“Political Economy Problems” In the Analysis of Trade Policy

1. “Political Economy Problems”In the Analysis of Trade Policy Doug Nelson School of Economics

2. Blinder’s Law • Blinder’s Law: Economists have least influence on policy where they know most and are most agreed; they have the most influence on policy where they know the least and disagree most vehemently. • Blinder’s main examples of the former are • Trade policy • Environmental policy.

3. Consider Trade Policy • Virtually all countries provide protection which is: • Non-uniform across sectors; and • Seems hard to rationalize in terms of any obvious economic welfare argument. • In many sectors protection is sufficiently high that the net costs are positive, even large (e.g. agriculture, textiles, steel), but • In some sectors protection is positive, but below estimates of the optimal tariff, so welfare could be raised by increasing protection.

4. How do we explain this phenomenon? • Politicians are ignorant • Economists are ignorant • Politicians are (possibly very) smart, but their goal is something other than pure social welfare maximization That is: Trade policy is a “political economy problem”

5. On “Political Economy Problems” • For most economists, this is a conversational trick meaning • The world isn’t behaving the way theory suggests it should, but • it isn’t our fault, so let’s pass over this unfortunate problem in silence. • For a small, but growing group of economists this is the opening gambit in an attempt to extend the tools of economics to the domain of political and political economic analysis.

6. What I want to do in this lecture • Discuss the nature of the very real successes in the political economic analysis of trade policy; • Discuss two “political economy problem” problems: • The “mystery of the missing protection”; and • The “normative political economy” problem.

7. What is an Endogenous Policy Model? • Basic Idea: Embed a simple model of political process in a well-specified model of the economy. • Use the economic structure to identify citizen preferences; and • Use the political model to map the preferences into outcomes. • These are essentially models of preference induced equilibrium.

8. What Can You Do With An Endogenous Policy Model? • Audit the logic of informal political economy analyses. • Account for policy outcomes apparently inconsistent with “best practice” • Provide a framework for positive and normative analysis.

9. Endogenous tariff theory and policy preferences • Derive the effect of a tariff via comparative static analysis for the small country case. • In general a tariff lowers aggregate welfare; however • With heterogeneity of factor-ownership or tastes across households, there are distributional effects (e.g. Stolper-Samuelson theorem); and • Tariff income is usually redistributed in a welfare neutral fashion.

10. Endogenous tariff theory and a tariff referendum • Now suppose that the tariff is chosen by referendum in which: • All households share the same preferences, and own 1 unit of labor, but own different quantities of capital • Preferences are single-peaked over the tariff; and • Individuals are non-strategic in their voting behavior.

11. Endogenous tariff theory and a tariff referendum • Black’s theorem states: if preferences are single-peaked over a one-dimensional issue, the most preferred point of the median voter cannot be defeated in a majority rule contest. • Hotelling-Downs theorem provides a mechanism for picking this outcome in 2-party competition. • Majority rule over a one-dimensional issue is an Arrovian democratic social welfare function.

12. Endogenous tariff theory and a tariff referendum • Mayer’s theorem states that in almost all cases the equilibrium policy will involve a non-zero tariff. • NOTE: • The social welfare maximizing tariff is zero (by the small country assumption); but • The democratically optimal tariff is nonzero.

13. Successes and Failures • Successes of endogenous tariff theory: • Clear formalization of the “political economy problem” • Interesting cautionary tale • The problem is non-trivial, i.e. the problem is not corruption here; rather • The problem is an inconsistency between the democratically optimal and the welfare optimal trade policy. • There are, of course, ways to make free trade democratically optimal (i.e. redistribution of income), but • We don’t observe much of this; and • If redistribution is chosen democratically along with trade, the dimensionality goes up with ugly consequences.

14. Successes and Failures • “Narrow” Failures • Additional theoretical effort on preference-induced equilibrium generates little additional content. • Empirical work on the political economy of trade policy is only loosely connected to the models • “Broad” Failures • The Mystery of the Missing Protection • These models are developed to explain bad policy, in this case protection; but the essential fact about modern trade policy is how liberal it is, not how protectionist. • Utter lack of compelling normative analysis.

