Paul Krugman on Tariffs: "Oops!"

Gary North - October 30, 2019

Paul Krugman is the best-known Keynesian economist in the United States. He won the Nobel Prize. He has a regular column in The New York Times.

Recently, he wrote an article for Bloomberg. Because Bloomberg has a pay wall, the public normally could not get access to Krugman's most recent article. So, his admission of a blunder 25 years ago would not be not available to the general public. The headline declares: What Economists (Including Me) Got Wrong About Globalization. The subhead explains: "The models that scholars used to measure the impact of exports from developing countries in the 1990's underestimated the effect on jobs and inequality."

The good news is this: MSN has reproduced the article here. I get to have some fun at his expense. I get to explain his thinking. But before I analyze his article, I want to review the basics of the economic and philosophical case in favor of free trade.

THE LOGIC OF FREE TRADE

The case for free trade across borders is conceptually identical to the case for free trade inside borders. I want to make this point clear from the beginning.

Let us say that two men, Brown and Smith, trade with each other. Each of them specializes in a particular form of production. Each of them finds that it is more profitable for him to specialize than to be a generalist. Through the agency of the free market, the two men can exchange money with each other, and each of them gets more money by specializing in production. There is nothing radical about this concept. It goes back to Adam Smith and The Wealth of Nations (1776).

There is a third man, Jones. He specializes in the production of goods that Brown specializes in. But he is out of the running. His prices are too high. The quality of his products is too low. Smith doesn't consider buying anything from Jones.

Because Smith, Brown, and Jones live inside the same geographical borders, there is nothing that Jones can do about the fact that he doesn't sell anything to Smith. Anyway, there is nothing with respect to barriers at a border. There is no border. He can find other ways for the government to intervene in order to restrict Brown's ability to sell to Smith, but he cannot do anything about it with respect to a border.

Jones' inability to sell to Smith does not get counted in any government-funded survey. He has been out of the running for so long that his lack of income due to his inability to sell anything to Smith is not counted by the government or anybody else. Jones is what we call an also-ran. He is a loser in the competitive marketplace. He needs to go into another line of work. Or maybe he has to find customers who have not heard about the tremendous advantages of buying from Brown.

A fourth man then comes along, bringing an offer to Smith. His name is Wong. He lives in China. There are invisible legal barriers between Wong and Smith: two national borders. These borders, in and of themselves, do not favor either Wong or Smith. Yet.

Smith finds that Wong's products are even better than Brown's. So, he stops buying from Brown. He decides that he prefers to trade with Wong.

Brown is now out of the running. He loses money. Because he used to make money by selling to Smith, this reduction in income is counted by the government in its statistics-gathering. But the statisticians still ignore Jones, who was never in the running.

Brown is outraged by Wong. He had a good deal going by selling to Smith. He doesn't think he can sell to any of Wong's peers in China. But he sees an opportunity. If he gets together with Jones, the two of them can pressure the government to erect tariff barriers (sales taxes) that increase the costs of Wong's goods inside the United States. Brown thinks to himself: "That'll teach that gook a lesson." But, understanding the terrible dangers of hate speech these days, he keeps his thought to himself.

After the tariffs are imposed by the government, Wong is a loser. He doesn't sell as many goods to Smith as he did before. This means he cannot get access to as many dollars -- his profits from selling to Smith. That means he cannot buy as many goods from somebody in the United States who is exporting goods to China.

The statistics will now indicate that Brown is making money again. Things will look much better statistically for Brown. Jones, still a loser, won't make any money selling to Smith. He hoped he might, but he won't. But maybe he can sell to somebody else who has not heard of Brown, and who will not be able to afford anything sold by Wong.

The case for free trade is the case for freedom. The case for free trade is the right of anybody to offer his goods and services for sale to anybody else. Here is the logic of the free market, which is a gigantic auction: "high bid wins." This is the logic of free-market economics. It has to do with individuals making decisions whether to exchange goods and services with each other.

An invisible barrier known as a national border has nothing to do with the logic of free trade.

