Category: Authors

Originally published on September 22, 2014

This week the UN will convene a climate summit where Secretary General Ban Ki Moon will ask leaders to bring “bold announcements and actions that will reduce emissions, strengthen climate resilience, and mobilize political will for a meaningful legal agreement in 2015.”

For those who have marched in cities around the world this weekend demanding change, the Summit offers a new opportunity to finally set the world on a corrective path that will avert an imminent global disaster.   This summit follows on the heels of previous UN conferences in Copenhagen, Cancun, Durban, and Doha, each of which had ambitious goals but which failed to prompt world leaders towards substantive action.   Frustration and disappointment has become the norm. As Felipe Calderon, chairman of the Global Commission on the Economy and Climate said, “If the evidence is so clear, why have we not acted?”

This summit has little chance for success. Even if it did result in some agreement by leaders, the eventual successful implementation would be extremely unlikely. The simple reason is that the world is severely addicted to fossil fuels and because of that, even the recognition and acceptance of the problem is simply not sufficient to inspire coordinated action.

A convincing argument can be made using an analogy between an individual’s addiction to cigarettes and fossil fuel usage by society.[1]  Smoking is commonly recognized as an addiction and it is important to note that smoking exhibits a similar pattern of costs and benefits over time as fossil fuel usage. Both cigarette and fossil fuel consumption generates immediate benefits to users; smoking causes the seductive effect of nicotine in the brain and social camaraderie among peers; fossil fuels provide affordable energy for transportation, heating and electrical needs – it is a part of everyone’s daily life. Both smoking and fossil fuels have the potential to cause long term damage in the future: with smoking comes the higher incidence of cancer, heart disease, and emphysema; with fossil fuels comes the potentially deleterious effects of super storms, droughts, and rising sea levels caused by climate change.   Finally, both smoking and fossil fuel usage are difficult and costly to discontinue: smoking cessation causes sometimes severe withdrawal costs and continual urges for resumption; fossil fuel substitution requires costly replacements of energy systems and higher energy costs.   In addition, the future effects of both smoking and fossil fuel usage are uncertain. Smoking does raise the probability of contracting a disease, but, as many as 50% of smokers never experience these negative effects. Fossil fuel consumption may certainly be raising global temperatures, but knowledge of who will be affected, to what degree, and when, remains speculative at best.

It is the presence of withdrawal costs that makes smoking addictive. Because it is painful for smokers to quit, even those with full understanding of the potentially detrimental future effects, can become trapped in their current habits and smoke until it kills them. Similarly, high relative costs of energy substitutes will also make it difficult to kick the fossil fuel habit as well.

Consider the campaign aimed at breaking the addiction to smoking, which began in earnest after the 1964 US Surgeon Generals report.   Since then, anti smoking groups have initiated educational campaigns, advertising bans, higher taxes, and successful litigation against cigarette companies. The efforts were a success with a substantial reduction in adult smoking rates in the US from over 40% in the 1960s to around 20% today.

In the early stages though, resistance to change was strong and many people simply denied that smoking was harmful. Today the vast majority of people, including smokers themselves, accept the dangers posed by smoking. Still, despite that knowledge, it may seem somewhat surprising that fully one-fifth of the US adult population continues to smoke. If we consider smoking around the world, noting that many similar regulatory programs and high taxes have been imposed in Europe and elsewhere, it is surprising that as much as 30% of the adult male population continues to smoke. Thus, despite many successes over more than a 50-year campaign, it has been grudgingly difficult to break peoples’ addiction to cigarettes.

Now consider fossil fuel usage. As described above, fossil fuel usage displays a similar pattern of costs and benefits over time as cigarettes and thus can be thought of as an addictive process.   However, fossil fuel usage is different from smoking in an important respect that will make breaking this addiction many times more difficult.

To curtail smoking one has to convince an individual to change his or her behavior in order to have a long term positive effect directly upon him or herself.   In contrast, with fossil fuels one must convince billions of people to change their behaviors in order to have a positive impact on future generations of people. Individual action on fossil fuel usage will have no meaningful impact on the future outcome for oneself, or the world. In fact, even if hundreds of millions of individuals in several large countries change their fossil fuel usage it will still have little effect on climate change if the rest of earth’s population maintains its current habits. This means that climate change mitigation is a collective action problem, on top of being an addictive process, and this is the reason the UN is convening regular summits to reach a collective agreement.

But while collective action can work when the benefits of the actions will have immediate positive impacts, it is unlikely to work when the benefits are highly uncertain and in the distant future. Also, although world leaders may pay lip service to climate change mitigation and even implement policies to prompt modest reductions in fossil fuel use, significant reductions in carbon emissions in democratic countries will ultimately require the support by a majority of the national electorates. With respect to smoking abatement policies, such as higher taxes and strict regulations, the majority of the population are non-smokers who are perfectly willing to support such restrictive policies. In addition, the cigarette industry is a very small sector relative to the size of the entire economy so legal attacks against it provoked little resistance. In contrast, policies to restrict fossil fuel usage and carbon emissions will affect 100% of the world’s population and impact industries that are the largest companies in the world employing tens of millions of people. The supply chains for fossil fuels and the profits that flow from them are well understood and both directly and indirectly benefit everyone on the planet. Attempts to break these fossil fuel “habits” will be met with an indefatigable resistance that will include continuing propagation of climate change denials and intense lobbying against any policy change that threatens these well-established patterns.  For these reasons, UN summits have virtually no chance for success. It won’t matter how many meetings are held or how many marches take place.

All hope need not be lost though. There are several viable alternatives to collective action. However, one of these alternatives faces high uncertainty regarding its potential effectiveness. And although the second option has high potential to be effective, it faces substantial resistance even from those most concerned about climate change.

The first option is a concentrated effort to reduce the cost of switching to low carbon alternative energy sources such as solar, wind and nuclear. If alternatives can satisfy consumer energy demands at a lower cost, then consumers will surely demand them. However, one additional requirement for this to work is that energy companies must be able to make greater profit supplying these alternatives than they can supplying fossil fuels.   Only in this way will there be a rapid changeover sufficient to crowd out fossil fuel usage. Whether low cost and highly profitable alternatives can be found quickly enough is highly uncertain.

The second possible solution is to use geo-engineering efforts to directly offset the greenhouse gas effect caused by rising carbon dioxide levels.  Several potentially viable options have been proposed including carbon capture methods and use of atmospheric reflective materials, which could be implemented at a relatively modest cost. However, despite the fact that it was scientific discoveries that have motivated the demand for fossil fuels during the past two centuries in the first place, people nevertheless resist the application of science to mitigate the negative effects that are resulting from its use.   Even if one accepts that there is a scientific consensus of the anthropogenic effects on climate change, that consensus does not imply that the only way to solve the problem is by forcing the reduction in fossil fuel use.

For these reasons the world would do well to abandon its efforts to reach climate change agreements. These efforts will be fruitless and are likely to result in rising hostilities as climate policy advocates increasingly chastise world leaders for their inaction while demonizing the oil, coal and gas companies who are simply delivering the world’s energy needs in the most habitually, efficient way.  The more effective approach is to use science to solve the problem caused by science. Better to pour collective efforts into the development of viable and profitable non-carbon energy sources and in the event that does not succeed, to be ready to act with effective science-based interventions that can help regulate and control the earth’s climate.

[1] For a more complete analysis see Suranovic, Steven (2013), “Fossil Fuel Addiction and the Implications for Climate Change Policy,” Global Environmental Change, 23(3) 598-608.

Originally published on April 29, 2014

Co-Authored by Pegi Ylli.

In the past century, the world’s economies have grown at a phenomenal rate leading to rising standards of living across the world as billions of people have been lifted out of poverty. Despite these advances though, there remains an unfortunate regularity; income inequality remains uncomfortably high, while income and standards of living among the poor in the poorest countries lag far behind the high incomes and standards in the developed countries in the world. Clearly many people are being left behind, inspiring a search for solutions.

For some observers, the primary reason for the growth of living standards within developed economies is the expansion of markets and an international division of labor based on comparative advantage. One solution for poorer countries, then, is to facilitate their entry into the international trading system by promoting the liberalization of international trade and investment. This is the primary goal of the multilateral trading system embodied in the World Trade Organization (WTO).

Another approach to the lagging living standards in poorer developing countries is embodied in the alternative trade organizations that have arisen; most importantly the fair trade labeling initiatives. In this system, specific products that are traded internationally, such as coffee, tea and cocoa, can receive a Fair Trade label after a Fair Trade labeling organization has adjudged that a fairer share of the final price has accrued to the poorer farmers of the product and that the product is produced under fairer labor conditions. A fair price to the poorer farmers is usually a guaranteed minimum dollar amount per unit designed to provide the farmers with something closer to a living wage. Fairer labor conditions generally means the establishment of longer term contracts between intermediaries and the primary good producers and adherence to sustainable farming standards.

Proponents of each approach to economic development tend to view the alternative approach with suspicion. Thus, proponents of free trade and the WTO system tend to believe that fair trade is a subjective concept that does not translate into simple and widely acceptable policy guidelines. The guidelines that are used to justify a label are somewhat arbitrary and may lead to greater inefficiencies in production resulting in more harm than good. In contrast, some proponents of fair trade tend to consider the large inequalities in income to be caused largely by the promotion of freer international trade and believe that the WTO expansion contributes to the promotion of poverty. In their view, fair trade is a superior substitute to the multilateral trade system. Other supporters of fair trade, however, believe it is acceptable to “mainstream” fair trade products by working with large-scale multinational firms who benefit from the multilateral trading system. Under this view, fair trade is complementary to the system of multilateral trade liberalization, and the two can advance together.   To better understand the interaction between these two systems, it is worth elaborating on the features of both.

Free Trade Promotion and the Multilateral Trading System

Some critics of the WTO contend that the poor nations of the South are “straitjacketed by … (the) trade rules in the WTO (and) cannot use import duties to protect their weak economies, their fledgling industries, or their small farmers from unfair international competition” (Jaffee, 2007). In this view, the WTO rules allow rich countries to take unfair advantage of poorer countries. However, this view is a misrepresentation of the WTO. In actuality, there are no WTO “rules;” instead there are promises made by each participating country to liberalize its own trade policies. These policies are liberalized not to some harmonized standard, but instead to a lower level than that same country had in place prior to the agreement.   Developing countries are not expected to maintain the same low tariff barriers as developed countries; instead they are allowed much more flexibility in setting tariffs than the most advanced countries. For example, whereas average bound (or maximum) tariff rates in the US are about 3.5% and in the EU 5.2%, middle income countries are allowed to maintain higher tariff bindings (WTO). Brazil has bound tariffs at an average of 31.4%, Argentina at 31.9% and Chile at 25.1%. For poor developing countries, the negotiated maximums are even higher. In Guatemala, the average bound tariff is 41.2%, in Nicaragua 40.7% and in India 48.6%. Although developing countries currently set, or apply, their tariffs at a much lower rate (on average at about 12%), these countries have the ability to raise tariffs in times of trouble without violating their international WTO commitments.

The area of agricultural policies is where developing countries can rightfully complain about the multilateral trading system. Developed countries support their agricultural industries with a complex system of domestic support programs and export subsidies, usually to the benefit of entrenched interests and to the detriment of farmers in less developed countries.   However, the WTO is a forum that can be used to pressure developed countries into liberalizing their agricultural industries via adjustment to the Agreement on Agriculture within the WTO. Indeed, because further WTO adjustments (like completion of the Doha round) can only occur if there is a consensus, coalitions of developing countries have been able to prevent a Doha deal if it does not include acceptable changes in agricultural policies.   That there is no comprehensive Doha deal even after more than a decade of discussions is testament both to the new power of developing countries within the WTO system, as well as to the power of entrenched and resistant agricultural interests in the developed countries.

Many of the inequities and disadvantages for farmers in the South are because free trade does not prevail in those markets. Instead, powerful agricultural interests in the North work against the goal of trade liberalization in precisely those product areas in which the South has the greatest advantages. Although trade barriers are much lower in developed countries, they remain notably higher in agricultural goods and in textile and apparel products. The WTO goals are to reduce or eliminate these discrepancies, but unfortunately, despite decades of discussions to reduce or eliminate special protections for developed country agricultural industries, very little progress has been made.

The Fair Trade System

The goals of the fair trade system focus on one issue that is not a focal point of the free trade system, namely inequality. Laura Raynolds describes the movement as “a critique of historically rooted international trade inequalities and efforts to create more egalitarian commodity networks linking marginalized producers in the global South with progressive consumers in the global North” (Raynolds, 2009). This alternative trade model aims to establish better prices, long-term trade contracts, and resources for improving social and environmental standards for Southern producers of commodity goods. In short, fair trade is designed to provide compassionate consumers in the developed countries who care about poverty alleviation with a simple method to ensure that a greater share of commodity revenues goes towards improving the livelihoods of the poorest farmers.

Certification is central to how the fair trade system ensures product quality and production sustainability. Fairtrade International is an organization that monitors production, trade groups, and the Fairtrade certification process to assure that a set of principles is upheld.Fairtrade certification promotes these main principles: fair prices, fair and safe labor conditions, direct trade, democratic and transparent organizations, community development, and environmental sustainability (Fair Trade Resource Network). The Fairtrade label thereby assures Northern consumers that Southern producers were treated according to these principles and thus that their purchases will help alleviate poverty.

We may well ask why these goals of the fair trade movement are not satisfied by the multilateral trading system in the WTO. One reason is that free trade’s goal is not reducing inequality, per se, but rather the improvement of economic efficiency, which would generate a greater amount of goods and services available for consumption. This outcome could reduce poverty if the additional surplus were distributed to the world’s poor. However, if greater efficiency leads to production that is only consumed by the world’s wealthy, then the poor may be left further behind. For most free market advocates, improving world standards includes a twofold solution of maximizing production via free trade, then redistributing income so that the poor can enjoy a share of the extra benefits.

The fair trade system can complement to the free trade system because it offers a mechanism by which income can be transferred from rich to poor along a commodity chain. Because the fair trade system is voluntary, it does not violate any of the WTO trading principles and can operate independently alongside a free trade system. One problem with fair trade though is that the certification and monitoring process incurs extra costs that are then passed onto to the conscientious consumer.   The lower these implementation costs can be maintained, the larger can be the transfer to poorer farmers.   If these costs are too high though, the fair trade product premium will be higher, reducing the number of Northern consumers who would be willing to participate. One big advantage to fair trade, compared to outright foreign aid or charity, is that it does not look so much like charity.

A second reason that fair trade can complement the multilateral trading system is that it aims to correct for unfair outcomes. The poor may not be sharing the benefits of freer trade because free trade has not been achieved in many commodity markets. Already we have suggested that tariffs remain high for agricultural products. Protection reduces competition for import competing firms and results in economic inefficiencies. Additionally, many have argued that there is a concentration of market power along many commodity supply chains (Nicholls and Opal, 2005). These supply chains are like an hourglass, in which many producers supply many consumers on the other end, but the product must pass through the hands of a small number of wholesale intermediaries. If competitors cannot enter, these intermediary firms act like a monopsony, forcing a lower commodity price and taking advantage of poorer farmers while capturing a greater share of the surplus value generated by trade.

Imposing a minimum price floor for fair trade products raises the producer price closer to the price they would obtain in a truly competitive market, that is, a market in which intermediaries could not exercise their monopsony power.   The fair trade labeling process therefore creates a non-governmental method of maintaining a minimum wage and can therefore correct for an unfair outcome (Hayes, 2006). In this case, the price floor guaranteed to farmers through the fair trade system helps create an outcome closer to what would have arisen with free trade in a competitive market.

This complementarity of fair trade with the multilateral trading system has prompted some in the fair trade movement to support “mainstreaming.”   This involves partnering with big corporations and expanding marketing efforts through these new channels, thereby attracting a greater consumer base, increasing awareness, and giving producers more trading options. The promise of mainstreaming is the potential for rapid growth of the fair trade market.

However, fair trade purists believe that fair trade is a model for an alternative trading system that might one day substitute for the free trade multilateral system. In this view, “mainstreaming” is a sellout that threatens to divert fair trade away from its core values of establishing partnerships with like-minded organizations.

The Future of Fair Trade

Some resolution of the growing rift between the two approaches to fair trade may be necessary before fair trade can expand beyond its current niche market. In either case, expansion would require consumer acceptance of higher prices for commodity products and consumer awareness of alternative trading methods. An increase in the production of fair trade goods would also require quality controls and proper labeling. If fair trade wages continue to increase, other producers might claim to have fair trade products too, in order to benefit from higher prices, although those goods may not necessarily abide by the true certification guidelines. Also, if consumer demand for fairly traded goods rises substantially, the demand for conventional products would fall, causing a reduction in those prices, and perhaps reducing the wages of workers in the conventional markets. Thus, expansion of fair trade faces many obstacles to overcome in the future.

Fair trade is making strides towards achieving fairness in the global economic community by directly addressing the existing inequality gap between the developing and developed world, but for the moment it seems to have achieved little more than niche status. The fair trade movement will need to solidify its vision for the future if it can have a chance for further expansion.

Works Cited

Hayes, Mark. “On the efficiency of fair trade.” Review of Social Economy 64.4 (2006): 447-468.

Jaffee, D. (2007). Brewing justice: Fair trade coffee, sustainability, and survival. Univ of California Press.

Nicholls, A., & Opal, C. (2005). Fair trade: Market-driven ethical consumption. Sage.

Overview of fair trade in n. america. (2013, 09). Retrieved from http://www.fairtraderesource.org/wp/wp-content/uploads/2007/09/Overview-of-Fair-Trade-in N-America-vSeptember2013.pdf

Raynolds, L. T. (2009). Mainstreaming fair trade coffee: from partnership to traceability. World Development, 37(6), 1083-1093.

The World Trade Organization. (2014). Retrieved from http://www.wto.org/index.htm

Originally published on March 19, 2013

(Cross-posted on Aspenia Online)

In his State of the Union address in February US President Barack Obama announced the start of negotiations on a comprehensive Transatlantic Trade and Investment Partnership with the European Union. The stated intention of this Trans-Atlantic Free Trade Area (TAFTA), as well as that of the other ongoing US trade negotiation – the Trans-Pacific Partnership (TPP) – is to create jobs.

The politician’s logic is simple. By negotiating for reduced barriers to trade from our trade partners, in the form of lower tariffs and changes in regulatory policies for services and investment, our exporting firms can expand into new markets and reach new customers, creating new job opportunities for domestic workers. The regrettable cost of a free trade agreement – again, from the politician’s perspective – are the concessions that must be offered. These include reductions in home trade barriers and regulatory changes that open up market access to foreign companies and generate a loss of jobs in the import-competing sectors.

The economic case for free trade is a bit different. Economists focus on the well being of consumers and ask what will achieve the highest overall standard of living. To the economist, free trade reduces discriminatory taxes and regulations and opens up markets to greater competition. Competition forces firms to continually reduce costs and innovate to improve the quality of their products in order to remain in business. As a result consumers can buy better products at lower prices, and one’s income generates a rising standard of living.

One key difference in these two rationales is that the economics case for free trade does not depend on the other country’s decisions. Increased competition from lower tariffs generates benefits for domestic consumers whether the counterpart liberalizes or not. Unilateral free trade is a winning scenario. In contrast, to the politician unilateral free trade offers concessions without providing job-creating benefits. It is a losing scenario.

Nevertheless, since the Great Depression of the 1930s, trade liberalizing efforts have progressed, in the GATT, the WTO, and in the formation of free trade areas – under the politician’s logic. Economists have gone along with this process because it has offered a politically viable method to achieve the goal of trade liberalization. And via this method, tariffs did come down substantially around the world and international trade has grown phenomenally since the 1930s, which has surely contributed to the improvement of living standards around the world.

However, now that negotiations in the Doha round of the WTO have stalled for over 10 years and multilateral trade liberalization has ground to a halt; now that free trade areas around the world have grown to more than 200 in the past few decades; and now that discrimination in trade has become more the norm than the exception, it is unclear whether the continuing expansion of free trade with an agreement like the TAFTA is still satisfying the economic objective of spurring competition, raising economic efficiencies, and improving standards of living.

First, consider trade in manufacturing goods. The average weighted US tariff on imports from the EU is at 1.1%, while the average weighted EU tariff on imports from the US is at 1.5%. Reductions of these tariffs to zero will have an almost imperceptible effect. In agriculture the tariffs are only slightly higher. For example, the average weighted US tariff on agricultural imports from the EU is just 2.1%. Thus, even trade liberalization in agriculture, which is much more heavily protected, is unlikely to have much effect for either bloc. Of course, there are some regulatory issues that could be settled, such as the future rules regarding hormone–treated beef and genetically modified organisms, but they have been under constant discussion and it seems likely that the US will continue to demand greater access while the Europeans will continue to resist.

An ambitious negotiating agenda would put the larger issue of domestic agricultural support policies in play, with the hope of implementing major reforms to reduce the distortions that continue to affect agricultural goods like cotton, grains, and sugar. However, it is largely the intractability of this issue, caused by the unwillingness of all sides to compromise, which has led to successive failures of the multilateral negotiations in the Doha Round. Even a relatively minor problem, like trade in bananas, took over 15 years of continual wrangling between affected countries to reach an agreeable resolution last fall. Thus, it seems unlikely that much progress will be made on this front.

Another hidden problem that arises as new free trade areas are formed is the set of special restrictions that go into place to prevent third countries from receiving the same preferences offered to the free trade partner. These “rules of origin” specify what portion of a product must originate in the FTA member country to be granted duty-free entry under the FTA. The rules vary from product to product and necessitate a careful, and economically costly, accounting of a product’s production pedigree. This exercise is becoming increasingly difficult, and pointless too, because, as Pascal Lamy, the Director-General of the WTO, recently said, products are no longer Made in the UK or Made in Switzerland, rather they are Made in the World. Supply chains stretch across multiple continents making national origin an increasingly arcane concept. Nonetheless, national origin becomes increasingly embedded in these regional trade agreements.

One final suspicion I have about the new TAFTA is that it is really intended to do two things that have little to do with improving living standards in the affected regions. First, it is meant to offer easy talking points to support the notion that governments are trying to do something to get their countries out of the economic quagmire that they remain stuck in. Because a TAFTA will have few large economic impacts, it is a tepid response that sounds bold but will not upset very many constituents. Secondly, a TAFTA may be inspired by a continuing desire to isolate China and ward off the competitive pressures that emanate from Asia. Perhaps it is not a coincidence that the only FTAs the US is actively discussing comprise Trans-Pacific and Trans-Atlantic partnerships that exclude the one country whose trade has been growing the fastest. No wonder China feels like they are being treated as an economic enemy rather than a friend and partner.

Overall, it quite possible that a TAFTA will not have much of an economic impact, will not tackle the persistent distortions in agriculture, will introduce even more trading costs in a world with increasingly discriminatory trade policies, and may even irritate other important countries that feel they are being left out of yet another trade liberalizing deal. Thus I wonder if TAFTA is worth the effort, especially if it is just being done to score a few political points. On the other hand, it is encouraging that in these troubled economic times politicians still think it prudent to support some kind of free trade deal.

Originally published on November 9, 2012

Hurricane Sandy left devastation in its wake and has created numerous hardships for the residents of the area that will continue for some time to come. One of the problems affecting most residents, even those whose homes were not significantly damaged or did not lose electricity, is the ongoing gas shortage. New York State, following on the heals of New Jersey, announced gas rationing to go into effect today. This is in response to the continuing long lines at service stations throughout the area. The problem is that these mechanisms do not allocate gas fairly, wastes valuable resources, and prolongs the suffering.

Long lines mean that people and businesses are diverted from their usual activities to acquire this needed commodity. The wait is frustrating and leads to anger and unrest often because some people in line have a very high immediate need for gas while others have noticeably less need. Some people need gas to run their business, or to operate their emergency vehicles, others like retired people need gas because they will drive to the post office and store 3 times a week; some need gas to run their generators because the power is still out at their business or home, others need gas to run their lawn mower this week.

The allocation mechanism with lines is simple though; it is first come, first served. Unfortunately, the people with the most time to wait in line, like a retired person for example, are also the ones who probably have lesser need for the gasoline right now. Those desperate for gas are more likely to try to cut ahead in line which is sometimes enough to provoke violence. This is a reason police officers have been assigned to keep order at service stations. But it also means more worker time (policemen) is diverted from other activities towards gas rationing.

In the end, the line, and the rationing, will mean that everyone lucky enough to get gas after the long wait (and some might be turned away if gas runs out) will get the same amount; in other words, high need people and low need people will be treated equally. Of course, government leaders have appealed to people to buy only what you need, but because there is uncertainty about when gas supplies will be restored, every individual believes they need the maximum amount they can get, and so these appeals are rarely heeded.

There is a fairer and simpler allocation mechanism available, but unfortunately most people don’t understand it and would not accept it in this situation. Nonetheless, this mechanism would assure that the limited available gas goes to the consumers and businesses that need it the most. The mechanism would eliminate the lines and allow people to use their valuable time more productively. And the mechanism would help to bring greater gas supplies to the area more quickly so that life could return to normal.

That mechanism is the free market price mechanism. Here’s how it would work. First, when the storm hit, gas supplies suddenly dropped, largely because electricity outages froze the pumps. The sudden need for gas for generators and because of future uncertainty about supply, led to an increase in demand and the formation of lines. In a free market, service stations with gasoline to sell would recognize the line as a gas shortage and would raise their price immediately to make more profit. Knowing what price is needed will be difficult with so much uncertainty, but a rule of thumb would be to raise the price until the line disappears, and you return to your normal sales rate. However if you fear that supplies will not be arriving as usually scheduled, the owner might raise the price even further to shorten the sales rate. What price would be needed is hard to guess, but perhaps in this situation the price might be raised to $8 or $10 per gallon, or even more. Different service stations would raise the price to different levels. Those with a lower price increase would see their gas disappear faster as consumers would choose the lower priced gas.

With high prices, demand will fall. People with low gas needs will conserve gas or stay home and wait for the prices to fall. People with intermediate needs will look for energy alternatives. They might drive to Pennsylvania to get the cheaper gas because even going out of the way is cheaper than paying the high local price. Still, the people who most need the gas, for example, the emergency and delivery vehicles, will recognize their high need and will buy gas despite the high price.

I understand that this mechanism does not produce happy people, but then neither does waiting in line with the alternative mechanism. The underlying shock remains the same; there is still, say, 50% less gas to go around and somebody is not going to get their usual amount. There is no way around that until gas supplies return to normal. However, with the price mechanism the businesses and individuals who need gas the most at this moment will be able to drive into a service station, without waiting in line, and buy gas in the midst of the crisis.

Furthermore, the price mechanism will send a signal to gas suppliers elsewhere that if you can quickly move gas into the area, you can make a big profit. The bigger the price increase, the bigger the profit and the more swiftly profit seeking oil companies will move gasoline into the area. Consider a simple example. A tanker truck is about to deliver gasoline to a service station in Pennsylvania. But when the price rises in NJ, it makes sense to give up the PA delivery and sell it for a higher price in NJ. Since the station is now selling gas for $8, say, they will pay the tanker company much more for the shipment. If the price rose to $12 a gallon … then tanker trucks from Colorado might begin to show up! The supply response will be larger the greater the price increases. In contrast, when prices are kept low, as is typical in these situations, oil companies have no greater incentive to move gas to NY and NJ and so the gas shortages will last longer.

Of course, the price mechanism creates some equity problems and this is the major reason it is rejected by most people. The first reaction to price increases is to ask how a service station owner could be so callous as to try to make more profit when people are suffering in the aftermath of a natural disaster. The second reaction would be that wealthy people can afford the high prices and will get all the gas, while poorer people will suffer.

There are several ways to assure greater fairness despite the high prices though. First, is to recognize that high prices assure that gas goes to the greatest needs and that may not always be to wealthier people. (For example, consider a small delivery business with high daily gasoline needs). Second, recognize that the needs of poorer people are not always better served with low prices and lines. Poorer people still need to wait in long lines, probably taking them away from a job with a necessary income. Furthermore, lines allocate more on the basis of luck and persistence rather than based on low income. Third, if moral indignation is to be raised, it is better if it is turned to social pressure to return the extra profit to the community rather than pressure to avoid the price increases in the first place. I imagine that even service station owners, living in a distressed community, will exhibit compassion for their neighbors. Suppose service station owners who increase their prices, decided to open a window and offer cash payments to buy gasoline to customers in distress. That owner would contribute money to a family whose home was destroyed but not to the family whose lawn might not be mowed this week. Or, perhaps the owners would contribute a large share of the profit to local charities who are better equipped to determine who in the community is in more desperate need. Relief organizations can help poorer families too, perhaps by giving out gas vouchers that can be redeemed at local service stations and are reimbursable to the gas supplier at full market price at the time of the transaction. Many other solutions like this exist that would allow the price mechanism to allocate gas on the basis of greatest need, but at the same time provide compensation to the poorer families and to those in most distress in the community.

The price mechanism will not work perfectly but it seems likely to work more efficiently and will resolve the problems faster than the alternative. However, the price mechanism is never given a chance. This is largely because the general public and policy makers do not understand or accept that profit seeking behavior in this situation will eliminate lines, allocate temporarily scarce gasoline to its most important uses, and promote a more rapid return to normal supply levels. Profit seeking in this instance, (though not in all instances I should add), serve the public interest as well as the private interest. Nevertheless, although the price mechanism is accepted in normal times, people do not accept its benefits in situations like this. Instead, politicians have put into place anti-market legislation such as price gouging laws, which appease the public, but which only serve to make a very bad situation even worse.

Originally published on October 8, 2012

Reposted from Aspenia Online.

As the US Presidential election enters its final month, both candidates are emphasizing how their policies will create more jobs for Americans, while at same time criticizing their opponent for either not creating enough jobs or actually destroying them.   President Obama criticizes Mitt Romney for having fired workers or having outsourced jobs when he was at Bain Capital.  Romney argues that President Obama hasn’t been tough enough on the Chinese and that has contributed to a loss of US manufacturing jobs.  With US unemployment uncomfortably high at over 8% for almost four years running, voters clearly want to hear ideas that will promote a rapid increase in employment.  Unfortunately though, the arguments being made by both candidates are unlikely to improve outcomes for most Americans and instead are symptomatic of the continuing influence of special interests over both political parties.

