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.