Surprise!

At Cafe Hayek, Don Boudreaux has a blog post discussing the rather frequent argument used by some protectionists who object to foreigners owning American assets.  Don writes:

One of the facts that I pointed out [in Don’s recent debate with Ian Fletcher] is that a U.S. trade deficit is good for the U.S. insofar as such a deficit means that capital is flowing into the U.S. and creates new businesses (or bolsters existing businesses).  Think, for example, of BMW’s factory in Greer, South Carolina, or of any of the many Ikea stores across the United States.

In reply, Fletcher agreed that such investment is productive, and even that it’s beneficial for Americans.  “However,” he replied (and here I quote from memory), “it would be even better if those assets were owned by Americans.”

The core error in Fletcher’s reply is the assumption that the productive assets that are brought into being by foreign investment would exist in the absence of foreign investment.  Fletcher assumes, for example, that the successful Ikea store in Dale City, Virginia, would exist in the absence of Ikea’s decision to build and operate a store there.  Fletcher assumes, in other words, that the ownership of an asset is economically distinct from the creation of an asset.  But this assumption is plainly mistaken.  Nothing prevented Americans from building a large furniture (or other kind of) store on that very location before Ikea built its store there – nothing, that is, other than the failure of any Americans to have the vision or the willingness to do so.  Ikea’s entrepreneurial vision and willingness to take the risk of building a store in Dale City added tothe capital stock in America (and in the world).

To build upon Don’s point:

People like Fletcher treat assets and resources as if they are mana from Heaven, that these factories and stores and the like just fall to the Earth, waiting to be claimed by whoever walks by.  But goods and services are brought into existence and traded through human action. It’s man, not God, that transforms and produces. God just gave us the faculties to do so.

However, there is also a crucial element of what Israel Kirzner called “surprise” needed.  That is, being aware when an opportunity presents itself.  Allow me to explain via metaphor:

Two shoe salesmen land in a foreign country. Both notice no one in this country wears shoes. The first calls back to headquarters: “I’m headed home. There are no sales opportunities here. No one wears shoes!” The second calls back to headquarters: “Send me more people. There are lots of sales opportunities here. No one wears shoes!”

The point of this story is that entrepreneurial activity includes “surprise,” that is: being aware of an opportunity that presents itself even when not actively searching for it.  One of the salesmen, the one who thought no opportunity existed, had no such element of surprise.  The other did.

There’s no reason to assume that if Ikea hadn’t shown up, someone else would have. This isn’t a “search cost” thing (ie, other people did not simply look hard enough and Ikea just looked harder/longer), but rather an entrepreneurial surprise thing. Ikea spotted an opportunity and invested. It’s probable no one else would have spotted (or, at least spotted at the same time) this opportunity.

But let’s say more. Let’s say that some American firm did spot the same opportunity at the same time and were competing against Ikea for the same resources (land, labor, etc). Would it be safe to say that the community would be better off if the assets were owned by the American firm rather than Ikea? Not necessarily. Given that Ikea won the bidding war, that probably means Ikea had a higher value on the resources than the other firm. This, in turn, means that Ikea can likely produce more value out of the resource, which means providing value to the consumers of furniture. By being more efficient (that is, using fewer inputs to achieve the same or greater outputs), Ikea produces more value for the community than the other firm that lost the bid.

Economic growth occurs through the mechanisms of discovery and surprise (a la Kirzner) and resources going to their most valued uses.  We cannot take for granted either one of these processes.

Optimal Tariffs and Blackboard Economics

Don Boudreaux favorably quotes Doug Irwin over at Cafe Hayek.  Below is a slightly edited comment I left:

What Iriwn, like Hayek and Coase before him, points out I think is just brilliant: the scarcityists’ arguments are one long exercise in begging the question. They’re assuming they have the very knowledge they’re trying to show they can acquire. Yes, if one just happened to know the complete set of preferences and demand curves for all people in the nation, then one could create an optimal tariff or policy for that given moment in time. But it’s in getting that knowledge where the trick lies.

Note that the key word here is “knowledge,” not “information.” You don’t need data points to feed into a machine, but precise observations about the nature and time and place of each individual, observations the individual himself does not necessarily know. Collecting these necessary observations are impossible.

But there is another thing to keep in mind: Bastiat. Let’s grant the scarcityist’s assumptions and say we can set an optimal tariff policy. Such a policy is optimal in name only; it’s optimal only through incomplete accounting. It’s optimal only from the point of view of the country levying the tariff. But economics is not about only looking at one person in one time period (the seen). We must look at all people over all time periods (the unseen). An optimal tariff in the US may temporarily raise US net welfare, but at the same time, the world as a whole is made worse off. A poorer world means fewer buyers of US products and fewer sellers of goods to the US (exacerbated by the tariff). A poorer world also means increased instability, and likely more war. Both these effects will rebound on the US, leading to a poorer US as well over time. In short, even if we grant the assumptions of the scarcityists, the outcome from tariffs, when explored across all people in all time periods, is still negative.

