Flaws of GDP when Discussing International Trade

Gross Domestic Product, better known by its acronym GDP, is frequently cited and understood by non-economists as the measurement of the economy.  But GDP is not the measure of the economy, it’s a proxy measurement for economic activity (creating a measurement for the economy is problematic because the economy is not something that can be measured in its entirety.  Its the grand sum of all human actions, some of which are measurable and observable and some of which are not).

One of the most commonly known things about GDP by non-economists is its accounting formula:

GDP=Consumption (C)+Investment (I)+Government Expenditures (G)+Net Exports (NX), with Net Exports being defined as the difference between imports and exports (Exports-Imports).

It is on this Net Exports figure I will focus the conversation as it is from whence the confusion about the effects of international trade on economic activity comes from.

Often in news reports, we will see a report along the lines of this:

US economy grows 3.0 percent in third-quarter  8:51 AM ET Fri, 27 Oct 2017 | 01:51

The U.S. economy unexpectedly maintained a brisk pace of growth in the third quarter as an increase in inventory investment and a smaller trade deficit offset a hurricane-related slowdown in consumer spending and a decline in construction.

…

Exports increased at a 2.3 percent rate in the third quarter, while imports fell at a 0.8 percent pace. That left a smaller trade deficit, leading to trade adding 0.41 percentage point to GDP growth.  (Source)

However, this reporting, which states that the trade deficit affects GDP which leads many non-economists to the conclusion that international trade and imports are bad for the economy, is incorrect.  it is based off a misunderstanding of the GDP calculations.  To explain why, we need to understand exactly what GDP is:

GDP stands for Gross Domestic Product.  “Domestic” is the key word there.  We’re focusing on consumption, investment, government expenditures, and exports of domestically produced goods.  So, why are imports in the equation at all?  Why not just simply sum all the consumptions, investment, government expenditures, and exports of domestically produced goods?  Simple: we don’t know what proportion of these components contained imports and what proportion contained domestic goods.  But we do know how many goods/services were imported.  So, we can simply subtract out the imports from the equation to give us the true GDP factor.  In other words, imports are an adjustment factor, not a component of GDP!  Without the import adjustment factor, we’d be overestimating GDP.

I think a simple numerical example will help explain:

For the sake of simplicity, assume a closed economy (no international trade) and only one type of activity, Consumption.  Thus:

GDP=C.

Since all goods are produced domestically, we can say:

GDP=Cd, where Cd stands for Consumption of domestically produced goods/services.

Assume Cd=5.

Thus: GDP = Cd, GDP = 5.

Now, assume the economy opens and only imports (that is, they have a trade deficit).  GDP is now:

GDP=C-Imports (I).  However, C = Cd+Ci, with Ci defined as consumption of imported goods.

Let’s say imports = 6.

Our GDP formula is GDP=C-I.

Rewritten: GDP = Cd+Ci-I

GDP = 5+6-6

GDP = 5.

As we can see here, once we adjust for imports (which is necessary because we’re dealing with gross domestic product), GDP does not change because of the trade deficit!  It is incorrect to say that imports reduce GDP, QED.

To be clear, there may be secondary effects imports have on GDP (say, for example, imports drive out domestic producers, which can reduce Cd, which can reduce GDP), but it is not a given that imports reduce, as I have shown here.  But even then, it is not necessarily a bad thing if GDP falls because of more imports.  GDP is a proxy, not a measurement, of economic activity and well-being.  If one is made better off by buying imported goods rather than domestic goods, then that will not show up in GDP, but it is a real gain nonetheless (for an explanation of this point, see the previous posts in this series).

Update: Here is Pierre Lemieux on this very same topic.

International Trade

The previous blog posts have discussed how trade benefits the traders.  We began with the observation that people act purposefully.  Then, we developed that observation to answer the question “why do people trade” and found that people trade because such a transaction is mutually beneficial.  That led us to a graphical representation of the question: the supply and demand diagram.  Finally, we were able to show the gains of trade that occurred.  At the end of this blog post, we touched on the claim that these gains from trade do not depend on the geographic or political location of these actors (gains from trade do not change whether the trade is inter-neighborhood, inter-town, inter-state, or inter-national).  I will now expand on that point.

