Something very clever Bryan Caplan wrote in 2007 on “Anti-Foreign Bias”

I must admit that I am somewhat depressed by the state of the world today. Deflationary monetary policies in Europe, increased protectionist tendencies and war and geopolitical tensions around the world. It is no secret that I think it is all connected.

But why do voters around the world rally behind the cries for closed borders and even more military build-ups? Why do policy makers – democratic and non-democratic – find it in their interest to stir up anti-immigrant sentiment, geopolitical tensions and to introduce protectionist measures?

Bryan Caplan might provide the answer – the “anti-foreign bias” of rationally irrational voters – this is from a piece Bryan wrote for Reason from 2007: 

A shrewd businessman I know has long thought that everything wrong in the American economy could be solved with two expedients: 1) a naval blockade of Japan, and 2) a Berlin Wall at the Mexican border.

Like most noneconomists, he suffers from anti-foreign bias, a tendency to underestimate the economic benefits of interaction with foreigners. Popular metaphors equate international trade with racing and warfare, so you might say that anti-foreign views are embedded in our language. Perhaps foreigners are sneakier, craftier, or greedier. Whatever the reason, they supposedly have a special power to exploit us.

There is probably no other popular opinion that economists have found so enduringly objectionable. In The Wealth of Nations, Adam Smith admonishes his countrymen: “What is prudence in the conduct of every private family, can scarce be folly in a great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry.”

As far as his peers were concerned, Smith’s arguments won the day. More than a century later, Simon Newcomb could securely observe in the Quarterly Journal of Economics that “one of the most marked points of antagonism between the ideas of the economists since Adam Smith and those which governed the commercial policy of nations before his time is found in the case of foreign trade.” There was a little backsliding during the Great Depression, but economists’ pro-foreign views abide to this day.

Even theorists, such as Paul Krugman, who specialize in exceptions to the optimality of free trade frequently downplay their findings as abstract curiosities. As Krugman wrote in his 1996 book Pop Internationalism: “This innovative stuff is not a priority for today’s undergraduates. In the last decade of the 20th century, the essential things to teach students are still the insights of Hume and Ricardo. That is, we need to teach them that trade deficits are self-correcting and that the benefits of trade do not depend on a country having an absolute advantage over its rivals.”

Economics textbooks teach that total output increases if producers specialize and trade. On an individual level, who could deny it? Imagine how much time it would take to grow your own food, while a few hours’ wages spent at the grocery store can feed you for weeks. Analogies between individual and social behavior are at times misleading, but this is not one of those times. International trade is, as the economic writer Steven Landsburg explains in his 1993 book The Armchair Economist, a technology: “There are two technologies for producing automobiles in America. One is to manufacture them in Detroit, and the other is to grow them in Iowa. Everybody knows about the first technology; let me tell you about the second. First you plant seeds, which are the raw materials from which automobiles are constructed. You wait a few months until wheat appears. Then you harvest the wheat, load it onto ships, and sail the ships westward into the Pacific Ocean. After a few months, the ships reappear with Toyotas on them.”

How can anyone overlook trade’s remarkable benefits? Adam Smith, along with many 18th- and 19th-century economists, identifies the root error as misidentification of money and wealth: “A rich country, in the same manner as a rich man, is supposed to be a country abounding in money; and to heap up gold and silver in any country is supposed to be the best way to enrich it.” It follows that trade is zero sum, since the only way for a country to make its balance more favorable is to make another country’s balance less favorable.

Even in Smith’s day, however, his story was probably too clever by half. The root error behind 18th-century mercantilism was an unreasonable distrust of foreigners. Otherwise, why would people focus on money draining out of “the nation” but not “the region,” “the city,” “the village,” or “the family”? Anyone who consistently equated money with wealth would fear all outflows of precious metals. In practice, human beings then and now commit the balance of trade fallacy only when other countries enter the picture. No one loses sleep about the trade balance between California and Nevada, or me and iTunes. The fallacy is not treating all purchases as a cost but treating foreign purchases as a cost.

Anti-foreign bias is easier to spot nowadays. To take one prominent example, immigration is far more of an issue now than it was in Smith’s time. Economists are predictably quick to see the benefits of immigration. Trade in labor is roughly the same as trade in goods. Specialization and exchange raise output—for instance, by letting skilled American moms return to work by hiring Mexican nannies.

In terms of the balance of payments, immigration is a nonissue. If an immigrant moves from Mexico City to New York and spends all his earnings in his new homeland, the balance of trade does not change. Yet the public still looks on immigration as a bald misfortune: jobs lost, wages reduced, public services consumed. Many in the general public see immigration as a distinct danger, independent of, and more frightening than, an unfavorable balance of trade. People feel all the more vulnerable when they reflect that these foreigners are not just selling us their products. They live among us.

It is misleading to think of “foreignness” as a simple either/or. From the viewpoint of the typical American, Canadians are less foreign than the British, who are in turn less foreign than the Japanese. From 1983 to 1987, 28 percent of Americans in the National Opinion Research Center’s General Social Survey admitted they disliked Japan, but only 8 percent disliked England, and a scant 3 percent disliked Canada.

