Throwing Out the Baby With the Bath Water

At Cafe Hayek, Don Boudreaux highlights a new paper by Jonathan Rothwell challenging the findings of David Autor et al that trade with China is harming American workers.  The abstract of the paper sounds interesting, but I want to focus on one point in particular (Emphasis mine):

At the community level, Autor, Dorn and Hanson (2013) find that local areas have experienced slower job and wage growth and higher unemployment because of import competition with China. Upon analyzing their data, I conclude that their results are biased by the weaker macroeconomic performance of 2000-2007 relative to the 1990s. When I analyze inter-local area economic changes — rather analyzing changes within and across areas — I fail to reject the null hypotheses that import competition has no effect on wage or employment growth, except within the manufacturing sector during the most recent period, or that it has no effect on many other outcomes, including labor force participation, intergenerational mobility, and mortality.

There’s an interesting lesson to be learned here, beyond just what Rothwell finds:

Findings can depend on how one slices the data. To wit, Autor et al find significant negative effects when the data is within or across areas and Rothwell finds significant positive effects when the data is inter-local area. We see the same in minimum wage (time series vs panel data, etc).

Any statistician can tell you that regression models can change depending on how you cut and categorize the data: different “n” can give different outcomes, different controls and dummies can give different signs, etc. We try for robustness, but it is still at the end of the day a model.

Of course, none of this is to disparage the work of Autor et al or Rothwell, or even econometrics in general (an important field, if used correctly). But we need to fully understand its limitations and our own assumptions, and be very careful before tossing out theory.

Gordon Tullock, in his 1967 paper in the Western Economic Journal, demonstrates exactly this.  Tullock begins with a conversation regarding welfare costs from monopolies and tariffs, citing recent research that finds these welfare losses are pretty minimal.  In fact, they’re so small that Tullock finds:

Judging from conversations with graduate students, a number of younger economists are in fact drawing the conclusion that tariffs and monopolies are not of much importance.  This view is now beginning to appear in the literature.

Does this mean our theory about trade and tariffs are wrong?  Does this mean tariffs can be helpful, or at least not substantially harmful?  Does this mean microeconomists spend too much time focusing on tariffs at the expense of other topics?  Or is it a measurement issue and the theory is fine?  Tullock explores this issue and finds it is a measurement issue, not a theoretical issue.  In other words, our tools not theory were incomplete.  Tullock explains in the article the need to factor in lobbying costs which do not show up in the standard welfare analysis but are nonetheless substantial (read the article for yourself to see his argument.  It’s short, 9 pages, and not technical at all).

Had Tullock not looked beyond the initial challenge to trade theory, had he (and other economists) just thrown off the theory based upon the small welfare losses, the world would be a far worse place.  As it is, his (and Jim Buchanan’s) explorations eventually lead to the field of Public Choice and provided us with a cleaner understanding on the theory of trade, tariffs, monopolies, politics, and the costs associated therefrom.

The story of Gordon Tullock in the 1960’s is why anyone should be weary of claims that theory of any kind is “mistaken” or “proven wrong” by this or that study.  We see this all the time with minimum wage.  The good economist (or scientist) will ask the question, as Tullock (and Mundell) did back in the 60’s: Is the theory invalid, or our tools?  It may be the theory is (such as with the case of geo-centrism) or our measurement tools are lacking.  In fact, we see this with regards to minimum wage: measurable job losses may be minimal, but there are many other margins firms adjust along, not all of whom are measured.  It would be mistaken to toss out the theory.

Economics is still a young science.  I suspect, as has already happened, some of our theories will be tossed out as we gain more insight and knowledge.  But we musn’t be too hasty in doing so (especially when there is political pressure to do so), lest we sacrifice knowledge for convenience and insight for what my professor Thomas Startmann calls “naive analysis.”

All Pain, No Gain

In a Facebook response to this cartoon, a Tim Moyers argues for protectionism because:

[H]e [will] get on a new bike. One that doesn’t need supplies from china. Sure there will be short term injury, but there will be long term gain.