If politicians were really concerned with the general well-being of Americans they would spend more time talking about what is best for average households and consumers and much less about jobs.  They would explain how free markets, when subject to certain rules, can deliver the goods and services that consumers most desire at the lowest possible prices, thereby improving most everyone’s welfare.  And, they would argue that the best mechanism available to achieve that outcome is competition.  What government can do to help create prosperity is to implement policies that promote rather than restrict competition.  And yet many of the policies being suggested by both candidates will restrain competition with the promise of creating jobs.  This promise to create jobs via direct government intervention is a ploy by special interest groups that has permeated the political conversation for many years.  And voters are being duped!

Consider the argument that our trade deficit with China must be eliminated in order to create jobs.  Many citizens accept the notion that buying American goods is better for our economy than buying foreign goods.  Why do they believe that?  The argument is that when you buy a US made good you support a US worker, but when you buy a foreign product you help a foreign worker instead.  But this notion is incomplete because it doesn’t look far enough into the economic mechanisms at work.   When an American buys a Chinese made good, an exchange of currency must first occur.  A hundred US dollars, say, must be exchanged for 630 yuan.  The American then uses the 630 yuan to buy the Chinese made product, some of which pays the salary and supports a job for a Chinese worker.  But what happens to the one hundred dollars?  It is acquired by a Chinese resident.  If he were to purchase a US good for $100 then some of that will pay the salary of a US worker and support his job.  Trade would also be balanced and presumably everyone would be content: trade seems fair!

But what if the US dollars are acquired by the Chinese government and held as reserves.  In this case the money does not support a US export and an American job, right?  Well, this is wrong!  The reserves acquired by the Chinese government are saved in the US, mostly by buying US government securities.  When the US government borrows money it does so because it will spend it immediately on military, highways, education and transfers to other people. The borrowed $100 supports US jobs just like when it is spent on US exports, it just takes another step through an intermediary before it gets there.  The critical difference is that this job effect is hidden, non-obvious, and ignored by all the groups that want citizens to believe that buying American and eliminating deficits with China is good for the country.

Policies that restrict imports from China, or would force Americans to buy American products to reduce our purportedly unfair deficits, are not good for the average American.   Instead they are only good for a small group of special interests; these interests are the firms that compete directly with imported products and the workers who work in those industries.  However, these policies will also reduce competition and result both in higher prices and a reduction in product qualities for these goods.  Most Americans are consumers of these goods, not producers, and so the majority of Americans will lose.  The small minority who will gain from higher profits and enhanced job security will be obvious for all to see, but the losses felt by most Americans, though larger in total value, will be dispersed across a large number of US consumers and so will be difficult to see and measure.  This is how special interests capture the political process and fool average Americans into thinking that what is bad for them is good.

Or, consider the issue of outsourcing.  The popular opinion is that outsourcing is damaging to the economy because it involves laying off American workers and substituting them with less expensive foreign workers.  The immediate effect is indeed harmful to those American workers who lose their jobs.  However, if we consider the process more completely, a firm that outsources is engaged in a reorganization intended to make itself more competitive, which means finding ways to improve its products qualities and/or reducing costs.  It is true that the firm’s management, and the workers who remain employed, will profit from this adjustment.  But this is good profit because it achieves a better product with lower costs that are passed on to the benefit of American consumers.   Thus, the process of outsourcing will lower the cost for many American consumers, the sum of which can outweigh the losses incurred by the laid off workers.

The next part of the process is crucial though and not always fulfilled.  In a well functioning free market, workers that are laid off seek new jobs in other organizations and after a short period are re-employed in an industry where their skills are more needed than at the previous firms.   When an economy is booming, people don’t complain as much about outsourcing because workers find new jobs quickly.  So what should be done if workers can’t find new jobs because the unemployment rate exceeds 8%?  There are several approaches.

President Obama’s approach is to demonize firms who outsource and propose policy changes that will punish outsourcing firms with higher taxes.  In other words, change business incentives so they will hire more domestic workers.  The workers whose jobs are threatened by outsourcing welcome these policies.  However, this approach will also make the US firms less competitive and once the economy picks up again, the anti-competitive policies are likely to remain in place permanently.  Thus, the policies are pro-(potentially-outsourced)-worker but anti-consumer.  Nevertheless, because the potentially outsourced workers who benefit are small in number while the consumers who lose are large, it represents another example where a smaller special interest gains protection at the expense of a larger group of Americans.

An alternative approach is to seek to maintain competitive forces but solve the underlying market failure.  Outsourcing is not a market failure …  nor is a trade deficit a market failure. Instead the failure is the lack of alternative jobs for the workers who have been laid off.  In a well functioning market, as in boom times, workers in contracting industries would find other jobs quickly and the pressure for special protection would be mild.

Unfortunately, solving the underlying growth and employment problem is very difficult.  Richard Fisher, the President of the Dallas Fed bank and a member of the FED Open Market Committee candidly admitted at a speech at the Harvard Club last month that,  “Nobody really knows what will work to get the economy back on track.”  This statement applies to both Presidential candidates and to their economic advisors.  Nonetheless politicians know that they must propose something because of citizen pressure.  And so they propose a collection of policy options that respond to the loudest voter concerns and which they hope, and maybe even believe, will work.

The real problem though is that special interests, in this case import competing firms and their workers, are using the situation to convince voters and the candidates to rally around anti-competitive policies.  These policies are claimed to be effective in creating “JOBS” …  meaning jobs in the aggregate economy that will reduce the unemployment rate.  But that won’t happen!  Instead these policies will secure “jobs” …  meaning perhaps a few hundred thousand jobs in select industries that happen to be located in important swing states.  Politicians claim that these policies will punish the unfair actions of foreigners and help all Americans.  But they won’t!  The cost to secure these jobs will be paid by the vast majority of Americans who do not work in import competing industries and who will suffer a decline in the purchasing power of their already tight household budgets.

In Richard Fisher’s remarks he also noted that CEOs are refraining from expanding their businesses and hiring more workers in large part because of uncertainty about the future.  One source of uncertainty is the continual suggestion of bold new policies.  Will the next administration touch off a trade war with China?  Will firm reorganization decisions today result in higher tax liabilities in the future?

If Americans are lucky the Presidential candidates will forget about these promises once elected.  Possibly cooler, non-political heads in the US Treasury will prevent the declaration of China as a currency manipulator.  Possibly, export oriented US firms will use their influence to prevent the government from implementing policies that punish outsourcing and from declaring a trade war on China.   But on the other hand, maybe they won’t!

Originally published on September 28, 2012

By Michael Bush* and Steve Suranovic

Republican presidential nominee, Mitt Romney, focused much of his attention last week connecting the decade-long skid of the U.S. manufacturing sector with President Obama’s trade policy on China, specifically Obama’s failure to apply the currency manipulator label. The large trade deficit with China, presumably the result of the undervalued yuan, provides voters with a visual manifestation of high unemployment and stagnant incomes. China is an easy target. Trade sanctions against our largest trading partner, the argument goes, would reduce the trade deficit, level the playing field for U.S. producers, and create American jobs. This message plays especially well in manufacturing‐heavy cities like Cleveland, OH, where recently reinforcements arrived with a provocative documentary titled “Death by China.” However, labeling China’s monetary policy currency manipulation is not only misleading, but the recommended trade remedies that would follow are likely to hurt, more than help Americans.

For starters, China has not actively lowered its currency value. Like many other U.S. trading partners, China has adhered to a fixed currency regime for over two decades. To maintain that fixed rate, and because of high demand for the yuan during the past decade, China’s central bank has purchased over a trillion dollars of currency reserves that are invested mostly in U.S. treasuries. These actions by China’s central bank are what Romney and others refer to as currency “manipulation”. However, this characterization overlooks three important things: first, a fixed currency regime is not unique to China; second, the yuan has been appreciating against the dollar for almost a decade; and third, currency appreciation does not automatically eliminate trade deficits.

According to the International Monetary Fund (IMF), over 100 countries have some form of a fixed exchange regime. Thus, it is misleading to single out China as a currency manipulator when other U.S. trading partners engage in the same practice. Regardless, China has adopted a crawling peg system, which permits the central bank to periodically adjust the yuan with respect to the dollar. Since 2005, the yuan has appreciated by 23 percent in nominal terms. Taking into account inflation, that number increases to almost 50 percent.

To put a nearly 50 percent appreciation into context, as well as provide a historical touchstone, Congress proposed legislation back in 2005 that would slap a 27.5 percent tariff on all Chinese imports. Why 27.5 percent? At the time, this was estimated to be the amount the yuan was undervalued. Fast-forward to today, the Chinese yuan has appreciated by almost twice that amount and the U.S. still has a trade deficit with China! One might argue that a 50 percent increase in the value of the yuan simply wasn’t enough to do the job. In this case, consider the 1980s when the U.S. faced worrisome trade deficits with Japan. Since the 1980s the yen has appreciated by 220 percent to the dollar and yet this has not prevented a sizeable US trade deficit with Japan in every year since.

This evidence alone should give hesitation to anyone who thinks a simple currency adjustment will eliminate the trade deficit and create U.S. jobs. Trade deficits are influenced by much more than just the currency value; notably low U.S. savings and high consumption levels.

In addition, while changes in currency values would probably have a negligible impact on the trade deficit, sanctions against China would hurt more Americans than they would help. U.S. consumers who buy Chinese clothing, furniture, toys, appliances, electronics and many other products would have to pay more for these items. Holidays would become much more expensive! And, it would likely be the less wealthy who will suffer the greatest reduction in purchasing power. Moreover, the retaliatory tariffs that China would most certainly pursue would harm U.S. companies that export to China, as well as the U.S. affiliates in China that ship goods back to the U.S. So, who will benefit from the tariffs? The U.S. industries and associated workers that compete with Chinese imports will prosper most, but this represents only a small fraction of U.S. stakeholders.

Thus, while politicians claim that America will gain from getting tough on China, the reality is that a subset of influential U.S. producers will benefit at the expense of most American consumers. This should hardly be surprising given the perennial accusations that powerful lobbies have commandeered international trade negotiations. Rather than blaming China for the turbulent economy, Americans would be much better served by looking internally and addressing its savings problem while simultaneously reining in its own spending. Unfortunately, this does not play well on the campaign trail. To be fair, President Obama’s position on China, though not as strident, is not markedly divergent. Regardless of what side of the aisle it originates from, public censure of China is more political maneuvering than sound economic policy.

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* Michael Bush is an MA student at the Elliott School of International Affairs.

Originally published on September 26, 2012

Today I noticed a prime example of how the media can exaggerate a story.  The charitable interpretation is that they do so merely to provoke viewer interest.  The cynical view is that they do it to provoke a popular bias.  Regardless of the motivation though, its effects perpetuate gross misunderstandings of news events and taints the popular discussion of important policy issues.

The story in question is a report about the launch of China’s first aircraft carrier.

Fox news with Bret Baier reported it this way:  “China is taking a huge step towards eventually challenging the US for naval supremacy in the Pacific.  Correspondent Adam Housley on what could be a military sea change.”   Watch the story and see if you agree that it suggests a major and worrisome development.

However, then look at this article today in the New York Times, which offers some important details. The most important of which is this sentence: “China does not have planes capable of landing on the carrier and so far training for such landings has been carried out on land,…”  Hmmm…. an aircraft carrier with no planes!  Is that a real threat?  I’m no military expert, but come on!

Of course the statement at the start of the FOX broadcast isn’t wrong since they did say “China took a huge step towards EVENTUALLY challenging the US …. “   It’s just that they didn’t really give the extra details that would suggest eventually might be 10-20 years away.

Bloomberg reported it this way …  quite a bit more neutral in its presentation.

Originally published on August 30, 2012

Economic storm clouds continue to form around the world.  The problems in Europe threaten not only Europe, but the rest of the world economies too.  Even the countries that weathered the 2008 storm relatively easily, such as Brazil and China, are now developing symptoms of economic distress.   Following a several month stay teaching and traveling in some of the major cities in China, I come away with a more pessimistic outlook about China’s future than most of the Chinese people I have talked to.  If my pessimism is borne out, the effects could be very serious for China and the rest of the world.  However, there are some things the US could do now to avert a possible catastrophe.

A quick visit to China’s most vibrant cities like Shanghai, Beijing and Shenzhen suggests a country that is jumping ahead of the rest of the world.  Arrive at their newly designed airport terminals, ride their clean and efficient subway systems that extend to all parts of the city and continue to be expanded, gaze up at hundreds of modern skyscrapers towering over head and spread out across the cities, travel between cities on their high-speed trains traveling over 300km per hour (Beijing to Shanghai .. 1300km  .. in just over 4.5 hours), walk through the shopping malls and see the customers in the Gucci, Chanel, and Louis Vuitton stores, choose from a growing assortment of tony restaurants and stay at one of the hundreds of 5-star hotels, and it is easy to see why so many first-time visitors to China come away with a sense that China is poised to take over the world.

However, these obvious displays of the real progress that China has made over the past 30 years belie a very different experience hidden beneath the shiny surface.  In the wake of the world financial crisis in 2008 China maintained its high growth largely by expansive government support for infrastructure projects.

As a result investment spending in China has recently approached 50% of its GDP (this compares with about 15% on average in the US).  Much of that investment has been in the form of apartment buildings sprouting up across cities throughout China.  This has contributed to the real estate bubble that is beginning to burst.  Other investment has been channeled through the state-controlled banking system to build capacity within state-owned enterprises.  This investment keeps China’s GDP growing at a heady pace, however, this cannot be maintained forever using this same approach.  For government directed investment to work as a long term strategy, the investments must yield a return eventually, and this is the rub.

Travel between cities in China and you will see numerous newly built 20-30 story apartment buildings, many constructed as complexes with several similar buildings side-by side.  During the daytime one can marvel at the rapid progress.  But at night one will notice something strange … many of the buildings have very few lights on.  Many finished buildings have no lights at all …  they are completely unoccupied.  People in China say it is very common for buildings to have numerous vacant flats.  People buy them hoping to ride their investment to higher future values, but don’t rent them out because current prices fetch no renters.  As a result there is enormous excess capacity in the property market at the current price levels.  Some experts say that one-quarter of all housing is unoccupied in China.  The only way to clear this capacity is either to wait a very long time for the economy to catch up, or for prices to plummet.  At some point soon, if not already, the realization should set in that it does not make sense to build even more unoccupied apartment buildings.

I suspect a similar excess capacity is developing in the industrial sector as well, especially since the government has been pushing loans out the door to keep GDP growing.  Those investments will pay off only if demand for the companies’ final products grow sufficiently fast.   However, with stagnating demand for goods and services from Europe and the rest of the world economy, Chinese businesses are struggling.  I spoke with someone who works for a company that supplies intermediate inputs to private businesses in China in a wide range of sectors.  This company hasn’t made a profit in over six months.  Numerous manufacturing sectors are cutting back as they face the drop in world demand for their products.  (Exports in July rose only 1% compared to 11% the month before.)  At some point soon, if not already, the realization should set in that it does not make sense to expand factories even more if the market demand is not there.

In the best scenario, a significant economic downturn will be averted in China in the next few years.  Most people I talked with in China expect that the Chinese government will prevent a serious economic crisis.  If China’s downturn is mild, there is little to worry about in the US.  Even if China continues to expand at breakneck speed, it cannot, and will not, become a dominant economic power anytime soon.  Numerous impediments prevail including China’s inefficient state-owned enterprises, its tightly controlled banking sector, its archaic legal system, its problems with local corruption, and its non-convertible currency.  A significant improvement in these conditions is decades away in China and so there should be few fears that China will soon catch up and dominate the Western countries economically.

Militarily the story is similar (though I am no expert here).  Although the Chinese are eager to improve their military technological capacities, and are taking steps to do so, they are a long way away from duplicating US capabilities.  Only note that China launched its first aircraft carrier this year … and that was a refurbished Russian model.  Another refurbished aircraft carrier was launched last year …  as a hotel.  The US by comparison has 11 active carriers with 3 more under construction.

Despite these obvious realities, Chinese fear-mongering has become a popular activity in the US.  What most don’t realize though is that the threat from China becomes greater the worse their economy becomes.  Most China observers, and the Chinese themselves, recognize that the most important consideration of the Communist Party in China is the preservation of the Communist Party.  This is natural.  If there were a significant downturn in the Chinese economy though, it may seriously threaten the Chinese peoples’ faith in the Party and could in turn lead to political instability.  Many times in history we have seen regimes, whose existence is threatened by a loss of confidence from their own people, attempt to deflect criticism by creating an external enemy.  Nationalism is a powerful political antidote for destabilizing domestic troubles.

This tendency is not unique to China or to Communist regimes.  US politicians have already begun to do the same thing by blaming China for many of the US economic problems, including the persistently high unemployment rate.  China, in turn, responds tit-for-tat to every unfair trade charge the US makes against them.  In times of growing economic prosperity, these kinds of charges and counter-charges are innocuous.  However, when economic conditions get tough, these spats can quickly get out of control as they can also serve as a tool for political diversion.

Currently there is growing tension in the South China sea.  This summer China has taken control of several disputed islands in the region to the dismay of the Philippines and Vietnam.  The US calls for a peaceful and negotiated settlement of these disputes, but at the same time is slowly ramping up its military presence in the Asia-Pacific region much to the dismay of China.  This kind of situation could easily erupt into unnecessary hostilities, which become more likely if economic troubles at home continue to grow.

As an American, traveling in China is wonderful because the Chinese people love Americans.  A person couldn’t ask for more hospitality and kindness.  But that goodwill can change on a dime if America can be portrayed as contributing to China’s decline.  There is a very strong nationalism in China that can be turned on in an instant if the conditions are right. Already, China’s internal press is sharply criticizing America’s growing presence in Asia.

The safest US response with difficult times ahead is simple: stop portraying China as a villain.  Here are a couple suggestions.  First, work China into the Trans-Pacific Partnership discussions.  A failure to do so either means the US is not fully committed to the principles of rising prosperity through trade, or the US really is working with other countries in the region to put China at a disadvantage.  A second simple fix is to stop blaming cheap Chinese products, intellectual property infringements, and China’s undervalued currency for US economic problems.  Of course, there are bilateral issues and problems, but these should be worked out in a cooperative manner not in a confrontational way.  America is not stronger because it talks tough to China, as some US politicians seem to think.  America will remain strong only by maintaining its unparalleled military capacities AND by looking internally and focusing attention on its own economic problems.

Originally published on April 9, 2012

The US lost an appeal last week in a WTO dispute case involving the regulation of cigarettes.  The case was brought by Indonesia against a new US ban on the sale of clove and other flavored cigarettes.  As usual critics of the WTO are arguing that the WTO is infringing on US rights to establish its own health and safety standards.  In actuality, the WTO agreement acknowledges a country’s right to establish any standards it likes, as long as the standard treats domestic products in the same way as foreign products.   As an example, in the WTO, countries have agreed that you can’t ban unfiltered cigarettes from foreign sources, but not ban them from domestic sources, even if reducing the consumption of some unfiltered cigarettes would have a positive health impact.  Why not?  Because to do so would unfairly discriminate against foreign producers.  You can ban all unfiltered cigarettes if you want, because that will conform with our promise to provide national treatment.

Indonesia successfully argued to an independent and objective panel of experts that US policy violated national treatment because the ban covered only some flavored cigarettes but not all flavored cigarettes.  In particular clove cigarettes, exported largely by Indonesia, were banned, but menthol cigarettes, produced largely in the US, were not banned.

Now we can go on and on about whether menthol cigarettes and clove cigarettes are like products.  If they are like products, the US loses; if they are unlike the US wins!  A case can be made that since they are both flavored they are alike. However, because they have different characteristics and are smoked by different groups of people they are unlike.  For me this issue is only interesting because lawyers are paid a lot of money to make arguments to determine an answer to a question like this, which, to my mind, is largely unanswerable.   In the end if you are in the US and you want the law to stand, then you will believe the “unlike-product” arguments (and there are many), while if you are Indonesian and want the law to fall, then you will believe the “like-product’ arguments (and there are many).   If you are on the panel and must decide,  …  maybe you decide on the basis of the “preponderance of the evidence;” or maybe you decide based on who spoke most authoritatively or was best-dressed.  Who knows?

But what I want to consider from this case is something more fundamental …  namely …  why can’t I buy and smoke a clove cigarette (assuming the US refuses to change its law)?    I am an adult who knows about the risks of smoking …  in fact I have studied it professionally.  I also know that one clove cigarette (or even a whole pack) is unlikely to harm me or anyone else near me.  I might enjoy the smell and the feel of it …  I know because I have smoked a few of these in my day and they are very pleasant.   But as it stands now, it is illegal for anyone to sell a clove cigarette to me.

I understand the arguments.  I know that it is not really me the law is designed to protect.  Instead it is targeted at teens.  The law is meant to prevent teens from being seduced into smoking by the aroma of cloves.  If they start smoking they might become hooked (although some won’t) and become lifetime smokers (but some will quit earlier).   Those that do smoke their whole lives may put a strain on the health care system and inflict a cost on others.  Of course, for those that die early, they will not inflict the cost of long term elderly care which is estimated to be much more expensive.  The net cost to society by unhealthy smokers has been estimated by some researchers (not all) to be negative …  meaning smokers may actually save society money because on average they will die younger.

In the end, the ban is really targeting just a small group of people in the entire population.  That we have to restrict the freedom of everyone in order to have this small effect on a small group seems innocuous to most people, especially since most people don’t really want to smoke a clove cigarette.  In a sense the government is only preventing a potential freedom rather than an actual one.  Also, most people are perfectly happy to support rules designed to make people healthier, especially when they have heard some of the arguments about how other people’s smoking behavior is a drag on state budgets.

For me though, I keep thinking about my sixth grade class.  I can remember several occasions when Sister Assumpta would punish the entire class, forcing us all to do some annoying exercise, all because of the bad behavior of one or two students.  I remember the feeling of injustice.

That same feeling of injustice wells up inside me when I think of issues like this.  Sure, the burden imposed on me by not having the freedom to smoke clove cigarettes is about as innocuous as the burden of writing a sentence 100 times in my notebook.   It isn’t much!  Still I wonder why I have to be restricted from an activity because of the presumed bad behavior of others.

Like why can’t I buy gin on Sunday evening in VA?  Why do I have to pay over $10 to buy a pack of cigarettes in NY?  Why can’t I smoke an occasional joint?  Why can’t I self-administer a strong pain reliever?  Why can’t I have a partner of the same sex and enjoy the same government benefits as a husband and wife?    Why can’t I commit suicide?  Why can’t I …..  the list can go on and on.

In all of these cases, individual freedoms are restricted in the name of some larger social good.  Proponents always believe that society is improved when these restrictions are in place.  They believe they know what’s good for you and are happy to put in place restrictions to engineer a better outcome.   Opponents of such “sensible” laws are often demonized or vilified.  Most people don’t really care because the restriction doesn’t affect them directly …  therefore if they must take a position it is natural to choose the do-gooders.  As a result, restrictions on individual freedoms are easy to implement.

Still, if we keep on this road, of accepting small reductions in individually unimportant freedoms for the sake of a presumed larger good, we risk losing more and more freedoms.   Soon, we will have more restrictions on what we can eat.  Food may be taxed differentially to shift our consumption in presumably healthier ways.  Our entire lives may become more and more “controlled” to create a more perfect society.

Remember though that every one of these restrictions of freedom are based on a presumption that someone else knows better than you do what is best for you.  Someone else’s preferences, intelligence and calculations are accepted as better than your own preferences, intelligence and calculations.

Sometimes …  occasionally, I’d like to smoke a clove cigarette.  Why can’t I, again?

Originally published on March 30, 2012

The titles of yesterday’s news stories offer an unambiguous condemnation of unfair labor practices at Apple’s Foxconn assembly plants in China:

Apple’s factories in China are breaking employment laws, audit finds;

Update: Apple supplier Foxconn hit on poor working conditions;

Illegal overtime reported on Apple assembly line;

Apple supplier audit finds major wage and overtime violations.

However, rather than joining the chorus of outrage against greedy firms who exploit workers in foreign countries and take jobs away from American workers, I want instead to suggest some of the unmentioned effects of well-intentioned fair labor regulations.

First, a bit about regulations in general.  A regulation is a command issued by a government that a person or company must do something in a particular way.  Failure to do so results in some penalty or punishment.  By design, a regulation restricts freedom.  Presumably that restriction of freedom is acceptable because it is restricting the freedom to do a bad thing.

Consider labor regulations of the sort Foxconn was found to be violating.  One violation was that workers were found to have worked more than the allowable maximum of 36 hours of overtime per week.  Another involved the underpayment for overtime work.

Regulations like these are needed to prevent the exploitation of workers ….  (and I’m sure most people would agree that 35 hours of overtime per month is not exploitative but 37 hours surely is!)

Possibly many readers may have worked more than 36 hours of overtime at some point in their lives.  Whether you were exploited depends on the circumstances.  Once regulations are formulated it quickly becomes clear that the rule cannot apply to everyone.  So the rules are usually written to exclude certain types of workers.  This is one reason regulations often take dozens of pages to explain; because all of the exceptions must be outlined.

For example, the overtime rule is likely to apply only to wage workers but not salary workers.  If you are a salary worker you might be expected to work say 60 or 80 hours a week …  as you might if you are a young lawyer or doctor.  This would not be considered exploitation, I suppose, because high income earners cannot be exploited in this manner.  Of course, if you are a wage worker who wishes to work 60 hours per week, even for a month in an emergency circumstance,  (perhaps to become a higher income earner to pay some bills) you would not be allowed to do so because of the regulation.  Your freedom would be restricted …  but it is for your own good.

Now lets come to the process of maintaining a regulation such as this.  As soon as a labor regulation like this is in place, a firm must prepare for the potential that someone might charge a violation.  So the first order of business might be to implement an overtime tracking system to document and prevent excessive overtime.  That means the company needs to assign some personnel to the issue.  The more regulations there are, the more documentation and procedures will be needed and the greater the number of workers to be assigned.  Of course, these will be higher paying jobs because the firm will need accountants and computer programmers and legal experts to manage the regulations.  We might call them regulation management.

On the other side we have the auditors, the checkers and verifiers.  Once the regulations are in place we will need to hire some people to check and see that the rules are being followed.  That’s what the Fair Labor Association was doing with Foxconn in China.  They were hired to audit the labor practices to see if there were violations.  Who hired them?    Apple Computer did; …  largely because stories in the press about worker exploitation in China threatened to tarnish their reputation and cost them millions.  Of course to protect that reputation costs million as well.   They must pay for the audit, the regulation management team, and the public relations staff involved in the incident.  Tim Cook, the CEO of Apple, even traveled to a Foxconn assembly plant in China to showcase the efforts that Apple is making to do the right thing.

All of this activity takes a lot of time and costs a lot of money.  The time takes highly trained individuals away from the immediate task of the company; namely to design and produce fantastic computer products.  Therefore it will mean that fewer consumer products will be built.

And who pays for it all?  If you said that it comes out of the high salaries of top executives at Apple Computer, you are probably wrong.  Instead it is more likely to come from the slightly higher prices that will now be charged for IPhones and IPads.  Even an extra 50 cents will generate tens of millions of extra dollars to pay for all of these regulatory costs.  But higher prices, even a little bit, will reduce the total number of products sold and so fewer consumers will be able to enjoy the product.

In the US the process can play out a little differently and the money stakes are even larger.  In the US it is typical for some law firms to seek out disgruntled workers at large corporations who have been exploited by the violation of US labor laws, perhaps the underpayment of overtime.  If evidence can be gathered that the violation is a standard practice throughout the company and not an isolated incident for a few employees, then the law firm can file a class action suit against the company.   I spoke with a couple of lawyers last week who work on such cases and learned that most large corporations settled these cases before going to court in order to avoid the excessive defense fees.  When they settle, employees in the class action suit will get some compensation for the company’s wrongdoing …  perhaps as much as a few hundred dollars each.   The big winners in all of this though are the law firms who sometimes walk away with millions or billions (yes, billions!) of dollars in the settlement.

So, here’s a quick assessment of the expected effects of the labor regulations in this case.  First, the exploited workers get a small share of wages returned and a feeling that justice has been done.  Second, numerous regulatory management jobs are created for college-educated upper middle class workers. And finally, a small group of already wealthy lawyers, become fabulously wealthy.   Who pays? That would be the consumers who buy the product.  They pay a little bit more for this product and have a little bit less left over to buy other things.

On a final note, take this story about labor law and extrapolate the effects across numerous regulations, industries and issues.  Think about all the examples of somebody doing something to protect themselves against regulatory lawsuits.  If this assessment of the effects is accurate, then what we have, perhaps, is an ingenious system that purportedly protects the poor and defenseless members of society, (and maybe does a little bit) but which actually serves to transfer a lot of money from average consumers into the hands of a smaller group of upper middle class and wealthy people.

Oh, by the way, there is an alternative system …  but rest assured that system has been denigrated sufficiently that anyone who defends it is quickly branded a naïve and insensitive cad.  So I better not mention it.

Originally published on March 23, 2012

The US economy is growing stronger every month. GDP, total employment, and the stock market index are all rising, while the unemployment rate is finally coming down. Still, despite the good news, there seems to be a notable lack of excitement and exuberance. This good news has been too long coming and the pace of economic growth remains lackluster compared to previous economic recoveries. In addition, many serious problems remain and their solutions still seem out of reach.  Read the rest at Aspenia Online ……

Originally published on March 7, 2012

REPOSTED FROM ASPENIA ONLINE

As the Republican candidates campaign in the Midwestern states – states that are suffering from several years of high unemployment, a decade of factory flight to Mexico and China, and more than a generation of increased import competition with industrial and manufacturing decline – they are asked what they, as president, would be prepared to do to alleviate these problems.  Because all of these problems will remain mostly unchanged by the November elections, both the Republican nominee and President Obama will want to present a convincing plan to attract votes in these important swing states.      Unfortunately, what is being offered as a solution by both parties may attract votes, but is unlikely to be very effective in resolving the underlying problems; in fact, some of the proposed solutions may make things worse. ….   to read more click HERE.

