This week the CEOs of the “Big Three” US auto makers boarded their private jets in Detroit and touched down in Washington to beg and plead in front of Congress for a “low-interest bridge loan” from the US government to help them avoid bankruptcy. They are asking Congress for $25 billion of taxpayer money to give them the chance to re-structure and re-equip themselves for the future.

Below are eight arguments based on basic economic principles for why a bailout of the United States automobile industry is a bad idea and is bound to fail:

1. Incentives matter: A bailout of the US auto industry ignores the basic economic principle that incentives matter. Individuals and firms respond to incentives, pursuing behavior that is likely to bring them the greatest rewards. In the face of falling demand for their product and ever-increasing competition from more efficient foreign producers, providing a $25 billion bailout creates a disincentive to drastically reduce costs and increase competitiveness, and an incentive to continue using tired old techniques and providing the same old models for which demand has declined among Americans for over a decade.
2. Comparative advantage: The basic economic principle of comparative advantage states that in an era of free trade and globalization, countries should produce the types of goods for which they have the lowest opportunity cost. Since the average American car of a particular class costs the Big Three $2000 more in wages and benefits for workers than its Japanese counterpart, it makes sense that Japan (and other lower-cost countries) produce more cars, and the Big Three produce less.
3. Efficient allocation of resources: The United Auto Workers Union has a member ship of over 400,000 workers. Since the 1970s the union has lost over 1 million workers. Clearly the US auto industry has been in decline for decades, a fact that should be taken as a sign: resources employed in America’s car industry are inefficient and represent a over-allocation of resources. A drastic down-sizing of the auto industry, while resulting in short-run hardships for the hundreds of thousands whose jobs will be lost, will in the long run strengthen the US economy as labor and other resources will be freed up to be employed in sectors in which the US has comparative advantage.
4. Economic Darwinism or “the survival of the most efficient”: America has stood for free trade in the world since helping found GATT in 1948 and later the WTO. The gains from embracing free trade are shared among all stakeholders in the economy. Consumers enjoy lower prices (thus higher real income), firms enjoy access to cheaper inputs and larger markets for their products, and governments enjoy the increased tax revenues from rising incomes driven by export-led economic growth. To bail out an uncompetitive, inefficient, and long-declining industry is to spit in the eye of free trade and denies America any moral suasion it may hold in the future over potential trading nations in our attempt to open their markets to our nation’s products. To protect our own dying industry now will send a clear message to our trading partners. “America does NOT stand for free trade”. If we believe in free trade and the allocative power of markets, then we must let the dinosaurs of American industry meet the fate the natural selection of the marketplace has determined for it.
5. The benefits enjoyed by the few represent costs born by the many: A bailout by the US government of the auto industry will protect a few hundred thousand jobs for a few years at the most but spells a reduction in the disposable incomes and spending power of millions for years to come. The US does not have $25 billion laying around to give the Big Three, which means the money must be borrowed. Increased government borrowing raises interest rates now (further tightening the credit markets) and will result in increased taxes down the road. All government debt must eventually be paid off, and in the immediate future interest on this debt must be paid directly from tax revenue. A $25 billion bailout is the same as a subsidy, meaning it redistributes income and welfare from consumers to producers. Millions are asked to sacrifice for the continued survival of a few hundred thousand in an industry that has failed to evolve in a global auto market that has seen increased competition and efficiency from foreign firms for decades.
6. Moral hazard: Bailing out the Big Three today represent a classic case of moral hazard. When American industries fail to take steps to increase their efficiency and remain competitive in the face of increased global competition, they find themselves not surprisingly on the brink of collapse. To reward these firms by taking money out of Americans’ pockets and handing it to them to do as they will, we send the wrong message and create the wrong incentives in the American economy. The message is: “Don’t worry, the market doesn’t choose the winners and losers in the economy, the government does, and certain industries are too big to fail”.
7. Market failure, or Firm Failure?: The fate of the auto industry is in the hands of the US government. But so is the fate of the free market. My fear now is that the pendulum will swing too far to the left in America’s state of panic over the ill-fated downfall of the financial markets, rooted in the irrational exuberance and over-leveraging of big financial institutions. The failure of the financial markets, however, is an entirely different story from that of a dinosaur industry like automobiles. The Big Three have had decades to reform themselves, lower their costs, improve their products, and remain competitive. THEY have failed, NOT the market. Government intervention is necessary in instances of market failure, but NOT IN CASES OF FIRMS’ FAILURE TO COMPETE IN A WELL FUNCTIONING MARKET like the global auto industry.
8. Inflexible labor markets: I saw the president of the UAW on the news today giving 101 reasons why the government should approve a bailout deal for the Big Three. In fact, the unions that supposedly represent American Auto Workers are a big part of the problem the industry is facing. For decades the UAW has fought against wage and benefit cuts for auto workers, lobbying instead for higher tariffs and other barriers aimed at keeping foreign cars out of the country. This anti-competitive behavior is a major reason the Big Three cannot compete with European and Asian car makers today. Wage inflexibility leads to higher unemployment. Unions keep wages from going down, leaving the Big Three with one of two choices: Drastically downsize your workforce and employ fewer high paid auto workers, or beg the government for a multi-billion dollar subsidy to that the unions can be placated and you can survive for a couple more years until you’re in the same situation all over again. The unions helped cause the problem, now they should pay the price by experiencing the downsizing their demands inevitably foretold.

