Cooking the trade-account books

One of the madder recent ideas to come out of the Trump administration in the U.S. is  a plan to change the way the U.S. calculates trade deficits. The administration suggests not counting re-exports in the U.S. trade balance. That is, the administration wish to exclude from U.S. exports any goods first imported into the country, e.g. cars, and then transferred to a third country, e.g. Canada or Mexico, unchanged. This would make the country's trade gap appear larger than it now. Data on trade balances and surpluses are at the center of a political battle in the U.S. over whether existing trade agreements the U.S. has with other countries should be retained, renegotiated or tossed out altogether. Should the change be implemented, it would have a large effect on the data involving countries that have free trade deals with the U.S. In some cases this new methodology would even change a trade surplus into a trade deficit.

Professor Mark J. Perry makes four points with regard to the the administration's idea,

1. This proposal is apparently based 100% on politics and 0% on any economic theory or on standard, well-established double-entry national income accounting practices.
2. The proposal’s main (and possibly only) motivation is to manipulate and artificially exaggerate America’s trade balance for goods, mostly (exclusively?) for political purposes – to re-negotiate trade deals or provide reasons to impose import tariffs.
3. The proposal is a departure from well-established double-entry national income accounting procedures that consider imports and exports without regard to the economic concept of “value-added.” That is, the proposal would switch from double-entry accounting for the cross-border movement of goods to a new “single-entry accounting” methodology that would count all goods entering the U.S. as imports, but would fail to count some U.S. exports if they are defined as “re-exports.” This would represent a significant departure from the way imports and exports have been calculated by the Department of Commerce for nearly 100 years.
4. Most of what gets exported from the U.S. contains some amount of imported content, so why only change the way “re-exports” are calculated? For example, many Ford and GM cars contain more than 50% non-U.S. content. If those automakers export cars assembled domestically, the value of those exports count 100% as U.S. exports, even though some “domestic” cars could contain 60% or more foreign content. And yet, if Ford or GM imports a car from Mexico and re-exports those vehicle to Canada, those exports would not count at all for U.S. export? Further, it’s possible that GM and Ford cars assembled in Mexico could contain parts and content imported from the U.S., which further makes the new manipulated recalculation questionable.

Perry continues by making the point this idea is being proposed purely for political reasons,

This proposal for recalculating trade balances is a manipulative single-entry accounting scam that is being proposed for political reasons only. A single-entry accounting approach to calculating trade balances serves only one political purpose/outcome – to artificially inflate the trade deficit for goods — and is not supported by any economic or national income accounting theory or standard practice.

All this is just one more reason to worry about the Trump administration's views on international trade.

An interesting bit of history on the expression "There’s no such thing as a free lunch"

From an interview (pdf) with Milton Friedman.

QUESTION: Can you tell us—I don’t happen to know—under what circumstances you first said the famous words “There’s no such thing as a free lunch”?

FRIEDMAN: Peggy Noonan, who has written some very good words that you have all heard such as “Read my lips”—it’s too bad she wasn’t able to enforce the words she wrote—asked me if I could remember when I first used the words “There’s no such thing as a free lunch.” The answer is no, I don’t remember. However, I am not really the originator of that statement. A colleague of mine at the Hoover Institution traced it back to some time in the nineteenth century in the parlance of saloons: If you bought a beer, they would give you a free lunch. That’s where the phrase originally came from. It was made popular by Robert Heinlein, a science fiction writer who wrote a wonderful novel called The Moon Is a Harsh Mistress. The novel’s setting is a settlement on the moon that revolts using the motto TANSTAAFL (There ain’t no such thing as a free lunch). I may say that the revolution was a success because of a wonderful near-human computer.

But Adam Smith didn't say that

In a recent posting on the death of Kenneth Arrow Tim Harford writes,

Two achievements [of Arrow's work] are particularly celebrated: his impossibility theorem about the paradoxes of social choice, and his welfare theorems, which formalised the most famous intuition in economics — Adam Smith’s idea that a market produces social good from individual selfishness.