Objective measures like the volume of trade or the trade deficit are often secondary to physical, linguistic, and cultural similarity. Trade with Canada or Great Britain generates only mild alarm compared to trade with Mexico or Japan. U.S. imports from and trade deficits with Canada exceeded those with Mexico every year from 1985 to 2004. During the anti-Japan hysteria of the 1980s, British foreign direct investment in the U.S. always exceeded that of the Japanese by at least 50 percent. Foreigners who look like us and speak English are hardly foreign at all.

Calm reflection on the international economy reveals much to be thankful for and little to fear. On this point, economists past and present agree. But an important proviso lurks beneath the surface. Yes, there is little to fear about the international economy itself. But modern researchers rarely mention that attitudes about the international economy are another story. Paul Krugman hits the nail on the head: “The conflict among nations that so many policy intellectuals imagine prevails is an illusion; but it is an illusion that can destroy the reality of mutual gains from trade.” We can see this today most vividly in the absurdly overblown political reactions to the immigration issue, from walls to forcing illegal workers currently in America to leave before they can begin an onerous procedure to gain paper legality.

 

 

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At 25 Bob Hetzel had become a Friedmanite. At 80 Milton Friedman had become a Hetzelian

Watch this after 11:35.

…yes, Friedman went further than Bob. Friedman had also become a market monetarist. He wanted to use the market not only to evaluate monetary policy, but also to implement monetary policy.

HT Sassa

Talk about being disappointed…By the Bundesbank

Take a look at this list of Bloomberg headlines coming out today:

*BUNDESBANK: INFLATION EXPECTATIONS NOTICEABLY BELOW ECB MANDATE

Wauw will the Bundesbank advocate monetary easing?

*BUNDESBANK DOESN’T SEE TURN IN GERMAN ECONOMIC FUNDAMENTALS

Yeah it sure looks like that!

*BUNDESBANK SAYS RUSSIA SANCTIONS LIKELY TO DAMP GERMAN EXPORTS

Yes, yes the Bundesbank is surely dovish

*BUNDESBANK SAYS GERMAN ECONOMIC OUTLOOK HAS CLOUDED

This gotta mean the Bundesbank will support QE

*BUNDESBANK SAYS DATA CAST DOUBT ON GERMAN 2H ECONOMIC REBOUND

Increadibly dovish Bundesbank…

*BUNDESBANK SAYS ECB PACKAGE ACCEPTABLE GIVEN LOW INFLATION

Yes, yes… have the market monetarists taken over in Frankfurt?

*BUNDESBANK SAYS EURO-AREA REBOUND TO BE WEAKER THAN EXPECTED

Yeah! Now the Bundesbank surely will endorse QE! No doubt!

*BUNDESBANK SAYS EXPANSIONARY POLICY MAY HARM REFORM EFFORTS

Or maybe not! Talk about being disappointed…

“If goods don’t cross borders, armies will” – the case of Russia

Recently I have been thinking quite a bit about the apparent rise of protectionism across the globe and in my quest to find data on the rise of protectionism I found some very interesting comments regarding the Global Trade Alert‘s annual report for 2013 (here reproduced from the Moscow Times January 11 2014):

Russia enacted more protectionist trade measures in 2013 than any other country, leaving it as the world leader in protectionism, according to a new study.

Furthermore, Russia and its partners in the Customs Union, Belarus and Kazakhstan, accounted for a third of all the world’s protectionist steps in 2013, said the study by Global Trade Alert, or GTA, a leading independent trade monitoring service.

A total of 78 trade restrictions, almost a third of all those enacted by Group of 20 countries, were imposed by Russian legislators last year, the study said.

With the new restrictions, Russia now has 331 protectionist measures in place, or a fifth of all protectionist policies registered worldwide .

Belarus is ranked second, with 162 measures.

The Russian-led Customs Union, which the Kremlin has presented as an alternative to the European Union, came under harsh criticism from the report’s authors.

“The Customs Union was responsible for 15 times as many protectionist measures as China while having only an eighth of the population,” said GTA coordinator Simon Evenett, in comments carried by Reuters.

He described Russia’s policy of economic restructuring as “nothing more than a potent mix of rampant subsidization and aggressive protectionism,” which contradicts the World Trade Organization’s principles.

Russia joined WTO in 2012.

The other members of the Customs Union, Kazakhstan and Belarus, are negotiating entry into the WTO.

Of Russia’s protectionist policies, 43.4 percent were targeted bailouts and direct subsidies for local companies, the report said. Tariff measures accounted for 15.5 percent, while anti-dumping, countervailing duty or safeguard provisions constituted almost 10 percent. Other steps included cuts in foreign worker quotas, export subsidies and restrictions, and sanitary measures

A surge in protectionism occurred around the world starting in 2012, the report said. The 2013 data indicate that the trend, which could slow down international economic growth in the next several years, is likely to continue.

Given recent events in Ukraine it is hard not to come to think of the old free trade slogan normally attributed to Frédéric Bastiat “If goods don’t cross borders, armies will”.

—–

PS if you want to think of a “model” of the recent rise in geopolitical tensions around the world then think of this causal relationship: Monetary policy failure => deflationary pressures => rising political populism and an increase in protectionist measures => increased geopolitical tensions. I will try to return to this topic in later posts as I increasingly think there is a relationship between monetary policy failure and increased political uncertainty and geopolitical tensions.

PPS 14 years ago I wrote a short article on the relationship between protectionism and war. You will find it here (page 25-26). It is unfortunately in Danish, but Google Translate might help you.