The US government should allow the free market to function and let the dinosaurs go extinct. Cars will still be made in America, they’ll just be made by the better, more efficient firms that emerge from bankruptcy when this is all over, as well as the numerous foreign firms already making cars in the US. Survival of the most efficient, that’s what markets are all about. Allowing the market to work will strengthen the US auto industry far more than a “short-term low-interest bridge loan” ever will, it will free up labor and capital resources to be employed by industries the country is better at, and make sure household income is NOT reallocated to inefficient firms to be squandered on the manufacture of a product for which demand has steadily declined for the last decade plus.

FT.com | The Economists’ Forum | The case for forward-looking protectionism in the US

Free trade is an ideal. This is a theme of my IB Economics class which I emphasize repeatedly during year two of the course. Free trade, defined as the exchange of goods, services, resources, and financial assets based on the principle of comparative advantage, results in a more efficient allocation of the world’s resources, an increase in total world output and welfare, and increases the opportunity for growth and development for all countries that prescribe to its principles. This is the ideal, at least.

In the real world, free trade is rarely practiced. Free trade agreements between nations represent managed trade; the selected removal of protections such as tariffs, quotas and subsidies on the exchange of particular goods does not represent free trade, rather managed trade. The problem with free trade in the real world is simply that it has never been truly practiced, therefore the adjustments that both developed and developing countries would have to undergo to adopt widespread free trade would be extremely disruptive both economically and socially. Entire industries would disappear from the developed countries as manufacturing resources were reallocated to low cost countries. Poor countries trying to build their manufacturing industries would lose any competitive advantage offered by protectionism, forcing their “infant industries” to wither and die in the face of global competition from countries that long ago achieved economies of scale in manufacturing. Farmers used to heavy subsidies would see their livelihoods disappear as the world’s food would be sourced from the countries with true comparative advantages in agriculture. Simply stated, the social costs of the widespread adoption of free trade are not politically palatable, thus leaders have only hesitantly pursued this ideal on the world stage.

For decades, America has stood for the ideal of free trade, proselytizing its advantages and urging developing countries to reduce or remove their barriers to the free flow of resources and goods from nation to nation. Today, however, the United States faces the very fate free trade prophesized as its own automobile industries teeters on the edge of collapse. As many as 3 million American jobs stand to be lost if the auto industry goes under. Today, America faces the ultimate test of its will to stand for and defend free trade in the world. Should America erect new barriers to trade, bail out its auto industry, and save this dying sector from collapse to avoid the political hardships its death would incur? Or should America stand for the ideal of market liberalization and allow the auto industry to disolve as the principle of comparative advantage indicates it should?

