Yes, trade policies do matter

One of my blog readers, Kalasend, responded to Thursday’s entry by asking about the composition of US-Chinese trade, and I think the question is interesting enough to be discussed in a separate entry, rather than in the comments section. In his response he pointed out that “China’s exports are mostly light manufacturing goods like toys, garments and other labor intensive goods which the modernized west simply lack the competitiveness and the will to do.”

I have heard this statement many times before, usually as part of a broader argument that since China is mainly exporting things that the US and Europe can’t or don’t want to make, macroeconomic policies aimed at adjusting the trade relationship are unlikely to make a difference on the actual trade balance. We are stuck, in other words, with the current trade relationship and probably for very good reasons.

Although I think there is a lot to be said for this argument, I nonetheless think it is fundamentally wrong for at least three reasons. The first reason is just the obvious point that macroeconomic policies that alter the factors that affect production and consumption necessarily affect the balance between the two, and the trade account is simply that balance. If the United States, for example, decided to provide large amounts of very low-cost credit to the US manufacturing industry, US production would automatically rise faster than US consumption, and so the US trade deficit would shrink. It may not be easy or possible to predict in advance the actual changes in the composition of the trade balance, and those changes might even be harmful in the longer term, but they would nonetheless occur.

By the way, any country that engages in any form of industrial policy must, at the very least, believe that my first objection to the argument above is correct, otherwise industrial policy aimed at altering the mix and structure of industrial activity would simply be a waste of time. I would also add that the none other than one of my great heroes, Alexander Hamilton, understood this very well when he designed the policies – especially in his 1791 Report on the Manufacturers – that virtually created the US as a manufacturing power and which were subsequently copied, very explicitly, by Germany after 1870 and Japan shortly thereafter. This is from the first paragraphs of his Report:

The expediency of encouraging manufactures in the United States, which was not long since deemed very questionable, appears at this time to be pretty generally admitted. The embarrassments, which have obstructed the progress of our external trade, have led to serious reflections on the necessity of enlarging the sphere of our domestic commerce: the restrictive regulations, which in foreign markets abridge the vent of the increasing surplus of our Agricultural produce, serve to beget an earnest desire, that a more extensive demand for that surplus may be created at home: And the complete success, which has rewarded manufacturing enterprise, in some valuable branches, conspiring with the promising symptoms, which attend some less mature essays, in others, justify a hope, that the obstacles to the growth of this species of industry are less formidable than they were apprehended to be, and that it is not difficult to find, in its further extension, a full indemnification for any external disadvantages, which are or may be experienced, as well as an accession of resources, favorable to national independence and safety.

My second reason for arguing against the claim – that trade and macroeconomic policies can’t affect the trade balance because China produces things the US won’t – is that both the US trade deficit and the Asian trade surplus have grown sharply in the past decade. Unless we make the argument that rising US asset prices caused US households significantly to increase their purchases only of things that Americans never made before, it is hard for me to see how this could have happened without some process in which US producers of those goods were replaced by foreign producers of those goods.

And if this only happened in the past ten years, I find it hard to be believe that this process of foreign producers replacing US producers is irreversible (I don’t even bring up the impact of Chinese textile producers in recent years on the southern European textile industry). Could it really be true that the decline of the US car industry or parts of the steel and chemical industries reflects refusal by Americans to continue their production, and so is irreversible? Can it be true that this process was not speeded up by specific policies affecting the car, steel or chemical industries in the exporting countries? On a related point, the Chinese government has recently announced that China plans to build a domestic competitor to Airbus and Boeing, but if the trade balance was simply a function of China making things that the US or Europe are no longer willing or able to make, wouldn’t this whole airplane-manufacturing strategy be a complete waste of time and likely to have zero impact on Chinese purchases of foreign airplanes?

Notice I am leaving aside the issue of whether or not it is in the US long-term interest to continue manufacturing things that can easily be manufactured in much less developed countries. I happen to believe that the future of the US, and indeed its great strength, is the fact that it is at the forefront of technological innovation and that it always skips forward to higher levels of productivity, and perhaps there is enough of a social Darwinist in me to wonder if the pressure placed on the US by industrial policies in less advanced countries might, while causing undeniable pain in the short term, actually speed up this brutally innovating process. That, however, is more of a normative judgment (I think I am using the word “normative” very loosely) than a statement of fact.

My third reason for disagreeing against the argument that the US can’t make the stuff it imports from China, so trade policies are irrelevant, is that the hidden assumption in this argument is that trade balances can only change at the bilateral level. But of course this is not true. If US policies or conditions cause a contraction of net demand, and Chinese policies or conditions cause a contraction of net supply, that doesn’t mean that Americans will start producing domestically things that China used to produce and sell to the US.

What is more likely to happen is that the trade accounts of several countries at different stages of productivity and technology will all adjust, so that US producers of high-tech product A end up taking domestic market share away from producers in a slightly less advanced economy, whose producers of slightly-less-high-tech product B then take market share away from an even less technologically advanced economy, and so on down the chain to China. Given the complexity of international trade relations, any significant change in trade conditions or policies is likely to lead to a whole series of shifts among many different countries.

