Juneteenth Marred By An Economic Fallacy

28 Saturday Jun 2025

Posted by Nuetzel in Economic Development, Slavery

Tags

1619 Project, Abolition, Antebellum South, Capital Deepening, Civil War, Coercion, Emancipation, Juneteenth, Nathan Nunn, Phil Magness, Redistribution, Reparatiins, Rod D. Martin, Slavery, Welfare Loss

The Juneteenth holiday (June 19th) marks the anniversary of the abolition of slavery in the U.S. It should be viewed as a celebration of basic human rights. However, in purely economic terms, slavery was (and still is in many parts of the world) a complete revocation of property rights (self-ownership). But not only was slave-holding the worst sort of theft, it represented a total suspension of the labor market mechanism and had dire consequences for long-term economic development, especially in the south.

Government sanction of slaveholding in the southern U.S. and an extremely low effective wage for slaves promoted an excessive and inefficient dependence on, and utilization of, the low-cost input: slave labor. As a result, slavery created an obstacle to economic development, innovation, and capital deepening. The overall impact on the U.S. was to reduce economic welfare and development, and the dysfunction was obviously concentrated in the south.

That hasn’t stopped some activists from making the claim that slavery enabled the success of American capitalism. For example, this book contends that:

“… the expansion of slavery in the first eight decades after American independence drove the evolution and modernization of the United States.“

The so-called 1619 Project has promoted this narrative as well. Interestingly, this is similar to claims made prior to emancipation by defenders of slavery.

Of course, one can’t overemphasize the injustices suffered by American slaves, like those of other enslaved peoples throughout history. But it is foolhardy to attribute the long-term economic success of the American economy to slavery. Even today, 160 years after emancipation, it’s a safe bet that most Americans would be better off without its legacy.

To be clear I’ll outline several assertions I’m making here. First, if slaves had been free workers, they would have enjoyed freedoms and captured the value of their labors from the start. (Though it is not clear how many Africans would have come to America voluntarily as free workers, had they been given the opportunity. Some, however, were already enslaved.)

Under this counterfactual, more efficient pricing of labor would have led to deeper capital. At the same time, while many black non-slaves would still have worked in agriculture, blacks would have been more dispersed occupationally, working at tasks that best suited individual skills. The resulting efficiency gains would have been magnified by virtue of working in combination with more capital assets, enhancing productivity. And these workers would have been free to build their own human capital through education and work experience. Meanwhile, government would not have wasted resources enforcing slave ownership, and plantation owners (and other slave holders) would have made more rational resource allocation decisions. All these factors would have produced a net gain in welfare and improved economic development from at least the time of the nation’s founding.

There is no question that enslavement and the welfare losses suffered by slaves (and many of their descendants) far outweighed the gains captured by those who employed slave labor, as well as those who consumed or otherwise made use of the product of slave labor. A proper economic accounting of these losses acknowledges that slaves were denied their worker surplus and their ability to earn an opportunity cost, and they were often punished or tortured as a means of coercing greater effort. This serves to emphasize the implausibility of the argument that the America reaped net economic benefits from slavery.

Slavery was so powerful an institution that it permeated southern culture and perceptions of status. Wealth was tied-up in slave-chattel, and the free labor made for a handsome return on investment. Thus, both economic and cultural factors acted to lock producers into an unending series of short-run input decisions.

Furthermore, as Phil Magness explains in a letter to the Editor in the Wall Street Journal:

“… slavery’s economics … largely depended on government support. Fugitive slave patrols, military expenditures to fend off the threat of slave revolts and censorship of abolitionist materials by the post office were necessary to secure the institution’s economic position. These policies transferred the burden of enforcing the slave system from the plantation masters on to the taxpaying public.“

Meanwhile, the distortions to the cost of labor slowed the adoption of a variety of production techniques, including horse-drawn cultivators and harrows, steel plows, and steam-powered machinery. In other words, planters had little incentive to modernize production. Other technologies commonly used in the north during that era could have been applied in the south, but only to its much smaller share of acreage dedicated to grain crops.

Southern agricultural practices were “frozen in place”, as Rod D. Martin puts it. Ultimately, had southern planters adopted labor-saving technologies, and had southern governments shifted resources away from protecting slavery as an institution toward more diversified economic development, the antebellum economy would have experienced more rapid growth.

Growth in demand for cotton exports was certainly a boon to the south during the years preceding the Civil War, but the reliance on cotton was such that the southern economy was heavily exposed to risks of draught and other shocks. Furthermore, the lack of industrialization meant that southern states captured little of the final value of the textiles produced with cotton. The inadequacy of transportation infrastructure in the south was another serious detriment to long-term growth.

The work of Nathan Nunn, which is cited by Martin, generally supports the hypothesis that slavery retards economic growth. Nunn found a strong negative correlation between slave use and later economic development across different “New World” economies, as well as U.S. states and counties.

Martin goes so far as to say that the Union’s victory over the Confederacy was due in large part to economic under-development attributable to slavery in the south. That narrative has been challenged by a few scholars who claimed that the south was actually wealthier than the north. The owners of large southern plantations were quite well off, of course, but estimates of their wealth are unreliable, and in any case slaves themselves were highly illiquid “assets”. That meant planters would have been hard pressed to raise the capital needed for investment in labor-saving technologies, even if they’d had proper incentives to do so.

On the whole, there is no question the north was far more industrialized, diversified, and prosperous than the south. It was also much larger in terms of population and total output. Thus, Martin’s assertion that slavery explains why the south lost the Civil War is probably a bit too sweeping.

Nevertheless, the slavery “ecosystem” helps explain the south’s historic under-development. It was characterized by artificially cheap labor, illiquidity, a lack of diversification, a rigid social hierarchy based on the aberrant ownership of human chattel, and state subsidization of slave owners. These conditions restricted the supply of investment capital in the south. This was a drag on economic development before the Civil War. Those characteristics, along with the direct costs of the war itself, go a long way toward explaining the south’s lengthy period of depressed conditions after the Civil War as well.

It’s certainly not a knock on the slave population prior to emancipation to say that they were not responsible for the success of American capitalism. It’s a knock on the institution of slavery itself. Our wealth and the bounties produced by today’s economy are not supercharged by the efforts of slave labor in the distant past. If anything, our prosperity would be far greater had slavery never been practiced on U.S. soil.

I oppose reparations as a form of redistribution partly because most prospective payers today have absolutely no connection to slave-holding in antebellum America. It’s ironic that certain activists now argue for reparations based on imagined economic benefits once used to defend slavery itself.

Indecorously Jaw-Boning an Unhurried Fed

21 Saturday Jun 2025

Posted by Nuetzel in Inflation, Monetary Policy

≈ 1 Comment

Tags

Budget Reconciliation, Donald Trump, Fed Funds Rate, Federal Open Market Committee, FOMC, Inflation, Jerome Powell, Policy Uncertainty, Quantitative Tightening, Tariffs

President Trump engaged in one of his favorite pastimes on June 18 while the Federal Reserve Open Market Committee (FOMC) was concluding its meeting on the direction of monetary policy. He publicly called Fed Chairman Jerome Powell “stupid” for not having cut rates already, and later said the Fed’s board was “complicit”.

“”I don’t know why the Board doesn’t override this Total and Complete Moron!“

Trump also tagged Powell with one of his trademark appellations: “Too Late”. Yep, that’s how Trump says he refers to Powell.

Later that day, the Fed once again announced that it had decided to leave unchanged its target range for the interest rate on federal funds. Powell described the overall tenor of current Fed policy as mildly restrictive, but FOMC members still “expect” (loosely speaking) two quarter-point cuts in the funds rate by year end.

Of course, Powell and the FOMC really were far too late in recognizing that inflation was more than transitory in 2021-22. Now, with inflation measures tapering but still higher than the Fed’s 2% target, Trump says “Too Late” Powell and the Fed are again behind the curve. Of course, because the central bank is outside the President’s direct control, it makes a convenient scapegoat for whatever might ail the Trump economy, and Trump frets that unnecessarily high rates will cost the U.S. Treasury hundreds of billions in interest on new and refinanced federal debt.

The President has no appreciation for the value of an independent central bank, as opposed to one captive to the fiscal whims of Presidents and Congress. Despite his frequent criticism of inflationary sins of the past, Trump doesn’t understand the dangers of a central bank that could be bullied into inflating away government debt.

The day after the Fed’s meeting, Trump said rates should be cut immediately by a huge 2.5%! As the Donald might say, no one’s ever seen anything like it!

Trump, however, is delusional to think the Fed can engineer reductions in the spectrum of interest rates by aggressively slashing its fed funds target. The Fed does not control long-term interest rates, nor is that part of the Fed’s formal mandate. In fact, an aggressively large reduction in the fed funds rate is likely to backfire, feeding expectations of higher inflation and a selloff in credit markets.

Let me reiterate: the Fed does not control long-term interest rates. Short-term rates are more heavily influenced by the Fed’s rate actions, and by expectations of Fed policy, but the Fed is likewise influenced by those very expectations. In fact, the Fed often follows market rates rather than leading them. In any case, a general truth is that long-term interest rates go where market forces direct them, not where the Fed might try to push them.

