Schumpeter

Free trade, fair trade, or what?

pnrj core principles, critique of neoclassical economics, development economics, public policy , , , , , , , , , , , , , , , , , , , , , , , , ,

JDN 2457271 EDT 11:34.

As I mentioned in an earlier post, almost all economists are opposed to protectionism. In a survey of 264 AEA economists, 87% opposed tariffs to protect US workers against foreign competition.

(By the way, 58% said they usually vote Democrat and only 23% said they usually vote Republican. Given that economists are overwhelmingly middle-age rich White males—only 12% of tenured faculty economists are women and the median income of economists is over $90,000—that’s saying something. Dare I suggest it’s saying that Democrat economic policy is usually better?)

There are a large number of published research papers showing large positive effects of free trade agreements, such as this paper, and this paper, and this paper, and this paper. It’s hard to find any good papers showing any significant negative effects. This is probably why the consensus is so strong; the empirical evidence is overwhelming.

Yet protectionism is very popular among the general public. The majority of both Democrat and Republican voters believe that free trade agreements have harmed the United States. For decades, protectionism has always been the politically popular answer.

To be fair, it’s actually possible to think that free trade harms the US but still support free trade; actually there are some economists who argue that free trade has harmed the US, but has benefited other countries like China and India so much more that it is worth it, making free trade an act of global altruism and good will (for the opposite view, here’s a pretty good article about how “free trade” in principle is often mercantilism in practice, and by no means altruistic). As Krugman talks about, there is some evidence that income inequality in the First World has been exacerbated by globalization—but it’s clearly not the primary reason for rising inequality.

What’s going on here? Are economists ignoring the negative impacts of free trade because it doesn’t fit their elegant mathematical models? Is the general public ignorant of how trade actually works? Does the way free trade works, or its interaction with human psychology, inherently obscure its benefits while emphasizing its harms?

Yes. All of the above.

One of the central mistakes of neoclassical economics is the tendency to over-aggregate. Instead of looking at the impact on individuals, it’s much easier to look at the impact on aggregated abstractions like trade flows and GDP. To some extent this is inevitable—there are simply too many people in the world to keep track of them all. But we need to be aware of what welose when we aggregate, and we need to test the robustness of our theories by applying different models of aggregation (such as comparing “how does this affect Americans” with “how does this affect the First World middle class”).

It is absolutely unambiguous that free trade increases trade flows and GDP, and for small countries these benefits can be mind-bogglingly huge. A key part of the amazing success story of economic development that is Korea is that they dramatically increased their openness to global trade.

The reason for this is absolutely fundamental to economics, and in grasping it in 1776 Adam Smith basically founded the field: Voluntary trade benefits both parties.

As most economists would put it today, comparative advantage leads to Pareto-improving gains from trade. Or as I’d tend to put it, more succinctly yet just as thoroughly based in modern game theory: Trade is nonzero-sum.

When you sell a product to someone, it is because the money they’re offering you is worth more to you than the product—and because the product is worth more to them than the money. You each lose something you value less and gain something you value more—so you are both better off.

This mutual benefit occurs whether you are individuals, corporations, or nations. It’s a fundamental principle of economics that underlies the operation of markets at every scale.

This is what I think most people don’t understand when they say they want to “stop sending jobs overseas”. If by that all you mean is ensuring that there aren’t incentives to offshore and outsource, that’s quite reasonable. Even some degree of incentive to keep businesses in the US might make sense, to avoid a race-to-the-bottom in global wages. But I get the sense that it is more than this, that people have a general notion that jobs are zero-sum and if we hire a million people in China that means a million people must lose their jobs in the US. This is not simply wrong, it is fundamentally wrong; it misses the entire point of economics. If there is one core principle that defines economics, I think it would be that the universe is nonzero-sum; gains for some can also be gains for others. There is not a fixed amount of stuff in the world that we distribute; we can make more stuff. Handled properly, a trade that results in a million people hired in China can mean an extra million people hired in the US.

Once you introduce a competitive market, things get more complicated, because there aren’t just winners—there are also losers. When you have competitors, someone can buy from them instead of you, and the two of them benefit, but you are harmed. By the standard methods of calculating benefits and harms (which admittedly leave much to be desired), we can show quite clearly that in general, on average, the benefits outweigh the harms.

But of course we don’t live “in general, on average”. Despite the overwhelming, unambiguous benefit to the economy as a whole, there is some evidence that free trade can produce a good deal of harm to specific individuals.

