Thursday, July 24, 2014

Long-Term Budget Deficits

Much of the sound and fury about U.S. budget deficits involves what should happen in the next year or so. Of course, short-run decisions about red ink do matter, and have a way of bleeding over into long-term decisions. But this focus on the short-term also risks missing the longer-term context of how U.S. government deficits and debt have changed since the Great Recession started in 2007, and where they are headed in the next couple of decades. For this purpose, my go-to starting point is "The 2014
Long-Term Budget Outlook" published  this month by the Congressional Budget Office.

Here's an overview of the basic CBO budget forecast, which shows some of the costs of the current path, but as I will explain, is probably to optimistic. This "extended baseline" forecast is based on existing law, including any ways in which the law requires future changes: for example, if current law requires a tax to be changed a few years in the future, that future change is included in this forecast. This figure shows government spending and revenues as a share of GDP. The gap between them doesn't look large, but remember that with the US GDP now in the range of $17 trillion, a gap of 1 percentage point is a deficit of $170 billion.

I'd draw two lessons from this figure. First, you can see the large jump in accumulated federal debt during the Great Recession, from less than 40% of GDP in 2008 to 74% of GDP in 2014. Federal debt relative to GDP is now at the second-highest level in US history, trailing only the explosion of debt used to finance the fighting of World War II. Second, federal debt in the longer term is projected to rise more slowly in the next few years, but to keep rising to 106% of GDP by 2039--which would be equal to the debt/GDP level in 1946.

Here's a figure showing the government debt/GDP ratio throughout U.S. history. You can see the previous debt/GDP peaks at the Revolutionary War, the Civil War, World War I, the Great Depression, World War II, and the 1980s and early 1990s. According to the CBO, the U.S. government is currently on autopilot to set an unwelcome new record.

The discussion of the effects of large budget deficits often seems to be an argument over the possibility of catastrophic debt overload and the risk of Greek-style or Argentinian-style debt defaults. But arguing over catastrophe misses the real and near-term costs of the higher budget deficits. The CBO lists three of them.

First, the current high level of government debt, and the projections for the next 25 years, mean that the U.S. government lacks fiscal flexibility. Before previous debt spikes, we had started with a relatively low debt/GDP ratio, and so we had room to borrow as needed. But with the debt/GDP ratio already at 74% and rising, we now lack that flexibility. I sometimes say that the U.S. could afford to fight the Great Recession with large budget deficits. But having done so, it wouldn't be nearly as easy to enact a similar deficit boost in the future if economic or foreign policy considerations might seem to warrant it.

Second, the current spending patterns of the U.S. government are starting to crowd out everything except health care, Social Security, and interest payments. The bottom three lines on this graph show rising government spending on major health care programs (like Medicare and Medicaid), on Social Security, and on interest payments on past borrowing. The top dark green line shows spending on everything else the government does, falling steadily as a share of GDP over time. Again, this is the projection based on current law.

Third, large government borrowing means less funding is available for private investment. CBO writes: "Large federal budget deficits over the long term would reduce investment, resulting in lower national income and higher interest rates than would otherwise occur. Increased government borrowing would cause a larger share of the savings potentially available for investment to be used for purchasing government securities, such as Treasury bonds. Those purchases would crowd out investment in capital goods—factories and computers, for example—which makes workers more productive. Because wages are determined mainly by workers’ productivity, the reduction in investment would reduce
wages as well, lessening people’s incentive to work."

These long-run dangers don't mean that an abrupt large reduction in budget deficits should happen immediately, when the economy is still struggling to generate a respectable recovery. But it does mean that we should be thinking seriously about small changes for the near future that will phase into larger effects over the next couple of decades.

I said earlier that this scenario is optimistic. I don't mean that the CBO has biased its baseline estimates: indeed, the report goes through in some detail the underlying projections behind these numbers about productivity and economic growth, health care costs and life expectancy, and interest rates (which affect the costs of financing government borrowing). But the baseline estimate, by law and custom, focuses on what is specifically in the law. This seemingly sensible rule offers a temptation to politicians, who can enact spending cuts or tax increases that aren't scheduled to start for five or 10 years. These proposals make the projected deficits look better over the next five or ten years, and then the policies can be changed later.