TARIFFS ARE LIKE DIRT ROADS

Whenever barriers exist between traders, such as poor transportation facilities, this keeps people poorer than they would otherwise have been if the transportation facilities were better. When the transportation problems are overcome by new technologies, some people will get richer because they can trade with each other. But some of those people who previously prospered as a result of the poor transportation facilities will now lose market share. Their goods and services no longer meet the standards of those local individuals who now decide to buy from somebody far down the newly paved road.

Would any economist in his right mind worry about the loss of revenue that is sustained by a few local sellers because the previously dirt road is now paved? I hope not.

Unfortunately, Keynesian economists and supporters of tariffs do not understand the logic of economics. They do not understand that lowering a tariff barrier has the same effects as paving a road between two towns that previously had not traded much. Similarly, they do not understand that raising tariffs has exactly the same effects as dropping bombs on paved highways.

Tariffs reduce trade. Tariffs reduce liberty. Tariffs reduce the net income of people who previously had traded with each other.

Whenever somebody tells you that it is a good idea to raise tariffs, think of somebody who tells you that it would be a good idea for the federal government to send out bombers to drop bombs on America's highways.

KRUGMAN'S BELATED ADMISSION

It is now time to analyze Paul Krugman's semi-mea culpa.

Concerns about adverse effects from globalization aren’t new. As U.S. income inequality began rising in the 1980's, many commentators were quick to link this new phenomenon to another new phenomenon: the rise of manufactured exports from newly industrializing economies.

Economists took these concerns seriously. Standard models of international trade say that trade can have large effects on income distribution: A famous 1941 paper showed how trading with a labor-abundant economy can reduce wages, even if national income grows.

And so during the 1990's, a number of economists, myself included, tried to figure out how much the changing trade landscape was contributing to rising inequality. They generally concluded that the effect was relatively modest and not the central factor in the widening income gap. So academic interest in the possible adverse effects of trade, while it never went away, waned.

Let me put this in language that I hope you will understand. I return to my metaphor of bombing paved highways. I need to revise Krugman's statements slightly. I want to take them from the 1990's back to the 1950's. I will also shift from tariffs to roads.

Concerns about adverse effects from paving roads aren’t new. As U.S. income inequality began rising in the 1940's, many commentators were quick to link this new phenomenon to another new phenomenon: the rise of manufactured exports from newly industrializing towns down the road.

Economists took these concerns seriously. Standard models of paved highways say that trade can have large effects on income distribution: A famous 1941 paper showed how trading with a labor-abundant town can reduce wages, even if regional income grows.

And so during the 1950's, a number of economists, myself included, tried to figure out how much the paved roads were contributing to rising inequality. They generally concluded that the effect was relatively modest and not the central factor in the widening income gap. So academic interest in the possible adverse effects of paved roads, while it never went away, waned.

Are you beginning to get the picture? Yet if Krugman were to read this article, I seriously doubt that he would get the picture. That is because he thinks in terms of aggregates, not individuals. He does not start with individual freedom of exchange. He starts with statistical aggregates based on statistics collected by force by the United States government. So do his Keynesian peers.

He continues.

In the past few years, however, worries about globalization have shot back to the top of the agenda, partly due to new research and partly due to the political shocks of Brexit and U.S. President Donald Trump. And as one of the people who helped shape the 1990's consensus — that the contribution of rising trade to rising inequality was real but modest — it seems appropriate for me to ask now what we missed.

I will translate again.

In the past few years, however, worries about paved highways have shot back to the top of the agenda, partly due to new research and partly due to the political shocks of Brexit and U.S. President Donald Trump. And as one of the people who helped shape the 1950's consensus — that the contribution of paved highways to rising inequality was real but modest — it seems appropriate for me to ask now what we missed.

What Krugman missed was economic theory. What he missed is a theory of individual well-being that begins with individual liberty. That is to say, what he missed is what all Keynesian economists miss.

The 1990's Consensus

There was confusion and debate during the mid-1990's over how to use data on trade to assess wage impacts. Most studies focused on the volume of trade and the amount of labor and other resources embedded in imports and exports. Some economists objected to this approach, preferring to focus on prices rather than quantities.

