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The US trade gap shrank in June, as US imports fell, and exports grew. This contrasts with much of the rest of the world, particularly the Eurozone and East Asia, which seems to be struggling right now. The shrinking US trade gap is no fluke. You don’t need a magical crystal ball or training in the “psychic arts” to have seen it coming. Rather, when Adam Smith penned The Wealth of Nations 236 years ago, this is exactly the type of result he might have predicted.
As most of you are aware, Smith’s thesis was that free trade benefited all nations. If we all exported the products and services we produced the most efficiently, and we imported the ones that others produced more efficiently, we’d all have greater wealth. It’s a concept called comparative advantage and the logic behind it is difficult to counter.
A Simple Example
Let’s look at an easy example with only two nations: Japan and the United Kingdom. We’ll create a basket of five goods: computers, bicycles, tables, mattresses, and couches. In order to make things very simple to understand, we’ll assume that the Japanese Yen (“JPY”) and the British Pound (“GBP”) are at parity; or that is to say, that one JPY buys one GBP. We’ll also assume that each nation manufactures a “standard quality” so that the computers manufactured in Japan are not superior or inferior to the ones manufactured in the UK.
The table below lays out the price to manufacture all five of the goods in each of the two nations:
Without free trade, you can say that the basket of goods will cost 450 Yen in Japan, and 435 Pounds in the UK. However, the price for the basket of goods falls to 400 in both nations (since the currencies are at parity) with free trade. That’s a cost savings of 11.1% for Japanese consumers, and 8.0% for British consumers. It’s easy to see how consumers in both nations are better off in this scenario.