Thus, CBO calculates an "alternative fiscal scenario," in which it sets aside some of these spending and tax changes that are scheduled to take effect in five years or ten years or never. Remember that the extended baseline scenario projected that the debt/GDP ratio would be 106% by 2039. In the alternative fiscal scenario, the debt-GDP ratio is projected to reach 183% of GDP by 2039. As the report notes: "CBO’s extended alternative fiscal scenario is based on the assumptions that certain policies that are now in place but are scheduled to change under current law will be continued and that some provisions of law that might be difficult to sustain for a long period will be modified. The scenario, therefore, captures what some analysts might consider to be current policies, as opposed to
current laws."

What changes are assumed in the alternative fiscal scenario? As one example, the category of "Other Non-Interest Spending" in the chart above does not plummet: "Federal noninterest spending apart from that for Social Security, the major health care programs (net of offsetting receipts), and certain refundable tax credits would rise after 2024 to its average as a percentage of GDP during the past two decades—rather than fall significantly below that level, as it does in the extended baseline."

On the tax side, the usual political trick is to have various tax deductions or credits scheduled too expire in the future, which makes the projected deficit appear lower, except that when the time comes for expiration the tax provisions are renewed again. Thus, the baseline revenue estimates rise from 17.6% of GDP in 2014 to 18.3% of GDP by 2024 and 19.4% of GDP by 2034 (and keep rising after that). In the alternative fiscal scenario," tax revenue rises to 18.1% of GDP, which is "slightly higher than the average of 17.4 percent over the past 40 years," notes the CBO--but then tax revenues don't continue to rise above that level.

My own judgement is that the path of future budget deficits in the next decade or so is likely to lean toward the alternative fiscal scenario. But long before we reach a debt/GDP ratio of 183%, something is going to give. I don't know what will change. But as an old-school economist named Herb Stein used to say, "If something can't go on, it won't."

Wednesday, July 23, 2014

Unemployment and Labor Force Participation: Revisiting the Puzzle

The US unemployment rate has been painfully high in the Great Depression and its aftermath, but the high unemployment rates of the early 1980s look even worse--at least at first glance. However, the 1970s and 1980s were a time when a rising share of the adult population, and especially women, were entering the (paid) labor force, while the last few years are a time when the share of the adult population is in the labor force is declining .  Indeed, it's been a standard concern in the last few years that the official unemployment rate is not capturing the true pain in the labor market, because the official unemployment rate only includes those who are looking for work--not those who have become discouraged and given up looking. What's is the interaction between the unemployment rate and the labor force participation rate telling us?

Here'a figure showing the post-World War II unemployment rate. The monthly peak of the unemployment rate at 10% in October 2009 was second-highest of any post World War II recession, behind the peak of 10.8% in November and December 1982. In addition, from December 1979 to August 1987, a period of almost eight years, the monthly unemployment rate exceeded 6%. More recently, the unemployment rate first rose above 6% in August 2008, and as of June 2014 was at 6.1%. Thus, it's plausible that that the current stretch of monthly unemployment above 6% will last a little more than six years--which is dismal, but still with some way to go before matching the high unemployment rates that prevailed during most of the 1980s.

However, this comparison doesn't feel quite fair. After all, during the 1970s and 1980s, the labor force participation rate (that is, the share of adults who either had jobs or were unemployed and looking for jobs) was rising from 60% to about 67%. Since the start of the Great Recession, the labor force participation rate has fallen from 66% down to about 63%. An unemployment rate falling back below 6% was more comforting in the 1980s, with a rising share of adults working, than it would be in 2014, with a falling share of adults working. Here's a figure showing the labor force participation rate in the post World War II period.

To investigate these issues, the Council of Economic Advisers has just published "The Labor Force Participation Rate Since 2007: Causes and Policy Implications." The rise in the labor force participation rate from about 1960 up through the mid-1990s was driven both by the baby boom generation reaching working age, and the dramatic entry of women into the (paid) labor force. The decline since about 2000 is largely because the rising proportion of women in the labor force levelled off, and the aging of the baby boom generation is raising the number of retirees. Here's a figure from the report showing the labor force participation rate for men and women separately.