Today the Fed is attempting to walk a line between precipitating divergent and potentially negative outcomes. It wants to see clear evidence that inflation is settling down at roughly the 2% target. Also, the Fed is wary that Trump’s tariffs might generate a near-term spike in prices. Under those circumstances, prematurely easing policy could rekindle more permanent inflationary pressures. It seems clear that the Fed currently judges inflation as the dominant risk.

At the same time, the real economy shows mixed signals. Clear signs of a downturn would likely prompt the Fed to cut its fed funds target sooner. After the latest meeting, the Fed announced that it had reduced its own forecast for real GDP growth in 2025 to just 1.4%. Recent employment gains have been moderate, but jobless claims are trending up. The unemployment rate is low, but the labor force has declined over the past few months, which incidentally might be putting upward pressure on wages.

Policy uncertainty was a major theme in the Fed’s June rate decision. Tariffs loom large and would be a threat to continued growth if producers, facing weak demand, were unable to pass the cost of tariffs through to customers, undermining their profit margins. Prospects for passage of the budget reconciliation bill create more uncertainty, providing another rationale to stand pat without cutting the funds rate.

Again, Jerome Powell says that Fed policy is “modestly restrictive” at present. In fact, estimates of the “policy neutral” Fed funds rate are in the vicinity of 2.75%, well below the current target range of 4.25-4.50. However, the money supply (M2) has drifted up over the past year and by May was up 4.4% from a year earlier. That would be consistent with 2% inflation and better than 2% real growth, the latter being higher than the FOMC’s expectation.

Another consideration is that the Fed has nearly ended its quantitative tightening (QT) program, having recently trimmed the passive runoff of maturing securities in its portfolio to just $5 billion per month. This leads to less downward pressure on bank reserves and less upward pressure on the fed funds rate. In other words, policy has already shifted toward greater support for money growth. But out of caution, the Fed wants to defer reductions in the funds rate to avoid undermining the central bank’s inflation-fighting credibility.

Jerome Powell and the FOMC probably could not care less about Trump’s exhortations to reduce interest rates. For one thing, it is beyond the Fed’s power to force down rates that could spur housing and other economic activity. And Trump should be grateful: such a reckless attempt would risk great harm to markets and the economy, not to mention Trump’s economic agenda. Better to wait until near-term inflation risks and policy uncertainty clear up.

Trump can jawbone as aggressively as he wants. He cannot fire Powell, though he keeps saying he “should”. However, no matter what actions the Fed takes, he will almost certainly not reappoint Powell to lead the Fed when Powell’s term expires next May. Sadly, Trump will try to appoint a replacement he can rely upon to do his bidding. Let’s hope the Senate stands in his way to preserve Fed independence.

Pros and Cons of the “Big Beautiful Bill”

16 Monday Jun 2025

Posted by Nuetzel in Federal Budget, Fiscal policy

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Big Beautiful Bill, Budget Baseline, Budget Reconciliation, Congressional Budget Office, Deficit Reduction, DOGE, Dominic Pino, Donald Trump, Elon Musk, EV Subsidies, filibuster, Homeland Security, Mandatory Spending, Medicaid, No Tax On Overtime, No Tax On Tips, Rand Paul, SALT Deduction, Senior Deduction, Social Security, Supplemental Nutritional Assistance Program, Tax Cuts and Jobs Act

The GOP’s “Big Beautiful Bill” (BBB) has generated its share of controversy, not least between President Trump and his erstwhile ally Elon Musk. It is a budget reconciliation bill that was passed by a single vote in the House of Representatives. It’s now up to the Senate, which is sure to alter some of the bill’s provisions. That will require another vote in the House before it can head to Trump’s desk for a signature.

Slim But “Reconciled” Majority

As a reconciliation bill, the BBB is not subject to filibuster in the Senate, and only a simple majority is required for approval, not a 60% supermajority. Obviously, that’s why the GOP used the reconciliation process.

I hate big bills, primarily because they tend to provide cover for all sorts of legislative mischief and pork. However, the reconciliation process imposes limits on what kinds of budgetary changes can be included in a bill. A reconciliation bill can alter only mandatory spending programs like Medicaid and other entitlements, but not discretionary or non-mandatory spending. Social Security is an entitlement, but it would be off limits in a typical reconciliation bill (owing to an arcane rule). Reconciliation bills can also address changes in revenue and the debt limit.

The BBB includes provisions to reduce Medicaid outlays such as work requirements, denial of benefits to illegal aliens, and controls on fraud. These are projected to cut spending by nearly $700 billion. Of course, this is a controversial area, but efforts to impose better controls on entitlements are laudable.

Elon Musk criticized the bill’s failure to aggressively rein-in deficit spending, prompting what was probably his first public feud with Trump. At the time, it wasn’t clear whether Musk really understood the limits of reconciliation. If he had, he might at least have been mollified by the effort to tackle Medicaid waste and fraud. Entitlement programs like Medicaid are, after all, at the very root of our fiscal imbalances.

Extending Trump’s Tax Cuts

The Congressional Budget Office (CBO) says that BBB will reduce tax revenue by $3.8 trillion over the next ten years. The Trump tariffs are not addressed in the BBB, but those won’t come close to offsetting this projected revenue loss.

The CBO’s score compares spending and tax revenue to “current law”. Thus, the baseline assumes that the 2017 tax cuts under the Tax Cuts and Jobs Act (TCJA) expire in 2026. With spending cuts under the BBB, primary federal deficits (non-interest) are projected to rise $2.4 billion over that time. With interest costs on the higher federal debt, the increase in deficits rises to about $3 trillion. I’ll briefly address some of the major provisions below, including their budget impacts.

Spending Cuts

In addition to Medicaid, other significant cuts in spending in the BBB include reductions in benefits under the Supplemental Nutritional Assistance Program (food stamps, -$267b). This includes tighter work requirements, eligibility rules, and higher matching requirements for states. Also included in BBB are more stringent student loan repayment rules and changes in other education funding programs (-$350b).

Other spending categories would increase. The bill would authorize an additional $144 billion for Armed Services and $79 billion for Homeland Security, including $50 billion for the border wall. Senator Rand Paul has called the border security provisions excessive, though many of those favoring greater fiscal discipline also believe defense is underfunded, so they probably don’t oppose these particular items.

~~Voting~~ Tax Incentives

In terms of revenue, the BBB would extend the provisions of the TCJA. The deduction for state and local taxes (SALT) would be extended and increased to $40,000 at incomes less than $500,000. This would have a combined revenue impact of -$787 billion. No wonder deficit hawks are upset! A larger SALT deduction creates an even greater subsidy for states imposing high tax burdens on their residents. There’s an expectation, however, that this provision will be dialed back to some extent in the Senate version of the BBB.

There are also provisions to eliminate taxes on overtime (-$124b) and tip income (-$40b), and to increase the standard deduction for seniors (-$66b). As I’ve written before, these are all terribly distortionary policies. They would treat different kinds of income differently, create incentives to reclassify income, and impose a highly complex administrative burden on the IRS. The senior deduction creates an incremental revenue hole as a function of Social Security benefit payments. This is the wrong way to address the needs of a system that is insolvent. These policies were selected primarily with vote buying in mind.

The timing of some of these provisions differs. Some would expire after 2028, while others would be permanent. Apparently, the Senate version of the bill is likely to include immediate and permanent expensing of business investment, which would encourage economic growth.

Another notable change would eliminate subsidies and tax credits for EVs (+$191b). Some claim this was at the heart of Musk’s diatribes against the BBB. However, Musk has supported elimination of both EV subsidies and mandates for many years. He stated as much to legislators on Capital Hill last December, so this theory regarding Musk’s opposition to BBB doesn’t wash.

Defining a Baseline

Advocates of extending the TCJA say the CBO’s baseline case is inappropriate, and that the proper baseline should incorporate the continued tax provisions of the TCJA. Again, the extension increases the ten-year deficit by $3.8 trillion, but that total includes the revenue effects of other provisions. Perhaps $3 trillion might be a more accurate upward adjustment to baseline deficits. In that case, the BBB would actually reduce ten-year deficits by $0.2 trillion.

Another criticism is that the CBO does not attempt to estimate dynamic changes in revenue induced by policy. Those in support of extending the TCJA believe that this static treatment unfairly discounts the revenue potential of pro-growth policies.

I don’t have a problem with the alternative baseline, but the fact is that deficits will still be problematic. Over the 2025-2034 time frame, a baseline incorporating an extension of TCJA would yield deficits in excess of $20 trillion. That includes mounting interest costs, which might overwhelm serious efforts at fiscal discipline in the unlucky event of an updraft in interest rates. Of course, these large, ongoing deficits raise the likelihood of inflationary pressure. The recent downgrade in the credit rating assigned to U.S. Treasuries by Moody’s is an acknowledgement that bondholder wealth could well be undermined by future attempts to “inflate away” the real value of the debt.

Debt Ceiling

In addition to its direct budgetary effects, the BBB calls for a $5 trillion increase of the federal debt limit. I admit to mixed feelings about this large increase in borrowing authority. Frequent debt limit negotiations tend to create lots of political theater and chew up scarce legislative time. Moreover, it’s easy to conclude that they usually accomplish little in terms of restraining deficit spending. Dominic Pino argues otherwise, citing historical examples in which the debt limit “was paired with” reforms and spending restraint. In other words, despite its apparent impotence, Pino asserts that deficits would have been much higher without it. I’m still skeptical, however, that frequent showdowns over the debt ceiling have much value given entitlements that are seemingly beyond legislative control. In the end, elected representatives must respect the judgement of credit markets and face consequences at the ballot box.