Trade occurs because both parties benefit and thus gains from trade are realized.  The gains may not always be exactly perfectly realized the way they are depicted in the supply and demand model, but it is a very accurate representation of the economic gains.  Given the sheer repetition of human action and competition of buyers with buyers and sellers with sellers, gains will tend to be maximized.  If Joe values apples more highly than Sally, Jow can bid away Sally’s apples; he can offer her some kind of compensation to part with her apples.  Likewise, if Sally is competing with Brian to sell Joe apples, and Brian values his apples less than Sally (ie, he charges a lower price), then Brian can bid away Joe from Sally.  Brian views what Joe offers as more valuable than both apples, and more valuable than the value Sally puts on her apples, so there are gains from trade (apples moved from their least valued use to their more valued use).

Gains from trade hold in an international setting, too.  One of the chief objections put forth by protectionists scarcityists is that international trade is one-sided and that all the benefits accrue to just domestic consumers and foreign sellers.  Therefore, it is only the foreigners who pay the price for tariffs, and tariffs can result in a higher net benefit.  Absent some heroic assumptions, this cannot hold true.  Why?  Because of gains from trade!  If the gains to domestic producers were able to offset losses to domestic consumers, then domestic producers could simply bid away the domestic consumers from the foreign competitors.  Consider Joe, Sally, and Brian again.  Joe and Sally are both citizens of Motonia and Brian is from Hogeland.  If Joe buys apples from Brian, then Brian offers him the best deal.  However, if Sally can offer Joe a better deal, then she can simply bid away Joe’s business from Brian by willing to charge Joe a lower price.  You would get a higher net benefit by this action.  If Sally is unwilling to bid away business, then we can conclude her gains would not offset Joe’s losses, and the total surplus would shrink compared to trade with Brian.  From a net benefit perspective, international trade does not matter (nota bene: this same logic holds if we adjust the scarcityist claim and they try to make it an externality argument, that Sally’s job loss makes things a net benefit.  See the Coase Theorem).

There are other scarcityist arguments against free trade that I will not address here; they tend to be political or legal in nature, and that is beyond the scope of these blog posts.

Here ends the substance of this series on trade.  The next post will discuss trade and GDP, highlighting some of the flaws of GDP and why how it is currently understood by most non-economists is incorrect.  The following post will be a recap of all I have written.

Gains from Trade

Both parties will gain from a trade if the value to the buyer exceeds the price the seller is asking, and the price the seller receives exceeds the value he has for the good/service.

Returning to our beautifully hand-drawn graph (yup, we at a Force For Good are on the cutting edge of 19th Century technology), we can graphically show these gains from trade thus:

For every consumer price willing to be paid (as shown by the demand curve) that exceeds the price sellers are willing to receive (the supply curve) a trade is expected to occur, and the gains from these trades will be the difference between the price the consumer pays and the difference the producer receives.  The sum of all these gains is the green triangle above, what we in economics call total surplus.*  We see here what we have logically derived: trade is beneficial.

Up until now, we have been talking solely about interpersonal trade, one person trading with another.  To derive a market demand curve, that is all people trading in this market, we simply sum all the individual demand curves together (∑D) and all the supply curves together (∑S).  The logic is as follows: if one person is willing to buy one apple at $5, and a second person is willing to also buy just one apple at $5, then the market demand for apples at $5 is 2 apples.  Same with suppliers.  This summating function allows us to expand our specific conclusions derived from the past few posts to a more general claim: it doesn’t matter if the trade is inter-personal, inter-town, inter-county, or inter-state (note that externalities do not change this analysis.  See the Coase Theorem).  The conclusions are also true with the inter-national level, a topic which we will expand upon in the next blog post.

* Note that we could separate this out between consumer surplus and producer surplus, but for our purposes here, such a distinction does not matter.  It does not change the analysis one wit.

Supply & Demand

Trade is mutually beneficial.  This means that both parties benefit from the exchange; what they receive from the exchange is, in their estimation, of higher value than that which they must give up.  In economic terms, the benefits are higher than the costs.  The theory of exchange I just laid out here has two implications which help get us to the Laws of Supply and Demand: 1) there exists a price* that is sufficiently high that will induce someone to enter the market as a seller and 2) there exists a price that is sufficiently low that will induce someone to enter the market as a buyer.**  Graphically, these implications give us the old standard supply and demand diagram:

Look at the sublime beauty of this hand-drawn graph.

Now, consider what is going on with the points where Supply are valued less (that is, the price suppliers are willing to supply at is lower than the price buyers are willing to pay), say at points A and B in the above graph.  Sellers value the quantity in question at Pa and consumers value it at Pb.  Since Pb>Pa, a trade will occur (the buyer values the good/service higher than its current owner) and the gain from trade is Pb-Pa.  (Nota bene: on the right-hand side of the graph, where the value of supply is greater than the value of demand, no trade will occur).

