David Ricardo

Published: Mar 2013

Today, David Ricardo is remembered primarily for what he contributed to our understanding of economic growth and income distribution. As an economist, his theoretical works included explaining what causes economies to grow and decline, and how the three components of wealth – rent, wages and profits – are divided up within societies. Ricardo wrote from a staunchly free trade perspective, more so even than the man credited as founding father of classical economics and liberal capitalism, Adam Smith. International free trade, according to Ricardian theory, is an absolute must in order for nations to grow and prosper; protectionism, on the other hand, was a policy which always damages growth. In Ricardian economics, the introduction of tariffs almost always precipitates economic decline.

Early life

Ricardo was born on 18th April 1772 in London. He was the third child of Abraham Israel Ricardo, a Spanish Jew who had formerly worked as a stockbroker at the Amsterdam Stock Exchange. At the age of 11 he was sent to live in Amsterdam with his uncle – also a trader – to educate and prepare him for following his father into the world of trade and finance.

Upon returning to England, Ricardo took up work at his father’s office. He proved very capable, eventually earned himself such a reputation that London’s banks provided him with credit to establish his own office. The fact that Ricardo was able to establish himself as a trader so swiftly was fortunate because he was soon to become estranged from his father, a result of his disapproval over the young Ricardo’s romance and later, marriage to a woman from the Quaker religion.

Now working independently as a broker on the London Stock Exchange, Ricardo was able to amass a huge personal fortune through his knowledge and understanding of stocks, bonds and real estate investments. Having secured significant personal wealth while still in his 20s, Ricardo took the decision to dedicate the rest of his life in pursuit of his various intellectual and scientific interests – mineralogy, geology, mathematics and chemistry.

Ricardo the economist

Ultimately Ricardo would become renowned for his writings on economics. His career as an economist began after he came across a copy of Smith’s ‘The Wealth of Nations’ while on vacation in Bath. The text had a profound influence on Ricardo, even though the approach to economics he later developed would differ markedly. After reading Smith, he became inspired to study economics and would meet frequently for friendly debates with a group of other eminent intellectuals of the day, including the likes of James Mill, Jeremy Bentham and Thomas Robert Malthus.

Like many of the other classical economists before him, Ricardo immersed himself in the study of economic theory for a particular purpose – to develop practical solutions to the various economic and financial questions facing the UK in the first two decades of the 19th Century. In 1819, he purchased a seat in the House of Commons and served briefly as an MP for the Irish borough of Portarlington. His reputation within the legislature as an expert on financial and economic matters was quickly cemented, and he became known for often taking contentious positions on some of the important issues of the day including tariffs, taxation and agricultural trade.

In most economic textbooks today, the main references to Ricardo are to his theory of comparative advantage. Over two centuries on, Ricardo’s analysis on this matter is still used as the justification used by most economists against protectionist tariffs and in favour of free trade. But Ricardo did make at least three other important contributions to economic thought. His theories helped to explain the distribution of national income between profit, rent and wages and how that distribution changes over time. He also developed the labour theory of value which, somewhat paradoxically considering Ricardo’s liberal credentials, provided a framework later used by Karl Marx.

Why free trade can work for everyone

Smith’s ‘Wealth of Nations’ was the starting point for Ricardo’s analysis of international trade. Smith believed that if a given county was more efficient at producing certain goods than another country, then it would naturally endeavour to export those goods to the other country. This is what is referred to by Smith as “absolute advantage”. For example, a country with an absolute advantage in the production of food, clothes and cars will export those items to other countries. As a result, those other countries will begin to run up trade deficits.

But from Ricardo’s perspective it was comparative – not absolute – advantage that was the critical factor in international trade. It did not matter if one country was less efficient at producing all goods, he argued. It was relative efficiency that was decisive.

Ricardo observed that countries tended to export goods that they were relatively more efficient, or relatively less inefficient at producing. Therefore, the key to understanding comparative advantage is “opportunity cost” – that is the value of what is given up. In his 1817 book, ‘On the Principles of Political Economy and Taxation’, he used the example of Portugal and England to illustrate the point.

In Portugal, economic conditions meant that it was possible to produce both wine and cloth using less labour than it does for England to produce the same quantities. Portugal had, in the words of Smith, an absolute advantage in the production of both products. However, in this example it was the relative costs of producing the two goods that really mattered. In England, the natural environment is not particularly conducive for wine production; but producing cloth, by comparison, is not such an impossible challenge. So while it proves cheaper to produce cloth in Portugal, the opportunity cost is such that there is more incentive for Portugal to produce excess wine in order to trade of English cloth.

