The Economics of Subsidy

Here’s Dani Rodrik on export subsidies:

[T]he economic case for countervailing duties is extremely weak. (The standard economist’s line is that you should respond to other countries’ export subsidies by sending them a thank-you note, not by shooting yourself in the foot in return.) But presumably there is some (second-best or political) reason why WTO rules sanction countervailing against subsidies.

This paragraph struck me as delightfully odd. Two facts that don’t get along are stuck together and left to eye one another warily:

  1. Export subsidies are so widely perceived as harmful to recipient nations that the World Trade Organization, a body whose “overriding purpose is to help trade flow as freely as possible“, countenances trade barriers to combat them.
  2. Standard economics suggests that an export subsidy represents a windfall to recipient nations, an opportunity and a boon, not a harm at all.

What gives? In the wide and wonderful field of economics, is there no room at all for the commonplace observation that a subsidy often does harm to its recipient?

In everyday life, we know that in order to do more good than harm with a subsidy, we often need to make predictions about how the recipient will respond to the grant. Offering to cover an 18-year-old’s college tuition is very different than cutting a no-strings-attached check, even if the money’s the same either way. Some 18-year-olds would be better off with the cash than a paternalistic tuition grant. But most probably would not be.

This sort of analysis is a priori out of bounds to any economics that views people as rational maximizers. If the best thing a teenager could do with a couple hundred thousand dollars is to turn it into a four-year annuity for college, the utility maximizing teenager will do that. If she chooses to do something else, by revealed preference, that must be the better choice. Right? No.

We reject this kind of reasoning in real-life, even when considering fully competent adults. If we can understand why it is not nice to put a slice of apple pie on a struggling dieter’s plate, or why very low introductory “teaser rates” on a home mortgage can entice borrowers into dangerous situations, why can’t we understand that certain kinds of subsidies increase the likelihood an economy will trade short-term gains for long-term harms? Of course we do understand that, even the WTO understands it, but economics as a discipline has a remarkably hard time coming to terms with the intuition. Human choice is endogenous and stochastic, not exogenous and rationally determined.

There’s an important distinction between noting that certain subsidies increase the likelihood of bad outcomes for a recipient and suggesting that the provider of a subsidy is therefore culpable for the outcomes. It’s usually counterproductive to blame someone else’s generosity for ones own poor decisions, even if the generosity was cynical and the bad consequences were anticipated by the donor. A crucial feature of subsidy is that it may be refused. A dieter may prefer not to be tempted by the sights and smells of heaven à la mode. But if a host insists on offering, she should still refuse the pie. At the national level, things are more complicated. An export subsidy likely to cause long-term harm to a nation may unambiguously benefit some individuals. How does a nation “refuse the pie”?

By enacting countervailing import tariffs, according the the WTO. But that seems like poor table manners, like raising a middle finger when a simple “No, thank you” would do. If only they could get over the logic of “might as well eat”, economists would have little trouble devising polite but firm ways of saying no.

We’d still miss the pie. But maybe that’s for the best.


2 Responses to “The Economics of Subsidy”

  1. I don’t agree with this. It is sometimes the case that export subsidies can do long run harm. But lots don’t. That should be the starting point and some burden of proof put on the argument you’re advancing. Subsidies to steel and auto would be fine things for developing countries to have to cope with. Perhaps less attractive on their own agricultural exports – but in that case countervailing duties don’t do much good in any event.

  2. Nicholas — I don’t mean to suggest that export subsidies are always bad for recipient nations, just as I wouldn’t suggest that subsidies on an interpersonal level are always harmful. My main point here is to note that they can be harmful, and that economists’ trick, saying those who receive a subsidy “win”, end of story, is a deeply inadequate kind of analysis.

    In evaluating the benefit of a subsidy from a recipients perspective, I think the main things to think about are…

    1) Is the subsidy reliably permanent? If so, great, because any dependencies developed or choices made in the context of the subsidy will be sustainably good choices.

    2) If the subsidy is not permanent, is it likely to be used in a manner that leaves the recipient in a decent position after its removal? Is the manner of its removal reasonably assured to be such that adjustments will be gradual, and that transient weakness during the period of adjustment won’t be used as leverage by others in bargaining games with consequences adverse to the recipient’s long-term well-being?

    In practice, we have to evaluate the long-term incentives created by a subsidy. An export subsidy in capital goods, the expiration of which is gradual, transparent, and well telegraphed, could indeed be a great boon to a developing country. Indeed, many developing countries would probably be better served by this form of capital-goods export subsidy than by many forms of foreign aid, since profiting from the subsidy requires wise use of the resources and the development of infrastructure and technology that will outlive the subsidy. On the other hand, an export subsidy in the form of underpriced consumer credit (as I’d argue developing countries in Eastern Europe are, for example, receiving) could be very harmful, as the subsidy substitutes for sustainable productive capacity rather than encouraging its development.

    Obviously, though, my biggest complaint is not subsidy to the developing world, but subsidies by developing countries to developed countries. I think long-term investment decisions are being distorted by very large short-term subsidies. That is globally harmful in the present (capacity that should be put to good use is being dismantled as “excess”), and presages, I fear, terribly painful consequences for the “rich, industrial” world in the near future.

    But that’s a particular set of subsidies. Really, one of the best ways the industrial world might, or might have, responded to subsidies from emerging Asia and resource-exporters would have been to pass those subsidies along to the non-emerging third world in the form of subsidies on capital and infrastructure goods, increasing demand world-wide rather than shifting industrial-world demand to emerging-world supply.

    Some subsidies are like free college tuition — the enjoyment of the subsidy prepares one well for its termination. Others are like a 4-year all-expenses-paid beach vacation with lots and lots of free liquor. An economist might place a high dollar value on both, but to imagine that the dollar value is what matters is a shortcoming of economics, not a characteristic of reality.