Saving capitalism from capitalists

Karl Smith points to Don Boudreaux's post in Cafe Hayek where he argues that Paul Krugman undermines the apparently self-evident free-market principle (that markets increase human welfare) by reinforcing the misconceptions held by the "economically untutored instincts" of the "general public".

The underlying presumption is that the primary objective of economists is to "defend the case for free markets and free trade from the many vulgar misperceptions that prevent people from seeing the full play of market forces". In other words, public economists should defend free markets whose benefits are not very evident to the general public. Furthermore, deviants are purveyors of "vulgarnomics" – economics as popularly understood by the economically untutored.

For a moment let us ignore the sheer arrogance and anti-liberalism inherent in this premise and focus on the economics of the example of trade with China that Boudreaux has presented. He outlines the following "unseen" as inherent in free trade which the untutored general public should be enlightened about,

"The fact that many of these low-priced Chinese goods, used as inputs in America, allow some American producers to profitably expand their output; the fact that monies American consumers save because of lower-priced Chinese goods can be spent buying other goods and services, some of which are ‘made in America,’ that would otherwise be out of reach; the fact that that if Beijing truly is keeping the value of the renminbi too low the result will be inflation in China – which will eventually raise the prices Americans must pay for imports from China; and, most importantly, the fact that there’s very little difference from the perspective of Americans in China’s government subsidizing our consumption of Chinese-made goods and some natural source (say, a technological breakthrough) that lowers our cost of buying Chinese-made goods."

An analysis of each of these presumptions (Bourdeaux calls them "facts") reveals the following.

1. While the low-priced Chinese imports (used as inputs) by certain American producers will help expand their production, it will also come at the cost of local producers of such inputs and their employees. There is nothing "factual" about how the balance of costs and benefits will play out. The relative costs and benefits to each stakeholder is sector and market specific and can be assessed only through empirical analysis.

2. The causal relationship between the wealth effect (a net increase in their real disposable incomes) arising from purchasing cheaper Chinese goods and the savings being used to buy "made in America" goods (and presumably creating more jobs in the US) too is not as "factual" as is made out. While the wealth effect is undeniable, the same cannot be said about the latter. It is a subject of empirical assessment, with impacts varying across sectors and the environments.

3. The argument that Beijing cannot keep renminbi undervalued for too long since it would lead to inflation in China and eventual rise in export prices and erosion of Chinese export competitiveness is fallacious. While it may be literally correct to claim that Beijing cannot keep its currency undervalued for too long, it does not answer the question, "how much is too long"? There are too many imponderables to answer this with any degree of accuracy.

There is also fairly credible enough evidence to suggest that there is more to China's export boom than its undervalued currency. This would appear to question the apparently "factual" causal relationship between the value of renminbi and Chinese exports.

4. The last (and "most important") argument that Americans should not be bothered about the Chinese government subsidies keeping prices low for American consumers and equating its effect with that arising from a technological breakthrough is similarly misleading. Substantively, there are political economy effects, with profound impacts on market dynamics, associated with the former that stands out in stark contrast to the apolitical nature of the latter.

Ultimately, trade in a particular good is beneficial to a country only if

1. the labour market and local business dislocation due to more competitive imports is offset by the combined positive effect of the consumer and producer surpluses from cheaper imports and the successful transition of the capital and labour dislocated to other more competitive and value-generating sectors.
2. the balance is achieved within a reasonably short period of time.

Upholders of unbridled free markets assume that cumulated over all the sectors of the economy, this balance is a net positive and the transition happens quickly. As the aforementioned analysis of China-US trade reveals, the reality is far more complicated than simple causal relationships. And there is always the cautionary advice from Keynes, "In the long run we are all dead"!

Free-marketers fail to acknowledge that the emergent socio-economic outcome from any trade is determined by factors that go beyond the confines of standard macroeconomic models and are also determinant on several exogenous factors - initial social, political, and economic conditions; quality of governance; policies followed by competitors and partners etc. Further, a comprehensive assessment of the impact of these policies would require going beyond stage one and exploring the secondary effects of the multiple elements of a policy change like trade liberalization.

Most importantly, there are several social, political, and economic frictions that invariably come in the way of the natural flow of economic forces and prolong the transition period. Often, this transition settles at a less than desirable equilibrium, which generates a net negative balance.

Such illiberal intolerance becomes inevitable once we assume that an economy has to be shaped around defined principles and models which characterize a particular ideology. However, this assumption is flawed since, as we all know by now, it is impossible to straitjacket any social system into clearly defined principles and models. In the circumstances, prescriptions grounded rigidly on those principles fail the twin-test of efficiency and fairness.

Arguments that are driven by fixed assumptions and which refuse to acknowledge opposing views tend to stifle the free market in ideas. They pose the biggest danger to free-market capitalism. The objective of any economist or politician should not be to uphold any particular ideological system but to explore and adopt a system that ensures fair and efficient allocation of resources among its citizens.

My short point is not to refute the superiority of the market mechanism as the most welfare enhancing system known to man. But we should clearly and upfront acknowledge the numerous failings of the market system and respond with policies that can address these failures. This is necessary to increase the credibility and public acceptability of free-market capitalism. Unqualifed support for ideologically rigid policies will only increase the already growing alienation and distrust of free-market capitalism.

As Raghuram Rajan and Luigi Zingales famously wrote, "capitalism needs to be saved from capitalists".

Update 1 (15/1/2012)

"Capitalism’s real gravediggers, it turns out, are not Marx’s revolutionary proletariat but its own delusional cardinals, who have turned ideology into faith."

Arundhati Roy in FT