A Tale of Two Externalities

My latest column at libertarianism.org, A Tale of Two Externalities, is now live. A slice:

The distinction between pecuniary and technical externalities is crucial. Technical externalities can be a form of market failure. Pecuniary externalities are a sign of the market working. A competitive market necessarily means that incoming firms are cutting into existing firms’ profits (or, alternatively, incoming buyers are cutting into existing buyers’ profits). Superficially, these two externalities look the same in that they both affect profits. But in their operation, they act very differently. Furthermore, the distinction between the two help us understand why properly assigned property rights are key to market functioning.

Epistemological Humility and the Status Quo Bias

In economics, law, and religion, I tend to see an argument that flows along these lines: “Long-held theory/concept is logically incoherent/contradicted by commonly-observable empirical evidence and I am the first person to notice this!” (This attitude is probably prevalent in other sciences as well, but my reading and interests bias me to the above-mentioned sciences). This attitude of dismissiveness of long-held (or “traditional”/”conventional”) theories and concepts can lead to erroneous conclusions if improperly employed. I argue that epistemological humility (being aware of other knowledge outside what you know is out there) and a status quo bias (the burden of proof lies upon he who is attempting to overturn the current theory rather than the current theory to justify itself) are necessary to advance scientific understanding.

The following is an example I use in my introductory economics exams:

Joe works at a local grocery store. On Monday, he notices that the prices of oranges are $1/lb and 50 people bought a pound of oranges each. On Friday, he noticed the prices of oranges raised to $1.50/lb and that 60 people bought a pound of oranges each. Joe exclaims: "The price of the good rose and people bought more of it! The Law of Demand must be wrong!"

Is Joe correct or incorrect in his statement?

Joe is demonstrating both a lack of deference to the status quo (in this case, the Law of Demand) and epistemological arrogance. Despite centuries of economic theory and research, economics still has downward-sloping demand curves. However, Joe himself claims, through mere observation of everyday activities, that he has enough evidence to overturn the Law of Demand.

If Joe were to practice status quo bias, upon his observation he’d ask himself: “This is a simple observation. What’s the likelihood that economists have missed this?” His bias should have him put a low probability on economics as a whole never noticing a pattern like in the grocery store.

If Joe were also practicing epistemological humility, he’d follow up with the question: “Is there some element of economic theory I am missing here? Something that could rescue the Law of Demand?”

If Joe were to do a bit more research beyond his “bumper sticker” understanding of Demand, he’d quickly realize he has made a mistake: the observation he made can easily be explained by a shift in the demand curve or the demand curve being locally upward-sloping but downward-sloping overall. He would have realized that, indeed, the Law of Demand does hold and the supposed conundrum he noticed is no conundrum at all. The longevity of the Law of Demand does not spring from the fact no one has thought about potential objections to it, but rather that these potential objections have been thought of and rejected.

Now, the status quo bias I advocate here is just that: a bias. It is a maxim, not an axiom. It can and should be overcome. Long-held beliefs are overturned, but the burden of proof is extremely high, just like the presumption of innocence (or the “innocence bias” to keep the terminology consistent) in criminal law.

But failing to defer to the theory, and even worse failing to learn the theory and proceed in ignorance is to operate under the pretense of knowledge, to use Hayek’s phrasing. And unfortunately, a lot of people who argue for nominally just conclusions make this mistake all the time, significantly weakening their own standing and the credibility of their arguments and their position. After all, “[T]he worst thing that can happen to a good cause is, not to be skillfully attacked, but to be ineptly defended."

On Faith, Religion, and Science

This post is inspired by comments former GMU and current Chapman professor of economics Vernon Smith made on Facebook. Vernon writes:

Sasha Sagan, daughter of Carl Sagan, writes here about her much-loved father who believed, without evidence, that there could be no truth for which we have no evidence.

Scientists have no observational evidence that life exists anywhere except on earth. But they believe in that prospect strong enough to equip landing devices with instruments to look for life. Surely Sagan would approve. So his statement applies strictly to religious belief, but I do not think science can be demarcated from religion so easily, or indeed at all.

