The Political Economy of Trade Policy Part 2: On the Presumption of Liberty

As with any model in any science, we need to ask the questions: “how well does this model reflect real-world observations? Are its assumptions likely to hold and are they key to the model?” Negative answers to these questions do not necessarily imply the model should be scrapped. All models, after all, are simplifications. Any model that could handle every possible variation would be unwieldly and thus not provide much insight. Further, as Harold Demsetz warned us, just because the real world differs from some theoretical outcome it does not mean that alternatives are necessarily better, especially when one situation is viewed through the lens of reality and the other through the lens of theory.

In the previous post, I discussed some of the political realities surrounding economic justifications for trade restrictions, primarily using the optimal tariff model as an example. Are these objections enough to recommend against using policy to try to influence patterns of trade, or am I simply making the Nirvana Fallacy?

It is certainly true that markets can fail (broadly defined as failed to achieve some optimal level or distribution) and these failures can be corrected through judicious government actions. However, these actions can cause more harm than they actually solve. Indeed, for something like an optimal tariff, even if done with the best of intentions, it can backfire and result in a much worse scenario without much effort. Further, these justifications can be misused or hijacked to give intellectual cover for essentially selfish goals.

However, the biggest issue with trade policy is mistakes can become systematic and entrenched. Aside from the reasons discussed above, most political systems, and democracies/republics in particular, are designed to be slow-moving. This means if a policy is determined to be detrimental, it may take a while to repeal or alter even if we assume no self-interest lobbying or other barriers preventing the legislation from being changed.

National trade policy also necessarily must be general. As such, it is likely to be geared toward the average person or firm. The policy may be too restrictive for some and too broad for others; it may lead to a rather substantial misallocation in resources. Consider the following example: Imagine a room with 10 people inside, five of whom are six feet tall and five of whom are five feet tall. The average height of the room would be five feet, six inches. If there is a policy to build a door in the room so people may come and go, how would the policy be structured? Maybe it is structured so that the door must be at least six feet tall, thus everyone can easily use it, but that’d mean less wall space for windows and pictures and other things, and for half the people it’d be too tall a door. Likewise, they could order the door be at least five feet, six inches (the average height), but then the tall people would find the door inconvenient to use while the short people would have no problem. The necessity of general rules is part of the reason why government action should be limited to negative rules (eg, do not steal) rather than positive rules (eg eat five servings of veggies a day).

We also need to consider the knowledge problem. The actual level of knowledge necessary to accomplish these optimal policies is both dispersed and not even necessarily consciously known to the people holding the knowledge. Acquiring both the necessarily knowledge and acquiring it in a timely fashion are impossible. What’s more, what statistical information we can gleen has some major caveats attached. Economic data is collected primarily though the use of surveys to a sample of individuals and firms and then extrapolated to the aggregate level. However, as with any survey, these surveys are subject to the same caveats, assumptions, and error terms as anything else; they may not truly represent the real economic activity they are trying to measure. Further, as additional statistical techniques are run on them, the error terms must get larger and larger, not to mention the potential for error from sampling issues, violations of various assumptions, and the like.

With all these potential for errors, which are not limited to just the political realm, we are faced with the question “how to contain damage from failures?” As mentioned above, government rules quickly become systematic and entrenched. This means that an error in government policy could quickly affect the entire society. If, for example, government bets that the Next Big Thing is going to be autonomous cars and pours subsidies into their development, and then people decide they don’t want autonomous cars for whatever reason, the American taxpayers are held holding the bag. If the various government-supported firms go under, the taxpayers will not be reimbursed, nor have anything to show for the spending of funds that could have gone toward education, health care, infrastructure, or other uses. The error would be felt (to varying degrees) nationwide. Conversely, if a private firm makes the same bet and are subsequently proven wrong, the ones who feel the loss most acutely are the firm itself: the owners, the shareholders, and those who did business with them. The losses would be generally confined to those individuals and firms. Because of these potential losses, these private firms are more likely to be careful with their spending and their projects than would government-sponsored entities.

