A Keynesian Twist to the Free Trade Debate

As Dani Rodrik and I were going Heckscher-Ohlin on Greg Mankiw, we skipped over Keynesian aspects of his post:

Defenders of free trade rarely are in a position of having to defend exports, because people think that exports create jobs. When people complain about trade, it usually about the alleged job-destroying effect of imports.

The Heckscher-Ohlin theory presumes we stay at full employment. I started thinking about the Keynesian aspects as I read James Hamilton respond to some concerns from Kash with respect to the advanced estimate of GDP growth in 2007QI. Kash writes:

The thing that worries me the most is how personal consumption is now virtually the only thing keeping this economy going. But this may not be sustainable, given continued weak income growth and the end of the real-estate ATM that millions of individuals had used to bolster their consumption in recent years. If consumption growth starts to follow income growth, the US economy could be in for some serious trouble.

Dr. Hamilton replies with:

I do not see the fact that strong consumption growth alone was holding things up as being in and of itself alarming. If income growth is temporarily low, standard consumer theory suggests that consumption spending would continue on something close to its original trajectory, as consumers borrow to get past the temporary problems. Strong consumer confidence suggests that is how consumers currently see things. So, if you thought the other new negative contributions to 2007:Q1 growth (specifically the inventory drawdown and weak exports) were strictly temporary, this pattern might be exactly what you’d want and expect to be seeing. My view is the same as Calculated Risk

CalculatedRisk saw the modest increase in business investment as good news. Compare this to what I wrote:

So the only silver lining is that consumption demand is still growing at a 3.8% per year – at least for now. Yep – a further decline in national savings is keeping us of a recession. Not exactly the best news from a long-term growth perspective.

While being bearish on investment demand, I also was worrying about the long-term implications of low savings – rather than joining in on all the Keynesian concerns about aggregate demand. But Dr. Hamilton has a point about consumption smoothing – one should not draw inferences about the long-run direction of national savings from one quarter’s data. But more on this later as we turn to the Keynesian aspects of the trade debate.

Greg Mankiw is reminding us of what macroeconomists refer to as expenditure switching. When we open our markets up to free trade – import demand displaces domestic aggregate demand, but when foreign governments open up their markets to free trade, export demand rises. Angrybear readers likely wonder why I tend to dismiss these expenditure-switching concerns given the fact that I am a Keynesian. As I have noted, I tend to put a lot of stock into the Mundellian proposition that floating exchange rates make expenditure switching aggregate demand neutral. While this is the implicit assumption behind trade models such as the Heckscher-Ohlin model, others have argued we are in some form of a Bretton Woods II exchange rate regime.

Let’s plot the export/GDP and import/GDP shares since 2000 as I confess that about three or four years ago, I would have said imports weren’t worrying me as much as the decline in the export share was. The good news is that export demand growth has exceeded overall GDP growth. Whether it is stronger economies abroad, dollar devaluation, or trade liberalization abroad- we are seeing at least a little progress on the export side. Alas, import demand growth has also been strong. Now the Mundellian in me wonders why the dollar devaluation has not been greater. After all, the broad exchange rate index has devalued by only 21.4% from late March 2002 to late March 2007. And the dollar has devalued by only 6.5% with respect to the Chinese yuan since June 2005 when China allowed limited adjustments of its exchange rate. We have also plotted the ratio of exports to China and imports from China relative to U.S. GDP. In percentage terms, our exports to China have increased by more than our imports from China have increased. But as a share of GDP, our imports from China have grown from 1% to 2.4% of our GDP as our exports have grown from only 0.16% to 0.42%. Despite (limited) dollar devaluation and foreign aggregate demand growth, our net exports represent a net drag to our aggregate demand growth.

But let’s also look at the ratios of gross savings and investment to GDP from 2000 to today. While investment as a share of GDP is higher than it was during the first half of 2003, this is not exactly the supply-side miracle we here about in some circles. But with a gross savings running near 10.5% of GDP, it is no wonder that the Federal Reserve maintains moderately high interest rates – which does crowd-out investment. However, the real crowding-out comes in the form of net exports. So I remain very concern about the lack of national savings. If we could find someway of increasing national savings (hint – reverse George W. Bush’s fiscal irresponsibility), we might be able to enjoy the fruits of both lower interest rates and a weaker dollar. In other words, we could have more investment demand and rising net exports – even as we move closer to free trade. Alas, we are neither hearing much either from this President nor all those who wish to become President in 2009 about how they would move us closer to fiscal responsibility.