Vernon is absolutely correct. An unfortunate side effect of the Enlightenment period is widespread skepticism, and often outright rejection, of faith as a viable or desirable element of the human mind. Faith is sometimes as used as a pejorative, a way to dismiss something as unrealistic or naive: faith in God, faith in government, faith in free markets, etc. These people will hold up Science, with a capital S, as an alternative to faith, as something supposedly rational, evidence-based, and Absolute in Truth and Knowledge the way faith cannot be. This Science is the pinnacle of knowledge and humanity. Thus, religion and other faith-based things are inherently inferior and can never truly be Scientific.

In extreme cases, these people practice substantial forms of self-deception and claim that they’re “evidence-based” and “require proof for everything.” Thus, they reject God because there is no “proof” of Him, or they reject freedom and liberalism (ironically products of the Enlightenment) because there is no “proof” this or that pro-liberty reform will work in this exact case.

But, as Vernon states here, the scientific process is as much faith-based as evidence-based. If we were to rely solely upon evidence, not a single penny would be spent trying to find life of Mars or elsewhere in the Universe because, after all, there is no evidence to state there is life out there. And yet the faith of these scientists and their enthusiastic admirers is so powerful as to spend billions of dollars (and, indeed, through government programs, force others to spend money as well) as to search for life. Whether or not such programs are useful or beneficial is beside the point here. The point is that they are, at least initially, faith-based.

The argument for searching for life on other planets is reasonable. (Very) simply put, it is akin to this: “There is life on Earth. Surely these conditions are repeatable. Therefore, we look for life elsewhere.” Notice this follows a similar pattern to an argument for God (again, very simply put): “This life is highly complex but seems ordered in a certain way. Surely these conditions did not happen by random chance [ignoring the fact that “random chance” is not a cause”]. Therefore, there is likely some higher being.” Again, the point here is not to judge one way or the other, but rather to show the relationship between faith and science.

I am a Christian. I proudly recite the Nicene Creed. I take Holy Communion. I believe that God is the Father, Christ the Son, and the Holy Ghost is the Spirit. I read the Church Fathers and theologians. I listen to the sermons. I meditate on the Nature of God.

I am a scientist. I proudly recite the Hippocratic Oath in my research. I attend the conferences. I believe that data analysis, solid theory, and careful reading can gain knowledge. I read the classical and modern economists. I listen to the lectures. I meditate on the nature of human action and exchange.

And, above all, I have faith that my actions are not in vain. That, like all of us, we are striving the best we can toward a better world.

Science and religion are not at odds. Like Vernon said, it’s not that obvious there is even a line between the two. We will never truly have all the evidence or “proof” we need. Part of advancing knowledge, whether temporal or spiritual, is the faith that there is more to learn out there.

This post is dedicated to Vernon Smith, who inspired it, and to my religious teachers over the course of my life: Reverend Sandy and Reverend Bob (First Congregational Church, Wareham), Val Bailey-Fisher (Chaplan, Framingham State Protestants), and Pastor Emilia Halstead (First Congregational Church, Concord NH)

Jon Murphy
Murphy on Economics

Last week, I joined Dominic Pino and Rajee Agrawal from the GMU Econ Society on their podcast Loose, Vague, and Indeterminate. You can check it out here. We discuss a number of topics including: teaching economics, the Nobel Prize, and you can hear my impression of John Nye’s impression of Ronald Coase!

Jon Murphy
Economic Relationships

Candace Smith, someone whom I have quoted in the past, has another excellent post on personal etiquette. Candace writes:

When you were young you probably got used to asking permission to do things. Parents require this to be sure their child is safe within boundaries. But children tend to push back, testing limits, when they begin to individualize.

Part of gaining the right to expand boundaries comes from a parent’s approval; hearing the word “yes.” It’s a process based on concurrence. Getting the green light feels good.

The same principle applies when asking permission to join someone in an activity, a conversation, or a project. It feels good when someone says, “Sure! Join us.”

“May I join you?” is an influential question. It is immediately friendly, but at its foundation it reflects understanding and consideration.

She then goes on to list various introductory phrases which are variations on the theme of asking permission:


“Excuse me…”

“May I help you?”

“Hi, may I ask…”

“How are you?”

What’s interesting about these phrases is they are used in both personal and commercial life. Entering into a store, we are often greeted with a phrase above. “May I help you” is exceptionally common.