So far it may seem like I am making a case for trade protection, but I assuredly am not. I strongly believe that the US, and most other countries, generally benefit from open trade, and that it is in the best interests of the US, Europe, Japan and China to understand and work out those benefits within a stable institutional framework, but I also think the ease with which people who oppose trade protection make muddled or easily refutable arguments does no good to their position. In my opinion policies do matter to trade, and if we reject those policies it should not be on the specious grounds that they will have no impact.

But to turn from the airy world of abstractions to the real world, what is happening in the world of trade? Today’s Xinhua has an article urging Argentina to lift recently-imposed trade restrictions on Chinese goods.

Chinese business circles are deeply worried about the protectionist measures against Chinese products that the Argentine government has taken, a senior diplomat at the Chinese Embassy said in an interview published in La Nacion newspaper Sunday. “These import measures are discriminatory,” said Yang Shidi, economic and commercial counselor of the Chinese Embassy in Argentina.

The measures that Argentina has adopted since 2008 have affected many Chinese products and run contrary to the memorandum of understanding signed by China and Argentina in 2004, in which the Argentine side recognized China’s market economy status, Yang said. Argentina calculated the dumping margin for the Chinese products on the basis of the prices of a third country, he said.

“It is not fair,” because the costs of raw materials and manpower as well as productivity in China are different from those of other countries, Yang said. He stressed that a World Trade Organization member must respect related rules and regulations while introducing measures to protect its own trade. China stood firm against trade protectionism and urged to solve trade frictions through international consultation and cooperation, Yang said.

I checked out the original article in La Nacion and then wrote to an old Argentine banking friend of mine to ask what he thought about the article. He sent me the email equivalent of a grimace and said something unprintable about China’s standing firm against trade protection. I suspect that given the wide-spread perceptions, whether fair or not, of forceful Chinese intervention in trade matters, it probably doesn’t help China’s case to lecture too smugly against the evils of protection. From my friend’s reaction, and many, many conversations I have had and emails I have received, I am willing to bet that these lectures mostly just infuriate people.

There’s more, and bigger, on the trade front. Japan posted its first monthly current account deficit in 13 years (since January 1996) and its largest since the data first became available nearly 25 years ago. The deficit was $11.3 billion, with the merchandise deficit totaling $8.7 billion – largely on the back of a whopping 46.3% drop in exports (imports were down a very scary 31.7%).

These extreme conditions, not just in Japan but throughout Asia, are not going uncontested. Bloomberg today had another very worrying article about the response of Asian central banks:

Asian central banks are abandoning a six-month campaign of defending their currencies, reversing course to cheapen exports that are falling the most in a decade. Policy makers from India to Malaysia to Taiwan are letting their currencies depreciate after South Korea gave companies an edge by allowing the won to weaken 19 percent against the dollar this year. Shipments from South Korea, Indonesia, Taiwan and Malaysia fell 17 percent in January to $79 billion, twice the drop of April 1998, when the Asian financial crisis was wiping out a third of the region’s economy, according to data compiled by Bloomberg.

It seems that we may be on the brink of a series of competitive devaluations, and it’s no good for all us rational people to agree that competitive devaluations are useless. They are only useless in the aggregate, but individually it will be very difficult for policymakers to continue withstanding the pressure for more depreciation.

If we see a lot more weakness in Asian currencies, and a partial reversal of the trend so far in which other Asian countries have had to absorb far more of the global contraction in demand than China, I wonder how significant the pressure will be on China to allow some depreciation. My guess is that policymakers will hold off on devaluation pressure as much as they can while using every other means to achieve a similar effect – via subsidized labor, credit, and other costs to manufacturers – but ultimately the howling of the export sector is likely only to increase.

But not everybody is as pessimistic about trade as I am. Daniel Ikenson, at the Cato Institute, had an Op-Ed piece in today’s South China Morning Post arguing that fears of trade protection are seriously overstated.

Yes, India did recently raise tariffs and place other restrictions on some imported steel products, and Ecuador raised tariffs by 5 per cent to 20 per cent on 940 different products. There have been similar actions in other countries and more are likely in the months ahead. But that kind of “backsliding” is permitted under World Trade Organisation rules. The WTO affords some flexibility to governments to occasionally indulge protectionist pressures, which allows the system to bend rather than break. The risk of such measures causing a perceptible drop in global trade flows is remote.

According to recent estimates from the International Food Policy Research Institute, if all WTO members raised all tariffs to their maximum allowable rates, the value of global trade would fall by 7.7 per cent over five years. That’s a substantial decline from the 5.5 per cent yearly rate of growth during this decade, and would be quite painful.

But, to put matters in perspective, global trade plummeted 66 per cent during the protectionist pandemic in the first half of the 1930s. The absence of rules in the 1930s meant that there were no proffered courses of action, no sources of adjudication or remediation, and no limits to the actions governments could take in response to external economic policies. Today, we have rules and respected institutions that have worked reasonably well to ensure the integrity of the trading system. Nearly 400 disputes have been resolved successfully during the 14-year history of the WTO, and there have been no trade wars.

