Karl Marx

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Trade: A Defense

There has been an ongoing discussion sub-text throughout the entire crisis and recovery cycle I think we need to surface and make more explicit. That is the role of trade in our economy. There was not much reaction to President Obama’s recent commitment to expand US exports as a way of creating jobs. For some reason exports are seen as a naturally beneficial thing. By extension, I presume, imports are somehow not very good.

As in all things the answer is ‘it all depends’.

Here’s the primary issue: an economy is a vast allocative machine. It shuffles resources around between various activities and attempts to satisfy the needs and wants of its inhabitants as best as possible. If it does this well it allows those resources to be ever more productive. This means that any particular level of resources satisfies an increased level of needs or wants. As I have said before: productivity is the magic potion that allows this to happen.

A relatively free economy, one that has few artificial limits on the allocative machinery, will tend to be more dynamic in the way it seeks solutions to the ‘optimal’ distribution of resources. This is both an intuitive and a theoretically sound statement. But only so long as there are strict rules to put boundaries around the allocative effort: we have just experienced the consequences of a relatively unbounded economy in the financial sector, where the rules were so lax some people were able to gain a disproportionate allocation for themselves at the cost of a lesser allocation for others. They did this because the lack of rules enabled them to bias the allocative process in their favor. In essence they ‘cheated’ and prevented the competitive process from limiting their gains. Such people represent the antithesis of the archetypical denizens of a free market system. They are the rogues Karl Marx identified as the inevitable rotten core of capitalism. It was because Marx was spot on in his analysis that societies wanting to exploit the innovative aspects of capitalism all apply rules to limit its excesses. That way they avoid the trap he identified.

Within this allocative machine there are a number of things we can state with near certainty.

One of which is that if we allocate resources to one thing or activity, we cannot also allocate them to another. This implies that if we favor an activity, by giving it a tax advantage or by setting tariffs and so on, resources will flow into that activity and away from something else. Further: we have introduced a distortion. By bending the allocative process in an activity’s favor we have simultaneously burdened everything else. Those other activities will not take place, or will be reduced, because we have channeled resources elsewhere.

The only tike there is an exception to this distorting result is if there are excess or idle resources not currently being drawn upon. But even then such ‘spare capacity’ is a short term problem. Over the life of a full economic cycle, as resources are more fully drawn down for use, the distortion will eventually appear – things that might have been produced will not be because of the prior use of the necessary resources elsewhere.

This is all elementary.

And it applies to trade.

If we boost exports by giving them a tax advantage or other subsidy, we inevitably reduce the level of activity somewhere else in the economy. The number of jobs allocated to exports goes up, but at the cost of a decline in jobs doing something else. The total number of jobs stays the same. We have not increased employment, we have simply shuffled it about within the economy.

The only time this basic relationship can be altered is if aggregate world trade increases sufficiently to allow the increased export employment to co-exist with such economic growth that the total level of resources available expands and allows the disadvantaged activities to take place anyway. Even then the allocative machinery is still being biased, which means that somewhere within the economy there are needs or wants going unfulfilled because we have erected a barrier to prevent that fulfillment.

This introduction of bias can be done in a negative sense also: to disadvantage imports. This is protectionism.

The recent spat between the US and Europe over the US Air Force tanker contract is a good example of protectionism. The original contract bidding process produced a clear winner: the European Airbus version of a military tanker. It was larger, had greater range, greater carrying capacity, and was more cost effective than the US based Boeing version. Naturally the Air Force went with the European aircraft. This created a furor in Washington and, despite the fact that a significant part of the European plane was built in the US by Northrup, Congress forced the Air Force to re-submit the contract to bidding, this time re-written specifically to benefit Boeing. Rather than waste time on a clearly rigged bid, the European consortium, including Northrup, has declined to bid.

