Originally sent to VIXCONTANGO subscribers on January 14th, 2017, almost a year before Trump’s Tax Cuts And Jobs Act was signed
New Economic Geography
Ever since the fall of the Berlin Wall on November 9th, 1989, we have lived in the era of Globalism. Many long-standing economic and societal borders fell around the world between the Communist block that encompassed 70% of the civilized world and the Capitalist block that covered the more economically successful remaining 30%. Governments across the world started to build a new world order of international economic cooperation that was going to bring peace and prosperity. A major undertaking like that has a theory behind it and the creator of the theory of Globalism is none other than conservative pariah and liberal idol, Paul Krugman. Paul Krugman is one of the premier economists of our time and an extremely smart individual. And he would have been universally revered if he didn’t compromise his integrity by advocating for unreasonable radical economic solutions and misused his economic integrity in the pursuit of partisanship, thereby becoming a political hack with a limited shelf life.
Krugman major contributions to the world are 2 academic papers. The first paper is called “International Trade and Income Distribution: A Reconsideration” published in 1979. In it he lays out an economic theory called “New Trade Theory” (NTT). Prior to New Trade Theory, international trade theory emphasized that trade between countries is based on comparative advantage of countries with different characteristics. Saudi Arabia has oil, France has wine and they trade red gold for black gold. While that is still true to an extent, as borders and tariffs fell, international trade started to move differently and the original model couldn’t explain these movements. This is what Krugman’s paper did, explain the new patterns of trade. In it, Krugman observed that a larger share of trade happens between countries with similar characteristics. Why are Japan and the US, trading so much when both economies make the same things – cars, power tools, electronics, computer chips? Krugman says that consumers prefer a diverse choice of brands (expanded selection) and that production factors economies of scale. Consumer preference for diversity explains why you have 20 different car brands, but economies of scale make it so that production is localized. In addition to economies of scale, lower local transportation costs lead to a “home market effect”. A country with large demand for a certain good will produce more than the proportionate world share of the good and will over time become a net exporter of it and that process will kill off production of that good in smaller markets. So production doesn’t occur in all countries in the world but just one or two or three over time. That is why now you only have France and Napa Valley as the only wine producers of major sales consequence. Why only Japan, the US and Germany produce cars. Why only US and Europe produce airplanes. And why China and the US are the only ones making smartphones. This is New Trade Theory. It is very obvious, but it was not so obvious 35 years ago. In that paper Krugman also correctly predicts that while there are economies of scale in production, countries will eventually become “locked into” disadvantageous patterns of trade. Krugman points out that while globalization is a net positive, ultimately globalization turns into hyper-globalization which plays a major role in rising income inequality.
He expands on the concept of hyper-globalization in a paper called “Increasing Returns and Economic Geography” published in the Journal of Political Economy in 1991. In that paper he lays a new economic theory called “New Economic Geography” (NEG). In NEG, the “home market effect” is exacerbated and that results in disadvantageous patters of production inside a country and across economic geographies. Not only is production concentrated in countries, it increasingly becomes concentrated in metropolitan city regions. The regions with most production become more profitable and they then have the ability to attract even more production and kill off production in competing regions. So instead of production being spread evenly around the world, it becomes concentrated in a few countries, regions and cities which become very densely populated and feature higher levels of income. So the world becomes either a high rise city of highly paid professionals or a barren countryside with barns that are falling apart.
The body mass of all 7 billion people of the world inside the Grand Canyon
That is why if you live in Manhattan you are concerned with the “overpopulation” of the world and if you blow a tire in Fishkill only 50 miles away from Manhattan, you have wait 5 hours for the AAA truck to show up (trust me, it has happened). In other words, if you want to have a good high paying job, move from Detroit to New York. If you want to make money in real estate, sell Detroit, buy Brooklyn. I have personally observed this in my lifetime where landing me in New York was the best thing that ever happened to me professionally. I could always line up at least 2 job offers in the span of a week. That gave me both choice of work and an advantage in salary negotiations. I wanted to live in San Diego originally, but for my skills there were zero jobs there at the time. I looked for months. In New York, I didn’t have enough time to reply to all the job postings posted in a single day. And none of this is a function of how smart I am but simply the relative strength of the economic region.
