What Do People Need to Know About International Trade?

On the first day of my trade class, we read Paul Krugman's article "What Do Undergrads Need to Know About Trade?" In an admirably succinct four pages, it captures all the important things that orthodox trade theory claims to tell us about trade policy. I don't think orthodox views on trade policy have changed at all in the 20 years since it was written. [1]

So what's Krugman's answer? What undergrads need to know, he says, is just what Hume and Ricardo were saying, 200 years ago: If relative costs of production are different in two countries, then total world output, and consumption in each individual country, will always be greater with trade than without, and prices will adjust so that trade is balanced. Free trade is always beneficial for all countries involved.

Krugman's additions to this Ricardo-Hume catechism are mostly negative -- a list of things we don't need to talk about when talk about trade.

Don't worry about development. The idea that a country can benefit from changing the sectors or industries it specializes in is, he says "a silly concept." Yes, we look around the world and see workers in rich countries producing things like airplanes and software, which are worth a lot, and workers in poor countries putting the same effort into producing agricultural goods and textiles, which are worth much less. But

Does this mean the rich country's high standard of living the result of being in the right sector, or that the poorer country would be richer if it tried to emulate the other's pattern of specialization? Of course not.

Of course not. This blanket dismissal is rather odd, since the work Krugman won the Nobel for explicitly supports an affirmative answer to both questions. [2] It's a case of esoteric versus exoteric knowledge, I guess -- some truths are not meant for everyone. Or as Krugman delicately puts it, "the innovative stuff is not a priority for undergrads."

Don't worry about demand. In debates over policy, "the central issue is employment" in the arguments on both sides. But this is wrong, he says:

The level of employment is a macroeconomic issue, depending in the short run on aggregate demand and depending in the long run on the natural rate of unemployment, with policies like tariffs having little net effect. Trade policy should be debated in terms of its impact on efficiency…

It's not immediately obvious why the claim that employment depends on aggregate demand is inconsistent with the claim that trade flows have important employment effects. After all, net exports are a component of demand. The implicit assumption is evidently that the central bank (or some other domestic policymaker) is maintaining the level of demand at the full-employment level, and will offset any effects from trade. [3]

Don't worry about trade deficits, and the financing they require. "The essential things to teach students are still the insights of Ricardo and Hume. That is, trade deficits are self-correcting…"

The whole piece is frankly polemical -- it's clear that the goal is not to educate in the normal sense, but to equip students to take a particular side in public debates. This is not specific to Krugman, of course. If anything, most contemporary textbooks are even worse. [4] One  reason I am using Caves and Frankel in my class is that it has less obnoxious editorializing than other texts I looked at. But less is still a lot.

Enough Krugman-bashing. What's the alternative? What should people know about international trade? Matias Vernengo has one good alternative list. Here is mine.

There are three frameworks or perspectives in which we can productively think about international trade. The questions we ask in each case will depend on whether we are thinking of trade flows as the adjusting variable, or as reflecting an exogenous change to which some other variable(s) must adjust.

1. Trade flows are part of aggregate expenditure. On the one hand, a good way to predict trade flows is to assume that a fixed fraction of each dollar of spending goes to imported goods. As Joan Robinson and others have stressed, in the short run at least, adjustment of trade balances comes mainly or entirely through income changes. (This is also the perspective developed in Enno Schroeder's work, which I've discussed here before.) On the other hand, if we can't assume there is some level of full employment or potential output to which to which the economy always returns, then we have to be concerned with trade flows as one factor determining the level of aggregate income. This might be only a short-run phenomenon, as in mainstream Keynesian analysis, or it might be important to economic growth rates over the long run, as in models of balance of payments constrained growth.

2. Trade flows are part of the balance of payments. In a capitalist world economy, there are many different money payments and obligations between countries, of which trade flows are just part. In a world of liquidity constraints, certain configurations of money payments or money commitments are costly, or cannot be achieved at all. That is, a country in the aggregate cannot in general borrow unlimited amounts at "the" world interest rate. The tighter the constraints on a country's financial position, the more positive a trade balance it must somehow achieve. On the other hand, for a given level of financing constraint, a more positive trade balance allows for more freedom on other dimensions. This interaction between trade flows and financial constraints is central to the balance of payments crises that are such a prominent feature of the modern world economy.

