Kocherlakota on macro

An essay on the state of modern macroeconomics by Narayana R. Kocherlakota - President of the Minneapolis Fed. Kocherlakota writes

This essay describes the current state of macroeconomic modeling and its relationship to the world of policymaking. Modern macro models can be traced back to a revolution that began in the 1980s in response to a powerful critique authored by Robert Lucas (1976). The revolution has led to the use of models that share five key features:

a. They specify budget constraints for households, technologies for firms, and resource constraints for the overall economy.
b. They specify household preferences and firm objectives.
c. They assume forward-looking behavior for firms and households.
d. They include the shocks that firms and households face.
e.They are models of the entire macroeconomy.

The original modern macro models developed in the 1980s implied that there was little role for government stabilization. However, since then, there have been enormous innovations in the availability of household-level and firm-level data, in computing technology, and in theoretical reasoning. These advances mean that current models can have features that had to be excluded in the 1980s. It is common now, for example, to use models in which firms can only adjust their prices and wages infrequently. In other widely used models, firms or households are unable to fully insure against shocks, such as loss of market share or employment, and face restrictions on their abilities to borrow. Unlike the models of the 1980s, these newer models do imply that government stabilization policy can be useful. However, as I will show, the desired policies are very different from those implied by the models of the 1960s or 1970s.

As noted above, despite advances in macroeconomics, there is much left to accomplish. I highlight three particular weaknesses of current macro models. First, few, if any, models treat financial, pricing, and labor market frictions jointly. Second, even in macro models that contain financial market frictions, the treatment of banks and other financial institutions is quite crude. Finally, and most troubling, macro models are driven by patently unrealistic shocks. These deficiencies were largely—and probably rightly—ignored during the “Great Moderation” period of 1982–2007, when there were only two small recessions in the United States. The weaknesses need to be addressed in the wake of more recent events.

Finally, I turn to the policy world. The evolution of macroeconomic models had relatively little effect on policymaking until the middle part of this decade.1 At that point, many central banks began to use modern macroeconomic models with price rigidities for forecasting and policy evaluation. This step is a highly desirable one. However, as far as I am aware, no central bank is using a model in which heterogeneity among agents or firms plays a prominent role. I discuss why this omission strikes me as important.

Make of it what you will.

Finance, growth and development

In this audio from VoxEU.org Thorsten Beck of Tilburg University talks to Viv Davies about his current research in the areas of finance, growth and development - and the policy lessons for developing countries.

EconTalk last week

Ed Leamer of UCLA talks with EconTalk host Russ Roberts about the state of econometrics. He discusses his 1983 article, "Let's Take the 'Con' Out of Econometrics" and the recent interest in natural experiments as a way to improve empirical work. He also discusses the problems with the "fishing expedition" approach to empirical work. The conversation closes with Leamer's views on macroeconomics, housing, and the business cycle and how they have been received by the profession.

Unemployment solved !!!

Don Boudreaux has written an open letter to Ezra Klein of the Washington Post on the topic of productivity and employment:

Dear Mr. Klein:

You allege that when unemployment is high, a slowing of productivity growth is “good news” for the economy (“When bad economic news is good news,” May 6). The reason, according to you, is that the greater the number of workers required to produce a given amount of output – everything from a Starbucks’ latte to a Boeing 747 – the higher is the is the demand for workers.

The relationship between productivity and demand for workers isn’t this simple. (If your employer, the Washington Post, suddenly lost access to the Internet and found itself stuck with vintage 1890 printing presses, are you sure that the Post would hire more workers to compensate for its drop in productivity?) But assuming your premise to be true, why rely only upon unguided forces to reduce worker productivity? Shouldn’t government help this beneficial process along – say, by requiring that each employee drink three martinis before reporting to work?

Not only are drunk workers less productive than are sober ones, they’re also more likely to damage equipment. So mandating employee intoxication promises a helpful double-whammy during these recessionary times: employers would hire more workers to produce any given amount of output, and employers would hire more workers to repair damaged equipment. Presto! Unemployment problem solved!

Shall we drink to this proposal, Mr. Klein?

Sincerely,
Donald J. Boudreaux

I wonder why we didn't just outlaw all mechanical devices and computers. Surely this would drive down productivity and increase the need for workers. The unemployment problem would be solved in an instant. Then all we would have to do is solve the standard of living problem.

I guess we should be pleased to learn that its not just New Zealand newspapers that have crap economics written in them.

Happy birthday Friedrich Hayek

Yesterday was the birthday of Friedrich A. Hayek: born May 8, 1899.

Hayek at the London School of Economics in 1948.

Philip Booth writes in the Telegraph on why the Financial crisis shows why we should admire Freidrich Hayek.

Peter Klein at Organizations and Markets gives this set of readings for Hayek's birthday:

• Klein’s Biography of Hayek
• Hayek and Entrepreneurship
• Austrian Economics and Strategic Management
• The Use of Knowledge in Firms
• Austrian Economics and the Transaction Cost Approach
• Rothbard and Hayek
• Hayek versus Hayek

International trade doesn't affect the number of jobs: 1903 version

In an earlier posting I made the point that importing the new trains for Auckland from overseas would not affect the number of jobs in New Zealand. Now I find I am more than a hundred years late in making this point!

In the latest issue of Econ Journal Watch they reprint a anti-protectionism letter to the The Times (of London), and other papers, which appeared on 15 August 1903. The letter was signed by C.F. Bastable, A.L. Bowley, Edwin Cannan, Leonard Courtney, F.Y. Edgeworth, E.C.K. Gonner, Alfred Marshall, J.S. Nicholson, L.R. Phelps, A. Pigou, C.P. Sanger, W.R. Scott, W. Smart, and Armitage Smith, and supported after the fact by S.J. Chapman and J.H. Chapman. Now that is a serious list of heavy hitting British economists at this time.

What I find interesting is the following section of the letter:

Our convictions on this subject are opposed to certain popular opinions, with respect to which we offer the following observations:-
1. It is not true that an increase of imports involves the diminished employment of workmen in the importing country. The statement is universally rejected by those who have thought about the subject, and is completely refuted by experience.

Perhaps those at The Standard need to read a little more history.

International trade doesn't affect the number of jobs

Over at the (low) Standard a number of posters are getting very upset about the fact that Kiwirail will not, most likely, tender for local assembly of the new trains for Auckland. In particular they seem to think that buying these unit overseas will mean less jobs in New Zealand. They point out that BERL has claimed that 1200 jobs would result from building the units here. But the point to keep in mind is that trade has little effect on the total number of jobs in the economy. What it does is move jobs around, away from areas in which we don't have a comparative advantage into areas where we do. As Paul Krugman, of all people, has said

It should be possible to emphasize [...] that the level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with microeconomic policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency, not in terms of phony numbers about jobs created or lost.

and as another trade economist Douglas Irwin has put it

The claim that trade should be limited because imports destroy jobs has been around at least since the sixteenth century. And imports do indeed destroy jobs in certain industries: [...]

But just because imports destroy some jobs does not mean that trade reduces overall employment or harms the economy. [...]

Since trade both creates and destroys jobs, a frequently asked question is whether trade has any effect on overall employment. Unfortunately, attempts to quantify the overall employment effect of trade are I exercises in futility. This is because the impact of trade on the total number of jobs in an economy is best approximated as zero.

But perhaps Laura LaHaye puts it best

Of the false tenants of mercantilism that remain today, the most pernicious is the idea that imports reduce domestic employment. This argument is most often made by American automobile manufacturers in their claim for protection against Japanese imports. But the revenue that the exporter receives must be ultimately spent on American exports, either immediately or subsequently when American investments are liquidated.

Thus if the The Standard is really worried about unemployment, there are much more important issues to deal with than imports of trains, or the imports of anything else for that matter.

A talk from Esther Duflo

Here is Esther Duflo, this year's John Bates Clark medal winner, giving an overview of her work on using randomized trials to evaluate development policies.

(HT: Marginal Revolution)

EconTalk this week

Nassim Taleb, author of The Black Swan and Fooled by Randomness, talks with EconTalk host Russ Roberts about his latest thoughts on robustness, fragility, debt, insurance, uncertainty, exercise, moral hazard, knowledge, and the challenges of fame and fortune.