PPPS a couple of posts on monetary policy failure in Russia. See here, here, here and here.

Recommend reading:

Doug Irwin

 

 

Another argument for Open Borders: It is good for the quality for football!

There is no doubt that I strongly favour a policy of removing restrictions on immigrations. Nathan Smith in his recent guest post on my blog showed that a policy of global Open Borders would significantly boost global GDP. However, there might be even better arguments for Open Borders.

My friend Ben Southwood, Head of Policy at the Adam Smith Institute, in a new paper argues that the “crackdown on foreign players hurts English football”. You might not buy Nathan’s arguments, but you should certainly buy Ben’s arguments for Open Borders in international football (to my American readers: Soccer).

This is the abstract from Ben’s paper:

It is a very common view that “importing” foreign football players into the UK to play in the Premier League leads to less opportunity for English players to play for these teams. This means that English players get less high-level experience, and consequently aren’t as good as the players of Spain, France, Italy or Ger- man, who make up a larger fraction of the players playing in their home leagues. This, the argument runs, is an important factor in explaining the English national team’s perceived underperformance in international competitions. I review the literature and present novel data establishing a negative relationship between current performance (as measured by FIFA ranking) and the current amount of football played in a league by native players (across Spain, England, Germany and Italy). Further, I find no relationship between minutes played by English players in the Premier League five or ten years ago and current performance. Finally, I find strong evidence that a league’s overall strength (as measured by its UEFA coefficient) is predicted by the current amount of foreigners playing in it. To restrict foreign players would not directly benefit the English national team, but it would risk substantially curtailing the overall quality of the world’s most popular football league.

PS in my favourite team FC Copenhagen there are very few Danish players and the best “Danish” players have immigrant background. Thank god for immigration and free trade in footballers!

PPS this is my son’s favourite (now former) FC Copenhagen player Igor Vetokele.

Igor

Guest post: The Global Economic Impact of Open Borders (Nathan Smith)

On my blog I mostly writes about monetary policy issues. However, I from time to time I venture into other areas. Among the areas I would like to give more attention to is the economics of immigration. I used to teach immigration economics at the University of Copenhagen and have done research on the topic while working at the Ministry of Economic Affairs in Denmark 15 years ago. However, I have not worked professionally with immigrations economics for well over a decade and I have only followed the new research in this area from a bit of a distance.

However, since I started my blog I have had a tradition for inviting economic scholars and others to write guest posts on my blog. I am now continuing the tradition as I have invited Nathan Smith to write a guest post on a very interesting paper that he has been working on.

Nathan in his paper is trying to give an assessment of the Global Economic Impact of Open Borders. His results are extremely interesting and in my view illustrates just how big the economic potential benefits are if we moved towards a world of free movement of labour across borders.

This obvious is a very controversial topic so it is very welcomed that professional economists are contributing to a better understanding the topic. It is certainly about time that we start basing immigration policy around on a sound economic understanding of the topic rather than on emotions and populist rhetoric. I am therefore tremendously happy that Nathan has accepted my invitation to contribute to my blog on this very important topic.

Nathan would like to use this opportunity to welcome comments on his ideas and his paper. I would very much suggest that everybody interested in Nathan’s work and the economic of immigration in general leave comments here at the blog or drop Nathan a mail (see e-mail address below). You are obviously also welcome to drop me a mail (lacsen@gmail.com). It would be great if we could make this an example on a ‘real-time peer review’ of an academic paper.

- Lars Christensen

Guest post: The Global Economic Impact of Open Borders

by Nathan Smith (nathan_smith@ksg03.harvard.edu)

First, a little about me. I’ve been an open borders advocate for nine years now, first publishing in an online journal call Tech Central Station (see here, here, here, here, here, here, here, here, and here), then in my 2010 book, Principles of a Free Society, and most recently at the blog Open Borders: The Case and The Freeman. My work experience includes the Cato Institute and the World Bank. My education includes a Masters in International Development from the Kennedy School of Government at Harvard (2003), and a PhD in economics from George Mason (2011). Now, I teach economics (macro, public finance, investments, international trade, research methods) at Fresno Pacific University, a small Christian college in California. The website Open Borders: The Case was founded by Vipul Naik and is dedicated to describing and developing the case for open borders in a rational and balanced way.

Open borders is a question both of ethics and of positive economics. There are non-utilitarian arguments that deportation of illegal immigrants, exclusion of peaceful migrants, forcible separation of families, or other aspects of border enforcement violate human rights, are morally impermissible, and must cease regardless of the consequences. But even those who accept these arguments will be curious about what the consequences of doing our moral duty are likely to be. For utilitarians, the whole question will turn on what would happen under open borders. Others may accept that there are such things as rights, and that they may forbid some policies that would be adopted on the basis of a merely utilitarian calculus, but think that a substantial amount of migration restriction is consistent with rights. Open borders would then be evaluated on the basis of its consequences. So, putting my knowledge of development economics to work, I’ve just finished a draft of a paper, “The Global Economic Consequences of Open Borders,” in which I’ve been trying to guess what would happen if all migration restrictions were abolished. Lars was kind enough to offer me the chance to give a glimpse of my methods and results here.

