The Principle of Unintended Consequences

The WSJ has an opinion piece today about how US legislation intended to clean up the environment and reduce our dependence on foreign oil led to windfall subsidies for the US paper industry inspiring a paper subsidy retaliation by our Canadian neighbors. This trade skirmish is an obvious example (i.e., obvious after the fact) of how difficult it is to predict the full consequences of particular policy actions. It should make one wonder if there will be many unintended consequences in other new legislation, like say the 1200 page Energy bill passed by the house last Friday.

One worry I always have is that the more clauses and provisions there are in any bill, the more chances there are for companies to game the system; also the more reason there is for companies to devote time and energy to studying legislation and working to influence legislation in subtle ways. The greater the complexity of our regulatory system, the more resources are devoted exclusively to understanding that system. The problem with this is that the more time a company spends figuring out ways to game the system, the less time is devoted to product improvement and customer satisfaction. Regulations intended to improve some matters, may be unintentionally making others matters worse.

Government Ponzi Schemes are OK (!!??)

Last week we heard the announcement of Allen Stanford's arrest for perpetrating a ponzi scheme that defrauded investors of billions of dollars. Last year we saw the arrest of Bernie Madoff who purportedly instigated an even larger ponzi scheme. But of course, the largest ponzi scheme of all lies right in front of our eyes in full view. It's the US government welfare scheme set up years ago. The ponzi nature of it is described nicely in Robert Samuelson's piece today in the WP titled "Welfare in a Bad Way" .

What's required of all ponzi schemes is that positive returns to early investors are financed with contributions of later investors. As long as one can induce a larger and larger contribution from later investors (typically by increasing the number of contributors), one can maintain high returns for the earlier investors. Of course, using the term "investor" here is inappropriate since nothing like investing is taking place. Instead it is merely a transfer from one group of people to another. What is most curious about the US government ponzi scheme is that everyone who looks at it can see exactly what it is and yet it seems to be almost impossible to do anything to dismantle it. We decry and prosecute private ponzi schemes but sit back quietly as we watch the largest one in history gather steam before our very eyes.

Ponzi schemes can last a very long time as long as the new source of contributors rises sufficiently fast and/or if the returns paid to previous investors is not too large. But deviate from these requirements and the ponzi scheme will break apart by it's own internal logic. Changes in the US fiscal budget in the past year have clearly moved forward the time when the US government ponzi scheme will fail. To sustain the scheme for longer will require a reduction in current payouts (too hard to do politically!), or an increase in contributions, either by increasing the number of contributors (but that's too hard since it requires a higher birth rate or more immigration), or by increasing contributions per person (i.e., higher taxes, ... also not popular).

Since none of the changes that would be needed to sustain the government ponzi scheme are popular enough to allow a politician to even propose them seriously, we should expect the system will indeed break apart at some point in the future. If you're lucky you'll get out (meaning you'll die) before the collapse and thus receive your better than fair share. If you're not lucky though, ( that is if you don't die soon enough) you'll receive a set of broken promises and dramatic drop in your standard of living sometime in the future, just like the Madoff and Stanford investors will face today.

Any suggestions??

Cap and Trade Protectionism

George Will notes in his column today,

The cap-and-trade legislation passed recently by a House committee is Smoot-Hawley in drag: It contains provisions for tariffs on imports designated "carbon-intensive" -- goods manufactured under less carbon-restrictive rules than those of the proposed U.S. cap-and-trade regime. Eco-protectionism is a recipe for reciprocity.

For more information check out the transcript about a Green Trade War on NPR's Marketplace from May 26.

Protectionism can rise up in many other forms besides an increase in tariffs. It is worth noting that businesses are always eager to find ways to reduce competition. One method under our Safeguards law is to show that a surge foreign imports is injuring domestic firms. A new method after cap-and-trade legislation will be to argue that carbon-emissions by foreign firms exceed the limits required for domestic firms.

In every individual case people will wonder: are these actions merely an "excuse" that can help achieve the primary business motive to reduce competition ... or are the foreign carbon emissions so substantial they threaten disastrous global effects if not reduced? Determining the answer will involve an enormous amount of calculation and investigation for each case. In this way jobs will be created for these investigations. Nonetheless, foreign firms will naturally suspect it is the former motive rather than the latter in most cases and this will surely inspire contentiousness in trade.

A Bicycle Theory of the Economic Crisis

There is an excellent exchange between prominent experts (Bill Bradley, Niall Ferguson, Paul Krugman, Nouriel Roubini, George Soros, Robin Wells) about the causes and prospects of the current economic crisis. It is titled "The Crisis and How to Deal with It" and appears online at the NY Review of Books.

