Is Government Part of the Economy?

The question posed in the title of this post is key to understanding the relationship of governmental policies to individuals and the economy.

Traditionally, governments are considered as agents outside the system (in technical terms, exogenous).  For example, the following comes from Jack Hirshleifer’s 1970 textbook Investment, Interest, and Capital (page 11):

Following the standard tradition of economic analysis…government will be treated as an agency outside the social-exchange relationship, purportedly acting in the interests of society as a whole rather than the interests of the particular social grouping who happen to constitute the government.

A lot of welfare economics, from Pigou to modern, tend to treat government the way Hirshleifer describes. It’s an impartial spectator that can, with proper knowledge, set things right. Government can just come in and, with some perfectly crafted policies, fix any “market failure.”

But one of the things Public Choice teaches us (and this goes back to Bastiat) is that government is not separate from the system, but indeed part of it (in technical terms, government is endogenous). It is populated by the same people as those who make economic decisions. Governments are populated by people, and those people have hopes, dreams, desires, senses of right and wrong, just like the rest of us. They’re self-interested (which is not the same as selfish or self-centered), just like the rest of us. They respond to incentives, just like the rest of us.  Once we incorporate this simple fact, then the expectation of government “serving the public interest” becomes problematic.  Even if we assume away the knowledge problem, to expect government to be “molded from finer clay”, so to speak, and to be able to adjust the system from afar without any impact on the government itself is the height of foolishness.

So yes, in theory, with extremely strong assumptions, one can construct a tariff or tariff system “free” from cronyism. But if we weaken those assumptions, if we take government as endogenous (internal) rather than exogenous (external), then simple welfare economics like Pigou goes right out the window.

Let the Market Process Work!

In response to this Carpe Diem blog post on steel tariffs, aiken_bob writes:

I think everyone needs to take a chill pill. I believe what Trump is doing on so many fronts is just testing the old rules to find out what really works today.
In the era of big government, both here and in the EU, there have been countless lobbyist working for the NGOs or corporate masters that have written the rules that benefit them. I have to believe that the vast majority are now outdated or just wrong.
It is pretty obvious that you can’t get congress to change every little law so enter Trump to shake things up. I really believe there is a method to his maddness.

You’ll get no argument from me that there are many, many, many rules and regulations written by lobbyists to benefit themselves.  However, if that is a problem (as both aiken_bob and I consider it to be), then Trump’s actions are just more of the same: more rule writing and more regulations written by lobbyists to benefit themselves at the expense of others.  Steel tariffs are just another line item in this ledger from Hell.

If the problem is the rules were written by lobbyists then the solution is simple: tear them up.  Unilateral free trade.  You will see very quickly what works and what doesn’t when subjected to the forces of competition.  Those that work will remain.  Those that do not will be chased out.  People will be allowed to choose what they will, act how they want, without lobbyists influencing/mandating their decisions.  As Mark Perry likes to say: competition breeds competence.  In short, let the market process work!

Today’s Quote of the Day…

…is from Page 6 of the Foundation for Economic Education’s 1996 edition of Bastiat’s classic 1850 magnum opus Economic Harmonies:

The moving parts [of economies] are men, that is, beings capable of learning, reflecting, reasoning, of making errors and of correcting them, and consequently of making the mechanism itself better or worse. They are capable of pain and pleasure, and in that respect they are not only the wheels, but the springs of the machine. They are also the motive forces, for the source of the power is in them. They are more than that, for they are the ultimate object and raison d’être of the mechanism, since in the last analysis the problems of its operation must be solved in terms of their individual pain or pleasure.

Economics has long forgotten this simple insight: economies are human.  They are made up of human actors who have their own motives.  The bundle of plans, what my GMU professor Richard Wagner likes to call “an ecology of plans”, that emerges from these trillions of interactions is what we call an “economy” or “society.”

Models are helpful for thinking about a situation, but we musn’t forget that our models are populated with people and not “representative agents.”

Trade Wars are Fought Within, Not Among, Nations

President Trump likes to talk of trade wars: with China, with Canada and Mexico, with Europe.  It doesn’t matter.  Trade wars are easy to win.  But, Mr. Trump and his enabler advisor Peter Navarro mistake who the enemy is in a trade war; it is not the foreign nation or their producers; they are, at best, collateral damage.  Rather, the enemy, the one who bears the brunt of a trade war, are the domestic consumers.

The Economist reports on a number of industry associations that oppose Trump’s tariffs on steel and aluminum.  Many of these industries are ones that were clamoring against foreign production and demanding tariffs of their own just a few months ago (eg Boeing, Ford).  If the steel and aluminum tariffs stick around, then these same companies will be put at a disadvantage.

