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.