But Adam Smith didn't say that. As the historian of economic thought Mark Blaug notes,

"[ ... ] Smith's faith in the benefits of 'the invisible hand' has absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect a la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support of what is now known as the 'fundamental theorems of welfare economics' is a historical travesty of major proportions. For one thing, Smith's conception of competition was, as we have seen, a process conception, not an end-state conception. For another society, a decentralised competitive price system was held to be desirable because of its dynamic effects in widening the scope of the market and extending the advantages of the division of labour - in short, because it was a powerful engine for promoting the accumulation of capital and the growth of income" (emphasis added)

In short, it's not clear to me, at least, that Smith would have been much impressed by the work of McKenzie, Debreu and Arrow et al with regard to the approach and results of general equilibrium theory. In fact, in today's terms, I often think of Smith being more Austrian-like than neoclassical-like.

Ref.

• Blaug, Mark 1996. Economic Theory in Retrospect. 5th edn. (pp. 60-1). Cambridge: Cambridge University Press.

Boudreaux on the minimum wage and free trade

Jacob Hornberger and Richard Ebeling discuss the economics of the minimum wage and free trade with Donald J. Boudreaux on the "Libertarian Angle" (from the Future of Freedom Foundation).

Bottleneckers: gaming the government for power and private profit

From the Cato Institute comes this Cato Daily Podcast in which Caleb O. Brown talks to Dick M. Carpenter II about so-called "bottleneckers" and how they restrict competition and harm the public. Brown and Carpenter of the Institute for Justice discuss Carpenter's new book, Bottleneckers.

Governments and the "war on drugs"

An interesting talk on why governments are loosing the "war on drugs". Affecting demand is more important than changing supply.

When fighting the war on drugs, governments typically devote enormous resources trying to reduce the supply. But is this effective? Journalist and author Tom Wainwright, of the Economist and author of Narconomics, talks with EconTalk host Russ Roberts about the ways that the drug cartels respond to government attempts to reduce the availability of drugs. Like any business trying to maintain profitability, cartels look for ways to cut costs and maintain or grow revenue. Wainwright uses extensive on-the-ground interviews and reporting to understand the behavior of the cartels and argues that reducing demand would be a much more effective strategy for reducing drug use.

A direct link to the audio is available here.

Some thoughts on the role of firms and government interference in the market

This is from the third instalment in (oddly named - seems more pro-state than anything) ProMarket's new interview series on the economic theory of the firm. In this instalment, they ask Chicago Booth’s Steven Kaplan how the existing theory should be modified. Kaplan is the Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Booth School of Business.

Q: The neoclassical theory of the firm does not consider political engagement by corporations. How big an omission do you think this is?

I am a bit confused. Hasn’t the idea of regulatory capture and, implicitly, political engagement, been a subject of economic study since George Stigler’s “Theory of Economic Regulation” in 1971? In other words, it would be a big omission if, in fact, it were omitted. In reality, economists have paid attention to political engagement for a long time.

Q: To what extent is political engagement by corporations responsible for the current populist discontent?

Very little. The biggest source of populist discontent is the dislocation caused by technological change and globalization. That dislocation has made the global economy much better off overall. The global poverty rate has declined substantially. Billions of people now earn a living rather than starving. It is a huge success. As Nobel Prize winner Angus Deaton wrote, “Life is better now than at almost any time in history. More people are richer and fewer people live in dire poverty. Lives are longer and parents no longer routinely watch a quarter of their children die.” At the same time, this success has challenged the less skilled in developed countries—particularly the U.S. and Western Europe.

The second biggest source of discontent comes from the policies implemented in those countries that make it more expensive to hire less skilled workers. Raising the minimum wage, licensing rules, and other employment mandates increase the costs of hiring less skilled workers. At the same time, technology and globalization reduce the costs of substitutes. The net effect is fewer jobs. France is the best example. Germany is one of the few countries that moved in the opposite direction and has had less of an employment problem. Immigration policies also have fueled discontent.