Under the status quo, markets for labor and human capital clear at the national level. Under open borders, they would clear at the global level. At any rate, that is how I model the main difference between the status quo and open borders. Everything else, initially, is either held constant—total factor productivity (TFP), country risk premia on investment capital, the total world population, the total world human capital stock—or changes because of the way global labor and human capital markets clear—the population and GDP of different countries, the global stock of physical capital, the wages of raw capital and the premium paid to human capital around the world. But before solving for a new global equilibrium in the labor and human capital markets, I had to develop a description of the world under the status quo. That is, I had to develop a stylized description of the current world economy, which was consistent with a theoretical model that could subsequently be solved for a new, open borders equilibrium, and which, at the same time, fit tolerably well with the data.

At the heart of my description of the status quo are the factors of production. I follow Mankiw, Romer, and Weil (1992) in explaining international income differences primarily by differences in physical and human capital per worker. TFP still plays an indispensable role, but it varies across countries much less than does average human capital. It is indispensable because—as was pointed out by critics of Mankiw, Romer, and Weil (1992) such as Paul Romer—to explain international income differences entirely by international differences in physical and human capital per worker, requires one to claim that these differences are very large, with counter-factual implications for the marginal product, and therefore the price, of these factors of production across countries. As Lucas (1990) observed, if international income differences depended on physical capital alone, the marginal product and price of physical capital would be orders of magnitude higher in poor countries vis-à-vis rich ones, and if capital is internationally mobile, all new investment would occur in poor countries.

If international income differences depended on human capital alone, then human capital ought to have a higher marginal product and earn more where it was scarce, and we should see mass emigration of smart college grads from the US to India, rather than the other way around. But fairly small differences in TFP—say, a factor of three between the most and least productive countries—suffices to reconcile a factor endowments explanation of most international income differences, with plausible factor prices. Table 1 shows, for selected countries: average human capital and the country risk premium on investment capital, as imputed on the basis of data; TFP, a residual used to reconcile GDP per capita with average human capital and the risk premium; and the “wage of raw labor” and “human capital premium,” as predicted when national labor and human capital markets are solved for equilibrium.

table 1 Nathan Smith

Table 1 features very large differences in average human capital across countries. Some of the world’s least developed countries have less than 5% of the human capital of the average American. Average human capital was imputed on the basis of the UN’s Human Development Index (HDI), but the HDI was interpreted as (linearly related to) the log of average human capital. A possibly surprising, but on reflection plausible, feature of the status quo world as described in Table 1 and the underlying model, is that the wages of raw labor differ enormously across countries, but the human capital premium, though it, too, tends to be positively correlated with human capital, differs much less.

Lastly, it must be mentioned that there is a spatial model at work here. Working in Stata, I generate a data set of two million “settlements,” meant to fit major stylized facts about how the human population is distributed among cities, towns, and villages. I imputed TFP at the settlement level. I won’t try to describe the spatial model in detail here, but I do want to mention why it matters. A general problem for open borders models is that it’s hard to give strictly economic reasons why anyone would want to stay in unproductive places when they could move to productive ones.

To address this question, I start by noting that some domestic locations seem more productive than others, and asking why some people live in, say, Elko, NV, instead of New York. My spatial model is based on (a) increasing returns, (b) congestion disutilities, and (c) differences in local TFP. So, Elko, NV has lower TFP than New York, and ends up with fewer people and less physical and human capital per worker, but people still live there for the cheap land and lack of congestion. By the same token, why would anyone stay in Mexico, Indonesia, or Malawi under open borders, when they could live in the USA? Because the best city sites in the USA will get congested, and some places in Mexico, Indonesia, and Malawi may be better than some places in the USA.

So, what are my results? First, let me stress that these are preliminary. After some very helpful real-time peer review from my colleagues at Open Borders: The Case, I plan to refine the spatial model, and somehow I need to come up with better ways to deal with anomalies in imputed TFP, mostly arising from natural resource wealth. The paper describes two scenarios, “Scenario 1” which implements the model in the most literal fashion, and “Scenario 2,” in which I add in some other adjustments, such as human capital growth in response to the new incentives and opportunities of a world with open borders, falling country risk premia due to remittances and generally movements of people facilitating movements of money, and TFP adjustments due to cultural/institutional influences, positive and negative, and to the fact that TFP partly reflects congestible public goods.

In Scenario 1, over 5 billion people migrate, and the world economy comes to be dominated by a few “Countries of Reinforced Dominance” and “New Settler Societies,” while the largest western European countries become “Corridor Countries,” which see much of their native human capital emigrate as they absorb a flood of less-skilled immigrants, and most developing countries become “Countries of Emigration,” losing much to most of their populations to emigration, or “Ghost Nations,” in which less than 2% of the native population stays. While I actually find these large patterns somewhat plausible, the “Countries of Reinforced Dominance” and “New Settler Societies” include too many resource-rich countries like Qatar, East Timor, and Botswana. Since everything else is mobile, high TFP outliers have an outsized impact on global outcomes.

So, I’ll reserve judgment until I come up with a better way to get at “essential” GDP, reflecting the inherent productivity of a place’s institutions, deducting natural resource windfalls. For the record, unskilled workers’ living standards under Scenario 1 converge to 23% of the current US level; the human capital premium rises almost everywhere, converging to $66,535 per annum; average (but not necessarily median) incomes rise for natives of every country in the world; the global capital stock rises more than 100%; and world GDP rises by 80%.

