Models of Trade Policy

1. Models of Trade Policy Lecture 7– Tuesday, 29 SeptemberJ A Morrison Eli Heckscher 1879-1952 David Ricardo 1772-1823 Jacob Viner 1892-1970

2. Models of Trade Policy • Choosing the Means to Achieve Balance • Imbalances: Causes & Consequences • Going on to Trade • The DV: Trade Policy • The Cases for Free Trade • The Cases for Managed Trade

3. Models of Trade Policy • Choosing the Means to Achieve Balance • Imbalances: Causes & Consequences • Going on to Trade • The DV: Trade Policy • The Cases for Free Trade • The Cases for Managed Trade

4. Friedman: How to Resolve Imbalances • Adjustment of Reserves • Adjustment of Domestic Incomes & Prices • Adjustment of Exchange Rate • Exchange Controls to Manage Capital & Current Account

5. But don’t make the mistake of assuming that all of these responses are equal!

6. “It cannot be too strongly emphasized that the structure and method of determining exchange rates have a vital bearing on almost every problem of international economic relations…The only other alternative to movements in exchange rates is direct control of foreign trade. Such control is therefore almost certain to be the primary technique adopted to meet substantial movements in conditions of international trade so long as exchange rates are maintained rigid. The implicit or explicit recognition of this fact is clearly one of the chief sources of difficulty in attempts to achieve a greater degree of liberalization of trade in Europe…” (MF, 196-197)

7. Friedman, in fact, was following JM Keynes…

8. “The problem of maintaining equilibrium in the balance of payments between countries has never been solved…So far from currency laissez-faire having promoted the international division of labour, which is the avowed goal of laissez-faire, it has been a fruitful source of all those clumsy hindrances to trade which suffering communities have devised in their perplexity as being better than nothing in protecting them from the intolerable burdens flowing from currency disorders.”-- Keynes (1941)

9. So, what does Friedman propose?

10. “There are no major economic difficulties to prevent the prompt establishment by countries separately or jointly of a system of exchange rates freely determined in open markets, primarily by private transactions, and the simultaneous abandonment of direct controls over exchange transactions. A move in this direction is the fundamental prerequisite for the economic integration of the free world through multilateral trade.” (MF, 203)

11. So, Keynes and Friedman worried that prioritizing a fixed exchange rate would force policy makers to rely on exchange controls—particularly trade restrictions—to resolve BoP imbalances.

12. Barry Eichengreen & Doug Irwin have just finished a paper highlighting the significance of the commitment to gold (a fixed ER) in the 1930s.

13. But what happens when a state, committed to the multilateral free trade regime, maintains an undervalued exchange rate to promote trade?

14. Models of Trade Policy • Choosing the Means to Achieve Balance • Imbalances: Causes & Consequences • Going on to Trade • The DV: Trade Policy • The Cases for Free Trade • The Cases for Managed Trade

15. So, policy makers have a variety of ways to ensure that their payments balance.And prominent theorists suggest that some of those choices (flexible ERs) are better than others (exchange controls).

16. But this raises some questions with extraordinary contemporary relevance:(1) what causes imbalances of payments in the first place?(2) what are the effects of sustained imbalances?

17. II. Imbalances: Causes & Consequences Two Explanations The Stakes: Contemporary Application

18. Doug Irwin has developed one perspective on this vital question.

19. “Trade policy cannot directly affect the current account deficit because trade policy has little influence on the underlying determinants of domestic savings and investment, the ultimate sources of the current account. If a country wishes to reduce its trade deficit, then it must undertake macroeconomic measures to reduce the gap between domestic savings and investment.”(D Irwin, Free Trade Under Fire, 90)

20. Hmm. Interesting.Now compare that to this…

21. “When a country is growing in wealth somewhat rapidly, the further progress of this happy state of affairs is liable to be interrupted, in conditions of laissez-faire, by the insufficiency of the inducements to new investment…the opportunities for home investment will be governed, in the long run, by the domestic rate of interest; whilst the volume of foreign investment is necessarily determined by the size of the favourable balance of trade…At a time when the authorities had no direct control over the domestic rate of interest or the other inducements to home investment, measures to increase the favourable balance of trade were the only direct means at their disposal for increasing foreign investment; and, at the same time, the effect of a favourable balance of trade on the influx of the precious metals was their only indirect means of reducing the domestic rate of interest and so increasing the inducement to home investment.” (Keynes, General Theory, 335-336)

22. What is the relationship each theorist sees between macroeconomic (monetary) policy, the patterns of investment & saving, and the balance of trade (the current account)?

23. Irwin versus Keynes • Irwin • Macroeconomic policy  patterns of saving & investment  balance of trade • Keynes • Balance of trade  patterns of saving & investment  macroeconomic effects (on domestic price level)  The causal chains are reversed!

24. II. The Cause of Imbalances of Payments Two Explanations The Stakes: Contemporary Application

25. This directly relates to the current global financial crisis.What caused the housing bubble that ripened conditions for the crisis?

