The Economics and Politics of Trade

Paul Krugman (hat tip: Mark Thoma, as usual) says:

…I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect.

Greg Mankiw asks:

But what if those who are worried about trade are protectionists? Should we still respect them?

Until Paul Krugman gives his own answer, I think we can presume that the answer is yes. Respecting protectionists doesn’t mean we are willing to give in to their protectionist demands, but it does mean that we appreciate their concerns and presumably that we are interested in finding some way of accommodating those concerns, short of actual protectionist policies.

It helps, I think, to separate the positive question from the normative question. The positive question is, “Who is helped by trade, and who is harmed?” The normative question, in the abstract, is, “How much weight should we give to the interests of the various parties that are helped and harmed by trade?” Twenty years ago, there was an easy answer to the first question: “Nearly everyone is helped in the long run, and in the short run, only people in a few specific industries are harmed.” That made the answer to the normative question irrelevant. Unless one wanted to give a ridiculously high weight to the short run interests of industries that were hurt by trade, the conclusion was always that trade was good, and protectionism was bad. And anyone who disagreed could be written off as either representing a special interest or misunderstanding the positive economics, thus not deserving our respect.

The answer to the positive question is no longer easy, and Prof. Krugman suggests that the answer now may be something like this: “Rich Americans and poor foreigners are helped, while typical Americans are harmed.” I think most American economists, including both Greg Mankiw and Paul Krugman, will agree with my answer to the normative question: “Since poor foreigners are much, much, much, much poorer than typical Americans, any reasonable notion of distributive justice, utilitarian optimization, or human charity requires that we give more weight to the interests of poor foreigners.” But that answer is unattractively convenient for American economists, since, whether or not they are personally rich, they fall into the functionally defined category of “rich Americans” that benefit from trade. As Archie Bunker once said, “It’s always good to be generous when it don’t cost you nothing.”

The ultimate answer may be even more convenient for Paul Krugman, because it justifies his prior political preferences. He advocates addressing the concerns of protectionists by means of (broadly speaking) redistributionist policies that benefit typical Americans (trade losers) at the expense of rich Americans (trade winners). That answer is convenient, but nonetheless, provided that Prof. Krugman can substantiate his positive conclusions, pretty convincing (though perhaps I’m not one to judge, since I tend to agree with his prior political preferences anyhow). Whatever ones initial preferences regarding equity-efficiency tradeoffs, a recognition of the politics of trade should shift them a bit to the equity side. Or, more precisely, if the marginal efficiency gains (and equity gains at the global level) from trade are first order and you are already at your domestic optimum for the equity-efficiency tradeoff, then, with the introduction of the political constraint, the envelope theorem requires that you revise that domestic optimum.

Indirect Effects of Export Demand

Today let us be thankful for multiplier and accelerator effects. And in any case let us at least be aware of multiplier and accelerator effects. In particular, if you want to talk about the potential role of export demand in preventing a US recession, the story you tell should mostly be about multiplier and accelerator effects rather than direct effects. If you tell the story without mentioning multiplier and accelerator effects, the prospect looks pretty dismal, as in the following from an otherwise excellent commentary by Martin Wolf:

But exports are only some 12 per cent of GDP. They must grow by considerably more than 10 per cent a year, in real terms, if the contribution of net trade to the rate of growth is to be as much as 1 percentage point. It is likely to be much less.

“Much less” than 1 percentage point sounds like a pretty feeble force to set against the likely effects of a meltdown in housing and a collapse of credit, given the apparent importance of credit and of the “wealth effect” in maintaining consumer spending. But borrowing and wealth effects have never been the primary elements used to explain consumer spending: rather, they are factors that help explain deviations from the normal relationship between spending and income. That relationship has certainly not disappeared, and income is still the primary factor. The personal savings rate may be unusually low, but this doesn’t mean that consumption has started to follow a path independent of income. And when income rises, as it would from an increase in exports, we can expect consumption to rise also.

A little quick Keynesian arithmetic should make the point. Let’s suppose that the marginal propensity to consume is 0.7. That is, for every dollar in new income that households receive, they increase their consumption by 70 cents. (There may be other things happening simultaneously that reduce their consumption, so I don’t necessarily expect consumption to grow at 0.7 of the growth rate of income, but 0.7 seems plausible to me as an estimate of the direct effect of income. It’s certainly a lot more conservative than what we would get from the rule of thumb that takes the average propensity to consume as an estimate of the marginal propensity.) Then, as the familiar story goes, people in the export industry will spend 70% of their new income; then the people from whom they buy will spend 70% of their new income; and the people from whom those people buy will spend 70% of their new income; and so on. The sum of that infinite series is 1/(1-0.7) or 3.3. The total effect of that hypothesized 1 percentage point contribution from export growth becomes 3.3 percentage points. Suddenly I’m glad the actual export contribution is unlikely to be that high: I wouldn’t want the Fed to have to raise interest rates dramatically to prevent overheating.

I’ve ignored the effect of taxes, because I think 0.7 might be a reasonable guess at the marginal propensity to consume out of gross income, including the effect of taxes. US consumption shows a striking tendency to gravitate toward about 70% of GDP, though the mechanism might be something completely different. Anyhow, I’ll leave it to real economic modelers to sort out the details. The point is just that the multiplier effect is quantitatively important, and if one tries to discuss the effect of exports without it , one will miss more than half the picture.