As Candace notes in her post, these phrases ask permission to enter into a person’s personal space. When one enters a store, the store employee shows respect and sympathy to the customer with the phrase “may I help you?” It is a way of saying “welcome to my store. I respect your personal space but i would like to serve you if you will allow it.”

These sort of manners are vital forms of competition for producers and buyers. We tend to think of competition in purely monetary (ie price) terms, or along margins like quality of product. But striving to build a quasi-personal relationship with the consumer with such manners as Candace discusses are also vital for firms to compete with others. Competition is, to paraphrase Hayek, how we decide who will serve us best. And one such way is for a producer to signal sympathy with us with the common greeting of “may I help you?” These signals tell consumers that this firm is worthy of forming an economic relationship with.

Jon MurphyEconomic Thought
Economics versus Accounting

This past Thursday, I recorded a podcast with the GMU Econ Society. Their podcast is called “Loose, Vague, and Indeterminate.” The episode will air in a few weeks and I will post a link when it does.

One of the points I discussed in the podcast was the difference between economics and accounting. Oftentimes, the two get mixed together and accounting identities are treated as akin to economic theories, or accounting outcomes are treated as akin to economic outcomes.

One such stark example of this is the optimal tariff. The optimal tariff is an implication of the so-called Standard Trade Model where, if a country has some pricing power in the market (ie, they are a large enough part of the market that reducing the amount bought can affect world prices), then there exists a tariff which can be imposed by the domestic government that is non-zero and maximizes net economic welfare.

However, there is a key feature causing the optimal tariff to be a net economic welfare gain: it relies on not counting costs to foreigners. If the costs to foreigners are included in, then the tariff becomes just like any other tax and is net welfare reducing.

So, the results of the optimal tariff are driven by accounting decisions (what is included, what is not, and how we add them up) but not economic theory. The economics of the model do not change regardless of whether or not foreigners are included in the welfare calculation: people still face scarcity, there are trade-offs, folks respond to incentives, etc. Further, economic theory does not necessarily tell us whether foreigners should be included in the calculation or not. The responses of foreigners are included (and is why most economists treat the optimal tariff as an interesting theoretical tidbit rather than a serious policy consideration), but whether or not they should be included in the accounting is not.

Economists sometimes get caught up in the accounting. To be fair, it does serve a purpose. Welfare analysis helps test our theories, although it must be done carefully. When economics becomes about accounting, we tend to lose a lot of the economic insights and the science is reduced to mere maximizing. What James Buchanan argued was economists should keep in mind the entire universe of exchange. That economics is about human interaction. The economist focuses not just on welfare calculations or NIPA accounts, but the whole world in which these transactions and interactions take place. That is our subject matter, and keeping that focus in mind will prevent many silly economic fallacies from taking hold.

An Appeal From the New to the Old Economists

The Economic Way of Thinking (EWOT) is a very powerful tool. It sheds light on many aspects of human behavior and societal outcomes that otherwise seem obtuse or unusual. It gives us insight into institutional frameworks and behavior that helps shape our understanding of law, politics, markets, and other forms of collective action.

But EWOT is not omnipotence. Economics alone cannot inform us of what institutions should be. Economics can tell us various implications for different property right regimes, or what an effect from this tax or that tax will be. Economics can show us how people exchange in differing institutional settings. But it cannot tell us what those institutions should be.

Those folks to advocate for certain institutional arrangements because “economics says so,” are inherently practicing what Hayek called “scientism,” or the “slavish imitation of method and language of Science.” Economics cannot tell us that free trade should be adopted. It can tell us its benefits, its costs, its likely outcomes, but there is no normative judgment in that. Ultimately, some normative choices are made whenever discussing policy.

What can help us in these normative moments? Moral philosophy. If we are to discuss property rights, we need a concept of just property rights. Why should property rights be private? Economics cannot answer that question, but moral philosophy can. Why should we trade with other nations freely and benefit their workers? Economics cannot answer that question, but moral philosophy can.

To paraphrase Hayek, the man who knows only economics is a positive danger to himself and economics. By making blind appeals to models to justify various policy positions or institutional arrangements is no good. Careful considerations of why these institutions exist in the first place is absolutely necessary. We must remember that we are social scientists, and humans are moral creatures.

Let us follow in our intellectual ancestors’ footsteps: let us study moral philosophy and law and rhetoric and literature and art and jurisprudence. Let us immunize ourselves from the “man of system” mentality. let us not be mere maximizers, mere number-crunchers. Let us be scholars of the grand tapestry of life!

