Trade models I teach - the Ricardian trade model

In my last post, I wrote:

I myself have participated in this, in the Introductory Macroeconomics course I TA for at the University of Michigan. We always include a lecture that pits pro-free-trade arguments against anti-free-trade arguments, and we make sure that the former always come out the "winner" at the end of the day. We use the very simplest models of trade, and we never mention industrial policy or the manufacturing sector or mercantilism. And another four hundred students tramps off to be America's next generation of businesspeople, lawyers, journalists, professors, and voters...

So to follow up on this, I thought I would explain the trade models I teach - and those I don't teach but which are in common use - and illustrate why these models say that free trade is always good. The first model I talk about will be - must be - the classical, or "Ricardian" trade model, which is the one I teach in introductory macro courses.

The Ricardian trade model deals with aggregate trade between countries - in other words, it treats each country as a single person, saying "Brazil can produce 100 cows or 50 peppers, Argentina can produce 75 cows or 25 peppers." You may already be able to see how this setup already assures that free trade is always optimal. The reason is: if Brazil is a single person, and Argentina is a single person, they wouldn't agree to trade if trade weren't good for both of them.

This is actually a very deep principle in economics. It's called the "first welfare theorem," and it says: two people will not engage in any economic transaction that doesn't benefit both of them. Thus, any economic transaction that happens - such as international trade, for example - must make both parties better off. the only way a transaction is bad is if it has some kind of effect on a third party not involved in the transaction - a side effect, or "externality." An example is pollution; when I sell you a piece of metal that I mined by dumping arsenic in a river, people get hurt who had no say in whether or not we did the deal.

But if there's only two people in the world ("Brazil" and "Argentina"), there can't be any externality, by definition! Thus, no matter what kind of forces drive international trade in the Ricardian setup, it must conclude that free trade is always and everywhere good. Game over.

But just in case you want to know, the Ricardian theory is all about something called "comparative advantage". This means that each country specializes in the thing it can produce relatively cheaply. To use an example from Mankiw's intro textbook, suppose I'm a lawyer who can make $2000/hr. lawyering or $100/hr. typing. And suppose my secretary types only half as fast as I do. It still makes sense for me to pay my secretary to do the typing, even though I'm twice as good at typing as he is, because I can make more money for an hour of lawyering than for an hour of typing. Even though I have an "absolute advantage" in typing, my secretary has a "comparative advantage" in typing, because he can't lawyer at all. It's impossible to have a comparative advantage in everything, so countries will always have an incentive to trade.

So that's how that works. But notice - "comparative advantage" is not necessary to conclude that free trade is always good. That conclusion was assured by the fact that the model treats each country as a single person. The mere fact that free trade allows more trade is what makes it automatically good in that sort of setup, comparative advantage or no; if trade is bad for one of the country-persons, that country-person will simply refuse to trade!

In fact, the only argument one can muster against free trade in the Ricardian setup is the "winners and losers" idea. This is the idea that, even if a country as a whole benefits from free trade, some people inside the country (for example, producers who lose their jobs when cheap imports put them out of business) might lose out. And this is the "argument against trade" that we always trot out in Econ 102 to explain why people aren't always happy about trade. But in the end, this argument always loses, because we just say "Instead of restricting free trade, we should find ways to have the 'winners' compensate the 'losers'" (you see those terms, "winners" and "losers," a lot in articles about trade). And voila, free trade is good.

So if you read a commentary by some smarty-pants columnist who says "Of course free trade is good, because comparative advantage exists, you dummy!", then now you realize that he's wrong. If externalities exist, then comparative advantage might not be enough to make free trade good. If you have a model that assumes no externalities, like the Ricardian model and many others, then free trade is good whether there's comparative advantage or not.

