Ricardo Hausmann on What it Takes to Win a Trade War

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1:49Hello and welcome to another episode of the OddLots podcast. I'm Joe Weisenthal. And I'm Tracy Alloway. In this ongoing trade war, I don't know, I guess it's a trade war, all the trade headlines, I have to say one of the things I always think about is, and I write about it and we reference it, the two of us reference it all the time, the complexity and the importance of sort of building complex things as a marker of a sort of country's capacity for wealth and the sort of complex international trade webs that undergird the production of complex things. Joe, I know what you think about. It's monkeys and trees.

2:25That's what you think about. That's what you think about. That's what you think about. I do think about that. Okay, the reason I think about monkeys and trees is because a couple years ago, we had Ricardo Hausman on the podcast, and he used this metaphor to describe why some countries are richer, more economically developed than others. And the metaphor was that certain products or industries are like trees in a forest and the firms are like monkeys. And so businesses kind of jump from tree to tree. And so what you find is if a country gets good at one particular product, then the business, the monkey, will jump to the next tree, the next adjacent product, and use that experience to build out their offerings.

3:08And so you tend to see, you know, the more complex economies, the bigger forests, the more monkeys swinging from trees are indicative of greater advancement and more wealth. Right. And this is how you can have a country that at one point specialized in rubber becoming a major player in cell phones or a economy that at one point made T-shirts, which requires some level of coordination of supply chains from the thread and the electricity to power the looms, suddenly become much more advanced in any number of things. Anyway, I think that's a very powerful idea. But when I think about, you know, the idea that, OK, now there's this trade barrier between the U.S.

3:49and Canada, for example, and we have these complex webs of supply chains in which goods cross the border multiple times. Do we constrain our capacity to do complex things? Are the monkeys going to slam headfirst into a trade wall? Yeah, it's literally it, right? Like they're swinging around and they're making these webs and densifying. And then suddenly they slam into a wall. In a very real way, what does it mean for American wealth if America sort of like constrains this ecology of trade? I think it's a very valid question. Well, I'm very excited. Back on the podcast, we're going to be speaking with Ricardo Hausman, professor at the Harvard Kennedy School and the founding director of the Harvard Growth Lab.

4:34So, Professor Hausman, thank you so much for coming back on OddLots. Thank you for having me. I'm really happy to be back. It does not seem like if we're thinking from the complexity framework, right? If we're going to start like putting up nets, maybe it's nets. If we're going to start putting up nets in the forest between the trees from place, it does seem harder for the monkeys to swing. Well, the way I think about the problem is that the complexity that you were talking about in the introduction is really the amount of knowledge that you have to put together. Yeah. in order to be able to do things.

5:12And the question is a little bit, you know, how mobile is that knowledge? How easy it is for you to get to that knowledge? And that knowledge takes, if you want, three forms. It takes the form of embodied knowledge and tools and materials. So when you buy a cookbook, it says, if you want to make an omelet, it says, you know, take eggs, take milk, take this, take that. It doesn't tell you how to make eggs. It doesn't tell you how to make milk. look, you just buy the eggs and you disregard all the technologies that go into making chickens and to making eggs and to feeding the chickens. You disregard all of that.

5:51You just buy the eggs, right? And all the knowledge that was embedded in it, it's just in the eggs. So embodied knowledge is one form of knowledge, and trade is one way to get it, right? Okay. Codified knowledge is the knowledge that exists in recipes, formulas, algorithms, do files. You know, you just need to have the code and follow the instructions if you want. And then the third form of knowledge is know-how in brains. And the problem with knowledge is that there's very little knowledge that fits in a brain. So if you want to run a company, you need a lot of knowledge. You need knowledge about accounting, about finance, about human resource management, about procurement, about production, about branding, about marketing, about taxes, about contracts.