Reading it made me think about an analogy between the progression of the world economy and the movements of a bicycle. Think of a well functioning economy like a bicycle moving rapidly along a road. The rider represents the government whose modest adjustments, left and right, keep the bicycle on a steady path. However an even greater force keeping the bicycle upright is the torque created by the spinning wheels. The torque is analogous to the forces exerted by the private market in an economy. As long as the bicycle (economy) moves sufficiently fast (grows), the rider (government) needs only exert a small level of checks and balances to keep it moving steadily forward: mostly though it is the torque (private market activities) that keep the bicycle upright and moving.

The current economic crisis is like the bicycle hitting a big bump in the road. No one knows precisely how or why we hit the bump, but hit it we did, and the bicycle (our economy) has slowed down and is beginning to tumble over. But as we all know, a slow moving bicycle requires many more adjustments by its rider; and the slower the movement, the more aggressive must be the rider's reactions to keep the bike from falling over.

In the dialogue described above, Krugman's argument is like saying that the bicycle is moving so slow right now that we need dramatic rider reactions (government intervention) to correct for the lack of bicycle momentum due to the slower speed. (i.e., the private sector has chosen to save much more, or demand much less, and the government must substitute by spending instead - in other words, the government must pedal for awhile. Government borrowing is not a problem, he says because the private sector is unwilling to do it itself.)

Ferguson's argument (and others) however is a concern about another point in time during the adjustment process. He is worried about what happens later because of the massive fiscal deficits and the borrowing demands they will require. This concern arises once the bicycle has begun to gain more momentum again. Note, this is China's major concern right now too.

So suppose Krugman is indeed right, that we need a major government corrective effort to right the bicycle. Well, what happens if, after the bicycle is about to fall over to the right, the adjustment by the rider is so strong to the left that although the bike will indeed become vertical again, it will also eventually begin to topple over leftward. If the rider cannot correct the movement fast enough a near collapse to one side will be righted only temporarily as the bicycle begins to topple over to the other side.

More specifically, a government intervention that gets the economy humming along again quickly, may also stimulate consumption (thereby reducing savings demand) and leave the government still with a huge fiscal deficit and no way to finance it without printing money. This is when the bicycle may begin to topple over in the other direction.

Krugman's analysis would be more credible if it were apparent that the fiscal stimulus would be spent mostly in the next year and if thereafter government spending would revert to its previous levels. In other words, if the projected deficit this year were 12% but next year it goes back to 3% of GDP, then one could support the idea that the correction
is not excessive.

Finally, as with a wobbly bicycle, although reactions are necessary to keep the bicycle from falling over (Krugman is right), overreactions are almost the norm (Ferguson is probably right too), perhaps several times, before the bicycle can get back to its normal progression. If the analogy is accurate then, any improvement in the economy now, is likely to be followed by another collapse, perhaps next time with higher inflation and another economic slowdown even after markets seem to be rebounding.

With this said, hopefully the analogy is wrong.

Cap and Trade Delusions

This week listening to the radio I heard the cap and trade system described as something that would raise the price of carbon-based energy while lowering the cost of alternative energy. That cap and trade will raise carbon-based energy prices is correct. However, that cap and trade will lower alternative energy prices is correct only if one makes several other assumptions.

First, the statement is true if one adds the qualifier "relative;" alternative energy prices will fall relative to carbon-based energy. But this doesn't mean alternative energy becomes cheaper, only that it becomes slightly more attractive in relation to oil and gas. Unfortunately because the price of alternative energy is currently much more expensive than carbon based fuels, this may not induce much substitution unless the price of carbon based rises substantially. Ron Bailey's article "Cap and Trade Delusions" in Reason points out that electricity from solar energy costs 33 cents per KwH, from wind costs 9 cents per KwH and from coal costs just 6.5 cents per KwH. Cap and trade may only induce substitution to these alternatives if the carbon fuel prices rise substantially.

The statement is also potentially true if cap and trade induces sufficient innovation in alternative fuels that lowers the cost of these energy options. This is indeed likely to occur but there is no way to know how long it will take. Research has been conducted for many years on alternatives but they still don't come close to providing energy at the same cost.