But where's the proof? If there are no externalities (and as long as a nation distributes its gains from trade properly among its citizens, which we assume it can), then free trade is always good. But how do we know there are no negative externalities to trade? The Ricardian model just assumes they don't exist! Of course, you can't prove a negative, so the burden of proof is on a free trade opponent to come up with an idea for a negative externality (a few have tried; so far, they have not been paid much attention). But merely having an assumption in place that no negative externality exists is not the same as evidence in favor of free trade.

If I were to teach trade models honestly, I would say: "Look, if these assumptions are right, then free trade is always good. But the fact is, we're not sure they're right, and we need to look into the matter a lot more before we bet our credibility on the statement that free trade is always good." But I don't teach trade models honestly, because scientific skepticism will not help my students pass their exams.

When on The Go... How Your Homeowner Liability Insurance Follows You

Homeowner liability insurance provides financial protection against legal obligations of the insured arising out of activities and conditions at the premises where the insured maintains a covered residence.

This coverage also extends to a personal activities of the named insured and household members anywhere in the world. You are on vacation in Europe- you’re covered; your child is on a mission trip in Mexico- you’re covered.

The homeowner policy defines an insured location as:

1. The qualifying residence premises where the named insured resides and which is shown as the residence premises described in the declarations.


2. The part of the premises used by the named insured as a residence and shown in the declaration, such as a seasonal residence.


3. Any premises used in connection with a residence as defined by one and two above.


4. The part of any premises not owned by an insured where the insured is temporarily residing. Examples would include a hotel room or vacation condo.


5. Vacant land, other than farmland, owned by or rented to an insured. Vacant land is generally defined as land upon which no man-made structures exist. An exception to this is land owned or rented to an insured on which a one to four family dwelling is being built as a residence for the insured.


6. Burial plots or vaults of an insured.


7. The part of premise occasionally rented to an insured for other than business use. An example would be a rented hall for a wedding reception.
   

An insured is defined as the person named in the declarations; that person’s spouse, as long as a resident of the household; relatives residing with the insured at the residence; and persons under the age of 21 and in care of the named insured, spouse or resident relative. This would include foster children or children for which the insured has guardianship.

The sum of all heresies

Tim Duy weighs in on the industrial policy discussion touched off by Andy Grove's article in Business Week. His post is telling, because it gives voice, all at once, to all the nagging suspicions that are gnawing away at the guts of so many observers of current events. He writes:

Only one word describes the American labor market outcome of the last decade - abysmal. Not only is job growth well below trend, but the quality of jobs is in question. The jobs deficit is even more striking considering the supposed gains in productivity over the past 15 years. Job growth should not stagnate. Resources - including labor - released via higher productivity are supposed to be channeled into expanding sectors. Moreover, productivity growth is supposed to yield improved economic outcomes via higher real wages. Yet as spencer famously shows, labor's share of output has been steadily decreasing since the early 1980s...

Why has the American jobs machine failed so spectacularly? This should be the most pressing issue facing economists and policymakers. Are either up to the task?

Yves Smith directs us to an intriguing piece by Andy Grove, former CEO of Intel. Rajiv Sethi follows up and summarizes...I think the Yves-Sethi conversation is remarkably important, and should lead one to reexamine the importance of the manufacturing sector. I admit that in past years I tended to dismiss the manufacturing sector, seeing its relative decline as simply a transition to more productive knowledge-based work...

The loss of manufacturing capacity in the Groves scenario critically impacts the potential growth of the nation...

Note that a number of trends all begin in the 1980s. Absolute manufacturing declines, the rise of persistent trade deficits, the decline in labor's share of output, growing income inequality, and the Great Moderation. That the combination of these trends is coincidental seems unlikely...

If manufacturing is critically important to driving trends of national well being, an exploration of the decline of that sector is crucial. But that exploration almost always leads back to a very difficult place - international trade. And every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley. Therefore, the examination ends. Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

[The modern pro-free-trade orthodoxy] fails to acknowledge that while free trade produces net positive effects, that process can certainly be upset by the deliberate manipulation of currency values. And make no mistake, those values have been manipulated. There can be no other excuse for the massive buildup of official reserve assets in global central banks.