6:44So you need a lot of knowledge. And to bring that knowledge together, you need a team of people that you need to put together. And complexity comes from the breadth of the team that you have to put together. Yeah. Now, the more you can kind of codify stuff, then you don't need to put the brains together because it's all in the code. That's one of the things that we may talk about artificial intelligence. It makes things in some sense simpler because the knowledge is in the machine. It's no longer you no longer need a brain to do it. Now, what these trade barriers are doing is that they are preventing you from, say, buying the eggs, right?

7:22So that now you need to know how to do the eggs yourself. So in some sense, it's making things harder to do. As Larry Summers has pointed out, there are about 60 times more jobs using steel than jobs making steel. so you know you protect steel you're making it easier for all those guys that were going to make omelets by making now the eggs harder to get and that's going to come at a detriment you're going to get maybe more jobs in steel making in the u.s and you're going to make all the people who use steel have more trouble competing in the domestic market with their products and more trouble selling their products abroad because now they're buying more expensive eggs, more expensive steel in this metaphor.

8:12So in some sense, yes, what you're saying is that trade barriers are going to make the ability to put things together harder in the U.S. It's going to incentivize some of the things that are being protected, but it's going to create difficulties for everybody who uses those things to make other things. Is there a way to design tariffs or other protectionist trade measures in such a way that you would preserve knowledge and, I guess, preserve access to some of the components you need to build out more complex industries? I mean, an interesting question is, what is the case for intervening in the market?

8:55Why would you need a policy? And then the second question is, would trade, would tariffs be your instrument? Okay. So I would say that economic theory gives you at least three good reasons to intervene in a market that might justify something you might want to call industrial policy. And then the question is, is tariffs the right industrial policy? Because now they're putting tariffs on steel and aluminum. They want more steel and aluminum being made in the U.S. If you wanted more steel and aluminum made in the U.S., what instruments could you have used and is tire of the right one okay so first um there is um the argument that in order to make something you have to know how to make it you know it's hard to make things you don't know how to make and typically when you start something you don't you're not particularly good at it but maybe over time you become better at it there are some learning curves and you want to get into those learning curves and that's a compelling reason maybe to intervene in a relatively new industry where you haven't yet to figure things out, say maybe like solar panels or batteries or something that's relatively new that you still have yet to figure out.

10:11You wouldn't do it for a mature industry like say like electric gas turbines because they've optimized that to death and there's no significant breakthroughs for decades now. So steel would not be the obvious thing that would come to mind, right? It's a 19th century technology. It's an industry that's quite mature, et cetera. But you might have, I don't know, national security reasons to protect it or something, but definitely not learning curves. By the way, those learning curves, if they are like inside the company, if it's something that the company is learning and the company owns, Markets have been super happy to fund that.

10:55I mean, markets have funded Amazon for decades while the company was losing money because they were saying, no, no, the company is figuring out how to sell stuff on the Internet. Eventually, when they do figure it out, they will have access to a humongous market. And that's going to be super valuable. So markets supported negative cash flows in Amazon for a very long time. So you have to argue that these learning curves somehow spill over into the value chain, spill over into more complicated things to coordinate, and that's why you need some kind of action. Sometimes the reason why industry is getting into trouble is that you have chicken and egg problems, that the supplier is not there because you are not there and you are not there because the supplier is not there.

11:44So there's a good equilibrium in which both you and your suppliers are there. And there's a bad equilibrium in which neither of you is there. So how do you go from the bad equilibrium where none is there to the good equilibrium where both are there? And that's a problem that we know how to solve. In each one of these cases, tariffs may not be the right instrument. So, for example, if you wanted the supplier and you to be there, well, maybe the government comes and says, you know, I'm going to give a supplier the guarantee that you're going to buy from them. and I'm going to give you a guarantee that the supplier is going to be there to sell you.

12:22So you install your plant, he installs his plant, and the guarantee expires worthless. So the government can coordinate on the good equilibrium, essentially spending no money and taxing nobody. A set of guarantees would do the trick. If you want the firm to learn, I mean, one thing is to have these temporary, what they call infant protection. and the term in the literature is infant industry protection. So you take an industry at its infancy and you give it some protection until it finds its way and then you open up. An alternative to that is you subsidize their capital investment or you guarantee their demand, maybe government procurement or something else, or you give it a special tax treatment.

