Download NOTES EC 302 Intermediate Macroeconomics Spring 2016 II. Trade

NOTES
EC 302 Intermediate Macroeconomics
Spring 2016
II. Trade
A. Why We Trade & Why We Restrict Trade
Background: We now extend the same process and framework (setting it up, thinking
it through, logic & evidence) that we’ve applied to fiscal and monetary policy to trade
policy. Our model already includes international trade flows in the ‘net export’ term (x =
x0 - x1y - x2r). We noted some demand side applications when a change in autonomous
net exports shifted IS and AD and spread its impacts through the macroeconomy.
For example, when a trading partner slips into recession, their drop in income and
spending will show up as a drop in our exports of goods and services (–∆x0) to them,
contracting our IS and AD etc. Not surprisingly, the economic ups and downs in one
economy are shared to some degree with its trading partners through import and export
markets. But even more important than these demand side linkages is the impact of
trade on the supply side of the economy through the degree of specialization. As trade
increases some of our scarce resources (labor, capital, etc.) are moved out of our
shrinking import-competing industries and into our expanding export industries. The net
impact of this move toward a ‘comparative advantage’, as we’ll see, is an overall gain in
economic efficiency. So events and policies that alter our volume of foreign trade show
up in the ‘institutional efficiency’ (inst) term in the production function, y*=F(n,k,tn,inst).
For the next few weeks we focus specifically on the demand and supply side economic
interconnections across nations and trace their costs and benefits through our analytical
framework. As you know, international trade is a high-profile and highly controversial
topic these days. It has always been controversial except, interestingly, among
economists. We’ll see the reasons for this. In the current climate there don’t seem to be
any politicians willing to say anything in favor of expanding international trade. At best
we may hear one say something to the effect that ‘I favor free trade but only if it’s fair
trade’. As we’ll see this is generally just a way to oppose free trade while pretending not
to.
In our discussions of fiscal and monetary policy we saw a number of popular
misconceptions about the economic impacts of taxes, spending, deficits, debt, and
interest rates. Trade policy is even more widely misunderstood, in part because it
brings in an emotional ‘us/them’ factor that makes it difficult for many of us to think
clearly and logically. So in this section we’ll continue to explore the ‘unintended
consequences’ that so often result from seemingly common sense policy responses that
fail to consider key interactions and relationships.
In class I tried to provoke your interest by challenging some very common, seemingly
obvious, statements about foreign trade and its consequences. I’ll list some of these
and in the classes and readings you’ll find a more systematic development of these
points.
1. Trade across nations is fundamentally no different than any other trade. Like trade
within nations, It involves the opposing interests of buyers and sellers and lenders and
borrowers. Economic activity happens when they find a mutually acceptable
compromise and make a deal.
2. Voluntary trade is, by definition, a win/win deal among the participants in the
transaction.
3. The value of a trade (say the amount of dollars spent to buy a product) is the same
for both sides. For example you buy/import a new iPhone and you pay/export $400.
The seller prefers the $400 and you prefer the phone.
4. Trade is the process through which we try to use our time and resources to our best
advantage. Without trade, each of us would have to produce whatever goods and
services we consumed by ourselves. It might be very satisfying in certain ways but our
material standard of living would be extremely low. Though ‘self sufficiency’ can seem
to have a nice ring to it, in truth it’s an extremely inefficient and unproductive way to live.
(A chapter in The Choice is titled ‘Self-sufficiency is the road to poverty.’)
5. Hence we specialize in doing some things and trading for others. Whether we trade
across nations, states, counties, cities, or neighborhoods, the borders have no
economic impact on the mutual gain from voluntary trade. This is an important and not
obvious point and we’ll develop it in various ways in coming classes.
6. Any economic change (due to acts of man or God) creates winners and losers. This
is equally true for events within as well as across nations. When technology changes,
when consumer tastes change, when zoning laws change . . . there are always winners
and losers. Natural disasters create business for the construction industry. Medical
breakthroughs make past medicines, treatments and often specialists obsolete. This
process of ‘creative destruction’ always accompanies economic change. Losers, of
course, complain and understandably want something done to reverse the outcome.
The role of economics in this is to try to understand the net impacts of such changes,
including as we’ll see changes in trading patterns. What can we say about the
magnitude of the losses relative to the gains? Overall, is there in some sense a net
economic gain or loss to the economy as a whole. Another way to think about it is
whether the change has caused resources to move from less productive to more
productive uses.
7. In addition to the creative destruction accompanying changing levels of trade is the
issue of trade balance. I put a simple us/them flow diagram on the board to begin the
discussion. We’re all familiar with the notion of trade deficits and trade surpluses. Just
the connotations of these words almost forces us to think of surpluses as ‘good’ and
deficits as ‘bad’. This is terrible economics and terrible logic and breaking away from
this predisposition seems to be extremely hard. I started by simply noting that in any
exchange/trade the value of the amount paid is the same as the value received. Any
trade flow, in this sense, balances. In fact it’s a definition of voluntary trade. If we
extend it to an international context we can say it this way: total trade flows always
balance. The value of the amount paid is equal to the value of the amount received.
The confusion comes from the fact that the things we buy and sell can be current goods
and services (the exports and imports that enter into current economic activity,
y=c+i+g+x) or they can be stocks or bonds or other assets that we will collectively call
securities. Think of assets as potential claims to future goods and services (if you sell
them and spend the proceeds). These are traded just like goods and services on stock
and bond and currency and real estate markets and can be sold and converted into
current goods and services.
8. So our exports of goods & services AND securities is identically equal to our imports
of goods and services AND securities whenever we make a trade. Suppose we buy
$100 billion of Chinese goods and services and no assets from them. They receive the
$100 billion and, let’s suppose, decide to buy $50 billion of our products, use $40 billion
to buy attractive US stocks and bonds and real estate and hold the remaining $10 billion
in US $. We have a $50 billion trade deficit (it only includes goods and services) with
China. But it doesn’t mean they gave us $100 billion of theirs in exchange for only $50
billion of ours. For obvious economic reasons they find our financial assets relatively
attractive and decide to send some of their savings out of their economy to invest in
ours. They are said to have a trade surplus but the mirror image of that is that they
have a ‘capital account deficit’ – a net outflow of savings/investment. The US on the
other hand has a ‘capital account surplus’ – a net inflow of savings/investment from
abroad. The mirror image of our trade deficit, then, is a capital account surplus. Total
trade flows always balance.
