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Archive for May 2016

Open or closed borders, that is the question

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Trade bottleneck: The border between Zambia and Zimbabwe in 2008 (Photo: Johan Fourie)

Trade bottleneck: The border between Zambia and Zimbabwe in 2008 (Photo: Johan Fourie)

Most professional economists would agree that open world trade increases economic growth and raises living standards. Trade barriers such as tariffs and non-tariff barriers – which include rules-of-origin clauses or sanitary and phytosanitary conditions – reduce countries’ ability to specialise in those goods and services which they are good at, and force them to produce things that they are not good at.

But despite this important insight that dates back to Adam Smith and David Ricardo, economists also know that free trade is not always good for everyone. Industries that are uncompetitive but employ many thousands of people can suffer when trade barriers protecting those industries fall. Many countries protect certain key industries, arguing that they are industries of national security. The classic examples here are military spending or food security. (This can have ridiculous consequences: Gilette argued that its razors deserve tariff protection during the Second World War, ostensibly because soldiers could not go unshaven.) Other industries are protected because they are young and, it is argued, will become more efficient once they obtain certain economies of scale. This is known as infant industry protection. The problem is: many infants never grow up. The South African clothing and textile industry has received government support since the 1930s, and we still pay exorbitant import tariffs on clothes.

But sometimes it does work. As Concrete Economics, a new book by Stephen Cohen and Brad de Long, explains, the United States became the manufacturing hub of the late nineteenth and early twentieth centuries because it was protecting its local industries from cheap British imports. In Economics jargon, their comparative advantage (the thing they were relatively better at making) switched from agricultural goods to manufacturing goods. And with manufacturing came higher paying jobs and more dynamic technological innovation.

It is this same model that the East Asian Tigers followed, copying the basic and later advanced technological products of the West, building a domestic industry behind high tariffs, and once they’ve built up the necessary technological know-how, exported their way to prosperity. Now they are at the technological frontier designing and building new phones (Samsung, Korean) and computers (Lenovo, Chinese) and robots (Honda, Sony, Fujitsu, Hitachi and Toyota, all Japanese firms, have built human robots).

But this strategy did not work everywhere. The evidence for Latin America is mixed: attempts at import-substitute industrialising failed to propel Argentina, Brazil and many other smaller South American countries to prosperity in the same way it did East Asian countries. And in postcolonial Africa it only managed to impose a heavy burden on poor consumers without stimulating any large-scale industrial activity. Many African countries remain incredibly protected – just ask any importer to Nigeria, for example – and this has contributed little to the rise of African industry.

So are open borders good or bad? A new paper by Pable Fajgelbaum and Amit Khandelwal in the Quarterly Journal of Economics gives the standard economist response: it depends. Some consumers buy more tradable goods and are therefore more affected by relative price changes caused by international trade. They find, using a novel methodology, that those consumers who gain most are often the poor, who buy more tradable goods and services. Open borders, they claim, is a very good thing if you are a poor person.

So policy makers are stuck between a rock and a hard place: close borders in the hope that some industries grow beyond infants, at the cost of cheaper goods and services for poor people. Or open the borders and allow the poorest access to cheap goods and services, but with the caveat that some uncompetitive industries suffer injury.

Take South Africa’s dispute over chicken imports. Chicken is the largest protein for poor South Africans. By denying them access to cheap food we not only hurt them but also their children’s ability to consume nutritious protein so critical for early childhood development. We thus perpetuate the cycle of poverty. And by protecting chicken imports, do we really stimulate local economic development in dynamic industries with agglomeration and spill-over externalities? Probably not.

In contrast, we protect the local automotive industry because it not only creates direct jobs but because vehicles support an entire value-chain, from raw material to assembly. Unlike chicken producers, building a car requires vast numbers of engineers and other skilled artisans that may have large (and unexpected and unplanned) spill-overs in related industries.

What made Japan, the first Asian Tiger, so successful was a capable bureaucratic administration that could, with little political influence, judge which industries required support and which did not. Some that received support failed to deliver, and support was quickly removed. We only recognise the successful ones: Panasonic, Kawasaki, Canon.

Wherever protection has failed, it has done so because supported firms gain political influence to protect their support. Bureaucrats are people too – often poorly paid – and find it difficult to challenge entrenched interests of the firms they initially supported. The government bureaucrats that steered Japan’s miracle were not only well remunerated (making them less corruptible) but were also the top graduates from Japan’s best universities. They had the foresight to invest in industries of the future.

In general, then, open borders are likely to be more beneficial than closed ones, especially to those people who are worst off in society. But this is not to say that there is no role for industrial policy. If political influence can be thwarted – and that’s a big ‘if’, especially given the recent revelations of state capture in South Africa – support for strategic industries that have large spill-overs can play an important role in building a thriving economy. The hard questions remain, though: Who picks the winners? And what happens when they fail?

