Do Wages Benefit From A Shrinking Labour Force?

Dean Baker says yes:

The retirement of the baby boom cohorts means that the country’s labor force is likely to be growing far more slowly in the decades ahead than it did in prior decades. The United States is not alone in facing this situation. The rate of growth of the workforce has slowed or even turned negative in almost every wealthy country. Japan leads the way, with a workforce that has been shrinking in size for more than a decade.

Baker concludes:

With a stagnant or declining labor force, workers will have their choice of jobs. It is unlikely that they will want to work as custodians or dishwashers for $7.25 an hour. They will either take jobs that offer higher pay or these jobs will have to substantially increase their pay in order to compete.

This means that the people who hire low-paid workers to clean their houses, serve their meals, or tend their lawns and gardens will likely have to pay higher wages. That prospect may sound like a disaster scenario for this small group of affluent people, but it sounds like great news for the tens of millions of people who hold these sorts of jobs. It should mean rapidly rising living standards for those who have been left behind over the last three decades.

Of course, Baker could just look at the data from Japan. Real wages there have been depressed in recent years, even while the labour force has shrunk:

Japanwages

Even more damningly, labour’s share of income in Japan has declined even more considerably than the United States, and other nations with a growing working-age population:

ShareofLabourincome

Matthew C. Klein asks an important question:

Perhaps Mr Baker was thinking of an older example: the Black Death, which killed about half the people in Europe. Many (including me until I looked it up) believe that the resulting shortage in agricultural labour led to soaring real wages for peasants and a redistribution of economic power away from landowners. Recent evidence, however, casts doubt on this hypothesis. While nominal peasant wages did indeed increase in the aftermath of the Black Death, real wages may have actually fallen for decades. That may have helped heavily indebted peasants, but everyone else had to endure punishing declines in their standard of living, not to mention the psychological trauma of surviving such a devastating plague.

And the evidence on the Black Death seems conclusive:

In southern England, real wages of building craftsmen (rural and urban), having plummeted with the natural disaster of the Great Famine (1315-21), thereafter rose to a new peak in 1336-40. But then their real wages fell during the 1340s, and continued their decline after the onslaught of the Black Death, indeed into the 1360s. Not until the later 1370s – almost thirty years after the Black Death – did real wages finally recover and then rapidly surpass the peak achieved in the late 1330s.

And if we look at China — a country which has seen stunning real wage growth in recent years — it is clear that that growth has come in the context of a growth in the working-age population. China’s working-age population hit one billion for the first time in 2011.

To me at least, this seems to suggest that while all else being equal, a shrinking working age population might lead to a more competitive labour market, all else is not equal. Employers invest in more capital-intensive processes like automation and robots to compensate for a lack of workers, or in our globalised world they shift operations to somewhere with a stronger labour force (like China today, or perhaps like Africa further into the future). Even more simply, a falling population as a result of a natural disaster like the Black Death, or even just as a result of demographic trends like Japan, may lead to an economic depression due to falling demand.

This suggests that Baker’s conclusions are extremely optimistic for labour, and that shrinking populations may be bad news for wages.

Explaining The WTI-Brent Spread Divergence

Something totally bizarre has happened in the last three years. Oil in America has become much, much cheaper than oil in Europe. Oil in America is now almost $30 cheaper than oil in Europe.

This graph is the elephant in the room:

3 year brent spread

And this graph shows how truly historic a move this has been:

brent-WTI-spread

Why?

The ostensible reason for this is oversupply in America. That’s right — American oil companies have supposedly been producing much, much more than they can sell:

This is hilarious if prices weren`t so damn high, but despite a robust export market for finished products, crude oil is backing up all the way to Cushing, Oklahoma, and is only going to get worse in 2013.

Now that Enterprise Products Partners LLP has let the cat out of the bag that less than a month after expanding the Seaway pipeline capacity to 400,000 barrels per day, The Jones Creek terminal has storage capacity of 2.6 million barrels, and it is basically maxed out in available storage.

