Tuesday, June 19, 2012

I think Stephen Gordon gets trade wrong


Stephen Gordon writes about trade in the Globe and Mail:
[T]he [Canadian] Conservatives are selling trade agreements with the European Union and India...as a way of increasing Canadian exports. 
[But t]he real benefit to international trade is the opportunity to obtain goods more cheaply than by producing them domestically. The proper way to view exports is as a cost: in an ideal world, foreigners would provide us with an infinite amount of imports for free.
It seems to me that this is misleading and incomplete. Here's why.

The "ideal world", in which foreigners provide us with infinite free imports, is impossible. In the real world, imports must always be paid for, either today or tomorrow. We pay for them with exports - either current exports or future exports. But pay we must.

Suppose I increase imports by one dollar today without increasing exports. Am I better off? According to Gordon, yes I am. But in reality it is not clear. Because the way I pay for that dollar of imports - since I don't export anything in return - is with a financial asset. I give one dollar of stocks, or bonds, or real estate, or collectible trading cards, to the foreigner who gave me the dollar of imports. 

The foreigner now holds a claim on my future output. Someday I must give the foreigner some real good, in order to pay back my debt. And the foreigner will charge me some interest, so I end up exporting more tomorrow than I imported today. 

Do I come out ahead or behind? It depends on the amount of interest, and on how much I value future consumption vs. present consumption. If I value future consumption very highly, and if the interest rate is very high, I should boost exports today, rather than imports. Yes, as Gordon says, these exports are a cost; but they are an investment, not a loss. This difference makes all the difference. It is perfectly reasonable to want to boost exports if you care a lot about the future.

OK, so that's the first point. Here's the second. Gordon says "The real benefit to international trade is the opportunity to obtain goods more cheaply than by producing them domestically." But that is not the only benefit of trade, even in the simple Ricardian model. Trade also allows countries to specialize in what they do best; some of the increased consumption from trade comes from increased domestic production, not from imports. In some cases, this effect can dominate. (Also, just to nitpick, in a less simple model of trade - Krugman's New Trade theory - trade doesn't just decrease price, it increases variety.)

So to say that the gains from trade come from cheap imports and not from increased domestic production is also misleading. A lot of the gains from trade come from increased domestic production. And exports are a way of getting future imports. The Canadian Conservatives are not, in this one case at least, misleading the Canadian people. And I think Stephen Gordon is oversimplifying the case for trade in a way that - I am guessing - is unlikely to resonate with Canadian voters.

23 comments:

  1. Of course the biggest reason voters and politicians care about trade is that in a demand-constrainted economy, net exports are a source of demand. (And relax the balance of payments constraint, allowing greater domestic demand as well.)

    You seem to share Gordon's assumption that the economy is always at full employment. Can't really blame you -- that's what the schools all teach. But it doesn't really leave you in much of a position to criticize him for making arguments that won't resonate with voters...

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  2. Of course the biggest reason voters and politicians care about trade is that in a demand-constrainted economy, net exports are a source of demand.

    I doubt this. First of all, most voters and politicians don't seem to understand demand constraints, given the failure of advocates of fiscal stimulus or QEIII to gain much political traction in the U.S. or Europe.

    Second of all, trade agreements last a lot longer than demand constraints, and trade agreements are what is being discussed.

    You seem to share Gordon's assumption that the economy is always at full employment.

    No, I don't. But the issue at hand is an FTA, and the effect of that FTA on aggregate demand is hard to know in advance, so I considered aggregate demand issues to be somewhat beside the point here. Not that it's not a worthy topic for another post.

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    1. So this is the "supply-side matters most of the time, demand-side matters during recessions" view? So does this imply that China and Germany have been suppressing their economies most of the time by running trade surpluses, helping only during recessions?

      I can see the intuitive appeal of this, but it just seems so at odds with reality. Germany outgrows Greece over the long term, China has grown rapidly not over the past few years but over the last few decades... They aren't simply exporting now so they can import later, they're gaining the ability to produce more themselves later in the process, creating long run growth. The reality that exports go hand in hand with growth seems to me to be pretty strong evidence that demand is not merely a short term concern but also important in determining long run growth.

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    2. The more I think about this, the less the supply side view makes sense. China manipulates demand by buying financial assets and providing us with easy credit, and the result is de-capitalization of our economy and rapid growth in theirs, long before the hypothetical day when they take advantage of those financial assets by running trade deficits? It is clear that stimulating demand for their goods at the expense of demand for ours has been driving increased growth for them over the long run, not simply providing recession proofing or providing the growth at some future time.

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  3. My real goal in that piece was to get past the instinctive mercantilism used to sell FTAs.

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    1. Boo! Substituting one misleading, incomplete argument in favor of FTAs for another misleading, incomplete argument in favor of FTAs does not seem like a particularly worthwhile Canadian initiative to me...

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    2. Noah, if you lived in a continent whose major economy seemed to believe that all countries should run trade surpluses all the time, you might be more sympathetic to a bit of simplification.

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  4. "In the real world, imports must always be paid for, either today or tomorrow"

    Just guessing... Germany? Since 50 years no single year with negative trade balance. Japan? China?

    In the real world exporters seems to export just for fun. Or?

    I understand your point but it is far from an obvious truth

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  5. You are assuming that each dollar of imports (financed by borrowing) is incremental consumption. In other words, debt financed imports allow a nation to live beyond its means for some period of time.

    However, what if the dollar of imports replaces a dollar of domestic production and the resources (labor / capital) are not reallocated to some other type of production? In that case, the dollar of imports is strictly welfare reducing. The additional foreign debt matches the imports, but domestic production and income have declined by one dollar.