13:12So you have other ways to intervene. The moment you intervene with tariffs, you're essentially dumping the cost on the consumers of that industry. And the consumers of that industry are going to become less competitive and their size will shrink and they may become vulnerable to other attacks. So it's not the ideal instrument. There's an additional reason why it may not be the right thing to do. The U.S. is, and politically, part of all this policy is based on the fact that the Midwest did very poorly. The Rust Belt did very poorly. They lost a lot of manufacturing jobs, and you would like jobs to go back to the Midwest.

13:57Pittsburgh lost its steel industry. Garandiana lost its steel industry. Youngstown, Ohio, Cleveland, Detroit, et cetera. These cities lost jobs in some industries. Now you put the barriers, you put tariffs at the national level. It doesn't mean that the industries are going to go to the Midwest. They may go to right-to-work states in the South. They may go to the Southwest. So it's not an obvious solution to the places that you're trying to help. Those might be better dealt with using place-based instruments.

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16:35That's public.com. Paid for by public investing. All investing involves the risk of loss, including loss of principal. Brokerage services for U.S.-listed registered securities, options and bonds, and a self-directed account are offered by Public Investing, Inc., member FINRA and SIPC. Crypto trading provided by Backed Crypto Solutions, LLC. Complete disclosures available at public.com. You know, I really like this idea of physical products as embedded knowledge. So that if I'm making some recipe that calls for eggs, that the eggs that I buy are the end result of all the knowledge of the farmers.

17:06I don't have to have that knowledge myself. It makes it a simpler process. I was reading a speech recently. Ellen Young, this speech was given, I think, in 1928. He was the former president of the London School of Economics. And he said, it is generally agreed that Adam Smith, when he suggested the division of labor leads to inventions because workmen engaged in specialized routine operations come to see better ways of accomplishing the same results, missed the main point. The important thing, of course, is that with the division of labor, a group of complex processes is transformed into a succession of simpler process.

17:36So, therefore, making something with eggs is simpler because someone else is doing the simple job of making – of growing eggs. I'm making the simple job of maybe making an omelet or something. something becomes a succession of simpler jobs. But the question I have is, does that mean that sort of like sheer market size as measured by even by things like population, et cetera, become important in these questions? Because if we're going to make complex things, doesn't that on some level require either through our population or our friends' population, a decent number of people who can then do all of these individually simple tasks?

18:14Well, I mean, that's the reason why value chains have become longer, that you just slice it into more modules and then you bring those modules together and then some OEM, some original equipment manufacturer that is putting 50 ,000 pieces together. And then each one of the 50 ,000 pieces, it becomes a more manageable task. But some industries require a lot of talent that has to come together. And for example, when you go to the – you see a film in the movies, sometimes they put at the end of a movie, it says the end. But it's a misnomer because after they put the end, they start showing you the credits.

18:57And the credits go on for minutes and minutes. You know, there's the casting, there's the sound effects, there's the visual effects. There's editing, director of photography. So you need a whole massive team of people that are involved in that movie making industry. Well, an industry that requires this deep pool of differentiated talent tends to locate only in very large cities, say like Los Angeles or New York. That's the only place where you could put together all that necessary talent that is required. So industries that require a more diverse pool of talent tend to locate themselves in bigger cities.

19:43And the ones that are kind of simpler, lower complexity, they can afford to locate in a smaller city because in that smaller city, they could probably find the more limited diversity of skills that they need. Now, one of the things that is a feature of the American economy over the last 20 years is that the industries that tend to locate in large cities have done dramatically better than the industries that tend to locate in smaller cities. The industries that tend to locate in smaller cities, they tend to demand more land and not that diverse a labor force. So they're not willing to pay the high prices of land of big cities so they can buy more land.

