The Debt Bias: Or, how good reforms do bad things to good people

I’ve been reading a lot of economic commentary and analysis around two things lately: (1) is, naturally, the negotiations surrounding the “fiscal cliff,” and (2) is Prof. Anas Admati’s argument that the best financial reform we could undertake would be to require banks to have a higher equity ratio (that is, to finance more of their assets through stock and less through debt, reducing their leverage). I hope to write at greater length about (2) in the future, but, for now, suffice it to say that both of these things center on the “debt bias” in the U.S. tax-code, a bias which piqued my interest and so which, after a little research, I should like to tell you about.

Let me start out with some econ for poets. Suppose you’re a business and you want to make a big expansion–setting up lots of new stores, opening a new R&D facility, etc.–that will cost you $1 billion.  Unless you have a lot of cash on hand (which you probably shouldn’t–it would have been wasteful to have just accumulated it) there are two ways you could fund this expansion. One, you could issue more shares in your company (that is, sell more stock to the public)–this is equity. Or, two, you could get a loan from a bank to do this–this is debt. Which option should you choose? Well, naturally, you should choose whichever one is cheaper–technically, whichever funding option’s obligations have a lower net present discounted value (the debt’s obligations being interest and principle, and the equity’s obligation being a share of profits and ownership). In reality, which one will be cheaper? Well, theoretically, since these two instruments are both providing the same good–financing–they should be about equally expensive. Think about it: if interest rates were relatively high, meaning that debt was more expensive than equity, firms would rush to issue more shares, which would reduce stock prices by increasing their supply, and eschew bank loans, which would force banks to lower their ‘prices’ (their interest rates), until the two became equally expensive. So in a perfect market, equity and debt should be about equally expensive for companies, and companies would make their financing decisions as follows:  they would fund their activities through equity if they thought that their shares were slightly overpriced, and through debt if they thought their shares were relatively underpriced.

Now, we’ve just done some typical Econ 101 theory above, about an ideal market. But in the real world corporate financing decisions are distorted. One major distortion is the U.S. tax code, which includes a deduction for interest payments on debt. The tax code does not include a deduction from dividend payments to shareholders. To the contrary, corporate profits returned to shareholders are taxed twice: once as corporate profits (just before they have been returned to shareholders), and again as capital gains (once they are in the shareholders’ hands). What does this do? Well, it gives companies a strong “debt bias” relative to the ideal market we laid out above. Because the obligations they incur from debt-financing in fact reduce their tax burdens, corporations are incentivized to rely relatively more heavily on debt, and less on equity.

Why is this a problem? Well, it isn’t always, necessarily, a problem for everyone. Indeed, if you’re a shareholder of a firm that has really great growth prospects for the future, you should be happy with debt-financing–this “leverage” means that you will get a higher share of whatever is left over once debt-obligations are paid off, than if your share had been diluted by the issuance of more equity. But the problems are twofold. First, in general, we as a society want companies to devote their analysis to trying figure out, and their energies to trying to meet, our needs as we express them in the marketplace–not make their decisions based on how best to game the tax code.  But, second, debt becomes a very big, very tangible problem during an economic downturn, when it can cause a credit crunch, a massive financial crisis, and thence a recession/depression, as you may have heard. We often hear debt analogized to “leverage,” because it makes the good times better for companies’ owners (shareholders) and the bad times worse. Consider this super simplified model of a firm buying one asset in one year, with a 2% interest rate: If you’ve financed a $100 million asset through $50m of equity and $50m of debt (a debt-equity ratio of 1 to 1), if the value of that asset suddenly declines to $85m, you’re still easily okay–you can pay back your creditors their $51m, and still have $34m left, which is now the value of your shareholders’ stake, a loss of $16m for them. But if you financed that through $10m of equity and $90m of debt (a debt-equity ratio/leverage of 9 to 1), the same decline in the asset’s value will bankrupt you: You owe creditors more than you have, and so your shares are worth less than nothing, and you have to enter bankruptcy. If you get the conceptual gist here, you can probably also see how, in good times, when firms are making high profits, “leverage” (a high debt-equity ratio) can increase the profits that are returned to shareholders. (But, and this is a bit technical, it does not technically increase shareholder value, because the leverage makes the expected return-on-equity riskier.) It also makes it much easier for firms to slip into bankruptcy when the times are not as good as they had predicted.

