Krugman on Competitiveness

In the State of the Union Address President Obama spoke of building America’s competitiveness as a theme.  Paul Krugman, a Nobel prize and John Bates Clark medal recipient, explains why the new buzzword is the old buzzword in “The Competition Myth.”   

Meet the new buzzword, same as the old buzzword. In advance of the State of the Union, President Obama has telegraphed his main theme: competitiveness. The President’s Economic Recovery Advisory Board has been renamed the President’s Council on Jobs and Competitiveness. And in his Saturday radio address, the president declared that “We can out-compete any other nation on Earth.”

This may be smart politics. Arguably, Mr. Obama has enlisted an old cliché on behalf of a good cause, as a way to sell a much-needed increase in public investment to a public thoroughly indoctrinated in the view that government spending is a bad thing.

But let’s not kid ourselves: talking about “competitiveness” as a goal is fundamentally misleading. At best, it’s a misdiagnosis of our problems. At worst, it could lead to policies based on the false idea that what’s good for corporations is good for America.

About that misdiagnosis: What sense does it make to view our current woes as stemming from lack of competitiveness?

…ultimately, we’re in a mess because we had a financial crisis, not because American companies have lost their ability to compete with foreign rivals.

Krugman’s current article echoes his classic work, “Pop Internationalism.”

Many people who know that "competitiveness" is a largely meaningless concept have been willing to indulge competitive rhetoric precisely because they believe they can harness it in the service of good policies. An overblown fear of the Soviet Union was used in the 1950s to justify the building of the interstate highway system and the expansion of math and science education. Cannot the unjustified fears about foreign competition similarly be turned to good, used to justify serious efforts to reduce the budget deficit, rebuild infrastructure, and so on?

A few years ago this was a reasonable hope. At this point, however, the obsession with competitiveness has reached the point where it has already begun dangerously to distort economic policies.

As an aside, I may owe Krugman an apology.  In the past I have criticized him for supporting less than truthful statements by politicians to achieve policy he deems beneficial because of statements like those bolded above, but maybe I have misunderstood his meaning.  Perhaps he just has more tolerance for this political behavior.   

Ethanol and the Production Possibilities Frontier

People acting through their government face trade-offs.  The production possibilities frontier is a simple model showing food and ethanol production that illustrates some trade-offs.  In the United States, ethanol is made from corn.  To get more ethanol, resources have to move from the production of food and into the production of ethanol.

Markets are usually the best way to organize economic activities.  The graph shows the market production combination point.  Economic agents, acting through markets, buy a great deal of food and little ethanol.  People acting through markets do not consume much ethanol. 

Governments can sometimes improve market outcomes.  In the light of rising oil prices, a warming climate, and the war in Iraq, some suggested that oil production is associated with three significant negative externalities that contributed to each problem.  Economists usually recommend that negative externalities be taxed.

This is not the course the government took.  At the urging of almost all corn growers and a few environmentalists, the Congress passed and President Bush signed legislation that subsidized the production of ethanol in three ways: consumers must buy blended gasoline containing 10% ethanol, blenders received a 45 cent per gallon subsidy for mixing the gasoline and ethanol, and importers must pay a 54 cent per gallon tariff (taxes on imports) on foreign ethanol.  In response to these incentives, farmers took resources from food production and put it into ethanol production.  Forty percent of corn production in the United States is now used to make ethanol.  This is shown in the graph at the point “Production Combination with Ethanol Subsidies.”

Environmentalist no longer support ethanol production.  The EPA believes that corn production has a minimal to negative impact on the environment.  David Pimentel, a Cornell University scientist, estimates that the United States would achieve only a 4% reduction in oil consumption if the entire corn crop were devoted to ethanol production.  Let me suggest that, at the margin, such a small reduction in oil consumption would not significantly reduce the odds of entering a war to protect oil production.

At a time of slow growth, lingering high unemployment from the Great Recession, and budget deficits that threaten the financial stability of the government, ethanol subsidies should be ended.  Instead, protection has been extended and expanded.  When consumers did not buy the mandated level of ethanol, the Obama administration lifted the cap on how much ethanol could be blended into gasoline from 10% to 15% and increased the number of car models that are approved to use the 15% blend.  The Congress also extended subsidies to ethanol production. 