20:30And they don't rely so much on this diverse labor force. But the industries that require a deep, diverse pool of talent, they are willing to pay the higher price of land in larger cities because they don't use that much land. So what I would put it to you is that part of the drama of the U.S. is the fact that there's been this shift in demand in favor of the things that happen to be done in bigger cities. And by the way, let me make a very important point. We just saw the elections in Poland. And the elections in Poland meant that, you know, the president that won that election is a more, call it a more Trump-like figure.

21:15And in fact, his party, PIS, got elected more or less 10 years or 11 years before Trump. So there was already kind of like a Trumpian motivation behind the election of that party. They were upset about trade and globalization and Europe and so on. Now, the interesting thing about Poland is that Poland is at the exact opposite experience of the U.S. in terms of trade. Poland has seen rising market share across the board in all industries, in agriculture, in manufacturing, in cars, in machinery, in textiles. They have made out like bandits. Trade has exploded positively in Poland. But the thing that has exploded in Poland has benefited these larger urban areas and has hurt the smaller, less metropolitan parts of the country.

22:22And that has generated a political backlash.

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24:36Visit metronome.com to see how companies like OpenAI and Anthropic launch billing as fast as they launch products. That's metronome.com. So even if the gains have been absolute for Poland overall, I guess the relative differences within the country have become a grievance. Yes. Let me say one point that we often do not emphasize. We often think of countries as small open economies. They're small in the sense that what they do is not going to change the global economy. The U.S. is relatively bigger, but many countries think a smaller open economy. When you think of a city, a city tends to be an even smaller and even more open economy.

25:22It's smaller, right? Much smaller than the country it's in, right? And it's more open because it trades with not only the rest of the world, but the rest of the country. And the labor force can either come from the rest of the country or leave to the rest of the country, right? So what tends to characterize a city, for a country, its export base is super important. For a city, its export base is even more important. Because a city is less self-sufficient than a country. A city needs to consume a lot of things that it doesn't make. Most cities don't make cars. Most cities don't make antibiotics.

26:06biotics, most cities don't make. X-ray machines, they don't make, you know, eggs. So all of these things have to be brought in. And to pay for these things that they want to consume in the city, they need to earn money from outside the city. They need to export in order to be able to import. So the set of export activities in a city determines very much the life of the city. If those export activities in the city get into trouble, then it's not just that those jobs in those export industries are lost, but those workers used to go to the barber, go to the grocer, go to the dentist. So all those jobs in all of these local services also get lost and get this multiplier local effect.

26:55And people start leaving the city. The moment people start leaving the city, their housing prices go down. There's less money to pay for education. So the quality of the education deteriorates and you get all of these negative local effects in the city. Okay, that's associated with the export industry of your city getting into trouble. So what I'm saying is that the shift in demand has hurt cities, the kinds of industries that tend to locate in smaller cities, the kind of industries that need less of a deep pool of talent and more land. And the car industry is a good example. The whole steel, you know, steel is a dirty, complicated, large thing.

27:42So it may hire a lot of workers, but it doesn't want to have too many people around them. They need a lot of land. So they're not going to go to Los Angeles. They're going to go to a place where they can acquire a lot of land to put their big plant. And it's the fact that the export sector of cities in the Midwest, say, got into trouble, the fact that the export activities in some parts of Poland got into trouble, that they got into this negative spiral. As people, you know, left because they had better opportunities in maybe other parts of the country, in larger cities, they leave behind a deteriorating economic and social situation.

28:24I promise not to get too hung up on metaphors and monkeys, but I just want to go back to the egg analogy for one second. So I understand, you know, division of labor, expertise can lead to efficiency and absolute gains economically for everyone. However, you know, I'm thinking back to when egg prices were very high in the U.S. earlier this year. And I joked on this podcast that I was going to get my own chicken so that I could declare egg independence, egg autarky, and have my own supply. Are there not arguments, you know, for certain things that you would want to have the capacity to build those components at home in order to enable you to build more complex items?