Adjustment costs vs steady states

Consider four issues:

1. John McDonnell objects thusly to the EU-India Free Trade Agreement:

If multi-brand retailing is suddenly and without safeguard opened up to EU retailers such as Carrefour, Metro and Tesco, 1.8 million jobs may be created, but at the cost of up to 5.7 million people working as street vendors.

But there are reasons to agree with Peter Mandelson that those 5.7 million are only “short-term losers”. Those 1.8 million new jobs will be (relatively) high productivity an high wage ones. As those workers spend their higher incomes, they’ll create new demand which will create other, maybe better, opportunities for those displaced street vendors. It’s not at all clear that trade liberalization leads to lasting unemployment and poverty (big pdf).

2. One justification for a benefits cap is that the squeeze on housing benefit will force landlords to reduce rents. But in the process, some people might become homeless.

3. Jonathan Portes says it is possible that immigration raises unemployment in the short term, but that in the longer-term, joblessness depends other, macro, factors.

4. A return to national currencies within Europe might be superior to monetary union. But the cost of making the return - a huge banking crisis - is huge.

These look like four different issues. But they have a similar structure. In all cases, we have a problem of adjustment costs. Free trade, limited housing benefit, free migration or floating exchange rates might be superior to the alternatives, but there are costs of making the move.

So far, so straightforward. But here’s a quirk. It is, in theory, quite reasonable to say “state B is superior to state A, but the costs of moving are prohibitively high. So let’s stick with A.” But, I suspect, few people take this position. It’s far more common to conflate the adjustment costs with the argument that B is actually inferior to A even as a steady state.

Here’s another quirk. Our first three cases above all have something else in common. People who think that markets operate reasonably smoothly will believe the adjustments are small, and so in all three we have a debate between market optimists and pessimists. But the issue of adjustment costs needn’t always take this form. Consider a fifth case, thus:

A “John Lewis economy” would be superior to one with external shareholders, as workers will be more productive, there’ll be more effective oversight of management, and there’ll be less inequality. However, a transition to a John Lewis economy requires that shareholders be expropriated and their stakes transferred to workers.

(I could add a sixth - the idea of cancelling debts).

I suspect that attitudes to this will be the opposite to that in our first three cases. The folk who think adjustment costs tolerable in those will think them intolerable in this. They might be right; if the state can violate property rights once, they can do so again, so such an expropriation might scare off future investors and thus depress economic activity. But this is arguable.

Which brings me to my concern. Could it be that popular debate about adjustment costs consists of a lot of fact-free hand waving?

I’m tempted to add - as Jonathan says - that it is overly influenced by cognitive biases such as the availability heuristic that causes us to focus too much upon lively anecdotes to the detriment of equilibrium thinking. But the complication is that the anecdotes are about real people, whereas equilibrium thinking is not.

I fear the issues here are trickier than are generally realized.

Comments

[Luis Enrique]

I like this point: some people see some varieties of adjustment cost (sorry, you have to lose your job in interests of efficiency) as perfectly acceptable, and other varieties of adjustment cost (sorry, you have to have your six-figure salary capped) as outrageous and utterly unacceptable.

[Gareth]

"John McDonnell objects thusly to the EU-India Free Trade Agreement"

It is amazing we have an economy which works at all with idiots like this in parliament. If today's left had been in power at the time of the industrial revolution, they would have banned it.

[Metatone]

The big flaw in Jonathan's defence of his work is that he doesn't quantify how long "the short term" is.

What we know from the plight of graduates who enter the labour market during a recession is that the short term doesn't have to be that long to put people at a permanent disadvantage in earning power.

So, despite his hand-waving there are real effects at work that he refuses to study.

[john b]

There's also a point to be made here about the ease of bearing adjustment costs. If a graduate in England can't get a job for a couple of years, that's frustrating for him. If a poverty-line vendor in India loses his job, then he's liable to die in a ditch.

[DrBlighty]

So it's acceptable for the government to use hapless tenants as pawns in pursuit of getting landlords to lower their rents? Not according to Kant, it isn't. Why not re-establish the old system of rent controls where tenants could apply to the local authority to have their rant "fair rented"? Once a fair rent had been determined the landlord would not be permitted to charge more.

[Account Deleted]

What you've highlighted is essentially confimation bias - i.e. we proceed from a belief that a certain course of action should be pursued (or avoided) and then search for evidence to support our belief.

This is typical of most cost/benefit analyses, which are more correctly labelled justifications. The impact of business consultancy culture on government and think-tanks over the last 50 years has been pernicious in this regard.

Every day businesses make decisions about large amounts of money (and people's jobs) based on cost/benefit studies lacking any empirical rigour. It's not just "hand-waving", it's voodoo. In extreme examples (e.g. financial trading), we elevate gut (and risk-taking) over brain and celebrate the fact.

The John Lewis case is interesting because one's reaction to the proposal is largely determined by the emotive language: "... that shareholders be expropriated and their stakes transferred to workers."

I'm sure Nick Clegg could come up with a less threatening form of words.

[Neil Harding]

The benefit cap will allow landlords to increase rent as families split up to avoid the cap thereby increasing demand for rented accommodation.

[Neil Harding]

And forgot to add, increasing costs on the taxpayer.

[David Hurley]

The government should have to do some serious work otherwise people will through them out of the seats.