Different Rules for Different Worlds

It’s Christmas Time.  That magical time of year where friends get together, families visit, and, for a little while, all seems well.

But, as sure as Christmas time comes around, we also get economic defenses of Scrooge and calls for cash to be given rather than gifts.  From a mainstream economic point of view, there’s nothing inherently wrong with these articles.  However, they miss a larger point, a point once known to economists, but have since been forgotten (or trivialized): moral rules matter.

Humans, as social creatures, live in two worlds at once (to paraphrase Hayek).  We live in our personal worlds, which have their rules, and we live in the commercial/interpersonal world, which has its own set of rules.  We must move in between these worlds constantly and manage the two rule regimes.  What is appropriate in one world may not be appropriate in the other.

By way of example, imagine if a friend asked you for a ride somewhere.  It’d be frowned upon if you asked him for money (outside gas money or maybe tolls). However, for a taxi to do the same thing, you’d expect to pay and there’d be no impropriety. No one would accuse the taxi driver of inappropriate behavior and no disapprobation levied on him. However, for a friend to make a profit, it’d be inappropriate and he would be saddled with disapprobation (considered a bad friend, etc).  Asking for money would violate the rules in the personal world but not the interpersonal world.  To try to apply the rules of one to the other would be problematic.

We expect people to behave in certain ways.  The cold indifference Scrooge shows toward Cratchit elicits feelings of disapprobation, especially during Christmas.  We expect this time of year to bring about beneficence and we expect employers to treat their employees a certain way.  When the interpersonal rules are applied in this situation, they appear wholly inappropriate, at least within a certain level of propriety.   Further, Scrooge’s transformation at the end of A Christmas Carol is itself praiseworthy.  He becomes benevolent, which is virturous.

I hasten to point out that nothing Scrooge does, either before or after his transformation, is unjust.  Scrooge, at no time, violates any rules of justice: he does no harm to anyone.  But simply because an act is just does not mean it is praiseworthy.  As Adam Smith says, the rules of justice can be obeyed by sitting still and doing nothing; but that behavior is hardly grounds for any approbation.  Justice is a negative virtue; it only affects other people when ignored.  Benevolence and the other virtues are positive, and they can do real good through acting.  While Scrooge was surely just, he was hardly praiseworthy.

Another example of the difference between these two worlds is from cash as a Christmas gift.  Again, from a purely economic point of view, there is hardly anything to object to.  But we are not in the interpersonal world of economics, but rather the personal world, where different rules exist.  One of those rules is: you give gifts to those you love.  Money is unacceptable according to these rules.  Loved ones are expected to exchange thoughtful gifts, not cash.  Violations of those expectations lead to hurt feelings and disapprobation.

One of the things these economic models of gift-giving do not take into account is the moral currency from obeying the rules.  This is likely why an institution that is so inefficient on its face (gift-giving) has remained a tradition for centuries.

Humans are social creatures and we live in multiple worlds at once.  Using a set of behavior from one world as a role-model for the other is a poor choice.  We must consider what makes a person good and just.  And that is the role of moral philosophy.

What, Exactly, is Free Trade?

Calls for government intervention into the economy usually focus on some supposed deviation in the free market system: currency manipulation, tariffs by trading partners, taxation, etc.  As the argument goes, because these things deviate from the ideal assumptions of the model, some government intervention (usually in the form of retaliatory or punitive actions against their citizens) becomes necessary.

However, this form of argumentation represents a fundamental misunderstanding on what free trade is and is not, and more importantly the uses of economic models.  This post is an effort to clear up these misconceptions.

Free Trade is Not a Policy

The language surrounding is misleading, both by its advocates and its opponents.  Both coach free trade in terms of policy: “Government needs to do laissez-faire!” or “Government needs to reign in free trade!” or something like that.  Free trade, however, is not a policy.  One does not implement free trade.  A government can take action to promote free trade (reducing tariffs, cutting regulations, etc), but it cannot adopt a free trade policy per se.

Free trade is nothing more than allowing peaceful interactions between consenting individuals.  It requires no active government policy.  In a free trade society, any governmental role would be naturally be limited to a passive role of enforcing contracts and protecting rights (what Jim Buchanan calls the “Protective State“).

