America's Secret Manufacturing Success (And Why It Doesn't Matter)

The Center for Economic and Policy Research argues America needs more manufacturing: it's really the only way to pay for the goods we import. Services, they say, won't cut it. It's amazing how many mistakes they make in five short paragraphs. Here's the full text.

The NYT devoted a major Sunday magazine piece to this question. It never raised the most fundamental question, if we buy all our manufactured goods from someone else, how are we going to pay for them?

Our goods deficit is currently running at annual rate of around $800 billion or 5.3 percent of GDP. We have a surplus on services of around $170 billion a year, less than 1.2 percent of GDP. If we lost all our manufacturing, then the deficit on goods would increase by about $1.2 trillion to more than 13 percent of GDP.

What services do we think that we will export to make up this gap? We are rapidly losing ground in many areas. For example in software and computer services we are already a big net importer from India. It is hard to see how this gets reversed any time soon. We do earn a lot of patent licensing fees, but these fees will always be vulnerable to a tide of free trade sentiment. Besides, it is very hard to imagine them rising beyond a couple of percent of GDP as a maximum.

One of our biggest surplus areas is tourism. This raises the prospect that the anti-manufacturing crowd thinks that we are too sophisticated to work in factories, but not to clean toilets and make beds. There is nothing wrong with latter (I have done it as a summer job), but it's not what most folks would consider upscale employment.

The bottom line is that unless we think someone is going to hand us trillions of dollars worth of manufactured goods for nothing indefinitely, then there is zero doubt that America needs manufacturing. It also needs people writing on economic issues who know arithmetic.

OK, let's start with what they got right. First, yes the net exports on services is much smaller than that of manufacturing: $170 billion on services and $800 billion on exports. And as more services go abroad, that first number is likely to get a lot smaller.

But basic arithmetic doesn't get you very far here; it's much more complicated than it seems. Trade deficits are arbitrary distinctions between net exports and capital flows. Every dime that flows out of the country is a dime that flows in. Sometimes it's as an import but more often it's an investment. In other words, Americans pay for imported goods by supplying investment opportunities for foreigners. Despite all that's happened in the past few years, the US is still a hub of promising entrepreneurial activity. But more on that in a second.

This relates to what the CEPR foolishly suggests: that the trade deficit generates debt. Thus the "need" to develop manufacturing jobs because there is no debt. None. Zero. Nada. No debt is generated from the trade deficit. When I buy something from Japan, my debt does not increase (unless I borrow to buy that thing I bought). I owe Japan nothing.

Now it's true that few Americans work in manufacturing, but it's not because of trade as the CEPR implies. It's technology. Americans produce about 20% of the world manufacturing output: that's equal to Brazil, Russia, India, and China combined. And the reason why so few Americans produce so much is because each American is so productive. Technology allows one person do to the work of ten or a hundred which is why productivity is high while the number of jobs is low.

But even if you ignore all of that, trade deficit statistics suffer a fundamental accounting problem. A $600 iPhone imported from China increases the trade deficit to China by $600. But only a small fraction of that money goes to Chinese workers. Most of it (60%) goes to American workers for design, engineering, marketing, and profit. Adjusted for valued added, a new paper argues that the US's trade deficit with China (about $133 billion) isn't a deficit at all but a surplus at about $32.25 billion.

In other words, the US manufactures A LOT: they're called ideas.

When To Tariff

Subsidizing an industry (ignoring positive externalities) is not good for efficiency. This sort of argument is often cited about trading with China and its alleged undervalued currency. I have some thoughts about fixed exchange rates, but I'll post them another time. Right now, I'm more interested in the talk about if the US should institute retaliatory tariffs against China on the basis of its more direct subsidization (i.e. giving money directly to firms, not keeping the exchange rate down).

The nice thing about retaliatory tariffs, is that if they succeed, China will stop subsidizing industries. This is not good because the US will export more; it's good because it decreases price distortions. Wealth (on a global scale) increases. But such tariffs can back-fire if China doesn't back down. Instead of having one problem, you have two.

Suppose China will remove subsidies at a probability of x. If W is world wealth, S is the effect subsidies have on world wealth, and T is the effect tariffs have on world wealth, the US (assume the US cares about the world's wealth, not just American wealth) should not threaten a tariff if:

W - S > W - (1 - x)(S + T)

or...