Jon Murphy
Today's Quote of the Day...

…is from page 2 of Vernon Smith and Bart Wilson’s 2019 book Humanomics: Moral Sentiments and the Wealth of Nations for the Twenty-First Century:

If the solidarity and love for our fellow compatriots that we do not personally know led us to forbid the importation of goods from other producers that we also do not personally know - say, like those in Asia or Europe - we would destroy the ability of markets to support specialization and thereby create wealth and human betterment. Such conflict prominently takes the form of sharp controversies over inequality in the distribution of income and wealth, and whether or to what extend wealth creation generates inequality through innovation and the subsequent distribution of its benefits.

JMM: Absolutely correct. The arguments against trade are legion, and like those demons of the Biblical story, they serve to tempt man away from a virtuous path. Trade promotes virtue among its participants. That is not to say that all people in commerce are virtuous, of course, but that markets tend to promote virtue.

Concerns about inequality and distribution of gains from trade are always around. But, as part of my dissertation discusses, and what Smith and Wilson discuss in their book, how we build relationships with those who serve us affects those distributions. This relational knowledge encourages producers to share more of the gains with us (and vice versa). We truck, barter, and exchange with those who serve us best, with those whom we trust, with those whom we have a relationship with.

When markets are disrupted, through politics or what-have-you, that ability to build that relational knowledge is disrupted. Virtuous behavior is replaced by vicious behavior, where commerce becomes not about serving your fellow man but by scoring political points or manipulation of the system in your favor.

The market system may not always be perfectly “fair” (however one wishes to define that), but the alternatives are worse.

Deadweight Loss from Tariffs are Probably Greater Than Models Predict

Yesterday, I quoted from Randy Holcombe and Russ Sobel’s paper Public Policy Toward Pecuniary Externalities. Elsewhere in the paper, they write:

In a comparative statics setting such as that developed by Bator (1958), monopolies are inefficient because they produce too little out put. In a dynamic setting, monopoly power can also result in inefficiencies because a single firm has an incentive to take account of the pecuniary externalities that innovation can have on the firm’s existing investments. Thus, the inefficiencies from monopoly are larger than the simple comparative statics model of monopoly suggests.

When government creates incentives for firms to take account of pecuniary externalities by either implicitly (via regulatory protection) or explicitly (via legal monopolies) giving them property rights in the value of their output, it gives them incentives to defend that value from said externalities. In the example quoted above, the monopolist can hold back innovation, prevent stores from opening, lobby against competition, etc.

With regard to protectionist tariffs, the situation is similar. Typically, the only deadweight loss from a tariff is the result of higher price paid and lower quantity achieved, as well as the encouragement of inefficient production techniques, by the domestic country. But those static models are incomplete for a few reasons: first, in the typical public choice framework, protectionist tariffs do not just arise out of nowhere and there are resources firms spend to lobby for protection. Secondly, and related to the point Holcombe and Sobel make above, the static model strips away the dynamic role of competition. Protectionist tariffs give domestic firms an implicit property right to the value of their output. Subsequently, this means firms could spend resources defending these values, either in the form of maintaining protectionist tariffs or in the form of preventing domestically produced pecuniary externalities.

“But wait, Jon you handsome devil,” one might object. “Did you not say that even the threat of competition can cause a firm to act in a perfectly-competitive manner? These domestic firms are still competing against one another and thus there would be no deadweight loss from protection of pecuniary externalities domestically!”

It is true that competition, either real or shadow, does cause a firm to innovate. But remember the goal of protectionist legislation is precisely to prevent such innovative competition from occurring at all. The domestic firms must be “protected” from foreign competition because it is impossible for domestic firms to meet their costs of production (for whatever reason). Thus, even then we will still get the deadweight loss because, even if domestic firms are competiting against each other, it is unlikely they will operate at the same price level that was achieved with free trade because 1) they are cut off from foreign (and potentially cheaper) sources of inputs and 2) they were unable (supposedly) to compete at that price level anyway without incurring pecuniary loss from their current position. If they were, they would not have called for the protectionist tariffs. Furthermore, if a new entrant enters the market with a cheaper production technique, given the implicit property rights awarded by the government, firms have an incentive to fight this domestic entrant. Likewise, they have interests in protecting their profits by not expanding their own production, as Sobel and Holcombe discuss. Thus, by removing (or, at least, reducing) this incentive to innovate, the deadweight loss of tariffs is likely worse than the static models predict.