But let’s not forget the accelerator effect either. After the last 5 or 25 years, the US is probably not geared up to be an export powerhouse. Recent export growth has nonetheless been impressive. But with few economists predicting a significant recovery in the dollar any time soon, the important question for businesses is not how much they can export immediately but how much they can export over, say, the next 10 years. The process of gearing up becomes a worthwhile proposition in itself. Thus it is to be expected that export demand should induce a significant increase in the category of nonresidential investment (although, as with consumption, it may be partly offset by other factors causing a decline in nonresidential investment). Then there is the interaction between the multiplier and accelerator effects: some investment will also be needed to support the new consumption that results from export demand, and so on.

It may have gone out of fashion to talk about multiplier and accelerator effects as such. But we still read statements like, “Gains in employment and income will support growth in consumer spending.” The gains in employment and income don’t come out of nowhere; there has to be some underlying source of demand. A scenario under which exports provide an underlying source of demand, and the indirect effects offset weakness in other areas, seems quite possible to me.


[UPDATE: I forgot to include the hat tip to Mark Thoma for that Martin Wolf commentary.]

Why doesn’t Europe have a large trade deficit? (Part 2)

The first rule of this game is that you’re not allowed to answer, “Because Europe has a high savings rate.” The whole point of Paul Krugman’s post to which I linked in Part 1 (as well as this 1995 Krugman piece to which he links therein) is that there has to be some mechanism by which a higher savings rate leads to a smaller trade deficit (or a surplus). The usual mechanism is the exchange rate, but in this case, the dollar has not appreciated against the euro. (It has depreciated in nominal terms and probably mildly depreciated in real terms also.) You can’t just say that when people save more, they buy fewer imports: if this were the only mechanism, then an increased savings rate would necessarily lead to a huge recession, because people would also buy fewer domestic products. Once the central bank and the financial markets make the necessary adjustments to avoid that recession, they increase the demand for imports again, and we’re back where we started. Unless something else – such as the value of the currency – changes.

I’m somewhat disappointed that I haven’t yet seen an answer that is both convincing and conventional. Apparently, there is no easy story that explains the divergence in trade balances between the US and Europe. (When I say Europe, BTW, I mean the Euro Zone – since I’m speaking with reference to exchange rates. Steve Waldman points out that there is diversity within the Euro Zone, with Germany running a surplus and most of the others running deficits. At a pinch, I’ll make this whole discussion about Germany and say, “Why does Germany still have a trade surplus?”)

There were a couple of interesting unconventional answers that involve complementarity. Karl Smith (in a comment that he develops more fully on his own blog) suggests a complementarity between Asian production and US distribution. In this story, the major cause of the US trade deficit is what might be called the “Wal-Mart effect.” Imports have become cheap to buy in the US, not so much because they have become cheap to produce in Asia, but because US retailers have learned to operate on thinner margins. European retailers, on the other hand, have not.

A couple of people hinted at another possible complementarity: between European (i.e., German) exports and the Asian production process. If the Asian (Chinese) investment boom has created a specific demand for European (German) capital goods, then the resulting export demand could outweigh the effect of euro’s appreciation. It’s not entirely clear to me why it wouldn’t also create a demand for (presumably cheaper) US capital goods, but then I know very little about the details, so perhaps US capital goods just aren’t the kind that China needs.

Some people suggested various things, such as European protectionism and the VAT, that might help explain why Europe has in general had a stronger trade balance than the US, but as far as I can tell, they don’t explain why the US has developed a trade deficit over the past decade and Europe hasn’t. The VAT was there a decade ago, when the euro was weaker and Asia was less productive, so why didn’t Europe have a large trade surplus at that time?

Gabriel M. asks why it all matters. He wants the answer to boil down to welfare. Steve Waldman gives an answer which may help satisfy Gabriel. As for me, I don’t have an answer that boils down to welfare, because in this case I’m one of the agents trying to form my own expectations about exchange rates. The observation that the US is importing a lot more than it is exporting, and the presumed unwillingness of people outside the US to keep sending goods to the US without eventually receiving something in exchange, suggests to me that the dollar is overvalued. The fact that a similar argument cannot be made for Europe suggests that the euro is undervalued against the dollar. But I’m troubled because there is a piece of the puzzle that doesn’t seem to fit.

Why doesn’t Europe have a large trade deficit?

Paul Krugman (hat tip: Greg Mankiw) points out that, for national savings (and investment) to affect the trade balance, it first has to affect the exchange rate. (In particular, if the US had a higher savings rate, the trade deficit wouldn’t fall unless the dollar depreciated further, so it is absurd to blame the weak dollar on the low savings rate.) One of the implications of this realization is that one can talk about the immediate causes of trade imbalances without mentioning national savings or investment: the cause has to be either in the (real) exchange rate or in the business cycle.

In terms of exchange rates, it’s pretty easy to see why the US has a large trade deficit today. (For now I’ll leave out the oil issue, though that’s part of the explanation.) The Asian countries (and China in particular) have become dramatically more productive over the past decade. Therefore their prices for traded goods have fallen dramatically, but they have not allowed their currencies to appreciate commensurately. Consequently, the dollar is overvalued (in real terms) relative to those currencies today. Ergo, the US has a trade deficit.