I don't think it is a coincidence that the absolute decline in manufacturing accelerated in the wake of the US strong Dollar policy, which provided the freedom for China to pursue an aggressively mercantilist economic strategy, perfecting what Japan's policymakers began in the 1980s. Thus I don't think the pernicious hollowing out of America's industrial base is simply the result of comparative advantage. I grow increasingly convinced that the disappointing economic outcomes of the last decade are the culmination of decades of industrial neglect...And I am increasingly convinced that these trends have been largely dismissed by the economics community because acknowledging them would cast doubt on value of free trade, failing to recognize that currency manipulation was turning free trade into a zero-sum game.

In short, I have become a heretic.

But what then is the appropriate policy response? Unfortunately, we are held captive by fears of a debilitating trade war...

Bottom Line: Something more than cyclical forces is weighing on the American jobs machine. Here I have tried to extend the Grove/Smith/Sethi discourse with additional focus on absolute declines in manufacturing jobs and distressing declines in capacity growth rates. These trends may be critically important in understanding the dismal performance of US labor markets. If they are in fact critical, they raise serious questions about US trade policy - questions that few in Washington want to address. Given the extent to which manufacturing capacity has already been offshored, those questions go far beyond the recently announced tiny shift in Chinese currency policy. Simply put, accepting the importance of manufacturing capacity and the possibility that offshoring has had a much more deleterious impact on the US economy than commonly accepted would requrie a significant paradigm shift in the thinking of US policymakers. If you scream "protectionist fool" in response, then you need to have a viable policy alternative that goes beyond the empty rhetoric of "we need to teach better creative thinking skills in schools." That answer is simply too little too late.

Tim Duy's post is not an economics paper, and it does not prove his case. But it tells a story (which is all most econ papers do anyway) that weaves together a number of disturbing threads - the decline of American manufacturing, Chinese mercantilism, rising inequality, stagnant real wages, and job insecurity. This is a story that is not supported by any economic model that I know of...but, given economists' ability to write down a model that supports any conclusion, and given the tendency of models that defy the free-trade orthodoxy to languish unread in third-rate journals, I'm inclined to give Duy a pass for now.

The fact is, many people instinctively believe that mercantilism can work if your trade partners don't fight back; that the export (or import-substituting) manufacturing sector is especially important for job growth and living standards; and that it is no coincidence that our inequality, stagnant living standards, and insecurity have worsened as our trade balance with China (and with the other Asian nations in China's supply chain) has worsened. These beliefs are considered heretical, but they just refuse to go away.

Now, many instinctive, heretical beliefs are actually totally false: for example, "young-Earth" theories, global warming denial, or disbelief in quantum mechanics. But in the case of the free trade orthodoxy, there is no hard evidence that free trade is always and everywhere the optimum policy. There is no fossil record, no climate record, no electron double-slit experiment that free-traders can hold up and say "Look, unbelievers! HERE'S THE PROOF YOU ARE WRONG!" Instead, economists have a bunch of models, all of which assume that free trade is good and proceed from there.

So instead or arguing from evidence, the free-trade orthodoxy relies on shouting down and insulting any who deny its precepts. I myself have participated in this, in the Introductory Macroeconomics course I TA for at the University of Michigan. We always include a lecture that pits pro-free-trade arguments against anti-free-trade arguments, and we make sure that the former always come out the "winner" at the end of the day. We use the very simplest models of trade, and we never mention industrial policy or the manufacturing sector or mercantilism. And another four hundred students tramps off to be America's next generation of businesspeople, lawyers, journalists, professors, and voters...

And yet the nagging little voice in the backs of our heads continues to whisper the things Tim Duy has dared to say in the light of day. It continues to tug and worry at the corners of our faith in free trade, crying "E pur, non e libero!"

