The ‘cure’ for the trade deficit is in the budget deficit.

In light of current Trump trade policy, it is perhaps worthwhile to review some common sense principles about international trade.

The first, most basic and most important principle is that countries do not trade, only individuals trade. The U.S. does not trade with China. Such a statement is meaningless. Rather, some individuals residing in America buy valuable things (goods and services) from individuals residing in China. These are imports from China. At the same time other individuals resident in America sell valuable goods and services to other individuals resident in China. These are exports to China. (Often these individual actions are expressed through the legal fiction of companies, but the essential units of trade are individual people). There is absolutely no reason why the total dollar value of the first set of transactions (American imports from China) should exactly match the dollar value of the second set of transactions (American exports to China). Such a zero trade balance would be a very strange coincidence indeed, and not a very satisfactory one. In the normal course of trade we expect to import more from some places in the world (for example where manufactured goods are cheapest) than from others, and those places are likely not the places where the demand for our exports highest.

The matter is no different from what happens when people in Texas trade with people in New York. No one expects the balance of trade between Texas and New York to be zero. In fact, almost no one knows or cares what that balance is. Residents in Texas would not be surprised to learn that the trade balance between Texas and other US states varies considerably, some being negative and some being positive and probably none being zero. Negative trade balances are paid for by capital inflows – investments or trade credit. If people in New York as a whole sell more to people in Texas than people in Texas as a whole buy from people in New York, then it must be true that funds to pay for those sales must be flowing from New York and other places to Texas in the form of investments or extensions of credit. These financial transactions are private transactions that automatically ensure that payments always balance. Any aggregate negative (or positive) trade balance is equaled by an aggregate positive (or negative) capital account balance. It happens automatically through the market process. People work it out voluntarily in the routine actions of purchase and sale, investing and granting credit. Prices and quantities adjust to achieve the balance.

By the same token, the balance of trade with China should be of no concern. Logically it should be balanced by a favorable aggregate capital account balance with our trading partners including China. And, yes, it is. And that would be the end of the matter but for one important fact, namely, government involvement. In cases involving trade across national borders, often involving the conversion of currencies, governments are involved. One might say that governments have polluted the situation by insinuating themselves into what would otherwise be self-adjusting private trade in goods and finance. For this reason, trade balances have become intimately involved in domestic government spending. Government budget deficits are financed in large part by foreign capital inflows.

For example, when Chinese exporters receive dollars from American buyers the Chinese government takes those dollars in return for local yuan currency. For many years these accumulated dollars have been invested in U.S. treasuries. In other words, the U.S. has borrowed from the trade surplus earned by Chinese sellers, to finance its spending in the U.S. This is facilitated by the Chinese government in effect appropriating that surplus. Essentially the U.S. government has obligated its citizens to pay the extent of the debt owed to Chinese citizens who have been obligated by their government to lend money to the U.S. government. The same is true for our other large trading partners.

In October 2018, the Chinese government held $1.14 trillion of U.S. debt. It's the largest foreign holder of U.S. Treasury securities. The second largest holder is Japan at $1.023 trillion. The impetus for this policy has been a Chinese government fear that if it did not ‘neutralize’ the inflow of dollars by buying them, thus increasing the supply of domestic currency, the price of dollars (the exchange value in terms of yuan) would fall. This would mean Chinese exports to the U.S. would become more expensive and imports from the U.S. to China less expensive. In other words, the Chinese government has for many years been motivated by the same disastrous export-led, protectionist goals as the Trump administration now is. Each country wants to limit imports and boost exports by not only imposing tariffs, but also by countering natural flows of goods and finance with inhibiting monetary and fiscal policy. Despite the Chinese government's occasional threats to sell its holdings, it apparently continues to be happy to be America's biggest foreign banker.

At the same time, the U.S. government has become dependent on these foreign sources of finance. And as the debt keeps mounting up, the interest on the debt increases with it. With each passing day babies born in America inherit an increasing debt to our foreign bankers.

Is that a legitimate reason to be concerned about the large trade deficit with China (and other nations) that is fueling the current Trump protectionist trade strategy? No, not really. It is not the trade deficit that is the real problem. It is the U.S. government budget deficit that should receive our attention. Quite simply our government should not be borrowing so much money. The best way to fix this is to reduce government expenditure, not to increase taxes. The latter will hurt the economy and may not even result in a significant increase in revenue; in fact, it may reduce revenue. It is the overall size of the federal government that is the overarching problem of both foreign and domestic economic policy.