So what, then, is the problem with leverage if it just helps shareholders on the upside, and hurts them or causes bankruptcy on the downside? Why should I care if I’m not a major shareholder, or involved in any way with a highly-levered firm? Or if I am a shareholder, shouldn’t I be okay with this as long as I have a diversified portfolio that is collectively non-risky? The problem is that, during a credit crunch and financial crisis, bankruptcy is contagious. That is, when a highly-levered firm (which could itself be a bank–see my upcoming post on Admati) can no longer meet its obligations and enters bankruptcy, it is failing to pay out a cash flow that a bank had been depending on to finance its own activities. So that can send that bank into bankruptcy, or leave it unable to roll over the debt of another firm, sending that firm into bankruptcy. This is basically what a “credit crunch” is–everybody being so indebted to everyone else, that a small economic downturn can cause a string of interlocking insolvencies–and this is pretty much the story of what has happened in the economy from 2007-present. If companies had had less debt, and financed more of their activities with equity, an economic downturn would have caused their shareholders to take an unpleasant hit, but it would not cause this contagious domino-effect of insolvency.

A lot of what I’ve written about firms is also true of people, except for the fact that we people don’t really have the option (yet) of getting outside equity-financing (though some are proposing to equity-finance college loans–more on this later). For example, we humans have a mortgage-interest deduction, which provides us an incentive to take out relatively larger mortgages on our homes. There are a couple of problems with this. First, since the real-estate market is in reality largely an arms-race to get into the best school district possible, people generally buy the most expensive house they can afford, and so, according to many economists, the economic value of the mortgage-interest deduction is simply capitalized in higher home prices–i.e., in the aggregate, it doesn’t provide any easing of financial burdens to homeowners at all. Second, it distorts the market for buying vs. renting property–and there’s no particularly compelling reason to do that. And third, and most importantly, as we, again, saw in the financial crisis, more debt makes it easier for you to get wiped out by even small changes in the value of your assets. Suppose bad employment prospects have made it difficult for you to make your mortgage payments–if, in addition, the value of your house has declined, leaving you “underwater,” you won’t be able to refinance your house, and so you’ll default. That will reduce the cash flow to the bank that is entitled to them which, in turn, can cause Lehman… You get the picture. So personal bankruptcies, just like company bankruptcies, are contagious, and they become likelier and more harmful the more debt we all have.

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I hope that you, gentle reader, do not spend as much time reading economics commentary as I do (because then what use would I be to you?), but one thing I’ve noticed is that almost all econ-theory minded people want to get rid of all of these distortions. Everyone seems to agree that the ideal tax reform involve lower rates, while getting rid of loopholes and deductions, such that we can actually raise more revenue, while imposing fewer distortions on the marketplace. There’s a consensus among them. But if there’s a consensus, why can’t we get some policy and legal changes done? The answer, of course, is “vested interests.” But that term sounds mean, and derogatory, and, more importantly, it understates the difficulty of our challenge.

Because, in this case, the term ‘vested interests’ doesn’t just mean super-rich super-evil tobacco lobbyists, or some such fun-to-hate villain, but actually literally means your mom and dad. Even if your mom and dad have already finished paying off the mortgage on your house, getting rid of the mortgage-interest deduction would hurt them, because it would reduce the sale-value of their house, because it would hurt the real-estate market as a whole (since new buyers won’t get such large mortgages if they can’t write them off). And the same goes for the corporate interest deduction–if we eliminated it, a lot of medium-size firms would  lose a lot of money when they can no longer write off the interest on bonds they issued a decade or two ago. And the same goes for a lot of other loopholes:  if we get rid of the federal deduction of state income taxes, medium-high-income people in high-tax states are going to get badly hurt. All of these people were, when they made these decisions, responding rationally to the incentives our public polices had put in place. They formed rational expectations for the future based off of those expectations. They were good people doing the right thing, in the circumstances and policy landscape that they were presented with, and now the policy changes that we are proposing are going to hurt them and disrupt the life path that the old policies had led them to expect. These people are, quite justly, going to be very upset if their representatives do it.

This is why reform is hard. 

Nonetheless, I’ll reiterate that we really should do the right thing and eliminate these distortions and tax loopholes if we can. It would obviously be wrong to leave bad policies in place forever. But the longer we leave them in place, the more and more good, rational, reasonable people build their lives around those policies, making them even more costly to be rid of in the future. So the very best time to take the plunge is right away.