Political engagement by corporations would be far down the list of important forces.

The basic issue being discussed is that the standard (economic) theory of the firm is silent on the role firms can play in shaping the rules of the game under which they operate. It is argued that in reality, many firms lobby politicians and try to capture regulators in order to modify the rules of the game in their favour.

What I do find strange is 1) Its not clear what exactly they mean by the "standard economic theory of the firm". At times they seem to talk about the neoclassical theory of the firm as if it is in fact a theory of the firm but has Coase pointed out many years ago it's not. If they are not talking about the neoclassical model then what are they talking about? As I have written,

While the post-1970 theory of the firm literature has began the task of developing a genuine understanding of the firm, and closely related issues, it has yet to coalesce around one model or even one group of models. Even within the contemporary mainstream there are a number of competing models, to say nothing of those we could add into the mix if we were to consider the heterodox literature.

2) I’m not sure what they are talking about is a problem with the theory of the firm, they seem to be talking more about a theory of government or regulation or pressure groups or some such thing. Yes firms can influence government policies but so can churches, trade unions, environmental groups etc as well. So I’m not sure their issue is one to do with the theory of the firm as such. 3) As Kaplan points out economists have been thinking about these issues for a long time, even if not as part of the theory of the firm. But as I say in 2) its not clear to me that it is part of the theory of the firm. It's a wider issue than to do with just firms.

A brief prehistory of the theory of the firm

A first draft of a new working paper on the (pre)history of the theory of the firm/theory of production.

The mainstream theory of the firm didn't exist until around 1970. Before then what we had was the `prehistory' of the theory of the firm. For more than two thousand years tools were available that could have given rise to a theory of the firm or, at least, a theory of micro level production, but none appeared. During this time the best that occurred were discussions of macro level or aggregate production. Given the long empirical history of and the importance to the economy of firms one may assume that economists have long been developing a detailed and sophisticated theoretical understanding of the firm but it turns out this is not the case. Up until the 1970s the development of the theory of the firm was a story of neglect and disinterest.

A brief prehistory of the theory of the firm by Paul Walker on Scribd

Seasonality and the invention of agriculture

Why was agriculture invented in one of the big questions in economic history. In a new working paper, The Ant and the Grasshopper: Seasonality and the Invention of Agriculture, Andrea Matranga argues that there is a link between seasonality and agriculture.

During the Neolithic Revolution, seven populations independently invented agriculture. In this paper, I argue that this innovation was a response to a large increase in climatic seasonality. Hunter-gatherers in the most affected regions became sedentary in order to store food and smooth their consumption. I present a model capturing the key incentives for adopting agriculture, and I test the resulting predictions against a global panel dataset of climate conditions and Neolithic adoption dates. I find that invention and adoption were both systematically more likely in places with higher seasonality. The findings of this paper imply that seasonality patterns 10,000 years ago were amongst the major determinants of the present day global distribution of crop productivities, ethnic groups, cultural traditions, and political institutions.

Tyler Cowen on Trumponomics

I still think Trumponomics won’t work. It is too divisive; it will be applied politically, targeting favorites and enemies, rather than in accord with the dictates of efficiency; it may destroy rather than create jobs on net; and most of all it badly damages the U.S.’s global reach by cooperating less on issues of trade and migration. I think of the program as a whole as cashing in on the capital asset of America’s foreign reputation and redistributing some of those rents to Trump-supporting regions. That is a form of shortsightedness, and a sign of the decay of our republic.

That's from Cowen's column, The Left Underestimates Trump's Economic Plan, at Bloomberg. While Trumponomics may very well damage the US economy we also have to keep in mind what damage it will do to the world economy. Trumps moves on trade could spark a trade war which could damage the world trading system. The last thing we need is a repeat of the Smoot-Hawley episode. No one wins a trade war.

"Silent Revolution" by The Benevolent Dictators

"Silent Revolution" by The Benevolent Dictators. The first song from the upcoming album about Adam Smith. Inspired by Book 3, Chapters 2-4 of "An Inquiry into the Natures and Causes of the Wealth of Nations" by Adam Smith.