So the bout of protectionism has produced a perverse effect. The US Air Force has been forced into accepting an inferior product in order that Boeing wins the deal. The upshot, presumably is that one national interest – the maintenance of military related production by Boeing, trumped another – the security capability of the US Air Force. We cannot argue that the economy benefitted much if at all: presumably Boeing can expand its overall production and thus employ more people, but unemployment in Boeing’s production locations is already low, and it will probably have to entice workers to move to its locations in order to recruit the necessary workforce. Where might they come from? Well maybe from the areas where Northrup will obviously not be hiring now that it lost the bid. Net? The economy as a whole gains little. But it definitively loses something: the taxpayers end up subsidizing Boeing who makes a less attractive product. So we get a less cost effective plane and diminish our national security all in the name of protectionism.

A less well known example of the damage done by protectionism is the intervention in the steel industry by George Bush prior to the 2004 election. There was a clear political motive: protect US steel workers in Pennsylvania. This goal was wrapped in the usual verbiage about ‘unfair’ foreign competition. So tariffs were introduced on certain types of steel – coincidentally just the types produced in Pennsylvania, and so steel prices rose to levels that made the US producers competitive with those abroad – in this case mainly in India. The result was a big jump in prices for industries that use that type of steel. They, in turn tried to raise their prices to recoup this cost, and found themselves being undercut by competitors who still had access to the cheaper foreign steel.

The net effect?

We saved jobs in Pennsylvania. But lost many more than that as our other manufacturers lost market share. We ended up with fewer manufacturing jobs than we started with. I give Bush credit: he abandoned the tariffs when this all played out, but so far most of those lost jobs have not come back because they were outsourced to factories abroad where the access to cheap steel was not subject to US tariffs.

In other words we suffered a permanent loss of jobs from an ill advised intervention.

A second major thread through most discussions of trade is that some countries have ‘done well’ by supporting export industries and thus run ‘healthy’ trade surpluses. These countries are often looked upon as somehow ‘thrifty’ or diligent when compared with others who run trade deficits.

Once again the reality is more ambiguous than this surface analysis suggests.

A more perceptive analysis tells us that a country with a perennial surplus is actually running a massively unbalanced economy.

There are two major points to make here.

First: the perpetual surplus means that the exporting nation is devoting more resources to satisfying foreign needs and wants than it is to its domestic needs and wants. If it turns out that its domestic economy is fully satisfied, then the situation is worse: the exporter has allocated resources to something utterly dependent on factors abroad over which it has no control. This means that its standard of living is at the whim of others and is not under its own control.

Germany and Japan are good examples of this dependence on foreign demand.

But even this is shallow. Germany is proud of its export industries and bristles that it should boost its own demand. In the context of the current spat it has with Greece, German voters seem to think that everyone should be as self restrained as they are. They presumably overlook the simple fact that were that the case then German factories currently devoted to exports would sit idle – they would not be needed. Thrift is a two edged sword. For those idle German factories to remain open the Germans would have to buy more stuff themselves and give up some of their vaunted thriftiness. Put another way: the current German standard of living depends on other countries being willing to consume products made in Germany. Once that willingness ends, the Germans have to consume their own stuff or face the fact that they will have idle resources sitting around going to waste. That means even higher unemployment than they now have.

The Japanese are in exactly the same situation. They too are proud of their controlled consumption and their heavy emphasis on trade. Their standard of living, which has stagnated for a long time now, depends upon foreign consumption. The Japanese themselves consume far too little to justify all the factories and jobs that they have.

Both Japan and Germany under consume given the level of resources they have to allocate. They prefer to export and not consume. This choice implies that their respective populations are not purchasing as much as their economies can produce. They depend on foreigners to an extraordinary degree for their lifestyles.

China is a different case, although just as distorted. In their case the government manipulates its currency in order to stimulate exports. By doing this is attempts to establish production and thus grow jobs in those industries. But as I pointed out earlier, this implies that it is under-allocating elsewhere. Chinese domestic demand is much less than it could be, so there must, by implication, be very many Chinese people unable to grow their standard of living to the level they desire because there are insufficient goods and services to satisfy their need or wants. Those goods and services are being shipped abroad.

