Scott Sumner  

Why the new old Keynesians are wrong about trade

The Huemer-Caplan Exchange... Johnson Bet...

Ramesh Ponnuru directed me to a Greg Ip article, discussing the strange new fascination with protectionism within the Keynesian community. A few decades ago the "dark underworld" of Keynes's General Theory had gone out of favor. Economists still accepted "Keynesian" models such as IS-LM, but no longer put much weight on ideas like the paradox of thrift, or the theory that protectionism can create jobs. With the return of near-zero interest rates, there is renewed interest in some of these old Keynesian ideas. In my view that's a mistake.

If workers lose their jobs to imports and central banks can't bolster domestic spending enough to re-employ them, a country may be worse off, and keeping those imports out can make it better off.

This occurs only in certain conditions, says a new paper by Harvard University's Larry Summers and two co-authors, but those conditions may now be present.

In fairness, Summers himself is not a protectionist:

Mr. Summers, a former Treasury secretary, is no protectionist and no fan of Mr. Trump, whose election, he warns, could lead to recession in the U.S. and financial crisis abroad. But he does worry that chronically weak demand could make protectionism both respectable and irresistible.

Others, such as New York Times columnist Paul Krugman and Michael Pettis at Peking University have already noted how in a world with too little demand, one country's trade surplus inflicts unemployment on the country with a deficit.

One argument against this view is based on monetary offset, which I have previously discussed in this blog. Contrary to Summers, the condition he describes (interest rates at the lower bound) is not applicable to the US. The Fed has set interest rates at 0.5%, and the lower bound is probably around negative 0.75%. So the Fed could cut rates 5 times if they wished. Instead, they Fed is more likely to raise rates next, as it is worried about the economy overheating. (And it would certainly raise rates if tariffs pushed up inflation.) Summers may not share the Fed's worry about inflation, nor do I. But it doesn't matter what he or I think, all that matters (for monetary offset) is what the Fed thinks.

But it's even worse. The old Keynesian liquidity trap model is wrong even at the zero lower bound, and even where monetary offset does not apply. And that's because Keynesians forget two key facts:

1. The supply side also matters
2. Supply and demand shocks can be entangled at the lower bound on rates.

If the world moves toward protectionism, it will almost certainly reduce business confidence and reduce investment. There will be a decline in what Keynes called "animal spirits" And this is not just a hypothesis---an almost perfect example occurred during the Great Depression, with the debate over Smoot-Hawley, and then its passage in late June, 1930. During the first 4 months of 1930, US stocks did pretty well, recovering a good bit of the ground lost in the October 1929 crash. As the Smoot-Hawley bill moved closer to passage, US stock and commodity prices fell significantly. Hoover thought about whether or not he should veto the bill, and then on a Sunday announced he would sign it. The next day stocks plunged by 6%, the biggest single day loss of the year. Commodity prices also fell sharply throughout late June. Foreign countries announced retaliation. During the second half of 1930 the Depression intensified significantly.

Smoot-Hawley reduced aggregate supply and this reduced what's called the Wicksellian equilibrium (or natural) interest rates. In the Keynesian model, a fall in the natural rate of interest (at the zero bound) is contractionary, as it leads to tighter monetary policy. That's why commodity prices fell in response to Smoot-Hawley. Normally, supply shocks are inflationary. But at the zero bound supply and demand shocks become entangled, and falling AS leads to falling AD. So even if you are one of those "AD is all that matters" extreme Keynesians, protectionism is a fool's game, even when monetary offset is not in play.

Smoot-Hawley was a disaster for the global economy. I won't say that Brexit is a disaster for the UK, but all indications are that it will lead to lower growth, despite the BoE's recent rate cut. I am very discouraged by all the recent revisionism on trade, both in terms of the impact of specific countries, such as China, and the impact of overall trade deficits. Trade imbalances do not cost jobs. Not in theory, and not in practice. The economics profession is making exactly the same mistakes that we made in the 1930s, wrongly assuming that "everything's different" at the zero bound. Not so, policies that create inefficiency and destroy wealth are harmful at all times, not just at full employment.

Greg Ip's article does a good job of presenting both sides of the argument, and ends up with some strong arguments against protectionism, including this one:

Most models that conclude trade agreements make countries richer assume full employment in the long run. In the short run, though, some workers do go jobless and lose a lot of income. Yet Robert Lawrence and Tyler Moran, in a paper for the Peterson Institute for International Economics, find the short-run costs of higher unemployment and lost wages from TPP amount to just 6% of its benefits during the first 10 years. Brandeis University trade economist Peter Petri finds that once retaliation ‚Äčis factored in, Mr. Trump's protectionist policies would lead to a larger, not smaller, U.S. trade deficit.