The question is dire, and it’s one that Barack Obama will be forced to address early in his term as president. Cambridge economcis professor Ha-Joon Chang argues the case for protectionism by America in this time of economic turmoil:

Mr Obama’s trade policy… is already causing controversy. He has vowed to protect American jobs and even argued for re-negotiating the NAFTA. There is already some hand wringing among free-trade economists, worrying that his protectionist policies may destroy the world trading system in the same way the infamous Smoot-Hawley Tariffs of 1930 did after the Great Depression. They counsel that the US should maintain its historical commitment to free trade.

However, contrary to what most people think, the US is the true home of protectionism. Between the 1830s and the 1940s, against superior European competition, the US developed its industries behind literally the highest tariff wall in the world, with the average industrial tariff rate ranging between 35% and 55%. Even the Smoot-Hawley Tariffs were not an aberration – the average US industrial tariff in 1931 was, at 48%, well within the historical range.

Moreover, the theory that justified such protectionism, namely, the ‘infant industry’ argument, had been first developed by none other than the first Treasury Secretary of the US – Alexander Hamilton (that’s the guy you see on the $10 bill). Hamilton argued that producers in relatively backward economies needed to be protected and nurtured through tariffs, subsidies, and other government policies before they mature and can compete with producers from more economically developed countries.

Of course, the protectionism that Mr Obama is advocating is protection to ease the adjustment of mature industries, rather than to promote infant industries. The case for such protectionism is not as overwhelming as that of infant industry protection. However, well-designed and time-bound protection of mature industries can facilitate, rather than hinder, trade adjustment and industrial upgrading. Japan and some European countries in the aftermath of the 1970s Oil Shocks come to mind.

Mr Obama should use protectionism in a similarly forward-looking way. Industries that can be revived through re-tooling of its factories and re-training of its workers should be given protection, but only if they fulfill certain conditions regarding investment and training. Industries that have no future should be given strictly temporary protection to ease phasing-out through orderly liquidation and redundancy.

…Keeping its market open is not enough for the US to play a genuinely positive role in the world trading system. The US should also stop pushing for trade liberalization in developing countries and give them the chance to use (intelligently-designed, of course) infant industry protection, which it invented and benefited so much from. Mr Obama should take a lead in creating a world trading system that allows asymmetric protectionism between the rich countries and the poor countries, with the latter protecting their markets more and gradually opening up in line with their economic development.

All these call for a much more activist role for the US government than it has been the norm. Providing protectionism to facilitate structural changes, and not just to protect existing jobs, would require a much closer coordination between trade policy and those policies to upgrade American industries, such as R&D support and worker training. Redesigning the welfare state as a vehicle to promote skills upgrading and labor mobility would push the US government into an uncharted territory.

These are big challenges. However, the US cannot continue its peculiar mixture of free-trade mythology and uncoordinated, ‘reactive’ protectionism that has served ordinary Americans and the developing nations so poorly.

Mr Obama has turned a new chapter in US history by becoming the country’s first Afro-American president. He will turn a new chapter in world history if he can come up with a forward-looking protectionist strategy that that both protects American jobs better in the long run and help developing countries develop faster.

Discussion Questions:

1. What is the difference between the protectionism America needs today and the protectionism it used in the late 19th and early 20th centuries?
2. How could protectionism be used responsibly by developing countries to promote economic growth and development?
3. Professor Chang argues that responsible protectionism should allow industries with no future to be phased out “through orderly liquidation and redundancy”. What does he mean by this and why is such a policy so hard to accomplish politically?

Russell Roberts of George Mason University is a well-known advocate of free trade. This article is one of my favorite and certainly one of the clearest explanations of the mutual benefits resulting from free trade that I have read.

Foreign Policy: Why We Trade - by Russ Roberts

To hear most politicians talk, you’d think that exports are the key to a country’s prosperity and that imports are a threat to its way of life. Trade deficits—importing more than we export—are portrayed as the road to ruin… Politicians are always talking about the necessity of other countries’ opening their markets to American products. They never mention the virtues of opening U.S. markets to foreign products.

This perspective on imports and exports is called mercantilism. It goes back to the 14th century and has about as much intellectual rigor as alchemy, another landmark of the pre-Enlightenment era.

