"Push Back"

Tim Duy responds to Ryan Avent:

Push Back, by Tim Duy: Free Exchange pushes back on my concerns about the widening trade deficit and the declines in manufacturing capacity. I appreciate that - I am well aware that I am taking an unpopular position. Not quite so sure it is "lazy," but definitely unpopular.

Regarding my disbelief that higher paid grocery clerks are the answer to declining manufacturing capacity, Avent writes:

This is a lazy and unpersuasive assessment of what's involved in service sector activity. Obviously there is much more to service employment, including work in financial, information, education, and health services, much of which is (and will increasingly be) tradable.

True enough, I oversimplified service sector jobs. Maybe. Yes and no. To begin with, it is not exactly clear that the expansion of the financial sector has yielded a good outcome, unless you believe that greater financial volatility and widening income inequality is good. More importantly, Avent is arguing that service jobs are just as tradable as manufacturing jobs, and therefore a job is a job. Refer to Alan Blinder's hypothesis back in 2007:

We economists assure folks that things will be all right in the end. Both Americans and Indians will be better off. I think that's right. The basic principles of free trade that Adam Smith and David Ricardo taught us two centuries ago remain valid today: Just like people, nations benefit by specializing in the tasks they do best and trading with other nations for the rest. There's nothing new here theoretically.

But I would argue that there's something new about the coming transition to service offshoring. Those two powerful forces mentioned earlier -- technological advancement and the rise of China and India -- suggest that this particular transition will be large, lengthy and painful.

It's also going to be large. How large? In some recent research, I estimated that 30 million to 40 million U.S. jobs are potentially offshorable. These include scientists, mathematicians and editors on the high end and telephone operators, clerks and typists on the low end. Obviously, not all of these jobs are going to India, China or elsewhere. But many will.

Avent is essentially arguing that the US has a comparative advantage in service sector jobs. Blinder views these jobs as very vulnerable to offshoring, suggesting a lack of comparative advantage. If Blinder is right, then America apparently has little left in the comparative advantage department.

Avent continues:

As far as I can tell, Mr Duy seems to want to embrace a crash programme of protectionism against China. I don't know how this is supposed to boost America's long-term economic fortunes or what evidence he can present that it will. I don't know why Mr Duy is convinced that another spurt of manufacturing capacity growth, similar to that observed in the 1990s, isn't a possibility. And I have no idea why he is so confident that a return to the manufacturing economy observed in the immediate postwar decades—a time when technologies were vastly different, when the global economy was vastly different, and when a much larger share of the world's population lived in dire poverty—is a good idea.

I will deal with the protectionism argument later. I don't view American manufacturing as incapable of rebounding. But there are no price signals to prompt that rebound. That price signal should be delivered via currency values. The dollar should adjust to spur a net increase in export and import competing industries. It is not complicated. For some reason, however, that process is not happening. Something is interfering with the adjustment. That interference prompts American firms to expect that any new innovation needs a China strategy for production, if you believe the Andy Grove hypothesis.

Also, whenever you stick your neck out and say that manufacturing might be important, you suddenly get accused of being a barbarian trying to reinvent the 1950s. Of course manufacturing technology has fundamentally changed, as well as the mix of goods produced. But in the past, that productivity growth yielded more overall output and more manufacturing employment, even if the proportion of manufacturing jobs decreased relative to overall jobs. I can even buy into that story when capacity is rising and employment is stagnant. But something very different happened this decade. Capacity stagnated as millions of jobs were lost.

Avent continues:

This is simply a very empty and disappointing view of the evolution of economic activity. Mr Duy is implying that there is only so much producing of good stuff that can go on, and America used to have most of it and now China is taking it all and America needs to fight to get it back. He's wrong. The movement of some kinds of economic activity to China is creating new opportunities in America. America's problem isn't that some jobs are leaving. It's that it's doing a poor job of preparing its workers to take advantage of the new opportunities.

