Frank Rill Chen: Economy Analysis

Rocks below the surface

Tue, 28 Nov 2006 09:14:50 GMT

Economics focus

Nov 23rd 2006
From The Economist print edition

Democracies get rid of tariffs, but they may encourage subtler forms of protectionism

LISTEN to the campaign rhetoric of America's victorious senators and congressmen (not recommended), and you might easily conclude that bashing trade wins votes. Politically, the calculation looks easy. The benefits from freer trade are diffuse and the winners do not always know in advance who they are. On the other hand, sheltered industries know precisely how much they stand to lose if left bare and unaccommodated.

But look further afield and the affinity between open politics and open markets seems clear. As use of the ballot box has spread, especially to poorer parts of the world, tariffs have fallen. In 1981, for example, the world had only about 40 democracies; and the average tariff in developing countries was almost 30%. By 2003 the roll call of democracies had more than doubled and tariffs had fallen by more than half.

Why? For one thing, voters are also consumers who do not like paying extra for imported goods. Democratic governments can withstand some consumer disgruntlement, especially if it is too thinly spread to swing many votes. But autocracies need pay it no heed whatsoever.

Voters are also workers. The poor countries, where many of the new democracies have flowered, are typically endowed with abundant labour but scarce capital. If they cut themselves off from trade, manpower will be cheap relative to capital. The plutocrats who profit from this economic isolation are the natural allies of autocratic government. Democracy, by contrast, enfranchises a wider circle of people who stand to gain from selling their labour at something closer to world prices.

For both of these reasons, freer trade often follows freer elections. One recent estimate found that a transition from airtight autocracy to full-throated democracy (in a hypothetical developing country of average size, income, and so on) yields a fall in tariffs of seven percentage points, from about 22% to 15% or so. Indeed, Daniel Kono, of the University of California at Davis, claims this finding is “among the most robust in the field of international political economy.”

But it may be less robust than it looks, he argues*. Democrats may shy away from simple tariffs, but they still bash trade by other means. These include “safeguards” which pop up and down as imports surge and recede, and a bewildering array of sanitary and “phytosanitary” standards aimed ostensibly at keeping out pests and disease. Russia, for example, imposed onerous inspections on American poultry exporters, because it said their chicken legs, imported in great quantities after the arrival of democracy, might contain salmonella. The European Union banned Mauritania's award-winning camel cheese because the camels were milked by a pastoralist's hand, not by a gleaming machine.

By Mr Kono's reckoning, the transition from despotism to democracy results in lower tariffs but higher barriers of other sorts. Indeed, the share of imports touched by quotas, antidumping duties and the like would rise by seven points, he finds. Moreover, the product coverage of quality, health and safety controls would increase from less than 9% to more than a fifth.

The uses of obscurity

Tariffs may irk price-conscious consumers but at least they raise revenue for the public coffers. Why then do governments resort to other kinds of barriers, such as quotas and “voluntary export restraints”, which impose costs on consumers without raising any duty? Their appeal lies in their obscurity, Mr Kono argues. Politicians indulge in “optimal obfuscation”. They resort to trade barriers that are difficult for voters to discern and tricky for political opponents to attack.

The burden of a tariff is easy to explain to the electorate: my opponent wants you to pay more for your milk and cars. Antidumping duties are a more slippery target: dumping does not sound like something a responsible politician should favour. And campaigning against health and safety standards can easily backfire: who wants to be in favour of drowning sea turtles in fishing nets so that people can eat cheaper shrimp?

You may ask if such standards deserve to be attacked. If voters want to conserve sea turtles, ban shoddy imports and stamp out salmonella, democratic politicians surely have a duty to respond. Perhaps these trade barriers simply reflect genuine consumer concern. Perhaps. Mr Kono looks at several proxies for consumer sensitivities, including the stringency of a country's environmental regulations, the purity of its water and the number of quality-marks its companies receive from the International Organisation for Standardisation. Countries that fiercely enforce safety, greenery and quality at the border are not, he concludes, especially anxious to enforce these things at home.

In other cases, however, governments have promised to fight dumping in order to win support for radical trade reform. Several of Latin America's young democracies, for example, were keen to slash tariffs and peg their exchange rates to fight inflation. They promised to defend companies against super-cheap imports as a way to sugar this free-trade pill. Mexico, for example, launched 83 antidumping investigations in 1993, more than any other country. But this was partly to shore up support for the North American Free-Trade Agreement.

Trade is probably still freer under democracies than under the alternatives. It is just that this hunch, as Mr Kono shows, is more difficult to prove than previous scholars had thought. Which is more damaging to trade: a tariff on Mexico's tuna or a demand that its fishermen show greater courtesy to dolphins? The answer is obscure, optimally so.

*“Optimal Obfuscation: Democracy and Trade Policy Transparency”. American Political Science Review, August 2006.

Winner's Curse Applet

Sat, 16 Sep 2006 16:02:38 GMT

How much should you offer for a company of uncertain valuation?

This applet demonstrates the winner's curse.

You are the Chief Financial Officer for your firm. Your firm is considering making a takeover offer for a small, privately-held Internet startup. The "true" value, V, of the shares of the startup are known with certainty only to its management. However, valuing Internet startups is quite challenging, and you only know that the shares are worth somewhere between $0 and $1000 per block of shares, and each possible value has equal probability. So, as far as you are concerned, someone has thrown a 1001 sided die, with each face having an integer between 0 and 1000, to determine the share value, V, and the outcome of this toss of the die was observed by the startup's management but not by you.

Because of corporate synergy, you know that the shares would be worth 50% more than their current value to your firm if you successfully acquire the startup. That is, after you acquire the startup, the value of each block of shares will increase 50% from V to 1.5 V.