OK, so far it makes sense, but wait a minute: productivity growth in Europe has not been much faster than productivity growth in the US over the past decade. Prices of traded goods produced in Europe have not fallen. The euro has not, on balance, depreciated against the dollar. And Europe didn’t have a huge surplus with the US a decade ago (despite the booming US economy at the time). So if Asian goods are cheap today relative to US goods, then Asian goods must also be cheap relative to European goods. So why doesn’t Europe have a large trade deficit like the US?

If I get a chance, I’m going to download actual data on trade balances and exchange rates and see if I can figure this out. For now, though, it’s a puzzle. And it makes me wonder if we should start to get really worried about Europe’s trade balance now that the euro has appreciated dramatically against the dollar.

For Richer or Poorer

Robert Reich (hat tip: Mark Thoma) says that the weak dollar is going to make Americans poorer (except for those who are rich enough to hedge against the dollar’s fall) and that “the real worry isn’t inflation” but “our pocketbooks.” Reich’s scenario is indeed what you get from a comparative static exercise in a simple full-employment model: when the terms of trade shift against you, you end up worse off, and (provided nobody expands the money supply) inflation isn’t an issue because falling prices outside the tradable sector (like, let’s say, in housing) offset rising prices for tradables.

But real life is not a comparative static exercise, and everything else doesn’t get put on hold when we go from an old equilibrium to a new one. In the past, the overwhelming tendency has been for the US (as a whole, anyhow) to get richer over time, and I doubt that the terms-of-trade shock, by itself, will be enough to reverse that tendency over the next few years. The US may get a recession, and that may make the US temporarily poorer, but if we are heading for a recession right now, it is in spite of, not because of, the falling dollar. Aside from the possibility of a recession, the US capital stock will continue to grow as usual, technology will continue to improve as usual, and, provided that the terms-of-trade shock is not too precipitous, improving domestic productivity will offset the deteriorating terms of trade.

What if the terms-of-trade shock is too precipitous? Then the US will get poorer, temporarily, but the long-run improvement in productivity will continue, and after a few years, we should catch up again. But a precipitous shock would lead me to question Professor Reich’s assertion that “the real worry isn’t inflation.” A sudden deterioration in the terms of trade would (as I argued in my earlier posts about labor cost targeting) put the Fed in a difficult position. Given the stickiness of many domestic wages and prices, the diminution of living standards that Reich foresees would not happen without a fight, and the result of the fight would be either inflation or recession. I would be more worried about either of those possibilities than I would about the fact that some people will have to make modest reductions in their standards of living.

It’s also not unthinkable that the falling dollar could end up improving US living standards, paradoxical though that may seem. The overvalued dollar has pushed a disproportionate fraction of US resources into the nontradable sector. One has to wonder whether this imbalance has damaged productivity growth. It’s a lot easier to imagine productivity growth happening in tradable industries like manufacturing and Internet-based services than in, say, construction and mortgage finance. Surely real investment will make a much greater contribution to productivity if it goes into plant and equipment for export industries rather than into residential housing. And as one who believes that there is more slack in the US labor market than is generally recognized, I hold out the hope that the stimulus from a weak dollar will help us discover that slack and give the US a Keynesian free lunch to offset the rising cost of the French wine we’ll be drinking with that lunch.

Professor Reich also suggests that the weak dollar will have a regressive effect on distribution, but again I’m skeptical. The tradable sector is where most of the good working class jobs are (or were, and presumably could be again). Reduced foreign competition will also put workers in a better position to negotiate a bigger slice of the pie in industries where there’s room for negotiation. If it becomes relatively more economical to produce in America, that’s no net advantage for the world’s capitalists (who will lose, for example, on European production what they gain on American production), but it will be a big advantage for the American workers who are available to do the producing.

Having said all this, I want to point out that, while the prognosis for the dollar is certainly not good, reports that the dollar is already dead have been greatly exaggerated. Yes, the dollar is at a record low against the Euro, but this doesn’t mean that the dollar has crashed. It just means that the dollar’s general downtrend, which has been in place for five years, is continuing, and that we happen to have been in a declining phase of the variation around the trend. There is a good chance that the dollar will keep going down from here and that the general trend will accelerate. But that’s hardly a foregone conclusion. Anyone who remembers the fall of 2004 should know to be cautious in extrapolating the weak dollar into the immediate future.

Fire and Ice*

Marc Shivers of The Talking Fed notes the following new material from Ben Bernanke’s speech on Tuesday (referring to the way that current global imbalances might end, given Bernanke’s argument that they are caused by a global savings glut):

What implications would a gradual rebalancing have for long-term real interest rates? The logic of the global saving glut suggests that, as the glut dissipates over the next few decades and thereby reduces the net supply of financial capital from emerging-market countries, real interest rates should rise

Upon which the blogger comments:

He presumably leaves it as an exercise for the reader to figure out what implications a sudden rebalancing would have on long-term interest rates, like might happen, for example, if U.S. consumers collectively decided tomorrow that they no longer wanted to be the consumers of last resort for the rest of the world. I'm guessing this is what the FOMC was referring to on Aug 17 when they said "the FOMC judges that the downside risks to growth have increased appreciably."

Despite Bernanke’s research linking the two, though, I think we should be careful to separate conceptually the issue of the savings glut from that of the international imbalance. In principle it is possible to have either one without the other. One might ask separately the questions, “How (and when) will the savings glut end (and will it ever end)?” and, “How (and when) will the international imbalance end (and will it ever end)?”