S < (1 - x)(S + T)

If that equation looks familiar to you, then bravo to you! It's the Learned Hand Rule. To quote the Wikipedia entry,

an act is in breach of the duty of care if:
B < PL
where B is the cost (burden) of taking precautions, and P is the probability of loss (L). L is the gravity of loss. The product of P x L must be a greater amount than B to create a duty of due care for the defendant.

In other words, you're held liable for something if it was cheaper to remove the possibility of the bad thing from happening than it was to suffer the bad thing, weighted by the probability that the bad thing would happen. For example, it's easy to install a guardrail, likely someone will fall and very harmful if the person falls. So if you don't install a guardrail and someone falls, you're held liable.

My equation runs a similar vein, though you tolerate a subsidy instead of put up a guardrail. If the cost of suffering the subsidy is less than cost of the subsidy and tariff, adjusted for probability, you shouldn't threaten a tariff. Not tolerating the subsidy is negligent as threatening the tariff exposes the world economy to an inefficient level of risk.

Let's rewrite the equation:

S/T < (1-x)/x

If the above inequality holds, then threatening a tariff would be negligent. Let's summarize the right handed side with a graph. If S/T is above the line, you should threaten the tariff; if below, you should not.



Suppose we agree that subsidies and tariffs have an equally negative impact on wealth, or S/T is one. That means if x < 0.5 (Chinese have less than even odds at backing down), don't threaten. If x > 0.5, then you should threaten. Yes, you can get into a lot about reputation building, threatening (and following through) even if x is low in an attempt to increase x. But this post is already quite long and would make this model very complex.

It's politically harder to get rid of subsidies than tariffs, I'd wager, since tariffs are a tax and people love seeing their taxes fall. Therefore, S > T because the long term damage is higher. But it also means x is lower than we thought since it's harder for the government to give up something that is so popular. Assume S is twice as bad as T (S/T = 2) because it is twice as hard as we thought to get rid of (x is 0.5x). Because of the curve of the graph, x would have to be 0.67 (before adjusting for the change due to political viability) before you get the same payoff threatening a tariff as you do letting the subsidy stand. That's higher than the even odds I mentioned earlier.

The point of this post is to get us to think more about retaliatory tariffs as an efficiency goal, not a justice goal. Lots of people point to "leveling the playing field" and "fairness" when they advocate retaliatory tariffs, as if the aim is to punish people for wrong doing. But that's a means to an end, which is to stop subsidies. Recognizing that some subsidies aren't worth the risk of retaliation is the first step to being smarter about trade policy.

The Profit Motive of Eureka

Yesterday on Morning Joe, Joe Scarborough mixed up his economics. While expressing disgust that a 4% of the world "taking" 25% of its resource output, he proposed that if

....we control the next wave of energy, we will own the 21st Century...in America we have eight of the top ten research universities on the planet. Why not tap into that and really have a focused effort to create the next wave of energy resources....

Those in the developed world do not take resources; they buy them. And they can afford so much because they produce so much, notably the technology that Scarborough wishes to see. Since private investors and inventors are creating the next waves of technology, his insistence of an American focused effort can only mean some sort of central government planning. This deadly pair--economic nationalism and government centralization--is truly wasteful. Technology becomes harder to produce under such large bureaucracies, especially when you restrain where in the world you can draw your inputs for discovery from.

There is a big push for new technology and it's been that way since the dawn of human civilization. Only in the past few hundred years has government been laissez-faire enough to let it truly flourish. And look how far we've come so quickly! Technology creates resources far more than it consumes them. It is our greatest source of genuine growth and with so much wealth up for grabs, it instantaneously creates a vast network of entrepreneurs far more focused than Scarborough could ever imagine.

Waxman-Markey-Dobbs

The DC area gets policy advertisements, ones I never remember getting when I lived in Iowa or Wisconsin. Perhaps that's just because of population density, but I have feeling the "company" of this company town has a lot to do with it. Lately I hear a lot about the Waxman-Markey bill, a bill supporting cap and trade for carbon emissions. If cap and trade is better or worse than a carbon tax is debatable and I'm not sure on my position, but the arguments put forth looks like they were authored by Lou Dobbs.