But does the action stop there?  Absolutely not.  These same companies, seeing the bounties bestowed upon Nucor and Alcoa will, in turn, demand their own tariffs and their own subsidies (as they already have, in the case of Boeing).  Other producers will seek protection as well, further raising tariffs or subsidies.  There is no logical or natural stopping point for the trade war; indeed, all this becomes even worse if foreign nations raise their own trade barriers.  Internally, more and more calls for protection* arise and the government fights a trade war with its own people.  Every protectionist action will have a negative consequence on some other domestic actor who will have the incentive to seek his/her own protection.  What’s more, even producers not directly involved may seek some of the rents the government hands out.

Trade wars are devastating, but they are inaccurately described as being between two nations.  In reality, however, trade wars are civil wars.

*A point I should make explicit: tariffs are not the only form of protection firms might lobby for.  They may aim for tax breaks, subsidies, grants, etc.  This internal trade war can be fought even if tariffs never rise.

Trade and Production

Over at Cafe Hayek, Don Boudreaux posts a helpful thought experiment as a way of thinking about trade:

A reliable mental experiment when discussing jobs and trade or innovation is to imagine that you’re Robinson Crusoe stranded alone on a desert island.  You have to work very hard to supply yourself with the bare necessities of survival.  Would you regard yourself as being blessed or cursed if, upon awakening one morning, you discover that some friendly natives from a nearby island have deposited on your island – as a gift to you – a year’s worth of food along with a promise to annually provision you with food in this way?  Of course you would regard yourself as blessed.  It’s clear that these generous foreigners have enriched you even though they have “destroyed” the jobs that you would otherwise have performed to supply yourself with food.  You are clearly and unconditionally made richer by this job destruction.

What holds true for Crusoe who occupies an island alone holds true for, say, the 325 million of us Americans who occupy the landmass that cartographers call “the United States.”

Protectionists tend to object to this thought experiment by complaining such “presents” would destroy the nation’s productive capabilities; the nation would become dependent on these gifts and be unable to produce anything for themselves should the need arise.

However, this objection falls flat because it forgets what, exactly, these “productive capabilities” are.  They are, above all, human.  Factors of production, labor, capital, land, etc are all inert until human action is taken.  A tractor is only as good as the person behind the wheel.

Productive capabilities are never truly destroyed. Resourses shift around, and so do productive capabilities. The factors of production that once went to making food, to stick with the Crusoe example above, now go to making a raft or shelter. If the resource supply is disrupted (the friendly natives stop sending shipments), those productive capabilities are then shifted back into the production of the suddenly-scarce good.  Ultimately, it is Crusoe who is the productive capability, not his farm or fig tree.  In other words, the only way the productive capabilities of an economy could be destroyed is if the people are destroyed.

Unfair Trade and General Rules

Unfair trade has dominated the political conversation lately. Allegations that China, South Korea, Mexico, Canada, and many others are being unfair, whether they pay too low or they subsidize some industry, or their tariffs are too high, whatever, abound. These allegations justify the use of tariffs to punish the offending nation(s). Free trade, they say, cannot exist in the face of such injustice and, while it is a fine general case, exceptions must be made for these injustices to be corrected.

But do injustices that occur from a general rule justify exceptions therefrom or to even overturn the rule?

Consider the following general rule: All people in the United States, when accused of a crime, will be tried in an open court before a jury of their peers.  The ruling of that jury, barring legal issues, is final.

With that rule in mind, consider the following:

A man is accused of rape.  The evidence seems straightforward.  After a long trial, the jury retires to deliberate.  After a few days of deliberation, the jury returns a verdict of “not guilty.”  There is an uproar within the local community.  “He was clearly guilty!” they cry.  “The decision should be overturned!  The jury system failed to deliver justice!”

The natural inclination of any spectator of this situation would be to decry the jury rule.  It had clearly failed to deliver its promise.   But would overturning such a rule be in the best interests?  I think prudence and wisdom suggest “no.”  Or, at least, extreme caution.

A general rule, like trial by jury, serves a particular purpose.  By nature of its generality, it will not be perfect in all cases.  But because it is so general, it can work in most cases.  In the case of the jury process, the particular purpose of this rule is to prevent unfair prosecutions and to have evidence judged on its merits; by presenting to a lay audience, it is a test to see if it is plainly obvious that a crime has been committed.  Wisdom and prudence suggest that, since this rule has persisted so long, caution should be exercised before overturning it.  it may lead to undesired consequences (perhaps tyranny, in the case of juries).