Originally published on January 26, 2012

In President Obama’s State of the Union address this week, he criticized countries that don’t play by the rules of international trade.  He noted that his administration had initiated nearly twice as many trade cases against China as the previous administration.  He criticized countries (read China) who let movies, music and software be pirated.  And he exclaimed that it is unfair if foreign manufacturers get a leg up because of foreign government subsidies.

To resolve these problems and to help promote jobs in the US, President Obama then announced the creation of a NEW Trade Enforcement Unit that will be responsible for investigating unfair trading practices in countries like China.  Finally, he said that if only the playing field were level, America would always win.

To the American people, especially to labor union workers or others whose jobs may be threatened by rising imports, this new initiative will surely be welcomed.   The President has proclaimed that he has been tough and will get even tougher on China.

But what is really the point of this new unit?

The US already has numerous agencies charged with monitoring foreign countries’ trade policies and protecting US companies from unfair trade actions.  The Executive branch’s US Trade Representative (Ron Kirk) is the lead organization in this effort.  The USTR represents the US at the World Trade Organization, negotiates free trade areas, including the new Trans Pacific Partnership (TPP), and monitors foreign practices that negatively affect US exports, including intellectual property violations.  It is responsible for the several WTO dispute cases that the US has ongoing against China and other countries.   To protect against unfair trade practices we have several trade laws including the antidumping code, the anti-subsidy code and the safeguards procedures.  These are administered jointly by the International trade Administration in the Department of Commerce and the US international Trade Commission.   These agencies are also currently investigating several cases against China and others.  Other agencies are also involved in trade policy matters including the Department of Agriculture and even the Defense Department.

So what will this Trade Enforcement Unit do?  My guess is that it will spend an enormous amount of time trying not to step on the toes of all the other authorities that already have jurisdiction in these matters.  One might argue that the unit could serve as a coordinator between all these different units, except that the President’s office is already supposed to be doing that.  If the Trade Enforcement Unit is housed within the USTR office, then it will just be a new name placed around a group of individuals who are already supposed to be doing this anyway.   And furthermore, if the President wants to take stronger actions against China or others, he already has some authority to do that within the current structure.

So, why do we need a NEW Trade Enforcement Unit?

The answer must be political.  The President wants another bullet point that he can refer to in speeches highlighting how he is getting tough on China and protecting workers against unfair trade practices.  As a result, the Obama administration is doing what all political leaders tend to do …. create more initiatives.  For leaders to justify their existence they need to demonstrate that they are doing something.  And the easiest thing governments can DO is to create more government.  The greater the number of NEW initiatives the greater the number of talking points one will have in campaign speeches.

In this case, I expect the Trade Enforcement Unit will be inconsequential.  The unit will probably consist of a small group of government workers, maybe many reassigned from other units so it may not even involve the growth of government.  The unit will spend a lot of time coordinating with others and may be given credit for some of the initiatives that are already being investigated …  this, because in the end, the unit will have to be shown to be a success.  So this announcement is not a big deal.

However, the political incentive to DO SOMETHING whenever a problem is identified, has contributed to the growth of government across all administrations.  This has led to the creation of new government agencies and the growth of existing agencies as each one is asked to expand their services with each new administration.  The Trade Enforcement unit won’t affect the size of government much …  but when we recognize the incentive behind this benign announcement and expand this action across numerous issues, numerous years, and numerous administrations  … the effects are not so benign.

Originally published on November 20, 2011

In the past week President Obama has taken several opportunities to stand up to the Chinese and reassert American dominance.  This BBC article describes the past week’s events in three Acts.  In Act One the US moved swiftly to advance the Transpacific Partnership, which would create a free trade area among major countries in the Pacific Rim, but for now would exclude China.  While China was told the door was open, the underlying message was that entrance would require some swift internal changes on their exchange rate policy and the protection of intellectual property.  In Act Two, President Obama announced the deployment of up to 2500 troops in Northern Australia.  Although President Obama asserted this had nothing to do with China, no one really believes that.  Finally in Act Three in Bali Indonesia, President Obama signaled his desire to discuss the ongoing territorial disputes in the South China Sea (or is it the West Philippine Sea, or the East Vietnamese sea??)  Naturally, the smaller nations in the area welcome the presence of the US in negotiations with China over rights in the area.  Equally naturally, China finds the US presence to be especially unwelcome and would prefer to deal with each nation separately.  To add further to the dispute, India announced today its intention to explore for oil in the South China Sea.

In normal times a little bit of angry rhetoric between countries is harmless.  Leaders posture and pronounce but little else comes of it.  Hopefully that will be true this time too.  However, we are not living through normal times.  The economic climate in the world is increasingly dismal.  There is a strong chance that sluggish growth and high unemployment will remain for some time in the US.  In China there is a real danger that growth could slow tremendously and they will suffer their first major recession since the transformation to freer markets began in the late 1970s.  If this economic malaise continues, popular discontent may rise up in both countries and leaders will seek ways to quiet their masses.

One effective technique is to turn popular anger outward rather than inward.  Politically, it is preferable that unhappy citizens vent their frustrations towards a foreign enemy than towards the current leadership.  The political incentives are similar in China and the US.  The blame game can be effective if you can convince one’s citizens one of two things:  either 1) that the current troubles are really being caused by the unfair actions of other parties, or 2) that the greater prosperity of an external group is a sign of some inequity.  The first of these is currently being applied by the Obama administration as well as by many in the Republican presidential field (with the exception of Jon Huntsman).   The second is the more likely response of the Chinese as they fend off accusations of blame from the US, their much more prosperous trading partner.

The main problem with these public pronouncements is that they can lead to real hostilities with shots being fired and soldiers being killed.  Hopefully, it will not come to this.  But simply imagine a year or two from now.  Imagine the US Presidential election with even more accusatory rhetoric from both political parties each trying to demonstrate they will be “tough on China!”  Imagine the US economy continuing to struggle, and China’s economy beginning a serious economic downturn.  Under such circumstances, minor incidents could have serious repercussions.

Recall the incident 10 years ago when a Chinese jet damaged a US reconnaissance plane in flight forcing it to land in China.   A similar incident today after a period of harsh rhetoric could escalate into something much more serious.  In China there is a well-known reluctance to “lose face” in the arena of public opinion and thus they may be encouraged to stand up to the Americans.  However, the reluctance to lose face would be just as strong in the US after a period of harsh rhetoric.  Neither side would be able to back down from such an incident for fear of looking weak against its professed antagonist.

If economic conditions in China led to internal instabilities, the Chinese government might be inclined to divert its citizens’ attention by wrestling control of energy resources in the South China sea, or by reasserting its professed rights over Taiwan.   If the US responds by defending the rights of the Asian countries, China could easily rally internal popular opposition to the interference by the US hegemon in the Asia region.

Again, hopefully, these scenarios will never occur.  I raise them merely to suggest that they are plausible under the right set of circumstances.  Some of those circumstances, like the length and severity of the economic downturn, are difficult to prevent.  However, some of the conditions, like the accusatory rhetoric against each other, can be avoided.  A better approach to problems in the US-China relationship is to discuss them in diplomatic circles.  Exchange rate policy and monetary policy coordination can be (and is) discussed on a continual basis in meetings between government officials at many meetings between the countries.   Intellectual property rights are also discussed by government and the businesses that are directly affected by enforcement problems.   The underlying problems are real but they will take a long time to resolve.  For example, China cannot immediately solve intellectual property problems.  The changes will take decades and China is working slowly in the right direction.  But, even if they picked up the pace, it is unlikely to have noteworthy effects in the short term.  In much the same way the US cannot just snap its fingers and resolve its unemployment problems.  Achieving an outcome requires much more than desiring the outcome.

For these reasons it would be prudent for leaders on both sides to avoid the accusatory rhetoric and prevent two associated face-saving problems.  The first problem is that public pronouncements that another country change its ways is more likely to inspire resistance to change rather than the change that is desired.  What proud country wants to be seen capitulating to the demands of another?  And both the US and China are proud countries.   Secondly, the accusations can paint leaders into the corner suggested above:  if real hostilities ever accidentally broke out, neither country would be able to renounce it previous positions and unnecessary military escalation could become a reality.

President Obama suggested last week that China needs to act more like a grown up in the world.  My suggestion is that both countries act grown up, which means not using accusatory rhetoric against the other in public for political purposes.  I am doubtful that such restraint will prevail, however, there were some hopeful signs of cooperation on the South China sea issue at the end of the East Asia Summit in Bali.

Originally published on November 15, 2011

The US and China stepped up their sparring against each other last weekend in Honolulu at the APEC summit.  Reuters reports, “While insisting he wanted stable ties with China, Obama in quick succession demanded it “play by the rules” of international trade, said its export-driven powerhouse “throws the whole world economy out of balance,” and insisted it act like a “grown up,” rather than posturing as a developing nation.”

China was quick to respond, arguing that it would only abide by trade rules that it participated in negotiating, not ones unilaterally determined, as I suspect China views the US demands to raise its currency value.   Legislation, stalled in the US Congress, would label China a currency manipulator and make it easier to initiate trade remedy actions against Chinese imports.  From China’s perspective, its currency has been held semi-fixed at the same or rising value for the past 20 years.  This is similar to many other countries that continue to maintain fixed exchange rates to promote stability and reduce uncertainty in international transactions.  While it is certainly true that a low currency value can make exports easier and inhibit imports, contributing to China’s trade surplus with the US, it is also true that many other factors influence trade imbalances, including price and interest rate differences, savings rates, and the potential for future economic growth.  Indeed even at a fixed exchange rate, China’s exports are already becoming more expensive because inflation is rising by as much as 2-4% faster than in the US.  Additionally, an appreciation of China’s currency alone offers no guarantee that it will make any dent in the US trade deficit.  In many episodes with other countries in the past, appreciating currencies did not make a significant dent in a country’s trade surplus with another.  The best example of this, perhaps, is the large appreciation of the Japanese yen during the 1980s and up till today which has still not caused our trade deficit with Japan to turn to surplus.  The point then is that too many other factors cause trade imbalances to expect that a simple yuan appreciation will cause a big turnaround in our trade deficit.

Instead our continual sparring with China over currency and other matters, is likely to do little more than irritate the other and result in increasing trade actions and reactions rather than dramatic changes in trade imbalances that will miraculously resolve the US unemployment problem.

Originally published on October 6, 2011

The US is the largest economy in the world. Sure China may be number two, but when you consider it in per capita terms the US is near the top and China is closer to 100 in rank. The US has the most integrated market, its labor force is highly skilled and flexible, it has innovative entrepreneurs that are the envy of the world, it has a smoothly functioning and reliant legal system, it preserves and promotes intellectual property creation, it has an higher education system that attracts students and researchers from all over the world, and it has a living environment and opportunities that attract people in much greater numbers than we would like to admit. Add to that a military capacity with power and reach that is truly ominous in comparison to any other country and you have a country that is the equivalent of the NY Yankees in the 20th century.

Yes, the US economy is stumbling and the mood for the future is dour. But many other countries, including China, have conditions that are far worse in many respects. China is strong militarily, but they can’t project power on the other side of the globe like the US has done (rightly or wrongly) in Afghanistan and Iraq. China just commissioned its 1st aircraft carrier! The US has 11 with three more under construction … more than all other countries combined. China’s economy is expanding but they face enormous internal stability problems. They have an immature financial sector, a highly dubious legal system, and the potential for rural-urban migration in future years in numbers that exceeds the population of the US. They also have an aging population entering retirement, as does the US, only China’s is 5 or 6 times larger. And still their per capita income is only1/6th that of the US.

The US unemployment rate is currently over 9%. But is this something the US cannot endure and overcome? The unemployment rate was well over this in Spain and some other European countries during our previous boom years. In South Africa the unemployment rate is 25% … that’s as high as it was in the US at the height of the Great Depression in 1933. Remember, that while 9% unemployment is twice as bad as 5 years ago, there is still 91% of the labor force working. (some will say it is much less because of discouraged workers but I am trying to tell the “glass half filled’ story!) An impressive variety of goods and services that households buy remain on the shelves and while economic growth has slowed, the US economy continues to produce a vast amount of goods and services every year and will surely continue to do so.

So how must it look when a dominant country like the US stumbles economically and rather than looking inside itself to resolve its inner imperfections, instead it looks outside its borders to the things it cannot control and blames others for its problems. By this I mean the new Senate bill seeking to brand China as a currency manipulator. This action looks weak, not strong, … even more so because the target of our accusations is decidedly poorer and weaker than the US. Do people really believe that China can exert so much influence over the US economy via its exchange rate policy as to force the current recession and the loss of millions of US jobs? Not only is this outcome not in China’s own interests, it is not the likely effect merely by running trade surpluses with the US. (see my previous post explaining why the lost jobs argument is specious). Furthermore, even if China let its currency float freely, there is no guarantee that it will rise in value to the level some American observers would like.

Politicians are trying to rally American support around a policy position that has very little hope of generating the intended outcome. They are trying to act tough on China, largely because they have very little else to go home and tell their constituents. Within six months politicians will be campaigning for re-election and what are the accomplishments they can tell their constituents about? Not many! A bill that gets tough with China will give them something to ballyhoo.

There is one reason passage of this bill will create jobs though. What the bill seeks is to allow exchange rate undervaluation to be used in the determination of anti-subsidy actions. These actions allow an industry in the US to obtain higher import tariffs if it can be shown that a foreign government has implemented targeted subsidies on exports and if those exports cause injury to the import-competing firms. These actions require firms to file petitions with the US government, which in turn requires skilled legal assistance. These investigations must be then be conducted by government employees. If these petitions rise in number due to the new law we can count on more lawyer, lobbyist, and government jobs will be required to make the process work. On top of that we can surely expect that the Chinese would immediately file a complaint with the WTO and claim that the US was violating its trade commitments. This will inspire further investigations that will take years to resolve requiring even more Washington lawyers and lobbyists. In fact we may even see the Chinese hiring US lawyers to help them in their dispute with the US (many law firms in DC specialize in helping foreign countries with their trade disputes). Now it is highly unlikely that this bill will create millions of jobs. However, it is virtually certain to create hundreds or thousands of high-paying jobs for Washington lawyers and lobbyists. Is this the best way to devote our economic resources … enabling lawyers to earn millions of dollars arguing that government X violated promise Y and caused harm to firm Z? Hardly! Instead it will make a country that traditionally has championed free trade and free markets, look hypocritical, petty, and weak.

Originally published on September 30, 2011

As economic troubles around the world continue to mount there is increasing pressure uponpoliticians to do something forceful to revive their economies while deflectingcriticism from themselves. One traditional method has always been to blame foreigners for one’sdomestic troubles. In the 1980sthe US blamed Japan and worried that its economic strength would soon lead to adiminished US presence. Today thesame process is playing out only this time China is the presumed enemy.

This week Senator Schumerfrom NY introduced another bill that would brand China as a currencymanipulator and allow the US to take more forceful action against theirpresumed unfair trading policies.   This action follows on a report issuedearlier this month by the EconomicPolicy Institute indicating that the US trade deficit with China has cost theUS 2.8 million jobs.   Theirline of reasoning is immensely popular and goes as follows:  because China fixes its currency at avalue deemed too low by US observers, Chinese goods are kept artificiallycheap, inspiring larger US imports of Chinese goods.  The relatively high $ value makes US goods more expensive tothe Chinese thereby discouraging US exports.  Thus, if only China would allow its currency to rise invalue, then Chinese imports would fall, US exports would rise, trade will bebalanced and US jobs will be created. It is a convincing story … except for the fact that is not entirelycorrect  …  the errors lie in the parts of thestory that are missing, the untold story that make the causes and effects quitea bit more complicated.

Let’s firstlook at the 2.8 million jobs supposedly lost due to the trade deficit.  Now to be fair, if you read the reportcorrectly, EPI doesn’t actually say that jobs are lost, only that the jobs are“lost or displaced.”  Displacementis a more accurate term because the jobs are less likely to have been lost dueto the trade deficit than they are to have been moved to the non-tradablesectors in the economy.  In otherwords the trade deficit doesn’t cause a loss of jobs as much as it causes adisplacement to other sectors of the economy.

To see whylet me illustrate the fallacy of trade deficit induced job losses.  Between August 2010 and July 2011 theUS imported $288 billion more from China than it exported.  If trade had been balanced instead,then either there would be $288 billion more in exports (thereby creatingmillions of jobs) or $288 billion less in imports (creating millions of jobs inimport-competing US industries), or some combination of the two.  Seemingly the deficit resulted in moremoney flowing out of the country to buy the extra imports, than flowed back into buy our exports.  That lostmoney and the corresponding lost jobs is what EPI is counting in itsestimate.  The fallacy is that themoney is not lost and it does not stay in China.  What China has done with that extra money is purchase assetsin the US.  In other words, theyhave lent the money back to us and are allowing us to use it instead.  More technically, any trade deficit(current account deficit really) is offset by a financial account surplus ofequal value, implying that our balance of payments with China is always inbalance … there is rarely any money lost.

Most of themoney that China has lent back to the US has been loans to our federalgovernment.  During the past decadeChina has purchased around $1.1 trillion dollars of US treasury securities.  This is money the US governmentborrowed to finance its deficit spending. In other words, that $1.1 trillion of money was spent by the USgovernment, inducing demand for US products and creating jobs for USworkers.

So how manyjobs were created by that $1.1 trillion of spending?  Well, for that we could use EPI’s own estimates of the jobcreating effects of fiscal stimulus. Across a variety of articles (See hereor here),EPI’s estimates range anywhere from 5,000 to 10,000 jobs created for every $1billion of additional government expenditures.  Because $1.1 trillion of those expenditures were made possibleby Chinese loans during the past decade, EPI should conclude that the Chinesetrade deficit “created or displaced” 5.5 – 11 million jobs during the pastdecade because of the added fiscal stimulus made possible by their loans to us.

Thus, usingEPI’s methods, but evaluating the FULL effects of the trade deficit with China,could actually lead one to the conclusion that there was a net increase in thetotal number of jobs.  (I’m notsaying this happened, I’m just applying their method in a more completefashion.)  It is worth mentioningat this point that if you look at a graph of the US trade deficit with respectto the world, and compare it to the US unemployment rate during the past 30years avery curious thing is seen: whenever the US trade deficit is rising, US unemployment is falling andwhenever the trade deficit is falling US unemployment is rising.  This is exactly the opposite of whatyou would expect if trade deficits really did cause job losses!

So EPI’sreport is propagating a fallacy. It is suggesting that the trade deficit with China is costing the USmillions of jobs.  It is inspiringpoliticians to stoke up populist support against external entities, surely as away to divert attention from their own mismanagement at home.   This is a common political ployused by politicians many times before. When economic times get rough at home, better to stoke up anger againstan external threat, instead of turning attention inward.  This political inclination has led todamaging trade wars in the past and even more damaging shooting warssometimes.

The Chineseeconomy is currently in a precarious position.  Although the impression in the West is that their economy isbooming at the expense of ours, in reality the Chinese government may have runout of tools to keep things bubbling along.  China is facing rising goods inflation and risingwages.   They have a propertybubble that looks ready to burst. They face another round of slow demand for their exports and risinganxiety at home.  Put that togetherwith a rickety financial sector, a legal system that is years behind the West,and a government that often corrupt and determined to remain in power, and youhave an economy and a society that is just trying to keep things together…  not one ready to take over asleader of the world.

Even ifChina responded to US demands right now and gave up defending their currencyvalue, the result might not be what the US hopes for.  Suppose for a moment that the Chinese suddenly allowed theyuan to float freely.  No morecurrency manipulation!  Because ofthe new uncertainties in the Chinese economy though and the prospects ofproperty price declines, many wealthy Chinese might take that as an opportunityto move money to the US and other countries.  In other words, in the present environment, the effect mightbe capital flight form China.  Ifthat were to occur the yuan would fall even further in value making Chinesegoods even cheaper.  Strangerthings have happened in international currency markets.

My point thenis that our ability to adjust simple levers, like the exchange rate value, (orforce other countries to do so) and generate improved outcomes such as jobcreation at home is extremely limited. The world economy is too complex to expect that a simple adjustment inthe dollar-yuan exchange rate will suddenly create millions of US jobs.  Our politicians would do better to getour own house in order instead of trying to pin the blame for our troubles onother countries.  The blame game isa diversionary tactic and US citizens would be smart not to buy into it.

Originally published on September 19, 2011

For a competitive 3rd party to arise it will have to have a unifying theme that can be used to establish positions across a range of economic and social issues.  To be effective, that theme will have to attract supporters from the right and the left.  Perhaps the best candidate for that unifying theme is the growing disdain the general populace has for special interests.  Conservatives and liberals alike complain about the problems caused by special interest politics.  Almost everyone can tell a tale about a policy or process that causes them to lose (screws them over) while at the same time benefiting some special interest.   Anger arises in people who feel they have been ripped off.

One problem with the special interest issue though is that everyone is a part of some special interest.  If you work in a specific industry, you have an industry interest.  If you are part a union you have a labor interest.  If you are over 65 you have a senior interest and health care interest.  In you are male or female, you have a gender interest.  If you have faith in a God you have a religious interest.  Belong to a particular race and you have a racial interest.  If you are an immigrant, a consumer, gay or lesbian, a friend of Israel, or have a child with autism, then you have characteristics that establish a special interest.

It is also natural to support policies that favor your own special interest.  If you are a farmer, agricultural subsidies make sense; a worker in an import-competing industry, then protection against Chinese imports makes sense; a senior citizen, then social security and medicare in its present form is an absolute necessity; work at Goldman-Sachs, then government bailouts are needed;  if you are poor and unemployed then benefit expansions are good; own your home then the mortgage interest deduction is important;  ….  I can go on and on.

The main problem with special interest policies is that each one is discriminatory; each special policy bestows benefits on some group of people at the expense of others.  Usually supporters of a particular special interest policy will argue that their policy is good for the nation.  But, usually that’s not true.  Supporters of import protection will say the policy will save or create jobs, but they won’t talk about the higher prices to consumers.  Supporters of bank bailouts will say the actions prevent the collapse of the financial sector, but they won’t say much about the risk to taxpayers.  Social security and medicare beneficiaries will say that those benefits are only fair because they made payments into the system previously, but they won’t be willing to consider that generous future benefits will have to reduce the disposable income of future taxpayers.   Unfortunately everyone considers their own special interest a necessity, or a right, and will argue that the elimination or change in their policy will surely harm the nation.

A potentially successful moderate platform could include a goal to reduce the influence and sway of all special interests.  This is the kind of unifying theme that could draw bipartisan and independent support.  Unfortunately an effective strategy to reach that goal is elusive.  Consider the recent suggestions to simplify the tax code.   This is a laudable goal since, as I’ve heard Lawrence O’Donnell on MSNBC say,  “everyone knows the tax code is unfair!”  The tax code contains all sorts of special exemptions for this or that interest group.  Eliminating, or at least reducing, these exemptions are something many people can support.  However, because every powerful special interest will fight to retain their handout, it will be difficult, or impossible, for politicians to actually make these changes.

The growth of the lobbying industry is a clear indication of how special interests increasingly control government.  That growth makes sense once the government starts handing out more and more special favors.  If you are a special interest group and you see others getting special benefits then it only makes sense to hire some representatives for yourself and have them track and attempt to influence the policy changes under discussion by government.  If government is writing new rules that favor some over others, one might as well try to make sure some of those rules favor you.

One reaction to this situation has been attempts to limit the influence that lobbyists have over politicians.  Campaign finance reform, rules regarding political action committees, and many other examples, are attempts to restrain special interest influence.  Despite these rule changes, lobbyists and special interests continue to exert their control

A moderate candidate with a platform to tackle the special interest policies could focus national attention on the problem.  Unlike a Republican or Democrat, a moderate candidate would be free to highlight that some special interest policies benefit traditional conservative interests, while others benefit traditional liberal interests.  Surely one reason for the continuing growth of government influence in both Democratic and Republican administrations is because each party in power directs policies towards their own special interests.  The problem is on both sides of the aisle, which may be why a candidate from either side will be unlikely to tackle the problem.

Lately there has been a lot of talk of sacrificing for the good of the nation.  President Obama has said that millionaires and billionaires need to contribute more.  A moderate candidate might be the only one who could explain and emphasize that the shared sacrifice all Americans should consider is a willingness to accept the elimination or adjustment of policies targeted at their own special interests.  Chances are very good that the benefits each of us will reap when others’ special interest policies are revoked will more than outweigh the losses we will incur by losing our own.  The goal should be a government that does not discriminate, rather than the government we now have in which special interest discrimination has become its very foundation.

Originally published on August 30, 2011

The hype and hoopla about Hurricane Irene this past weekend offers a potential window into understanding the global climate change debate … but not because of claims that this is evidence of climate change itself but rather because the reaction to the hurricane represents a natural human response in this day and age.

As the hurricane developed and approached there was an impressive display of scientific evidence including the satellite images, wind speeds taken by planes flying through the hurricane, the projected paths using numerous simulation models, and the potential strength and wind speeds at various points along the projected path.

Together with the indisputable immediate scientific evidence and the “disputable” projected evidence there came pronouncements of the historic nature of the storm like … “worst storm to hit the East coast in a hundred years.” There also came all sorts of projected effects: storm surges destroying the barrier islands, high winds, downed trees, lost electricity, etc. In New York City, there were scenarios of broken skyscraper windows and storm surges that flooded subways and covered significant parts of Manhattan and Long Island. As is natural, most of the devastation was projected to occur along the coast since as I heard over and over, the storm surge does the most damage and the winds are highest there.

Of course I am sure there are examples of almost all of these effects happening in one place or another because of the storm: windows were broken, storm surges did do damage, floods occurred and electricity was lost. However, the overall extent of the damage was much less than was projected and predicted. What is more notable though, is that the places with the greatest devastation, like parts of Connecticut and Vermont (and I’m sure others) were not the places that were being hyped as the storm was approaching.

Thus while scientific evidence was very useful in predicting the path of the storm and the potential effects it ‘could’ have, science is not precise enough to predict the overall extent of damage that will be caused nor the precise locations that have more reason to worry.

The same might well be true about global climate change; namely, even though scientific evidence is very good at predicting the types of possible impacts that higher carbon emissions might have on the planet, it might not be very good at predicting the overall extent of the damage caused or who is more likely to be affected. As with the hurricane we might expect global climate scientists, and the media that reports about it, to exaggerate or hype the scenarios that are most dramatic. But also, we may expect, as with the hurricane, that the unexpected effects of global climate change may turn out to be more significant than the anticipated and exaggerated ones.

One more thing … because of the hurricane warning and the hype about its potential effects, many people responded by leaving the beach areas, boarding up windows, stocking up on food, water and candles, and staying out of harms way. Surely this contributed to lower overall damage. In a similar vein we might well expect that people will adapt to the effects of global climate change as it slowly impacts the world’s ecosystems. As they adapt to the changes, the overall impacts will be reduced.

Lastly, it is worth highlighting the scale of the differences between these two processes. Predictions about the hurricane involved scientific measurements of a relatively simple weather system, examples of which scientists have had the chance to observe over and over again across decades of hurricane seasons. Global climate change involves measurement of a hugely complex array of variables spread across the globe, other examples of which are scarce, if they exist at all.

My question then is: If we can’t precisely predict the impacts of a hurricane system one week in advance, why should we expect the 50-100 year predictions of global climate change scientists to be accurate representations?

Originally published on August 27, 2011

The Wall Street Journal this week suggests that we should “Expect a Third-Party Candidate in 2012.” The authors claim the US is “in the midst of what we would both call a prerevolutionary moment, and there is widespread support for fundamental change in the system. An increasing number of Americans are now searching beyond the two parties for bold and effective leadership.”

This idea is a recurring theme in American politics especially because there is a large swath of people who do not identify perfectly with the conservative right or the liberal left. These citizens often identify themselves, or are called, unaffiliated, independent, or moderate. From observers firmly ensconced on the right or left, these citizens are sometimes considered unprincipled, confused, or muddled in their thinking!

To be sure, the political opinions of those who consider themselves moderate or independent are highly varied. A good place to explore the diversity of opinion on political issues is a 2011 Pew Research report titled, Beyond Red vs. Blue: The Political Typology. According to that report, 35% percent of voting Americans are classified as “Mostly Independent.” Among these Americans some tend to lean more Republican or conservative on some issues, some more Democratic or liberal. Thus even though there seems to be a large voting bloc in the “middle” of the political spectrum, that does not imply that all of these voters share a sufficient number of viewpoints to form a competitive 3rd party. For example, among the three groups in the survey classified as independent, 73% of the respondents in one group believe businesses make too much profit while only 13% of respondents in another group believed the same.

Nonetheless, if a 3rd party does emerge, it will have to be located in the moderate segment of the political spectrum if it is to be competitive with the prevailing parties. Only a “moderate” platform has a chance to attract enough Democrats and Republicans to one day capture a majority of votes.

But herein lies the dilemma. If moderates and independents do not share a sufficient number of viewpoints, then how can a new 3rd party unite them?

One critical feature of an effective 3rd party is that it has a simple unifying principle that will attract supporters. For example Green parties in Europe elect candidates that have strong environmental concerns. In the US, the Tea Party is effective partly because it stands on one simple principle; smaller government. However, the Tea Party is not a true political party. It has no central organization, and no convention organizing a slate of candidates at different government levels.

For a competitive 3rd party to arise it will have to stand for more than simply a position on one particular issue; instead it will have to have a unifying theme that can be used to establish positions across a range of economic and social issues. In this post, and several others to follow, I will identify what I see as some of the similar characteristics of many moderate-independents and based on this reflection suggest a few unifying principles that could possibly form the basis for a successful third party.