The conclusion Ricardo draws is still considered to be one of the cornerstones of the doctrine of international free trade. By specialising in a good where it has comparative advantage, cross-border trade can be beneficial for both, and, indeed all nations.

Rent, profit and wages: a theory of income distribution

Ricardo’s second important contribution to the science of economics was a theory explaining how income is distributed between workers, landlords and capitalists. There are three elements to the model that Ricardo devised – a theory of rent, a theory of profits and a theory of wages. The conclusion he reached was that profits are inversely related to wages, which in turn fluctuate on account of the rise and fall of the price of food staples. As populations grow, the rents on land also increase owing to the increasing costs of producing larger quantities of food for the expanding populace. However, unlike his good friend and intellectual rival Thomas Malthus, Ricardo did not see much tendency towards unemployment. He did consider, however, that a rising population might adversely affect the incomes of workers, pushing wages down to a subsistence level.

Ricardian economics for the 21st Century?

Ricardo, along with the other classical economists, is often cited for the historical importance of their work. But do the writings of an economist who lived two centuries ago still hold relevance today? What insights can today’s policymakers draw from the theories that Ricardo is known for?

In any economics textbook today, if you come across any mention of Ricardo, a majority of them will be in reference to his theory of comparative advantage in international trade. For that reason, agricultural protectionism is likely to be the ideal starting point for any discussion of the classical economist’s ‘legacy’. Dr. Terry Peach, Professor of Economics at Manchester University, argues that Ricardo will continue to hold some relevance to economics for as long as governments continue to play politics with trade and give in to pressure for protectionist policies.

“What you’ve got from Ricardo, far more than with Smith,” he reasons, “is what amounts to an extreme free trade position. There is barely any role for government at all.” Today this position would clearly put Ricardo at odds with some current laws on the statute books – the EU’s Common Agricultural Policy (CAB) being one which immediately springs to mind. “Ricardo would find the idea of agricultural protection completely abhorrent,” Dr. Peach adds. “In his view, there should be no restrictions on trade activity – this should all be left to the market.”

We can also draw some insight from Ricardo on that perennial issue in financial markets over the past few years: sovereign debt. Again, Ricardo would almost certainly have taken a dim view of the budgetary deficits racked up by Western governments in recent history, even if some of that debt was the product of nations acting to rescue the free markets he so cherished. He was once reported to have said that the UK would be the happiest nation on earth if it only “got rid of two great evils – the national debt and the Corn Laws”. Had his advice been heeded by government, according to Dr. Peach, the past several centuries may not have been quite as bloody.

“In the case of the national debt he argued that it should be paid off in a two year period. It was astonishing,” Dr. Peach says. In a proposal that echoes some current debates within the UK’s coalition government, Ricardo suggested that the debt be paid off through the imposition of a property tax. Then, once paid off, governments should run a balanced budget and steer clear of the capital markets, particularly with regards to funding costly foreign conflicts.

“His argument was that war should always be financed out of current taxation, never by government borrowing,” explains Dr. Peach. “The logic follows that if you finance it through government borrowing, then governments would be far more likely to engage in these adventures. On the other hand, if the position was that any foreign adventure had to be financed by current taxation then there would be far more public hostility.”

Ricardo would almost certainly have had something to say on the subject of recent trends in monetary policy too. Asked what Ricardo would have thought about the Federal Reserve’s quantitative easing (QE) and recent reports about countries engaging in competitive currency devaluations, Dr. Peach is unequivocal. “Ricardo was very much in favour of independent central banks,” he says. “His last publication was promoting the idea of a national bank which he would set up in place of the Bank of England (BoE), for which he had no time for whatsoever. The commissioners of the bank would be appointed by the government, but could only be dismissed by a vote of both houses of Parliament, not on the decision of a Chancellor alone.”

Crucially, Dr. Peach says, this central bank would have one objective: control of the money supply in order to maintain price stability. “Interestingly, the last Labour government moved in that direction, but then subsequently rowed back.”

It is safe to assume that Ricardo probably wouldn’t have been much of an admirer of fiat currencies either. One could imagine the economist being rather bemused by the mounting tensions resulting from attempts by governments to manage the exchange values of their currencies to ensure export competitiveness. Would he side with the liberal clique arguing in favour of a return to the gold standard? Probably.

“His view was that exchange rates should be fixed – at that time that meant gold prices. Once that was done, he didn’t think there would be any need for further intervention adjustments because disequilibria would be resolved through price changes internally, with an attendant period of unemployment during that adjustment,” says Dr. Peach. But in his view, Ricardo was not a pessimist, as some other scholars have claimed. “His position was that these adjustments would be generally frictionless. They would occur for a very short period of time.”

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