It is from the expectation of failure and not success that I argue for the presumption of liberty in policy. With managed trade policy, while there is the potential for upside, there is a rather substantial risk of a large downside, too. Should that downside occur (a very probable event in my opinion), it’s effects would be systemic and hard to remove. Conversely, if private individuals and firms make errors, they would be the primary recipient of the downsides. Thus, I argue that free markets are more robust to error than government is. This is not an argument from Nirvana, but rather from Hell.

A Discussion on Transaction Costs

This post is a riff on a recent op-ed column by Don Boudreaux at the Pitt Tribune “Minimum Wage & Technology.”

As Don writes:

When I explain to my students that minimum wages prompt firms to substitute technology for labor, they often react as if this greater reliance on technology is an upside of the job-destroying nature of minimum wages. But my students are mistaken.

This attitude is often portrayed as justification for all kinds of government interventions: minimum wage, labor restrictions, scarcityism, etc.  Technology is a sign of advancement, so we must advance!

But advancement is not a costless procedure.  Not only, as Don points out in his article, is there costs to developing said technology, but there are also costs to implementing and adopting such technology.  If a self-help kiosk is installed at a fast-food restaurant, its costs are more than just the new machine: it needs to be wired, staff trained (which reduces their productivity in the meantime), company policy created (and all other kinds of backroom stuff), etc.  All these things take time and resources; they all have costs.  If these costs, plus those that Don mentions in his article are higher than the benefits, then the intervention in the market, even if it produces newer technology, is a net loss.

This is an important point that is implied in the above discussion but I want to make explicit: just because there is a hypothetical “better” outcome, it does not mean that the market has failed!  If that outcome does not occur because the transaction and transition costs are too high, then the current outcome, with all its flaws, is the most optimal.

Indeed, there is really only one condition under which we can say with any certainty that a true market failure has occurred: if the outcome is suboptimal, and the transaction costs were misestimated, and this misestimation should have been known to the market participants.  This is an extremely high bar to reach, one that is made all the higher given it requires a huge judgment call on the part of the analyst.  In a sense, the analyst ends up begging the question since he has to assume his judgment and knowledge and subjective evaluations of the costs and benefits are equally shared by the participants (or he knows their inner workings).

Among economists of all stripes, the presumption of liberty, that is the promotion of free markets even when they are imperfect, remains predominant for exactly the reason discussed here: the knowledge of transaction and transition costs are highly personal and their existence gives the economist pause whenever discussing “welfare enhancing” policies specifically designed to control economies.

Today’s Quote of the Day…

…comes from pages 149-150 of Carl Dahlman’s 1979 Journal of Law & Economics article The Problem of Externality (emphasis added, footnote omitted):

In case I, the laundry owner correctly anticipates the costs of bargaining to be low enough for him to gain from reducing the smoke outpour from the steel mill: the externality becomes internalized by the steel operator. In case II, he correctly anticipates the cost of smoke reduction would be too high: he thus lives with the smoke. The externality is now internalized by the laundry operator, and there is no inoptimality problem. In case III, the laundry owner decides to bargain for reduction in smoke outpour but finds in the process of bargaining and policing the agreement that it cost him too much to do so. In case IV, he decides to live with the smoke in the belief that it would cost too much to reduce it but is incorrect: he would have gained from reducing it in view of the costs of transacting with the steel operator.

We have already noted that in cases I and II there is no Pareto-relevant externality remaining; the question remains whether there is one in cases III and IV. In case number III there is obviously no Pareto-relevant side effect remaining; on the contrary, there is too little smoke. The laundry owner lost by having the smoke reduced, so total income is lower in case III than it would have been if the smoke had been endured. In case IV, however, the laundry owner should have bargained for a reduction in smoke outpour but failed to do so. This is then the only case that can qualify as a potential externality.
From the point of view of the laundry owner, it would not appear that it is a mistake to endure the smoke: given the information that he has at his disposal, he performs his constrained optimization and does nothing. His information is incomplete or wrong, so he makes the wrong decision: given the correct information there is a loss of income from the enduring of the smoke, and the situation looks very much like  that we associate with an  externality. Yet that interpretation is fundamentally incorrect, for, with the information that the laundry owner has at his disposal when he makes the decision, he decides correctly, as constrained optimization procedures would have it. It is only later that he may realize that he has made a mistake, in view of additional information that was not available at the time. This can be regarded as an externality only if you assume that “he should have known better” or that there is someone else who does know better.

