Cause, Effect, and Misallocation

In preparation for a price theory book I am writing, I am re-reading George Stigler’s classic 1966 text The Theory of Price.  The following is found on page 19 (3rd edition):

[I]t has become a major task demanded of all economies: they are required (as soverigns use this word) to provide technological advances, capital accumulations, improved labor forces, and larger incomes.  So strong is this demand, that sometimes a method by wich western nations become richer–industrialization–is confused with the growth itself, and inappropiate industries that reduce a nations’s income are adopted to increase it.

Confusing cause with effect is a major problem facing all analysts.  This becomes doubly true when discussing economic growth when policy is involved.

Industrialized nations are wealthy, but it doesn’t necessarily mean such industrialization is the cause of wealth.  Rather, industrialization is itself a symptom of a deeper cause, that is the division of labor.  “Industrialization” is a term without definition, as it can refer to many kinds of industries.  Comparative advantage is what tells us what kind of industrialization is needed to foster growth.

The United States has a comparative advantage in high tech industries; we are an extremely intelligent people with lots of capital (both human and machine) at our disposal.  China, however, has a comparative advantage in low tech industries; they have lots of unskilled labor at their disposal.  It makes sense for the US to industrialize in high tech industries and China to industrialize in low tech industries.

But even within countries, industrialization is varied.  In the US, the vast middle of the country has some of the most fertile farmland in the world.  It makes sense for those states to be agriculturally-based and other places, like Texas, to be resource-based, and others, like Massachusetts, to be tech-based.

A scheme based on the mistaken notion that “industrialization = progress” will lead to misallocation of resources.  Resources, such as labor, capital, time, will be diverted into less productive and more costly areas.  This, in turn, leads to a net decline in wealth compared to where it otherwise would have been.  An example of this is China during the “Great Leap Forward.”  Industrialization, specifically of steel, was all the rage of the Communist Party.  All production was geared toward steel production.  This inherently meant a rapid decline in production of other items–like food.  China’s poverty deepened.

The Great Leap Forward is an extreme example, but other historical cases of misallocation of resources due to the mistaken belief of “industrialization = wealth” include the USSR, modern Venezuela, and North Korea.

When examining the causes of economic growth, one must be very careful in determining cause and effect.  This is where price theory really shines.

Grad School Advice from a Grad Student

What follows below are some of the lessons I’ve learned while in school.  I write them here to share them with you:

Econ 101 is called “fundamental” because it is just that. Everything you’ll learn in your higher level classes are built off of Econ 101. All the theories, all the techniques, all the tricks you’ll learn are spawned from Econ 101. Just as calculus is built off of mathematical operations like addition, subtraction, division, and multiplication.

When I am doing research, I often find it is best to go back to my introductory Econ textbook (either Alchian & Allen or Tabarrok & Cowen) and review the material. Several times, I’ve found either a mistake in my reasoning or a better way of exploring my problem.

It’s easy to drink one’s Kool-Aid and become enraptured with the mathematics and statistics of economic analysis. It’s trivally easy to prove just about anything you want. But do not fall into that trap. Use the mathematics and statistics as a tool to tease out your assumptions. Translate your formulae into English. If you can’t do that, burn the mathematics. (Paraphrased from Alfred Marshall)

One thing about grad school is that it is extremely tough on the ol’ ego. There are constant rejections, frustrations, failures, and nonsense. There are insane levels of stress and pressures and it takes a lot to get even one praiseworthy bit of work done.

What makes it bearable are the people you surround yourself with. Mentors are invaluable. But so are friends, colleagues, and collaborators (who are often one and the same). Without my friends here at GMU, I’d probably go insane. 

 Grad school isn’t an individual effort. It’s a team sport. We pick each other up when we’re down, we boost each other to get over obstacles, and we share in each other’s victories and defeats. I’m part of a fraternity that they couldn’t pay me enough to leave.

Find your friends. Stick by them. Remember that we’re all strapped to this roller coaster named Life together.

A Note on China

On an earlier post, frequent commenter Greg G writes in two separate comments (condensed here for readability):

I think the best argument for tariffs is the astonishing economic success of China in lifting so many people out of poverty in such a short time. It’s not easy to explain how they did that if tariffs are really so inimical to the interests of their own people. Those of us in favor of free trade (and I count myself among that group) need to admit we can’t explain that. As always, we could argue that they would have done even better in some counterfactual where everyone listened to us but that is a very weak argument for a couple reasons. One is that it is always available to everyone. The other is that none of us would have predicted in advance that such an economic miracle was possible even if we had been guaranteed we could dictate policy.