A Review of Rajan’s and Zingales’ “Saving Capitalism for the Capitalists”

Raghuram Rajan and Luigi Zingales make an excellent contribution to economic literature in “Saving Capitalism for the Capitalists.” Their writing style is crisp and animated even as they maintain scientific precision. The authors’ seem to write as concerned but detached outsiders looking into various national economies. Perhaps that is the perspective they gained by living, studying and working in many countries. Anyone with an interest in economics could benefit by reading it including the professional economist; the notes are clear and the authors reference a great deal of economic literature.

Economists have long observed that the laws and institutions within a country determine the level of wealth. If a country is not wealthy, it has bad institutions and those institutions should be changed. This approach treats an economy like a building or a machine to be constructed or fine tuned. Rajan and Zingales approach is almost biological. They theorize that a country’s economic and political institutions grow symbiotically in the same national environment and they offer two types of relationships or capitalisms.

Relationship capitalism is the most common and produces the least wealth. The relationship between economic and political institutions is parasitic.  Because economic laws and institutions do not protect property rights, the ability of an entrepreneur to produce goods and services depends on her political and business relationships. A political regime’s power is also derived from relationships with incumbent firms, unions and other special interests. The political regime protects incumbents’ economic status by limiting competition from internal and external forces. This exposes an internal weakness of relationship capitalism. The ability to protect incumbents is in part dependent on the economic efficiency of the incumbents the political regime protects from efficiency promoting competition.

Change to a commensal symbiotic relationship or arms-length capitalism, comes in two phases beginning with the “taming of the government.” In general, the government is not tamed by a great leader working for the masses but an incumbent politician attempting to solidify his position or eliminate political rivals. To do so, political incumbents must attract new allies and they can only do so with a credible commitment to protect their property. The second phase, the “taming of the incumbents,” comes by exposing incumbents to internal and external competition. Rajan and Zingales see finance as a vital agent of change making competition in capital markets as important as competition in trade. Economic challengers can grow faster when the financial industry is strong because they do not have to rely on profits to fund growth.Arms-length capitalism produces political challengers. Schumpeter’s “winds of creative destruction” blow hard, challenging weak economic incumbents in good times, and spawning more political opponents during downturns. Rajan and Zingales suggest that challenged incumbents will combine with the economically displaced to politically threaten arms-length capitalism using protection of the masses as a pretext to protect the interests of the wealthy owners of the incumbent firms.

The authors propose a set of policies that protect arms-length capitalism and the dispersed wealth that it creates by reducing incumbents’ incentives to appeal to political markets. My review is incomplete but highlights some of the proposals I find most interesting. They begin with a property tax to replace or augment the income tax. An income tax is inefficient, favoring businesses and individuals with extravagant expenditures and resultant lower profits or savings over the efficient who produce large profits or savings. The property tax favors the efficient over the extravagant by subjecting both to the same taxes. They also propose an inheritance tax on transfer of control not on wealth. Because heirs typically do not have the entrepreneurial talents of their progenitors, transfer of controlling interest would increase inefficiency. The tax could be avoided by transferring wealth in diversified portfolios.

Rajan and Zingales also propose an enhanced safety net that insures people directly and not through firms. The presence of the expanded safety net reduces the incentive of those displaced by innovation to act in political markets. Their safety net would concentrate on health and education to allow people to protect themselves through permanent changes in the economy rather than cyclical changes.

As an economist who appreciates the wealth creation of arms-length capitalism and the higher standard of living that it engenders, I find their proposals intriguing. They decrease incentives for malignant action in political markets, protecting economic innovation. They protect the poor and other displaced with minimal disruption of markets and create economic mobility for the motivated and talented of all economic classes.

Didn’t See It Coming

In response to the post, “Markets and Government,” a student asked, ”I would like to know if economist knew that we were going to suffer from the financial crisis? If so, why didn't they do anything about it? I find it kind of interesting that nothing was done to keep us out of the financial situation we are in now....or was it just too late?”

