Economic Errors

Money and Wealth

when you accumulate wealth, where do you that that comes from?? other people losing money is you gaining money, that’s just how it works. what’s more, even if it was possible for everyone to profit, that would just cause inflation that makes that profit defunct (Post on X)

One of the difficulties in teaching economics is that the students believe they already understand it. They are frequently wrong, not in the sense of missing the fine points but of believing plausible sounding nonsense. That post illustrates one version. If you imagine wealth as money, stacks of hundred dollar bills, the logic is clear. Given a fixed number of hundred dollar bills, if one person gains, gets more, another person must lose. If someone, the Treasury or a counterfeiter, prints more hundred dollar bills, more money is now chasing the same amount of goods, pushing prices up: inflation.

But wealth is not always, not even usually, money. A millionaire is not someone with a stack of 50,000 twenty dollar bills. He probably isn’t someone with a million dollars in his bank account. Most wealthy people hold most of their wealth in forms such as land, buildings, stocks and bonds. If a company I own stock in does well its value increases, which does not require anyone else’s stock to go down.

One way of seeing why the poster’s intuition is wrong is to consider a society of self-sufficient farmers. If there is a good harvest this year everyone gets richer, measured not in stacks of currency but bushels of wheat, sides of beef. To see how wildly wrong it is, consider how much richer we are than people in the past. The average real income of the globe through most of history was the equivalent of four or five dollars a day, about one twentieth to one thirtieth of the average in the US at present. Over recent centuries world population has increased a great deal. If there was only a fixed amount of wealth to be distributed, income per capita should have gone down. In fact it went up.

Trade and Jobs

International trade is another area where common views of economics, common not only among commenters online but among newspapers and politicians, are wrong. The clearest evidence that the usual pictures doesn’t make sense is the common claim that the reason some foreign country, currently China, can make things cheaper than we can is that their workers will work for less. It does not occur to most people making that claim that Chinese workers are paid in Yuan, American workers in dollars; until you know the exchange rate between the two there is no way of comparing wages in the two countries. Current Chinese wages would be much higher than US wages if a Yuan exchanged for a dollar, if it exchanged for a cent much lower. An essential first step in understanding why we can get some things less expensively by importing them than by making them ourselves is to ask what determines the exchange rate between our currency and theirs.

The exchange rate is a price, the price of dollars in Yuan, and like other prices is determined by supply and demand. Its equilibrium level is that price at which people buying dollars for yuan want to buy as many dollars as people selling dollars want to sell. If the only reason to trade Yuan for dollars was to buy US goods and import them to China and the only reason to trade dollars for Yuan to buy Chinese goods and import them to the US, the exchange rate would automatically make the dollar value of each country’s exports equal to that of its imports. The existence of a US trade deficit means that someone is buying dollars for some purpose other than to buy US goods and take them out of the country, usually to buy US capital assets such as government securities, shares of stock or land. Since what is purchased does not leave the country it does not get included in the trade balance. Number of dollars sold equals number of dollars bought, as it must, but imports do not equal exports.

The usual arguments for tariffs ignore all of this, implicitly assume that the only direct effect of a tariff is to make foreign goods more expensive to Americans, decreasing how much we import, increasing the demand for goods made in the US and hence for US labor. The usual argument against, implicit in the term “trade war,” is that our trading partners will retaliate by imposing tariffs on our exports.

They might, but they don’t have to. As long as there is no change in the foreign demand for US assets, the exchange rate will automatically do it for them. Fewer imports from China to the US mean fewer dollars offered in exchange for Yuan to buy them with, which means a smaller supply of dollars on the dollar/Yuan market, so the price of the dollar shifts up. Dollars are used to buy US goods, so US exports are now more expensive, so Chinese buy fewer of them. Imports are down, exports are down, and as long as nothing changes the number of dollars bought to be used to buy US capital assets the trade deficit is unchanged. More Americans are being employed to make import competing goods, fewer are being employed to make export goods.

In order to figure out the effect of a tariff on the demand for labor you must answer three questions:

1. How does the ratio of price to labor cost compare between export industries and import competing industries? If the former sell a dollar less and the latter a dollar more, does the demand for labor go up or down.