Final Thoughts on BBB

Superficially, the Big Beautiful Bill looks like an abomination to deficit hawks. The GOP decided to structure it as a reconciliation bill to strengthen its odds of passage. That decision sharply limited its potential for spending restraint. Other legislation will be required to make the kinds of rescissions necessary to eliminate wasteful spending identified by DOGE.

As for the bill itself, the effort to extend the 2017 Trump tax cuts was widely expected. That, in and of itself, is neutral with respect to a more reasonable baseline assumption. Elimination of EV tax subsidies is a big plus, as are the permanent incentives for business investment. Unfortunately, Trump and his congressional supporters also propose to create the additional fiscal burdens of no taxes on tips and overtime pay, as well as an increased standard deduction for seniors. The ill-advised increase in the SALT deduction was a compromise to ensure the support of certain blue-state republicans, but with any luck it will be curtailed by the Senate.

On the spending side, the big item is Medicaid. Reforms are long past due for a system so riddled with waste. In addition, there are new rules in the BBB that would reduce SNAP outlays and increase student loan repayments. Outlays for defense, Homeland Security, and border security would increase, but these were known to be Trump priorities. Too bad they’ve been paired with several wasteful tax policies.

But even with those flaws, the BBB would reduce deficits marginally relative to a baseline that incorporates extension of the TCJA. Yes, excessive ongoing deficits still have to be dealt with, but spending reductions on the discretionary side of the budget were out of the question this time due to reconciliation rules. They will have to come later, but that sort of legislation will face tough political headwinds, as will Social Security and Medicare reform. arever introduced.

My Foolish Hopes For Free Trade Bargaining

24 Saturday May 2025

Posted by Nuetzel in Central Planning, Free Trade

≈ 2 Comments

Tags

Balance of Payments, Big Beautiful Bill, central planning, Coercion, Cronyism, Donald Trump, Eric Boehm, Fiscal Restraint, Foreign Investment, Free trade, Liberation Day, National Security, Non-Tariff Barriers, Price Pressures, Punitive Tariffs, Reciprocal Tariffs, Retaliatory Tariffs, Selective Tariffs, Tariff Exceptions, Tariff Incidence, Trade Deals, Trade Deficit

Just a few weeks back I engaged in wishful speculation that Trump’s drastic imposition of “reciprocal” and punitive tariffs could actually prove to be a free-trade play, but only if the U.S. used its universally dominant position in trade wisely at the bargaining table. I worried, however, that any notion Trump might have along those lines was eclipsed by his antipathy for otherwise harmless trade deficits. Another bad indicator was his conviction that manipulating tariffs could restore “fairness” in trade relations while raising revenue to pay for the selective tax cuts he promised for tips, overtime wages, and social security benefits.

Aside from that, I won’t repeat all of Trump’s fallacies about trade (and see here and here) except where they’ve impinged on recent developments.

One Raw Deal

My hopes for reduced trade barriers were dashed when the first “deal” (or really a “Memorandum of Understanding”) was announced with the United Kingdom. The U.S. runs a trade surplus with the UK, so one might think Trump would find it unnecessary to levy tariffs on U.S. imports from the UK. No dice! Clearly this was not motivated by the trade deficit bogeyman of Trump’s fever dreams. The White House stated that buyers of goods from the UK will pay the minimum 10% tariff (up from 3.3% before Trump took office).

Trump simply likes tariffs. Apparently he’s never given much thought to their incidence, which falls largely on domestic consumers and businesses. The MAGA faithful are in blissful denial that such a burden exists, despite ample evidence of its reality.

As Eric Boehm notes, the U.S. received a few concessions on British tariffs under the deal, but the reductions only amount to about a 2% equivalent. There are sharp reductions in special tariffs on U.S. agricultural products, especially meat. There are also exceptions to tariffs on certain British goods, like autos (up to 100,000 units). The selective nature of the concessions on both sides underscores the cronyist underpinnings of this style of economic governance, which amounts to ad hoc central planning.

Also troubling is the misleading spin the Administration attempted to put on news coverage of the deal. They claimed to have reduced tariffs of goods imported from the UK, which is true only in comparison to post-“Liberation Day” tariff levels established in early April. In fact, the baseline tariff now applied to most UK goods sold in the U.S. has more than tripled since last year! As Boehm states, American consumers and businesses are paying a lot more for this “deal” than their British counterparts.

Raw Deals To Be?

The “deal” with China is worse, partly because it’s only a 90-day pause in implementation (pending negotiation), and partly because the “reciprocal” tariff rate of 30% applied to Chinese goods is much higher than before Trump imposed the punitive rates. Still worse, the 10% tariff on U.S. exports to China applied during the pause is also much higher. What a deal! And it could get worse. These tariff hikes have little to do with “national security” and they are regressive, having disproportionately large burdens on lower-income consumers and small businesses.

The only other agreement announced thus far is with India. It is not a “trade deal” at all, but a so-called “Terms of Reference On Bilateral Trade Agreement”. It is a “roadmap” for future negotiations. Perhaps it will come together quickly, but it’s hard to expect much after the UK agreement.

Uniting Western Civilization

Just this week we had another hardball move by Trump: a 50% tariff on goods from the European Union starting in June, up from an average of about 3.8% on a trade-weighted basis. The new tariff rate is also higher than the 10% baseline tariff in place since the 90-day pause was announced in April. Trump claims the EU has been levying tariffs of 39% on U.S. goods, which might include what the Administration would call effective tariffs from non-tariff barriers to trade. Or it might refer to retaliatory tariffs announced by the EU in response to Trump’s Liberation Day announcement, but all of those have been paused. In any case, the World Trade Organization says EU tariffs on US goods average 4.8%. Quite a difference!

The move against the EU is much like Trump’s earlier ploy with China, but he says he’s “not looking for a deal”. He also says talks with the EU are “going nowhere”, though the Polish Trade Minister reassures that talks are “ongoing”. The outcome is likely to be a disappointment for anyone (like me) hoping for freer trade. The EU will probably make commitments to buy something from the U.S., maybe beef or liquified natural gas. But U.S. tariffs on EU goods will be higher than in the past.

So, thus far we have only one “deal” (such as it is), one roadmap for negotiations to follow, and a bunch of pauses pending negotiation (China included). The Trump team says about 100 countries hope to negotiate trade deals, but that is a practical impossibility. Even Trump says “… it’s not possible to meet the number of people that want to see us.” But it could be easy: just drop all U.S. trade barriers and allow protectionist countries to tax their own citizens, denying them access to free choice.

Bullying Enemies, Allies and Producers

Higher U.S. tariffs will put some upward pressure on the prices of imports and import-competing goods. We haven’t seen this play out just yet, but it’s early. In a defensive move, Trump is attempting to bully and shame domestic companies such as WalMart for attempting to protect their bottom lines in the face of tariffs. He also warned automakers about their pricing before carving out an exception for them. And now Apple has been singled-out by Trump for a special 25% tariff after it had announced plans to move assembly of iPhones to India, rather than in the U.S.

You better stay on Trump’s good side. This is a loathsome kind of interference. It encourages firms to seek favors in the form of tariff exemptions or to accept what amounts to state expropriation of profits. Cronyism and coercion reign.

Swamped By Spendthrifts?

The market seems to believe the negative impact of tariffs on economic growth will be more than offset by other stimulative forces. This includes the extension of Trump’s 2017 tax cuts. The so-called “big beautiful bill” passed by the House of Representatives also includes new tax breaks on tip and overtime pay, and an increase in the deduction for state and local taxes. While the bill reduces the growth of federal spending, there is disappointment that spending wasn’t reduced. The Senate might pass a version with more cuts, but the market sees nothing but deficits going forward. This is not the sort of “fiscal restraint” the market hoped for, particularly with escalating interest costs on the burgeoning federal debt.

Conflicting Goals

Trump has bargained successfully for some major investments in the U.S. by wealthy nations like Saudi Arabia and Dubai, as well as a few major manufacturing and technology firms. That’s wonderful. He doesn’t understand, however, that strong foreign investment in the U.S. will encourage larger trade deficits. That’s because foreign capital inflows raise incomes, which increase demand for imports. In addition, the capital inflows cause the value of the dollar to appreciate, making imports cheaper but exports more expensive for foreigners. It would be a shame if Trump reacted to these eventualities by doubling down on tariffs.

Conclusion

Alas, my hopes that Trump’s bellicose trade rhetoric was mere posturing were in vain. He could have used our dominant trading position to twist arms for lower trade barriers all around. While I worried that he massively misunderstood the meaning of trade deficits, and that he viewed higher tariffs as a magic cure, I should have worried much more!

Hey, Careful With Those Economic Aggregates!

