Krugman on Stolper Samuelson Effects in US Trade

In case you missed it, Paul Krugman's Friday column focused on the distributional consequences of international trade. He argues that as imports from developing countries have risen during the last fifteen years, trade flows have begun to follow the expectations of standard comparative advantage. Consequently, trade has a more pronounced impact on wage inequality in the US today than it did fifteen years ago.

I am predisposed to the general argument, but am puzzled by the magnitude he claims. He asserts that "it’s hard to avoid the conclusion that growing U.S. trade with third world countries reduces the real wages of many and perhaps most workers in this country...The highly educated workers who clearly benefit from growing trade with third-world economies are a minority, greatly outnumbered by those who probably lose."

He draws on textbook Stolper-Samuelson logic to make the argument: "workers with less formal education either see their jobs shipped overseas or find their wages driven down by the ripple effect as other workers with similar qualifications crowd into their industries and look for employment to replace the jobs they lost to foreign competition. And lower prices at Wal-Mart aren’t sufficient compensation.

Yet, exactly how many workers have lost jobs to "foreign competition?" The competition Krugman emphasizes comes from imports of manufactured goods. The Bureau of Labor Statistics reports that manufacturing employment fell from roughly 17 million in 1997 to 14 million in 2006. That's a reduction of 3 million manufacturing jobs over ten years--300,000 per year on average--in a total labor force of 136 million people. To assert that this displacement imposed a substantial wage reduction on others seems a bold claim to make without providing any evidence to support it.

I look forward to seeing Krugman's research on this question develop. He has posted a few short pieces about the paper he is writing on his blog, here, here, and here. If you want to read what appears to be the state of the art on trade and income distribution, see Robert Lawrence's paper here.

How do We Extract Signal from Noise?

As we head toward the New Year, I offer some fundamental skepticism. In a very cheery examination of the current financial situation, Ambrose Evans-Pritchard seems almost to relish the collapse of the international financial system. He seems uncannily able to find bankers willing to make extreme statements, such as: "Things are very unstable and can move incredibly fast. I don't think the central banks are going to make a major policy error, but if they do, this could make 1929 look like a walk in the park." How's that for a little New Year cheer?

I feature Evans-Pritchard's recent work because it nicely highlights one of two questions I have been pondering for the last two weeks (I will post on the second question tomorrow). How do we humans extract meaningful signal from all the noise? We seem strongly attracted to worse-case scenarios; we compare the current situation to 1929 rather than to other financial episodes that did not produce a global cataclysm (1987, for example, or the bursting of the dot com bubble). The media feeds us quotes with no evidence about where the people quoted fall in the distribution of opinion and analysis. Are the quoted bankers representative of the median view, or is the writer drawing from the gloom-and-doom end of the spectrum? Do the people quoted have incentive (monetary or other) to portray events in a particular manner rather than present "objective analysis?" In short, how does one figure out the "truth" in a world in which the critical question is "what is going to happen?", when the information we have at hand is of uncertain quality and quite possibly biased, but the degree of bias is unknown (and unknowable)?

This seems to be a very hard problem, and yet one we face on a regular basis. For those not interested in the current financial crisis, then ask the same question of global warming. If you are unwilling to fall down the global warming warren hole (and having disappeared into that hole for a full week, I can hardly blame you if you are not), then ask the question of genetically modified organisms. If GMOs do not interest you, then what about economic development? All of these issues pose the same dilemma: we are asked to make decisions today to achieve some future consequence relying on knowledge first produced and then reported by groups of people who may or may not be motivated by the objective quest for truth and that therefore may or may not be biased in ways we cannot accurately measure.

In short, why do we believe what we believe, and should we? How do we extract the meaningful signal from all of the noise, and how do we know that we have extracted the meaningful signal? I don't have the answer, but we seem to believe that the political process is good at selecting the "correct signal." Why do we believe this? Should we?

Krugman on the Fed and the Financial Crisis

"What’s going on in the markets isn’t an irrational panic. It’s a wholly rational panic, because there’s a lot of bad debt out there, and you don’t know how much of that bad debt is held by the guy who wants to borrow your money.

How will it all end? Markets won’t start functioning normally until investors are reasonably sure that they know where the bodies — I mean, the bad debts — are buried. And that probably won’t happen until house prices have finished falling and financial institutions have come clean about all their losses. All of this will probably take years.

Meanwhile, anyone who expects the Fed or anyone else to come up with a plan that makes this financial crisis just go away will be sorely disappointed."

Pushing on a String?

Keynes argued that the Great Depression persisted in part because of a "liquidity trap" wherein banks are unwilling to lend regardless of the nominal interest rate. In such a world, monetary policy is useless--he equated trying to use a monetary expansion to stimulate lending to trying to move a weighty object by pushing on the end of a string.

One might ask if global credit markets have now entered a period in which monetary policy amounts to pushing on a string. Credit markets are frozen because banks are uncertain about which banks among them hold how much bad debt (non-performing sub-prime mortgages and associated instruments). Because no one wants to lend to banks who hold a lot of this debt, and no one knows who these banks are, no one is willing to lend to any banks. Consequently, credit markets freeze. The underlying problem is an information asymmetry of the kind that for which Joseph Stiglitz won a Nobel Prize (well, not technically a Nobel, but you get the point).

Yesterday's announcement that US and European central banks will cooperate to provide liquidity to credit markets is best interpreted in this context. "The Fed has not only opened its vault doors to the banking industry, they are now trucking it to their place of business," said Scott Anderson, a senior economist at Wells Fargo, in a written report. "If that doesn't get the banks excited about lending again, nothing will...The Fed's action attempts to deal with a difficult problem confronting the world's central banks: Financial institutions globally are so worried about losses from U.S. mortgage securities and other exotic investments that they are hoarding cash, unwilling to lend it to each other except at unusually high premiums."