These gains of trade will be discussed in more detail in the next blog post.

*A quick note on price: We tend to think of prices in monetary terms, but they needn’t be.  A price is just whatever it costs to acquire something.  Prices represent opportunity costs.

**For a neat proof and thorough discussion of this point, see Investment, Interest, and Capital by Jack Hirshleifer, Chapter 1, especially pages 4-15

Trade is Mutually Beneficial

Let me begin by precisely defining what I mean by trade: trade is the voluntary exchange of resources between two or more parties.  Note that we are discussing voluntary exchange.  That means involuntary exchange (eg theft, slavery, anything where at least one of the parties object) is not considered.  When we consider the definition of trade I use here, then the title of this blog post becomes a tautology.  Another condition, this time deriving from the “exchange” part of “voluntary exchange,” is that trade involves swapping resources.  With that in mind, non-exchange interactions (eg, charity) are not considered here.  None of this is to say involuntary exchange or non-exchange interactions are unimportant, just the opposite, but they are beyond the scope of this series of blog posts.

Keeping with the tautology, what does “mutually beneficial” mean?  It means that all parties involved stand to gain.  Both Smith and Jones have something the other person wants and they trade because both of them gain from that trade.  The implication here is that all parties to trade are, at all times and everywhere, both suppliers and demanders (both producers and consumers).  In a trade situation, it is impossible for one of the parties to only be a consumer or only be a producer since to trade one needs to give something up before he can get something in return (in the second-to-last section, when I discuss international trade, this distinction will become important when addressing some of the fallacies of tariffs).

Trade is mutually beneficial.  Combine that with ever-present scarcity, and it leads us to the supply and demand curves, which are covered in the next blog post.

Let’s Begin at the Beginning

Most conversations about trade begin in the middle.  The conversation revolves around international trade, about people in one nation trading with people in another.  The conversation revolves around GDP and regulations and tariffs and tribunals and all these things tangentially related to trade, but never about trade itself.  The problem with starting the conversation in the middle like this is we miss the all-important fundamentals that are developed in the beginning part of the conversation.  For economists, this gloss isn’t a problem; we’ve been trained and trained on trade.  But for presidents, politicians, pundits, and prophets, this gloss is problematic.  They do not understand the basis upon which trade is built, the logic of the argument because they miss it (I suspect this is a good amount of the reason opinions diverge so strongly between economists and the man-on-the-street on the nature of international trade).  Therefore, I offer this blog post as a humble contribution to the conversation.

Let’s begin at the beginning: Why do people act?  They act because they must feel, given the information they have at the time, that their action serves some desired end/purpose.  In other words, that action is purposeful.  Given purposeful action, why do people trade?  What causes Smith and Jones to exchange their goods with one another?  The answer is obvious (by which I mean its literal interpretation (derived from observation) as opposed to its more colloquial use of “trivial”): Both Smith and Jones benefit from this trade.  If either party did not benefit, then no trade would happen.  It is from this first principle that we must build the conversation around trade, but it is this first principle that much of the political conversation ignores.

In the coming days,  I will be posting a series of blog posts exploring trade from the first principle that trade is mutually beneficial.  The outline is as follows:

–Trade is Mutually Beneficial

–Supply and Demand

–Gains from Trade

–International Trade

–Problems with GDP

-Summing Up

Stay Tuned!

Institutional Diversity and Trade

A popular argument against free trade is that the logic of trade requires identical (or at least similar) rules/institutions between the trading parties.  Dani Rodrick recently made this argument, and you can see Don Boudreaux’s response here.  There is absolutely nothing in the logic or argument for free trade that necessitates similar institutions between the partners.  Only one thing is required: both parties benefit.

However, for both parties to benefit from trade, they must inherently be different from each other.  If the two were identical, then no trade would ever occur.  Diversity in tastes, in endowments, in incomes, even in rules, are desirable and, to differing degrees, necessary.  The idea that trading partners must be similar to one another, including in their belief structures, undermines the logic of trade.

Moving from the individual level to the national level, institutional diversity helps show actual costs and benefits of various institutions.  For example, if the whole world were as protectionist as Red China in the 1950’s, no one would know what a horrible scheme that is as the whole world would have looked like massive starvation.  Fortunately, the Chinese realized their mistake and have become rapidly more open-trade, thus leading to their huge economic gains lately, but it was the fact that institutional diversity existed that such folly was understood.  If a given national government decides not to allow peaceful trading between their citizens and another group of citizens, then their citizens are harmed and the true costs of their institutions, as well as their true benefits, are not known.