Flaws of GDP when Discussing International Trade

Gross Domestic Product, better known by its acronym GDP, is frequently cited and understood by non-economists as the measurement of the economy.  But GDP is not the measure of the economy, it’s a proxy measurement for economic activity (creating a measurement for the economy is problematic because the economy is not something that can be measured in its entirety.  Its the grand sum of all human actions, some of which are measurable and observable and some of which are not).

One of the most commonly known things about GDP by non-economists is its accounting formula:

GDP=Consumption (C)+Investment (I)+Government Expenditures (G)+Net Exports (NX), with Net Exports being defined as the difference between imports and exports (Exports-Imports).

It is on this Net Exports figure I will focus the conversation as it is from whence the confusion about the effects of international trade on economic activity comes from.

Often in news reports, we will see a report along the lines of this:

US economy grows 3.0 percent in third-quarter  

The U.S. economy unexpectedly maintained a brisk pace of growth in the third quarter as an increase in inventory investment and a smaller trade deficit offset a hurricane-related slowdown in consumer spending and a decline in construction.

Exports increased at a 2.3 percent rate in the third quarter, while imports fell at a 0.8 percent pace. That left a smaller trade deficit, leading to trade adding 0.41 percentage point to GDP growth.  (Source)

However, this reporting, which states that the trade deficit affects GDP which leads many non-economists to the conclusion that international trade and imports are bad for the economy, is incorrect.  it is based off a misunderstanding of the GDP calculations.  To explain why, we need to understand exactly what GDP is:

GDP stands for Gross Domestic Product.  “Domestic” is the key word there.  We’re focusing on consumption, investment, government expenditures, and exports of domestically produced goods.  So, why are imports in the equation at all?  Why not just simply sum all the consumptions, investment, government expenditures, and exports of domestically produced goods?  Simple: we don’t know what proportion of these components contained imports and what proportion contained domestic goods.  But we do know how many goods/services were imported.  So, we can simply subtract out the imports from the equation to give us the true GDP factor.  In other words, imports are an adjustment factor, not a component of GDP!  Without the import adjustment factor, we’d be overestimating GDP.

I think a simple numerical example will help explain:

For the sake of simplicity, assume a closed economy (no international trade) and only one type of activity, Consumption.  Thus:

GDP=C.

Since all goods are produced domestically, we can say:

GDP=Cd, where Cd stands for Consumption of domestically produced goods/services.

Assume Cd=5.

Thus: GDP = Cd, GDP = 5.

Now, assume the economy opens and only imports (that is, they have a trade deficit).  GDP is now:

GDP=C-Imports (I).  However, C = Cd+Ci, with Ci defined as consumption of imported goods.

Let’s say imports = 6.

Our GDP formula is GDP=C-I.

Rewritten: GDP = Cd+Ci-I

GDP = 5+6-6

GDP = 5.

As we can see here, once we adjust for imports (which is necessary because we’re dealing with gross domestic product), GDP does not change because of the trade deficit!  It is incorrect to say that imports reduce GDP, QED.

To be clear, there may be secondary effects imports have on GDP (say, for example, imports drive out domestic producers, which can reduce Cd, which can reduce GDP), but it is not a given that imports reduce, as I have shown here.  But even then, it is not necessarily a bad thing if GDP falls because of more imports.  GDP is a proxy, not a measurement, of economic activity and well-being.  If one is made better off by buying imported goods rather than domestic goods, then that will not show up in GDP, but it is a real gain nonetheless (for an explanation of this point, see the previous posts in this series).

Update: Here is Pierre Lemieux on this very same topic.

International Trade

The previous blog posts have discussed how trade benefits the traders.  We began with the observation that people act purposefully.  Then, we developed that observation to answer the question “why do people trade” and found that people trade because such a transaction is mutually beneficial.  That led us to a graphical representation of the question: the supply and demand diagram.  Finally, we were able to show the gains of trade that occurred.  At the end of this blog post, we touched on the claim that these gains from trade do not depend on the geographic or political location of these actors (gains from trade do not change whether the trade is inter-neighborhood, inter-town, inter-state, or inter-national).  I will now expand on that point.

Trade occurs because both parties benefit and thus gains from trade are realized.  The gains may not always be exactly perfectly realized the way they are depicted in the supply and demand model, but it is a very accurate representation of the economic gains.  Given the sheer repetition of human action and competition of buyers with buyers and sellers with sellers, gains will tend to be maximized.  If Joe values apples more highly than Sally, Jow can bid away Sally’s apples; he can offer her some kind of compensation to part with her apples.  Likewise, if Sally is competing with Brian to sell Joe apples, and Brian values his apples less than Sally (ie, he charges a lower price), then Brian can bid away Joe from Sally.  Brian views what Joe offers as more valuable than both apples, and more valuable than the value Sally puts on her apples, so there are gains from trade (apples moved from their least valued use to their more valued use).