Once the logical implications of bargaining under transaction costs are fully accepted, it is seen that all existing side effects are internalized one way or the other. An assertion that externalities represent a deviation from an optimal allocation of resources then implies that the analyst considers himself in possession of superior information than what is available to market transactors: he knows the “true” probabilities, as it were. The issue of whether an alternative and improved allocation of resources exists is then seen to hinge on whether there is available relevant information about better alternatives.

People will act on the best information they have at the time.  That information may be incorrect; they may make mistakes, and mistakes that were obvious in retrospect.  But they are exactly that: retrospect.  Unless we assume the policymaker has superior knowledge of everyone’s costs and benefits (possible but not probable), we cannot say ex ante that some policy prescription is necessary or beneficial for solving externalities or other societal ills.  It’s quite probable, given people’s subjective costs and benefits, that all costs of an externality have already been internalized, that is to say, an optimal level has already been achieved.

Any political policy that alters how a market works, anything ostentatiously designed to correct a “market failure” runs into the same problem Dahlman discusses here: a knowledge problem.  The analyst or policymaker must either prove he has superior knowledge (itself a high hurdle to clear) or merely assume he does.  But it is only by retrospect can we determine if there actually is a market failure; it is damn near impossible to see one in real time.

Cooperation, Coordination, and the Law

Markets, by definition, rely on cooperation and coordination.  Buyers must cooperate with sellers in order to exchange; the seller must offer something the buyer wants and the buyer must offer something the seller wants.  Only through this cooperation can a trade occur.

Likewise, buyers and sellers must coordinate.  The buyer must be in the same place as the seller*.  A coordinating agent (ie a middleman) may sometimes be used to bring buyers and sellers together (think, for example, a realtor that brings home buyers to the home seller).  Similar to cooperation, buyers and sellers must coordinate on what to exchange and what their expectations are.

Cooperation and coordination are vital to the market process.

Economic texts tend to focus primarily on the coordinating and cooperation aspects of the market process, as they rightfully should, but a key factor is left out of the equation; that factor is the law.

Law here refers to the “rules of the game.”  Law is both written and unwritten; it is the set of rules, customs, norms, etc that develop through people’s interactions with one another.  Law, while shaped by peoples’ interactions, also shapes those interactions.

Law provides a useful form of coordination: who can sell what, what/how promises should be kept, what remedies exist for lawbreaking, that sort of thing.  Without law, and especially property rights, the coordination necessary for the market process would break down.

Consider, for example, property rights.  Property rights are a form of law; they may be formal (in the case of a deed registered at a local governmental authority) or it may be informal.  Property rights allow the market process to occur by defining who can trade what.  In other words, who owns the right to the use of a piece of property.  Ultimately what is being traded in any situation is a bundle of property rights.  If these are not clearly defined, then folks cannot know how to trade.  There cannot be coordination nor cooperation in this case.

Clearly-defined property rights are important to market transactions, but no property right will always and everywhere be perfectly clear.  We live in a world of “incomplete contracts.”  Not all possible situations can be anticipated and to write and understand property rights that take into account all possible conflicts is both physically impossible and economically wasteful (marginal cost exceeds marginal benefit).  In these ambiguities is where law also helps the market process.  Law, preferably by drawing on established rules of adjudication and precedent, can resolve these conflicts and allow the market process to function better (this was one of the great insights of Ronald Coase).

Law, of course, can have its own problems.  Just like any institution (including the market), it can be abused.  But it is vital to the coordination and cooperation functions of the market process.  Without law, trade cannot exist.  Only war.

