Words Of Wisdom On Krugman And Protectionism (Wonky)

Well I’m putting this piece from Claus Vistesen up here wholesale, since I think he advances some very important arguments that need a wider airing. Basically I started off agreeing with Paul here, but now Claus has convinced me: we cannot get out of this if we don’t address the global imbalances which produced the whole situation, and we can’t address the imbalances if we don’t start to think about the asymmetric demography which lies behind them (I wonder what the “visionary” Taleb set have to say about all this?). As Claus himself says:

First of all, I think that the Economist’s intuition is fundamentally right; the probability that short term protectionism would be anything but this is very large. I am not necessarily referring to the historical example with Reed Smoot and Willis Hawley, but rather to the point that since this crisis is going to be long lived the risk of using protectionism in what ever explicit form is too large.

Secondly, I think that global current imbalances are important to take into account here and if we want to allow economies to enjoy the ability to substitute consumption for saving (and vice versa) over time one fundamental pre-requisite is a commitment to openness. This does not mean that this will be the solution in and of itself. As I also pointed out above, this openess and the factors which may be deliberate in a political sense (e.g. pegging to the USD forming BW II) or more structural (demographic) are also one of the roots to why we are here. Yet, I think that we are still better off not considering protectionism for the simple reason that I believe whole economies (and not just small ones) would be devastated as a result.

A case for (short term) Protectionism?

by Claus Vistesen

It is not only economic data and the punditry and commentary following this which is all at rage at the moment, so is a growing mixture of more or less interesting debates amongst (academic) economists about public spending v. tax cuts, bloodletting v. actually doing something and, as it were, the odd case for or against protectionism. Add to this the growing array of voices attacking the inner workings of the economics profession and it seems that all the pieces are there to make it a nice rejuvenating time for economics as a social science. I still have my sincere hopes that this is true, but I am not sure that significant steps have been taken at this juncture.

Thus, and as much as I would like to have a go myself at the various themes and agendas flying around I have opted to stay a bit clear; or so I thought. As it turns out and with my most recent post I have inadvertently hauled myself into the eye of the storm in connection to the potential next major arena in the context of the discussion on protectionism, whether there is an extraordinary case to be made for it in the short run, and how the economics debate is still tainted by old ideologist knee jerk reactions (of which I may myself have fallen victim).
Yet before I get ahead of myself, let us return briefly to the initial writ which set my commenters and thus myself in motion.

My immediate impetus for writing the post was a leader in the Economist strongly opposing the provisions included in the recent fiscal stimulus passed before congress about buying American. I strongly latched on to the Economist’s critique if anything then for my need to express the opinion that I wholeheartedly agree with those who are worried about the emergence of protectionist and nationalist voices from all over the globe as the going is set to get decidedly tough in 2009. Especially, I agree with the point that protectionist and economic nationalism are not likely to be merely short term even if good intentions are abound in the initial stages.

Now, the world is never black and white and most certainly not as black and white as the old and essentially arcane models of Ricardo’s comparative advantage and Hecksher-Ohlin’s three factor model would have us think (although the latter actually can predict why some factors (e.g. labour) loose out when engaging in free trade). In this way, I realize that just as I have been, on a personal level, much annoyed by the amount of knee-jerk ideologism and freshwater v. saltwater bla. bla. in the current debate, I realize that I may, inadvertently, have added myself to the roster of knee-jerk ideologists with my post on the Economist’s leader. At least, I feel that I was rightfully taken somewhat to task by one very smart frequent commenter, Geert, who pointed me towards the danger of falling into the trap that Einstein so eloquently warned us against about making things simpler than the complexity of the situation demands (or so I understand his points). His full comment reads;[1]

Nationalism and protectionism should not be confused. The link made between them serves the purpose of mutening the debate on protectionism. What should be done is investigate whether the benefits of international comparitive advantages through specialization really exist and consequently why in some cases protectionism led to an ugly outcome.History shows that mutual advantages through specialisation do not really exist at least not in the long term and not in an objective sense, and that supposed free trade creates imbalances that are themselves the root of the ugly outcome that is contributed to protectionism. Most confuse symptoms and causes.The core issue is that in an ideal world where every country plays the game of free trade by the rules, it works, but that world never existed and will never exist. And it’s easy to recognize the cheaters and benefitors of the game for they shout the loudest to keep “free” trade in this non-utopian world.