9. This all sounds very different from the ‘common sense’ about trade that we hear
every day. What about their stealing our jobs, out-negotiating us in trade deals, taking
advantage of our markets but restricting their own to us, and all the rest? The readings
and class discussions will try to help you see the whole picture of trade’s costs and
benefits. These are complicated and important issues. The superficial level of the
media and political discussion of the impact of trade on the economy results in
emotional responses that bring about the unfortunate ‘unintended consequences’ that
we’ve seen before.
______
IV. Trade Across Nations
A. Why We Trade & Why We Restrict Trade
We resumed the discussion of the nature and consequences of trade and, in particular,
voluntary exchange between buyer/seller and borrower/lender. This activity is one of
win/win and mutual gain. It’s not the competitive win/lose scenario that is sometimes
attributed to markets and to a capitalist system. It may seem paradoxical to think about
competition (among sellers and lenders) to attain cooperation (with buyers or
borrowers) in a win/win exchange. But that is precisely what voluntary trade (and a
market system that enables it) is about. 1
1
This duality is sometimes termed ‘coopetition’, a phrase attributed to, among others, NASCAR driver Darryl Waltrip
in the context of cooperating by ‘drafting’ on one another’s cars while competing to win high speed races like Daytona
Adam Smith argued that the ‘wealth of nations’ is created by the very markets that bring
buyers and sellers together, i.e., it’s trade that constitutes the economic activity that
generates income and output in the economy. Sellers want high prices, buyers low and
the market is a process of finding a workable, mutually acceptable, compromise. (From
another perspective, it’s a mechanism for ‘conflict resolution’.)
Markets generate various ‘signals’ (such as prices, wages, profits, interest rates,
exchange rates etc.) that guide our spending, saving, investment and career choices.
As long as these markets are relatively competitive (many independent buyers and
sellers), then simply following our economic self-interest ends up channeling our actions
into individually and socially beneficial activities (as if guided by an ‘invisible hand’ said
Smith).2 Businesses succeed if and only if they provide the goods and services that
consumers want at a competitive price. So competition among firms pushes them to
essentially cooperate with (‘cater to’) consumers.
Those who think of trade solely as a dog-eat-dog, survival-of-the-fittest struggle to
vanquish an opponent let the adrenalin and/or testosterone-induced exhilaration
obscure the point of it all -- every trade is, in fact, a win/win event. A market-oriented
system uses the accompanying price/wage/interest rate/profit signals to convey
information to buyers and sellers who, acting in their own self-interest, direct scarce
resources (n,k,tn) to move from lower to higher-value uses.
Where an economic transaction actually becomes a win/lose activity is precisely when
markets are restricted or non-existent. Without competition, buyers become the prey of
those in power. This shows up as variations on the theme of ‘pillage and plunder’ that
characterize systems run by barbarian invaders, war lords, emperors, kings, czars,
dictators, communist planners, ‘crony capitalists’, and other practitioners of economic
coercion. The ‘rules of the game’ associated with a market system (legal protection of
property, contracts, and individual rights as well as laws against collusion,
discrimination, and other forms of market coercion) are designed to turn raw competition
for limited resources into competition to cooperate in guiding resources to their most
efficient uses. Economic exploitation starts with the suppression, not the existence, of
competitive markets.
Economics as a field of inquiry was in fact born in the context of the 18th century laissez
faire or classical liberalism of Adam Smith, David Hume and others who saw a system
of largely unfettered markets as protection from coercion and exploitation by corrupt
rulers who gains at our expense largely by restricting trade and limiting our options.3
and Indianapolis. Situations of ‘market failure’ where individual incentives are at variance with socially desirable outcomes (national
2
security, moral and cultural prohibitions on specific goods and services, and market spillovers or externalities that
impose direct costs or benefits on third parties) can and often are legitimately and efficiently addressed with specific
market restrictions that bring the outcome closer to the competitive market ideal. 3
That liberal tradition lies at the heart of modern ‘libertarianism’ today, but confusingly the word ‘liberal’ especially in
the US has taken on a different meaning – as protection by (not from) the government to limit the alleged damage
done to us by markets themselves. If you find all this left wing/right wing and liberal/conservative and
This section of the course is designed to help you break away from the sound bites and
campaign slogans that largely define and distort the public discussion of foreign trade.
Instead I’ll try to get you to a more thoughtful, inclusive, and practical view of the pros
and cons of (voluntary) trade as a cooperative linkage of buyers/sellers and
lenders/borrowers. Nationality, gender, religion, race, culture, language, and all the
other us/them distractions employed to justify trade restrictions simply ignore the
elephant in the room – mutual gains from specializing in what ‘we’ do relatively best and
trading for what ‘they’ do relatively best. Bottom line: the instinctive and sometimes
irresistible urge to view trade as a zero-sum, win/lose, us vs. them activity gets it entirely
wrong. It is markets and trade that enable the specialization that underlies productivity
growth for all, ‘them’ as well as ‘us’.
The most controversial aspects of international trade (such as job loss, trade deficits,
unfair practices and others that we’ll be discussing) arise equally in any trade -- within or
across nations. They’re important issues to address, as we will, but thinking that trade
restrictions are the solution is simply wrong. Trade restrictions would only redistribute
some of the gains and losses while bringing a net overall decline in economic wellbeing.
Any economic change (whether from trade, technology, tastes, demographics, climatic
changes, economic policies, etc.) creates winners and losers. This vector of outcomes
is captured in a useful phrase coined by Austrian economist Joseph Schumpeter,
‘creative destruction’. We want to focus on the full picture and determine the net
impact of such changes on the overall economy. Has economic efficiency and
productivity, on balance, been enhanced or diminished? In situations like expanded
trade that enhance specialization and productivity, we can think of ways to compensate
the losers by taxing the winners while still increasing the size of the pie (real output).
Easier said than done but a more useful way to think about the issue than simply
prohibiting any activity or policy if it brings harm to anyone.
