Economic Growth is Not A Given

A large amount of macroeconomic thought is given toward the question: “what causes recessions?”  Monetarists, Keynesians, Austrians, New Insitutionalists, Neo-classical all often approach macroeconomic thought in this manner (note well: I am not saying this question is central to the above-mentioned schools-of-thought, just that their practitioners will study this question).  In my opinion, this is the wrong question to ask.  The right question is not “what causes recessions” but “what causes growth?”

This may seem like a semantic game; aren’t I just stating the inverse of the first question? Yes and no.  If we know what causes growth, we can (generally) inverse that and learn what causes recessions.  But the second question remembers what I think is crucial to economic understanding: growth is not the state of nature; stagnation is.  Humanity, by sitting on its collective ass didn’t generate the Industrial Revolution or invent medicine.  Despite terms like “natural unemployment” or “natural rate of growth”, none of those are natural.  The true natural unemployment rate is 100%.  The true natural rate of economic growth is 0%.  Growth requires effort to occur; it requires trading and production.  It requires human action.

This lesson is important because it prevents us from making mistakes that can be detrimental to economic well-being.  For example, some trade-protectionists worry about trade deficits because it means foreigners are buying more and more US assets.  This, supposedly, is a bad thing.  Here’s why, according to a commentator, Ed Rector, at Cafe Hayek [emphasis added]:

However if the Chinese use their trade-surplus US dollars to buy already existing US assets (USG debt, office buildings, hotels, etc.) there is no significant increase in employment in the USA [compared to building new factories]. So to that degree the existing wealth of the USA IS transferred to foreign ownership, where it will presumably generate investment returns to the foreign owners.

Here, Mr. Rector makes the mistake I mention at the beginning: he assumes growth is given.  The counterfactual here is not whether an American or a foreigner owns an asset, but whether that asset is owned at all.  The fact the asset is up for sale tells us it is likely no longer productive to its current owner; if it is not sold, the asset would likely become idle and produce nothing.  When it is bought, the asset remains productive (indeed, this is how it generates returns for its owners).  By remembering that the default is not growth but stagnation, we are counseled to not fret about who owns an asset, just that it is owned and productive.  We cannot take the productivity as given.

Today’s Quote of the Day…

…is from pages 5-6 of Frederic Bastiat’s 1850 essay The Law (Mises Inst. Edition):

But [man] may live and enjoy, by seizing and appropriating the productions of the faculties of his fellow men.  This is the origin of plunder.

Now, labor being in itself a pain, and man being naturally included to avoid pain, it follows, and history proves it, that wherever plunder is less burdensome than labor, it prevails; and neither religion nor morality can, in this case, prevent it from prevailing.

When does plunder cease, then?  When it becomes more burdensome and more dangerous than labor.

As with anything, people will choose the least-costly option for their actions, in this case in the trade off between labor and plunder (Bastiat uses the phrase “plunder” here meaning the legal appropriation of one’s property by the state to transfer to another person).  As the cost of labor rises (or the cost of plunder drops), the attractiveness of plunder increases.  Things like occupational licenses, tariffs, and even progressive taxation all increase the costs of labor, and thus make plunder more attractive, which in turn leads to more lobbying and resources spent to get a share of the plunder.

Respect for the law cannot long be preserved when the law becomes a tool for plunder rather than preventing it.

In Defense of the Law

The great French economist and philosopher Frederic Bastiat wrote in The Law:

The mission of law is not to oppress persons and plunder them of their property, even thought the law may be acting in a philanthropic spirit. Its mission is to protect property.

The law is justice — simple and clear, precise and bounded. Every eye can see it, and every mind can grasp it; for justice is measurable, immutable, and unchangeable. Justice is neither more than this nor less than this. If you exceed this proper limit — if you attempt to make the law religious, fraternal, equalizing, philanthropic, industrial, literary, or artistic — you will then be lost in an uncharted territory, in vagueness and uncertainty, in a forced utopia or, even worse, in a multitude of utopias, each striving to seize the law and impose it upon you. This is true because fraternity and philanthropy, unlike justice, do not have precise limits. Once started, where will you stop? And where will the law stop itself?

Bastiat’s point, that the law exists to serve justice and nothing more, is the essence of the rule of law.  The rule of law is the idea that no one is above the law, but also no one is beneath the law.  Many people remember the first part, but conveniently forget the second.

Over the past few years, and especially since the election of Donald Trump, the law has come under attack, both by those on the Left and the Right.  Both want to carve out exceptions to the law, either by eliminating protections under the law for disliked groups (the Left for the alt-right, the Right for immigrants and Muslims) or by giving themselves greater share of “legal plunder” (tariffs, welfare, subsidies, etc etc).  As a classical liberal, it disheartens me to see my country, one founded on (if not always practiced) the ideals of justice, liberty, and the rule of law so willingly and vehemently attack these very ideals for the sake of political virtue-signalling or simple spite.

