A Hidden Danger of Aggregation

I have been verbally outspoken against macroeconomics (not so much writing).  Macroeconomics, that is the examination of aggregate economic data for the purpose of discovering observable phenomena, is quite distinct from microeconomics.

Despite my verbal abuses, macroeconomics does have uses.  Observing these phenomena, such as the impact of interest rates or foreign exchange rates or GDP, can provide useful information.

But they are only useful insofar as the assumptions behind these aggregate measures hold; only insofar as they are used as a signal.  GDP, for example, is used as a measurement for economic well-being.  In a relatively free market, with a working price system and protected property rights, it acts as a pretty good indicator.  Given these assumptions, if GDP rose, say, 4% over the course of a year, it’s reasonable to conclude the people who make up the economy are likely approximately 4% better off than they were the previous year.

However, once those measurements become an object of choice, then they lose all value.  GDP growing at 4% due to market forces tells us important and helpful information.  GDP growing at 4% due to deliberate actions taken by governments to increase that number (say, arbitrarily increasing government spending) does not tell us anything useful.  If anything, it can be misleading.  The signal is distorted.

This argument is the same as discussions on the distortion of price signals.  A price, when determined by supply, demand, and all their components, provides valuable information on the relative scarcities of goods.  A price, when it becomes an object of choice and is thus manipulated to meet some desired level (eg, minimum wage, price controls, tariffs, etc) provides no useful information.  The price no longer functions as a price.

The great sin of macroeconomics is confusing this point; how often do we hear an argument along the lines of “Higher GDP is good.  This action would increase GDP.  Therefore, we should do it”?  But a higher GDP is only useful insofar as it conveys market transactions.  Anything else, and it becomes useless.

Should Economic Growth be Traded for National Defense?

One of the stronger arguments against free trade is the national defense argument: some industry may be so vital to national security to warrant its protection from foreign competition.  This justification may be easily abused, but let’s ignore that possibility for the moment.  Is it still worth restricting trade and reducing opulence for the sake of national security?

The trade-off between security and opulence doesn’t appear too clear cut to me.  Protected industries tend to become listless, stagnant, and non-dynamic.  Protected from the forces of competition, they can become complacent.  As AEI economist Mark Perry likes to say: competition breeds competence.  These protected industries may become so undynamic, so technologically backward or stagnant, that in the event of a national emergency, they are unable to handle the military needs.

Furthermore, protected industries (especially if they are subsequently subsidized) may discourage development of newer technologies that may be better suited for national defense.  Let’s say, for example, that the steel industry is vital for national defense.  Since steel is protected from competition, it can make it a more attractive investment for people given its security.  This would divert resources away from other developments that could rival the industry, say some sort of lighter metal or steel substitute.

If an industry is protected from competition and it becomes listless and non-dynamic, not only is it coming at a sacrifice for national wealth but may also be a hindrance to national defense as well if it cannot adapt to changing war needs.  This becomes deadly true if a climate of rent-seeking rather than innovation takes hold in the national economy.

In short, while theoretically, tariffs could be helpful for national defense, they could very well end up being detrimental.

People Trade, Not Countries

In a short post on EconLog, Pierre Lemieux points us to the flawed thinking of many scarcityists.  In the article, he quotes Trump:

“Their consumer habits,” [Trump] explained about Europeans, “are to buy their cars, not to buy our cars.”

What the scarcityists don’t understand, even with their fancy models, is that trade is ultimately and everywhere a microeconomic phenomenon.  It is people’s preferences that shape the pattern of trade, and merely imposing some tariff here to removing some tariff there may not be enough to create “balanced” trade.  In a world of free trade, people will be free to make their own choices.  In this case, the people have spoken: Europeans prefer European cars to American.  And to a tyrant like Trump, that is unacceptable.


Thinking about Collective Nouns

This semester at GMU, I am teaching two sections of international trade (Econ 385: International Economic Policy and Econ 390: International Economics).  In both classes, I began with a lecture (reiterated in subsequent lectures) that the focus of analysis is the individual: the government does nothing.  The decision-makers in government do something.  Ford Motor Company does nothing.  The CEO (or COO, or purchasing manager, etc) do something.

As such, these collective nouns (the government, the firm, the society, etc) can be useful shorthand so long as it is understood that the individual remains the focus of analysis.  But they can also be highly misleading.  In international trade, for example, nations do not trade.  It doesn’t make sense to talk about China trading with the US or the US specializes in X and Croatia specializes in Y (even as a shorthand).  Bobby in Boston buys a toothbrush from Li in Lanzhou.  End of story.  These transactions may be aggregated upward based on all the transactions that occur within some political boundary, but ultimately it is still individuals who trade.

When does it make sense to use a collective noun such as government or firm?  When the action taken calls for collective action.  In other words, when there is a margin being adjusted upon that the individual cannot adjust upon.

Perhaps an example will help.  Consider two men trying to load a heavy box into a truck.  The effort is not merely the summation of their two efforts.  If Joe lifts and then Richie lifts, the box ain’t going anywhere.  It is only through their combined efforts at the same time that the box is moved.  The two men working as a team adjusts along a margin (moving the box into the truck) that individually they could not do alone.

So, it makes sense to refer to a collective noun as a collective noun when there is some effort going on that only the collectivity can achieve.  Only Ford by its nature as a firm man design, manufacture, market, distribute and retail cars. It is the collective action taken by many individuals whose individual contributions are hard to separate from the collective goal; where anyone individually working alone would face costs too high to make the action occur.  The team of Joe and Richie does and Joe and Richie cannot alone do.  It makes sense to refer to them as a team.

The way international trade is discussed and taught is largely misleading if one is not careful about this subtlety.  International trade remains, ultimately, a microeconomic event.