But there’s something fishy about this explanation. I don’t know for sure about the underlying causality — and it is not impossible that the oil companies are acting incompetently — but are we really supposed to believe that today’s oil conglomerates in America are so bad at managing their supply chain that they will oversupply the market to such an extent that oil sells at a 25% discount on the price in Europe? Even at an expanded capacity, is it really so hard for oil producers to shut down the pipeline, and clear inventories until the price rises so that they are at least not haemorrhaging such a huge chunk of potential profit on every barrel of oil they are selling? I mean, that’s what corporations do (or at least, what they’re supposed to do) — they manage the supply chain to maximise profit.

To me, this huge disparity seems like funny business. What could possibly be making US oil producers behave so ridiculously, massively non-competitively?

The answer could be government intervention. Let’s not forget that the National Resource Defence Preparedness Order gives the President and the Department of Homeland Security the authority to:

(c)  be prepared, in the event of a potential threat to the security of the United States, to take actions necessary to ensure the availability of adequate resources and production capability, including services and critical technology, for national defense requirements;

(d)  improve the efficiency and responsiveness of the domestic industrial base to support national defense requirements; and

(e)  foster cooperation between the defense and commercial sectors for research and development and for acquisition of materials, services, components, and equipment to enhance industrial base efficiency and responsiveness.

And the ability to:

(e)  The Secretary of each resource department, when necessary, shall make the finding required under section 101(b) of the Act, 50 U.S.C. App. 2071(b).  This finding shall be submitted for the President’s approval through the Assistant to the President and National Security Advisor and the Assistant to the President for Homeland Security and Counterterrorism.  Upon such approval, the Secretary of the resource department that made the finding may use the authority of section 101(a) of the Act, 50 U.S.C. App. 2071(a), to control the general distribution of any material (including applicable services) in the civilian market.

My intuition is that it is possible that oil companies may have been advised (or ordered) under the NDRP (or under the 1950 Defense Production Act) to keep some slack in the supply chain in case of a war, or other national or global emergency. This would provide a capacity buffer in addition to the Strategic Petroleum Reserve.

If that’s the case, the question we need to ask is what does the US government know that other governments don’t? Is this just a prudent measure to reduce the danger of a resource or energy shock, or does the US government have some specific information of a specific threat?

The other possible explanation, of course, is ridiculous incompetence on the part of US oil producers. Which, I suppose, is almost believable in the wake of Deepwater Horizon…

The Importance of Free Immigration

Judge Andrew Napolitano has incensed critics of immigration with his defence of the idea of immigration as a natural right:

Since the freedom of speech, the development of personality, the right to worship or not to worship, the right to use technologically contemporary means for self-defense, the right to be left alone, and the right to own and use property all stem from our humanity, the government simply is without authority to regulate human behavior in these areas, no matter what powers it purports to give to itself and no matter what crises may occur. Among the rights in this category is the freedom of movement, which today is called the right to travel.

The right to travel is an individual personal human right, long recognized under the natural law as immune from governmental interference. Of course, governments have been interfering with this right for millennia. The Romans restricted the travel of Jews; Parliament restricted the travel of serfs; Congress restricted the travel of slaves; and starting in the late 19th century, the federal government has restricted the travel of non-Americans who want to come here and even the travel of those already here. All of these abominable restrictions of the right to travel are based not on any culpability of individuals, but rather on membership in the groups to which persons have belonged from birth.

Americans are not possessed of more natural rights than non-Americans; rather, we enjoy more opportunities to exercise those rights because the government is theoretically restrained by the Constitution, which explicitly recognizes the natural law. That recognition is articulated in the Ninth Amendment, which declares that the enumeration of certain rights in the Constitution shall not be used by the government as an excuse to deny or disparage other unnamed and unnamable rights retained by the people.

So, if I want to invite my cousins from Florence, Italy, to come here and live in my house and work on my farm in New Jersey, or if a multinational corporation wants the best engineers from India to work in its labs in Texas, or if my neighbor wants a friend of a friend from Mexico City to come here to work in his shop, we have the natural right to ask, they have the natural right to come here, and the government has no moral right to interfere with any of these freely made decisions.

I agree with Napolitano. Giving the state the power to restrict freedom of movement is a dangerous precedent, and a dangerous concentration of power. Powerful and well-connected groups and industries can use the largesse of the state to protect their own uncompetitive ventures by restricting immigration.

And why should the state have the power to determine who can and who cannot live where? Surely market forces are a better determinant of the need for workers and migration than a central planner setting migration targets based on their own dislocated criteria?