First, I think that most moderates-independents are located where they are on the political spectrum because they recognize that there are valid arguments made by both parties. Sometimes they are convinced by a conservative argument, sometimes by a liberal argument. There is a good reason for this. It seems unlikely to me that in the grand scheme either the conservative policies and positions are 100% correct and the liberals 100% wrong, OR liberals are 100% correct and conservatives 100% wrong. Instead there are strengths and weaknesses to every position and it is more likely that in the grand scheme both sides have some arguments that are stronger than the other side AND both sides have weaker arguments. Also, different people evaluate these strengths and weaknesses differently, which is why reasonable people can come to different conclusions.

In contrast, staunch conservatives and solid liberals (i.e., ideologues) are more inclined to believe that their opinions and positions are 100% correct and whoever disagrees is 100% wrong. Anger and hostility in political discourse arises because individuals can’t understand why others don’t see the logic of their own arguments and beliefs. To the ideologue the truth is crystal clear and any deviation from that ideology is considered unprincipled, ignorant or even traitorous. For example, many staunch conservatives are certain of their Christian principles, that the US is a Christian nation, and in their opposition to abortion and gay marriage. This is why every Republican candidate for President must declare his or her allegiance to these principles to have any chance of capturing the Republican nomination. On the other side, many solid liberals are certain in their belief in science and the ability to use human intelligence to guide the economy and society towards more just outcomes. This is why the left is so quick to discredit any viable political candidate on the basis of a presumed lack of intelligence. These unflailing beliefs also make ideologues inclined to view the opposition as an enemy that must be defeated. Victory presumably means ridding the country or the world of people who think incorrectly from their point of view.

Moderates-independents, on the other hand, are more inclined to accept that the truth is nebulous and that our ability to perceive it is limited. Consequently moderates-independents are more inclined to accept diversity of opinion on different topics. And it is also why independents themselves hold a diversity of opinion.

But a moderate position need not be an unprincipled one. It need not consist of a compromise in which principles are weakened in an attempt to appease the rigid sensibilities of the right and left. Instead a moderate position can be based on the recognition of the diversity of opinion and the search for principles and policies that allow people with different belief systems to live amongst each other. More on how to do this in later posts.

Finally it is worth noting that moderation has a long philosophical history as an ideal worthy of striving towards. Aristotle noted in the Ethics that, “ …virtue is concerned with passions and actions, in which excess is a form of failure, and so is defect, while the intermediate is praised and is a form of success.” For example the mean virtue of courage lies between the deficiency of cowardice and the excess of rashness. Similarly temperance is a mean virtue between the deficiency of insensibility and the excess of self-indulgence. Today’s recommendation that several glasses of red wine per day could improve one’s long term health represents a moderate consumption ideal that lies between the deficient teetotaler and the excessive alcoholic.

I am not suggesting that conservatism is a form of deficiency and liberalism a form of excess, or vice versa, although I am sure many readers would be happy to provide examples why this is the case. Instead I merely wish to suggest that some middle position between extremes can be a virtue. A principled moderate platform that can appeal to people who lean a little left as well as those who lean a little right is possible. Stay tuned for further thoughts on this.

Originally published on August 18, 2011

For over a year now we have been hearing about the government debt problems in Europe; especially in Greece, but also in the larger economies of Ireland, Portugal, Spain, Italy and even France. Greece’s outstanding public debt is now about 150% of its annual GDP. In Italy it is over 120%, in Ireland about 95%, France 85%, Portugal 82% and Spain 65%.

These worries and figures invite comparison to the US. In the US, total Federal outstanding debt to GDP is almost 100%. Another figure sometimes presented though is Federal debt held by the public, which stands at about 60%. The second figure eliminates the public debt purchased mostly by the Social Security Administration. The so-called trust fund – this is the excess of SS tax revenue over SS disbursements (which have been substantial in past years) – has been invested in US Treasuries.

In any case, because many observers keep mentioning default in Greece and other European countries, and because of the debt ceiling debate in the US, it is worth asking whether the US is in danger of becoming another Greece. The short answer is no.

There is virtually no chance the US will default and be unable to pay back principal and interest on its maturing treasury bonds. This conclusion was no different a month ago before the debt ceiling deal and before the S&P downgrade. As I have explained elsewhere, even if we had not raised the debt ceiling, the US would have continued to pay back principal and interest on its bonds. Other bills would not have been paid, but these bills would have. The simple proof of this lies in the fact that the US treasury market faced no disruption leading up to the debt ceiling deal. That means that the collective opinion of bond holders, which is whose opinion matters most, was that there was no chance of imminent default. In fact, even after the S&P downgrade, which was mild at best from AAA to AA+, demand for US Treasuries rose, indicating that they continue to be viewed a safe haven for investors.

Greece, on the other hand, (and Ireland, Portugal, and Spain), could conceivably default. (Although Greece is perhaps the only place where default is plausibly imminent) But one might ask, if US debt as a percentage of GDP is on a path to the same level as Greece, won’t the US eventually face the same default potential. Again the answer is no!

The important difference is the currency the outstanding loans are denominated in and the source of that currency. In the case of Greece, it has borrowed Euros mostly. However, Greece does not control the number of Euros that are issued; that is controlled by the European Central Bank (ECB). In contrast the US debt is denominated in dollars, and it is the US Fed that is the issuer of those dollars.

Consider an extreme case. Suppose one day the US Treasury needs to issue $50 billion of new debt in order to finance the government budget deficit and pay back maturing securities. Suppose further that our debt has risen so much that tax revenues alone don’t even cover the repayment of maturing bonds. Suppose also that nobody wants to buy newly issued government bonds – which would allow us to rollover and extend repayment – without demanding an oppressively high interest rate. Well, if the US ever reached that situation, and I should point out that we are nowhere near this kind of scenario, then the problem could be immediately ”solved” and default avoided if the US Fed under Ben Bernanke simply purchased the $50 billion in new bonds. To pay for it the central bank must merely make an accounting notation that says the government now has a $50 billion credit on its account. In this way money is created out of thin air to finance the government’s borrowing and to rollover the outstanding debt. (Note: This power is what drives Ron Paul nuts!)

Now one could say that because the Fed is independent of the federal government, it could refuse to make the transaction. This is true, however, given the problems associated with outright default and the simple ability to “solve” the problem by printing money, it is reasonable to expect that the Fed would relent and money would be printed in this case. This is about as dire a situation we could imagine in the US and in this case it is reasonable to conclude that the US would not technically default.

The same is true in any country that borrows in its own currency and controls the issuance of that currency. Thus it applies to Japan, whose government has debt over 200% of GDP. Japan is unlikely to default on its debt. However, this conclusion does not apply to any country that borrows in a currency that it does not issue. Since Greece does not issue Euros its excessive debt makes it a viable candidate for outright default. The same was true for many other countries in the past: Argentina, Brazil, and Mexico to name a few.

The ECB could offer to buy all the debt that Greece needs to issue to maintain its large budget deficits, however, this would result in an increase in the overall euro money supply and those euros would circulate throughout the euro zone. The ultimate effect of extra money circulating in an economy that is not growing sufficiently fast is inflation. Too much money chasing too few goods puts upward pressure on prices of goods and services. And this would negatively affect all countries in the Euro-zone acting much like a tax on all of the EU’s citizens.

Indeed, any country that finances its deficits by printing money is using inflation as a hidden tax. The alternative to printing money is to raise taxes to balance the budget (or decrease government spending). However, inflation lowers the purchasing power of everybody’s money, which essentially shifts buying power from all citizens to the government in this case. It also effectively lowers the real value of the outstanding government debt. This is because inflation lowers the purchasing value of the repaid principal and interest and creditors get back less than was originally expected. This is sometimes referred to as a partial default. We might also think of it as a “stealth tax” because no one can easily connect the loss of purchasing power to the actions of the government. It is also why it is always the most politically expedient exit strategy for governments.

As a quick example, suppose someone lends the government $1 million for one year at the interest rate of 3%. At the end of the year this person will receive back $1,030,000. But suppose inflation during this period unexpectedly turns out to be 10%. This means that it will now cost $1,100,000 to buy what last year cost $1 million. Thus the $1.03 million returned by the government is actually worth less than enough to keep even. The debtor gains at the expense of the creditor.

Back to the EU, this is one reason the ECB doesn’t want to bail out Greece, Portugal, Ireland, etc. The more it does, the more inflation is likely eventually and the more everyone in the euro-zone have to pay for the excesses of the minority.

One other solution for Greece is to drop out of the Euro zone. In this case they would reestablish the drachma as their national currency. But then what would they do with their Euro debt? The most likely recourse would be to renege on euro repayment and convert them to drachma. Thus a creditor might be told they won’t get paid back in euro but in the equivalent in drachma instead. Of course this would be less valuable to the creditor since drachma could only be used to buy goods in Greece, not in the wider EU, and because the new Greek central bank would be able to lower the value of these drachma by printing money and creating inflation in the economy. In this way the burdens of excessive government borrowing would be shifted to the creditors holding Greek bonds and to the Greek people. Because money is printed, causing inflation, this amounts to a partial default. Again, this is not a technical default because all the bonds will be repaid in full, but they will be repaid with currency that is worth less than originally expected.

Now back to the US. Since the US borrows in its own currency, there is no reason for it to ever technically default. It will always find a way to pay back its outstanding principal and interest. However, because the US can print money to finance budget deficits, it could default partially via inflation. A stealth default is possible. In this case, everyone gets the nominal value of their money back as promised, only those repayments won’t buy as much as originally expected. This is a real worry that China has: the fear that their more than $1 trillion of US debt is eventually paid back with dollars that will not purchase as many goods and services.

Originally published on August 16, 2011

One of the main reasons for the unemployment problem around the world is excessive debt. Only when we eliminate the underlying source of our problems will we be able to sustainably reduce the unemployment rate. In my last post about debt I talked about mortgage debt. This post is about government debt.

Consider the Greek debt problem. Examples of Greek government largesse are easy to find on the internet. For example, government workers get some of the best benefits anywhere in the world. All are paid in 14 monthly paychecks per year. (the two extra amount to negotiated bonus payments). Some workers can retire with a full pension as early as age 45. Pensions of deceased military officers continue to be paid to their unmarried daughters for life or until she weds. Some union members were once granted free unlimited transportation on the national airline. The state railroad payroll is 4 times larger than total ticket sales. There are many more examples like this.

To finance these generous benefits, and to remain popular, the Greek government had to borrow enormously. When the economic crisis hit in 2008, Greek government debt had already reached 100% of GDP. This year Greece’s total debt is expected to exceed 150% of GDP, which amounts to over $450 billion. And still the Greek government continues to run large budget deficits to fulfill promises that are clearly untenable.

The situation is a mess and the problem just keeps getting pushed further into the future. One necessary outcome is for Greece’s budget to be balanced quickly or even moved into surplus to reduce their enormous debt. However, if this is done too quickly it could cause sharp contractions in economic activity making it even harder to pay down the debt. The Greek people have already risen up riotously this year (and last year) to protest the proposed cuts in government programs or increases in taxes. After all, profligate or not, the Greeks feel entitled to these promises, just like Americans feel entitled to their Social security, Medicare and tax breaks. They are surely not willing to rein in excesses without a fight. Besides what is excess to one person is another person’s monthly paycheck.

Greece’s government doesn’t want to make the needed budgetary changes (no sane politician would!) because the changes are very painful and unpopular. So the only way to continue the largesse, quiet the protests, and move along is to get someone to lend them even more money. But with a CCC bond rating (worse than junk bond status) they can’t borrow on the private market unless the interest rate was extremely high to compensate for the high risk of default. The risk premium on short term Greek bonds currently exceeds 25% and borrowing at that rate would push up their deficits and debt even faster.

In July 2011, for the second time, the EU stepped in to provide up to $160 billion in loans to allow Greece to continue to borrow at relatively low interest rates and with longer maturities. In essence this is like an increase in Greece’s debt ceiling, allowing it to continue running deficits. However, these EU bailouts are funded by the other EU countries. Thus, if Greece can’t repay these loans, the losses will be borne by taxpayers in the other EU countries.

Of course, in accepting these bailouts Greece is required to bring its budget into balance in a reasonable time period. Interestingly Greece has not been doing a very good job at this. In the first half of 2011 – this is after the bailout loans they received last summer – the Greek budget deficit rose 24%. Of course some of this has to do with the fact that the economy is stagnant and unemployment remains above 15%.

So growth is slow to nonexistent, tax revenues are falling, government promises remain generous, and any attempt to reduce spending leads to massive riots in the streets. So why do they keep getting bailed out?

There are several reasons.

First, creditors – that is, the institutions holding the $450 billion in Greek bonds – want to get their money back someday. (Note it is not the bank’s money in jeopardy.. it is depositor’s money .. that’s the people’s money) If Greece defaults then some creditors may not get anything back. Better to get a deal and wait longer than get nothing. Also, defaults can be disorderly as creditors line up trying to squeeze as much value out for themselves as possible. For example, if Greece owes $50 billion but only $25 billion in cash, who gets paid and who doesn’t? Figuring that out can sometimes take years.

The bailouts amount to promises that creditors will get their money back eventually, but will have to wait longer for it. So the bailouts buy time. For Greece though, the bailouts result in forced austerity, especially for those most dependent on government programs or those who pay taxes … which, of course, means pretty much everyone, … hence the riots in the streets!

Actually it is worth noting that another way to solve the problem for Greece is an outright default. If Greece defaulted, they would have to first settle with the creditors to decide who will not be repaid (this is a contentious process) and second balance their budget immediately because no one will lend them money for a long while. Thus the austerity will be even more painful in the short run. If Greece receives bailouts, then the austerity still has to happen, but it will be spread out over a longer period into the future. One question worth considering is whether it is better 1) to suffer a greater austerity quickly, resolve the debt problems (basically determine who is getting money back and who isn’t) and move on with a healthy balance sheet, or, 2) to suffer a longer and milder, though still painful, austerity and hope that the economy can grow and change into a healthy one in the distant future?

Perhaps the bigger problem for the world economy, though, is contagion. Many observers say Greece is small and so the problems there don’t matter much. That’s true, Greece is about the size of Maryland. But Portugal, and Ireland, and Spain and Italy are facing similar problems. If Greece’s problems migrate to these other countries then creditors will worry about the value of their loans to these countries too. And these loans are much bigger.

If Greece defaults, maybe the banking institutions can handle the losses. But what if Portugal, or Ireland, or Spain, decides to default? These could be large enough to force innumerable financial bankruptcies and threaten the entire financial system. Or what about the EU and IMF bailout of Greece? Again the values aren’t that large. But, what if the EU needs to lend money to Portugal, Ireland and Spain to keep them afloat too? (Note: they’ve already begun to do this!) How deeply into debt and how much risk are the Germans, French and other EU members willing to bear?

The essence of the true problem then is that numerous financial institutions around the world have taken deposits from its citizens and have saved the money by lending it to governments. Some of that money is in jeopardy of not being returned in full, but no one knows whose money is most in jeopardy or when those losses will materialize. Add on to this the US debt ceiling debate and the downgrading of US debt by S&P and we have financial institutions around the world questioning the true value of an enormous amount of their outstanding loans. It is worries like these, spread across the globe, that prevents the expansion of credit and the necessary risk taking that inspires economic growth. Sure, lending is occurring, but it is mostly safe and highly secured loans. These can keep the economies of the world running in place, but it is unlikely to fuel the rapid expansion we need to bring unemployment rates down.

If we want to solve the unemployment problem, there is no recourse but to alleviate the debt problems. There remains too much risk and uncertainty about the true value of outstanding loans for the world markets to function effectively. This is a reason why a large stimulus program may not work in this environment. Yes extra government spending can increase demand and create a few jobs for a little while, but this probably won’t speed up the debt restructuring. So if after the demand boost runs out, there remains a large number of underperforming loans, then we will also remain stuck in a stagnant economy. Only now we will be stuck with an even scarier level of government indebtedness that in turn could exacerbate the debt problems.

A useful analogy may be to think of the debt problem described above corresponding to a car that has been downshifted into 2nd gear. A fiscal stimulus represents stepping on the accelerator. Yes, the more we step on the gas (the bigger the stimulus) the faster the car goes, but if we remain in 2nd gear we’re in danger of burning out the engine. We can only return to a comfortable highway speed by upshifting to 3rd or 4th gear, and that requires resolving the debt problem first.

Originally published on August 13, 2011

A Politco story released this week regarding comments by S&P senior director Joydeep Mukherji is being used to suggest that Tea party intransigence is the root cause of the debt downgrade. However, I think the finger is really pointing at the Administration instead.

Joydeep Mukherji said the stability and effectiveness of American political institutions were undermined by the fact that “people in the political arena were even talking about a potential default,” “That a country even has such voices, albeit a minority, is something notable,” he added. “This kind of rhetoric is not common amongst AAA sovereigns.”

It is worth noting that had the debt ceiling not been raised then it would have been up to the Treasury under Secretary Geithner, in consultation with the President and Congress, to decide which bills would be paid and which would be suspended. Tea Party Republicans, like Michelle Bachmann, assumed that the government would never default on our debt obligations. It was accurate to say that the government would not have to default since there were plenty of revenues coming in to cover all principal and interest repayments. Instead, the government could have suspended payments on discretionary programs and the effect would be much like a partial government shutdown. These effects would not be small or inconsequential but they would not amount to a default on debt.

However, this isn’t what the administration was saying. In Timothy Geithner’s Jan 6, 2011, letter to Majority leader Harry Reid he implores Congress to reach a deal to raise the debt limit.

He says in paragraph two, “Failure to raise the limit would precipitate a default by the United States.” He also says in the letter that failure to raise the debt ceiling would not be the same as a partial government shutdown. He wrote, “Those government shutdowns, which were unwise and highly disruptive, did not have the same long-term negative impact on U.S. creditworthiness as a default would, because there was headroom available under the debt limit at that time.”

In other words, the reason things would be different this time, is because we would fail to make our interest payments. At the end of the letter, he describes likely economic impacts of failure to raise the debt limit, most of which would clearly be the consequence of an actual default on US debt repayment. Thus, Geithner is strongly suggesting that the US might be inclined not to make some debt repayments if the debt ceiling were not raised.

Or listen to Obama’s Economic advisor Austen Goolsbee in January. He talks about default as if we would not make repayment of our principal and interest and does not make the distinction between discretionary spending and repayment of debt. Clearly he describes as catastrophic the impact of debt default.

But then listen to President Obama later in June. In this clip President Obama seems to equate the term default with not paying some government bills. So, for example, if the government did not pay some social security obligations, one might say the US had defaulted. So maybe when he says default he doesn’t really mean a debt default. However, at the end he asks whether we really would choose to send interest payments to China to avoid default on the debt rather than sending out social security checks. He doesn’t answer the question, but if I had to infer what his preference was based on the way he presented it, I’d have to say he’d prefer to pay the SS checks. The inference is that had the debt ceiling not been raised, the President may have been inclined to “really default” on some interest payments.

These are the voices S&P is more likely referring to, especially since these are the individuals who are empowered to administer the payment of government obligations. The administration could have avoided this criticism by saying throughout the crisis that the full faith and credit of the US would not be impaired EVEN IF we hit the debt ceiling. They then could have explained the serious repercussions if we were forced to go through a partial government shutdown. However the administration didn’t do that. Instead they told the default implication story over and over again and did not accurately reflect the true situation. That is …. unless it really WAS President Obama’s intention to default on debt to avoid a reduction in social security and other government payments!!

Originally published on August 12, 2011

In the national conversation about the economy the continual refrain is that we need to create more jobs. However, one of the main reasons for the unemployment problem around the world is excessive debt. Only when we eliminate the underlying source of our problems will we be able to sustainably reduce the unemployment rate.

A little bit of debt is never a problem. Most households borrow money to buy a home and a car and successfully pay back these borrowed funds over their lifetimes. Financial institutions are the vehicle that allows some people’s savings to be used to finance other people’s consumption. It is important to remember that banks receive money from people who say, “I want to forgo consumption today and wait to consume in the future instead.” to other people who say “I want to consume more today and pay it back by consuming less in the future.” These institutions create contracts, what we commonly call loans, which specify the terms of the repayment. These are promises that borrowers have made to pay the money back with extra interest payments according to some predetermined schedule.

Debt becomes a problem whenever a borrower discovers that he cannot repay the lender according to the original contract. Actually, the problem may occur even earlier when the creditor begins to suspect that the borrower will not be able to fulfill the contract.

Consider the US mortgage market. In the US today more than 20% of home mortgages are underwater (over 11 million in number). Because of the collapse of home prices, the home values, which serve as collateral, are less than the value of the mortgages. If a household stops making payments, the bank will foreclose, reclaim the house and try to sell it at the market price to recoup as much value as possible. This process takes time, is costly, and results in the bank receiving much less than the amount of money originally owed. It also means that someone’s savings, the bank depositors for example, will not get back all of the money they lent. This is an example of a partial default: the lender/saver didn’t lose all of their principal and interest, only some of it.

What is the best way to resolve this situation? Well, that depends on whether you are the lender or the borrower. The lender wants the original contract fulfilled; it wants to get all the principal and interest that was promised. The first best option, then, is to hold out and demand full repayment. If the borrower really can’t pay now, one way to fulfill the contract is to agree to an extension. Simply give the borrower more time to pay it back, but of course, charge more interest as well. This way all the money gets repaid with interest, but it takes longer to get it back. This is the second best option for the lender. The third best option would be to renegotiate the contract, agree to a partial default, and accept less than was originally expected. This is what happens in a foreclosure when the borrower is underwater.

From the borrower’s perspective it is not clear what the best outcome is. If borrower continues payments for long enough then he can hope the value of the house eventually rises above the mortgage value. But what if the price remains depressed for a very long time? Imagine paying on a $500,000 mortgage every month when the house is now worth $300,000? If that situation persists, it will not inspire household confidence and consumer demand. Furthermore, the household is stuck. The family can’t move anywhere without coming up with an extra $200,000 to pay off the old mortgage. (Imagine 11 million households in this situation to understand why consumer demand and confidence is so low.)

If the borrower walks away from the mortgage and suffers foreclosure they will have to leave the house and move elsewhere, most likely into a rental unit. The household will also suffer a stain on its credit rating for many years. Its reputation will be tainted and the household would have to live for a while without being able to borrow. On the other hand, all of the negative equity will be erased so the household’s balance sheet will immediately look healthier. The family is also free to move elsewhere and is no longer mired in a depressing situation. To use a fishing analogy, this is the “cut bait, and run” approach. One advantage to this latter approach is that both the household and the bank can accept the losses and move on, rather than being mired in a long, drawn out struggle to fulfill, perhaps unrealistic, promises.

One reason for the poor economic performance we now are living with is that there are millions, maybe hundreds of millions of debt contracts in the world, similar to the one described above, that are in jeopardy of full or partial default. That means there are numerous financial institutions that will not be getting back the full amount that was originally promised. Now some people might be inclined to say, “so what if the banks lose money?” That’s fine except for the fact that the banks didn’t use their money to make all these loans .. they used our money. By that I mean any money deposited in a financial institution. It means checking accounts, savings accounts, and retirement accounts, etc. If you engage with any financial institution; a bank, an insurance company, a mutual fund etc. then you have contributed to the pool of savings that has been lent out to someone else. And therefore your money is at risk of not being returned to you in full.

The struggle that is playing out now and will continue for several more years is a struggle to determine who is going to pay more and who less. Banks are struggling to maintain the performance of their loans, so they can preserve value for their shareholders and depositors. They don’t want to be the ones to suffer losses. When banks receive government assistance it is a way of unloading some of their burdens on the taxpayers of the country. It also allows the burden to be spread over a larger number of people and over a longer period of time. This way somebody else pays for the losses incurred due to the decisions of the bank.

With this explanation as background, I can now say, in a very indefinite way, when we will be out of the current crisis. It will be once the number and value of the debt contracts that are in danger of total or partial default becomes manageable. Even in a healthy economy there are non-performing loans. There are always some loans contracts that are not fulfilled. But in good times these losses are just swept into slightly higher interest rates that all depositors and borrowers pay for. No one notices. In financial crises, those non-performing loans are too large to go unnoticed. They threaten bank failures, they threaten bank runs and they cause high unemployment, stagnant growth and a loss of confidence.

Once we clean up most of these nonperforming or partially performing loans, confidence will be restored, consumers will start buying more, banks will start lending more, and the economy will move along at a healthy clip. Only then will the unemployment rates fall in a sustainable way. How long it will take to get there though, is anyone’s guess.

In my next post I’ll discuss the problems with government debt, using Greece as the example. The government debt problems are also excessive but they have slightly different characteristics and raise other issues.

Originally published on August 9, 2011

The economic news is riveting this week especially to an economist, but it amazes me all the BS I hear and read about as people are asked to assess the situation. Harry Frankfurt, a Princeton philosophy Professor, wrote a brief treatise titled “On Bullshit” a few years ago in which he tried to answer an obvious question, “Why is there so much BS out there?” One answer he gave was that too many people are expected to have an opinion about matters in which they do not know very much. Another reason must be the 24 hours news and commentary shows that some people are addicted to. It is curious how having more time to report the news does not result in much teaching about how things like the economy work.

So let me mention just a few things that have irritated me in the last few days.

1) I just watched a FOX report on the decline of the market today and they were showing how the market went down even faster while President Obama was making his speech in the afternoon. I’m a novice about stock trading but wouldn’t it make sense that trades that took place at 1:45pm or so are probably based on orders received sometime earlier and that it is unlikely that traders are evaluating the President’s speech, feeling bad about its implications, and then in real time placing more sell orders? Someone please correct me if I’m wrong.

2) I can’t believe how nasty people have been in their comments about S&P. Again I am not an expert on S&P but I do know that they are an independent company that makes risk evaluations on different types of assets. They have been in business for a very long time and they are staffed by a group of professionals that are trained in risk analysis. If they do their job right they should not be swayed by outside opinions of what the ratings should or should not be. Their business is based on their reputation and so they have an incentive to do the best independent evaluation they can provide to maintain that reputation. Their opinion on US debt is just that … their opinion. Yes, they did rate mortgage backed securities as too safe in the past but the risk involved in those was mostly systemic risk that was, and continues to be, very hard to evaluate.

Still it would be professional to treat them like the professionals they are rather than criticizing them as incompetent. Yes, you can disagree and argue that US treasuries are still safe and even S&P would agree that that’s true. Afterall, it is only one opinion.

Two side points. First, I’ve read several stories that some government regulations require that some companies invest in only AAA bonds as evaluated by S&P. Such regulations seem very bad form. I would suspect that rules like that were written to favor important special interests (i.e. S&P) to give them a favorable position in the risk analysis market. This downgrade could act as a wake-up call to eliminate such rules. (not to punish them but as an excuse to eliminate a bad rule) Second, I did think it was very bad form for S&P to announce that any debt deal would need to cut $4 trillion from the deficit to prevent a downgrade. That does suggest an independent agency with too much power to influence policy outcomes. S&P is an evaluator … not a policy recommendation agency, … at least not this branch of S&P. Again I think we can criticize S&P and the whole ratings system but can’t people do it in a more professional way?

3) Isn’t there an inconsistency in the statements by the administration? Wasn’t President Obama, Secretary Geithner and Ben Bernanke all claiming a few weeks ago that brinksmanship on the debt ceiling was threatening a US default? Before the agreement was reached I heard news organizations nonchalantly reporting that a deal needed to be made before the US “defaults” on August 3. I wrote in February why regardless of what the “experts” were saying there was really no chance we would default even if the debt ceiling were not raised on time.

OK, so now we get past the debt deal and to the S&P downgrade and we hear the administration saying that there is absolutely no way the US will ever default on its debt! But wait a minute … aren’t we going to get to another debt ceiling vote again at some point … and can’t the same brinksmanship occur, … and if last time you said default was possible … well, then how can you say the US will never default? This kind of wavering cannot inspire confidence in the administration. [BTW, my opinion is that the US is not in danger of default anytime soon, regardless of brinksmanship in the future and the S&P rating at AA+ doesn’t indicate that anyway]

My first two points can be explained by Frankfurt’s hypothesis, the third point cannot. The third point can only be attributed to politics … politics that is very bad for building confidence in our economy.

Originally published on August 7, 2011

As we come out of the debt ceiling debate in the US Congress and face the prospect of a word economy that seems destined to remain in the doldrums for some time to come, the debate over what to do next is heating up. Should we ignore the budget deficit and debt issues and go all in for anther massive government spending program to kick start the economy as economists like Paul Krugman suggest? Or should we follow the conservative track and put a credible debt reduction plan into place while revising the tax code and reducing future entitlement promises?

This discussion is sure to become even more heated due to the S&P downgrade of US Treasury notes and as the US Presidential race kicks into high gear by late this year. For many observers it is difficult to cut through the ideological rhetoric on both sides to decide what is the most appropriate course. Although many economists and political pundits declare that they know the answer, my suspicion is that no one really knows what is the best course to take, including myself.

But just because we must make decisions under great uncertainty doesn’t mean we can’t make decisions. Thus, rather than adding to the interminable ideological platitudes that appear online and on the nightly discussion shows, let me try to offer a more balanced evaluation by highlighting why both approaches have potential to succeed but both are also risky in different ways. I’ll suggest at the end that we might be best served to choose the less risky approach going forward.

I’ll begin with the liberal proposal that we should use Keynesian expansionary policy to put people back to work. The idea is to increase government spending, perhaps massively, especially on “shovel-ready” infrastructure and public works projects. One idea is to create a new Works Progress Administration as was created in the depression years by FDR. The WPA employed millions of unskilled US workers to construct roads and public facilities. According to Wiki, the budget in its first year was almost 7% of GDP. In today’s dollars, that would mean an expenditure of about $1 trillion per year.

The argument is that an expansion of government demand for goods and services, especially one this extensive, could substitute for the lack of private demand, and put millions of people back to work quickly. With the reduction in the unemployment rate and the rise of economic security, private sector demand might soon rebound. With confidence restored, the new WPA could then be wound slowly down as private sector job creation picks up the slack.