Robert Higgs debates James Galbraith on Obamanomics

From the Independent Institute comes this audio in which Independent Institute Senior Fellow Robert Higgs debates James Galbraith (Professor of Economics, University of Texas; son of infamous, “liberal”, Keynesian economist John Kenneth Galbraith) on Antiwar Radio regarding the folly of government bailouts for insolvent banks, creation of the Glass-Steagall Act as a means to prevent FDIC insured banks from taking excessive risks, benefits and detriments of public and private regulation and oversight, problems of regulatory capture and revolving door politics, divergent opinions on the causes of the Great Depression and efficacy of the New Deal and the arguments for and against government spending on public infrastructure.

Tax freedom day

From the New Zeland Business Roundtable comes the news that Tax Freedom Day this year is again 11 May, at least as far as the central government tax burden is concerned. Tax Freedom Day represents the notional day in the year when the average New Zealander stops working for the government and starts working for themselves. So the average New Zealander effectively spends more than one third of the year working for central government. Aren't we lucky?!!

In the UK Tax Freedom Day 2010 is May 30, so we are doing a little better than them. In the US it is April 9, a month before us.

Latest data continue to show little impact of government stimulus on GDP

John Taylor writes on his blog Economics One that

The 3.2 percent growth rate of real GDP in the first quarter (released by BEA yesterday) confirms that the recovery is looking more U-shaped than V-shaped. But it also provides further evidence that the stimulus package of 2009 has had a small contribution to the recovery. Most of the recovery has been due to investment—including inventory investment, which was positive in the first quarter after declining for all of last year—and has little to do with discretionary stimulus packages.

So thus far the stimulus package seems to be having little effect on recovery. Taylor gives two charts that show the percentage contribution of investment and government purchases to real GDP growth in the first quarter and in the preceding quarters since 2007. The charts clearly indicate that the changes in real GDP growth have been mostly due to changes in investment and little to changes in government purchases. This makes New Zealand's not doing much response to the crisis look more like a good policy.

US monetary and fiscal policy in the 1930s – and now

In this audio from VoxEU.org Price Fishback of the University of Arizona talks to Romesh Vaitilingam about whether the current US economic situation is really comparable to the Great Depression. He argues that today’s monetary policy response is heavily and positively influenced by the failures of the past – but that today’s fiscal stimulus is far stronger than in the 1930s and out of proportion to the problem.

Alcohol and adverse selection

Another positive to drinking. Drinking can be helpful if you wish to reveal that you are a trustworthy person! Jan Heufer has a paper in which he shows that drinking can help people reveal that they are trustworthy since alcohol can act as a technology to give up some control over your actions and words which makes your actions and words more credible. Thus it helps you reveal your "type", thereby helping overcoming adverse selection problems. The abstract of the paper reads:

It is argued that drug consumption, most commonly alcohol drinking, can be a technology to give up some control over one’s actions and words. It can be employed by trustworthy players to reveal their type. Similarly alcohol can function as a “social lubricant” and faciliate type revelation in conversations. It is shown that both separating and pooling equilibria can exist; as opposed to the classic results in the literature, a pooling equilibrium is still informative. Drugs which allow a gradual loss of control by appropriate doses and for which moderate consumption is not addictive are particularly suitable because the consumption can be easily observed and reciprocated and is unlikely to occur out of the social context. There is a tradeoff between the efficiency gains due to the signaling effect and the loss of productivity associated with intoxication. Long run evolutionary equilibria of the type distribution are considered. If coordination on an exclusive technology is efficient, social norms or laws can raise efficiency by legalizing only one drug.

Markets and moral hazard

In the Marsden Jacobs report on the costs and benefits of alcohol (available here and here) Marsden Jacobs write, at paragraph 58:

They do not bear the full costs because friends, families, partners and governments act to offset these costs. A rational fully informed drinker would recognise and anticipate this support when making his consumption decisions. If the subsidy from the welfare system and/or from the support of other individuals were removed, the individual would make different choices. This is a form of moral hazard since drinkers (even if perfectly informed of the costs and risks) know that they will not bear the full costs. The individual drinker does not count the cost of these subsidies since they are a benefit to him, but they are a cost elsewhere.

In a reply to this argument at Offsetting Behaviour Eric Crampton writes,

Is there any consumption - cars, movies, anything at all - for which this would not be true? Do we say that the cost of McDonald's food is not internalized because people on welfare would buy less McDonald's food if they didn't get welfare payments? Do we reckon that Corvettes are horrible things because men in their late 40s buy them and impose those costs on their families? This is ludicrous.

and further writes,

On cost shifting to family and friends, I can't help but wonder whether their argument proves too much: all kinds of consumption decisions we make have effects on friends and family. I may spend too many late nights reading shonky alcohol policy reports and be grumbly the next day; if I had to bear all of the costs thereby imposed on my family, I might do less of that. But, of course, families have ways of internalising those effects: my wife rightly ensures as much.

Even if we accept the Marsden Jacobs argument that there is a moral hazard problem here we still have to ask what is the best way of dealing with it? We know from other examples of moral hazard that markets can, and do, deal with the problem better than the government does. Insurance companies, for example, deal with moral hazard via things like excesses or no claim bonuses. Most research shows that asymmetric information isn't a big problem for most markets. We can buy insurance or a good used car so the asymmetric information problems have to have been dealt with, at least, to a degree which allows the market to function. So why would government action be better in this alcohol related case?

As Eric notes Mrs C can internalise any costs that Eric imposes on his family from spending too many late nights reading shonky alcohol policy reports and being grumpy the next day and his friends at work can also take action to deal with the problem. What I don't see is how the government could do any better. Would a tax on alcohol reports really better than the actions of Mrs C and Eric's workmates?

The question that the Marsden Jacobs argument raises is that even if we accept the reasoning, is government action really the best way of dealing with the problem? Many would have doubts that it is.

Olympic Games have no long-term impact on employment

We are told about all the great things that having big sporting event in our country will so for us, but is any of it true? This posting comes from the Economic Logic blog:

Is it worth holding mega-event like Olympic Games? Repeatedly, they turn into a financial fiasco, yet new organizers keep believing they can pull it off. Usually, they manage to obtain some public guarantees or even financing on the grounds that such an event and the infrastructure will kick-start an economy and encourage tourism beyond the event.

Arne Feddersen and Wolfgang Maennig show that these beliefs are wrong, at least for the 1996 Olympic Games in Atlanta. They concentrate on the impact of these games on employment, and using monthly data they cannot find any impact in any sector, except for the sectors directly affected by the event, and only for the duration of the Games: retail trade, accommodation and food services, arts, entertainment, and recreation.

Now if only the organisers of events like the Rugby World Cup and the government could understand this point, it would save the taxpayers a lot of money.

Three weeks of EconTalk

Paul Romer of Stanford University talks with EconTalk host Russ Roberts about charter cities, Romer's idea for helping the poorest of the poor around the world. Romer envisions a city where the rules about property and safety and contract and so on are rules that allow individuals to flourish in an urban setting in contrast to the cities they live in now where so many aspects of economic and personal life are dysfunctional. Charter cities would be havens for the world's poor and could be created on uninhabited land in either rich or poor countries. This concept raises many difficult practical questions--some of them are discussed here along with how Romer came to be interested in creating the concept and how he hopes to bring it to reality.

Mike Munger of Duke University talks with EconTalk host Russ Roberts about the world of profit, money, love, gifts, and incentives. What motivates people, self-interest or altruism? Both obviously. But how do these forces interact with each other? Does relying on one always provide a stronger incentive than the other? Do charities, for-profit businesses or government agencies do a better job providing a good or service? Munger and Roberts have a wide-ranging discussion across these issues including a section where they discuss whether Christmas gift-giving and gift-giving in general is inefficient.

