Pop Internationalism
One of the most long-established propositions in international economics is that a 10% across the board tariff on imports, when combined with a 10% across the board subsidy to exports, would have essentially no effect in the long run. And this is true despite the fact that each policy, considered in isolation, would distort trade and reduce welfare.
The intuition here is simple. Exports are the way we pay for imports. So this combined tax and subsidy would be like the Federal Government simultaneously imposing a 10 cent tax on the purchase of gasoline, and a 10 cent subsidy on the sale of gasoline. This is why I specified the long run; in the long run all imports must be paid for by exports.
The combined tariff/subsidy policies are also very similar to a 10% devaluation of a currency. And it is well known that a 10% devaluation will not change the real exchange rate in the long run, as the domestic wage and price level would simply rise 10% in response. But in the short run wages and prices are sticky, and thus either a 10% devaluation or a 10% tariff/subsidy scheme could lead to a real currency depreciation, and hence would affect trade.
I don’t doubt that author of Pop Internationalism is well aware of what I just wrote, but I think Paul Krugman’s readers may well have misunderstood his argument:
An export subsidy is WTO-illegal. An import tariff is WTO-illegal. A deliberately undervalued currency, maintained by massive foreign exchange intervention over a period of years, is in effect a combination of an export subsidy and an import tariff.
So how can China’s actions be legal, and a US response illegal? Well, the rules on currency manipulation are written in a confusing fashion, and seem to pass the buck or maybe the yuan “” back and forth between the WTO and the IMF.
But I basically can’t believe that the fine points here can override the clear merits of the case. If China’s currency policy were two separate policies, the US would have every right to respond; arguing that by combining the policies China somehow acquires immunity is just too tricky.
I can’t tell whether Krugman is referring to legal arguments or moral arguments. There is no moral argument against a permanent tariff/subsidy combo, because it is neutral. But “clear merits of the case” seems to imply a moral argument, not a legal argument.
It is important to distinguish between arguments that policy X will cause trade distortions, and those that claim policy X will lead to trade surpluses. Trade surpluses are not caused by trade barriers; rather they occur because of high levels of private or government saving within a country. Real exchange rates (on average) reflect economic fundamentals (including government saving as a fundamental.) China is currently experiencing a higher inflation rate than the US, because that’s nature’s way of moving its real exchange rate to equilibrium when the Balassa-Samuelson effect is pushing the yuan higher but the government pegs the nominal rate. Will this process eliminate China’s trade surplus? No, because the surplus is caused by high levels of Chinese saving, not a nominal exchange rate that is out of line. Again, I think Krugman may agree with this, as in earlier posts I recall that he suggested the deeper problem is the Chinese government’s massive accumulation of foreign exchange (i.e high saving) and the undervalued yuan merely reflects that policy.
But if the real problem is Chinese government purchases of foreign exchange, which permanently depresses the real exchange rate for the yuan, then it’s hard to draw an analogy to a tariff/subsidy combination, which doesn’t have any real effects once prices and wages adjust.
The intellectually respectable case for banning tariffs and subsidies is that, in isolation, they are trade distorting. I.e., these policies should not be outlawed by the WTO because they affect trade balances, but rather because they distort trade. On the other hand, a policy of massive foreign exchange accumulation can have a long run effect on trade balances, but is not trade-distorting in the usual sense of the term.
If the WTO wants to install a set of rules that ban countries like Germany, Japan, Switzerland and Singapore from pursuing high saving rates through government policies, then by all means do so. But if they aren’t go to do so, then it is disingenuous to single out a country that is half communist and thus forced to pursue its high saving policies in a more obvious and unsubtle fashion.
What do I mean by “unsubtle?” Policies that encourage private saving are more subtle than those that involve public savings. And policies that achieve high public savings rates through budget surpluses are more subtle than policies that pursue public saving through foreign exchange accumulation. China saves money in just about the most unsubtle way possible.
But make no mistake; there are many countries who are running trade surpluses that are vastly larger than China’s on a per capita basis, or even as a share of GDP, but are not being singled out because they are much smaller, and achieve the objectives using more subtle methods.
Krugman seems to want to deputize the WTO to enforce his theory of macroeconomics in a liquidity trap, which is that there is nothing that deficit countries like the US can do (or will do?) to offset the negative impact of Chinese trade surpluses on our domestic aggregate demand.
If we are going to have the WTO and IMF doing any investigations, I’d like to see them examine whether the Fed, ECB and BOJ are artificially raising the value of the dollar, euro and yen—where value is measured against goods and services, not other currencies.