Thus, as Bailey points out, there is no way that cap and trade will not raise energy prices and reduce the overall number of jobs throughout the economy as a result of the drag on the economy. Remember that energy is an input into every good and service in the economy and with higher energy prices the cost of all goods will rise, without a comparable increase in individual incomes to compensate ... That is unless you take latch onto the new rents that will accrue to the lucky few. (See today's article by Bjorn Lomborg in the WSJ)

How to "Do No Harm"

Yesterday's FT article by Gary Becker and Kevin Murphy titled, "Do not let the 'cure' destroy capitalism" is worth reading. In it they highlight three basic flaws with the current approach to the crisis. They are

a) an overly broad diagnosis of the problem,
b) a misconception that market failures are readily overcome by government solutions, and
c) a failure to focus on the long-run costs of current actions.

The problem is also a problem of democracy. Governments are intervening in part because its constituents want someone to solve the problem quickly. And no entity can do so much so quickly than government. This would occur regardless of which party were in power. Democratic representation will always call upon politicians to "do something" to solve distress in the market. And both parties could be expected to react in similar ways. I have little doubt that if Republicans were in power we would still have a TARP (oh right, that happened when Republicans were in power!) , we would still have a fiscal stimulus plan, and we would still have some assistance to Chrysler and GM. Perhaps the degree of intervention would be different, but Republicans would still have taken similar actions.

In the far future, the only way to prevent politicians from doing too much (and thus forcing them to do no harm) under similar circumstances will be to tie their hands in some way. There are two ways to do that. One way is via commitments to international agreements. For example, the world might be able to prevent a free fall into rampant protectionism, IF, countries abide by their WTO commitments. This is a big if (hence the capitals). A second method is with constitutional restraints. As an example state balanced budget amendments prevent states from becoming overly reckless in their spending. A similar requirement does not hold for the federal government though, and thus the US is destined to run deficits in the trillions of dollars for at least several years in the future.

My utopian vision for the future is a world in which politicans are ignored by the press and the people because everyone recognizes that they have very little ability to affect outcomes in their lives. It's a pipe dream, I know!

Climate Change and Uncertainty

The two sides in debate about climate change and the proposed response of a cap and trade system are represented by two recent opinion pieces in the WashPost. Robert Samuelson presents the skeptical view in an April 29 article Selling the Green Economy. Kristen Sheeran and Mindy Lubber offer a rebuttal in the May 6 article The Cost of Climate Inaction.

My objective in this post is to highlight how the climate change issue is similar to the problem of cigarette smoking. Both problems involve actions taken today that have uncertain long term consequences. In the case of climate change the use of carbon guzzling technologies today may lead to climate change coupled with economic disasters. Sheehan and Lubber write that climate change "promises to disrupt agricultural patterns, set off a scramble for dwindling resources, raise sea levels, propel population shifts and require massive emergency spending ..." However as Samuelson points out "models have a dismal record of predicting major economic upheavals or their consequences. They didn't anticipate the present economic crisis. They didn't predict the run-up in oil prices to almost $150 a barrel last year. In the 1970s, they didn't foresee runaway inflation." In other words the disasterous effects are highly uncertain.

Smoking is similar. Although there is clear statistical evidence that cigarette smoking raises the probability of contracting heart and lung disease, emphysema and other maladies, smoking does not affect all smokers this way. No one really knows why some people are affected and others are not. Nonetheless, young smokers know that whatever the probabilites are, most effects will not occur until long in the future.

In the meantime smoking generates definite short run benefits in much the same way as use of carbon guzzling technologies is cheaper than using clean alternatives. It is easy to explain why many young people choose to smoke in the face of the evidence; they clearly believe that the short term benefits outweigh the uncertain long-term costs. In the same way we can explain why energy users will prefer to keep their addiction to cheaper carbon guzzling technologies. Again the short term benefits exceed the uncertain long term costs. This is why when gasoline prices rose to over $4 per gallon in the US last year we did not hear people applauding the changes and saying how they wished the price would rise even further so they could avert the climate disaster in the future. Instead there was dispair coupled with anger directed at the oil companies. We might expect a similar outcry if a cap-and-trade system significantly raises carbon technology prices.

There is one important difference between smoking and climate change though. The long term effects of climate change are much much much more complicated and uncertain than the effects of smoking. The effects of smoking have been studied intensively for 50+ years and there are still gaping holes in our knowledge of its effects. Nonetheless in contrast to climate change effects, smoking effects are incredibly simple. With smoking we're talking about no more than the effects of various chemical substances on an individual human body. In contrast the economic effects of climate change are so much more complicated that they really should be viewed as unknowable at this stage.