The answer to the first question is a little embarrassing, few economists saw the financial crisis coming.  Although not a satisfying answer, the main reason so few recognized the danger is that the vast majority of economists have expertise and interests outside of the housing market and finance.  The answer is not satisfying for a second reason, few financial economists saw it coming either and their warnings were largely ignored. Raghuram Rajan, who I quoted in “Markets and Government,” was one economist who saw the writing on the wall.  Others included Nouriel Roubini, and Nassim Taleb.  The financial crisis was the confluence of many problems, most of which were seen and understood.  Government officials carefully created a system of regulation to deal with these problems and economists added a great deal of insight into these regulations.  This implies that my student’s assumption in framing the second question is probably wrong, it wasn’t that the government did nothing; it was that the steps it took were ineffectual or inadequate.  As Seabright wrote in Foreign Policy,  “The Imaginot Line,”

There are important lessons to be learned from the [financial] crisis. But we'll learn them better if we realize that the intellectual and political architects of the system that failed us were not naive at all, but immensely clever and subtle; it was their cleverness and subtlety that undid them. And that is bad news for all of us, for naivete can give way to learning, but cleverness has no obvious higher state.

Seabright explains the regulatory philosophy that guided the government and why it failed.  His article is a good place to start, but the issue of what caused the financial crash is so enormous that economists will debate its root causes for a century. 

Markets and the Government

I read the articles by President Obama and Paul Seabright today.  They speak to the relationship between a market economy and the government.  The remaining three quotes are by very good economists on the same topic; they are presented in alphabetical order.

President Barak Obama.  Wall Street Journal, “Toward a 21st-Century Regulatory System.”

For two centuries, America's free market has not only been the source of dazzling ideas and path-breaking products, it has also been the greatest force for prosperity the world has ever known. That vibrant entrepreneurialism is the key to our continued global leadership and the success of our people.

But throughout our history, one of the reasons the free market has worked is that we have sought the proper balance. We have preserved freedom of commerce while applying those rules and regulations necessary to protect the public against threats to our health and safety and to safeguard people and businesses from abuse.

Paul Seabright, Foreign Policy,  “The Imaginot Line.”

There are important lessons to be learned from the [financial] crisis. But we'll learn them better if we realize that the intellectual and political architects of the system that failed us were not naive at all, but immensely clever and subtle; it was their cleverness and subtlety that undid them. And that is bad news for all of us, for naivete can give way to learning, but cleverness has no obvious higher state.

Daron Acemoglu, ("The Crisis of 2008: Structure Lessons for and from Economics,").

A deep and important contribution of the discipline of economics is the insight that greed is neither good nor bad in the abstract. When channeled into profit-maximizing, competitive and innovative behavior under the auspices of sound laws and regulations, greed can act as the engine of innovation and economic growth. But when unchecked by the appropriate institutions and regulations, it will degenerate into rent-seeking, corruption and crime. It is our collective choice to manage the greed that many in our society inevitably possess. Economic theory provides guidance in how to create the right incentive systems and reward structures to contain it and turn it into a force towards progress.

F.A. Hayek, “The Fatal Conceit.”

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.

Raghuram Rajan and Luigi Zingales, “Saving Capitalism From the Capitalists.”

We do not believe that capitalism is fundamentally flawed, because we believe that markets can be given the political support to remain free. Much of this book has been about why that support is necessary: markets cannot flourish without the very visible hand of the government, which is needed to set up and maintain the infrastructure that enables participants to trade freely and with confidence. But who has an interest in pushing the government to support the market? For even though everyone collectively benefits from the better goods, the services, and the equality of access that competitive markets make possible, no one in particular makes huge profits from keeping the system competitive and the playing field level. Thus, everyone has an incentive to take a free ride and let someone else defend the system. A competitive market is a form of public good (a good, like air, that is useful but hard to charge for), and somewhat paradoxically, collective action is needed for its maintenance.

Given its dependence on political goodwill, democratic capitalism’s greatest problem is not that it will destroy itself economically, as Marx would have it, but that it may lose its political support. Capitalism’s biggest political enemies are not the firebrand trade unionists spewing vitriol against the system but the executives in pin-striped suits extolling the virtues of competitive markets with every breath while attempting to extinguish them with every action.