The logic of “exports, good—imports, bad” seems straightforward at first—after all, when a factory closes because of foreign competition, there seem to be fewer jobs than there otherwise would be. Don’t imports cause factories to close? Don’t exports build factories?

But is the logic really so clear? As a thought experiment, take what would seem to be the ideal situation for a mercantilist. Suppose we only export and import nothing. The ultimate trade surplus. So we work and use raw materials and effort and creativity to produce stuff for others without getting anything in return. There’s another name for that. It’s called slavery. How can a country get rich working for others?

Then there’s the mercantilist nightmare: We import from abroad, but foreigners buy nothing from us. What would the world be like if every morning you woke up and found a Japanese car in your driveway, Chinese clothing in your closet, and French wine in your cellar? All at no cost. Does that sound like heaven or hell? The only analogy I can think of is Santa Claus. How can a country get poor from free stuff? Or cheap stuff? How do imports hurt us?

We don’t export to create jobs. We export so we can have money to buy the stuff that’s hard for us to make—or at least hard for us to make as cheaply. We export because that’s the only way to get imports. If people would just give us stuff, then we wouldn’t have to export. But the world doesn’t work that way.

It’s the same in our daily lives. It’s great when people give us presents—a loaf of banana bread or a few tomatoes from the garden. But a new car would be better. Or even just a cheaper car. But the people who bring us cars and clothes and watches and shoes expect something in return. That’s OK. That’s the way the world works. But let’s not fool ourselves into thinking the goal of life is to turn away bargains from outside our house or outside our country because we’d rather make everything ourselves. Self-sufficiency is the road to poverty.

And imports don’t destroy jobs. They destroy jobs in certain industries. But because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones. That’s why we trade—to leverage the skills of others who can produce things more effectively than we can, freeing us to make things we otherwise wouldn’t be able to afford.

Discussion Questions:

1. “Self-sufficiency is the road to poverty” - Discuss…
2. Explain the logical economic fallacy of the mercantilist philosophy of “exports good, imports bad”
3. “…because trade allows us to buy goods more cheaply than we otherwise could, resources are freed up to expand existing opportunities and to create new ones”. What basic economic principle is Professor Roberts alluding to here?

More misleading economic statements from uninformed people who have never taken an economics course!

What about, you say?

I’m glad you asked!

It seems like I continuously read and hear in the American press that the United States is creating a giant wealth transfer by buying oil from other countries. Those “wealth transfer” words imply to the typical citizen that somehow our U.S. money supply is leaving our country, never to return again, and somehow our country is then poorer after the transaction and the country we imported from is now richer!

That is only a half-truth! Yes, the other country becomes richer, but we grow richer also by an equal amount! Both countries always gain economically from trade!

Let’s first get a few things straight before I elaborate: I am not happy either as gas prices rise ($3.50 a gallon in the U.S. as of this writing, although down from over $4.00 recently). I am also not happy that a fairly large share of oil purchases are from countries like Saudi Arabia and Venezuela whose loyalty to our country is certainly questionable. Luckily, the U.S. produces 40% of its own oil consumed and the other 60% consumed is imported from many different countries with 85% of our imports coming from 15 countries with Canada and Mexico being the largest two.

However, when we buy from any of these countries, both countries benefit equally and there is NO transfer of wealth. When the U.S. buys oil from any other country those U.S. dollars paid on the purchase are immediately returned to the United States and are spent almost immediately in our country since the other country cannot use our dollars in their country. What is really happening is that both countries’ citizens GAIN (not lose!) equally as we are, in essence, trading one product for another for both countries to enjoy!

Let’s use an example. Let’s say the U.S. buys 1000 barrels of oil from Saudi Arabia. At today’s price per barrel of $100 that would mean the U.S. would pay Saudi Arabia $100,000 and Saudi Arabia would then, in turn, be forced to turn around and use the paper ($100,00 USD!) on say, a bunch of iPods from Apple. Yes, the Saudi’s are listening to “I Kissed a Girl” by Katy Perry with their IPods under those smart head robes they wear! Ladies and gentlemen: that is why they call it trade: the essence of the transaction is that we have traded some of our iPods for some oil to fuel our cars and heat our homes. Both of us have gained! Katy Perry is hot on the charts and the Saudi’s “got their hands in the air”, and we can now drive to 7-Eleven for a Big Gulp and stay warm in the winter.

