Buy Local, Quantively

This is a follow-up to a previous post. Buying local products has always been popular: we should encourage thy neighbor and help save the environment by reducing transportation. Encouraging thy neighbor does not make much economic sense though, since doing so generally increases living expenses. However, due to the taxation of income, helping thy taxation neighbor really does help us financially through the coffers of the state.

When you buy a product, a seemingly useless label tells you where the item was made. Why not state the tax that was received by each level of government in making the product? I'm not taking about sales taxes (which are uniform across all products), but rather in the complex set of dividend, capital and employment income tax collected in the manufacturing and delivery of the product.

For example, a Volkswagen car made is Brazil barely contains any Canadian capital & labor (say 10%). But a Toyota built at the Cambridge (Ontario) plant contains much more Canadian capital/labor (say 50%). So an Ontario resident gets 25% (tax rate) of 50% (car value generated in Ontario) back in taxation when he buys a Toyota, whereas he would only get 25% or 10% were he to buy a Volkswagen. Saying that the Toyota is 10% cheaper than the Volkswagen because of taxation is only partly correct, because if we were to not buy the local product, the Canadian capital used in making it would be re-allocated (with some loss) to another sector.

By using the capital reallocation loss instead of the percentages above, it would be possible to show the tax contribution behind the purchase of a local product over that of a foreign product. Rational consumers should consider this percentage like a "mail-in rebate" that they are getting statistically when buying the local product. Like many situations, the system only works well if everyone abides by the buy local rule; if everyone but one person buys local, then that black sheep is getting a cheaper product and almost all the tax benefits of buying locally.

To fully account for this externality, it makes sense to impose subsidies/tariffs on products that reflect the local capital reallocation costs to achieve maximum economic efficiency.

Am I actually saying this? Alternately, having either no local capital, local capital that can be reallocated with no loss, or no taxation proportional to the value of local capital (ie. a head tax) eliminate this messy problem.

The Legacy of Paper

A major misconception in the workings of monetary systems is that non-interest bearing paper money must exist. As a substitute for fixed denomination paper money, we could trade using only variable interest-rate perpetual bearer bonds bound to the fed funds rate.

A key advantage of such a system is the possibility of imposing negative interest rates, preventing the "money under mattress" harmful effect of deflation. Thus a target of extreme price stability becomes possible (near zero percent inflation) without the risk of triggering a deflationary spiral (as occurred in Japan in the 1990s). It is unclear what the inflation target would be for optimal economic growth in this system; I would assume somewhere between 0% and 2%.

The switch from cash to variable interest-rate bonds is very easy to do: on January 1st 2009, all US paper currency in circulation could be automatically converted into interest bearing bonds. Thereafter, cash can only be held in electronic form in bank accounts managed by the Fed. The interest on all electronic deposit accounts would be very close to the fed funds rate, otherwise one would prefer holding variable interest rate paper bonds. Financial institutions outside the US electronic banking system could only hold paper bonds; they could no longer hold paper cash, since all US cash must be electronic and interest bearing.

Each variable interest rate bond, regardless of the emission date, would simply bear the January 1st 2009 cash equivalent denomination. The price of goods quoted in this bond's denomination (rather than the current cash denomination) would generally deflate over time, as interest rates are usually positive. The price of goods quoted in electronic cash denomination would follow the current trend, slowly inflating over time.

Since prices would be primarily denominated in electronic cash (as is done today), transactions executed using paper bonds would need to be adjusted using cumulative fed funds rates. In such a system, electronic cash accounts would be preferable, avoiding the tedious currency conversion. Persons who require anonymity in money transfers could still trade bearer bonds anonymously, but would need to be good at multiplying by a fraction. You could then tell your kids: "Timmy, if you want to be a mobster like M. Soprano, you'll need to get better math grades!"

In your face socialism

Billing people for government services without actually charging them anything much allows them to adjust their behavior in order to minimize the cost they impose on others. Right now it is very difficult to asses how much my choices (going to the doctor, going to school, etc) cost the government and my fellow tax payers.

Unenforced moral behavior tends to be quite popular in North America: recycling is a good example. Were the government to pay for 99.9% of all services you use, and thus bill you on monthly basis to collect the 0.1% not covered (which would amount to a few dollars a year), individuals would finally have the feedback necessary to adjust their consumption behavior of free services offered by the government.

Some selfish individuals do not react to purely moral incentives, so the system is not fool proof, but I think it would be a very good step forward. Making this information public for all individuals would greatly increase peer pressure on this immoral group, but would also be an unacceptable violation of privacy in my opinion.

Dealing with Dutch Disease

When I was young, I remember my parents talking to me about countries such as Saudi Arabia and Kuwait that were immeasurably rich, much more so than my native Canada, because they had oil. It turns out my parents’ hyperbole was unfounded: in practice, these countries have tended to do rather poorly over the long term, despite periods of wealth during commodity booms, because of something known as Dutch Disease which affects countries for whom natural resources are a significant source of export revenue.

Dutch Disease refers to the tendency of a country’s exchange rate to rise when it exports more natural resources because the price of resources can fluctuate much more quickly than labor productivity, the main determinant of an exchange rate. If my country discovers oil, we will export some (or import less): consequently, our exchange rate will rise, making other exports less competitive. As a whole, the economy of the country does better, but non-resource industries suffer.

This would not be a problem except for two reasons: volatility and rent-seeking. The price of natural resources tends to fluctuate wildly, much more so than other industries whose prices are determined by labor productivity and capital investment. At some periods of time natural resources will be the only interesting investment; if the price crashes, there are no other sectors of the economy that have built-up capital to take up the slack.

In countries with weak institutions, the problem of rent-seeking is even greater: this refers to the effort expended to gain control of the natural resources. In other words, if control of a piece of land is worth $10 billion, then various factions are likely to expend close to $10 billion of lobbying, lawsuits and bribes to gain control of it. The country as a whole ends up with close to zero benefit.

There are two solutions to avoid these problems. The first is taxation: there is reason to tax natural resources more than other industries because of their pernicious effect on the rest of the economy. This also guarantees that the country as a whole benefits from its resources, no matter who owns the land. Because we are trying to rein in overproductive industries rather than the traditional goal of protecting unproductive ones, export tariffs work best.

The second avenue is nationalization. By nationalizing the exploitation of the resource, the government thus ensures that the money won’t go in the hands of a few lucky barons. Nationalization means giving up efficiency; this is an unavoidable consequence. However, by orienting all the profits of the state corporation into a fund that buys up foreign assets, the country can reap all the benefits of the world price of its resources without increasing the exchange rate. This is the solution that has been adopted by Norway regarding its North Sea oil.

A free-marketeer like myself always finds it painful to advocate limitations on the market, since the solutions usually just cause more problems. In this case, however, the track record of resource countries is unambiguous: either they minimize the impact of resources on the rest of their economy, as Norway and Abu Dhabi have done, or the discovery of natural resources will be a curse disguised as a blessing. Just ask the Dutch.