In my own mind, I have an easier time imagining a more-or-less “permanent” savings glut than I do imagining a “permanent” international imbalance. The case that comes to my mind is the 1930s, when the world had a prolonged savings glut. Indeed the glut might have gone on indefinitely if the brilliant economists in Nazi Germany and Imperial Japan had not hit on an ingenious method for coordinating international policies.** During the course of the savings glut in the 1930s, however, there were some successful attempts to alter the international balance.

Ben Bernanke imagines that the global rebalancing will be the result of the elimination of the savings glut (just as – in his view, anyhow – the original imbalance was itself the result of the savings glut). Marc Shivers, on the other hand, imagines what might happen if the global rebalancing resulted from an intensification of the savings glut – that is, if the US joined the glut instead of the rest of the world ending the glut. He imagines that scenario as a sudden change, but it could also happen gradually.

In the sudden scenario, I think long-term interest rates would go down, but there is some ambiguity, because the inflationary impact of sudden weakness in the dollar might lead the bond market to anticipate tight money. In the gradual scenario, there isn’t much ambiguity: a gradually weakening dollar would not have a dramatic inflationary impact, so the bond market should anticipate easy money to stimulate an economy weakened by slowing consumer spending.

I see at least one reason to expect that “gradual widening of the savings glut” scenario: demographics. The children of the baby-boomers are now at the point of graduating from college or otherwise experiencing full emancipation. Without the expenses of caring for their children, baby-boomers – that bulge in the US age distribution – will have surplus income at a time when it is becoming increasingly difficult to ignore the specter of retirement. That realization isn’t something that happens overnight to everyone at once, but I imagine it will happen faster than the matter of decades over which Ben Bernanke sees the rest of the world regaining its appetite for real investment.


*The title is an allusion to Robert Frost, but frankly, I like Pat Benatar’s version better

**UPDATE: I guess the US has tried something similar recently, but the international coordination doesn't work unless you attack a country that has allies. Just like George W to screw things up ;)

The New York Times on Exchange Rates

Greg Mankiw and Dean Baker are beating up on an editorial in today’s New York Times. I think their attacks are a bit unfair. The editorial says that the Bush administration is reducing the trade deficit by “letting the dollar slide,” which the Times suggests is not a good idea, but instead, “to be truly effective, a weaker dollar must be paired with higher domestic savings.” Greg and Dean ridicule the editorial by pointing out that a weaker dollar is exactly the mechanism by which higher domestic savings would reduce the trade deficit. (Dean also allows for the possibility that higher savings could cause a recession, which would reduce the trade deficit but obviously would not be desirable.) So if “letting the dollar slide” is a bad thing, they suggest, how could increasing domestic savings be a good thing, when increasing domestic savings would only cause the dollar to slide further?

I grant you the editorial does not appear to have been written by someone who had just finished getting an A in a course in open economy macroeconomics, but I think the editorial has a point, which Greg and Dean are missing. There are two reasons that the dollar can weaken. First, it can weaken because US interest rates fall (relative to foreign rates), making dollars less attractive. That is a “movement along” the demand curve for dollars. Second, it can weaken because people demand fewer dollars at any given interest rate. That is a “shift” in the demand curve for dollars*. What the Times is saying is that the right way to weaken the dollar is by inducing a movement along the demand curve, whereas Bush administration policies are instead causing the curve to shift.

While it’s debatable just how much influence public policy has on the position of the demand curve, it certainly has some influence. Surely Dean Baker, who perpetually complains about the Clinton-Rubin strong dollar policy, will not deny this. I’m personally skeptical about Dean’s maintained hypothesis that Clinton-Rubin policies had much impact on dollar demand, but I think there is a good case to be made that the Bush policies identified by the Times do have considerable impact. When a nation continues to run budget deficits in the face of a negative personal savings rate, there is a tendency for investors to lose confidence in that nation’s currency and to demand less of it at any given interest rate.

The difference in effect between a shift in the demand curve and a movement along the curve is important, though I don’t think the Times identifies that difference quite correctly, or at least the Times doesn’t make the true difference clear. The editorial implies that a shift in the currency demand curve is more inflationary than a movement along that curve. That may be true in the long run, but it's not obvious that it’s true in the short run. The true difference (assuming monetary policy is working well) is that, with a shift in the demand curve, the stimulus from the improved trade balance is offset by reduced domestic investment, whereas, with a movement along the curve (assuming that movement results from increased domestic savings), the stimulus is offset by reduced consumption. I think Greg and Dean will agree that the latter is preferable.

In the long run, less investment leads to a lower growth rate of productive capacity, which slows the rate of labor productivity growth, and much contemporary opinion holds that slowing productivity growth brings about an unfavorable shift in the Phillips curve, causing inflation to accelerate more rapidly (or decelerate less rapidly) at any given level of employment. Thus, in a sense the Times is right to argue that the “shift” strategy is inflationary (because it reduces investment). Perhaps the anticipation of such future inflationary conditions is what reduces the Fed’s “room to maneuver” in the face of a weakening currency. The Times doesn’t spell out this argument, but it makes some sense to me if that’s what they had in mind.


* In the model I have in mind, the quantity of dollars demanded depends on relative interest rates, and then the foreign exchange value of the dollar depends on the quantity demanded (as if the supply of dollars in the foreign exchange market were perfectly inelastic). The demand curve to which I refer represents the first relationship, and the value of the dollar is then determined by the second relationship. Obviously this is a simplification, since the bond markets and the foreign exchange market have to come into equilibrium simultaneously, and there really is not a perfectly inelastic supply of dollars. For purposes of the present analysis, however, I don’t think this simplification distorts the point I’m trying to make.

