Is China trade inflationary?
I like contrarian arguments, but the hypothesis in the title is a bit too much for even me to accept. Instead I’ll argue that the fans of the recent paper by Autor, Dorn and Hanson (ADH) are implicitly making this claim—probably.
I’m going to work with the AS/AD model, so let me start off by reminding you that the AS/AD model (i.e. the simple diagram) doesn’t really rule out any hypothesized transmission mechanism. There are four possible co-movements in P and Y, and any are possible depending on the type of shock that hits the economy.
As I pointed out in a recent post, it’s not entirely clear what ADH were arguing, but most people (including me) seem to read them as questioning the standard view (among economists) that free trade with China benefits the US. ADH point out that lots of jobs were lost in specific areas, and there’s not much evidence of workers being reallocated to other sectors. I criticized this argument, partly on the grounds that they were drawing macro implications without an adequate macro model. For instance, there was no discussion of factors such as monetary offset.
I also pointed out that the period they considered (1990-2007) saw excellent macro outcomes for the US, and we were not at the zero bound. Thus it was reasonable to assume that the Fed had the path of NGDP pretty much where they wanted it. Furthermore, any attempt to boost AD through actions such as trade barriers on imports, almost certainly would have triggered offsetting tightening by the Fed, leaving total AD no higher than before. Indeed if you view the Fed as an inflation targeter, not an NGDP targeter, we would have been worse off with trade barriers.
Then I argued that the “reallocation of labor problem” was the only plausible transmission mechanism that could make their hypothesis true, and also pointed out that ADH frequently discussed the reallocation problem.
So if the hypothesis that China trade reduced AD makes no sense on either empirical or theoretical grounds, then let’s assume that fans of the ADH paper are thinking in terms of the reallocation problem. What are the implications of this hypothesis, in terms of the AS/AD model?
The implication might surprise you. If we assume that the Fed keeps AD stable, and offsets shocks that would move it left or right, then China trade can only have hurt the US economy by reducing AS. Now that’s certainly possible; if reallocation didn’t go well, it would result in higher unemployment, would depress RGDP. But it would also raise prices. In other words, the only plausible mechanism by which China trade could have hurt the US as a whole (rather than just specific groups impacted by imports) is also a mechanism that implies China trade had an inflationary effect on the US economy.
Maybe it did.
I would guess that if you polled Americans, the majority might believe that imports from China hurt the US economy. I think a majority would also acknowledge that China trade somewhat lowered the cost of living, relative to no trade with China. That means we shouldn’t take seriously what average people believe, because their beliefs are not even internally consistent. They don’t understand economics. Asking average people about the net benefits of trade is like asking them whether they favor the Copenhagen interpretation or the “Many Worlds” interpretation of quantum mechanics.
I don’t agree with those who claim ADH is an important paper calling into question the claim that free trade with China benefits the US economy. That doesn’t mean I am not willing to consider their views—I am willing. But only if they combine their support for ADH with a loud affirmation that:
Trade with China has an inflationary effect on the US!
Will they proudly affirm that view? Or will they shy away, in fear of being ridiculed? Let’s keep a close watch on this issue, and see how it plays out. Please send me links to any posts you see where ADH fans claim China trade is inflationary for the US. If we don’t see any, then we need to draw the obvious conclusion.
PS. If you are wondering whether the same argument applies to fiscal stimulus during the 1990-2007 period, the answer is yes. During that period fiscal stimulus was expansionary if and only if it was deflationary (assuming monetary offset). That’s actually an implication of the New Keynesian model; I’m not making it up.
PPS: I have a post on trade deficits over at TheMoneyIllusion.