Proponents of this plan argue that a subsequent increase in the deficit and national debt is tolerable if the plan gets the economy growing rapidly. What is more, because interest rates are so low on US Treasuries, the cost of borrowing to finance this plan is almost miniscule.

Of course, such a plan is not without its problems and risks. One such problem is the deficit and debt problems we face. As a hypothetical, suppose the US had had a Federal balanced budget requirement for the last 50 years. Suppose further that several emergencies through the years had forced the government to run periodic deficits in some years that did not get completely paid off in boom periods. Suppose the national debt had built up to say 10% of GDP (about $1.5 trillion). If that were the US debt situation at the start of this recession few economists or political leaders would hesitate to implement a large public spending program.

The lesson we learned in WWII is that a huge government driven demand can quickly put people back to work and inspire a nation to produce again. However, it is worth highlighting that overcoming a recession by revving up a war machine in response to existential threats is not the preferred way to recover from an economic depression. Although unemployment fell to about 1% in 1944 we were also suffering about 2500 military deaths every week. Although we can certainly say we were out of the depression in the midst of WWII, we achieved that feat by enduring an even worse catastrophe.

It is also worth pointing out that the WPA was implemented in 1935 and yet unemployment remained at 19% in 1938, 3 years later, and 14.6% in 1940, 5 years later. On the surface, the massive jobs creation program had seemingly little effect. The spending that followed with the war machine was much more extensive. But one might ask then whether massive government spending to get the country out of a depression is only likely to be as effective when the country faces an existential threat as we did in WWII, but perhaps not when it is just a large public works project.

Nevertheless, the point I am trying to make is that the risk of a massive government stimulus program is relatively low when a country has not borrowed unconscionably in its past. Had the US been in that situation in 2008, there would be fewer objections to a Krugman-style stimulus. But because the US did have a reasonably high national debt to begin with, and because the recession raised the debt at an almost unprecedented pace, and because the seeds of the entire recession was excessive private debt fueling a real estate bubble, a further stimulus at this point in time must be considerably riskier. This is the concern of conservatives, which has inspired the whole debt debate. More on that in a minute …

A second big problem with another big fiscal stimulus at this point in time is the seeming failure of the first stimulus. Reasonable people could argue about whether the $800 billion stimulus bill passed in 2009 had no effect on unemployment or whether it prevented a much higher unemployment rate. If it did the latter, one could say it worked. Unfortunately though, it is impossible for anyone to know what we did not observe (e.g. a 15% unemployment rate without the stimulus) and so the former situation that it had almost no effect is more credible.

Also, if we recall the process by which the stimulus was enacted, it seemed never to adhere to the guidelines put forth by Obama’s own economic advisor Larry Summers that it be timely, targeted and temporary. Instead the stimulus funded State government shortfalls, was spread over several years, and seemed to fund a whole slough of pet projects that were lying in wait for the funding floodgates to open. Most observers on both sides agreed the stimulus was poorly designed. But one reason for that is that any stimulus will invariably be “designed” by the political process and not by some committee of wise experts. A similar outcome is likely if another stimulus were to be seriously considered.

Thus, although the idea of a stimulus is not crazy or without merit, it does carry important risks. We really cannot be sure that it would work effectively and if it didn’t, given that it would place an enormous burden on an already enormous government debt, it could put us into extreme economic jeopardy in just a few years.

That brings me to the other side of the debate. The tea party grew out of a grassroots concern for the growing size of our federal debt and the expansiveness of government. These are not ridiculous concerns or imagined problems. Through history there are plenty of examples of economic ruin caused by the excessiveness of government borrowing, and the often-concomitant increase in money supply to feed an ever-burgeoning government sector. In addition there are real concerns about the effectiveness of an economy in which a substantial percentage is driven by the non-market demands of the government sector. Many people, with good reason, believe that governments do not produce goods and allocate resources as effectively as private markets and thus are concerned about a government sector that keeps getting larger and larger with every passing year.

As with arguments about the effectiveness of Keynesian policy, reasonable people can also argue about the appropriate size of government and when the government influence over the economy is too large. Surely the presence of debt itself is not a problem for a household, a firm, or a government, when its overall size is a small share of either income or wealth. However, if an institution’s debt becomes excessive, the threat of bankruptcy and default or a long period of austerity becomes very real. One dilemma of course is that there is no simple delineation to decide when an institution’s debt becomes too large. Consequently, we have a difference of opinion among economic decision-makers.

Conservative Republicans, and Tea Party members especially, believe the debt has risen to very dangerous levels and that the country faces, either default, high inflation, or serious austerity if the present deficit course is not changed quickly and convincingly. Liberals and Democrats believe the debt, although too high, remains manageable and furthermore that the only chance to revive the stalled economy is by stimulating more government demand with continued short-term deficits. In other words they believe that additional deficits and debt are the only way to jumpstart the sagging economy.

So what’s the answer? As I suggested before, there no way for anyone to know for sure. What we hear on the airwaves and over the internet is just a lot of educated guesses. Further, as the debate heats up with rising stakes in the near future, stubborn intransigence will surely result in even more vitriolic rhetoric. Unfortunately, we are all in for a very unpleasant ride ahead.

Why can’t we discuss policy proposals and offer opinions and ideas without calling the opposing arguments, or the opponents themselves, stupid and inane?

So let me finish this discussion with what I would suggest is a more moderate evaluation of our current economic dilemma.

More fiscal stimulus ala Krugman, could expand demand, reduce unemployment and revive enough private confidence in the economy to reinvigorate rapid growth. The risk is that the positive effects are slow to appear, unemployment does not fall rapidly enough (remember the unemployment numbers after the WPA in 1935), and private confidence does not rebound. If this were the outcome, our national debt might be soon be approaching that of Japan’s at more than 200% of GDP. And with several decades building up international indebtedness (the US is a debtor nation internationally, while Japan is a creditor) the US economy could face several decades of austerity. (It is hard to know what the impact would be and how to describe it, but it would be pretty bad).

On the other hand, taking care of our fiscal deficit and trying to rein in our growing indebtedness, as the Tea party favors, could put our government on a firmer fiscal footing, restore our credit rating, restore confidence in the economy and prevent the calamity of future default and even greater austerity. If this restores business and consumer confidence, soon private sector demand may begin to revive economic growth. The risk is that quick reductions in the government deficit will lower payments to government contractors, federal workers, teachers and doctors, and thereby reduce demand for goods and services in the economy. This could cause an increase in unemployment and reduce consumer confidence even further. Getting to a healthier economy might require a worsening of the economy in the short-run, and what if that short-run is 3-5 years?

The downside of both of these approaches is pretty grim. It is why it is fair to say we are stuck between a rock and a hard place.

If I had to choose between these two approaches I would go with the approach to reduce the government deficit instead of the fiscal expansion path for several reasons. First, I think it is less risky. If the fiscal stimulus program doesn’t work then we’ll have even larger debt and economic problems in the future and it is hard to see how that won’t lead to possibly decades of economic hardship. If the balanced budget approach doesn’t work, we may suffer a little more in the short run, but at least we’ll have a smaller debt burden in the future. Overborrowing is a scourge for households, businesses and governments and it has got to be better in the long term to take every opportunity to reduce the extravagance.

Second, it is always politically expedient to raise deficits. Citizens always like more benefits and lower taxes because it seems like you’re getting something for nothing. Governments perpetuate this myth by first overborrowing and eventually by overinflating to resolve the overborrowing problem. Often, what is politically expedient, is simply the wrong thing to do economically.

Finally, I happen to believe that the private sector does a better job allocating resources to produce goods and services than government do. Government allocations are made for political reasons, and those are heavily influenced by special interests. Those special interests include big business, the military complex, labor unions, and other influential and powerful groups. Since every expansion of government debt involves raising the role and scope of government it is hard to imagine that another fiscal stimulus at this stage won’t have the same effects.

Thus for these reasons I would support politicians’ efforts to rein in the growing budget deficit even though it may contribute to the continuing stagnation of the economy. If legislators could simultaneously overhaul the tax system to take away most of the special provisions that have been given to curry favor with this or that interest group through the years, then maybe they could revive excitement in the private sector and jumpstart the economic engine even sooner. The chance of anything like this happening though is virtually zero because it is never politically expedient to rock so many special interest boats at the same time. But as I said before, if it’s NOT politically expedient, there’s a better chance that it’s the right thing to do economically.

Originally published on April 26, 2011

Read my article “Is Greed the Problem with Capitalism” at Liberty Magazine online and decide for yourself.

Originally published on April 5, 2011

We read a lot about excesses these days: excess government spending, excess budget deficits, excess money supply expansions, excess foreign exchange reserves. One other excess worth watching in the US is excess bank reserves over and above the banks’ required reserves. These excess reserves could unleash a torrent of economic activity and spark the rapid inflation that some say is imminent.

Here’s how inflation would arise. Under a fractional reserve banking system, a bank is allowed to lend only a fraction of the money deposited in checking, savings and other accounts. In the US, large banks must hold 10% of deposits as cash or reserves at a Federal Reserve bank. (reserves are like a checking account the banks have with the Fed). The remaining 90% they can lend out to businesses or consumers. When they do, those loans are spent by the borrowers and ultimately deposited back into the banking system. These newly created deposits can stimulate further lending up to the 90% limit, thereby creating even more deposits. Since deposits are spendable by their holders they represent a part of the money supply in an economy. And since the lending of excess reserves has a multiplier effect on total deposits, it also increases the money supply several times over. There is a limit though, and in a simply situation, the total money supply increase from a one dollar increase in deposits would be the reciprocal of the reserve requirement, or (1/0.10 = 10) ten times. In other words, a one dollar increase in excess reserves can cause a ten-fold increase in the money supply. Finally, if the money supply increase is too rapid compared to the growth of GDP, then inflation will arise.

Normally, and by normally I mean in every month from Jan 1959 to August 2008, banks lent almost all of their excess reserves (the data is here). The reason is simple; by charging an interest rate on loans that exceeds the rate paid to depositors, banks make a profit. Once the financial crisis hit in September 2008 though, things changed. Suddenly banks were holding on to excess reserves rather than lending them out; the risks were too great. In successive months excess reserves exceeded required reserves by two, three and four times. That trend continues today. In the latest Fed report excess reserves in the US banking system topped 1.3 trillion dollars. This means excess reserves are almost twenty times required reserves. Never before has this occurred.

But is this dangerous? What is the problem?

The main problem is a potential one; namely the inflationary impact if these reserves were quickly lent out to the public. If this were to occur the US money supply could rise ten times the excess reserve level, or by well over 10 trillion dollars. For comparison sake the M1 money supply currently is about 1.8 trillion dollars. Putting more than five times the current money supply into circulation suddenly is certainly enough to cause a severe hyperinflation.

However, this is not happening yet. The inflationary effect of the Fed’s expansionary monetary policy (like the QE2) has not occurred in part because these lendable reserves remain unlent. That could change soon though especially since inflation is unlikely to occur until after economic growth begins to pick up steam. In other words, good news today that our economic troubles are passing may be the harbinger that unleashes these reserves and spurs the inflation that so many people worry about.

But this inflation is not a foregone conclusion. The Fed has an important new tool at its disposal to prevent the rapid expansion of loans. Beginning in late 2008, as the financial crisis hit, the Fed implemented a new rule allowing it to pay interest on excess reserves held by banks at the Fed. This means that the Fed essentially changed excess reserve holdings from a checking account for banks into a savings account. To prevent lending from rising too rapidly, and thus to stem the inflationary pressures, the Fed can simply raise the deposit rate on excess reserves. This power gives the Fed considerably more leverage to control the outstanding money supply and thus allows it to control inflation more effectively.

Let’s only hope the Fed can manage these excesses as adeptly as they promise.

Originally published on February 25, 2011

In Alan Blinder’s commentary today, “The Economic Silly Season is Upon US,” in the WSJ, he emphasizes how “silly” legislators have become in their proposals and debates. It is true that politics often does seem absurd, but rather than pointing fingers and calling people silly, it would behoove us to try to understand the constraints imposed in the political system that lead legislators into these silly positions and statements.

For example, after Blinder explains how any reduction in the national debt requires a cut in expenditures and/or an increase in taxes, he suggests that it is silly to simply command the debt not rise by refusal to increase the national debt ceiling. Although he accepts that this approach may be a tactic to force necessary cuts, he argues that it might also damage the creditworthiness of the US government in order to achieve something the Congress has the power to do anyway.

This conclusion ignores the political realities though. Although Congress has the power to balance the budget and reduce the national debt, individual legislators have little personal incentive to vote to do so since it would open them up to damning criticisms in their next election campaign and threaten to thwart their own personal goals. This is a reason why some “device,” like a refusal to raise the debt ceiling could force the changes and allow legislators some political cover from future criticism. Any action that will effectively reduce the deficit must be politically palatable to a majority of voting members to have any chance of passage. Having some scapegoat to point the finger at is sometimes effective. Most States have the statutory requirement to balance their budgets … and this rule provides the necessary leverage to tie legislators’ hands. It provides the political scapegoat that is needed in most instances. In this way legislators can truthfully say, “I didn’t want to cut your benefits, or lay off workers, or raises taxes; but the law made me do it!”

Refusing to raise the debt ceiling might also provide political cover since it would force unpalatable cuts in spending to comply with the law. Critics of this approach, including Blinder, argue that it would damage the creditworthiness of the US government. However, for several reasons this outcome seems highly unlikely.

For example, there is little to no chance that a refusal to raise the debt ceiling would force a default by the US government on its debt. Interest payments on the debt, while sizeable, would surely be considered a top priority, precisely because maintaining these would be necessary to assure investor confidence. In other words, if the debt ceiling is raised the US government can and will continue to service its debts and live up to its previous commitments. Because investors will recognize this same strong incentive, it is unlikely they will flee US treasuries, unless of course they naively begin to believe the hyped-up rhetoric of the fearmongers.

At the same time a refusal to raise the debt ceiling would force the US government to balance its budget right now! That would mean making drastic cuts in spending or raising revenues. Basically it would force a pay as you go system in which spending must equal revenues … and if the revenues are not there, then they cannot be spent.

Given the size of our current deficit these dramatic changes in spending are likely to cause severe pain and disruption in the short run. It would be similar to a household having its credit cards cut up and forced to live solely on its annual income. Although the effect would surely be painful to endure, the household is likely to emerge healthier financially in the long run. The same may be the effect of the US government.

I am not convinced myself that refusing to raise the debt ceiling now is the best way to force the changes that legislators are politically disinclined to make on their own. However, I do think it is important to realize that imposing hard constraints, such as refusing to raise the debt ceiling, is precisely the kind of silliness we need in order to get our legislators to implement more sensible policies.

Originally published on February 19, 2011

The recent protests in Wisconsin by public sector employees against the proposed increases in employee pension and health care contributions may just be the first of the budget battles we will soon see spreading across the US. The news event also offers an opportunity to reconsider the advisability of public sector unions.

A standard argument for the right to form unions is that they provide protection to workers who may be exploited by business owners. That exploitation may include racial discrimination, low wages, inadequate benefit packages and insufficient health and safety precautions. Firms might be expected to mistreat workers in their attempt to reduce costs and achieve higher profits for themselves.

However, a public sector union presumably does not face an exploitative employer. The employer is the government itself, which is at the same time the regulator of potentially harmful business practices. The government’s aim is not to generate higher profit and therefore it should not have the business incentives that might inspire exploitation.

In a democracy, the government is really the agent of the people. The people pay for government services via their taxes. The people are the true employers of the public sector workers.

Interestingly though, when public sector workers use their collective bargaining rights to negotiate for higher wages and more generous health care benefits and pensions, they do not negotiate directly with their employer (the people), but rather with the people’s agent (the government). In contrast, a private sector union negotiates with the owners of the firm, whose own profits are negatively affected by any concessions to the union.

In the public sector though, the elected officials are not often negatively affected when concessions are made. Indeed the effects may be the opposite because elected officials receive campaign contributions and electoral support from the public sector unions. That means that the more generous elected officials are to the unions, the greater their own gain will be as well.

This process gives public sector unions the ability to “exploit” the taxpayers. A prime example of this is overly generous defined benefit pension plans for public workers. When elected officials make promises of future benefits to current public sectors employees it does not impact the current budget balance. Public employees receive generous lifetime income guarantees while elected officials get contributions that help them stay in office. The only losers are the “future” taxpayers, some of whom may not even be born yet. It is an ingenious scheme.

By virtue of the recent recession, government budgets from Greece to Wisconsin, New Jersey and California, have been thrust into deficits, revealing the long-term unsustainability of the numerous promises that have been made. Governments will go bankrupt if changes are not made. The sooner the better since the longer we wait the more difficult will be the adjustment. Concessions will have to be made, not only by public sector workers, but also at the national level by social security, Medicare and Medicaid recipients. I suspect most people don’t realize this now, …. but when they do we can expect many more marches of discontent.

Originally published on February 14, 2011

Private businesses are continually subjected to the vagaries of the market. While demand may grow steadily for long periods, unexpected shocks invariably hit from time to time. The 2008 recession is the latest episode of falling demand in a wide range of industries. The immediate effect for business is falling sales and reduced revenue. To remain in operation, businesses have no choice but to cut costs as quickly as possible.

Although the process is difficult and painful for those who lose their jobs, for the businesses themselves an economic downturn can force a kind of cleansing. The ones that survive will be those that cut costs in the most effective way, ridding themselves of unnecessary expenses or ineffective workers. For example, a firm with some employees who are lazy and unproductive may find it difficult to fire them when business is good. Once the business faces an emergency though, the least efficient workers can be released with a clearer conscience; firings become the market’s fault.

Thus, one way business weeds out inefficiencies is by suffering through a lean period of low demand and lower revenue.

Inefficiency in government could be reduced in the same way. When US legislators discuss how to reduce government spending they usually try to identify whole programs that might be cut or sharply curtailed. These proposals always generate resistance because entire groups are singled out as being a part of a wasteful endeavor. Additionally, it is hard to imagine that legislators know enough about the details of particular programs to know which are best to cut and which not.

A better approach is to reduce the budgets of all government agencies, perhaps equally, although some variation in the cuts could certainly be considered. An across the board reduction would mimic a recession, only this time it would be a government recession not a business recession. Agencies, forced to survive on less revenue, should be expected to deliver the same services but at lower cost. Of course this would not work with legislated transfer programs like social security, so the cuts could only be made on discretionary spending, including defense and on the administrative component of transfer programs. These internal investigations would have a better chance of identifying inefficiencies than legislators who are too far removed.

Of course, probably the quickest route to improve an agency’s efficiency would be to fire ineffective workers, just like private businesses do. For government though this may be more difficult if union rules make it difficult to fire people. Nevertheless, retiree positions may not be replaced and new hires may cease, leading to a reduced work force in time. This, together with other process adjustments, can lead to a more efficient and effective government at whatever level of government spending we need to achieve more balance in the budget.

Originally published on January 14, 2011

In his NYT column (Jan 14, 2011), Paul Krugman explains why he believes we are a “deeply divided nation and are likely to remain one for a long time.” He sees a moral divide that admits to no middle ground. He writes:

“One side of American politics considers the modern welfare state — a private-enterprise economy, but one in which society’s winners are taxed to pay for a social safety net — morally superior to the capitalism red in tooth and claw we had before the New Deal. It’s only right, this side believes, for the affluent to help the less fortunate.

The other side believes that people have a right to keep what they earn, and that taxing them to support others, no matter how needy, amounts to theft. That’s what lies behind the modern right’s fondness for violent rhetoric: many activists on the right really do see taxes and regulation as tyrannical impositions on their liberty.

There’s no middle ground between these views.”

Krugman may be right in his observations but is wrong in his conclusion. There is a middle ground between the two extremes he presents.

The Right is not averse to all taxation. They do not advocate anarchy, but rather limited government that provides for the national defense and the provision of social services such as fire and police protections, the road and transportation systems, the judicial system, et. al. In addition I suspect most on the Right are perfectly willing to provide modest transfers to people in need ( a safety net) via a progressive taxation system … the so-called compassionate conservatism discussed in years past. For example, most on the Right are unlikely to support a complete dismantling of the social security system.

What the Right is most vocally opposed to today, especially the Tea Party, is the excessiveness of government taxation. The moderate and restrained taxation of limited government would not be considered theft, but current taxation levels that seem to be growing uncontrollably are increasing viewed as theft by those on the Right.

The current economic slowdown has increased the tension between the Right and Left largely because the Left has used the crisis to support an even faster expansion of the role for government in the lives of people, using the arguments that it is only right (i.e., correct) for wealthier people to help out those that are less fortunate. The Right sees unprecedented Federal budget deficits, a ballooning national debt, State governments on the verge of default, government pension obligations that are enormously generous, and commentators on the Left like Paul Krugman continually arguing that all of this extra government spending has been much too small!!

The middle ground that Krugman can’t see is a system that does include government and taxes, that does protect people via a national defense and a social safety net, that is compassionate to the needs of the less fortunate … but at the same time does provide people with autonomy and freedom to control and affect their lives as they see fit. There is a compromise position that a majority of people would be very comfortable with. Unfortunately that compromise position is not even on the radar screen for commentators like Krugman on the Left and others on the Right. For them there is no happy medium, and unfortunately it is they who get most of the attention.

Originally published on January 14, 2011

In a Dec 19 column, The Bipartisanship Racket, Frank Rich highlights precisely what is needed to bridge the divide between the hyperpartisan right and left; a common enemy. That enemy is the process in which, “both parties are bought off by special interests who game the system and stack it against the rest of us.” Can’t all sides agree that when organizations use lobbyists to bend the rules in their favor, it is not in the national interest? The problem is that the right and left see the rule-bending in different places. The left sees it in the tax policies and regulations that favor major corporations at the expense of the average worker. The right sees it in the policies that favor labor union workers at the expense of consumers and taxpayers. The left sees it in our defense policies. The right sees it in our environmental and immigration policies. The trick is to get both sides to agree that rule-bending and gaming the system is equally inappropriate for every special interest that uses it … even when it’s a special interest that you support!

Originally published on December 21, 2010

See the letter to the Washington Post on Mon., Dec 19 here: http://www.washingtonpost.com/wp-dyn/content/article/2010/12/19/AR2010121903461.html

Originally published on December 13, 2010

The WSJ posts two enlightening articles today. The first is by Gov. Tim Pawlenty about the inappropriateness of government unions and how generous States and the federal government have been in raising the pay and the benefits of many government workers. The extent of this problem is new to me in the past year and it represents a huge growing burden on the health of the economy. Pawlenty is right, there is no good rationale for a government union. The effect of the union seems to be to exploit the democratic process, in a legal way, that results in more transfers from taxpayers to fund higher salaries and benefits. This is great if you are a government worker and in this case you have every incentive to support the union. If this resulted in better government services at the same time it might make sense. However, instead it funds an industry that faces no competitive pressures to improve outcomes, and offers generous guarantees for employment, salaries and benefits all at taxpayers expense.

Although it is true that taxpayers could, in principle, throw the excess spenders out of office, even then it is likely to have little effect as shown by the second interesting article in the WSJ today. This one shows the unrelenting influence of special interests in the ethanol industry. Even though science now seems to refute the positive environmental effects of ethanol in lieu of gasoline, the ethanol industry and all who stand to gain from it continue to influence legislation in their favor. Even though the election seemed to send a message that voters are fed up with the ways of Washington, Washington continues as it always did. The voters can only vote into office a slightly modified legislature, all of whom will face the same distorted incentives as the previous legislatures. So why should we expect the new crop of people to change decidedly, especially when old-timers run the show?

It is like we are playing a game of rock, paper, scissors, with special interests always trumping the general interests. It would seem the only way to change the behavior is to change what legislatures are allowed to do. And that can only come through a change in the Constitution, or perhaps, adherence to the rules put forth in our Constitution. For example, the US Constitution is supposed to limit the capacity of the Federal government to do anything in special group interests: they are only to spend money on things that satisfy the national or general interest. National defense clearly satisfies this condition. Subsidies to the ethanol industry clearly do not.

Originally published on December 10, 2010

Following up on yesterday’s post there is another way to look at the extent of the fiscal stimulus effects during the economic downturn and recovery. Remember that stimulus spending over two years or so was about $800 billion in total, which is about 6% of annual GDP.

The BEA publishes a table each quarter highlighting the contributions to growth of each component of our GDP. For example, in 2010 QIII, GDP grew by 2.5% and the portion of that growth caused by government consumption and investment demand was just 0.81%. The majority of the growth (1.97%) was caused by the increase in personal consumption.

Now of course this is just a “back of the envelope” kind of calculation since the fiscal stimulus did increase transfer payments as well and that could have affected consumption a or investment spending as well. Nonetheless we might have expected a bigger share of government contribution to growth especially when all the shovel ready projects were apparently under way. Below is a table showing GDP growth, Government’s contribution to GDP growth and then what growth would have been without the government’s contribution going back to the third quarter 2008.

The point to be made is the same as yesterday. The fiscal stimulus appears to have had at best just a minor impact on GDP growth. Perhaps if it were twice as big as Paul Krugman would have preferred, more of it would have been spent stimulating job creating demand. However, economic decisions tend to be made by the politicians rather than by following the guidance of their economic advisors. Larry Summers advocated at the time that any stimulus package should be timely, targeted and temporary. The final package looked anything but that.

Originally published on November 13, 2010

See the letter to the Washington Post on Wed., Nov 3 here: http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307478.html

Originally published on November 1, 2010

Paul Krugman has another piece today in the NYT about the need for more government stimulus. So again I want to suggest conditions under which the Krugman stimulus would work and conditions under which it would not work. The key, I think, is the effect the stimulus has on people’s confidence and expectations of the future.

In my last post I emphasized that because citizens see a ballooning budget deficit and rising debt while there seems to be no clear effect of government policy on unemployment, it is dashing their confidence of the future and keeping them from resuming their old spending habits.

In the meantime Krugman says we must substitute government demand for household and business demand for as long as the private sector needs to pay down debt and resume their own confidence. This does make sense if it can work as intended, but there are several problems with the implementation.

First of all, because of the political process the types of spending that would do the most to reduce the unemployment rate quickly are not the same as the pet projects that legislators have in mind when they construct a stimulus plan. If real legislation could mimic what Obama’s own advisor Larry Summers suggested, and probably what Krugman would advise, then the plan has a better chance of working. However, a second stimulus would likely be constructed in the same way as the first and lead to too much waste.

Second, a massive fiscal stimulus now would be much less worrisome to households and businesses if government had not accumulated so much debt during the good times of rapid economic growth. Imagine if our national debt were only $500 billion dollars when the crisis began. In that case the effect of spending $1 – $2 trillion quickly to avert disaster would have been received more favorably and thus could have inspired confidence in the private sector.

This leads to two lessons; first, it suggests the importance of keeping the government budget deficits low in all periods so that fiscal policy will be effective in an emergency; and second, it suggests that the impression the government makes on the people is critically important.

Many citizens lost confidence long ago that the government could manage its budget prudently. With that impression in place any new plan to spend more is met with doubt and uncertainty. This is especially true when all of the best and brightest who should know what is best are disagreeing over policy.

All this means that even if Krugman’s policy could work in principle, it very well may not work in practice and in this situation. Households and businesses have little confidence that the government knows what it is doing. Thus, any grand proposal to spend more will only be met with falling expectation and confidence.

Krugman is right that if only people didn’t think this way, his plan could work. But there is no way a few columns in a newspaper is going to shift the beliefs of a large group of people. These beliefs were created out of years of government excesses that we cannot wish away.

Appropriate government policy today must take full account of these beliefs and expectations and policymakers need to learn how to shift them in a more positive direction. Chances are good that positive expectations will not arise from leaders within the current political parties.

Originally published on October 30, 2010

One of the key macroeconomic policy decisions looming is whether to implement another fiscal stimulus program. Because unemployment remains stubbornly high, many are contemplating the advice of Paul Krugman that not only is more stimulus called for but the original stimulus plan back in 2009 was too restrained.

The logic behind the stimulus is straightforward. Because households have become cautious, they have reduced consumption and boosted saving or paid down debt. The reduction in consumption means a drop in demand for many products and a slowdown in sales growth in many industries. Families buy fewer TVs, go on fewer or shorter vacations, and put off purchasing a new sofa. Without a pickup in sales, businesses will not add to their workforce.

However, if the government increases its demand for products to offset the drop in demand by consumers, then businesses will sell more and hire more workers. As the unemployment rate falls, consumer confidence will rise and eventually will revert to old spending patterns. Once confidence is restored, the government stimulus can end.

The key to eliminating high unemployment, then, is the restoration of consumer confidence. But consumer confidence will not return if the government stimulus plan does not clearly arrest the unemployment problem and if confidence isn’t further dampened by fears of rising budget deficits.

The problem with the 2009 stimulus is that people are not convinced that it affected the unemployment situation but are convinced it contributed greatly to rising deficits and government debt. Because of this consumer confidence is falling over time instead of rising.

If a new fiscal stimulus plan is implemented soon, consumer confidence could fall even further if the plan doesn’t quickly and decisively reduce the unemployment rate. Otherwise the fear of excessive government indebtedness will grow even further and the slow economy will sputter along for good while longer.

Originally published on October 6, 2010

James Taranto’s discussion of Green Supremacists in the WSJ highlights an interesting phenomenon in public discourse today; the mixing of comedy and political commentary. Of course in one sense there is nothing new since comedians going back to Johnny Carson, Jack Paar and Groucho Marx have poked fun at politicians. What’s different today is that many comedy shows are designed to look like newsrooms and present skits based on the content of the daily news. Some shows also do interviews with authors and politicians, mixing in discussion of current events with humorous asides.

What’s also new is that the extreme rhetoric used routinely by comedians has made its way into traditional policy discussion venues including radio talkshows and the Sunday morning opinion shows.