Mr. Moyers has the situation exactly backwards.  Tariffs do not cause short-term pain and long-term gain.  They cause long-term pain for (maybe) short-term gain.  The gain are whoever keep their jobs for a little while longer and whatever company remains in business for a little longer (however, by the very virtue they need protecting, we can conclude their time will likely not be long).  In the long run, however, many more resources are poured into keeping these non-preferred firms operating: higher taxes, less resources used in more productive/valuable means, all of which in turn leads to a lower standard-of-living than what would otherwise occur.  To block or slow these innovations would lead to long-term pain in the economy.  Perhaps not enough to crash an economy (although the Smoot-Hawley Tariff didn’t do anyone any favors), but certainly enough to lower the trajectory.

Ruminations on Rationality

A key assumption in economics is the assumption of rationality on the part of economic actors.  This assumptions tends to be controversial, especially among non-economists.  However, I want to argue that the nature of the assumption has implications beyond just the economic model implications.  Implications that are applicable to all sciences, not just economics.

Let’s first begin by defining what we mean by rationality.  All rationality means is that actors move forward toward a goal based on the information they have.  Since that information is not perfect, their actions may not be perfect in achieving that goal, but generally speaking people, once they make a decision, will move purposely.  For example, a hungry person would rationally move toward trying to eat: buying food, stealing food, forging, etc.  All of these are rational actions.

What can this assumption mean beyond economic models?  I think, from a scientific point of view (or, at least, a social scientific point of view), the rationality assumption forces humility on the part of the analyst.  If we assume the actor is rational, then we look at any action he takes as purposeful, even if we ourselves wouldn’t take such an action.  In short, it forces us to ask the question “why does this outcome occur?”  It forces us to avoid, or at least question, to urge to direct another through policy or “nudges.”  If Jones takes an action, it is likely because Jones views that action as the best of the available alternatives to his best knowledge.

In the social sciences (and in this, I am including political science), i think the rationality assumption provides both awesome insight and forces humility on the part of the analyst, a valuable trait to remaining unbiased and avoiding what Hayek called “the pretense of knowledge.”

Markets Make Mistakes. That’s A Good Thing

Free markets are not perfect.  In fact, they are anything but (a topic I have spilled lots of digital ink in discussing, for example here).  Markets may end up in inefficient allocation of resources, may give rise to monopolies, or any number of other non-perfect competition outcomes.  However, the fact markets aren’t perfect, that people make mistakes, is a feature, not a bug, of markets.

When a market imperfection (or “market failure”) arises, it indicates that there is some “surplus” (that is, welfare) not being captured.  It’s being lost.  This signals a profit can be made for anyone willing to exploit this failure and correct it.  If, for example, the price of Good X is “too high” because of monopoly power, it encourages people to look for ways to enter the market to capture some of that profit.  This, in turn, brings more of Good X to the market which helps lower the price of Good X.*  The market mechanism helps fix the misallocation.

Of course, enticing others into production is not the only way the market can “heal” itself.  Relatively high prices also cause people to search or create substitutes.  A good example of this is what Mark Perry highlights at Carpe Diem: synthetic diamonds created to combat the cartel power of diamond miners. In fact, the failure or missteps of markets is a major driver of innovation!

However, the profit motive is itself not perfect.  When dealing with public goods or poorly defined property rights, the profit motive may break down.  There is a lot of discussion to be had on that topic, and thus I will avoid it for now.  Rather, I want to focus on the larger message: markets stumble, but they also have mechanisms built in to correct those stumbles.**

The market has failed.  Long live the market.

*This example assumes no government barriers protecting the monopoly.  Other barriers, such as geographical or technological, that help create a monopoly can be broken down eventually.  Government barriers, not so much.

**I’m hesitant to use this language as it may cause the reader to conclude, incorrectly, that markets are machines that can be designed.  I hope readers know markets are organic and not mechanical.

Can a Trade War Create Free Markets?

Craig Walenta’s comment on this blog post at Cafe Hayek got me thinking.  Craig says:

“Well they’re [tariffs] also a way to maybe compel a foreign country to cease its protectionist activities they’re engaging in.”

Craig makes a common (at least among some free market supporters) argument for tariffs on the grounds of promoting free markets, but I’m not quite sure it’s a likely outcome.  The reason is incentives.

