Monthly Archives: April 2014

What is the greatest threat to freedom and prosperity?

FLORENCE— Bernardo Caprotti was a 45-year-old entrepreneur when he agreed to buy a suburban plot of land for a new supermarket.

Building permits recently came through. He’s now 88.

So begins an enlightening story in today’s Wall Street Journal on Italy’s sclerotic economy. The story continues:

Italy has emerged as a Technicolor example of the [EU’s] problems. Its growth has been stuttering for 20 years. Since 2008, its economy has shrunk by 9%, and this year it is struggling to expand by even 1%.

It is tempting to think that a simple solution is new leadership, that Italy just needs to elect more market-oriented politicians to sweep away the layers of red-tape and barriers to entrepreneurship that have ensnared the country’s entrepreneurs.

But the problem is much more intractable because established businesses benefit from the status quo:

The roots of the problem, say many Italians, lie in how vested interests in the private and public sectors gum up the economy, preventing change that replaces old practices with new, more efficient ones, and repeatedly frustrating political attempts to shake up the country.

It adds up to “deep-seated cultural obstacles to growth,” says Tito Boeri, a professor at Milan’s Bocconi University who is one of Italy’s top economists.

Years ago, Milton Friedman put his finger on the problem:

A few months ago, I attended a conference on the intersection between politics and capitalism (what we’ve called government-granted privilege). The eminent economic historian Robert Higgs was there and he said something that has stuck with me (I’m paraphrasing, but he just approved the quote):

I believe crony capitalism—the alliance between business and government—is the biggest problem of our age. And the reason is that it is robust. As alternatives to free-market capitalism, communism and old-fashioned fascism are thankfully dead. And genuine socialism has no real constituency in America. But crony capitalism, unfortunately, has a very active, organized, well-funded, and vocal constituency. It is the greatest threat to our prosperity and our freedom.

 

The unseen costs of the Ex-Im bank

The great 19th Century French economist Frederic Bastiat had good advice when thinking about economics. Actions, habits, and laws, he said,

[produce] not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them.

The good economist, he said, “takes into account both the effect that can be seen and those effects that must be foreseen.”

So it is with the US Ex-Im bank.

The independent federal agency helps foreign firms finance the purchase of American-made products. They do this by selling insurance to these foreign purchasers, by directly loaning them money, and by guaranteeing loans that others like Goldman Sachs make to these firms.

Ex-Im’s activities produce some seen benefits and these are widely touted by the bank and it’s boosters, such as the National Association of Manufacturers. These seen benefits are:

The gains to foreign purchasers

Since most foreign purchasers are sub-prime borrowers (what could go wrong, right?), the bank’s assistance allows them to obtain credit that private lenders would otherwise be unwilling to extend. At least in the short run, this helps these foreign purchasers.

The gains to U.S. manufacturers

Ex-Im’s loans, loan guarantees and insurance all increase demand for some domestic manufacturers’ products. This allows them to sell more stuff and to sell it at higher prices than they otherwise would. The bank boasts that, on average, “87% of transactions benefit small business exporters of U.S.-made goods and services.” Note the use of the words “transactions” and “small.” The bank is slicing the data here in a way that isn’t entirely honest. More on which below.

But as Bastiat would tell us, these seen benefits are less than half the story. There are also a host of less-conspicuous effects, and all of them are bad. These include:

Excessive risk

Rational lenders are unwilling to finance risky bets unless they are compensated with higher rates of return. These higher interest rates, in turn, make risky borrowers think twice about undertaking bad investments. This is a feature of a well-functioning financial system, not a bug.

Like all goods, capital is scarce and this feature helps ensure it isn’t wasted, steering it to the projects where it can do the most good for people. Ex-Im’s activities, on the other hand, steer capital—at artificially low interest rates—to sub-prime borrowers so they can buy big, expensive products. This is bad for the world economy because it misallocates capital. But in the long run it’s bad for many of the borrowers themselves because it encourages them to take on risks they can ill-afford (which is why I hedged above when I said they gain “in the short run”). Another great French economist, Veronique de Rugy, highlighted this fact in a recent post. As she points out, this isn’t just a hypothetical concern:

In the 1990s, the Ex-Im Bank was so excited to “support” the people of the Republic of Nauru by extending financing assistance to Air Nauru to purchase some, you guessed it, Boeings. When Air Nauru defaulted in 2002, the Ex-Im Bank seized Nauru’s only jet straight off of the runway — leaving the country’s athletes stranded on the tarmac after the Micronesian Games.

Higher prices for manufactured products

Next consider the unseen effect on domestic purchasers. Like Air Nauru, domestic airlines such as Delta, United, Southwest, and dozens of others also buy Boeing aircraft. Unlike Air Nauru, these firms don’t receive loan subsidies. This hurts all of them once, and some of them twice.

First, the international carriers among this group like Delta lose market share to Ex-Im-privileged firms like Korean Air and Emirates Air. This explains why Delta has filed a lawsuit against Ex-Im.