Free market theory predicts that all these state interventions should be bad for Chinese consumers yet no other country’s consumers in history have enjoyed a comparable jump in their standard of living in such numbers in such a short time. Yes, I know they started from a place of extreme poverty and even more Draconian state interventions where it was easy to make big percentage gains. Even so, there are countless other countries that started in extreme poverty and stayed there both with and without a lot of state intervention in the economy. I am not pushing any economic theory that I prefer to free trade but I do still think that the Chinese example stands as a challenge to some of the economic theories that we prefer. It’s at least a little bit awkward that the regime that engineered the biggest economic leap forward in history still calls itself Communist.

Let me begin with a quick point.  Free market theory does not predict that all state interventions are bad.  There are many theoretical cases where interventions such as tariffs can be beneficial.  However, such theories require strong assumptions and a level of knowledge we deem impossible to possess, so we are skeptical of the applicability of such arguments.

More specifically on China:

Greg is right to wonder about China’s massive increase in wealth over the past 30 years.  It is astonishing.  Does it represent trouble for the free market thesis?  I don’t think so.  It adds a lot of credence, indeed.  China has been rapidly reducing tariffs over the past 30 years.  Non-Tariff barriers are falling, too.  In short, China opened their markets to the international market.  I think this has contributed to their economic growth.  It could be better, sure, but they’re steps in the right direction.

However, I fear if China does not institute market reforms, they could find themselves stagnating.  Japan had a similar growth strategy as China in the 70’s and 80’s.  They saw rapid growth but subsequently stagnated from 1990 to present as their protected firms became moribund and unable to handle competition or anticipate market changes.  Unless they allow true market reforms beyond what they already have, China will likely also face such stagnation, albeit at a higher level than Japan.

Murphy in the Library of Economics and Liberty

Here is a link to my latest column at the Library of Economics and Liberty.  A slice:

One last point on the national defense argument. If China, a national security threat and military threat for influence in the region according to President Trump’s economic advisor Peter Navarro were dumping steel in the U.S. market to gain some military advantage, the logical thing for the U.S. government to do would be not to encourage U.S. exports but, rather, to encourage Chinese imports. Since steel is a scarce resource, sending it abroad (i.e., encouraging exports) necessarily reduces the stock of steel in the United States, whereas imports increase it. If China is dumping, then it means that the product is being sent to the United States rather than being used in Chinese markets; for every unit of steel sent to the United States, that is one less unit that could be used for a Chinese war machine and one more for a U.S. war machine. The logical action for the U.S. government would be to purchase a lot of low-cost steel from China and simply stockpile it, thus depriving China of war materials while maximizing U.S. steel stockpiles. In the event of war, the United States would have a large stockpile from which to draw, while China’s would be reduced.

The Law of Demand in Action (or Why Monopoly Power is Fleeting)

Writing at Human Progress, Martin Tupy has an excellent article on the real effects of predatory pricing and monopoly.  Here is the upshot (although one should read the whole article.  It is excellent):

In a 2014 Council on Foreign Relations report, Eugene Gholz, an associate professor of public affairs at the University of Texas at Austin, revisited the crisis and found that the Chinese embargo [of rare earths to Japan] proved to be a bit of a dud.  Some Chinese exporters got around the embargo by using legal loopholes, such as selling rare earths after combining them with other alloys. Others smuggled the elements out of China outright. Some companies found ways to make their products using smaller amounts of the elements while others “remembered that they did not need the high performance of specialized rare earth[s] … they were merely using them because, at least until the 2010 episode, they were relatively inexpensive and convenient.” Third, companies around the world started raising money for new mining projects, ramped up the existing plant capacities and accelerated plans to recycle rare earths.

In other words, when faced with a sudden shortage, people compensated through other means.  It’s almost as if demand curves slope downward.

Monopolies are still subject to the whims of consumers.  They cannot raise their prices with impunity.  As prices remain high, people will innovate around them.  This indicates that the fear of predatory pricing, that a firm (or country) will seize market power and use it to jack up prices or manipulate people, are greatly overblown.

 

The Role of Money in Trade and Economics

Is money a means or ends?  Confusion over the answer to this question dominates much of the popular conversation regarding economic policy and methods.  Those who see money as an end tend to focus on the production side of economics; wealth is generated by producing and selling things.  The more you sell, the higher your profit, the more wealthy you are (this is the main argument behind mercantilism).  When money is treated as a means, then the focus tends to shift more towards the consumption and trade side of economics: wealth is created when people trade things of lesser value for things of higher value (this is the main argument behind free trade).  Precisely exploring the role of money in trade and economics will go a long way to understanding the means of wealth in society.

