Key Trends in the World Economy

Paul Krugman's economic illogicalities on China

One of the strangest, because most illogical, economic campaigns currently being waged is that by Paul Krugman calling for selective tariffs against China. It is ‘strange’ because Paul Krugman is self-evidently a highly sophisticated and trained economist who, on this issue, uses arguments he would not allow to let pass in another context. It is ‘illogical’ because its arguments are not valid even in the terms in which Paul Krugman puts them forward. It is therefore worth briefly dealing with both aspects.

First, regarding arguments that Paul Krugman would not let through in another context, he makes claims that are simply not factually true. For example, talking about China’s balance of payments, including service and investment income as well as trade, in his New York Times column he claimed that ‘the International Monetary Fund expects China to have a 2010 current surplus of more than $450 billion.’

No source is given, which is not responsible regarding such a claim, but if any IMF statistician had by chance made such an assertion it is quite inaccurate – as Paul Krugman could have verified by checking the figures.

Once China’s balance on services and income is included, and the standard statistical correction for freight and insurance made, China’s annual balance of payments surplus is about $120 billion over its unadjusted trade surplus - calculated from the IMF’s International Financial Statistics. The latter was $198 billion in 2009 and falling – in the 12 months to August 2010 it was $170 billion. Therefore, there is no way China’s balance of payment surplus will reach anything approaching $450 billion this year.

Second, Paul Krugman makes no attempt to prove that China’s exports and imports are price elastic – that is that the increase in price of exports, and the fall in price of imports, will be more than offset by a decreased volume of exports and an increased volume of imports. There has been another post here on that issue, dealing with the economically correct comments made by Joseph Stilglitz, so these arguments will not be repeated here – readers are referred to the previous article.

Third, and most illogically of all, Paul Krugman’s arguments in favour of protectionism in fact don’t apply to his call for specific tariffs against China.

Regarding protectionism Krugman attempts to justify his position in the following way:

“If you think in terms of slogans like 'free trade good; protectionism evil', you find it outrageous that a credentialed economist might actually consider trade sanctions on China justified. Sacrilege!

“If you think in terms of models, however, you know that the case for free trade is profound, but also conditional: it depends, among other things, on having sufficient policy levers to achieve more or less full employment simultaneously with free trade. Without that, the picture is very different. As Paul Samuelson wrote long ago,

“With employment less than full and Net National Product suboptimal, all the debunked mercantilist arguments turn out to be valid.

“So what I’ve been saying about China comes out of the same model I’ve been using to make sense of our broader economic problem.”

Actually, there are there are very strong and well known arguments against generalised protectionism and mercantilism – by reducing division of labour and economies of scale it reduces productivity and profitability, and therefore standard of living and employment. But Krugman’s quotation, which is from (Samuelson, 1964), is in any case quite irrelevant to the issues he is discussing. Krugman is not presenting the case for generalised protectionism – i.e. imposition of tariffs against all countries on specific or all imports. He is calling for selective tariffs against China.

For selective tariffs against China to have a beneficial effect on US employment, or other desirable US goals, it has to be shown, not only that the general negative effect in raising costs are outweighed but that imports from China would not be replaced by imports from other countries. The latter point is the difference between specific tariffs against China, which Krugman is advocating, and generalised protectionism which is what the Samuelson quote deals with. In overall protectionism, as the tariff is general, of course imports from China could not be replaced by imports from another country that were not subject to the tariff. This does not apply to a specific tariff against China.

Not accidentally Paul Krugman makes no attempt to prove that imports from China subject to a specific tariff would not be replaced by imports from another country not subject to the tariff. The reason he doesn’t attempt to prove it is because it is clearly not true. The U.S. does not produce, nor could it profitably produce, goods that it imports from China as opposed to more cheaply importing them from elsewhere. If tariffs were imposed on China, similar low-priced products would be imported from Mexico, India, Bangla Desh, Vietnam etc. They would not be produced in the US. No jobs would be created in the U.S., as US workers cannot be hired for the wages paid in China, India, Mexico or Vietnam – which is why production took place elsewhere in these industries in the first place.