Needless to say Krugman’s theories have been very prescient, what they have described has become a focal point of international affairs and very deservedly he was awarded a Nobel Prize in 2008. In fact, in his case, even a Nobel Prize is an inadequate reward for his intellectual achievements. What is even weirder is that his theories foresaw the rise of desolate economic regions, the resulting increase in inequality and the rise of political movements to counteract this effect of hyper-globalization. And of course having foreseen it, he has fought the emergence of economic nationalism tooth and nail from the very beginning. What is unfolding right now is his worst nightmare come to life.
In the mind of our leading economists, globalization is really the preferred approach to worldwide economic organization because it leads to larger cross-national economic regions. Larger economic regions result in increased economic activity via trade, result in higher specialization which means higher paying and more interesting jobs and results in efficiencies of scale which results in higher standards of living (people pay less for the same good over time). It is undeniable that they mean well for the world as a whole. There is hardly much to be argued with from a theoretical perspective.
But explain that to an air conditioning mechanic with 20 years of experience who just lost his job and there is no other such job anywhere in the entire country. He has to move to Mexico and learn a new language at 45-years of age in order to receive a lower salary. In the meantime, how is he going to pay for the $100,000 outstanding on his house loan given that his house value just tumbled by $40,000 dollars and if he sells his house, he is $40K in the hole which exceeds his meager savings? Economic theory is great, but the reality of life tends to get in the way of economic perfection.
The main factor that is NOT considered in globalist economic models is the concept of nations. Nations are not organized as such because they have a comparative economic advantage but because they have are a conglomeration of people of similar ethno-centric group, similar religion or simply a militaristic agglomeration. In fact nations exist for all kinds of reasons but economic advantage is not one of them. The reason why economics is not a reason for nation-state organization is because the economics of war, of military conflict, are highly asymmetrical. And have been since the beginning of time. A simple cheap cannon can destroy many houses that took years of effort, materials and investment to build. A nuclear bomb can destroy the combined accomplishments of thousands of years of civilization in a given city in an hour. As such the cheapness of military conflict and its ability to asymmetrically inflict economic damage, is the reason why nations are defined based on military characteristics more than anything else. Economic globalism is therefore a very fragile function of global peace.
Not only is the concept of nations not covered in Krugman’s theories, but also many more mainstream economic considerations such as:
Economic debt and credit levels
If a nation has high debt levels and loses its productive capacity, the leverage speeds the decline of the nation into bankruptcy. A bankrupt nation is therefore not capable to contribute as a consumer to the economic system. So a system with 10 participants, because of NEG becomes a system with only 3 rich participants and 7 bankrupt participants that ceize to be economic units. Production is concentrated but in the long run sales become economically concentrated as well as bankrupt consumers fall off the map.
Lower living standards
When productive capacity in an economy or country is removed, also its ability to pay taxes is removed. As such the citizens of this country experience a lower standard of living as they get less benefits. This not only does not stimulate economic growth it actually eliminates it.
Lack of flexibility in adverse circumstances
If all production is concentrated, during a war it becomes a very simple task to be destroyed quickly by simply eliminating a few important economic units. Decentralization is key component of war and of survival in general. A human can breathe through the nose and through the mouth. In case one thing malfunctions, the other one can take its place. That is why there are 2 eyes, 2 ears, 2 hands and 2 legs. Not because they are useful, but because they are redundant. They provide backup and added resiliency for survival in case the primary mechanisms are attacked or malfunction. Similar concepts apply to complex systems such as economies or computer systems. Centralized globalist economies are thus much more in danger of quick destruction than decentralized ones.
It is perhaps very befuddling for Krugman to witness the age of slow economic growth in the US over the past 20 years. He couldn’t have foreseen that the largest economic power will fall victim to Globalization. After all power should’ve concentrated more and more in the US as it is the dominant producer and the home market effect should’ve enabled that across a number of industries. The problem for an economic theory as always is reality and the lack of inclusion in it of enough important factors. For example, in Krugman’s theories nowhere is there made a reference to taxation regimes. In practically all of the world except the US, consumption is deemed a bad societal characteristic and is thus taxed. Countries with communist lineage love to tax consumption via VAT. Also in non-secular countries, religions often postulate that consumption is unholy or that interest is unholy. Consumption = bad. So the USA is pretty much the only country where consumption is not taxed because it is socially acceptable. So in the WTO, the US is the only country that taxes production and not consumption and everybody else taxes consumption but not production. The net effect is that corporations will choose to produce where they are taxed less and then sell where they are taxed less. Pretty logical choice, right? So corporations will chose to produce outside of the US and sell in the US. Normally, these discrepancies would get fixed by currency adjustment. But what if currencies are not allowed to adjust? What if China pegs its currency to the US dollar? Then the imbalance remains forever and heavily impacts economic activity.