Losses from Trade?

Karl Smith has an interesting idea about trade, explained here discursively and with a link to his paper in progress here. The traditional Ricardian theory of gains from trade applies in the case of certainty: those who benefit from liberalized trade will have sufficient benefits that they could (theoretically) compensate the losers and still end up better off, so trade is Kaldor-Hicks efficient ex post. But in a world with uncertainty (and with incomplete insurance markets), liberalization of trade can be Pareto inefficient ex ante. That is, the increased risk to everyone could be such a disadvantage that it outweighs the average expected gains and makes the contemplated liberalization a net disadvantage to everyone involved.

The same could presumably be said for any change that increases uncertainty, which might include technological change. I have a vague, intuitive sense that trade introduces more uncertainty than does technological change, but right now I don’t have any evidence to support that idea.

The Blinder Approach

OK, Alan Blinder, there’s something here I don’t understand. I get the point that things may get tough for a lot of American workers over the next 30 years. I get the point that this makes the case for providing better social insurance stronger than it used to be. I get the point that it makes the case for encouraging more research and development stronger than it used to be. I get the point that it makes the general case for facilitating more and better education and training stronger than it used to be. But here’s what I don’t get:

…we need to rethink our education system so that it turns out more people who are trained for the jobs that will remain in the United States. … many electronic service jobs will move offshore, whereas personal service jobs will not. Here are a few examples. Tax accounting is easily offshorable; onsite auditing is not. Computer programming is offshorable; computer repair is not. Architects could be endangered, but builders aren't. Were it not for stiff regulations, radiology would be offshorable; but pediatrics and geriatrics aren't. Lawyers who write contracts can do so at a distance and deliver them electronically; litigators who argue cases in court cannot.

So apparently we want to train people for onsite auditing, computer repair, building, pediatrics, geriatrics, litigation, and similar occupations. But why? Don’t we already have enough – or at least almost enough – auditors, computer repair people, builders, pediatricians, geriatricians, and litigators? Is there any reason to expect that offshoring will increase demand for those occupations? What model do you have in mind wherein foreign competition increases the demand for non-tradable services?

In my crass Mundell-Fleming conception, here’s what happens when offshoring occurs. Suppose a lot of people from India learn to do American tax accounting, computer programming, architecture, and so on, undercutting American service producers. A bunch of American accountants, programmers, architects, and such will lose their jobs. The Fed will notice the slack labor markets and cut interest rates. As a result, the dollar will depreciate, causing an increase in demand for some other American products. Which products, exactly, we don’t know, but they have to be products that are exportable – not auditing, computer repair, and building, and pediatrics. There will be excess demand for certain kinds of workers, but not, ultimately, for the categories of workers whose jobs can’t move offshore.

I grant you that we do not live in a small country with perfectly substitutable assets, so things won’t happen exactly the way I suggested. There will be a temporary demand for certain non-tradable services – specifically the ones that are interest-rate sensitive, like building. That, in fact, is already happening, or perhaps has just finished happening. But today I think one might be rather glad to have passed up the opportunity to train for a job in the construction industry. In the longer run, surely we cannot expect that foreigners will be willing to finance ever higher amounts of non-tradable services for Americans. Perhaps we can maintain a large trade deficit, but surely we can’t keep running ever larger trade deficits, to create ever greater demand for domestic non-tradable services.

So do we need to rethink our educational system? Perhaps, but as to how, exactly, I have no idea. I don’t understand why we would want to restructure it to turn out more people trained for non-tradable service jobs.

The Chinese Exchange Rate and US Borrowing

One cool thing about having my own blog is that I get to comment on Tyler Cowen even when he closes comments. (This is even better than bringing back deleted comments from Brad DeLong’s blog.)

Tyler Cowen argues against pushing for yuan revaluation on the grounds that revaluation would only tie the hands of the US:

The fundamental problem in the U.S., to the extent we have one, is our propensity to spend, especially given our long-run demographic position and our government's fiscal irresponsibility. I don't see how pressuring a more rapid change in one set of relative prices (namely U.S. vs. China), which are likely to change anyway, will cure that ailment in a significant way….

A key reason to be skeptical of yuan revaluation is that it tries to address a relative prices problem by shrinking the opportunity set facing the U.S. That is not obviously the right way to go. The point is not to claim that all elasticities are zero, but rather that a trade balance shift, through revaluation, really does require a loss of resources. What fact about the world would make that the best way to go?

What fact? Two words: sticky prices. Consider the four possibilities:

1. Weak yuan + US borrows


2. Strong yuan + US borrows


3. Weak yuan + US does not borrow


4. Strong yuan + US does not borrow

Which of these possibilities is optimal for the US? Tyler Cowen would probably choose #3, but he’s wrong. Not being a Keynesian, however, he won't appreciate why the correct answer is #4 (although Greg Mankiw should, so maybe he can tell me why I’m wrong).

