Saturday, January 2, 2010

The Year of the Tiger: Paul Krugman’s spurious case for protectionism

Free trade – domestic, international, global – is certainly efficient, provided that a large number of usually unspoken but well known conditions are satisfied concerning, broadly, the nature of technology, competition in the markets for goods and factors, and government policy instruments. Efficiency – in the Pareto sense of cost minimization or output maximization under constraint – is not a foregone implication of free trade, but it can reasonably be presumed until it is specifically disproven for a given time and given trade partners: the burden of proof rests with protectionists.

Paul Krugman, in his Chinese New Year (The New York Times, 31/12/2009) argues that China’s refusal to allow a revaluation of the yuan, on the strength of associated unilateral controls on capital inflows, justify the “very mild protectionism” that China is confronting at the moment. Should such an under-valuation persist, Krugman envisions and recommends the escalation of mild protectionism into “something much bigger”.

“China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.”

“Here’s how it works: Unlike the dollar, the euro or the yen, whose values fluctuate freely, China’s currency is pegged by official policy at about 6.8 yuan to the dollar. At this exchange rate, Chinese manufacturing has a large cost advantage over its rivals, leading to huge trade surpluses.”
Yuan appreciation is prevented by Chinese restrictions on capital inflows and by its large scale purchases of dollars, leading to cumulative reserves of over $2 trillion. In the past Chinese dollar purchases contributed to keeping the US interest rate low (a mixed blessing, for it helped inflate a housing bubble). Today, “China’s bond purchases make little or no difference” to the US interest rate; instead, Krugman argues, “that trade surplus drains much-needed demand away from a depressed world economy. My back-of-the-envelope calculations suggest that for the next couple of years Chinese mercantilism may end up reducing U.S. employment by around 1.4 million jobs”.

This is how Paul Krugman arrives at such a devastatingly high contribution to US unemployment. For 2010-2014 a Chinese current account surplus of 0.9 percent of gross world product has been projected (Blanchard and Milesi-Ferretti, two IMF top-officials, though speaking in a private capacity). This can be thought of as a negative trade shock to the rest of the world, actually slightly larger than China’s current account surplus because an identical shock would produce a lower surplus by depressing also Chinese trade. Ignoring this small correction, and assuming an average multiplier applying also to all other autonomous national expenditure items, of a plausible order of magnitude of, say 1.5, “we’re looking at a negative impact on gross world product of around 1.4 percent. Not huge — China isn’t the principal obstacle to recovery — but significant."

"And, if we think of the United States as bearing a proportionate share, and also use the rule of thumb that one point of GDP = 1 million jobs, we’re looking at 1.4 million U.S. jobs lost due to Chinese mercantilism.” (See Krugman’s post Macroeconomic Effects of Chinese Mercantilism, 31/12/09).

To buttress his argument, Paul Krugman quotes Paul Samuelson: ““With employment less than full ... all the debunked mercantilistic arguments” — that is [Krugman adds] claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He [Samuelson] then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.” (Krugman, The Chinese Year, cited).

Krugman’s argument is a Curate’s Egg: good, but only in parts. It is - up to a point - devastatingly right in his new-found support for protectionism, and it is irredeemably irrelevant with respect to yuan undervaluation.

If the economy is nowhere near full employment, as Krugman rightly notes to be the case, the domestic opportunity costs of both inputs and outputs are lower than their prices. This is, by itself, a sufficient case for government subsidies to lower prices down to opportunity costs, which for fixed production factors can be taken as close to zero, or for protection by means of a countervailing tariff. This regardless of whether there is an exchange rate mis-alignment. But what if the artificial undervaluation of an international competitor’s currency is so large that even bridging the domestic gap between prices and opportunity costs, or introducing equivalent import tariffs, domestic competitiveness cannot be restored? In that extreme case, there is simply no longer a case for protection, but only a case for wage restraint, or productivity promotion, or other competitiveness-enhancing measures.