Governments tend to like tariffs for multiple reasons, and among those are: 1) they’re vote-getters, 2) they generate tax revenues.  If we assume governments, like all organizations and people, are self-interested and rational, then the case for tariffs becomes obvious: it’s a relatively cheap (in terms of political effort) method of promoting one’s political power.  It is not in the interest of the government to reduce tariffs.  Reduction in tariffs would either mean an increase in other, perhaps less politically safe, taxes or cutback in spending (assuming this to be revenue neutral) and the politician himself would need to look elsewhere for votes.  When a foreign nation enacts protectionist measures against a country, it is unlikely they would respond to removing their tariffs because they face the same incentives as the host nation.  Further, the host nation has no incentive to reduce tariffs even if it “wins” the trade war.

In short, I strongly suspect an “arms race” will develop among the competing nations, one which will only lead to higher tariffs and lower standards of living.  Just as war cannot promote peace, a protectionist trade war cannot promote free markets.

Some Data on International Trade

Warning: A bit wonky

Mercantilism and protectionism have come back into vogue lately, not just in the US but across the world.  Although there is all kinds of literature out there on trade, I thought I’d add just a little of my own.  However, a disclaimer is necessary: the results I will be discussing should be taken with a grain of salt.  This analysis has not passed though any other form of review other than myself (which is why this is a blog post as opposed to academic paper).  I’ll leave you, the reader, to judge their value for yourself.

With that said, let’s get started.

The Shortcomings of Cost-Benefit Analysis

In the comments section of a previous post, Ron H and Steven make good points on Cost-Benefit Analysis (CBA).  I regret not addressing them sooner, but I have been sick with a nasty cold.  Allow me to address them now:

Steven writes:

Well, this is the problem, you can’t force anyone to accept a Kaldor-Hicks criteria. They use a measure which substantially discounts those costs, and there is not a sense in which they’re wrong in terms of economic logic.

Steven is 100% correct.  Kaldor-Hicks (the technical name for cost-benefit analysis) is a bit subjective in how these costs and benefits are measured; the assigned values of the like.  He and I, both trained economists, could both use CBA on the same problem and come out to different answers.

Steven continues:

Also,can’t this same distributional argument you make against instating the minimum wage can be used against removing it? There are losers in both situations. Pareto improvements are elusive.

This is also a good point.  Pareto improvements (that is, improvements that occur so that no one is made worse off) are elusive (or, one might say, damn-near impossible).  A CBA argument can just as easily be made to keeping minimum wage as eliminating it.

Ron H writes:

There is also a moral question here. Is it OK for third parties to decide that one person’s well being should be advanced if it means another person will lose their job?

There is a moral question, one which CBA cannot, or does attempt to, answer.  And thus why we must rely on our own facilities to answer them.  In describing one of the shortcomings of CBA, one of my professors likes to point out that, given certain conditions, the Holocaust could be a net benefit if there were more Nazis (this professor is not advocating the Holocaust but pointing out that, under a strict Kaldor-Hicks analysis, if the benefits to the Nazis were higher than the costs to the Jews, then it would be seen as a Kaldor-Hicks improvement).

These points raised by the commentators I would have brought up in this post by myself, but they beat me to it.  These shortcomings are not to be ignored, and why I stress CBA is a starting point in the conversation.  It is what we economists can contribute; it should not be the whole conversation.  We would need our ethical considerations to play into it, too.  Sometimes CBA can help inform this process (“the current FDA procedure kills 2 people for every 1 saved” for example) or may not.  But regardless, it is a good starting point.

Better Living Through Trade

Allow me to take a brief digression from my previous posts on cost-benefit analysis.

I have spent the past few days battling a rather nasty cold.  Fortunately, a number of products are available to me at a moment’s notice and at low prices to help combat this cold.  They are (in no particular order):

1. Orange juice (Florida)
2. Cold medicine (Israel)
3. Lemons (Mexico)
4. Tea (England/India)
5. Oatmeal (Canada)
6. Warm sweater (Made in Singapore with US materials)

Each of these items have helped combat the cold, either physically or mentally.  Each is available to me thanks to trade.  Absent the ability to trade for these items, my cold’s duration would be longer and more miserable.  But the cornucopia of trade provides all kinds of goods, including those which help us when we are sick.