If the Treasury borrowed less, and/or if China decided to lend less (buy fewer U.S. bonds, or no bonds), what would happen? The dollar exchange rate would fall, imports would become more expensive, and exports would become cheaper and more attractive. Ironically that is what Trump says he wants. But it would happen automatically and it would mean downsizing the government, so don’t hold your breath.

A shorter version of this was published on January 2, 2018 in the Dallas Morning News.

https://www.dallasnews.com/opinion/commentary/2019/01/02/reducing-deficit-solve-trumps-china-trade-imbalance-problem

It is difficult to change one's mind regarding long-held beliefs.

Milton Friedman was a genius in discussing social policy. He always seemed to have just the right words to communicate to and disarm the critics of his argument, or his proposals. An economy of expression and a master of clarity.

From reading him I came to believe in free markets. But I remember it was not a pleasant experience - not at first. When he opposed federal aid to victims of flooding located in flood planes, I just "knew" that he could not be right, but reading his logic, I could not figure out where he was wrong. And so it was with many similar issues. I felt anger and resentment at him. So damn sure of himself with his ice-cold logic.

I am no Milton Friedman, but I frequently encounter this reaction when I use the same logic against free-market critics. I am sure many of my like-minded friends do as well. Instead of rational counter arguments I encounter hostility - an impugning of my motives, a labeling of my position, a refusal to engage with the logic. Given how I felt back then I understand this reaction; it is understandable, but it is not excusable - not if it is stubbornly maintained. I came to change my mind, once I got past my ego, and became an admirer of Friedman. Perhaps I am asking too much when I am expecting others to do the same.

[I am not referring to those who have a coherent counterargument, based, necessarily on a different worldview. I am referring to those who have no logical counter argument, but just refuse to accept the implications of that.]

On Keynesian economics and the economics of Keynes.

Clower and Leijonjufjud reconstructed Keynes against the Keynesians - dynamic Keynesianism against static formal modelling - real time versus model time. They pointed to real-world experiences of changes in real time of prices and quantities produced by people acting on their disparate expectations. If incomes adjust rapidly - more rapidly than prices - an "income-constrained" process is possible. Production and employment may fall as a result of pessimistic expectations (loss of confidence, uncertainty) however produced.

My interpretation of real-world history suggests that this is not only logically coherent, it is also possible, and has happened from time to time. One may wonder whether the bounce-back of Keynesianism in the wake of the dot.com bust and the financial crisis, can be defended on the basis of this dynamic Keynesianism. On this I say the following.

1. Though one may see, if one looks hard enough, echoes of the Leijonhufjued-Clower reconstruction in the current climate of Keynesian opinion, it seems to me most of it is simply of the old ISLM, AS-AD variety, either explicitly, or else by implication inside the more sophisticated macro-models (stochastic or otherwise).

2. One may see in recent events evidence of income-constrained processes.

3. But this alone does not a Keynesian policy make. It is one thing to suggest that under some circumstances, the unsupported macro-economy may experience downturns. It is quite another to claim that, therefore, activist macro-policy is called for. There is no 'therefore' about it. Activist policy to be successful requires solutions to formidable knowledge and incentive problems. Failure to overcome these problems makes such policy destabilizing. And there is absolutely no attempt by the reborn Keynesians to grapple with this.

4. The conditions that produce significant income-constrained processes are worthy of examination, and, I would suggest are usually characterized by an accumulation of bad macro intervention policies - like artificially low interest rates, regulatory distortions on a macro scale (housing), etc.

5. Though income-constrained processes occur in the absence of policy distortions, they are likely to be relatively short-lived - quickly self-correcting. This is the empirical counterpart to recognizing the cogency of the argument while arguing against its significance in supporting activist, discretionary policy.

6. Non-Keynesians, Austrians and others, have not denied the possibility of income-constrained processes, like the 'secondary depression' that Hayek refers to. To claim that the unfettered market is basically stable, is not to claim that it is perfect, that it is free of all errors, or that adjustments to change are painless.