Also, think of it this way: when an American buys a gallon of gas the money is, in substance, going to an American business such as Apple! All spending of US dollars is spent back into our economy, and all spending of Saudi dollars (actually they call their currency the “dollar” also but it doesn’t look like ours!) benefit the Saudi economy.

Yes, trade is mutually beneficial. I would rather a warm home this winter and forego another Katy Perry song!

PickensPlan

The Pickens Plan is an initiative put together by the hedge fund manager of BP capital Management T Boone Pickens. The plan puts forth a model to get America off its addiction to foreign oil and on a path towards sustainable energy sources produced in the US of A. Watch the following video and read through the following information and comment on the questions.

“America is addicted to foreign oil. It’s an addiction that threatens our economy, our environment and our national security. It touches every part of our daily lives and ties our hands as a nation and a people. In 1970, we imported 24% of our oil. Today it’s nearly 70% and growing.

As imports grow and world prices rise, the amount of money we send to foreign nations every year is soaring. At current oil prices, we will send $700 billion dollars out of the country this year alone — that’s four times the annual cost of the Iraq war. Projected over the next 10 years the cost will be $10 trillion — it will be the greatest transfer of wealth in the history of mankind.

America uses a lot of oil. Every day 85 million barrels of oil are produced around the world. And 21 million of those are used here in the United States. That’s 25% of the world’s oil demand. Used by just 4% of the world’s population. The simple truth is that cheap and easy oil is gone.”

THE PLAN

Discussion Quesitons

1. Is Pickens correct in saying that America’s addiction to foreign oil is a problem? Be sure to use the concept of comparative advantage and specialization in your answer.
2. If we assume it to be a problem, what solution would you recommend? Do you agree with Pickens?

FT.com / World / Americas - US economy threatens Dominican Republic

Trade based on comparative advantage… the theory originally articulated by Adam Smith, later fine-tuned by David Ricardo, the theory that suggests that if each nation specializes its economic activity on the products for which it faces the lowest opportunity cost, then trades with its neighbors, total world output and efficiency can be maximized: today this theory represents the philosophical underpinning of all free trade agreements signed between and among the nations of the world.

Through trade, countries can exchange their extra output with other nations for the goods specialized in by others, enabling all nations to enjoy a level of consumption beyond what they’d be able to achieve if they tried to produce all goods domestically.

For many developing countries, with their abundance of either land or labor, comparative advantages tend to lie in either agricultural goods or low-skilled manufactured goods. Since global prices for food are highly unstable and dependency on healthy harvests, good weather, and stable rainfall are all highly risky endeavors for a poor country, developing nations prefer to foster the growth of manufacturing sectors in their path towards economic development.

Strategies for economic growth available to developing nations include export-oriented and inward-oriented growth. A country like the Dominican Republic, the largest economy in the Caribbean, has pursued a predominantly export-oriented growth strategy, promoting through “free zones” the growth of a textile industry aimed at producing goods for consumers in developed countries, primarily the US.

To the Domincans, producing textiles for export to America has successfully given the people of this poor nation a grip on a rung of the ladder towards economic development. The import of capital has taken previously unproductive workers out of agriculture and put them into an industry where productivity, thus income, has risen, leading to improvements in living standards. Export-led growth, however, runs some serious risks of its own, as is being realized by the people of the Dominican Republic today.

It had been clear for some time that Luis Caraballo’s textile factory, in one of the Dominican Republic’s largest “free zones”, was struggling.

Finally, last December, he closed the factory gates for the last time: cut-throat competition from China and Vietnam, a weakening US dollar and unsustainable costs had become too much.

Once a hot destination for American companies looking for a cheap place to “off-shore” production of labor intensive textiles, the Dominican Republic today faces new competition, and is finding its comparative advantage slip slowly away from textiles…

The Dominican Republic depends heavily on the US, which is the destination of more than 85 per cent of exports. But textile exports – these days accounting for less than a third of total exports – fell by 32 per cent over 2007.

