Friday, December 28, 2007

Krugman on Trade (!)

Long before he became a pundit, Paul Krugman was one of the world's leading trade economists, so it was nice to see him take a break from picking on Barack Obama to write about trade in his NY Times column today. Interestingly, the argument he makes in the column implies that his own theory is becoming less relevant as a description of US trade patterns.

In standard textbook neoclassical trade theory ("Heckscher-Ohlin"), countries specialize according to their factor (resource) endowments - e.g. a country with a large amount of arable land (relative to other factors) will specialize in food production, while a capital-abundant country will specialize in manufactured goods. The countries will exchange food for manufactured goods. That is, trade occurs because the countries are different, and they specialize in different goods.

One significant weakness of this theory is that much of the trade that actually occurs in the world is between similar countries, trading similar products ("intra-industry" trade) - e.g. Canada exports cars to the US, and the US exports cars to Canada; Italy exports wine to France, and France exports wine to Italy.

In his earth-shattering paper "Increasing Returns, Monopolistic Competition and International Trade" (Journal of International Economics, 1979), Krugman developed a model to explain how two similar countries gain from trading similar products. In Krugman's model, firms in each country produce differentiated varieties of similar goods (e.g. Heineken and Samuel Adams are both varieties of beer). Trade allows the firms to produce on a larger, more efficient scale, because they can sell their product in a larger market, and consumers gain access to more varieties of goods.

This is what he is talking about here:
Trade between high-wage countries tends to be a modest win for all, or almost all, concerned. When a free-trade pact made it possible to integrate the U.S. and Canadian auto industries in the 1960s, each country’s industry concentrated on producing a narrower range of products at larger scale. The result was an all-round, broadly shared rise in productivity and wages.
What is new, according to Krugman, is:
We now import more manufactured goods from the third world than from other advanced economies. That is, a majority of our industrial trade is now with countries that are much poorer than we are and that pay their workers much lower wages.
On his blog, he provides a graph. In terms of trade theory, what is going on is that a larger share of trade is with countries that have different factor endowments - e.g. China is abundant in unskilled labor and the US is abundant in skilled labor (this recent Washington Post story has some good examples of this type of trade). Krugman:
Although the outsourcing of some high-tech jobs to India has made headlines, on balance, highly educated workers in the United States benefit from higher wages and expanded job opportunities because of trade. For example, ThinkPad notebook computers are now made by a Chinese company, Lenovo, but a lot of Lenovo’s research and development is conducted in North Carolina.

But 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.

That is, a growing share of our trade is explained by the neoclassical model (and a smaller share by the Krugman model). Neoclassical theory has very clear distributional implications - trade increases the relative returns to the abundant factor. For the US that means skilled workers will see increased wages, and wages for unskilled workers will fall. This leads to the conclusion:

It’s often claimed that limits on trade benefit only a small number of Americans, while hurting the vast majority. That’s still true of things like the import quota on sugar. But when it comes to manufactured goods, it’s at least arguable that the reverse is true. The highly educated workers who clearly benefit from growing trade with third-world economies are a minority, greatly outnumbered by those who probably lose.

As I said, I’m not a protectionist. For the sake of the world as a whole, I hope that we respond to the trouble with trade not by shutting trade down, but by doing things like strengthening the social safety net. But those who are worried about trade have a point, and deserve some respect.

Greg Mankiw promises we will hear more from Krugman in the Brookings Papers on Economic Activity.

Update (12/29): On his blog, Krugman responds (He says: "Earth-Shattering? I’m proud of my early work on trade, but not this proud still, thanks for the compliment." I could have said "seminal" but I don't think that would have quite done it justice... he, along with a few others, really did change trade theory. Unfortunately trade pedagogy and trade policy discussion haven't really caught up). Krugman also offered some background on the issue of trade and wages. His column prompted thoughts from KNZN on the politics and economics of trade, and Free Exchange weighed in, too.


Anonymous said...

It seems to me that Paul is still struggling with the implications of this view. He concludes the column by saying, twice, that he is not a protectionist, but he also says that we should respect "those who are worried about trade." But what if those who are worried about trade are protectionists? Should we still respect them?

We are all Protectionists, Greg, especially you. It all depends on what you are trying to protect. In your case (Mankiew) I suspect you prefer to protect the trickle down thing.

Very Snarky. I would think that one of the chief architects of the bubble economy (Mankiew) would at least try to avoid the republican labeling and shoutdown.

Bill C said...

That first paragraph is from Mankiw's blog post (he doesn't allow comments any more).

I think this whole business of arguing over who is, or isn't, "protectionist" has become really counter-productive. The word is basically a shorthand for "ignorant of trade theory" and/or "putting narrow interests ahead of national welfare."

That even such an eminent trade economist as Krugman has to say "I'm not a protectionist, but" is just silly. Anybody who really pays attention in their trade class - i.e. doesn't just shut their brain off after a simple example from the Ricardian model validates their own 'free market' prejuduces - realizes there are real issues of distribution and market power (alas that criticism applies to professors as well as students). Moreover, the WTO and all the various "free trade agreements" are about much more than lowering tariffs - they are complicated beasts, influenced heavily by political power, so to be critical of them is not necessarily to be "anti-trade."

Unfortunately, trying to sort out who's a "protectionist" gets in the way of a serious discussion of the real issues. Dani Rodrik has had some excellent things to say on this issue on his blog - especially see his May 4 post "And now on to something economists can really discuss."