Suppose you live in the US and your job is to assemble iPads. You’re good at it, you like it, it pays pretty well. But now Apple says that they want to “reduce labor costs” (they are in fact doing nothing of the sort; to really reduce labor costs in a deep economic sense you’d have to make work easier, more productive, or more fun—the wage and the cost are fundamentally different things), so they outsource production to Foxconn in China, who pay wages 1/30 of what you were being paid.

The net result of this change to the economy as a whole is almost certainly positive—the price of iPads goes down, we all get to have iPads. (There’s a meme going around claiming that the price of an iPad would be almost $15,000 if it were made in the US; no, it would cost about $1000 even if our productivity were no higher and Apple could keep their current profit margin intact, both of which are clearly overestimates. But since it’s currently selling for about $500, that’s still a big difference.) Apple makes more profits, which is why they did it—and we do have to count that in our GDP. Most importantly, workers in China get employed in safe, high-skill jobs instead of working in coal mines, subsistence farming, or turning to drugs and prostitution. More stuff, more profits, better jobs for some of the world’s poorest workers. These are all good things, and overall they outweigh the harm of you losing your job.

Well, from a global perspective, anyway. I doubt they outweigh the harm from your perspective. You still lost a good job; you’re now unemployed, and may have skills so specific that they can’t be transferred to anything else. You’ll need to retrain, which means going back to school or else finding one of those rare far-sighted companies that actually trains their workers. Since the social welfare system in the US is such a quagmire of nonsensical programs, you may be ineligible for support, or eligible in theory and unable to actually get it in practice. (Recently I got a notice from Medicaid that I need to prove again that my income is sufficiently low. Apparently it’s because I got hired at a temporary web development gig, which paid me a whopping $700 over a few weeks—why, that’s almost the per-capita GDP of Ghana, so clearly I am a high-roller who doesn’t need help affording health insurance. I wonder how much they spend sending out these notices.)

If we had a basic income—I know I harp on this a lot, but seriously, it solves almost every economic problem you can think of—losing your job wouldn’t make you feel so desperate, and owning a share in GDP would mean that the rising tide actually would lift all boats. This might make free trade more popular.

But even with ideal policies (which we certainly do not have), the fact remains that human beings are loss-averse. We care more about losses than we do about gains. The pain you feel from losing $100 is about the same as the joy you feel from gaining $200. The pain you feel from losing your job is about twice as intense as the joy you feel from finding a new one.

Because of loss aversion, the constant churn of innovation and change, the “creative destruction” that Schumpeter considered the defining advantage of capitalism—well, it hurts. The constant change and uncertainty is painful, and we want to run away from it.

But the truth is, we can’t. There’s no way to stop the change in the global economy, and most of our attempts to insulate ourselves from it only end up hurting us more. This, I think, is the fundamental reason why protectionism is popular among the general public but not economists: The general public sees protectionism as a way of holding onto the past, while economists recognize that it is simply a way of damaging the future. That constant churning of people gaining and losing jobs isn’t a bug, it’s a feature—it’s the reason that capitalism is so efficient in the first place.

There are a few ways we can reduce the pain of this churning, but we need to focus on that—reducing the pain—rather than trying to stop the churning itself. We should provide social welfare programs that allow people to survive while they are unemployed. We should use active labor market policies to train new workers and match them with good jobs. We may even want to provide some sort of subsidy or incentive to companies that don’t outsource—a small one, to make sure they don’t do so needlessly, but not a large one, so they’ll still do it when it’s actually necessary.

But the one thing we must not do is stop creating jobs overseas. And yes, that is what we are doing, creating jobs. We are not sending jobs that already exist, we are creating new ones. In the short run we also destroy some jobs here, but if we do it right we can replace them—and usually we do okay.

If we stop creating jobs in India and China and around the world, millions of people will starve.

Yes, it is as stark as that. Millions of lives depend upon continued open trade. We in the United States are a manufacturing, technological and agricultural superpower—we could wall ourselves off from the world and only see a few percentage points shaved off of GDP. But a country like Nicaragua or Ghana or Vietnam doesn’t have that option; if they cut off trade, people start dying.

This is actually the main reason why our trade agreements are often so unfair; we are in by far the stronger bargaining position, so we can make them cut their tariffs on textiles even as we maintain our subsidies on agriculture. We are Mr. Bumble dishing out gruel and they are Oliver Twist begging for another bite.

We can’t afford to stop free trade. We can’t even afford to significantly slow it down. A global economy is the best hope we have for global peace and global prosperity.