To extend this to trade, the general rule is that people may trade with whomever they want so long as it is voluntary.  There are relatively few ways in which the state can object to trade (obviously prohibited items like drugs, prostitution, etc).  But this general rule has led to some undesirable outcomes: people have lost jobs to import competition and automation.  Some of these job losses, it is observed by some, occurred because this competition is “unfair” due to state subsidies, tax preferences, etc.  They, therefore, want to overturn the general rule (or create exceptions to it).  Tariffs, restrictions, or outright bans are often banded around as solutions.

But, again, prudence and wisdom urge caution before overturning such a rule.  Could it lead to a “slippery slope?”  Are the protections granted by the general rule worthwhile?  Would the exceptions to the general rule that are granted lead to other forms of rent-seeking, and unfair actions taken by domestic groups (eg, everyone starts clamoring for protections)?  The benefits of the general rule are obvious; the costs and consequences, not so much.

Even if we grant that the actions taken by some governments to “support” their trade position are indeed unfair, like the jury example above, creating exceptions to the general rule may achieve more mischief than good.

A final point in conclusion: none of this is to claim status or say the status quo is always and everywhere preferable.  General rules can, and should, be examined and overturned when necessary.  Rather, what this post is to do is to urge caution when it comes to overturning general rules; a willy-nilly attitude can destroy any and all respect for law and legislation.

An Open Letter to Peter Navarro

13 March 2018

Mr. Peter Navarro
White House National Trade Council
1600 Pennsylvania Ave., NW
Washington, DC  20500

Mr. Navarro:

Last week, you said to Bloomberg: “My function, really, as an economist is to try to provide the underlying analytics that confirm [President Trump’s] intuition. And his intuition is always right in these matters.”

Ignoring the fact your statement is circular in its logic, I must object to your slander of all economists everywhere.  We do not exist to confirm the intuition of the president or anyone we work for.  We do not exist to provide intellectual cover (i.e., “provide the underlying analytics”) for political decisions.  We exist to study the economy.  We exist to study human action and the market process.

Economists are not political shills.  We are scientists and scholars.  Your comments demean us all.

Regards,

Jon Murphy
Ph.D. Student, Economics
George Mason University
Fairfax, VA

The Parable of the Two Shipmasters

A prudent ship captain his crew set sail for a multi-month journey.  In port, he makes sure he has enough supplies for his crew for the entire journey and then some (just to be safe).  While underway at sea, he checks the galley and finds that about half of his food stores are spoiled because there was some unforeseen blight in the crops he bought.  The captain gathers his crew together and says: “Mates, we have a problem.  Half of our food is gone.  Unfortunately, this means I must put you all on half rations for the remainder of our voyage.”  The crew, understandably, begins to grumble.  They enjoyed their rations and now there will be half?

“But sir!” cries one young sailor, “We were used to our old rations!  The life on the ship was fun.  We had beer and bread and meat.  It gave us strength and kept morale high.  Why must we be tortured so?”

“Because,” replied the captain, “otherwise we may not have enough food to survive our journey.  We are weeks from the closest port and these stores must last.  I promise it is better to have a dearth now than a famine later.”

The crew grumbles, but they comply.  Two months later, the ship arrives at its destination with the full complement of crew who are tired but alive.

…

At the same time as the above story, a second imprudent ship captain also buys the same amount of food for his journey of the same length.  While out at sea, he also suffers the blight and loses half his stores.  He gathers the crew around and says: “Mates, half our food stores are gone.  It looks like I may have to cut rations.”

“But sir!” another young sailor objects.  “Half rations are no good!  We won’t be merry!  Our lives will be tougher.  This is no good!”

“Agreed,” said the captain.  “The happiness of my crew must come first.  We should not have to suffer inconveniences.  Rations will not be cut!”  The crew cheers.

Two months later, a ghost ship drifts into the port full of emancipated men who have not eaten in over a month.  The few that survived resorted to eating whatever they could find, including each other when necessary.

…

The above parable is adapted from Adam Smith’s Wealth of Nations, in particular, Book IV Chapter V.  In times of scarcity, prices must rise in order to encourage conservation of resources (in this case, the price acts as the ship captain rationing food).  Prices rise through the acts of speculators buying goods in periods of relative plenty and selling in times of relative scarcity (thus the maxim “buy low sell high”).  It is obvious that the higher prices cause discomfort.  People eat less or less desirable things.  But the alternative to this discomfort is famine.  If prices are not allowed to adjust for whatever reason (the ship captain who keeps rations the same), then the resource is consumed too quickly and famine can quickly set in.  The discomfort is delayed to the future, but it is repaid with heavy interest.

Are Tariffs Taxes on Consumption or Production?