China's making energy efficient lightbulbs and has other "green" industries, jobs they "took" from Americans. According to the ad, the bill will let us take those jobs back. If this the best argument for the bill (and it might be; Tyler Cowen reveals the benefits are hard to find), then we got a big problem. As Don Boudreaux likes to say, costs are not benefits. By forcing the costs of production higher (reflected by the fact that firms will produce these things in the more expensive US without additional gain), the economy becomes poorer, not wealthier. If jobs were wealth, the best thing the government could do is not eliminate trade, but eliminate technology.

I Think I'm Getting Soft In My Old Age

I've decided to offer my students some extra credit. Here it is:

This extra credit is worth three points, added to your final grade (for perspective, this is the equivalent of 60 points added to a homework assignment). You must answer it in 75 words or less. If you use anything more than that, even by one word, than it will be worth zero points. Your answer must be typed with few spelling or grammatical errors (if it needs to be stapled, you did something wrong).

“It is through exchange that difference becomes a blessing, not a curse.”
—Jonathon Sacks, The Dignity of Difference, 2002

This quote opens our syllabus and captures a subtle theme of the course. What’s the theme? (There are probably multiple answers to this question.) In answering this question, you better off using information from at least one of the following podcasts, preferably two. Indicate via footnote which podcast(s) you use; these references do not count to your word limit. You might want to listen to more than you intend to use; some of these podcasts are better for answering this question than others.

Leamer on Outsourcing and Globalization
Brook on Vermeer's Hat and the Dawn of Global Trade
Bernstein on the History of Trade
Munger on Middlemen
Boudreaux on the Economics of "Buy Local"

This assignment is due on May 4, 2009.

Corn Laws and the Ironies of History

In the 1840s, England's Corn Laws (corn being a generic term for wheat, barely, and rye) were under a hot debate. The Laws issued a series of tariffs ensuring bread prices stay two to three times higher than they were 100 years ago. But as the Industrial Revolution pushed forward, mill owners knew cheaper food was crucial to feed their employees. There thus arose a battle between the landed aristocracy, arguing mercantilism and questioning this "new" economy, and manufacturers, citing Adam Smith and the logic of free trade. Thankfully the latter, led by Richard Cobden, won the day.

Manufacturing, once a great advocate of free trade, now in the West is its enemy. And if Lou Dobbs, a vocal opponent of free trade on the grounds that it hurts factories, lived a century and a half ago, he would be raging against the very sector he so persistently defends today.

Krugman on the Virtues of Protectionism

When I read Paul Krugman, I first think "that's crazy! He's insane." Then I read it again and that usually (but not always) becomes "that's interesting, but it still wrong." Reading Krugman's February 1st article (spawning a nifty debate here, then here, then here) led me to the typical reaction.

I'm still reading through the responses, but Krugman's basic argument is that fiscal stimulus benefits other countries in addition to the one doing the stimulating (for now, let us assume Keynesian economics works the way Keynesian insist it does). The country being directly stimulated imports from other countries, which help their economy. But these economies share none of the debt generated by the stimulus package. Thus the funding country gets a smaller benefit than they should and we have too few economic recovery acts. Short term protectionism internalizes the benefits to those that are paying for it, thus we get more such packages when we need them.

It's a clear argument but to see why it doesn't work, let's follow the money. Suppose the exporting foreign country is Japan. They now have (say) American dollars. What do they do with this crazy American money? They can't spend it in their country. There are two things they can do with it.

(1) They can import from America. This means that money Keynesians want to stay in the US will come back. It's just adding another step. Instead of Government to Domestic Market, it's Government to Foreign Market to Domestic Market.

(2) They can invest in America. Instead of buying goods, they buy companies (or just capital). Again, the money comes back into the economy, but now there are two steps before it enters domestic consumption (Foreign market to Domestic Company to Domestic Market). Again, it's a wash.

You could argue time is an issue but money moves pretty quickly, especially in the era of Internet and telecommunication satellites. And, because the government's buying international, it's going to get a better deal which will help in the long run (when this huge debt will have to pay off). It's hard to imagine that extra delay is really such a huge problem.