As I say, TFP anomalies are the Achilles heel of the model, and I like Scenario 2 better in part because it deals with them, albeit in a somewhat rough and ad hoc fashion. In Scenario 2, immigrants from low TFP places to high TFP places raise TFP in the places they come from, and reduce it in the places they go to. This is less about negative congestion externalities, which the spatial model has already tried to take into account, as it is about social norms and institutions. Take littering. Citizens of developed countries tend to have a “no littering” norm pretty firmly imprinted in their minds. Citizens of many developing countries do not. So, immigrants from developing countries would probably make litter more common in developed countries, since at least some of them would bring their bad habits with them.

At the same time, the social disapproval and legal penalties they would face for littering in the West would change the habits of some of them, and return migration and letters home would facilitate the spread of a “no littering” norm back to migrants’ countries of origin. The same would apply to many other useful protocols and practices of developed countries, from tipping to not stealing napkins from food courts to not paying bribes to democratic tolerance to culturally valuing literacy and book learning, which open borders could be expected both to dilute at home, and to spread abroad. As it happens, these plausible assumptions about institutional transmission also tame the implausible ascent of high TFP outliers. Since “founder effects” are important, however, I give natives five times the weight of immigrants in determining the TFP, under open borders, of a country of (net) immigration, while emigrants have only one-fifth the weight of those who stay home, in determining the TFP, under open borders, of a country of (net) emigration.

Scenario 2 represents, for the moment, represents my “best guess” of what a world of open borders would “really” look like. Even then, a strange qualifier must be added: I am holding things like world population and TFP constant even as I project the end-point of a transition that would take decades to play out, so the results must be interpreted as if the transition dynamics to open borders are “fast-forwarded” while other changes underway in the world economy are frozen in place. Total migration under Scenario 2 is a little over 3 billion, about 44% of mankind. Interestingly, international geographic mobility under open borders would look similar to interstate mobility in the USA today.

The global human capital stock would rise by 50%, world GDP by 69%, and the global stock of physical capital by 88%. Most developed countries would turn into “host nations,” seeing immigrants from developing countries swell their populations, while most developing countries would see a large fraction of their populations emigrate. However, under Scenario 2, there would be no “ghost nations”: the worst-off countries would be “rescued” by the benign effects of their diasporas, and would see institutions improve, average human capital rise, and investment capital become more available. Some high TFP outliers would turn into “new settler societies,” but (setting to one side the special experience of the USA) these countries would end up with only about 10% of world population. The aggregate experiences of major geographic-cultural regions, shown in Table 2, give a pretty good description of how open borders would change the world under Scenario 2.

Table 2 Nathan Smith

 

The most striking feature of Table 2 is the dramatic rise of the West, defined as the EU plus the English-speaking USA, Canada, Australia, and New Zealand. The West’s population would soar to over 3 billion. It would be home to 43% of the world’s population, but about two-thirds of physical and human capital, and it would generate two-thirds of world GDP. Of course, the West might become less Western as it absorbed billions of immigrants, mostly from East and South Asia, so some might see this as, not the rise, but the end of the West. But polities that represent rival civilizations, such as India and China, would certainly see their relative power decline.

More important, though, is the impact on individuals. And it is here that the strength of the case for open borders really shines through. “The Global Economic Impact of Open Borders” is meant as a contribution to positive, not normative economics. Evaluative judgments are included to keep the prose from being too dry, but are not what the paper is really about. Yet for anyone who cares about the welfare of the foreign-born, Table 3 cannot but be a powerful moral argument. For under Scenario 2, it is precisely the world’s poorest who would benefit most from open borders. Natives of the benighted Democratic Republic of the Congo would see their labor incomes rise, on average, by +1801%. Natives of Ethiopia, Burma, Tanzania, Kenya, and many other very poor countries, would see their incomes rise several-fold, partly because tens of millions of them would emigrate, partly because human and physical capital would become more abundant, partly because the diaspora’s influence would improve institutions. Natives of middle-income countries would see smaller, but still substantial, gains.

Table 3 Nathan Smith

Natives of developed countries would have a more ambiguous experience. There, the wage of raw labor would fall. The living standards of unskilled workers worldwide would converge to 44% of the US level. The human capital premium would rise in most places, even in the West, but in the USA, it would actually fall. This would occur because (a) the USA would be such a powerful magnet for skilled workers that average human capital, already high under the status quo, would actually rise slightly, and (b) TFP would fall by about 9%. In the large countries of Western Europe, natives would become minorities in the countries where they were born, but their average labor incomes would actually rise, thanks to gains from trade with immigrants, even as national TFP fell. But the median worker, having below average human capital, would probably earn less than under the status quo, and earnings would become more unequal. But the USA, where even the average worker would earn less than under the status quo, provides an especially good test case for the status quo.

Whether Americans would really be worse off under Scenario 2 is tricky. Their labor incomes would fall, but those who own land—and most Americans are homeowners—would see its value rise more than three-fold. Also, the US government would enjoy a far larger tax base, which it might use to hold natives harmless in the midst of enormous changes. But if we think of open borders as a sacrifice by Americans for the benefit of the foreign-born, it has the merit of being enormously effective on a per dollar basis. Global open borders would reduce Americans’ labor incomes by 10%, while increasing by multiples the welfare of billions of the poorest among our fellow human beings around the world.

