Tread carefully - unleashing prosperity by unleashing our waters

There is a characteristic of complex systems that people who study systems dynamics like to point out a lot. It’s called non-linearity — the idea that small perturbations can often lead to major consequences in systems that are sufficiently complex. The “butterfly effect” is a popular thought experiment about non-linearity.

It is also often pointed out by these experts that it is very difficult, to near-impossible, to predict precisely how a certain set of changes may alter such a system. There is no clear, tractable formula, or set of proportional relationships, that can predict whether a butterfly going about its business in China will, in fact, cause a hurricane to swallow Miami.

However, such admonitions have rarely stopped people from trying. The human mind must know! Our desire to predict outcomes is hardwired into us, for better or worse.

Project Puraka has recently been focused on exploring America’s use of our waterways for shipping. As I researched this question, it became clear that certain government policies are heavily impacting the viability of water-based transportation as an option for domestic shipping, which has had noticeable effects on our entire logistics infrastructure.

A major source of contention is the Jones Act, a hundred year old policy that mandates that any shipments between two American ports must be carried in ships that are built in the U.S., crewed by Americans, owned by Americans, and registered in the U.S. Created with benevolent national security intentions, the policy has insulated the domestic shipbuilding and ship logistics sector from foreign competition, inadvertently leading to more inflated freight rates and pushing the brunt of America’s domestic cargo onto our roads and railways.

Experts who oppose the policy have spilled much digital ink laying out its various direct and indirect costs. I became curious if anyone had attempted to comprehensively quantify those costs, and hence, the potential benefits of reversing the policy. I stumbled onto a recent OECD paper that attempted to do something in that direction.

Like other opponents of the Act, the paper empirically confirms that the cost of transporting goods domestically via ship and the cost of building ships in the U.S. is several multiples higher than foreign comparisons. The authors then proceed to estimate how exposure to foreign competition would impact shipbuilders and the broader U.S. economy.

The model makes various assumptions, but the two key assumptions are related to changes in the overall cost structure of water-based shipping that would be wrought by abolishing the Jones Act.

The first assumption is a reduction of domestic ship prices by 50%. Domestic shipbuilders charge anywhere from 2–5x as much as foreign builders for ships. Exposure to foreign competition will force these builders to bring their prices down by at least half as more productive firms outcompete less productive firms to gain market share. The reduction in ship prices represents a reduction in capital costs for shippers who use them to move goods. These shippers could then reduce freight rates by nearly 15%. This logic represents the paper’s first Scenario.

The second Scenario assumes a 50% reduction in the freight rates themselves. This seems to be based on empirical data showing that shipping goods from Florida to Puerto Rico (a route that would fall under Jones Act restrictions) costs about twice as much as shipping from Florida to the Dominican Republic (where Jones Act restrictions don’t apply). Since the route is roughly similar in all aspects except Jones Act compliance, the authors conclude that a removal of Jones Act restrictions would force the inflated rate down to the international equilibrium. It stands to reason! Scenario Two implicitly combines the decline in capital costs (caused by 50% lower ship prices) with the decline in operational costs as shippers can enlist foreign crew members and drive down personnel costs.

The paper anticipates multiple effects of a repeal of Jones Act restrictions. In the authors’ own words, once the economy adapts to the shock of the repeal -

“[T]he shipbuilding industry will have reached international productivity levels, water transportation services will have approached the price levels of non-Jones Act conform vessels, and intra-US maritime trade will have been stimulated by lower freight rates.”

In other words, the U.S. will build ships more cheaply, it will produce more ships, those ships will cost less to operate, and the economy will use the ships to move goods more often.

They predict sizeable increases in demand for ships which is interesting, but relatively small in terms of impact. The major benefit of the repeal in the OECD model comes from the indirect effect it has on overall production in the economy.

This is the non-linear, “butterfly effect” element that the model tries to quantify. Their prediction is bold and quite interesting — a reduction in domestic maritime freight rates will not only shuffle some cargo off trains and trucks and onto ship hulls, but it will actually spur a net increase in overall industrial activity. More water-based transport will drive down the cost of goods and increase overall demand. This will incentivize more production. American producers will produce more stuff because the cost of shipping via water decreases.

And the OECD doesn’t expect this increase to be puny.

“The total U.S. economy may benefit from an increase in final demand in the range of USD 22 billion (scenario 1) and USD 74 billion (scenario 2) which represent a rise between 0.12% and 0.39% in the long-term. US total output is likely to increase between USD 40 billion (0.1%) and USD 135 billion (0.4%). In terms of domestic value added the results amount to around USD 19 billion and USD 64 billion, making up an increase of around 0.1% and 0.36% for the total US economy.”