Diane Ravitch of NYU talks with EconTalk host Russ Roberts about the ideas in her new book, The Death and Life of the Great American School System: How Testing and Choice Are Undermining Education. Ravitch argues that the two most popular education reform movements, accountability and choice, have had unintended consequences that have done great harm to the current generation of students. She argues that the accountability and testing provisions in legislation like No Child Left Behind and similar reforms have actually corrupted the testing process, taken time away from subjects other than math and reading, and failed even to boost success in math and reading. She argues that the empirical record has provided little evidence that school choice as it has been implemented has boosted achievement. The discussion closes with a discussion of what reforms might indeed make a difference.

Banking panics and banking reform

From VoxEU.org comes this audio in which Michael Bordo of Rutgers University compares US banking panics in the early 1930s with panics in the shadow banking system and the repo market in 2007 and in investment banks and the universal banking system after Lehman failed. He argues that the bailouts of ‘too big to fail’ banks may lead to future crises, and discusses possible remedies.

The use of aggregates

In the previous post the following point is made about the use of aggregates in economics:

The “aggregates” of the mainstream economists are merely statistical totals. But one total does not affect another: what actually drives things is the specific actions of the individuals who face the specific choices. [...] Statistical formulae tell us nothing.

I'm not sure this is a uniquely Misesian idea. In work I'm currently involved in I say about whether or not we can know if we are in a "knowledge" or "new" economy:

However while this macro level [productivity] data can tell us that something has changed, it can not tell us what changed and why. The productivity data is the aggregated result of changes at the micro level, in this case at the level of the firm. Such changes require a microeconomic explanation.

So I'm not convinced that mainstream economists are as unaware of the uses and limitations of aggregates as the first quote would suggest. Also aggregates can tell us somethings. In my example the aggregate productivity data shows that for the US there was an increase in productivity post 1995. This alerts us that we need to go looking for a micro explanation of what caused this jump.

Ludwig von Mises – A Primer

A new book by Eamonn Butler from the IEA.

Mises brought new life and insights into the Austrian School of economics, and cultivated many of the leading Austrians today. He developed and systematised the Austrian view that, to understand economics, we must trace it back to the actions and motives of individuals as they make choices. The “aggregates” of the mainstream economists are merely statistical totals. But one total does not affect another: what actually drives things is the specific actions of the individuals who face the specific choices. Different people react differently to events – and the same person may react differently to the same choice at different times. Statistical formulae tell us nothing. To understand economics, we have to understand human values.

Mises applied this insight to a particularly important economic phenomenon, namely money. It is not some lifeless medium of exchange, nor even some objective measure of value, he insisted. It is an economic good like any other – the more of it that people value what it does for them (facilitating exchange), the more they demand (to keep in their wallets or bank accounts), and so the more its price (what we call its purchasing power) rises. Again, the behaviour of money is not mechanical but depends entirely on how individuals value it.

From there, Mises (along with Hayek) explained that booms and busts, like the crash we have just suffered, stem from governments and banks creating too much money and too cheap credit. That makes people feel wealthier and they spend more freely. Encouraged by this and by low interest rates, entrepreneurs invest more in new plant and equipment. But when the money and credit boom subsides, reality reasserts itself, and those investments are exposed as over-optimistic malinvestments that cannot be sustained. Factories are closed, plant scrapped, and workers fired. Only strict limits on the creation of money – such as a gold standard – can prevent such monetary booms and their inevitable, real, human consequences.

Mises also exposed the fact that socialism had no rational way of working out what to invest in, making malinvestment inherent in its system. Under socialism, the means of production are collectively owned, so never bought and sold. There is therefore no way to price them. We cannot know which of the millions of possible production processes are the cheapest – and effort and resources are wasted. The market economy, by contrast, places producers under daily pressure to deliver the highest-valued outputs for the cheapest feasible mix of inputs.

Ludwig von Mises – A Primer can be purchased here and downloaded here. While you are buying this book you should also purchase a copy of another Eamonn Butler book, Adam Smith - A Primer. Both well worth the money.

George Selgin interview

An interesting interview with George Selgin at the Daily Bell. Selgin is very interesting when discussing free banking:

Daily Bell: Can you please compare Austrian economics and free banking.

George Selgin: I suppose that all self-styled Austrian economists favor "free" banking, understood to mean banking with no special government regulations or barriers to entry. However [free-market Austrian economist] Murray Rothbard believed, and his followers continue to believe, that in the absence of special government interference all banks would hold 100-percent reserves – presumably of gold or silver coin or bullion –against any of their notes or deposit balances redeemable on demand.

Daily Bell: You don't hold that view?

George Selgin: Larry and I and other non-Rothbardian students of "free banking" generally take for granted that unrestrained market forces would favor "fractional" reserve banking. The disagreement has given rise to numerous articles from both sides. As these are readily available there's no point in my trying to summarize them.

Daily Bell: It's been a passionate debate because Murray Rothbard has proven a very powerful force in Austrian economics, especially in the US.

George Selgin: I am always shocked when I read some Rothbardian assertion to the effect that "if we had real freedom in banking, banks would be forced to hold 100 percent reserves, or something close to that," as if the question were entirely hypothetical and there was no empirical evidence to draw upon. In fact, there have been many past episodes of free banking, or of banking that was approximately free, and every one of them refutes the claim in question.

Daily Bell: That brings us to Scottish free banking.

George Selgin: In the Scottish free banking system, which flourished from roughly the mid 18th century to the mid-19th, banks often held gold reserves equal to less than 2 percent of their combined notes and demand deposits. Yet the system performed very well, with what were (in comparison to other arrangements both then and since) very meager banknote and deposit-holder losses. The Scottish people were in fact so trusting of their banks that they considered it a nuisance to be handed a gold coin rather than a Scottish banknote.

I must confess that I have never understood why free banking shouldn't be "fractional" reserve banking. As long as people know what the bank is doing and are ok with that, I don't see why "fractional" reserve banking couldn't be the result of free banking.

Debating the merits and morality of trade

Don Boudreaux at the Cafe Hayek blog notes that,

The eloquent, wise, and well-informed Scott Lincicome debates free trade with Ian Fletcher of the US Business and Industry Council). Very much worth the read.

Begin here.

Then go here.

And then here.

Is "unpaid" below the minimum wage?

This question is asked by Greg Mankiw on his blog. Mankiw points us to an article in the New York Times for discussion. Apparently, some government regulators think unpaid internships might violate minimum-wage laws. Mankiw also notes that the internship as the Council of Economic Advisers is unpaid! The CEA provides the US President with economic analysis and advice on the development and implementation of a wide range of domestic and international economic policy issues.

Why take an unpaid internship? The fun of it? May be, if you enjoy the work. But if it increases your human capital then it could make economic sense as well. An increase in human capital leads to better and more highly paid jobs in the future and so can increase the discounted value of your lifetime income stream.

EconTalk this week

Yochai Benkler of Harvard University talks to EconTalk host Russ Roberts about net neutrality, access to the internet, and innovation. Benkler argues in favor of net neutrality and government support of broadband access. He is skeptical of the virtues of new technology (such as the iPad) fearing that they will lead to less innovation. The conversation closes with a discussion of commons-based peer production--open source software and Wikipedia.

Repugnant transactions in New Zealand

Al Roth at his Market Design blog has a posting on Repugnant transactions in New Zealand: Easter Sunday sales. He quotes from the NZ Herald:

"The number of shops found to be trading illegally over the Easter weekend appears to be similar to last year, the Department of Labour says. The Department will consider the prosecution of 38 retailers after 19 were caught trading on Good Friday and another 19 on Easter Sunday.

"The issue of Easter trading hours remained a contentious issue this year, with business owners calling for more clarity on the laws. Auckland business advocate Cameron Brewer, who was lobbying this year for changes to the law, said "confusion reigned high" as some towns were banned from trading while others were not. Licensed premises, cafes, gardening and hardware stores were also a problem, he said. "Cafes can open if they have ready-to-eat food, but what is ready-to-eat food? More and more hardware stores, most of which have big gardening departments, are opening and facing $1000 fines, even though gardening shops can legally open on Easter Sunday. "This weekend there has been more confusion and frustration than ever before around Easter trading laws. It can't go on any longer."