What difference can it possibly make, from a competitor's economic viewpoint, whether a country is internationally super-competitive because of low wages – whether due to high unemployment, or low unionisation, strike prohibition or authoritarian rule – or high productivity, because of state subsidies or exchange rate undervaluation – whether due to direct controls or Central Bank market intervention? The prices at which China is willing to trade are what they are, the US can take them or leave them. If there is an advantage from US trade with China when China’s competitiveness is due to its low wages it will still be there when it is due to exchange rate undervaluation instead. Or not, as the case may be. Or won’t it?
Obviously when a country signs an international trade Treaty, or joins a Common Market, and a fortiori a Currency Union, concerns about fairness will induce all signatories to adopt general common rules enhancing competition, promoting institutional harmonization and economic convergence, preventing or limiting state subsidies, as well as tariff and non-tariff restrictions, while retaining the ability to introduce protectionist measures in cases of failure to comply with these rules. But Paul Krugman confuses the moral and legal right to implement a protectionist trade policy, in the face of unfair under-valuation, with the economic case for it.

The economic case for protectionism, or the lack of it, must be the same regardless of the ultimate source of a competitor’s super-competitiveness. And, by the way, I do not believe that Paul Samuelson might have referred to "nations ... effectively steal[ing] jobs from other countries" only in the case of under-valuation: any devaluation, if successful in improving the trade balance, exports unemployment regardless of whether it leads to an undervalued or an overvalued or an appropriate exchange rate.


chilosi said...

America’s woes are entirely of its own, not Chinese, making: Krugman is barking to the wrong tree
1. The usual complaint of the Americans towards the China, to which Krugman has added his voice, reminds me of Italy’s vs. Germany before the Euro. Often Italy had problems with the Lira, which underwent periodic devaluations, in relation to the DM, in particular, and a chronic tendency towards deficits of its balance of payments. Italians at the time tended to blame the ugly Germans, their propensity to not revalue, and their stricter monetary policy, instead of themselves and their weak institutions leading to higher public debt, higher inflation, high (especially long-run) unemployment, and a more sluggish economy. Of course I don’t want to say that the present woes of the USA are the same as those of Italy, nor that China now is the same as Germany then, it only reminds me of the psychological attitude to find an external scapegoat for the problems of one’s own making.
2. Let us go to basics: China is heavily financing the USA by accepting US Treasuries that render (at the moment) almost nothing in exchange of a supply of goods that keep American prices down, and enhance the purchasing power of American wages (we may call it the Walmart effect). Thanks to the Walmart effect the Federal Reserve could carry an expansionistic monetary policy leading to high economic growth without endangering monetary stability (in the consumer market at least). However the bonanza of the persistent willingness by the Chinese (and not only they) to allow Americans to use more resources than they were producing has turned sour because American faulty institutions have led to bad use of those additional resources. Instead to utilize them to invest, either at home or abroad, in order to draw a return higher than the interest on the debt and enhance their wealth, they have enhanced their consumption (including the wars abroad, which according to some point of view could be an investment for avoiding worse troubles), and part of the investment they have made was faulty (in particular excessive production of unaffordable housing), because of incentive incompatibility in the working of the financial system with the task of allocating investible resources in a reasonably efficient way. The ensuing financial crisis has resulted in a real shock because of a sudden decrease or real money due to the contraction of bank credits. With this the Chinese have nothing to do. The expansionistic operations of the Fed and the financial rescue of the banks have been sufficient to avoid a deep depression as in the thirties, but insufficient to avoid the deep recession we are in at the moment. The crisis has been too sudden, the American representatives too conservative in what is financially permissible to the administration, the fear of possible future inflation and of the future burden of debt (perhaps rightly, perhaps wrongly) too deep. If the problem is insufficient aggregate demand, the problem lies with the unwillingness of the American representatives to reflate adequately, rather than with the Chinese (who are doing their part as far as the reflation of their own economy and ensuing consequences on world demand are concerned). Owing to Chinese reflationary policy, an adjustment of the yuan real rate of exchange could come from Chinese inflation rather through adjustment of the monetary rate of exchange (but the latter can follow anyway, at least if the Americans will not talk too much about it; see “China's exchange-rate policy”, Economist, 19/11/09). If the Americans on the other hand will take protectionist measures they will probably shoot themselves (and others too) in the foot, as they already did in the thirties.

chilosi said...