Taxation is one factor that is seriously crimping Krugman’s vision. Others are loss of tax revenue, loss of government benefits, state subsidies and other mercantilist policies and the overall reality that global trade is a shark tank where each actor tries to get as much advantage as they can get and screw the others. The Globalist kumbaya is largely a figment of Krugman’s imagination. Every incomplete or bad theory eventually meets its inglorious demise and so does Krugman’s theory of New Trade and Globalization in 2016. So while Krugman’s theories crumble, the US has to adjust and somehow start collecting the tax revenue it ceded to China and other mercantilist players. How?
Border Adjustment Taxation
Before I delve further I want to make 100% clear one thing. The Border Adjustment IS NOT A TAX. Repeat again. The Border Adjustment IS NOT A TAX OR A TARIFF.
As I go further into the specifics of the House GOP (“The Better Way”) tax plan, it is very important to note that there isn’t a single tax hike anywhere in the plan. There isn’t a single tariff. The price of any good imported in the United States will not go up by a single cent. In other words, $100 of Mexican avocados in the US will still be $100 of avocados after the GOP plan passes, because there will be no additional tax or tariff applied to them. What changes is underneath the surface and is brilliant in its design and simplicity. And yet, it will result in massive amounts of money being put in the government coffers:
So what is the Border Adjustment?
Eliminate the deduction of imported goods and exempt sales of exported goods.
That’s it. A simple accounting trick. Anything purchased abroad can no longer be deducted and anything sold abroad is no longer taxable (which is essentially what a territorial regime is). In other words, it makes complete sense even at the most fundamental of levels. If you bought it abroad, this is not economic activity in the USA so therefore why should it show on your US taxes in any form or fashion? Likewise, if something is sold abroad, that is where it gets taxed. What the heck does the US have to do with its sale? In all honesty, it is not even an accounting trick. It is how things should be.
This is the taxation regime of many countries in the WTO already. There is nothing earth shattering here. It is what corporations have always wanted – territorial taxation. Tax the sales where they occur, not where the corporation is headquartered or where the production plant is. In a cloud world, it gets very hard to pinpoint concepts such as headquarters or production plants. A web company with a global software engineering team produces in all 20 countries where it has engineers. Does that mean it has to pay production tax in 20 countries where each dude is? How much value add each dude contributes to the final product? It is a logistical nightmare to figure this out. It is much simpler to simply tax where the sales occur. And that is that. That immediately kills the need for inversions, because being headquartered in the US doesn’t mean you have to share 35% of profits in Saudi Arabia with Uncle Sam anymore. What you sell in Saudi Arabia gets taxed there and that is that.
What does that mean in practice? That means that importers will pay more in taxes as their import costs will not get deducted and what they pay extra in tax will get transferred to exporters who then get a tax credit. Very simple. The imports subsidize the exports. And make exporters more desirable on an after tax basis. No changes for domestic companies. And importers – they have to pay more in tax.
Source: Kyle Pomerleau, Tax Foundation
The most important thing of this is that prices for consumers will not change one iota because there is no tariff on an additional consumption VAT tax anywhere to be seen. Effectively from a retail sales perspective, the GDP growth projections do not have to change one cent. It is just that being an importer becomes a less profitable business. You know I feel really bad for the Chinese princelings that own the major Chinese import companies in the US. It’s going to put a crimp on their lifestyle. But not much else.
Would the WTO object to this? Here is what the Tax foundations says:
The World Trade Organization generally allows and expects consumption-based taxes (called “indirect taxes”) to be border adjusted. However, it objects to income-style taxes (called “direct taxes”) being border adjusted. So the corporate income tax is considered not eligible for border-adjusted treatment. This is the conventional treatment going back to the 1950s. However, there is a case for treating this tax as an indirect, consumption-based tax. Once a business tax allows full and immediate expensing of capital investment spending, it takes on the nature and tax base of a consumption-based tax.
Brilliant move, right?
VIXCONTANGO BLOG 