Generally speaking, in economics consumption takes are less disruptive than production taxes.  Since people produce to consume, if a tax falls on production then it reduces production which in turn reduces consumption.  Conversely, if a tax falls on consumption, it can have less of a negative effect.  Tariffs are sometimes defined as a consumption tax, and thus would appear to be preferable to a tax on production like a corporate tax rate or capital gains tax.

Whether or not a tariff is preferable to corporate taxes or capital gains tax would be an empirical question, and one I am not interested in answering at this time.  Rather, I want to push back on the definition of a tariff as a consumption and not production tax.

Much of the US’ imports are of raw/intermediate/capital goods (I forget the exact statistic off the top of my head, but I believe it’s around 55-60%).  Since these are used in the production process, a tariff is necessarily a tax on production.

But what about the other 40%, the consumer goods?  Would a tariff be a tax on production here as well?  I’d argue “yes.”  This is a little counterintutive at first: why would a good imported into the US and sold to consumers without some manufacturing done to it be considered production?  Let’s take a look at the definition of production (emphasis added):

Production occurs when the physical characteristics of resources are improved.  Although we commonly think of production as changing the form of material–from ores to steel, from steel to cars or I-beams–production also includes improving the time of avalibility or location of a good.  moving water from a well into a house is productive, as are carrying coal from a mine to a furnace; tilling the soil, planting seeds, or caring for the crop; harvesting, cleaning, grading, transporting, preserving, and distributing the crop to retail stores; or advertising, wrapping, and delivering a good to the customer’s home.  (Source: Page 136)

Imports enter the US in some port (LA, New York, Boston, etc).  They then must be transported to warehouses and retail stores before they can be consumed.  Since transportation is part of production (it is improving both the time availability and location of a good), then a tariff necessarily is a production tax since the goods are used in some form of production.

Again, whether or not a tariff is preferable to other kinds of taxes is an empirical question.  The point of this post is to discuss a terminological issue.

Predatory Pricing, Tariffs, and the Second Law of Demand

Predatory pricing is a common justification for government intervention in a marker (predatory pricing is when a firm or government tries to gain monopoly power in a market by selling below cost, undercutting competitors and forcing them out, and then raising prices to a monopoly level.  For a great treatment of predatory pricing, see here).

On a recent Cafe Hayek post, Craig Walenta (friend of the blog) objected to a lack of concern vis-a-vis Chinese dumping thusly:

 Of course that which is seen, but that which is unseen are the incidental effects because this absolutely must be incorporated into your business judgment, or you’d just be a complete idiot, and you’re not going to have any sense of what the unseen is unless you actually own a business and talk to other business owners who will tell you that the general rule is that ‘if it can be done in China, EVEN IF IT CAN BE DONE HERE CHEAPER, don’t do it’ — indeed foreign and domestic favoritism clearly impacts businesses that have absolutely no relation to the favored industries in question.

Mr. Walenta’s concern is legitimate.  Why would business owners compete in a market if someone is going to undercut them?  There may be people who do not enter some industry for fear of competition.

But does that mean China can, once they receive monopoly power, can raise and keep prices high with the mere threat of undercutting prices again?  Not likely, because of the Second Law of Demand.

The Second Law of Demand is, to quote Armen Alchian and William Allen (Page 28):

[T]he longer the time allowed to adjust amount demand in response to a price change, the greater is the change in amount demanded, that is, the greater the elasticity…For example, if the price of water were doubled, consumption would immediately decrease some–but would decrease by a great deal more within a few months, after people had more economically made adjustment to their water-using equipment[.]

In other words, people initially make little adjustments to a rise in prices but the longer prices stay high, the bigger their adjustments become.  To stick with the water example, if the price of water spikes quickly, people may water their lawn less or wash their car less, but that’s about it.  If the price of water stays high, people may rip out their lawns and go for rock gardens (eg, Arizona), may shower together to save water, may move to disposable plates rather than washable dishware, etc.

To bring this back to China, if China were to gain a monopoly power and raise prices, even if they were to maintain their monopoly power with the mere threat of lower prices, it is unlikely they would succeed.  At first, they may be able to command monopoly prices, but the high price of steel will eventually force people into different areas: maybe more plastic is used for automobiles than steel.  Maybe wood and brick replace architectural steel.  Maybe some new metal alloy is created to replace steel, or there are shifts to titanium or something like that.  Maybe someone develops a super-lightweight but super-strong material that renders steel obsolete (like Kevlar for buildings).  It’s impossible to know what path things would take.  What we do know is the Law of Demand says that people will adjust, and thus it is highly improbable anyone who gains monopoly power through predatory pricing will be able to maintain monopoly profits.