When simple econ models don’t work

Reading recently: The Globalization Paradox by Dani Rodrik.

Should countries impose taxes on imports?

The bog standard economist answer is: no! The theory of comparative advantage says that trade is positive sum. Tariffs are a prisoner’s dilemma and we should fix the game theory with multilateral treaties. It’s too bad that lobbyists and entrenched interests fight against it.

There are (at least) three major things this answer leaves out.

• Tariff reductions are positive sum, but they still have negative components. When I reduce taxes on grain imports, it means that price signals cause my production capacity to be reallocated from inefficient grain production, to other more efficient things. Great, I’ve improved efficiency! But I’ve also transferred an enormous amount of money from my grain-producers to my non-grain-producers. Rodrik estimates¹ that if the US moved to complete free trade today, every $1 in efficiency gained by reducing tariffs would be accompanied by $50 (!) of wealth transfer from domestic producers (whose goods are less competitive) to importers (who have to pay less in tax).

• Most countries want their citizens to have things to do. Not having stuff to do is really bad! Being unemployed is incredibly stressful, scary, and depressing; in fact, long-term unemployment measurably decreases life expectancy. The financial shock can mess up not only your life but also all your dependents’. Socially, high unemployment tends to cause political unrest, anger, xenophobia and crime.

• Most countries want more stuff now, but also want more stuff later. That means they care about improving growth. The easiest way to do that (if you’re not one of the richest countries) is to catch up your citizens’ human capital to rich-country levels. Some types of production are much better for that than others.

  If you’re mostly exporting minerals, all you really need to know is pickaxe technique. The human capital ceiling here is pretty low. But if you’re building cars, you need people who understand how to put the cars together, what each part does, how to fix it if it’s making weird noises, how to make sure everyone else in the car plant is doing their job, and so on. Those are much more productive, hence valuable, skills.

  If you look at countries that have developed most quickly in the last 50 years—mainly East and Southeast Asia—you see that all these countries actually had fairly aggressive tariffs and export subsidies at various points, and did things that weren’t very free-market-oriented, in order to gain the advantages they now have in electronics, manufacturing, etc.²

It’s perfectly possible to incorporate these caveats into the naive model of inter-country trade. But most of the time you ask an economist about tariffs they don’t try to do that; they just tell you that the optimal level of tariffs is zero. Rodrik thinks that most economists justify these elisions by saying that you can make trade liberalization a Pareto improvement by implementing redistribution from the beneficiaries of free trade (i.e., net importers) to the harmed parties (domestic producers, unemployed people, and sectors with positive growth externalities).

But even if these redistributions are possible in principle, it seems very hard to size them properly. No one knows exactly how much it will harm domestic producers if you reduce import tariffs on their goods—let alone how much it will affect unemployment (which depends on skill transferability, union negotiations, future economic conditions, etc.) or growth (which nobody understands at all).

Given that, it’s actually hard to see how you could broker any deal involving such large transfers. If your grain tariff reduction takes away $50 from Pat and gives $51 to Dana, you could try to make it palatable by legislating a separate direct transfer of $50 from Dana to Pat. But if Dana underestimates how much they’ll benefit from the tariff reduction by even 2%, they’ll object that the second compensatory transfer is too big! In order to fix the redistribution, the parties need to agree really precisely on the magnitudes of the costs and benefits.

The pattern here is that the naive model assumes a way a bunch of stuff, and then treats it as a second-order problem when those assumptions are violated—but, because the assumptions are actually about very large effects, they only need to be violated a little bit in order to dominate the calculation.

What happens if you generalize this to other things that economists say?

I think this suggests you should freak out a lot more about technological unemployment. It’s true that the historical track record suggests that technological improvements are usually worth it in the long run. But, the historical track record also suggests that it’s often accompanied by very painful short-term dislocations, people running around the countryside smashing looms, and so on. It seems like it should be possible to do better—but it’s unlikely that we will do better if economists limit their policy suggestions to “yeah, it should be possible to fix that with some redistribution.”

More speculatively, I think it the same reasoning suggests that we should be a lot more confused about wage controls. This is another example where the naive economic analysis strongly suggests liberalization, but also makes a lot of spherical-cow assumptions. In this case, those assumptions are mostly about the efficiency of the relevant markets. It seems like it’s not too hard to imagine scenarios where a minimum wage improves efficiency—for instance, if local employers have much more market power than employees, or if the transaction cost of changing jobs is high enough that the job market isn’t very efficient, or if people are averse to changing jobs for behavioral reasons. An analogous case also applies for rent controls.