I find much sense in these points and especially so in the context of how comparative advantage does not constitute an objective truth even if it does seem so when you derive the increase in welfare after that horizontal tariff line has been removed in the SS/DD diagram. In this sense naturally, I stand on fairly wobbly ground with my initial stab at the protectionism discourse where I forcefully oppose the idea. I thus contend that even the most seemingly solid convention should not be believed nor asserted in too uncritical a manner.

So much for the mea culpa then, because it does not end here, far from it.

Consequently, my good friend Veronica also moved in with a comment and more concretely with a link to a post by Paul Krugman in which he makes the claim that perhaps, just perhaps, short term protectionism is warranted in the current situation. This naturally thickens the plot quite extensively and although I sort of squirmed out above, of my position taken initially, let me now reaffirm it by ever so humbly attempting to take the recent nobel laureate to task on this.

First of all and as could have been expected Krugman has taken a lot of flack for his hmm, let us call it musings on protectionism and for example in response to FT correspondent Clive Crook’s comment on his suggestion Mr. Krugman labels the article as hysterical. Now, in all fairness, Crook’s article is behind the firewall for me so I shall neatly stear clear of comment on that specific piece but Henry over at the Crooked Timber engages in an eloquent summary and discussion of the current combat between economic pundits, bloggers and journalists. As for Krugman, he makes the following point that I would like to emphasise;

Speaking of which, Clive and others have, in my view, a fundamentally flawed view of how to defend free trade. They believe that you should scream “Heresy! Sacrilege!” at anyone who even suggests that the world is more complicated than the simple Ricardian model of comparative advantage.

From the above it should be immediately be clear that I agree especially with the spirit of the argument and what is more, no sane economist would seriously believe that Krugman is advocating to slam on the tariff barriers and see the US return to some version of the old king of the hill doctrine (in an economic sense). Now the reason I reiterate this is that while I don’t agree with Krugman here, I do think that it is worthwhile to see what in fact it is he argues since it does raise some very important points. More importantly, I tend to see Mr. Krugman in quite a high regard since I consider him one of the few economists in the know (Bernanke would be another, but that is for another day I think). On that note, let me begin my explaining what I actually think Mr. Krugman means since, and to be fair, he does not really articulate his view very well or does not want to spend time articulating what, perhaps, is ultimately a hypothetical point. For me the key quote is this …

Let’s be clear: this isn’t an argument for beggaring thy neighbor, it’s an argument that protectionism can make the world as a whole better off. It’s a second-best argument — coordinated policy is the first-best answer. But it needs to be taken seriously.
(…)

The right argument, I think, is in terms of political economy. Everything I’ve just said applies only when the world is stuck in a liquidity trap; that’s where we are now, but it won’t be the normal situation. And if we go all protectionist, that will shatter the hard-won achievements of 70 years of trade negotiations — and it might take decades to put Humpty-Dumpty back together again.

But there is a short-run case for protectionism — and that case will increase in force if we don’t have an effective economic recovery program.

Now, in my post which set this off I said the following;

(…) arguments in favor of protectionism to ward of recessions are still build on nonsensical arguments; this recession is global and thus we must act globally to counteract it. More specifically, the free flow of goods, services, and capital is chief in whatever recovery we want to engineer.

With respect to Krugman’s points there is an interesting link here. I argue a global way out, but to Krugman the idea of acting globally clearly seems an ideal but is, in the current environment, not possible and thus each economy should be able to ward for themselves. Of course, I have not fleshed out what I mean by “acting globally” and I shall not belabor it here since it is besides the immediate point I think [2].