The Common Sense Appraisal of Regulation

The way I see it there are only two possible justifications for regulation (aka interfering in other people's private decisions).

1. people are too stupid and/or uninformed to make their own decisions
2. peoples actions have effects (good or bad) on others (third parties) which they do not take into account in their decisions.

When I say "justifications" I do not mean that if they were true then interventions connected with them would be justified. In fact, particularly with 1. I do not see it as a justification at all. But, most people who support regulation fall back (when you boil it down) on either or both of these and nothing else. So it is worth examining them a bit more closely.

Let's consider 1. Is it true? Maybe in part, but not to the extent that most interventionists think. I think most people are more inclined and able to be informed if they are encouraged ("incentivized") to be so. But let's assume it’s true. So what? As most people reading this already know, there is no reason to presume that the regulators know any more than the people they are regulating do, or that, if they do, they can be trusted to do the right thing - the well-known knowledge and incentive problems. Further, there are strong reasons to believe that when acting in their own interests people will do better than regulators acting for them - because they know more about their own preferences and circumstances and because, in acting in their own interests (which includes the interests of those they care about), they have a greater incentive to get it right. The reward for doing so, and the cost of not doing so, is greater for them than for some disconnected regulator. I conclude that this is a bad justification after all - it is an elitist position better served to satisfy the ego and conscience of the elites than of the people they purport to help. 

Let's consider 2. The tired "externality/market failure" argument. Logically this is more resilient to criticism. If it is understood as essentially a question of the lack of property rights, and if it is not a simple matter to establish clear and enforceable property rights, (for example automobile emissions, global warming, protection from foreign invasion) then it might be persuasive to say that some kind of regulation is worth considering. But to be decisive a few questions have to answered affirmatively first. Is the external cost or benefit proven? Can the magnitude be estimated? And, most importantly, can it be decisively shown that regulation to deal with it will work and will be worth the cost in resources and loss of freedom? Every economist knows that to justify regulation it is not sufficient to identify an externality - though it may be considered necessary. In addition it has to be shown that the external effects of the intervention itself is justifiable. Those who support individual freedom and autonomy and distrust big-government initiatives, no matter how well-intentioned, will require a hefty burden of proof, one that can be seldom overcome. The knowledge and incentive problems apply just as much to this justification as to the previous one. 

The public sphere and the private sphere are not neatly compartmentalized spheres of action in which human's act wisely and benevolently in the former and not in the latter. Fallible human beings occupy both spheres. The reason the private sector is so much more successful than the public (government) sector is because it does not rely on the good judgment and good intentions of central administrators, but rather on the simple exercise of self-interest by simple people.

From my FB page - The real Obama and why it matters.

This afternoon (November 17, 2012) I heard Richard Epstein talk on the implications of the recent election for the economy. He gave the annual distinguished scholar lecture as the SEA meetings. To hear Epstein talk is awe-inspiring. Hard to describe. Always without notes, he delivers intricate, clever, funny, insightful prose without hesitation, seamlessly weaving his web of logic, backwards and forward, while making knockdown points.

What he said today reinforced my conviction that Obama is by far the worse of the two candidates we faced in this election - though both were pretty bad. Epstein's knowledge of the details of each and every Obama program, the law, the economics, the bureaucracy, ... left me with little doubt on this score - and pretty pessimistic for what lies ahead. In addition Epstein has the rather unique advantage of knowing Obama personally from his University of Chicago days.

This is a situation where personality matters a lot. According to Epstein, Obama is the exact opposite of his convivial exterior. He is someone who is unlikely to change his mind on anything and who takes criticism extremely badly. He brings to the White House not your standard self-serving, but flexible politician. He is, rather, someone who is a principled and stubborn believer in policies and values antithetical to the health of the American economy and its civil society. His serious agenda is not the "liberal" agenda of the 1960's which focused on civil rights; rather it is the agenda of the Progressive era in America, wherein social planning politician sought, by the power of government, to redesign society from top to bottom. And you see this in every part of the various programs he has already addressed.

