Be Skeptical of Regulations Because Knowing the Market is Difficult (Even for Experts)

Given how much money business consultants make, one would think they have pretty good insight into a given industry or market.  And sure, they may have lots of information unavailable to most people, but does that necessarily imply they are better?

All data received, we must remember, is context-dependent.  Data never, ever, speak for themselves.  Interpreting and developing models for given market structures is extremely difficult in this regard because it requires certain assumptions.

Consider the following real-world example: when the guys from Xerox (the copy machine company) wanted to start selling their machines to businesses, they met stiff resistance from consultants and financial backers.  “Why would anyone spend thousands of dollars on a copy machine when we have a perfectly good, cheap substitute: carbon paper?  Copy machines will never sell.”  Prima facie, this criticism seemed legitimate.  Firms and experts observed secretaries and typists using carbon paper to make copies for distribution.  There didn’t seem to be any demand for copy machines.

Undeterred, the Xerox guys pressed on.  They decided to give companies the hardware, toner, and paper for free up until the first 2500 copies per month.  Firms jumped at the idea.  After all, how were they ever going to use 2500 copies a month?

Well, the rest is history.  Xerox is still around.  Carbon paper is not.

Why?  What did the experts get wrong?

They got wrong the scope of the market.  Copy machines weren’t for people writing letters.  They were for people receiving and distributing letters!  The market for copy machines was for the owner who got a letter from his lawyer who wanted to distribute it to the rest of the team.  It was for the product manager who needed to itemize his costs for different departments.  Etc etc.

There is an implicit conceit in economics that we know the market, the shapes of demand and supply curves.  But the reality is, we never do.  We have only data points in a certain context which may or may not provide useful information about other contexts.  This implicit conceit becomes vitally important when we start talking about regulation or “optimal taxes,” which require knowledge of the scope and shape of the market.  Knowledge we simply do not have.

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.

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.

So Much for “Draining the Swamp”

In a recent tweet, Alan Tonelson argued that Veronique de Rugy’s warning against tariffs is actually an argument for tariffs.

His argument that downstream tariffs should be approved every time upstream tariffs are approved is weak, both economically and ethically.  But such a scheme would also undermine the supposed goal of the Trump Administration to “drain the swamp.”  Opening up the possibility of protections for downstream industries will increase the lobbying by said industries to get protections.

Furthermore, we run into an issue of who, exactly, are “downstream” industries?  Economics teaches us there are countless unseen connections we may be unaware of.  For example, let’s say a tariff on steel and washing machines causes people to buy fewer washing machines: people use more laundromats.  In turn, they now refloor the old laundry room with hardwood rather than tile.  Tile manufacturers would be injured here.  Would they be eligible for protections?  They’d certainly try.  And subsequently, the hardwood flooring manufacturers would lobby.  As would, then, the distributors, the loggers, the facemask and chainsaw manufacturers, etc etc.  There is no logical stopping point here.

Rather than drain the swamp, this scheme would vastly increase it.

Dangers of Interpreting Silence

Writing at EconLog, David Henderson has an excellent short article on his experiences circulating a letter on the 1990 Invasion of Iraq, namely the political claim at the time that Saddam could use his power over the oil market to inflict harm on our economy.

The economics of his argument is interesting enough, but I want to draw attention to some prominent names who did not sign his letter:

Gary Becker
Paul Samuelson
Sam Peltzman

All three are highly renowned economists, and two are Nobel laureates.  Why did they refuse to sign the letter?  Did they know something Henderson did not?  Did they disagree with the analysis?

Fortunately, Henderson gives us some insight into the matter:

Gary S. Becker: I agree with the economic point you made. But I won’t sign. I’m not a signer. Also, Saddam Hussein is a threat in other ways. But I agree that the threat does not arise from his power over the price of oil.

Paul A. Samuelson: This war isn’t about the price of oil.

Henderson: Maybe it’s not but that’s the justification that’s being given by Bush and Baker. [I should have said “one of the main justifications.”]

Samuelson: It is and it isn’t. But I won’t sign.

Henderson: Do you agree with my analysis?

Samuelson: I don’t have any quarrel with your analysis.

Henderson: If I’m ever asked, can I quote you to that effect?

Samuelson: (Pause.) Sure. Your analysis was correct.

 

Sam Peltzman: The analysis is right but I won’t sign.

Henderson: Can I quote you as saying the analysis is right?

Peltzman: Why do you want to quote me?

Henderson: You’re a name. You said the same thing that Paul Samuelson, Murray Weidenbaum, and Gary Becker said. You guys are names. Can I quote you?

Peltzman: Sure. I don’t care.