Andy Grove comes out in favor of industrial policy

Andy Grove, the famous Intel boss who built the company into the world's leading semiconductor manufacturer, has come out in favor of old-fashioned industrial policy. His arguments are twofold: 1) that industrial policy creates more middle-class jobs than our current approach, and 2) that industrial policy creates "network effects" among industries that give advantages tomorrow's technology startups. Some excerpts from his article:

On job creation:

You could say, as many do, that shipping jobs overseas is no big deal because the high-value work—and much of the profits—remain in the U.S. That may well be so. But what kind of a society are we going to have if it consists of highly paid people doing high-value-added work—and masses of unemployed?

Since the early days of Silicon Valley, the money invested in companies has increased dramatically, only to produce fewer jobs. Simply put, the U.S. has become wildly inefficient at creating American tech jobs.

On industrial network effects:

There's more at stake than exported jobs. With some technologies, both scaling and innovation take place overseas.

Such is the case with advanced batteries. It has taken years and many false starts, but finally we are about to witness mass-produced electric cars and trucks. They all rely on lithium-ion batteries. What microprocessors are to computing, batteries are to electric vehicles. Unlike with microprocessors, the U.S. share of lithium-ion battery production is tiny (figure-E).

That's a problem. A new industry needs an effective ecosystem in which technology knowhow accumulates, experience builds on experience, and close relationships develop between supplier and customer. The U.S. lost its lead in batteries 30 years ago when it stopped making consumer electronics devices. Whoever made batteries then gained the exposure and relationships needed to learn to supply batteries for the more demanding laptop PC market, and after that, for the even more demanding automobile market. U.S. companies did not participate in the first phase and consequently were not in the running for all that followed. I doubt they will ever catch up...

[In the U.S. there is] a general undervaluing of manufacturing—the idea that as long as "knowledge work" stays in the U.S., it doesn't matter what happens to factory jobs. It's not just newspaper commentators who spread this idea. Consider this passage by Princeton University economist Alan S. Blinder: "The TV manufacturing industry really started here, and at one point employed many workers. But as TV sets became 'just a commodity,' their production moved offshore to locations with much lower wages. And nowadays the number of television sets manufactured in the U.S. is zero. A failure? No, a success."

I disagree. Not only did we lose an untold number of jobs, we broke the chain of experience that is so important in technological evolution. As happened with batteries, abandoning today's "commodity" manufacturing can lock you out of tomorrow's emerging industry.

And on what to do about it:

The first task is to rebuild our industrial commons. We should develop a system of financial incentives: Levy an extra tax on the product of offshored labor. (If the result is a trade war, treat it like other wars—fight to win.) Keep that money separate. Deposit it in the coffers of what we might call the Scaling Bank of the U.S. and make these sums available to companies that will scale their American operations. Such a system would be a daily reminder that while pursuing our company goals, all of us in business have a responsibility to maintain the industrial base on which we depend and the society whose adaptability—and stability—we may have taken for granted.

Now, in many intellectual circles in America it has come to be regarded as an article of faith that "protectionism" and "industrial policy" are the road to ruin (just as in Asia the exact opposite has become an article of faith). Just the other day, for example, a friend of mine - a very smart lawyer - suggested that Washington Post columnist Steven Pearlstein be "flayed" for arguing that only the threat of tariffs can get China to change its currency policy.

But after actually reading some trade theory and development theory at the highest academic level, I have to say that the only thing I'm more sure of is how little I ought to be sure of when it comes to this topic. Sure, trade in general is awesome. But to let the light of that basic truth blind us to the subtler questions of industrial policy, strategic trade interactions, etc. is as absurd as to let the fact that communism failed blind us to the efficiency of some kinds of government intervention in the economy.

The bottom line: I am not sure whether Andy Grove is right about industrial policy. But I am reasonably sure that no one else is sure whether he's right, especially the vast commentariat that shrieks "trade war" and "protectionism" whenever anybody suggests anything like what Grove is suggesting. And I am sure that Andy Grove, though old, is a very smart guy. And when very smart guys - like Grove, or like Paul Samuelson, the greatest economist of our age - start saying things that contradict our conventional wisdom, we should at the very least pay close attention.

