In a recent blog post, Paul Krugman tried to illustrate a point about the GOP tax cut plan by imagining interplanetary trade with Martians. (At least he’s now entertaining voluntary transactions, rather than an alien invasion.) Yet in his zeal to downplay the potential benefits to workers from a corporate tax cut, Krugman ends up shortchanging the versatility of markets. As a teaching exercise, I’ll walk through the full implications of Krugman’s story about Martians, to show the elegance of capitalism.
Krugman’s Martian Scenario
The context for Krugman’s fanciful thought experiment is the GOP plan to cut the corporate income tax rate from 35 to 20 percent. In order to sell this plan as pro-worker, the GOP defenders are arguing that capital is very mobile on the international market. Therefore, global investors can be picky, and must earn the same after-tax rate of return (due account being made for risk), wherever they invest. This means — so the GOP argument continues — that a large cut in the US corporate tax rate will simply invite a flood of foreign capital into the US, pushing down the pre-tax rate of return to reestablish equilibrium across all countries. Yet this process helps American workers, who are now mixing their labor with a larger capital stock. Because labor productivity is higher with more tools and equipment, wage rates end up rising. Thus, so the argument concludes, the primary beneficiaries of the GOP tax cut won’t be international capitalists, but instead will be American workers.
As you can imagine, Krugman has been doing his best to throw cold water on this chain of reasoning. One line of attack has been the casual assumption that a flood of new foreign investment could come into the United States and quickly increase the capital stock, in order to push down the earnings of capital (while raising the earnings of workers). Krugman argues that because global markets are not fully integrated, that the adjustment process could take decades, meaning that workers would have to wait a long time to see the alleged benefits from the big tax cut on corporations.
To drive home his point, Krugman dreams up a Martian scenario:
In such matters, it’s often helpful to start with extreme cases. What if nothing were tradable? Suppose, for example, that we were to discover a capitalist society on Mars, with a stock market, a corporate profits tax, and everything. We could easily send data back and forth, with only a few minutes’ delay imposed by the speed of light. We could conceivably trade assets, since ownership is really nothing but data. But until Elon Musk finds a way to reduce transport costs by several orders of magnitude, we can’t really ship useful stuff to or from our new Martian friends.
So, suppose Mars cuts its corporate tax rate. How much is the incidence of that cut affected by the existence of an interplanetary capital market? Not at all: we can’t send physical capital to Mars, we can’t convert any earnings on Martian assets into something with any Earthly use, so nothing happens. The total lack of real integration makes financial integration irrelevant.
Now suppose that somehow a teensy bit of Martian output becomes tradable – say, certain services that can be provided over the Solar Wide Web, amounting to 1 or 2 percent of Martian GDP. Surely this can’t drastically change the story. [Krugman, bold added.]
It’s this last part of Krugman’s scenario that I think is wrong. Depending on the specifics, the opening up of Mars to (limited) trade with Earth could have large consequences for the Martian capital market. How to Beam Factories to Mars
In this short post, I am not of course trying to exhaust all possible thought experiments involving Martian economic growth. My modest purpose is to show that Krugman—motivated no doubt by his desire to pooh-pooh the defenders of the GOP plan—was far too hasty when concluding of the Earth/Mars trade channel that “Surely this can’t drastically change the story.”
So let me stack the deck in my favor by picking an extreme example. Suppose the Martians have very high time preference, meaning that (other things equal) they strongly prefer to consume sooner rather than later. Before they make contact with the Earthlings, the Martians have a real interest rate of (say) 100%. Because they are so prodigal, the Martians don’t save much, even at this high interest rate. Consequently they have very little physical capital invested per worker. Indeed the entire Martian capital stock only represents 2% of GDP. Currently, the Martians only save and invest a tiny amount each year — say, 0.2% of GDP — to replace the worn-out tools and equipment as they depreciate.
Now suppose that the Martians finally get their wifi routers working, and they are shocked to discover intelligent life on the nearby blue planet. After figuring out how to communicate and consummate financial transactions, an amazing thing happens: Massive amounts of financial capital from human investors start pouring into the Martian economy. The human investors are amazed at the real interest rates of 100% available on the red planet, and rearrange their portfolios accordingly. This pushes down the market rate of interest on Mars, and pulls up the market rate of interest on Earth, until the Martian interest rate — due account being made for the riskiness of the investments — is comparable to the yield on terrestrial assets.
Yet to answer Krugman, we need to be more specific about how this process occurs physically. Well, in the extreme example I’ve constructed, we can imagine that the huge Earth economy swamps the Martian economy. So what happens in the first year is that all trade goes one-way. Specifically, anything that can be imported from Earth is imported from Earth. This includes database and cloud hosting, CPA services, math tutoring, and website design. Any work that can be done by Earthlings and then beamed to Mars, will be performed.
Yet as Krugman says, this may only account for, at most, 2% of the Martian economy. Even so, consider the impact. The Martian workers who used to maintain databases and perform CPA services, will now be freed up to do other jobs. Indeed, Martian workers and industries will be reshuffled so that they now devote 2% more of their economic output to the production of machines, tools, and other equipment.1
The capitalists on Earth ultimately wanted to send physical capital goods to Mars, where the “marginal product of capital (goods)” is much higher than on Earth. But because of prohibitive shipping costs, instead what they did was export electronic services to Mars, in order to earn the Martian currency with which to hire Martians to build capital goods. Then the Earthlings retained ownership of those capital goods (located on Mars), where they would generate high earnings because capital goods are so initially scarce.2 Does It Matter?
Finally, we can ask of our fanciful scenario: Would the option of trading with Earth matter to the Martians? Yes, it certainly would in the extreme example I constructed. Specifically, the influx of 2% of Martian GDP’s worth of foreign investment would allow the capital stock on Mars to double in the first year.3 (Remember I said that they started out with a capital stock equivalent to 2% of Martian GDP.) This would push down Martian interest rates and would raise the real wages earned by Martian workers. (Note that we should be careful not to confuse physical and financial capital, as I explain here. But for our simple story we can be somewhat loose.) So contrary to Krugman, we can’t automatically dismiss the impact of 2% of the economy being tradeable.
The point of my article isn’t to defend the GOP tax plan, and it’s certainly not to study the economy of Mars. Rather, Krugman’s whimsical thought experiment provided an opportunity to showcase the ingenuity and opportunities that can be unleashed in financial markets. Even if they were limited to transfers of information, we have seen how capitalists on Earth could effectively “beam factories” to Mars, in order to boost the productivity of Martian workers.