A trade war would actually lead to net loss of US jobs. In addition to the overall negative cost consequences of replacing cheaper Chinese goods with (probably marginally) more expensive goods from Mexico, Vietnam etc any country facing trade sanctions inevitably retaliates – not to do so would invite further sanctions. And China would evidently not take action against, for example, non-existent US cheap toy manufacturers, but against sectors where the U.S. is competitive – farm products and high-tech.

The U.S., therefore, would not gain any jobs by blocking Chinese imports – these jobs would go to Mexico, India, Bangla Desh or Vietnam – and would lose jobs in farming, high tech and other competitive industries. The net result would be less US jobs and not more.

Only if Paul Krugman were proposing generalised protectionism would his arguments, for example those produced in the quotation from Samuelson, be applicable – and then, of course, quite different arguments on the benefits of international division of labour and economies of scale would apply against them. But to deploy arguments in favour of generalised protectionism in favour of a selective tariff is incoherent in economic terms.

Paul Krugman is evidently a powerful critic, as this blog has underlined, of attempts to oppose fiscal stimuli in the US with arguments, shown to be factually false, that such a deficit would lead to rising US interest rates. He is correct that the US requires a further stimulus package – one which should be directed at raising investment. But his arguments on China are regretably neither economically nor logically coherent and should therefore be abandoned. He should be concentrating on the real problems, which lie inside the US economy itself, and not in its relations with China.

 

Notes

Joseph Stiglitz hits the nail on the head regarding China’s exchange rate

Nobel prize winner Joseph Stiglitz hit the nail right on the head regarding the economically invalid character of most arguments presented in favour of RMB revaluation in a video on the Wall Street Journal site on 9 October. He said: “Changes in the exchange rate can actually increase imbalances. The reason is that if the demand elasticities for Chinese goods are relatively low, then when the exchange rate increases the quantity goes down less than the price goes up.  And US spending actually goes up. So the net increase could be an increase in the trade imbalances. So the notion that this is a panacea is clearly wrong.”

Exactly and put beautifully succinctly. To explain the point at rather greater length, less gracefully and in more detail, we would cite this blog on 15 June: “The RMB’s exchange rate is clearly an issue deserving the most precise economic analysis given that it involves the world’s largest exporter, China, and the world’s largest economy, the US. It might therefore seem surprising that a frequent feature of calls for early RMB revaluation are attempts to justify this through what are in a quite literal sense economic 'non sequiturs' - non-sequitur being Latin for ‘it does not follow’.

“Such arguments consist of two sentences. ‘China runs a trade surplus. Therefore to eliminate it China should increase the exchange rate of the RMB.’

“Unfortunately elementary economic reflection will show that the second sentence does not necessarily follow from the first. Consideration of supply and demand reminds us that an increase in the exchange rate of the RMB will only reduce China’s export earnings if demand for China’s exports is elastic – that is any percentage fall in sales is greater than any percentage rise in price resulting from revaluation. Equally China’s imports in value terms will only rise if any increase in their volume is greater than any fall in their price due to revaluation.

“The question of whether China's trade surplus will fall or rise in response to RMB revaluation is therefore a matter of fact, not of logic, which therefore has to be examined empirically - as the paper below notes. It quite simply does not follow that an increase in China’s exchange rate will logically necessarily lead to a fall in China’s trade surplus. Indeed it is quite possible logically, for example if demand for China’s exports is inelastic, and the volume of its imports is not particularly price sensitive, that a rise in the RMB’s exchange rate will lead to an increase in China’s trade surplus.

“Given the seriousness of the issue one would have thought that if this matter were being dealt with objectively the US administration would have produced a mountain of material to justify its claim that an increase in the RMB’s exchange rate would lead to a fall in China’s trade surplus - China has certainly produced abundant data, including directly by the Commerce Minister, showing the opposite. But no such material has been forthcoming from the US administration. Instead there is the intoning of a literal non-sequitur.