Personally I don't find Easter trading at all repugnant, in fact I'm all in favour of it. I wonder just how many people really do find Easter trading repugnant. Perhaps we should do a comparison of the number of people who went to church over Easter versus the number of people who went shopping over Easter. The obvious solution is just let any business who wants to trade over Easter do so. Or do the Churches just not like competition when it comes to what people can do with their time.

The effect of lottery prizes on physical and mental health

In this audio from VoxEU.org Andrew Clark of the Paris School of Economics talks to Romesh Vaitilingam about his research on the relationship between income and health, which examines changes in the health and health behaviours (smoking and drinking) of British people who win prizes in the national lottery.

And for what its worth, if you win money on lottery you smoke and drink more! Just don't tell the health fascists, they will want to do away with lotteries.

Leaky homes and taxes

Recently both Matt Nolan and myself got irritated about this report of a comment made by North Shore City Mayor Andrew Williams with regard to government tax revenues from leaky buildings repairs,

Williams said the report showed that the Government's contribution to a rescue package should be at least 25 per cent because the tax receipts would make it cost-neutral.

Williams made this comment based on a report by economic consultants Covec which stated that about 25 per cent of spending on leaky building repairs would go back to the Government in tax revenue. I now see that the Covec website has the following statement on it:

Following work we carried out recently regarding leaky buildings, some comments have been made in the media which, unfortunately, have not accurately characterised our analysis. Consequently, we have provided the report below along with the following clarifications:

* Tax receipts from leaky building repairs should not be considered additional ‘windfall’ revenue. In the absence of spending on leaky buildings, the Govt would have collected revenue from other spending.
* The fact that the Govt obtains 25% tax revenue from spending on leaky building repairs does not provide an economic justification for the Govt to fund repairs to the tune of 25%, or any other amount. (Emphasis added.)
* However, there is a strong policy rationale for some form of Govt involvement. Although the costs of repairs has been estimated at approximately $8bn, the total economic cost of this problem, including dispute costs (e.g. legal expenses, expert witnesses, court time) has been estimated at $11.3bn. Consequently, without effective Govt intervention, the country could end up incurring $11.3bn in costs to fix an $8bn problem.
* From an economic perspective, the extent to which the Govt intervenes should be based on a full cost-benefit analysis, where the costs of intervention (i.e. costs of Govt funding) are compared to the benefits, which include avoided dispute costs and public health benefits of quicker repairs.

Well done Covec for correcting misinformation about their work.

The broken window fallacy

Tom Palmer and Austin Petersen from the Atlas Economic Research Foundation have put together a nice, short video looking at Bastiat's Broken Window Fallacy by asking why people think natural disasters are good for the economy.



(HT: Coordination Problem)

Academic writing in one lesson

I have had a copy of this cartoon on my door for years:

April fools posting from Aid Watch

Laura Freschi and William Easterly at Aid Watch put up the following post on April 1st:

IRINA News, April 1, 2010

Geneva, Switzerland—A coalition of aid agencies meeting in Geneva today announced a historic agreement to reform the international aid system. In signing the agreement, heads of aid agencies formally committed to accept the verdicts of independent evaluators of the programs and projects in their portfolios.

The new measures require the 39 multilateral and bilateral aid agencies to scale up only those programs with a proven track record of success. Programs shown by independent evaluation to have no impact—or a negative impact—on their intended beneficiaries will not be funded.

“An international agreement of this type is long past due,” said Mr. Poshtoff Van der Peet, the spokesperson for the coalition. “We believe this is a major step towards making sure our aid monies are spent in such a way that they actually reach the poor. Some of use may even have to go out of business, but this is a price well worth paying to make sure aid reaches the poor.”

We were very glad to see this story on the wires today. Because of this breakthrough, Aid Watch blog will discontinue operations itself effective immediately. Laura Freschi and William Easterly will shift to doing research on the fundamental determinants of long run prosperity, leaving the commentary on aid in the safe hands of independent evaluators.

I guess the Pope has become an atheist as well.

Reminder: 2010 Condliffe Memorial Lecture

2010 Condliffe Memorial Lecture

by Professor Charles Plott

Tuesday, 13 April, 5:30 - 6:30pm

Coppertop, Commerce Building, University of Canterbury.

The lecture outlines the development and use of laboratory methods, including the key discoveries and applications. The early science focused on the basic laws of supply and demand and how they operate to create a process of price discovery.The science evolved to include how information is transmitted through prices and the possibility of bubbles and market instability. More recent evolution finds the research focused on the design of competitive institutions to solve complex resource and environmental problems. The lecture focuses on the nature of the discoveries and how they are known through the application of laboratory experimental methods.

RSVP: Please RSVP, by Friday 9th April, for this event by contacting: Glenda.Lorimer@canterbury.ac.nz.

Cameras in taxis: why regulate? (updated)

I have written on this idea before when I pointed out How not to organise an industry. At that time the issue was that the Government was looking at forcing taxi companies to install cameras or screens in cars. It turns out that its cameras. I said in the previous post,

Why does Joyce think the government has to mandate anything? If the taxi drivers want extra safety equipment do they not have all the incentive they need to install it? After all it is the taxi driver's lives that are at risk, that would seem like the best possible incentive to attend to safety measures.

And I still say that. Matt Nolan at the TVHE blog takes a similar line. Eric Crampton claims its just an anti competition measure. May be, but show me who is being kept out of the market. Is the cost of a camera really so high that it will keep people out of the market? Don't see it myself.

More likely the taxi federation is just trying to score brownie points with the government so that when the federation wants something in the future the government will play ball. Either that or both the government and the taxi federation are working on "we must do something about this problems, this is something, lets do it" type logic.

Update: Not PC on Nanny Joyce on camera.

EconTalk this week

Arthur De Vany, of the University of California, Irvine, and creator of Evolutionary Fitness, talks with EconTalk host Russ Roberts about performance-enhancing drugs in baseball and Evolutionary Fitness, De Vany's ideas about diet and fitness. In the first part of the conversation, De Vany argues that there is little physiological or statistical evidence that steroid use increases home run totals in baseball. The second part of the conversation turns to De Vany's theories of diet and exercise. De Vany argues that our diet and exercise regime should take account of our evolutionary origins, an earlier time when we ate no grains and our exercise was a mix of intense activity punctuated by much milder activity. He argues that jogging is unhealthy and that we would live longer and feel better if we followed a different exercise routine than most Americans do today.

I'm with Matt on this one ... 2

At the TVHE blog Matt Nolan writes with reference to "foreign investment":

Think of it this way. There are private individuals that happen to be New Zealanders that own things. There are private individuals that happen not to be New Zealanders that would like to buy these things, and guess what – they value them more highly than the New Zealanders do. So they trade.

And what is wrong with that I would ask. Trade benefits both the buyer and the seller so why would we want to prevent people voluntarily trading? I can see no good economic reason for stopping foreign investment in New Zealand. And if there is such a reason wouldn't the same logic apply to New Zealanders investing overseas? If we want to stop people investing here do we also not have to stop New Zealanders investing overseas?

Robert Higgs interview

From Antiwar Radio comes this audio interview with Robert Higgs, Senior Fellow at the Independent Institute, editor of the Independent Review and author of Depression, War and Cold War. Scott Horton and Higgs discuss the many factors working against a “V” shaped economic recovery, mainstream economists who don’t account for the malinvestment of government stimulus funds, shortsighted economic planning that is focused on election cycles instead of the business cycle, huge bank reserves that could cause inflation if ever lent out and why specific economic predictions are incredibly difficult to get right.

Gary Becker interview

In the Wall Street Journal, Peter Robinson reports on an interview with Gary Becker. Robinson writes,

"No, no. Not at all."

So says Gary Becker when asked if the financial collapse, the worst recession in a quarter of a century, and the rise of an administration intent on expanding the federal government have prompted him to reconsider his commitment to free markets.

When asked about the recent health care bill in the US Becker says,

I begin with the obvious question. "The health-care legislation? It's a bad bill," Mr. Becker replies. "Health care in the United States is pretty good, but it does have a number of weaknesses. This bill doesn't address them. It adds taxation and regulation. It's going to increase health costs—not contain them."