The same question can be asked of particular kinds of labor. An argument I have seen from supporters of tariffs is that the export industries employ high paid programmers, the import competing industries less highly paid factory workers, so an auto tariff benefits the latter at the cost of the former, which some consider a good thing. To actually support that claim would require more detailed evidence than I have seen offered — software is an export industry, but so is agriculture. But it is at least logically possible.

2. Does the tariff affect the foreign demand for US capital assets and if so in which direction? If foreign investment in the US goes down, so will the trade deficit, since they are two names for the same thing; exports will decline by less than imports. If investment goes up so will the deficit.

3. Is more or less of a foreign dollar invested in the US spent on labor than of a dollar spent buying US exports? Investment in the US might mean buying bonds to finance building a factory or a highway. It might mean buying T-Bills, lending money to the federal government. It might mean buying a share of stock or a federal security or a piece of real estate from its American owner, in which case the question becomes what he does with the money. If the effect on the demand for labor of a dollar invested is the same as the effect of a dollar spent on imports then the answer to question 2 doesn’t matter. If not, it does.

Two more points are worth making. The first is that if the objective is to reduce the trade deficit, a more direct way of doing it is to reduce the budget deficit. The more money the federal government has to borrow, the higher the interest rate it has to pay. The higher the interest rate on money invested in the US, the more attractive such investment is. The more dollars are spent on buying US capital assets the fewer are available to buy US exports and the greater the trade deficit.

The second is that I have only been looking at the effect of tariffs on the demand for US labor. I have done so because the rhetoric supporting tariffs is put mostly in terms of creating American jobs. As I hope I have shown there is no particular reason to expect tariffs to do so. They might increase the demand for labor, decrease it, or leave it unaffected, depending on the answers to the sort of detailed questions covered in 1-3 above. My point so far is not that tariffs are good or bad but that the usual arguments for them depend on not understanding, not thinking through, the logic of foreign trade, are made by people whose confident view of that issue is almost as far divorced from reality as the view of wealth expressed by the poster on X I quoted at the beginning of this post.

I am, like most economists, a free trader, but the reason has little to do with the effect of tariffs on the demand for labor. Standard economic arguments show that imposing a tariff, under most but not all circumstances, makes the country that imposes it worse off, defined in terms of the concept of economic efficiency that I discussed in an earlier post.There are problems with that definition, discussed in the same post, making it logically possible for a decrease in economic efficiency to be a desirable change measured by some vaguer but more appealing criterion such as total utility, but I see no reason to expect it.¹

Sources of Error

Why, in these cases and others, do people believe things that are not true, that can be shown not to be true by thinking through their internal logic? One reason is that people like to think highly of themselves, hence want to believe they understand things. If their beliefs have little effect on what they do, if false beliefs produce little negative feedback, it is easier to believe simple ideas and never think them through, pleasanter to believe things that support your self-image or political commitments.

A second and related reason is that false ideas are sometimes easier to understand than true ones. We all are familiar with wealth in the form of money in our wallets. It is easier to think about the logic of the distribution of wealth and income by imagining that it is just the distribution of currency writ large. It also makes your view of your own unimpressive level of wealth less depressing if you imagine that those who have more got it at the expense of someone else, possibly you.

We are all familiar with economic interactions within a single country, where wages can be compared without worrying about exchange rates. Working out the logic of trade between countries is, as I may have convinced you, a harder problem. Why bother when the simple picture lets you believe that a tariff both protects American workers against unfair competition and protects Chinese workers against exploitation?

False beliefs about trade are more common than the confusion of currency with wealth. One reason is that while tariffs are usually a net loss economically they are often a net gain politically, a way of benefiting a concentrated and organized interest group such as the auto industry at the expense of a dispersed and disorganized group, all purchasers of cars and all producers of export goods. A second reason is that the trade war model, tariffs as a weapon, benefiting us at the expense of our trading partners, fits the pattern of conflict with which we are already familiar in other contexts. It also explains the pattern of trade negotiations. It seems odd for countries to bargain over each agreeing to stop hurting itself if the other does. The observed pattern makes sense only if you realize that what hurts the country may still benefit its political leaders — and they are the ones doing the bargaining.

1. For other arguments for tariffs that do not depend on economic ignorance, see this post.