WSJ article gets a lot right and a little wrong.

A recent article by David Luhnow in the Wall Street Journal, “Saving Mexico,” contains a lot of good economic analysis of the market for illegal drugs, as well as a few statements that a completely economically literate writer would not have made. Dealing with the whole article in depth would take an article in itself, so I’ll just hit some highlights.

First, what journalists call the dec (sp?) line, the line after the title that tells the gist of the article, doesn’t do justice to the article. The dec line is:

To weaken the cartels, some argue the U.S. should legalize marijuana, let cocaine pass through the Caribbean and take the profit motive out of the drug trade.

It’s that last part, “take the profit motive out of the drug trade,” that is incorrect and, fortunately, the author doesn’t make that mistake, although he comes close.

The gist of the article is that if the U.S. were to legalize not only possession, but production and sale, of marijuana, the demand for drugs from Mexico would fall, assuming that all the currently-illegal drugs from Mexico remain illegal to produce and sell in Mexico.

At first, I thought, that can’t be right. Making a drug illegal is like imposing a high tax, most of whose proceeds are eaten up in avoiding the tax. Reduce the huge tax wedge in the U.S. by legalizing it here, and the net demand for drugs increases, which means the net demand for drugs from Mexico increases. Luhnow even quotes Mexican officials saying something similar, writing:

While this strategy may make sense domestically for the U.S., Mexican officials say it is the worst possible outcome for Mexico, because it guarantees demand for the drug by eliminating the risk that if you buy you go to jail. But it keeps the supply chain illegal, ensuring that organized crime will be the drug’s supplier.

But as I thought about it, I realized that my one-sentence statement of the argument above is correct: the demand for illegal drugs from Mexico would decline. The reason is simple: the implicit tax in the U.S. would fall to zero. The implicit tax imposed by the Mexican government would stay high. It’s as if the U.S. government was imposing both a tariff on imports, a tax on domestic production, and a tax on domestic consumption, and then suddenly ended the tax on domestic production and the tax on domestic consumption. The amount demanded would rise because of the lower tax, but domestic production, suddenly facing a much lighter tax burden, would be advantaged relative to imports. Therefore domestic production would rise, crowding out imports. The net effect on imports is likely to be negative. So, yes, the supply chain in Mexico would be illegal and organized crime would be the supplier, but they would supply less to the United States, the main area of consumption.

What else do I like about the article? A few things. Take this statement:

Because governments make drugs illegal, the risk associated with transporting them translates to high rewards for those willing to take that risk.

That’s a nice statement of the idea that the apparent high profits are a return to risk-bearing. David Luhnow, the author, even gives the mark-ups at each level. Unfortunately, he falls into a trap after giving the mark-ups, writing:

With markups like that, the business is bound to keep attracting new entrants, no matter what governments do to stop it.

There’s no “bound” about it at all. Whether it attracts new entrants depends on the mark-ups relative to the risk. I think the main reason it attracts new entrants is that the existing producers die, are imprisoned, or make their bundle and retire.

Another thing I like throughout this piece is the author’s feel for how markets adjust to new laws. For example:

Governments also have a hard time stopping the drugs trade because, like any good business, trafficking organizations innovate and adapt. Mexican customs has stumbled upon a long list of ingenious methods to transport cocaine, including one shipment of liquefied cocaine smuggled in red wine bottles. Another recent bust yielded 800 kilos of cocaine–worth an estimated $40 million–stuffed inside a batch of frozen sharks.

After Mexico restricted the importation of pseudoephedrine to slow the manufacture of methamphetamines, drug gangs found another way to make the drug using different, unrestricted chemicals widely used in the perfume industry. “I’ve always thought these guys had a good research and development arm,” says one exasperated Mexican official.

This reminds me of some of the best business reporting I’ve read in the 37 years I’ve been reading the Journal regularly.

Two final highlights:

Marijuana is also less risky to a drug gang’s balance sheet. If a cocaine shipment is seized, the Mexican gang has to write off the expected profits from the shipment and the cost of paying Colombian suppliers, meaning they lose twice. But because gangs here grow their own marijuana, it’s easier to absorb the losses from a seizure. Cartels also own the land where the marijuana is grown, meaning they can cheaply grow more supply rather than have to fork over more money to the Colombians for the next shipment of cocaine.

This is what I call the “I wish I owned a candy store because then I could eat all the candy I want” fallacy. I believed in this fallacy when I was six. I don’t now. There is one possible little bit of truth here. One could argue that a particularly risky part of the business is transacting and that, therefore, vertical integration is cheaper. But there must be limits to this argument: otherwise, the whole industry would be vertically integrated.

Finally and disturbingly:

A new 2% tax on cash deposits greater than $1,250 in bank accounts gives tax authorities a better picture of Mexico’s cash economy–the currency of the drugs trade.

Wow, talk about seigniorage!