Krugman on monetary offset and China trade
By Scott Sumner
Back in February I wrote a very long post, which was somewhat skeptical of a study (by Autor, Dorn and Hanson) of the impact on Chinese exports on US employment, during the period from 1990 to 2007. Other pundits seemed to accept their results, and Noah Smith went so far as to suggest it showed that economists were being dishonest in arguing that free trade was good.
In contrast, I argued that it didn’t tell us anything about the overall impact of China trade on jobs, just the relative impact on certain regions:
There is a more sophisticated argument that CA deficits reduce AD, but only at the zero bound. Paul Krugman has suggested that when interest rates are zero, a CA deficit may depress the equilibrium interest rate, making monetary policy effectively tighter. Because we are at the zero bound, the Fed may not offset this shock and total AD may decline.
There is one big problem with this theory; it doesn’t apply to the 1990-2007 period considered in the ADH study. Interest rates were never at zero, and thus monetary offset clearly applied. Try to imagine a policy counterfactual involving a ban on Chinese imports. Unemployment was only 5.2% in June 1990, near the peak of the Reagan boom. By June 2000 it had fallen to 4.0%, near the peak of the Clinton boom. In the subsequent recession it never got higher than 6.3%, and then fell back to 4.6% in June 2007. Whatever you think about this data, the Fed clearly thought AD was adequate, or they would have eased policy further. Thus if a ban on Chinese imports did somehow boost AD, its effects obviously would have been offset by the Fed. I’m pretty sure that even Keynesians like Paul Krugman would agree with that claim. So I think it’s safe to assume that whatever the channel was by which China trade hurt the US economy, it was certainly not the AD shock channel.
. . .
Overall, I had a lot of trouble making sense of this paper. To draw macro implications, you’d need a macro model, including assumptions about monetary offset to evaluate a counterfactual with no China trade. But I couldn’t find this model.
Paul Krugman recently chimed in on the ADH paper, and said exactly what I would have expected:
OK, what about the effect on overall employment? In general, you can’t answer that with a similar computation, because it all depends on offsetting policies. If monetary and fiscal policy are used to achieve a target level of employment – as they generally were prior to the 2008 crisis – then a first cut at the impact on overall employment is zero. That is, trade deficits meant 2 million fewer manufacturing jobs and 2 million more in the service sector.
. . .
Up through 2007 we basically had a Fed which raised rates whenever it thought the economy was overheating; in the absence of the China shock it would have raised rates sooner and faster, so you just can’t use the results of the cross-section regression – which doesn’t reflect monetary policy, which was the same for everyone – to predict how things would have turned out.
I’m really glad to see Krugman confirming my intuition, as I was worried by the fact that all of the other major pundits I read seemed to accept the ADH claims, which made no sense to me. I wondered if I missed something. After reading Krugman I think I was right, and that the rest of the profession missed something.
PS. I suppose both Krugman and I could be missing something here. If so, I’d appreciate if someone would explain what that is.
PPS. Krugman also added this comment:
Since 2008, of course, we’ve been in a liquidity trap, with the Fed either unable or unwilling to hit its targets and fiscal policy paralyzed by ideology, so trade deficits are in practice a major drag on overall employment.
Actually, we are not in a liquidity trap, and the 4.7% unemployment rate is roughly where the Fed wants it. If they wanted lower unemployment then they’d cut rates. If the Congress did something (on the demand side) to create jobs, then the Fed would raise rates to prevent any net increase in jobs, just as they did in response to rising AD in the period before 2008.
HT: Michael Darda