The CEA also notes that during every recession, the labor force participation rate tends to fall a little, as some people give up looking for jobs and thus aren't counted as officially "unemployed." After presenting its own analysis, and showing that it fits fairly well with previous studies of the subject, the CEA notes: "Up until the beginning of 2012 the [labor force] participation rate was generally slightly higher than would have been predicted based on the aging trend and the standard business cycle effects. But in the last two years, the participation rate has continued to fall at about the same rate even though the unemployment rate has been declining rapidly."

In other words, the drop in the labor force participation rate up through about 2012 was explainable based on the aging of the population and the common patterns during a recession. (Here's a post from April 2012 that refers to a study making this point.) In this telling, the real puzzle is not why the labor force participation rate fell up to 2012, but why it has continued to fall so quickly since 2012. To explain what is different about the period since 2012, compared with the period after previous recessions, the CEA report focuses most heavily on how long-term unemployment has been different in the aftermath of the Great Recession. For example, here's one figure showing the share of the total unemployed who have been out of work more than 27 weeks. In past recessions, this share peaked at about 20% of the total unemployed. In the Great Recession, the share of long-term unemployed peaked at above 40% of all unemployed, and even now remains at historically high levels. (Here's a post from July 2013 on the legacy of long-term unemployment.)

Another measure of long-term unemployment is the average duration of unemployment. Again, remember that only those who are actually looking for a job are counted as officially unemployed, not those who have become discouraged and stopped looking. In the last few recessions, the average length of unemployment peaked at around 20 weeks. In the Great Recession, it peaked at about 40 weeks, and is still at a discomfitingly high 35 weeks.

The CEA report looks at some other potential reasons for why labor force participation has dropped off, like a rising share of the 16-24 year-old age bracket being in school, and other breakdowns by age, gender and disability status. At least to me, the most important bottom line is not to focus on the somewhat sterile argument of who should "really" be counted as unemployed. After all, the Bureau of Labor Statistics does also collect statistics on "discouraged" workers and "marginally attached" workers. Instead, the key message is that the lower unemployment rate includes a much larger than usual share of long-term unemployed. Waiting for the U.S. economy to re-absorb these workers has not been showing good results. 

Tuesday, July 22, 2014

The Next Wave of Technology?

Many discussions of "technology" and how it will affect jobs and the economy have a tendency to discuss technology as if it is one-dimensional, which is of course an extreme oversimplification. Erik Brynjolfsson, Andrew McAfee, and Michael Spence offer some informed speculation on how they see the course of technology evolving in "New World Order: Labor, Capital, and Ideas in the Power Law Economy," which appears in the July/August 2014 issue of Foreign Affairs (available free, although you may need to register).

Up until now, they argue, the main force of information and communications technology has been to tie the global economy together, so that production could be moved to where it was most cost-effective. As they write: "Technology has sped globalization forward, dramatically lowering communication and transaction costs and moving the world much closer to a single, large global market for labor, capital, and other inputs to production. Even though labor is not fully mobile, the other factors increasingly are. As a result, the various components of global supply chains can move to labor’s location with little friction or cost." 
But looking ahead, they argue that the next wave of technology will not be about relocating production around the globe, but changing the nature of production--and in particular, automating more and more of it. If the previous wave of technology made workers in high-income countries like the U.S. feel that their jobs were being outsourced to China, the next wave is going to make those low-skill workers in repetitive jobs--whether in China or anywhere else--feel that their jobs are being outsources to robots. Brynjolfsson, McAfee, and Spence write:
Even as the globalization story continues, however, an even bigger one is starting to unfold: the story of automation, including artificial intelligence, robotics, 3-D printing, and so on. And this second story is surpassing the first, with some of its greatest effects destined to hit relatively unskilled workers in developing nations.
Visit a factory in China’s Guangdong Province, for example, and you will see thousands of young people working day in and day out on routine, repetitive tasks, such as connecting two parts of a keyboard. Such jobs are rarely, if ever, seen anymore in the United States or the rest of the rich world. But they may not exist for long in China and the rest of the developing world either, for they involve exactly the type of tasks that are easy for robots to do. As intelligent machines become cheaper and more capable, they will increasingly replace human labor, especially in relatively structured environments such as factories and especially for the most routine and repetitive tasks. To put it another way, offshoring is often only a way station on the road to automation.
This will happen even where labor costs are low. Indeed, Foxconn, the Chinese company that assembles iPhones and iPads, employs more than a million low-income workers -- but now, it is supplementing and replacing them with a growing army of robots. So after many manufacturing jobs moved from the United States to China, they appear to be vanishing from China as well. (Reliable data on this transition are hard to come by. Official Chinese figures report a decline of 30 million manufacturing jobs since 1996, or 25 percent of the total, even as manufacturing output has soared by over 70 percent, but part of that drop may reflect revisions in the methods of gathering data.)
If this prediction holds true, what does this mean for the future of jobs and the economy?