16 Friday May 2025

Posted by Nuetzel in Economic Aggregates, Macroeconomics

≈ 1 Comment

Tags

Activist Policy, Argentina, Benchmark Revisions, Charles Manski, Creative Destruction, Double Counting, Fischer Black, Hong Kong, Identification Problem, Interventionism, John von Neumann, Market Monetarism, Measurement Errors, Oskar Morgenstern, Paul Romer, Phlogiston, Policy Uncertainly, Price Aggregates, Real Business Cycle Model, Real GDP, Reuben Brenner, Scott Sumner, Simon Kuznets, Tyler Cowen

As a long-time user of macroeconomic statistics, I admit to longstanding doubts about their accuracy and usefulness for policymaking. Almost any economist would admit to the former, not to mention the many well known conceptual shortcomings in government economic statistics. However, few dare question the use of most macro aggregates in the modeling and discussion of policy actions. One might think conceptual soundness and a reasonable degree of accuracy would be requirements for serious policy deliberation, but uncertainties are almost exclusively couched in terms of future macro developments; they seldom address variances around measures of the present state of affairs. In many respects, we don’t even know where we are, let alone where we’re going!

Early and Latter Day Admonitions

In the first of a pair of articles, Reuven Brenner discusses the hazards of basing policy decisions on economic aggregates, including critiques of these statistics by a few esteemed economists of the past. The most celebrated developer of national income accounting, Simon Kuznets, was clear in expressing his reservations about the continuity of the U.S. National Income and Product Accounts during the transition to a peacetime economy after World War II. The government controlled a large share of economic activity and prices during the war, largely suspending the market mechanism. After the war, market pricing and private decision-making quickly replaced government and military planners. Thus, the national accounts began to reflect values of production inherent in market prices. That didn’t necessarily imply accuracy, however, as the accounts relied (and still do) on survey information and a raft of assumptions.

The point is that the post-war economic results were not remotely comparable to the data from a wartime economy. Comparisons and growth rates over this span are essentially meaningless. As Brenner notes, the same can be said of the period during and after the pandemic in 2020-21. Activity in many sectors completely shut down. In many cases prices were simply not calculable, and yet the government published aggregates throughout as if everything was business as usual.

More than a decade after Kuznets, the game theorists Oskar Morgenstern and John von Neumann both argued that the calculations of economic aggregates are subject to huge degrees of error. They insisted that the government should never publish such data without also providing broad error bands.

Morgenstern delineated several reasons for the inaccuracies inherent in aggregate economic data. These include sampling errors, both private and political incentives to misreport, systematic biases introduced by interview processes, and inherent difficulties in classifying components of production. Also, myriad assumptions must be fed into the calculation of most economic aggregates. A classic example is the thorny imputation of services provided by owner-occupied homes (akin to the value of services generated by rental units to their occupants). More recently. Charles Manski reemphasized Morganstern’s concerns about the aggregates, reaching similar conclusions as to the wisdom of publishing wide ranges of uncertainty.

Real or Unreal?

Estimates of real spending and production are subject to even larger errors than estimates of nominal values. The latter are far simpler to measure, to the extent that they represent a simple adding up of current amounts spent (or income earned) over the course of a given time period. In other words, nominal aggregates represent the sum of prices times quantities. To estimate real quantities, nominal values must be adjusted (deflated) by price aggregates, the measurement of which are fraught with difficulties. Spending patterns change dramatically over time as preferences shift; technology advances, new goods and services replace others, and the qualities of goods and services evolve. A “unit of output” today is usually far different than what it was in the past, and adjusting prices for those changes is a notorious challenge.

This difficulty offers a strong rationale for relying on nominal quantities, rather than real quantities, in crafting certain kinds of policy. Perhaps the best example of the former is so-called market monetarism and monetary policy guided by nominal GDP-level targeting, as championed by Scott Sumner.

Government’s Contribution

Another fundamental qualm is the inconsistency between data on government’s contribution to aggregate production versus private sector contributions. This is similar in spirit to Kuznets’ original critique. Private spending is valued at market prices of final output, whereas government spending is often valued at administered prices or at input cost.

An even deeper objection is that much of the value of government output is already subsumed in the value of private production. Kuznets himself thought so! For example, to choose two examples, public infrastructure and law enforcement contribute services which enhance the private sector’s ability to reliably produce and deliver goods to market. To add the government’s “output” of these services separately to the aggregate value of private production is to double count in a very real sense. Even Tyler Cowen is willing to entertain the notion that including defense spending in GDP is double counting. The article to which he links goes further than that.

Nevertheless, our aggregate measures allow for government spending to drive fluctuations in our estimates of GDP growth from one period to another. It’s reasonable to argue that government spending should be reported as a separate measure from private GDP.

But what about the well known Keynesian assertion that an increase in government spending will lift output by some multiple of the change? That proposition is considered valid (by Keynesians) only when resources are idle. Of course, today we see steady growth of government even at full employment, so the government’s effort to commandeer resources creates scarcity that crowds out private activity.

Measurement and Policy Uncertainty

Acting on published estimates of economic aggregates is hazardous for a number of other reasons. Perhaps the most basic is that these aggregates are backward-looking. A policy activist would surely agree that interventions should be crafted in recognition of concurrent data (were it available) or, even better, on the basis of reliable predictions of the future. Financial market prices are probably the best source of such forward-looking information.

In addition, revising the estimates of aggregates and their underlying data is an ongoing process. Initial published estimates are almost always based on incomplete data. Then the estimates can change substantially over subsequent months, underscoring uncertainty about the state of the economy. It is not uncommon to witness consistent biases over time in initial estimates, further undermining the credibility of the effort.

Even worse, substantial annual revisions and so-called “benchmark revisions” are made to aggregates like GDP, inflation, and employment data. Sometimes these revisions alter economic history substantially, such as the occurrence and timing of recessions. All this implies that decisions made on the basis of initial or interim estimates are potentially counterproductive (and on a long enough timeline, every aggregate is an “interim” estimate). At a minimum, the variable nature of revisions, which is an unavoidable aspect of publishing aggregate statistics, magnifies policy uncertainty.

Case Studies?

Brenner cites two historical episodes as support for his argument that aggregates are best ignored by policymakers. They are interesting anecdotes, but he gives few details and they hardly constitute proof of his thesis. In 1961, Hong Kong’s financial secretary stopped publishing all but “the most rudimentary statistics”. Combined with essentially non-interventionist policy including low tax rates, Hong Kong ran off three decades of impressive growth. On the other hand, Argentina’s long economic slide is intended by Brenner to show the downside of relying on economic aggregates and interventionism.

Bad Models, Bad Policy

It’s easy to see that economic aggregates have numerous flaws, rendering them unreliable guides for monetary and fiscal policy. Nevertheless, their publication has tended to encourage the adoption of policy interventions. This points to another issue lurking in the background: the role of economic aggregates in shaping the theory and practice of macroeconomics and the models on which policy recommendations are based. The conceptual difficulties surrounding aggregates, and the errors embedded within measured aggregates, have helped to foster questionable model treatments from a scientific perspective. For example, Paul Romer has said:

“Macroeconomists got comfortable with the idea that fluctuations in macroeconomic aggregates are caused by imaginary shocks, instead of actions that people take, after Kydland and Prescott (1982) launched the real business cycle (RBC) model. … [which] explains recessions as exogenous decreases in phlogiston.”

This is highly reminiscent of a quip by Brenner that macroeconomics has become a bit like astrology. A succession of macro models after the RBC model inherited the dependence on phlogiston. Romer goes on to note that model dependence on “imaginary” forces has aggravated the longstanding problem of statistically identifying individual effects. He also debunks the notion that adding expectations to models helps solve the identification problem. In fact, Romer insists that it makes it worse. He goes on to paint a depressing picture of the state of macroeconomics, one to which its reliance on faulty aggregates has surely contributed.

Aggregates also mask the detailed, real-world impacts of policies that invariably accompany changes in spending and taxes. While a given fiscal policy initiative might appear to be neutral in aggregate terms, it is almost always distortionary. For example, spending and tax programs always entail a redirection of resources, whether a consequence of redistribution, large-scale construction, procurement, or efforts to shape the industrial economy. These are usually accompanied by changes in the structure of incentives, regulatory requirements, and considerable rent seeking activity. Too often, outlays are dedicated to shoring up weak sectors of the economy, short-circuiting the process of creative destruction that serves to foster economic growth. Yet the macro models gloss over all the messy details that can negate the efficacy of activist fiscal policies.

Conclusion

The reliance of macroeconomic policy on aggregates like GDP, employment, and inflation statistics certainly has its dangers. These measures all suffer from theoretical problems, and they simply cannot be calculated without errors. They are backward-looking, and the necessity of making ongoing revisions leads to greater uncertainty. But compared to what? There are ways of shifting the focus to measures subject to less uncertainty, such as nominal income rather than real income. A number of theorists have proposed market-based methods of guiding policy, including Fischer Black. This deserves broader discussion.

The problems of aggregates are not solely confined to measurement. For example, national income accounting, along with the Keynesian focus on “underconsumption” during recessions, led to the fallacious view that spending decisions drive the economy. This became macroeconomic orthodoxy, driving macro mismanagement for decades and leading to inexorable growth in the dominance of government. Furthermore, macroeconomic models themselves have been corrupted by the effort to explain away impossibly error-prone measurements of aggregate activity.

Brenner has a point: it might be more productive to ignore the economic aggregates and institute stable policies which reinforce the efficacy of private markets in allocating resources. If nothing else, it makes sense to feature the government and private components separately.

