Trade Theory

A.1 The theories of trade have evolved over time. The first trade theory to be postulated was the theory of mercantilism. It originated in England in the mid-sixteenth century. The genesis of the theory was conceived in the womb of colonialism. This theory was popular during the heyday of Spanish imperialism in the New World. The basic purport of the theory of mercantilism is that the government should intervene in the economy to promote the maximization of a country’s exports and the minimization of a country’s imports. At that point of time gold and silver were the currency of trade between countries. Exporting goods led to an inflow of gold and silver in the exporting country. On the other hand if the same country were importing goods from other countries then there would be an outflow of gold and silver. The proponents of the theory of mercantilism asserted the optimization of trade surpluses. This would increase national wealth, prestige and power. Consistent with this line of thought the mercantilists advised the governments of their countries to foist tariffs and quotas on imports while subsidizing exports with the intention of accumulating as much bullion as possible. The writer Thomas Mun was one such mercantilist.
However, the mercantilist theory of trade was not without its detractors. The classical Scottish economist David Hume was one such person who did not endorse the mercantilist stance towards trade. He pointed out the loophole in the mercantilist stream of thought. He explained that if there were two countries and one country had a balance of trade surplus while the other had a balance of trade deficit then the country with the balance of trade surplus would amass gold and silver. A continuous influx of gold and silver would increase money supply in the country with the trade surplus. There would be a situation of more money chasing fewer goods and this would consequently lead to inflation in the country with the trade surplus. On the other hand in the country with the trade deficit there would be an outflow of gold and silver and this would lead to a decrease in money supply. There would be a situation of less money chasing more goods. This would lead to deflation or a persistent fall in prices. This change in relative prices would cause the country with the trade surplus to start importing goods from the country with the trade deficit because the imported goods are cheaper. Ultimately the country with the trade surplus would suffer a deteriorating balance of trade while the country with the trade deficit would enjoy an improved balance of trade until one country’s surplus and the other country’s deficit was eliminated. Therefore in the long run no country could sustain a large surplus in balance of payments.