This time it's (really not) different, Part IV

Dumping.

The importance of fixed capital in the 19th century production process gave rise to potentially dangerous dumping practices.
But Chinese dumping isn't a threat, especially given the US's success with the WTO.
Nor is Germany's advantage caused - or best solved - by trade policy.
And the risk of tariffs spreading to broader protectionism is as real now as it was over a century ago - if not more so.

WILLIAM JAMES ASHLEY’S PROTECTIONIST MOVEMENT

William James Ashley’s favourite (and most exhaustively discussed) exception to free trade in the late 19th/early 20th century was ‘dumping’.

Dumping is the practice of flooding a foreign market with produce, often at below cost, so as to drive foreign competitors out of business, or simply to relieve the domestic market of an oversupply. And Ashley suggested Adam Smith and David Ricardo overlooked this possibility because they ignored the role of fixed capital in the economy.

Capital intensive production didn’t really exist in Adam Smith’s time. And Ricardo thought capital was mobile enough that price would always approximate the cost of production. So one could never dump at below cost, because these losses would cause capital to leave the industry until price returned to the cost of production (arguably, Ricardo thought this because his analysis focused on the banking sector, where capital was either mobile or little-used).

But the incidence of mass production, high-fixed capital industries allowed for the possibility of companies exporting at a price below average cost. This is because, even if they shut down operations while prices were temporarily below their total (variable and fixed) costs, they may save on their variable costs (wages, materials, etc.), but they would still have to incur their fixed costs (interest, maintenance, etc.). So as long as the price was high enough to cover their variable costs and any of their fixed costs, it was worth producing. In such a case, “business at any price [was better] than no business at all”. As Ashley put it:

“… industrial mills of the modern age had to keep running at high volumes, and this was, contrary to the Classical vision of the market economy (in which crises induce immediate retrenchment), even more important when the mills were confronted with losses during cyclical downturns.”

And this greater incentive to produce in the face of the “inexorable needs of fixed capital” meant the industry was susceptible to supply gluts. Thus, foreign markets become necessary to relieve the domestic glut, even at low prices (dumping). Even if things “right themselves” in the long run, or it only lasts a short period until prices recover or the glut ends, “it may be long enough to do irreparable damage to competitors”. Ashley foresaw the complete destruction of certain British staple industries (especially metallurgical). And in times of war when import supply is not guaranteed, “a nation that cannot repair its ships and build new ones … is as helpless as a nation which cannot feed itself” (see ‘defence is more important than opulence’ national defence argument in previous blog).

Ashley said this was the case with US and German producers exporting to England. This was especially concerning because even then, the US was an enormous market. And as the US had the largest demand, they'd have the largest capital-intensive production, and thus, probably the "largest periodical surplus", and could flood Britain with just their excess. This made the US the most dangerous to other nations' manufacturers.

Furthermore, lower unit costs from larger scales of operation encourages US firms to spread ther huge fixed costs over large output (e.g. the economies of scale associated with transport, bulk materials orders, better division of labour, etc.). Adding this to the size of the US domestic market, the united structure of US industrial cartels, and the US "tariff wall" (which encouraged even greater production because it supported domestic prices) induces dumping. This is because "a foreign sale at a low price added to a home sale at a higher price may produce a greater net profit than the home sale alone at the high price, since it's costs of production would be relatively higher" at lower levels of output (i.e. average costs are lower at higher levels of output). "These considerations would justify, under certain circumstances, a policy of permanently lower foreign prices, and not simply an emergency policy".

Philadelphia iron production for example, saw massive capacity expansions in the early-to-mid 1870s in the face of strong prices. But when prices plummeted late in the decade, millions of tons continued to be produced at huge losses for six years! “To allow their furnaces to go out of blast was to allow their businesses to go to ruin”. Even the US Industrial Commission Report justified keeping operations “full and steady” via below-cost export prices. And the Carnegie Steel Company admitted that they were looking not just at Germany and England, but also their colonies, as dumping grounds, boasting America’s ability to outdo England and Germany in their own markets.

Ashley argues such a policy had not been heard of before because US firms were too busy with their own market during prosperous times to worry about foreign markets. Dutch merchants in the East Indies too, used to destroy part of the spice crop when the market was in danger of glut. Now, producers/manufacturers seem to export it. Both are ways to avoid domestic gluts.

And “this statement does not signify that the export of domestics is a new thing … but that for the first time the existence of an important outlet for such goods saved manufacturers from a disastrous glut.”

Thus, by selling abroad at “slaughter prices” at strategic points of the business cycle to avoid a glut putting pressure on the domestic market, US firms incurred an “immediate temporary loss” to spare themselves lower domestic prices that would only recover slowly.

So they kept producing, covering variable costs but not fixed costs, in the hopes that they’d survive to see better years (which naturally, some did).

Surely this contradiction of traditional economic theory surrounding the notion of free trade justified protection of British industry with significant temporary “defensive and retaliatory tariffs” or outright prohibition (given foreign firms were selling at such low prices), because this US overflow was not guaranteed in the future (only when the US had a glut). So Britain should not rely on it. Even the Economist, “still abid[ing] by the doctrines of State inaction” labelled this behaviour as “unhealthy competition”. And surely Smith, even though such circumstances didn’t exist in his time, didn’t mean “buy in the cheapest market and sell in the dearest” in complete disregard for all other circumstances. Rather, one should buy from those countries which were “continuously and permanently cheaper [because of their] own peculiar advantages”.

Ashley was a well-respected voice for the protectionist movement, even by those on the free trade side. Bertrand Russell respected Ashley for "wisely grasping the historical fact, so often overlooked by free traders, that many economic conditions change over time". "Professor Ashley's work is, probably, the best presentation in existence of the case for Protection and Imperial Preference." His text The Tariff Problem was “the best account of the protectionist position”.

SO WHY WAS THIS SUPPOSEDLY REASONABLE STANCE SO DANGEROUS?

Ashley was also criticised for this argument, even before the additional historical case study of the post-Depression wave of protectionism which seems to support all the below criticisms. Ashley made it sound like there was a vast international industrial conspiracy that England wasn’t ‘in on’ (sound like someone we know?).

Ashley acknowledged that one could see the benefits of free trade but still recommend protective measures where the specific advantages outweigh the losses (in his words, “to put the mischief of individual liberty under restraint”). And this need not represent a betrayal of principle or any form of dishonour, nor risk opening the floodgates to widespread government intervention. Ashley believed “these are antitheses of controversy, but not of real life, [and that free trade and protectionism need not be] … self-complete and mutually exclusive”.