A Cooked-Up “Crisis” In U.S. Manufacturing

05 Monday May 2025

Posted by Nuetzel in Liberty

≈ 1 Comment

Tags

Brian Albrecht, Data Security, Don Boudreaux, Donald Trump, Economic Security, Health Security, Jeff Jacoby, Job Security, National Security, Protectionism, Ross Douthat, Strategic Goods, Tariffs, Trade Barriers, Tyler Cowen, Veronique de Rugy

Supporters of President Trump’s hard line on trade make so many false assertions that it’s hard to keep up. I’ve addressed several of these in earlier posts and I’ll address two more fallacies here: 1) that the U.S. manufacturing sector is in a state of crisis; and 2) that tariffs played a key role in promoting economic growth in the U.S. during the so-called gilded age of the late 19th and early 20th centuries.

Security

First, let’s revisit one tenet of protectionism: national security demands self-sufficiency. This undergirds the story that we must produce physical “things”, in addition to often higher-valued services, to be a great nation, or even to survive!

Of course, protecting industries critical to national security might seems like a natural concession to make, even for those supportive of liberalized trade. Ross Douthat says this:

“I think trying to reshore some manufacturing and decouple more from China makes sense from a national security standpoint, even if it costs something to G.D.P. and the stock market.“

Unfortunately, this kind of rationale is far too malleable. There is never a clearly defined limiting principle. Someone decides which goods are “critical” to national security, and this deliberation becomes the subject of much political jockeying and favor-seeking. But wait! Economic security is also cited as an adequate excuse for trade protections! And how about data security? Health security? Job security? Always there is insistence that “security” of one sort or another demands that we provide for our own needs. For definitive proof, take a look at this nonsense! Give them an inch and they’ll take a mile.

Pretty soon you “protect” such a wide swath of industries in a quest for self-sufficiency that the entire economy is unmoored from opportunity costs, comparative advantages, and the information about scarcities provided by market prices. Absolute “security” comes at the cost of transforming the economy’s productive machinery into a complacent hulk rivaling the inefficiency of Soviet industrial planning. Competition is the solution, but not limited to firms under the same set of protective trade barriers.

Manufacturing Is Mostly Fine

Trade warriors, including members of Trump’s team, insist that our decline as a nation is being hastened by a crisis in manufacturing. However, value added in U.S. manufacturing is at an all-time high.

There has been a long-term decline in manufacturing employment, but not manufacturing output. In fact, manufacturing output has doubled since 1980. As Jeff Jacoby notes, “the purpose of manufacturing is to make things, not jobs.” If our overarching social goal was job security, we’d have revolted long ago against the tremendous reduction in agricultural employment experienced over the past century. We’d rely on switchboard operators to load web pages, and we’d dig trenches and tunnels with spoons (to paraphrase Milton Friedman).

The secular decline in manufacturing employment is a consequence of growth in manufacturing productivity. Economy-wide, this phenomenon allows real income and our standard of living to grow.

Take That Job and …

It’s also significant that few Americans have much interest in factory work. It’s typically less dangerous than in times past, but many of today’s factory jobs are still physically challenging and relatively risky. Perhaps that helps explain why nearly half-a-million jobs in manufacturing are unfilled.

Jacoby describes the transition that has changed the face of American manufacturing:

“… US plants have largely turned away from making many of the low-tech, labor-intensive consumer items they once specialized in — sneakers, T-shirts, small appliances, toys. Those jobs have mostly gone overseas, and trying to bring them back by means of a trade war would be ruinous. Yet America remains a global manufacturing powerhouse — highly skilled, highly innovative, and highly efficient.“

And yet, even as wages in manufacturing have grown, many factory jobs do not pay as well as positions requiring far less strenuous toil in the services sector. It’s also true that the best manufacturing jobs in the U.S. today require high-level skills, which are in short supply. These factors help explain why manufacturers believe finding qualified workers is one of their biggest challenges.

Isolating Weak Sectors

There are specific sectors within manufacturing that have fared poorly, including textiles, furniture, metals, and low-end electronics. The loss of competitiveness that drove those sectoral declines is not a new development. It has, however, devastated communities in the U.S. that were heavily dependent on these industries. These misfortunes are regrettable, but trade barriers are not an effective prescription for revitalizing depressed areas.

Meanwhile, other manufacturing sectors have enjoyed growth, such as computers, aerospace, and EVs. While we’ve seen a decline in the number of manufacturing firms, the performance of U.S. manufacturing in the 21st century can be described as mixed at the very worst.

The author of this piece seems to accept the false notion that U.S. manufacturing is moribund, but he knows tariffs aren’t an effective way to strengthen domestic goods production. He has a number of better suggestions, including a commitment to infrastructure investment, reforms to education and health, and reconfiguring certain corporate income tax policies. Unfortunately, his ideas on tariffs are sometimes as mistaken as Trump’s,

The Gilded Age

Finally, the other false assertion noted in the opening paragraph is that tariffs somehow spurred economic growth in the late 19th and early 20th centuries. Brian Albrecht corrects this protectionist fallacy, which lies at the root of many defenses of Trump’s tariffs. Albrecht cites favorable conditions for growth that were sufficient to overwhelm the negative effects of tariffs, including:

“… explosive population growth, mass European immigration, rapid technological innovation, westward expansion, abundant natural resources, high literacy rates, and stable property rights.”

While cross-country comparisons indicate a positive correlation between tariffs and growth during the 1870 – 1920 period, those differences were caused by other forces that dominated tariffs. Cross-industry research discussed by Albrecht indicates that tariffs on manufactured goods during the gilded era reduced labor productivity and stimulated the entry of smaller, less productive firms. Likewise, natural experiments find that tariffs allowed inefficient firms to survive and discouraged innovation.

Conclusion

The U.S. manufacturing sector is not in any sort of crisis, and its future growth won’t be powered by attempts to restore the sort of low-value production offshored over the past several decades. What protectionists interpret as failure is the natural progression of a technically advanced market-based civilization, where high-value services account for greater shares of growing total output. Of course, low-value production is sometimes “crowded out” in this process, depending on its trade-ability and comparative advantages. The logic of the process is encapsulated by Veronique de Rugy’s recent discussion of iPhone production (HT: Don Boudreaux):

“Then there’s [Commerce Secretary Howard] Lutnick, pining for a world where Americans flood back into massive factories to assemble iPhones. This is nostalgic industrial cosplay masquerading as economic strategy. Yes, iPhones aren’t assembled by Americans. But this isn’t a failure; it’s a feature of smart economic specialization. We design the iPhone here. That’s the high-value, high-margin part. The sophisticated chips, software, architecture, and intellectual property are all created in the U.S. The marketing is done here, too. That’s most of the value of the iPhone. The lower-value labor-intensive assembly work is done abroad because those tasks are more efficiently performed abroad.“

There is certainly no crisis in U.S. manufacturing. That narrative is driven by a combination of politics, rent seeking, and misplaced nostalgia.

Letting Protectionist Nations Tax Themselves

22 Tuesday Apr 2025

Posted by Nuetzel in Comparative advantage, Protectionism, Tariffs

≈ 3 Comments

Tags

Arthur Laffer, Benn Zycher, Currency Manipulation, Domestic Content Restrictions, Donald Trump, Export Subsidies, Inelastic Demand, Protectionism, Quotas, Stephen Moore, Tariffs, Tax Incidence, Trade Barriers

First, a few more comments re: my speculative musings that Donald Trump’s tariff rampage could ultimately result in a regime with lower trade barriers, at least with a subset of trading partners. Arthur Laffer and Stephen Moore suggested last week that the White House should propose reciprocal free trade with zero barriers and zero subsidies for exports to any country that wishes to negotiate. A more cynical Ben Zycher scoffed at the very possibility, noting that Trump and his lieutenants view any trade deficit as evidence of cheating in one form or another. Zycher is convinced that Trump lacks a basic understanding of the (mostly) benign forces that drive trade imbalances.

I’ve said much the same. Trump’s crazy notions about trade could scuttle negotiations, or he might later accuse a trading partner of cheating on the pretext of a bilateral trade deficit (he’s done so already). And all this is to say nothing of the serious constitutional questions surrounding Trump’s tariff actions.

The mistaken focus on bilateral trade deficits also manifests in certain proposals made during trade negotiations: “Okay, but you’re gonna have to purchase vast quantities of our soybeans every year.” This sort of export promotion is a further drift into industrial planning, and it’s just too much for Trump’s trade negotiators to resist.

This might well turn out as an exercise in self-harm for Trump. However, I’ve also wondered whether his trade hokum is pure posturing, especially because he expressed support for a free trade regime in 2018. Let’s hope he meant it and that he’ll pursue that objective in trade talks. Please, just negotiate lower trade barriers on both sides without the mercantilist baggage.

Which brings me to the theme of this post: it would probably be simpler and more effective for the U.S. to simply drop all of its trade barriers unilaterally. There should be limited exceptions related to national security, but in general we should “turn the other cheek” and let recalcitrant trade partners engage in economic self-harm, if they must.

Okay, Wise Guy, What’s Your Plan?

I have a few friends who bemoan the lack of “fair play” against the U.S. in foreign trade. They have a point, but they also hold an unshakable belief that the U.S. can be just as efficient at producing anything as any other country. They are pretty much in denial that comparative advantages exist in the real world. They are seemingly oblivious to the critical role of specialization in unlocking gains from trade and lifting much of the world’s population out of penury over the past few centuries.

Furthermore, these friends believe that Trump is justified in “retaliating” against countries with whom the U.S. runs trade deficits. If tariffs are so bad, they ask, what would I do instead? Again, here’s my answer:

Eliminate (almost) all barriers to trade imposed by the U.S. Let protectionist nations choke themselves with tariffs/trade barriers.