Taranto’s story highlights the problem with a group running a political ad in support of policies to arrest climate change. Dissenters are blown up at the end in a graphical and gruesome way. The scene certainly grabs one’s attention because it is so shocking. How someone perceives this ad depends greatly on the context.

If the ad were not an ad but a skit instead, if it appeared in the middle of a Saturday Night Live show, then everyone would know it is supposed to be humorous. Some people may take offense due the graphic nature, but most would chuckle and be ready to move onto the next skit.

However, if the ad is presented on TV, let’s say, as a political ad to garner support for climate change policies, then the ad seems violent, mean and in very poor taste. Taranto analyzes the content of the ad through this lens and notes, “The “crime” for which the children in the video are “executed” is one of omission, not commission. They are murdered not even for dissenting against 10:10’s political crusade, but merely for being indifferent to it. This is the essence of totalitarianism.”

If we assume it’s a comedy routine again though, Taranto’s concerns now demonstrate why you never try to explain a joke to someone. Of course jokes have absurdities, that’s what makes them funny! So a response to any criticism of the ad could be, “hey, can’t you recognize a joke when you see it?”

All of this is making people very confused. It is becoming increasingly difficult to separate the overblown, humorous, remarks about public policies and our leaders from the angry and bigoted remarks of others. This is a real problem.

Originally published on September 27, 2010

The intensity of debate over the US-China trade relationship was racheted-up this past week especially regarding the pressure for China to revalue its currency. The clarions call in the US is to charge China with being an unfair currency manipulator. China’s response has largely been to take more WTO-legal trade remedy actions against the US, or to file complaints about US trade remedy actions at the WTO dispute settlement board. These tit-for-tat trade actions may possibly increase as the country’s look for more ways to demonstrate the unfairness of the other.

Today I noticed something else though, reading Robert Samuelson’s piece in the Washington Post today. His piece presents the now standard narrative about why China is an unfair trader, in a way that suggests that the facts are so obvious, and the responses so necessary that only a fool could accept something different. My issue is with the conviction and certainty that Samuelson displays about what is really a much more complicated issue. This I think bodes poorly for the future easing of tensions.

For example he says that, “China has never genuinely accepted the basic rules governing the world economy. China follows those rules when they suit its interests and rejects, modifies or ignores them when they don’t. ” He goes on to say that other nations would like to do this but they can’t get away with it. Of course, he doesn’t mention the many times the US has lost WTO cases only to thumb our noses at the prescription and go about our business as usual.

He goes on to claim that China’s undervalued currency “hurt(s) most trading nations, from Brazil to India.” He doesn’t mention how lower import prices help millions of low income Americans (and Brazilians and Indians) and businesses using Chinese inputs. A low exchange value has both positive and negative effects in every country and it is very difficult to know which effects outweigh the other.

He also reports with near certainty how studies show that between 300,000 and 3.5 million jobs will be created with a substantial currency revaluation. The implication is that unemployment could be reduced substantially. Of course, these same studies ignore the fact that jobs may be lost due to lower financial flows on the balance of payments, nor do they recognize the aggregate relationship that has existed for the last 30 years in which unemployment tends to rise as trade deficits fall. Would that relationship continue to prevail after a Chinese currency revaluation? I don’t know, but, the outcome on jobs and unemployment is simply not so clear.

Finally, he goes on to say that a trade war with China would be unlike Smoot-Hawley since it would only be against one nation, not every nation. He ignores the notion that success in protecting against Chinese imports may inspire protectionist movements on a much broader scale; afterall, why stop with China, we import a much larger amount of goods from other countries combined and why not create millions more jobs by choking off even more trade?

Finally, to make his point as strong as possible, he argues that the choice is between two concepts of the world order. Yes that’s right, the “world order!!” In other words, this time it isn’t just a trade war, it’s a war about whether China or the US will be the dominant player. He says that failure to act now wouldn’t be a bad idea, or imprudent; no, it will be “potentially disastrous.” (At least he threw in the word “potentially!”)

It would seem that no well–informed observer can object to this narrative. A trade war may be imminent now because by accepting this dominant narrative there is no other choice.

I for one do not accept the narrative. I believe a yuan revaluation will have both positive and negative effects in the US, in China, and around the world. I do not think we can know, that is I am agnostic, about whether the action will help “our country,” or whether it will cause our unemployment rate to fall.

I think the Chinese main goal is not to “stick it to the US,” but rather to maintain internal economic, and therefore political stability. That is in our larger interests as well. China’s faces a potential real estate bubble explosion just as we did. They are extremely worried about making quick changes that would cause a reduction in the export earnings, the failure of Chinese businesses, and a rising unemployment rate. It is not in our larger interest to push the Chinese economy into a tailspin.

Finally, China, as a proud and increasingly influential nation in the world community, will naturally resist external pressure to change its policies in the way we would like. Every nation would do the same. Thus, the more we pressure China publicly, the slower China will act. For several reasons, China would like to allow its currency to rise in value. However, they are very reluctant to make quick changes, and they certainly don’t want to appear weak in the face of foreign pressure.

So why is this a big issue now? Mostly it’s political posturing. Whenever economic conditions are bad, it is useful to find a scapegoat, somebody to blame. The same tendency is seen with rising nationalism during hard times. If leaders can find an enemy to blame and attack, then one can rally the electorate around that cause and deflect criticism of oneself. For the moment, we just face the possibility of a trade war. At least, that is much better than the alternative diversion sometimes used when things get really bad economically; an all out military war.

Originally published on September 26, 2010

Yesterday Oliver Stone’s sequel to Wall Street, Money Never Sleeps, opened in theaters around the country. In it America will hear Hollywood’s usual message; finance and business is evil and greed is the culprit. The movie is set in 2008 just before the financial crisis hit. Gordon Gekko (Michael Douglas) is out of jail after doing prison time for insider trading and is on a book tour. His book’s title – “Is Greed Good?” – recalls his famous speech made at the end of the original Wall Street movie …

“Greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, (for) knowledge has marked the upward surge of mankind.”

In an interview clip on Youtube, Michael Douglas recounts how many investment bankers have come up to him over the years to say how inspiring the Greed is Good speech was. He laments that they seemed to have missed the real message, which is, of course, that “greed is bad!”

In the new movie he gives another speech to a crowd of listeners who enthusiastically applaud at every anti-business, greed-is-bad, remark. Unfortunately for the storytellers though, this speech is not nearly as inspiring and is unlikely to be long remembered.

As the story progresses and the near financial collapse occurs, the movie shows us a mixture of fast-paced trading scenes, discussions of bubbles and the financial terminology that accompanies it, and panoramas of wealthy people living opulently. The clear message is that unrestrained greed by those in the financial sector, fueled the extravagant lifestyles and brought the financial system to the brink of collapse.

What’s touted as good in the movie are operating websites that expose the injustices of the world, alternative non-carbon based energy (in particular unlimited energy from water using fusion), and nursing. As some other movie reviewers have said, it also tries to emphasize the importance of family, although I can’t say that came across very strongly for me.

What’s missing from the film to make it worth the watch is any lesson about a viable alternative. Mostly the movie tells us, greed is out there and we’re gonna get screwed over and over again by it. This is disappointing especially because Hollywood once did know how to make movies that carried a clear lesson.

Probably the best movie about business ethics that I know about is a film called “Executive Suite.” It was a blockbuster movie back in 1954 with a cast of Hollywood legends: William Holden, Fredric March, Walter Pidgeon, Barbara Stanwyck, Shelley Winters, and June Allyson.

This story explores two separate approaches to business; the Loren Shaw (Fredric March) approach is one based on reverence for the bottom line no matter what methods are used to achieve it. He engages in blackmail to achieve his position, is proud of accounting tricks to reduce tax incidence, and is willing to push low quality products to reduce costs. The alternative is the MacDonald Walling (William Holden) approach based on hard work and innovation. Walling is the VP in charge of research at the furniture plant. His primary goal is to produce superior products that customers will desire and the workers themselves can be proud to make.

The moral superiority of one approach over the other is obvious by the end of the movie. Clearly greed inspiring hard work, innovation and pride wins out over greed inspiring fraud, blackmail and accounting tricks.

I’m sure Oliver Stone, knows these lessons. Stone provides the commentary on the Executive Suite DVD so he knows that movie well. I’m also quite sure that the producers of Wall Street don’t consider the money they will make on the movie to be objectionable. And there is good reason for that. It isn’t objectionable. Hollywood is making money by producing services that people wish to purchase in the marketplace. If they produce a superior service, they’ll make lots of money and it will satisfy their greed. That’s OK because they are following the Walling approach. It’s just too bad they don’t get that message across in today’s movies.

In America today, we need to resurrect the Walling approach to business. We need to be reminded how aspiration, inspiration and greed, appropriately directed, can generate a workplace filled with well-treated, motivated, workers striving to produce a superior product for its customers. Indeed, Hollywood can show us a way out of the current economic crisis; too bad it is not today’s Hollywood.

Originally published on September 20, 2010

The US trade deficit with China has become a lightning rod for discontent in the US Congress especially since the Chinese have responded so slowly to US requests/demands to revalue their currency. Indeed everyone seems to accept that the undervalued yuan is, at the least, responsible for our slow recovery and, at the most, is a major cause of the global imbalances that set off the economic crisis in the first place. The popular impression though, that the undervalued yuan has benefited China at the expense of the US and the rest of the world, is misguided. As with most public policy discussions it is common to hear only one side of the story. This post is meant to highlight the expected costs for the US of a Chinese revaluation; the part of the story that is not often told.

The exchange rate is simply a price, a terms of exchange between two countries currencies, and as with any other product, price changes in either direction will help some and hurt others. In particular, an undervalued currency makes Chinese goods cheaper for Americans. This is one reason for the high level of imports from China and it is what leads to lower priced clothing, and toys, and garden tools, and appliances, and tires and all sorts of other things. In many cases the less expensive products are those purchased by lower income families who shop at Walmart and Target etc. If China raises its currency value significantly, as is desired by the US government, then these products will surely become more expensive. Low income households will suffer a reduction in their real incomes because the prices of the goods they buy will increase.

Curiously, the hope for the revaluation is that Chinese goods will become more expensive, thereby allowing US companies to compete easier by raising their prices, expanding US production and creating more jobs. Indeed, the more the prices rise and the more poor households are hurt, the more jobs in the sector will be created. This is great for an unemployed worker since having a job and paying higher prices is probably better than no job and lower prices. However, for the 90% of workers who are already employed they will just face higher prices.

Further, there is a chance that both the price effect and the job effect will be small. If importers respond to the higher Chinese prices by shifting their imports from other countries like Vietnam and Malaysia, then the US prices may not rise as much and poor families will be hurt less. However, that will also mean fewer jobs created.

Secondly, the Chinese can maintain their fixed exchange rate at a rate considered too low only by buying dollars on the foreign exchange market. These acquired dollars have been lent back to the US mostly in the form of loans when they purchase Treasury bonds. If the Chinese revalue their currency then they will lend less money to the US government.

This would come at a time when the US is borrowing more and more to finance its stimulus programs and is running larger deficits than ever before. These deficits are there, it is said, to fuel demand and allow for the creation of more jobs. However, if a source of funds to finance this spending is reduced then the US will be hurt in several possible ways. First, we might respond to the reduced Chinese lending by reducing the deficit accordingly. That would reduce government demand, presumably, and would reduce the jobs created out of that spending. In this case, the change in the Chinese currency value might create some jobs in the import competing sector while reducing jobs arising out of government spending.

Alternatively, the US could maintain its government budget deficit and borrow the money from someone else. However, to acquire extra funds may require higher interest rates to make them attractive. That would cost US taxpayers more, if not now, then in the future.

The point of this post is that a Chinese revaluation is not obviously a good thing for the US, as it has been portrayed. Instead it would have both positive and negative effects for the American people. Furthermore, it is not at all clear that the positive effects would outweigh the negative effects.

Originally published on September 17, 2010

The WSJ has a good piece today (China’s Real Monetary Problem) providing better details about problems associated with the fixed value of the Chinese yuan. In particular the article explains the process of sterilization. Let me elaborate on some of the details. (see here for a textbook version of this)

In China’s case for the past 10 years or so, there has been an excess demand for yuan on the foreign exchange market that has required the Chinese central bank (CCB) to purchase dollars and sell yuan to satisfy that demand and to maintain the fixed exchange rate. If the CCB did not intervene in this way, the yuan would appreciate with respect to the dollar. By keeping the yuan at a value that is lower than what the market would choose, of course, Chinese goods remain lower in price for US purchasers. However, the foreign exchange intervention, if this is all that were done, should have another internal effect; namely the process will cause an increase in the yuan money supply internally forcing two effects. First, more yuan in circulation would lower yuan interest rates and in a world with highly free capital mobility between countries (between the US and China it is just slightly free) the lower interest rates would ultimately reduce demand for yuan by foreign investors. In the longer term, the higher yuan money supply would cause inflation and as yuan prices increase, even though the exchange rate remains fixed, Chinese goods would become more expensive to US importers and the demand for Chinese yuan would fall. In other words, internal adjustments will compensate for the lack of external adjustments.

However, the Chinese do not want inflation to rise up in their economy. They want to keep the economy on as even a keel as possible. This is the reason they sterilize. Sterilization means that for each billion US dollars purchased form foreign investors and traders to maintain the exchange rate, the CCB sells a billion dollars worth of Chinese government securities and thereby buys up the extra yuan that would have been floated on the market. In this way the internal economy is not upset by the foreign exchange intervention. The problem of course is that this also will mean that both interest rates will not fall and prices will not rise internally and therefore the excess demand for yuan will not be eliminated.

Thus the point of the article is that the problem is not the fixity of the exchange rate but the sterilization that takes place. Eliminate the sterilization and China can go ahead and keep the fixed exchange rate since internal adjustment will allow for the gradual adjustment of the trade imbalances.

Originally published on January 20, 2010

I received the following request that I am happy to post. A return to normalcy is going to take a long time in Haiti and relief crews will need resources long after the event has passed. Please consider donating to the following organization.

International Medical Corps is a global, humanitarian, nonprofit organization, founded by volunteer doctors and nurses and dedicated to saving lives and relieving suffering through relief and development programs. Our emergency response team is in Haiti responding in force. There are still thousands of patients seeking treatment of which approximately 80% are in need of surgery and are running out of time – especially with the tremendous aftershocks still devastating this country. The team is treating crush injuries, trauma, substantial wound care, shock and other critical cases with the few available supplies – And they’re in it for the long haul.

Please check out the following link and give if you can:

http://www.imcworldwide.org/haiti

Thanks very much.

Originally published on December 3, 2009

As I was reading the WSJ article today on the new doubts about the credibility of climate science I thought this situation might be analogous to something in the science of economics: the distinction between micro and macro.

First, it is easy to see the amazing advances of science right before our eyes. Science has made the computer and television and cellphones and airline travel and all sorts of other things possible. Similarly, in economics we understand all sorts of simple interactions between households and businesses and governments. We are confident that higher prices will almost always reduce demand, we know that tariffs will reduce imports and benefit domestic industries, and we know that too much money chasing too few goods will be inflationary. This interactions and these simple applications are “micro” in their orientation because they attempt to understand or explain only what is happening in a narrow range. In this micro realm we do pretty well in both science and economics.

However, climate science is “macro” in its focus not micro. Climate science is trying to link together numerous cause and effect relationships and use that to make projections and predictions about our climate 50-100 years into the future. In a similar way macroeconomics takes basic micro principles and tries to explain and predict the complex workings of our domestic and international economy. Economists should have been aware long before the current economic crisis that our predictive power over the economy is extremely limited … that is, unless we assume current trends continue (a brave assumption) and if we don’t try to project very far into the future (not very satisfying).

My point is that economics does pretty well at the micro level. It helps us understand simple cause and effect relationships and can be applied in a variety of helpful ways at a small scale. Similarly with science. However, at the macro level economics fares pretty poorly, not because we don’t understand the possible interrelationships, but rather because it is just too complicated a system to make prediction credible. Likewise then with climate science. The underlying mechanics of the science, that is the micro relationships, may have great consensus in the scientific community, but applying those principles at the global level may be as difficult or impossible as it is in economics.

Originally published on November 27, 2009

Charles Krauthammer’s appeal today for three simple fixes to our current health care problems seems perfectly sensible, reasonable and low in risk. Although these fixes (malpractice reform, interstate competition and deductability reform) even if well designed and fully implemented may not solve all of the problems with the health care/health insurance system, they are likely to step the system in a favorable direction. Most importantly though, they are changes that are low in risk because they do not involve a complete revamping of the entire system and more importantly, if they didn’t work they would be more easily reversible.

The problem is that simple fixes such as these are politically impossible to implement. As he highlights, powerful special interests have prevented any of these ideas from rising to the top. This is a standard story in Washington. Although the motivation for reform is to help the “consumer” of health care, the way in which reform is implemented is to protect, or advance, the interests of particular special interests like the trial lawyers group, or the union workers, or the health insurance industry. Each of these groups represent a small share of the US economy and still they command a disproportionate effect over the policy choices considered by the government.

I’ll admit that I don’t know many of the details of the current bill, but I am confident that for each set of passages in the 2000+ page bill there is a small group of individuals who recognize that the rules described in that passage will open up an opportunity for them: e.g. Group X sees benefits on pages 355, Group Y sees benefits on page 1567, etc. For the general consumer though, no one can point to a particular passage … instead consumers are expected to have faith that somehow this complicated new system will work to their benefit.

The political process that generates these kinds of outcomes is what needs fixing. Unfortunately, I haven’t heard many good ideas about how to do that. Mostly politicians say we need more “resolve.” Fred Barnes writes about this problem in today’s WSJ. He highlights how little President Obama has been able to accomplish regarding his campaign promises to change the lobbying culture in Washington. Indeed the problem has probably gotten worse. The reason is simple .. put more money on the table and more people show up to try to secure a share of it. The reverse is surely true too … put less money on the table (i.e., reduce the size of the government) and fewer people will show up. Of course, how to do that seems to be even more impossible in today’s economic climate.

Originally published on November 19, 2009

An article in the WSJ by Ron Paul and Jim DeMint today discusses the issues of FED independence and transparency. They mention a “puzzling assertion made by the Fed and its supporters … that the Federal Reserve has some sort of independence from the government.” They continue to argue that the FED is not independent, but instead is a government run monopoly whose mandate to maintain stable prices has caused them to expand the money supply thereby causing an inflationary effect rather than, what they claim to be, the natural deflationary tendency caused by ever rising productivity. Indeed in their first paragraph they mention that in the past 96 years the US dollar has lost 95% of its purchasing power.

OK, but here’s what they haven’t mentioned. First, one problem with deflation, especially if it’s persistent, is that it can slow down the growth of economies. The reason is that expectations that prices will soon fall will make consumers and businesses hold off on purchases waiting until they can get the better deal. Anyone buying a computer in the past few decades knows how frustrating it can be to buy when you know that in 6 months the same expenditure will get you a faster computer with more features. Thus deflation can reduce the velocity of money, or the rate at which transactions are made. For this reason it makes some sense to maintain a low and steady inflation rate.

The second thing they fail to mention is the experience of many other countries that did not have semi-independent central banks. The problem that often arises is that legislatures are pressured to raise government spending and programs, thereby pleasing voters, but are reluctant to increase taxes to pay for these programs, which will clearly displease voters. Borrowing to finance a government deficit is always the next option, but sometimes this can be expensive especially if the government is running up large and potentially unsustainable deficits forcing them to raise interest rates to a high level to attract lenders. (currently the US has the large deficits, but not yet the very high interest rates). The other option, which seems relatively painless, is to force the central bank to “lend” the government the money it needs to finance its large deficit. Of course, central bank lending also means the printing of money, which if not counteracted by a drop in money elsewhere, is certain to have inflationary consequences.

Studies in the past have suggested that countries who have had severe hyperinflations in the past (e.g. Latin American countries in the 70s and 80s) are also those whose central bank was NOT semi-independent from its legislature. However, the countries whose central banks are more independent, like the US, have had a much lower inflationary path.

Thus, there are some good reasons to maintain FED independence that have been overlooked in this article. That’s my main point!

Originally published on November 12, 2009

The Wall Street Journal today has two opinion pieces that highlight hidden details of the House health care bill that may have a major impact. The first article identifies a 69% capital gains tax increase that will hit high income individuals as of January 2011. The second identifies a nod to the trial lawyers that would encourage states to “identify an alternative medical liability law” to ensure a “fair resolution of disputes. However, the passage also states that States only qualify if its new law “does not limit attorney’s fees or impose caps on damages.”

As I mentioned in my previous posting, any bill in Congress typically has numerous add-on clauses inserted by different members of Congress. That’s what causes basic proposals to blossom to thousands of pages. But what I’d be interested in knowing is the source of each of these clauses. Ideally it would be great to know who wrote each passage. I suspect, because I have heard it mentioned, that the language in these clauses is typically written by the special interest group itself who then peddles it to a member of Congress to get it inserted into the bill. These interest groups “write” most of these bills … and yet the public has no knowledge about the authors. I wonder how many authors there are in this health care bill!!

One way to fix this imperfect information problem might be to require that every passage of a bill have authorship attached. In this way the public who will be affected by the bill would have better information concerning the role of special interests in shaping particular pieces of legislation.

Of course this might be impractical especially when a passage is changed and adjusted by numerous individuals during its development. Nonetheless, each passage should have no more than a handful of “major” authors. Another problem with such a proposal is that many interest groups wouldn’t want the public to know that they authored particular clauses (eg the trial lawyers’ association). As a result, a requirement to display authorship would quickly lead to diversionary tactics. Interest groups might outsource the writing of bills to independent consulting groups. Or, the true authorship might simply be fabricated.

Alternatively, each clause could be identified with the Congress member who inserted it. Possibly this info is already available. If so it could be helpful to publicize that info and discuss it more widely.

Although, having more of this information, especially for such major legislation as the health care bill or cap-and-trade, would be very revealing, it seems impractical to simply legislate reporting requirements. Thus, the next best alternative in a free society is to encourage more reporters, bloggers and other interested parties, to investigate these details and make it available more widely. The WSJ has done some of that work today. Surely much more of it has been done in other publications.

If you know of some, and have a link, please post it here.

Originally published on August 20, 2009

I have to admit that this whole health care debate confuses me. I understand some of the main problems with the current system; things like non-portability of insurance across jobs and across states, the high incidence of medical malpractice lawsuits, the large numbers of people uninsured, and the rapidly rising costs. Clearly the current system has major problems and may be unsustainable in the long term. But what I can’t figure out by reading the popular press, listening to the pundits, or reading blogs is what is the central core of the health care reform proposal and how precisely does it solve these particular problems?

There are several reasons I think an answer to these basic questions are hard to come by.First, there isn’t one reform proposal out there.Different legislators have different plans and different ideas they hope to integrate into whatever becomes the final bill.As a result discussion of the issue gets distracted away from the core elements of the plan to its particular features … like the brouhaha about death panels for example.Or, the discussion becomes overly abstract, like, do we want socialism or not?

Another problem arises because of the way democratic reform works in our system. Any legislator who wishes to revamp the health care system may begin with a core plan and a simple structure to solve some of the major problems. However, as the legislation works its way through committees and is discussed among stakeholders (and bear in mind with health care reform, everyone is a stakeholder) amendments are made to the core legislation. First the powerful groups will weigh in. The insurance companies will suggests adjustments to the legislation to assuage their concerns and the changes will be added to appease that group. The American Medical Assn. representing physician interests will weigh in and propose changes and adjustments. The pharmaceutical companies will propose some changes and they will be included. Etcetera, etcetera, etcetera.

By the time a final bill is passed in committee and moved into the House or Senate, any simple plan that was originally proposed has now become a monster bill with so many pages and so many qualifications and special regulations that nobody – nobody at all – can understand the full ramifications.

This is one reason supporters begin speaking in platitudes. For example, President Obama said this week “What is truly scary—what is truly risky—is if we do nothing,”and “We can’t keep the system the way it is right now,”Since no one knows all of the specifics of the bill, not even the President, it is only really possible to talk about it in very general, one might say political, terms.

This is also why opponents search out and focus attention on the specific and suspicious minor clauses and raise these to the head of the debate.(like death panels)In any bill of monster proportions there will be plenty to object to and it is never hard to shine the spotlight on these and thereby cast doubt upon the entire proposal.

It is true that this is the way compromise works in a democracy.All interested parties have a chance to voice their concerns.Legislators weigh the importance of each argument, and amend the legislation whenever doing so pleases an important group.In the end every legislator cares primarily about making enough people happy so that they themselves can secure reelection in the future.That’s surely why the most influential groups are the one’s with the most money, who can, at least indirectly, influence the greatest future number of votes.

However, although the democratic system facilitates compromise of this sort, that doesn’t mean it generates an efficient or even a reasonable outcome. The main thing that concerns me is that complexity breeds inefficiency.The greater the number of special conditions and clauses here are in the bill, the harder it will be for system participants to figure it all out.That means health insurance companies, hospitals, pharmaceutical companies and others will all need to hire consultants and specialists to maneuver most effectively through the tangle of regulations.For well-educated professionals that will mean more jobs and higher salaries.But the more of these administrative jobs are needed to wade through the system, the more time and effort will be spent on that and the less time and effort will be spent delivering high quality healthcare.Or, if the amount of healthcare provided is maintainable, then the overall price tag will rise to pay for all of the extra administration.

So here’s what I’d like to see before supporting any kind of health policy reform. First I’d like to see a short, sweet and simple proposal; not one that’s thousands of pages long. Of course this is well nigh impossible since it would mean all the special interests would have to take out all their favorite clauses and the chances they would do that are virtually zero.

OK then, if this can’t be done then at least I’d like to see a proposal that is simple enough so that it can be explained to the average American.Someone, President Obama preferably, needs to be able to point to the different components of the bill and explain how and why it’s an effective means to solve the health care problems.How will it reduce costs … don’t just proclaim that it will?How will it solve the portability issue?How will it cover all Americans?Until at least this happens I think it’s far better if nothing is done at all.

Originally published on June 29, 2009

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.

Originally published on June 22, 2009

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??

Originally published on June 11, 2009

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.

Originally published on June 3, 2009

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.

Originally published on May 21, 2009

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)

Originally published on May 20, 2009

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!

Originally published on May 6, 2009

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.

Originally published on May 4, 2009

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.

Originally published on April 27, 2009

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.

Originally published on April 23, 2009

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.

Originally published on April 6, 2009

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.

Originally published on March 30, 2009

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.

Originally published on February 13, 2009

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.

Originally published on January 27, 2009

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.

Originally published on January 21, 2009

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.

Originally published on 01/14/2009

Here’s the logic behind the fiscal stimulus. Because of falling wealth levels and rising unemployment, household and business demand for goods and services is falling. Instead of spending money as quickly as they once did, households save more, either keeping more currency at home or maintaining larger bank balances. In normal times, any money deposited in banks is lent out (mostly) to other households and businesses who wish to spend more for the moment. If there isn’t enough demand for bank loans, banks will lower the interest rate to stimulate the extra demand. However, today, banks are more afraid to lend to others because they are worried that many households and businesses will become insolvent and be unable to repay the loans in the future.

Thus, the circulation of money – what’s known as money velocity – from businesses to households and back to businesses is slowed. One way to get things moving again is to pump more money into the system. This is what the FED has already done with expansionary monetary policy and lower interest rates. However, if much of the extra money the FED has pumped in is simply held onto by households, businesses and banks then demand for goods and services continues to stagnate. It does no good.

However if the government comes along in a period of slowed private demand and substitutes for that demand with extra government demand for goods and services, then presumably GDP can be maintained at near current levels. In other words, suppose for every dollar that is not spent by households, the government demands one extra dollar of goods or services, then total demand in the economy is maintained. Businesses could then continue producing at previous levels and they would not need to lay off workers. Hence by quickly substituting government demand for the declining household demand, GDP and employment is kept near the original level and a severe recession can be prevented.

That’s the logic at least. The next post will highlight some problems that could make a fiscal stimulus possibly not so effective.

Originally published on 01/09/2009

In economics there is a theory that can help a policy maker determine the most efficient, or most effective, policy to solve a particular problem. The theory is known as the theory of the second-best. Without going into the details (you can read more about the theory here) it says that the best way to correct for an economic problem is to choose a policy that will attack the problem in the most direct way possible, one that really goes to the heart of the matter. Such a policy choice is called a first-best policy, while all other policies, which may correct the problem somewhat but less effectively, are called second-best policies.

For example, in a trading context, if the problem is rising unemployment because of surging imports, some policymakers might suggest a tariff to remove the competitive pressure caused by imports and thus save jobs. However, this policy would be a second-best policy since the source of the problem isn’t really the imports. Instead the real economic problem is the unemployment that is caused because workers cannot easily find new jobs once released from the import-competing firms. Given the changed trade circumstances, shifting workers quickly to the next most effective industry is the best way to realize the full potential of the country’s comparative advantage. Thus, a more effective policy, i.e., a first-best policy, would be one that targets worker mobility in the labor market and assists workers to find new jobs as quickly as possible.

In light of our current macroeconomic crisis, we can evaluate proposed policies in a similar way. For example, to decide whether the $775 billion fiscal spending package proposed by President-elect Obama yesterday, is the right policy for us to implement, we might ask to what extent it gets at the heart of the problem. In other words is a massive fiscal stimulus package a first-best or second-best policy option?

To answer this we need to first identify what the heart of the problem is. Although I’m sure some would disagree, it seems to me that the underlying cause of our current predicament is relatively simple. First, the crisis was surely set off because of the large number of mortgage foreclosures last year, which caused falling housing prices and a drop in construction activity. This in turn led to the crisis in confidence in the financial industry in September when financial institutions could not easily value their mortgage backed securities, forced several financial giants into bankruptcy or buyouts, and led to the curtailment of lending. The drop in confidence in the financial sector and the future economy led businesses and households to sell off stocks causing the plummeting market values and a loss of over $1 trillion in wealth – this on top of the losses everyone was experiencing in the real estate market. Faced with an impending and severe recession most households have become frugal, first because they all feel poorer, (despite the fact that many have no plans to spend their retirement funds or use the equity in their houses soon), and second because they fear a near-term job loss.