An implicit assumption of Krugman's argument is that exports are inherently good for an economy and imports are not. But that's completely wrong. While Krugman might paint my argument as grounded in theology and not economics, the case for free trade is so strong, and for protectionism so weak, such interpretations are closer to being grounded in laws of economics as irrefutable as gravity or motion.

The Siren's Song of Manufacturing

Today on Morning Joe Pat Buchanan mourned the decline of the manufacturing sector, whose members now (supposedly) work at Wal-Mart. Forget that over the past thirty years median individual income rose about 40%. Even if they were becoming nurses and lawyers (and they are), Buchanan still prefers manufacturing cars, toys, and electronics in America, by American firms.

Manufacturing is no more important than farming, customer support, or mining. The key is never one sector. The key to American prosperity (among other things) is trade. Freer trade opens the plethora of human ingenuity to more people at steadily decreasing amounts of effort. Alaskans get bananas year round. Nevadans get free tech support. Indianans get toys under the tree. Just because we can't point to a single area where everyone works doesn't mean they can't find good jobs, obtain consumer goods, or live a fuller life. Freer trade means all these things are more common, not less.

Fallacies of Fallacy

Naming a fallacy is very powerful. It signals that not only is something logically incorrect, but so many get it wrong it's worth naming. But like so many powerful things, it's misused. I found this list of "7 Economic Fallacies" written by Tejvan Richard Pettinger, a teacher at Cherwell College, Oxford. Of the seven, three are not fallacies.

Tax Cuts make people work harder.

When you work you are really swapping one valuable resource (time) for another (money). Cutting taxes (which is the equivalent of a pay raise) could mean the person spends more time to get much more money. It could also mean they spend less time to get the same amount of money. It depends on their preferences. As Pettinger implies by his explanation this is an empirical question, not a fallacy.

A Current Account deficit [also known as the trade deficit] doesn’t matter.

That happens to be true. Many of his explanations for why the trade deficit is a problem happen to have logical fallacies, though. Concerns of an "unbalanced economy" are inconsistent with a lack of concern about trade flows between cities; concerns of capital flows ignore that the current account is the mirror image of the capital flow, by definition; concerns that a current account deficit means more foreign liabilities ignores that the trade deficit is not debt (when two people trade, no debt is created). That Pettinger acknowledges "some economists" don't think the trade deficit matters demonstrates that this is not a fallacy.

Tax Cuts will boost the Economy.

The reasoning behind this supposed fallacy is that of increasing consumption, a straw man since in the strict mathematical sense this won't change anything. (Government spends less and consumption plus investment increases by an equal amount.) The logic behind the argument is in how the funds are spent. Money in the hands of private citizen is more likely to be used more efficiently than money in the hands of political agents (for the normal incentive reasons). Thus tax cuts could easily better efficiency and thus the economy. Granted, Pettinger is correct that borrowing in response to a tax cut does little (it only shifts the spending burden to later generations while crowding out the investments today) but the other way to balance of the budget, cutting spending, won't have such adverse effects.

Popular opinions of economics are filled with blatant nonsense. There are so many, we don't need to the lower the bar and paint differing opinions as something so flawed as a fallacy.

The Joker's Lesson on Free Trade

When I saw the midnight showing of The Dark Knight I doubt my fellow moviegoers were learning something about free trade. I didn't see the lesson at first but once I noticed it, it became painfully obvious.

***Spoiler Alert***

At the climax of the movie the Joker scares the population of Gotham to evacuate, leading to two ferries packed with people trying to escape the city. The Joker places a bomb on each ferry and then gives the two captains the detonation device for the other bomb. Ferry A can blow up Ferry B and vice versa. They have fifteen minutes to decide what to do or the Joker will blow them both up.

This is obviously a prisoner's dilemma game with the standard Nash equilibrium (the captains pull the triggers at the same time, killing each other). But that's not what happened. Each crew was overwhelming in favor of blowing the other up (confirmed by a vote), but no one was willing to actually do the deed. In other words, there's a very real morality cost that altered the payoffs. People would rather die than kill someone but they would rather have someone else kill than die.

If you look at polls Americans are mostly against free trade. (Last week's Economist cited only 33% of Americans think free trade is good for the economy.) Yet that's not how they act at the market. A choice between a cheap import and a more expensive domestic leads to people favoring the import. We don't of course need government action to limit free trade--people could just refuse to buy imports. But, as in the ferries, no one is willing to shoulder the cost of doing it themselves. They want someone else to do the deed.