How old is behavioural economics?

I came across an interesting paper the other day that suggests behavioural economics is older than most people think. The paper "The Relations of Recent Psychological Developments to Economic Theory" by Z. Clark Dickinson in The Quarterly Journal of Economics, Vol. 33, No. 3: 377-421 dates from May 1919!

The summary of the paper reads,

The purely objective factors in economics, 377. - Psychological principles necessarily used in addition, 381. Social assumptions, 385. - Psychical factors are human motives, 387; their analysis needed for most social problems, 389. - Adequacy of psychology assumed in economic theory in dispute, 390. - Analysis of arguments pro and con, 392. - Hedonistic foundation, 394. - Costless production, 401. - Industrial peace, 404. - Sums of utility, 406. - Social demand, 407. - Institutional economics, 409. - Most accurate psychology needed, of producers' motives, 415; of consumers' demands, 419.

Dickinson concludes,

And so our tentative conclusion is that an accurate knowledge of the psychology involved in economic behavior is needed in economic theory, not so much for static as for dynamic purposes. It is needed for static theory if we want to be assured that our static theory is as complete and fundamental an explanation as the existing state of knowledge permits. But it is vital for dynamic theory, which looks beyond the existing conditions of wants, social structures and industrial devices, and prophesies what would be the result of various supposed innovations, if they were made. In this same fashion we have long predicted the probable results of hypothetical taxes and tariffs on production, distribution, etc. If we can set up hypotheses as to ways of changing consumers' demands, or producers' springs to action, which psychological science shows to be plausible, and trace their effect on economic life, we shall be adding to the purely scientific theorems which the legislator or reformer may find helpful. And aside from the possible applications to pure economic theory, such knowledge of motives is bound to be useful in the practice of social art.

So suggesting the use of psychological ideas in economics is older than I guess most economists would think.

The populist parallels of Sanders and Trump

From the Cato Institute comes this Cato Daily Podcast in which Caleb O. Brown talks to John Samples about the parallels between Sanders and Trump.

President Donald Trump and Senator Bernie Sanders have some strong parallels in their populism.

32% off the greatest book ever written

Right now the Book Depository has 32% off The Theory of the Firm: An overview of the economic mainstream with their price being NZ$159. Actually given the publisher price is 95.00 pounds that isn't a bad price.

Those of you with a Kindle, Amazon has it at US$49.68.

Protection and job losses

At the Cafe Hayek blog Don Boudreaux makes the point that protection does not stop job losses.

You are correct that under a regime of free trade some people, through no fault of their own, lose jobs. You are also correct that such experiences are unpleasant. But protectionism does not stop job losses from occurring. Even if Uncle Sam were to completely shut the American economy off from global markets, job losses would still occur. American consumers would still change their spending patterns such that goods and services that were in high demand yesterday would be in lower demand today. Entrepreneurs would still experiment with new products and with new, labor-saving methods of production and distribution. Economic churn would still happen, complete with its unavoidable job losses.

The difference would be that, being denied access to the creative insights and productive efforts of 95 percent of the world’s population as well as to the bulk of the world’s resources, we’d all be much poorer.

What changes in trade policy do is change who has jobs, not the total number of jobs. Change trade policy and you just move jobs around the economy without having much effect on the total number of those jobs. As Paul Krugman has written,

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.

But the other point made by Boudreaux is also important, protection makes us poorer. The more we protect, the more we have to do things we are (relatively) bad at doing and the less time we spend on doing things we are good at doing. In the process we make ourselves worse off. It is better for us to concentrate on what we are good at producing and trading that for the things we are bad at producing with people who are good at producing it. As Krugman notes efficiency is what matter and by doing things we are bad at we become less efficient, not more.

Interesting graph on the relationship between US growth and the trade balance.

This graph is from the Econofact website:

You have to be very careful about causation. Does a trade deficient affect growth or does growth affect the trade balance or do third factors affect both?