Today's Quote of the Day...

…is from Randy Holcombe and Russ Sobel’s 2001 Public Finance Review paper Public Policy Toward Pecuniary Externalities:

If property rights were limited to the right to own and use property unencumbered by the interference of others, and if all scarce resources had clearly defined property rights, technological externalities would be prevented. The political process goes further by allowing individuals to assert claims not only to the use of resources they own but also to the value of those resources. Fluctuations in the value of resources are an integral part of the market process, however, and the efficiency of the market process is impaired when public policy acts to prevent pecuniary externalities. If the legal system made it clear that rights to the ownership of economic resources would be protected but rights to the value of resources would not, the problem would be reduced. However, when political decisions rely more on democratic politics than on legal rules, the opportunity to use the political system to be compensated for pecuniary externalities increases. In a political environment, rent seeking for compensation from harm due to pecuniary externalities may even have an advantage over other types of transfers, because pecuniary externalities do impose costs, increasing the apparent legitimacy of a claim for compensation.

JMM: What Holcombe and Sobel call “technical externalities” are what we currently think of externalities: pollution and things like that which affect a firm or individual’s production (they produce fewer goods with the same input). Pecuniary externalities, on the other hand, are when the value of output is reduced, but not the ability to produce, such as through competition. For example, if Burger King were to open next to McDonalds, it inflicts a pecuniary externality onto Burker King by eating (pun intended) into their profits, but there is no technical externality.

A Hayekian Walk Down Wall Street

The always enjoyable Candace Smith, Etiquette Advisor to the Stars (my description), has a great short post on the etiquette of going for a stroll. Candace’s post is full of excellent nuggets of general polite rules of walking in public. These rules are not legislation; for the most part, they are convention. People, even those new to the society, quickly pick them up and obey; to not do so would be against their self-interest. These rules developed over time and, as Candace notes, have connections to similar activities we partake in (“The general rule here in the United States: keep to the right and pass on the left, exactly as if one were driving”). These rules, in other words, emerged from human interaction with one another in out society and they exist outside those members (in other words, the rules are not just the reflection of the current members of the society but have power over newcomers as well). In that sense, they are more like laws.

But there is another aspect of Candace’s post I wish to draw attention to: namely, the unarticulated rules. Candace is articulating many of the unspoken rules of walking, but there are things she leaves out, not because of incompleteness on her part but simply because those things are inarticulatable.; they are very loose, vague, indeterminante, and subjective.

Consider her common-sense rule: “Stay mindful and off your phone as you will be moving in and out among others, gauging their movement without bumping into them or pushing up against them.” This rule is simple enough, but what it fully means is not captured in this short sentence. The actual steps needed to be taken will vary from situation to situation, from person to person, from moment to moment. No one could explain all the lightning-quick decisions made while on a walk. Don’t believe me? Try to guide someone who is blindfolded down a street only by your words (articulation). I bet it would be impossible.

These inarticulate rules still influence us despite their inarticulate nature. We try to articulate them as much as we can, like Candace, but even that is incomplete. There is so much background knowledge we need in order to make our actions coherent, to make them in concert with other people.

And that is the fundamental insight of FA Hayek.

Jon MurphyPrice Theory, Knowledge
Today's Quote of the Day...

…is from pages 79-80 of the 2016 Mercatus Center re-issue of Don Lavoie’s 1985 book National Economic Planning: What is Left?

[O]ne can argue that just as an articulated statement only carries meaning to other people because of a shared denominational background in unarticulated assumptions about the use of language, so too do articulated prices only carry meaning to those who calculate with them because of a shared background in unarticulated assumptions about the characteristics of the priced goods and services. Just as articulated statements in science constitute an indispensable aid to our advancement of a largely inarticulate understanding of the world, so too do articulated prices provide an indispensable service to our largely inarticulate production activities. But neither articulated statements nor posted prices have any meaning when divorced from their inarticulate foundations.

