Recently in Economics-Inequality Category

In their work, economists are typically are not nationalistic. National boundaries mean little to them, other than that much data happen to be collected on a national basis. Whether a fellow American gains from a trade or someone in Shanghai does not make any difference to most economists, nor does it matter to them where the losers from global competition live, in America or elsewhere.

I say most economists, because here and there one can find some who do seem to worry about how fellow Americans fare in the matter of free trade.

In a widely noted column in The Washington Post, "Free Trade's Great, but Offshoring Rattles Me," for example, my Princeton colleague Alan Blinder wrote:

I'm a free trader down to my toes. Always have been. Yet lately, I'm being treated as a heretic by many of my fellow economists. Why? Because I have stuck my neck out and predicted that the offshoring of service jobs from rich countries such as the United States to poor countries such as India may pose major problems for tens of millions of American workers over the coming decades. In fact, I think offshoring may be the biggest political issue in economics for a generation. When I say this, many of my fellow free traders react with a mixture of disbelief, pity and hostility. Blinder, have you lost your mind?

Professor Blinder has estimated that 30 million to 40 million jobs in the United States are potentially offshorable -- including those of scientists, mathematicians, radiologists and editors on the high end of the market, and those of telephone operators, clerks and typists on the low end. He says he is rattled by the question of how our country will cope with this phenomenon, especially in view of our tattered social safety net.

"That is why I am going public with my concerns now," he concludes. "If we economists stubbornly insist on chanting 'free trade is good for you' to people who know that it is not, we will quickly become irrelevant to the public debate. Compared with that, a little apostasy should be welcome."

What do you think?

This led Mark Thoma to wisely say:

Saying that everyone could be made better off with increased international trade is not the same as people actually being made better off. There are winners and losers from increased international trade, and while I agree that the gains exceed the losses in almost all cases, the gains haven't been distributed in a way that leaves everyone, or even most everyone, better off (see, e.g., widening inequality and where the costs of these kinds of adjustments fall). When some people are made better off and others made worse off at the same time, economists cannot say it is unambiguously better or worse. If we are going to make the argument that trade is good because everyone could potentially be made better off, we should do much more than we have to ensure that this potential is realized, i.e. that the gains from trade are distributed widely across the population rather than concentrated among a smaller set of winners.

Which in turn led Tim Worstall to reply:

But this argument then generally morphs into an insistence that we should not have free trade until that compensatory mechanism is put in place, so that, say, I, who will be gaining from that free trade will be compensating those who will lose from that free trade.

Hmm. But do you see what is implicit in that argument?

That there are gains that I am not getting, gains that are going to some other, as a result of our not currently having free trade.

This is obvious: if free trade benefits me and disbenefits you, then not free trade must disbenefit me and benefit you.

Which leads to the question: are you compensating me for those benefits you are getting and the disbenefits I am getting from the absence of free trade?

Where, in short, is my check from those benefitting from protectionism?

I'd like to see Worstall defend that one in front of a class of principles of econ students who have seen jobs in their towns go overseas or south of the border.

Seeing as how for the last 16 years I've been defending free trade to classes of principles students who have seen jobs in their hometowns disappear because of free trade, I feel like I can take a crack at this.

Blinder gets it absolutely spot-on.  Print this one and post it on your wall.

If we economists stubbornly insist on chanting 'free trade is good for you' to people who know that it is not, we will quickly become irrelevant to the public debate.

That is exactly what 16 years of defending free trade to Midwestern college students has taught me.  And since I have no desire to become irrelevant to my students, I have found it useful to focus their attention on what I was taught about free trade.

You see, it is the potential for a Pareto improvement that makes free trade desirable. There are winners and losers.  But the winners gain more than the losers lose.  So effect a transfer from the winners to the losers that still allows the winners to gain but compensates the losers for what they lost.  Only then can you really say that free trade (with the compensating side payment) benefits everyone.  If the compensation is not there, then I cannot unconditionally advocate free trade.  I must call attention to the fact that some will lose.  Call it professional ethics.

I have shared this approach to teaching trade with liberal and conservative economists alike.  Economists, even many liberal ones, like Pareto improvements a lot better than redistribution--if a Pareto improvement is possible.  I've never really thought of this as controversial.  The devil is in the details, of course, since the transfer payment can be very hard to estimate and implement.  Economists are usually content to point out to their students that in the abstract it seems reasonable to try to compensate those who lose from free trade because the losers are usually few in number and identifiable (e.g. workers whose factory moves to Mexico) while the winners are numerous so a small tax on the many can compensate the few who lose their jobs.  We then leave it to the wonks to write legislation like the Trade Adjustment Assistance Act.

