Why the new old Keynesians are wrong about trade
Ramesh Ponnuru directed me to a Greg Ip article, discussing the strange new fascination with protectionism within the Keynesian community. A few decades ago the “dark underworld” of Keynes’s General Theory had gone out of favor. Economists still accepted “Keynesian” models such as IS-LM, but no longer put much weight on ideas like the paradox of thrift, or the theory that protectionism can create jobs. With the return of near-zero interest rates, there is renewed interest in some of these old Keynesian ideas. In my view that’s a mistake.
If workers lose their jobs to imports and central banks can’t bolster domestic spending enough to re-employ them, a country may be worse off, and keeping those imports out can make it better off.
This occurs only in certain conditions, says a new paper by Harvard University’s Larry Summers and two co-authors, but those conditions may now be present.
In fairness, Summers himself is not a protectionist:
Mr. Summers, a former Treasury secretary, is no protectionist and no fan of Mr. Trump, whose election, he warns, could lead to recession in the U.S. and financial crisis abroad. But he does worry that chronically weak demand could make protectionism both respectable and irresistible.
Others, such as New York Times columnist Paul Krugman and Michael Pettis at Peking University have already noted how in a world with too little demand, one country’s trade surplus inflicts unemployment on the country with a deficit.
One argument against this view is based on monetary offset, which I have previously discussed in this blog. Contrary to Summers, the condition he describes (interest rates at the lower bound) is not applicable to the US. The Fed has set interest rates at 0.5%, and the lower bound is probably around negative 0.75%. So the Fed could cut rates 5 times if they wished. Instead, they Fed is more likely to raise rates next, as it is worried about the economy overheating. (And it would certainly raise rates if tariffs pushed up inflation.) Summers may not share the Fed’s worry about inflation, nor do I. But it doesn’t matter what he or I think, all that matters (for monetary offset) is what the Fed thinks.
But it’s even worse. The old Keynesian liquidity trap model is wrong even at the zero lower bound, and even where monetary offset does not apply. And that’s because Keynesians forget two key facts:
1. The supply side also matters
2. Supply and demand shocks can be entangled at the lower bound on rates.
If the world moves toward protectionism, it will almost certainly reduce business confidence and reduce investment. There will be a decline in what Keynes called “animal spirits” And this is not just a hypothesis—an almost perfect example occurred during the Great Depression, with the debate over Smoot-Hawley, and then its passage in late June, 1930. During the first 4 months of 1930, US stocks did pretty well, recovering a good bit of the ground lost in the October 1929 crash. As the Smoot-Hawley bill moved closer to passage, US stock and commodity prices fell significantly. Hoover thought about whether or not he should veto the bill, and then on a Sunday announced he would sign it. The next day stocks plunged by 6%, the biggest single day loss of the year. Commodity prices also fell sharply throughout late June. Foreign countries announced retaliation. During the second half of 1930 the Depression intensified significantly.
Smoot-Hawley reduced aggregate supply and this reduced what’s called the Wicksellian equilibrium (or natural) interest rates. In the Keynesian model, a fall in the natural rate of interest (at the zero bound) is contractionary, as it leads to tighter monetary policy. That’s why commodity prices fell in response to Smoot-Hawley. Normally, supply shocks are inflationary. But at the zero bound supply and demand shocks become entangled, and falling AS leads to falling AD. So even if you are one of those “AD is all that matters” extreme Keynesians, protectionism is a fool’s game, even when monetary offset is not in play.
Smoot-Hawley was a disaster for the global economy. I won’t say that Brexit is a disaster for the UK, but all indications are that it will lead to lower growth, despite the BoE’s recent rate cut. I am very discouraged by all the recent revisionism on trade, both in terms of the impact of specific countries, such as China, and the impact of overall trade deficits. Trade imbalances do not cost jobs. Not in theory, and not in practice. The economics profession is making exactly the same mistakes that we made in the 1930s, wrongly assuming that “everything’s different” at the zero bound. Not so, policies that create inefficiency and destroy wealth are harmful at all times, not just at full employment.
Greg Ip’s article does a good job of presenting both sides of the argument, and ends up with some strong arguments against protectionism, including this one:
Most models that conclude trade agreements make countries richer assume full employment in the long run. In the short run, though, some workers do go jobless and lose a lot of income. Yet Robert Lawrence and Tyler Moran, in a paper for the Peterson Institute for International Economics, find the short-run costs of higher unemployment and lost wages from TPP amount to just 6% of its benefits during the first 10 years. Brandeis University trade economist Peter Petri finds that once retaliation is factored in, Mr. Trump’s protectionist policies would lead to a larger, not smaller, U.S. trade deficit.