3. Trade flows involve specialization. Thinking now in terms of baskets of goods rather than money flows, the essential thing about international trade is that it allows a country's consumption and production decisions to be made independently. Given that productive capacities vary more between countries than the mix of consumption goods chosen at a given income and prices, in practice this means that trade allows for specialization in production. If we take productive capacities as given, it follows that trade raises world output and income by allowing countries to specialize according to comparative costs. This is the essential (and genuine) insight of Ricardo. On the other hand, if we think that inherent differences between countries are small and that differences in productive capacity arise mainly through production itself, then international trade will lead to a historically contingent pattern of international specialization in which some positions are more advantageous than others. If causality runs from trade patterns to productive capacities and not just vice versa, then there is a case for including activity trade policy in any development strategy.

The orthodox trade theory has legitimate value and deserves a place in the curriculum. As we'll discuss in the next post, simple textbook models of the Ricardo-Mill type can be used to tell stories with more interesting political implications than the usual free-trade morality tales. But they are only part of the picture. Much of what matters about trade depends on the fact that it involves flows of money and not just exchanges of goods.


[1] Have Krugman's views changed since he wrote this? As reflected in his textbooks, no they have not. As reflected in his blog, seems like sometimes yes, sometimes no. Someone should ask him.

[2] For example, one of Krugman's more widely cited articles is this one, which develops a model in which an innovating region ("the North") develops new products, which it exports to a non-innovating region ("The South"). In the model,

Higher Northern per capita income depends on the quasi-rents from the Northern monopoly of new products, so the North must continually innovate not only to maintain its relative position but even to maintain its real income in absolute terms. 

This is hard to distinguish from the arguments for industrial policy that Krugman dismisses as silly.

[3] What's especially odd here is that orthodox theory says that in a world of mobile capital, the only tool the central bank has to maintain full employment is changes in the exchange rate. In standard textbooks (including Krugman's own), it is impossible for monetary policy to boost employment unless it improves the trade balance.

[4] For example, David Colander's generally undogmatic intro textbook includes a section titled "If trade is so good, why do so many people oppose it?"The answer turns out to be, they're just confused.

The Interest Rate, the Interest Rate, and Secular Stagnation

In the previous post, I argued that the term "interest rate" is used to refer to two basically unrelated prices: The exchange rate between similar goods at different periods, and the yield on a credit-market instrument. Why does this distinction matter for secular stagnation?

Because if you think the "natural rate of interest," in the sense of the credit-market rate that brings aggregate expenditure to a desired level in some real-world economic situation, should be the time-substitution rate that would exist in a model that somehow corresponds to that situation, when the two are in fact unrelated -- well then, you are going to end up with a lot of irrelevant and misleading intuitions about what that rate should be.

In general, I do think the secular stagnation conversation is a real step forward. So it's a bit frustrating, in this context, to see Krugman speculating about the "natural rate" in terms of a Samuelson-consumption loan model, without realizing that the "interest rate" in that model is the intertemporal substitution rate, and has nothing to do with the Wicksellian natural rate. This was the exact confusion introduced by Hayek, which Sraffa tore to pieces in his review, and which Keynes went to great efforts to avoid in General Theory. It would be one thing if Krugman said, "OK, in this case Hayek was right and Keynes was wrong." But in fact, I am sure, he has no idea that he is just reinventing the anti-Keynesian position in the debates of 75 years ago.

The Wicksellian natural rate is the credit-market rate that, in current conditions, would bring aggregate expenditure to the level desired by whoever is setting monetary policy. Whether or not there is a level of expenditure that we can reliably associate with "full employment" or "potential output" is a question for another day. The important point for now is "in current conditions." The level of interest-sensitive expenditure that will bring GDP to the level desired by policymakers depends on everything else that affects desired expenditure -- the government fiscal position, the distribution of income, trade propensities -- and, importantly, the current level of income itself. Once the positive feedback between income and expenditure has been allowed to take hold, it will take a larger change in the interest rate to return the economy to its former position than it would have taken to keep it there in the first place.

There's no harm in the term "natural rate of interest" if you understand it to mean "the credit market interest rate that policymakers should target to get the economy to the state they think it should be in, from the state it in now."And in fact, that is how working central bankers do understand it. But if you understand "natural rate" to refer to some fundamental parameter of the economy, you will end up hopelessly confused. It is nonsense to say that "We need more government spending because the natural rate is low," or "we have high unemployment because the natural rate is low." If G were bigger, or if unemployment weren't high, there would be a different natural rate. But when you don't distinguish between the credit-market rate and time-substitution rate, this confusion is unavoidable.

Keynes understood clearly that it makes no sense to speak of the "natural rate of interest" as a fundamental characteristic of an economy, independent of the current state of aggregate demand:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest — namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest”, which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. 

I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural” rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment. 