Second: A trade surplus has a flip side. By definition a country with a trade surplus has a capital ‘deficit’. It imports more capital than it exports. China uses this imported capital to buy foreign bonds and other assets, hence all the fuss over the Chinese ‘grip’ on the US Treasury.

Once again this a two edged sword.

What would happen if the Chinese sold its US bonds?

The price of those bonds would drop, so the Chinese would lose a lot of money, and the US Dollar would also decline in value making US exports much more competitive and making Chinese goods much more expensive. Neither of these would harm the US much at all. So the Chinese ‘grip’ is an illusion. The only problem they can cause would be the disruption in the market for US bonds were they to sell all at once. Such disruption could stop the US from selling enough bonds to finance its budget deficit in the near term – although longer term I don’t see that as a problem. Either way the Chinese would have to end up stimulating their domestic economy in order to shift their resources now allocated to sending stuff to America and instead send stuff inwardly.

These examples all seem to suggest that countries should not run trade imbalances, but that they should seek to allow the allocative machinery to fulfill demand in whatever way optimizes the amount of needs or wants it can cover.

And this is why trade itself is generally beneficial for those who engage in it.

Trade is often maligned because it can appear ‘unfair’ or ‘strategically damaging’. Countries, it is argued, should be able to put limits on trade to prevent these anti-social consequences.

I agree up to a point.

But.

Trade is a benefit. It allows us to allocate our resources more effectively. It is the extension of the allocative process to encompass multiple economies rather than simply focusing on one.

The result of trade is that each country involved can allocate its efforts towards those things that make most sense in its own circumstances. Saudi Arabia sits on top of a pot load of oil. Which has very little use or purpose unless it trades it to others who want it. There is no way the Saudis could use all the oil themselves – it has not value domestically, in fact it would be near worthless. It has value only in the context of the needs and wants of others who are prepared to pay for it. Likewise the abundance of cheap workers in China are of little value to themselves at the moment: they do not make enough money yet to justify buying all the stuff they can make. That pool of labor is much more valuable in the context of the American economy where the Americans want to allocate resources to things like movie making, internet start-ups, and professional sports than to factories paying low wages.

All trade should be viewed in such contexts. It is a manifestation of the way in which the allocative machinery is allowed to work. The more we interfere the more we distort the outcome.

As I pointed out at the beginning the introduction of a bias has a two edged effect: we privilege one thing or activity, and inhibit another. We deliberately move resources from one set of needs or wants and employ them on another set. The cost is reduced choice: we place a limit on the way in which resources can be used; and reduced potential: we employ resources on satisfying needs and wants that could be satisfied more effectively – more cheaply – elsewhere. Both these actions diminish the amount of needs and wants we can satisfy with any given level of resources. For example limiting imports of finished goods by taxing them, increase their prices. That leaves us all with less to spend on other things. For society as a whole this has odd outcomes: we can build fewer schools because we are using our money to prop up inefficient manufacturing.

The beauty of economic theory is that it makes this all clear. It also forces us to be explicit when we choose to interfere in the allocative machinery in order to limit or privilege activities.

Attacking trade should be done with the inevitable consequence made clear: we all lose something else. That something else is usually wealth we could have employed on something else we like: hospitals, schools, roads, health care and so on. Diminished wealth is not simply the diminution of consumerism. It is the diminution of the entire economy. Simply put: with restrictions on trade we end up satisfying fewer of our total needs or wants than we could have done. It is no accident that in periods of world history when trade has flourished, so have incomes. Conversely in periods when trade is restricted income growth has suffered.

So trade is not the problem: rigging the allocative machinery for private gain is another story. Corrupt or undemocratic politics trump the benefits of trade every time. Which is why interfering in the machinery to even out access and opportunity is a very different kind of interference and should never be conflated with protectionism. As long as we learn from Marx about the weaknesses of our system we can avoid the results he foresaw.

But that’s for another time.