These are by no means the most significant arguments for the freedom of movement. Ludwig von Mises theorised:

vonMisesimmigration

This is a critical dynamic. If a government enacts laws that are undesirable, workers (if they can) will move to another jurisdiction with more desirable laws. Freedom of movement is the status quo today for capital — under the current global regulatory framework, the free flow of capital means that governments have to compete to attract capital from around the globe. Governments do not have to do the same thing for labour, as the flow of immigration is very restricted compared to the flow of capital. This disparity may well have contributed to the extant reality that around the world — but particularly in the United States — capital’s share of output is increasing, while labour’s share is shrinking. Freer immigration could change all that.

There are various misconceptions of immigration. Perhaps most prominent is the idea that immigrants cost natives jobs. But the evidence suggests that this is not true. Eduardo Porter notes:

For years, economists have been poring through job market statistics looking for evidence that immigrants undercut less-educated Americans in the labor market. The most recent empirical studies conclude that the impact is slight: they confirm earlier findings that immigration on the whole has not led to fewer jobs for American workers. More significantly, they suggest that immigrants have had, at most, a small negative impact on the wages of Americans who compete with them most directly, those with a high school degree or less.

Meanwhile, the research has found that immigrants – including the poor, uneducated ones coming from south of the border — have a big positive impact on the economy over the long run, bolstering the profitability of American firms, reducing the prices of some products and services by providing employers with a new labor source and creating more opportunities for investment and jobs. Giovanni Peri, an economist at the University of California at Davis, estimated that the wave of immigrants that entered the United States from 1990 to 2007 increased national income per worker by about $5,400 a year on average, in 2007 dollars. He also concluded that the wave had a small positive impact on the average wage of American workers, by lifting the overall economy. If immigrants hurt anyone, it was the previous cohort of immigrants, with whom they most directly compete in the labor market.

Recent estimates have concluded that a liberalisation of global immigration policies could lift global GDP significantly. More importantly, empirical studies have confirmed the reality that immigration eases the fiscal balance — helpful for developed countries with ageing populations and a shrinking tax base. A 2011 report by Madeleine Zavodny of the American Enterprise Institute found that immigrants on average pay much more tax than they consume in government services:

fiscalimpact

This means that one frequent objection to immigration — that immigrants overstretch government programs and infrastructure — is irrelevant. Working immigrants pay more than enough in taxes to fund their own costs — often many times over.

The study also found that rather than taking up jobs, each immigrant worker generated jobs for the native population. The supply of work is not fixed. Each additional 100 H1-B workers were found to have generated 183 new jobs for the native population, and each 100 additional H2-B workers generated 464 new jobs for the native population.

But what about the countries that immigrants leave behind? Surely the countries left behind by thousands or millions of workers will fall into recession? Well, perhaps to some extent — although not so much in countries with higher birth rates or slack employment — but that’s the point. Countries that suffer a labour drain may have to reform their legal and political structure to attract workers. This alone would significantly boost competitiveness in the long run. And emigrants frequently send money back to their country of origin, and acquire new skills while working abroad that they can bring back home, in turn enriching their home country.

On the other hand, it might be unwise for countries to immediately switch from a restrictive policy to an open-door immigration policy. While freedom of movement is an essential economic freedom, a radical change in policy could prove destabilising, and cause significant cultural and social dislocation, friction or ghettoisation. Such a large change in policy should be undertaken slowly and cautiously — it would be unwise for governments to rush forward with policies that are unwanted and unpopular with the wider population.

But in the long run, though, the benefits of freedom of movement are clear, and will likely become clearer in the coming decades as more countries and blocs experiment with freer migration policies.

Cameron’s EU Policy Uncertainty

So, David Cameron wants a referendum?

I believe that small is beautiful, and that the European Union system is big and fragile. I am all for free trade, freedom of movement and immigration. But as for regulatory, monetary and fiscal integration — which is the direction that Europe has taken, especially since the self-inflicted Euro crisis that grew out the fundamentally flawed Euro system — how can Europe be responsive to its citizens when they are so numerous, so diverse and so geographically and linguistically dispersed? How can it be viable to have the same regulatory and political framework for Poland, Spain, Austria, Britain, Denmark and Greece? Political and monetary frameworks that are local and decentralised are usually responsive and representative. Big bureaucratic juggernauts are very often clunky and unresponsive.

