Wednesday, March 20, 2013

In Which I Apologize to Lord Palmerston and the Parliament of 1839: Terms of Trade Edition

I've been on a bit of a China kick lately, so here's another one but in a more historical vein. The century (+10) of 1839-1949 is referred to by the Chinese as "the century of humiliation," in which their country was systematically cut up into concessions and spheres of influence by the Western powers, Japan, and Russia. 1839 marks the beginning of that century because it was in that year that China was invaded for the first time by, who else, the British (those guys were nothing if not well traveled).
The curious thing about the episode is WHY the British invaded, and the tale is one of history's less savory. For many decades, the East India Company had been operating what amounted to a warehouse and a living compound in a small portion of Canton, one of the only places the Chinese allowed foreigners to do business. The Confucian regime deplored commerce and hated "foreign devils," but permitted limited trade because they were able to levy such heavy taxes and duties on Western merchants. The EIC exported Chinese silk, tea, jade, and other luxury goods to Britain, where they were in great demand. The Chinese, in turn, had no interest in British manufactures, so they were paid by the company in silver. John Company (as it was known) got clever and found something that Chinese consumers did demand: opium, or, in modern parlance, heroine. When the Chinese administration objected to the large-scale poisoning of its population (opium left whole regiments of the imperial army practically skeletons) and seized opium shipments coming into Canton, the British company Jardine and Matheson, which had replaced the EIC as the main dealer in opium, lobbied Parliament for intervention. The intervention was not long in coming, the results were swift, and not to China's advantage.
This story has always fascinated me, but I always regarded the British position not only as ethically dubious (the crypts and bloods have nothing on Lord Palmerston), I also found it economically pointless. If the Chinese wanted to be paid in silver, there was no theoretical reason for the British to seek a substitute to export. Per the price-specie flow model, silver would flow from Britain to China,  and goods from China to Britain. This fall in the British money supply would result in British deflation, lowering the silver price of British exports relative to other markets such as the Continent or the Americas; Britain would end up paying for it's Chinese silk by selling Sheffield flatware to Boston households. The war to avoid the silver-silk transaction with China was an expensive waste, so I thought, because the British made the classical mistake of viewing an outflow of bullion as an outflow of wealth.
I was thinking it over today, (how lame) and I realized I had missed a critical point, in fact several. I had simply thought of the situation in terms of balance of payments and the purchasing power parity theory of the real exchange rate; I had entirely neglected to consider the terms of trade that is determined by reciprocal demand. While the long run real exchange rate between any two countries is unity, meaning that output in one country is not inherently more expensive in real terms than another, the terms of trade between trading partners is an index value of how much exports one country needs to give up to pay for its imports. It has nothing to do with exchange rates or financial flows, merely product prices. Take silver out of the equation, and it becomes clear the Chinese really were eating Britain's (boiled) lunch, because while the British were willing to pay through the nose for Chinese commodities, the Chinese had extremely low demand for British goods, causing the price of British exports to be low in terms of Chinese exports. This is known as reciprocal demand, and its a big part of the terms of trade.  So the British basically went searching for, and found, the ultimate export good: a highly addictive drug! Now, instead of having to sell x quantity of flatware to France to get y quantity of silver to get z quantity of silk from China, they could sell x quantity of opium to China for z quantity of silk, with opium (x) having less silver value than flatware(x) and the Brits pocketing the difference!
I only bring this up because the Opium Wars started the process that led to the Chinese revolution in 1911 and the subsequent fall of China to the Communists in 1949, which is increasingly relevant. And it's reassuring to know the whole thing was at least not predicated on faulty economic logic.

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