Drafting a good bill would have been easy, he continues. Health savings accounts could have been expanded. Consumers could have been permitted to purchase insurance across state lines, which would have increased competition among insurers. The tax deductibility of health-care spending could have been extended from employers to individuals, giving the same tax treatment to all consumers. And incentives could have been put in place to prompt consumers to pay a larger portion of their health-care costs out of their own pockets.

"Here in the United States," Mr. Becker says, "we spend about 17% of our GDP on health care, but out-of-pocket expenses make up only about 12% of total health-care spending. In Switzerland, where they spend only 11% of GDP on health care, their out-of-pocket expenses equal about 31% of total spending. The difference between 12% and 31% is huge. Once people begin spending substantial sums from their own pockets, they become willing to shop around. Ordinary market incentives begin to operate. A good bill would have encouraged that."

On markets Robinson writes,

Capitalism has produced the highest standard of living in history, and yet markets are hard to appreciate? Mr. Becker explains: "People tend to impute good motives to government. And if you assume that government officials are well meaning, then you also tend to assume that government officials always act on behalf of the greater good. People understand that entrepreneurs and investors by contrast just try to make money, not act on behalf of the greater good. And they have trouble seeing how this pursuit of profits can lift the general standard of living. The idea is too counterintuitive. So we're always up against a kind of in-built suspicion of markets. There's always a temptation to believe that markets succeed by looting the unfortunate."

Becker is right, that markets can, and do, increase the general standard of living is counterintuitive, but its also right. It needs to be explained a lot more often.

Robinson ends his article by writing,

"But when Milton [Friedman] was starting out," he continues, "people really believed a state-run economy was the most efficient way of promoting growth. Today nobody believes that, except maybe in North Korea. You go to China, India, Brazil, Argentina, Mexico, even Western Europe. Most of the economists under 50 have a free-market orientation. Now, there are differences of emphasis and opinion among them. But they're oriented toward the markets. That's a very, very important intellectual victory. Will this victory have an effect on policy? Yes. It already has. And in years to come, I believe it will have an even greater impact."

The sky outside his window has begun to darken. Mr. Becker stands, places some papers into his briefcase, then puts on a tweed jacket and cap. "When I think of my children and grandchildren," he says, "yes, they'll have to fight. Liberty can't be had on the cheap. But it's not a hopeless fight. It's not a hopeless fight by any means. I remain basically an optimist."

Repugnant market or not?

One man's repugnant market is another man's employment market. This from Al Roth at the Market Design blog on China's theme park of dwarves.

Quotes reflecting opposing views of repugnance:

“I think it is horrible,” said Gary Arnold, the spokesman for Little People of America Inc., a dwarfism support group based in California. “What is the difference between it and a zoo?” Even the term “dwarf” is offensive to some; his organization prefers “person of short stature.”

"But there is another view, and Mr. Chen and some of his short-statured workers present it forcefully. One hundred permanently employed dwarfs, they contend, is better than 100 dwarfs scrounging for odd jobs. They insist that the audiences who see the dwarfs sing, dance and perform comic routines leave impressed by their skills and courage."

I just wonder why Mr Arnold in America thinks he has the right to tell Mr Chen in China how to make a living.

Equality shoes

From Alex Tabarrok at Marginal Revolution:

2010 Condliffe Memorial Lecture

2010 Condliffe Memorial Lecture

by Professor Charles Plott

Tuesday, 13 April, 5:30 - 6:30pm

Coppertop, Commerce Building, University of Canterbury.

Given my previous posting on Robert Sugden talking about Experimental Economics I feel I should point out the upcoming Condliffe Memorial Lecture by Professor Charles Plott which is also talking about Experimental Economics. The lecture outlines the development and use of laboratory methods, including the key discoveries and applications. The early science focused on the basic laws of supply and demand and how they operate to create a process of price discovery.The science evolved to include how information is transmitted through prices and the possibility of bubbles and market instability. More recent evolution finds the research focused on the design of competitive institutions to solve complex resource and environmental problems. The lecture focuses on the nature of the discoveries and how they are known through the application of laboratory experimental methods.

Dr. Plott is founder and Director of Caltech’s Laboratory for Economics and Political Science. Dr. Plott’s research is focused on the basic principles of process performance and the use of those principles in the design of decentralized, electronic processes to solve complex problems. The contributions include over 180 scientific papers, the development of widely applied laboratory tools, and participation in the design and implementation of computerized market mechanisms for allocating complex items (such as the markets for pollution permits in Southern California, the FCC auction of licenses for Personal Communication Systems, the auctions for electric power in California, the allocation of landing rights at the major U.S. airports, access of private trains to public railway tracks, access to natural gas pipelines, and the application of complex procurements). He is the discoverer of the ability of markets to collect and aggregate information and his recent research is focused on information aggregation mechanisms (sometimes called “prediction markets”).

Dr. Plott is a member of the National Academy of Science, the American Academy of Arts and Science and the Fellows of the Econometric Society. He is a Guggenheim Fellow, Fulbright Senior Scholar, and a Fellow of the Center for Advanced Study in the Behavioral Sciences. He was recently elected as a Distinguished Fellow of the American Economics Association. He holds a Ph.D degree in Economics from the University of Virginia and an MS and BS at Oklahoma State University. He holds honorary doctorate degrees from L'université Pierre Mendès France and from Purdue University.

RSVP: Please RSVP, by Friday 9th April, for this event by contacting: Glenda.Lorimer@canterbury.ac.nz.

Experimental economics: evolution, methods and achievements

From VoxEU.org comes this audio in which Robert Sugden talks to Romesh Vaitilingam about the new book of which he is a co-author, ‘Experimental Economics: Rethinking the Rules’. They discuss the development of experimental research in economics over the past 30 years, the design of laboratory experiments and the achievements of these methods in increasing understanding of economic behaviour.

I'm with Matt on this one ...

Over at the TVHE blog Matt Nolan writes,

Serious, what in the hell. I am sick of reports that talk about these massive benefits of government spending without actually looking at them in context with, you know, opportunity cost.

I was annoyed with the way a PWC report was used, and now this release on a Covec report is similarly dodgey. The report is probably fine (although I have not had the good fortune of reading it), and probably defines exactly what they are looking at and why – I have faith in NZ economists. But this:

Williams said the report showed that the Government’s contribution to a rescue package should be at least 25 per cent because the tax receipts would make it cost-neutral.

But wait, isn't every dollar we spend on leaky home repair a dollar we don't spend on something else? The dollar for repairs has to come from somewhere, and that somewhere will lose a dollar in spending and thus the government loses gst.

Matt goes on to say,

The only reason to get involved is real externalities, doing a partial eqm analysis and saying the tax take rises involves ignoring where the hell the tax comes from and the opportunity cost. Treasury is right when they say this is neutral.

Well said that man, Williams is a b/s artist.

One for the management department

This is from Mark Goetz:

How the IMF thinks

From VoxEU.org comes this audio of a discussion between Jeffrey Chwieroth of the London School of Economics, and Romesh Vaitilingam about the evolution of economic ideas at the International Monetary Fund, drawing on his book, ‘Capital Ideas: The IMF and the Rise of Financial Liberalization’. They discuss changes in IMF thinking about capital controls, the Tobin tax and macroeconomic policy – as well the possibility of IMF intervention in Greece.

What do the bingers drink?

Well Australian binge drinkers anyway. A study by Preety Srivastava and Xueyan Zhao looks at What Do the Bingers Drink? Microeconometric Evidence on Negative Externatilities of Alcohol Consumption by Beverage Types. The abstract reads,

The recent debate on alcohol tax reform and recommendations from the Henry Tax Review in Australia have highlighted the need for quantifying externalities of excessive alcohol consumption by beverage types. This paper presents micro-level information from the Australian National Drug Strategy Household Surveys to examine the association between risky drinking behaviour, drinker characteristics, health and labour market status, and types of alcohol beverages consumed. Drinkers of regular strength beer (RSB) and RTDs in a can (RTDC) have the highest incidences of heavy bingeing, and low alcohol beer and fortified and bottled wine least likely. Bottled spirits (BS), RSB and RTDC are most likely linked to risky behaviour such as property damage and physical abuse under alcohol influence. All three spirit products are overwhelmingly the favourable drinks for the underage and young drinkers. Risky drinking behaviour is not found to be strictly associated with the alcohol strength of the products.