15. A quick word on narrow failures • Political economy applications with more empirical success • Local public economics—school finance; • Macro political economy • Better match between theory and data than in the trade case: • Actual referenda on trade extremely rare; and • Data and models on lobbying severely underdeveloped

16. The Mystery of Missing Protection • Over the last three decades there have been hundreds of papers and books on the the political economy of trade. • The overwhelming majority have focussed on the political economy of protection or the failure of liberalization. • This might lead us to suspect that protection is the most significant phenomenon facing us • This is simply not the case.

17. The Mystery of Missing Protection • At least for industrial countries the single most striking fact of the last half century is the liberality of trade. • The average tariff has reached a historical low and shows no likelihood of increasing. • Statutory tariffs are locked in by GATT/WTO commitments • Standard data can’t show anything but liberalization • Consider the US data

18. The Mystery of Missing Protection

19. The Mystery of Missing Protection • At least for industrial countries the single most striking fact of the last half century is the liberality of trade. • The average tariff has reached a historical low and shows no likelihood of increasing. • Statutory tariffs are locked in by GATT/WTO commitments • Standard data can’t show anything but liberalization • Consider the US data • Administered protection provides increase at the margin • Empirical work finds it very hard to tap this protection. • This is small potatoes compared to the magnitude of liberalization

20. Explaining Liberalization:Permissive Factors • Income tax (16th Ammendment, 1913) • RTAA 1934: Delegation from Legislature to Executive • RTAA 1934: Administered v. Legislated Protection • Based on Lowi’s “Arenas” Typology • Legislated protection as distributive politics (private good) • Administered protection as regulatory politics (public good) • Shift in definition of arena induces shift in lobbying consistent with a lower equilibrium tariff. • GATT/WTO: Role of international commitments in policy lock-in

21. Explaining Liberalization:Fundamental Accounts • Congressional learning : “Congress” learned that the Hawley-Smoot Tariff caused the Great Depression. • Two Problems • No evidence of link between tariff and depression • Timing of changed voting behavior inconsistent • Changed economic fundamentals • Link between factor mobility and politics of protection • Changed factor mobility changes politics

22. Explaining Liberalization:Fundamental Accounts • Changed political fundamentals • Based on Key/Burnham theory of party systems • Transition from System of ’96 to New Deal involved disappearance of trade as a political issue • Hall/Kao/Nelson (1998) argue that female franchise is consistent with both the collapse of the System of ’96 and the disappearance of trade as a political issue.

23. Explaining Liberalization:No General Theory of the Specific • External Events • Both changed fundamentals stories are of this sort • Macroeconomic Crisis • Leadership • Harberger: “A Handful of Heroes” • Institutional change and the need for leadership • The unprotecting of liberalization in the US • End of the cold war • End of traditional Ways & Means • Democrat v. Republican presidents: • Carter v. Reagan • Clinton v. Bush • Pro-Business should not be confused for Pro-market. • What do leaders do?

24. Explaining Liberalization:No General Theory of the Specific • Learning • Elite learning: interesting problem • Clear transition in elite opinion on trade • No one has studied how this occurred • Public learning • Hall/Nelson (2002) show strong evidence of footloose public preferences on NAFTA; and • Provide a simple theory based on information cascades. • This approach provides leverage for informed policy advice (though it also supports all kinds of propaganda).

25. The Normative Political Economy Problem • This is where political-economy research on trade policy begins : Tullock and Krueger on rent-seeking; Bhagwati on DUP • As political-economic welfare analysis, this is misguided • All lack a coherent welfare analysis of political activity • Some political activity is clearly corrupt and undermines democratic legitimacy, but much has the positive value of participation. • A closely related problem is normative analysis without a politically plausible alternative • Consider the case of antidumping

26. Back to Blinder • Do economists really have no impact at all? • Is it just interests? (this is the implication of Blinder’s law and the fundamental basis of Chicago political-economy). • Blinder doesn’t think so, neither does Becker, neither does Paul Krugman. • The rest of us shouldn’t either So what should we be doing?

27. Back to Blinder • More Blinders, Beckers, and Krugmans • We need to be better engaged, explaining to real people, in language they can understand, why we believe that markets work. • Expecting most people to think like professional economists is just a mistake. • In my belief this extends to the structure and content of economics education at the principles level.

28. Back to Blinder • More honesty • Admit that getting the gains from trade means adjustment which is costly and falls asymmetrically. • If we are going to argue for liberalization we need either to argue for income transfers that support general gains and general political support; or explain why we don’t. • Potential gains from trade arguments convince no one. • More real political realism (not cheap cynicism) • This means more and better political economy • Which is where we started.