The Value-Added Fallacy

Andrew Coyne is great on Canada's Value-added fallacy:

Just now, Practical Men are quite convinced that, rather than pipe crude oil south or west for refining in foreign lands, we should be refining it here at home. How do they know this? Well, it’s obvious, isn’t it? We ship them bitumen, they ship us saran wrap and pantyhose. What we should be doing is moving into higher value-added activities….

You hear a lot of this sort of thing. We ship them coal, they ship us steel. We ship them logs, they ship us dining-room sets. At best, it betrays a basic confusion of concepts — what is sometimes called the value-added fallacy. What companies want are higher profits. What workers want are higher wages. What both want is higher productivity. It’s productivity that ultimately determines wages and living standards — not where you happen to be in the value-added chain.

This value-added fetish is often rooted in a kind of “techno-aesthetic intuition” (to use the economist David Henderson’s phrase) that certain activities — manufacturing rather than resource extraction, high technology rather than low — are more befitting of an advanced economy. Hence that most Canadian of fears, being “hewers of wood and drawers of water,” in a country with one of the world’s richest supplies of both.

We hear this a lot in New Zealand as well - even from Alan Bollard when he came back to visit from Singapore last year:

During a flying visit home to Wellington former Reserve Bank governor Alan Bollard has reflected on New Zealand's response to rising incomes in East Asia and the risk of remaining stuck at the low-tech, low-return end of the value chain by just pumping out more primary production.

I was more than a little sceptical:

I asked him there what's stopping Kiwi businesses from picking up the $20 notes laying on the sidewalk if there are such great returns in those activities: whether Kiwis are just stupid; whether there are regulatory impediments to their being able to realise returns; whether they're already innovating and he's not noticed it; or whether a lot of that work is really better done elsewhere and that pushes for value-added here might not be value-destroying.

He noted that Fonterra is constrained by its cooperative structure and that capital markets here might not be deep enough. I note that Fonterra is investing into Chinese dairy to have better understanding of and access to Chinese markets, that they're already doing a lot of milk processing beyond straight powder drying, and that opening to greater foreign investment seems a decent idea. I'm pretty agnostic about Fonterra's governance structure, but that too would seem a $20 note on the sidewalk: if they could be so much more valuable under a fully corporate structure, they will eventually convince their farmer-members of it.

Back to Coyne:

By contrast, the strange, unworldly theory to which economists so stubbornly adhere is merely to suggest that, rather than issue grand pronouncements on what sectors “we should” be investing in, based on little more than hunches, we would do better simply to compare the relative costs and benefits of each. If there are greater returns to be had from producing raw materials, then raw materials it is. Which offers the better returns: to sell crude whatsit for $6 that costs you $2 to produce, or to “move up the value-added chain” and sell refined whatsit for $8 that cost you $6?

And who better to make these comparisons than the people whose money is actually at risk? Refining bitumen is an expensive, capital-intensive business. If it were really wiser to refine it here than sell it to refiners elsewhere, investors are at least as capable of realizing it as anyone else. If instead they choose to export, why not trust their judgment — why, other than the sort of divine dogma the Practical Man claims to disdain?

The fox, it is said, knows many things, but the hedgehog knows one thing. The Practical Man knows nothing. But he knows it with utter certainty. [emphasis added]

The University of Calgary's Trevor Tombe warns of the consequent dangers:

This misunderstanding can have serious economic consequences. The first and most obvious consequence is that public subsidies to so-called value added activities expose governments (and taxpayers) to financial risks. Projects may or may not work out, leaving government to pick up the tab. These costs can add up. The Canadian Taxpayers Federation reckons the Government of Alberta under premiers Peter Lougheed and Don Getty blew roughly $2.3 billion by the early 1990s on failed attempts at diversifying Alberta’s economy (not adjusting for inflation). The biggest failure was NovaTel – a joint telecommunications venture between the Nova Corp. and Alberta Government Telephones, Telus’ predecessor – which eventually cost taxpayers over half a billion dollars. Not all of the Alberta government’s diversification efforts were failures, but as Ted Morton and Meredith McDonald found in their comprehensive review for University of Calgary School of Public Policy titled The Siren Song of Economic Diversification, the losers far outstripped the winners.

A broader consequence of subsidizing firms on the basis of their supposed value added is lower productivity in the overall economy. Suppose for a moment that labour markets function perfectly. In this case, the economic value of a worker is revealed in the going wage rate. Firms that have valuable jobs will be willing and able to pay this wage; those that don’t, won’t. A subsidy distorts this decision. With access to government funding, a firm could afford to hire the worker even if the underlying value of the job is low. This will deny the worker to other firms and the overall economy suffers. Simply put, a subsidy can shift employment towards subsidized activities that are potentially less valuable than others.

I expect I'll be picking up Tombe's primer on value-added fallacies when next the NZ government worries about too much hewing of wood and drawing of milk. HT: @StephenGordon