*An edited version of this first appeared in Finweek magazine of 21 April.

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Is our financial sector too big?

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Roads to prosperity? Sandton is the hub of South Africa's financial industry

Roads to prosperity? Sandton is the hub of South Africa’s financial industry

Most economists would agree that a growing economy requires a well-functioning financial system that is able to move capital between its owners and those who need it. The larger the financial sector, the argument goes, the more likely it is that capital will be efficiently allocated, and the better for the economy. Of course, the same is true for other intermediate services, from law and consulting to auditing and marketing, which performs intermediate services that helps firms to specialise, and flourish.

But a new working paper by economists Stephen Cecchitti and Enisse Kharroubi at the Bank for International Settlements questions this logic. They argue instead that a too-large intermediate sector (they specifically refer to finance) can actually hurt growth. Neoclassical theory argues that mergers and acquisitions (M&As) create value through the takeover of undervalued products, as typically recognized through stock market valuations. The larger the financial sector, the more resources are available for these transactions to take place.

There are two caveats to this. First, instead of focusing on the long term value of a firm, executives often embark on M&As to further their own short term gain, e.g. prestige and increased compensation of managing a large firm. Second, and independent of M&A activity, the larger the financial sector, often the more complex it becomes and the more resources must be spent to analyse and understand it. And sometimes, despite these resources, it still spins out of control, as in 2008.

Cecchitti and Kharroubi finds that there is a threshold beyond which growth of the finance industry actually reduces total factor productivity growth. All developed economies are already beyond this threshold, they find, and provide evidence of a clear negative correlation between financial sector growth and R&D-intensive industries. One mechanism through which this happens is that finance consumes resources that could have been utilised more productively in other sectors. A complex financial system needs highly-qualified engineers, for example, clever people that could have been employed in research industries that would have had a bigger impact on society.

This is worrying for a country like South Africa where financial and other intermediate services are, like the US, a large part of the economy. The more finance and other intermediate service firms employ our smartest students (a precious resource), the fewer there are of them to start their own businesses producing stuff that we can export, or doing research that can invent new things. I’ve seen this myself: the largest consulting firms pilfer our best graduates (promising the incomes and status that come with these jobs – and the luxurious Sandton offices) at the expense of far less appealing jobs in industries that our economy desperately need. Who wants to work in a factory anyway?

In their book Concrete Economics, Brad Delong and Stephen Cohen explain why the finance industry grew so rapidly, from roughly 3% in 1950 to almost 9% of US GDP today. It happened as a result of the deregulation that already began in the 1970s but intensified in the 1990s. Some of this was good, like the innovation of low-cost brokerages and low-cost investment funds, just like the deregulators had hoped. Unfortunately, these were the exceptions rather than the rule. Financial intermediaries soon realised that it is much easier to promise clients that ‘they could beat the market and become rich’ than provide value to their clients by ‘soberly matching risks to risk-bearing capacity’. And so, instead of charging lower fees which would benefit investors, a freer market made financial intermediaries move into fancy office blocks, recruiting the smartest minds, and charging higher fees as a signal that their portfolios are the ones with the best returns.

In South Africa, I would venture that this also happened in other intermediate sectors, like auditing and consulting. Between 1981 and 2006, our service sector increased by 42%. Finance may have benefited from deregulation, but the tightening of accounting standards and other types of well-intentioned regulation to safeguard businesses from fraudulent practices meant that these highly concentrated industries had a captured market for their services.  High prices – and Sandton office towers – followed.

But, as DeLong and Cohen aptly summarise, ‘nobody eats the advice of M&A strategists’ (or the audits of accountants, or the powerpoints of consultants). Our large intermediate services sector means that we have fewer innovative firms that can produce products and services to sell to a global audience. Our best minds should be developing new genetically-modified crops or mobile apps, not more complex financial instruments.

How we fix this is a more difficult question. It is unlikely that change will come from within these firms; in fact, expect lobbying for more rules and higher standards which require bigger teams of experts selling better advice. Why kill the goose that lays the golden eggs? A concerted effort by government is instead necessary to reduce the demand for and market power of these intermediate services firms. Reducing excessive bureaucratic red tape can help with the former. Competition policy can help with the latter.

Perhaps the emphasis should instead be on growing other sectors, specifically manufacturing. But what regulators should realise is that, unlike fancy office towers, bigger is not always better when it comes to finance and other intermediate service industries.

*An edited version of this first appeared in Finweek magazine of 5 May.

Written by Johan Fourie

May 26, 2016 at 07:22