Trade Measures and the Capital Account

Peter Dorman comments on Mankiew's NYT piece on the trade deficit.  This concerns the extent to which the balance of trade depends on capital flows and what this implies when thinking about the consequences for output and employment.

There are a couple of points worth emphasising here:

1. Measures aimed at improving trade performance will have no impact on the trade balance if capital account flows remain unchanged (also assuming investment income is unchanged).

2. Such measures do not actually need to change the trade balance in order to be effective.

The first point is simply an accounting statement, but it helps highlight some important mechanics.

Net trade flows can only change if capital flows change.  So in order to understand how net trade will respond to trade measures, we have to also understand how capital flows will respond.  The miracle of accounting ensures that every piece of trade will be matched by a financial flow.  But it is not only the item of trade that has to acceptable to the agents involved.  The change in balance sheets also has to be acceptable.

If it is not, something has to give.  This is probably the exchange rate and in the extreme case this would stop the trade item happening by making it no longer attractive.

Now, measures taken to improve trade performance may have consequences which impact on the preferences agents have for financial balances.  The most obvious possibility here is again movements in the exchange rate.  But, in the extreme case, where financial preferences do not respond, there can be no change in the trade balance.

However, this does not mean that trade measures can have no effect unless they change balance sheet preferences.  This brings us to the second point.  The easiest way to show this is to start with some simple identities.  We have net exports (NX) as exports (X) less imports (M):

NX = X -M

and we define the import propensity (m) as imports divided by GDP (Y)

m = M / Y

An elementary re-arrangement gives:

Y = ( X - NX ) / m

This shows that, if our concern is the impact on output and employment, then trade measures can be effective without needing to change the trade balance.  If the trade balance is in fact driven by inelastic flows on the capital account, measures that increase exports or reduce the import propensity can still raise output.

Productivity growth is about what you make, not how much.

In his Autumn Statement speech, the UK chancellor Philip Hammond talked about the UK falling behind in productivity.  He made the comment that "...it takes a German worker 4 days to produce what we make in 5".

Productivity matters because it drives what we earn.  A nation with higher productivity will be able to pay a higher real wage.

The first point to make here is that it is the average that matters.  So, nobody is claiming that for example, that  it takes a British hairdresser 25 minutes to cut one head of hair, when it only takes a German hairdresser 20 minutes.  And the average is what matters for pay.  Hairdressers in rich nations earn more than those in poor, because overall productivity in those nations is higher.  Not because they are quicker at cutting hair.

So, whilst there are some areas where productivity is the same in different nations, there are others where it will be different.  So, maybe in the car industry for example, German workers are producing more cars per day than British workers.

Now, this may be the case.  But on the whole, it is not so much about quantity as quality.  Productivity growth tends to arise not because we learn how to make more off the same stuff with less effort, but because we develop new and better products.  We have better televisions than we had 50 years ago; not simply more of the same old model.

It may not be so much that German workers produce more cars in a given period, than that they produce better cars in that period.  And in practice, being "better" simply means commanding a higher price.  (Productivity is derived from volume measures of output, which have to use estimates for the relative quality of new or improved products.  These estimates are often based on relative price.)

Therefore, what Hammond's comment means is that the output of the average German worker sells for 125% of what the average British worker's output does.  Fixing this comes not making more of the same thing per day, but from making stuff that is in higher demand and sells for more.  Positioning in international trade is a key part of this.

Devaluation and Tariffs

Chris Dillow has a post comparing devaluation and tariffs.  This raises some interesting points but misses what seem to me to be some of the most important distinctions.

First, tariffs raise revenue for the state that levies them.  This transfer from private to public sector represents a form of fiscal tightening with a potentially contractionary impact on demand.  To make a better comparison with the impact of devaluation, it is therefore useful to consider an imposition of tariffs combined with a reduction in general sales tax or value added tax, to the extent that the net tax take is unchanged.