COMMENTS (14 to date)
ThaomasH writes:

I agree with Summers, we should be investing in infrastructure, not keeping out imports, but the key thing about is not whether the Fed could offset an increases in demand that might come from import restrictions, but would it? The Fed COULD increase rates enough to make additional investment in infrastructure fail an NPV test, but WOULD it?

bill writes:

Question on the effect of Brexit. Should it reduce future growth or should there be a significant initial drop and then similar or reduced growth from there? ie, opening up one's markets should lead to faster growth. But I question if closing markets has the exact inverse mechanism.

dbeach writes:

Would the Fed really raise rates to fight inflation in response to a (presumably one-time) increase in the price level caused by hikes in import tariffs? That seems like exactly the sort of thing the Fed should ignore. Tightening in response to a supply shock would just risk causing a recession.

B Cole writes:

Global free trade is orthodoxy, that is true.

But does global free trade and immigration benefit the middle class of developed nations given current structural impediments and central-banking predilections?

Why are the Australians and the Canadians implementing barriers against foreign ownership of housing?

Is it really a sensible position that open immigration from a populous poor third-world nation to a rich first-world nation will not have an impact on wages?

Then there is the strange reality that many right-wing globalists also scream constantly for tighter money. In other words, they do not want monetary offset for global trade imbalances or the reduction in wages caused by mass immigration. Sometimes vulgar Marxian analysis actually appears to have value.

What explains the popularity of Don Trump?

Anand writes:

B Cole:
About your question: "Is it really a sensible position that open immigration from a populous poor third-world nation to a rich first-world nation will not have an impact on wages?", firstly nobody is proposing completely open immigration. Secondly, if one wants to discuss "really existing immigration", see this very long literature review on economic effects of immigration on wages, among other things.

meets writes:


Have you seen Krugman's latest argument in favor of fiscal policy?

He admits we are no longer in a liquidity trap, but still argues in favor of infrastructure spending because it takes a long time to ramp up and we don't know what the macro environment will be like in the future i.e. we may be back in a liquidity trap.

It's a fiscal spending as insurance in case we return to a liquidity trap.

Seems absurd on a few levels to me.

Don Boudreaux writes:


Well done.

Another valid response to these Keynesian protectionists is even simpler - namely, there's no reason to believe that a change in domestic spending patterns that results in more dollars being spent on imports is any more likely to result in less domestic spending than is a change in domestic spending patterns the reach and effects of which are confined exclusively to the domestic economy (that is, a change that does not result in more dollars being spent on imports).

Suppose that Americans start buying more steel, plywood, and grapes from foreigners and buy less of these goods from Americans. It's possible that these foreigners will sit on (that is, neither spend nor invest) X% of the dollars they earn from their sales to Americans and, thus, cause a reduction in aggregate demand in the U.S. But the very same is true if Americans start buying more steel, plywood, and grapes from west-coast American sellers of these goods and buy less of these goods from east-coast American sellers. The west-coast American sellers of these goods might also sit on X% of their new dollar earnings.

What reason have we to suppose that a change in spending patterns that results in more imports is more likely to cause aggregate demand in the U.S. to fall than is a change in spending patterns that does not result in more imports? None that I can see. (Indeed, if someone wishes to get more full-on hydraulic Keynesian about the matter, it can be asserted that citizens of poorer countries have a higher marginal propensity to consume than do Americans and, therefore, a change in American spending patterns that results in more imports will increase aggregate demand in the U.S.!)

The bottom line is that even if it were true (as Krugman has asserted) that many of the basic laws of economics somehow stop working when there are unusually large quantities of un- and under-employed resources, a change in spending patterns that results in more imports is no more likely to reduce domestic aggregate demand than are changes in spending patterns whose reach and effects are confined exclusively to the domestic economy.

Lorenzo from Oz writes:

Nice post, ta.

Protection benefits scarce factors of production, because it protects their scarcity. Free trade benefits plentiful factors of production, because it gives them access to a wider market. (Straight Rogowski.[pdf])

More transactions mean a larger economy and cheaper goods (including for those not actively producing), so free trade is, on balance, better overall. But there are still losers.

