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.

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.

Today’s Quote of the Day…

…comes from page 111-112 Adam Smith’s 1776 masterpiece, An Inquiry into the Nature and Causes of the Wealth of Nations:

But perhaps no country has ever yet arrived at this degree of opulence. China seems to have been long stationary, and had probably long ago acquired that full complement of riches which is consistent with the nature of its laws and institutions. But this complement may be much inferior to what, with other laws and institutions, the nature of its soil, climate, and situation might admit of. A country which neglects or despises foreign commerce, and which admits the vessels of foreign nations into one or two of its ports only, cannot transact the same quantity of business which it might do with different lawsand institutions. In a country too, where, though the rich or the owners of large capitals enjoy a good deal of security, the poor or the owners of small capitals enjoy scarce any, but are liable, under the pretence of justice, to be pillaged and plundered at any time by the inferior mandarines, the quantity of stock employed in all the different branches of business transacted within it, can never be equal to what the nature and extent of that business might admit. In every different branch, the oppression of the poor must establish the monopoly of the rich, who, by engrossing the whole trade to themselves, will be able to make very large profits.

JMM:  The nature of the institutions and the legislation that is enforced in a given country has a lot to do with the potential growth of the economy.  Institutions and legislation that protect and expand the scope of markets, in other words, institutions and legislation that allow human cooperation to flourish, will bring opulence.  Conversely, those that reduce the scope of markets will bring stagnation.

The Confusion Around Shithole

Predictably, Trump made an undiplomatic description of certain people and countries and, just as predictably, people on the Left have objected to his comments.  And, just as predictably, Trump defenders have appeared with cries of “political correctness.”

However, the problem with Trump’s comments is not the profanity or disparaging of certain countries, as undiplomatic as they may be.  The problem is much older:

Socialism, like the ancient ideas from which it springs, confuses the distinction between government and society.

Given the context of Mr Trump’s comments, that he was questioning the wisdom of having immigrants from “shithole” countries, Mr Trump makes exactly the mistake Bastiat discusses: he confused people for the government.  The countries may, in fact, be shitholes (however one defines that), but the people aren’t necessarily so.  We are not our government; we are individuals.  And, as I have written elsewhere, the institutions under which we live matter a whole lot.

In their rush to criticize Trump, the Left has made similar errors.  They have focused on defences of the targeted nations or of blanket cries of “racism.”  They’ve ignored the individual aspect of immigration (no surprise given the Left’s overt infatuation with socialism).

Similarly, in their rush to defend Trump, many of his supporters miss the context and point of Trump’s comment.  They wonder why Trump can’t call a country a shithole, citing concerns about political correctness.  But they too make the mistake of confusing the government and the society.

In short, Trump, his defenders, and his detractors on the Left all show their socialist leanings, and subsequent fallacious thinking, with this flap over shithole and immigration.

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!

Conclusion

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.

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.