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Prof. Krugman and Chinese Mercantilism
Raymond Richman, 1/4/2010

In his op-ed in the NY Times (12-31-09) entitled Macroeconomic Effects of Chinese Mercantilism, Nobel economics prize-winner Paul Krugman charges China with practicing mercantilism Prof. Krugman is rather late in condemning China’s mercantilism. We called attention to it in our book Trading Away Our Future (January, 2008). Indeed, in the book, we quoted from a column of his that appeared in Slate Magazine in 1997.

Professional trade alarmist Alan Tonelson’(s) … claim is that as emerging economies grow – that is, produce and sell greatly increased quantities of goods and services – their spending will not grow by a comparable amount; equivalently, he is claiming that they will run massive trade surpluses. But when a country grows, its total income must, by definition, rise ... Maybe you don’t think that income will get paid out in higher wages, but it has to show up somewhere. And why should we imagine that people in emerging countries, unlike people in advanced nations, cannot find things to spend their money on?" (p. 70)

 The Chinese people can find plenty of things to buy from us but their government as Japan’s government before it chooses not to permit it. Well, Tonelson was clearly right and Krugman wrong. Prof. Krugman, an international trade specialist, ought to have been aware that Japan had been pursuing the same mercantilist policy of expanding exports and restricting imports for five decades when he wrote those words.

 Now he writes: “China has become a major financial and trade power. But it doesn’t act like other big economies. Instead, it follows a mercantilist policy, keeping its trade surplus artificially high. And in today’s depressed world, that policy is, to put it bluntly, predatory.”  

 But we disagree with much of the rest of his recent op-ed. He writes that China’s “accumulation of foreign reserves, many of which were invested in American bonds, was arguably doing us a favor by keeping interest rates low — although what we did with those low interest rates was mainly to inflate a housing bubble.” We disagree that his statement China’s investment in American bonds, like the Japanese investment before, was “arguably” of any benefit at all to the U.S. economy. U.S. money supply should be determined by the Fed, not by any foreign power that is unarguably attempting by that policy to cause us to import more from them. It did contribute to the housing bubble but employment gains in construction were offset by the displacement every year of hundreds of thousands of industrial workers and caused  wage stagnation as those workers competed for lower-paying service jobs.

He writes: “Unlike the dollar, the euro or the yen, whose values fluctuate freely, China’s currency is pegged by official policy at about 6.8 yuan to the dollar. At this exchange rate, Chinese manufacturing has a large cost advantage over its rivals, leading to huge trade surpluses.” For example, as the dollar fell against the Euro and other countries’ currencies, the yuan, pegged to the dollar, fell against those currencies. As he sees it, China should let the yuan float. We agree, but it is doubtful that it would do much to reduce the trade deficit with China. Germany still has a sizable trade surplus with us even thought the dollar has fallen fifty percent against the Euro.

He argues that “right now the world is awash in cheap money. So if China were to start selling dollars, there’s no reason to think it would significantly raise U.S. interest rates. It would probably weaken the dollar against other currencies — but that would be good, not bad, for U.S. competitiveness and employment. So if the Chinese do dump dollars, we should send them a thank-you note.” The notion that a weakening dollar would stimulate U.S. exports and discourage U.S. imports is widely accepted by economists who ignore its political consequences.

Most of the world’s trade in commodities is conducted in U.S. dollars. It is appropriate that the currency of the world’s leading economic power be accepted as the world’s currency. But already as a result of the falling dollar, there are calls – especially by the BRIC countries and some UN agencies – for replacement of the dollar by another currency, the currency suggested most often being some version of IMF drawing rights. The way, in our opinion, to sustain the value of the dollar is to balance trade. There is no reason for the US dollar to fall against the Euro and other currencies when the U.S. trade deficit is the result of trade with China and the oil exporting countries.