Financial Transactions Tax: For and Against

In recent weeks, as we’ve debated tax policy in light of the looming “fiscal cliff,” one idea that has been floated as a good way to generate extra revenue is a Financial Transactions Tax. It’s been getting a lot of support, including from Elliot Spitzer and Ralph Nader.  Basically, a financial transactions tax (FTT) would be just that — a tax levied on each incident of a financial transaction, calculated as a very small percentage of the face value of the asset. The percentages we hear proposed are often in the range of 1 cent on every $100 transaction (i.e., .01%).

Would an FTT be a good way to raise extra revenue (or replace other revenue sources)?  To answer this question, I think we need to answer two others. First, what is it that we want traders and trading in the finance industry to do? And, second, how would an FTT impact that?

There are a few things we definitely want from financial markets. First, we want them to use our savings to invest in productive ventures that can satisfy human needs now and in the future–that is, we want them to efficiently allocate capital. Second, we want them to help us redistribute risk — futures contracts on wheat, for example, allow more of us to share the benefits to, and pad the harms to, farmers whose harvests are subject to unpredictable weather events. And third, we want the assets traded in financial markets to be liquid–if you’re a saver/investor who suddenly needs/wants cash, you want to be able to sell your claims to any financial assets quickly, and at a fair price. That liquidity will encourage you to get into the market in the first place, and make your life (or, if you are a business, your financing projects) a lot easier. Now, venture capitalists, investment bankers, etc., help provide the first kind of thing–connecting our savings to long-term funding for valuable projects, etc. But shorter-term traders are essential to providing the latter–liquidity. Because traders are trading these assets on short-term bases, they ensure that there is always a market for the asset they are trading. Liquidity is why you always know, up to the minute, how much your stock portfolio is worth (the $ value you see is, fundamentally, the sum of the last transactions traders made in the underlying assets), but you’re never quite sure exactly how much your property could sell for.

Financial Transactions Taxes could raise a lot of revenue, according to most estimates. But would they detract from these important functions of financial markets? The simple answer to that is: it depends on how large the taxes are. FTTs wouldn’t really interfere with the first function of financial markets too much– if you’re a venture capitalist, you’re not going to turn Facebook away just because you might need to pay 2 cents for every $100 when it’s time to sell your shares. But they could, if large enough, reduce the liquidity of some financial markets, by reducing the viability of shot-term trading. For example, if you’re a trader placing a large, short-term, highly-leveraged bet on a small price-movement you’re predicting in that asset, even a small tax could make that bet unprofitable. It’s pretty straightforward: a .02% FTT makes each trade .02% less profitable, which could cut out some short-term, highly-leveraged trades, by making them unprofitable; but it would have less impact on longer-term trades that predict a larger price movement. So FTTs can definitely theoretically reduce liquidity. But the important question is, would they hurt market liquidity enough to hurt the real economy? That’s more debatable. My own sense is that it’s hard to believe that, with American capital markets as robust and deep as they are, a .01% FTT could clog markets enough to hurt the real economy, through making savers nervous about investing the stock market, or making it hard for companies to cash out when they want to. More, its advocates claim there could be broader benefits: FTTs would decrease the profitability of super-high-frequency trading, which is generally considered socially unproductive. By curbing high-frequency trading, we would both incentivize America’s brightest minds to find more socially productive outlets, and we could also forestall events like the 2010 flash crash. We would give investors more incentive to try to predict bigger, more significant market movements, and be less focused on temporal volatility. A very small FTT, its supporters consequently claim, could raise some extra revenue from the finance industry and improve the stability and long-term focus of financial-markets trading, without substantially interfering with the functions of financial markets.

I think it’s a pretty persuasive argument, especially if we’re talking about FTT’s on the lower end of the range proposed–.01%, etc.

Why might we oppose an FTT? I can think of four possible objections: 

(1) You might think, for much broader ideological reasons, that the amount of revenue the federal government takes in is quite enough already, thank you very much. You might think raising extra revenue will just give it more room to continue to fail to curb expenditures. But if this is your objection, you should probably still at least be able to support substituting an FTT for other, worse, more distortionary taxes–i.e., you should get behind a revenue neutral reduction in income or corporate taxes offset with a higher FTT.

(2) You might worry about the potential for offshoring. That is, you might think America’s global economic leadership is an inherently good thing, and worry that, if the U.S. institutes an FTT while its competitor nations do not, then firms that profit from HFT may move offshore, focus more on foreign exchanges, pressure other companies to list abroad, etc., etc. Theoretically, this could drive the finance industry–and the larger economic ecosystem it helps support–out of NY and Connecticut. That could be bad.

