TERMS OF TRADE AND WORLD DEMAND

1. TERMS OF TRADE AND WORLD DEMAND A THEORETICAL EXPLORATIONPRABHAT PATNAIK

2. This paper seeks to put forward the following basic argument. If we divide the world economy into two segments: the core capitalist countries and the “outlying region” or periphery, which includes all non-core countries, then a terms of trade movement against primary commodities produced by the latter has an asymmetric effect on world aggregate demand: of stimulating demand at the core and contracting it in the periphery. • This argument, namely that an adverse terms of trade movement for primary commodities stimulates aggregate demand in the core countries, is the exact opposite of Arthur Lewis’ argument that it would lower core aggregate demand due to standard “underconsumptionist” reasons.

3. Our argument can be expressed somewhat differently. In any single period where investment is given, total world investment must equal total world savings, which in turn determines the total world profits under Classical/Kaleckian savings assumptions. • The distribution of these profits between the core capitalists and those in the periphery however is determined by the terms of trade of primary commodities. (Note: we are talking not of distribution between profits and primary producer incomes, but of profits per se). • Since profits are a certain share of non-primary commodity output, this ipso facto determines such outputs in the two segments. And a shift in the terms of trade against primary commodities expands core output and contracts that of the periphery.

4. A SIMPLE MODEL • I assume that there are only two regions, the core and the periphery. The core produces, under capitalist conditions, a sophisticated manufactured good, while the periphery produces a primary commodity, entirely through petty production, and a simple manufactured good under capitalist conditions. The primary commodity is used wholly for consumption and not as an input for manufacturing. • The money wage rates of the workers in both regions and the money prices of the manufactured goods are given. • All wages are consumed; all realized incomes of petty producers, i.e. incomes obtained from sales of the primary commodity, not incomes in the form of additions to stock-holding, are also consumed; but all profits everywhere are saved. • This being a single-period model, investments in both regions, which I define as excluding additions to stock-holding of the primary commodity, are assumed to be given; government expenditures are ignored; and trade deficits are assumed to be easily financed.

5. I believe that there is evidence to show that the core has very low income elasticity of demand for the periphery’s product, and vice versa. But I express these (what I consider) “stylized facts” starkly through the assumption that in the single period in question the absolute physical magnitude of the simple manufactured good demanded in the core is fixed irrespective of the core region’s income, so that any increase in real income at the core is associated exclusively with a larger demand for core’s own output of the sophisticated manufactured good. Likewise in the periphery the demand for the sophisticated manufactured good is fixed in absolute terms irrespective of income and any variation of real income simply leads to a variation in the demand for the simple manufactured god produced by the periphery itself. I thus express “low income elasticity of demand”, starkly, as zero income elasticity of demand. • Likewise I also assume a fixed absolute demandboth in the core and in the periphery for the primary commodity. • Finally I assume that all investment expenditure, no matter where it is undertaken, is on the sophisticated manufactured good.

6. Let us denote the price of the primary commodity by p and its output by Q. Let us denote the total consumption of the primary commodity in the core capitalist countries by A and the total consumption of the primary commodity in the periphery, by the entire working population, including the petty producers themselves, by B. A and B are constants in the single period by our assumption. • Let us use the subscripts 1 an 2 respectively for the core and the peripheral economies, with respect to all variables, viz. prices, labour coefficients, money wages, investments and outputs of the manufactured goods produced in the two regions. • Let us use the symbol w for money wages, I for real investment, O for output, M for the fixed absolute physical consumption by core workers of the simple manufactured good and N for the fixed absolute physical consumption by periphery workers and petty producers of the sophisticated manufactured good.

7. We then have the following output determining equations. • O1 = I1 + I2 + N + (O1.l1.w1 - p.A – p2.M)/p1 …(i) • O2 = M + [O2.l2 w + p.(Q- ΔS) - p.B- p1.N)/p2 … (ii) • where ΔS, the addition to primary commodity stocks, is given by • ΔS = Q-A-B … (iii) • and is a function of the primary commodity price p, • ΔS = f (p), with f’<0. (iv) • These four equations determine the outputs of manufactured goods in the two regions, the addition to primary commodity stocks ΔS, and the money price of the primary commodity p, for given levels of investment and other parameters like labour coefficients, primary good output, money wages and prices of manufactured goods, and the fixed levels of manufactured goods consumption.

