Monday, July 4, 2016

Trade and Jobs and Fallacies of Composition

Paul Krugman (partly) takes on David Autor and his coauthors (co-Autors?), who found large impacts of net imports from China on manufacturing jobs in the US during the period leading up to the 2008 financial crisis.  Krugman takes the position that, in theory, any loss of employment through the trade channel can be offset by more expansionary monetary and fiscal policy, so that trade deficits per se are not consequential (in this respect).  He notes that policy was not expansive enough during the heyday of the China deficit, so there was an employment impact, but smaller than the one estimated by Autor et al., who don’t take into account policy spillovers.

Dean Baker takes Krugman to task for relying on unemployment rather than employment data.  If you look at the number of jobs in the economy rather than the number of jobless workers looking for work, he says, the China effect is much larger.  He also points in passing to the potential impact of trade on wages, an argument made powerfully by Dani Rodrik almost twenty years ago and not, as far as I know, rebutted.

Here I want to make a different point, that Krugman’s analysis suffers from a serious fallacy of composition of its own.  The key point has to do with the national income accounting framework used to measure trade and capital flows, the one that’s in the back of every economist’s mind (or should be) when thinking about issues like this.

Trade is the main component of the current account and measured as net exports or imports.  It’s a component of GDP, which is linked to employment through an Okun’s Law mechanism, but, as Krugman points out, policy makers have the ability, at least in part, to offset fluctuations in NX with policies to alter government spending, taxes (and therefore consumption) and investment (via interest rates).  So far, so good.  But here’s the thing: assuming no changes in the holdings of currency, the balances on the current and capital account are identically the same.  (The capital account measures net inflow or outflow of capital—financial assets.)  All else being equal, the US trade deficit with China corresponds to an equal and opposite capital inflow, i.e. borrowing.

Economists are used to thinking of the national accounts as separate boxes.  You can analyze trade with China today, sleep on it, and then tomorrow you can analyze capital flows.  Much economic writing treats these items as things that require some process out there in Marketland to make them equal.  Not so, however: the accounting boxes are for mental and measurement convenience, but the two items are identical: they’re the same thing, the way a purchase and a sale are the same thing, not two different things.

When the US runs a trade deficit with China it is borrowing in some fashion to finance its net purchases.  (I realize, of course, that the trade-and-finance system works multilaterally, and that China could exchange a portion of its dollar-denominated assets for assets in other countries, with subsequent rounds of displacement effects, but I’m keeping things simple here.)  This is the same logic that we are familiar with at the individual level.  If you spend more than your income, to buy a house or car for example, you are simultaneously borrowing money to cover the difference.  You may be using an auto dealer’s trade credit, a bank’s mortgage facility, credit cards or some other device, but the financing in some form is identically what the purchase-in-excess-of-income means.  It would make no sense to analyze the purchase and treat the financing as a separate, unrelated  topic.

So back to China.  How did the US finance its humongous trade deficit with that country during the glory years of the early to mid 00's?  To a large extent, this was achieved by selling mortgage-backed securities to the Chinese.  At the peak, a quarter of Fannie Mae and Freddie Mac loans were Chinese-held, and there is no reason to believe their share of non-GSE mortgages was much different.  In other words, to purchase Chinese imports in excess of their international income (earned through exports), US consumers were building up debt, especially through mortgage finance, as a vehicle for borrowing from China.

Bottom line: the immense trade deficit during this period took the form of a housing credit bubble.  If you want to analyze the impact of unbalanced trade with China you have to look at the whole thing.  It’s reasonable to ask, what would have been the economic effect of these deficits if they had been financed differently—through larger fiscal deficits, for instance, or more corporate debt or some other channel?  It’s not clear how policy choices could have made this happen, but hypothetical counterfactuals, as Krugman noted in his blog post, are the right way to go.

The big picture, from my point of view, is that the US is a chronic deficit country and has been since the 1970s.  It has not developed an export capacity capable of generating income at a level comparable to its somewhat-full-employment import demand, but it has been very successful at generating financial assets that foreign wealth holders wish to accumulate.  (During the final phase of the housing credit bubble this foreign demand was nearly all official.)  To repeat, these are not separate events; it’s one event seen from two perspectives.  China is an important part of this story, but we can’t understand how it connects to US economic development, including employment effects, by looking only at the spending side and not the financing.