Diversity is a necessary ingredient of trade.

Today’s Quote of the Day…

…is found in a letter from Frederic Bastiat to Richard Cobden (leader of the Anti-Corn Law League) dated 8 April 1845.  The letter can be found on page 58 of the Liberty Fund’s collection of Bastiat’s correspondence, The Man and the Statesman (emphasis added):

Sir,

Since you have permitted me to write to you, I will reply to your kind letter dates 12th December last.  I have been discussing the printing of the translation [of Cobden’s speeches and pamphlets] I told you about with M. Guillaumin, a bookseller in Paris.

The book is entitled “Cobden and the League, or the Campiagn in England in Favor of Free Trade.”  I have taken the liberty of using your name for the following reasons: I could not entitle this work “The Anti-Corn Law League.”  Apart from the fact that this would have a barborous sound for French ears, it would have brought to mind a limited conception of the project. It would have presented the question as purely English, whereas it is a humanitarian one, the most notably so of all those which have brought campaigning to our century.

By presenting the issue of free trade as a humanitarian issue rather than a sectarian or nationalist issue, he demonstrates the universality of the principles of free trade.  Many opponents of free trade like to argue that free trade is conditional.  They may argue that free trade requires “transnational rule-making institutions.”  Or that trade only is good if one nation (ie the nation of the speaker) benefits.  Or that free trade needs to be “fair” (whatever that means).  But Bastiat makes no such prerequisites.  Bastiat and Cobden both argue that free trade is not an English concern, not a French concern, not an American concern, but a human concern.

The Anti-Corn Law League that Cobden was part of was founded in opposition to the Corn Laws, a series of mercantilist legislation that raised the price of food within Great Britain by restricting imports.  Given this legislation occurred at the same time as the Irish Potato Famine, the Corn Law, by artificially increasing scarcity of food, likely caused many deaths in Ireland from the famine.  The Corn Laws contributed to a humanitarian crisis.  We are seeing similar situations going on in Puerto Rico, where scarcity is increased because of the Jones Act, and Houston and Florida where scarcity is increased because of anti-price-gouging legislation.  Free trade is a humanitarian concern, not a sectarian concern.

Richard Thaler Wins Nobel Prize

University of Chicago economist Richard Thaler wins the 2017 Nobel Prize in Economics for his contributions to behavioral economics.

Personally, I am happy with this outcome.  Thaler is a very good economist whose recognition is long overdue (his sometimes co-author and frequent collaborator, Daniel Kahneman, won the Prize back in 2002).

Over at Marginal Revolution, my GMU professor Tyler Cowen has a great write up on Thaler’s work, including some areas I did not know about.

Two books of Thaler I highly recommend are The Winner’s Curse and Nudge (co-authored with Cass Sunstein, another person worth reading).  Both are fascinating, and challenging looks at the standard assumptions of economics and provides surprising insights.

Today’s Quote of the Day…

…is from page 155 of the Liberty Fund’s edition of Adam Smith’s 1759 book The Theory of Moral Sentiments (emphasis added):

In war and negotiation, therefore, the laws of justice are very seldom observed. Truth and fair dealing are almost totally disregarded. Treaties are violated; and the violation, if some advantage is gained by it, sheds scarce any dishonour upon the violator. The ambassador who dupes the minister of a foreign nation, is admired and applauded. The just man who disdains either to take or to give any advantage, but who would think it less dishonourable to give than to take one; the man who, in all private transactions, would be the most beloved and the most esteemed; in those public transactions is regarded as a fool and an idiot, who does not understand his business; and he incurs always the contempt, and sometimes even the detestation of his fellow-citizens. In war, not only what are called the laws of nations, are frequently violated, without bringing (among his own fellow-citizens, whose judgments he only regards) any considerable dishonour upon the violator; but those laws themselves are, the greater part of them, laid down with very little regard to the plainest and most obvious rules of justice. That the innocent, though they may have some connexion or dependency upon the guilty (which, perhaps, they themselves cannot help), should not, upon that account, suffer or be punished for the guilty, is one of the plainest and most obvious rules of justice. In the most unjust war, however, it is commonly the sovereign or the rulers only who are guilty. The subjects are almost always perfectly innocent. Whenever it suits the conveniency of a public enemy, however, the goods of the peaceable citizens are seized both at land and at sea; their lands are laid waste, their houses are burnt, and they themselves, if they presume to make any resistance, are murdered or led into captivity; and all this in the most perfect conformity to what are called the laws of nations.