Worstall's logic seems appealing though.  If I gain and you lose from free trade, then the status quo harms me to enrich you.  That hardly seems fair.  So if you're not compensating me now, why should I compensate you under free trade?

There's a hint of utilitarianism in Worstall's logic as well.  If there is some inherent unfairness in either state of nature, then which one is preferred?  It must be the one that has the highest total utility.  If you're going to punt on the issue of distributional equity, then overall efficiency must be the primary, indeed maybe the only, criterion.

That's fine in a representative agent model, of course, because in such a model distributional equity means nothing.  The representative agent contains in his person both the winner and the loser, so there's no need to worry about compensation.  The representative agent model does allow us to gloss over some of the distributional questions to highlight the aggregate gains, but no responsible economist would stop there.

But ultimately what is wrong with Worstall's logic?  For me, it boils down to the notion of a social contract.  People make decisions, many of which are irrevocable or nearly so, on the basis of the best information and their expectations of the future.  Sometimes the biggest influences on our expectations are the existing law and the political environment.  If I then make a decision in good faith based on existing law, only to have the law change to my disadvantage, I will feel wronged.  That I benefited from the way the law was should not be held against me when arguing to change the law.

This is a big reason for the political process moving as slowly as it does sometimes.  There is rightly a reluctance to change if a change will harm people who made good faith decisions based on what they expected to prevail.

Take the mortgage interest deduction, for example.  Everyone who has a mortgage enjoys higher property values because the mortgage interest deduction is built into the capital value of the house.  I paid extra for my house to get it.  When I sell, I'll get it back.  If the present discounted value of the benefit equals the additional amount I paid for the house, then I'm not getting a free lunch.  I weigh the costs and benefits and made my decision--so did those who chose not to buy a house.  We all knew the rules.  The mortgage interest deduction is a thumb on the scale, but we all know that the thumb is there--and we all expect it to stay there and set our prices accordingly.

Take the thumb off the scale and it's no longer in balance.  Take away the mortgage interest deduction and my property value goes down in a way that I probably could not insure against, and certainly wasn't expecting.  I would feel wronged.  Since taking away the mortgage interest deduction would harm so many people, politicians will think twice about doing it.  People make decisions in good faith based on existing law.  We tend not to change the law arbitrarily and capriciously on them.

And that's why Worstall's logic fails the test of reality.  People make life decisions based on protectionism.  No, not directly just like that.  But trade protection has kept the factory in their hometown going.  They graduate from high school and apply for a job.  Maybe it was the only job in their hometown.  Sure, they could have gone to the big city to wait on tables or drive a cab but that would take them away from home and family.  The made the decision that was best for them based on what they knew and could in good faith expect.

And some people would say to heck with them.  What are we coming to?

When you break a contract in law, you must compensate the other party.  Sometimes it is in the best interest of both parties to allow that.  The social contract is no different.  We can, and indeed we should, at times rewrite the social contract, but when we do, the winners must compensate those who made good faith decisions based on the old contract.  If we do not, then the law is worth no more than the paper it is printed on, and that will lead to less economic activity for fear that it can always be taken away with the stroke of a pen.

Believe it or not, this sort of dovetails with my previous post. Here's Robert Reich in the NY Times:

We're sliding into recession, or worse, and Washington is turning to the normal remedies for economic downturns. But the normal remedies are not likely to work this time, because this isn’t a normal downturn.

...

The only lasting remedy, other than for Americans to accept a lower standard of living and for businesses to adjust to a smaller economy, is to give middle- and lower-income Americans more buying power — and not just temporarily.

...

The only way to keep the economy going over the long run is to increase the wages of the bottom two-thirds of Americans. The answer is not to protect jobs through trade protection. That would only drive up the prices of everything purchased from abroad. Most routine jobs are being automated anyway.

A larger earned-income tax credit, financed by a higher marginal income tax on top earners, is required. The tax credit functions like a reverse income tax. Enlarging it would mean giving workers at the bottom a bigger wage supplement, as well as phasing it out at a higher wage. The current supplement for a worker with two children who earns up to $16,000 a year is about $5,000. That amount declines as earnings increase and is eliminated at about $38,000. It should be increased to, say, $8,000 at the low end and phased out at an income of $46,000.

Median household income is about $48,000. What would be the ramifications of making almost half of all households receive the earned income tax credit? The EITC is a great program, and probably could be expanded in the sense of giving a larger amount to the lower income earners. It's the closest thing we have to Milton Friedman's negative income tax. It is a potentially powerful anti-poverty program.

But I'm less sanguine about making the EITC a middle class entitlement, which is exactly what would happen if we were to follow Reich's advice. I'm not sure a middle class entitlement is what Friedman had in mind.

Reich is right about one thing though.