I don't know whether to be scared or reassured by this latest development. That is, does this unprecedented action mean that the central banks have things well in hand, or does it mean that things are worse than we realize?

Final Exam Update and Essay Outline

I have completed grading the final and will try to get the final grades to the registrar by Friday. If you are curious about what I was looking for in the essay, keep reading.

Here, in outline form, is what I was looking for in the essay.

1. All global current account imbalances reflect underlying Savings-Investment imbalances.

2. All global imbalances are financed via the deficit (borrowing) country issuing promises to pay the surplus (lending) country(ies) in the future in exchange for loans in the present. The nature of what is promised, to whom, and via what intermediary (if any) varies across episodes. The US telling Germany in the 1960s, "hold dollars today and I will give you gold at $35 an oz next year" is identical in essence to Thai banks saying to Japanese commercial banks, "take my promise to pay you tomorrow what you give me today plus interest." (Though, in the US case it does not promise to pay interest too).

3. Imbalances transform into crises when lenders lose confidence in the borrower's ability to make good on its promise to repay. What triggers the crisis in any given instance will be different, but all crises are triggered by this sudden loss of confidence by lenders in the ability of borrowers to make good on their promises. Dollar overhang, therefore, is not fundamentally different than the popping of the property-market bubble in Thailand. In both cases, borrower's short term liabilities>their available liquid assets.

4. Adjustment plays out in different ways; developing country debtors get pushed into the IMF/WB process and tend to bear the largest share of the adjustment costs; advanced industrialized countries tend to negotiate and the costs do not necessarily end up falling on the debtor country. One might even argue that since 19302, the US has been pretty good at pushing the costs onto other countries ("Our currency, your problem.")

5. Implications for contemporary imbalance. Recognition that the US is vulnerable to sudden losses of confidence, recognition that if that happened it could be a bad thing, and some consideration of:

• how likely is a sudden loss of confidence in the American ability to make good on its promises?
• how governments would respond in the event of such a sudden loss of confidence--more like Latin America and Asia, or more like Bretton Woods and Plaza-to-Louvre? Obviously, there is no "right" answer here, but there are good and less good answers.

Most of you wrote reasonably strong answers that focused on these issues. If there was a collective bias, it was toward emphasizing specific details and hence uniqueness of the two episodes you examined, rather than the more general pattern and commonalities. If there was a single area in which I found the answers less developed than I would have liked, it was in the last section (5 above).

Surrealism and Economic Development

There is something deeply surreal about this:

"Gordon Brown plans to harness at least 20 of the world's biggest multinational companies, including Google and Vodafone, to tackle a "development emergency" in the world's poorest countries and put the international community back on course to achieve seven UN development goals by 2015...Ministers have been holding intensive discussions with the private sector in the hope that firms can be persuaded to use their expertise to improve infrastructure, upgrade skills and provide capital for fresh investment. Although the prominence given to multinationals is likely to be controversial with parts of the development community, Brown believes a lack of enterprise is hindering least-developed countries - especially in sub-Saharan Africa - achieving the development goals."

The episode encapsulates everything wrong with the West's approach to development. First, we assume that we can actually create a plan that eliminates poverty (we can't, sorry J.Sachs). And when we fail to meet arbitrary targets, we declare an "emergency." Second, we think that we can solve "the-lack-of-enterprise-is-hindering-least-developed-countries" problem by forcing unwilling MNCs to invest in developing countries (we can't). Third, we worry about what some ill-defined, anti-market, though well-meaning "development community" will think about encouraging private business to invest in developing countries (we shouldn't, because they are not eliminating poverty either). Fourth, not a word from the impoverished societies we are supposedly "rescuing" (why?).

The ECB, Asymmetric Shocks, and Monetary Policy Dilemmas

Standard theories of monetary union suggest that they work best when the participating countries experience the same shocks. They work least well when they experience asymmetric shocks. I have always found it difficult to teach this, because until now the EU's monetary union has not really had to deal with a big shock. The fall out from the US sub-prime crisis is imposing an asymmetric shock on euroland. Consequently, we now begin to see the dilemma that EMU creates for its members and its single central bank.

The core problem is that the ECB must choose between inconsistent objectives. As the Telegraph summarizes, "Mr Trichet has to tread a delicate path between the eurozone's Germanic and Latin blocs, pulling ever further apart. The credit and housing booms have begun to deflate in the Club Med region. The Bank of France's governor, Christian Noyer, said this week that Europe was facing a "huge shock" as contagion spread from the US sub-prime crisis...Spain in particular is now in serious trouble, with a "staggering" current account deficit of 9pc of GDP and a huge overhang of unsold property from the housing bubble."

Germany, in contrast, is struggling with rising inflation: "The hard-line bloc [is] led by the two German council members, Bundesbank chief Axel Weber and the ECB's chief economist Jurgen Stark. The latest spike in oil and food costs has pushed German inflation to 3pc, the highest since the launch of the euro and fast approaching the level where it may erode popular support for the currency."

Thus, one monetary policy but divergent economic developments across euroland. Someone has to accept a monetary policy that not only fails to address their current needs but will actually further worsen their situation. The dilemma is complicated by uncertainty; the more German unions question whether the ECB will use policy to keep inflation down in Germany (i.e., the more they believe that monetary policy will target Spain and the Med) the larger the nominal wage increases they will seek. Hence, to keep inflation down in Germany, the ECB must be hard line and build a reputation. But, being willing to raise interest rates to build this reputation risks making things even worse for "club med."

Not surprisingly, this "technical decision" is spilling over into politics, as French and Italian politicians have chastened Trichet for the hard line he is adopting.

It is precisely this problem that caused me to write, more than ten years ago, that EMU is not obviously a very good idea.