The political economy of protectionism

Update: Paul Krugman has a very good response to my earlier post. He is NOT endorsing protectionism:

"First of all: my piece was NOT an endorsement of protectionism — it was an explanation that there is an economic case for it, but also that there is a strong political economy case (which I consider dominant) against acting on that economic case."

He also looks at what happens when you change the assumption about expectations of exchange rates, while assuming flexible rates.

My original post follows:

I really like Paul Krugman's political economy argument for protection. It's a lovely piece of economic analysis. But I still think it's wrong. (The basic macroeconomics behind it is also wrong under flexible exchange rates, but that's another story, discussed in my previous post.) Once politicians are allowed to use the policy lever of protectionism, they won't just move it to where Paul Krugman wants them to move it; they will move the lever all the way to "full".

Here is my understanding of Paul Krugman's argument for temporary protectionism. Each country has a cost to pursuing an expansionary fiscal policy (its debt rises). Each country has a private benefit from pursuing an expansionary fiscal policy. But each country also creates a positive externaility when it pursues an expansionary fiscal policy, because some of the extra demand will leak out to benefit other countries. Because of this positive externality, fiscal policy won't be expansionary enough (the equilibrium will have too little fiscal expansion). If all countries were allowed to follow protectionist policies, this would internalise the externality, because all the extra demand would stay at home. So protectionism creates a better equilibrium with more expansionary fiscal policies in all countries.

I disagree with the basic macroeconomics behind his assertion that fiscal policy creates a leakage of demand to other countries. Under flexible exchange rates, there will be no such leakage, and hence no externality. But just for the sake of argument, let's assume I'm wrong on this point, and that the world really does have fixed exchange rates. Or we are talking about fiscal policy within the Eurozone, for example. Is the political economy part of the argument right?

Let's start in an initial world with unemployment, no protectionism, and no expansionary fiscal policy yet (each country is still trying to decide on how big a fiscal expansion to choose). Suppose a world referee can choose whether or not to allow countries to restrict new government spending to domestic goods only. In this case, Paul Krugman's argument may be right. The equilibrium may be better if the referee allows protectionism. (I say 'may' be better, because there are still standard arguments for trade, and the protectionist restrictions will cause the wrong mix of goods to be produced, and the costs of the wrong mix may offset the benefits from having a bigger total quantity of goods).

But there is no world referee who can be relied on to enforce the rules restricting protection to new government spending, i.e. government spending that would not otherwise have taken place. No referee could prevent governments extending protection to old spending as well (spending they would have done anyway). No referee could prevent governments extending protection to private spending as well. If there were a referee able to make such fine judgements, and powerful enough to enforce them, we wouldn't have this problem anyway. The referee could just tell governments they had to adopt more expansionary fiscal policies.

There is no world referee. World rules are conventions, established slowly and painstakingly. They are enforced only by fear of mutual backsliding ("if you break the rules, so will I"). I find it very hard to believe that countries will establish a new convention overnight. Especially not any convention which makes an overly nice distinction between "new" and "old" government spending, and between government and private spending.

If we allow governments to break the glass cover on the protectionist lever, they are going to move that lever all the way to "Full". Who's going to stop them?

Comments

[anonymous]

That's a great argument, but again, the stimulus package is not protectionism! Nobody is raising tariffs! The government is simply choosing where it purchases (a tiny proportion of goods) from selectively, which is the right of any consumer in the market. The populace is free to spend their paycheck on goods from whatever country they want.

And contrary to the "slippery slope" claim, it looks like the "buy American" clauses in the stimulus might be removed anyway due to the international pressures you mentioned.

[Nick Rowe]

anonymous: Thanks, and an interesting counter-argument from you. Now, suppose every country agreed with you, and said that this policy is not "protectionism". If so, there might be a "line in the sand" between these policies and full-blown protectionism. Symbols like this matter in coordination games with multiple equilibria. They provide focal points. But I'm less optimistic. Many trade agreements (I think) have defined them as "protectionism". And they have similar effects, in other contexts, though not in this political economy context, as I have learned from Paul Krugman's post.

[pgl]

Nick - I also commented on Paul's recent post on this topic:

econospeak.blogspot.com/2009/02/buy-american-is-there-trade-off-between.html

[Mark Dowling]

Canada could counter that with a declaration that Buy National policies which impact Canadian exporters will decide which countries' auto companies get bailouts.

[JohnGalt]

I agree with you.

But then again, you can always expect clear thinking from an economist.

By the way, you did a great job predicting the present crisis. Who knew that the future could be so easily predicted by graphs and charts. Predicting economic trends from graphs and charts is almost as reliable as reading the entails of freshed killed fowl.