Healthcare, financial regulation, environmental policy, protectionism in international trade, trade unionism, education, and more. In every case Obama has skillfully constructed a powerful regulatory apparatus. Where he has been able to use Congress he has obtained the legislation he wanted (and designed), legislation deliberately vague, so as to leave as much discretion for the bureaucracy as possible. Where legislation was unnecessary, or unobtainable, he has resorted to administrative discretion, issuing decrees often without the necessary Congressional approval. He knows that the regulated companies and organizations have the option of either obeying or taking the government to court, and that the latter is costly inconvenient and risky, so they almost always comply. In this way, little by little, our freedoms are regulated away.

Epstein pointed out that the accumulating regulations act like taxes to sap the creative power of private economic initiatives and when combined with macro tax and spend policies can only have one outcome. The prospect for the future is one of dwindling growth, smaller technological advances, less capital investment in America and slowly declining standards of living, not only for or mostly for the 1%.

I wish I could do his analysis justice. I can't even come close. But he has expressed this in parts in various places available on the internet and I will be looking for them so as to be able to share more specific detail.

(Complex?) Thoughts on Heterogeneity and Complexity; Quality and Quantity

Considering the concept of heterogeneity throws light on the relationship between quantity and quality.

All observation and explanation proceeds on the basis of classification (categorization). Phenomena are grouped into categories according to our perception of their essential similarity (homogeneity). The elements of any category (class) might be different in some respects, but in all respects that ‘matter’ to us they are identical. Items within a particular category can be counted, quantified. The ability to quantify is crucially dependent on being able to count items in this manner. The number and type of categories (variables) is known and fixed. Thus, the arrival of a new category cannot be accommodated within a scheme of simple quantitative variation and must be considered to be a change in quality. Qualitative differences are categorical differences.

All quantitative modeling proceeds on the basis of the assumption that the individual elements of any given quantifiable variable are identical (homogeneous) and are different in some important respect from those of another variable. Variables are essentially distinguishable categories. In addition the elements of a quantifiable category do not interact with each other – else they could not be simply counted. Each element is an independent, identical instance of the class. (Most obvious is the case of ‘identical randomly distributed variables’). This does not preclude the elements themselves being complex – being the result of lower-level interactions, like identical molecules or biological cells, which are incredibly complex phenomena.

We may think of this in terms of structure. Structure implies connections/interactions. A structure is composed of heterogeneous items that are more than simply a list of those items. There is a sense of how the heterogeneous items work together to ‘produce’ something. (We see here how a capital-structure is both a metaphor for and a particular case of the phenomenon of complex structures in the world.) A structure is an ‘order’ in Hayek’s sense, in which it is possible to know something about the whole by observing the types and the ways in which they are related, without having to observe a totality of the elements. Structures are relational. Elements are defined not only by their individual characteristics but also by the manner in which they relate to other elements. These interactions are, in effect, additional variables.

Thus, though the elements of a quantifiable category may be unstructured, these elements may be composed of structured sub-elements. This is the basis of the phenomenon of modularity. Self-contained (possibly complex) modules may be quantified. This dramatically simplifies the organization of complex phenomena, as has been noted in a fast growing literature on the subject. Modularity is a ubiquitous phenomenon in both nature and in social organizations. It is an indispensable principle of hierarchically structured complex systems. The benefits of modularity in social settings include the facilitation of adjustment to change, and of product design, and the reaping of large economies in the use and management of knowledge (see for example work by Baldwin and Clark 2000, Langlois 2002, 2012) and it is clearly an aspect, perhaps the key aspect, of Lachmannian capital-structures. Capital-goods themselves are modules, which are creatively grouped into capital-combinations which constitute the modules of the (non-quantifiable) capital-structure.

Returning to the theme of the relationship between quantity and quality, quantitative modeling works when both the independent and dependent variables are meaningful, identifiable quantifiable categories that can be causally related. The model ‘works’ then in the sense of providing quantitative predictions. The inputs and outputs can be described in quantitative terms. But, when the outcome of the process described by the model is a new (novel) category of things, no such quantitative prediction is possible. Ambiguity in the type and number of categories in any system destroys the ability to meaningfully describe that system exclusively in terms of quantities. We have a sense then of the effects of heterogeneity. Variation applies to quantitative range.Heterogeneity (variety) applies to qualitative (categorical) range.Diversity incorporates both, but they are significantly different. Heterogeneity may not be necessary for complexity, but heterogeneity does militate in its favor. For example, compound interaction betweenquantitative variables (categories) can be an important characteristic of complex systems, but complex systems are likely to result from substantial heterogeneity, especially where heterogeneity is open-ended, in the sense that the set of all possible categories of things is unknown and unknowable.  