China, protectionism, and free trade

About free trade one could say the same as what Churchill said of democracy, and we may say of capitalism: a very bad system, pity nobody has invented one better. All those stuffy arguments in favour of protectionism (dumping, social dumping, unfair subsidies, infant industries and so on and so forth) are in most cases just a thin veil for the power of organized interests against the common advantage. As to China, an advantage of free trade is “capitalist peace”, the possibility for an emerging power to gain through free trade rather than through conquest and domination, as Japan was once induced to do under the sway of protectionism. With China we have the awakening of an economic giant and the raise of what could become a dominant world power: it is much wiser to try to tame it through trade than to irritate with protectionism.

Nora said...

Speaking as a non-economist, why should we wish to pay more for Chinese goods than the price at which the Chinese are perfectly happy to sell them?

D. Mario Nuti said...

Well, this is an old chestnut. If we buy from China at 90 euro, say, what could be produced domestically at a total labour cost of 100 euro, consumers save 10 euro on the cost of the product, but as a nation we lose 100 euro which would have accrued to domestic workers in exchange for their labour, who are now unemployed. Net result from the operation = a loss of 90 euro.

Only after the displaced workers have been re-deployed doing something useful elsewere, can the benefit from cheap Chinese imports be fully reaped.

There remains the risk - even after such a successful and efficient re-deployment of labour - that the Chinese might destroy our manufacturing capacity with their cheap exports and, afterwards, raise their prices to levels which would have made our own production competitive, but too late for our competitive capacity to be resurrected. Not a totally absurd scenario...

chilosi said...

The above scenario would be a possible one if the Chinese were the only producers of the manufactures we import, so that after having destroyed our manufacturing capability they could exact monopoly prices. But this is not really the case. There are many producers, and possible producers, in the world, for instance, of the cheap textiles the Chinese are producing. The same applies to consumer electronics, or, for that matter, to steel rods and steel pipes. Imposing a tariff on those imports invites retaliation and restriction of trade to the disadvantage of everybody concerned. It reduces the purchasing power of consumers and the real wage of workers, it reduces the competitiveness of the industries that use those roads and pipes. On the whole the jobs preserved through protection may cost a higher number of jobs elsewhere in the economy. Of course every structural readjustments due to either change of comparative advantage, technological change, changes in consumer preferences, changes in the structure of primary commodity prices, implies a cost of readjustment. But this cost is lower whenever the economic structure is more adaptable and the labour market more flexible, and the social security net more comprehensive. It may be lower in the USA where long run unemployment is a marginal feature of the labour market and is particularly low, and labour highly mobile, but for the lack of a comprehensive social security net. It may be higher in Italy, where long run unemployment is massive, labour mobility low, and the social security net highly patchy. Finally, protection is certainly not an adequate measure whenever, as it is now apparently the case, the economy is in recession and increased unemployment is the consequence of a contraction in aggregate demand.

D. Mario Nuti said...

A very plausible indeed likely vision, Alberto. The only thing I would disagree with is that
"... protection is certainly not an adequate measure whenever, as it is now apparently the case, the economy is in recession and increased unemployment is the consequence of a contraction in aggregate demand." I would have thought it is precisely unemployment due to demand contraction that provides both an incentive and a (short-run) case for protection.

chilosi said...

It may appear that in recession protection could be a way to divert demand internally from foreign towards national producers, but this is a dangerous illusion. Protection at home calls for protection abroad, and what demand can be created internally by import substitution can be lost abroad by export reduction. Even if protection is intended to be time limited it will likely to be swiftly counteracted abroad, worsening the climate of international economic and political relations. In the end everybody loses and the contraction of trade increases costs and deepens the recession. The experience of the thirties is very telling in this respect. Moreover in recession in particular protection tends to be directed towards the branches of production where a country is least competitive, the dying industries rather than the nascent industries, and the branches that have more clout in the political process, rather than those that have the greatest prospect of growth and can benefit the most from increasing dynamic returns to scale, contrary to the usual cases for sectoral protection.