(3) You might worry that, given popular attitudes toward the finance industry, an FTT, once implemented, would inevitably be raised to the point where it would reduce market liquidity. This is a slippery slope argument, which is formally considered a logical fallacy, but in this case seems like a plausible prediction, and something to be guarded against.

(4) You might also worry how the compounding effects of the FTT could eat into, say, someone’s retirement savings invested through a mutual fund. I don’t have the energy to do the calculations right now, but it seems to me that even a .02% tax, levied on a portfolio that turns over, say, three times per year, could add up to a significant dent over 30-40 years. I would hope that, if we did levy FTTs, we might be able to find some way to make exceptions for long-term retirement savings invested through mutual funds by non-super-rich people, etc.

A Potpourri

Some scattered thoughts at this late hour:

1. Scott Sumner has a nice report from Foreign Policy magazine’s Top 100 Global Thinkers conference. He writes:

My favorite speaker was Google’s Sebastian Thrun , who remarked that California was wasting a fortune on a train that would connect two obscure Central Valley towns in 2020, by which time self-driving cars would be more energy efficient (and convenient) than high speed rail.  His friend remarked that in-vitro meat could cut agricultural greenhouse emissions by 95%.  (I doubt it.)  Both seemed to think policymakers in Washington were clueless about technology.

The observation affirmed two things I’ve been mulling over recently. I remember reading Nouriel Roubini’s Crisis Economics in the wake of the financial crisis. He predicted that the debt crisis would yield a long period of deleveraging, causing a long depression generated by the “paradox of thrift.” His prescribed the traditional Keynesian response of large public expenditures toward repairing the U.S.’s national infrastructure–he was particularly strongly in favor of building more and better rail in the U.S.. This was just before driverless cars became such a hot topic. Now, I’m no fever-swamp Austrian, so I do agree with the mainstream Keynesian economic theory that suggests we should try to make government spending countercylcical to the extent that we can. But issuing a lot of debt in order to build lots of high-speed at that time probably would have been unwise, because those investments couldn’t have paid dividends for very long–they’ll be completely overtaken by technology in just a few years after the projects would have been completed. Sumner, above, also notes Thrun’s remarks that policymakers in D.C. are clueless about technology in general. I have no reason to doubt this claim.  This highlights the kind of trade-off we always face in setting policy. We know, from theory and empirical data, about a lot market failures; we know how markets tend to underinvest in technology and research that will only be valuable in a very long time, because it’s hard for individual investors to capture those benefits. But the proposed alternative solution–government–is also subject to predictable failures, due to the pressure it faces from lobbyists, and the limited knowledge and expertise of bureaucrats. So it’s not always clear that government is the right way to ‘correct’ a market failure, such as underinvestment in long-term R&D and technology.

I’m excited not just by how driverless cars will change transportation policy, but also by how they could totally revolutionize domestic life. In fact, I wonder if in the future we won’t have driverless cars so much  as driverless RVs. Like, I’m imagining a family living in a spacious place in the Catskill mountains, sleeping in beds in an RV that’s pre-programmed to start driving toward Manhattan at 7 a.m. At 8:00 a.m, still on the road, getting close to Manhattan, they all wake up and cook breakfast in the kitchen and read the paper, as a family, inside the driverless RV, which then drops kids off at school uptown, before taking parents to work downtown. At 6pm, the driverless RV picks parents up at work, so they’re getting dinner ready by the time kids get in the car, after practice at 6:15pm, and they’re on their way back to the Catskills. Family dinners inside a driverless RV may seem a bit utilitarian right now–but I think we’ll get used to it, and it’s better than no family dinner at all, ruined by too-long commutes. If driverless cars allow people to do more of their normal daily functions while commuting, then this will (1) be a gain for human welfare, and (2) massively change residential geographic distribution. Ex-ex-exurbs could become much bigger, as longer commutes become more tolerable.

Lastly on this diversion, I wonder how much of Google’s good deeds we can attribute to some things that we are traditionally told are bad — its monopoly power, its perhaps less-than-perfect commitment to the interest of its shareholders. It’s now clear how Google’s driverless cars can be really awesome for society, but it’s less clear how they fit in with Google’s core business–and that’s totally cool with me. It’s like we’re enjoying the benefits of a benevolent monopoly, with a lot cash to throw around, that its happy to spend on its own pet projects and not give back to shareholders. Benevolent monopoly. Nice ring to it.