Before getting into that, I’ll address one fact that is often denied by protectionists.

Yes, a Tariff Is a Tax!

Protectionists often claim that tariffs are not really taxes on U.S. buyers. However, tariffs are charged to buyers of imported goods (often businesses who sell imported goods to consumers or other businesses). In principle, tariffs operate just like a sales tax charged to retail buyers. Both raise government revenue, and they are both excise taxes.

In both cases, the buyer pays but generally bears less than the full burden of the tax. That’s because demand curves slope downward, so sellers (foreign exporters) try to avoid losing sales by moderating their prices in response to the tariff. In both cases, sellers end up shouldering part of the tax burden. How much depends on how buyers react to price: a steep (inelastic) demand curve implies that buyers bear the greater part of the burden of a tariff or sales tax.

People sometimes buy imports due to a lack of substitutes, which implies a steep demand curve. Consumer imports are often luxury items, and well-heeled buyers may be somewhat insensitive to price. Most imports, however, are inputs purchased by businesses, either capital goods or intermediate goods. In the face of higher tariffs, those businesses find it difficult and costly to arrange new suppliers, let alone domestic suppliers, who can deliver quickly and meet their specifications.

These considerations imply that the demand for imports is fairly inelastic (steeper), especially in the short run (when alternatives can’t easily be arranged). Thus, import buyers bear a large portion of the burden in the immediate aftermath of an increased tariff. By imposing tariffs we tax our own citizens and businesses, forcing them to incur higher costs. Correspondingly, if demand is inelastic, an importing country tends to gain more than its trading partners by unilaterally eliminating its own tariffs.

Tariffs on imports also trigger price hikes by import-competing producers. Sometimes this is opportunistic, but even these producers incur higher costs in attempting to meet new demand from buyers who formerly purchased imports. (See this post for an explanation of the costly transition, including a nice exposition of the waste of resources it entails.)

Other Forms of Blood Letting

Beyond tariffs, certain barriers to trade make it more difficult or impossible to purchase goods produced abroad. This includes import quotas and domestic content restrictions. These barriers are often as bad or worse than tariffs because they increase costs and encumber freedom of choice and consumer sovereignty.

Another kind of trade intervention, export subsidies, must be funded by taxpayers. Subsidies are too easily used to protect special interests who otherwise can’t compete. Currency manipulation can both subsidize exports and discourage imports, but it is often unsustainable. The common theme of these interventions is to undermine economic efficiency by shielding the domestic economy from real price signals.

Let Them Tax Themselves

Suppose the U.S. simply turns the other cheek, eliminating all of our own trade interventions with respect to country X despite X’s tariffs and other interventions.

To start with, the existence of barriers means that both countries are unable to exploit all of the benefits of specialization and mutually beneficial trade. Both countries must produce an excess of goods in which they lack a comparative advantage, and both countries produce too few goods in which they have a comparative advantage. Both incur extra costs and produce less output than they could in the absence of trade barriers.

Unilateral elimination of U.S. tariffs and other barriers would reduce high-cost domestic production of certain goods in favor of better substitutes from country X. But Country X gains as well, because it is now able to produce more goods and services for export in which it possesses a comparative advantage. Therefore, the unilateral move by the U.S. is beneficial to both countries.

On the other hand, U.S. export industries are still constrained by country X’s import tax or other restraints. These would-be exporters are no worse off than before, but they are worse off relative to a state in which buyers in country X could freely express their preferences in the marketplace.

What exactly does country X gain from tariffs and other trade burdens on its citizens? It denies them full access to what they deem to be superior goods and services at an acceptable price. It means that resources are misallocated, forcing abstention or the use of inferior or costlier domestic alternatives. Resources must be diverted to relatively inefficient firms. In short, the tariff makes country X less prosperous.

Empirical evidence shows that more open economies (with fewer trade barriers) enjoy greater income and productivity growth. This study found that “trade’s impact on real income [is] consistently positive and significant over time.” See this paper as well. Trade barriers tend to increase the income gap between rich and poor countries. The chart below (from this link) compares real GDP per capita from the top third and bottom third of the distribution of countries on a measure of trade “openness”. Converting logs to levels, the top third has more than twice the average real GDP per capita of the bottom third. And of course, the averaging process mutes differences between very open and very closed trade policies.

The chart also shows that countries more “open” to trade have more equal distributions of income, as measured by their Gini coefficients.

An important qualification is that domestic production of certain goods and services might be critical to national security. We must be willing to tolerate some inefficiencies in that case. It would be foolish to depend on a hostile nation for those supplies, despite any comparative advantage they might possess. It’s reasonable to expect such a list of critical goods and services to evolve with technological developments and changing security threats. However, merely acknowledging this justification leaves the door open for excessively broad interpretations of “critical goods”, especially in times of crisis.

Setting a Good Policy and Example

Here’s an attempt to summarize:

Tariffs are taxes, and non-tariff barriers inflict costs by distorting prices or diminishing choice
Trade barriers reduce economic efficiency and produce welfare losses
Trade barriers deny the citizens of a country the benefits of specialization
Both countries gain when one trading partner eliminates tariffs on imports from the other
The demand for imports is fairly inelastic, at least in the short run. Thus, the gain from eliminating a tariff will be skewed toward the domestic importers
Both countries gain when they agree to eliminate any and all trade barriers
Across countries, trade barriers are associated with lower incomes, lower income growth, and more unequal distributions of income

The U.S. has a large number of trading partners. Every liberalization we initiate means a welfare gain for us and one trading partner, who would do well to follow our example and reciprocate in full. Not doing so foregoes welfare gains and leads to incremental losses in income relative to more trade-friendly nations. Across all of our trading relationships, a unilateral end to U.S. trade barriers would almost certainly convince some countries to reciprocate. Those that refuse would suffer. Let them self-flagulate. Let them tax themselves.

Trade Charades and a Capital Crusade

15 Tuesday Apr 2025

Posted by Nuetzel in Balance of Payments, Federal Budget, Protectionism

≈ 4 Comments

Tags

Balance of Payments, Capital Account, Capital Deepening, Capital Surplus, central planning, Cronyism, Current Account, Donald Trump, Federal Budget Deficit, John Cochrane, Reciprocal Tariffs, Scott Lincicome, Trade Barriers, Trade Deficit

I’m nowhere near eating crow over the skepticism I’ve directed at Donald Trump’s trade offensive. The uncertainty created by his erratic policy changes is very likely to drag the U.S. into recession. However, there were signs last week of movement in a more promising direction, as he placed a 90-day pause on the targeted “reciprocal” tariffs announced in early April. However, a “baseline” universal tariff of 10% still applies to all imported goods. So do tariffs targeted at China, which have ratcheted up through a few rounds of retaliation. Now, he’s announced exemptions for some key electronics products, many of which come from China, and there are signs that he’s ready to exempt imports of auto parts. Needless to say, the tariffs and their exemptions represent an ill-advised escapade in central planning, replete with ample opportunities for politically-motivated favoritism and prejudice.

Why the Pause?

The pause in reciprocal tariffs was ostensibly intended to allow time to negotiate lower trade barriers with “more than 75 countries” that came forward to engage with Trump rather than retaliate. Now, there are said to be as many as 90 countries that wish to negotiate. This more or less aligns with an evolution of the strategy I described in my last post: game theory suggests that a dominant trading partner may be able to threaten or impose higher tariffs and ultimately achieve agreement on a regime with lower trade barriers on both sides. In Trump’s case, that would involve reaching many different bilateral agreements within a very short time, an imposing challenge given the history of trade negotiations. So far we have no deals, though Trump claims some are close. If only we didn’t have to reach formal agreements not to interfere with mutually beneficial trade!

A debate ensued almost immediately over whether Trump’s pause showed that he “caved” to the negative market reaction to his tariffs, but perhaps he acted primarily because a number of nations approached with hats in hand. Trump knew he had the leverage to force other nations to make concessions on trade barriers. They obviously responded.

The timing of the pause was surely a combination of those overtures, market reaction, advisor opinion, and Trump’s own instincts. This view is buttressed by the unaltered universal 10% tariffs, the remaining special tariffs on specific nations and product categories, and the punative tariffs on China. Furthermore, Trump knows he can reimpose a targeted tariff on any country that refuses a deal satisfactory to him. Let’s hope he’s reasonable and doesn’t allow his love affair with tariffs to color his position in these talks.

My hope is that the Trump Administration can negotiate a large number of new agreements with trading partners to reduce or eliminate tariffs and other barriers to trade. Obviously the pause is no guarantee of success, and severe challenges remain with more belligerent trading partners, especially China.

Disclaimer!

None of the foregoing is intended as a dispensation for the many apparent misconceptions Trump has about trade. In the MAGA cult clamor to defend all-things Trump, there have been a number of absurd claims about tariffs and trade, such as: tariffs are not a tax; tariffs don’t raise the price of imports; trade deficits are a deduction from GDP; tariffs can replace the income tax; trade deficits will bankrupt the country; high tariffs produced rapid growth in the late 19th century; “reciprocal” tariffs will eliminate our bilateral trade deficits; U.S. manufacturing is in crisis; value added taxes are trade barriers; it’s better to export goods than services; and trade deficits reduce investment. Every one a laugher, but I’ll leave most of them aside for now.