26. China & Germany Follow Irwin’s Perspective • US has loose monetary policy; Germans & Chinese have tight monetary policy  US savings rates fall  German & Chinese savings rates rise • An abundance of US capital causes Americans to buy more of everything  Because interest rate is low, US consumers buy houses rather than invests in businesses; this caused the housing bubble

27. US Follows Keynes’ Perspective • US has excess demand for Chinese goods  negative BoT • US: this should either appreciate the ER or raise prices in China, which would correct the imbalance • BUT China limits appreciation and inflation • it absorbs USD into reserves ($1.3trillion) and invests in US • Glut of capital in China  Chinese savings rate • Excessive foreign capital  housing bubble • Limited appreciation of RMB  US trade deficit

28. Our answer to the cause of these imbalances will determine the policies we undertake in the current crisis…Germany insists that the US tighten monetary policy.The US insists that the surplus countries (China & Germany) stop promoting exports unfairly.

29. Models of Trade Policy • Choosing the Means to Achieve Balance • Imbalances: Causes & Consequences • Going on to Trade • The DV: Trade Policy • The Cases for Free Trade • The Cases for Managed Trade

30. PS 0304 Int’l Pol Econ ✔ • Unit 1: Studying the Global Economy • Topic 1: Introductory • Topic 2: Perspectives on IPE • Topic 3: Explaining Foreign Economic Policy • Unit 2: Trading Goods & Services • Topic 4: Trade in Theory • Topic 5: Trade in Practice • Unit 3: The International Monetary System • Unit 4: Migration • Unit 6: Special Topics in IPE

31. Here’s what you should have taken away from Unit 1…

32. Unit 1 Goals • Define the Basic Questions in the Study of IPE • Develop Broad Range of Theories of Political Economy • Introduce Some of the Major Decisions that have Shaped the Modern World Economy • Introduce Stories of People who Made a Difference

33. A very quick recap of the last month…

34. Topic 1: Introductory • What is IPE? • Who studies IPE, and how do they do it? • Economists versus political scientists • “British” versus “American” schools • How has the study of IPE changed over time?

35. Topic 2: Perspectives • Study of IPE is Organized around Defining Questions • What is the end of politics? • What is the natural state of the economy? Is market failure pervasive or minimal? • What is the optimal relationship between politics & economics? • How should states maximize the benefits of integration without losing policy autonomy? • Theories are developed in response to these Defining Questions

36. Topic 3: Explaining FEP • How do we explain foreign economic policy? • What are the key variables that shape FEP? • Structural Theories: distribution of power & international institutions/regimes • Domestic Theories: ideas, interests, institutions • What is the Relationship between these variables? • Smith, Hegel, Marx & Keynes: ideas versus interests • Schonhardt-Bailey: 3 I’s combine to create policy outcomes

37. So, that was Unit 1.

38. PS 0304 Int’l Pol Econ • Unit 1: Studying the Global Economy • Topic 1: Introductory • Topic 2: Perspectives on IPE • Topic 3: Explaining Foreign Economic Policy • Unit 2: Trading Goods & Services • Topic 4: Trade in Theory • Topic 5: Trade in Practice • Unit 3: The International Monetary System • Unit 4: Migration • Unit 6: Special Topics in IPE On to Unit 2!

39. Mode for Units 2-4 • Deploy economic theories • International economics without politics • Develop political economic models to explain FEP • Evaluate Relevant History • Test models • Contextualize and explain the landscape we see today

40. Models of Trade Policy • Choosing the Means to Achieve Balance • Imbalances: Causes & Consequences • Going on to Trade • The DV: Trade Policy • The Cases for Free Trade • The Cases for Managed Trade

41. Our dependent variable of interest here is trade policy.Trade policy is that set of policies designed to influence patterns of trade in goods & services between domestic and foreign markets.

42. Trade Policy Tools • Tariffs: Specific and ad valorem • Nontariff Barriers (NTBs) • Subsidies • Quotas & Voluntary Export Restraints (VERs) • Product standards • Currency Intervention • Exchange Rate manipulation • Capital controls

43. What are the implications of this complexity?  It is damned hard to evaluate the level of trade management. (See Krasner, p 24.)

44. Note that intentionality (“design”) matters here.In IPE, we treat product standards requiring full disclosure of ingredients differently from “standards” that require minimum wages.

45. So, how will we operationalize our dependent variable? How do we evaluate trade policy?

46. Extremes of the Trade Policy Continuum • Managed Trade: government intervenes to affect patterns of trade between domestic and foreign markets • Free Trade: government does not intervene towards this end

47. What are the costs and benefits of each type of trade policy?

48. Models of Trade Policy • Choosing the Means to Achieve Balance • Imbalances: Causes & Consequences • Going on to Trade • The DV: Trade Policy • The Cases for Free Trade • The Cases for Managed Trade

49. V. The Cases for Free Trade The Classical Model The Neoclassical Model Additional Arguments

50. Free Trade before Smith • Economists before Smith recognized potential benefits of free trade • Their arguments: • Free trade expands markets and deepens division of labor • Free trade increases competition •  Smith used the same arguments.