Why not #3? Because if we choose what’s behind door #3, we get a huge and prolonged recession. A fiscal tightening, in the presence of a still-strong currency, will knock out the economy. (We kind of already tried that one back in 2000-2001. In that case the fiscal tightening came from the business sector, which continues to run a large surplus unto this very day. We have since had a recovery, a slow and painful one, brought about mostly by households and government, which are borrowing heavily, partly from China.) As long as China keeps our trade sector weak by keeping its currency weak, our optimal strategy is to borrow.

Furthermore, as long as the US is willing to borrow, it is in China’s interest (given the conservative preferences of its leaders) to keep its currency weak. If the US suddenly stopped borrowing, it would lower US interest rates and make dollars less attractive relative to yuan, forcing China to absorb incredibly huge numbers of dollars, and ultimately, I suspect, China would give up and let the yuan rise. As it is, the path of least resistance for China is to maintain the peg.

So there are two Nash equilibria, and we are stuck at the bad one. As long as the US borrows, it is optimal for China to peg. As long as China pegs, it is optimal for the US to borrow. Ultimately, both countries would be better off if the US stopped borrowing and China stopped pegging, but, as we say in Boston, you can’t get there from here.

I’m not sure how you get out of this bad equilibrium, but one possible way is by trying to change the preferences of China’s leaders, so that it will no longer be optimal for them to peg. I’m not sure how one goes about that, and Tyler Cowen may be right that political pressure is the wrong way, in which case I’ll concede the war but not the battle.

Tariff Revenue

Dean Baker makes a good point about trade: to the extent that trade liberalization comes in the form of tariff reductions, the amount of gain depends critically on how the government makes up the consequent revenue loss. Most likely, it will be made up by some other form of distortionary taxation, so that a tariff reduction merely substitutes one form of distortionary taxation for another. The “gains from trade” will be partly offset by the loss due to the distortionary effect of the new taxes. In principle, the gains could be fully offset, and the trade liberalization could have no net benefit. In practice, I think tariffs are probably quite a bit worse than the next alternative form of taxation, but the point is well taken that conventional estimates of the gains due to trade liberalization are overstated.

Weak Yuan in the Long Run?

In a comment on an earlier post, reader mvpy points out that labor’s share of national income has a very robust tendency to revert to its mean over time. How, mvpy suggests, can I therefore argue that the weak yuan policy can have lasting effects on US income distribution?

The answer is, I can’t. Even on theoretical grounds, there is no reason (generally) to think that the weak yuan policy would have long-run effects on anything. (The exception – not accounted for in traditional theory – is path-dependence – the effect of the past on the future. For example, the weak yuan may make it profitable to build factories in China. If the yuan subsequently strengthens, but those factories have already been built, it may still be profitable to run them.)

Let’s be clear on this: exchange rates are a short-run phenomenon. In the long run, if China maintains the weak yuan, the strong demand in China will cause inflation, and the weak demand in the US will cause deflation (relatively speaking). The ultimate result is that it will no longer be cheaper to buy things in China than in the US. This phenomenon is known as “real appreciation,” and, in the long run, it renders exchange rate policy irrelevant.

The concern I have is that the long run may take a lot longer to arrive this time around. Ordinarily, when exchange rates are out of whack, it is because some country is trying to defend its currency at an unrealistically high value. To avoid running out of exchange reserves, that country has to tighten monetary policy, which has a deflationary impact and hastens the real depreciation of its currency.

China is in the opposite situation, and the picture is not symmetric. China does not have to worry about running out of reserves. Therefore, China can sterilize its foreign exchange intervention to blunt the inflationary impact. China need not follow a loose monetary policy, so the real appreciation may be a long time in coming. So (though again I hesitate to blame the low labor share in the US predominantly on China’s exchange rate) don’t be too surprised if labor’s share remains away from its mean for a lot longer than usual.

Distributional Effects of the Weak Yuan in the US

In general, having a strong currency (e.g. the dollar against the yuan) tends to benefit consumers and hurt producers. Consumers get more for their money, and producers face weaker demand (lower prices) because of the competition. In our society, most people are both producers and consumers. However, richer people tend to do more consumption than poorer people (in absolute terms, though not as a fraction of income), whereas richer people probably don’t, on average, do more production than poorer people. Consequently, the weak yuan tends to shift distribution from poorer to richer people in the US.

You might argue that only those producers who compete directly with the Chinese are hurt by the weak yuan. The problem is, though, that US workers – even those in different industries – compete with one another. If you get laid off because your job is being outsourced to China, and then you come and apply for my job, it makes my boss that much less likely to give me a raise.

US workers compete with other US workers, nationally, but US capitalists compete in a global capital market. Thus, even though capital is part of the production process, the capital side of production isn’t hurt (at least not in aggregate) by the weak yuan. Sure, if you have all your money in one domestic business, and the Chinese start making your product more cheaply, you’ve lost part of the value of your investment. But if you have a diversified portfolio of capital assets, you’ll take losses on some and gains on others. If the expected return on US capital goes down, you stop investing in the US and start investing abroad. Workers don’t have an analogous option.

Just as most consumers are also producers, most workers are also capitalists, but again it is a matter of degree. Poorer people, and younger people, tend to derive most (or all) of their income from labor, whereas richer people, and older people, derive a comparatively greater share from capital. Thus, again, the weak yuan tends to shift distribution from poorer to richer people in the US (and from younger to older people).

