Response to Red on the “New Red Scare”

by robekulick

Here is Red’s comment on my post:

(Red’s comment is below, that link is to my previous post)

By the way, it is pretty funny that Red’s first comment on my blog is one about a new “Red Scare”:

“Great entry! Though worded a lot better, this is almost exactly what I’ve been trying to tell people for years about China’s trade policy — that the US benefits. I was struck though about a week ago by a comment Michael Pettis (an economist on China) said about US protectionism and wondered what you thought.

“As the US fights over the fiscal deficit and whether or not it is the right way to expand domestic demand, more and more politicians will focus on the expansionary impact of trade protection. There will be an increasing tendency to intervene in trade …

As unemployment persists, and as the political pressure to address unemployment rises, the US will, like Britain in 1930-31, lose its ideological commitment to free trade and become increasingly protectionist. Also like Britain in 1930-31, once it does so the US economy will begin growing more rapidly – thus putting the burden of adjustment on China, Germany (which will already be suffering from the European adjustment) and Japan.

Trade policy in the next few years will be about deciding who will bear the brunt of the global contraction in demand growth. The surplus countries, because they are so reliant on surpluses, will be very reluctant to eliminate their trade intervention policies. Because they are making the same mistake the US made in the late 1920s and Japan in the late 1980s – thinking they are in a strong enough position to dictate terms – they will refuse to take the necessary steps to adjust.

But in fact in this fight over global demand it is the deficit countries that have all the best cards. They control demand, which is the world’s scarcest and most valuable commodity. Once they begin intervening in trade and regaining the full use of their domestic demand, they will push the adjustment onto the surplus countries. Unemployment in deficit countries will drop, while it will rise in surplus countries.”
(Towards the bottom)

What I think he’s arguing is that while free trade would normally be good because of the very peculiar circumstances we’re in, protectionism might benefit the US at the expense of other countries. Normally I would have fought against such an argument, but Pettis is an economist I really respect. Do you think there might be something to his argument even if it is very much a beggar-thy-neighbor suggestion?”

Pettis’ logic, as I see it, is like this. China will refuse to do anything significant about its currency. At some point, the US will get upset and impose tariffs on China. Pettis doesn’t say that China will respond by giving into the US’ demands, so we can only conclude that his logic is that the tariff itself is the device by which he posits unemployment in the US will be brought down. I note this because it is actually very different from the argument made by Sam G. in his comment on my post which I’ll respond to tomorrow (hopefully!).

Anyway, my short answer is no, I think this is absolutely wrong for a few reasons. This is very much the sort of logic that investment bank economists like to employ. It sounds very good at first, but once you place the arguments under the scrutiny of rigorous economic models, the story starts to fall apart.

The foundation of the economic view on trade is the model of comparative advantage. This model first suggested by 19th Century economist David Ricardo, shows that by engaging in trade two countries can increase the total output enjoyed by both countries, even if one country is uniformly more efficient at production than the other country. This happens because the more efficient country produces what it is most efficient at producing and leaves the production of other goods to the other country. By trading, both countries end up with more goods than they would have otherwise.

Now Pettis doesn’t say anything about total output in his post and I’m sure he’s aware of the magic of comparative advantage, so his argument has to be that the goods that the US currently is specializing in producing vis-a-vis trade with China are ones that are highly-capital intensive. Thus he believes it follows that there would suddenly be more jobs in the US if the labor intensive jobs returned to the US. But for this argument to be true, it has to be the case that the US consumers are at this point completely satisfied and the problem is that the economy simply isn’t innovative enough to find uses for people outside of the labor intensive jobs that are currently held by Chinese workers. This obviously is not true. What’s causing unemployment is some combination of supply-side factors, like businesses and entrepreneurs being unwilling to invest in the face of large amounts of uncertainty and “sticky-wages” preventing wage rates from falling so that the demand for labor increases again. Certainly, a tariff just discourages entrepreneurship both by decreasing businesses access to foreign markets and by making intermediate production goods more expensive. Furthermore, since it would take some-time for new factories and such to get going in the US I don’t see how a tariff would help with the sticky-wage problem either. And of course, for labor intensive industries to commit to building in the US following a tariff, they would have to expect that the tariff would stay in-place after the recession, ie the US would have to commit to bad policy even after the recession. Thus, I think the net affect of the tariff is very clearly to increase unemployment in the US rather than decrease unemployment in the US.

One point that got buried in there is particularly important. Capital and labor are actually complements rather than substitutes for the most part. So by increasing the cost of intermediate capital goods, tariffs decrease the demand for labor and thus induce unemployment.

Finally, Red asks if his case is more credible because of the unusual state of the US economy. Pettis’ only assumption distinguishing tariffs now from tariffs under normal economic circumstances is that long-term unemployment in the United States will be permanently higher for the foreseeable future, or in economic terms, the natural rate of unemployment in the United States has increased. This very well might be true, but for the tariff to affect unemployment in the United States it has to do so by affecting aggregate demand. But economic theory indicates that in the long-term, the natural rate of unemployment is driven by supply-side factors.

So, please Red, don’t give up your faith in free trade! Throwing mines in our harbors is still as bad an idea as it sounds (see my previous post for context on this statement).