PS. Don’t respond with “in the long run we’re all dead.” I get the fact that we need more economic stimulus RIGHT NOW. I just think we’re more likely to get it from a robust price level target than a futile attempt to twist the arm of the Chinese. US stocks soared early last week on strong Chinese exports numbers. That doesn’t prove cause and effect; both items probably reflect a stronger world economy. But there is very little evidence that growing Chinese exports are what’s keeping the US depressed while many other countries are recovering rapidly. We need to look in the mirror.
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14. June 2010 at 11:04
If we’re going to have the benefit of the petrodollar / world reserve currency, all the other banks / countries get to price against it as they wish.
btw, I think Krugman jumped back to the topic because the Chinese workers are all getting raises, which will make their products cost more the old fashioned way. Damn them.
14. June 2010 at 16:58
The tariff/subsidy clearly distort the composition of both the Chinese economy and the US economy. Goods that are tradable across international boundaries are overproduced/underconsumed in China (relative the non-intevention equilibrium) and the reverse effect will be seen on their trading partners.
So the analogy to a subsidy and tax on gas doesn’t strike me as a good one. Their government policy is something more like taxing gas while subsidizing (domestic)coal.
One of the interesting things about the distortion is that there are a number of economists who believe that the positive learning externalities and the sectoral productivity shifts in China more than offset the dead weight loss of intervention for China. On the other hand, no one believes that their are similar positive externalities for her trading partners, and there may be negative ones associated with skill erosion and financial market distortions.
Also, including government savings as a ‘fundamental’ doesn’t fit since that’s the precise mechanism that China uses to enforce the tax/subsidy.
You are right that China is being singled out in large part because of its size, but as Pettis points out China has the largest CAS as a share of world GDP in modern history. The paths of development that are available to small countries like Singapore and Taiwan may not be available to China simply due its size and the stress those policies place on the global trade/finance system as well as political economy.
Here’s Krugman, which doesn’t in many ways disagree with you:
“Although people don’t always think of it this way, what the Chinese government is doing here is engaging in massive capital export – artificially creating a huge deficit in China’s capital account. It’s able to do this in part because capital controls inhibit offsetting private capital inflows; but the key point is that China has a de facto policy of forcing capital flows out of the country.
Now, bear in mind the two basic balance of payments accounting identities:
Capital account + Current account = 0
Current account = Domestic savings – Domestic investment
By creating an artificial capital account deficit, China is, as a matter of arithmetic necessity, creating an artificial current account surplus. And by doing that, it is exporting savings to the rest of the world.
http://krugman.blogs.nytimes.com/2010/03/16/capital-export-elasticity-pessimism-and-the-renminbi-wonkish/
14. June 2010 at 18:23
“There is no moral argument against a permanent tariff/subsidy combo, because it is neutral.”
Aren’t there permanent distributional effects? It seems to me that this could permanently decrease the welfare of those who want something that we will always import, without necessarily compensating them as individuals, even over the long run. How are you defining moral argument?
15. June 2010 at 06:04
Morgan, Yes, and the wage increase just shows that exchange rates really aren’t the issue. Costs will adjust to reflect market conditions.
OGT, Yes, I pointed out that Krugman probably agreed with me on the saving issue.
You are flat out wrong about the tariff/subsidy question. It is a well-established proposition of international trade theory, accepted by all economists as far as I know. Oil and gas are two different products. Exports and imports are two sides of the same transactions. We pay for imports with exports. Tax one and you are taxing the other. A 10% tax on imports is identical to a 10% tax on exports. This is all generally accepted by economists.
Mike, I am saying that the tariff/subsidy policy has zero effect. It is like moving a dollar from the right to the left pocket of the same person. It doesn’t affect trade flows, and it doesn’t affect government revenue.
16. June 2010 at 08:25
Scott-
Doesn’t this proposition require that trade be balanced? Plus this mechanism has to work through exchange rate changes, and China’s exchange rate is currently fixed.
Take an economy initially in trade balance. Then a 10% export subsidy and 10% import tariff is imposed. A trade surplus results, as exports increase and imports decrease. This has a real effect, as production increases in both export and import competing industries.
The mechanism through which this policy has no effect is that the exchange rate appreciates, reducing exports, increasing imports, and returning the economy to trade balance. However, the trade surplus between China and the USA remains, so this mechanism seems not to be in effect.
When you say that we “pay for exports with imports”, this is true in a model with no capital account. With a non-zero capital account, a country can “buy” net imports with capital inflows, or “sell” net exports with capital outflows.
