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.

International Trade: What Are the Questions?

This semester, I'm teaching an upper-level class at Roosevelt on international trade. Trade is an interest of mine, but not something I've ever taught. So it will be a learning experience for me at least as much as for the students.

One way to organize a class like this is to start with the orthodox approach and then present the various heterodox alternatives. I don't know if that's the best way to do things; but it is what I am doing. So we divide things up:

1. Orthodox trade theory. Orthodox approaches to trade (the first half of any standard textbook; we are using Caves and Frankel) treat trade as an exchange of goods for goods. We assume that trade is always balanced and that all resources are fully employed, and show how specialization by different countries in their preferred activities leaves everyone better off. We can divide this approach into Ricardian models, which treats countries preferred activities as dictated by inherent differences in productive capacities, on the one hand; and on the other, the Heckscher-Ohlin models that regard countries as having the same productive technology but different "endowments" of (a relatively small number of) "factors of production." As far as I can tell, these two kinds of models are not associated with distinct schools of thought in any larger sense; but it seems to me that the tension between them is one of the more interesting things in the orthodox theory.

2. Keynesian approaches. Here the important thing is the systematic relationship between income-expenditure and trade flows. On the one hand, we think a predictable fraction of incremental expenditure will fall on imports, and on the other, net exports are a form of autonomous demand boosting income. The short-run version of this approach used to be fully respectable; one very good presentation is Dornbusch's 1980 textbook, Open Economy Macroeconomics. [1] The long-run version of the Keynesian approach is Thirlwall's model of balance-of-payments constrained growth. I don't know that this has ever been respectable but I think it's useful and sensible and, I hope, teachable.

3. New trade theory. The starting point here is that while orthodox theory says that the biggest gains come from trade between countries that are most different (in terms of productive capacities or factor endowments), what we see in the real world is that most trade is between basically similar industrialized countries. The explanation, according to this approach, is that most trade is not in fact driven by comparative advantage, but by increasing returns, which reward specialization even in the absence of any inherent differences between countries or regions. This is the stuff Paul Krugman got his prize for. One puzzle about the new trade theory is that its practitioners almost all endorse the same free-trade policy orthodoxy underwritten by the old trade theory, even though the substantive content would seem to undermine it. What the new theory says is, first, that the pattern of specialization between countries is in some important respect arbitrary and at least potentially shaped by choices; and second, that the global distribution of income is a function of who ends up with which specialty. in this sense, there is some affinity between the new trade theory and Marxist theories of imperialism, dependency and unequal exchange. I'd wondered for a while if anyone had written about this connection. The answer turns out to be yes: Krugman himself. He even cites Lenin!

4. Development, dependency and unequal exchange. There is a large body of radical theory here, which I admit I have not quite got my arms around. For current purposes, let's think in terms of two strands of analysis -- or at least two sets of questions, which may or may not correspond to different schools or bodies of theory. First, there is the relationship between trade and economic development. Historically, we could put this at the very beginning of the list, since it seems that many of the earliest writers on what we now call economics were centrally concerned with this question. But for our purposes, we are interested in the tradition that runs from Hamilton to Friedrich List to Gerschenkron to Dani Rodrik and Ha-Joon Chang. These mostly pragmatic analyses, associated politically with rising rivals to the current hegemon, include a mix of infant industry/"import protection as export promotion" arguments, and trade restrictions as devices to expand the domestic policy space (the positive side of mercantilism emphasized by Keynes.) Second, there are the various theories that go under the names of dependency and unequal exchange. The key claim here is that there is a systematic movement of prices that favors the North and disfavors the South. We may further subdivide these theories into Prebisch-Singer and related approaches, and more Marxist analyses from Hobson, Lenin and Luxembourg through Baran to Frank, Wallerstein, Amin and Emmanuel.

Another way of looking at this: Among the assumptions of the orthodox theory are that all resources are fully employed, that prices always adjust so as to balance trade (or equivalently, that goods trade directly for goods), and that countries' productive capacities can be taken as exogenous and determine the pattern of trade. Keynesian approaches reject the first two of these assumptions, the new trade theory rejects the third; the various development/dependency approaches also reject the third assumption and in some versions the first two as well.

There reason I'm posting this here is I'd like to integrate my teaching more with this blog. So the hope is to have a bunch of posts about all this over the next few months. I'm sure I'll get a lot of things wrong; maybe the readers of the blog can correct some of them.

[1] On the other hand, this contemporary (and very admiring) review of the Dornbusch book does chide him for starting with 

a nonmonetary "Keynesian" model with rigid prices, fixed exchange rates, and unemployment ... The basic consideration is short-run full employment; long-run problems of allocation and prices are left in the background. Economists with a more "classical" turn of mind may be a little disconcerted to find tariffs introduced as instruments to raise employment and to see real wages explained by the "claims" of trade unions. They would probably prefer to start out with the long-run picture, linking monetary aspects firmly to the pure theory of international trade. 

So maybe it wasn't ever fully respectable. One thing I'd like to understand better is exactly when and to what extent "Keynsian" theory was accepted among academic economists.