Paul Krugman on Protectionism and Trade Balances: Wonkish and Wrong

Fighting off a Trump-induced melancholy, Krugman has posted a brief analysis of the expected effect of a potential across-the-board tariff.  After a few sensible observations about why a VAT is not protectionist, he continues with:

The starting point for a simple analysis of trade balances is the accounting identity, 

Current account + Capital account = 0 

where the current account is the trade balance broadly defined to include services and income from investments. The standard story then runs as follows: the capital account is determined by international differences in savings and investment opportunities, with capital inflows to countries that offer good returns. The real exchange rate then adjusts to ensure that the trade balance offsets these desired capital flows.

The rest of his argument can be distilled into these further claims:

1. The first-level effect is that, if the trade balance is fixed, a tariff will have to be offset by appreciation, restoring the pre-existing balance at a lower level of both imports and exports.

2. But reduced openness will make US financial assets less attractive, reducing net capital inflows.

3. This will put downward pressure on exchange rates, reducing the trade deficit and eventually moving the account into surplus.

4. But this would happen anyway without protectionism, since the attractiveness of a country’s capital assets depends on its expected future exports.  A trade deficit (insufficient export) requires an ever-weaker currency to attract investment (cheapening domestic assets), which sooner or later turns it into a surplus.

Says Paul, summing up: “.... trade deficits are always a temporary phenomenon, to be followed eventually by surpluses, and vice versa.”

5. The net effect of achieving the inevitable trade turnaround by protectionism rather than letting nature take its course is that it will require a greater depreciation to produce a given shift in flows under reduced openness.

Before jumping on this extraordinarily mistaken analysis, I should say in all fairness that PK himself is not to blame for it.  He is presenting in his usual limpid way the mainstream view of international macro, one you would find in almost any textbook.  He is transmitting error, not creating it.  Still, the error is there.

The starting point, as you would expect if you’ve read my previous posts (or my textbook, for that matter) is that the equation Krugman begins with is not an equation at all, but an identity.  It is not that some causal process (like exchange rate adjustment) makes the current account equal (with opposite signs) to the capital account; they are two ways of measuring the same thing.  Let’s put it in the terms Krugman does:

A trade deficit, assuming it is reflected as a current account deficit, is an inflow of savings.  If I buy a bottle of wine produced in the US, I spend a sum of money for it, and that same sum is received by other people in the US as income.  (I’m putting aside the possibility that some payments may leave the country, for instance if the winery is foreign-owned.)  Individually, I’m doing the spending and someone else is getting the revenue, but when you add it up at the national level, the expenditure from my purchase is exactly the same as the income from it.  Again, this is an identity, not an equality.  There is no process that causes one to equal the other; they are two different measures of the same transaction.

Now, suppose I go for a foreign wine instead.  Let’s say I buy it on a trip abroad, so I bypass domestic retailers.  Now an expenditure is recorded for “people in the US” but no corresponding income, just as income is recorded in the selling country but no corresponding expenditure.  There’s still an identity at the world level, but not nationally.  The immediate effect of my purchase in the US is that there has been an increase in spending without an increase in income: that is a reduction in savings, identically.  Abroad there is the opposite, an increase in savings, identically.  This is what the balance of payments identity, current account ≡ - capital account, is telling us.

What’s the point of harping on the identity?  First, an identity is instantaneous, true at each moment in time.  If A≡B it doesn’t mean that first A is what it is and then, some time later, B changes to match it.  Second, there is no process that causes B to equal A.  Processes could fail, after all, but identities can’t.  All the reasoning Krugman provides for how the current account should adjust to a balance on the capital account is not simply superfluous but wrong.  No process occurring over time can relate the two.

So to be specific:

Krugman’s premise is wrong.  The current account balance is not passively determined by the capital account balance, any more than vice versa.  They are two measures of the same thing.  The balance of payments position of a country is the outcome of all the forces acting on the choices people make that cause this balance to be what it is.  That includes micro-level decisions about what products, domestic or foreign, to purchase, portfolio decisions about which assets to hold, speculative pressures in foreign exchange markets—everything.  If I develop a taste for foreign wine, that has a tiny but nonzero effect on the US balance of payments, including the capital account position, just as if I become convinced that another country’s assets are a better investment than domestic ones.  Once you understand what an identity means you can’t claim one kind of factor is determinate at the BOP level, while the other is the outcome of some causal process resulting from the first.

Therefore claim (1) is false.  The trade balance is not fixed.  If protectionist policies (including likely responses by other countries) induce expenditure-shifting, that should influence the payments position.  Of course, insofar as protectionist measures may also alter desired international capital flows, the outcome may be difficult to predict in advance.

Claim (2), although Krugman doesn’t state it, is the result of a limit assumption.  Foreign capital inflows are attracted by the promise of repatriated earnings and capital gains.  A country with a current account deficit/capital account surplus cannot continue to sustain this position indefinitely; at some point depreciation must occur to reverse it, but expected future depreciation makes foreign earnings less attractive.  If you also assume rational expectations or its near-equivalent, the anticipation of BOP reversal moves its date forward to the near-present.  (The role of the limit assumption makes BOP reversal structurally the same as Ricardian Equivalence.)  Whether the global economy obeys limit-cycle dynamics in this fashion is really an empirical question, however.

Is it actually true that countries cycle back and forth between external surpluses and deficits?  The view of international political economy, which I share, is no.  There is tremendous serial correlation.  (Check it out.)  For extended periods of time, countries sort themselves into chronic surplus or deficit entities, characterized by various policies and institutions that are conducive to one or the other.  (In my macro book I loosely characterize three types of surplus countries—resource exporters, followers of the east Asian development model, and social democratic collective competitors—and four types of deficit countries—less dynamic developing countries, former members of the Soviet Bloc, English-speaking developed countries, and peripheral Europe.)  Incidentally, the factors that tend to consign countries to one side of the ledger or the other are both micro (“competitiveness”) and macro (mobilization of savings).

What enables countries to run external surpluses and deficits for extended periods of time?  We don’t have a clear answer, in my opinion.  First of all, we don’t have long enough time series to draw conclusions, given that the world economy is punctuated by cataclysms (wars) that cause immense discontinuities in capital stocks, financial obligations and trade flows.  There are also periodic crises at the national level that cause an economic reset.  Perhaps the eruption of crisis is the form that sustainability limits take in a world of limited foresight.

In any case, the textbook (wrong textbook) analysis Krugman applies to a possible Trump tariff tells us almost nothing about the effects such a policy would have on the economy.