That means that I am quite open to the idea of Britain leaving the political union, so long as we retain the economic framework that Britain voted for in a referendum on joining the European Economic Community — the predecessor to the European Union — in the 1970s. Britain never voted for political union, and the British public has been shown again and again in polls to be broadly against such a thing.

But David Cameron’s plan for an In-Out referendum in 2017 — but only if the Conservatives win the 2015 election — is misguided. It will just create five years of totally unnecessary policy and regulatory uncertainty.

There is empirical evidence to suggest that policy uncertainty can be very damaging to the economy. A 2013 paper Scott Baker, Nicholas Bloom, and Steven Davis used automated text analysis techniques to count key words relevant to uncertainty in the media. They combined the news analysis with data from tax code changes, disagreement among economic forecasters, and information from equity option markets to create an “uncertainty index”:

UncertaintyIndex

They looked at changes to gross domestic product, private investment, industrial production and unemployment, and found that spikes in uncertainty foreshadow large and persistent declines in all four. First, GDP and private investment:

GDPInvestment

Next, industrial production and unemployment:

Policshocks

The last thing that Britain needs is five years of policy uncertainty. If Cameron wants to have a referendum on E.U. membership, why not do it now? 82% of the public favour such a referendum — presumably not only UKIP and Conservative voters, but also Liberal Democrats and Labour voters. If we vote to leave, then we leave, if we vote to stay, we stay. We — and the markets — will know exactly where we stand.

Frankly this strikes me as more of a political ploy. The Conservatives are haemorrhaging support to UKIP. They are roughly ten points behind Labour in the polls. This strange announcement just seems like an attempt by Cameron to claw back support and distract from the disastrous state of the economy which just entered a triple-dip recession and which has been depressed since 2008. Ironically, this announcement may actually worsen the economic woe.

Could America Get Sucked Into a China-Japan Conflict?

So China and Japan are both threatening conflict in their fairly brutal ongoing argument over a few tiny disputed islands (and their mineral rights):

Senkaku islands

With global growth slowing, both countries’ leaders might look to a war as a way to distract from economic woe. While a limited war between China and Japan over the islands — perhaps of the scale of the Falkland War between Britain and Argentina in the 1980s — would be unsettling for the global economy, the real question is whether or not such a conflict could spiral into something bigger. 

The first critical point to note is that both countries’ leadership are increasingly hawkish in tone and character. China is in many ways seeking to establish itself on the world stage as a global military and economic powerhouse. Countries seeking to establish themselves on the global stage have traditionally sought out conflict. Japan is an ideal candidate for Chinese hostility. There is a lot of resentment — Japan’s invasion and occupation of Manchuria was brutal, and filled with war crimes (war crimes that the Japanese continue to deny). But more than that, Japan is an American protectorate, dotted with American bases, and subject to a mutual defence treaty. If China is to eclipse the United States as a global superpower, China must be able to show that she can impose her will on America.

And Shinzo Abe, Japan’s new Prime Minister has made it his life’s work to change Japan’s pacifistic constitution. Japan is faced with a twenty year economic depression, falling birthrates, a population of “herbivore” males with an aversion to sexuality. Abe may see hostility against China as a gateway to greater nationalism, and greater nationalistic fervour as a gateway to a national recovery.

First of all, it is critical to note that the United States is not legally obligated under its with Japan treaty to intercede on Japan’s behalf. The treaty states that the United States is required to report any such event to the UN Security Council, instead:

Each Party recognizes that an armed attack against either Party in the territories under the administration of Japan would be dangerous to its own peace and safety and declares that it would act to meet the common danger in accordance with its constitutional provisions and processes. Any such armed attack and all measures taken as a result thereof shall be immediately reported to the Security Council of the United Nations in accordance with the provisions of Article 51 of the Charter. Such measures shall be terminated when the Security Council has taken the measures necessary to restore and maintain international peace and security.

Very simply, this means that China can attack Japan without fearing an inevitable American retaliation. That fact alone makes a small skirmish fairly likely.