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2. Today, being an entrepreneur is almost synonymous with working for a techie startup, or doing something with apps. Apps are great, very helpful for making our lives more convenient. Seriously. But the fact that people seem so unwilling to pay much at all for almost anything on the web or on their iPhones suggests to me that maybe their unsatisfied needs in that space are not so great. It seems to me that really, really ambitious entrepreneurs shouldn’t be focusing on creating some derivative of Yelp or Pandora or Facebook, but should be trying to find ways to undercut the enormous expenses of education and health care. Since people are right now, already paying $50,000+ a year for college degrees, that’s proof enough there’s a lot of money to be made in that space. And a lot of good to be done for the world, too. Right now, middle-class incomes are stagnating, at the same time that more and more of that income disappears into education and health care. In the future, as Asia continues to industrialize and technology replaces a lot of old jobs, it’s not at all certain that middle-class incomes will start to rise again. The best we can do might be to focus on improving quality of life through lowering these massive expenses.

I don’t know how to revolutionize higher ed and health care. If I did, I’d be keeping it secret and trying to get rich. But I just think our society should be trying to generate more excitement about how technology can be used to revolutionize medical care, education, transportation, and urban design, rather than trying to guess which new startup based around a single app might do well for a couple of months.

The Solar Panel Trade War

There has been an ongoing conflict between the U.S. and China, taking place in WTO courts, private meetings, and policy debates in D.C. and Beijing, over China’s exports of solar panels to the United States. Basically, both China and the U.S. are WTO members. This means they’re both supposed to support free trade in the interest of overall global progress, and to eschew old-fashioned efforts to erect massive tariffs and trade barriers in the interest of helping their own domestic industries while hurting foreign ones. The basic theory, dating to David Ricardo, is that the world as a whole does best when everyone can freely trade, across borders, for goods in which other nations enjoy a comparative advantage, while exporting those goods in which they enjoy a comparative advantage. Trade barriers hurt human welfare by, most obviously, preventing us from making use of the best quality/best priced goods, if they happen to come from another country, and, over the long run, unnaturally distorting markets by artificially propping up particular industries in particular nations where they do not have a comparative advantage.

Recently, the U.S. has slapped substantial tariffs on imports of solar panels from China. China claims this is a WTO violation. However, the U.S. claims to be doing this only to cancel out the effect of Chinese state subsides on these panels — we, Washington claims, are not the aggressors in a trade war, but merely responding to China’s aggressions. With our tariffs, Chinese solar panels now reach American shores at the same price they would have sold for in the absence of Chinese state subsidies. Now the international law aspects of this are beyond my ken — one interesting point of contention is that, given the state’s ubiquitous involvement in the economy in China, it’s hard to clearly delineate the boundaries between the state and private firms, and consequently difficult to prove just how extensive Chinese subsidies to its solar industry are. But I want to avoid this legal debate, and take an economic approach to this trade war. My bottom line is that I do think the U.S.’s strategic response to China is justified here, but it is justified for reasons that are more complicated than the economically naive would assume, so exploring this issue will be educational.

First, why is it a problem, from the U.S.’s perspective, that China is subsidizing its solar exports? Let’s abstract away from this question. Suppose China were to massively subsidize its green-tea industry. This would, in my view, be an unquestionably good thing for the American economy. The reasons are very simple. I like green tea. A lot of us do. If we can get more of it, cheaper, that makes us better off. It’s as if China is just giving stuff away to us. If your friend gives you something for free, that’s a great thing from your perspective; and it’s the same with another country. It’s really that simple. Would anybody get hurt by this subsidized Chinese green tea? Yes: American domestic green-tea producers, and them alone. They would have more trouble competing with the lower-priced Chinese green-tea exports, and likely go out of business. Still, from the perspective of America as a whole, this is a good thing. If China is going to permanently produce lower-priced green tea than our domestic manufacturers will, regardless of whether that low price has to do with state subsidies or natural comparative advantage (superior climate, lower agricultural labor costs, etc.), then there’s no good reason for green-tea manufacturers to exist in the United States.

How are solar panels different? In a lot of ways it’s the same; in some ways, it’s an even better deal. With Chinese taxpayers subsidizing their solar exports, it’s as if China is just giving us some solar panels for free. And, indeed, given the threat of climate change, the use of solar panels has large positive externalities–that is, benefits that accrue to society as a whole, not just to individual users of solar panels. Since the cheaper solar panels become, the faster and more eagerly they should be adopted by domestic firms, China’s subsidized solar exports are good for the environment, too. If China wants to pay us to buy their solar panels, and if American consumers want to use them to reduce their carbon footprints, why on earth would we would want to stop any of them?