While these results are not, in my view, rigged to favor open borders, they are of course highly contestable at the level of positive economics, as well as open, if accepted, to many normative appraisals. Yet I hope they will nonetheless help to dispel the notion that open borders are a “utopian” proposal. Open borders would not free mankind from work, or death, or turn the sea into lemonade, as one early utopian socialist dreamed. There would be major changes, and winners and losers, but on balance the changes would be positive, as well as highly egalitarian. Open borders is probably best compared to the abolition of slavery: a radical but not revolutionary reform, which seems quixotic, but which reason shows is attainable, and which will harm certain powerful vested interests, but benefit most of mankind, especially the worst-off, while expanding human freedom and reducing the amount of violence and coercion in the world.

At any rate, that’s my best guess as to what would happen. But my results are preliminary, and I will be grateful for feedback and criticism.

Three terrible Italian ‘gaps’

Yesterday we got confirmation that Italy feel back to recession in the second quarter of the year (see more here). In this post I will take a look at three terrible ‘gaps’ – the NGDP gap, the output gap and the price gap –  which explains why the Italian economy is so deeply sick.

It is no secret that I believe that we can understand most of what is going on in any economy by looking at the equation of exchange:

(1) M*V=P*Y

Where M is the money supply, V is money-velocity, P is the price level and Y is real GDP.

We can – inspired by David Eagle – of course re-write (1):

(1)’ N=P*Y

Where N is nominal GDP.

From N, P and Y we can construct our gaps. Each gap is the percentage difference between the actual level of the variable – for example nominal GDP – and the ‘pre-crisis trend’ (2000-2007).

The NGDP gap – massive tightening of monetary conditions post-2008 

We start by having a look at nominal GDP.

NGDP gap Italy

We can make numerous observations based on this graph.

First of all, we can see the Italian euro membership provided considerable nominal stability from 2000 to 2008 – nominal GDP basically followed a straight line during this period and at no time from 2000 to 2008 was the NGDP gap more than +/- 2%. During the period 2000-2007 NGDP grew by an average of 3.8% y/y.

Second, there were no signs of excessive NGDP growth in the years just prior to 2008. If anything NGDP growth was fairly slow during 2005-7. Therefore, it is hard to argue that what followed in 2008 and onwards in anyway can be explained as a bubble bursting.

Third, even though Italy obviously has deep structural (supply side) problems there is no getting around that what we have seen is a very significant drop in nominal spending/aggregate demand in the Italian economy since 2008. This is a reflection of the significant tightening of Italian monetary conditions that we have seen since 2008. And this is the reason why the NGDP gap no is nearly -20%!

Given this massive deflationary shock it is in my view actually somewhat of a miracle that the political situation in Italy is not a lot worse than it is!

An ever widening price gap

The scale of the deflationary shock is also visible if we look at the development in the price level – here the GDP deflation – and the price gap.

Price gap Italy

The picture in terms of prices is very much the same as for NGDP. Prior to 2007/8 we had a considerable level of nominal stability. The actual price level (the GDP deflator) more or less grew at a steady pace close to the pre-crisis trend. GDP deflator-inflation averaged 2.5% from 2000 to 2008.

However, we also see that the massive deflationary trends in the Italian economy post-2008. Hence, the price gap has widened significantly and is now close to 7%.

It is also notable that we basically have three sub-periods in terms of the development in the price gap. First, the ‘Lehman shock’ in 2008-9 where the price gap widened from zero to 4-5%. Then a period of stabilisation in 2010 (a similar pattern is visible in the NGDP gap) – and then another shock caused by the ECB’s two catastrophic interest rate hikes in 2011. Since 2011 the price gap has just continued to widen and there are absolutely no signs that the widening of the price gap is coming to an end.

What should be noted, however, is that the price gap is considerably smaller than the NGDP gap (7% vs 20% in 2014). This is an indication of considerably downward rigidity in Italian prices. Hence, had there been full price flexibility the NGDP gap and the price gap would have been of a similar size. We can therefore conclude that the Italian Aggregate Supply (AS) curve is fairly flat (the short-run Phillips curve is not vertical).

The Great Recession has caused a massive output loss in Italy

In a world of full price flexibility the AS curve is vertical and as a result a drop in nominal GDP should be translated fully into a drop in prices, while the output should be unaffected. However, as the difference between the NGDP gap and the price indicates the Italian AS curve is far from vertical. Therefore we should expect a major negative demand shock to cause a drop in prices (relative to the pre-crisis trend), but also a a drop in output (real GDP). The graph below shows that certainly also has been the case.

Output gap Italy

 

The graph confirms the story from the two first graphs – from 2000 to 2007 there was considerably nominal stability and that led to real stability as well. Hence, during that period real GDP growth consistently was fairly close to potential growth. However, the development in real GDP since 2008 has been catastrophic. Hence, real GDP today is basically at the same level today as 15 years ago!

The extremely negative development in real GDP means that the output gap (based on this simple method) today is -14%! And worse – there don’t seems to be any sign of stabilisation (yesterday’s GDP numbers confirmed that).

And it should further be noted that even before the crisis Italian RGDP growth was quite weak. Hence, in the period 2000-2007 real GDP grew by an average of only 1.2% y/y – strongly indicating that Italy not only has to struggle with a massive negative demand problem, but also with serious structural problems.

Without monetary easing it could take a decade to close the output gap  

The message from the graphs above is clear – the Italian economy is suffering from a massive demand short-fall due to overly tight monetary conditions (a collapse in nominal GDP).