What eventually emerged was a “but for” approach: asking how different wages would have been but for the rise of manufactured exports from developing countries — increases that were minimal in 1970 but higher by the mid-1990's. It turned out that imports of manufactured goods from developing countries, while much larger than in the past, were still small relative to the size of advanced economies — around 2% of their gross domestic products. This wasn’t enough to cause more than a modest change in relative wages. The effect wasn’t trivial, but it wasn’t big enough to be a central economic story, either.

Again, I need to translate.

The 1950's Consensus

There was confusion and debate during the mid-1950's over how to use data on paved highways to assess wage impacts. Most studies focused on the volume of trade and the amount of labor and other resources embedded in imports and exports between regions. Some economists objected to this approach, preferring to focus on prices rather than quantities.

What eventually emerged was a “but for” approach: asking how different wages would have been but for the rise of manufactured exports from developing regions — increases that were minimal in 1940 but higher by the mid-1950's. It turned out that imports of manufactured goods from developing regions, while much larger than in the past, were still small relative to the size of advanced towns — around 2% of their gross domestic products. This wasn’t enough to cause more than a modest change in relative wages. The effect wasn’t trivial, but it wasn’t big enough to be a central economic story, either.

When you read it this way, the academic jargon remains incomprehensible, but the logic becomes clearer. These people don't like liberty. They think that liberty is a liability because people who cannot compete under the conditions of paved roads deserve special consideration. If they don't do well because of the paved roads, the government statisticians will record this, and Keynesian economists and mercantilist supporters and tariffs will then become deeply concerned because the paved roads force unproductive people who live in the town's at both ends of the roads to go into another line of work. That's what the market does. Through competition, it forces unproductive producers to go into other lines of work. That is a major argument for the free market. Consumers want better products, and free market exchange enables them to gain better products for the same amount of money.

Hyperglobalization

These assessments of the impact of trade made around 1995, inevitably relying on data from a couple of years earlier, were probably correct in finding modest effects. In retrospect, however, trade flows in the early 1990's were just the start of something much bigger, or what a 2013 paper by economists Arvind Subramanian and Martin Kessler called hyperglobalization.

Until the 1980's, it was arguable that the growth of world trade since World War II had mainly reflected a dismantling of the trade barriers erected before the war; world trade as a share of world GDP was only slightly higher than it had been in 1913. Over the next two decades, however, both the volume and nature of trade moved into uncharted territory.

Let me translate.

Hyperasphaltization

These assessments of the impact of paved highways made around 1955, inevitably relying on data from a couple of years earlier, were probably correct in finding modest effects. In retrospect, however, trade flows in the early 1950's were just the start of something much bigger, or what a 2013 paper by economists Arvind Subramanian and Martin Kessler called hyperasphaltization.

Until the 1950's, it was arguable that the growth of interstate trade since World War II had mainly reflected a dismantling of the trade barriers that prevailed before the war; local trade as a share of national GDP was only slightly higher than it had been in 1947. Over the next two decades, however, both the volume and nature of trade moved into uncharted territory.

Woe, oh woe! The coming of the asphalt economy was disrupting the economy of dirt roads. What could be done?

Krugman offers an answer.

This chart shows one indicator of this change: manufactured exports from developing countries, measured as a share of world GDP. What seemed in the early 1990's like a major disturbance in the trade force was just the beginning.

What caused this huge surge in what was, in the 1990's, still a fairly novel form of trade? The answer probably includes a combination of technology and policy. Freight containerization was not exactly new, but it took time for businesses to realize how the reduction in transshipping costs made it possible to move labor-intensive parts of the production process overseas. Meanwhile, China made a dramatic shift from central planning to a market economy focused on exports.

Translation:

This chart shows one indicator of this change: manufactured exports from developing regions, measured as a share of national GDP. What seemed in the early 1950's like a major disturbance in the trade force was just the beginning.

What caused this huge surge in what was, in the 1950's, still a fairly novel form of trade? The answer probably includes a combination of technology and policy. Shipping by 18-wheelers was not exactly new, but it took time for businesses to realize how the reduction in transshipping costs made it possible to move labor-intensive parts of the production process south of the Mason-Dixon line. Meanwhile, the South made a dramatic shift from good old boy central planning to a market economy focused on exports.