So next we can ask how well the proposed fiscal stimulus program will do to solve the underlying problems … but all that will have to wait for another post. Stay tuned.

Originally published on 01/08/2009

A WSJ article today titled, Steel’s Buy America Ploy, discusses a simple method a US industry can use to get government support to sustain it against its competition without asking for a handout. By asking for Buy America clauses in the expected-to-be-gigantic infrastructure spending plan, the steel industry and other US materials supply companies will receive protection against foreign competitors. This amounts to a “pick the winners” strategy since US companies will receive contracts regardless of their efficiency (except vis-a-vis each other). Foreign suppliers would be locked out of this substantial business regardless of the quality and cost of their products. As a result, every project will cost more for the US taxpayer than is necessary.

What many don’t realize is that a Buy America clause, which sounds patriotic and perfectly reasonable to many observers, is equivalent to raising tariffs against these imported projects just like the notorious Smoot-Hawley tariffs of 1930. It is protectionism in another form. However, since it’s in another form, it may be possible that this action will attract substantial Congressional support since legislators can always proclaim afterwards that they didn’t raise tariffs like in the 1930s.

Will Congress and President Obama succumb to this protectionist pressure? We’ll have to wait and see. But for those convinced of the positive competitive effects of free markets, it is important to raise awareness that Buy America is just disguised protectionism.

Originally published on 01/07/2009

In “Boost Private Investment to Boost the Economy,” Hal Varian provides an excellent, succinct description in today’s WSJ of the basic problems we face in the economy today. He starts by saying,

These days it seems like it is our patriotic duty to consume more. And if we don’t choose to spend more money ourselves, the government will do it for us.

But wait a minute. Isn’t it excessive spending that got us into this mess in the first place? Spending more now seems like drinking Scotch to cure a hangover.

This apparent paradox is straightforward to explain. The problem is that excessive spending by some individuals, facilitated by easy credit, put them under water in a market with declining property values. The subsequent defaults, and the prospect of future defaults, weakened the financial sector by substantially raising the risk of borrowing, and hence lending slowed precipitously last summer. The meltdown in finance in September inspired the FED/Treasury interventions designed to preserve confidence in the system but at the same time inspired fear across the world by revealing the likelihood that the economy would plummet into a recession.

The average household around the world is now faced with two financial problems, even if they have not previously overborrowed and are not underwater on their mortgage. First, household wealth has fallen with the drop in real estate and stock markets, thus everyone feels poorer – since on paper they are. Second, the prospect of a possibly severe recession, with rapidly rising unemployment, raises the chances that one will lose his or her job. The natural response to both of these realities is to protect what one has by spending less and saving more.

Unfortunately when everyone consumes less and saves more at the same time, the economy gets worse rather than better, especially, as Varian points out, when that savings does not flow into additional private investment as it would in normal times.

If only we could inspire all of the people who will not lose their jobs and who are not underwater on their mortgages (and this describes most people in the economy) to spend and consume like they have traditionally done, then the economy would not sink so deeply. Unfortunately, no one knows whose jobs will be safe – there is no way to predict that – and hence it makes individual sense to be cautious in spending.

But what I wanted to emphasize in this post is that we should be cautious about broad sweeping statements to describe the economy. For example, we should not say that Americans have borrowed excessively and spent too freely, because this describes only some Americans, not all. Many Americans are living within their means, although we never hear about this in the popular press because people always present the averages, or the popular impressions, as if that describes everybody equally.

Thus, it is true that some Americans have borrowed excessively and been forced into default and it is also true that the size and extent of these defaults have crippled our financial system for the moment. However, at the same time it would be best if those households who have not overborrowed would maintain their consumption at previous levels. Since that seems unlikely to happen naturally, for the reasons described above, massive government spending plans, with all their inherent complications and difficulties, are the policy choice of the day.

Originally published on 10/23/2008

Governments around the world moved quickly this month to shore up their economies by announcing major rescue plans for their banks. The intention by central banks everywhere is to restore confidence in the financial sector by guaranteeing a source of liquidity. Depositors will know that the protected banks will not be allowed to fail.

Although these actions will keep the major banks solvent, they cannot assure a continuation of business as usual. The real sector of the economy is only beginning to be seriously affected. After watching housing prices tumble over the past year, and share prices tumble even faster during the past month, consumers will naturally begin to reduce their spending. Demand for big screen TVs, new automobiles, and home renovations, to name just a few, will fall swiftly as consumers tighten their belts, in part because they are less wealthy than before, and in part because they will fear a possible job loss in the near future.

Reduced consumer spending will have several effects. The immediate effect is to put numerous firms at risk of failure. Not every TV, automobile or home renovation firm will fail, but some will. Workers in those firms will lose their jobs and unemployment will rise. These changes will reinforce the loss of consumer confidence even among consumers who keep their jobs. Thus, there is a reinforcing effect: a drop in demand causes job losses, which inspire a continued drop in demand.

Reduced spending by consumers may raise available savings in the financial sector. In normal times, the increase in deposits can lead to an increase in lending at reduced interest rates to businesses seeking to expand or to other consumers anxious to spend. Unfortunately though very few businesses will be able to expand with a deepening recession and there will be very few consumers eager to spend. In addition, normal lending is probably a thing of the past for a while. Even nationalized banks, with an assured source of liquidity, will not be quick to lend to others. Recall that the onset of the credit crunch developed because the market for mortgage-backed securities (MBS) disappeared. When the market prices of these securities fell to near zero, using mark-to-market accounting, numerous institutions were possibly insolvent, but no one knew which ones. In this case, even a short-term loan to a major company may not yield a positive return if the company is on the brink of bankruptcy. In addition, lending risks rise because the onset of a recession means that a greater percentage of these firms are going to fail – thus it may be best not to lend, or at the least to be very, very careful.

So what to do about the crisis? Is it appropriate to bail out the banks? Are the bank bailouts enough?

First, the bank bailouts are an unfortunate necessity. It is in everyone’s interest for the financial system to remain sound and to prevent significant bank runs. The conditions in the bailout plans are particularly onerous though, with high interest rates on preference shares, to restrictions on future dividends and caps on CEO salaries. These conditions, while necessary to make the plans politically palatable, also reduce the chances of success. For example, in the original US plan to buy MBS, the legislature added protections to reduce risk to the taxpayers. However, the whole point of intervention is for the government to “assume” the risk so the private sector can get back to business. That’s what is needed to restore confidence. Also, because of time delays, by the time the MBS purchase plan was approved the financial problem had cascaded to a liquidity problem and the US was forced to refocus on bank buyouts. For the moment the “toxic” debt remains on the books though, which means the insolvency problem continues.

Moving forward it is critically important for every political leader to speak confidently about the prospects for a quick recovery. The recession will be longer if policymakers keep squabbling over the details of the rescue plans or if prominent individuals announce that this or that proposal has no chance of working. Most importantly, leaders must assure its citizens that the quick and massive government interventions will prevent the recurrence of a Great Depression. After coordinating policies within and across countries, governments must then project a unified, consistent and positive message. If they do so, the world economy will be back on track within several quarters.

Originally published on 09/27/2008

The Southeast is experiencing a temporary gas shortage due to last week’s hurricane in the Gulf states. The effect has been long lines at the pumps, gas stations running out of gas, and a huge amount of anxiety for the residents of Georgia, Tennesee and the Carolinas.

Twitter is a-twitter with information about gasoline availabilities in the Atlanta area with messages like these:

“BP on Roswell Rd in Sandy Springs has gas, 40+ car line, cops and an ambulance present”

“Costco sandy springs is now out of gas”

“I was just told by phone Costco Dunwoody has gas. 90 mins wait. Members only”

“I’m searching for gas near cumberland mall or ponce and moreland or anywhere in between, Thanks!”

Bloggers have also related their experiences:

I have been looking all around for gas and I have already called my boss and told him that I might not be able to work tomorrow. I also might not get to see my daughter this weekend. Thanks Gov. Perdue! Your delayed reactions have costed you my vote. – Helpless

 

When this gas crisis first hit a week or so ago, I didn’t rush out and fill my tanks or engage in any of the so-called “panic” behavior. This past weekend, my small, rural hometown ran completely out of gas. Closest station with gas was 18 miles away. Luckily, I had some gas in a jug that I keep for my lawnmower. Lesson learned. Now, whenever I get below a half tank, I’m topping off. – Lee

Two hours, six gas stations, and two $25-fill-ups later, I have a full tank for the first time in two weeks. Now I understand why other people have been topping off every chance they get…. – concerned

Why does a shortage warrant raising of the prices??? I see where some stations are going to be investigated, but who is investigating why it is still over $4 a gallon?? – cin

The curious thing is that all of this waiting, panic, and anxiety is completely unnecessary if people could simply understand and accept the functioning of a free market. The market, however is not free in these states because the governments have imposed price gouging laws to prevent service stations from raising their prices when supplies are lower than normal. Indeed, in Georgia alone 1300 price gouging complaints have been filed and 130 service stations are under investigation.

The market solution is simple: allow service stations to charge whatever they want. Yes, allow them to “price gouge”! If they were allowed to do so, here’s what would happen.

First, as soon as service stations learned that they would not be receiving the same frequency of gas shipments, they would immediately raise their prices. Each station’s objective would be to reduce demand so that the supply they have remaining would last until their next shipment. They would also make more money per gallon, but given the shortage they will be selling less gas over the week too. And yes, it will maximize their profits.

When supply conditions change suddenly and unexpectedly the stations will not be sure what price to set. Ideally they would like to set a price such that the last gallon of gasoline in their storage tanks is sold just as the tanker truck arrives to fill them up again. But this will be difficult to do. A higher price will normally reduce demand, but by how much will be greatly uncertain. It will also depend on what the prices and supplies are among competing stations in the neighborhood. If other stations increase by more, one station may even see its demand increase despite a higher price. If this happens the station should respond by raising its price even more to moderate its sales. If demand falls too much they should adjust downward. The greater the uncertainty, the greater the volatility in the prices.

Some firms may overreact relative to their competitors. Maybe a station will raise its price to $8 a gallon. What to do about this? As the Beatles would sing: “Let it Be! Let it be-ee! Let it Be! Let it Be!” A station that greatly overprices will discover it has no demand, since there will be other stations open with cheaper gas. Eventually one of two things will happen. Either , this high priced station will recognize that a new gas shipment will soon arrive and to make any profit at all, will be forced to lower its price, perhaps below its competition for awhile. Or, this station will watch as those firms who underpriced run out of gasoline and people are forced to buy the $8 gas. If the latter happens this high priced station, and others like it, will be the ones that provide the greatest public service. That’s because if shortages are that significant, these stations will be the ones that assure that there will always be a service station open and everyone will always be free to go in and buy as much as they like.

What’s the effect for consumers. Well, undoubtedly they will pay more for gasoline and they won’t be happy. But, the higher price will cause many of them to reduce their consumption. Especially in this case, because the supply disruption is expected to be temporary, those who don’t absolutely need to fill up, won’t. Those who only need a little gas, will fill up a little, also waiting for later when the price will go down. But the most important effect for consumers is that if the stations are allowed to raise their prices to whatever they want, then there will always be open gas stations and there will be no lines. For everyone with an unexpected emergency, for example a person with a parent that suddenly becomes ill across the state, they will at any moment, day or night, be able to find a station that’s open and be able fill up their tank. With no lines consumers will not have to consider the what if question: namely what if there is no gas tomorrow or next week when I really need it?

Because of the lines and the closed stations, all the consumers in the southeast are asking that question today. And, because the market doesn’t work right, they are responding by filling up their tanks every chance they get and filling up gas cans on top of that … all of which makes the situation worse. They’re behavior, which is perfectly rational and reasonable given the situation, causes stations to run out of gas, creates lines at every station that is open, and raises the anxiety and in some cases the panic among the population.

So, the solution to the chaos is simple. Eliminate the price gouging laws and leave the firms free to charge whatever they want. By doing so, the government and the service stations would be providing a public service; namely the elimination of wasteful gas lines and its associated anxiety.

Originally published on 09/05/2008

Here’s an informative article in today’s Wall Street Journal about the trade-offs between bilateral free trade areas and how they may affect the multilateral discussions in the Doha round of the WTO.

Originally published on 08/04/2008

The failure of the Doha round talks last week is one sign among many that the conventional reciprocal concession approach to trade liberalization is becoming ineffectual. With so many issues on the agenda and so many countries involved, it may now be impossible to reach any meaningful agreement to substantially reduce trade barriers. Perhaps the time is ripe for a new approach.

If the American Presidential candidates are sincere about making a true break from the past and if they truly want America to shine as an example worthy of emulation then here is one idea worth considering.

American Unilateral Trade Liberalization

Rather than enduring the endless discussions of “we’ll give you a little , if you give us a little (i.e., liberalization)” perhaps it is time for America to lead by example. By announcing a plan for a gradual transition to complete free trade, over perhaps the next five years, the US could disengage from the entire negotiation process. We might immediately announce zero barriers on all goods coming from the least developed countries, (despite GSP and other trade concessions to the LDCs, we continue to maintain barriers on agricultural and textile products from many countries). These changes would induce substantial adjustment in some sectors and admittedly many businesses will disappear. But, as they do, new businesses will appear. And these new businesses will capture some of the new markets in this dynamic and ever changing world.

The one feature about the future that all should be able to accept is that it will be significantly different from the present. How it will differ no one knows. But for a country to be economically successful in this environment, it must get used to continual change and be prepared to adjust. Indeed the more we practice and endure economic adjustments, the better our businesses and workers will be at it.

But what about the unfair trade policies that US competitors will keep in place? What should we do about that? The answer; adjust to them. The US economy is the largest most innovative and dynamic economy in the world. If we want it to remain an economic superpower then we should respond to foreign economic practices with a “bring it on” kind of attitude. If foreign governments subsidize certain export products, then let’s buy up the cheaper goods and produce something else. If a country maintains a low valued exchange rate, then let businesses adjust to the prevailing prices and produce something else. If foreign countries repond and remove their own protections, then US firms should adjust to fill void. – Jack be nimble, Jack be quick. – If we establish an economy that thrives on adjustment, then the US will weather any economic storm, including the competitive pressures that will surely come from China, India and others.

Tony Blair, the former prime minister of Great Britain, once did an excellent job describing the appropriate worker and societal attitudes that are necessary to maintain a strong vibrant economy when he said,

“The character of this changing world is indifferent to tradition, unforgiving of frailty, no respecter of past reputations. It has no custom and practice. It is replete with opportunities, but they only go to those swift to adapt, slow to complain, open, willing and able to change. Unless we “own” the future, unless our values are matched by a completely honest understanding of the reality now upon us and the next about to hit us, we will fail. … in the era of rapid globalization, there is no mystery about what works — an open, liberal economy, prepared constantly to change to remain competitive.”

Blair’s, “slow to complain” remark is consistent with Phil Gramm’s concern that the US has become a nation of whiners. Complaining about foreign trade or wage or exchange rate practices, and forcing foreign countries into countless discussions about what they need to do to make us better off are not the actions of a strong leader. Rather they are the actions of a giant who feels threatened of being toppled.

But, to achieve anything as radical as a proposal to move to unilateral fee trade, requires a leader who is willing and able to present a vision of a future America that is based on strength, resilience, nimbleness and sacrifice. These are characteristics that are needed to make unilateral free trade a winning strategy. And these are the characteristics most Americans would be proud to rally around.

Now if we can only find a leader who can be so inspirational. I confess I haven’t seen it in this election.

Originally published on 07/08/2008

People love to watch a battle between fierce competitors and root for their side to win. To the victor goes the spoils. Sport is the modern equivalent of warfare, wherein battles can be waged every day to the delight of the competitors and the audiences. I suspect our desire for the spectacle is something that’s part of our evolutionary heritage; something so rooted within us that we cannot squelch it.

I watched the Wimbledon final last Sunday between Roger Federer and Rafael Nadal. It was the most intense tennis “battle” I have ever seen. Federer, the Tiger Woods of tennis, winner of 12 grand slam titles, the five time Wimbledon champion, looking to be the first in modern times to win six titles in a row. Nadal, his opponent for three years running at Wimbledon, the guy who dominates the French open as much as Federer does Wimbledon and who beat him handily in the French finals three years in a row, the guy whose game just keeps on improving and has looked invincible in all recent matches.

A tennis match is much like a battle between two gladiators. In this modern version no weapons are used and no blood is shed. Indeed, the players never even touch each other except for the final handshake. In some ways it’s also like a video game where each person has multiple lives. Each point that’s played is an attempt by one player to “kill” the other. Once the kill is complete, the score is noted, and the next battle ensues. When a player attains a sufficient number of kills, based on the odd scoring system, the winner is declared. In this match Nadal killed Federer 209 times to Federer’s 204 kills of Nadal.

The intensity is seen most clearly by the players and the audience when a rally rages for a long time and when one or both players make spectacular shots. Those shots are like unbelievable swipes of the sword or incredible defenses and close misses. These are the times when everyone’s adrenaline starts flowing. When a battle like that is won the victor instinctively screams and pumps his fist into the air. The audience does almost the same thing.

This instinctual desire to fight and kill an opponent carries over into many other venues beyond sport. One such place is politics, where the weapons are words. An example in the US today is the war of words in the media each day between conservative talk show hosts like Rush Limbaugh, Sean Hannity and Mark Levin versus liberal talk show hosts like Al Franken, Ed Schultz and Mike Malloy. As the verbal battle rages, each side does its level best to tear down the opposition.

Here’s a few examples,

Rush Limbaugh says,

“How many times have you sat here and heard me define liberalism as clearly and as explicitly as it can be? They hate the country.” [dead link]

and

“There is no rational explanation for liberalism, folks. One of the biggest mistakes we all make is trying to explain it rationally.” [dead link]

Rush Limbaugh also says he doesn’t want to win over liberals, he wants to DEFEAT liberals.

More colorfully Mark Levin call liberals “… a bunch of walking hemorrhoids!!!!”

On the other side Mike Malloy says about conservative Republicans,

“ … I defy you to locate a spark of humanity in their persona, their demeanor, their language, … they’re not human, they’re Republicans.”

I don’t know who started it, but there has lately been a book writing frenzy with titles designed to diss the opposition.

Al Franken, a comedian, liberal talk show host and now candidate for the US Senate, has written a series of books, one which is titled,

“Lies and the Lying Liars who Tell Them: A Fair and Balanced Look at the Right.”

Ann Coulter responds with books titled,

Slander: Liberal Lies About the American Right

and

If Democrats Had Any Brains, They’d Be Republicans

As the war of words escalates, the attacks became more personal, perhaps beginning with Al Franken’s book titled,

“Rush Limbaugh is a Big Fat Idiot and Other Observations,”

Rush Limbaugh makes personal attacks of his own on his show. Recently he said,

“Brian Lehrer is a good card-carrying New York liberal, and he’s very dull as a result. He’s very boring and very dry. And as such, is regaled as very intelligent.” [dead link]

A few more personal attacks in book titles include Joe McGuire’s

Brainless: The Lies and Lunacy of Ann Coulter

and Clint Willis’s

The I Hate Ann Coulter, Bill O’Reilly, Rush Limbaugh, Michael Savage, Sean Hannity. . . Reader

Natural human tendencies to battle each other carry over into politics as well as sport. Perhaps this is why talk show radio is so popular. Audiences likely respond to every verbal jab at the opposition in the same way they respond to a great passing shot. The sharper the criticism and the greater the personal invective, the more likely the audience will respond with an adrenaline rush and a fist pump in the air. This may be why the more outrageous the comments, the greater the audience. And of course, each attack by one side against the other invites a retaliatory response.

The question I have is whether turning politics into a sport is an effective way to discuss public policy issues. Does the choice process improve as the discussions become more competitive, or does it get worse? Do the discussions offer any hope of bringing people together, or do they merely continually fan the flames of contentiousness? Does any one side have any chance of defeating its opponent, or does the war go on forever? Should politics be waged like a competitive sport, or would it be better if people channeled their competitive natures on the tennis court, the football field, and the soccer pitch? (Or, possibly even in business?)

Originally published on 06/26/2008

Popular opinion is clearly rising up against the idea that free trade is a good thing. For an account of all of the problems associated with free trade, and none of the benefits, see David Sirota’s piece in the Huffington Post. This is a good example of how rhetoric is used to raise fears. Notice the language used in this article to describe trade agreements:

Tearing down tariffs and protections without regard for the consequences…

… a wage-cutting, environment-destroying, union-busting race to the bottom.

… slash their own wages to compete …

… to reduce their pollution controls and human rights …

… these deals are managed to enrich the elite …

… helping murderous developing-world governments continue to brutalize workers

… quadrennial cycle of deception …

… deranged trade fundamentalists who cloak economic terrorism in the language of enlightenment. ….

This writing is very colorful. It is interesting and exciting because it suggests a terrible conspiracy. The author has written a book called Trade Uprising that explains the growing negative sentiments against “so-called” free trade agreements. (no, I won’t provide a link!)

As the debate over globalization intensifies, though, these kinds of writings are extremely divisive. Sirota states that “it’s hard to argue with NAFTA backers because they aren’t interested in facts.” That’s not true at all. It’s hard to argue with NAFTA backers because those with opposing views have just called NAFTA backers elite, deceptive, environment destroyers, complicit with murderers, and deranged. Why should anyone have a dialogue with someone who seems so sure of his own answers and is filled with hatred towards anyone with opposing views?

Originally published on 05/20/2008

It is business as usual in the US Congress. For years the US has preached to developing countries around the world the benefits of free and open markets, unfettered by government taxes and regulations. However, the US continues to practice distorted trade replete with government subsidization in the area of agriculture. Although the US tells other countries in the Doha trade liberalization discussions that they need to do more to open their markets to US exports, the US (along with the Europeans, the Japanese and others) continue to do less. For two good articles discussing the issues see Sebastian Mallaby’s article in the Post yesterday and David Brooks’ piece in the NYT today.

People around the world are being held hostage by an industry that employs less than 2% of the workforce in the US. The US people say they want change in many areas. And, now is a perfect time to commit to change in agriculture especially because with rising world prices for food, subsidies and other supports could be more easily cut back without inflicting as much harm to the US farm industry. And still two US Presidential candidates (Obama and Clinton) support business as usual. McCain supports vetoing the bill. But even though McCain supports change, even if he were President there is little he could do about it. The Farm bill has a super majority support so that any veto (like President Bush in proposing) will be overridden by Congress and passed into law anyway.

This issue raises an important concern that the Presidential candidates are unwilling and unable to answer. Even if a candidate has great ideas about how to protect jobs, or revamp the health care system, or stimulate economic development, he or she must still work within the political process to effectuate the change. That requires dealing with all the special interests who will come out of the woodworks when any new plan is proposed. How will the candidates deal with that reality? I surely don’t know. Do they know?

Originally published on 05/14/2008

Robert Samuelson has an article today noting that the presidential candidates say things that will be virtually impossible to implement. He writes,

Candidates make alluring promises (to “fix the economy,” “defeat special interests” or “achieve energy independence”) and offer freebies to voters (more tax cuts, health care, college aid). … There’s a vast gap between the country’s problems and the candidates’ agendas and rhetoric. The candidates dissemble because they believe that Americans don’t want the truth. It would be too upsetting. They’re probably right.

He continues by noting that Presidents have very little power to control the massive economy, that dealing with budget deficit problems will require reduced spending or higher taxes, that high oil prices are largely outside of the President’s control, and that energy independence is a pipedream.

Many people recognize the disconnect between rhetoric and reality and it’s one reason politicians are often considered untrustworthy. But what’s the reason behind the disconnect? Samuelson suggests that the public doesn’t want to hear the truth. There’s something to that since the public would surely prefer to hear that public spending will increase, taxes will be reduced and the budget deficit will fall all at the same time.

However, another reason politicians cannot be more forthright is because of political retaliations. For example, John McCain said that he know less about the economy than he does about foreign policy. Given McCain’s extensive experience in foreign policy issues this is clearly a truthful statement. However, it is one statement McCain never should have made since now his opponents regularly proclaim that McCain himself says he doesn’t know anything about the economy.

Since rhetorical retaliations are used by all political parties equally, this suggests that the only “politically safe” posture for a politician to take is to assure the voters that you have answers for everything, and that your policies will have only benefits and will cost next to nothing. Or, if a policy proposal does cost something, that cost will be borne by the wealthy and never by the middle class or poor. It is politically foolish to claim anything else. Perhaps this is one reason truthful and realistic politicians never rise to the top.

Originally published on 07/14/2008

If one were to pick out a country in the world right now where economic conditions cannot get any worse, that country would have to be Zimbabwe. Every time I see a story about the country, I am overwhelmed. I can’t say I have ever heard of a country failing as miserably as Zimbabwe is now. And still it’s sad that such a terrible calamity doesn’t get more press in the Western world. Here’s some of their stats:

Zimbabwe is a country of 13.3 million people. It’s GDP is currently estimated at $1.6 billion. That’s about $120 per person at current exchange rates. In the last 5 years their annual GDP growth rates were -10.4%, -3.8%, -6.5%, -4.6% and -2.8% respectively.

The unemployment rate in now around 80%. Yes, that’s right! … only one in 5 people are working. (In comparison, when the US economy reached the depth of its Great Depression in the 1930s, unemployment was around 25%) According to a BBC news story, Zimbabweans are fleeing the country looking for work elsewhere and most of the economy is surviving on remittances from abroad.

The inflation rate is hard to pin down. A quick look around the internet finds inflation estimates anywhere from 50,000% to 100,000% per year (This is NOT a typo!) It means that something that costs 100 zimbabwean dollars today may cost 275 Z$ tomorrow and 760 Z$ the next day.

The government budget deficit is actually respectable (in comparison) at 8.6% of GDP. However, its national debt is 220% of its annual income. It’s international debt stands at 300% of its GDP. (Data courtesy of the Economic Intelligence Unit)

Oh and to add insult to economic injury, Zimbabwean’s life expectancy at birth is 39.5 years and at least 25% of its population is infected with the HIV/AIDS virus. (data from the US CIA world factbook) Clearly things can’t get much worse than this for a country.

However, luckily Zimbabwe is a democracy and they plan to hold elections on March 29. But, will elections be free and fair? This question strains credulity.

Imagine yourself a citizen of Zimbabwe. Could you imagine anyone living in these conditions voting for the current leader, Robert Mugabe, who has been in power since 1987? Mugabe has presided over one of the worst economic collapses in recent times. Second, could you imagine a leader in a free and fair democracy believing he even has a chance to win reelection with these kinds of economic conditions? Wouldn’t a leader in such a democracy have resigned in shame and perhaps even fled the country long ago? But, not Robert Mugabe! He intends to stand for reelection and believes he has a chance to win! This time he has a serious and credible opponent in Finance Minister Simba Makoni so maybe Mugabe will be ousted.

One last thought, wouldn’t it be irrefutable evidence that elections were NOT free and fair on March 29 simply if Robert Mugabe actually wins?

Originally published on 02/07/2008

There was an article in the WSJ yesterday by David Ranson about the presidential candidates’ stated positions on trade, both Democrat and Republican. It is worth a look. He concludes that McCain seems most consistently free trade oriented. However, one comment McCain made in a recent debate was a little troubling; namely pointing out that Romney’s work at Bain & Assoc. resulted in lost jobs. Jobs will always be lost when markets are free to adjust to changing demands …. and consumers demands are always changing. It would be great if politicians would stop using every job loss as a reason to criticize others or an excuse to do something about it.

Originally published on 01/17/2008

From campaign financing by special interest groups, to rising government budget deficits, to the mishandling of the Katrina disaster and the war in Iraq, to the utter distrust for anything politicians say, I think it is more than clear to everyone that the American populace is increasingly fed up with the antics in Washington. So a call for change is extremely appealing.

So on the Democratic side, which candidate is the candidate for change, Hillary Clinton or Barack Obama? (or one of the others?)

Barack Obama is clearly a fresh new appealing face. He speaks eloquently and is inspiring larger and larger groups of supporters. Hillary Clinton in the past week has been arguing that ‘talking about change’ is different from ‘making change happen’

The point is valid. I have read parts of Obama’s book, “The Audacity of Hope,” and as an example, he writes knowledgeably and convincingly about the problems with campaign financing and what it takes to be elected. He seems to understand precisely what many of the problems are. And yet, we really must question whether knowledge of the problem is sufficient to change the problems for the better. Certainly it is a necessary first step, but is it enough?

On the other hand, I sensed one thing this week that probably won’t change if Hillary Clinton is elected; that is the so-called “politics of personal destruction.” During every President’s tenure, he is assailed by the opposition. Investigations, charges of misconduct, extreme distrust has become the norm in politics … to most everyone’s dismay. President Bush has been put through the ringer in many respects, but it hasn’t been nearly as bad for Bush as it had been for the Clintons.

We have heard that Hillary Clinton has very high negatives among the general population. Indeed, after listening to right-wing talk show radio it’s probably accurate to say that many people despise her and her husband. The Clintons, after having been attacked and investigated for so long during the 1990s, continue to harbor great hostility towards their critics.

The hostility to opposition surfaces occasionally as it did this week in the discussion about race and gender between Obama and Clinton. On Monday, Bill Clinton, who would probably become a kind-of co-president if Hillary Clinton is elected, indicated that there were 80 instances of personal attacks by Obama against his wife in the past six months. He also ridiculed stories about Obama’s stance on the Iraq war, calling them “fairy-tales.”

What seems obvious is that the Clintons can both still be riled pretty easily by attacks against them …. and it is no wonder given what they’ve been through. That annoyance and anger towards opponents surfaces in many of our politicians, but it seems vitriolic in the Clintons.

If Hillary Clinton is nominated as the Democratic candidate, I think there is little doubt that personal attacks by the Republican opposition will be harsher than those towards another candidate who pretty much shares the same views. If Clinton is elected President, I wouldn’t be surprised to see the personal attacks continue for four more years. Now maybe there is no more dirt to dig up on the Clintons … but I doubt it … where there’s a will there’s a way in politics.