But economist FY Edgeworth criticised Ashley for focusing on the benefits that are possible from protectionism, not the evils that history shows are probable.

“Experience shows that protection, when it has once taken root, is likely to extend beyond the limits at first assigned to it and is very difficult to extirpate. ... Protection, once introduced into the body politic, is apt to increase and multiply; engendering not only its own kind, but also the evils of jobbery and corruption, perhaps more serious than the diversion of industry from its natural course. We might have expected the historical economist to balance, against the benefits which may be conceived in speculation as possible, the evils which are proved by experience to be probable. History … warns us that such attempts elsewhere have established the tyranny of monopolies sustained by the corruption of public life.”

This was a particularly damning criticism given Ashley's preference for historical analysis over abstract theories. I too have written before about the ease with which case-by-case protectionism can spread far beyond its initial intended scope, causing widespread damage. In other words, protection of individual industries is a slippery slope to the protection of less worthy industries, "the loss of purity in politics, the unfair advantage given to those who wield the powers of jobbery and corruption, unjust distribution of wealth, and the growth of 'sinister interests'".

But Edgeworth did respect Ashley's restraint in only wanting temporary import duties and focusing on the “more aggressive forms of 'dumping' which may be conceived”. But he was suspicious that Ashley's suggestion of protection for the purposes of retaliation is just a half-way house to widespread protection.

Bertrand Russell agreed:

"Protection is only electorally feasible if it is universal"; and it would take more than "a mere Executive act" to remove the tariffs - "at least two General Elections, and mountains of agitation" would be required.

Russell also suggested Ashley exaggerated the extent of dumping that was actually occurring, as well as the US’s potential for economies of scale, and underestimated Britain’s ability for them, thereby exaggerating the potential for ‘industrial ruin’. Furthermore, it is next to impossible to structure tariffs to only target dumping.

Also, the British Empire didn’t have a single central government, making it harder to hold everything together once the evils of protection are unleashed. This is relevant now because if national governments start acting in isolation and not as a collective global economy whose decisions affect one another, this suggests such protectionism is apt to get out of control, and will be very hard to reign in again.

And as for the ability to preserve (let alone bring back) Britain’s superior manufacturing status, Russell stated that nothing would restore “the manufacturing monopoly [Britain] once possessed”, given the growth of American and European competition in Britain’s staple industries. A similar argument could be used against Trump’s desire to return US manufacturing from China and the developing world – even 19th century Britain knew that lost manufacturing generally couldn’t be brought back. And this is not even necessarily a problem unless "superiority to other nations be more desired than prosperity" to the protectionists. The loss of these staple industries just meant Britain needed to specialise in more sophisticated manufacturing – just like the US does now.

HOW DOES THIS RELATE TO TODAY?

As mentioned above, traditional manufacturing won’t (and shouldn’t be made to) return to the US. It would be a highly destructive and disruptive process, and isn’t what the US should be focusing on. Furthermore, it is still true today that once protectionism has taken hold, vested interests are likely to cause its spread far beyond initial intentions or desires – especially when these vested interests can lobby someone as fond of ‘making deals’ as Trump (is it that hard to imagine Trump telling, for example, the car industry “maybe if a few of your executives stayed in Trump Hotel, I could do something about those pesky Chinese imports that are bothering you so”?).

In terms of dumping specifically, as I’ve mentioned before, China is not even a top 10 steel exporter to the US. What is the dumping concern? Furthermore, historically, the US has been remarkably successful in taking China to the WTO to resolve trade disputes – an international organisation which didn’t exist in Ashley’s time (and which Ashley suggested wouldn't be effective even if it did exist). So this somewhat undermines the notion that the US needs tariffs to stop Chinese dumping (which isn’t happening), when there is a body that has almost consistently ruled against China and in favour of the US on trade issues.

Trump has also accused Germany of ‘cheating’, given its large trade surpluses. While this actually has some merit, it has nothing to do with trade policy. If Germany had its own currency, it would be a lot stronger than the Euro to which it is currently pegged. This is because Germany has been outperforming the rest of the Euro since the debt crisis hit southern European countries so hard. But Germany being pegged to a currency that also has to take into account their weaker neighbours and therefore is too low for Germany’s individual circumstances means it is effectively running an unfair trade surplus (though not entirely deliberately). And this will continue until their internal inflation rates rise (or other Euro country inflation rates fall) enough to re-establish relative competitiveness and reduce their trade surplus. And along with criticising the ECB’s attempts to reflate the Euro economy, Germany also underwent unnecessary and unforced fiscal austerity, which slowed their inflation rates, thereby worsening and prolonging the deflation in southern Europe needed to rebalance the Euro internally, and extending Germany’s trade advantage.

But, this slow process of adjustment in Germany – of reducing their trade surplus through internal inflation or external deflation – that Trump is bemoaning is exactly the process that would happen under a Gold Standard – the thing Trump has toyed with implementing. If Trump is upset that Germany is running a trade surplus because it is temporarily enjoying/sustaining an undervalued currency until the rest of the Euro area internally depreciates and Germany internally appreciates (and that China ran a surplus by artificially undervaluing its currency until a few years ago), then it is hypocritical to propose a Gold Standard where countries that are temporarily stronger than their fixed exchange rate indicates will similarly enjoy (and can choose to artificially sustain) trade surpluses until internal inflation or external deflation eliminates it. It’s the same process over the same time horizon as Germany’s current situation.

So how can the US address this unfair German advantage? Well not by nonsensically accusing a key ally of “horrific barriers and tariffs”. It would be better to, firstly, learn the basics of economics:

·         That US exporters currently enjoy a tariff of just 3% in the EU.

·         That Germany’s 19% sales taxes aren’t an unfair disadvantage to US exporters, because German producers pay them too (see my previous blog). Likewise, both German exporters and US producers are exempt from sales taxes in the US. This is why sales taxes are considered legal by the WTO – because they don’t tilt the playing field at all.

·         That trade surpluses don’t mean ‘winning’ and trade deficits don’t mean ‘losing’ (see my previous blog).