So what if China successfully captured the islands — and perhaps even more Japanese territory — as we can perhaps assume given China’s overwhelming size and military-spending advantages? Well, the United States and presumably the international community other than China’s allies would seek to diplomatically pressure China to stand down and reach a peaceful arbitrated resolution via the UN.

If China refused to stand down and accept a diplomatic solution — that is, if China was absolutely set on staring down the United States — then the United States would be forced to choose between providing military support to Japan — and possibly ultimately escalating up to a global war between China and her allies and the United States and her allies — or facing a humiliating climbdown, and accepting both Chinese sovereignty over the islands, as well as any other Japanese territory that China might have captured, as well as face the possibility of further Chinese incursions and expansionism in the Pacific in the future.

Who will blink first is uncertain. Only the Chinese really know how strong they are, how far they are willing to push, and how much of their threats are a bluff.

On the other hand, as I wrote last year:

The relationship between China and the United States today is superficially similar to that between Great Britain and Germany in 1914. Germany and China — the rising industrial behemoths, fiercely nationalistic and determined to establish themselves and their currencies on the world stage. Great Britain and the United States  — the overstretched global superpowers intent on retaining their primacy and reserve currency status even in spite of huge and growing debt and military overstretch.

Mutually assured destruction can only act as a check on expansionism if it is credible. So far, no nation has really tested this credibility.

Nuclear-armed powers have already engaged in proxy wars, such as Vietnam. How far can the limits be pushed? Would the United States launch a first-strike on China if China were to invade and occupy Taiwan or Japan, for example? Would the United States try to launch a counter-invasion? Or would they back down? Launching a first-strike is highly unlikely in all cases — mutually assured destruction will remain an effective deterrent to nuclear war. But perhaps not to conventional war and territorial expansionism.

The chance of global war in the near-term remains very low. But so long as China and Japan continue their antagonism, the chance of global war in the long-term is rising.

Is the Gold Price Dependent on China?

China now buys more gold than the Western world:

Gold_Demand_China_WGC

Does that mean, as some commentators are suggesting, that future price growth for the gold price depends on China? That if the Chinese economy weakens and has a hard landing or a recession that gold will fall steeply?

There’s no doubt that the run-up that gold has experienced in recent years is associated with the rise in demand for gold from emerging markets and their central banks. And indeed, the BRIC central banks have been quite transparent about their gold acquisition and the reasons for it.

Zhang Jianhua of the People’s Bank of China said:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

Indeed, this trend recently led the Telegraph’s Ambrose Evans-Pritchard to declare that the world was on the road to “a new gold standard” — a tripartite reserve currency system of gold, dollars and euros:

The world is moving step by step towards a de facto Gold Standard, without any meetings of G20 leaders to announce the idea or bless the project.

Some readers will already have seen the GFMS Gold Survey for 2012 which reported that central banks around the world bought more bullion last year in terms of tonnage than at any time in almost half a century.

They added a net 536 tonnes in 2012 as they diversified fresh reserves away from the four fiat suspects: dollar, euro, sterling, and yen.

The countries driving the movement toward gold as a reserve currency by building their gold reserves is that they are broadly creditor nations whose dollar-denominated assets have been relatively hurt by over a decade of low and negative real interest rates. The idea that gold does well during periods of  falling or negative real rates held even before the globalisation of U.S. Treasury debt.

The blue line is real interest rates on the 10-year Treasury, the red line change in the gold price from a year ago:

fredgraph (15)

The historical relationship between real interest rates and the gold price shows that it is likely not “China” per se that has been driving the gold price so much as creditors and creditor states in general who are disappointed or frustrated with the negative real interest rate environment in dollar-denominated assets. What a slowdown in the Chinese economy (or indeed the BRICs in general) would mean for the gold price remains to be seen. While it is widely assumed that a Chinese slowdown might reduce demand for gold, it is quite plausible that the opposite could be true. For instance, an inflationary crisis in China could drive the Chinese public and financial sector into buying more gold to insulate themselves against falling or negative real rates.

Of course, this is only one factor. That are no hard and fast rules about what drives markets, especially markets like the gold market where many different market participants have many different motivations for participating — some see gold as an inflation hedge, some (like the PBOC) as a hedge against counterparty risk and global contagion, some as a buffer against negative real interest rates, some as a tangible form of wealth, etc.