1) Outsourcing would become much less common. After all, if most of the cost of production is embodied in capital like robots and 3D printers, then the advantage to cheap labor becomes minimal. Brynjolfsson, McAfee, and Spence write: "As work stops chasing cheap labor, moreover, it will gravitate toward wherever the final market is, since that will add value by shortening delivery times, reducing inventory costs, and the like."

2) For low-income and middle-income countries like China that have thrived on being the workshops and manufacturing centers of the global economy, their jobs and workforce would experience a dislocating wave of change.

3) Some kinds of physical capital are going to plummet in price, like robots, 3D printing, and artificial intelligence doing many more tasks in both manufacturing and services. Especially as robots become capable of building more robots, capital goods will be abundant in a way that will not generate high returns to capital.

4)  So if many workers are going to find their jobs disrupted and many makers of capital equipment are going to find themselves in a brutal competitive battle to reduce price and raise capabilities, who does well in this future economy? For high-income countries like the United States, Brynjolfsson, McAfee, and Spence emphasize that the greatest rewards will go to "people who create new ideas and innovations," in what they refer to as a wave of "superstar-based technical change." For the MBA students at MIT and NYU, where these authors are based, this probably qualifies as thrilling news. But for the typical worker, the largely unspoken implication seems fairly grim. If you aren't a superstar entrepreneur, then you are likely to be replaced by a robot, or a lower-paid work in another country, or you'll have to scramble against all the other non-superstars to find a job in the remainder of the economy.

This final forecast seems overly grim to me. While I can easily believe that the new waves of technology will continue to create superstar earners, it seems plausible to me that the spread and prevalence of many different new kinds of technology offers opportunities to the typical worker, too. After all, new ideas and innovations, and the process of bringing them to the market, are often the result of a team process--and even being a mid-level but contributing player on such teams, or a key supplier to such teams, can be well-rewarded in the market. More broadly, the question for the workplace of the future is to think about jobs where labor can be a powerful complement to new technologies, and then for the education and training system, employers, and employees to get the skills they need for such jobs. If you would like a little more speculation, one of my early posts on this blog, back on July 25, 2011, was a discussion of "Where Will America's Future Jobs Come From?"

Monday, July 21, 2014

Are Labor Markets Exploitative?

Here's a vivid description from a newspaper article about 150 years ago of why competitive labor markets are necessarily exploitative and immoral.
Where all men are equals, all must be competitors, rivals, enemies, in the struggle for life, trying each to get the better of the other. The rich cheapen the wages of the poor; the poor take advantage of the scarcity of labor, and charge exorbitant prices for their work; or, when labour is abundant, underbid and strangle each other in the effort to gain employment. Where any man engaged in business in free society to act upon the principle of the Golden Rule--doing unto others as he would that they should do unto him--his certain ruin would be the consequence.
Especially if you are predisposed to feel some sympathy with this line of argument, you will be intrigued to know that it's from a pro-slavery essay that appeared in the Richmond (Virginia) Examiner, July 17, 1861, as quoted in Fighting Words, a 2004 book by Andrew S. Coopersmith (pp. 49-50). Here's the full passage: 
Christian morality is impractical in free society and is the natural morality of slave society. Where all men are equals, all must be competitors, rivals, enemies, in the struggle for life, trying each to get the better of the other. The rich cheapen the wages of the poor; the poor take advantage of the scarcity of labor, and charge exorbitant prices for their work; or, when labour is abundant, underbid and strangle each other in the effort to gain employment. Where any man engaged in business in free society to act upon the principle of the Golden Rule--doing unto others as he would that they should do unto him--his certain ruin would be the consequence.