Over the longer term, inequality can be reversed only through better schools for children in lower- and moderate-income communities. This will require, at the least, good preschools, fewer students per classroom and better pay for teachers in such schools, in order to attract the teaching talent these students need.

Except that he forgets to mention that it also requires a change in the way we fund schools at the state and local level. The federal government is impotent to do anything about that, and that's probably a good thing. Though it is tempting to think that the federal government could swoop in with a grand fix, I fear that they would make things worse. Our recent record on federal government intervention in K-12 education is not exactly stellar.

Compared to Friday the news is that there isn't much news on the liquidity front. The Fed today injected only $2 billion. That effectively takes out nearly all of what they put in on Friday. There still is an extra $12 billion or so from a 14 day repo that took place last Thursday. But the upshot of all of this is that according to CNBC the fed funds rate is trading at or just a little higher than the target.

In other words, nothing too out of the ordinary, and the Fed might just be content to let the funds rate sit a little bit higher today. It's as if they are telling the market not to count their chickens before they are hatched when it comes to that rate cut the street has been calling for. Everybody and their brother is talking about moral hazard, and rightfully so. It is still my opinion that a rate cut is not desirable and would only be used if something like what happened on Friday turned into something close to a true global meltdown.

But it didn't. Mr. Bernanke won this one. He stared down the analysts calling for a rate cut and didn't blink. He did exactly what was required of him and the Fed. Simply put, the funds rate started trading above the target on Friday. So the Fed injected the liquidity to get it back down to the target. Full stop. Nice job.

As I watched CNBC this morning, I also began to get a fuller sense, as did anyone else who was listening carefully, of what was really happening. I heard one of the analysts say that the leverage in the hedge funds had dropped dramatically and that a significant amount of cash had been injected into those funds. That, of course, is exactly what needed to be done, and when you step back and think about it, everything that happened on Friday starts to make sense. A lot of people were in some pretty risky positions and got out of those positions and onto firmer ground. Of course, on Thursday and Friday, without knowing what was really going on it looked like more of a panic. If it is true that the leverage has decreased, then there should be less of a chance of something like that happening again, or worse.

Are the hedge funds and the other big financial firms hunkered down to weather any more fallout from subprime delinquencies? We can hope so. And if it is so, it is largely because of the Fed's injection of liquidity on Friday that made that process take place in a more orderly fashion. When the final story is written, that action may look pretty heroic. But like all good heroes, the Fed would say they were just doing what needed to be done.

Of course, hearing that July retail sales were up more than expected also helped everyone get off to a good start today. But I want to call your attention to some other news, which I think will be the most under-reported story of today.

China's inflation rate now stands at 5.6% with food prices rising around 15%. Why mention that in the context of what the Fed is doing? Because just as the Fed has to be on guard for deflationary pressures being transmitted internationally, they need to be on guard from inflationary risks overseas. Higher prices from China are already showing up on our shores. The Fed needs to make sure that we don't end up importing inflation from China.

Of course that was far from our minds on Friday, and rightfully so. However, with that danger passed, at least for now, we need to keep an eye on the other risks out there.

Russ Roberts saw this and wrote, "This is so cool." You really need to take 20 minutes of your day and watch this Google video of Hans Rosling giving a presentation on economic development at the recent TED conference.

Back in January, I linked to Rosling's site, http://www.gapminder.org. I'm about to start lecturing on growth in my intermediate macro course, and I intend to use the wonderful interactive tools on the site.

UPDATE: The video is also available from the TED blog along with other videos from the conference.

David Leonhardt dishes up his Economix column for the NY Times and writes of preschool programs in Oklahoma. Here's a choice quote:

...Long before children turn 5, there are already enormous gaps in their abilities. One study found that 3-year-olds with professional parents know about 1,100 words on average, while 3-year-olds whose parents are on welfare know only 525. Much of the gap is caused by environment rather than genes, according to a wide body of research.

...

James J. Heckman, a Nobel Prize-winning economist at the University of Chicago, even argues that spending on preschool ultimately pays for itself. Early childhood education is so important that it makes workers more productive and reduces crime....

Click the link above to go to the study. Now, while I don't want to mandate enrollment in preschool, I do like the idea of providing incentives for low-income families to send their children to preschool if they choose. Compared to a lot of government spending, this would be money well-spent, and I would gladly have my taxes increased by a small amount in order to provide those incentives. I would structure it as a voucher system so that people could choose the preschool program that best fits their needs and/or beliefs. In any case, I would not want to set up a system of public preschools. This is a market in which competition is working, and could work on a larger scale as well. We have a lively market for preschools in Macomb--some church sponsored, one university sponsored, and some private-nonreligious. Pick the one that suits you. We are fortunate in that regard. Not all communities have as many affordable options.

But it would be nice if more communities did.