Fri, 12 Mar 2004

Gregory Mankiw, II

TM Lutas comments again, saying that I just don't get it:

There are two reasons to create a trade imbalance which impoverishes your people and enriches your partner. One is because you need to put an enormous number of people to work in order to avoid bad political outcomes and the second is to create such a preponderance on debt held by you that you can crash your partner's economy at will and extract a never ending stream of concessions to avoid that fate.

He's conflating two different topics. If you're trying to explain and elucidate, as opposed to convince, you shouldn't do this. Topic #1 is "What do you do when a foreign trader is willing to sell you things for a price substantially below their value to you?" Topic #2 is "What do you do when a foreign trader sells and sells and never buys from you?" I'll address them separately, as they deserve to be treated.

Selling below value

In a certain sense, everyone does this. In a free market, nobody sells something for less than they think it's worth. How does trade, then, occur? Simple: because people value things differently. Anybody who sells something for money values the money more than the thing. Anybody who buys something for money values the thing more than the money.

When can this be a problem? In a free market, it can't. The trouble is when governments interfere with markets, by, for example, fixing exchange rates, by fixing interest rates too low, by allowing slave labor, or by capping wages. In each of these, the government is destroying information about who wants what, and how badly. Another term for that is censorship. (As a side note, I wonder why leftists decry government censorship but allow government interference in markets?)

The trouble with this censorship is that it can lead country A's customers to buy products from country B even though country A can "really" produce the products more cheaply. Some might argue that it's inherently unfair for one country's citizens to be set against another country's citizens. They're right, it is inherently unfair, but the unfairness is created by country B's government against its citizens. They're producing something which is "really" cheaper for country A to produce. Country B's citizens should be left free to produce some other product which they can "really" produce more cheaply.

I put "really" in quotes above because you can't really separate out the actions of a government from the economy of the country. Any government is going to use its power to extract income from the citizens of the country. This inherently distorts the economy. A good government will make sure that it only does things which are good for its citizens in both the long and short terms. I must point out here that a country which elects new caretakers every few years is going to have a hard time maximizing its long-term welfare. In part, the incumbent factor, and bureaucrazy and "Washington insiders" that so many people decry function to mitigate this factor.

From outside a country, it's hard to tell on a market basis if coal is cheap in the country because they have so much of it, or because it's being mined by slave labor. In other words, a free marketplace is going to treat the product as it appears in the marketplace. If a government acts against the interests of its citizens by causing them to produce less than they might, then that is the government that those citizens deserve. This is one of the impacts of economic ignorance that I'm trying to communicate to you, gentle reader

Regardless of the cause of the low price from country B, the producers in country A are going to be priced out of the market. Regardless of the cause, the producers in country A are going to go out of business. While one might regret that the citizens of country B are harmed, and in being harmed, are creating an externality that harms country A, the exact cause is really besides the point. Conditions are such that country B can produce the product cheaper than country A.

TM Lutas's implication that "country A ought to do something" about country B is wrong. All that country A can do is say "thanks for the products" and move on.

Selling and never buying

International trade seems hard to understand, at least judging from the number of people that are confused about it. Bring it back down to the level of the household, and it's much easier to understand. What happens when you buy something? You have to pay money for it. When you sell something? You get money for it. International trade works the same way. When someone in the US buys something from another country, they pay dollars. When someone in the US sells something to another country, they get dollars.

The key complicating factor here is that, in another country, dollars are nothing more than collectible monochrome presidential portraits (and of US presidents, to boot). Dollars are a very widely accepted currency all over the world, but you have to want to buy something. Some countries sell a lot to the US, in particular Japan and China. These two countries have not been buying products from the USA (or products from other countries who have already bought from the USA and who now need more dollars). Instead, they have been accumulating dollars and buying Treasury Notes.

The point to which TM Lutas was referring is that you have a small number of entities which control those Treasury Notes. They can choose to destroy some of their accumulated wealth by selling those Treasury Notes in large quantities. This has a negative effect on them, but also a negative effect on the USA as well. The USA government is getting its spending money (on the margin) by selling Treasury Notes. If the price it gets for them drops, it has to sell more to get the same amount of money.

In essence, these external borrowers have a doomsday device located in the USA. They can harm our economy by dumping large numbers of Treasury Notes. They can use this leverage to extract political favors. Here's the problem with that threat: it's a paper tiger. They can sell Treasury Notes, but they have to sell them for dollars. The very same reason why they do not sit on dollars would force them to buy something else with the proceeds of the sale of those Treasury Notes. Yes, they could cause some short-term harm, but they are subject to their own internal pressure to do something useful with those dollars. The harm they cause by dumping Treasury Notes will be made up by the benefit caused by whatever else they do with those dollars. There is nothing they can do to eliminate that pressure except to destroy the dollars. That would hurt them more than it would hurt us. We can be confident that they won't do that.

TM Lutas is worrying about a mirage of quicksand.

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