Wednesday, June 3, 2009

What We Can Learn from the Breakdown in the Motor City

Are Michigan's woes a cautionary tale regarding international trade?

Trade between different states within the United States is not exactly analogous to international trade, but there may still be some valuable lessons in such a comparison. The key to understanding why international trade occurs and how countries benefit from it is a concept called comparative advantage.

Imagine two states, Wisconsin and Michigan, making two goods, cheese and cars. It may be the case that MI is actually able to produce both cheese and cars more cheaply than WI (I know, not possible, just go with me, it's a hypothetical), but this does not mean that MI doesn't stand to gain from trade. In this case MI and WI would each be better off if they produce the particular good that they can produce at a lower cost and then trade with each other.

Don't think of lower cost in terms of dollars and cents, but in terms of the other good. If MI is good at making cars relative to cheese, they may only give up a little bit of cheese if they decide to spend their time making cars, this lost cheese is the cost of making a car in MI. Over in WI, they may be better at making cheese relative to cars. This means that if they choose to make cars, they give up more cheese production than MI does. Since every car MI makes costs less in terms of cheese, trade theory tells us that MI should make cars, WI should make cheese, and then they should trade with each other. This way they both have more cheese and more cars than they would if they each made both goods themselves.

Since there is a benefit to trading, both MI and WI will likely do so. As time goes by each state will likely increase its specialization in its one good, meaning that its economy is highly concentrated one sector. An economy that is highly concentrated is obviously less capable of handling a shock to their particular sector. This is what we see in Michigan now.

Here is an item from the Chicago Fed's blog from 2005:
Michigan’s traditional heavy reliance on the domestic auto industry has been troubling its economy over the past five years....job losses are felt more keenly in Michigan since, even among the Midwest troika of auto states, Michigan is by far the most dependent on automotive. Michigan’s job base is 7 times more concentrated than the nation in automotive parts, versus 5 and 3 for Indiana and Ohio.
And that was in 2005, prior to the current recession. For April of 2009, Michigan's unemployment rate was at 12.9%. This is 4% higher than the nation as a whole.

It is definitely the case that the world benefits from international trade, but countries (and states) are weakened when their economies are highly concentrated in one particular sector. The concentration has a double effect in that it means a shock to the sector disproportionately affects the concentrated economy and the concentration is often difficult to dilute in response to the shock, making recovery harder and slower.

As I said though, Michigan's economy is not a microcosm of the U.S. economy. The national economy is enormous and incredibly diverse, right? Here is economist Simon Johnson writing in The Atlantic (E.A.):
From 1973 to 1985, the financial sector never earned more than 16 percent of domestic corporate profits. In 1986, that figure reached 19 percent. In the 1990s, it oscillated between 21 percent and 30 percent, higher than it had ever been in the postwar period. This decade, it reached 41 percent.
While concentrated profits is not exactly the kind of concentration found in Michigan and the auto sector, it is a type of concentration. This also makes it clear why a global financial crisis will have a great impact on the American economy.

A country as rich and highly developed as the United States will be better able to weather a crisis than less highly developed nations, even a crisis that affects a sector in which it specializes. But this dependence on financial sector profits may partially explain why a country like Canada would be less affected by a global financial crisis than the U.S.

While protectionism will never solve our economic problems, the U.S. would do well to remember Michigan's example and maintain a high degree of economic diversity.

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