JMM: In the wake of any disaster, we see a great effort by many people to unmoor prices from their inarticulate foundations via price gouging legislation. But when this is done, the meaning of the price becomes skewed and sends confusing messages to those who have to deal with the price. Its meaning becomes obscure and gibberish, much like how an understanding of sunlight would become gibberish if the word was divorced from the idea of sunlight.

Prices convey information. We may not like what that information is, but pretending it does not exist is not helpful.

The Definition of Insanity...

The following is an open letter to the editor of the New York Times:

To the Editor:

Your 11 September 2019 article on a new housing bill in California proudly proclaims “California Approves Statewide Rent Control to Ease Housing Crisis.” However, the caption of the accompanying photograph tells us that the headline is incorrect, that the bill will not end ease the crisis, but rather make it worse: “San Francisco has had rent control for decades, but it has not been spared from a housing squeeze and rising homelessness.”

In your article, you allude to some of the economist objections to rent control, and the caption quoted above indicates those objections are correct. But there is very little in the article dedicated to addressing those objections. Most of the article is on the intentions of the bill, intentions that will not be realized. The fact that the California bill calls such control “price caps” does not change this fact. The fact that the California bill is not as strict as other cities’ bills does not change this fact. The fact is: California has taken steps to make the housing crisis worse. Restricting supply will not allow more supply to come to the market.

Jon Murphy

Jon MurphyPrice Theory
Morality and ECON 101

In Fall 2018, I was assigned to teach International Economic Policy (Econ 385) at George Mason University, a trade class for non-economics majors.  As a student of Adam SmithFrederic Bastiat, and Don Boudreaux, I was excited to teach this class. The miracle of the market was such an eye-opener for me as a high schooler. I could not wait to share my love of economics with students!

My enthusiasm was immediately dampened as I realized I faced many students whose mindset seemed hostile.  Extolling the virtues of trade in the standard mutual-gains manner would not fly with this crowd.  I had to find another way.

These are the opening lines to my guest post on EconLog entitled Morality and ECON 101. Do check out the whole thing.

Today's Quote of the Day...

…is from Henry Home, Lord Kames’ 1751 treatise Essays on the Principles of Morality and Natural Religion and can be found on page 87 of the 2005 Liberty Fund edition:

It is agreed on all hands, that justice is established among men for making them good citizens, or, in our author’s words, for public utility; consequently that public utility is the sole end of justice. It ought however carefully to be attended to, that in no case is it made our duty to act for the public good: we are left at liberty by the moral sense to act for the public good if we incline; but the moral sense lays us under no obligation. The good of mankind, or even of our own country, resulting from an endless variety of combined circumstances, is an object too complex and intricate to be taken under consideration by a creature so limited in capacity as man.

JMM: For Lord Kames, a duty is something that is compelled by a [natural] law. It is something heavily imbued within us that goes beyond mere approval or disapproval and can often be compelled. They are “plain and simple acts” (this quote appears later on the same page): things like obeying parents, being grateful to benefactors, not robbing or causing violence, etc. It does not entail benevolence, as these rules are (as Adam Smith would put it about 8 years later) loose and vague and what constitutes a “public good” is highly complicated. Thus our duties are simple to one another, and other virtuous acts are applauded but not compelled; what is virtuous and what is vicious can depend heavily on the situation at hand.

The Paradox of Tariffs for Free Trade

One of the myrid of excuses we’ve heard for Trump’s various trade wars is that the ultimate goal of the tariffs is to reduce/eliminate other countries’ tariffs on US goods (see, for example, here). Indeed, in The Wealth of Nations, Adam Smith mentions as a possible justification for tariffs the “recovery of a great foreign market,” although Smith just hedge on this justification (emphasis added):

The recovery of a great foreign market [from prohibitively high tariffs imposed on domestic goods] will generally more than compensate the transitory inconveniency of paying dearer during a short time for some sorts of goods…When there is no probability that any such repeal can be procured, it seems a bad method of compensating the injury done to certain classes of our people, to do another injury ourselves, not only to these classes, but to almost all the other classes of them. (WN Pg.468.39).

Where the paradox alluded to in my title arises is from this “recovery of a great foreign market.” How much benefit is the domestic nation likely to incur from such a recovery? I argue: not much.