*This place need not be physical

Trade-Offs and Public Policy

This semester, I have been studying Law & Economics with Robin Hanson at GMU.  In class, we have been discussing the legal system, how it is structured, and other ways to structure it.  Questions we’ve pondered include: why can one appeal on matters of law and not matters of evidence?  Why are rules of evidence what they are?  Should all contracts be enforced or what limits should be placed on them?  Why are property taxes structured they way they are?  Why common law in the US as opposed to civil law?  Etc.

Simultaneously, I am evaluating a book for my course this summer: Trade-Offs by Harold Winter.  Trade-Offs is a public policy-focused look at economic reasoning.  In the book, he points out one of the dangers of public policy analysis (Page 5, original emphasis):

Even if there is agreement on the broad objective of maximizing social welfare, policy objectives may differ due to differences in the definition of social welfare.  A good example of this can be found in the economic analysis of crime.  To deter crime, we must use resources for the apprehension, conviction, and punishment od criminals.  But should the benefits that accrue to individuals who commit crime (also members of society) be added to social welfare?  If yes, this may suggest that fewer resources can be used to deter crime, because crime itself has offsetting benefits.  If not, crime is more costly to society, and more resources may be needed for deterrence.  Notice, however, that it is a fact that a criminal reaps a benefit from commiting a crime (or why commit the crime?), yet it is an opinion as to whether that benefit should be counted as social welfare.  Policy objectives and definitions of social welfare are subjectively determined.

What is also subjectively determined, as explained by Carl Dahlman in his 1979 Journal of Law & Economics article The Problem of Externality, is the effectiveness of the policy change proposed.  When a policy proposal is made, the proposer implicitly assumes that whatever institution he is invoking (government, market, etc) can necessarily solve the problem he’s subjectively identified better than the status quo (otherwise, why would he make such a proposal?).

All this subjectivity means that discussing “optimal” policy gets really tricky.  Optimal tariffs, Pigouvian taxes, optimal forms of law, legislation, etc are going to depend greatly on how we measure social welfare.  When discussing tariffs, should the welfare of foreign producers and consumers be counted?  If so, why?  If not, why not?  When discussing Pigouvian taxes, should the welfare of clean-up companies be taken into account (eg, the laundromat who loses business because fewer people are washing soot-caked clothes) and is government necessarily the best solution?  What makes sense given a certain accounting of social welfare doesn’t with a different accounting.

Answers to these questions can go a long way in helping us consider supposed market failures: whether something optimal or suboptimal will depend a lot on how these trade-offs and welfare are measured (to Winter’s point above, if the welfare of criminals is taken into account, there may be too much police activity.  If the welfare of criminals is not, there may be too little).  In this sense, optimality is in the eye of the beholder.

I’d argue that the subjective nature of social welfare policy suggests a strong presumption of liberty for people to choose their own way.  Indeed, there is no initial reason to believe any given action taken by an individual is somehow sub-optimal given the subjective nature of social welfare.  Even something like pollution is subject to these conditions.  This realization also should force economists (and their consumers) to ask the question “what are we assuming?” and “how are my biases affecting this analysis?”

Economists rarely argue about data.  It’s somewhat rare that someone made a math mistake or jumbled data (ideally, that gets caught long before publication).  Outcomes are not in question, but the subjectivity of trade-offs are.

Unfair Trade and General Rules

Unfair trade has dominated the political conversation lately. Allegations that China, South Korea, Mexico, Canada, and many others are being unfair, whether they pay too low or they subsidize some industry, or their tariffs are too high, whatever, abound. These allegations justify the use of tariffs to punish the offending nation(s). Free trade, they say, cannot exist in the face of such injustice and, while it is a fine general case, exceptions must be made for these injustices to be corrected.

But do injustices that occur from a general rule justify exceptions therefrom or to even overturn the rule?

Consider the following general rule: All people in the United States, when accused of a crime, will be tried in an open court before a jury of their peers.  The ruling of that jury, barring legal issues, is final.