You are required to recommend to your firm the amount that should be bid for the startup (per block of shares). The startup will agree to your offer if you bid more than V, and will turn you down if you bid less than V. This is your only chance - if your offer is rejected, there is no room for renegotiation.

How much do you bid per share?

Consider the expected value of the firm. Since any value between 0 and 1000 is equally likely, on average, the firm is worth 500. However, if you bid 500, notice that you will only win if V < 500. But, if the firm is worth at most 500, it is worth on average only 250, so you overpaid! Even with the synergies, 250x(1.5) = 375 is much less than you bid. This is the winner's curse! To be successful, you have to recognize that the expected value of the firm is irrelevant. All that should concern you is the expected value of the firm if you win, which depends on your bid.

This applet lets you try different bidding strategies. You will select the range of the firm's possible values (0 to 1000 in this example) and the extent of the synergies (50% in this example). Then, after entering a bid, the applet will simulate twenty firm values, and calculate your average profits.

The uses of adversity

Mon, 21 Aug 2006 13:03:04 GMT

Aug 17th 2006
From The Economist print edition

Why some people think a recession could be good for America

IN 1871 America added about 6,000 miles of track to its railways, an endeavour that occupied a tenth of its industrial labour force. But by 1875 track-building had fallen by more than two-thirds, and employed less than 3% of America's workers.

According to Brad DeLong, an economic historian at the University of California, Berkeley, the violent ups and downs of the railway industry help to explain the popularity, before the Great Depression and John Maynard Keynes, of a fatalistic view of the business cycle. Recessions, however unpleasant, were cathartic, and therefore necessary. They released capital and labour from profitless activities (such as laying the year's 6,000th mile of track) as an essential prelude to redeploying them elsewhere. “Depressions are not simply evils, which we might attempt to suppress,” wrote Joseph Schumpeter. They represent “something which has to be done”.

In Schumpeter's day, this fatalism was shared by many at America's Federal Reserve. But today's Fed acts quickly to suppress recessions, which it recognises are mostly due to a lack of demand, not an excess of track. For the Fed, recessions are good for one thing, and one thing only: curbing inflation.

Unfortunately, this task is now an urgent one. According to figures released this week, core consumer prices rose by 2.7% in the year to July—too fast for comfort. In theory, curing this inflation could be painless. If the Fed's commitment to price stability is credible, and if people look forward, not backward, when settling their wages and setting their prices, they will respond to the Fed's promises.

Unfortunately, in practice, inflation suffers from strong inertia. Hence cutting it typically requires a slowing of the economy as well as a lowering of inflationary expectations.

Like pagans sharpening their knives, economists debate the size of this “sacrifice ratio”: the number of people who must lose their jobs to appease the gods of price stability. Some models, including one of many that guide the Fed's deliberations, put this ratio as high as 4.25, which means that unemployment must rise by one percentage point (or 1.5m people) for 4.25 years to reduce inflation by one percentage point. But other, less bloodthirsty economists suggest the ratio is more like 2 or 2.5.

Ratios like these mean that for the first time in years America's domestic economists, who track their country's inflation and unemployment, are as worried about the future as its international economists, who fixate on the country's external imbalances. The internationalists have long feared that a recession might lie ahead should foreigners abruptly abandon the dollar. The prospect of a more conventional downturn—engineered not by foreign central banks, but by America's own—suggests the cart and horse belong in a different order. A recession might bring about a reversal of the current-account deficit, rather than the other way around. Recessions were, after all, part and parcel of Portugal's current-account reversal, which began in 1982, Britain's from 1989 and Spain's from 1991.

In principle, again, current-account deficits can be closed without a slowdown in production. America's gross domestic purchases of its own and foreign goods are currently running at about 106% of gross domestic product. In other words, there is enough domestic demand to buy all of America's output and more. In principle, these purchases could fall by six percentage points of GDP, eliminating the deficit, without anyone in America needing to fall out of work. America would not suffer a recession. But it would feel like one: every man, woman and child would have to curtail their spending by $2,600 a year.

Without import tariffs, however, it is not possible to curb consumers' purchases of foreign goods without slowing their purchases of everything else too. When domestic demand falls, it tends to decline across the board. In some models, such as the one offered by Maurice Obstfeld, also at Berkeley, and Kenneth Rogoff, of Harvard University, the price of non-tradable goods falls by however much is necessary to clear the market and keep everyone at work, producing an undiminished amount of traded and non-traded goods.

Euthanasia of the realtor

In reality, however, America's deficit is unlikely to close without its industrial structure changing substantially. Only about a quarter of what it now produces can be sold across borders. Andrew Tilton of Goldman Sachs has calculated that to boost exports and narrow its deficit to 2.5% of GDP by 2010, America would need to increase its manufacturing capacity by about 17%. But until this year, it was housing, a non-traded good par excellence, which has attracted extra labour and capital. In 2005 the share of construction workers in payroll employment was the highest in 50 years, and residential investment accounted for the biggest chunk of GDP since 1951. Schumpeter, no doubt, would call this “maladjustment”.

Might a recession do for housing what it did for late-19th-century railways? The last downturn was accompanied by substantial restructuring, according to a widely cited paper by Erica Groshen and Simon Potter of the Federal Reserve Bank of New York. Workers who lost their jobs in the 2001 recession did not return to the same industry during the recovery. Instead, those who did not leave the labour force altogether slowly migrated to new industries. Companies, the authors wrote, saw the recession “not as an event to be weathered but as an opportunity—or even a mandate—to reorganise production permanently, close less efficient facilities and cull staff”. Schumpeter could not have put it better himself.

Recession is not inevitable. But if a 2007 slowdown curbs inflation, narrows the trade deficit and clears space for an American manufacturing revival it will prove a surprisingly fruitful period of dearth.