If that is true, then there should be millions of jobs available to soak up the workers released from manufacturing, and wages should be soaring because we have a structural flaw in economy - the skills of the released workers do not match those needed by expanding sectors. That structural flaw should be sufficient to encourage workers to gain more education and employers to provide more on the job training. While I am sure that is true in a few sectors, in aggregate real wages and nonfarm payrolls have been stagnant for a decade. Where are these high wage paying jobs? Or even median wage paying jobs at this point? Silly me, I actually believe the unapologetic and unquestioning supporters of free trade need to answer this question. We are millions of jobs below trend, and we have lost millions of jobs in manufacturing - the manufacturing of goods that we still consume, no less. Moreover, these two trends occurred in the same decade, in concert with a third trend - the sharp rise in foreign official reserve accumulation. How can you not be even allowed to suggest that there just might be a connection?

As always, questioning the nature of trade patterns this decade means you are an ignorant protectionist. Blinder tried to get ahead of this argument:

What else is to be done? Trade protection won't work. You can't block electrons from crossing national borders. Because U.S. labor cannot compete on price, we must reemphasize the things that have kept us on top of the economic food chain for so long: technology, innovation, entrepreneurship, adaptability and the like. That means more science and engineering, more spending on R&D, keeping our capital markets big and vibrant, and not letting ourselves get locked into "sunset" industries.

What is amusing about the whole analysis is that I believe free trade works, but I also believe we don't really have free trade. In reality, foreign central banks manipulate currency levels such they accumulate massive amounts of foreign exchange reserves that effectively recycle Dollars back into the US to support consumption activities, and thus impact the dynamics of trade flows in an obviously mercantilistic fashion. This has been accomplished with the full acceptance and even cooperation of the US Treasury. It was an outcome of the strong Dollar policy, and it is why China has not been named a currency manipulator since 1994. But those central banks are immune from criticism on free trade because they interfere in the financial side of the external accounts, not the current transactions side. Indeed, one cannot even question the negative impacts of this dynamic. Avent essentially falls back on the same argument I lamented about last week:

... every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley. Therefore, the examination ends. Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

Another version of this argument: International trade is driven by comparative advantage. If manufacturing jobs are lost from international trade, is must be the result of a relative comparative disadvantage. The financial side of the account is irrelevant.

If you fall back on the pro-free trade argument that service sector jobs will compensate for the offshoring in manufacturing, you ignore the fact that the currency manipulation that impacted manufacturing will have the same impact on the service sector jobs if they are truly tradable. If service sector jobs are just as offshorable as manufacturing jobs, then Blinder's prescription is destined to fail unless there is a concerted, sustained effort to control the accumulation of reserves among foreign central banks.

I very much recommend Michael Pettis for an another view of what I consider to be the same problem:

...As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge. And at first they will surge. Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.

But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit. This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.

I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.

The US, in other words, is not likely to face the “nuclear option” of a Chinese disruption of the US Treasury bond market. It is far more likely to be swamped by a tsunami of foreign capital. This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment. It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.[Emphasis added]

Therein lies the problem. A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite. Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge. So the problem isn’t too little capital inflow or a sudden boycott of USG bonds. On the contrary, the US will see too much capital inflow.

All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets. Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit? I would be willing to bet that we do.

The patterns of capital flows and how those flows have impacted production and consumption location outcomes is a critically important issue. Even more so if the flows into the US are simply supporting consumption spending via fiscal deficits but creating relatively few jobs because that spending is quickly directed overseas, and the pace of that direction accelerates as industrial capacity contracts. Yet if you even suggest the shift in production outcomes is creating very serious and long lasting problems, your thoughts are considered "fairly poorly reasoned."

Bottom Line: When I express concerns over free trade, I am really expressing immense frustration over an international financial architecture that sustains and maintains global imbalances that yield outcomes that I believe are very difficult to justify and yet are accepted due to a blind faith in free trade. In essence, the ability to manipulate capital flows has made a mockery of the free trade crowd. I know. I used to be in that crowd, and in many ways still am. But I can no longer wrap myself in the free trade flag to justify the negative impacts of financial account manipulation. And if the US cannot seriously address financial account manipulation on a global basis - and if the Pettis article is correct, the US Treasury will fall short of what is needed even with the announced adjustment to Chinese currency policy - what choices are you left with? Either accept continued economic stagnation, or act unilaterally on the current transactions (tariffs) or financial (reciprocative devaluation or capital controls) side of the accounts. None of which are pleasant options.