When a nation has relatively free trade already, they don’t stand to benefit particularly much from increased free trade; the nation has already capitalized the gains from free trade. To take an example, when the US entered NAFTA, greatly reducing tariffs between the US, Mexico, and Canada, US real incomes rose only 0.1% (see Paul Krugman’s article “The Uncomfortable Truth About NAFTA”). The US was already a largely free-trade nation and there was already moves toward integration before NAFTA came about. Thus, a small increase in real income. Let’s assume a no-NAFTA world and let’s say the US were to launch a trade war with Mexico to reduce tariffs. The above analysis indicates that, for the US, costs of the trade war (ie, the higher prices paid by domestic citizens) would very quickly outpace the benefits of lower tariffs (ie, increased trade with Mexico). For Mexico, however, they would stand to gain from increased trade more than the US. They would be able to launch a longer trade war as their potential benefits are higher. Thus the paradox: the country least likely to benefit from a trade war to reduce tariffs is the country already free-trade oriented and the country most likely to benefit from a trade war to reduce tariffs is the country tariff-oriented. The free-trade country would stand to lose from the trade war.

One might object, reasonably, that in my example Mexico is relatively small, and thus a larger economy like China would be a bigger boon to the US. While that is true, I argue that it doesn’t change the analysis a whole lot. Real incomes in the US would be unlikely to increase a lot from increased trade with China because, as mentioned already, the US has already capitalized on much of the gains from free trade. US tariffs on Chinese goods are fairly low (even with Trump’s tariffs, but let’s discuss pre-trade war for now). Thus, reducing tariffs even more are unlikely to increase imports a whole lot and unlikely to reduce the prices of those imports a whole lot, thus leaving the consumers of those goods relatively unchanged. Exporters would stand to gain from reduced Chinese tariffs on their goods, but even then it is unlikely to cause a major increase in exports. Currently, US trade with China (total, so imports + exports) works out to be about 3.5% of US GDP. Imports would not likely change, but let’s assume for the sake of argument that US exports to China double if China eliminates tariffs. Total trade with China would rise to 4.3% of GDP, a gain of approximately $180 billion. These improvements, and improvements they are, are relatively small (it’s also worth noting that these numbers are a quick and dirty calculation).

For China, however, they stand to gain. By reducing tariffs, the real income of their consumers would increase dramatically as they suddenly have access to all kinds of goods cheaper. The purchasing power of their wages goes up and their standard of living increases. Their exports likely remain the same, but their imports increase, enriching the nation. Thus, though the US would still benefit from lower tariffs with China, the US’ ability to launch a trade war against China for the purposes of reducing tariffs is limited.

The short version of the above: paradoxically, the nation best equipped to win a trade war where the goal is the reduction of tariffs is the nation that is relatively protectionist. But, if the nation’s government is protectionist by design, a trade war is unlikely to get them to change that stance.

Today's Quote of the Day...

…is from Scott Sumner’s August 24th 2019 blog post at EconLog “There’s No Reason to Go Heterodox” (emphasis added):

During the 1970s, high interest rates did not seem to slow inflation. As a result, all sorts of heterodox theories of inflation were invented. Too much union power, crop failures, monopoly power, budget deficits, oil prices. And each one failed, because it was monetary policy that was driving 11% NGDP growth (1971-81), which made 8% inflation inevitable. As soon as Volcker did an orthodox tight money policy, inflation promptly came down and heterodox theories of inflation were abandoned. Heterodox macro theories are the result of bad macro policies.

JMM: Scott’s final sentence can be generalized: heterodox theories tend to be the result of bad policies. Oftentimes, people (including seasoned analysts) make the mistake of analyzing some event in a vacuum: Outcome X has occurred, standard theory does not seem to have an answer for X, therefore theory must be incorrect/incomplete. Thus, all sorts of theories come about. We’re seeing this with International Trade right now with all the various (and often competing) theories coming out of the White House.

Of course, none of this is to say that heterodox theories are necessarily bad. In a sense, all theories start out heterodox. Rather, this is to say to be careful of tossing out established theory without a darn good reason.

The Perpetual Trade War

The thing with a trade war, like any war, is you need not only a will to win, but an end-game as well. One of the things that have led to the quagmire wars of Afghanistan and Iraq is the clear lack of objectives in the wars. Thus, they become perpetual with any small excuse being used to justify ongoing operations. With no clear and obtainable goal, the war will just drag on and on until the soldiers are tired of fighting and just quit. Just like Vietnam.