The deeper issue is how well a society's social bargaining manages that awkward fact. Currently, in a lot (but not all) Western societies, not so well. That seems to me to be a more crucial issue than going "open good/closed bad", as that doesn't get us far if social bargaining remains somewhat broken. In fact, it may make things worse if one then just uses it is an argument boo! folk who are inclined to the closed side of a particular issue.

(Which is to say, I was rather less impressed with The Economist's recent piece on open v closed than you were.)

James Alexander writes:

Almost excellent post. Supply side matters at all times.

Brexit may end up protectionist, but it is not meant to be. Almost the opposite - except for free movement. If it was only free movement of labour it would be OK, but cradle-to-grave, "free" healthcare, housing, education, welfare states make this a challenge.

Then the straw that broke the camel's back was movement of non-EU migrants invited into the EU by one country in particular, Germany. The economics and the politics of "refugees welcome" we're disastrous even if the sentiment was laudable.

Scott Sumner writes:

Bill, I think it's symmetrical.

dbeach, It's not the supply side effects I am focusing on here, those are contractionary. I agree that they might not offset those. I'm focussing on the claim that trade protection would boost AD. They most certainly would try to offset any positive AD shock.

Ben, You asked:

"But does global free trade and immigration benefit the middle class of developed nations given current structural impediments and central-banking predilections?"


Meets, I agree, that's a really weak argument. The Keynesians insist that it's not the level of G that matters for fiscal stimulus, it's the change. So if the level is higher during an expansion, it will be that much harder to boost the level during a recession. I realize he would claim that it puts sand under the tires of monetary policy, but I doubt this effect is strong enough to offset the inability to boost G as much.

Don, That's sounds right to me, but I have to think about it a bit more. They must have some sort of "model" that provides their result. I presume it's based on the assumption that the trade surplus countries are somehow boosting global saving and reducing global AD. But I'm dubious of those models. Their models also tend to rule out currency depreciation as an offset to any aggregate demand effects from trade deficits, which is a highly unrealistic assumption.

Lorenzo, Here's a question to think about. Why doesn't the US Federal government have a special program to help American workers hurt by intra-American trade. Say the Massachusetts shoe and clothing workers who lost jobs to southern competitors a few decades back?

Also, what about a program to help those who lose their jobs to automation (a much more numerous group than those who lose their jobs to imports)?

When you start to think about things this way, you quickly realize that these debates aren't quite what they seem to be. There are other issues lurking in the background, including unawareness of Ricardian trade theory, and a natural distrust of foreigners. It's obvious that many voters upset about imports don't know that the issue is essentially identical to automation. They think the country as a whole is being hurt by imports, but helped by automation.

James, You said:

"Brexit may end up protectionist, but it is not meant to be."

I guess "meant" is open to interpretation, given that this piece of legislation had 17 million co-sponsors.

James Alexander writes:

Fair point. I didn't know about these guys before the referendum but they do argue well for highly realistic, pro-free trade, Brexit plans - and they seem to be gaining influence.

As usual with us modern Libertarians, you and I are uncomfortable discussing the challenge of free movement versus the itinerant poor. Classical Liberals passed the Poor Law Amendment Act of 1834 to cope. It worked pretty well for nearly a century. The US until much more recently was still run in the same spirit. Massive population booms in Central Asia and Africa thanks to modern medicine and nutrition has given rise to a similar problem. What to do?

The Arthurian writes:

Sumner: "...the theory that protectionism can create jobs."

Keynes did not say that protectionism creates jobs. He said free trade just pushes unemployment onto the nation that is worsted in the struggle.

Keynes was telling nations that they need to achieve full employment, each on their own. In other words, if you can't solve your unemployment problem in your own nation, you're not going to solve it by merging nations into a superstate.

Lorenzo from Oz writes:

Scott: there's a touch of the autism of economics in your response. The answer is not yet more special programs, but it might be to have a good hard look at ways governments are inhibiting responses to change and abilities to cope with change. Or whether other concerns might be better addressed. There are few things more socially corrosive than the feeling of being comprehensively ignored.

To its credit, the Obama Administration has pointed the way in at least this case.

Lorenzo from Oz writes:

Also, free trade does not seem to have been the issue. A recent poll found that 73% of Brits favoured free trade with Europe, it was whether there should also be free movement of people where there was much more resistance.

Comments for this entry have been closed
Return to top