In the 1930s, there were far fewer domestic constituencies advocating against protectionism. Today, there are burgeoning interests in a diversity of countries who favour lower tariffs because their livelihoods depend on access to imported raw materials, components and capital equipment. The fact that most WTO members’ tariffs are well below their maximum allowable rates suggests that something besides the rules compels openness to trade.

He may be right, of course, but I am not comfortable with comparisons between the relatively benign trade environment of the recent past and that of the 1930s. The recent past should be compared with the 1920s, when the trade environment was also relatively benign, but it changed sharply as unemployment rose and net demand contracted. We need to wait to see if this happens again.

By the way, while on the subject of trade, there are big rumors that February’s trade surplus has collapsed to $7 billion. If this is true (and these sorts of rumors often are), it would broadly be a very good thing, I think, and would certainly relieve trade friction pressure, but the real trick will be to see why it declined. One suggestion making the rounds: China has significantly increased its import of commodities to rebuild commodity stockpiles. That would be a less-than-good reason for a drop in net exports. Let’s see what the number is.

Meanwhile whereas many people are happily celebrating the “recovery” of the Chinese economy, I continue to be extremely skeptical and worry that whatever short term boost we have recently seen may be coming at the cost of a reduced ability to engineer expansion later (and to tell the truth I am not really sure what that boost was, since it seems to me that the best and most widely celebrated “indicator” of economic recovery has been that the contraction implied by PMI was less in January than in November and December – a weird indicator of recovery). I increasingly think Nick Lardy was remarkably prescient when he argued that the hard-landing/soft-landing debate (was it two years ago?) had it all wrong – what we were going to see is a long landing.

For example the steel industry isn’t looking all that good. On Friday Bloomberg published an article which began:

Baosteel Group Corp., China’s largest steelmaker, said prices are close to its production costs, indicating that the country hasn’t had a “real” demand recovery. Baosteel is “cautious” about the demand outlook, Wang Jing, the company’s general manager for international trading, said in an interview in Beijing, while attending the National People’s Congress.

Benchmark steel prices in China jumped 46 percent between November and February on optimism that the government’s 4 trillion yuan ($585 billion) stimulus package would revive metals demand. The price recovery was because of traders replenishing inventories, Wang said today. “Demand hasn’t had a substantial recovery, but output rose faster because of higher prices,” Wang said. “Our prices are on the verge of production costs.”

Also, in spite of all the eagerness to boost consumption, it seems that old habits die hard. Last weeks’s China Daily had an article celebrating the return of thrift to China’s feckless youth:

Many Chinese are tightening their belts during the country’s economic downturn despite government efforts to boost domestic consumption and replace evaporating export orders.

Wang Hao, 24, a Beijing office worker, made a public resolution in June last year to limit his weekly living expenses to 100 yuan ($14.6 dollars). That’s the cost of eight Big Macs in China. “The financial crisis has taught a spending lesson to young people in China, including me,” said Wang.

Bizarrely enough, the article concludes with:

The frugal lifestyle seems to be endorsed by authorities. In a commentary published last week in the People’s Daily, the writer said frugality did not conflict with the government’s demand-stimulating policies, as it called for reasonable rather than reckless spending. Frugality could also help people spend their limited money on the most needed things. “The neo-frugal way of living should become a fashion, especially in the financial crisis,” said the writer Wang Jinyou.

Before closing, as if I need to extend an already too-long post, I thought I might throw in something a little bit lighter. Today’s People’s Daily has an article on the recent development model, from which I quote:

As some Western media questions why China works, the world’s economic experts and scholars are also wondering the same thing: What tools China has to keep its economy resilient and why it is well-positioned to weather the financial crisis?

The answer lies in the nation’s unique growth mode featuring a “scientific outlook on development.” Over the three decades of reform and opening-up, China has evolved its own growth mode that aims to achieve development through scientific approaches based upon China’s national conditions and the international situation, analysts said.

The essence of such a growth mode is to seek a balance between development, stability, equity and clean environment, they said.

3 Responses to "Yes, trade policies do matter"

  1. phil   March 9, 2009 at 9:29 pm

    America’s loss of comparative advantage is the result of years of American policy made by experienced, qualified idiots, AND on the other side of the equation, the policy made by pragmatic deceitful chinks.

  2. Pete Murphy   March 10, 2009 at 7:07 am

    Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the wealthiest nation on earth – its preeminent industrial power – into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It’s a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9.1 trillion. What will happen when those assets are depleted? Today’s recession is the answer.Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.Clearly, there is something amiss with “free trade.” The concept of free trade is rooted in Ricardo’s principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn’t consider?At this point, I should introduce myself. I am author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world’s population.Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at or where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It’s also available at forgive me for the somewhat spammish nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.Pete MurphyAuthor, “Five Short Blasts”