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Your broad story is correct, but you way overstate it. It is simply not correct that any trade deficit must be financed by borrowing. The usual story is that the capital account and the current account must balance, but there are other items in the current account than just the trade balance, with the US generally running a surplus on income that is pretty substantial, despite our international net debtor situation. This is because our assets abroad earn much higher returns than the stuff foreigners hold here. Anyway, right now that income surplus finances about a third of our trade deficit.

OK, so we run pretty substantial current account deficits that must be covered somehow. But in fact they are not covered by a fully offsetting capital account balance. Thus in the second quarter of 2015, selected randomly, nothing special about it I know of, the current account deficit was $ 109.7 billion while the capital account surplus was merely $ 59.7 billion. Technically an offset can be direct government transfers known as "gold flows," but those do not happen these days. Instead, the $60 billion gap is "statistical discrepancy," probably a measure of some balance in the flows of goods and money in the illegal or broader underground unreported sector, but also simply bad reporting of either or both numbers in the accounts.

So broadly you are correct that when our trade deficits rose with China so did borrowing money from China, with their purchases of long term US govt bonds helping to hold down those interest rates, which indeed helped aggravate our housing bubble. But you should be careful about absolute declarations suggesting in particular that trade balances are offset by capital flows.

Peter Dorman said...

As you can tell, Barkley, I greatly simplified for purposes of blogability. I thought my biggest bit of corner-cutting was jumping from bilateral to multilateral, but right up there is simply ignoring the other components of the current account. Yeah, I left out investment income as well as remittances etc. If I were unscrupulous I might invoke ceteris paribus, but I'll refrain. Incidentally, the statistical discrepancy is getting a lot of attention thanks in part to Gabriel Zucman's analysis of dark flows. People are looking into whether or not incorporating these flows would alter what we think we know about differential rates of return.

Sandwichman said...


You are overstating "overstate."

Bruce Wilder said...

I don't think we can close the loop here without taking note of the role of financial investment in manufacturing. The ability to manufacture rests on sunk-cost investments in organization, including factories and systems and infrastructure and networks and so on: there are potentially huge economic rents associated with successful development of manufacturing capability.

Yes, the U.S. was financing its trade deficit and housing bubble by selling financial securities to China, and . . . China was financing its investment in export-oriented manufacturing capacity.

Can we not take notice?

Autor's story -- of imports depressing domestic U.S. manufacturing employment -- is only half of a story, in which financial investment in manufacturing capacity in China is made less risky and more profitable, while the financial signals to U.S. manufacturing is in favor of disinvestment and abandonment. All driven by a housing bubble that encourages U.S. workers to try to maintain their consumption despite declining labor income with home equity loans.

Krugman is making a technical point about the proper analysis of macroeconomic effects of microeconomic developments, without acknowledging the financial dynamics. He's talking rather vaguely about monetary and fiscal response and Fed policy, without acknowledging relevant details of actual policy: the largest bubble in the history of the world, for example, or Bernanke's "savings glut" and U.S. tolerance of China's management of the exchange rate.

If we didn't like Krugman, one might almost suspect him of having reprehensible motives. But, it is conventional in economics to adopt frameworks such as the one Krugman uses here, which leave out everything that matters. So, if the financialization and globalization that made New York prosper was destroying Detroit and Akron in an exacerbation of de-industrialization, why shouldn't we obscure that with talk of smoothly substituting service jobs?

ProGrowthLiberal said...

I was about to raise the net income from abroad puzzle but Barkley raised it for me. This puzzle was dubbed "Dark Matter" over a decade ago. China has the opposite situation - something I recently called Dark Anti-Matter. Over a decade ago in my Angrybear days, I noted the two competing hypothesis of what is going on - the Dark Matter claimed that we are exporting a lot of intellectual property income versus transfer pricing manipulating the GNP accounts. I recall a rather biting critique of this stuff from Willem Buiter.

But let's say the original Dark Matter thesis were correct. We are deriving a lot of income that is income of the owners of intellectual property but are running deficits in actually making things. I suspect the distributional implications write themselves.

George H. Blackford said...