I then gave you a dose of spurious history by thinking of our class as comprising the
entire economic universe and recapitulating economic development. Initially, survival
(and, necessarily, procreation) propelled us to move from hand-to-mouth self-sufficiency
toward specialization and bartered trade. The added specialization brought material
gains to all parties. As barter yielded to a monetized economy, a sharp decline in the
cost of trading (in terms of time and resources) released resources to further expand
trade, deepen specialization, and raise our standard of living. Those who did well and
prospered could accumulate savings that might be loaned to others with innovative and
productive projects who lacked the purchasing power to implement them. The resulting
development of specialized financial and capital markets in turn enabled additional
inventions and innovations that continued to enhance specialization, productivity and
economic well-being.
capitalist/socialist banter confusing, you’re right. It’s not you. It’s the fact that these terms are used in different ways
by different people at different times and different places, often to intentionally disguise their real agendas.
This process of economic development and growth through markets and trade came
strictly from changes within our classroom economy. When we then discovered another
such classroom economy directly south of us (3210 Nelson to our 4210), the same
process of specialize and trade came into play again. This availability of even larger
markets with more potential customers for our products and more businesses
competing for our consumer dollar brought additional specialization, expanded trade,
and a better economic life. It doesn’t happen automatically (as virtually all of your
ancestors would attest) but in a world where self-interest is channeled through
competitive markets, it can become continuing and self-reinforcing. Markets and trade,
to return to the central point, aren’t a world of ‘us vs. them’ but of mutual gains for us &
them.
In each of the successive steps above, it was expanding trade that increased our
income and output levels. This shows up in our formal model as successive
improvements in ‘institutional efficiency’ [y↑ = F (n,k,tn,↑inst)] leading to +∆AS* and
+∆y*.4 We’ll talk more about what’s going on at this disputed border between ‘trade’
and ‘don’t trade’ in coming classes, but the most important factor to keep in mind here is
that voluntary trade is economic activity. The more efficiently that trade is conducted
(e.g., the extent of our market choices as buyers, sellers, lenders, and buyers) then the
more productive our given resources (labor, capital, technology) will be and the higher
our economic well-being.
B. Trade Flows Across Nations – Mistaken Views of Balances & Imbalances
I then returned to a discussion begun in the previous class about the economic
implications of trade imbalances, i.e., trade deficits and trade surpluses. The
connotations of these words are so emotionally loaded that it’s a real challenge to think
clearly about them. It may take a while for all this to sink in and become part of your
common sense.
One way to come at it is just to remind ourselves that when an exchange takes place,
the economic value of the trade is the same to the buyer and the seller. Suppose a
product is bought/sold for $400. The seller ‘exports’ the good and ‘imports’ the money
while the buyer does the opposite. Hence the assertion that ‘total trade flows always
balance’.
Why then is the topic of trade balance so confusing since it always balances? The
standard way that exchanges across nations (rather than within nations) are viewed
further divides this total trade flow into two components -- the flow of goods and
services and the flow of financial assets or securities. The sum of the two will be equal
on both sides but only by accident (termed ‘balanced trade’) will each of the
components be equal.
4
Note that restrictions of trade work symmetrically, reducing our overall productivity and eventually, if we get back to
barter and self sufficiency, restoring the primitive world of poverty that most of our ancestors endured until, in
historical time, quite recently when the industrial revolution, private property, and expanded capital markets came into
the picture. The difference between these worlds is the level of specialization and trade! When you hear invocations
to ‘Buy American’ or ‘buy local’ and other calls for restrictions on voluntary trade, pause to think it through. This is in
the same category as assertions that reducing tax rates will increase tax revenues and reduce the budget deficit –
sheer buncombe. Pursuing this line of thought, suppose you want a new digital camera for $400 but don’t
have enough cash. The on-line seller is willing to accept $200 and your IOU for the
remaining $200 (0% credit, let’s suppose) a year later. The transaction is for $400, the
market price of the phone, but you’ve incurred a debt (and the seller a credit) of $200.
You’ve borrowed and the company has become a lender.
Now if the camera was made and sold in the US there would be nothing more to say
since we don’t talk about trade balance within the nation. If instead the camera was
made and bought online from, say, a Japanese company it would show up differently.
For example, suppose the Japanese company uses the $200 in cash to buy some US
products (or sells the $ to someone for yen who, say, then uses the $ to finance a
semester abroad at NC State). We imported $400 worth of Japanese goods and
services while they bought just $200 of ours. The US trade balance vis-à-vis Japan
would be -$200, a trade deficit.
At the same time Japan is buying a financial asset (your IOU) giving us the extra $200
of products in exchange for a claim on our future output. They have an outflow of
saving used to buy one of our assets. They’re a lender, we’re a borrower. Put another
way, they have a ‘capital account’ deficit (exports of securities minus imports of
securities) of $200 and we have a capital account surplus of $200.
Total trade flows (products plus securities) continue to balance: 200+200 to Japan from
US, 400 + 0 from Japan to US. There’s no trade gap, no one is getting cheated, and
there’s no unfair trade in any sense. But there is an imbalance in the composition of
those flows between goods and services and securities. What does this imply? If the
US has better investment opportunities and less savings than Japan, common sense
tells us this is a win-win deal. They get a higher return from sending their savings to the
US and we get low-interest rate funding that enables us to take advantage of even more
investment opportunities than if we had to finance them ourselves. Both sides win and
both economies experience more economic growth than if savings were prevented from
flowing to higher value uses when they have to cross a national border.
The process is no different than expanding trade first within our 4210 Nelson economy
and then to our Southern neighbors in 3210. Competitive and open markets, driven by
the power of self-interest, give us the goods and services we want at the lowest
possible price. Restrictions on the flow of products and/or securities across or within
economies reduce our ability to specialize in what we do best and results in a lose/lose
decline in total output. When such restrictions are the result of a protectionist trade
policy (e.g., ‘we’ll show them, we’ll put a 45% tariff on Chinese goods coming into the
US’ or ‘we’ll restore all those jobs that China has taken away from us’) it brings
presumably unintended economic consequences to those who claimed to be protecting
and strengthening the US economy. This would more accurately be termed a selfinflicted wound. Yet how many politicians, at any level, can you find who speak against
trade restrictions and for free trade? Think about why such obvious ignorance persists.