Well I'm glad to see we wine drinkers are the least likely to indulge in heavy bingeing. Interestingly the study finds that drinking is mostly done at home, thus outside the reach of potential controls in public places. All this points to the fact that if you want to use a beverage tax then the tax should be based, at least in part, on type of drink. Spirit products should have the highest tax while low alcohol beer and wine the lowest. It is also interesting that risky drinking behaviour is not found to be strictly associated with the alcohol strength of the products, so a tax based on alcohel content is not a good idea.This assumes of course that drinkers are responsive to price changes and this responsiveness is not substantially weaker for binge drinkers.

Measuring management practices

From VoxEU.org comes this audio of a discussion on measuring management practices. How important are management practices in driving the performance of firms and the productivity of nations across Asia, Europe and North America? John Van Reenen, director of the Centre for Economic Performance (CEP) at the London School of Economics, talks to Romesh Vaitilingam about CEP’s research programme on the economics of management and productivity.

Looking for new tools to help exporters: Why? short version

Tim Worstall offers a shorter version of my much longer Looking for new tools to help exporters: Why? argument:

Imports are going shopping. Exports are just the shite that we do so we can go shopping.

That says it all!

Productivity commission, Why?

Over at Kiwiblog David Farrar writes on Labour on Productivity Commission. He says,

I’m pleased to see Labour supportive of this initiative, for two reasons.

The first is simply because it is a good idea.

The second is because the sucess of the Australian Productivity Commission is partly because it does have bipartisan support. and I have long stressed that any NZ counterpart needs to also have such support, to be truly effective.

A good idea? Success of the Australian Productivity Commission? What success? Can David give one example of things the Australian productivity commission has done and show the growth that resulted from its actions? This question is asked because it is not clear that governments can do all that much to increase long-term growth. In this paper John Landon-Lane and Peter Robertson ask "Can government policies increase national long-run growth rates?" and their answer isn't encouraging. Their abstract reads,

We obtain time series estimates of the long run growth rates of 17 OECD countries, and test the hypothesis that these are the same across countries. We find that we cannot reject this hypothesis for the first and last three decades of the 20th century. We conclude that: (i) there are few, if any, feasible policies available that have a significant effect on long run growth rates, and; (ii) any policies that can raise national growth rates must be international in scope. The results therefore have bleak implications for the ability of countries to affect their long run growth rates. (Emphasis added).

The paper concludes,

The results therefore have stark implications for the ability of most countries to determine their own long run growth rates. The many policy packages used across these countries, including differences in tax, research, education and investment, did not have significant long run effects on relative growth rates. We conclude therefore that long run growth rates are determined by international factors, and are insensitive to national policies, especially for small countries. This implies severe restrictions of the ability of most governments to increase national long run growth rates.

At the Stumbling and Mumbling blog Chris Dillow writes,

To get an idea of what they mean, here are some annualized real GDP growth rates for some significant countries between 1980 and 2007. I present the figures in ranges, such that we can be 95% confident that true growth is within this range. I do this because, even over a period as long as 27 years, it’s possible for two countries with identical true growth to differ if one has good luck and the other bad.

France: 1.7-2.5%.
Italy: 1.3-2.2%
Spain: 2.4-3.6%
Sweden 1.6-3.0%
UK: 2.0-3.2%
US 2.4-3.7%

These ranges suggest we can be pretty confident that Italy has done worse than the US or UK. But we cannot be at all confident that the US has out-performed Sweden, or vice versa. The opposing poles of mixed capitalism - social democratic Sweden and freer market US - are consistent with similar, maybe indistinguishable, growth rates.

Big differences in institutions and policies, then, seem to generate similar growth rates. Which suggests that - at least within the wide parameters set by actually-existing mixed capitalisms - policies (or at least those that have been tried) might not make much difference to trend growth.

So I have to ask, Where is the evidence that a productivity commission will do anything to our long-term growth rate? What I fear we will get is just a another group of bureaucrats wasting taxpayers money for no good purpose. Perhaps, therefore, we shouldn’t look to national governments to promote long-run growth.

Over at the TVHE blog Matt Nolan asked a while back, When did NZ’s right become communist?

Long-term growth is based on technology, resource allocation, and to some degree the structure of institutions in the economy. I severely doubt that the government can turn around and improve any of these things to the degree required to “catch Australia”. Hell, Australia is closer to its markets, has a larger set of currently important natural resources, and gets “economies of scale” due to its higher population. No government policies can magically fill this gap.

Thus back to my question: productivity commission, Why?

NZ-US free trade

At the Offsetting Behaviour blog Eric Crampton writes on New Zealand's negotiations with the US for free trade area. At the end Eric writes,

I'm also skeptical. Worth giving it a try, but also worth remembering that no deal is better than many deals that could emerge when enforceability is factored in.

Let me add another reason for being sceptical.

The trade economist Jagdish Bhagwati has written a book explaining why such preferential trade agreements can have a down side. See Termites in the Trading System: How Preferential Agreements Undermine Free Trade

Bhagwati is arguing that Preferential Trade Agreements (PTAs) are bad for free trade. This is relevant for New Zealand since most PTAs are in the form of Free Trade Agreements (FTAs), a number of which New Zealand has signed in recent years and we are, obviously, currently in negotiations with the US.

The standard objection to PTAs, due to Jacob Viner, is simply that they could divert trade from the cost-efficient nonmember countries to the relatively inefficient member countries. The reason, of course, is that the nonmembers continue to pay the pre-PTA tariffs, whereas the higher cost member countries no longer have to. It is obvious that shifting production away from a low cost country towards a high cost country must sabotage the efficient allocation among countries and thus reduce total welfare. This process is known as trade diversion. Viner was the first economist to note the possibility of trade diversion arising with discriminatory reductions in trade barriers via PTAs. But the negative effects of trade diversion can go further. The liberalising country itself may also be hurt. How so? Because when a country (call it the "home" country) shifts to a higher cost within-the-PTA supplier it is buying its imports more expensively, incurring what economists call a "terms of trade" loss. The terms of trade is the ratio of export prices to import prices. As import prices increase the terms of trade decrease which implies that the volume of imports that can be bought with one unit of exports decreases.

Bhagwati notes, however, that

Trade diversion is not a slam-dunk argument against PTAs, for offsetting the loss from trade diversion can be a gain if trade creation takes place. Trade may grow because consumers in the home country now pay lower prices in their own markets; the higher cost supply from the member country is still cheaper than what the domestic consumers had to pay before the PTA was formed. Again, the import competing producers in the home country will reduce their own inefficient production as the domestic price of imports falls after the PTA comes into operation; this also leads to welfare-enhancing trade creation. Therefore, whether a specific trade-diverting PTA brings loss or gain to a country depends on the relative strengths of the trade diversion and trade creation effects. (p. 50)

The important point about trade diversion is that we can no longer assume that it does not matter how we liberalise trade. The use of PTAs is a two-edged sword in which we could end up impaled. It can matter whether we liberalise via bilateral or multilateral agreements.