    Is this possible? Of course, it is. Any number of countries have run huge trade deficits with high unemployment. For example, the U.S. has a vast deficit in consumer goods that could easily be made with unemployed domestic labor.

    Conversely, there are cases where trade protection demonstrably raises income. The UK in the 1930s finally abandoned free trade and implemented a system of "colonial preferences". Accounts of the time indicate that it was a success in raising incomes in the UK and its commonwealth.

    Greece provides a tragic modern example. Greece ran huge CA deficits in the run-up to the crash. When external financing dried up, resources were not shifted from domestic production to exports. The economy simply crashed. Apparently, Greece is still running a CA deficit.

    Another commenter noted that trade theory (almost invariably) assumes full employment. Without that assumption, imports can be directly income reducing.

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    1. Running a trade deficit reduces the revenue available to domestic industries. See:http://anamecon.blogspot.com/2010/04/effects-of-unbalanced-trade.html Money is sucked out of the domestic economy and sent overseas. This cuts into domestic producers' profits. They are also forced to reduce production. This leads to idle factories, higher unemployment, reduced tax revenues, etc.

      The productive factors of an economy are damaged, and contract, when that economy runs a trade deficit, making it less able to repay with future production.

      An underlying assumption of the free traders is that trade be balanced, but it rarely is. With balanced trade the winners and losers also balance, plus you have the gains from trade. Production shifts, but its level is maintained. Producers lose with unbalanced trade. And since consumers are first of all producers...

      Unless Canada can guarantee balanced trade, or it expects to run a surplus, it should be wary.

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    2. All true. But Noah does make the valid point that it's not a priori obvious whether this agreement will shift Canada's trade balance toward surplus or toward deficit.

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  6. Also: would the Chinese really want to see a reversal of their enormous trade surpluses with the US? Engineering a trade surplus seems to be the fastest way to acquire technology and expand your economy's productive potential. Sub-Saharan African countries and the European periphery have had trade deficits of various dimensions for the last 60 years.

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  7. I'd add learning-by-doing and backwards supply links as a hugely under appreciated factor in trade value (by most economists). Given that the financial assets that China, for example, is accumulating against the US are almost certainly going to be repaid in a substantially depreciated form, their policies don't make any sense in a simple Ricardian model. But, then, it's not a great model when it comes to economic development, as they and the Taiwanese, Koreans, Hong Kong, and Japan all learned.

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  8. Noah: think of Stephen's "exports" and "imports" as referring to vectors of dated commodities.

    The cost of imports (understood as the vector of different goods at different dates) is exports (understood as the vector of different goods at different dates).

    Your point is a bit like saying that Ricardo was wrong, because England might export more barley rather than more wheat to Portugal to pay for imported wine. So that the benefits to England of exporting more wheat is that it would need to export less barley.

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    1. Noah: think of Stephen's "exports" and "imports" as referring to vectors of dated commodities.

      But people are not going to understand it this way. I said I thought this point was misleading, not wrong.

      The part I said was wrong was the part about the benefit of trade not coming from increases in domestic production. Part of it does.

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    2. Alas I recall Ricardo's example was actually cloth from England in exchange for wine from Portugal. And just happens that we now know that trading those two products has immensely different implications for development, textiles being a huge key to the industrial Revolution!

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  9. most voters and politicians don't seem to understand demand constraints, given the failure of advocates of fiscal stimulus or QEIII to gain much political traction in the U.S. or Europe.

    Well, there's understanding and there's understanding. Obviously, yes, most elected officials seem less confident about the effectiveness of fiscal policy than you or I would be. But whenever someone says "jobs" in a political context, they're talking about demand constraints. And people say jobs a lot.

    Second of all, trade agreements last a lot longer than demand constraints, and trade agreements are what is being discussed.

    See, this is the debate I would like to be having. Are demand constraints in fact limited to the short run? Can we assume the long run path of output is determined entirely on the supply side?

    the issue at hand is an FTA, and the effect of that FTA on aggregate demand is hard to know in advance

    Now this is a fair point.

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  10. Skeptical Economist, OGT and Alex Hamilton also make good points.

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  11. Anonymous11:47 AM

    Trade also allows countries to specialize in what they do best...
    For instance, some countries specialize at having few protections for labor and the environment, and miserable wages, making them best at providing leverage for the elite of other countries to drive down average wages, concentrating their wealth.

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  12. I would rethink this using empire as a starting point. Exploiting low wage workers in foreign countries is how you get rich, especially when your workers back home can't produce the same goods... right?

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  13. Suppose a foreigner ha a million dollar in his pocket. So according to the 'exports are cost, imports are benefits' theory we would have to pay that at one point in time.

    Now let's give this man a us passport and make him an american citizen. Suddenly we don't have to pay back the million dollar anymore?

    There can only be one conclusion: your nationality must be irrelevant. Otherwise the logic doesn't hold up.

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  14. Misaki3:40 PM

    >The foreigner now holds a claim on my future output. Someday I must give the foreigner some real good, in order to pay back my debt. And the foreigner will charge me some interest, so I end up exporting more tomorrow than I imported today.

    Dollar bills don't pay positive interest, they pay negative interest.

    Compare this description:

    A final note, about the whole "buy local" thing. Imagine that money used to purchase goods from China went to a black hole, or maybe an extra-dimensional market that will sell any amount of goods at a constant price. Normally you would expect prices to go down if that money never returned to the United States, but of course the US can always just print more money to replace what was lost. Since the money leaves the system, it doesn't even cause inflation. Taxes could go to zero and printing money would support all government services. I don't know what people see wrong with this. On the other hand, if money does come back, then there is no reason to discriminate about the country of origin for goods, is there?

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