The damage done by subsidies

From the Economist magazine comes this piece on China'a subsidies to ship building. In 2006 China enacted a “Long and Medium-Term Plan” [read subsidies to shipyards] to enlarge its shipping industry by 2015.

Yet economists’ views on subsidies have hardened over time. China’s policy provides subsidies both for the construction of ships themselves and for the building or expansion of shipyards. These interferences can distort trade, resulting in inefficient production. In deciding whether a subsidy flouts trade rules the World Trade Organisation (WTO) uses a “price gap” approach. The idea is simple: if a country is producing and selling something at a big discount to what others are charging, there is probably something fishy going on.

Price gaps provide a quick warning system, but are a poor way to judge the full extent of subsidies, according to a 2013 book by Usha and George Haley, of West Virginia University and the University of New Haven. It is a static approach, ignoring how demand for each shipyard’s differentiated products varies over time. It also fails to account for variations in efficiency. Whereas Chinese workers may be relatively cheap, large South Korean or Japanese shipyards exploit economies of scale that smaller Chinese yards cannot. The balance of all these factors, in addition to subsidies, should influence a shipyard’s costs and prices.

Recognising this, a 2014 working paper by Myrto Kalouptsidi of Princeton University provides a new way to spot subsidies and measure their impact. Using detailed quarterly data on factors like a shipyard’s age, size, capacity and staffing levels Ms Kalouptsidi estimates cost functions—the relationship between a yard’s output and its cost of production—for 192 yards across China, Japan, South Korea and Europe. By analysing data between 2001 and 2012, she can isolate the impact of China’s 2006 policy.

The results are striking. A simple price-gap approach shows that Chinese ships cost 7.3% less than rivals’. Controlling for quality differences—Chinese ships are seen as lower quality and so should be around 3.5% cheaper, even in the absence of subsidies—gives a 4% gap, hardly justification for WTO rage. But Ms Kalouptsidi’s estimates show this is just part of the story. Government help artificially lowered Chinese firms’ costs by between 15-20%. The aid will have included explicit subsidies and hidden benefits, such as tolerating losses at state-owned yards. China’s market share jumped as the policy was introduced.

As in [Adam] Smith’s day, this has shifted resources. By comparing the costs and productivity of the shipyards in her sample, Ms Kalouptsidi forecasts how the market might have developed in the absence of China’s subsidies. Her analysis points to a big resource reallocation: absent the meddling, Japan’s market share would have been around 30 percentage points higher. Since many South Korean or Japanese yards are more efficient than China’s, it means that the true cost of ship production may well have risen. Bloated by subsidy, China’s yards have turned out a surfeit of vessels, often poorly matched to customers’ demands.

The important point here is that many of the distortions introduced by government meddling are hard to find but dangerous and expensive nonetheless.