________ I spent most of the class discussing, from different angles, the implications for trade of
the notion of ‘specialize and trade’ embodied in the theorem of comparative advantage
(or roundabout way to wealth). Remember that when we talk about ‘trade’ it’s equally
about trade within the nation as well as across. A policy of largely unrestricted trade
with other nations (called ‘free trade’) is based upon the notion that the combination of
self-interest and competitive markets will result in a more efficient and productive use of
resources than if the government imposed trade barriers (tariffs, quotas, and voluntary
export restraints) to alter the outcome produced by unrestricted markets.
Several of the required readings address comparative advantage in clever ways that
may help you see it more clearly. Roberts ‘The Choice’, Ingram in his fable about Mr. X,
and Monsieur Bastiat in his classic ‘Petition of the Candlemakers’ each expose the
economic damage done by restrictions on foreign trade. Please note that the views
they criticize, ridicule and/or satirize are virtually identical to those so eagerly cheered
every day in the news.
When buyers and sellers respond to the various signals generated by competitive
markets (i.e., prices, wages, interest rates, profits, exchange rates), economic
resources flow to those activities that consumers value most highly. Changing events
and policies (such as technology, tastes, regulations, transportation costs etc.) cause
changes in those prices that, combined with watching out for our self-interest, lead us to
choices that move production and specialization toward a different configuration of
comparative advantage. As discussed earlier, all such changes create winners and
losers but our focus for now is on the net impact on overall economic activity. We’ll
return to the distributional impacts and our options for dealing with it a bit later.
I organized the class presentation of trade and trade restrictions around a series of
points:
1. What is ‘comparative advantage’? It’s both an obvious and elusive notion. As you
read over the material be sure you’re clear on what it is and isn’t. For example, it
doesn’t say simply ‘do what you do best and trade for what they do best’. That’s called
absolute advantage (Smith’s view of trade) and can’t account for obvious gains from
trade between rich, productive and poor, unproductive economies.
Ricardo’s comparative advantage is more comprehensive and more subtle: specialize
in those goods and services that you produce relatively better than other products,
relative to your trading partners. Trade them for those things they do relatively better
(again, relative to other goods and services and relative to you). What this comes down
to is essentially that there’s only 24 hours in a day and if you use your resources,
including time, for one thing you can’t also use them for another. Even if you could
produce virtually everything at a lower cost than your trading partner, it will be win/win
for both if you specialize where your absolute advantage is greatest and trade to them
for the things where your absolute advantage is least. It sounds a bit complicated but
the common sense of it is straightforward. You’ll find a number of everyday examples
that Dave points out to Ed in The Choice.
2. How do we know where our comparative advantages lie, especially in an everchanging economic environment? This is the notion of the ‘invisible hand’ and selfinterest responding to changing market signals (discussed in class and mentioned on
the previous page).
3. What happens to nations who are so unproductive that they don’t have a
comparative advantage in anything? As explained, this is logically impossible. Your
comparative advantage, to put it negatively, is in those things that you do less badly
relative to everything else and relative to your trading partners. Even those who are, for
whatever reason, spectacularly unproductive in all things can have a comparative
advantage in something if they will accept wages and working conditions far below what
would be acceptable in richer nations. The ability to work for sweat shop wages is,
ironically, what gives them a comparative advantage. Programs to abolish sweat shops
without exploring the next best alternatives for these workers have created some tragic
unintended consequences.
Another example would be a desperately poor and unproductive nation agreeing to
accept the garbage and other wastes of richer economies. Unsavory and unhealthy as
it sounds, it may be better for them than not doing it. They might then use the payments
to undertake the changes that will help their economy begin on a path of sustained
growth. The US went through an extended period of child labor and indifference to work
place conditions as well as the environmental degradation before the gradual rise in
income and wealth made it possible to afford the cost of restrictions against such
practices.
4. What if your comparative advantages are in areas that yield a near-subsistence
rate of return? You’ll be poor, of course, but you’ll be less poor growing coffee beans,
for example, than if you undertook things in which you didn’t have a comparative
advantage, e.g., making wine or automobiles instead. Rather than abandoning a
comparative advantage, think of using it to leverage to more productive and lucrative
areas of comparative advantage.
5. Can we create better, more productive areas of comparative advantage? Of
course, that’s what economic history is all about. As we know, some countries and
regions succeeded in breaking away from poverty relatively early and continued to
sustain growth and enhance their productivity. Others clearly didn’t or had stop-andstart, intermittent periods of growth and decline. China and India in the past few
decades have experienced remarkable gains in economic activity by reallocating
resources as well as changing institutions and regulations that restricted markets and
market signals. Much of this was done simply by moving closer toward free trade, both
inside the country and with the rest of the world.
But, as we discussed in class, there’s no short cut here and a poor agriculturalproducing nation can’t just decide it will no longer engage in low wage occupations and
instead only have high paying, high tech or high end manufacturing jobs. They would
be moving their resources to areas where they don’t have a comparative advantage and
no realistic prospects of achieving one in the near future. This will end up being a
misallocation of resources that reduces productivity and further lowers the standard of
living.
In this regard, some nations use explicit ‘industrial policies’ in which government
decision-makers over-ride certain markets signals and use various taxes, subsidies, and
regulations to redirect resources to what they expect to be more productive uses. This
presumes that private decision makers and existing market signals are somehow
overlooking more profitable options that these bureaucrats, spending other people’s
money, have discovered. The history of such policies is not encouraging and suggests
that where markets are not doing the job well the far better policy would be market
reform (various kinds of regulations to make them more competitive, e.g., not ‘too big to
fail’) and also enhancing underlying institutions (infrastructure, good governance, court
systems etc.).
6. Put another way and using a metaphor from the ‘uncivil wars’ now engulfing us: free
trade builds bridges, trade restrictions build walls.
7. Restrictions on trade alter market signals, change incentives, and thereby
reallocate resources. Stopping textile imports from China, for example, would
certainly have ‘saved’ many jobs and created a quite different economic landscape in
North Carolina than we now have. Some would clearly have been better off than what
they’ve experienced with the closing of the mills. But if we stop there we miss the larger
consequences of what is essentially a continuing bailout of a weak industry.