Essentially, the “long-run trade balance” assumption of many trade models is not holding for the USA if the long run includes 1994-present. I’m not saying “in the long run we’re all dead”, just that the long run for the US-China trade imbalance is longer than most economists thought.
16. June 2010 at 18:49
Sumner- I can only think that your subsidy/export model is assuming no capital account intervention, as Just Another Economist mentions. That’s, of course, not the case in China as you know. The peg is just a piece of the Chinese government’s systematic intervention, something I most often see misunderstood by apologists for the peg as they expect a quick adjustment in the real exchange rate, like Morgan above. To date that has not happened.
I am tempted here to excerpt all of your friend Prof Pettis’s latest post, but I’ll make do with this piece and the link to the entire thing:
But this (expected rebalancing) inflation didn’t happen. There have periods of inflation in China in recent years, and even a brief inflationary scare in 2007 and 2008, but on average inflation has been far less than what was needed to revalue the currency sufficiently.
So what happened? Why has inflation been muted – as it has by the way in other countries that followed the so-called Asian growth model, including most importantly Japan in the past several decades?
Two months ago University of Chicago economist, Robert Aliber, came to speak at my central banking seminar at the Guanghua School of Peking University. In a fascinating discussion he explained that in fact there was another possible resolution of the imbalances caused by relatively rapid productivity growth in the tradable goods sector.
He pointed out that if the nominal exchange rate is not allowed to rise, policymakers can still contain inflation by what economists call financial repression, made possible by their control over the banking system in countries where banks completely dominate the financial system. In the Chinese context, financial repression exists because the vast bulk of Chinese savings is in the form of bank deposits, and the deposit rate is set at extremely low levels.
http://mpettis.com/2010/06/china-where%E2%80%99s-the-inflation/
17. June 2010 at 07:03
justanothereconomist, I said that the proposition held in the long run, over which time both the trade and capital accounts balance out to zero. I did mention that if prices are sticky there might be a short run effect. But my point was that Krugman was confusing two very different issues. One is a misaligned nominal exchange rate, which get quickly fixed as wages and prices adjust, and the other is a trade surplus created by international saving imbalances, which can last for decades, as you note.
OGT, You said;
“I can only think that your subsidy/export model is assuming no capital account intervention, as Just Another Economist mentions. That’s, of course, not the case in China as you know. The peg is just a piece of the Chinese government’s systematic intervention, something I most often see misunderstood by apologists for the peg as they expect a quick adjustment in the real exchange rate, like Morgan above. To date that has not happened. ”
Actually, it’s not my model, it’s the standard model of international economics. Second, it in no way depends on whether there is capital market intervention.
The real exchange rate is roughly where it should be given the savings rates in the US and China. Many people make a fundamental error, assuming that “equilibrium” in trade means a zero trade balance. Actually that is only true in the long run. The exchange rate reflects both the current and capital accounts. The current nominal rate for the yuan can remain the equilibrium rate for decades, if China keeps buying up lots of American financial assets. The real question (and I think Krugman would probably agree with me here) is whether China is saving too much. The low real rate for the yuan is merely a symptom of that saving. I think good arguments can be made either way (and hence I am certainly not an “apologist” for China) but in any case I don’t think it’s any of our business how much they save.
Regarding the Pettis quotation, I agree that China should liberalize its financial sector (although who are we to lecture them about banking reform!) Those reforms might impact the current account balance. But in any case that’s China’s decision, not ours. We have gained enormously from China’s move away from communism, and would gain even more if they moved even further away. But the point of my post was that it was somewhat misleading to link long run savings issues with the tax/subidy scheme, which only has a short run effect on the real exchange rate (or none at all if nominal exchange rates are floating.) In contrast, saving imbalances affect real exchange rates even if the nominal rate floats and the government doesn’t intervene at all in the forex markets.
17. June 2010 at 22:47
“his theory of macroeconomics in a liquidity trap”
Now you’re just being sloppy. “His theory?” You sound like the climate change deniers who ridicule “Al Gore’s” theory of global warming. Address the merits of the argument or don’t address the argument at all.
18. June 2010 at 14:15
Jimmy, There are about 100 pages of this blog devoted to debunking that theory. Would have have me repeat the arguments in every post?
BTW. Isn’t that an insult to global warming scientists? Suggesting that their theory rests on foundations as weak as liquidity trap economics?
And when I said “his theory” I was refering to an expectations trap model developed by Krugman. Last time I looked Al Gore had not created any global warming models.