"Every man for himself'" is the necessary morality of such society, and that is the negation of Christian morality. . . On the other hand, in slave society, . . .it is in general, easy and profitable to do unto others as we would that they should to unto us. There is no competition, no clashing of interests within the family circle, composed of parents, master, husband, children and slaves. . . . When the master punishes his child or his slave for misconduct he obeys the golden rule just as strictly as when he feeds and clothes them. Were the parent to set his chidden free at fifteen years of age to get their living in the world, he would be guilty of crime; and as negroes never become more provident or intellectual than white children of fifteen, it is equally criminal to emancipate them. We are obeying the golden rule in retaining them in bondage, taking care of them in health and sickness, in old age and infancy, and in compelling them to labor. . . .

'Tis the interest of masters to take good care of their slaves, and not cheat them out of their wages, as Northern bosses cheat and drive free labourers. Slaves are most profitable when best treated., free labourers most profitable when worst treated and most defrauded. Hence the relation of the master and slave is a kindly and Christian one; that of free laborer and employer a selfish and inimical one. It is in the interest of the slave to fulfill his duties to his master; for he thereby elicits his attachment, and the better enables him to provide for his (the slave's) wants. Study and analyze as long as [you] please the relations of men . . . in a slave society, and they will be found to be Christian, humane and affectionate, whilst those of free society are anti-Christian, competitive and antagonistic.
Of course, the fact that a point of view has some appalling allies doesn't make it incorrect. Most points of view, from all perspectives, have some appalling allies. So the fact that slaveholders saw wage labor as exploitative and slavery as moral certainly doesn't prove that wage labor is not exploitative, at least at certain times and places and situations. But it does suggest that before you condemn labor markets as exploitative--especially labor markets that operate in modern high-income societies with democratic governance--you should consider the alternative social mechanisms over time that determined what jobs people would do and how much they would be paid. 

My own views about the value of labor market are closer to those expressed by Nobel laureate Edmund Phelps in an interview with Howard R. Vane and Chris Mulhearn published in 2009 in the Journal of Economic Perspectives. Phelps said: 
I’ve been trying to develop a new justification for capitalism, at least I think it’s new, in which I say that if we’re going to have any possibility of intellectual development we’re going to have to have jobs offering stimulating and challenging opportunities for problem solving, discovery, exploration, and so on. And capitalism, like it or not, has so far been an extraordinary engine for generating creative workplaces in which that sort of personal growth and personal development is possible; perhaps not for everybody but for an appreciable number of people, so if you think that it’s a human right to have that kind of a life, then you have on the face of it a justification for capitalism. There has to be something pretty powerful to overturn or override that.
The questions about when, where, and how paid labor markets can be said to be exploitative aren't going to be settled in a blog post. For a quick sketch of some of the arguments about about how working for wages is either an instrumental act divorced from morality or part of a deeper moral engagement with society and nature, my essay on "Economics and Morality" in the June 2014 issue of Finance and Development offers a starting point.

Note: Thanks to Ann Norman, the Assistant Editor and my general co-conspirator at the Journal of Economic Perspectives, for pointing out the slavery quotation.

Friday, July 18, 2014

Evidence on the Samuelson Conjecture

"The Samuelson Conjecture" sounds a bit like the title of one of those old Robert Ludlum novels (The Bourne Identity, The Parsifal Mosaic, The Aquitaine Progression, The Sigma Protocol, etc.) But among economists, it refers to an article called "Where Ricardo and Mill Rebut and Confirm Arguments of Mainstream Economists Supporting Globalization," written by the great economist Paul Samuelson, and published in the Journal of Economic Perspectives in the Spring 2004 issue. (Full disclosure: I've been Managing Editor of the JEP since the first issue in 1987.)