In the remainder of this post, I’ll focus on Trump’s aims for coaxing firms, via tariff avoidance, to make capital investment in the U.S., and the implications of that effort for the trade balance. An influx of capital might be construed as a strength of Trump’s policy agenda, though his effort to “cut deals” in this manner is a form of economic meddling as well as a vehicle for cronyism. Moreover, he doesn’t understand the nexus between foreign investment, the federal deficit, and the balance of payments. He’ll be disappointed to learn that his notion that trade deficits are ruinous conflicts with his vision of encouraging foreign accumulations of productive U.S. assets.

Oh No! A Capital Surplus!

It isn’t a widely understood equivalence, but each year we have a surplus in foreign purchases of U.S. assets (the capital account surplus) that is roughly matched by a deficit in trade for foreign goods and services (the current account deficit). This is why the balance of payments (BoP) balances! Here is the near mirror image of these two sides of the BoP, from Scott Lincicome’s “Things Everyone Should Know about Trade Deficits”:

The two sides of the BoP are very much codetermined. One does not exclusively drive the other.

It’s wonderful to be in a position to avail ourselves of foreign savings to invest in our economy. Unfortunately, a large portion of this foreign investment finances our huge government budget deficit, and that is a real problem. Otherwise, the investment would make a greater contribution to U.S. growth.

Funding the Federal Deficit

As John Cochrane explains, transfer payments account for a large share of government spending and borrowing. In turn, these transfers are spent by recipients on consumer goods, some of which come from overseas. Cochrane emphasizes that we are borrowing from abroad, as shown by our capital surplus, to finance this consumption, rather than investing foreign capital in productive assets. While one might conclude that our capital surplus and our trade deficit are creating a long-term vulnerability, the root of the problem is the federal government’s largess.

There is a sense in which different prongs of Trump’s policy agenda could act to address this problem. These are his efforts to reduce government waste, deregulate, and encourage direct investment in new plant and equipment. Reducing the federal budget deficit is paramount, but huge doubts remain over his determination to control spending or undertake real entitlement reforms. Tariffs will generate some revenue, but part of that will be required to offset other tax breaks Trump is contemplating.

Deepening the Capital Base

Trump harps on the need for firms, both foreign and domestic, to produce goods here in the U.S. Currently he’s taking credit for $5 trillion of new investment in the U.S., though we really don’t know whether all of these are “new deals” or had already been planned. Deregulation can improve incentives to invest in physical capital and increase the speed with which it comes online. To the extent that investment in productive capital replaces government borrowing, the debt we accumulate (held by foreign and domestic lenders) will be more sustainable.

However, Trump seems oblivious to a fact made inescapable by the balance of payments relationship. This new investment, should it come to fruition, will bring with it future excesses of imports over exports. Foreign demand for U.S. capital assets lifts domestic income and leads to a stronger dollar, both of which boost imports and the trade deficit. The trade deficit will persist even if foreign investment in new factories fully replaces the bloated federal deficit as a use of foreign capital.

Of course, the intent of Trump’s reshoring campaign is for new domestic output to substitute for imports and increase exports. That would bring positive returns for domestic and foreign capital, but rising income and a stronger dollar will stimulate demand for other imports, while exports would flag with the strength of the dollar. In any case, the new investments and a larger capital surplus will increase the trade deficit.

The Tariff Games

08 Tuesday Apr 2025

Posted by Nuetzel in Protectionism, Tariffs

≈ 3 Comments

Tags

Bilateral Trade, Bill Ackman, Dominant Trade Partner, Donald Trump, Elon Musk, Foreign Policy, Game Theory, Iowahawk, Liberation Day, Repeated Rounds, Tariffs, Trade Barriers, Xi Jinping

Donald Trump’s imposition of higher tariffs — much higher tariffs — on our trading partners carries tremendous risk. See this article for a good summary of the tariffs Trump levied (and now paused for 90 days) on imported goods from different countries. The President believes he can win major concessions from other nations in terms of trade barriers as well as foreign policy objectives. But he would also have us believe that we’ll be better off even if those concessions fall short of his hopes.

Perhaps he’s posturing, but Trump seems to thinks tariffs are some kind of elixir. That is nonsense for a variety of reasons. I’ve discussed several of those previously and I’ll add more in a subsequent post. Here, I’ll attempt to give Trump his due. I’m highly skeptical, but I’ll be happy to eat crow if he is successful in achieving a trade regime with lower tariffs and other barriers across many of our trading partners.

Markets

The tariff announcements last week on “Liberation Day” spooked markets, prompting a continuation of the classic flight to safety we’ve witnessed since Trump began to rattle his trade saber. This has driven bond prices up and long-term interest rates down, though now we’re seeing a partial reversal (if it holds). Will lower interest rates help save the day for Trump? It will bring lower borrowing costs to many borrowers, including the federal government, and it should help to buttress stock values, softening the blow to some extent.

The tariffs, should they remain in place, are likely to boost inflation temporarily (a one-time increase in the price level) and could very well tip the U.S. economy into recession. Depending on the severity, those developments would undercut the GOP’s hopes of maintaining a congressional majority in the 2026 mid-term elections. Then, he’d truly have managed to cut off his nose to spite his face. Still, Trump thinks he knows something about tariffs that markets don’t.

Dominoes

Bill Ackman has expressed a view of how markets are reacting and how they might evolve under Trump’s trade policy. He thinks markets would be fine had the President set tariffs at levels matching our trading partners (doubtful at best), but Trump went bigger in order to jolt other nations into negotiating. Ackman thinks there might be a “tipping point” when countries line up at the negotiating table. And indeed, as of April 7, the administration said “up to” 70 countries had reached out to enter new trade negotiations with the U.S. That probably helped bring investors out of their doldrums, pending actual deals.

Elon Musk states a desire to see tariffs eliminated between the U.S. and the EU, and the EU has made a limited offer along those lines. This might be indicative of similar thinking by others in the administration. But Trump insists he’ll always revisit tariffs wherever he sees a bilateral trade deficit. Contrary to all economic logic, he is convinced that trade deficits are harmful, when in fact they mainly reflect our relative prosperity.

Hard-Nosed, High Stakes

Economists have been almost uniform in their condemnation of Trump’s approach trade. To some extent, that’s a visceral reaction to Trump’s pro-tariff rhetoric and revulsion to his opening moves. But is there an economic rationale for this type of aggressive attempt to bargain for lower trade barriers? Yes, and it’s not a terribly deep insight, and it carries great risks in the real world.

From a game-theoretic perspective, it’s possible that a dominant trading partner, in repeated rounds, can ultimately achieve lower bilateral trade barriers through the threat or imposition of higher barriers to imports from a trading partner. The key is the difference in costs that barriers impose on the two nations. One is in a position to leverage its dominant position, inflicting greater costs on the other nation as an inducement to gain concessions and achieve improved conditions for mutual trade.

The U.S. is almost uniformly the dominant partner in bilateral trade relationships. That’s because U.S. GDP is so large and U.S. trade with any given country is a comparatively small fraction of GDP. But dominance can mean different things: there are countries that supply critical goods to the U.S., like oil, semiconductors, or rare earths, which may give certain countries disproportionate leverage in trade negotiation. Those products along with many others are exempted from Trump’s tariffs.

Other Cards

Nevertheless, the U.S. has economic leverage over individual trading partners in the vast majority of cases, which Trump certainly is willing to exploit. And Trump has another powerful tool with which to negotiate with some trading partners: U.S. military protection. Using it might expose the U.S. to strategic disadvantages, but don’t put it past Trump to bring this up in negotiations!

Trump is doing his best to prove a readiness to escalate. That might build his credibility except for a couple of critical facts: first, his actions have already violated at least 15 existing treaties. Why should they trust him? Second, some groups of nations are likely to present a united front, putting them on a more equal footing with the U.S. This makes a trade war between the U.S. and the rest of the world more likely. One nation in particular stands ready to capitalize on severed relations between other nations and “Donald Trump’s” America: Xi Jinping’s China. Bilateral trade with China might just be the Super Bowl of these tariff games. Unfortunately, it could be a Super Bowl where everyone loses!

An additional complication: while the U.S. has dominance in most of its trade relationships, the barriers to U.S. goods erected by other nations are often supported by powerful special interests. Trump’s ability to strike deals will be complicated where governments are captive to these interests, which might be concentrated among powerful elites or of a more diffuse, nationalist/populist nature.

Deep In the Woods

There is optimism in some quarters that a few successful trade deals will lead to a “tipping point” in the willingness of other nations to negotiate with Trump. Despite the sudden clamor among our trade partners to negotiate, we’re a long way from getting solid agreements. Investors still assess a greater risk of a world trade war than vanishing barriers to trade.