Although other countries in the Caribbean are also suffering from Asian competition – with Chinese textile exports to the US tripling between 2000 and 2005, while Vietnam’s multiplied almost 117 times – the Dominican Republic has been worst hit.

Here’s the thing: a nation’s comparative advantage may shift over time (from land to labor to capital intensive goods) as the structure of the global economy evolves. Once an economy like the Dominican Republic’s has undergone a period of structural adjustment, away from agriculture and towards industry, the flow of low wage workers from farm to factory begins to slow to a trickle, leading to rising wages and increased competition from countries with more abundant supplies of cheap labor.

The challenge for policy makers is to manage the structural changes as they come, minimizing the deleterious impact such global shifts of productive resources has on the citizens of a country like the D.R. Clearly, it is in the country’s interest to prepare its citizens for a “new economy”, one in which skilled labor will play a larger role. The problem is, this requires a solid education system, which the D.R., it turns out, does not yet have:

There is widespread acceptance of the need to develop a better-educated workforce, but so far education spending has been inadequate.

“The government simply doesn’t have enough resources,” said Mr Montás. About 40 per cent of its budget goes on debt obligations and another 15 per cent is dished out through subsidies. Just 1.5 per cent goes towards education.

It also turns out that this is a balance of payments story:

Mr Montás calculated that for every percentage point the US economy contracted, the Dominican Republic’s GDP would shrink by 0.4 per cent.

Not only will exporters be hit, but also the huge tourism sector and remittance flows…

One possible result of the decline in exports and flows of remittances from the US will be a depreciation of the D.R. peso, as demand for pesos by Americans falls. A weaker peso might make the country’s exports attractive once again, assuming the exchange rate is allowed to adjust on foreign exchange markets. A weaker peso should help slow the decline in the D.R.’s exports to the US, at least until new competition emerges, perhaps elsewhere in Asia, maybe even from Africa or other Latin American countries.

In all likelihood, given the increased competition from Asian textile manufacturers, continued economic growth in the Dominican Republic will depend on the country’s ability to educate and train its workforce to adapt to a more capital, technology and information-based economy, which, if successful, will eventually lead to rising incomes and higher standards of living for the people of the this rising Caribbean nation.

Comparative advantages evolve with the emergence of new competition among developing and developed countries. The negative impacts this evolution has on a particular economy can be managed if wise policy actions are taken to assure a country’s workforce is educated and trained to participate in tomorrow’s economy, rather than yesterday’s or today’s.

How do Chinese granite quarries and a decline in the US death threaten a family business in rural Vermont?

Listen and find out…

 

 Chinese headstones [4:09m]: Play Now | Play in Popup | Download

Source: NPR Economy Podcast, 2/29/2008 

You Are What You Spend - New York Times

Fact: The richest 20% of Americans earn 15 times the income of the bottom 20%.

Fact: The richest 20% of Americans only consumer 4 times as much as the poorest 20%.

Question: Why don’t the richest 20% consume 15 times as much as the poorest 20%?

The author of this NYT opinion piece claims that the gap between America’s rich and poor is not as stark as the income figures suggest. While before tax income of the top 20% is around $150,000, the poorest 20% earn only around $10,000. Clearly these numbers indicate an enormous income gap in America.

However, when it comes to consumption, the poor consume an average of $18,000 on everything from food to housing to entertainment to transportation. The richest 20%, on the other hand, consume an average of only $70,000, less than half their before-tax income.

So the question is, is standard of living based on our income, or on our consumption? If it’s income, then there’s certainly a huge gap in standard of living between the rich and poor. But if we believe it’s consumption, then the gap is narrowed dramatically. The author claims the latter:

To understand why consumption is a better guideline of economic prosperity than income, it helps to consider how our lives have changed. Nearly all American families now have refrigerators, stoves, color TVs, telephones and radios. Air-conditioners, cars, VCRs or DVD players, microwave ovens, washing machines, clothes dryers and cellphones have reached more than 80 percent of households.

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