Then maybe the US could help Germany and the Euro to fix their own situation – internal imbalances and that are far more damaging to Europe than the US. Help Europe (and the US for that matter) finally destroy this zombie austerity idea so they can reflate their economy and incidentally, start buying more US exports, helping the US trade balance. Don’t spark a trade war where everyone essentially starts doing the exact same thing, causing everyone to be worse off.

I will end this blog with one final thought. Despite WJ Ashley being well respected by both his supporters and his opponents, and the coherence of his knowledge and historical insights … his protectionist movement failed. Britain opted to maintain its free trade positions. With all the parallels between late 19th/early 20th century Britain, and the modern-day US, I hope the US will make a similar decision and do what it can to de-escalate these trade disputes.

This time it's (really not) different, Part III

Of infants and reciprocity.

Aluminium and steel are not infant industries in need of support.
Trump does not have anything against which to justly retaliate.
China has not caved in to Trump’s demands.
Even attempting to use tariffs as bargaining chips can too easily result in retaliation, an all-too-convenient slide into general protectionism, or just pointless disruption and self-harm.
It’s just not worth it.

The infant industry argument

One of the arguments in favour of protectionism about which I have previously written is the infant industry argument. John Stuart Mill postulated that supposedly, a young industry in which a nation potentially possesses a strong advantage may not command sufficient initial resources to become competitive and so, warrants temporary protection until it matures to a state competitive enough to survive independently. So Mill believed temporary protective duties, when used “in hopes of naturalising a foreign industry in itself perfectly suitable to the circumstances of the country” may be acceptable.

In the long run, the benefits of gaining such an internationally-competitive industry will supposedly outweigh the costs of the initial support. Adam Smith argued that a country should pursue the present and immediate advantages of buying goods at their lowest “present exchangeable values” via free trade. But surely the possible productive powers of a country are important too. Thus, “it might be worthwhile to incur a loss for a time in order to secure a more than proportionate future gain”. A country’s advantages after all, are dynamic and ever-changing, not static and permanent.

Furthermore, tariff revenue can be used to finance social welfare programs too (e.g. Germany supposedly benefited greatly from its tariffs in centuries past).

Even being a supporter of Smith’s notions of personal liberty, Mill still acknowledged this infant industry argument, a relatively small concession in Mill’s mind but much to the horror of other free-traders, especially the damage that could be inflicted if ‘infants’ didn’t ‘grow up’. Trusting government to “pick winners” has worked poorly in the past (as I’ve written about Argentina). Smith also acknowledged such an infant industry argument (though not in those words) but dismissed it as an unlikely situation.

Retaliation or bargaining

Another argument in favour of tariffs is their use in retaliation or for bargaining. Tariffs can be a bargaining tool to get trade concessions from other trade partners. Bertrand Russell acknowledges the potential power of tariffs in negotiations to reduce foreign tariffs and increase world trade. But, perhaps out of arrogance, if this tactic fails, people are often happy to leave the tariffs in place just to keep foreign goods out, not get domestic goods out, as was the original (and better) intention.

We need to distinguish the intention just to retaliate and gain ‘leverage’, from the intention for an easy and popular transition to protection. Also, is retaliation on free-trade principles worth risking a trade war? There is limited evidence of such retaliation actually working (no, Trump’s tariffs against China haven’t worked, see below) – countries rarely bow to such threats, especially when the political protectionist interests are stronger than the local exporter interests (e.g. the 14th and 15th century Italian condottieri [mercenaries] whose livelihoods depended on war, not peace) and/or national pride is at stake. And you’re just hurting your own economy.

And even if retaliation successfully lower foreign tariffs and increases exports, it'll also increase imports, which may (wrongfully) scare policy-makers into adding more tariffs to reduce imports that resulted from their own successful policy – a popular ‘Mercantilist’ fallacy from which Trump and Co. clearly suffer.

Eventually, the power to negotiate became less important than the freedom to import (as Robert Peel noted in light of the failure of the Corn Laws which placed tariffs on the importation of French corn in the 19th century, as well as the French with respect to their significant tariffs on British manufactured imports). And tariffs can force a country to start producing what it is not apt to produce, resulting in sub-optimal distribution of labour and capital, lower total national output and thus, impaired wealth levels. So often it’s just better to lower tariffs out of own self-interest, independent of any quid pro quo. And this “eventual triumph of universal free trade” will only be hindered by retaliating.

How do these arguments relate to Trump protectionism?

As I’ve written before, steel and aluminium are not infant industries in the US. And even if Trump does want to bring back these older traditional manufacturing industries, they are, by their very nature, lower wage (to compete with the developing countries that can do it just as well) and lower skill jobs than the service, technology and knowledge jobs in which the US should be specialising, bringing lower standards of living with them. And they are highly mechanised and automated now, so their ‘return’ wouldn’t generate a lot of employment anyway.

As Paul Krugman says, attempting to get these old industries back in the US is like running someone over, then attempting to ‘undo’ it by backing over them again. The damage has been done. Entire industries, production facilities and supply chains are now structured around the world based on the assumption that free trade will continue. It’s not simply a matter of bringing jobs back. Reversing this trend – that has been running for decades – will just cause the same disruption all over again but in reverse, as these industries, production facilities and supply chains restructure themselves again (only this time, sub-optimally) to this new protectionist world. Such traditional manufacturing has gone from the US. You won’t bring it back, at least not without significant and destructive disruption.

As for retaliation/bargaining, Trump isn’t retaliating. His claims of great tariffs in Germany and China are wrong. The German taxes Trump refers to as being applied to US exports are sales taxes, to which Germany’s own companies are subject, so it’s not an unfair disadvantage to US exporters. And US companies enjoy an average Chinese tariff of just 3%. So what is he retaliating for? The trade deficit with China? That is not a bad thing either (see previous blog).