Furthermore, since free trade is no policy, it is not dependent upon the assumptions of the economic models to function (I will return to this point in the next section).  None of the arguments for free trade require perfect information, identical principles between buyers and sellers, known utility functions and universal preferences, etc.  Free trade is robust to deviations from the ideal; the system still works because it is a process, not a policy.  Deviations from the ideal, movements away from equilibrium, present opportunities for entrepreneurs to correct issues; the many plan for the many and do not require the guiding hand of government to correct for deviations.

Models as Analysis and as Policy Tools

Models serve two roles: first as a means of analysis and second as a means of directing policy.  In these two roles, the characteristics of the model matter.

An analytical model, which is the proper use of economic models, involve simplifying assumptions in order to explore (or “analyze”) a particular question.  By way of example, let’s look at minimum wage.  The question is: “What effects will minimum wage have?”  Through a set of assumptions contained in the supply and demand price theory model, we can make a pattern prediction: a binding minimum wage will cause a surplus of labor in the market.  We can make this pattern prediction because our model reasonably reflects reality, even though it has many simplifying assumptions which are, to be frank, unrealistic (for example, the model contains the assumption of “all else held equal,” a condition which never happens).  Our analytical models give us the tools to analyze.

Where the problem comes in is using an analytical model to guide policy (both free-market supporters and opponents make this mistake).  To guide policy, you need a descriptive model, not an analytical model.  In other words, you need a model that is descrptive of reality, not one that reflects reality.  When attempting to guide policy, this is where the assumptions of the model become important.  To impose an “optimal tariff,” you need to know the demand and supply curves (something which is unknowable), you need to know indifference curves and von Neumann-Morgenstern utility functions (which are unknowable), true relative prices and equilibrium, etc etc.  To paraphrase Hayek, to use these models to guide policy, you need to assume knowledge that the price system alone can actually give you!  When using models to guide policy, deviations from the model’s assumptions become critical!


Any good scientist needs to know the limitations of the tools he uses.  Price theory models are extremely helpful in providing a lens through which to analyze the world.  They allow us to make pattern predictions and conduct analysis.  What they do not allow us to do is to make point predictions and guide policy with any level of accuracy needed.  Anyone who pretends otherwise is operating under the pretense of knowledge; he is not acting as a scientist, but rather as a charlatan or a fool: a charlatan if he deliberately knows the limits of his models but pretends they are more accurate than they are and a fool is he believes his own models give him the ability to shape policy.

The Law of Demand in Action

On Monday, Virgina began imposing flexible tolls on the I-66 stretch between the Beltway and Washington, DC.  I-66 is one of the most congested roads in the nation during rush hour and the goal of these tolls was to have drivers look for alternative routes so that the interstate remained relatively free-flowing for those who needed to get into the city quicker.


Lo and behold, it worked:

Traffic moved smoothly throughout the morning, and WTOP’s traffic center reported that the number of drivers on I-66 declined compared to typical Monday morning volume.

“There were no delays inside the Beltway; that’s the point of congestion pricing — to keep the carpools and paying solo drivers moving. As demand goes up, the price does too,” said WTOP’s traffic reporter Dave Dildine.

VDOT reported that the average speed on I-66 during the morning rush hour was 57 mph, up from 37 mph at the same time a year ago.

The George Washington Parkway absorbed the brunt of the traffic, with Virginia Route 123 and U.S. 50 picking up extra drivers as well.

As price rises, quantity demanded falls as people seek substitutes.  Those who are willing to pay the higher price are those who value the resource most highly.

There has been a backlash, of course.  No one wants to pay a $40 toll one-way.  There have already been calls to cap the tolls.  How does the state respond?

“If we don’t get the tolling right, all we’re going to do is clog up those lanes again, and so that’s why the algorithm is multifaceted. It may change, we’ll study it. But in terms of moving traffic, it looks like it’s doing its job,” [Virginia Transportation Secretary] Aubrey Layne said.

“I know all the publicity is ‘Oh, $40,’ but the whole idea is for the person to make a rational decision. ‘Is it worth [it for] me to pay this to use it or is another method better?’ If you start limiting that, you impact the entire network,” Layne said of requests to cap tolls or make other dramatic changes.

Price goes up, quantity demanded falls.  You put a price ceiling on the market, you “impact the entire network.”

Good to see some Econ 101 knowledge on the part of the Transportation Secretary.


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:


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.