I am now no longer of the opinion that the concept of a “natural” rate of interest, which previously seemed to me a most promising idea, has anything very useful or significant to contribute to our analysis. It is merely the rate of interest which will preserve the status quo; and, in general, we have no predominant interest in the status quo as such.

EDIT: In response to Nick Edmonds in comments, I've tried to restate the argument of these posts in simpler and hopefully clearer terms:

Step 1 is to recognize that in a model like Samuelson's, "interest rate" just means any contract that allows you to make a payment today and receive a flow of income in the future. It would be the exact same model, capturing the exact same features of the economy, if we wrote "profit rate" or "house price-to-rent ratio" instead of "interest rate." Any valid intuition the model gives us, applies to ALL asset yields, not just to the the credit-instrument yields that we call "interest rates" in every day life.

Step 2 is to think about the other factors that enter into real-world asset yields, besides the intertemporal exchange rate Samuelson is interested in -- risk, liquidity, carrying costs and depreciation, and expected capital gains. Since all real-world asset yields incorporate at least one of these factors, none correspond exactly to Samuelson's intertemporal interest rate.

Step 3 is to realize that not only are credit-instrument yields not exactly the Samuelson "interest rate," they aren't even approximately it. The great majority of credit market transactions we see in real economies are not exchanges of present income for future income, but exchanges of two different claims on future income. So the intertemporal interest rate enters on both sides and cancels out.

At that point, we have established that the "interest rate" the monetary authority is targeting is not the "interest rate" Samuelson is writing about.

Step 4 is then to ask, what does it mean to say that some particular credit-market interest rate is the "natural" one? That is where the dependence on fiscal policy, income distribution, etc. come in. But those factors are not part of the argument for why the credit-market rate is not even approximately the intertemporal rate.

A Greek Myth

Most days, I'm a big fan of Paul Krugman's columns.

Unlike his economics, which makes a few too many curtsies to orthodoxy, his political interventions are righteous in tone, right-on in content, and what's more, strategic -- unlike many leftish intellectuals, he clearly cares about being useful -- about saying things that are not only true, but that contribute to the concrete political struggle of the moment. He's so much better than almost of his peers it's not even funny.

But -- well, you knew there had to be a but.

But this time, he's gotten his economics in his politics. And the results are not pretty.

In today's column, he rightly dismisses arguments that the root of the Euro crisis is that workers in Greece and the other peripheral countries are lazy, or unproductive, or that those countries have excessive regulation and bloated welfare states. "So how did Greece get into so much trouble?" he asks. His answer:

Blame the euro. Fifteen years ago Greece was no paradise, but it wasn’t in crisis either. Unemployment was high but not catastrophic, and the nation more or less paid its way on world markets, earning enough from exports, tourism, shipping and other sources to more or less pay for its imports. Then Greece joined the euro, and a terrible thing happened: people started believing that it was a safe place to invest. Foreign money poured into Greece, some but not all of it financing government deficits; the economy boomed; inflation rose; and Greece became increasingly uncompetitive.

I'm sorry, but the bolded sentence just is not true. The rest of it is debatable, but that sentence is flat-out false. And it matters.

The analysis behind the "earning enough" claim is found on Krugman's blog. He writes,

One of the things you keep hearing about Greece is that if it exits the euro one way or another there will be no gains, because Greece basically can’t export — so structural reform is the only way forward. But here’s the thing: if that were true, how did Greece pay its way before the big capital flows starting coming? The truth is that before the euro and the capital flow bubble it created, Greece ran only small current account deficits (the broad definition of the trade balance, including services and factor income)...

And he offers this graph from Eurostat:

The numbers in the graph are fine, as far as they go. And there is the first problem: how far they go. Here's the same graph, but going back to 1980.

Starting the graph ten years earlier gives a different picture -- now it seems that the near-balance on current account in 1993 and 1994 wasn't the normal state before the euro, but an exceptional occurrence in just those two years. And note that that while Greek deficits in the 1980s are small relative to those of the mid-2000s, they are still very far from anything you could reasonably describe as "the country more or less paid its way." They are, for instance, significantly larger than the contemporaneous US current account deficits that were a central political concern in the 1980s here.

That's the small problem; there's a bigger one. Because, what are we looking at? The current account balance. Krugman glosses this as "the broadest measure of the trade balance," but that's not correct. (If he taught undergraduate macro, I'm sure he'd mark someone writing that wrong.) It's broad, yes, but it's a different concept, covering all international payments other than asset purchases, including some (transfers and income flows) that are not trade by any possible definition. The current account includes, for example, remittances by foreign workers to their home countries. So by Krugman's logic here, the fact that there are lots of Mexican migrant workers in the US sending money home is a sign that Mexico is able to export successfully to the US, when in the real world it's precisely a sign that it isn't.

