Monday, March 15, 2010

Krugman's Trade War Fiction

I used to think that while Krugman was terrible on macroeconomics he was good on trade. But since his awful macroeconomics is poisoning his judgment on trade, the latter part doesn't seem to hold true anymore.

This was again confirmed today when he wrote a column calling for punitive tariffs on China unless they revalue their currency. I have already discussed the most fundamental errors of Krugman's analysis of China's currency policy. Here I would like to discuss another assertion made by Krugman: that under current circumstances capital inflows don't boost domestic demand, and that trade deficits (the flip side of capital inflows) will therefore reduce output.

As you may remember, this is the old GDP accounting identity:


Where Y is GDP, C is consumer spending, I is investments, G is government spending and NX is net exports.

Protectionists/mercantilists often mistakenly believes that this implies that if the trade deficit increases (net exports decreases), then GDP will fall. After all, if one component on the right side of the equal sign is reduced, shouldn't there be an equal reduction of the left side?

Actually, no. The reason for this is that the equality of sums on both sides of the equal signs can just as well be achieved by increasing C and/or I and/or G as it can be achieved by reducing Y. In fact, under normal circumstances, equality will be achieved by increasing domestic demand (C+I+G).

The reason for this is that first of all, lower net exports means a greater domestic supply of goods and services, increasing domestic purchasing power. And secondly, the capital inflow that is the flip side of lower net exports will lower interest rates, increasing domestic demand in general and investments in particular.

Krugman argues that this second mechanism is closed because of the "lower zero bound barrier" for interest rates. But as he concedes later, this applies only to short-term Treasuries. It does not apply for medium to long-term Treasuries, or for that matter to other securities.

However, Krugman is unconcerned with this effect because he argues that the Fed can always compensate for this by buying more long-term Treasuries and perhaps other securities, and lower interest rates by a similar amount.

But why can't the Fed do that anyway? With long-term Treasuries and even more so other securities being far above the "lower zero bound barrier", there is no conflict between Chinese purchases of securities and Fed purchases of securities. If it would be desirable after a revaluation, it would be desirable now too. If one feels that a further monetary "stimulus" is needed, it could just as well be achieved by pushing down interest rates further rather than by reducing the trade deficit.

So, the second mechanism does still apply to the U.S. today. And not surprisingly, Krugman completely ignores how the purchasing power of U.S. consumers will be reduced by a dramatic increase in the value of the yuan.