So this is a very serious argument that we should not only not fight Chinese solar subsidies, but actually be grateful for them.

But the Obama administration is pretty smart and environmentally conscious. So surely they must be aware of that argument, and must, in turn have a reason of their own for slapping these tariffs on. What are those reasons? There are two possible interpretations: one cynical and one more intellectual. The cynical interpretation is that America’s domestic green-tech industry is politically aligned with the Democratic party, and an important source of donations, & etc. So the Obama administration is seeking to protect its donors from foreign competition, even though America as a whole would benefit from being able to import solar panels more cheaply from China. As a pessimist/realist, I do think this is, descriptively, an important explanatory factor.

However, some more complex economic theory shows that there is a way in which Chinese solar subsidies could be bad for America in the long run, and protecting our solar industry could benefit us. This economic theory depends on the economics of “clusters,” which I have discussed in some of my other posts on economic geography.

Basically, the argument goes something like this: Energy is a very big deal. A bigger deal than green tea. The world runs on energy, and will require more and more of it as Asia and Africa develop. And because oil is non-renewable and threatens to exacerbate climate change, clean-tech is an even bigger deal. We can reasonably expect that in a few decades, green energy, particularly solar energy, will be incredibly important to the global economy. But this still doesn’t explain why we should dislike China’s subsidies: sure, clean tech is a big deal, but why not let the Chinese pay for this big deal thing as long as they want to?

This is where clusters come in. Industries tend to develop in clusters. The traditional example of this is how all of the Big Three auto manufacturers located in Detroit. Each had an incentive to locate there, because the city had workers with the knowledge and skills relevant to the auto industry — and those workers, in turn, had an incentive to stay in Detroit, where the auto employers all were. So this kept the American auto industry “locked in” in Detroit, and any other city that tried to, after this cluster developed, win back some of the auto business, was very, very hard pressed, and generally unsuccessful (until Japan competed with superior technology and human capital, and then China, particularly Shenzhen, used lower labor costs). We can expect the same of green tech. As more and more firms attempt to enter the green tech market, they will disproportionately want to locate in geographies that already have the workers with skills and experience in that industry. And those workers will increasingly move to geographies where those firms are located. Also, the “knowledge spillovers” between green-tech firms in that region will help those green-tech firms just do better, helping beat back foreign competitors.

So whichever country gets a “first-mover” advantage in developing a green-tech industrial cluster can hope to get “locked in” to a pretty permanent advantage in that industry, which will provide lots of employment for that country. This is why the U.S. and China are engaged in a trade war over solar panels, and why they would not get locked in a trade war over green tea. Each wants to get a “first mover” advantage in producing the major green-tech cluster within its own borders, in order to lock itself into advantages for a century or more to come, in an industry that we can expect to be really huge in the future.

There are also higher-level clustering externalities involved here. Green-tech firms tend to employ lots of highly-skilled, highly-educated people. and so they both (1) attract highly skilled foreigners and (2) provide incentives to Americans to pursue higher skill and educational levels. So clusters in high-skilled industries cause their local area to become more highly-educated, which makes pretty much everything else there better as well. (This is why, for example, Rochester, N.Y.’s decline has not been as bad as Detroit’s decline–both of them have lost major employers, but Rochester’s old industries had attracted more highly skilled workers, who were thus better equipped to create new firms and employment opportunities in the old firms’ wakes.)

So overall, I’ll make an exception here to my generally laissez-faire trade principles, and say that this is a situation in which the U.S. is justified in raising tariffs–the long-term stakes are high enough to justify the short-term costs this will impose on the American economy. But I can’t say I’m certain this will work out in the end. There are good theoretical reasons for America to try to nurture its green-tech industry. But what’s good in theory often flails in the government hands. Witness the complete boondoggle of biofuel in the U.S., which, in my understanding, hard-core environmentalists think is very bad for the environment, because the subsidies are so large that they, e.g., incentivize firms to use large quantities of non-renewable energy sources to make ethanol — complete, utter insanity. Every reasonable person seems to agree it’s a big boondoggle. But it’s hard to get rid of ethanol subsidies, because once you subsidize it once, you create entrenched incumbent interest groups who use their lobbyists to keep the money flowing. That kind of public-choice problem is definitely a risk in using industrial policy to nurture a solar-energy cluster in the U.S., and so we should be intensely aware of and guarded against that as we move forward.