The politics of personal destruction may not disappear, (read about the antics in SC) but it would sure be nice if it could be toned down a little. I doubt if there’s any hope for change on that front if Clinton is elected. With Obama, there a better chance for change if only because he has not been attacked as much … at least not yet!

Originally published on 12/21/2007

I was browsing through the candidates websites today to learn what they have to say about trade. Today here’s a few quotes and comments about Mike Huckabee’s position on trade.

First he says the following:

I believe in free trade, but it has to be fair trade. We are losing jobs because of an unlevel, unfair trading arena that has to be fixed. Behind the statistics, there are real families and real lives and real pain. I’m running for President because I don’t want people who have worked loyally for a company for twenty or thirty years to walk in one morning and be handed a pink slip and be told, “I’m sorry, but everything you spent your life working for is no longer here.”

The last sentence suggests that to be handed a pink slip after 20 or 30 years because of foreign competition makes everything the worker has worked for, for naught. I suspect this is a popular sentiment among workers. However, the sentiment is based, I think, on a presumption that workers and companies have formed a kind of family relationship. For thirty years the worker has offered his efforts in return for a weekly paycheck and his own family’s sustenance. The worker has counted on the company as much as the company has counted on him. But then when the company decides to move a plant overseas or must close down, the workers feel abandoned. It’s almost as if the family has thrown them out onto to street to fend for themselves.

While it is true that any group of people who work together for a long period of time build family-like connections, I would respectfully suggest that, this is not the purpose of a business or company. The reason workers are hired is to help a company produce the goods or services that its customers are buying. If one recognizes this as the central purpose of an organization, then one will also see that the worker who worked for 30 years did not do so for nothing. Instead every week and every month each worker contributed in some way to deliver a product to customers who purchased, consumed and derived well being in the process. Every day of work had value and should be commended. Each day was also rewarded because the worker received a wage.

“Fair trade” policies, like Huckabee proposes, would prevent companies from restructuring in order to save domestic jobs. Such policies, however, would inhibit companies from best serving their customers and thus thwart the primary objective of the business. Although this would seem fair to the workers whose jobs are saved, it would also reduce US competitiveness and raise prices for consumers. In other words, to be fair to these workers we would have to be unfair to the consumers of these products.

US trade policies should work to enhance US competitiveness as its primary objective to best serve it broadest and least represented constituents, namely consumers. To focus on job security instead, purportedly in the name of fairness, can only be done by harming and thus being unfair to a much larger group.

Interestingly, Huckabee seems to understand this in the next paragraph when he says,

As the Industrial Revolution raised living standards by allowing ordinary people to buy mass-produced goods that previously only the rich could afford, so globalization gives all of us the equivalent of a big pay raise by letting us buy all kinds of things from clothing to computers to TVs much more inexpensively.

But if he understands the importance of serving the consumers’ interests – which is everyone’s interests – then why does he also seem willing to provide more job security to import competing firms, contrary to consumer interests? Could he be trying to curry favor with different groups with diverging interests simultaneously? Hmmm, but then that would make him a politician!!

Originally published on 10/30/2007

An issue often raised is that some countries, like China, may have more lenient environmental and labor regulations than other countries. That could mean lower overall costs which could give them an advantage in international competition. Here’s a couple of thoughts.

1) We could think of government regulations like actions by a coach to get its team prepared for competition. Some coaches may require two-a-day practices or may pay for a trainer to come in and teach special skills. While that may give the team a competitive advantage it’s also true that all teams are free to use these tactics or not.

2) Second, if in a sports competition we required that all teams have players of the same size, strength and speed. If we required that practice times be exactly equal. If we required that coaches had the same level of experience and had precisely the same resources for team development, then there probably wouldn’t be much competition since every team would be equal in all respects. The same applies to international business. If every country paid the same wage rates, had the same internal laws and regulations, had the same resource bases, then there would be no advantage to trade. Trade allows both countries to take advantage of “differences,” so if we demanded that all differences be eliminated first, then trade disappears.

3) Third, to evaluate competition completely, one must consider all the conditions a country’s firms face, both positive and negative. Thus, although China and other developing countries may have lower environmental and labor costs, they also have primitive legal systems, poor contract enforcement, inexperienced workers, lack of access to capital, higher chances of labor unrest, etc. In other words, businesses face tremendous hurdles in developing countries that firms in the West do not face to the same degree. Many firms in developing countries can reasonably complain about all the “advantages” that developed country firms enjoy. Indeed these advantages account for the higher levels of productivity in the West. This is the reason developing countries give for needing higher tariffs, i.e., they believe they can’t compete with the more productive firms in the rest of the world.

Differences among sports teams are also a reality and this contributes to making competition more interesting. Sports analysts will spend hours discussing whether team A’s speed and agility will win out over team B’s power and strength. Every team has strengths and weaknesses. The secret of success in sports is to promote your team’s strengths and exploit your opponent’s weaknesses. In other words, figure out a way to win despite the obvious differences that exist. I suggest we do much the same in international business; firms should figure out how to compete and win against foreign competitors despite the obvious differences and stop crying foul so often.

Originally published on 10/09/2007

Skeptics of trade liberalization often argue that the current international trading system is unfair. It is said: workers in developing countries are paid abysmally low wages and must endure dangerous working conditions; profit seeking corporations seek out production locations with lenient environmental regulations contributing to global warming and unsustainable development; and firms produce products threatening consumer safety. The proposed solution is to promote fairness and global social justice. Surely this is something everyone can agree on, since who could possibly be in favor of unfair trade and global injustice.

The fact that there is no agreement means either that people have different conceptions of fairness or that they see fairness in different places. This post will begin an exploration of what people mean when they express concern about fairness in trade.

Let me begin with a simple proposition: Unfairness must involve perceived losses to someone caused by someone else. Stated a bit more emphatically: Unfairness means someone is getting “ripped off”.

Consider the low wages paid to workers in developing countries. Anyone who considers the low wages unfair, will almost surely argue the point by highlighting the much higher incomes earned further up the supply chain. Thus we’ll see comparisons of CEO salaries or sports celebrity promoters to the average production worker. The implication is that high wage management is ‘ripping off’ the low wage production workers. A more fair salary distribution would provide income to the production workers sufficient to provide for themselves and their families by reducing the astronomical salaries earned by top executives in the company.

Or try another example. Proponents of a fair tax code generally argue that special exceptions provide opportunities to evade taxes. However, to take advantage of these opportunities one needs to be wealthy enough to hire competent tax accountants and attorneys who are experts in the complexities of the tax code. Average and low income households rarely can take advantage of these exceptions. The implication here is that wealthy individuals and corporations pay less than their fair share of taxes while the lower income groups pay a disproportionately larger share. In other words the tax code allows wealthy individuals to rip-off poorer people. One commonly suggested solution is a flat tax, whereby every household will pay a fixed percentage of their income in taxes with no special exceptions allowed.

If the above proposition is true it does not necessarily follow that the reverse implication is also true. Indeed I will argue it is not true. Stated formally: Losses to one person caused by someone else are NOT necessarily unfair. In other words, a loss caused by another does not always mean someone is being ripped-off.

The example that demonstrates the exception is a competitive sporting event; say a soccer match. If Manchester United and Chelsea come together in competition, play 90 minutes, adhere to the rules of the game as judged by the officials, suffer the consequences of any penalties (also according to the rules of the game), it is quite likely that one team (CFC) will win and the other lose (MU). (although of course, sometimes the teams will tie!) In this instance the loss by one team is clearly caused by the other, and yet we would not argue that the loss was unfair. That is unless one is a “sore loser.”

Sore losers are those who look for excuses to explain their loss; they are prone to argue that the loss was due to poor officiating such as botched calls and favoritism. They may even look further and contend that differences in player salaries give one team an unfair advantage.

Numerous fairness issues arise from this simple sports analogy. In a later post I’ll explore the interesting parallels between sports competition and economic competition.

Originally published on 09/14/2007

One thing I’ll do with this blog is to periodically provide information that I present to students in my classes. One thing we looked at this week was the US Tariff Schedule. The whole schedule is available from the US International Trade Commission’s website here. For teachers and students, a look through the US tariff schedule offers a quick illustration of several important features of international trade and methods of protection.

First, Chapter 91 covers tariffs on clocks and watches. The list begins with several pages of definitions. Note how precisely the products are defined. On page 10 the tariff schedule begins. The standard MFN tariff, applied automatically to all WTO member countries, is shown in column 1 (General). Note the complexity of the tariff on the watch identified in category 9101.11.40. A 51 cent specific tariff is levied on each imported watch, together with a 6.25% ad valorem tariff on the case and strap, and a 5.3% tariff on the battery.

Column 1 (Special) shows the tariff rate for countries the US has negotiated special arrangements such as Free Trade Areas (FTAs), as with Australia (AU), Chile (CL), Canada (CA) and Mexico (MX), and other special arrangements like the African Growth and Opportunity Act (D), among others. Note that for all of these the tariff is “Free” meaning 0%. However, for watches in category 9101.11.80, Chile currently has a tariff applied that’s in between the General rate and zero. This reflects the transitional part of an FTA. Most of them involve a gradual reduction in tariffs over a 10-15 year period.

Finally, notice that column 2 tariff rates are significantly higher. These are sometimes referred to as the non-MFN tariff rates. These rates could be applied to all non-WTO countries, however, for important countries with whom the US wants to encourage trade, like Russia and Ukraine, MFN tariffs rates have been approved by the US Congress. The only countries that receive column 2 rates are those we have no special agreement with – currently only Cuba and North Korea.

Chapter 7 shows the tariff schedule for certain agricultural goods. Some things worth noting here are; 1) agricultural tariffs are more likely to be specific tariffs rather than ad valorem, this because specific tariffs are more protective when commodity prices fall; 2) as seen with cabbages in category 0704.10.20, some products have different tariffs depending on the time of entry, this to protect US producers more during the domestic harvest season, and 3) the rise in the tariff between category 0704.10.40 (10%) and 0704.10.60 (14%) is an example of tariff escalation, this to protect US food processing industries.

Originally published on 07/18/2007

The Washington Post had a report on Sunday about the economic costs of climate change. It highlights several important points worth emphasizing.

1) Controlling climate change will be costly. The costs will have to include higher energy prices for traditional carbon based fuels. Tax increases are being proposed to help finance research into alternatives and to reduce consumption. This will make it more expensive to drive your car, heat your home, and warm your water. It will also add to the cost of all goods that need to be transported to you, the consumer. Cost of living will rise for everyone. Of course, this will affect poorer households more than richer ones.

2) It is a fiction to believe that creating new technologies to combat climate change will be good because it will create new industries and new jobs. This belief is based on a misunderstanding of “opportunity cost.” All of the money spent, and jobs created to produce more fuel efficient cars, carbon-capture technologies, wind and geothermal electricity plants, etc., etc., is money that will not be spent on other things, like food, clothing, health care and entertainment. In order to do one thing – i.e., clean the environment – we must not do other things – i.e., provide other goods and services that people want.

3) Currently people do not value environmental cleanup as much as they value the other goods and services they demand and buy. If they did, there would be no need for government to intervene to change what people choose. Government tax and regulatory policies to combat climate change will force people to change to what the government, or environmental advocates, want them to choose.

4) Most Americans, and probably most in the world, do not really want to change much of what they do to combat climate change. If they did, they would welcome higher gasoline prices. Higher oil and gas prices are perhaps the most effective way to reduce consumption of carbon-based fuels. To reduce carbon emissions to the levels suggested in the Kyoto protocol, for example, would require substantial increases in oil and gas prices. But in the US, when gasoline prices rise to levels that are significantly below what prevails elsewhere in the world, Americans scream!!

If we were addicted to gasoline, but recognized that this addiction were harmful, then Americans might respond to higher gas prices grudgingly, but with quiet acceptance. It would be much like a cigarette smoker who wishes to quit and realizes that higher cigarette prices will help him achieve what he really wants. However, Americans don’t respond to higher gas prices this way, at least not most of them. This means Americans, and probably most around the world, will accept climate change policies only if they don’t have to change their behavior very much.

5) The main reason there is so little concern about climate change is because the problem is invisible. Or, if it does affect us in an important way, it won’t be until much later in our lives. It might not even happen till we are long gone. Imagine trying to convince cigarette smokers (in a hypothetical alternative) that although no one has yet died from smoking there is growing evidence that people will die from smoking in the distant future. Do you think many people would quit smoking NOW under these speculative circumstances? I doubt it given that even when people know the full consequences of smoking, many continue to smoke. This is the kind of hurdle faced by climate change advocates. This is also why you will hear that hot summer days and Hurricane Katrina are the results of global warming even though these events are perfectly consistent with a no global warming scenario.

6) Ideally, it would be great if global warming were shown to be false or greatly exaggerated. Personally, I think we should all be rooting for this outcome. We should continue to evaluate how likely it is for catastrophic global warming to arise. Since if global warming were indeed exaggerated, we could go back to using the cheapest most efficient sources of energy available and devote our time and energies to providing more food, clothing, housing, health care, and entertainment services, especially to the people in the world who have not had the good luck to enjoy many of these things. If we have to redirect our best and brightest resources to climate change though, then maybe these folks will have to wait a little longer. Perhaps till their next life!

Originally published on 05/16/2007

Alan Blinder, in an interview with Marketplace, suggests the following to deal with increased competition from China and with globalization more generally:

First, I would say don’t succumb to the allure of protectionism. It doesn’t work, and it certainly won’t work for electronic trade. I mean, how can we stop electrons? Secondly, as I was saying before, we just have to do a better job with the social safety net, so that job displacement doesn’t hold the ravages that it now holds to the typical American. Thirdly, I think we have to think, in terms of those kids you were talking about, about what we need to do with our educational system so that we’re training kids for the jobs that will actually be available in the United States when they leave the school system. Not the jobs that will have migrated overseas. And then finally, I think we have to get used to the idea that if we want to stay the richest country in the world — which I presume we do — we can’t try to hang on to sunset industries. We have to specialize in sunrise industries.

Succumbing to protectionism [dead link] is a very real possibility today. The US Congress, reflecting popular impressions, is becoming increasingly wary of freer trade. Legislators hear the anxiety of workers facing international competition and feel they must do something. Of course, since the benefits of international competition are so widely dispersed among the entire population, these benefits are less obvious and do not result in equal political pressure to resist protectionist actions. When the economy is humming along and growing briskly, the pressures to protect, which are always there, are easier to deflect. But if the US and other countries were to enter into even a mild recession sometime soon, given the current political atmosphere, I suspect we are destined to follow much the same protectionist path as in the 1930s. Since the system remains much the same now as then, legislators would likely respond similarly, despite the knowledge we now have of protectionism’s ineffectiveness.

One change that has occurred since the 1930s can act to reduce protectionist pressures on legislators. That change is the presence of a safety net. Although Blinder suggests the current US system “ravages” the typical American worker, it is worth pointing out several things. First, the social safety net available in the US today, with 26 weeks of unemployment compensation, tremendous educational opportunities at numerous levels, the widespread availability of credit and the presence of welfare programs as a last resort, are all programs that simply did not exist in the 1930s. Then, people had to rely on family or the kindness of strangers even to feed themselves at times. Now, it’s not nearly as bad. True, the protections for US workers are not as generous as in Europe, but they are available nonetheless. The second point to make is that the US safety net system for displaced and unemployed workers is much more generous than in most developing countries. Ask yourself if you’d rather be unemployed in the US, or in China or India, … or Zimbabwe? I think the answer is obvious. And yet, global competition is going to create as much turmoil in developing countries as it will in the US, if not more. Although China is growing rapidly, in time they too will need to give up some industries that contributed to their early success. They will suffer job losses as well as gains. They also must deal with hundreds of millions of underemployed workers stuck in the countryside with very little to do. Transitioning to the global marketplace without fanning the flames of social rebellion is a tremendously delicate balancing act that the Chinese government has so far been very successful maintaining. Similar problems exist in many other developing and globalizing countries.

Blinder adds that we need to train UIS kids for the jobs that will be available in the future, not the ones that people have now. This begs the question, which jobs will those be? As I wrote in a previous post, predicting the future jobs is virtually impossible. There is an alternative to prediction though. It involves developing the ability and mindset of flexibility.

Embracing flexibility and learning how to adapt rapidly is a very important attribute to develop. It means recognizing that learning is a lifelong endeavor, that some career paths will be deadends and there is very little way to know which ones beforehand, and that experimentation at the level of the individual firm and the individual is the source of sustained growth. It means accepting that bad outcomes are often not “someone’s fault” and that the best response to a lost job, or a closed business, is to focus on retooling and new opportunities, rather than trying to preserve the old.

Indeed this is Blinder’s final point. We need to move our energies into sunrise industries and be willing to let go of sunset industries … admittedly, easier said than done! Especially because, although politicians will pay lip service to the dynamism of a competitive economy and all of its virtues, nothing buys votes more effectively than protection. This is why the US has begun to point the accusatory finger at China lately. These actions are meant primarily for US domestic consumption, to show voters that the US government will help protect them.

A little pressure on China, India or others will do little harm, but if the pressure rises, the US risks weakening itself economically even though its intention is to strengthen. If the US wishes to remain the most important force for positive economic change in the future, it would do so more effectively by accepting the “unfair” trade practices in the world and striving to overcome them with higher quality, lower cost products nonetheless. Sure, the Chinese and Indians have certain competitive advantages – lower wages, more lenient standards – but at the same time they have enormous disadvantages as well – archaic legal systems and stultifying bureaucracies. When people in the developing world look at the US, all they see are overwhelming advantages for workers and firms. Isn’t this why so many people seek to emigrate to the US?

I see the problem like a basketball game between US and Chinese players. The US has a competitive professional National Basketball Association league and the Chinese have one notable strength – Yao Ming. We could complain, of course, arguing that the Chinese height advantage is “unfair” – we could try to force them to put height restrictions into place to “level the playing field.” Of course, the Chinese would react to this request incredulously. They would look at the discipline of the US players, the college feeder system that helps young players develop, the extensive competitive experience embodied in the coaching and would wonder why the US insists on taking away their only advantage.

It is much the same way in the economy. If the US wishes to remain influential in the world economy, it is best to look at the competitive advantages of other countries merely as challenges that need to be overcome. Head-on competition is the way to face those challenges in a way that empowers and strengthens. Protection, or finger pointing, is a way to face the challenges in a way that slowly zaps the strength and vitality of the economic system. The choice is there to make.

Originally published on 04/13/2007

Alan Blinder, in a radio interview on NPR a few days ago, warned that competition from China and India would be like a tsunami on American shores. That competition threatens jobs, either because of a flood of imported goods, or from the backwash of jobs lost to offshore entities. The US response to a competitive tsunami, a tsunami I think is almost inevitable, will greatly influence future US standards of living and its position in the world. The US has two options.

First, the US can build a barrier to the tsunami. This means taking actions to protect what the US currently has. Protection might involve placing restrictions on US firms who move factories or jobs to overseas facilities. It might mean placing higher tariffs on goods from China until they revalue their currency to our liking, or enforce intellectual property rights for our products. It could mean refusing to lower subsidies and other supports to agricultural products. It could mean refusing to negotiate free trade areas or other liberalization initiatives until we get assurances that other countries will strengthen their environmental and labor standards. It could mean conceiving of lots of other “excuses” to justify temporary, or even permanent, protections for US industries and US jobs in those sectors.

These are all actions the US Congress has contemplated, or implemented, in recent months. Each action, regardless of the motivation, represents another brick or two in a wall that will protect the US from the competitive tsunami.

Building a wall has both positive and negative effects. The positive effects are obvious; thousands of workers in thousands of jobs will keep those jobs for a little while longer. For the typical US worker age 45, 50, 55 or older, the protection may get them to retirement. That’s a big plus, … for THEM. However, the negative effects are simultaneously more subtle, longer lasting, and will touch more people. First, each brick of the wall we put up, makes it more likely other countries will add bricks to their walls as well. As countries protect from each other, they slowly lose the ability to export abroad and to enjoy cheaper imported products for all its consumers. The wall also slows down the dynamism of the local economy. Adjustments to new industries and the creation of new products is no longer as important as before. Thus, over the long term total output will not grow as rapidly. These effects hurt people much later, never right then when the wall is built. This is one reason why building a wall is often so popular.

But there’s an alternative approach that’s both harder and healthier. The alternative is to let the tsunami roll in. Of course, to do this effectively requires some adjustments to mitigate the destructive effects. But we can never eliminate the destruction entirely … that’s why accepting the tsunami is hard. However, if we let the destruction occur then just like a real tsunami on a virgin shore, the rebirth of life will proceed rapidly. The vegetation will return, perhaps hardier than before, and the whole ecosystem can change in light of new conditions.

So it can go for an economy. As the tsunami rolls in and jobs are lost, it opens up a whole new world of opportunities and possibilities. If a nation can arise from that destruction without its spirit being broken, then it can channel its energies into completely new creations. Brand new products, services and sectors can arise out of no where. And with these new industries come renewed vitality for the economy overall.

To make accepting the tsunami possible though, we need more people to recognize the kind of trade off we face. Short term salvation is possible by building a wall but we give up longer term vitality and opportunities by doing so. If we want to create as many opportunities as possible for the next generation then we need to suffer the short term destructive costs of the tsunami.

Where will the US go? I’m afraid the current trend is to build a wall. The chances it will build a high one are larger if the economy suffers a small recession sometime soon. If the US continues to grow reasonably well though, then it’s more likely the it will put up only a partial wall. However, because of politics, I don’t see much chance the US will choose to accept the tsunami. To me, the more resistant the US becomes to this change, the weaker it will be in the future, both economically and otherwise.

Originally published on 03/22/2007

Q. On the issue of harmonious trading, the WTO has been tasked as the guardian of free trade and to promote and settle trade disputes in a fair manner. Yet there are many who oppose the WTO for being too powerful and it can compel sovereign states to change laws and regulations by declaring these to be in violation of free trade rules, it is run by the rich for the rich and does not give significant weight to the problems of developing countries among other complaints. What are your views on the WTO and how could it do better?

A. I suspect most who oppose the WTO don’t quite understand the way it works. The WTO is not an organization that can “compel sovereign states to change laws and regulations by declaring these to be in violation of free trade rules.” The free trade rules referred to here are really promises, or commitments, that countries have made to each other. After making these promises, last made at the conclusion of the Uruguay round in 1994, officials went home and had the commitments approved by their legislatures. Every democratic country had the privilege of saying no to these commitments – but no one did. Instead every country said we’ll promise to liberalize trade by this much, if you promise to liberalize by that much, or, we’ll open our markets a little to your products if you open your markets a little to our products.

What the WTO really is then is a place to complain about and investigate broken promises. If one country believes that another has broken a commitment, it can raise the issue at the WTO’s dispute settlement board (DSB). The DSB meets regularly and has one representative appointed by each WTO member country. The only kind of issue that can be dealt with here is one related to the WTO agreement.

Consider the 2nd dispute case brought to the DSB. Venezuela complained that US regulations to promote cleaner air violated the US national treatment promise because imported gasoline from Venezuela was required to be cleaner than domestic gasoline produced in the US. Any complaint sets in motion a well-defined legalistic procedure to settle the dispute. The first step is called consultations because countries are required to sit down with each other and try to work out the problem on their own. If that fails, and it did in this case, the DSB creates a panel of three to five people – drawn from a list of international legal experts – to assess whether the country violated its commitment. In this case, the panel determined that the US had violated its national treatment commitment. The next step allows the losing country to appeal the decision to another panel. The US did and lost again. Next, the DSB, which really means the group of WTO member countries look to the offender to change its laws so as to live up to its previous promise.

So when people say the WTO “compels a country to change its laws,” what it really means is that a country is “asked to change its laws to that which was previously promised.” That’s a little different. In the case of Venezuela and the US, the US did change its environmental regulations to comply with the ruling.

What if a country refuses to change its laws? That has happened occasionally. The first effect is that a country looks bad in front of the international community. It’s kind of like catching someone in a lie and the person refuses to come clean. Not good! Imagine if the US had done that with the 2nd DSB case. That would have looked especially bad given the US was one of the primary advocates of the WTO.

But if a country does refuse to change, the second recourse is for the other country to suspend its previous concessions. In other words, a country is allowed to rescind some of its promises of market access to the offending country. This is like saying, if you’ve only lived up to 95% of your promises to us, then we’ll only live up to 95% of our promises to you. This is the only “punishment” the WTO can sanction. But it’s really a quid pro quo.

The other part of the above question suggests the WTO agreement does not give “significant weight to the problems of developing countries.” This may well be true especially given that the current Doha round of trade liberalizing talks was designated to be a “development round.” That designation was made largely because the majority of WTO members are developing countries and they have felt that insufficient special treatment was given to the issue of development. However, in many instances developing countries have been given differential treatment. One example I’ll mention is that developing countries have not been expected to lower their trade barriers to the same degree as developed countries. See the info on Tariff Bindings [dead link].

Much more can be said on this issue, but it will have to wait. Suffice it to say, overall I think the WTO is a pretty fair system. One way to fix it is to teach more people why it is an effective institution, even the way it is. I also think the WTO agreement does not take advantage of developing countries as much as is often claimed. However, the evidence here is surely mixed. Also, as with anything, improvements are always possible.

Originally published on 03/20/2007

Q2. There are some nations who feel that free trade is not fair trade. What are your views on this?

A2. I think free trade is more fair than any proposed alternative. The problem is that free trade means more international competition for most firms which in turn will result in successes for some businesses and failures for others. Those that fail will lead to hardships for the workers, management, and investors in those industries. For those who suffer losses, a natural human response is to identify all the relative advantages the winners have and argue that it’s unfair. For example, workers who lose jobs to trade point to the greedy management who moved the factory abroad (unfair!) or the foreign workers with low wages (unfair!) or the lax labor and environmental policies abroad (unfair!) etc., etc.

I think competitive sporting events provide a good analogy. Consider basketball. When two teams come together and compete, one always wins, the other loses. That’s the nature of competition. But remember the teams are not the only participants; there are the fans too. And if there weren’t a winner and loser, the fans would never come and watch the game. Every losing team could easily find examples of unfairness if it wanted. The other team’s center was much taller, or they didn’t have an injured player, or the referees clearly favored them, etc., all of which is unfair(!). But think about it. Would we really want the teams to be equalized in every respect? Sure, we do expect the environment to be the same; the baskets the same height, one team can’t be forced to wear ice skates, etc.; but we expect there will be many other variations between the teams too.

Furthermore, the possibility of losing, or even persistent losing will lead to attempts to improve the team. Some players will be traded for others. The coach may be fired. The team may practice more frequently. These incentives mean the teams (even the winners) continually try to improve their performance. Without the chance of losing, teams would never progress or change very much. And since both teams keep innovating the fan continue to come to the game because you still never know who’s gonna win.

So it goes in international business. Firms that compete will continually seek ways to improve their product by reducing cost and raising quality. If they don’t do this effectively, they’ll lose. But just like in sports, that’s OK. Workers and management need to use the threat of losing to help strive for excellence. By stimulating competition, free trade serves the consumer (i.e., the sports fan) best. In this sense it is a fair system, despite the ups and downs.

Originally published on 03/20/2007

I received an email with a series of questions about trade. I will answer some of them in a series of posts. Here’s the first.

Q. Could you explain what are the benefits of trade blocs? On the other hand, since trade blocs give preferential treatment to its member countries, does this inherently violate the principles of free trading or is this disguised protectionism?

A. Trade blocs and unions provide the same economic efficiency benefits as any movement to freer trade. The main distinction is that blocs are typically bilateral or regional and thus exclude all countries outside the bloc. As such, blocs are discriminatory since they give favorable treatment (i.e., zero tariffs) to some countries but not to others. In principle, blocs violate the MFN rule at the WTO which states that all WTO member countries should receive the very best (or most favorable) trade policy that any country offers. However, Article 24 of the original GATT agreement allowed for an exception in the case of free trade areas since these represented a movement in a trade liberalizing direction.

Nonetheless, because of the discrimination, blocs provide benefits to some industries while excluding or harming others. For example, one advantage of many export industries in Chile, Singapore, Australia, Costa Rica, and in other countries who have signed free trade agreements with the US, is that their products can enter the US market without paying tariffs (at least within a few years), whereas exporters from China, Vietnam, Pakistan and others outside these blocs must continue to pay the tariffs to sell products in the US. This gives firms in US trade partner countries a definite cost advantage and helps them to compete against the Chinese and others. This is an important reason why many countries are eager to join blocs especially with the US and the EU.

Originally published on 03/15/2007

March Madness started today in the US as 65 college basketball teams vie for the National Championship in a single elimination tournament. Many Americans participate in office pools to see who can guess the most winners in the 63 games that will be played during the next few weeks. I put an entry in the Facebook pool for a chance to win $25,000 (a very small minuscule chance!!) When I looked today to see what the 1st prize was, I found an unusual requirement in the rules. It says,

Canadian participants must also correctly answer a mathematical skill-testing question, without human or mechanical assistance and within a specified time limit, before being declared a prizewinner.

A little investigation led me to this Wiki Page. It explains that “the Canadian Criminal Code bans for-profit gaming or betting,” but “the law does allow prizes to be given for games of skill, or mixed games of skill and chance. In order to make the chance-based contests legal, such games generally have mathematical skill-testing questions incorporated.”

The Canadian government is smart enough to realize, though, that groups may attempt to circumvent the skill test by asking ridiculously simple “skill” questions like, “What is 1 + 1?” A Canadian court ruling assures the skill test will not become a joke by requiring that any skill question “contain at least three operations to actually be skill testing; for example, a common question might be “(2 × 4) + (10 × 3)” (Answer: 38).” Interestingly, “getting the answer wrong is also often not an obstacle to claiming a prize.”

The Facebook rule is in place to keep the contest legal in Canada. Clearly Canadians are better protected from the dangers of contests than we are in the US!

Know any other bizarre government regulations and the creative ways they are circumvented? Post them here.