And with the global monetary system in a state of flux — with many nations creating bilateral and multilateral trade agreements to trade in non-dollar currencies, including gold — emerging market central banks see gold — the oldest existing form of money — as an insurance policy against unpredictable changes, and as a way to win global monetary influence.

So while emerging markets and particularly China have certainly been driving gold, while U.S. real interest rates remain negative or very low, and while the global monetary system remains in a state of flux, these nations will likely continue to gradually drive the gold price upward.

The Return of Mercantilism

Mercantilist trade policies have returned in a big, big way.

Dani Rodrik:

The liberal model views the state as necessarily predatory and the private sector as inherently rent-seeking. So it advocates a strict separation between the state and private business. Mercantilism, by contrast, offers a corporatist vision in which the state and private business are allies and cooperate in pursuit of common objectives, such as domestic economic growth or national power.

The mercantilist model can be derided as state capitalism or cronyism. But when it works, as it has so often in Asia, the model’s “government-business collaboration” or “pro-business state” quickly garners heavy praise. Lagging economies have not failed to notice that mercantilism can be their friend. Even in Britain, classical liberalism arrived only in the mid-nineteenth century – that is, after the country had become the world’s dominant industrial power.

A second difference between the two models lies in whether consumer or producer interests are privileged. For liberals, consumers are king. The ultimate objective of economic policy is to increase households’ consumption potential, which requires giving them unhindered access to the cheapest-possible goods and services.

Mercantilists, by contrast, emphasize the productive side of the economy. For them, a sound economy requires a sound production structure. And consumption needs to be underpinned by high employment at adequate wages.

These different models have predictable implications for international economic policies. The logic of the liberal approach is that the economic benefits of trade arise from imports: the cheaper the imports, the better, even if the result is a trade deficit. Mercantilists, however, view trade as a means of supporting domestic production and employment, and prefer to spur exports rather than imports.

Today’s China is the leading bearer of the mercantilist torch, though Chinese leaders would never admit it  – too much opprobrium still attaches to the term.

I have three things to add.

First, states around the world including in the West, and especially America, have massively adopted corporatist domestic policies, even while spouting the rhetoric of free trade and economic liberalism publicly. One only has to look at the growth trend in American Federal spending to see that America has drifted further and further and further away from its free market rhetoric, and toward a centrally planned economy.

Second, the key difference between a free market economy, and a corporatist command economy is the misallocation of capital by the central planning process. While mercantile economies can be hugely productive, the historic tendency in the long run has been toward the command economies — which allocate capital based on the preferences of the central planner — being out-innovated and out-grown by the dynamic free market economies, which allocate capital based on the spending preferences of consumers in the wider economy.

Third, these two facts taken together mean that the inherent long-term advantage of the free market system — and by implication, of the United States over the BRICs — has to some degree been eradicated. This means that the competition is now over who can run the most successful corporatist-mercantilist system. The BRIC nations, particularly China, are committed to domestic production and employment, to domestic supply chains and domestic resource strength. America continues to largely ignore such factors, and allow its productive base to emigrate to other nations. And the production factor in which America still has some significant advantage — design, innovation, and inventions — has been eroded by the fact that the BRIC nations can easily appropriate American designs and innovations, because these designs are now being manufactured predominantly outside of America, and because of (American) communication technologies like the internet. This is the worst of both worlds for America. All of the disadvantages of mercantilism — the rent-seeking corporate-industrial complex, the misallocation of capital through central planning, the fragility of a centralised system — without the advantage of a strong domestic productive base.

Latvia Is No Success

Anders Aslund of the Peterson Institute is fairly certain that austerity during depressions works:

After five years of financial crisis, the European record is in: Northern Europe is sound, thanks to austerity, while southern Europe is hurting because of half- hearted austerity or, worse, fiscal stimulus. The predominant Keynesian thinking has been tested, and it has failed spectacularly.

The starkest contrasts are Latvia and Greece, two small countries hit the worst by the crisis. They have pursued different policies, Latvia strict austerity, and Greece late and limited austerity. Latvia saw a sharp gross domestic product decline of 24 percent for two years, which was caused by an almost complete liquidity freeze in 2008. This necessitated the austerity that followed.