Trump’s trade war lacks clear objectives; it lacks an end-game. The supposed reasons for the tariffs change on a daily, sometimes hourly, basis. One moment we’re told they’re to get more “fair” trading practices. The next, we’re told they’re for national security. Then, we’re told they’re to bring back manufacturing jobs. Then, we’re told they’re to chase jobs out of China. Then we’re told they’re to address the trade deficit. Then we’re told they’re to address IP theft.

And all that is just from the Administration! Never mind the vast ad-hoc end-games we hear from the Trumpeteers: they’re to screw over China, they’re just optimal tariffs, they’re to force a regime change in China, they’re because Europe didn’t support us in the Iraq invasion, they’re to screw over the libs, they’re just for negotiating, or my absolute favorite “You need to just shut up and trust Trump knows what is best for you as an American.”

With such disparate and often mutually exclusive, not to mention poorly-defined, goals, how can the trade war ever be won? It can only ever be perpetuated.

Today's Quote of the Day...

…comes from page 66 of “Miscellaneous Writings”, part of the Liberty Fund’s collection “The Selected Writings of Edmund Burke.” This quote in particular is from Burke’s 1795 treatise “Thoughts and Details on Scarcity”

First, then, I deny that it is in this case [of the laborer working for an employer], as in any other of necessary implication, that contracting parties should originally have had different interests. By accident it may be so undoubtedly at the outset; but then the contract is of the nature of a compromise; and compromise is founded on circumstances that suppose it in the interests of the parties to be reconciled in some medium. The principle of compromise adopted, of consequence the interests cease to be different.

JMM: One of them ore egregious mistakes people make when discussing economics is the idea that labor and management are at odds with one another, that labor is in competition with employers. But in reality, labor enhances employers (otherwise they wouldn’t be employed). Employees cooperate with employers and compete with other employees, not the other way around.

The Subtle Adam Smith

Over the past week, I was in Holland, MI attending a conference sponsored by the Liberty Fund called “Liberty and Responsibility in Adam Smith.” One topic that came up was the face that Smith will sometimes split his discussion of a topic into multiple parts, scattered throughout his book. This, of course, can make interpreting Smith difficult and can lead to some accidental cherry-picking of his writings to justify various things.

An interesting example of him splitting the discussion occurs in the Wealth of Nations. On page 83-84 of the Liberty Fund edition, Smith warns against political power of concentrated groups:

It is not, however, difficult to foresee which of the two parties must, upon all ordinary occasions, have the advantage in the dispute, and force the other into a compliance with their terms. The masters [employers], being fewer in number, can combine much more easily; and the law, besides, authorises, or at least does not prohibit their combinations, awhile it prohibits those of the workmen, We have no acts of parliament against combining to lower the price of work; but many against combining to raise it. In all such disputes the masters can hold out much longer. A landlord, a farmer, a master manufacturer, or merchant, though they did not employ a single workman, could generally live a year or two upon the stocks which they have already acquired. Many workmen could not subsist a week, few could subsist a month, and scarce any a year without employment. In the long-run the workman may be as necessary to his master as his master is to him; but the necessity is not so immediate.

From this passage, one might (reasonably) conclude that Smith would potentially support anti-trust legislation (broadly defined here to include things like trade groups which conspire to control prices of labor, such as cartels).

But Smith’s discussion doesn’t end there. He makes a very similar, but more descriptive, comment later on. On page 145, he writes (emphasis added):

People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the publick, or in some contrivance to raise prices. It is impossible indeed to prevent such meetings, by any law which either could be executed, or would be consistent with liberty and justice. But though the law cannot hinder people of the same trade from sometimes assembling together, it ought to do nothing to facilitate such assemblies; much less to render them necessary.

Notice what is going on: Smith is qualifying his statement and his discussion on page 83-84. Yes, people of the same trade will conspire against the public good. But that conspiracy does not in and of itself justify legislation against it! Indeed, such legislation would be unjust!

Smith is a very nuanced writer. He is hard to pigeonhole into pre-defined political categories. But one thing we see over and over with him is his caution on legislation. Smith certainly has a presumption of liberty and just because some event may justify a legislative response does not mean that legislative response is desirable.

For more on this, see my short piece at Adam Smith Works.