Sheehan and Lubber ignore this problem when they say, "Each new scientific report brings proof of a changing climate that promises to disrupt agricultural patterns, ..." (my italics). However no objective observer should accept this proof and these promises. Sheehan and Lubber are building an argument based on faith instead.

In contrast Samuelson is absolutely correct when he says, "Actually, no one involved in this debate really knows what the consequences or costs might be. All are inferred from models of uncertain reliability. Great schemes of economic and social engineering are proposed on shaky foundations of knowledge. Candor and common sense are in scarce supply." His argument is not based on faith, but rather on the recognition of our scientific limitations.

The Threat of Inflation/Deflation

Allan Meltzer has an excellent article in the NYT today about the possibility of inflation. It isn't here yet but given the underlying conditions of high money supply (and low interest rates) and high budget deficits, inflation may come much faster than the FED is able and willing to respond effectively.

On the same day Paul Krugman warns in the NYT about the problems of wage deflation. He points out that Japan faced the same problem in the 1990s and suffered more than a decade of stagnation. His solution is greater fiscal expansion ... which clearly will raise budget deficits and raise the threat of inflation that Meltzer warns about.

Unfortunately Krugman's argument makes inflation an even greater possibility. That's because calls for more fiscal expansion by prominent economists will make it more likely that the FED response to inflation will be too slow in coming. Remember that FED response to inflation takes time. Ideally the FED should act many months before the inflation is even apparent. But this almost surely won't happen. The FED will more likely wait until it becomes obvious that inflation has reignited and and that time the only way to prevent overheating of the economy on the upswing would be to recreate a 1981 style recession.

Thus, I think the possibility of a double-dip recession is rising.

More on the Economic Crisis

This week I had the opportunity together with other local scholars to meet with Chinese trade officials visiting Washington DC to discuss the economic crisis. Commerce Minister Chen Deming's article in the WSJ about the rise of protectionism includes some points raised in the discussion. Other topics for discussion include the following questions for which I offer some observations.

1. Recently, some U.S. macroeconomic indices have improved. Does this mean the hardest time has passed and the economic stimulus package, to some extent, has taken effect? How about the recovery prospect of US economy? What industry or sector will be the primary backbone of the future US economic development?

That some economic indicators have stopped their freefall or turned around is a good sign. As many observers suggest though, these data probably indicate a slowing of the decline at this stage rather than a reversal. Complete economic recovery will probably not return until after many episodes of improvement followed by episodes of worsening. Optimism will be replaced by pessimism many times over.

Complete recovery will surely come eventually ... it always has in the past regardless of the nature of the crisis. What no one can answer is how long that recovery will take. An important element to sustained recovery though is a return to the general belief that the financial sector is sound. As long as the banks remain mired in bad debt, a return to normalcy will not occur. The financial system is like a lubricant that greases the economic engine. We learned from the Japan experience that if the financial sector remains gridlocked, no amount of fiscal stimulus matters.

It is unlikely that the fiscal stimulus plans have had much effect since very little spending would have actually occurred yet. Disbursements to agencies may have occurred but not the actual spending. The only way the fiscal stimulus could have such an immediate effect is if it raises confidence substantially. I am doubtful that it has.

As for which industry will lead the recovery that is hard to answer, especially if it is a market-led recovery. However, the nature of industry may change if government interventions are substantial. For example, subsidies to clean technologies will surely inspire rapid growth in those industries as businesses seek government handouts.

2. Will the current crisis change the US economic pattern of low-saving and high-consumption dramatically? What effect will the crisis have on the US economy in the long run?

Much depends on the length of the recession. If the recession lasts a year to 18 months and is followed by a rapid recovery, savings and consumption rates may quickly return to previous levels. However, if the recession lasts longer, or if the recovery is slow, then changing behavior in the short-term may become habitual. This is what happened to the generation that lived through the Great Depression; many remained frugal for the rest of their lives.

3. What effect will the financial crisis have on the globalization process and the pattern of international trade? For developing countries, especially those emerging economies, how will the crisis influence their economic development pattern? What lessons are there? Will the east-Asia-US supply chain be impacted?

This too depends on how deep the recession is and how long the crisis lasts. If unemployment rises to double digits in the US and around the world, protectionist pressures will grow rapidly. Already governments, including the US, are engaged in what has been called “murky protectionism;” that is, measures like industry bailouts, subsidies, increased antidumping and safeguards actions, among other things. Some of these measures are WTO-consistent, but some are questionable. If unemployment rises a lot more, the measures may become less WTO-consistent and trade disputes and verbal wars may develop.