What about bargaining? Some have suggested that China has caved in to Trump’s demands and have made numerous concessions to appease him in a recent speech by President Xi Jinping. Unfortunately, either China has already been planning to make these moves for a long time, or they will have minimal impact on the US anyway (according to David Fickling of Bloomberg LP):

·         Opening up financial services and automotive joint ventures. These plans have been under consideration for almost five years and were enshrined in an economic planning document 12 months ago, as well as a Chinese policy announcement last November;

·         Reducing restrictions on foreign investment. Such reviews have been carried out periodically ever since Beijing’s current foreign investment regime was established in 1995. Relaxation of these restrictions generally follows Chinese companies reaching some sort of threshold where they can compete effectively with imports (see infant industry argument above);

·         Strengthening intellectual property protections. This is something the US actually worked very hard to enshrine in the provisions of the Trans Pacific Partnership (TPP), before Trump abandoned it. What was the point? And Xi even referred to it in a financial conference speech last July; and

·         Expanding imports and reducing their current account surplus by for example, reducing tariffs on cars. This is another long-established project as part of China’s ongoing long-term planned transition from an investment-led to a consumption-led economy, which will naturally involve more openness to imports. But even so, China only imports around 5% of its cars, most of which are luxury brands from Europe, not the more affordable ones that would come from the US (which simply can be produced far cheaper in China, not imported). Maybe the US can try to get in on the luxury car market. But they would be competing directly with Germany. Good luck!

I mean, did we really expect China’s reaction to Trump’s tariffs to be: “Oh, okay Mr Trump, we’ll give you what you want. Just please, don’t hurt us”? Far more likely is that China is attempting to trick Washington into declaring victory and abandoning its tariffs – which would actually be a good outcome, given one of the alternatives is all-out trade war.

But even if it turns out that Trump’s bullying of other countries actually does result in countries freeing up their trade policies further (in a real, not superficial and pre-planned way), is it really worth it? Is it worth risking a highly destructive trade war for marginally greater access to a few export markets? What message does this send to other countries? Should they too start making demands (fair or unfair) of the rest of the world, under threat of materially damaging other countries’ (and their own people’s) welfare?

People generally don’t put up with being bullied like this for long before retaliating.

Central Banking works - you just don't know it.

Bank of England policy has successfully supported the economy over the last decade, without worsening inequalities between different age, income and wealth groups.
But the general public, particularly older individuals, is sceptical.
Central Banks must sell their success – their independence (and our livelihoods) depends on it.

Perception is a lot more negative than reality.

There’s currently a gap between how effective Central Banks have been in averting the worst of the GFC, and how effective the general public believes Central Banks have been. Perception is a lot more negative than reality.

The academic and ‘elite’ in me is tempted to say: “Who cares? The general public doesn’t know what they're talking about. Central Banking is a complicated and critical art that must be left in the hands of experts, not ‘Joe Public’. So who cares what the public thinks?”

Well, as it turns out, it’s actually very important what the public thinks. Central Banks have become more powerful and have more independence to execute their will than at any point in history. But this isn’t a given. If enough public mistrust is generated as to the true motives and effectiveness of Central Banks, public opinion could influence politicians to take away this power, authority and independence.

The simple stroke of a pen could change or even revoke the very Act of Parliament that founded the Reserve Bank of Australia. Monetary policy could return to the hands of quibbling bureaucrats who do not have the expertise to respond effectively and swiftly in times of crisis.

Just imagine a politician that:

·        Overheats the economy because he was too afraid of mortgage holder opinion to raise interest rates earlier;

·        Causes the financial sector to crash because some misguided concerns about ‘moral hazard’ stopped him providing enough liquidity and/or acting as ‘lender of last resort’ during a financial panic;

·        Sends the economy back into Depression because some economically-illiterate ‘inflation hawks’ pressured him into raising interest rates and withdrawing liquidity from the market too soon in the recovery;

·        Makes monetary policy as politically-hamstrung as the US government was during the 2012 debt ceiling stalemate – or worse, as actively destructive as austerity-obsessed Euro governments during their debt crisis.

If Central Banks are to remain effective, they need to maintain the social contract they have with the public. It isn’t enough that they know what they are doing. They need to convince the public that they know what they are doing. Otherwise their independence and power could be taken away from them, and Central Banking could become just as ineffective – or actively destructive – as government.

And Central Banks do indeed know what they are doing.

So says Andrew Haldane, Chief Economist at the Bank of England, recent inclusion in the Forbes’ 100 Most Influential People in the World list, and presenter at the David Finch Lecture in Melbourne recently.

During the Brexit campaign back in 2016, a TV debate became quite infamous. After many experts spoke of the dangers of Brexit, and the loss of employment and GDP as a result of such a decision, an audience member stood up and bellowed:

“That’s your bloody GDP, not ours!”

This hit on a very important point. Public opinion had reached a point where people didn’t believe they were sharing in the general wealth of the country. Because of increasing inequalities in the developed world, ‘economic growth’ was no indication that everyone was benefitting. And no one had a satisfactory response to the above statement.

Enter, Andrew Haldane…

Andrew conducted an analysis of not just the aggregate impacts of Bank of England policy since the GFC (e.g. unemployment, inflation, economic growth), but also how these impacts were distributed amongst different age, wealth and income groups, so that he could determine exactly who benefitted and who lost from this Central Bank's policies.

Following the GFC, the Bank of England dropped interest rates by 5% and flooded the market with £375 billion worth of quantitative easing. The evidence is in – this policy unambiguously helped support GDP, employment and inflation. In fact, the average household income and wealth were boosted by £9,000 per year and £20,000 respectively (compared to if the Bank of England did nothing).

But one of the often-quoted costs of such policy is that it has squeezed the incomes of self-funded retirees through low interest rates on their savings. This helps to explain why surveyed people over 55 are particularly mistrusting of Bank of England policy over the last decade.

But what is overlooked is that these policies also supported stock and asset markets – benefits which accrued mostly to older and wealthier individuals, but to an extent that was no greater than existing inequality levels.

Furthermore, while younger individuals didn’t benefit as much at the hands of a stock or asset market boom, they did benefit from lower mortgage repayments at the hands of record-low interest rates (more so than older individuals who were less likely to still have a mortgage). Younger individuals also benefited more so than their elders from the employment levels that were supported by Bank of England policy.

So it seems public mistrust is rooted in a focus on the direct impacts of Central Bank policy (older individuals losing income on their savings), not the indirect impacts (wealth gains from asset market booms).

Conclusion – the distributional impacts of Bank of England policy across age, wealth and income groups are small and inconclusive. Not only did policy support economic aggregates, it did NOT worsen inequalities. Accounting for all these direct AND indirect impacts, virtually all age, wealth and income groups benefitted from Bank of England policy, to an extent that did NOT worsen inequality levels. Yes, the wealthy benefitted more than the poor. But not to any greater extent than their current income and wealth levels reflect. So relative inequality did not worsen.

Sell your success!

So in reaction to the above statement that “That’s your bloody GDP, not ours”, the response should have been:

“No, it’s your GDP too!”