In a comment to one of his blog posts, Greg Mankiw implicitly made the counterargument that (1) consumers benefit in proportion not to the total amount that they consume but to the amount of Chinese goods they consume, and (2) Chinese goods are widely consumed by the poor and middle classes. (“Inexpensive goods from China are sold at Walmart…”) This becomes an empirical issue: I won’t concede that rich people consume a much smaller proportion of Chinese goods until someone shows me the evidence.

Another counterargument (also perhaps implicit in Greg’s comment) is that, even though the distributional shift may be toward the rich, the poor still end up better off. When I see real wages falling, I’m rather skeptical of this argument, too. Of course, we can’t blame falling US real wages primarily on the weak yuan, but I’m guessing it’s a factor.

A possible counterargument

In my last post, I argued that China, with its high growth rate, has a comparative advantage in producing future goods and therefore should be running a trade deficit rather than a surplus. If there is a counterargument to be made, it would probably rest on the distinction between average productivity and marginal productivity. China’s average productivity is quite low compared to what it will be in the future. However, if the marginal factory worker in China is someone who otherwise would be sitting on a farm twiddling his thumbs, then, on the margin, productivity might be extremely high. In other words, if we demand a few more manufactured goods from China, and they take some otherwise useless person and put him to work in a factory, they have increased industrial production without giving anything up anything else (except the worker’s leisure). In that extreme case, if we ignore the worker’s foregone leisure, the marginal productivity would be infinite: the quantity produced goes up by some positive amount, while the total social cost of production goes up by zero. In that case, obviously, on the margin, China has a huge comparative advantage in producing present goods rather than future goods.

Something like this argument seems to be behind claims that China’s weak-yuan policy is useful to help “manage industrialization”. As a Keynesian, I’m vaguely sympathetic, but I think this argument misses some critical points. By most accounts, China is industrializing too quickly already. If there are really people sitting on farms twiddling their thumbs, surely the Chinese can come up with other useful things for them to do besides making toys for Americans. For example, how about training more of them to be doctors and nurses, or having them build new medical facilities, so that Chinese people can have better health care? Surely, if they put their mind to it, the Chinese government could think of a lot of domestic improvements that could be made by their newly available labor.

Essentially, China today is outsourcing its fiscal policy to American consumers. The communists have become so enamored of capitalism that they want to do everything the capitalist way. Traditional Keynesian fiscal policy is too socialist for them.

The Prosaic Economics of Currency Manipulation

I’m going to toss the two-country, two-sector, two-period model to which I referred in earlier   posts. The prose version of the argument about intertemporal comparative advantage turns out to be a lot simpler than what I said earlier.

Consider two countries, one still developing and the other already developed. Let’s call them the People’s Republic of Developing and the Developed States of America. They have two products, one called “current manufactured goods” and the other called “future manufactured goods”. Which country has the comparative advantage in producing future manufactured goods? If you recognize that developing countries tend to become rapidly more productive, while developed countries only slowly increase their already high productivity, it should be clear that the People’s Republic has the comparative advantage. Equivalently, the DSA has a comparative advantage in producing current manufactured goods. In the normal course of things, therefore, you would expect the DSA to sell current manufactured goods in exchange for future manufactured goods. In other words, the DSA should run a trade surplus, and the People’s Republic should run a trade deficit. (This is in fact the normal relationship between developing and developed countries and explains, for example, why superstar developing countries like South Korea used to run large trade deficits.)

So why is it that, in today’s world, the US runs a deficit, and China runs a surplus? Some might argue that it’s demographics. The US population is growing faster than China’s, so maybe the US actually has a comparative advantage in producing future goods. There are a couple of problems with this argument. First of all, both countries have a large nontradables sector which can employ the excess working population at any particular time, so it’s not as if all those extra workers in China today, or in the US in the future, will go to waste. Second, if you take into account both slower population growth and faster productivity growth, China’s total growth rate is still much faster than the US, and almost everyone expects that situation to continue for the foreseeable future.

A better explanation, I think, is that China is over-saving. Part of the reason for this over-saving is currency market intervention, whereby the People’s Bank of China saves newly minted money in the US. Part of the reason also is that taxes are too high, which forces Chinese people to save via their government. Part of the reason is that profits are high, and businesses tend to save their profits. Part of the reason is that the insurance system, particularly health insurance, is inadequate, so people have to save extra to allow for emergencies. Part of the reason is that the pension system is inadequate, so people have to save for a worst-case retirement scenario, and since all this saving pushes down returns on assets, the worst case gets even worse.

As I’ve said before, in the simple economics of it, China’s excess saving – including what is implemented through currency manipulation – clearly benefits the US. I’ve touched on reasons why Americans – in the not-so-simple economics of it – may actually be hurt, and my intention is to go into more detail later. When I get a round to it...

A couple of minor points about currency manipulation

Before I continue my series of posts about yuan-dollar manipulation, I want to deal with another couple of minor hydra-heads, which hopefully I can simply incapacitate without generating the usual multiplicative effect.

First is the use of the word “manipulation”. Some people would say that China is not “manipulating” its currency, just passively maintaining a peg to the dollar (or a slowly crawling peg to a basket of currencies that consists primarily of the dollar). This view might seem to cast doubt on the relevance of my assertion that “in a world without market failures, government intervention is always inefficient.” If China were maintaining its peg by means of monetary policy adjustments – the way such pegs are maintained in the textbook models – I would agree that this is not really a case of government intervention or manipulation.

