Sunday, January 11, 2009

Depression Economics

Interfliudity has a long thoughtful post today about the forms and manner of protectionism.  He points out that there are two distinct economic phenomena that sometimes get tagged with the same label -- competitive beggar-thy-neighbor trade barriers (import or export tariffs) are a negative sum game that raise the price for everyone, and hence lower aggregate demand; production subsidies, however, do not have the same pernicious economic effect, and, in fact, can be very useful if the problem at hand is a lack of aggregate demand.  He starts off by looking at subsidies as a form of investment:

A fair review of the history of "protectionism" would be much more mixed than the economic mainstream would like us to believe, with their stories of comparative advantage and expanding production possibility frontiers. (Thankfully, economists like Dani Rodrik and Paul Krugman weave more nuanced tales, but still "protectionism" rates somewhere just below coprophagia on the economic profession's list of distasteful things.) In some times and places, trade barriers have served to isolate and impoverish people. In other times and places, tariffs have protected infant industries that grew into powerhouses in countries (like the United States) that otherwise might have remained agricultural backwaters. That said, I think we should avoid tariffs, not in deference to economic pseudoscience, but because they are stultifying. Intercourse across borders is a per se good. A mixed-up, intermingling world is better than one made up of insulated national tribes. We should avoid tariffs not because of their adverse economic consequences, but despite their potential economic benefits.

But subsidy is a different story. Export subsidies do not diminish international commerce, they, um, subsidize it. From a libertarian perspective, there is a strong case against tariffs. Trade restrictions prevent free people across borders from interacting as they wish. But subsidies restrict no one. Sure, libertarians might complain of the wealth expropriated to fund the subsidy, but that critique applies to nearly all functions of modern government. Until we abolish public schools and the NIH, there's no reason we shouldn't have export subsidies.

China of course, has been a massive subsidizer of its export industries via the crawiling peg of its undervalued currency.  This subsidy takes the form of giving money to the United States by buying low-yielding treasuries.  Interestingly, his complaint is not of the typical "China is distorting the free market" flavor, but is of the "China is providing this subsidy in a round-about and non-transparent way" flavor.

As Brad Setser has described for years, in order to maintain a "crawling" currency peg, China's central bank has been forced to purchase US dollar assets on which it must expect an eventual loss in real terms. China's subsidy to foreign consumers has been hidden in this overpayment. China's policy of giving worked very well for it, but executing that policy by pretending to lend rather than to give has put the nation in a bind. The technocrats responsible for China's huge currency reserves must continually expand their losses by purchasing more dollars to keep the value of the dollar high and hide the costs of subsidies already granted. If they do not, the exposure of large financial losses might create a firestorm of domestic outrage. China's central bank might be able to hide reserve losses by engineering a large domestic inflation, so that its US dollar portfolio does not lose value in nominal terms. In either case, even though the development gains were almost certainly worth the financial cost of China's export support, China's leaders face a problem since they pretended there was no subsidy when in fact the subsidy was very large.

It would have been better for China as well as for its trade partners (who face traumatic currency devaluations) if its policies had involved explicit, sustainable, and broad-based subsidies to foreign consumers. Explicit subsidies paid over time are more politically palatable than sharp losses suddenly revealed.

This gets to the heart of the problem with currency pegging, in my opinion -- the inevitable sudden end of the regime is often disruptive enough to wipe out all of the gains that the peg produced to begin with.  But that's a sidelight to the main argument in this case.  Fine, China should have been more transparent about what it was doing, and not relied on the bank shot that accidentally careened off the table and produced the housing bubble.  But was it such a bad idea for them to subsidize US and European consumption as a way of turbocharging their industrialization?  I think this is a real question.

Of course, I came away from the Interfluidity's argument with a couple of questions. 

The first was whether the idea he lays out to have a market for consumption subsidies makes sense when we're not trapped in a depression economics scenario.  If the world is more or less in equilibrium, governments subsidizing consumption via vouchers or whatever would seem to be inherently inflationary.  There's no point in subsidizing consumption is everyone is working as hard as they can to produce what everyone is consuming already.  

The second question was related to the already built up imbalances that have resulted from China subsidizing consumption while the US has not.  This turns out to be outside the scope of the post, as was revealed in the comments.  Bascially, if you were the only one subsidizing consumption and everyone else was profligately living off your thrift, you would end up owning everything, which is an unstable equilibirum, to say the least.

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