Protectionism is always popular to jobless individuals eager to find someone else to blame, and politicians feed on these sentiments. Luckily we have a WTO in place today and thus the world should be more resilient to protectionist pressures than they were during the Great Depression. It was encouraging to hear Ambassador Kirk express support for continuation of the Doha discussions. Despite this though, I expect the Obama administration to be ambivalent about freer trade. Fundamentally they are more inclined to support workers over management. Thus while they will continue to say they want to maintain free markets, I worry that they will be more inclined to support “fairness,” which in most instances means protections for industries and their workers.

Supply chains will be disrupted around the world if protectionist measures grow. One way to prevent protection from getting out of hand is to try to keep the disputes out of the popular press. The more public the discussion, the more it will fan the flames of populist sentiment. In this light it was helpful that the US last week refrained from charging China with currency manipulation. Perhaps, now discussions regarding exchange rate policy can be done more quietly in diplomatic circles, rather than being played out in the press.

Of course, when charges against other countries do make it into the press it is necessary for countries to defend themselves. Fortunately, disputes can be adjudicated through the WTO DSB. Although this process is lengthy and has some important shortcomings, restrained use of the process can help support the agreement and perhaps keep countries from drifting too far from the core WTO principles.

4. The expansion of the virtual economy is considered one of the major causes of the current crisis. Therefore, will manufacturing “returning home” became popular again in some developed countries?

Returning manufacturing home will reduce the efficiencies that were achieved in the pre-crisis years. Admittedly, it fuels popular sentiment because it can create the appearance of saving jobs. Nonetheless, the main problem is that a greater level of less efficient employment in the short run can generate a lower standard of living in the longer run.

One thing I believe we need is better education in the US and around the world about how free markets work. In a free market, sectors are larger or smaller on the basis of comparative advantage. While some patterns may appear, any attempt to create “appropriate patterns” is contrary to the free market and should be avoided.

5. What influence will the financial crisis have on the international monetary system? Will there be some changes? Under the current international political regime, how should governments supervise and regulate financial operations across the world? Will the US dollar be impacted as the world currency? Is there any possibility of depreciation of US dollar and inflation after the Fed took such monetary policies as quantitative easing and treasury securities repurchasing?

The expansion of the US money supply and the fiscal stimulus plan raises very serious concerns about future inflation. I think the main problem involves lags in policy. At the onset of the crisis last fall the velocity of money in the economy fell quickly. The circular flow of money from sales to wages to spending is lower now partially because households have lost jobs or are worried about future job losses, because households have lost an enormous amount of portfolio and home wealth, and because banks are only lending to the very best credit risks. In response the US Fed has pumped an enormous amount of money into the economy. At the same time the fiscal stimulus bill has passed but the spending itself will take place with a lag over several years. Only a small amount will be disbursed in the next few months. Because of this drop in velocity though the main worry now is deflation not inflation.

However, deflation can quickly turn into inflation. If the banks turn out to be reasonably sound, if home values stop falling, and if the stock markets rebound a bit more and remain stable, then consumer confidence will return swiftly and with it the velocity of money could increase rapidly. But if all that happens just when the main fiscal stimulus spending occurs in 6 months or a year, and if the stock of money remains high, then the only outlet for the pressure will be an increase in prices. Inflation may ignite with a vengeance. The FED would surely respond to this with a rapid decrease in the money supply. However, because of the lag in monetary effectiveness it could take many 12-18 months before the drop in money catches up to the change in the economy. In the meantime inflation could be severe.

Although US recovery will be good for the world and would help assure the US dollar remains the currency of choice in international transactions, at the same time a rapid dollar inflation reduces international desires to hold dollars. Additionally, large US government budget deficits raise concerns about the safety of US treasuries. Of course, the US will pay back its debt, but if that debt is paid back with lower valued dollars, it will lose its attractiveness.

These things may reduce international demand for the dollar for use as an international currency. However, the diminution of dollar primacy would also require the rise of a viable alternative. At this stage there are no obvious candidates.

Internal Protectionism

In a comment a reader asks the following: “I still propose that until the detrimental distortions of our internal protectionism is fully understood, external protectionism cannot be fully understood either. My intuition is that they are inextricable, and that their effect on GDP and employment can only be understood if both "protectionisms" are studied as an intertwined entity.

My response: I think you are right. I think it is important to recognize that protectionism, both internal and external, are in the interests of business seeking to restrict competition. That is the key similarity. Business is always looking for ways in which they can gain advantage over their competitors. While it’s often easier to blame foreign competitors and seek trade protections, firms just as often seek internal protections from domestic competitors.