It’s useful to think of trade restrictions as barriers that create diversions and distortions
throughout the economy. For example, a) resources are kept in tasks in which we don’t
have a comparative advantage, b) all of us as consumers pay a larger share of our
income for these products than we would have, c) market signals (wages, profits, etc.)
altered by tariffs and quotas still show green lights to workers and investors, urging
them to bring their resources to the US textile industry, d) hence self-interest is not
directing labor and capital to areas in which we have a comparative advantage and
those industries are smaller than they would otherwise be (e.g., the plant that was never
built in Rahway, N.J.) and e) lower levels of economic activity means lower incomes and
tax revenues and hence less consumption and investment, private and public,
throughout the economy.
Historical examples of the different economic fortunes of economies closed off to trade
in comparison to those who open their borders provide dramatic evidence of the degree
to which trade restrictions can be a self-inflicted economic wound. In our framework this
decrease in institutional efficiency and corresponding drop in income and output is
sometimes characterized as a ‘dead weight loss’ (from y*↓ = F(n*, k, tn, ↓inst). It’s not a
simple redistribution where some lose and others gain and it all nets out. Instead it’s
what might be called a ‘transfer in a leaky bucket’, a net loss in efficiency and output. A
well-intended but short-sighted policy has ‘protected’ some by imposing even larger
costs on the rest.
As restrictions remain, the dead weight loss recurs year after year, lowering the
standard of living, slowing economic growth, and diminishing the economic possibilities
for the generations to come. One might wonder how we could even consider much less
adopt such destructive policies? But then consider how many members of Congress
have been elected in their geographically specific constituencies by arguing for more
trade, more outsourcing, lower trade barriers, and more immigration? Instead, of
course, it’s pledges to save jobs, protect industries, preserve ‘fair’ trade and, of course,
keep America strong.5
To the extent the election process involves gullible voters, big money from corporations,
and hit-and-run attack ads, it’s perhaps remarkable that we don’t have even more trade
restrictions than we do.
8. What should trade negotiators negotiate about? As we discussed, a policy of free
trade could be characterized as one of ‘unilateral disarmament’ in the trade wars. I’m
taking down my barriers regardless of what you do. As Dave says in The Choice,
overstating just a bit, ‘you only hurt yourself when you restrict imports’. Since tearing
down walls and building bridges for voluntary trade brings mutual gains, if a trade
negotiator had the interest of the overall economy in mind, they’d win the trade war by
not participating.
Following that logic, it’s clear that trade negotiations exist to serve the economic
interests of particular interest groups within the economy – industries, labor groups,
financial organizations and so on. All, as we know, are big contributors to political
campaigns, have well-paid lobbyists in Washington D.C. as well as in all state capitals,
and some even create so-called ‘think tanks’ that seek to lend scientific credibility to
various market restrictions.
9. Are there any economically ‘legitimate’ exceptions to free trade? Of course.
We create a market system to serve our economic interests and enhance our economic
well-being. In cases where the market signals don’t reflect some economic costs and
benefits, then altering/correcting those signals is entirely consistent with the goal of
using our resources to produce the products we want most efficiently.
All nations erect walls to certain economic transactions regarded as potential threats to
national security. Nothing could be more legitimate than protecting our lives and
property. Similarly, there are certain goods and services which, as individuals and
communities, we find objectionable. We impose what might be termed moral
restrictions on their production, distribution, and use. These differ across nations,
regions, communities, and cultures but represent politically acceptable limits to certain
economic activities that are widely viewed as offensive.
There will be those in the community who oppose such restrictions. Some will seek to
change the law (legalize certain recreational drugs, or gambling, etc.). Others may go
outside the law in search of profits and power in the resulting underground economy.
Prohibition of alcohol was an instructive experience of unintended consequences in the
early 20th century.
5
Samuel Johnson’s provocative ‘Patriotism is the last refuge of a scoundrel’ is a currently relevant
reminder of the difference between true patriotism and the sloganeering of false patriotism. Trade
restrictions don’t strengthen the overall economy, they weaken it.
Yet moral standards are important to all of us, which we rediscover when a longaccepted standard of behavior is violated by new practices. These can be social,
religious, cultural or just ordinary things of everyday life. For example, restricting phone
calls from telemarketers and limiting those of political campaigners seems particularly
desirable to me these days. Supporting a free market economy doesn’t mean we can’t
limit the domains in which self-interest can be pursued.
Another area in which we override market signals is to alter the distribution of income
and wealth produced by a market system. Government programs and the structure of
taxes work, in varying degrees, to provide a safety net for those whom a market system,
for varying reasons, fails.
Another important situation in which a market system can systematically distort
resources allocation from an economically efficient outcome is when market
externalities result in significant third-party spillover effects. The willing buyers and
sellers, in such circumstances, are not paying the full costs of production or are not
receiving the full benefits deriving from the goods and services. In this case the market
signals bring too many products with negative externalities (pollution, congestion) and
too few with positive externalities (education, roads, and national security in Adam
Smith’s Wealth of Nations).
Finally there’s a possibility, more theoretical than politically practicable, that where
potential economies of scale exist a government could subsidize an industry to secure a
comparative advantage so that other nations getting in later won’t be able to compete
economically. A variation on this is the enduring ‘infant industry argument’ in which the
argument is made that temporary protection by the government will enable it to mature
and stand on its own. The history of interventions justified as temporary is not
encouraging.
The rationale of both of these presupposes the ability of the public sector to ‘pick
winners’ that private decision-makers have overlooked. It presumes the presence of
highly intelligent, well-informed, far-seeing, and supremely objective public decisionmakers. These are not characteristics that most of us would associate with our elected
officials. ( . . . Why, then, do we keep voting people into office who lack such attributes?
It’s complicated . . .)
______
I began with one more pass on the fundamentals of trade upon which all the rest is built.
All trade, regardless of political boundaries, is about channeling self-interest through
markets (the more competitive the better for the overall economy) in a process of
‘specialize & trade’, built around comparative advantage (where to specialize) and
leading to mutually beneficial outcomes. In contrast, self-sufficiency, as ‘Dave’ tells it, is
the road to poverty.
Putting this together, we see that the gains from trade are created and sustained by
differences. Without differences across individuals and regions in the various inputs
(climate, resources, knowledge, preferences, wages, geography, transportation,
working conditions, and individual interests and abilities) there would be no economic
motivation for trade. Put another way, it is these differences that constitute
comparative advantage. Hence portrayal of such differences as constituting ‘unfair’
trade and imposing offsetting tariffs or quotas precludes the whole point of trade. It
reduces the ‘roundabout way to wealth’ (in Dave’s terms) and imposes a deadweight
loss on the overall economy.