Bhagwati goes on to argue that proponents of PTAs are too complacent about trade diversion. He considers seven arguments (p.52-7):

1. There is evidence of fierce competition in many products and sectors today, with few managing to escape with "thick" margins of competitive advantage that provide comforting buffers against loss of comparative advantage.Thus, even small tariffs are compatible with trade diversion as tariffs are removed from members of a PTA while they remain in place on nonmembers.
2. The thinness of comparative advantage also implies that today we have what I have called kaleidoscopic comparative advantage, or what in jargon we economists call "knife-edge" comparative advantage. Countries can easily lose comparative advantage to some "close" rivals, who may be from any number of foreign suppliers. So even if preferences today do not lead to trade diversion, the menu of products where you develop comparative advantage in a world of volatility and rapidly shifting comparative advantage will be forever changing, and any given preferences may lead to trade diversion in the near future, if not today.
3. While Article 24 requires that the external tariffs not be raised when the PTA is formed so as not to harm nonmembers, the fact is that they can be raised when the external (MFN) tariffs are bound at higher levels than the actual tariffs. In these cases, a member of the PTA is free to raise the external MFN tariffs up to the bound levels, whereas typically the scheduled tariff reductions in the PTA, when a hegemonic power is involved, will be hard to suspend. This is in fact what happened during the Mexican peso crisis of 1994, when external tariffs were raised on 502 items from 20 percent or less to as much as 35 percent, while the NAFTA defined reductions in Mexican tariffs on U.S. and Canadian goods continued. So the prospect of trade diversion actually increased, despite the intent of those who drafted Article 24.
4. Article 24 freezes only external tariffs when the PTA is formed, with no increase in the external tariff allowed. But it does not address the modern reality that "administered protection" (i.e., antidumping and other actions by the executive) is both elastic and can be used and abused more or less freely in practice. Once you take into account the fact that trade barriers can take the form of antidumping measures, which are arbitrary in their design and protectionist in their practice, there is a real danger that initially welfare-enhancing trade creation can be transformed into harmful trade diversion through antidumping actions taken against nonmembers. Thus, if a member country is gaining a market in the member "home" country, creating trade by replacing inefficient home country production with less inefficient production and imports from another member country, that pressure could be accommodated, not by allowing domestic industry to yield to these imports from a member country, but by discouraging imports from the nonmember countries by using antidumping actions against them. Thus trade-creating imports from member countries could be replaced by trade-diverting restrictions on imports from nonmember countries.
   Such an "endogenous" response of the external trade barriers, typically in the shape of antidumping actions, violates the spirit of Article 24, which explicitly prohibits trade barriers on non-members from being raised but is confined to tariffs and does not extend to "administered protection."
5. There is plenty of evidence that trade diversion can occur through content requirements placed on member countries to establish "origin" so as to qualify for the preferential duties. Thus, typically, to qualify for the preferential tariffs in PTAs that include the United States, one must satisfy requirements such as that the imports of raw materials and components must come from the United States. For example, if apparel exports to the United States are accorded preferential tariffs, they must be made with U.S. textiles. This naturally diverts trade in textiles from efficient nonmember suppliers to inefficient U.S. textile producers.
6. Many analysts do not understand the distinction between trade diversion and trade creation and simply take all trade increase as welfare-enhancing. However, some recent analysts who are familiar with the phenomenon of trade diversion have tried to estimate it using what is called the "gravity model." Dating back some decades, this equation simply explains trade between two countries as a function of income and distance. Adapting this simple equation to their use, the economists Jeffrey Frankel and Shang-Jin Wei, who pioneered the use of gravity analysis to estimate trade creation and trade diversion, estimated total bilateral trade between any pair of countries as a function of their income and per capita incomes, with bilateral distance accounted for by statistical procedures. If the countries belonged to, say, the Western hemisphere and they traded more with each other than with a random pair of countries located outside the region, that would mean that the PTA between countries in the Western hemisphere had led to trade creation. But it is clear that even if one disregards other objections, the real problem with the analysis is that more trade between partners in a PTA can take place with both trade creation and trade diversion, so that one simply cannot infer trade creation alone from this procedure. Hence, the recent estimates based on gravity equation, which are improved variations on the original Frankel-Wei approach and which sometimes (but not always) suggest that PTAs in practice have led to more trade creation than diversion, cannot be treated as reliable guides to the problem of determining whether or not a PTA has led to trade diversion.
7. Several economists have suggested that we need not worry about trade diversion and that beneficial effects will prevail if PTAs are undertaken with "natural trading partners." The initial proponents of this idea, Paul Wonnacott and Mark Lutz, declared, "Trade creation is likely to be great and trade diversion small if the prospective members of an FTA are natural trading partners." One criterion proposed for saying that PTA partners are natural trading partners is the volume of trade already between them; the other is geographic proximity. Neither really works.
   At the outset, note that though some writers, including Paul Krugman and Larry Summers, both heavy hitters, have occasionally argued as if the two criteria go together, they do not. There is no evidence that pairs of contiguous countries or countries with common borders have larger volumes of trade with each other than do pairs that are not so situated, or that trade volumes of pairs of countries arranged by distance: between the countries in the pair will also show distance to be inversely related to trade volumes. This is evident from Table 3.1 [on p.58], which contains destination-related trade volume for major regions in 1980, 1985, and 1990. There are some compelling examples. Chile shares a common border with Argentina, but in 1993 it shipped only 6.2 percent of exports to and received only 5 percent of imports from Argentina. By contrast, the United States does not share a common border with Chile , nor are the two countries close geographically. Yet in 1993, the United States accounted for 16.2 percent of Chilean exports and 24.9 percent of its imports. The volume-of-trade criterion would thus make the United States, not Argentina, Chile's natural trading partner, clearly contradicting the claim that the volume-of-trade criterion translates into the regional criterion, even in a broad-brush sense. The two criteria, and their inappropriateness in ensuring that trade diversion will be minimized and beneficial effects of the PTA guaranteed, must therefore be assessed separately, as immediately below. [This is done on p.57-60.]

The General Agreement on Tariffs and Trade (GATT) was designed to reduce trade barriers via multilateral trade negotiations. Exceptions to the multilateral nature of negotiations had to be explicitly provided for, Article 24 - referred to above - is such an exception for free trade areas and customs unions:

Article 24 --Territorial Application; Frontier Traffic; Customs Unions and Free Trade Areas

Customs unions and free trade ease (FTAs) are exempted from the MFN clause, but such an arrangement must not increase existing levels of trade restrictions affecting nonmember countries. If existing trade barriers are raised to outsiders, compensation may be required. The arrangement must lead to significant liberalization --in particular, it must cover "substantially all" trade between participating countries --and interim arrangements should lead to formation of Ff As or customs unions within a reasonable period of time. Article 24 also provides that, regardless of political status, any area that maintains its own tariffs and commercial regulations may be treated as a contracting party.

Another problem with the ever increasing number of PTAs is the "Spaghetti Bowl" that they give rise to. There are two basic problems here. The first is that when a country enters into a number of FTAs, a given commodity will be subject to different tariff rates if the trajectories of tariff reductions vary across FTAs. This is normally the case. The second issue is the fact that tariffs on specific goods must depend on where a product is supposed to originate which gives rise to inherently arbitrary "rules of origin". Bhagwati writes

With PTAs proliferating, the trading system can then be expected to become chaotic. Crisscrossing PTAs, where a nation had multiple PTAs with other nations, each of which then had its own PTAs with yet other nations, was inevitable. Indeed, if one only mapped the phenomenon, it would remind one of a child scrawling a number of chaotic lines on a sketch pad. (p.61)

Rules of origin are there to determine which product is made by whom. But in this globalised world where multinational firms source components from all around the world trying to determine the origin of a given good is in Bhagwati's description "a mug's game". It is virtually impossible to say which product is whose. This gives rise to endless problems. As Bhagwati explains

There are in fact numerous cases where such questions have led to disputes that come for resolution before arbitration and bilateral dispute settlement panels. In a classic case, the U.S. Customs Service refused to certify Hondas produced in Ontario, Canada, as "North American," and hence eligible for duty-free exports from Canada to the United States, on the grounds that, in its own estimation, Canadian Hondas did not meet the local content requirement of more than 50 percent imposed by the Canada-U.S. Free Trade Agreement (CUFTA). Honda countered that its estimates showed that they did. There is no surefire, analytically respectable way to determine the truth in such a case: it all boils down to who has greater stamina and whether Honda is willing to put moneys into legal costs. (p.68)

Such problems so not arise if there is a multilateral agreement which imposes the same tariff on goods from all countries. Bhagwati quotes Hong Kong businessman Victor Fung, from the Financial Times, on the distortions and costs imposed on business by the spaghetti bowls,

Bilateralism distorts the flow of goods, throws up barriers, creates friction, reduces flexibility and raises prices. In structuring the supply chain, every country of origin rule and every bilateral deal has to be tacked on as an additional consideration, thus constraining companies in optimizing production globally. In each new bilateral agreement, considerations relating to "rules of origin" multiply and become more complex. This phenomenon is what trade experts call the "spaghetti bowl effect." While larger companies have a hard time keeping track, for small groups it is impossible. Bilateral agreements cause the business community to work below its potential. In economic terms, bilateral agreements destroy value. If left unchecked, their continued growth has the potential to hinder the development of the global production system. (p.70)

Additional problems enter the picture when "trade-unrelated" demands are placed on an FTA. Such issues are easier to put in PTAs than multilateral agreements where the possible number of parties who will oppose the move is much greater. Issues such as intellectual property protection, which has more to do with collecting royalties than with trade, is an obvious example. Other examples would be "values-based" demands on things such as labour standards and environmental standards. In many cases demands to harmonise such standards are just a form of protectionism for oneself against foreign rivals.