Justice is blind.  That means she sees not the devils nor the angels of our nature.  She hears only the circumstances, and defends the wronged party.  Whether that party is black, white, Hispanic, Republican, Democrat, Christian, atheist, Muslim, of the “right” mind, of the “wrong” mind, it doesn’t matter.  Justice defends them all.  This must mean that, yes, we must give the Devil himself the benefit of the law for the sake of justice.

A couple of examples.  First, here is a NYT story explaining the jubilation many had after Richard Spencer (the notorious neo-Nazi) was attacked.  Second, this story from Reason responding to the Republican (and sometimes right-libertarian) argument that immigration should be restricted because immigrants tend to vote Democrat.  In both cases, we have an ‘in-group’ trying to carve out exceptions to the law (in the first case freedom of speech, in the second case freedom of migration and protection under the law) for an ‘out-group’ who thinks differently from the in-group.  In both cases, the in-groups are making a mockery of the law.

As a classical liberal, I will defend the rights of both out-groups, indeed all out-groups, because Justice cares not whether one is in or out, and the law shouldn’t either.  I will defend them, not because of any sympathies to neo-nazis (of which I have none) or particular love of immigrants but for my own safety’s sake.  If we weaken the protection of the law for out-groups, what happens when we find ourselves the out-group?  To borrow the language from A Man For All Seasons, if we cut down every law to apprehend the Devil, what will protect us when the Devil turns on us?  Yes, I would give the Devil the benefit of the law for my own safety’s sake!

Tyrants rarely run roughshod over the law, but rather use precedence set by those before them (this precedence, although itself a mockery of the law, gives the illusion that the tyrant’s actions are lawful).  Exceptions to the law, granted by angles to pursue angelic ends, then become the tools of the devil to pursue devilish ends.  Vast presidential powers, handed over by Congress to the Executive Branch, now lay in the hands of Trump.  A vast regulatory government, once in the hands of relatively moderates now exists in the hands of an ignorant, egomaniac populist.  When the moderates were in power and wanted more and more leeway, the classical liberals objected; like More in the clip above, we refused to cut down the law to pursue the Devil for the exact reason that now is in our face: the Devil has turned ’round upon us and many laws have been cut down.

We must defend the rule of law and its protections for all people, including the Devil himself.  Once the door is opened that people who have “wrong” opinions do not deserve the same protections and liberties as people with “right” opinions, then it’s damn near impossible to close that door.

Markets Make Mistakes. That’s A Good Thing

Free markets are not perfect.  In fact, they are anything but (a topic I have spilled lots of digital ink in discussing, for example here).  Markets may end up in inefficient allocation of resources, may give rise to monopolies, or any number of other non-perfect competition outcomes.  However, the fact markets aren’t perfect, that people make mistakes, is a feature, not a bug, of markets.

When a market imperfection (or “market failure”) arises, it indicates that there is some “surplus” (that is, welfare) not being captured.  It’s being lost.  This signals a profit can be made for anyone willing to exploit this failure and correct it.  If, for example, the price of Good X is “too high” because of monopoly power, it encourages people to look for ways to enter the market to capture some of that profit.  This, in turn, brings more of Good X to the market which helps lower the price of Good X.*  The market mechanism helps fix the misallocation.

Of course, enticing others into production is not the only way the market can “heal” itself.  Relatively high prices also cause people to search or create substitutes.  A good example of this is what Mark Perry highlights at Carpe Diem: synthetic diamonds created to combat the cartel power of diamond miners. In fact, the failure or missteps of markets is a major driver of innovation!

However, the profit motive is itself not perfect.  When dealing with public goods or poorly defined property rights, the profit motive may break down.  There is a lot of discussion to be had on that topic, and thus I will avoid it for now.  Rather, I want to focus on the larger message: markets stumble, but they also have mechanisms built in to correct those stumbles.**

The market has failed.  Long live the market.

*This example assumes no government barriers protecting the monopoly.  Other barriers, such as geographical or technological, that help create a monopoly can be broken down eventually.  Government barriers, not so much.

**I’m hesitant to use this language as it may cause the reader to conclude, incorrectly, that markets are machines that can be designed.  I hope readers know markets are organic and not mechanical.

Some More Thoughts On Immigration

Many people will complain that, so long as the institution of welfare and voting exist in this nation, we cannot have open borders in regard to immigrants.  They claim the immigrants will just come here and become welfare queens and vote away our democratic institutions for their socialist ones.  Ignoring the factual issues with these complaints (Immigrants use welfare at lower rates than domestic citizens and naturalized-immigrant voting patterns and policy views don’t differ much from Americans), there are larger issues at play here.