All three men agreed with the economic analysis but refused to sign for other reasons.  Without this information, however, it might have been concluded by an analyst that Becker, Samuelson, and Peltzman disagreed with the fundamental analysis; a conclusion we now know would have been incorrect.

Fortunately for us, Henderson was able to keep meticulous records of these conversations.  But if we did not have that record (or could still ask Peltzman as he is still alive), we would have to rely on the evidence of what was actually said/done.  The silence of Becker, Samuelson, and Peltzman would provide no evidence of their opinion on Henderson’s letter.

This story is important given a recent debate on whether or not Jim Buchanan and Public Choice was inherently racist, or somehow a reaction to integration movements in the US.  Nancy MacLean and her supporters have recently constructed an argument that Buchanan was silent on the possibility of his ideas being used to perpetuate segregation and therefore tacitly endorsed such behavior (note this is a switch from MacLean’s position in her book where she claims such support was more manifest).  But they are making the mistake of arguing from lack of evidence.  It would be akin to saying Becker must have opposed Henderson’s argument because Becker did not sign.

Lack of evidence is not the same as evidence.  It is not evidence that I am Batman just because I and Batman have never been seen in the same room.  Likewise, it is not evidence Buchanan was a segregationist or sympathetic to them just because he was silent on the issue.

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.

The Political Economy of Trade Policy (Part 1)

Writing at EconLog, Scott Sumner makes the following point in his excellent blog post entitled “Keynesian Fiscal Policy is Dead“:

Many non-economists do not understand fiscal policy; they view it as something that can be applied on a sort of ad hoc basis. But things don’t work that way, as Keynesian fiscal policy requires a countercyclical (full employment) budget deficit.  It’s a full-fledged policy regime that must be maintained over time, not a gesture to be employed at a point in time.  You can’t say “let’s do fiscal policy this year”.

Scott’s point can be expanded to include trade policy as well.  Trade policy is, likewise, not something that can be applied on an ad hoc basis.  Consistent and predictable rules are necessary to maintain trade.  What’s more, theoretical economic trade management (eg, an optimal tariff) requires an extreme level of precision and consistency.

But can we assume such consistency in policy?  I think not, especially in a democracy/republic.  If one of the parties does not buy into said policy regime, then maintaining it is virtually impossible, unless that party is deliberately kept out of office.  Or, if the two parties have differing points of view on the goal of trade policy.  If one group wants an optimal tariff and the other wants tariffs to match international taxation regimes (both, in theory, legitimate tariff goals), those two policies will be at odds with one another.  How the regime is established will depend on who is in power at any given time.

How likely is it, even with the same party in power, that the policy remains consistent?  That is not so clear.  Politicians, especially in a system where they face voter pressure, are subject to various whims; as Adam Smith puts it: “[statesmen] whose councils are directed by the momentary fluctuations of affairs (WN 468).”  Even if we assume consistency in policial parties, inconsistency in various affairs should give us pause when assuming consistency over time in policy goals.

But, even if we assume consistency in policy goal over time, we run into the issue of policy adjustment.  For example, an optimal tariff depends on how sensitive domestic consumers are to changes in price; if they are highly sensitive, then an optimal tariff would be extremely low.  If they are not very sensitive, then an optimal tariff could be relatively high.  But, this sensitivity adjusts over time (Second Law of Demand).  This would mean that the optimal tariff level would need to be adjusted periodically (ideally, constantly) to compensate for this changing sensitivity.

However, firms and individuals adjust to policies.  With any policy, we run into Gordon Tullock’s transitional gains trap.  Firms and individuals will fully capitalize the monopoly gains they get from policy protections, leading them to do no better than before the policy was initiated.  What this also means is that if the policy were to be changed or removed, these firms/individuals would face the potential for major losses.  It would be strongly in their interests to keep the policy from changing.  Furthermore, since these losses to the entrenched firms/individuals would be highly visible and concentrated, but the benefits dispersed among the entire society, it would be a relatively easy pitch for these entrenched interests to keep the policy in place.

Another point worth quickly mentioning in relation to the previous paragraph: most trade policy models assume no resources spent on lobbying.  If we relax that assumption and assume that firms/individuals do indeed lobby, either for or against various trade policies, then any potential gains from these policies are quickly eaten up in the costs of lobbying.  Further, because of the aforementioned dispersed costs and concentrated benefits, the entrenched interests would be willing to spend more on lobbying than the people harmed by the policy,* which could potentially cannibalize all potential gains from the policy and then some.

*This point may require some explanation.  Assume a society of 10 individuals.  A policy is proposed that could improve the wellbeing of one member by $200, but only through the cost of the rest of society by $300 (or $33.33 per person).  Therefore, the one member would be willing to spend up to $200 to lobby for this policy, but each individual may only be willing to spend up $33.33 to lobby against.