One can obviously imagine that the Italian output gap can be closed without monetary easing from the ECB. That would, however, necessitate a sharp drop in the Italian price level (basically 14% relative to the pre-crisis trend – the difference between the NGDP gap and the price gap).

A back of an envelop calculation illustrates how long this process would take. Over the last couple of years the GDP deflator has grown by 1-1.5% y/y compared a pre-crisis trend-growth rate around 2.5%. This means that the yearly widening of the price gap at the present pace is 1-1.5%. Hence, at that pace it would take 9-14 years to increase the price gap to 20%.

However, even if this was political and socially possible we should remember that such an “internal devaluation” would lead to a continued rise in both public and private debt ratios as it would means that nominal GDP growth would remain extremely low even if real GDP growth where to pick up a bit.

Concluding, without a monetary easing from the ECB Italy is likely to remain in a debt-deflation spiral within things that follows from that – banking distress, public finances troubles and political and social distress.

PS An Italian – Mario Draghi – told us today that the ECB does not think that there is a need for monetary easing right now. Looking at the “terrible gaps” it is pretty hard for me to agree with Mr. Draghi.

ECB’s failure in one graph

ECBs failure

…maybe it is about time the ECB actually tries to ease monetary policy. If you don’t know how here is a plan – and another plan and one more. It is not really very hard.

Cognitive dissonance in politics, markets and monetary policy

For a while I have wanted to write something about what psychologists call “cognitive dissonance”. The way I think about cognitive dissonance is that individuals tend to look for confirmation of their already held views.

To give an example imagine that I think that all Muslims are potential terrorists (I do not think so…) then I would take any news story about war or terror in the Middle East as confirmation of this bias, while I would tend to ignore all other information. That would be cognitive dissonance.

Politics and cognitive dissonance – partners in crime

It seems to me that cognitive dissonance is very common in political discussions. Just take a look at your Facebook feed. Your libertarian FB friends will put out stories about police brutality to show that the government’s use of unlawful violence is widespread. Your socialist friends will put out stories about the evils of multi-national corporations that exploit Chinese workers and your conservative friends will put out stories about immigrants who have committed crimes.

I am not a saint. I do exactly the same thing. I tend to read news stories, which tend to confirm my views rather than challenge my views. That is just how it is, but I am also fairly aware that this is how it is, while I think most people don’t really think much about it.

The reason cognitive dissonance is so widespread in the world of public political “thinking” in my view is that the individual cost of cognitive dissonance is very small. For the average Dane the cost of thinking that “all Muslims are terrorists” or that “all Romanians are criminals” is very small. You get some utility from having an idiotic view and you also get some utility spreading it to your Facebook friends who have similarly idiotic ideas and “likes” what you write, but you don’t feel an urge to spread views that might challenge your own and your friends biases. Somebody might tell you that you are an idiot for believing in gravity.

Rational politicians will happily play along. After all it would be rather costly for the average politician to speak out against the average voter’s wrongful biases. Voters normally don’t tend to vote for people who tell them that they are wrong.

This is of course a variation of Bryan Caplan’s rational irrational voter. What Bryan has argued in a number of papers and in his great book The Myth of the Rational Voter is that the cost for the individual voter of having wrongful biases is small. As a result voters for example tend to be nationalistic and protectionist, while economists tend to be “cosmopolitarians” and pro-Free Trade.

Markets make cognitive dissonance very costly

Imagine on the other hand a situation where having cognitive dissonance will be very costly to you. Lets say you are convinced that you can fly. That conviction can be deadly – I am on the top of the Empire State building. There is a queue to the lift. Why wait? I can just jump out from a window and fly down. And now you are dead…

I guess there is natural selection here – people who don’t believe in gravity or think they can fly end up killing themselves, while those us who understand basic physics tend to live a bit longer.

This is exactly how markets are dealing with cognitive dissonance. Lets take the example of financial markets.

Anybody who have spend a bit of time on a trading floor will tell you about the typical trader – the homo tradicus. The only thing important for the homo tradicus is his P/L – his profit and loss. His P/L on a second-by-second basis also tells him whether his view of the world – this trading position – is right or wrong. This tends to strongly reduce cognitive dissonance – suffering from cognitive dissonance would fast wipe out the homo tradicus.

This is likely also the reason why many traders seem so horribly (but rationally) “inconsistent” when you talk to them. It is very common than when you talk to a trader he will tell you how successful he has been buying dollars and then two days later he will tell you that he has been a seller of dollars all along. A successful trader will never fall in love with a certain position and he will know when to cut a loss.

A successful trader would follow Keynes’ dictum “When the fact change. I change my mind”.

This I in general believe goes for markets – markets will force economic agents to be unbiased contrary to in politics where cognitive dissonance actually seems to make you more successful.

Monetary policy and cognitive dissonance

I believe that cognitive dissonance also is highly relevant for the decision making process in monetary policy. Just take the concepts hawks and doves. A hawk (dove) is a monetary policy maker who in general believe that monetary policy should be tighter (easier).

But does it make any sense always or nearly always being in favour of a tighter or easier monetary policy? If on average the central bank hits its target over time then logically half of the time monetary policy needs to be tightened (eased), which would warrant monetary policy makers to be hawkish (dovish).