If we think of trade as a ‘bridge’ to mutual gain, then trade barriers are the ‘walls’ that
prevent those gains. They protect some at the greater expense of the many and, in our
framework, show up as a negative supply shock. Our given resources are being used
less efficiently than they could be. Hence, the notion of a ‘self-inflicted wound’.
As discussed last time there is a relatively small category of situations in which
restrictions are consistent with improved economic well-being (security, moral limits,
externalities etc.). But the vast majority of actual trade restrictions fall in the deadweight
loss category. The proponents of these barriers assert otherwise, of course. They point
to saving jobs, balancing trade, a level playing field, making us strong again, and even
helping exploited workers in other nations.
On the surface they may sound irrefutable, even irresistible. They resonate with the
gullible populist in us all. But, economics is about thinking it through. On closer
inspection, they turn out to be ‘transfers in a leaky bucket.’ They help some at the
greater expense of others. Several of the required readings are designed to help you
inoculate yourself against such shallow, populist arguments for protection against
foreign competition. Some of the readings do it with wit and sarcasm. Others proclaim
their protectionism proudly, if a bit obliquely and the challenge is to see what they’re
leaving out – not what they’re saying, but what they’re not saying or perhaps even
seeing.
B. Trade Balance & Imbalance
Recapping the issues surrounding a trade deficit/surplus/balance, I began by noting the
widespread suspicion that if we buy more of their goods and services than they buy of
ours, they are somehow cheating us and we’re the losers in the deal. Noting that total
trade flows always balance, we saw that our x<0 also means we export more securities
than we import, i.e., we have a capital account surplus. Put another way, our x<0
reflects a situation in which our securities are more attractive to them than theirs are to
us. What is actually a vote of confidence for our economy is thereby twisted into a
supposed exploitation of our open markets.
Those who see x=0 (trade balance) as somehow a desirable outcome and x<0 as
undesirable are saying that it’s okay to trade goods and services to foreigners but not
securities (assets). Put another way, it says that there can be no net flow of savings or
investment in or out of our economy. Economies who have an abundance of
investment opportunities but a relative shortage of available savings would not be
allowed to borrow from a ‘foreigner’. Those who have a paucity of investment
opportunities but a surplus of saving looking for profitable uses cannot access that
global capital market that would make them better off. Mutually beneficial trades
between eager lenders and eager borrowers are prohibited because of an erroneous
belief that it’s an ‘us vs. them’ situation when it crosses sovereign borders. Economic
activity is diminished as xenophobia spreads.
Suppose we get beyond the ‘balanced trade’ mentality and concede that in some cases
a trade deficit can bring mutual gain. The issue may then become concern that these
continued trade deficits (i.e., capital inflows) are not sustainable. Perhaps we’ll become
dependent on them and undermine our economic well-being by not being more selfsufficient. This is the same kind of argument we saw earlier that makes similar
allegations about government budget deficits not being sustainable.
For trade deficits, budget deficits, corporate borrowing (aka ‘deficits’), household
borrowing (‘deficits’), the economic response is the same. Is borrowing good or bad? It
depends on how much we pay for the funds and how productively the resources are
utilized (i.e., investment vs. consumption etc.). Borrowing that is not well-used will not
be sustainable and lenders, perhaps learning a costly lesson, will no longer risk their
savings.
In the late economist Herb Stein’s appropriate words “If something cannot go on
forever, it will stop.” Stein was addressing the generations-long moaning and groaning
over US trade and budget deficits. If our deficits hadn’t been sustainable they wouldn’t
have continued, yet we continue to whine and make dire warnings of imminent
catastrophe. It hasn’t happened. Could it happen? Is this a Chicken Little situation
(remember the sky never did fall) or is it a Boy Who Cried Wolf scenario? (The wolf
finally got him.) How do we know? Think it through.
Suppose that we have a large trade deficit and our investment prospects suddenly
diminish relative to that in other economies. What would happen? Our capital inflow
would end as savings heads toward more promising ventures elsewhere. If US savers
also join in the exodus, then our trade deficit would become a trade surplus. Incumbent
politicians would likely proclaim victory – ‘We restored our great nation’s trade surplus!’
You would not be taken in, right? You’d simply note that in fact they destroyed our
great nation’s capital account surplus by presiding over the deterioration of our great
nation’s favorable investment climate. Real patriotism doesn’t come from sloganeering
but from ‘thinking it through.’
C. Exchange Rates & Trade Balance
What’s the mechanism through which the world’s savings and capital flows are directed
and redirected as threats and opportunities present themselves? This is the role of
another ‘price’ – the cost of one currency in terms of another. The market or nominal
exchange rate (E) can be expressed as the amount of foreign currency per unit of
domestic currency. For example, E = €/$ = .90. What causes this market price to go up
and down? Like any other price, it goes up and down with the forces of supply and
demand. The supply curve slopes upward because the higher the price the more they
more they are eager to ‘sell’. The demand curve slopes downward because the lower
the price the more eager they are to buy. Reconciling these conflicting interests is the
foreign exchange rate, rising when there’s excess demand and falling when there’s
excess supply. The measure of a successful market price is it’s degree of flexibility to
changing conditions so as to keep the market ‘cleared’.
More specifically, what determines the demand for the US dollar on the foreign
exchange market (FOREX)? The D$ reflects their (‘THEM”) demand for $ to buy our
goods, services, and securities (collectively, ‘stuff’). What determines our (‘US’) supply
of dollars to buy their currency? It’s simply a reflection of our demand for their ‘stuff’.
We put this in a graph with the market exchange rate (E) on the vertical axis and the
amount of $ transacted on the horizontal, then used it to illustrate an equilibrium marketclearing exchange rate.
To illustrate the link between exchange rates and trade balance, let’s suppose that
suddenly the world decides US securities are no longer attractive and sends its savings
to other economies. The resulting drop in D$ would shift the demand curve to the left,
down the upward sloping S$ curve, reducing the international value of the dollar, -∆E.
The weaker $ makes them cheaper abroad and stimulates our exports whereas it
makes foreign goods more expensive to us and reduces our imports. Both work to
reduce, eliminate, or even reverse our trade deficit.