"For a country to accumulate foreign debt as it runs a persistent trade deficit is not, in itself, a bad thing. The United States followed this course throughout the nineteenth century and into the twentieth. But throughout that period we used that debt to import capital goods and foreign technology. We invested in public education and other public infrastructure that led to tremendous increases in productivity in agriculture and manufacturing. We built national railroad and telegraph systems and created steel, oil, gas, electrical, automobile, and aviation industries. Our trade policies protected our manufacturing industries as our economy grew more rapidly than our foreign debt, and as Europe squandered its resources in senseless conflicts, by the end of World War I the United States had become a net creditor nation and the economic powerhouse of the world.

"This is not the course we have followed over the past forty years. We have exported rather than imported capital goods and technology, and, in return, we borrowed to import consumer goods. We invested less rather than more in our public education, transportation, and other public infrastructure systems than other countries have invested. While we made huge advances in the electronics and computer industries over the last forty years, our trade policies have not protected our manufacturing industries, and we have outsourced the manufacturing and technological components of these industries to foreign lands. As a result, our economy is not growing more rapidly than our foreign debt, and it is the United States that is squandering its resources in senseless conflicts."

ProGrowthLiberal said...

Peter noted Zucman's contribution to the old Dark Matter debate. Here is the link of the paper I really need to catch up on:

George H. Blackford said...

"Free Trade can nowise guarantee the maintenance of industry, or of an industrial population upon any particular country, and there is no consideration, theoretic or practical, to prevent British capital from transferring itself to China, provided it can find there a cheaper or more efficient supply of labour, or even to prevent Chinese capital with Chinese labour from ousting British produce in neutral markets of the world. What applies to Great Britain applies equally to the other industrial nations which have driven their economic suckers into China. It is at least conceivable that China might so turn the tables upon the Western industrial nations, and, either by adopting their capital and organisers or, as is more probable, by substituting her own, might flood their markets with her cheaper manufactures, and REFUSING THEIR IMPORTS IN EXCHANGE MIGHT TAKE HER PAYMENT IN LIENS UPON THEIR CAPITAL, REVERSING THE EARLIER PROCESS OF INVESTMENT UNTIL SHE GRADUALLY OBTAINED FINANCIAL CONTROL OVER HER QUONDAM PATRONS AND CIVILISERS. This is no idle speculation. If China in very truth possesses those industrial and business capacities with which she is commonly accredited, and the Western Powers are able to have their will in developing her upon Western lines, it seems extremely likely that this reaction will result." Hobson,1902 And what did today’s experts think was going to happen?

It just gets curiouser and curiouser.

Random said...


Only in a fixed exchange rate system. Not in a floating rate system.

Trade deficits in the manner you describe *cannot exist* in a floating rate system. The balancing savings have to be taken *at the same time* or the import trade will run out of the right sort of money and not complete.

So a 'collapse' in an export trade necessarily eliminates imports unless the export is immediately replaced with excess savings (as it usually is, because that's what the finance system gets paid to do).

This may be directly or via a shift in the exchange rate forcing an exchange loss.

BOP crisis do not happen in the way it is traditionally described. If there are no foreigners prepared to save in your currency, then the import transaction fails due to lack of the right sort of money. There's no 'payment' as such. It just never happened in the first place.

But that also affects the exporter to your nation. Where are they then going to sell their stuff to keep their economy going?

Which is why you end up either with exporters taking less in their currency and maintaining prices in yours (an exchange loss), or doing financial manipulation to make the trade happen via the banking system (from a hard peg to soft discounting).

Essentially the 'trade balance' is a function of the accounting policy - drawing a hard political boundary around a currency zone that isn't limited to the political boundaries.

That produces a viewpoint that warps understanding.

See - Why economists fail at foreign trade:

Thornton Hall said...

I present to you my installation piece: "Nobel Prize winner can't use basic logic about subject he won Prize for and his colleagues demonstrate that correct application of logic leads to infinite correct answers when discipline lacks a systematic empirical check."

Or: The Enlightenment is Out of Gas

Jack said...

The posted comment and the resulting discussion, above, seem to deal with the effects of foreign trade imbalance. Why do these discussions not focus on the impetus for corporations to seek out localities around the globe as production sites? Why isn't the factors that result in foreign trade not the focus of attention? Does foreign trade actually occur as a result of the likely results of such trade? Do producers of products think about foreign trade balances when deciding where to locate their production facilities? It seems that some important factors in the foreign trade equation are being left out of the discussion.