Gains from trade hold in an international setting, too.  One of the chief objections put forth by protectionists scarcityists is that international trade is one-sided and that all the benefits accrue to just domestic consumers and foreign sellers.  Therefore, it is only the foreigners who pay the price for tariffs, and tariffs can result in a higher net benefit.  Absent some heroic assumptions, this cannot hold true.  Why?  Because of gains from trade!  If the gains to domestic producers were able to offset losses to domestic consumers, then domestic producers could simply bid away the domestic consumers from the foreign competitors.  Consider Joe, Sally, and Brian again.  Joe and Sally are both citizens of Motonia and Brian is from Hogeland.  If Joe buys apples from Brian, then Brian offers him the best deal.  However, if Sally can offer Joe a better deal, then she can simply bid away Joe’s business from Brian by willing to charge Joe a lower price.  You would get a higher net benefit by this action.  If Sally is unwilling to bid away business, then we can conclude her gains would not offset Joe’s losses, and the total surplus would shrink compared to trade with Brian.  From a net benefit perspective, international trade does not matter (nota bene: this same logic holds if we adjust the scarcityist claim and they try to make it an externality argument, that Sally’s job loss makes things a net benefit.  See the Coase Theorem).

There are other scarcityist arguments against free trade that I will not address here; they tend to be political or legal in nature, and that is beyond the scope of these blog posts.

Here ends the substance of this series on trade.  The next post will discuss trade and GDP, highlighting some of the flaws of GDP and why how it is currently understood by most non-economists is incorrect.  The following post will be a recap of all I have written.

Let’s Begin at the Beginning

Most conversations about trade begin in the middle.  The conversation revolves around international trade, about people in one nation trading with people in another.  The conversation revolves around GDP and regulations and tariffs and tribunals and all these things tangentially related to trade, but never about trade itself.  The problem with starting the conversation in the middle like this is we miss the all-important fundamentals that are developed in the beginning part of the conversation.  For economists, this gloss isn’t a problem; we’ve been trained and trained on trade.  But for presidents, politicians, pundits, and prophets, this gloss is problematic.  They do not understand the basis upon which trade is built, the logic of the argument because they miss it (I suspect this is a good amount of the reason opinions diverge so strongly between economists and the man-on-the-street on the nature of international trade).  Therefore, I offer this blog post as a humble contribution to the conversation.

Let’s begin at the beginning: Why do people act?  They act because they must feel, given the information they have at the time, that their action serves some desired end/purpose.  In other words, that action is purposeful.  Given purposeful action, why do people trade?  What causes Smith and Jones to exchange their goods with one another?  The answer is obvious (by which I mean its literal interpretation (derived from observation) as opposed to its more colloquial use of “trivial”): Both Smith and Jones benefit from this trade.  If either party did not benefit, then no trade would happen.  It is from this first principle that we must build the conversation around trade, but it is this first principle that much of the political conversation ignores.

In the coming days,  I will be posting a series of blog posts exploring trade from the first principle that trade is mutually beneficial.  The outline is as follows:

Trade is Mutually Beneficial

Supply and Demand

Gains from Trade

International Trade

Problems with GDP

-Summing Up

Stay Tuned!

Institutional Diversity and Trade

A popular argument against free trade is that the logic of trade requires identical (or at least similar) rules/institutions between the trading parties.  Dani Rodrick recently made this argument, and you can see Don Boudreaux’s response here.  There is absolutely nothing in the logic or argument for free trade that necessitates similar institutions between the partners.  Only one thing is required: both parties benefit.

However, for both parties to benefit from trade, they must inherently be different from each other.  If the two were identical, then no trade would ever occur.  Diversity in tastes, in endowments, in incomes, even in rules, are desirable and, to differing degrees, necessary.  The idea that trading partners must be similar to one another, including in their belief structures, undermines the logic of trade.

Moving from the individual level to the national level, institutional diversity helps show actual costs and benefits of various institutions.  For example, if the whole world were as protectionist as Red China in the 1950’s, no one would know what a horrible scheme that is as the whole world would have looked like massive starvation.  Fortunately, the Chinese realized their mistake and have become rapidly more open-trade, thus leading to their huge economic gains lately, but it was the fact that institutional diversity existed that such folly was understood.  If a given national government decides not to allow peaceful trading between their citizens and another group of citizens, then their citizens are harmed and the true costs of their institutions, as well as their true benefits, are not known.

Diversity is a necessary ingredient of trade.