But the reality is that China maintains its peg through direct intervention in the foreign exchange market while pursuing a monetary policy that often runs counter to its exchange rate objective. As a result, the People’s Bank of China accumulates large quantities of US Treasury notes and other US assets. Whether you want to call it “manipulation” is a semantic issue, but clearly the Chinese government is doing something that a purely passive government would not do: it is lending money. Depending on how you look at it, either the Chinese are following an active monetary policy that interferes with their passive exchange rate policy, or they are following an active exchange rate policy in spite of their sensible monetary policy. Either way, it constitutes government intervention. Though I recognize that other semantic conventions may be equally valid, I’ll continue to speak in terms of “currency manipulation”.

The second point is that the Chinese currency manipulation is partly just to compensate for another form of government intervention – capital controls. In other words, since China restricts its citizens from investing abroad, the government has to invest abroad to make up the difference. As I said in another post, a few economists think that, once China’s citizens fully realize their ability to invest abroad (beginning with the recent moves toward relaxation of capital controls), the government’s current currency policy will no longer require intervention. As I also said, those economists are a minority, and I am not one of them. Nonetheless it is important to keep in mind that not all of today’s yuan-dollar manipulation represents “net” government intervention.

Currency Manipulation, continued

I still haven’t bothered to solve my currency manipulation model, but I’m pretty confident in what it would show: in a world without market failure, attacking your own currency hurts your own country more than it helps your trading partners. And there was never any question that the manipulating country is the loser, and the trading partner is the winner. But when we look at the US and China, it’s quite clear that most of the support for currency manipulation is coming from the “loser”, China, while most of the opposition is coming from the “winner”, the US. Why?

Part of the answer is undoubtedly political. On both sides of the Pacific, there are both winners and losers within the population, and it happens that both the Chinese winners and the American losers are very important politically. For anyone who remembers the 2004 Presidential election (or anyone who studied the state-by-state results of the previous 10 Presidential elections), I can make this point about the US in just one word: Ohio. Although I know less about Chinese politics, I get the impression that marginal workers in the manufacturing sector are thought to be a potentially dangerous group.

But I really don’t think that’s the whole story. The fact is, we don’t live in a world without market failure. Human irrationality, sticky prices and wages, time to build, path-dependence, monopoly and monopsony power, pre-existing government distortions, externalities, missing markets, not to mention all the examples of market failure that I’ve forgotten – these things are not only present but, in my opinion, potentially important in understanding the US economic relationship with China. Moreover, the distribution issue discussed in the last paragraph is not just a political one: the US population, in aggregate, may benefit from China’s currency manipulation, but that doesn’t mean that the typical American benefits; if the benefit is sufficiently concentrated within the population, then the typical American can end up making a sacrifice for the benefit of the average American. (If you take a look at recent income distribution statistics, you may notice that the average American has been doing very well over the past few years, but the typical American – that is, the median American – has been losing ground.)

Trying to blog about the Yuan issue, I feel like Hercules battling the hydra. Every time I try to simplify the issue, it grows two more heads. I’ll have to deal with the latest heads in future posts.



Update: Another point regarding the “average American”: What conclusion you reach may depend on what quantity you are averaging. If you take average income, then, in the absence of market failure, the weak yuan policy clearly helps the US. But if the benefits go disproportionately to the rich while the costs fall disproportionately on the poor, then average welfare might be reduced. Because of diminishing marginal utility, a given amount of additional income is worth more to the poor than to the rich.

The “Simple” Economics of Currency Manipulation

I had forgotten how complicated economics becomes when you try to do it rigorously.

I want to explain why, in a “simple” world – meaning one without market failures – currency manipulation is inefficient. The easy answer is that, in a world without market failures, government intervention is always inefficient. But that answer is unsatisfying. (Some might say that real currency manipulation is impossible in a world without market failures, because prices will adjust to bring real exchange rates back to a market level. However, it is clearly possible for governments to accumulate reserve assets on which they will earn income, and this process must have real effects.) The more detailed answer is anything but simple.

Why is currency manipulation bad? Because it distorts the intertemporal terms of trade. Why is distortion of the intertemporal terms of trade bad? Two reasons. First, it distorts consumption decisions by reducing consumption when the currency is weak and increasing consumption when the currency is strong. Second, it distorts production decisions by shifting production into the tradables sector when the currency is weak and into the nontradables sector when the currency is strong. So, in a country whose government is attacking its own currency, the tradables sector will operate inefficiently at the margin, while in its trading partner the nontradables sector will operate inefficiently at the margin. Later, when the manipulation stops, the situation will reverse itself. In the end, total production could have been increased if the non-manipulating country had originally produced more tradables.

That explanation is already complicated, and the prose is somewhat ragged around the edges. The story does seem to fit well with the situation between the US and China today. In the US, nontradable industries like construction and health care are struggling to find workers and materials, obviously not being very efficient at the margin, while tradable industries like manufacturing are leaving both workers and physical capacity idle, apparently foregoing increases in production that could be very efficient. I’m less clear on what’s happening in China, but I get the impression that manufacturing is expanding at an unhealthy pace, while the health care industry is producing less than what would be healthy for the typical Chinese citizen.

I tried to put this explanation into a rigorous form, using the simplest possible assumptions in a two-country, two-sector, two-period model, to show that the manipulating country loses more than the trading partner gains. But there’s just too damn many equations, and it’s not worth the trouble of solving them. I wanted to make what I thought was a simple point, but it seems to require a whole research project.