This has the additional benefit that the overall price level for domestic sales is largely unchanged (ignoring any exchange rate movements that might result from the imposition of tariffs).  Prices of imports (or goods with high imported content) rise, but prices of domestically produced goods fall.

This is the key benefit (to the nation that levies them) of tariffs.  A devaluation raises the domestically denominated price of imported goods (generally by some fraction of the change in the exchange rate) and that of those foreign goods that compete with exports.  The rise in import prices not only has a direct impact on the general price level, but firms using domestic inputs are also able to raise their sales prices.  In the absence of any wage adjustment, this produces an immediate reduction in real wages and a drop in the wage share of national income.

What happens thereafter depends on the ability of labour to resist this erosion of the real wage.  If they are able to secure nominal wage increases then this further increases domestic based prices.  If this happens to a great enough extent, it may end up eliminating any impact of the devaluation on real price differences.  In which case, the devaluation no longer has any impact.

This is why tariffs (specifically a general tariff) may work when a devaluation does not.  It facilitates a favourable change in a nation's net export propensity without requiring a reduction in that nation's real wage level. 

In some cases, this may be the only way that particular nation can expand.  The problem is that it doesn't work if every nation imposes tariffs.  So, if some nations have to compete by having low unit labour costs, they might object to the lucky nation that gets to avoid doing so.  Particularly when it is a developed nation, with a relatively high standard of living.

However, nations often respond to a balance of payments constraint, not by devaluing, but by suppressing domestic demand, keeping the economy in a state of underemployment.  This does nobody any good and in such cases, at least in principle, a programme of tariffs may offer an improvement even for those nations that are on the wrong end of them.

Productivity Growth and Trade: A Model

I did a post back in May about manufacturing in the UK and its role in productivity growth and in foreign trade.  My purpose was to stress that, for an economy as open as the UK, industry concentration was more about trade than about productivity growth.  

The fact is that simply securing productivity growth can actually be detrimental for a country.  The reasons for this are not immediately obvious, so I drew up a little model to illustrate it. 

There are two countries: Country A and Country B.  Each country produces haircuts and one type of fruit - Country A produces apples and Country B produces bananas.  Haircuts are not traded internationally; fruit is.  So households in each country consume two types of fruit and domestic haircuts.

Wages are fixed in the currency of each country.  All prices are set at the same fixed mark-up to unit labour costs.  We'll call Country A's currency the $, and Country B's £.

The elasticity of substitution in demand is the same for each product and in each country.  We start by assuming that in both countries, households spend an equal amount on each of the three products they consume and that 1/3rd of the workforce is employed in producing haircuts and 2/3rds in producing fruit.

The £ / $ exchange rate floats to ensure that the value of exports equals the value of imports for each country.  The labour supply is fixed and demand is managed to ensure continual full employment.

So far, each country is identical.  The difference we want to introduce is to suppose that there is a 3% per period growth in labour productivity in the production of bananas.  There is no change in labour productivity in the production of apples or haircuts.

The charts below are based on an elasticity of substitution in demand of 0.75 and are normalised to give opening values of unity.

The first thing to notice is that the banana producing Country B has GDP growth and Country A does not.  (GDP is calculated here as a chained volume measure at opening year prices.) This is hardly surprising.  The GDP growth rate is less than the rate of growth in banana productivity, because there is no change in productivity in haircuts.

Rising banana productivity means falling unit labour costs and falling banana prices in the domestic currency, £.

 

At the prevailing exchange rate, a fall in the £ banana price would lead to a drop in the value of exports for Country B, even though the volume of exports rises, given that the demand elasticity is less than 1.  The exchange rate therefore has to change leading to a fall in the value of the £ against the $.  This means that the $ price of bananas falls by even more than the £ price.  It also means that £ price of apples rises, even though the $ price of apples is unchanged.