Let me tell you, the good old boys in South Carolina and Alabama were not happy with the change. Local businessmen no longer had to ask "how high?" every time the good old boys said to jump.

Krugman continues:

Trade Imbalances

One contrast between the way scholars measure globalization’s impact and the way the broader public looks at it — the approach taken by Trump, for example — is the focus on trade imbalances. The public tends to see trade surpluses or deficits as determining winners and losers. But the economic trade models that underlay the 1990s consensus gave no role to trade imbalances at all.

The economists’ approach is almost certainly right for the long run, both because countries must pay their way eventually, and because trade imbalances mainly affect the relative shares of traded and nontraded sectors in employment, with no clear effect on the overall demand for labor. Yet rapid changes in trade balances can cause serious problems of adjustment — a broader theme that I’ll return to shortly.

Translation:

Trade Imbalances

One contrast between the way scholars measure asphaltization’s impact and the way the broader public looks at it — the approach taken by Trump, for example — is the focus on trade imbalances. The public tends to see trade surpluses or deficits as determining winners and losers. But the economic trade models that underlay the 1950's consensus gave no role to trade imbalances at all.

The economists’ approach is almost certainly right for the long run, both because counties must pay their way eventually, and because trade imbalances mainly affect the relative shares of traded and nontraded sectors in employment, with no clear effect on the overall demand for labor. Yet rapid changes in trade balances can cause serious problems of adjustment — a broader theme that I’ll return to shortly.

Yes, sir, there have been serious problems of adjustment. If your market share was based on dirt roads, asphaltization is a threat to your income and your lifestyle.

Krugman says this:

Rapid Globalization and Disruption

The pro-globalization consensus of the 1990's, which concluded that trade contributed little to rising inequality, relied on models that asked how the growth of trade had affected the incomes of broad classes of workers, such as those who didn’t go to college. It’s possible, and probably even correct, to think of these models as accurate in the long run. Consensus economists didn’t turn much to analytic methods that focus on workers in particular industries and communities, which would have given a better picture of short-run trends. This was, I now believe, a major mistake — one in which I shared a hand.

It should have been obvious that the politics of globalization were likely to be much more influenced by the experience of individual sectors that gained or lost from shifting trade flows than by big questions of how trade affects the global blue-collar/white-collar wage gap or the broad statistical measure of inequality known as the aggregate Gini coefficient.

This is where the now-famous 2013 analysis of the “China shock” by David Autor, David Dorn and Gordon Hanson comes in. What they mainly did was shift focus from broad questions of global income distribution to the effects of rapid import growth on local labor markets, showing that these effects were large and persistent. This represented a new and important insight.

To make partial excuses for those of us who failed to consider these issues 25 years ago, at the time we had no way to know that either the hyperglobalization that began in the 1990's or the trade-deficit surge a decade later were going to happen. And without the combination of these developments, the China shock would have been much smaller. Still, we missed a crucial part of the story.

Translation:

Rapid Asphaltization and Disruption

The pro-asphaltization consensus of the 1950's, which concluded that trade contributed little to rising inequality, relied on models that asked how the growth of trade had affected the incomes of broad classes of workers, such as those who didn’t go to high school. It’s possible, and probably even correct, to think of these models as accurate in the long run. Consensus economists didn’t turn much to analytic methods that focus on workers in particular industries and communities, which would have given a better picture of short-run trends. This was, I now believe, a major mistake — one in which I shared a hand.

It should have been obvious that the politics of asphaltization were likely to be much more influenced by the experience of individual sectors that gained or lost from shifting trade flows than by big questions of how trade affects the global blue-collar/white-collar wage gap or the broad statistical measure of inequality known as the aggregate Gini coefficient, let alone the closely related Betty Sue coeffficient.

This is where the now-famous 2013 analysis of the “Bubba shock” by David Autor, David Dorn and Gordon Hanson comes in. What they mainly did was shift focus from broad questions of global income distribution to the effects of rapid import growth on local labor markets, showing that these effects were large and persistent. This represented a new and important insight.