The Circular Flow Diagram and Home Finance

The circular-flow diagram is a simple model used by economists to explain how households and business are connected through markets.  It assumes that households who own all resources and businesses produce all goods and services. 

Households interact with businesses through two markets: the market for factors of production and the market for goods and services.  The arrows that circle the diagram illustrate a physical flow and a financial flow.  The inner arrows represent the physical flow.  Resources or inputs are taken to the market for factors of production.  Use rights to these factors are acquired by businesses that use them to make goods and transport them to the market for goods and services where they are acquired by households.  The outer arrows represent the financial flows which move in the opposite direction.  Households pay businesses for the goods and services they acquire in the market for goods and services.  These revenues to the firm are used to pay their expenses in the market for goods and services.  These expenses are the wages, rents, interest, and profit earned by households. Wealth is created through specialization.  Markets allow households and businesses to specialize (Principle 8: A country’s standard of living depends on its ability to produce goods and services.).  And (Principle 7) “governments can sometimes improve market outcomes” with good law.

Rajan and Zingales explain in “Saving Capitalism for the Capitalist” how households benefit from businesses ability to take ownership of collateral pledged to cover a loan. 

Study after study has shown that the easier it is for a financier to seize collateral, the more lending takes place.  The ease with which a creditor can collect on pledged collateral differs amoung countries.  In England, or instance, it takes a lender on average a year and a sum of approximately 4.75 percent of the cost of the house to repossess a house from an insolvent borrower.  Mortgage loans amount to 52 percent of gross domestic product (GDP) in England.  In Italy, a country with roughly the same GDP per capita as England, it takes between three and five years at a cost of between 18 and 20 percent of the value of a house to foreclose on it.  Mortgage loans amount to a far lower 5.5 percent of GDP.

Likewise, businesses benefit from the bankruptcy code expands credit markets aiding both households and businesses as Rajan and Zingales offer this evidence.

The economic role of the bankruptcy law is not just to provide a mechanism for creditors to collect their money but also to offer a form of insurance to debtors, relieving them from some of their debt burden when it becomes overly oppressive.  When a borrower owes so much that he has small hope of repaying it, he will have little incentive to exert effort to earn money, because any extra dollar earned, while requiring his blood and toil, will simply go to repay creditors.  Both debtors and creditors may be better off in such situations if some of the debt is forgiven or renegotiated down in a bankruptcy proceeding.  Debtors will have an incentive to work harder if they know there is some chance of repaying their debt and keeping their businesses, while creditors will get something back instead of nothing at all.

Our laws governing collateral and bankruptcy may not be perfect, but they have improved credit opportunities for households and businesses.  Good law creates wealth by creating opportunities for trade and specialization through markets. 

Fox Shoots Hunter

Mankiw’s principle four is that “people respond to incentives.”  Apparently foxes do as well (“Fox shoots man during animal-human hunting scuffle”).

MOSCOW - A wounded fox shot its would be killer in Belarus by pulling the trigger on the hunter's gun as the pair scuffled after the man tried to finish the animal off with the butt of the rifle, media said on Thursday. 

Oil and Two of Mankiw’s Ten Principles of Economics

Greg Mankiw’s seventh principle of economics is that “governments can sometimes improve market outcomes.”  Modifying “can” with “sometimes” is common economic analysis built on tons of experience.  The production and consumption of oil exemplifies the problems that even government with the best of intentions faces.  We often associate oil production and consumption with two market failures: market power and negative externalities (pollution), and they are partially offsetting.  A government response to market power is to create more competition which would increase output, decrease price, and increase the negative externalities.  A government response to negative externalities is to impose a tax that would decrease production and consumption and drive up prices.  

The issue of oil production and consumption is more complex still.  Oil, and the products derived from it, add greatly to our national wealth.  At present, it does not have good substitutes.  In addition to directly creating wealth, it also creates positive externalities as do all market based transactions.  Because it is the cheapest form of energy for many uses, someone else’s use of oil benefits me because its consumptions leaves them wealthier and more able to buy the goods and services that I produce.  We know that steeply rising oil prices can act stop economic growth or even throw it into reverse.  (HT Drudge Report) That is why our eyes are on OPEC as the price per barrel of crude oil approaches $100 (Gene Ramos, “Oil off on U.S. data but OPEC eyed as $100 in sight”). 