Heterogeneity rules out aggregation, which, in turn, rules out quantitative prediction and control, but certainly does not rule out the type of ‘pattern prediction’ of which Hayek spoke. In fact, erroneously treating heterogeneous capital as though it were a quantifiable magnitude has led to misunderstandings and policy-errors, such as the those associated with the connection between investment and interest rates - errors that could have been avoided with a better understanding of capital heterogeneity and its effects. The capital-structure is complex, but it is intelligible. We can understand and describe in qualitative (abstract) terms how it works and render judgment on economic policies that affect it. And, as a result of Hayek’s insights into complex phenomena, we have an enhanced appreciation of what is involved.

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Baldwin, C. Y and K. B. Clark (2000), Design Rules (Cambridge, Mass.: MIT Press).

Langlois, Richard N. (2002), ‘Modularity in Technology and Organization,’ in Entrepreneurship and the Firm: Austrian Perspectives on Economic Organization, N. J. Foss and P. G. Klein, 24-47. Aldershot: Edward Elgar,.

Langlois, Richard N. (2012), ‘The Austrian Theory of the Firm: Retrospect and Prospect,’ Review of Austrian Economics, forthcoming.

Specialization and Spontaneous Order - more lessons for Obama

Perhaps it would have been more appropriate to have written this on July 4, rather than on Memorial Day. But you can’t argue with inspiration.

July 4 commemorates that date in the year of 1776, the date we pick to mark the Declaration of Independence and the launching of the grand and noble American experiment that is still playing out. It so happens that 1776 is also the year of publication of Adam Smith’s famous book, An Inquiry into the Nature and Causes of the Wealth of Nations, more commonly known simply as The Wealth of Nations.

It is not really an accident that these two works are so close in timing. They share a common intellectual tradition, the ideas of English liberalism that were ”in the air” – and had been around for at least a hundred years dating back at least to the works of John Locke and the other contributors to the English natural-law tradition. For the first time in human history all individuals are seen as possessing certain basic rights, simply by virtue of being human, the same rights regardless of their station in life. Ironically, for most of human history these rights were far from “self-evident.” But the American Revolution, and the essence of the Constitution that followed, was predicated upon them – the rights to life, liberty and property - even though amended by Benjamin Franklin to read “the pursuit of happiness.” What is the connection?

Adam Smith’s work affirmed that secure individual rights to property were absolutely necessary for a nation to prosper – a key to the wealth of nations – and thus to the pursuit of happiness.  And every infringement of that individual right, however small, is an impediment to the attainment of that ideal. There are two essential ideas in Smith’s work, that together fully explain the how this works.

The first is the idea that productivity is the result of a the division of labor – specialization, leading to an improvement in knowledge, skills, expertise, etc. that enhance production and lead to the introduction of new and improved methods and products. But this division of labor has to be organized. People have to decide what to do and how to do it, and their plans and actions needs to dovetail with those of many others upon whom they depend. How is this “proper” division of labor to be coordinated? As explained in my previous post, this is the function of the market process, that system of natural property rights that results in voluntary production and exchange on the basis of market-established prices that act as both incentives and signals to do the “right thing.” So, it is not from the benevolence of the butcher that we get our meat, but from his attention to his own self-interest in the pursuit of profit. He is led by an invisible hand to provide us with the meat that within his specialized ability to produce. Coordination is not organized, it emerges spontaneously – it is a spontaneous order.

The invisible hand and the division of labor together provide a basic understanding of how the market systems works – when it is allowed to work. It is not perfect. The world is not, and will never be, perfect. People make mistakes, lots of them. The pursuit of profits brings both profits and losses. But, overall, this is the best, the only, system that is consistent with national prosperity, with the escape from the poverty that was the common plight of most people in the world prior to the modern era, and is still the plight of billions.

Like the Declaration of Independence, Adam Smith’s Wealth of Nations, reads as fresh today as the day it was written A great thinker and communicator, Adam Smith’s message is one that all national leaders should take to heart, including those of the nation whose founding documents were based on it.