This is the message Central Banks need to sell – not just the aggregates, but how their policy helps individuals. And to the extent that anyone suffers at the hands of Central Bank policy, government policy (tax policy, infrastructure, income support, etc.) should do some of the heavy lifting too.

Sell your success, Central Banks! Your independence (and our livelihoods) depends on it.

This time it's (really not) different, Part II

Defence is more important than opulence.

The US is not in danger of a hostile foreign power cutting off its import supply.
It will adapt to the loss of traditional industries.
There are better ways to support those left behind than tariffs.

NATIONAL SECURITY CONCERNS ABOUT FREE TRADE.

In my previous blog, I talked about how economic theory arguably culminated in support of free trade over protectionism all the way back in 1776 with Adam Smith’s Wealth of Nations. But, as discussed in my dissertation, the first subsequent major movement away from free trade came after the Napoleonic Wars in the early 19^th Century – not long after Wealth of Nations. Arguably the most prominent academic pushing for such protectionism was Thomas Robert Malthus. And Malthus invoked a very specific reason for this departure from the new economic orthodoxy – national security.

During the Napoleonic Wars, Napoleon created a ‘Continental System’ which ended the export of all corn to Britain. But Britain had a significant agricultural industry that it was able to further develop so it was able to manage without European corn. And the monopoly that this trade ban gave to British farmers raised prices and encouraged them to produce even more.

But when the Napoleonic Wars unexpectedly ended and trade suddenly and impressively recommenced, corn prices halved, and British farmers were placed under significant pressure.

Britain was a corn exporter during Smith’s time, until 1793 (after Wealth of Nations, and 3 years after Smith died), so Smith was “in happy unconsciousness of the change that time was speedily to bring”, thinking that “the free importation of foreign corn could very little affect the interest of the farmers of Great Britain”, as they were heavily protected by high transport costs.

But if Smith had foreseen such a development, surely he would have acknowledged the national security risk. If Britain, heavily dependent now on French corn which had driven British farmers to disappear, were to recommence hostilities with France (or if France simply had a poor harvest), France could cut off Britain’s supply and the richest country in the world would starve – surely a national security issue. After all, there is virtually no country in Europe that hasn’t exercised the power to completely stop or heavily tax exports, if outright prohibition wasn’t already part of their general laws. And the political mistrust of the Napoleonic Wars continued long after the wars ended. Surely this justified protecting British agriculture with tariffs (to be called the Corn Laws in 1815) to stem agriculture’s already enormous losses and Britain’s potential complete ruin.

Malthus stood on the protectionist side of this debate, across from David Ricardo on the free trade side - the two most prominent academic voices of this debate. Though interestingly the two were still close friends (take note, modern society).

Support for such a protectionist exception could even be found in Adam Smith’s own work. Smith referred to Britain’s Navigation Act that protected the armed forces as “perhaps the wisest of all commercial regulations of England”, the one case where regulation was “positively expedient” despite the fact that it was “not favourable to foreign commerce” because in this case, “defence is of much more importance than opulence”. He believed the Act would assist an industry vital to the defence and health of the country (English mercantile shipping) at the expense of laying some burden upon a foreign country (at the time, Holland’s naval power).

Trump claimed national security reasons for his initial steel and aluminium tariffs. But with respect to steel, the US imports most of its supply from allies. China doesn’t even crack the top 10. So what’s the national security concern?

If the US imported a lot from non-allies, there may be a concern that the enemy (if war were to break out) could cut of the US’s supply, like Britain feared after the Napoleonic Wars. But even back then, this was arguably a non-issue. France cutting off Britain would cause massive financial losses to France, making it impossible for them to finance a war effort. And Britain, given its size and market power, could arguably obtain supply from elsewhere at short notice. Why not the US too in terms of steel?

But again, this is still a non-issue because these steel tariffs are aimed at US allies more than China.

MAYBE TRUMP'S ARGUMENT WAS MORE ABOUT NATIONAL ECONOMIC SECURITY.

Adam Smith once said:

"No regulation of commerce can increase the quantity of industry in any society beyond what its capital can maintain. It can only divert a part of it into a direction in which it might not otherwise have gone.”

But contrary to Smith’s (and Ricardo’s) desire for specialisation, a diversified country/town is less dependent on one industry and thus, less subject "to the unmitigated force of the fluctuations of a single trade". Thus, it is less subject to widespread depression.

In this way, pure specialisation isn’t desirable. Even though a purely manufacturing society is undoubtedly better than a purely agricultural one, certain evils of specialisation mean going to the extreme is unadvisable.

Labour mobility was also greater during Adam Smith’s time, when workers retained closer links to previous employments, such as agriculture. But during WJ Ashley’s time in the late 19^th/early 20^th century (and arguably even more so today), workers were more skilled/specialised, causing them to be more immobile and cling more to very specific occupations, even in declining industries.

Keynes supported protection of agriculture for this reason too:

“The case for protection of agriculture was less narrowly economic: a well-rounded society needed contact with the changing seasons and the experience of cultivating the soil. Agriculture, like art, was a public good that the nation could afford to maintain.”

In his Self-Sufficiency paper, he wrote:

“We have until recently conceived it a moral duty to ruin the tillers of the soil and destroy the age-long human traditions attendant on husbandry if we could get a loaf of bread thereby a tenth of a penny cheaper”.

Surely it is worth preserving agriculture at the expense of such a marginal immediate gain.

But he does caution against taking self-sufficiency too far, referring to Russia as such a poor example – “Let Stalin be a terrifying example to all who seek to make experiments”. Not only is this likely an inefficient use of resources, but it hinders the ability of developing countries to pull themselves out of poverty through one of the most important activities in which they have greater advantage – agriculture. Keynes simply didn’t want the world to be stuck in the pure cruel internationalist capitalism of their forefathers. But problems with retreating from free trade still needed to be avoided.

But rather than focusing on agriculture, Ashley wanted to re-establish Britain’s superior world position in light of:

“the increasing industrial strength of Imperial Germany and the United States; … Britain’s declining share of world trade in its chief manufacturing staples of cotton, textiles and machine tools; the entrenched poverty and persistent industrial unrest in the face of economic growth; and an expanding chorus of eugenicists asserting than an unworthy underclass would soon drag down the English middle classes.”

There were declines in Britain’s most significant export industries: cotton manufactures, cotton yarn, iron and steel, woollen and worsted, and linen, as well as shipping.

