Manufacturing, economics, and democracy

President Obama wants the government to do more to help rebuild America's manufacturing. Many economists have responded to his initiative by giving their opinion on the question of "Should the government intervene in the market to favor manufacturing?" and usually their answer is "no" - whether they are liberal or conservative. But the question is a loaded question because it implies that if the government does not encourage manufacturing, the market will be left to its own initiative. That is, the question is based on the assumption that the economy and economic markets normally operate on their own without interacting with government.  And that assumption is not correct.  For example, over the last 20 years the US government has worked to keep the exchange rate of the dollar high versus other currencies. This government policy favors the finance industry (because people want to keep money in dollars) and big importers like Wal-Mart (because their dollars buy more stuff) but it hurts US manufacturers. The  Federal tax policy that lets corporations keep foreign earnings tax free encourages US multinationals to shift investment (and jobs) overseas and gives them an advantage over companies that do not or cannot. The Federal government tax subsidies of oil companies and coal mining help those industries fight off competition from new energy providers - like wind and solar. The government low tax rate for "carried interest" makes it more profitable to run a hedge fund than to run a grocery store. All these government policies set the boundaries of markets and affect the incentives within those markets. The recent Dodd-Frank finance bill made it harder for Wall Street banks to borrow money to bet for themselves (perhaps against their own customers). The law was intended to limit the probability that taxpayers would have to bail out finance again, but it's also having other effects that are causing a lot of complaining on Wall Street:
If you’re a smart Ph.D. from MIT, you’d never go to Wall Street now,” says a hedge-fund executive. “You’d go to Silicon Valley. There’s at least a prospect for a huge gain. You’d have the potential to be the next Mark Zuckerberg. It looks like he has a lot more fun.”  Gabriel Sherman in NY Magazine.
From my point of view, it's great that smart people will want to do real engineering in Silicon Valley instead of financial engineering on Wall Street, but some economists will wring their hands about this government "intervention" in a supposedly free market. If we look at the history of Wall Street though, we can see the government did not start "intervening" last year, or 10 years ago, or 50 years ago, or even 100 years ago. Aside from high dollar policies, we have to also consider government financed securitization and mortgage insurance (via Fannie Mae/Freddie Mac/FHA), a huge bailout just a few years ago and another back in the 1990s, the operation of the SEC to regulate exchanges, lending from Federal reserve banking system, the government sponsored FDIC insurance of bank accounts, and so on. And the Federal Reserve started operating in 1913. So we have a strange situation where standard economics claims that the normal situation is markets operating "naturally" without government intervention, but those supposedly normal markets don't exist and never have existed. There was never a time in human history where significant economic markets were not strongly influenced by some government policy.

Here's Christina Romer, who used to work for President Obama, arguing against President Obama's manufacturing policy.
A related argument for subsidizing manufacturing involves learning by doing. It takes time for a production process to become efficient. But whether learning creates a role for government depends on whether the eventual returns are captured by the company taking the risk. If the company that jumps in first and eventually succeeds reaps all the rewards, there’s not a market failure. The company needs to count the learning period as part of the investment cost. And with well-functioning capital markets, it should be able to find investors without government help.
First she asks if there is "a role for government" as if there were a choice. But government always plays a role in any market - whether the government is directly managing business or setting tax policies or deciding who pays for pollution or managing exchange rates.

The more appropriate question to ask is whether, as the President proposes, the government should do more to encourage research and development on technologies that can become useful. Historically, this is exactly what the government has done. The US government invested in musket manufacturing, steamboats, canal building, airplane manufacturing, transistors, integrated circuits, and the development of the Internet, just to name some key technologies. The amount of business activity around the government's GPS satellite system is enormous - even though no firm could have made a profit from setting up such a satellite network on its own. And there would be no gene therapy industry without government R&D.  So Romer's question really should be whether we want to have growing manufacturing sector or not, because if the government is not encouraging manufacturing R&D, it is essentially tipping the scales towards something else - like an economy based on exporting scrap metal and corn instead of next generation machine tools, advanced avionics, and medical technologies. And this brings us to Romer's statement about capital markets which deserves to be requoted
with well-functioning capital markets, it [the company that wants to develop a new technology] should be able to find investors without government help.
Why would a hedge fund or private equity fund manager who can get 15% cap gains taxable income on 20% of short term stock gains invest in a long term, risky product development? The incentive caused by government tax policy will make him or her prefer to roll the dice on oil futures speculation or selling shares of company short or helping to finance the looting of a company by private equity investors. These investments, thanks to government tax policy could earn him or her enormous wealth that can then, thanks to government tax policy be sheltered in some offshore bank. Why would a pension fund investor put money into a Tesla Motors or a company proposing to come up with a new kind of machine tool when, thanks to government policy, the tax subsidized oil business is so profitable and hedge funds promises of high returns are thanks to government policy considered enough to make a hedge fund investment be prudent? Why would a bank lend money to a US manufacturer when its multinational competitor can shelter income thanks to government tax policy?

What President Obama proposes to do is to change government incentives to promote investment in domestic manufacturing instead of in speculation and foreign manufacturing. For economists who want to pretend that the existing economy is somehow the natural state of things, this is heavy handed government intervention. But the existing markets and incentives are the result of previous government policies. Banker incentives are not created by God with inalienable bonus provisions, they are a result of the interaction of market choices and government policies. In a democracy, we should look for government policies that "promote the general welfare" - that is, policies that increase national prosperity and opportunity. As President Obama said, we should not fight a meaningless battle about big versus small government, we should be concerned about smart versus dumb government.

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