Now turning to the economics of Krugman’s argument and thus to more safe grounds for yours truly I see the argument as a sort “bang for the buck” argument. The US is spending a lot of money on this fiscal stimulus and in stead of using all the greenback propping up the US deficit and by consequence the US’ creditors one should make sure that the money spent is actually to the benefit of the US economy. In essence, it seems as if Krugman believes that absent some targeted buy American strategy the fiscal stimulus would be somehow diluted. Now, whether this constitutes an argument about a closed economy relative to an open economy multiplier I shall not say, and before the ideological tomahawks come flying through the room I will not make inferences on this. In this immediate context, the argument may this sound a bit weird, but in fact it is not.

Consequently, I think that since one of the main economic features of the global economy is the nature of global imbalances by which the US is a provider of a huge amount of global capacity through the accumulation of more investment than is matched by domestic consumption, then one of the main routes we do not want to take is to take steps to solidify this trend. In this way, I concur that a world where the emerging world devalues at the same time as the OECD issues a truckload of IOUs to finance the cleanup is not necessarily the way ago. On the other hand, Italy is currently dependent on Libya to keep one of its biggest bank afloat and the US itself is also in a position where it needs to offload investment opportunities to foreign investors. So, it is not clear who would be helping who here.

Perhaps this is also here that I diverge from Mr. Krugman.

My own, albeit still most timid, research has lead me to the idea that the ability of economies to intertemporally substitute consumption for saving is not only central to understand the nature of the global economy, it is also at one and the same time the root as as the solution to our current plight. Let me explain further.

As a foundation, the idea of intertemporal substitution and consumption smoothing on the aggregate level is not new. In fact, it is almost as old as it gets. Originating from Irvin Fischer’s seminal Theory of Interest published in 1930 the idea of intertemporal preferences and substition governed by a market and a subjective discount rate form one of the backbones of neo-classical economic modelling [3]. In this sense I propose no novelty but rather what I am arguing is that in a time of great demographic shifts of the magnitude we are seeing the idea of macroeconomic intertemporal substitution (and incidentally a thorough understanding of time horizons) becomes a crucial vehicle through which to understand the global economy as demographic changes are transmitted to the economy through the life cycle and life course. Specifically, we need to ask who is in fact going to do the importing in the future to sustain the growing emergence of some economies’ intertemporal preference for excess domestic saving over investment and which economies should (can) we in, this context, rely upon to stand tall and perhaps even, oh dear oh dear, increase their debt towards its trading partners.

Krugman however starts elsewhere. For him, the reasoning seems to be that since we are in a global liquidity trap an uncoordinated global attempt to fight the fire would be less effective and that this is the reason why there might be a case for short term protectionism. This point is not without merit in terms of economic intuition. Since the different countries’ and regions’ response to this crisis by definition (almost) would be uncoordinated both in timing and measure, it might be better for each economy to allow for a home grown solution which are not diluted by carry traders and piggy backing by other economies reluctance to do something (and devalue instead) as its peers boost their economies fiscally. This, in my opinion, is what leads Krugman to argue that short run protectionism may in fact the world as a whole better off. Or perhaps if you would allow me to be polemical, it would make the US better off since what strikes me is that this argument is very well suited for the US situation since there is simply no way that the US can take up where it left before the abyss was opened by the subprime crisis.

It is thus on the global merits of short term protectionism that I disagree.

For me, the openness of the global economy and the recognition of why some economies have to export their way out of this mess is chief. As Krugman was adamant in pointing out on his behalf in the context of beggar thy neighbour policies, this is not an argument for a wave of competitive devaluations. However, I am quite confident in my claim that what we need is an asymmetry of responses whereby some economies should be allowed to devalue (export) their way out of trouble. If this turns protectionist in the form of some kind of “every man for himself” mantle, some economies will fall apart and their demise would have severe consequences for global financial and economic stability. However, I also recognize, for reasons stated above, that the US represents a somewhat special case in the sense that while I am fundamentally positive on the future of the US economy it is also now put in such a situation where desperate measures are needed. Yet, ultimately I don’t think that short term protectionism should constitute one of these measures and conclusively I would pin my argument on two points.