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The Two Economies Discussion

Reality has a very nasty way of intruding into the fancies of life. Economics is no exception. There is a growing realization amongst the ‘experts’ that the hoopla being accorded our imminent exit from recession is actually no big deal to a huge swathe of America. It won’t matter. As a result we are being treated to all sorts of articles and essays about the ‘two economies’ – or, in the case of the Wall Street Journal, the many economies. It’s as if, all of a sudden, that economists and those who work in investing are shocked when they perceive their magical ‘market’ as the amalgam of individuals that it truly is. And always has been.

I find all this both laughable and distresssing.

Of course there are a multitude of economies. Each of us has an entirely unique trajectory through the ‘space’ that encloses all economic activity. We experience it individually. There may be common features to those individual experiences such that economists can legitimately speak of ‘global properties’ of an economy, and can consequently talk abstractly about what a ‘market’ does, but we should never forget that those properties are never precisely played out at an individual level. Instead they are approximations.

Think of it this way: when we speak of a group of people having an average height of 5 feet 4 inches, we do not actually mean that any single person in that group is that height. The average is simply a useful way of describing an aggregate phenomenon.

Likewise with an ‘economy’ or a ‘market’.

When free market advocates speak about a market correcting itself, what they mean is that, eventually, enough people change their behavior that the average shifts direction. The word’ market’ is just a proxy for that average behavior.

Economists and market analysts are so inculcated with their ‘market speak’ that they tend to forget this simple truth. Thus when the economy turns a corner and moves from recession into recovery, they are surprised, apparently, to learn that the entire thing didn’t move. Only enough moved to alter the average.

The rest may still be mired in decline. For that group of people the ‘recovery’ may seem a distant mirage.

This inability to understand the economy as an aggregation of individual experiences is odd given the relentless ‘methodological individualism’ that underlies economic theory. Modern economics rejected the old analytical method of the ‘Classical’ era of economics – Adam Smith, David Ricardo, and Karl Marx being the standard bearers of that era – exactly because the Classicists tended to focus on groups within the population. The Classical analysis tried to explain the relationship between those groups – capitalists, landowners, landlords, and workers – and was thus concerned with a different sort of aggregate relationship. Obviously Marx is the most recognizable of this group, but his analysis of value and price structure is purely classical in its origins and is closely related to both Smith and Ricardo.

The roots of modern ‘market mythology’ can be found in the political ferment of the early industrial revolution, and the need for economics to present a counterpoint to the Marxist critique of capitalism. The problem was that his critique was accurate within the theoretical framework that then existed. So, in order to defend capitalism, a new framework was necessary.

This new framework was built around the individual, not ‘classes’ or ‘groups’, and sought to demonstrate that Smith’s metaphor of the ‘invisible hand’ was an accurate description of the power of the market. In the modern view, value and price flowed not from the costs associated with production, as the Classicists theorized, but from the ‘utility’ a product represented to a consumer. This is the way we envisage value today: something is ‘worth’ whatever someone will pay for it, no matter how much it cost to make. So modern economics blended Benthamite Utilitarianism – almost word for word – with engineering like concepts like ‘equilibrium’ and ‘efficiency’ to create model of a market faithful to Smith’s vision, yet capable of defending capitalism from Marx.

The problem is that in so doing economics sacrificed any analytical content attributable to ‘classes’ or ‘groups’.

So, returning to the two economies discussion: the modern view is that the economy is recovering. The measure we use is GDP, which itself is an accounting identity contrived to keep score of how much wealth we create each year. GDP does not speak to any of the questions that a Classicist like Smith or Ricardo would have been interested in. It tells us nothing about the welfare of workers or capitalists. It simply is an aggregate score card of wealth creation. And a flawed one at that – it excludes all sorts of things that are obviously sources of wealth [housework], and includes perverse things such as disaster relief as being a contribution to wealth [Katrina wiped out New Orleans, but added to GDP when the rebuilding started – did we accrete new wealth or simply replace old wealth?].