That is not to say that we should leave trade completely unregulated; trade policy can and should be used to enforce human rights standards. That enormous asymmetry in bargaining power doesn’t have to be used to maximize profits; it can be used to advance human rights.

This is not as simple as saying we should never trade with nations that have bad human rights records, by the way. First of all that would require we cut off Saudi Arabia and China, which is totally unrealistic and would impoverish millions of people; second it doesn’t actually solve the problem. Instead we should use sanctions, tariffs, and trade agreements to provide incentives to improve human rights, rewarding governments that do and punishing governments that don’t. We could have a sliding tariff that decreases every time you show improvement in human rights standards. Think of it like behavioral reinforcement; reward good behavior and you’ll get more of it.

We do need to have sweatshops—but as Krugman has come around to realizing, we can make sweatshops safer. We can put pressure on other countries to treat their workers better, pay them more—and actually make the global economy more efficient, because right now their wages are held down below the efficient level by the power that corporations wield over them. We should not demand that they pay the same they would here in the First World—that’s totally unrealistic, given the difference in productivity—but we should demand that they pay what their workers actually deserve.

Similar incentives should apply to individual corporations, which these days are as powerful as some governments. For example, as part of a zero-tolerance program against forced labor, any company caught using or outsourcing to forced labor should have its profits garnished for damages and the executives who made the decision imprisoned. Sometimes #Scandinaviaisnotbetter; IKEA was involved in such outsourcing during the Cold War, and it is currently being litigated just how much they knew and what they could have done about it. If they knew and did nothing, some IKEA executive should be going to prison. If that seems extreme, let me remind you what they did: They used slaves.

My standard for penalizing human rights violations, whether by corporations or governments, is basically like this: Follow the decision-making up the chain of command, stopping only when the next-higher executive can clearly show to the preponderance of evidence that they were kept out of the loop. If no executive can provide sufficient evidence, the highest-ranking executive at the time the crime was committed will be held responsible. If you don’t want to be held responsible for crimes committed by people who work for you, it’s your responsibility to bring them to justice. Negligence in oversight will not be exonerating because you didn’t know; it will be incriminating because you should have. When your bank is caught laundering money for terrorists and drug lords, it isn’t enough to have your chief of compliance resign; he should be imprisoned—and if his superiors knew about it, so should they.

In fact maybe the focus should be on corporations, because we have the legal authority to do that. When dealing with other countries, there are United Nations rules and simply the de facto power of large trade flows and national standing armies. With Saudi Arabia or China, there’s a very real chance that they’ll simply tell us where we can shove it; but if we get that same kind of response from HSBC or Goldman Sachs (which, actually, we did), we can start taking out handcuffs (that, we did not do—but I think we should have).

We can also use consumer pressure to change the behavior of corporations, such as Fair Trade. There’s some debate about just how effective these things are, but the comparison that is often made between Fair Trade and tariffs is ridiculous; this is a change in consumer behavior, not a change in government policy. There is absolutely no loss of freedom. Choosing not to buy something does not constitute coercion against someone else. Maybe there are more efficient ways to spend money (like donating it directly to the best global development charities), but if you start going down that road you quickly turn into Peter Singer and start saying that wearing nicer shoes means you’re committing murder. By all means, let’s empirically study different methods of fighting poverty and focus on the ones that work best; but there’s a perverse smugness to criticisms of Fair Trade that says to me this isn’t actually about that at all. Instead, I think most people who criticize Fair Trade don’t support the idea of altruism at all—they’re far-right Randian libertarians who honestly believe that selfishness is the highest form of human morality. (It is in fact the second-lowest, according to Kohlberg.) Maybe it will turn out that Fair Trade is actually ineffective at fighting poverty, but it’s clear that an unregulated free market isn’t good at that either. Those aren’t the only options, and the best way to find out which methods work is to give them a try. Consumer pressure clearly can work in some cases, and it’s a low-cost zero-regulation solution. They say the road to Hell is paved with good intentions—but would you rather we have bad intentions instead?

By these two methods we could send a clear message to multinational corporations that if they want to do business in the US—and trust me, they do—they have to meet certain standards of human rights. This in turn will make those corporations put pressure on their suppliers, all the way down the supply chain, to uphold the standards lest they lose their contracts. With some companies upholding labor standards in Third World countries, others will be forced to, as workers refuse to work for companies that don’t. This could make life better for many millions of people.

But this whole plan only works on one condition: We need to have trade.