I’ll close with a take on the situation by the reliably funny Iowahawk:

Look I've been as critical of tariffs as anyone but if the long term vision is domestic Nike sweatshops filled with fired DC bureaucrats, I'm willing to listen https://t.co/CmsJ7bx5vk
— David Burge (@iowahawkblog) April 7, 2025

Choosing DOGE Over a Prodigal State Apparatus

03 Thursday Apr 2025

Posted by Nuetzel in Big Government, DOGE

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Al Gore, Barack Obama, Bernie Sanders, Bill Clinton, Border Security, Chuck Schumer, DEI, Department of Education, Department of Government Efficiency, Department of Interior, Discretionary Budget, DOGE, Donald Trump, Elon Musk, entitlements, FDA, Force Reductions, Fourth Branch, Fraud, Graft, HHS, Indirect Costs, Jimmy Carter, Joe Biden, Mandatory Budget, Medicaid, Medicare, Nancy Pelosi, NIH Grants, Obamacare, Provisional Employees, Public debt, Severance Packages, Social Security, U.S. Digital Service, U.S. Postal Service, USAID, Voluntary Separations, Waste

I prefer a government that is limited in size and scope, sticking closely to the provision of public goods without interfering in private markets. Therefore, I’m delighted with the mission of the Department of Government Efficiency (DOGE), a rebranded version of the U.S. Digital Service created by Barack Obama in 2014 to clean up technical issues then plaguing the Obamacare web site. The “new” DOGE is fanning out across federal agencies to upgrade systems and eliminate waste and fraud.

A Strawman

For years, democrats such as Barack Obama and Joe Biden have advocated for eliminating waste in government. So did Bill Clinton, Al Gore, Bernie Sanders, Chuck Schumer, and Nancy Pelosi. Here’s Mark Cuban on the same point. Were these exhortations made in earnest? Or were they just lip service? Now that a real effort is underway to get it done, we’re told that only fascists would do such a thing.

I’m seeing scary posts about DOGE even on LinkedIn, such as the plight of Americans unable to get federal public health communications due to layoffs at HHS, while failing to mention the thousands of new HHS employees hired by Biden in recent years. As if HHS was particularly effective in dispensing good public health advice during the pandemic!

Those kinds of assertions are hard to take seriously. For reasons like these and still others, I tend to dismiss nearly all of the horror stories I hear about DOGE’s activities as nitwitted virtue signals or propaganda.

Many on the left claim that DOGE’s work is careless, and especially the force reductions they’ve spearheaded. For example, they claim that DOGE has failed to identify key employees critical to the functioning of the bureaucracy. The tone of this argument is that “this would not pass muster at a well-managed business”. A “sober” effort to achieve efficiencies within the federal bureaucracy, the argument goes, would involve much more consideration. In other words, given political realities, it would not get done, and they really don’t want it to get done.

The best rationale for the ostensible position of these critics might be situations like the dismissal of several thousand provisional employees at the FDA, a few of whom were later rehired to help manage the work load of reviewing and approving drugs. However, thus far, only a tiny percentage of the federal force reductions under consideration have involved immediate layoffs.

Of course, DOGE is not being tasked to review the practices of a well-managed business or a well-managed governmental organization. What we have here is a dysfunctional government. It is a bloated, low productivity Leviathan run by management and staff who, all too frequently, seem oblivious to the predicament. Large force reductions at all levels are probably necessary to make headway against entrenched interests that have operated as a fourth branch of government.

Thus, I see the leftist critique of Trump’s force reductions as something of a strawman, and it falls flat for several other reasons. First, the vast bulk of the prospective reduction in headcount will be voluntary, as the separating employees have been offered attractive severance packages. Second, force reductions in the private sector always feel chaotic, and they often are. And they are sometimes executed without regard to the qualifications of specific employees. Tough luck!

Duplicative functions, poor data systems, and a lack of control have led to massive misappropriations of funds. The dysfunction has been enabled by a metastasization of nests of administrative authority inside agencies with “incomprehensible” org charts, often having multiple departments with identical functions that do not communicate. These departments frequently use redundant but unconnected systems. A related problem is the inadequacy of documentation for outgoing payments. Needless to say, this is a hostile environment for effective spending controls.

It’s worth emphasizing, by the way, DOGE’s “open book” transparency. It’s not as if Elon Musk and DOGE are attempting to sabotage the deep state in the dark of night. Indeed, they are shouting from the rooftops!

Doing It Fast

Every day we have a new revelation from DOGE of incredible waste in the federal bureaucracy. Check out this story about a VA contact for web site maintenance. All too ironically, what we call government waste tends to have powerful, self-interested, and deeply corrupt constituencies. This makes speed an imperative for DOGE. In a highly politicized and litigious environment, the extent to which the Leviathan can be brought to heel is partly a function of how quickly the deconstruction takes place. One must pardon a few temporary dislocations that otherwise might be avoided in a world free of rent seeking behavior. Otherwise, the graft (no, NOT “grift”) will continue unabated.

The foregoing offers sufficient rationale not only for speedy force reductions, but also for system upgrades, dissolution of certain offices, and consolidation of core functions under single-agency umbrellas.

The Bloody Budget

It’s difficult to know when budget legislation will begin to reflect DOGE’s successes. The actual budget deficit might be affected in fiscal year 2025, but so far the savings touted by DOGE are chump change compared to the expected $2 trillion deficit, and only a fraction of those savings contribute to ongoing deficit reduction.

Uncontrolled spending is the root cause of the deficit, as opposed to insufficient tax revenue, as evidenced by a relatively stable ratio of taxes to GDP. The spending problem was exacerbated by the pandemic, but Congress and the Biden Administration never managed to scale outlays back to their previous trend once the economy recovered. Balancing the budget is made impossible when the prevailing psychology among legislators and the media is that reductions in the growth of spending represent spending cuts.

Federal spending is excessive on both the discretionary and mandatory sides of the budget. Ultimately, eliminating the budget deficit without allowing the 2017 Trump tax cuts to expire will require reform to mandatory entitlements like Social Security, Medicare, and Medicaid, as well as reductions across an array of discretionary programs.

DOGE’s focus on fraud and waste extends to entitlements. At a minimum, the data and tracking systems in place at HHS and SSA are antiquated, sometimes inaccurate, and are highly susceptible to manipulation and fraud. Systems upgrades are likely to pay for themselves many times over.

But all indications are that it’s much worse than that. Social security numbers were issued to millions of illegal immigrants during the Biden Administration, and those enrollees were cleared for maximum benefits. There were a significant number of illegals enrolled in Medicaid and registered to vote. While some of these immigrants might be employed and contributing to the entitlement system, they should not be employed without legal status. Of course, one can defend these entitlement benefits on purely compassionate grounds, but the availability of benefits has served to attract a massive flow of illegal border crossings. This illustrates both the extent to which the entitlement system has been compromised as well as the breakdown of border security.

On the discretionary side of the budget, DOGE has identified an impressive array programs that were not just wasteful, but by turns ridiculous or politically motivated (for example, the bulk of USAID’s budget). Many of these funding initiatives belong on the chopping block, and components that might be worthwhile have been moved to agencies with related missions. In addition, authorized but unspent allocations have been identified that seem to have been held in reserve, and which now can be used to reduce the public debt.

Research Grants?

Of course, like the initial scale of the FDA layoffs, a few mistakes have and will be made by DOGE and agencies under DOGE’s guidance. Many believe another powerful argument against DOGE is the Trump Administration’s 15% limit on indirect costs as an add-on to NIH grants. Critics assert that this limit will hamstring U.S. scientific advancement. However, it won’t “kill” publicly funded research. As this article in Reason points out, historically public funding has not been critical to scientific advancement in the U.S. In fact, private funding accounts for the vast bulk of U.S. R&D, according to the Congressional Research Service. Moreover, it’s broadly acknowledged that indirect costs are subject to distortion, and that generous funding of those costs creates bad incentives and raises thorny questions about cross-subsidies across funders (15% is the rate at which charities typically fund indirect costs).

No doubt some elite research universities will suffer declines in grants, but their case is weakened politically by a combination of lax control over anti-Semitic protests on campus, the growing unpopularity of DEI initiatives in education, and public awareness of the huge endowments over which these universities preside. Nevertheless, I won’t be surprised to see the 15% limit on indirect research costs revised upward somewhat.

More DOGE Please

I’ve criticized the numbers posted on DOGE’s website elsewhere. They could do a much better job of categorizing and reporting the savings they’ve achieved, and they have far to go before meeting the goals stated by Elon Musk. Be that as it may, DOGE is making progress. Here is a report on a few of the latest cuts.

As I’ve emphasized on numerous occasions, the federal government is a strangling mass of tentacles, squeezing excessive resources out of the private sector and suffocating producers with an endless catalogue of burdensome rules. There are many examples of systemic waste taking place within the federal bureaucracy. For example, since its creation by Jimmy Carter, the Department of Education has managed to piss away trillions of dollars while student performance has declined. The Small Business Administration has doled out millions of dollars in subsidized loans to super-centenarians as well as children. The U.S. Postal Service keeps losing money and mail while deliveries slow to a crawl. Big projects become mired in endless iterations of reviews and revisions, such as Obama’s infrastructure plan and Joe Biden’s infrastructure and rural broadband initiative.

And again, regulatory agencies are often our worst enemies, imposing burdensome requirements with which only the largest industry players can afford to comply. Indeed, the savings achieved through the DOGE process might pale in comparison to the resources that could be liberated by rationalizing the tangle of regulations now choking private business.

A significant narrowing of the budget deficit would be a major accomplishment for DOGE. Even one-time savings to help pay down the public debt are worthwhile. In this latter regard, I hope DOGE’s work with the Department of Interior helps facilitate the sale of dormant federal assets. This includes land (not parks) and buildings worth literally trillions of dollars, and sometimes costing billions annually to maintain.