In our book, we suggested that we restrict imports from China by the use of import licenses, a suggestion made by Warren Buffett. Personally, I favor a device that would change the relation between the yuan and the dollar without creating a costly new government bureaucracy. We can do this under World Trade Organization rules by levying a tariff on all imports from China. It has been suggested that the yuan is undervalued by 25 percent or more. The President currently may have the authority to impose such a tariff. In any case, it is easy to implement such a tariff and we already have in place the structure to collect tariffs. It’s real virtue is that it has the same effect as a fall in the value of the dollar because it makes all imports from China more expensive while keeping American goods as attractive as before. Another benefit is that it would add to federal tariff revenues which we could surely use.

Prof. Krugman deals with the claim that Chinese retaliation, such as dumping their hoard of American assets, would “wreak havoc” with the U.S. economy. We agree with him that we have little to lose while the Chinese have much more to lose. All countries gain from balanced trade as Ricardo showed two centuries ago. None benefit from an absence of trade. The current trade deficit with China is beneficial to China and has had disastrous consequences for American workers. In an addendum posted on his web site, Prof. Krugman estimates that our trade deficit with China has cost American industrial workers 1.4 million jobs. Our estimate is double that, 2.8 million,  and our trade deficit with the rest of world an additional 3.0 million or more.

Prof. Krugman concludes: “The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger.”  We disagree only to the extent that the decision is not China’s but ours.


Comment by Howard Richman, 1/4/2010:


As we noted in Chapter 3 of our book, Krugman once held that mercantilism is impossible in the modern world. Now, like us, he sees it as a significant threat. But, as you noted, he still doesn't have a way the United States can solve the problem. Here's the relevant passage from our book:

The only reference to mercantilism in his textbook on international economics is found in a box on page 542 entitled "Hume versus the Mercantilists." The mercantilists of the 16th through 18th centuries, as we pointed out, believed that a country’s wealth depended on its accumulation of gold which required a surplus of exports over imports. According to Krugman, "Hume’s reasoning shows that a perpetual surplus is impossible." An inflow of gold drives up prices in the surplus country and drives prices down in the deficit country which tends to correct the trade imbalance. Hume was wrong. If the goal of the gold mercantilists were to build their industry (not their gold hoard), they could have practiced the same system that the dollar mercantilists practice today by using the gold obtained from trade to buy assets in the trade deficit country.

According to Krugman, the possibility of mercantilism under a system of flexible exchange rates is similarly impossible. The flow of foreign currency into the surplus country would tend to depreciate the currency of the deficit country, lowering prices in the deficit country relative to the surplus country and raising prices in the surplus country. Krugman was ignoring the strategy that the dollar mercantilists have in fact been pursuing. Surplus countries simply stock up on the currency of the deficit country and use it to buy assets in the deficit country. These are acts which are appropriately called mercantilism because they are intended to perpetuate the surplus of exports over imports. They short-circuit the normal market correction.

Free-trade advocates, like Krugman, have been slow to come to understand the causes of the problem of dollar mercantilism and the US tax subsidies of foreign savings that have sustained the trade deficits. As a result, the remedies that they have so far proposed (increasing domestic savings, jawboning, or doing nothing) have been entirely inadequate. We will discuss each of these methods in turn. (pp. 72-73)


Howard Richman's response to this comment, 1/5/2010:
In the two years since we published "Trading Away Our Future", the economics profession has moved quite a bit in our direction. Professor Krugman is an indication of that. Just two years ago, we were just about the only ones talking about "mercantilism."

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  • [An] extensive argument for balanced trade, and a program to achieve balanced trade is presented in Trading Away Our Future, by Raymond Richman, Howard Richman and Jesse Richman. “A minimum standard for ensuring that trade does benefit all is that trade should be relatively in balance.” [Balanced Trade entry]

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  • [Trading Away Our Future] Examines the costs and benefits of U.S. trade and tax policies. Discusses why trade deficits matter; root of the trade deficit; the “ostrich” and “eagles” attitudes; how to balance trade; taxation of capital gains; the real estate tax; the corporate income tax; solving the low savings problem; how to protect one’s assets; and a program for a strong America....

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