparative advantage” of an alleged Yuan undervaluation is much overvalued: what a nation gains in export attractivity it has to accept as higher import prices (e.g. oil), i.e. China has to import goods at higher Yuan prices if the Yuan is undervalued. IT CUTS BOTH WAYS!
    If politicians see only one side of the coin, that doesn’t mean their policies have the effects they desire, in fact they hardly ever have!
    That said, there are lots of other variables, such as artificially LOW interest rates e.g. in the US and Japan. IF one were to chide China, then ALL variables would need to be considered … and that’s what economics teaches – DEREGULATE the markets: no currency manipulation, no interest rate manipulation, no tariff and no subsidies.
    What’s wrong with Economics?

    • Well, if you want to completely deregulate the market (“no currency manipulation, no interest rate manipulation”) you would have to regulate the current account: exports have to be equal to imports. If this is not the case, there will be a net exporting nation and a net importing nation which gets capital inflows, driving down the interest rate there. So what you propose is logically inconsistent.

      By the way: if you value Heckscher/Ohlin so much, why then does China try to “climb up the value chain” and move more and more into capital-intensive production, like Japan and South Korea did before, and successfully? Wouldn’t that be against the idea of comparative advantage?

      • Sorry for not coming back on this earlier – overlooked the comment notification somehow.
        “like Japan and South Korea did before, and successfully” – I’m not entirely convinced of those successes inasmuch as they were in Japan e.g. driven by a central planning bureaucracy called MITI and similarly the Korean government urging chaebols to form. Look at the mess Japan is in. States or politicians should in NO way interfere in their economies.
        “there will be a net exporting nation and a net importing nation which gets capital inflows, driving down the interest rate there” – that’s what I meant – the market regulates interest rates and thus restores equilibrium, only to then change in the next moment to again try and gravitate back towards equlibrium, and again, and again. No Greenspan can do that job for the market, it punishes those fools, but us with it and I don’t get paid like greenspan later to hold speeches about how brilliant I was. If these oafs were to pay for their damage, I wouldn’t have an issue with their idiocy.

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