First of all, I think that the Economist’s intuition is fundamentally right; the probability that short term protectionism would be anything but this is very large. I am not necessarily referring to the historical example with Reed Smoot and Willis Hawley, but rather to the point that since this crisis is going to be long lived the risk of using protectionism in what ever explicit form is too large.

Secondly, I think that global current imbalances are important to take into account here and if we want to allow economies to enjoy the ability to substitute consumption for saving (and vice versa) over time one fundamental pre-requisite is a commitment to openness. This does not mean that this will be the solution in and of itself. As I also pointed out above, this openess and the factors which may be deliberate in a political sense (e.g. pegging to the USD forming BW II) or more structural (demographic) are also one of the roots to why we are here. Yet, I think that we are still better off not considering protectionism for the simple reason that I believe whole economies (and not just small ones) would be devastated as a result.

[1] – He elaborates his points in a new comment, and it is well worth a look.
[2] – Although I would strongly argue that organs such as the IMF, World Bank, etc be heavily engaged in the global hot spots and especially emerging markets.
[3] – And before I am hauled into court for actually uttering the words neo-classical economic modelling let me say that I am not a fundamentalist as to how this idea should be modelled or articulated. It is however a historic fact that one of the main sources of knowledge on how economic agents “smooth” consumption through time comes from economists such as Fisher, Harrod, Modigliani and Friedman. I am sorry, but that is the way it is; whether you like lagrange multipliers, calculus and equilibrium analysis or not.

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

6 thoughts on “Words Of Wisdom On Krugman And Protectionism (Wonky)

  1. What do we want the multiplier effect of the stimulus to be?

    If a US company buys steel from China then the effectiveness of the stimulus is dampened.

    Also is this taxpayer money to provide corporations with higher profits, by purchasing lower cost materials from overseas, or is it to put US citizens back to work.

    Some people cannot see the economic forest from the dogma of free trade.

  2. George

    If you are happy for a Chinese company to buy American tractors or software, then letting American companies buy Chinese steel is the quid pro quo. Both governments have a stimulus package, and both countries export to each other (yes, American exports to the rest of the world are a third less than vice versa, but the inefficiency of being forced to buy the wrong product outweighs this).

    By letting both buyers go overseas to get the best product for their money, both economies are better off and the multiplier effect is unaffected.

    If you think you can stop imports to the US without affecting exports, then your theory may hold – in the short term – but it’s highly unlikely that will happen.

  3. Leigh,

    Very concise academic logic, but for the heck of it look at the relative strength of the US dollar to the currencies of our trading partners.

    Under the current economic conditions who will pay a premium to buy US goods?

    Like I said… can’t see the economic forest for the dogma

  4. Protectionism is a political decision rather than an economic decision. Protectionism is a defensive reaction where a net present value of public policy costs are brought into a previously simple economic question… who provides the cheapest goods? When times were good, free trade flourished as chasing the lowest priced goods maximized profitability.

    When elasticities changed (with the onset of the recession/depression) profitability is maximized by purchasing at home and “circling the wagons”. Think of protectionism as an insurance premium paid to insure against strong economic headwinds. This incorporation of public policy costs shows support for the home market and shows the company is a team player when the chips are down.

    The quickest way to stem protectionism is for the global economy to make the difficult decisions and de-leverage their economies. You will not be able to simply spend your way out of this recession/depression.

    Individual choices about public funded investment versus public funded waste will fuel individual investment decisions and individual consumption decisions (measures of confidence).

    Decrying Protectionism will be a futile effort. Local players will make those decisions which will be aggregated on a national level. Best of luck in bucking those local politics.

  5. Canucklehead,

    China is the perfect example for your post.

    From what I’ve read China will be building housing for the rural poor as an economic stimulus. Developers in China are sitting on tons of upscale apartment buildings that are empty. They want the government to subsidize rents so the poor can move into their buildings.

    The Chinese government knows there is nothing stimulative about helping private investors and is moving ahead with it’s low cost housing program.

    I don’t know if if outside contractors will be allowed to bid on the construction jobs but if I were a betting man…….

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