So as GDP starts to grow, our definition of a recovery, economists and analysts are befuddled and apparently fascinated by the fact that whole groups of people are experiencing nothing of the sort. In fact their prospects remain distinctly dim. So used are they to speaking in abstract and aggregate terms that they have forgotten that the economy is a very fragmented and diverse thing. It is full of contradictions and tensions that modern theory cannot cope with and, indeed, ignores for the sake of analytical purity.

To a worker whose job has just been eliminated so that an employer business can remain profitable and thus meet the stock market’s expectations of profit, the notion that we are now recovering is surely absurd. That there are nearly 7 million such people, and we can still speak of recovery, is preposterous. But that’s what we are doing.

It doesn’t take too much thought to realize that the recovery most likely will be fragile as long as there is such a large number of people who remain outside looking in as business gets underway.

I suppose it is not unusual for the business press to be so oblivious to this dichotomy within the economy, after all Wall Street obsesses over short term profits rather than long term themes, but now to listen to breathless discussions about how ‘suddenly’ we have two, or more, economies is just insulting. The enormous shift in the distribution of wealth in America over the past two or three decades implies that there are great rifts emerging in the fabric of society. Whole swathes of America are not just excluded from recovery, but they didn’t experience much of the prior growth. To those groups the notion of a diminution in wealth as a result of a stock market or house price collapse is simply irrelevant. They weren’t on that train.

The problem is that our economic theories treat distribution as irrelevant. This is a trace of that Marxist/Capitalist debate back in the late 1800’s: in order to eliminate the notion of ‘groups’ or ‘classes’ from theory we had also to eliminate any impact of a distribution between those groups. Everything was reduced to allocative efficiency: we don’t care who ends up with the wealth, as long as the process was ‘efficient’.

And because modern economics doesn’t give a hoot about distribution it is blind to differential experience that results from different distributions.

Consequently analysts brought up in the modern tradition get excited by the prospect of recovery and bid up stock prices in anticipation of the new wealth they see being generated over the next year or so. Articles trumpet recovery. Central bankers are lauded – or they laud themselves – for a job well done. Managers collect bonuses for ‘protecting profits’ and so on.

But not all the train leaves the station.

And, in our current case, enough of it sits stubbornly in decline.

Then suddenly those who are on the forefront of recovery realize their vulnerability: unless those rear cars get going we will fall back towards them.

Hence the ‘two economies’ discussion.

There have always been two economies. Perhaps even more. We just wanted to avoid the embarrassment of having to confront that fact.

Now we must.

We need jobs before we can return to the illusion that the American economy is a single entity.

A lot of jobs.

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Capitalists Can Bug Me – I Admit It!

As a committed child of the working classes, or more accurately a grandchild, nothing is more designed to get my back up than a conversation with an equally committed capitalist.

Now, having traveled through ‘B’ school and the banking industry for many years I have nothing against capitalism: I believe it to be the best system of wealth generation there is.

But.

It also needs to be kept in check. Unbridled capitalism produces enormous social cleavages and inequities that, as Karl Marx identified, sow the seeds of its own destruction. Marx was a brilliant economist, no history of economics can be written without acknowledging his contribution. It’s his politics that stunk up the joint. He made the terrible mistake of not recognizing that a strong democracy can rein in the capitalists such that the benefits of wealth creation still exist, but its excesses are properly mitigated. He thought we could only eliminate those excesses via the introduction of what history has shown to be a hopelessly idealistic ‘socialist’ system.

I digress.

The confrontation I had was a much smaller scale. The conversation was with a private equity fund partner. The conversation revolved around his complaint that Obama plans to raise capital gains tax up to the levels of ordinary income tax – something I applaud.

His argument was that capital gains should be privileged in the tax code with a lower tax rate because of all the wonderful side benefits of equity investment. To whit: the wealth creation I have mentioned above. To my ears this is tantamount to a claim that the profits of capital are more valuable than the profits of labor. And that I find reprehensible, because it enshrines, permanently, the advantages of wealth.

His argument conflates two separate themes.

