Buy American: Is There a Trade-off Between Free Trade and Full Employment?

Paul Krugman gets partial credit for expounding on an argument made by Dani Rodrik (here and here):

The economic case against protectionism is that it distorts incentives: each country produces goods in which it has a comparative disadvantage, and consumes too little of imported goods. And under normal conditions that’s the end of the story. But these are not normal conditions. We’re in the midst of a global slump, with governments everywhere having trouble coming up with an effective response ... how would this change if each country adopted protectionist measures that “contained” the effects of fiscal expansion within its domestic economy? Then everyone would adopt a more expansionary policy — and the world would get closer to full employment than it would have otherwise. Yes, trade would be more distorted, which is a cost; but the distortion caused by a severely underemployed world economy would be reduced. And as the late James Tobin liked to say, it takes a lot of Harberger triangles to fill an Okun gap.

As we noted, Dani was assuming a fixed exchange rate model. I suspect Paul is also assuming a fixed exchange rate model:

And one part of the problem facing the world is that there are major policy externalities. My fiscal stimulus helps your economy, by increasing your exports — but you don’t share in my addition to government debt.

We also noted that Nick Rowe considered the implications of floating exchange rates:

Nick’s floating exchange rate version of the model, however, has the exchange rate automatically adjust such that the ultimate change in net exports is zero. In this case, the multiplier for fiscal policy is 5 and the multiplier for mercantilist policy is zero. In other words, a $200 increase in government purchases still achieves the goal of increasing real GDP by $1000. Lesson learned – floating exchange rates can achieve the same goal as Dani’s mercantilism. There is one difference, however, between the two approaches. Mercantilism often works by protecting the import competing sector. Under floating exchange rates, we are more likely to see increased employment in the export sector.

Let’s expound on this in three ways. First of all – the choice between floating v. fixed exchange rates plus protection (as we noted earlier) comes down to whether one wants the benefits of fiscal stimulus to accrue partly to the export sector v. whether one wants a lot of the benefits to accrue to sectors such as the steel industry. A lot of economists who argue against the Buy American provisions on the grounds of efficiency are implicitly favoring the export sector over the import competing sectors.

Secondly, some rightwing pundits fear that a dollar devaluation will prove inflationary. I think most economists would argue that the kind of real devaluation that Nick is referring to will have only a modest impact on the overall price index. Besides, the Federal Reserve seems to be more afraid of deflation that a little inflation.

The third point comes from several of the comments surrounding Nick’s contribution – that being that we may be in a Bretton Woods II era if the Chinese government maintains a fixed exchange rate. In other words, the lessons learned from Dani’s and Paul’s fixed exchange rate model are not as easily dismissed as applying to the current situation. Paul noted that if we had better international coordination of macroeconomic and exchange rate policies, we might not need protectionism. Alas, such coordination does not seem to be on the horizon.

Update: Nick Rowe adds more to this debate.