Second, all US carriers—even those like Southwest that only serve the US market—end up paying higher prices for planes because Ex-Im privileges increase the demand for, and therefore the price of, airplanes. As Vero notes in this piece, this has many air carriers worried about a jet plane bubble. Simple economics, of course, predicts that some of this cost will be passed on to consumers in the form of higher ticket prices.

Privileges for banks

Presumably, many of the legislators who routinely vote to reauthorize Ex-Im do so because they want to subsidize domestic manufacturers. Unfortunately, the laws of economics dictate that the actual beneficiaries of a subsidy need not be the intended beneficiaries.

In the case of Ex-Im, a large chunk of the benefit is captured by privileged banks instead of by manufacturers. Thanks to Ex-Im’s loan guarantees, banks are able to make loans to foreign buyers while unloading most of the risk. This is yet one more way in which banks, “privatize gains and socialize losses” (to borrow a phrase used by Nobelist Joseph Stiglitz at an Occupy Wall Street rally).

This privilege sits on top of a pile of other privileges. The IMF recently estimated that in most years the biggest of these privileges—the too big to fail subsidy—is larger than bank profits!

Few gain at the expense of the many

Consider, again, the bank’s assertion that 87 percent of its “transactions” benefit “small business” exporters. Why focus on transactions? Wouldn’t it be more transparent to focus on the size of these transactions? When you break it down this way, as Vero does in this piece, you see that 81 percent of the value of Ex-Im assistance goes to “big businesses” as the bank defines them.

And just how do they define big and small business? Answer: not in the same way others like the Small Business Administration do. Ex-Im’s definition of “small” manufacturers and wholesalers is three times larger (by number of employees) than the SBA’s definition and it includes firms with revenues as high as $21.5 million a year.

A host of pathologies

As I emphasize in the Pathology of Privilege, these favors to a select few domestic manufactures and banks come with a host of problems. In short, privilege “misdirects resources, impedes genuine economic progress, breeds corruption, and undermines the legitimacy of both the government and the private sector.”

But Ex-Im and its beneficiaries don’t want you to see that.

With Government Shekels Come Government Shackles

Though privileged firms may not focus on it when they obtain their favors, privilege almost always come with strings attached. And these strings can sometimes be quite debilitating. Call it one of the pathologies of government-granted privilege.

Perhaps the best statement of this comes from the man whose job it was to pull the strings on TARP recipients. In 2009, Kai Ryssdal of Marketplace interviewed Kenneth Feinberg. The Washington compensation guru had just been appointed to oversee compensation practices among the biggest TARP recipients. Here is how he described his powers:

Ryssdal: How much power do you have in your new job?

FEINBERG: Well, the law grants to the secretary who delegates to me the authority to determine compensation packages for 175 senior executives of the seven largest corporate top recipients. The law also permits me, or requires me, to design compensation programs for these recipients, governing overall compensation of every senior official. And finally, the law gives me great discretion in deciding whether I should seek to recoup funds that have already been distributed to executives by top recipients. So it’s a substantial delegation of power to one person.

Another example of shackles following shekels comes from Maryland. That state has doled out over $20 million in tax privileges to a film production company called MRC. MRC films House of Cards, a show about a remarkably corrupt politician named Frank Underwood. The goal of these privileges was to “induce” (others might call it bribe) MRC to film House of Cards in Maryland. One problem (among many) with targeted privileges like this is that there is no guarantee that the induced firm will stay induced; there’s nothing to keep it from coming back for more.

In this case, MRC executives recently sent a letter to Governor Martin O’Malley threatening to “break down our stage, sets and offices and set up in another state” if “sufficient incentives do not become available.” Chagrined, state Delegate William Frick came up with a plan to seize the company’s assets through eminent domain. It is clear that Delegate Frick’s intention was to shackle the company. He told the Washington Post:

I literally thought: What is an appropriate Frank Underwood response to a threat like this?…Eminent domain really struck me as the most dramatic response.

As George Mason University’s Ilya Somin aptly puts it:

But even if the courts would uphold this taking, it is extremely foolish policy. State governments rarely condemn mobile property, for the very good reason that if they try to do so, the owners can simply take it out of the jurisdiction – a lesson Maryland should have learned when it tried to condemn the Baltimore Colts to keep them from leaving back in 1984. Moreover, other businesses are likely to avoid bringing similar property into the state in the first place.

My colleague Chris Koopman notes that there are also a number of practical problems with this proposal. The only real property the state could seize from MRC would be its filming equipment: its cameras, its lights, maybe a set piece or two. And by the U.S. Constitution, it would have to offer MRC “just compensation” for these takings. The company’s real assets—the minds of its writers and the talents of its actors—would, of course, remain intact and free to move elsewhere. So essentially Mr. Frick is offering to buy MRC a bunch of new cameras, leaving the state with a bunch of old cameras which it will use for…well that hasn’t been determined yet.

In this case, it would seem that the shackles are more like bangles.

The Maryland State House adopted Frick’s measure without debate. It now goes to the Senate.