Tag Archives: Paul Krugman

Ex-Im’s Deadweight Loss

To hear defenders of Ex-Im talk, you’d think that export subsidies are ALL upside and no downside. Economic theory suggests otherwise.

Clearly, some benefit from export subsidies. The most-obvious beneficiaries are the 10 or so U.S. manufacturers whose products capture the bulk of Ex-Im’s privileges (if they didn’t benefit, their “all hands on deck” public relations campaign to save the bank wouldn’t make a lot of sense).

Foreign purchasers who receive loans and loan guarantees from the bank in exchange for buying these products also clearly benefit.

The least-conspicuous beneficiaries are the private banks who finance these deals and get to offload up to 85 percent of the risk on to U.S. taxpayers. But they too clearly benefit.

Those are the upsides. But as economists are wont to say, “there is no such thing as a free lunch.”

Behind each of these beneficiaries is someone left holding the bag: there are taxpayers who bear risks that private lenders are unable or unwilling to bear. There are consumers who must pay higher prices for products that are made artificially expensive by Ex-Im subsidies. And there are other borrowers who lose out on capital because they aren’t lucky enough to have the full faith and credit of the U.S. taxpayer standing behind them.

One might be tempted to think that gains of the winners roughly offset the losses of the losers. But basic economic analysis suggests that the losses exceed the gains.

A few simple diagrams illustrate this point.

First consider any subsidy of a private (that is, excludable and rivalrous) good. Perhaps the most relevant example is a subsidy to private lenders. This is shown in the familiar supply and demand diagram shown below. The quantity of loanable funds is displayed along the horizontal axis and the price of a loan—the interest rate—is shown on the vertical axis.

People want loans to invest in their projects. We call this the “Demand for Investment.” It is shown as the blue, downward-sloping line. It is downward sloping because there are diminishing marginal returns to investment and because if you have to pay a higher interest rate, you will borrow less.

Other people have money to lend. We call this the “Supply of Savings.” It is depicted below as the solid red, upward-sloping line. It is upward sloping because there are increasing opportunity costs to lending out money and lenders must be enticed with higher and higher interest rates to lend more and more money.

The key to understanding this diagram—and this is a point that non-economists tend to find unintuitive—is that there is an optimal quantity of loans and it is not infinity. There is some point beyond which the marginal opportunity cost of further lending exceeds the marginal expected benefit from these investments.

Now consider what happens when the government guarantees the loans. Knowing that taxpayers will cover up to 85 percent of their losses, rational lenders will be willing to supply any given quantity of loans at a lower interest rate. Thus, the supply of savings shifts to the lower, dashed red line. But just because loan guarantees shield lenders from the true opportunity cost of these funds, it does not mean that the true opportunity cost goes away. In this case, taxpayers wear the risk. (For a dated but lucid explanation of the true opportunity cost associated with Ex-Im, see this Minneapolis Fed paper).

Society as a whole is made poorer because scarce resources are redirected from higher-valued uses toward lower-valued uses. In other words, those who lose end up losing more than the winners win. Economists call this “dead weight loss” (DWL). It is represented by the red triangle in the diagram below (click to enlarge).

DWL of a Subsidy

So far, this is the basic economic theory of a subsidy. But economists have developed more-specific models to understand subsidies in the context of international trade.

To get a handle on this, check out some videos by Professor Michael Moore of George Washington University. If international trade diagrams are new to you, I’d recommend looking at these diagrams before watching his videos. Then watch Professor Moore’s excellent illustration of an export subsidy in a small country, followed by the slightly more-complicated—but more relevant—case of export subsidies in a large country.

Small country case:

Large country case:

This is the basic case for free trade and it is widely accepted by economists. Some astute readers may know that there are some interesting theoretical exceptions to this rule. These exceptions derive from what are known as “strategic trade” models. They posit that in some situations—such as oligopolistic industries—governments can theoretically manage to use subsidies to make domestic firms win more than domestic consumers lose. The world is still poorer, but domestic winnings outweigh domestic losses.

These models are worth understanding. But the truth is they have not—and should not—undermine the basic economic case for free trade. The best exposition of this point is a classic piece by Paul Krugman called “Is Free Trade Passe?” In it, Krugman carefully walks the reader through the logic of these models. He then notes, quite rightly, that:

The normative conclusion that this justifies a greater degree of government intervention in trade, however, has met with sharp criticism and opposition—not least from some of the creators of the new theory themselves.

Krugman then ticks through the reasons why free trade should still be the reasonable rule of thumb. For one thing, since the strategic trade models seem to only work in oligopolistic industries, policy makers would need to know exactly how oligopolists will respond to these subsidies and the fact is “economists do not have reliable models of how oligopolists behave.” Then there is the problem of entry. Even if a government does solve the empirical problem of anticipating and accurately responding to oligopolists, it “may still not be able to raise national income if the benefits of its intervention are dissipated by entry of additional firms.”

Krugman’s final two critiques are fascinating because they are precisely the sorts of concerns a George Mason economist might raise. First, there is what Hayek might call the information problem:

[T]o pursue a strategic trade policy successfully, a government must not only understand the effects of its policy on the targeted industry, which is difficult enough, but must also understand all the industries in the economy well enough that it can judge that an advantage gained here is worth advantage lost elsewhere. Therefore, the information burden is increased even further.