Bryan Caplan notes there's a big difference between voting and buying. In buying you internalize all the costs and benefits of your actions. In voting such considerations are externalized onto someone else. Your gut feelings of xenophobia, survival, or old ideas are a lot easier to hold on to. But when faced with the true costs of your action, revealed preferences are quite different than the cheap talk from a voting booth.

Dump The Dumping Laws

Right now, an old friend of mine is awash with paperwork. He works for a company in the Midwest, importing steel from China. Last month his firm received a notice from the Department of Commerce (which insists on call itself "the Department" while abbreviating virtually everything else). They received a petition that my friend's firm (along with several others) are importing at an unfair price. An investigation is now underway.

First the department required that they spend dozens of hours filling out forms that summarize the company's activities with China (which basically means all their business). Then the department used that information and did acomparison study with India to determine their prices were "too low." The report reads why this is a problem:

The Petitioners contend that the industry's injured condition is illustrated by reduced market share, lost sales, reduced production, reduced capacity utilization rate, reduced shipments, underselling and price depressing and suppressing effects, lost revenue, reduced employment, decline in financial performance, and an increase in import penetration.

These are better known as the effects of competition.

The importer must now spend hundreds of man-hours demonstrating they operate in a free market or be hit with massive fines. People often complain that in an unregulated free market, corporations will set prices too high. Strangely, they now
argue that prices are too low because this company isn't in that same uncontrolled environment.

Democrats Vow To Block Out Sun

Exit polls from Wisconsin tonight revealed that a 70% of Democrats believe "trade with other countries causes the loss of American jobs." Both candidates argue against outsourcing and support having more jobs kept in America. Competition with cheap foreign labor and goods seems to be a great evil for Democrats.

Perhaps soon we'll see Hillary and Obama blame the sun for its product that floods our nation's borders. A product it sells for free. Free! Think of all those jobs the sun's rays take away: we have fewer electrical engineers, lighting manufacturers, power plant designers, construction workers, steel workers, glass blowers, and so many others. If we are to take their economic argument seriously then we must entertain the value of ending our dependence on foreign light.

Sen. Obama's Two Faces

In the midst of his victory in Wisconsin Obama spoke of respect for the free market and the importance of trade. But a sentence later he declared to give tax breaks to domestic industries to assuage outsourcing.

The logic of the free market does not stop at political borders. Entrepreneurs do not become stupid once they cross over to Mexico or China or Germany. Products made overseas are not inherently undesirable. And ones made within this country are not handed down from God.

Change is the essential element of all free markets and Sen. Obama should know this; he is the candidate for change. So he should celebrate our economy's evolution from manufacturing to service. He should revel in the constant experimentation and that remains so prominent. He praise people who find better ways to make the things we desire, embrace those that invent tomorrow's standards, and inspire more to engage in our oh-so dynamic economy.

Few forces are as potent sources of change--real, positive social change--than that of the free market. But it works best if we leave it unmolested and free to go places some may not want it to. As a self proclaimed free marketer and the candidate of change, Sen. Obama should know this.

The Tyranny of Oil?

During his Iowa Caucus victory speech, Barack Obama promised (among many, many other things) an end to the "tyranny of oil." Mr. Obama must be confused--Americans voluntarily buy countless barrels every day. We habitually downplay substitutes, opting to live far from city centers, shunning buses, and using candles primarily for romance. Claiming we are under a tyranny of the very thing we choose to buy is like accusing Google, McDonald's, and Nintendo of being dictators.

Mr. Obama ironically said this in Iowa, where farmers collect taxpayer money to grow corn. This is money taken by force and handed out to a select few, offering no clear benefit to society. Ethanol, not oil, is the closer autocrat.

Hillary's Magic Wand

My friend's support for Clinton encouraged me visit her site and poke around. While scanning the endless and all-too-familiar prattle of empty promises, I discovered a rather strange campaign promise of "ensuring our trade laws work for all Americans"

I don't think the former first lady realizes what a tall order that is. Freer trade will harm some farmers, steel workers, and other competitors of foreign imports. Protectionist policies will harm all other Americans. In competition, there must be losers.