So the issue of New Zealand's FTAs just got a whole lot more complicated. How we deal with these issues will determine just how beneficial our FTAs turnout to be. If there is anything to the arguments above it would suggest we may need to rethink a position with regard to bilateral v's multilateral trade agreements.

Looking for new tools to help exporters: Why?

Mike Smith writes over at The Standard

A really interesting three-quarter page article by Ben Heather in today’s DomPost is titled “Looking for new tools to help exporters.” Lord knows we need them.

But why do we need them? Why should we want to help exporters? Looks like more of the old "exports good, imports bad" modern day mercantilist mentality.

Note that Adam Smith pointed out more than 240 years ago that "Consumption is the sole end and purpose of all production" and that the measure of a country's true wealth, is the total of its production and commerce. That is, a country's wealth is what the people of that country can consume. The great 19th century French economic pamphleteer Frédéric Bastiat wrote, "Consumption is the end, the final cause, of all economic phenomena, and it is consequently in consumption that their ultimate and definitive justification is to be found." Note also that exports are things that we produce and send to other (overseas) people. That is, they are goods and services that we produce but do not consume and thus they lower our welfare. Imports on the other hand, are goods and services that other counties produce and send to us to increase our consumption. This means imports increase our welfare. So imports are welfare increasing and exports are welfare decreasing. Therefore "imports are good; exports are bad"

But this does raise the question of why do we bother to export and not just import? The obvious answer is that exports are the way we pay for our imports. If we want people to send their goods and services to us we have to send our goods and services to them in exchange. Adam Smith also noted that in any free exchange, both sides must benefit. The buyer profits, just as the seller does, because the buyer values whatever he gives up less than the goods he obtains. That's why we trade at all.

This simple idea blew a hole through the trade walls that had persisted for centuries. It destroyed the notion that "exports are good; imports are bad" which was the prevailing view of trade before Smith, and seemingly still the view at The Standard. Before Smith people believed that the measure of a nation's wealth was the gold and silver in its treasury. Imports were bad because this gold and silver must be given up in payment. Exports were good because these precious metals came in. Trade benefited only the seller, not the buyer, and a nation could get richer only if others got poorer.

Today, most, people know better. Trade benefits not only the seller but also the buyer, so importing increases our welfare. So back to my original question, Why do we wish to help exporters? Why not help importers for they increase our welfare.

EconTalk this week

Steve Meyer, music industry veteran and publisher of the Disc and Dat Newsletter, talks with EconTalk host Russ Roberts about the evolution of the music industry and the impact of the digital revolution. After discussing his background and experience in marketing at Capitol Records and elsewhere, Meyer argues for the virtues and potential of the internet in enhancing the music industry. He points out that the internet allows numerous artists to make money through their music and particularly enhances revenue from live performances. He describes the challenges facing record companies as a failure of imagination and suggests that the full potential of the internet as a distribution channel has yet to be fully exploited.

Broadband for all?

Jeffrey Miron writes

Federal regulators detailed a $20 billion, 10-year plan to ensure all U.S. households access to high-speed Internet service.

What could possibly justify federal or any government action in this arena? Private companies have ample incentive to expand internet service when the revenues exceed the costs. This FCC plan is just a transfer to rural households.

Stop me if you have come across such a stupid plan like this before.

Otteson on Adam Smith vs. Karl Marx

Recently Adam Smith scholar James Otteson gave a talk at the Freedom 2010 Homeschool Debate Tournament, which was held at the Foundation for Economic Education in Irvington, New York. The title of the talk was "The Classical Liberal Tradition: Adam Smith vs. Karl Marx." A video of the presentation is below:

The Classical Liberal Tradition: Marx v. Smith from FEE on Vimeo.

Well worth watching.

Trade and fairness

The Science Fair website has any interesting article about new research into why we are fair to strangers we'll never see again. The article points out that fairness makes possible the large, interconnected, market-based societies that have grown up mostly in the last 10,000 years. Two rival theories have been put forward as to why: one suggests that we're fair to strangers because we mistakenly treat them like kin, the other that social conditioning makes us this way. In a recent edition of the journal Science, new evidence is presented that comes down solidly on the side of social conditioning. The researchers found that people who live in small groups and who grow or catch most of their own food don't really care that much whether they're fair or unfair to strangers, or whether a stranger is punished for being unfair. But people who trade for a larger percentage of their daily food and therefore live in more integrated, larger social groups, are much more likely to be fair to strangers.

The Science Fair article continues

"We think its was really a lot of cultural learning, and it took 10,000 years of cultural evolution to get to the point where you have a well-run society with billions of people," says Joe Henrich, an evolutionary anthropologist at the University of British Columbia in Canada, the paper's lead author.

It also appears that religion plays a part as well. People who follow tribal religions are also more focused on their kin and friends and don't care too much about fairness with strangers. People who followed the two world religions in the areas studied, Christianity or Islam, were more likely to be fair to strangers and to want to punish unfairness.

The article goes on to say

One thing this means is that the assumption that markets run because people are selfish doesn't quite work. Actually, Henrich believes, markets run best because people have some motivation towards fairness and equality. "If you have fully selfish agents, markets don't work because people can't trust each other."

Actually economists don't argue that markets work because people are selfish but rather that markets work despite people being selfish. It is normally said that trust and fairness do help markets to work, they are very cheap ways of regulating commerce, but even with selfish people markets can lead to socially good outcomes. You don't have to have feelings of fairness towards those you trade with, although it does help.

EconTalk over the last few weeks

Garett Jones of George Mason University talks with EconTalk host Russ Roberts about the art of communicating economics via puzzles and short provocative insights. They discuss Jones's Twitter strategy of posting quotes and short puzzles to provoke thinking. Jones, drawing on his experience as a Senate staffer, discusses the interaction between politics and economics in the area of tax cuts and earmarks. For example, are earmarks good or bad? Jones gives an unconventional analysis. He also discusses the economics of the new workplace and why that might mean a different path for productivity over the business cycle than in the past.

Barry Ritholtz, author of Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy, talks with EconTalk host Russ Roberts about the history of bailouts in recent times, beginning with Lockheed and Chrysler in the 1970s and continuing through the current financial crisis. In addition to the government role in aiding ailing companies, Ritholtz also looks at the role of the Fed in discouraging prudence through its efforts to keep asset prices and the stock market at high levels. The conversation closes with a discussion of what Ritholtz has learned from the crisis.

Katherine Newman, Professor of Sociology at Princeton University, talks with EconTalk host Russ Roberts about Newman's case studies of fast-food workers in Harlem. Newman discusses the evolution of their careers and fortunes over time along with their dreams and successes and failures. The conversation concludes with lessons for public policy in aiding low-wage workers.

Don Boudreaux of George Mason University talks with EconTalk host Russ Roberts about public choice: the application of economics to the political process. Boudreaux argues that political competition is a blunt instrument that works less effectively than economic competition. One reason for this bluntness is the voting process itself--where intensity does not matter, only whether a voter prefers one candidate to the other. A second reason is that political outcomes tend to be one-size-fits-all, which often leads to dissatisfaction. Boudreaux defends the morality of not voting, while Roberts, who does vote from time to time, concedes that one's vote is almost always irrelevant in determining the outcome.