However, observing central bankers it is pretty clear that they tend to be very biased. Just take somebody like Dallas Fed president Richard Fischer. Since 2008 he has been consistently hawkish. As inflation (and inflation expectations) has more or less consistently been below 2% and unemployment has been high we today know that Fisher’s hawkish stance has been wrong. Had he been a trader he would probably long ago had been without a job.

Interestingly enough back in 2008-10 Fischer was warning about inflationary risks from Fed’s policies. Today Fisher is warning about bubbles. He has maintained his hawkishness, but changed the reasons for being hawkish. That to me is a very clear indication that Fisher is suffering from serious problems with cognitive dissonance.

Fisher is not unusual. In fact I believe that Fischer is a pretty “normal” central banker. Most of them suffers from cognitive dissonance exactly because the individual cost for them of being wrong is very low.

Dealing with cognitive dissonance in monetary policy making

There is numerous ways of reducing cognitive dissonance in monetary policy making.

The obvious possibility is simply to take away central bankers’ discretionary powers and instead leaving the implementation of monetary policy to the markets. This would essentially be what we would have if the central bank for example implemented monetary policy by “pegging” market expectations for inflation or nominal GDP growth as suggested by Robert Hetzel and Scott Sumner.

A slightly less revolutionary suggestion could let “good forecasters” have more votes in the monetary policy making body. Lets take the Fed’s FOMC. Here the members could be asked to make forecasts on the Fed’s two more or less explicit targets – unemployment and core inflation.

Then on a rolling six or twelve months basis each FOMC member would be ranked based on their “forecasting accuracy”. The two worst forecasters would then loose their vote on the FOMC for a period of for example six month.

This would introduce a cost – a “shaming cost” – for being biased. Obviously the individual FOMC member could still vote as they please and there wouldn’t necessarily have to be a consistency between their voting and their forecasts, but it is likely that too large inconsistencies between voting and forecasting would cause quite a bit of embarrassment for the most biased FOMC members. This I believe would do quite a bit to reduce cognitive dissonance among the FOMC members.

It should be noted that the FOMC actually has moved a bit in this direction over the last couple of years, but in my view the cost to the individual FOMC of being biased is still very small and cognitive dissonance therefore seems to dominate monetary policy making.

PS this post is actually a bit of an attempt to start dealing with my own problems with cognitive dissonance. I am not sure that I am succeeding, but I am at least trying to think of methods to get around cognitive dissonance problems.

UPDATE:  A couple of readers have suggested that I use the term “cognitive dissonance” in a wrong way. I surely acknowledge that I am a bit (maybe a lot) sloppy with the term here and it might have been more telling (or correct) to use the term “confirmation bias” instead or even Bryan Caplan’s term “rational irrationality”. This does, however, not change the conclusions.

Celebrating Friedman and Hetzel

Today Milton Friedman would have turned 102 years. Happy birthday Uncle Milty!

I have over the last couple of years done numerous posts celebrating Milton Friedman so this post will not be long. Instead I will leave the job to Robert Hetzel who I am also celebrating this year as Bob turned 70 years on July 3.

So I find it suiting that my readers should read Bob’s paper The Contributions of Milton Friedman to Economics. Here is the abstract:

Milton Friedman began his teaching career at the University of Chicago isolated intellectually. He defended the ideas that competitive markets work efficiently to allocate resources and that central banks are responsible for inflation. By the 1980s, these ideas had become commonplace. Friedman was one of the great intellectuals of the 20th century because of his major influence on how a broad public understood the Depression, the Fed’s stop-go monetary policy of the 1970s, flexible exchange rates, and the ability of market forces to advance individual welfare.

I my view Bob – with David Laidler and Edward Nelson – is one of the foremost Friedman scholars of the world. Friedman of course was Bob’s teacher and PhD thesis advisor at the University of Chicago.

This is a list of some of my earlier tributes to Milton Friedman:

Milton Friedman’s answer to a student at the “CEPOS Akademi”
There is a pragmatic (but not a libertarian) case for a “Basic Income Guarantee”
The end of Prohibition and two great monetary thinkers
http://marketmonetarist.com/2013/12/05/the-end-of-prohibition-and-two-great-monetary-thinkers/
If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING
Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)
This should teach you not to mess with Milton Friedman
15 years too late: Reviving Japan (the ECB should watch and learn)
“The Euro: Monetary Unity To Political Disunity?”
BYU radio interview with Christensen
Bernanke says Friedman would have approved of Fed’s recent actions – I think is he more or less right
The Hetzel-Ireland Synthesis
Woodford on NGDP targeting and Friedman
Friedman’s Japanese lessons for the ECB
Friedman, Schuler and Hanke on exchange rates – a minor and friendly disagreement
Dear Milton
You might know the words, but do you get the music?
I can hear Uncle Milty scream from upstairs – at James Bullard
“Free to Choose” now republished in Danish
Allen Sanderson on Milton Friedman
Understanding financial markets with MV=PY – a look at the bond market
Long and variable leads and lags
Christina Romer is also in love with Milton Friedman
A personal tribute to Milton Friedman
Dinner with Bob Chitester
Friedman should have supported NGDP targeting, but never did
Selgin is right – Friedman wanted to abolish the Fed
Friedman provided a theory for NGDP targeting
Friedman’s thermostat and why he obviously would support a NGDP target
Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5

See also my book on Milton Friedman (In Danish)

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