Most seriously, the current account includes transfer between governments. In the European context these are quite large. To call the subsidies that Greece received under the European Common Agricultural Policy export earnings is obviously absurd. Yet that's what Krugman is doing.

The following graph shows how big a difference it makes when you call development assistance exports.

The blue line is the current account balance, same as in Krugman's graph, again extended back to 1980. The red line is the current account balance not counting intergovernmental transfers. And the green line is the current account not counting any transfers. [*] It's clear from this picture that, contra Krugman, Greece was not earning enough money to pay for its imports before the creation of the euro, or at any time in the past 30 years. If the problem Greece has to solve is getting its foreign exchange payments in line with with its foreign exchange earnings, then the bulk of the problem existed long before Greece joined the euro. The central claim of the column is simply false.

Again, it is true that Greece's deficits got much bigger in the mid-2000s. I agree with Krugman that this must have ben connected with the large capital flows from northern to peripheral Europe that followed the creation of the euro. It remains an open question, though, how much this was due to an increase in relative costs, and how much due to more rapid income growth. By assuming it was entirely the former, Krugman is implicitly, but characteristically, assuming that except in special circumstances economies can be assumed to be operating at full capacity.

But the key point is that the historical evidence does not support the view that current account imbalances only arise when governments interfere in the natural adjustment of foreign exchange markets. Fixed rates or floating, in the absence of very large flows of intergovernmental aid Greece has never come close to current account balance. According to Krugman, Greece's

famous lack of competitiveness is a recent development, caused by massive post-euro inflows of capital that raised costs and prices. And that’s the kind of thing that currency devaluations can cure.

The historical evidence is not consistent with this claim. Or if it is, it's only after you go well beyond normal massaging of the data, to something you'd see on The Client List.

* * *

So why does it matter? What's at stake? I can't very well go praising Krugman for writing not only what's true but what is useful, and then justify a post criticizing him on the grounds of Someone Is Wrong On the Internet. No; but there's something real at stake here.

The basic issue is, does price adjustment solve everything? Krugman won't quite come out and say Yes, but clearly it's what he believes. Is he being deliberately dishonest? No, I'm sure he's not. But this is how ideology works. He's committed to the idea that relative costs are the fundamental story when it comes to trade, so when he finds a bit of data that seems to conform to that, he repeats it, without giving five minutes of critical reflection to what it actually means.

The basic issue, again, is the need for structural as opposed to price adjustment. Now if "structural adjustment" means lower wages, then of course Godspeed to Krugman here. I'm against structural whatever in that sense too. But I can't help feeling that he's pulling in the wrong direction. Because if external devaluation cures the problem then internal devaluation does too, at least in principle.

The fundamental question remains how important are relative costs. The way I see it, look at what Greece imports, most of it Greece doesn't produce at all. The textbook expenditure-switching vision implicitly endorsed by Krugman ignores that there are different kinds of goods, or accepts what Paul Davidson calls the axiom of gross substitution, that every good is basically (convexly) interchangeable with every other. Hey Greeks will have fewer computers and no oil, but they'll spend more time at the beach, and in terms of utility it's all the same. Except, you know, it's not.

From where I'm sitting, the only way for Greece to achieve current account balance with income growth comparable to Germany is for Greece to develop new industries. This, not low wages,  is the structural problem. This is the same problem faced by any developing country. And it raises the same problem that Krugman, I'm afraid, has never dealt with: how to you convince or compel the stratum that controls the social surplus to commit to the development of new industries? In the textbook world -- which Krugman I'm afraid still occupies -- a generic financial system channels savings to the highest-return available investment projects. In the real world, not so much. Figuring out how to get savings to investment is, on the contrary, an immensely challenging institutional problem.

So, first step dealing with it, you should read Gerschenkron. We know, anyway that probably the rich prefer to hold their wealth in liquid form, or overseas, or both. And we know that even if -- unlikely -- they want to invest in domestic industries, they'll choose those that are already cost-competitive, when, we know, the whole point of development is to do stuff where you don't, right now, have comparative advantage. So, again, it's a problem.

There are solutions to this problem. Banks, the developmental state, even industrial dynasties. But it is a problem, and it needs to be solved. Relative prices are second order. Or so it seems to me.

[*] Unfortunately Eurostat doesn't seem to have data breaking down nongovernmental transfer payments to Greece. I suspect that the main form of private transfers is remittances from Greek workers elsewhere in Europe, but perhaps not.