I remember reading a passage by Reagan administration OMB director James Miller who was surprised by the conversations he had with businesses about impending clean air legislation. He said (paraphrasing from memory), "...when we were considering new environmental legislation, I expected industry lobbyists to be very vocal in their opposition. Instead, industry groups would say, ‘We think this environmental bill is very important and we are willing to support it, however, you see in Section 5, sub section 3b where it says xxx. It would be much better if it said yyy’ After review we realized that a change to yyy would give this firm an advantage over its competitors."

That is the kind of internal protection that I think you are referring to, and it is undoubtedly rampant. This is the kind of protection that Chrysler and GM are seeking today. Anything the government does for them will make it easier for them to compete against Ford, Toyota, BMW and all the others. However, for these firms the protections are obvious and make the headlines. Most of the other internal protections are buried deeply in appropriations bills and other legislative acts.

The attempt by firms to seek protections from government is one of the reasons people have become suspicious of multinational firms internationally, and large and powerful firms domestically. There is a strong suspicion that these firms are using political influence to get benefits shifted in their direction. It is also suspected that these shifts account for the extremely high compensation packages paid to the top executives. I’m sure there is some truth to all these suspicions.

A problem we face today though, in today's economic climate, is that the blame is being misdirected towards the companies who are the petitioners for protection rather than to the government who are the providers of the special protections. It is becoming easy to indict the free market as the culprit; as the catalyst for greed and the widening disparities in income. However, I think the problem lies more in government rather than with firms.

Of course firms are greedy and want to secure the best possible position for themselves in the market. Nothing anyone does is going to change that basic motivation. However, when that greed is directed towards petitioning the government for special protections, either externally or internally, then time and energy is shifted from producing products for their own customers. If instead firms knew that governments wouldn’t, or couldn’t, offer special protections, then their greed would be redirected towards producing a better product for their customers. In other words they would be forced to compete and the most effective producers, that is those who satified customers desires to the greatest extent, would win out. In this case, profits made would be profits earned in the true sense of the word.

Explaining the Bubble

There is an excellent article in the WSJ today by Steven Gjerstad and Vernon Smith discussing the origins of the housing bubble. It offers a convincing case for why this housing bubble which so far has caused the loss of about $3 trillion in housing wealth has had a more depressing effect on the economy than the dotcom bubble in 1999-2002 that resulted in a loss of about $10 trillion in wealth. They also look at parallels with the Great Depression era and suggest that Friedman and Schwartz's contention that monetary contraction was the primary cause of the banking system collapse might now be discounted because the current injections of liquidity have not prevented a similar financial sector collapse.

Rising US Protectionism

In a time of recession, as economic growth stalls and unemployment rises, the safety and security of workers becomes preeminent. Indeed a kind of economic nationalism develops quickly as the public demands that all government interventions are targeted to favor domestic workers and businesses.

Hence, the new US government introduced "Buy American" provisions in its fiscal stimulus package, it is reluctant to push forward the free trade agreements with Colombia, Panama and South Korea, it reignited a feud with Mexico about trucking privileges under the NAFTA and now it has suggested the need to put tariffs in place to prevent outsourcing by high carbon using industries if a cap-and-trade environmental plan is put into place.

The demands for protection are high and rising. It will take tremendous political efforts to ward off these temptations. On a positive note I learned last week of Mexico's efforts to lower protection. Although, the news of last week focused on Mexico's retaliatory tariffs against new US restrictions on trucking, a less well known story from late last year shows that Mexico announced a gradual lowering of their MFN tariffs over the next few years. Although this action does not affect the US, since trade is mostly free between the countries due to NAFTA, it does represent a positive commitment to continue the push for market opening opportunities in the midst of a very difficult political climate.

Pro and Con on Buy American Provision

The NYT posted a pro and con debate about the Buy America provisions in the fiscal stimulus package. I can will add one point to the debate. First, it is important to note that many less developed countries have much more leverage to increase their protection of imported goods without violating their WTO commitments. That's because many have their applied, or actual, tariffs set lower than their bound, or maximum, tariff rate agreed to in the WTO agreement. For example, in 2007 India imported $1.3 billion of palm oil, it's largest agricultural import product. The applied tariff is currently set at zero. However, its maximum bound tariff is 300%. That means that India can raise its tariff significantly on this item and most other items too, without violating its WTO agreement. The US and EU in comparison have almost all of their applied tariffs set at the bound rates. That means there is almost no ability for the US to increase protection consistent with its WTO commitments.