8. In the above the price of the primary commodity is determined from within the system: as the price of the primary commodity declines the addition to stock holding increases in anticipation of a price appreciation in the future (which is a fairly standard assumption that Keynes had introduced in the Treatise on Money). • Primary commodity price in other words clears the market not through inducing changes in consumption but through inducing changes in stock-holding. • Reducing the primary commodity price can be done in this case through influencing the function f(.): for instance in the case of oil, a decision not to curtail the output has the effect of reducing f and thereby making p lower than it would have been if the decision had been to curtail output in future.

9. Let us now see what happens when p is reduced in this manner by lowering the function f(.). From the first equation a fall in p increases the level of manufactured good output in the core economies. The mechanism for it is quite straightforward. A fall in p means that less needs to be spent in the core economy on the primary commodity, and hence more purchasing power is available for expenditure on manufactured goods, which by our assumption goes exclusively to sophisticated manufactured goods produced within the core itself. Hence the output in the core economy increases with a fall in the primary commodity price. • By contrast it is clear from equation 2 that a fall in the primary commodity price necessarily lowers the output of the manufactured good produced within the periphery itself. The reason for this again is quite straightforward: a fall in primary commodity price reduces the purchasing power in the hands of the primary producers (which, it must be remembered, include in the real world the OPEC countries as well), which, by assumption reduces the demand for the simple manufactured good produced within the periphery.

10. When the primary commodity price falls not only will there be a net contraction in the vector of physical output and employment in the peripheral economy, but its fall in real income will be even larger owing to the adverse terms of trade effect. • What is more, its trade balance will necessarily deteriorate, since its level of investment would have remained unchanged even though its domestic savings would have fallen owing to the output contraction. • The significance of this result may be questioned on the grounds that there are many primary commodities, and not just one. But the primary commodities are by and large linked to one another as substitutes, either in use or in production; hence their prices tend to move together.

11. It follows that the core countries can “pass the burden of the crisis” to primary producers of the periphery, as a way of ridding themselves of the crisis. This what old Marxist theory had suggested in the 1930s, but wrongly (in the light of the Kaleckian-Keynesian revolution). What had been wrong at that time however has some validity today. • The fall in the price of oil is a contributory factor to the revival of consumer demand in the U.S. It is however reducing the demand for a range of peripheral products. This explains the paradox that when the crisis had begun, it is the advanced capitalist countries, especially the United States, that were particularly afflicted by it, while countries like India and China appeared to have escaped its impact. But with the passage of time, while the United States appears to be coming out of it (though not the other advanced capitalist countries), countries like India and China are getting deeper into it.

12. But “passing on the burden of the crisis” is unlikely to resolve the crisis for two reasons. First, it poses a threat to the financial sector: oil derivative prices have already fallen which constitutes a threat to this sector; if the deflation gets generalized then the problems highlighted by Irving Fisher may materialize; and, continuous provision of credit to the periphery to keep up its demand for core goods is unsustainable. V •  Secondly, the fall in the output in the periphery will over time lead to a reduction in investment and hence also in demands for the sophisticated manufactured goods produced in the core economy; on the other side the mild recovery in the core economy will not immediately give rise to much of an increase in investment since substantial unutilized capacities still exist there. It follows therefore that the recovery is likely to be an evanescent one, where the effects of contraction elsewhere will drag it down once more.

13. Given the fact that the fall in oil prices has not led to any recovery in core economies outside the U.S. (partly owing to the fact that oil consumption is much less important in these economies than in the U.S.), if the U.S. recovery itself is evanescent, because the negative effects of contractions in the rest of the world are bound to be felt upon the U.S. economy sooner or later, then it seems that world capitalism is headed for a serious and prolonged crisis.

14. A deflation of course will make matters worse, but even in the absence of a deflation the crisis is likely to persist, unless the State once again begins to intervene, through fiscal measures, in demand management. But this is not as easy as it sounds, for it would require a confrontation with finance capital.