Based on your brillant argument, I agree that there should be no protectionalism whatsoever anywhere in the world. This way the country with the lowest wages, the worse labor laws, and least amout of environmental protection can dominate the world economy.

And isn't this what would be best for the world?

[calmo]

Nick is winning my heart with this: It's a lovely piece of economic analysis. But I still think it's wrong. but he has no idea what a pest I can B with no economic credentials.
..so although this...exhilarating... dimension of criticism is irresistible, the illumination...not so much.
For instance: "(The basic macroeconomics behind it is also wrong under flexible exchange rates, but that's another story, discussed in my previous post.) " was an argument made by a Canadian economist (with tons of experience...and a sense of humor!...still, after all these years!) who witnessed a 30% swing in fx CAN/US$ in a week (ok, maybe it was only 4 days...short!)...demolishing for everyone else, the purity of the fx market whose flexibility is managed like the current stock market, by large private interests...the invisible hands...not yours and mine.
See? I'm not even out of the short 1st paragraph yet...a real pest!
Ok, that is my cue: 1 paragraph at a time.
Do you feel that the transnationals, who have no representation with the gov, also have no influence? [Once politicians are allowed to use the policy lever of protectionism, they won't just move it to where Paul Krugman wants them to move it; they will move the lever all the way to "full".] Steel tariffs did not last too long with the last admin....but of course nothing lasted. Hard to believe that the transnationals are as threatened as you suggest...of course, the real threat is NOW: the consumer base is...spent, I make it.

[Nick Rowe]

Test

[Leigh Caldwell]

If you look at section 1110 of H.R.1 you may be interested to spot a get-out clause in the Buy American provision:

http://www.knowingandmaking.com/2009/02/buy-american-get-out-clause.html

[Ken Houghton]

Leigh Caldwell nailed it, and NYC gets its Bombadier subway cars again.

"Now, suppose every country agreed with you, and said that this policy is not "protectionism". If so, there might be a "line in the sand" between these policies and full-blown protectionism. Symbols like this matter in coordination games with multiple equilibria."

Now suppose that w/e/ they and us (Canada) are the only ones who don't put country first. Find the equilibria, and specify why you would think that recovery would be quicker in those countries that let the others "free ride" on their non-protectionist efforts viz a viz, say, China.

[Alon Levy]

Ken, is the EU being protectionist, too? I was under the impression it was mostly just the UK. Either way, Germany's economy is too export-oriented for it to let the EU put up too many tariffs.

[calmo]

I'm losing it...not like those lawyers drafting that legislation that Leigh links to...they know how to carve out their business in advance --just write it in bold: "in the public interest".
So remind me again what itiz that needs protecting? Yeah, those national industries, but that was yesterday...when there seemed to be no end to what the US consumer could ingest...until they got all bunged up on House prices.
Don't forget Poland!
Did you?
Ok, those pickles, need protecting...against.
From now on it's hotdogs. Period.
Austerity is us. Hysteria if you are lucky!

Why do I think this issue is so twisted?
So deceptive...izit the house prices sitting way up there like an anvil about to fall?...or what's left of your retirement savings about to be zonked by a $US headed for the moon?
Do you figure that the transnationals are about to be vanquished or triumphant in this slosh?
Do you figure human beings can remain calm, cool and collected in an environment of scarce pickles?

[Mandos]

The move to protectionism is popular for a reason. Because the gains from trade in the USA have not been equitably distributed, as a visit to Michigan will immediately show you. In fact, speaking of political economy, it turns out that it is next to impossible under current political systems to distribute the gains from trade equitably. If so, than the American worker will quite rationally want to protect his/her position by restricting trade.

Until America has a growing industrial base, watch for protectionist pressures to increase. Or social unrest. One or the other. People are expecting Obama to save their jobs, not get them cheaper stuff at Wal-Mart.

[Nick Rowe]

Mandos: everybody wants protection against competition which harms them, but also wants protection against protectionism which harms them. It was ever thus. But the arguments pro and con protectionism are different in a world where aggregate demand is the constraint on output and employment. My argument is that protectionism does not increase aggregate demand, output and employment, even if other countries don't retaliate. One of the reasons protectionism is popular is because a lot of people think it does increase aggregate demand. They are wrong.

[Mandos]

Mandos: everybody wants protection against competition which harms them, but also wants protection against protectionism which harms them. It was ever thus.

NO. Everyone wants a stable income, a stable roof over their heads, and a future for their children which is the same or better than what they already have. What people want protection against is what harms what they currently have, and in particular the political choices of others who harm it for their own increase.

Protectionism is popular because they don't see why they should suffer for the political choices to adjust or maintain trade regimes that cause them to lose their jobs, homes, and communities en masse, not because of some abstract talk about aggregate demand.