With that rule in mind, consider the following:

A man is accused of rape.  The evidence seems straightforward.  After a long trial, the jury retires to deliberate.  After a few days of deliberation, the jury returns a verdict of “not guilty.”  There is an uproar within the local community.  “He was clearly guilty!” they cry.  “The decision should be overturned!  The jury system failed to deliver justice!”

The natural inclination of any spectator of this situation would be to decry the jury rule.  It had clearly failed to deliver its promise.   But would overturning such a rule be in the best interests?  I think prudence and wisdom suggest “no.”  Or, at least, extreme caution.

A general rule, like trial by jury, serves a particular purpose.  By nature of its generality, it will not be perfect in all cases.  But because it is so general, it can work in most cases.  In the case of the jury process, the particular purpose of this rule is to prevent unfair prosecutions and to have evidence judged on its merits; by presenting to a lay audience, it is a test to see if it is plainly obvious that a crime has been committed.  Wisdom and prudence suggest that, since this rule has persisted so long, caution should be exercised before overturning it.  it may lead to undesired consequences (perhaps tyranny, in the case of juries).

To extend this to trade, the general rule is that people may trade with whomever they want so long as it is voluntary.  There are relatively few ways in which the state can object to trade (obviously prohibited items like drugs, prostitution, etc).  But this general rule has led to some undesirable outcomes: people have lost jobs to import competition and automation.  Some of these job losses, it is observed by some, occurred because this competition is “unfair” due to state subsidies, tax preferences, etc.  They, therefore, want to overturn the general rule (or create exceptions to it).  Tariffs, restrictions, or outright bans are often banded around as solutions.

But, again, prudence and wisdom urge caution before overturning such a rule.  Could it lead to a “slippery slope?”  Are the protections granted by the general rule worthwhile?  Would the exceptions to the general rule that are granted lead to other forms of rent-seeking, and unfair actions taken by domestic groups (eg, everyone starts clamoring for protections)?  The benefits of the general rule are obvious; the costs and consequences, not so much.

Even if we grant that the actions taken by some governments to “support” their trade position are indeed unfair, like the jury example above, creating exceptions to the general rule may achieve more mischief than good.

A final point in conclusion: none of this is to claim status or say the status quo is always and everywhere preferable.  General rules can, and should, be examined and overturned when necessary.  Rather, what this post is to do is to urge caution when it comes to overturning general rules; a willy-nilly attitude can destroy any and all respect for law and legislation.

Can Protectionism/Scarcityism Encourage Industry?

Short answer: not likely

Long answer: Protectionists Scarcityists like to argue that protectionism is needed (or can otherwise) to encourage industry.  Foreign competitors use “unfair” practices to undermine the domestic industry and protectionism scarcityism is there to protect the industry from these shenanigans.  This, in turn, will foster more domestic investment and encourage industry.  But how likely is this to be?  Let’s take a look at the logic.

From a protected industry perspective, it is possible that scarcityist policies encourage some investment in that protected industry.  Domestic production increases (although this is merely a substitute for some of the imports and overall output decreases).  This increased production may encourage more investment, but it is hardly guaranteed to.  These protected industries are protected from competition, so there isn’t much incentive to invest and improve; they are output restrictors.

Enlarging our view to the economy as a whole, scarcityism is far more likely to reduce investment and industry.  As I pointed out above, scarcityism works because it reduces output, forcing prices to rise.  This necessarily means consumers have to spend more to achieve the same standard of living.  In turn, this means fewer savings and since savings are funds used for investment, this means less investment.*  Additionally, since imports are reduced, foreigners now have fewer dollars with which to buy exports or invest in the US economy.  Reduced savings, and thus reduced investment, comes from this area as well.

There are secondary effects of scarcityism as well.  Not only does it reduce overall output in an industry, it encourages the use of wasteful use of current resources.  The protected firms are using less efficient methods of production, which is eating up resources that could otherwise have been released for more valuable purposes.  This, in turn, means fewer resources for industry to use and grow.

In order for scarcityism to foster growth, it’d require an awful lot of luck and some highly specific conditions which are improbable in the real world.

*Note that this same logic holds even if consumers switch to a cheaper substitute for the now-more-expensive goods.