Yet Latvia’s economy grew by 5.5 percent in 2011, and in 2012 it probably expanded by 5.3 percent, the highest growth in Europe, with a budget deficit of only 1.5 percent of GDP. Meanwhile, Greece will suffer from at least seven meager years, having endured five years of recession already. So far, its GDP has fallen by 18 percent. In 2008 and 2009, the financial crisis actually looked far worse in Latvia than Greece, but then they chose opposite policies. The lessons are clear.

The notion that Latvia is somehow a success story is just absurd.  Latvia has shed some ten percent of its workforce during the economic turmoil — that would be like more than 20 million people emigrating out of the USA, or 4 million people emigrating from Britain. This is why the unemployment rate has fallen somewhat.  And Latvia’s economy is still deeply depressed, far, far below its pre-crisis peak. Would we be calling Britain and America success stories if millions and millions of people were leaving and output was still far, far, far below its pre-crisis peak?

This video from last year shreds the notion of Latvia as some kind of austerity-driven paradise:

The truth is that the binary choice between stimulus and austerity is false. The real decision is how best to produce productivity, creativity, entrepreneurship and growth. It is possible to do this without any debt-fuelled stimulus, and without any immediate fiscal contraction, by (for example) attracting more foreign investment, using bailed-out banks to provide business finance to the unemployed, and deregulating small businesses and entrepreneurs.

The fiscal trick is in learning to cut spending during the boom — something which very few governments have ever mastered, but which is necessary for long-term fiscal sustainability. In the United States during the mid-2000s, tax revenues were high, and growth was moderately strong. This gave the Bush administration a false sense of leeway that allowed them to embark on massive debt-fuelled spending at precisely the wrong time, starting two wars, and creating large-scale domestic spending programs like Medicare Part D and No Child Left Behind. If the Bush administration had cut spending during the boom, not only would it have offset some of the potential for bubbles in housing and stocks, but it would have left the American government in a much stronger financial position come the downturn.

Yesterday’s prosperity didn’t last forever (leaving us with collapsed tax revenues, and massive budget deficits) and today’s depression doesn’t have to last forever either, so long as we have the courage to create the environment for small business and entrepreneurs to thrive, and then to cut, cut, cut during the next boom. Trying to balance the budget in the way Anders Aslund seems to endorse is a road to deeper depression, extreme unemployment, and potentially to millions and millions of people leaving to look for work elsewhere.

The Interconnective Web of Global Debt

It’s very big:

article-2118152-124602BE000005DC-0_964x528

Andrew Haldane:

Interconnected networks exhibit a knife-edge, or tipping point, property. Within a certain range, connections serve as a shock-absorber. The system acts as a mutual insurance device with disturbances dispersed and dissipated. But beyond a certain range, the system can tip the wrong side of the knife-edge. Interconnections serve as shock-ampli ers, not dampeners, as losses cascade.The system acts not as a mutual insurance device but as a mutual incendiary device.

A mutual incendiary device sounds about right.

Comparative Advantage and Global Trade Fragility

One of the cornerstones of the global economic status quo is globalisation and integration of markets. Here’s the growth in world trade as a percentage of global GDP since the 1970s:

worldtrade

There have been two key forces behind this outgrowth in global trade. First of all, the American military acting as hegemonic global policeman with bases in more than 150 countries and backed has created a situation generally known as the Pax Americana where goods and intermediaries can be shipped around the globe with minimal fear of piracy, seizure, theft, etc. Second, the international community has incentivised trade liberalisation through the policies of organisations including the International Monetary Fund (IMF), and World Trade Organization (WTO) requiring nations requesting loans or aid to open their markets to foreign trade competitors.

Most global policymakers and trade economists remain committed to and ultra-bullish about the agenda of global integration of markets. The OECD claims:

If G20 economies reduced trade barriers by 50%, they could gain:

More jobs: 0.3% to 3.3% rise in jobs for lower-skilled workers and 0.9 to 3.9% for higher-skilled workers, depending on the country.

Higher real wages 1.8% to 8% increase in real wages for lower-skilled workers and 0.8% to 8.1% for higher-skilled workers, depending on the country.

Increased exports: All G20 countries would see a boost in exports if trade barriers were halved. In the long run, many G20 countries could see their exports rise by 20% and in the Eurozone by more than 10%.