Is it better to have a strong dollar or a weak dollar? Other things the same, of course,
strong sounds better but that misses the point. A stronger dollar is good for those
buying imports but harmful to those trying to sell exports abroad. What we want is not a
high E or a low E but one that is flexible and responds to changing economic
circumstances. In so doing it brings buyers and sellers together in mutually beneficial
trades.
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IV. Trade Across Nations
C. Exchange Rates & Trade Balance
We resumed discussion of the foreign exchange rate and its role in ‘translating’
purchasing power across different currencies. It’s a more specialized topic than we will
go into in this course but I want you to have a general understanding of its function in
facilitating the underlying trades of goods, services, and securities that create the
mutual gains from trade. ‘Enabling’ trade is the primary function of exchange rates.
How well it does in this task depends largely on how ‘flexible’ or responsive this rate
‘price’ is to changing market forces.
The actual, nominal, or market exchange rate is the cost of one currency in terms of
another, such as E = €/$ or ¥/$. It rises and falls in response to economic events and
policies in both economies as well as changing threats and opportunities elsewhere. In
terms of the flow of goods, services, and securities (‘stuff’) from US to THEM (in the
earlier diagram), anything that alters our demand for their ‘stuff’ relative to their demand
for ours will change the market-clearing equilibrium exchange rate. For example, an
increase in the attractiveness of our securities relative to elsewhere will mean an
increase in the demand for the dollar in the foreign exchange market (Forex). This
+∆D$ slides along the upward sloping S$ (reflecting our demand for their stuff) until the
initial excess demand for the dollar is extinguished by its rising price, +∆E and the
market is then cleared.
As with interest rates (market and real), changing price levels play an important role in
differentiating the market exchange rate (E) from the real exchange rate (e). The real
exchange rate measures not how many pieces of their ‘paper’ we can purchase with
one of ours, but how much of their purchasing power we get per unit of our purchasing
power. It is measured by scaling (deflating) the foreign currency by its consumer price
level and then comparing it to our currency deflated by our price level. That is,
e = (€/PEUR) / ($/PUS).
Since E=€/$ we can express it more simply as e = E(PUS/PEUR).
The distinction between E and e is very similar to that which we made between R and r.
One’s in nominal terms and makes no distinction between, say, a change that reflects
an underlying increase in inflation (remember our discussion of the ‘expected inflation
premium’). For example, a higher E tells us that we’re getting more units of their
currency for one of ours. But it doesn’t tell us what we really care about – not pieces of
paper but purchasing power. The real exchange rate, where both currencies are scaled
by their purchasing power, tells us whether the rise in E was purely cosmetic (merely
nominal) or means our dollar actually buys more, making foreign products less
expensive.
I went through a few illustrations of how exchange rates, overall trade flows, and trade
balance respond to certain events or policies.
1. An important function for the exchange rate is to help an economy recover from a
downturn. It’s actually part of the market-clearing process we’d talked about earlier. To
the extent that a recession reduces, say, foreign demand for our securities, the resulting
–∆D$ brings –∆E (and –∆e). Our goods are now cheaper abroad, stimulating our
exports of goods and services, increasing our aggregate demand and output.
The flip side is that an economy with a pegged or fixed exchange rate does not have
this ‘automatic stabilizer’ to stimulate economic recovery. Greece, now on the euro and
without its own currency and hence its own exchange rate, would have benefited from a
falling exchange rate to stimulate foreign demand for its exports. But the euro is a ‘one
size fits all’ currency for European Monetary Union members and overall they were not
in a downturn and the euro was staying relatively strong.
2. Another important aspect of a flexible exchange rate is to be a cushion or buffer
against differing inflation rates of trading partners’ currencies. For example, suppose
there was a fixed rate between the $ and the €, say 1 to 1 to keep it simple. Now
suppose there’s no inflation in the US but steadily rising consumer prices in the euro
economy. What happens to trade flows between the two?
Hypothesis 1 (. . . not likely) The immediate impact of the +∆Peur is to reduce our
real exchange rate, i.e., lower our purchasing power because of their inflation. If
we still give them $1 for a euro that has lost, say, 10% of its purchasing power to
their inflation, then we’re clearly damaged by events and policies of our trading
partners. But are we likely to just keep buying their products now that they’re
less competitive with ours and those from elsewhere? Hence, more likely . . .
Hypothesis 2 (known as the Purchasing Power Parity theorem). Their higher
prices reduce our demand for their products and so also for their currency. The
resulting –∆S$ (to demand euros) will slides along a downward sloping D$ to
increase E and clear the market. The market value of our currency will rise
proportionally to offset their rising price level. In the equation: e = E(PUS/PEUR),
the +∆PEUR will lead us to reduce our supply of dollars, causing +∆E such that
there will be little or no change in the real exchange rate, ∆e ≈ 0. A country
whose domestic inflation rate rises by 10% can expect to see its market
exchange rate fall by 10%.
If an economy has a fixed exchange rate then its E is ‘pegged’ at a given rate to another
currency. Hence ±∆E=0. So ups and downs in its inflation rate relative to that of the
other currency (e.g., ±∆(PUS/PEUR)) are forced into ±∆e. Therefore with a pegged E the
rising inflation of your trading partner reduces your purchasing power and creates an
incentive for you to inflate in return. There are particular circumstances where a fixed
exchange rate can work reasonably well but it is always a target for speculators if it gets
far out of line with what the market equilibrium would be. Currency crises are always a
threat.
3. I then talked about what’s involved when an economy decides to peg its currency to
another currency. This is a bit involved and since there isn’t time to develop it more
carefully I won’t inflict it on you again. (Take EC 449 to learn more about global
financial and currency markets.) In the process of trying to keep the value of your
currency at a level above the market equilibrium level, the central bank is forced to run a
continued contractionary monetary policy that will eventually cause a proportional –∆P
that offsets the artificially imposed +∆E. In the end, looking at the equation, the –∆P
and the +∆E offset and ∆e=0. They will have used up valuable foreign reserves and
lost the use of monetary policy for stabilization policy in order to achieve a purely
illusionary stronger exchange rate.
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IV. Trade Across Nations
Overview:
Perhaps the most fundamental and practical insight in this section of the course is that
viewing trade across nations as essentially ‘us against them’ is likely to result in a
restrictive trade policy that reduces our productivity and lowers are overall standard of
living. It ignores the basic fact that voluntary trade is a win/win activity which allows us
to specialize in the goods and services in which we have a comparative advantage and
trade for those in which others have a comparative advantage.