First is the simple theme of the search for profit – aka ‘greed’. There’s nothing wrong with this I as I have stated. The pursuit of personal wealth is our most effective inducement for innovation and consequently well being. But I think that this theme is sufficient to justify the actions of a capitalist. It needs no support.

Instead my capitalist friend justified his dislike of higher capital gains tax on the second theme: that capitalists, by being willing to take risks and support new ventures, create jobs and other ancillary goodies for society. They therefore deserve a break from the burden of taxes as an incentive to continue to invest. After all, this argument goes, without capitalists taking risks we would all still be in the Dark Ages.

I find this curious.

Here we have a true capitalist resorting to his worthy social impact as a defense of his lower tax bracket. So capitalists are really misunderstood, and potentially overtaxed, socialists? I think not.

This is the argument perennially wheeled out by right wingers to combat a tax hike: a rise in taxes is a disincentive and therefore diminishes the wealth generated in the future. We are hearing this a lot lately as the Obama budget gets debated in Congress.

There are a number of problems with it:

The data doesn’t support the case. Were incentives, growth and lower taxes tied together we should be able to see the relationship in the record. Periods of higher taxes should presage periods of slower growth and vice versa. So how do we explain the surge in growth after the Clinton or Reagan tax hikes? And how do we explain the unprecedented growth of the 1950’s and 60’s when tax rates were generally much higher than they are now? Conversely, why didn’t the Bush tax cuts of 2001 and 2003 set off a mammoth boom in growth instead of the anemic sputter that ended in 2007? I am sorry but I just don’t see the cause and effect that the tax cutters and my capitalist friend are so dogmatically sure exists.

More to the point: why should returns to capital be privileged at all? Isn’t there an element of fairness that needs to be accommodated here? The tax code allows investors to write off losses from risky investments that went wrong. But in an efficient market surely the returns to capital take into account the fact that some investments will inevitably be bad. So investors are already being compensated for their risks. Why should we double the compensation by allowing write-offs of losses. And then to compound matters, why should we then tax the resulting gains-net-of-losses at a lower rate than any other form of income? For this I must also apologize: I just don’t see why returns to capital have to be taxed at a different rate than the returns to anything else. I smell too much of a bias against regular folks in that one!

Lastly I fail to see the efficacy of the final argument put forward by my capitalist friend. That, well, if you tax him at the same rates you and I are taxed, then he’ll just take his money and go home. He just won’t invest, and then won’t we all be sorry when those jobs he would created don’t materialize. Ummm. I think he forgot the profit motive that he himself is so reliant upon. A higher tax rate will not stop all investment. Investors will still be faced with a decision regarding what to do with their excess funds. The notion that higher tax rates will prevent all forms of investment is absurd. It implies that all investors would be content with a zero rate of return on their funds. Somehow that doesn’t square with the image projected by my friend.

It was the great insight of Adam Smith to identify that the greed of individuals, all resolutely pursuing self-interest, can produce an outcome beneficial to all. Social well-being from personal greed is the magic that Smith attributed to the ‘invisible hand’ of the marketplace. The development of economic theory is largely the story of eliciting the processes and forces that contribute to this ‘magic’. But Smith was an ethicist, not an economist, so his concern was not just with markets but with the consequences of them. In particular he enjoined us not to trust those in commerce because they would inevitably try to conspire against the rest of us: after all they are self-interested.

Commercially driven people, entrepreneurs, and investors simply don’t leave money idle. They make it work. No matter what the tax rate is.

So don’t go giving me any of this ‘capitalists-need-a-break’ stuff. And the old ‘Obama-will-ruin-private-enterprise’ refrain won’t do either.

Greed will drive the search for profit under any circumstance. And if Smith is right, as I believe he is, we will all benefit anyway. There’s too many ‘selfs’ in a self-serving and self-righteous’ argument. Let’s raise that capital gains tax, we need the money. And lets’ applaud the risk takers too. Just let’s not get confused over their motivation: they want to make a buck not create jobs. That’s a consequence of private equity investment, not its goal.

As I said: some of these arguments can make my blood boil.