Those are substantial figures.

When theory meets reality

The projections of the OECD are enthralling. It makes a Jones Act repeal seem like a magic trick; like hidden in the unending reems of active U.S. legislation are a handful of innocent looking clauses that, if redacted, could just deliver nearly half a percent of GDP growth for free.

But I believe the paper’s core assumptions are a little too optimistic. The authors assume that American shipbuilders will simply increase their productivity and lower their prices when confronted by the force of foreign competition. Of course, some firms will fail to keep up and they will shutter. But some American shipbuilders will be able to meet the challenge and they will become stronger and win market share. This is the creative-destructive process in action, the logic of evolution rewarding the fittest creatures and punishing the weak.

Implied in that logic, though, is the fact that American shipbuilders actually have two options when confronted by the force of foreign competition. They could become leaner, more cost effective, and lower their prices to compete. Or they could just die.

And death, here, may not be as unpleasant an option as it sounds. “Dying” to the commercial shipbuilding sector doesn’t mean the shipbuilder needs to simply disappear. They could just focus their energies on acquiring government and military contracts instead. The government is already the largest buyer of large naval vessels from American shipyards anyway.

The paper cites data indicating that the American shipbuilding industry experiences disproportionately higher profits than shipbuilders in other nations — the “value added as a share of ship production value” in the U.S. hovered around 48% in 2015 compared to an average in the mid-20s elsewhere. The insinuation is that these profits can be exhausted to lower prices and compete with foreign builders.

However, “value added” includes employee salaries alongside profits. The authors themselves admit in another part of the paper that U.S. employees are inherently more expensive than foreign workers due to their “higher living standards, wage rates, and benefits.” The reduction in “value added” would not just come out of firm profits, it will probably have to come out of jobs and salaries. To pull that off will probably require a few more magic tricks.

How much would price reductions come out of profits vs employment? Are the profits coming primarily from a few types of vessels? Even if the value-added levels were brought in line with the global picture, would American ships be truly cost competitive with foreign built ships, especially given that foreign firms will aggressively market their products in the U.S. if Jones Act restrictions were lifted? These are some of the many questions that need to be explored more precisely to determine whether the necessary price decreases are truly feasible.

At first glance, at least when it comes to the development of large, ocean-faring vessels, our major shipbuilders don’t seem all that profitable. The Philly Shipyard, a commercial shipbuilder of large vessels based out of Philadelphia, posted a net loss of $14 million in its most recent quarter despite having an active order book worth nearly $1.9 billion.

A repeal of the Jones Act would force the price of ships and maritime freight to collapse. However, the lower-price environment can be reached in a variety of ways. Policy makers would need to study the likely trajectories closely to ensure that we don’t end up in an environment where our internal logistics system is excessively vulnerable to a foreign shock. The exact situation that led to the creation of the Jones Act in the first place.

Treading carefully

In the leadup to WWI, America’s system for domestic goods transport relied heavily on foreign-controlled ships. When those ships were recalled by their home countries for the war effort, or were otherwise rendered unusable due to the war, the American economy faced a crisis. America was still producing the goods it needed, but it couldn’t get them to market.

It is eminently reasonable to want to make domestic water-based transport a larger part of our internal logistics system. Nature has deemed water to be the most efficient form of moving goods; yet as of 2019, domestic water traffic was only 8% of freight ton-miles moved in the U.S. That’s down from 22% in 1980. Meanwhile, trucks, which are more expensive and less fuel efficient, transported 44% of U.S. ton-miles in 2019, up from 31% in 1980.

The efficient transport of goods is important to consumers because it keeps prices low. It is important for the society more broadly because it utilizes less energy. And as America pursues a path of re-industrialization, it may become even more important as a key component of a robust industrial base.

The Jones Act sits as an impediment to realizing the obvious economic gains of unleashing our waterways. A repeal of the Act seems like a simple, neat-and-clean solution that would unleash tremendous economic growth. And it would. But if that growth comes at the cost of eviscerating our domestic commercial shipbuilding capacity and creating a logistics system that is dangerously leveraged to foreign interests, then the cure may be worse than the disease.

The OECD paper offers a compelling thought experiment. It provides a useful framework for thinking through scenarios for how a Jones Act repeal would drive down shipping prices, and attempts to track the indirect effects of reform on overall production. However, when it comes to practical implementation, there are several options for reforming the Jones Act and making our maritime freight industry more cost competitive that don’t involve a full repeal. Given the potential pitfalls, those may represent a more wise starting point.