The sunk-cost fallacy

pnrj heuristics and biases , , , , , , , , , , , , ,

JDN 2457075 EST 14:46.

I am back on Eastern Time once again, because we just finished our 3600-km road trek from Long Beach to Ann Arbor. I seem to move an awful lot; this makes me a bit like Schumpeter, who moved an average of every two years his whole adult life. Schumpeter and I have much in common, in fact, though I have no particular interest in horses.

Today’s topic is the sunk-cost fallacy, which was particularly salient as I had to box up all my things for the move. There were many items that I ended up having to throw away because it wasn’t worth moving them—but this was always painful, because I couldn’t help but think of all the work or money I had put into them. I threw away craft projects I had spent hours working on and collections of bottlecaps I had gathered over years—because I couldn’t think of when I’d use them, and ultimately the question isn’t how hard they were to make in the past, it’s what they’ll be useful for in the future. But each time it hurt, like I was giving up a little part of myself.

That’s the sunk-cost fallacy in a nutshell: Instead of considering whether it will be useful to us later and thus worth having around, we naturally tend to consider the effort that went into getting it. Instead of making our decisions based on the future, we make them based on the past.

Come to think of it, the entire Marxist labor theory of value is basically one gigantic sunk-cost fallacy: Instead of caring about the usefulness of a product—the mainstream utility theory of value—we are supposed to care about the labor that went into making it. To see why this is wrong, imagine someone spends 10,000 hours carving meaningless symbols into a rock, and someone else spends 10 minutes working with chemicals but somehow figures out how to cure pancreatic cancer. Which one would you pay more for—particularly if you had pancreatic cancer?

This is one of the most common irrational behaviors humans do, and it’s worth considering why that might be. Most people commit the sunk-cost fallacy on a daily basis, and even those of us who are aware of it will still fall into it if we aren’t careful.

This often seems to come from a fear of being wasteful; I don’t know of any data on this, but my hunch is that the more environmentalist you are, the more often you tend to run into the sunk-cost fallacy. You feel particularly bad wasting things when you are conscious of the damage that waste does to our planetary ecosystem. (Which is not to say that you should not be environmentalist; on the contrary, most of us should be a great deal more environmentalist than we are. The negative externalities of environmental degradation are almost unimaginably enormous—climate change already kills 150,000 people every year and is projected to kill tens if not hundreds of millions people over the 21st century.)

I think sunk-cost fallacy is involved in a lot of labor regulations as well. Most countries have employment protection legislation that makes it difficult to fire people for various reasons, ranging from the basically reasonable (discrimination against women and racial minorities) to the totally absurd (in some countries you can’t even fire people for being incompetent). These sorts of regulations are often quite popular, because people really don’t like the idea of losing their jobs. When faced with the possibility of losing your job, you should be thinking about what your future options are; but many people spend a lot of time thinking about the past effort they put into this one. I think there is also some endowment effect and loss aversion at work as well: You value your job more simply because you already have it, so you don’t want to lose it even for something better.

Yet these regulations are widely regarded by economists as inefficient; and for once I am inclined to agree. While I certainly don’t want people being fired frivolously or for discriminatory reasons, sometimes companies really do need to lay off workers because there simply isn’t enough demand for their products. When a factory closes down, we think about the jobs that are lost—but we don’t think about the better jobs they can now do instead.

I favor a system like what they have in Denmark (I’m popularizing a hashtag about this sort of thing: #Scandinaviaisbetter): We don’t try to protect your job, we try to protect you. Instead of regulations that make it hard to fire people, Denmark has a generous unemployment insurance system, strong social welfare policies, and active labor market policies that help people retrain and find new and better jobs. One thing I think Denmark might want to consider is restrictions on cyclical layoffs—in a recession there is pressure to lay off workers, but that can create a vicious cycle that makes recessions worse. Denmark was hit considerably harder by the Great Recession than France, for example; where France’s unemployment rose from 7.5% to 9.6%, Denmark’s rose from an astonishing 3.1% all the way up to 7.6%.

Then again, sometimes what looks like a sunk-cost fallacy actually isn’t—and I think this gives us insight into how we might have evolved such an apparently silly heuristic in the first place.

Why would you care about what you did in the past when deciding what to do in the future? Well there’s one reason in particular: Credible commitment. There are many cases in life where you’d like to be able to plan to do something in the future, but when the time comes to actually do it you’ll be tempted not to follow through.

