Sunday, August 31, 2008

Diversifying the Economy II

A very good comment from "Anonymous" to my last post deserves some attention:
I think Rebecca Blank's comment is not against specialization and the division of labor. One thing is to specialize and become more efficient. It is another thing entirely to limit your source(s) of income. The more sources of income that you have (or potentially have), the less risk you are exposed to (hence, the reason we diversify our portfolios). If Michigan had a wider variety of strong industries, then the state as a whole would probably not be suffering as much. I agree that eliminating trade barriers will help Michigan, but as long as Michigan is reliant on one industry (I assume it is), then, it will always be exposed to risk (unless it insures itself against the risk).
I appreciate this comment and think this is an excellent description of why "diversifying the economy" is so appealing to many. Michigan has many barriers to a free market (they are 26th in Economic Freedom among North American states, as of 2005) so it is hard to know what industries they would or would not have, but under their current conditions resources have already flowed to their most valuable use.

If the state government begins reallocating resources in hopes of "diversifying" they will find themselves on the path to poverty, not prosperity. The individual actors who bear the consequences of their decisions when they specialize take into account the risk involved when they employ their resources. While firms are always looking for ways to reduce their risk, greater risk is only undertaken when it comes with greater reward, and attempts by the state to reallocate those resources will only distort those decisions.

The real problem here is thinking of "Michigan's problem" and looking for ways to stabilize its "income." There is no Michigan walking around who can earn an income. What they mean to say is that politicians in Michigan would like to maximize tax revenue, and they would like to have more industries to tax. Michigan is a tract of land of arbitrary size, and there is no reason to expect any arbitrary tract of land to happen to have a "sufficiently diversified" or "balanced" economy.

Another tract of land, my household, has an incredibly undiversified economy. My household has taken into account the risk involved with this lack of diversification and decided that any other allocation of resources would have less favorable outcomes. A government that tells me to diversify my income sources so that its risk is reduced when extracting a share of my production only serves to leave us all worse off. Worse still is the government that tells me to change my occupation, because it feels it has too many households of my occupation in their tax base.

I hope that helps.


Anonymous said...

I basically agree with what you are saying. The difference is that I feel there are some macroeconomic issues that need to be looked at concerning Michigan. I think the solution is (and I believe you are on the same page) one in which Michigan as a state adopts sound economic institutions that allow for a healthy economic environment. Then, Michigan might only have one industry or might have many; the market (hopefully free) will decide. I think the problem with Michigan is not that they have not specialized enough or that they have not diversified enough, rather I think that their strongest industry is protected so heavily that there is no incentive for other industries to develop. It may very well be that the optimal situation for Michigan is to specialize in the automobile industry, but when the automobile industry suffers, the Michigan economy should be capable enough to switch into other more profitable industries.

Justin M Ross said...

I think you are right then, I think it is unlikely that Michigan would have more industry if the automobile industry were not so protected (historically and present day). In addition, that industry would have found ways on its own to guard against risk if it were not relying on the state to do so.