Samuelson's article won't be a simple read for the uninitiated, but the basic intuition is straightforward.  The Samuelson conjecture starts from the basic insight that international trade is based on differences in productivity levels across industries that are driven by some mixture of natural endowments and past investments in education, physical capital, technology, and the legal and financial infrastructure. But what happens if a high-income and low-income economy start out in different places, but then the low-income economy develops in a way that it converges in education, investment, and technology toward the high-income economy? As the difference between the two economies decreases, the potential for gains from trade between the economies can also decrease. Or to bring this meditation abruptly to the real world, as the economy of China becomes more technologically similar to that of the United States, the standard of living in China undoubtedly rises, but the U.S. economy may suffer because the potential for gains from trade is diminished. Or as Samuelson puts it:
[S]ometimes free trade globalization can convert a technical change abroad into a benefit for both regions; but sometimes a productivity gain in one country can benefit that country alone, while permanently hurting the other country by reducing the gains from trade that are possible between the two countries. ... Historically, U.S. workers used to have kind of a de facto monopoly access to the superlative capitals and know-hows (scientific, engineering and managerial) of the United States. All of us Yankees, so to speak, were born with silver spoons in our mouths—and that importantly explained the historically high U.S. market-clearing real wage rates for (among others) janitors, house helpers, small business owners and so forth. However, after World War II, this U.S. know-how and capital began to spread faster away from the United States. That meant that in a real sense foreign educable masses—first in western Europe, then throughout the Pacific Rim—could and did genuinely provide the same kind of competitive pressures on U.S. lower middle class wage earnings that mass migration would have threatened to do. Post-2000 outsourcing is just what ought to have been predictable as far back as 1950. And in accordance with basic economic law, this will only grow in the future 2004–2050 period.
As Samuelson was at some pains to point out, this argument showing one possible theoretical outcome of how gains from trade can change as one country experiences technological development is not a new one; indeed, I often  have pointed out a version of this finding using the simple graphs in an introductory economics class. Samuelson was also at some pains to point out in his 2004 article that the argument didn't show that blocking imports from China was a good idea; after all, if the issue is how to keep gains from trade high, acting to reduce trade would be a peculiar way of accomplishing that goal. But for a few months after the article was published, a string of popular press articles made wildly overblown claims that the great Paul Samuelson had proven that globalization and international trade were harming the U.S. economy.

Theoretical models show what is possible, but empirical evidence shows the size of actual effects. In the American Economics Journal: Macroeconomics, Julian di Giovanni, Andrei A. Levchenko, and Jing Zhang have published "The Global Welfare Impact of China: Trade Integration and Technological Change" (6:3, 153–183). (Unlike the JEP, the AEJ-Macro is not freely available on-line, but many readers will have access through library subscriptions.) The authors do a simulation of the world economy, which is based on productivity estimates for many sectors across 75 countries: "We embed these productivity estimates within a quantitative multi-country, multi-sector model with a number of realistic features, such as multiple factors of production, an explicit nontraded sector, the full specification of input-output linkages between the sectors, and both inter- and intra-industry trade, among others."

The authors then focus on two scenarios for productivity growth in China. In one scenario, all of China's industries grow at the same productivity rate, so that the structure of China's economy remains fundamentally different from that of the U.S. In the other scenario, the productivity rate of China's industries grows in an unbalanced way, so that China's economy evolves in such a way that "China's productivity in every sector becomes a constant ratio of the world frontier."