This sort of thing happens all the time: When you take out a loan, you plan to pay it back—but when you need to actually make payments it sure would be nice if you didn’t have to. If you’re trying to slim down, you go on a diet—but doesn’t that cookie look delicious? You know you should quit smoking for your health—but what’s one more cigarette, really? When you get married, you promise to be faithful—but then sometimes someone else comes along who seems so enticing! Your term paper is due in two weeks, so you really should get working on it—but your friends are going out for drinks tonight, why not start the paper tomorrow?

Our true long-term interests are often misaligned with our short-term temptations. This often happens because of hyperbolic discounting, which is a bit technical; but the basic idea is that you tend to rate the importance of an event in inverse proportion to its distance in time. That turns out to be irrational, because as you get closer to the event, your valuations will change disproportionately. The optimal rational choice would be exponential discounting, where you value each successive moment a fixed percentage less than the last—since that percentage doesn’t change, your valuations will always stay in line with one another. But basically nobody really uses exponential discounting in real life.

We can see this vividly in experiments: If we ask people whether they would you rather receive $100 today, or $110 a week from now, they often go with $100 today. But if you ask them whether they would rather receive $100 in 52 weeks or $110 in 53 weeks, almost everyone chooses the $110. The value of a week apparently depends on how far away it is! (The $110 is clearly the rational choice by the way. Discounting 10% per week makes no sense at all—unless you literally believe that $1,000 today is as good as $140,000 a year from now.)

To solve this problem, it can be advantageous to make commitments—either enforced by direct measures such as legal penalties, or even simply by making promises that we feel guilty breaking. That’s why cold turkey is often the most effective way to quit a drug. Physiologically that makes no sense, because gradual cessation clearly does reduce withdrawal symptoms. But psychologically it does, because cold turkey allows you to make a hardline commitment to never again touch the stuff. The majority of successful smokers report using cold turkey, though there is still ongoing research on whether properly-orchestrated gradual reduction can be more effective. Likewise, vague notions like “I’ll eat better and exercise more” are virtually useless, while specific prescriptions like “I will do 20 minutes of exercise every day and stop eating red meat” are much more effective—the latter allows you to make a promise to yourself that can be broken, and since you feel bad breaking it you are motivated to keep it.

In the presence of such commitments, the past does matter, at least insofar as you made commitments to yourself or others in the past. If you promised never to smoke another cigarette, or never to cheat on your wife, or never to eat meat again, you actually have a good reason—and a good chance—to never do those things. This is easy to confuse with a sunk cost; when you think about the 20 years you’ve been married or the 10 years you’ve been vegetarian, you might be thinking of the sunk cost you’ve incurred over that time, or you might be thinking of the promises you’ve made and kept to yourself and others. In the former case you are irrationally committing a sunk-cost fallacy; in the latter you are rationally upholding a credible commitment.

This is most likely why we evolved in such a way as to commit sunk-cost fallacies. The ability to enforce commitments on ourselves and others was so important that it was worth it to overcompensate and sometimes let us care about sunk costs. Because commitments and sunk costs are often difficult to distinguish, it would have been more costly to evolve better ways of distinguish them than it was to simply make the mistake.

Perhaps people who are outraged by being laid off aren’t actually committing a sunk-cost fallacy at all; perhaps they are instead assuming the existence of a commitment where none exists. “I gave this company 20 good years, and now they’re getting rid of me?” But the truth is, you gave the company nothing. They never committed to keeping you (unless they signed a contract, but that’s different; if they are violating a contract, of course they should be penalized for that). They made you a trade, and when that trade ceases to be advantageous they will stop making it. Corporations don’t think of themselves as having any moral obligations whatsoever; they exist only to make profit. It is certainly debatable whether it was a good idea to set up corporations in this way; but unless and until we change that system it is important to keep it in mind. You will almost never see a corporation do something out of kindness or moral obligation; that’s simply not how corporations work. At best, they do nice things to enhance their brand reputation (Starbucks, Whole Foods, Microsoft, Disney, Costco). Some don’t even bother doing that, letting people hate as long as they continue to buy (Walmart, BP, DeBeers). Actually the former model seems to be more successful lately, which bodes well for the future; but be careful to recognize that few if any of these corporations are genuinely doing it out of the goodness of their hearts. Human beings are often altruistic; corporations are specifically designed not to be.

And there were some things I did promise myself I would keep—like old photos and notebooks that I want to keep as memories—so those went in boxes. Other things were obviously still useful—clothes, furniture, books. But for the rest? It was painful, but I thought about what I could realistically use them for, and if I couldn’t think of anything, they went into the trash.