This seems apparent to most of us if we think about trade within our economy. None of
us is remotely close to being economically self-sufficient. Our jobs and our schooling
are in specialized tasks in specialized businesses. We are engaged in producing one
particular good or service which we essentially exchange for the wide variety of things
we consume. Competition among producers to attract the consumer dollar is widely
viewed as the essence of the market-oriented, free enterprise system of which we are
so proud. Firms who do it best gain consumers, consumers get the things they want at
the best price, and the voluntary trade between them is one of mutual gain. Our scarce
resources have been directed from lower to higher value uses. This process and its
outcome are no different should the trades happen to cross a politically defined national
border. The nationality of the buyers, sellers, borrowers, and lenders has no impact on
either process or the outcome of the trade. (Appropriate trade restrictions with regard to
security, moral standards, and externalities are also equally valid for economic activity
within as well as across nations.)
The underlying common sense of adopting a ‘specialize and trade’ strategy is presented
in The Choice through the ‘roundabout way to wealth’. We ‘produce’ TVs (in the
roundabout way) by actually producing pharmaceuticals and trading them for TVs.
Putting our resources into those things in which we are relatively most productive leads
to higher overall income and less expensive TVs.
Bastiat’s ‘Petition’ makes the same point satirically through the supposed request of the
Candlemakers for government protection from the ‘unfair’ competition of a powerful
foreign competitor. Their argument for the economic benefits of such protection sounds
persuasive (and familiar) until we realize the underlying absurdity of using scarce
resources to produce something we could, in his story, have for free. He then points out
that this is equally true for things that we could acquire more cheaply by trade than
using our own resources to produce less efficiently.
Put another way, seeing trade as a threat when it crosses international borders but a
virtue when it doesn’t simply makes no economic sense. Failure to understand this
leads to an ‘us/them’ mentality that sees foreign trade as a threat rather than an
opportunity to further enhance our standard of living by focusing on those things we do
best. Lost jobs, trade deficits, and all the other aspects of foreign trade are no different
for trade within an economy. There are always winners and losers but when it’s
domestic trade we also see the overall net gains. But when the us/them dimension of
foreign trade is appears the exact same process is often seen as harmful and its net
gains ignored or simply denied.
The readings and class discussions are designed to help you see the logic/common
sense underlying the mutual gains from trade – across nations as well as within. The
exam questions will ask you to explain, not assert, why most arguments against trade
and globalization are, in varying degrees, incomplete or simply fallacious.
D. Economic Change & Creative Destruction
You’ve no doubt noticed that many of the allegations against trade (lost jobs, unlevelplaying field, unfair practices, etc.) are grounded in the very real fact that increased
imports hurt domestic firms, workers, and often whole regions of the country. Lowercost foreign competition brings falling prices, profits, and wages in those industries. The
economic and human costs are very real. In fact any economic change brings similar
patterns of ‘destruction’ as it redirects resources from dying to growing industries. This
includes technological change, changes in consumer tastes over time, changing
demographics, changing regulations of the work place, the environment, and so on. In
a world of scarcity and no free lunch, all changes create winners and losers. Any
useful analysis of impacts must look at both benefits and costs.
Economic analysis (logic + evidence) demonstrates that the net overall gains from trade
are very real. Why does that seem so widely unacknowledged? An important reason is
simply that the costs of trade, through smaller, are far more visible than its benefits. For
example, lower apparel costs from open trade benefit all of us a little by increasing the
purchasing power of our income. But the burden falls on the relatively small number
whose livelihoods were based on the textile mills. This obviously gets our sympathy,
particularly when we realize that similar changes (from changing technology, consumer
preferences, and so on) could happen to any of us. Someone will always be in the
wrong place at the wrong time when changes come.
Russell Roberts’ tale in The Choice helps us see the two worlds -- free trade and
protectionism – in terms of the impact on the lives of his characters. This entirely
imaginary story is based upon solid economic foundations. It allows us to see the
impacts on Ed’s workers and their families both when the plant closes and when it is
kept alive by trade restrictions.
After the exam we’ll look at alternative ways to use some of those net gains from trade
to soften the costs to the losers while still leaving net overall benefits. This is the notion
of an economic ‘safety net’. But the reality today seems to be that the visibility of the
benefit side of trade restrictions (‘saved’ jobs, less change) obscures the larger cost
side (resources used less productively, innovations that didn’t occur, plants never built
etc.). As a result the notion of ‘free trade’ itself is very much on the defensive in the
overall population. In such a climate, effective programs to retrain, relocate, and
otherwise assist those harmed by economic change are especially important. Without
them the directly visible costs of trade will obscure its larger benefits.
Note that this idea of compensating losers with some of the gains from the winners is
equally applicable to any economic change, the most disruptive of which is not trade but
technology. Most of us don’t think about restricting technological change. But when the
same kinds of threats come from changing trade patterns, many react quite differently.
Trade has much more of an us/them dimension, hence a perceived villain or scapegoat,
than technology.
E. Globalization: Costs, Benefits, and Alternatives
The process of ‘globalization’ usually refers to the total flow of products, capital, people,
ideas, cultures and so on that has been going on for centuries but has accelerated in
the past generation. It is currently under assault around the world as immigration
restrictions rise, the UK threatens to leave the EU, and nationalist parties in many
nations take stronger anti-immigrant and sometimes anti-trade positions.
The fact that no US presidential candidate can risk saying anything good about the
gains from foreign trade suggests that we are likely to see an increase in the level of
trade restrictions in the foreseeable future. This will have real economic consequences
for all of us. Trade restrictions reduce our overall economic efficiency and lock
resources in areas where they don’t have a comparative advantage.
Combining this self-inflicted negative supply shock with a continuing overall slowdown in
economic growth from other sources, dims our economic prospects still further.
Thinking about trade restrictions in terms of ‘burdens on the future’ is particularly
relevant. With all the challenges that we face on security, climate change, crumbling
infrastructure, deteriorating educational quality, and so on, a populist-driven
misunderstanding of the gains from trade is all the more unfortunate. The perceived ‘us
vs. them’ ends up being ‘us vs. us’.
_____