“The reason evidence has not been produced by either the US administration or by those in agreement with it is that at least as regards the immediate and medium term economic situation their argument is factually false. As is shown in the paper below an increase in the RMB’s exchange rate would immediately lead to an increase in China’s trade surplus and not to a fall – and this is one of the last things which the world requires while attempting to emerge from the international financial crisis.“

For those who read Chinese the article is available in the May edition of International Finance and for details of the factual material readers are referred to the original post. However to show the crucial point, one chart from the original article is reproduced here. This clearly shows that from 2005-2008 as the RMB’s exchange rate went up China’s balance of payments increased - driven by the trade surplus. This is exactly what would happen under conditions of inelasticity of demand for China’s exports and imports and the exact opposite of what would occur if demand for China’s exports and imports were elastic. In short, as the claim that China’s trade surplus would go down in response to an increase in the RMB’s exchange rate depends on demand for China’s exports and imports being elastic the evidence is that this is simply not true - for why they are not elastic readers are referred to the original article.

Figure 1

 

A student of economics learns in roughly week two of that course that what happens in response to an increase in price (in this case an increase due to a rise in the RMB’s exchange rate) depends on whether demand is elastic or inelastic. If demand is inelastic then the amount spent on the good goes up and not down.

That those calling for RMB revaluation are forced to 'ignore' such an elementary point in economics, which they assert with no proof and with the evidence being against, shows their arguments are not coherent. To demonstrate that China’s trade surplus would decrease with RMB revaluation they have to prove that demand for China’s exports and imports is elastic. The don’t do so because the evidence is the opposite. That is why claims are made that someone studying economics for two weeks would know have to be factually justified and are not being – that is, there is a logical hole right in the middle of the argument.

As an economist of Stigltz’s standing has now made the point one might hope that those promoting RMB revaluation as a way to reduce China’s trade surplus would feel forced to attempt to factually justify their arguments instead of merely repeating their economic non-sequitur. Unfortunately, as a large number appear more interested in prejudice than either serious economic argument or dealing with the very serious and real issue of global economic imbalances this is not necessarily going to happen.

Keynes famously wrote: ‘I am sure that the power of vested interest is vastly exaggerated compared with the gradual encroachment of ideas.’ (Keynes, 1936, p. 383) But by ‘gradual’ Keynes precisely acknowledged that this was a long-term process. Nevertheless the fact that an economist of Stiglitz’s standing has made the central point clearly and bluntly may, in a ‘gradual’ way, help put a stop to a campaign based on an economic non-sequitur and instead get down to a serious discussion on a very serious topic – i.e. how to correct current global imbalances.

Addition

A reader has pointed out that the graph reproduced from the original post showed China's balance of payments surplus plotted against its exchange rate - this was used in the original article as it was analysing the full international effect of China's surplus. They asked what about China's trade surplus plotted against the RMB exchange rate, to isolate the specific effect of the exchange rate on trade?

This is shown in the graph below. As may be seen the trend is exactly the same - China's trade surplus went up as its exchange rate went up.The only difference is that at the beginning of the period China had a -0.1% of GDP deficit on income from abroad and by the end of the period it had a 0.7% of GDP surplus, but there is no difference in trend.

 

Notes

Deming, C. (2010, March 31). The Surplus of Promise. Retrieved October 11, 2010, from China Daily: http://www.chinadaily.com.cn/opinion/2010-03/31/content_9665632.htm

Keynes, J. M. (1936). The General Theory of Employment, Interest and Money (Macmillan 1983 ed.). London: Macmillan.

Ross, J. (2010, June 15). The Real Consequences for the International Economy of an Early Increase in the RMB's Exchange Rate. Retrieved October 11, 2010, from Key Trends in Globalisation: http://ablog.typepad.com/keytrendsinglobalisation/2010/06/the-real-consequences-for-the-international-economy-of-an-early-increase-in-the-rmbs-exchange-rate.html

Stiglitz, J. (2010, October 9). Economist Joseph Stiglitz's Take on China. Retrieved October 10, 2010, from Wall Street Journal: http://professional.wsj.com/video/economist-joseph-stiglitz-take-on-china/C3577DCF-EA87-4F29-883E-471C27AB65BE.html?mg=reno-wsj