To make partial excuses for those of us who failed to consider these issues 65 years ago, at the time we had no way to know that either the hyperasphaltization that began in the 1940's or the New York trade-deficit surge a decade later were going to happen. And without the combination of these developments, the Bubba shock would have been much smaller. Still, we missed a crucial part of the story.

Krugman says not to worry.

A Case for Protectionism?

What else did the 1990's consensus miss? A lot. Developing-country exports of manufactured goods grew far beyond their level at the time that consensus emerged. The combination of this rapid growth and surging trade imbalances meant that globalization produced far more disruption and cost for some workers than the consensus had envisaged.

Does this mean that Trump is right and a trade war would be in the interests of workers hurt by globalization?

No. This answer is based not so much on some rigid commitment to free trade as on the nature of the losses that globalization imposed. The problem with surging globalization wasn’t so much changing demand for labor as the disruption that was caused by some of the most rapid changes in history. Rapid change now appears to be largely behind us: Many indicators suggest that hyperglobalization was a one-time event, and that trade has more or less stabilized relative to world GDP. . . .

As a result, major disruptions now would be more likely to come from an attempt to reverse globalization than from leaving the current trade regime in place. At this point, millions of decisions about where to put plants, and where to move and take jobs, have been made on the assumption that the open world trading system will continue. Making that assumption false, by raising tariffs and forcing a contraction of world trade, would set off a whole new wave of disruption along with a whole new set of winners and losers.

Translation:

A Case for Dirt Roadism?

What else did the 1950's consensus miss? A lot. Developing-county exports of manufactured goods grew far beyond their level at the time that consensus emerged. The combination of this rapid growth and surging trade imbalances meant that asphaltization produced far more disruption and cost for some workers than the consensus had envisaged.

Does this mean that Trump is right and a trade war would be in the interests of workers hurt by asphaltization?

No. This answer is based not so much on some rigid commitment to free trade as on the nature of the losses that asphaltization imposed. The problem with surging asphaltization wasn’t so much changing demand for labor as the disruption that was caused by some of the most rapid changes in history. Rapid change now appears to be largely behind us: Many indicators suggest that hyperasphaltization was a one-time event, and that trade has more or less stabilized relative to national GDP. . . .

As a result, major disruptions now would be more likely to come from an attempt to reverse asphaltization than from leaving the current trade regime in place. At this point, millions of decisions about where to put plants, and where to move and take jobs, have been made on the assumption that the paved highway national trading system will continue. Making that assumption false, by bombing highways and forcing a contraction of national trade, would set off a whole new wave of disruption along with a whole new set of winners and losers.

Krugman concludes: "So while the 1990's consensus on the effect of globalization hasn’t stood the test of time, its shortcomings don’t make a case for protectionism now. We might have done things differently if we had known what was coming, but that’s not a good reason to turn back the clock." Translation: "So while the 1950's consensus on the effect of asphaltization hasn’t stood the test of time, its shortcomings don’t make a case for dirt roads now. We might have done things differently if we had known what was coming, but that’s not a good reason to turn back the clock."

CONCLUSION

Keynesianism is mercantilism. It is a philosophy of economic analysis that begins with national aggregates rather than individual decision-making. Krugman's self-doubts about the economic analysis that he and his Keynesian peers provided in the 1990's is a rare but welcome admission on his part that these people were incompetent analysts.

Any economist who begins his analysis with national aggregates, state aggregates, county aggregates, city aggregates, or ZIP Code aggregates, is a mercantilist. He does not begin with individual liberty. He does not begin with individual responsibility. He does not begin with the assumption that the best person to decide what the best uses and opportunities are for his own property is the individual owner. Instead, he begins with the assumption that some central planner is the best person to decide the best uses for other people's property.

This is the Keynesian mindset. It was articulated best by Paul Samuelson on the first page of his Preface to his 1948 textbook, Economics. "National income provides the central unifying theme of the book." National income is a statistical aggregate that is based on an economic assumption, namely, that the best way to measure national wealth is by statistics that are collected by the national government through the threat of violence. This is a holistic mindset that is based on government coercion. All central planning, including Keynesian central planning, is based on government coercion.

This includes tariffs.