Update: Yves Smith and Rajiv Sethi respond to Grove's article. Smith is broadly supportive. Sethi is skeptical, but, like me, recognize economists' fundamental ignorance in these sort of matters and are made uneasy by the possibility that Grove is onto something. Tyler Cowen, meanwhile, goes for an off-the-cuff defense of the conventional wisdom. Mark Thoma agrees with me and Sethi, and points out (correctly, in my opinion) that the social inequality case for industrial policy is stronger (so far) than the innovation-and-efficiency case.

More Athreya smackdown

Just to add to the list of bloggers smacking down Kartik Athreya for his assertion that bloggers shouldn't talk about economics, we have great posts by Tyler Cowen, David Merkel, Jeffrey Harding, and Ambrose Evans-Evans-Pritchard, and a more-than-slightly unfair (but funny) one from Barry Ritzholtz. The money quote, IMHO, is this from Tyler Cowen:

I would say that economics is really, really, really, really, really, really, really hard. And that's leaving out a few of the "reallys."

It's so hard that experts don't always do it well. The experts are constantly prone to correction by non-experts, by practitioners, by people who are self-educated economic experts but not professional economists, and by people who know some economics and a lot about some other field(s). It is very often that we -- at least some of us -- are wrong and at least some of those other people are right.

Earthquake Insurance In Ohio?!

The big question going around on June 23rd was, “Did you feel the earthquake”. Many thought people were joking, but when they checked their Facebook page and saw that many of their friends in the Ohio area had felt the earth move, they knew the question was legit. The reason Ohioans felt the earth move was just north of us, Canada had a 5.0 magnitude earthquake.

Though we are not California or anywhere near California, Ohio still has their fair share of earthquakes. On average Ohio has 5 to 6 earthquakes a year. Year to date in 2010 we have already had 6, so the question that has to be asked of this insurance blog is should people in Ohio carry earthquake insurance? We at Fey Insurance Services feel that it is a good idea to have this coverage. It is something we always quote to our customers. For an average valued house the premium can range from $50 to $80 a year. Though we only have little earthquakes the potential for a large scale quake is there and if that happened the affects would be devastating to a home.

Feel free to get in touch with us to inquire about earthquake insurance.

Jobless recoveries - mystery solved!!!

Bill Gavin and Menzie Chinn solve the mystery of the "jobless recoveries" we've been having since the early 90s:

In the earlier postwar recessions, the unemployment rate began to fall very quickly once the expansion began. By contrast, the unemployment rate continued to climb even after the recovery had begun for the 1990-91 and 2001 recessions. No one is predicting a rapid drop in the unemployment rate this time around, either...

Bill called my attention to the contribution of temporary layoffs to this changing behavior in the unemployment rate. He noted that the Social Security Amendments of 1958 explicitly exempted unemployment insurance from income taxation, and recalled a 1976 paper by Martin Feldstein which proposed that this gave firms a strong incentive to use temporary layoffs in response to a business downturn. By temporarily laying workers off rather than asking them to work shorter hours, the firm could deliver maximal after-tax compensation to its labor force, intending to hire those same workers back as soon as business improved. Temporary layoffs accounted for up to a quarter of those unemployed at the worst of the 1973-75 recession.

Bill believes that the key developments that changed this dynamic were the Revenue Act of 1978, which subjected unemployment benefits to partial taxation under the income tax law, and the Tax Reform Act of 1986, which made unemployment benefits taxable as ordinary income. Since the mid-1980s, the above graph shows that temporary layoffs have become a much less important feature of recessions...

If you subtract temporary layoffs from the number of unemployed, here's what the adjusted unemployment rate would look like. The earlier recessions look much more like the recent jobless recoveries.

Now THAT is good economics work. Simple, empirical, and predictive.

Perhaps we should consider once again exempting unemployment benefits from taxation.