These further price changes alter trade volumes until the values of trade flows balance.  The chart below shows that this involves a big increase in the banana exports of Country B, whilst there is a slight decline in Country A's apple exports.  This is consistent with Thirlwall's Law and what is happening here to GDP.

The exchange rate movement also means that consumer prices fall by more in Country A than in Country B.  This means that real wages (based on a consumption price index - not the GDP deflator) rise more slowly in Country B than in Country A, notwithstanding that Country B is generating all of the growth in production.

In this model, Country A wages rise faster than those in Country B whenever the elasticity of substitution in demand is less than 1.  In fact, if the elasticity is less than about 0.61, then real wages in Country B actually fall, because the £ price of apples rises faster than the £ price of bananas falls.  This result is somewhat counter-intuitive.

These elasticity levels are not at all unrealistic for international trade flows. 

As a further point it is worth noting that Country B can mitigate the reduction in its own real wages by depressing domestic demand.  This reduces employment and GDP in Country B.  It raises real wages in Country B, but reduces them in Country A.  Imposing tariffs (whether on exports or on imports) will also raise real wages in Country B at the expense of those in Country A, but does not involve reduced employment.

The purpose of this post is simply to highlight two points:

1. GDP growth is not the same as growth in living standards.  A country that has a high proportion of activity in industries with strong productivity growth is likely to have high GDP growth.  But this, in itself, is not a good reason to concentrate on such industries.

2. Elasticities in traded goods are crucial.

However, it is not the purpose of this post to suggest that it is a bad thing to have industries with high potential productivity growth.  In practice growth in productivity is not mainly about producing more of the same for given inputs; it is about producing new and better products.  This innovation is itself important in developing and sustaining export demand.  We cannot separate developments in trade from what is happening with productivity growth.  The important point though is that trade is a critical part of the picture; productivity growth alone tells us very little.

Equation Listing

Consumption of each good in each country is based on a consumption index and the price relative to a consumption price index.

1.            C_Aa = C_A / 3 . (p_$a / p_A)^-ε

2.            C_Ab = C_A / 3 . (p_$b / p_A)^-ε

3.            C_Ah = C_A / 3 . (p_$h / p_A)^-ε

4.            C_Ba = C_B / 3 . ( p_£a / p_B)^-ε

5.            C_Bb = C_B / 3 . (p_£b / p_B)^-ε

6.            C_Bh = C_B / 3 . (p_£h / p_B)^-ε

With the price indices calculated as:

7.            p_A = ( p_$a . C_Aa + p_$b . C_Ab + p_$h . C_Ah) / C_A

8.            p_B = ( p_£a . C_Ba + p_£b . C_Bb + p_£h . C_Bh) / C_B

All domestic prices are set at the same mark-up to unit labour costs.

9.            p_£b = λ . w_B / σ_b

10.          p_£h = λ . w_B / σ_h

11.          p_$a = λ . w_A / σ_a

12.          p_$h = λ . w_A / σ_h

Import prices reflect the exchange rate.

13.          p_£a = e . p_$a

14.          p_$b = p_£b / e

The value of exports equals the value of imports.  (This equation is used to find the market clearing exchange rate.)

15.          C_Ab . p_$b = C_Ba . p_$a

Employment is based on consumption and productivity.  (In the basic scenario described, the levels of the consumption indices C_A and C_B are set so that all available labour is employed in both countries.)

16.          L_B = C_Bh / σ_h + ( C_Ab + C_Bb ) / σ_b

17.          L_A = C_Ah / σ_h + ( C_Aa + C_Ba ) / σ_a

Variables

C_Xy          Consumption of y in country X

C_X            Consumption index in country X

p_zy          Price of y denominated in z

p_X            Price index in country X, denominated in domestic currency

w_X           Nominal wages in country X, denominated in domestic currency

σ_y                  Labour productivity in production of y

L_X            Employment in country X

e             Exchange rate ( £ per $ )

σ is given the same value for each good, in the first period.