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Compared to Heaven, Earth Looks Like Hell

Economists have many models that exist in highly stylized theoretical settings (this is just a fancy way of saying “perfect settings”).  When we compare real-world institutions and situations to these stylized models, the real world often looks awful in comparison.  There are externalities, corruption, misallocation, a general lack of equilibrium, asymmetric information, etc etc etc.  Thus the models compared to real life look ever more better.  It’s severely tempting to use the flaws of the real life outcomes to justify moving toward theoretical approaches (eg. using market failures to justify government intervention).

But, as was discussed the other day in the Alchian quote, alternative institutional arraignments have flaws, too.  To compare a flawed institution to an ideal alternative is what Harold Demsetz called the “Nirvana Fallacy” and can lead to mistaken conclusions.  We need to compare institutions using the same assumptions about each one.  For example,   market operations are subject to externalities because of information asymmetry among the participants?  Government intervention must also be subject to such information asymmetry.  Markets misallocate due to imperfect information its participants?  The same must be said for government operators in the market.  And so on.  This application of consistent assumptions when comparing alternative institutions is, ultimately, at the heart of economics in general and Public Choice Theory in particular.

It is also important to note these flaws as well as virtues of alternative institutions because the situation may change and warrant different approaches.  Take, for example, trade tariffs.  As a general rule, the lower the tariff the better (I will refrain from proving this at this time and we will proceed with the assumption it is true for the sake of discussion)*.  Let’s say that the current tariff on Good X is 25%.  The economist would argue for lower tariffs.  Now, let’s say that a new government comes in and declares that tariffs on Good X will rise to 35%.  The economist’s position will now change to maintain the current 25% tariff.  The situation has changed and the comparatively better option is to maintain the status quo.**  Compared to Heaven, Earth looks like Hell.  But compared to Hell, Earth looks like Heaven.

When looking at institutions and discussing institutional change, we need to compare like with like.  Comparing a market failure with a highly stylized government intervention is unfair (and, likewise, comparing highly stylized markets with government failure is also unfair).  The flaws in each must be recognized and honestly discussed.  The existence of flaws in any given institution is not a reason to abandon it.

*If you disagree with this assumption, it doesn’t change the discussion.  Simply reverse the signs of the discussion in the paragraph.

**Of course, this is not to say the economist won’t/shouldn’t advocate for even lower tariffs once the 25% is met.  We’re just looking at this one situation.

Trump, Regime Uncertainty, and Why Rhetoric Matters

Some defenders of President Trump have tried to justify his trade rhetoric as just that: words.  They argue that Trump will never enact the tariffs, or do so at much lower rates, so firms and individuals will not change their behavior.  However, this is a mistake.  We all make choices in an uncertain world and our actions depend, in part, on our internal calculations of the likelihood of different events (not to mention our own risk tolerances).  With these calculations, we make our actions.  If something comes along to change our perceptions, then we also adjust internally.*

Let’s, for the sake of argument, say that Firm X is considering expanding operations in the US. Let’s say they want their annual profits in the US to be $50 million/year.  They need to spend $100 million to enter into the US and set up.  Through various research, the firm concludes that, given current expectations on 1 November 2016, they have a 95% chance of achieving that goal (or a 5% chance of earning nothing and losing their $100 million investment.  The binary nature of this situation, while perhaps unrealistic, is done so the point doesn’t get lost in the math).

So, the expected value of their operation on 1 November is ([95/100]*50)+([05/100]*-100)=$42.5 million.

Now, let’s say that Trump wins the presidency and the likelihood of tariffs has increased. Given that the firm imports some of their material and may wish to import more in the future depending on conditions, they now conclude the likelihood of earning $50 million per year has fallen to, say, 80%. So, now, the expected value of the move is: ([80/100]*50)+([20/100]*-100)=$20 million! That’s a decline of 52.9%!

The firm is now faced with a decision, just as all firms are, based on their assessments of probability. The expected value of the firm’s move has fallen, which means the firm is less likely to enact the move at all. And all this is based off a change in probability, not just the tariffs themselves.

Another important thing to note is this still holds with small changes in probability, too.  Let’s say, for example, the firm’s initial probability of 95% still holds.  However, after the election the firm determines there is still a remote, but still real, possibility of tariffs and thus their probability estimate falls to 94.9%.  Their expected value drops to $42.35 million, a decline of just 0.04%.  But it is still a decline.  What this means is many marginal investments may be cancelled.  These now nonexistent marginal investments, which would have produced jobs and goods for Americans, are weighing on US economic growth.  All because of words.

With rhetoric flying about, it becomes harder and harder for firms to determine their probabilities.  In this sense, it is no different than arbitrary policy changes that causes other forms of regime uncertainty.  In short, rhetoric matters, even if it doesn’t translate into policy.

*For the sake of clarity, I am not saying people walk around and manually calculate probabilities before each and every action they take, but they often act as though they do.  For example, if a person knows a particular part of town has a higher crime rate than another, he may avoid that part altogether.  However, if that part of town becomes more safe, he may venture in there more often.  These decisions are made based on his perception of probabilities, not his actual probability.