Mrs. Clinton's efforts to retrain them does not make the issue disappear. If they wanted to be retrained, they would have quit long ago. If all that was stopping them was the $440 million she wants to send to Trade Adjustment Assistance (TAA) program, then now the taxpayers are the losers.

Granted, it's not impossible for everyone to come out ahead in this match up. But given the uncertainty of finding a new job and constant calls for less trade, I wouldn't place money on this alleged Pareto improvement fulfilling its promise.

A Multitude of Villianies Do Swarm Upon Us

Set aside the rampant talk on the campaign circuit about universal health care. Table arguments for protection at the cost of fundamental civil liberties. It is possible there is a candidate who would bring yet more nonsense to next year's election: Lou Dobbs.

Right now trade and immigration--especially immigration--are in party platforms. Despite that these issues are pretty much the same (both move jobs to foreigners), each of the parties treats them differently. Democrats don't like free trade, Republicans don't like illegal immigration. A crude line to draw, but useful.

Lou Dobbs, on the other hand, doesn't like either. At least he has the virtue of consistency. But if he would enter the race, his popularity would surely encourage candidates to call to assuage both instead of neither. Dobbs doesn't even have to be a viable candidate, he merely needs to make enough noise on the campaign trail. And when you're as popular and opinionated as Dobbs is, such a feat is as second nature as breathing.

HT: Mike Mills

Trading With Prometheus

South Korean farmers are erupting in anger over the trade talks with the U.S. Fearful that American produce will flood their market, calling that their livelihoods are threatened and the agricultural sector will collapse. I'm sure such phrasing gets a lot of support in Korea, as labor unions are sympathized here.

But few mind when technology threatens jobs. Farmers rally against imports, not hydroponics: life should be autarkist, but not archaic. Few tears are shed when a new technology wipes out old jobs. Luddites are rare, particularly in today's society. But protectionists always seem to have the ear of the public.

It's strange because trade and technology are functionally the same. In both cases, a good is made cheaper. In both cases, jobs are lost to those that can do the same for less. In both cases, there are winners and losers. In both cases, society changes in unpredictable ways. People are perfectly willing to erect trade barriers to "protect jobs," but the same does not go for outlawing technologies. Such arguments center around the ethics of playing God, not ensuring employment.

If you like technology, if you think it makes us wealthier because it swaps the cheap with the valuable, then you are right. We get to do more with less and we are better off for it. But what difference does it make if the goods transform by man instead of machine?

Calling India

A student sent me this video after our class on outsourcing and trade. I made the claim that one reason, perhaps the core reason, why people don't like international trade is for what are ultimately racist attitudes. It's about "us" versus "them." Protectionists make ultimately flawed economic justifications which are often inconsistent with other opinions they have about the economy.

I hasten to point out that there are some good reasons for a company to hire from it's native population. Cultural differences, for example, can be costly for customers to interact with (i.e. discerning through accents). However, people in practice seem to be unwilling to pay the higher price needed to ensure that common cultural ground.

The line between racism and issues of quality is a hard one to draw, but the video has clear examples of both.

HT: Ritu Joshi

Santa Brings Limited Trade

The Epoch Times mistakenly noted that New Zealand and China settle on a free trade agreement by Christmas. If it takes that long to settle negotiations, it's not free trade. Free trade is the absence of legal barriers to exchange between countries. If it was truly a free trade agreement, it would take less than an hour to write and be a few paragraphs long. Limited trade would be a more accurate term.

This is not mere semantics. When "free trade" fails to live up to expectations, protectionists often call for more barriers to "fix the market" and "level the playing field." Little do people know, fewer barriers would make a real and positive effect. It's the gift that keeps on giving.

Business, Not Market, Failure

With the return of Real Time with Bill Maher this past Friday, Maher's tackled Chinese imports with a well-worn fallacy: bad business means a failed market. The two are rarely one in the same. When a business make a bad decision and they are punished for it (as Chinese manufacturers are experiencing) that's a success of market activity.

The costs of such sloppiness is exactly why we can trust markets to handle so many complicated problems. It is not perfect, but compare mistakes made by CEOs to those of politicians. In government, blame is more likely to be passed than shouldered; failure is more likely to persist than be purged.