It is true that when a country's Gross Domestic Product (GDP) is calculated, a trade deficit counts as a negative. But this is a matter of accounting.

By definition, GDP measures the value of the goods and services produced within a country's borders. To tally GDP we take the sum of what households consume, investment by firms and government spending and account for trade by adding what is produced in the nation but consumed abroad (exports) and deducting the value of imports. The (faulty) idea of a “trade deficit drag” comes from this accounting identity – if the difference between exports and imports is large, then a larger number is subtracted from what households, firms and the government consume and the resulting GDP number must be smaller as well.

But this does not mean that a trade deficit causes GDP to be smaller.

The flaw in this logic is that both the trade deficit and GDP are outcomes of other, underlying factors. For this reason, there is no simple, straightforward link between the size of the trade deficit and the level of overall economic activity as measured by GDP. Consider a case where the United States has a spurt of growth due to, say, an increase in infrastructure spending. This spending will raise incomes and, therefore, consumption – including consumption of imported goods. This would be a situation where faster growth is associated with an increase in the trade deficit. Alternatively, the trade deficit could very well decline when there is a recession that reduces consumption of all goods, including imports.

A two minute video in which Nobel Laureates give advice to President Donald J. Trump

Patents, prizes and innovation

The use of patents versus prizes to stimulate innovation is a long debated subject. Jean Tirole has written,

"Consider the patent system. It has long been recognized that patents are an inefficient method for providing incentives for innovation since they confer monopoly power on their holders. Information being a public good, it would be ex post socially optimal to award a prize to the innovator and to disseminate the innovation at a low fee. Yet the patent system has proved to be an unexpectedly robust institution. That no one has come up with a superior alternative is presumably due to the fact that, first, it is difficult to describe in advance the parameters that determine the social value of an innovation and therefore the prize to be paid to the inventor, and, second, that we do not trust a system in which a judge or arbitrator would determine ex post the social value of the innovation (perhaps because we are worried that the judge might be incompetent or would have low incentives to become informed, or else would collude with the inventor to overstate the value of the innovation or with the government to understate it). A patent system has the definite advantage of not relying on such ex ante or ex post descriptions (although the definition of the breadth of a patent does) " Jean Tirole, "Incomplete Contracts: Where Do We Stand?" Econometrica, Vol. 67, No. 4 (Jul., 1999), pp. 741-781.

Another round in the debate is about to open with a new NBER working paper on the topic of Prestige and Profit: The Royal Society of Arts and Incentives for Innovation, 1750-1850.

"Debates have long centered around the relative merits of prizes and other incentives for technological innovation. Some economists have cited the experience of the prestigious Royal Society of Arts (RSA), which offered honorary and cash awards, as proof of the efficacy of innovation prizes. The Society initially was averse to patents and prohibited the award of prizes for patented inventions. This study examines data on several thousand of these inducement prizes, matched with patent records and biographical information about the applicants. The empirical analysis shows that inventors of items that were valuable in the marketplace typically chose to obtain patents and to bypass the prize system. Owing to such adverse selection, prizes were negatively related to subsequent areas of important technological discovery. The RSA ultimately became disillusioned with the prize system, which they recognized had done little to promote technological progress and industrialization. The Society acknowledged that its efforts had been “futile” because of its hostility to patents, and switched from offering inducement prizes towards lobbying for reforms to strengthen the patent system. The findings suggest some skepticism is warranted about claims regarding the role that elites and nonmarket-oriented institutions played in generating technological innovation and long-term economic development".

So maybe prizes did not stimulate innovation and possibly patents were more effective. But I'm sure this will not be the last thing we hear on this topic.

The Marshalls (Alfred and Mary) on farming

In the past I have discussed the theory of the farm explaining why farming is one of the few areas left in the economy still dominated by family businesses. The standard argument as to why this is so is given by Allen and Lueck (1998, 2002).