Thus, if the Buy America provision provokes a response abroad it will be easy for many countries to raise tariffs against the US, and others since tariffs would have to be raised in an MFN consistent way, without violating the WTO agreement.

Fiscal Stimulus - Part 4

Let me return to the idea raised in Fiscal Stimulus - Part 1, namely the theory of the second best. This theory offers a guide that is widely applicable to many different situations. It says that policy interventions by government will be most efficient, and therefore work most effectively, if they are targeted most directly at the source of the current problems. Thus, we can ask, in terms of the current financial crisis, what are the problems and what types of solutions target the problems directly?

First, the crisis emanates in the financial sector. Overextension in the housing market lowered home prices leading to a wave of defaults and the eventual insolvency of many financial institutions. The US FED and Treasury acted quickly last year by lowering interest rates and injecting substantial money into the financial system. When a snowballing effect of financial meltdowns occurred in September, and as confidence in the financial system plummeted, the FED/TREAS sought Congressional funding and began to implement the Targeted Asset Relief Program. (TARP). Initially, the intention was to buy up the so-called “toxic” assets, primarily bad mortgages bundled up in mortgage backed securities (MBS) whose values were greatly uncertain. This action was appropriately “targeted” at the source of the immediate problem. Financial institutions had become extremely reluctant to lend to each other and this threatened to bring down the whole financial system, largely because no one knew who was safe and who not.

That uncertainty and the infection quickly spread to the non-financial, or real, sector, as manufacturing firms could no longer easily borrow, which then affected the stock market as financial managers began a flight to safer assets. The drop in the stock market coupled with the failure of some major institutions infected consumers who have responded by cutting back spending.

The current government stimulus plan is intended to substitute for the drop in consumer spending. There are two ways to do this, first by raising spending and second by cutting taxes. One could argue that this plan targets the problem of insufficient demand, however, it is not the most direct target since it doesn’t get to the source of insufficient demand, which presumably is the loss of consumer confidence. That loss of confidence, in turn, stems from the drop in asset values and the fear of insolvency among both business and households. At best the proposed stimulus package addresses a symptom of the economic problem.

There are a few ways for government intervention to get closer to the problems at hand. First, government money would be better directed to restore confidence in the financial sector. TARP-like proposals, such as the carving out of “bad” banks from goods ones with the bad ones run like the resolution trust company during the S&L crisis seem to be appropriate targets. Such a program might require much more than the current allocation of $750 billion, but it will be hard to add to this once the fiscal stimulus plan goes through. Second, supplemental and temporary government assistance to those who suffer a job loss would help ease the adjustment to those most directly affected. This is a better way to stimulate spending than tax cuts since many tax cuts will be to relatively more secure households who will save the refunds rather than spend them. Relatively insecure households are more likely to spend the extra cash. Thus general tax cuts are too blunt an instrument, not targeted enough at the source of the problem whereas additional benefits to the newly unemployed more directly targets and relieves one source of the fear.

Finally, one big problem with the fiscal stimulus plan is that it may substantially change the priorities of the economy from those chosen by the private sector to those mandated by the government. For example, there will be substantial increases in R&D spending for new energy technologies. Rest assured that every alternative energy company will be trying to get their hands on this money. Some companies may do good work in the end, but many undoubtedly will waste the money away. Since the decisions as to who will get the funding will be made politically, there is more reason to worry that those companies, or the technologies chosen will not be the most efficient way forward. Real competition assures that the most efficient and effective technologies will arise; government directives make it more likely that “influence” will determine the outcomes.

Also, although new spending initiatives will stimulate demand in some industries, it is not assured that the skills needed, say to produce solar energy, are the same set of skills among those workers recently laid off. Thus, while it seems reasonable that new jobs in new technologies industries will be created to offset the lost jobs elsewhere, it may not stimulate demand for the right types of workers. If a mismatch like this occurs, unemployment would not fall much (Circuit City employees will remain unemployed) while the workers who have the requisite skills (e.g., solar energy engineers) will see their relative wages rise.

In summary, there is much that can go wrong with the current stimulus proposal. It is unlikely to be the silver bullet that solves the problems at hand. Indeed, it is conceivable that the package makes things worse rather than better, largely because the lack of focus of the program may reduce the size of the more appropriate targeted interventions, and if the economy continues to stagnate will further reduce overall confidence.