“… all the older staple industries of Great Britain [were] either visibly declining in their exports or maintaining themselves with increasing difficulty”.

Countries that traditionally exported raw materials to Britain for Britain to turn into manufactures, were also increasingly beginning to manufacture for themselves, and capture other markets too, e.g. Indian cotton manufacturing. This was a development unpredicted by Smith, who thought England would maintain great natural manufacturing advantages.

But even if these industries couldn’t be brought back, Ashley argued that tariffs can still ease transitions, rather than allowing industries to lurch ceaselessly from depression to prosperity. Higher profits won't mean higher wages necessarily, but lower profits will almost definitely cause unemployment. The pain of unemployment and low wages far outweighs the joy of high wages and overtime. Even Adam Smith conceded the potential need to “ease the transition by temporary means of defence”.

Ashley also pointed to US and German protectionism, highlighting the fact that their wages (net of the cost of living) had gone up considerably during the period of protectionism, and unemployment and poverty were at far lower levels than had been allowed to occur in Britain.

Now, Trump supposedly has same concerns about the US’s decline, and loss of traditional industries to countries like China, and the potential for tariffs to fix it.

TARIFFS ARE STILL NOT THE BEST WAY THOUGH.

Ashley’s arguments were criticised for failing to appreciate that Britain (like the US today) would adapt. It may lose industries at which the US and Germany (China) were better/more powerful, but Britain (the US) would upskill and become proficient in new industries, not become a social and economic backwater of low skill poor slaves as Ashley feared. Arguably there was justification for temporary support during the transition – but preferably education, retraining, infrastructure, health care and income support, not something that upsets the trading partners.

Furthermore, the Corn Laws were repealed in 1846 specifically because of the damage they inflicted, and their inability to achieve price stability and domestic supply. The Lancaster cotton industry for example, suffered from its inability to cheaply import cotton from the US during the Corn Laws (like US car industry would from a lack of cheap imported steel). Why would Trump’s tariffs be any different?

Furthermore, as Bertrand Russell notes, the loss of an industry to international competitors is almost always a gradual one anyway (US manufacturing has been declining for decades), absorbed through reductions in investments rather than significant immediate hardship. "Heroic measures" are only necessary in the unlikely event of an "organised sudden attack" on an industry, which is not the case in the US.

So the US does not have to worry about a hostile foreign power cutting off its supply. And it will continue to adapt to new industries as old ones shift to other countries. Those individuals left behind should be supported productively, not with destructive protectionism. And history’s ongoing tendency to return to free trade supports this notion.

This time it's (really not) different, Part I.

A trade deficit does not mean you are losing!

My dissertation predicted it.

I’ve been wanting to discuss these thoughts ever since I first wrote them in my university dissertation in 2010. My dissertation was about how the ‘pinnacle’ of economic theory was arguably Adam Smith’s Wealth of Nations in 1776. As well as being quite the work of philosophy, it also extoled the virtues of free international trade, not protectionist measures aimed at driving exports and limiting imports. And this new free trade mentality seemed to underlay the field of economics ever since.

Even though periodically, there were strong movements back to protectionism, every time, they were either reversed in later years due to the damage they inflicted, or failed to get enacted in the first place.

Every protectionist period thought ‘this time is different’. This time we don’t have to follow the ancient wisdom of Adam Smith’s free trade theory because circumstances are different now. Free trade doesn’t work anymore.

Well, circumstances have indeed changed a lot since 1776. Specifically, my dissertation looked at three periods since 1776 where protectionism made a resurgence in light of such changes, and the academics behind them:

·         Thomas Robert Malthus and the early 19^th Century ‘Corn Laws’ in Britain;

·         William James Ashley and the desire to protect manufacturing and other staple British industries in the late 19^th and early 20^th century; and

·         John Maynard Keynes in the interwar period and the Great Depression global protectionist movement.

But the overriding superiority of free trade compared to protectionism always seemed to eventually win out.

That was the focus of my dissertation. And I’ve wanted to discuss it openly ever since, but it never seemed particularly relevant to current events. And I thought it never would be, because I was sure the world had learnt its lessons from the trade wars of the past.

Silly me.

Well now, it’s very relevant. Only this time, it is Trump and Co. who believe ‘this time is different’. That ‘trade wars are good and easy to win’. That protectionism is once again the way to go.

So let’s take a walk through history.

Adam Smith discredited Mercantilism almost 250 years ago.

Let’s start with Trump’s constant claims that the US is ‘losing’ because of its massive trade deficits with China, supposedly justifying tariffs. The man is almost 250 years out of date!

The ‘Mercantilist’ school of thought used to believe trade is a zero-sum game of who can export the most and import the least. Historically, when countries operated on the Gold Standard of exchange rates, such policy resulted in trade surpluses and the accumulation of precious metals (gold). Now, running trade surpluses means accumulating the foreign currency that was used to pay for your country’s exports. So mercantilists argued that tariffs on imports could help achieve this end – hence the common use of tariffs before 1776.

But trade is not a zero-sum game and need not involve these kind of ‘beggar-thy-neighbour’ policies that often resulted in trade wars.

In fact, this Mercantilist view was discredited by Adam Smith’s Wealth of Nations in 1776! According to Smith, a country’s wealth is not based on its accumulation of precious metals, it’s based on its social division of labour – it’s ability to specialise in the activities in which it has a comparative advantage (a process facilitated by trade, not hindered). Both sides of trade benefits from the transaction, not just the exporter. This means that even a country that has an absolute advantage in every industry would still benefit from trade by specialising in the industries in which it has a comparative advantage – the things at which it is most superior.

Trump seems to think that the US importing from China represents a ‘loss’ for the US.

But Smith dismissed “the notion that imports are paid for by money which might otherwise be spent at home [as] the crudest of all popular fallacies” because if it were true, “Ireland … would long ago have been completely denuded of money [and] England must have spent its whole currency twice in six years without anyone’s noticing.”

This is not how trade works, Mr Trump!

Even before Adam Smith, the idea of trade as a zero-sum game was under threat.