Given the basic idea of international trade--that is, the economic gains from trade happen when trading across economies with different relative productivity levels across industries--one might expect that if productivity in China becomes more similar to U.S. patterns, then the U.S. economy could suffer from a reduction in the potential for gains from trade. But the simulation results from di Giovanni, Levchenko, and Zhang show the opposite results. For most countries, including the U.S., the gains from trade with China are larger when the patterns of China's productivity growth converges to the U.S. patter. The authors explain.
The sheer size of the Chinese economy and the breathtaking speed of its integration into global trade have led to concerns about the possible negative welfare effects of China’s integration and productivity growth. These concerns correspond to the theoretically possible, though not necessary, outcomes in fully articulated models of international trade, and thus have been taken seriously by economists. However, it is ultimately a quantitative question whether the negative welfare effects of China on its trading partners actually obtain in a calibrated model of the world economy with a realistic production structure, trade costs, and the inherently multilateral nature of international trade. ... With respect to technological change, our results are more surprising: contrary to a well-known [Samuelson] conjecture, the world will actually gain much more in welfare if China’s growth is unbalanced. This is because China’s current pattern of comparative advantage is common in the world, and thus unbalanced growth in China actually makes it more different than the average country.
Of course, one set of empirical simulations is not an unarguable proof, either, and research in this area is sure to continue. But for now, at least, the evidence suggests that Samuelson's (2004) conjecture emphasized a theoretical possibility that does not seem to hold true in a fully articulated quantitative model of world trade, in which the productivity gains in China, in the context of all the countries and trading relationships in the world economy, do redound to the overall benefit of the U.S. economy.

One final thought is that the discussion here focuses on the gains from trade as driven by differences in relative productivity  across countries, and these "Ricardian" models of trade have seen a new surge of importance in recent years. However, since the 1980s there have also been several waves of economic analysis that focused on other gains from international trade. For example, one approach focuses on gains to consumers from having a variety of products available (for example, a variety of models of cars or smartphone). A second approach looks at how international trade adds to the economic pressures that push less-productive firms out of business and provide benefits more productive firms that can sell in world markets. A third approach looks at how trade leads to pressure for innovation, which in turn increases productivity levels.

For a useful starting point to thinking about how the rise of emerging economies like China affect global trade, I recommend a symposium in the Spring 2012 issue of JEP. Gordon H. Hanson starts with "The Rise of Middle Kingdoms: Emerging Economies in Global Trade."  "Gains from Trade when Firms Matter," by Marc J. Melitz and Daniel Trefler, looks at the benefits of trade offers introduction to modern models of trade driven from variety, shifts toward more efficient firms, and technological gains. For an introduction to models of international trade based on by differences in relative productivity across countries--like the model used by di Giovanni, Levchenko, and Zhang--that same has a useful article called "Putting Ricardo to Work," by Jonathan Eaton and Samuel Kortum. Finally, Jonathan Haskel, Robert Z. Lawrence, Edward E.  Leamer, and Matthew J. Slaughter look at "Globalization and U.S. Wages: Modifying  Classic Theory to Explain Recent Facts." 

Thursday, July 17, 2014

World Trade by Region

One prism for looking at patterns of global trade is to consider trade between regions of the world. The rows of the table show the origin of world merchandise trade according to the region of the country involved; the columns show the destination of that trade. Thus, if you go to the South and Central America row, you can see that countries of this region exported $201 billion in merchandise to each other in 2012, only slightly more than the $186 billion these countries exported to North America and the $172 billion they exported to Asia. At least to me, this suggests that there are substantial possibilities for gains from trade within the countries of South America.

I include this table in each edition of my Principles of Economics text (and if you're teaching an intro econ course, I encourage you to check it out). Here are some lessons try to highlight: 

First, the bulk of world trade involves high-income areas of the world, either as exporters, importers, or both. For example, the single biggest number is the $4,382 billion that countries in Europe sell to each other. The level of trade between North American countries appears low compared to Europe, but this is because the European Union includes 27 nations while the trade
in the North American region is between the United States, Canada, and Mexico. Remember,
exports from Germany to Sweden count as international trade, but sales from California to New York would not be counted in this table, since they occur within the U.S. economy.

Second, trade between high-income regions and low-income regions is fairly extensive. Perhaps the most vivid example of this point is trade of $3,012 billion between the nations of Asia.  Asia includes the high-income economies like Japan and Korea, upper-middle income countries like China and Thailand, lower-middle-income countries like Indonesia and Vietnam, and low-income countries like Cambodia. 

Third, high-income regions are important as markets to the other regions. The countries of Africa, for example, export more than three times as much to the European Union as they do to other countries of Africa. As noted above, countries of Latin America almost as much to North America than they do to each other.