This situation really is analogous to the Iraq war. In the case of Iraq it was argued (rightly or wrongly) that deposing Saddam Hussein was necessary to preserve the safety and security of the US. At the same time, the incursion into Iraq helped to promote other goals, like the spread of democracy. However, once Hussein was deposed it turned out that the long-term consequences were much harder to manage than was expected.

In a similar vein perhaps, today’s massive stimulus package is argued to be absolutely necessary to preserve the economic security of the country. At the same time the extra spending will help to promote other desired goals, like R&D into energy efficiency and infrastructure development. Nonetheless once the full effect of the spending occurs, we may well discover that the long-term consequences are much harder to mange than is being anticipated today.

Fiscal Stimulus - Part 3

Milton Friedman and Anna Schwartz’s Monetary History of the US motivated the conventional wisdom about the Great Depression, that is, that it was caused primarily because of low money growth and exacerbated by several other things including attempts to balance the government budget, protectionism via Smoot-Hawley tariffs, and of course the tremendous loss of confidence in banks leading to numerous bank runs.

Nonetheless the solution to the depression was thought to be found in the ideas of John Maynard Keynes, namely a substantial increase in government spending to create jobs in the economy. Most everyone agrees that the depression wasn’t really “solved” until WWII, despite the increases in government spending with Roosevelt’s New Deal. However, these New Deal increases only raised government spending from $9 billion in 1929 to $15 billion in 1939. Due to declining output this represents an increase from 9% to 16% of GDP. Although this looks expansionary, it wasn’t until the advent of WWII that government spending really began to rise. Government spending almost doubled to $26 billion in 1941 and peaked at $105 billion in 1944 at a staggering 48% of GDP. By 1944 the US unemployment rate was finally brought down to 1.2% (from its peak of 24% in 1933 and from 17% in 1939)

Unfortunately though history does not allow us to (easily) run a counterfactual. For example, what would have happened in the ‘30s if there were no substantial increase in government spending but there was a substantial increase in the money supply at the very onset of the depression, perhaps tied together with regulations to restore confidence in banking? Today, economic historians like Barry Eichengreen, contend that it is highly unlikely for us to suffer another great depression because deposit insurance can effectively prevent banks runs and maintain confidence in the financial sector and central bank managers know full well to raise the money supply quickly in response to a crisis in confidence. Possibly if that were done in the 30s, the depression would have been a temporary recession.

In this financial crisis, the FED and Treasury did respond by substantially raising the money supply, extending deposit insurance, and taking control or facilitating the buyout of “too big to fail” financial institutions. So how do we know that these actions will not be sufficient?

Seemingly, the massive increases in government spending in WWII substituted for depressed consumer spending and helped put people back to work. However, there was one other characteristic then that doesn’t hold today, at least not to the same degree. In WWII the Japanese flagrantly attacked the US in the Pacific, while at the same time the advance of the Axis forces in Europe threatened our very existence. It wasn’t too hard under those circumstances to rally workers to support the war cause and to quickly ramp up the defense sector. Suddenly everyone in the country had a central purpose, namely preserve our existence. So today the question to ask is, would a massive increase in government spending, without a clear sense of purpose to galvanize the workforce, have the same stimulating effect on the economy? Or again, would allowing the increase in money supply to work its way through be sufficient to prevent a serious decline?

Truth is, we don’t know. I don’t know, …. nor do the experts proposing it.

Regardless, the economic crisis offers an excuse to greatly expand the role of government in the lives of its citizens. Without the crisis, the new administration could never have done this. With the crisis, all sorts of things become possible. Once a $700 billion bailout was passed this past Fall, it doesn’t sound preposterous to propose another $800 or $900 billion in extra government spending. (Some economists like Krugman propose the stimulus should be even bigger)

Indeed the new administration now has the same kind of blank check in fiscal policy that the last administration had in foreign policy. The 9-11 attack made it politically possible for the US to invade both Afghanistan and Iraq. Both of these excursions have led to obligations that are difficult to disengage from and extend long after the initial actions. So similarly the expansion of government spending will lead to obligations that are difficult to reverse and will extend long after the initial actions.

Lastly, the popular impression is that the current economic crisis was caused in part by individuals and businesses overextending themselves and borrowing more than they could expect to repay in the future. Greed for prosperity led to insolvency. Now, we are proposing to fix the problem by greatly expanding government borrowing within a government that is already seriously overextended. (Had we entered the crisis with a tolerable level of government debt, the concerns would be greatly mitigated) In other words, government is about to do precisely what individuals and others were doing, overextending itself in the name of greed. Only this time it’s greed for social, environmental and presumed “good” government programs that will fuel the frenzy.