In fact, even before Adam Smith, Thomas Mun (1571-1641), as Director of the East India Company, was accused of undermining Britain’s prosperity by exporting gold to acquire cheaper foreign raw materials. But Mun saw the advantage of being able to use these cheap raw materials domestically to create elaborately transformed manufacturers that could be then sold for far more (and would employ a great number more hands) than could be achieved by simply exporting raw materials and reducing imports. And while he used this as a reason to argue in favour of protectionism for the manufacturing industry, and still supported the running of trade surpluses, it does represent a progression away from the zero-sum game of simply exporting more than importing. It represents a move towards exporting, importing and domestic production, of producing things more valuable than their inputs, regardless of where they were sold – over 100 years before Adam Smith.

David Hume’s (1711-76) Quantity Theory of Money also postulated than money is neutral in the long term, so a country’s wealth is not based on the accumulation of precious metals or currency, but in the quantity of goods and services and labour in the economy.

“Money is one of the wheels of trade … [but is irrelevant in the long run because] prices of commodities are always proportioned to the plenty of money”.

Therefore, the inflow of money resulting from a trade surplus would drive inflation (or the exchange rate if the country weren’t operating on a fixed [Gold Standard] exchange rate), reducing the country’s competitiveness, causing any surplus to naturally decline over time (see my previous blog about the inconsistency of Mercantilism and the Gold Standard). So if tariffs can’t maintain a trade surplus indefinitely because of the neutrality of money, free trade is preferable.

Hume also saw the potential for poorer countries to benefit from trade with wealthier countries via a “catch-up” or convergence effect due to the lower prices and wages that were generally inherent in poorer countries.

“Nature, by giving a diversity of geniuses, climates and soils, to different nations, has secured their natural intercourse and commerce”.

I know Trump is only interested in “America First”, but it’s worth noting the damage that a trade war can inflict on poorer countries.

So by the time we got to Adam Smith’s Wealth of Nations, trade was no longer seen as a zero-sum game. ‘Stealing’ from other countries by manipulating gold/currency flows with beggar-thy-neighbour trade policies was no longer seen as the optimal way to drive a country’s wealth. All countries could benefit from trade. Tariffs were in fact a hindrance.

Trade deficits do not represent ‘losing’.

A trade deficit with China simply means the US is buying stuff from China and selling its stuff elsewhere. China doesn’t have to buy the US’s stuff just because the US buys China’s stuff. That’s not how trade works. Should I get upset when I buy a burger from the corner store, just because the corner store didn’t buy something from me in return? Should this ‘trade deficit’ with the corner store make me angry? Of course not. Because that’s not how trade works. I’m exchanging the store’s burgers for my money, not my economics advice. This isn’t a bartering economy.

And even if you’re running a trade deficit with the entire world, it could just mean that your country has a lot of good investments locally in which the rest of the world is investing, and that trade deficit is largely returns on those investments paid to those foreign investors. You’re not losing! That is just international finance, and its actually facilitating your country’s wealth, not hindering it.

Paul Krugman argues there is one time when a trade deficit can be a bad thing – when there is mass unemployment, and the country really needs a lower exchange rate for exports to rise and imports to fall, thereby driving economic activity – like during the GFC, when the US claimed that China’s undervalued currency was stealing away part of the US’s recovery. But the US is near full employment now, and China is no longer undervaluing its currency (it actually had to be devalued a couple of times in recent years because it was overvalued), so the trade deficit is not a problem.

Once again, the US is not ‘losing’ just because it buys more from China than China buys from the US.

You can argue that China does not always play by the rules of international trade. Intellectual property laws are something that they arguably openly flout. But the way to deal with this is for the US to form a coalition of other countries to put pressure on China to play nicer. We could call it … a Trans Pacific Partnership, or TPP for short. Yes, that was a joke about how the TPP Trump abandoned was in fact designed to do just this – it was a trade deal that focused significantly on intellectual property rights, rather than actual trade of goods and services. The US had helped write a significant amount of provisions to this end, but as soon as Trump left the TPP, these provisions were largely dropped. This would have been the perfect way to get China on board, not unilaterally punishing them with steel and aluminium tariffs, in spite of the fact that China isn’t even a top-10 steel exporter to the US.

A trade deficit does not mean you are losing. And this kind of economic illiteracy at the highest levels of the largest economy on the planet has implications for us all.

Monetary policy in retrospect.

Lessons re-learnt. 

Monetary policy need not become impotent once interest rates reach zero.
Quantitative easing can still help generate confidence and incentivise government and private sector borrowing, even if not actually reflate the economy directly.
There are also other tools available that can effectively stimulate the economy, including forward guidance, negative interest rates, and even helicopter money.

This is an interesting paper by Paul Krugman, summarising many of his and (if I do say so myself) my own past thoughts on this issue.

He suggests that monetary policy becomes ineffective once interest rates reach zero (the 'zero lower bound', or ZLB), unless the central bank enacts significant (and most importantly, permanent) changes in policy. Even enormous temporary increases in the supply of money (as we saw from the Federal Reserve and European Central Bank following the GFC) won't feed into higher inflation. The extra liquidity just sits there. This is known as the 'liquidity trap'.

This is not a new idea. It has actually existed for 80 years. Even I acknowledged this phenomenon in some of my previous blogs (here and here). Unfortunately, many forgot it (or never knew it in the first place) when it was needed most, and opposed or delayed central bank actions following the GFC, fearing that it would spark inflation and debase the currency.

There are a couple of additions to Krugman's paper I would like to make though.

Firstly, while emergency liquidity measures during a financial crisis won't translate into significant (or even marginal) inflation, it is a necessary measure in preventing deflation. During the panic of a financial crisis, everyone (individuals, businesses, even the financial sector itself) increases their demand for money above what they normally do (as a hedge against the real or perceived risk of the crisis). And if the central bank doesn't swiftly act to meet this new demand (by increasing the money supply), the 'price' of money (as opposed to the price of goods and services, a.k.a. inflation) skyrockets. Translation - massive price deflation and unemployment.

So while this extra liquidity may not drive actual inflation and economic activity, it does act as a floor to stop the whole system tail spinning.

Secondly, by using their quantitative easing (QE) measures even after the initial panic had abated, central banks were able to buy long term assets, thereby driving long term interest rates to record lows. Simply manipulating short term rates (like central banks do in normal times) can be viewed with suspicion by private borrowers (and even government), given that this change will probably be reversed in at most a few years. But QE drove government 30-year(!) borrowing costs down to 0.24% by December 2012. This would be the perfect excuse for a government (if not the private sector itself) to borrow and invest big, thereby ending the economic slump.