Knowledge is Half the Battle

In my previous post, I talked about what I see as Economics’ contribution to the larger body of sciences.  But that is not the full story.  Formulating the cost-benefit analysis (henceforth in this post called “CBA”) is one thing.  Properly applying it is another.  By way of example, let’s look at some comments at a recent EconLog post:

Commentator Thaomas [sic] says (emphasis added):

But I’ve noticed that when it comes to policies people DO expect free lunches, or at least will not eat unless lunch is free. Take minimum wages. Folks point out that transferring income to low paid workers will cost some jobs (most folks think not very many, but some). Lunch is not free, but some people are willing to accept the cost.

Thaomas correctly notes that minimum wages cost jobs.  However, his mistake is his last line.  As Don Boudreaux explains (emphasis added):

You write, about minimum-wage policy, that you notice that “some people are willing to accept the cost” of lost jobs. Do you mean the people who actually lose, or who never get, jobs because of the minimum wage are among those who are “willing to accept the cost”?

…

But even for those relatively few minimum-wage proponents who admit that the minimum wage reduces job prospects for the very group of workers that it is ostensibly designed to enrich, it is not the minimum-wage proponents themselves who are “willing to accept the cost.” Instead, these proponents are willing to have others accept the cost.

Don’s last sentence is key.  Despite acknowledging CBA, Thaomas incorrectly applies it.  Those making the decision are not the ones facing the costs of their decision (if they face any at all).  Indeed, they may stand to benefit substantially (though political praise or power, for example).  This means that their own CBA is skewed positive since they face no costs but all benefits!  To them, this is a good move given the incentives they face.

But there is another group who actually faces the costs of a policy.  To them, the CBA is different and more personal.  And, dare I say, more accurate since they are the ones who bare the full responsibility for their actions.  The CBA of the policymakers leaves out a key factor: the subjective judgments of those involved.  This is key and something no policymaker can truly know (and even if they did not be able to act upon since they do not face the trade-off).

This is one of the more subtle aspects of CBA.  CBA is a powerful tool, but it can be misued or misunderstood as we see above.

No Dicipline Is An Island

Where does economics fit in within the great body of human knowledge?  What can we contribute to the other sciences, like environmental science, medicine, politics, law, philosophy, biology, chemistry, etc, that have given so much to us?  In short, why study economics at all?

Economics doesn’t exist unto itself.  While it has become a synonym for “business”, “money,” or “finance,” economics is much more than that.  Economics is a philosophy, a way of thinking.  It is a specialized lens for viewing the world.  One which can (hopefully) help other sciences in their thinking.

What can we contribute?  Cost-benefit analysis.  This may sound like we are mere accountants, but it is so much more than that.  Economists, as Don Boudreaux likes to say, make the invisible visible.  We are taught right from the get-go to look, not just at the visible and immediate benefits and costs of human actions, but at the invisible and long-term benefits and costs.  We look not just at those who have immediate consequences, but on all groups of people.  Further, this is not merely number-crunching dollars and cents.  We need to look at all consequences: emotional, psychological, financial, personal, etc.  All this helps us provide insight that other sciences can use.

The cost-benefit analysis as I described can also help answer difficult questions in other sciences.  Questions like “is there such a thing as too much safety?”  “Will this new policy be the most effective means of accomplishing a goal? (or, inversely, “will this policy accomplish said goal?”)”, “Is this outcome as bad as it appears on its face?”  and, perhaps the single biggest question, “as compared to what?”

I wish to stress that these questions are nothing more than starting points.  They are our contribution to the conversation.  Economics cannot speak to moral judgments, or even what is “preferable.”  These are often personal questions.  Economics cannot hope to answer those and it is irresponsible for an economist to pretend he can.

The economic way of thinking has already been applied to several sciences, with great results in helping us more deeply understand them.  Two of these areas are specialties here at George Mason: Law and Economics and Public Choice Theory (politics and economics).  The economic way of thinking has helped us better understand juries, drug trials, politics, property rights and the environment, etc etc.

I am biased, but economics has a lot to offer the world.