Finally, trade between some regions is very low; for example, between Africa and Latin America, or between the Middle East and the Commonwealth of Independent States. Indeed, some regions of the world seem economically disconnected from each other. I suspect that in a globalizing world economy, these connections will be gradually created and growing over time. 

Wednesday, July 16, 2014

Double Irish Dutch Sandwich

Want a glimpse of how companies can shift their profits among countries in a way that reduces their tax liabilities? Here's the dreaded "Double Irish Dutch Sandwich" as described by the International Monetary Find in its October 2013 Fiscal Monitor. This schematic to show the flows of goods and services, payments, and intellectual property. An explanation from the IMF follows, with a few of my own thoughts.

The IMF writes (footnotes omitted):

"So many companies exploit complex [taz] avoidance schemes, and so many countries offer devices that make them possible, that examples are invidious. Nonetheless, the “Double Irish Dutch Sandwich,” an avoidance scheme popularly associated with Google, gives a useful flavor of the practical complexities. Here’s how it works (Figure 5.1):
•• Multinational Firm X, headquartered in the United States, has an opportunity to make profit in (say) the United Kingdom from a product that it can for the most part deliver remotely. But the tax rate in the United Kingdom is fairly high. So . . .
•• It sells the product directly from Ireland through Firm B, with a United Kingdom firm Y providing services to customers and being reimbursed on a cost basis by B. This leaves little taxable profit in the United Kingdom. Now the multinational’s problem is to get taxable profit out of Ireland and into a still-lower-tax jurisdiction.
•• For this, the first step is to transfer the patent from which the value of the service is derived to Firm H in (say) Bermuda, where the tax rate is zero. This transfer of intellectual property is made at an early stage in development, when its value is very low (so that no taxable gain arises in the United States).
•• Two problems must be overcome in getting the money from B to H. First, the United States might use its CFC [controlled foreign corporation] rules to bring H immediately into tax. [Note: The "controlled foreign corporation" rules seek to reduce the ability of companies to move profits to another country via a pure paperwork transaction to what is really the same company.] To avoid this, another company, A, is created in Ireland, managed by H, and headquarters “checks the box” on A and B for U.S. tax purposes. This means that, if properly arranged, the United States will treat A and B as a single Irish company, not subject to CFC rules, while Ireland will treat A as resident in Bermuda, so that it will pay no corporation tax. The next problem is to get the money from B to H, while avoiding paying cross-border withholding taxes. This is fixed by setting up a conduit company S in the Netherlands: payments from B to S and from S to A benefit from the absence of withholding on nonportfolio payments between EU companies, and those from A to H benefit from the absence of withholding under domestic Dutch law.
This clever arrangement combines several of the tricks of the trade: direct sales, contract production, treaty shopping, hybrid mismatch, and transfer pricing rules.
A few quick thoughts of my own here.

1) The description of this arrangement is not from a muck-raking journalist nor from a lefty lobbying group. When it comes to knowing what happens in the world of international finance, the IMF is a mainstream and establishment source.

2) Under U.S. tax law, these profits would be subject to U.S. tax law if and when they are repatriated to the United States as dividends to shareholders. As the IMF writes (citations omitted): "The United States will charge tax when the money is paid as dividends to the parent—but that can be delayed by simply not paying any such dividends. At present, one estimate is that nearly US$2 trillion is left overseas by U.S. companies." Here's a post from about a year ago on the reasons why U.S. firms find it useful to hold liquid assets overseas.

3) There is an ongoing cat-and-mouse game in corporate tax avoidance, in which government tax agencies write regulations, well-paid corporate tax attorneys construct arrangements to pay lower taxes within the rules, the government tax agencies write more regulations, and so on--in a spiraling descent into ever-greater complexity and confusion. As with many pointless and destructive games, the answer is to define the rules for a different game. President Obama has proposed one corporate tax reform, and other proposals are floating around. When the economic incentives to shift profits are powerful, the corporate tax attorneys will find ways to make it happen. Thus, one goal of such reform should be to reduce the underlying incentives for this sort of profit-shifting.