The overarching intellectual motivation for these policies is found in the work of the English classical economist David Ricardo and his neoclassical successors. The concept of comparative advantage introduced by Ricardo and expanded and formalised via equilibrium models by neoclassical economists including Samuelson, Mankiw, Hecksher and Ohlin (etc) has underpinned most of these policies.

Comparative advantage is the idea that nations benefit from specialising in what they are best at. Ricardo introduced the notion during debates about Britain opening her markets to European trade. Ricardo pointed out that total output and welfare would be greater for all countries in total if they specialised in what they were best at, and traded with each other to get what they wanted.

This principle works in Ricardo’s simple verbal model (and in the more sophisticated equilibrium models developed since). However empirical studies and meta-studies of modern day trade liberalisation suggest that there are some problems with this theory in practice.

Dani Rodrik noted in 2001:

Do lower trade barriers spur greater economic progress? The available studies reveal no systematic relationship between a country’s average level of tariff and nontariff barriers and its subsequent economic growth rate. If anything, the evidence for the 1990s indicates a positive relationship between import tariffs and economic growth.

The evidence on the benefits of liberalizing capital flows is even weaker. In theory, the appeal of capital mobility seems obvious: If capital is free to enter (and leave) markets based on the potential return on investment, the result will be an efficient allocation of global resources. But in reality, financial markets are inherently unstable, subject to bubbles (rational or otherwise), panics, shortsightedness, and self-fulfilling prophecies. There is plenty of evidence that financial liberalization is often followed by financial crash — just ask Mexico, Thailand, or Turkey — while there is little convincing evidence to suggest that higher rates of economic growth follow capital-account liberalization.

So what’s the difference between theory and reality?

There are a number of potential reasons why the theoretical promise of comparative advantage has not played out in reality.

First is graft and corruption. If countries are taking on loans from international institutions, and those loans are being deposited in the Swiss bank accounts of corrupt officials or businessmen instead of being spent on improving industry, skills or infrastructure, then what chance do developing countries have of developing?

Second is the danger of bubbles during the liberalisation process. Global capital flows into newly-liberalised countries can stoke bubbles in almost every sector (but especially equities, real estate, etc). When the bubble bursts, capital flows out, leaving the domestic economy deeply depressed.

Third is the social upheaval costs to labour, skills and institutions. As we have seen in the United States, manufacturing jobs and skills migrated abroad. Workers often cannot be retrained cheaply and easily, and often do not want or cannot afford to migrate to wherever their skills would be best-compensated. This stickiness can result in endemic unemployment and resultant economic weakness.

Fourth is the cost to capital stock.

As Steve Keen noted:

Some capital is necessarily destroyed by the opening up of trade.

Since capital is destroyed when trade is liberalised, the watertight argument that trade necessarily improves material welfare springs a leak.

Converting capital stock again and again to keep up with changing economic winds can be an expensive, difficult and mistake-ridden process.

Fifth is the problem of trade fragility.  Events like natural disasters and foreign wars can disrupt production and trade flows. Specialisation could cripple a country that depends on imports from foreign disrupted countries. Dependency on imported goods and intermediates renders countries vulnerable to shocks outside their borders. Wars and disasters that affect exporters have at times seriously disrupted and damaged the economies of importers, and vice versa.

The fact that trade liberalisation can have large social costs, create economic fragility and produce asset bubbles is a cause for pause. Is IMF-imposed globalisation opposed by the wider public really producing freer markets, or is it a misguided central planning experiment? Has the dogmatic pursuit of globalisation left global industry fragile to supply chain shocks caused by natural disasters and wars? Can the status quo really even be considered free trade, given that it is supported and smoothed by huge military-industrial subsidies? Does freedom of trade not also include freedom of nations to choose to protect domestic industries, institutions and supply chains from foreign competition? Why should the industries of developing countries be expected to compete against corporate multinational juggernauts?

While global trade may have provide a major disincentive against trade-disrupting wars, it seems probable that it has created a deep underlying systemic fragility. Trade interdependence means that regional or domestic shocks to production like a war or natural disaster may have consequences throughout the entire world, transmitted through dependencies. Similarly to the interconnective global financial system and the 2008 financial crisis, geopolitical shocks in coming years may well be magnified by globalisation.