Central banks also have a tool called 'forward guidance' where, through public announcement such as their regular board meeting minutes, the central bank can state its intention to keep short term interest rates low for as long as it takes the economy to recover. If credible, this expectation of short term rates remaining low for the long term will cause long term rates to fall, just like under QE. QE however, is a firmer commitment - central banks actually driving down long term interest rates directly, rather than through the credibility of their 'promise' to keep short term rates low for the long term.

So again, while QE didn't generate real economic activity and employment per se (because it was just sitting there, as per the nature of a liquidity trap), it did further support confidence that the financial sector wouldn't run out of money, as well as lowering long term interest rates (upon which a sensible government would have capitalised). Krugman himself repeatedly pleaded with government to borrow at these low rates and end the slump sooner, so this point isn't something he hasn't considered. It's just something I think wasn't sufficiently appreciated in the above paper.

Thirdly, some central banks in Europe (and Japan) experimented in the aftermath of the GFC with negative interest rates. In normal times, a government may issue a $100 bond (i.e. borrow $100), and promise to pay back $105 in a year's time. This represents a 5% interest rate that the central bank can manipulate up or down to zero. Through an Act of Parliament however, a government can technically issue a $100 bond and promise to pay back just $95 in a year - a -5% interest rate.

Given that negative interest rates were an unprecedented development, and no one was precisely sure what unprecedented evils could be unleashed by such a measure, the furthest any country dropped them was Switzerland to -0.75%. And, as it turned out, there were no unprecedented evils, and actually some positive economic results evident from being able to drop interest rates further than zero.

Fourthly, central banks can always resort (though only as a last, last resort) to 'helicopter money'. This effectively means printing money and giving it directly to the Treasury (which they can spend on infrastructure, tax cuts, etc.), or giving it to households themselves. Some, including Paul Krugman himself, suggested the Fed could mint a new $1 trillion coin, transferred directly to Treasury, to overcome the government's debt ceiling debate. The problem with the above measures is that they still rely on government and/or the private sector to exploit these easy-money conditions, borrow and invest, thereby stimulating the economy. Helicopter money (named after the exaggeration that it amounts to throwing money from a helicopter across the country) however, puts money directly into the hands of those who will spend it.

The reason this is not done during normal times is obvious - it will spark inflation. Extra money without equivalent growth in the size of the economy makes the money less valuable. But during a depression, when the economy simply needs someone (households, industry, government) to be the first to start spending (but every group, through fear and uncertainty, is waiting for someone else to be the first), helicopter money can be that necessary trigger to get normal activity underway again. But as soon as it is, the measure must be wound in.

But the reason this was not done even following the GFC was fear and, ironically, hope. Such a measure would be unprecedented (a common theme in this blog, you may have noticed), and the results could be unpredictable and hard to reverse. Furthermore, central banks rely heavily on their own credibility. QE is one thing. It involves a central bank simply increasing liquidity in the financial sector - a standard crisis response for a central bank. Helicopter money however, is effectively a way to bypass the government's responsibility for its own finances. And given the public opposition to even QE, maybe central banks weren't willing to let their credibility take another hit by enacting helicopter money.

In terms of hope, central banks were still holding out for their governments to take advantage of remarkably low interest rates and borrow. As long as they had this hope (and as long as the economy was still recovering, albeit slower than desired), they weren't willing to take the next step.

So central banks have many tools at their disposal. And while governments (especially in Europe but also the US) didn't capitalise on this once-in-80-year opportunity of record low interest rates to rebuild their countries, it does illustrate that monetary policy isn't entirely useless at the ZLB.

If only governments had the same "courage to act" (Ben Bernanke, former Fed Chairman) and do "whatever it takes" (Mario Draghi, ECB President) like central banks.

There's a reason the pills that Morpheus offered Neo in The Matrix were red and blue - randomised trials.

THE MATRIX HAS YOU, NEO

Ever wondered why the pills Morpheus offered to Neo in the Matrix were red and blue? It’s because randomised trials revealed that people are more likely to believe a blue pill is a sedative (something to put Neo back to sleep to remain in the Matrix), and a red pill is a stimulant (something to make Neo ‘wake up’ and realise the truth).

And such randomised trials didn’t just teach us about red and blue pills. Apparently, yellow pills are better at treating depression, white pills at reducing pain, and green pills at reducing anxiety. 

So I learned at a recent lecture by MP Andrew Leigh, who was promoting his new book Randomistas: How Radical Researchers Changed the World. Andrew spoke of the importance of randomised trials – of having a control group to determine the effectiveness of a policy or action.

SHAM SURGERY AND THE PLACEBO EFFECT

Another example was on the effectiveness of a type of knee surgery where the cartilage between the thigh and shin bone (the meniscus) has been torn. In 2013, a group of Finnish doctors conducted a study whereby patients were randomly chosen to either have the surgery, or just have their knee cut open and sewn up again without actually doing the surgery itself. Of course, the patients couldn’t be told which group they were in. 

The result – statistically, those that had the ‘sham’ surgery still recovered just as well as those with the real surgery. The real surgery had no discernible benefits. The ‘placebo’ effect of the ‘sham’ surgery was clearly a lot stronger than expected, with three quarters of patients saying they “feel better” after surgery, even though half were subject to the sham surgery. 

A lot of people were clearly upset with the findings, given that this particular surgery was the most common orthopedic surgery in the US and Australia.  

Of course the placebo effect isn’t limitless – a randomised trial of the polio vaccine in the 1950s proved it to be far superior to a placebo injection of salt water. So it was subsequently universally rolled out. 

But this does highlight the importance of such randomised trials in getting over problems where the placebo effect, or reverse-causality, does exist.

OTHER FUN FACTS FROM RANDOMISED TRIALS

·        Today, only one in 10 ‘promising’ drugs actually make it through the three stages of randomised trials and onto the market.

·        Placebo injections have a larger impact than placebo pills, possibly because it gives the illusion of something more drastic.

·        Multivitamins and fish oil supposedly actually reduce your longevity.

·        A 1970 California study suggested that cutting a prisoner’s sentence by 6 months had no effect on whether they would re-offend.

·        Google’s precise shade of blue they use on their homepage is estimated to add $200m to their bottom line as a result of extra ‘clicks’.

WAKE UP, NEO!

And all of these findings came about through the use of randomised trials – not just the statistical analysis of big data, but the use of real world experiments to control for things that data alone misses.