And finally, there is the public choice problem. At the international level, “In many (though not all) cases, a trade war between two interventionist governments will leave both countries worse off than if a hands-off approach were adopted by both.” And at the domestic level:

Governments do not necessarily act in the national interest, especially when making detailed microeconomic interventions. Instead, they are influenced by interest group pressures. The kinds of interventions that new trade theory suggests can raise national income will typically raise the welfare of small, fortunate groups by large amounts, while imposing costs on larger, more diffuse groups. The result, as with any microeconomic policy, can easily be that excessive or misguided intervention takes place because the beneficiaries have more knowledge and influence than the losers.

To this, one could add a host of problems that arise when governments privilege particular firms or industries.

Which (finally) brings me to the bottom line: the economic case remains strong that export subsidies to domestic firms like Boeing and GE end up costing American consumers, borrowers, and taxpayers more than they end up benefiting the privileged firms.

Why do almost all economists oppose U.S. farm policy?

There are many policies about which economists disagree. To read the news you might think that economists disagree about everything. In reality, there are plenty of areas in which the economics profession has reached a consensus. One is farm policy. Economists from Greg Mankiw to Paul Krugman oppose the “insane” (Mankiw’s word) and “grotesque” (Krugman’s) handouts to farmers that constitute U.S. farm policy. More broadly, Robert Whaples has found that more than 85 percent of surveyed economists oppose agricultural subsidies. (I’m willing to bet that many of the remaining 15 percent also oppose agriculture subsidies but are uncomfortable ending them cold-turkey).

Why is there so much agreement on this issue? Here are a few thoughts.

Subsidies and Price Supports Create Dead Weight Losses

U.S. farm policy is a grab bag of over 80 separate programs with confusing names like the “shallow loss program” and the “dairy indemnity program.” But for all the arcane language, the programs match pretty neatly to the simple microeconomic models that we teach undergraduate economics majors. They are price supports, they are subsidies, or they are barriers to trade. And whatever they are, they are inefficient.

Consider the Dairy Product Price Support Program. According to the CRS, it “specifies minimum purchase prices of: block cheese, $1.13/lb.; barrel cheese, $1.10/lb.; butter, $1.05/lb.; and nonfat dry milk, $0.80/lb.”

With the mandated price set above the market price, consumers gain less from exchange than they otherwise would and producers gain more than they otherwise would. Importantly, though, the simple economic model of a price floor (see below) tells us that consumers lose more than producers gain. Economists call this “dead-weight loss.”

Minimum PriceOr consider the Direct Payments program. According to the CRS, it pays growers of “wheat, corn, grain sorghum, barley, oats, upland cotton, rice, soybeans, and other oilseeds” a fixed subsidy that does not vary according to the market price. This effectively lowers the marginal cost of production, lowering the price and increasing the quantity sold. In this case, producers and consumers gain, but taxpayers lose. Moreover, the simple producer subsidy model tells us that taxpayers lose more than consumers and producers gain. Thus, this program too creates a dead-weight loss.

SubsidyNo Coherent Story of Market Failure or Imperfection

These interventions might be rationalized by some sort of story about market imperfection (externality, monopoly, asymmetric information, etc.). But as a commodity industry with so many producers and so many consumers, agriculture is much closer to the textbook ideal of a perfectly competitive industry than one plagued by market failure.

Safety Nets for People Not for Firms

“Well yes,” a champion of farm policy might reply, “but poor American farmers deserve a safety net.” Lots of economists (even Milton Friedman and F.A. Hayek) have conceded that publicly-funded social safety nets might be worthwhile. But these nets should catch people when they fall, not the firms that these people work for. The farm safety net makes even less sense when you dig into the numbers. As Vincent Smith has shown in his recent Mercatus paper, average household farm income is substantial greater than overall average income. Moreover, about 80 percent of direct payments go to the largest 15-20 percent of farms and a majority goes to the top 10 percent “whose owners, for the most part full-time farm operators, typically earn many times the national average household income.”

As Smith points out, many in the farm lobby claim that farmers need the safety net because they are in a particularly risky line of business. But, he says, this claim doesn’t stand up to scrutiny:

Farms fail at an annual rate of 0.5 percent: only one in every 200 farms goes out of business because of financial problems.24 By comparison, the annual business-failure rate is over 7 percent, 14 times greater. Among small nonfarm businesses, the companies most comparable to farms in terms of sales, the failure rate is about 14 percent, almost 30 times greater than among farms.

The farm safety net makes even less sense when you think about justice on a global scale. Daniel Sumner explains it well in his Agricultural Subsidy Program entry in the Concise Encyclopedia of Economics:

Some of the poorest countries in West Africa have traditionally been cotton exporters. In 2001 and 2002, they faced a world price of cotton ranging from thirty-five cents to forty-five cents per pound. Meanwhile, cotton growers in the United States, the world’s largest exporter, received seventy cents or more per pound from the subsidies plus the market price. Economists have estimated that U.S. exports of cotton would have been substantially lower, and the world price of cotton 10 to 15 percent higher, if U.S. cotton subsidies had been unavailable during this period. Reducing farm subsidies in the United States and other rich countries would help poor cotton growers and other farmers in poor countries, and, moreover, would begin a process of relying more on trade rather than aid for economic growth.

Given the near-consensus among economists, why does the U.S. continue this grotesque and insane experiment? I’ll explore this question in subsequent posts.