Mankiw’s sixth principle is that “markets are usually a good way to organize economic activity.”  How do markets help?  In response to higher prices, consumers will shift consumption to energy efficient products.  Companies that make products that are not energy efficient will lose business unless they can modify their products to use less energy.  Markets even help solve market failures.  Pollution is often a sign of inefficient production.  Learning from BP’s example, oil companies will be more careful when drilling, not just to avoid cleanup costs, but to not waste a valuable resource.  The internal combustion engine has grown more efficient in part by polluting less.  A fuel efficient car in 1972 got about 25 miles per gallon on the highway, less than most modern minivans.  Firms exercising market power by withholding product to raise prices will face new competition from firms that want to grab part of the high profit market power creates.  Schumpeter referred to innovation threatening existing producers as the “winds of creative destructions.”  Are these winds sufficient to blow away oil’s twin market failures of market power and negative externalities?

Zach Osler on Jared Loughner

I occasionally post on a topic unrelated to economics; this is one of those occasions.  The video is of an interview of Zach Osler, a high school friend of Jared Loughner, conducted by Ashleigh Banfield.  Banfield’s interview is top notch.  She gives the stage to Zach who gives compelling insight into Loughner’s life and his own soul as he watched his friend descend into insanity.

December’s Unemployment Report

Upon reading a report that job creation did not meet expectations and that unemployment decreased because the number of discouraged workers (workers who are no longer seeking employment) I stopped reading, and refused to listen to the news to protect my optimistic mood.  Instead, I relentlessly prepared for classes that begin on Monday.  Not wanting to learn about an event because it is negative is decidedly unscientific.  

This morning, I decided to resume the role of an economist and read “US jobs report an ‘utter mess’” by Robin Harding of the Financial Times (HT Drudge Report).  I found the report excellent; it contained information on statistical reporting that is often absent.

The monthly Employment Situation report contains two different measures of employment: a survey of employers and a survey of households. Forecasters had expected private job creation would climb toward 200,000.  The survey of employers showed payroll growth of 106,000, hardly an encouraging report.  The survey of households showed that 297,000 more people were employed but that there were 260,000 fewer people in the labor force.  The combination of more employed workers (positive) and fewer labor force participants was mixed news.  The unemployment rate fell from 9.8 to 9.4% November to December but the labor force participation rate fell from 64.5 to 64.3% over the same period.  The conclusion, disappointingly slow growth continues.

I See Moonbeam Arising, I See Trouble on the Way

Yesterday, Jerry Brown began his third term as governor of California as the state faces extreme fiscal challenges: a $28 billion budget deficit, $88.3 billion of bond debt, and $500 billion of pension liabilities.  For those of us old enough to remember his first two terms, Jerry Brown may be a social liberal, but he was a fiscal conservative and he promises more of the same this term as reported by Michael Marois of Bloomberg (“Brown Faces a Reckoning in California as $28 Billion Gap Shadows Inaugural”).    

Brown is armed with a new law that authorizes lawmakers to pass spending plans with a simple majority rather than a two-thirds supermajority.  He is constrained by the 1978 proposition 13 which requires a two-thirds majority to increase taxes.  These voting rules can be interpreted differently.  Given today’s economic condition, it might be argued that they are they a statement by liberal Californians that they prefer low taxes and low spending.  Given more prosperous times, they might be a canonized method of keeping taxes low and spending high.

Burned by his opposition to proposition 13 during his first term, Brown has promised initial cuts in spending to induce voters to approve a ballot initiative in June that would, among other things, extend higher taxes on income, vehicles and sales set to expire this year (Kevin Yamamura, Sacrament Bee, “Brown to propose broad list of budget cuts”).

There is no doubt that the cuts Brown is proposing are real.  They include cuts to universities, parks, Medi-Cal (California’s version of Medicare), and cuts in other social services.  He proposes eliminating hundreds of redevelopment agencies and enterprise zones, two changes that I view as pro-market and anti-corruption. 

Will Brown be able to push budget cuts through the legislature dominated by his own party?  Come June, will voters find the proposed tax increases more painful than the spending cuts?