Money does not predate economic activity.  Money arose out of economic necessity.  In a simple two-person word, it’s easy to see how a barter economy based on comparative advantage can develop.  One person can make fishing hooks while the other fishes, for example.  They specialize in their comparative areas of expertise and barter physical goods for physical goods.  Both are made better off without the need for money.

But, as the world expands, the barter economy becomes more complex and can start to break down.  That is because barter requires double coincidence of wants.  In other words, to successfully barter, you need something that the other person wants.  I am an academic.  In a barter economy, all I can offer are my economic writings.  If I go to the grocery store and the grocer just happens to want an economic tome for the same amount of groceries I just happen to want, then a trade can be arraigned.  But, if he doesn’t, then no trade can occur.  What can solve this problem?  Well, what if there were some medium of exchange, something that both he and I wanted that could be exchanged in lieu of the physical goods/services but could itself be exchanged for physical goods/services?  A numeraire, if you will?  That numeraire is what we call “money.”

Money solves the double coincidence of wants problem.  I can sell my economic ramblings to some university or bookstore patron in exchange for money and turn around and exchange that money for groceries.  The bookstore patron needn’t necessarily have anything physical I desire other than his money; he needn’t provide me any good or service (he’s already done that for someone else).  He need only give me some pieces of paper.  Likewise, I needn’t perform any services for the grocer (I’ve already done that by providing the book to the patron).  I need only supply her with the desired amount of money.

Money also acts well in reducing transaction costs by being divisible.  Going back to our barter example, neither fish nor fishhooks are particularly dividable.  Selling someone one-and-a-half fishhooks is to really sell them one fishhook and a broken fishhook.  A barter deal may not come about because the amount needed to be exchanged in intact units would be too high.  But money solves this problem.  If, for example, my book sells for $10 and the number of groceries I want to purchase cost $5, then I can essentially sell half-a-book to pay for my grocery bill because money can be divisible.  So, the introduction of money as a numeraire into trade increases the number of transactions, thus the depth of the market and the potential wealth gains, into an economic system.

But, as this discussion shows, money is merely a means of increasing the number of transactions.  The goal is not to acquire money, but rather to acquire money in order to be exchanged for something else (don’t believe me?  How many people are clamoring for forms of money, like the Murphy-Bill, to pay bills?  I got a whole bunch of them for anyone who wants them).  In any given transaction, one may exchange their good/service for money, but that is because the money they acquire is desired to be used in other, more valuable, means (if the value they got from the money was less than the value they got from the labor, they’d not exchange).  Money, in and of itself, provides no other uses (indeed, one of the reasons something is chosen as money is because it has no other use.  For example, would anyone want pictures of dead people and numbers on paper if they couldn’t be exchanged for something else?).  You cannot eat money.  It can only satisfy wants and demands by being exchanged.

Let’s apply this reasoning to international trade.  Money is a means to an ends (consumption).  Thus, people trade with other people on the other side of political borders in order to consume.  Just as I traded my money with the grocer to consume food, I traded a few bills with a French producer to consume gin.  I “exported” my labor to the grocery store so I could “import” food.  I “exported” my labor to the French distiller so I could “import” gin.  Thus, we can see that “exports” are what are given up in a trade (the cost) and “imports” are what are gained (the benefit).  Unfortunately, much popular conversation surrounding trade has this exactly backward.  A “successful” trade is one where a person (or group of people called a “nation”) export more than they import.  In other words, they give up more than they get.  This would be akin to saying the person who is a “successful” grocery shopper is the one who spends the most at the grocery store and gets the least in return.  The “smart” shopper spurns all bargains, sales, discounts, and specials.  Indeed, the “winning” shopper would be the one who demands he pay higher prices.  The “best” shopper “laughs” at all the other shoppers who are buying food in bulk, buying what’s on sale, buying specials.  He laughs at the foolish shopper who, by taking advantage of low prices, buys a month’s worth of food for a week’s salary while he buys a week’s worth of food for a month’s salary.

If we treat money as something that merely represents a divisible number of physical goods and services, we can see that all trade is still ultimately bartering.  Just as the goal of barter exchange is to get as much as possible while giving up as little as possible (that is, to “import” as much as possible while “exporting” as little as possible), the goal of trade is to get as much as possible (import) while giving up as little as possible (export).  the inclusion of money into the equation does not change the underlying logic.

Leland Yeager, 1924-2018

Leland Yeager, the great monetary and trade economist, has passed away at the age of 93.  While I never met Yeager in person, he was a major influence.  His crystal clear and entertaining writing style could make even the hardest topics easy to understand (a collection of his writings can be found here).  Yeager covered many topics in his career, from international trade to monetary economics to philosophy.  Everything he wrote was punctuated with his clear thinking.

May he rest in peace.  Economics is a far better profession because of him.