The is key to understanding why so is that the incentives generated within agriculture favour family farms. The two basic issues are opportunities for hired workers to shirk due to random production shocks from nature and the limits on the gains from specialisation and the timing problems caused by seasonality. The trade-off between effect work incentives and gains from specialisation help determine the costs and benefits of different farm organisational types.

The abstract from Allen and Lueck reads:

Using a model based on a trade-off between moral hazard incentives and gains from specialization, this paper explains why farming has generally not converted from small, family-based firms into large, factory-style corporate firms. Nature is both seasonal and random, and the interplay of these qualities generates moral hazard, limits the gains from specialization, and causes timing problems between stages of production. By identifying conditions in which these forces vary, we derive test able predictions about the choice of organization and the extent of farm integration. To test these predictions we study the historical development of several agricultural industries and analyze data from a sample of over 1,000 farms in British Columbia and Louisiana. In general, seasonality and randomness so limit the benefits of specialization that family farms are optimal, but when farmers are successful in mitigating the effects of seasonality and random shocks to output, farm organizations gravitate toward factory processes and corporate ownership.

Allen and Luecks's paper is relatively recent, 1998, so this all looks modern using new ideas to so with contracting to explain family farms. But is it so? A week or so ago I was reading Alfred and Mary Marshall's “The Economics of Industry” published 1879 when I came across the following on pages 57-58:

§ 11. The largest industry is that of agriculture; but there is scarcely any other industry which is able to make so little use of the advantages of division of labour and of production on a large scale. For agricultural labourers cannot be grouped together in large masses ; they must be scattered over the country. And each season of the year has its special work: a man cannot spend his life in reaping. So that the work of agriculture cannot be broken up into a vast number of parts each of which is performed by a band of labourers who devote their lives to acquiring a special skill in this class of work.

Agriculture, however, seems to be following in the steps of manufacture. Field steam-engines are becoming common, and new machines to be worked by them or by horse power are appearing in rapid succession. The fields demand every day a smaller number of dull labourers and a greater number of intelligent mechanics.

This change is exercising an important influence in the competition between small and large farms. The small farmer cannot always afford to have a field steam-engine; he cannot afford to have a great number of machines for occasional use. Thus every year puts him at a greater disadvantage relatively to the large farmer. This disadvantage is diminished but not removed by the rapid growth of a subsidiary industry, which undertakes steam ploughing threshing, &c. for farmers, The growth of this industry is the most important step towards obtaining the advantages of division of labour that has ever been made by agriculture.

In comparison with a small farmer a large farmer gains something in economy of buildings, and in economy of materials. He is able to have a better rotation of crops; he can send a great many labourers into a field in which there is anything to be done quickly. He can, as a rule, borrow capital from the banks more easily than a small farmer can. Lastly, the large farmer is likely to have more knowledge and greater skill and enterprise than the small farmer, He probably received· a better education at starting; and he can afford to leave to subordinates much work that the small farmer does himself, so that he has more time and opportunity for increasing his knowledge, And as farms change hands from time to time, the ablest farmers are likely to find their way to the largest farms. Thus the economy of skill is carried further under a system of large, than under one of small, farms. On the other hand the large farmer loses in the matter of superintendence. The small farmer works hard himself: he watches for every trifling gain and every small saving: and those who work under him have little opportunity of being idle or dishonest.

Its often said that in the late 1800s-early 1900s the answer to any student's question about economics was "It's all in Marshall". Well it appears it is!

Refs.:

• Allen, Douglas W. and Dean Lueck (1998). "The Nature of the Farm", Journal of Law and Economics, 41: 343-86.
• Allen, Douglas W. and Dean Lueck (2002). The Nature of the Farm: Contracts, Risk, and Organization in Agriculture, Cambridge Mass.: The MIT Press.

Trump and trade: threatening Toyota via twitter

More on the wacky world that is Donald Trump and trade. From the Cato Institute comes this Cato Daily Podcast in which Caleb O. Brown talks to Simon Lester about Trump threatening companies.

Can the specter of a President-elect threatening companies with punitive taxes really make the U.S. a better place to invest?