Does mercantilism work in a Keynesian world?

Yes it does. And not just in theory, but also in practice.

The evidence comes from the 1930s, and from the work of Ben Bernanke himself (along with other scholars like Barry Eichengreen).  The important finding is that countries that devalued their currencies by getting off the gold standard were able to recover more quickly, thanks in part to an increase in their net exports relative to countries that stayed on gold.  Note that a currency depreciation amounts to a policy of combining import tariffs with export subsidies--hence the mercantilist intent and effect.

Interestingly, Bernanke finds that the increase in net exports came from the increase in exports, while imports did not decline more than it did in countries remaining on the gold standard.  He speculates that the reason has to do with the increase in income (thanks to the depreciation) which pushed demand for imports higher and offset the substitution effects. 

I am writing all this partly in response to Tyler Cowen's comment that any theory that suggests import protection can be a good thing must be a deeply flawed theory.  The experience with currency devaluations during the 1930s shows that the theory is in fact quite OK.

What the theory does not consider fully, which was rather my point, is that mercantilist policies--Keynesianism in one country--has adverse effects on others.  My net exports can increase only at the expense of yours.  Similarly, the worse thing about Smoot-Hawley was that it led to a vicious cycle of protectionism everywhere. 

So the implication is not that we throw the theory overboard, but that we foresee its global implications and apply the requisite remedy: a globally coordinated fiscal stimulus, which requires in turn that we provide the developing countries with the liquidity and fiscal resources needed to get on board.     

Comments

[Greg Ransom]

We've had $8 trillion in Keynesian "stimulus" in the last 8 years.

The Wil. E. Coyote has been "stimulated" right off the edge of the cliff with peddle to the metal "stimulus" and now he is in mid-air looking down at the canyon below ...

For discredited Keynsians to repeatedly recommend that Wil. E. Coyote push his foot harder on the floor board so he'll somehow permanently float and above the canyon floor -- well we've had enough of that nonsense.

Economists under the sway of the pseudo-science of Keynesian inspired macro must be blamed as much as anyone for our current situation.

Another dose of the Keynesian shamanism and the macroeconomists will simply have more to answer for.

[Greg Ransom]

Here's my recommendation.

What economists need to be doing right now is figure out how to heal thyself.

Macroeconomics is broken.

It's failed.

Fix it.

Leave the economy alone.

You've done enough to the rest of us already.

[Richard]

SDRs are a balance of payments support instrument. So the only way to translate new SDRs into fiscal space is to encourage central bank lending to government Treasuries, right? Wouldn't that be a setback to the structural reforms that have led to disinflation in developing nations?

[robertdfeinman]

I think Ha-Joon Chang's arguments in "Bad Samaritans" need to be addressed if one is going to make a case against protectionism.

His entire thesis is that protectionism is not only appropriate, but necessary if developing countries are going to get ahead.

Even in a country like the US one could make a case that there are segments of the market which need protection for some reason or other. Broad, sweeping, philosophical positions usually turn out to miss the important nuances that make the real world so hard to manage (or model).

We have a form of protectionism in the US. States use right to work laws to "protect" their local labor market from the competition of unionized workforces in other states. This makes it impossible for unions to export their service to these locales.

The competition over tax breaks offered for regional development is also a form of inter-state protectionism. One doesn't have to study international affairs to see the good and the bad of "trade" policies.

[Tord Steiro]

Greg Ransom:
You are missing the vital point here. Keynes was talking about solutions for Depressions. The US was hardly heading for a depression when Bush took office in 2001, and was certainly not in a Depression from 2005 onwards.

Hence there is absolutely nonsense to use that as evidence against a Keynesian crisis response. What you are refering to - the economic mismanagement of Mr. Bush - is anti-Keynesian in the sense that it inflated the boom rather than offset a bust.

So when you are criticizing Keynes, please keep that in mind. Use the policy responses in the 30 years after WWII to discredit Keynes rather than the past eight.

And for the record, I personally believe that although Keynes contributed significantly to economics and our understanding of how to deal with economic busts, but it is a pity tat he also paved the way for so much folly and populistic spending.

[Mark]

I thought the main effect of getting off the gold standard was it free up countries to practice inflationary monetary and fiscal policies. Is this different from "thanks in part to an increase in their net exports?" I know this all ties together, i.e. lower interest rates lead to a reduced dollar value which leads to increased exports. But are they all equivalent?

[Bill H]

Note that a currency depreciation amounts to a policy of combining import tariffs with export subsidies--hence the mercantilist intent and effect.

It's unclear to me that these two policies are equivalent in a country (such as the U.S.) with a relatively open capital market and a relatively flexible exchange rate. The impact of a broad tariff designed to reduce aggregate imports (and thereby reduce the trade deficit) would be to cause the dollar to appreciate further. This would cause some combination of an decrease in exports, an increase in imports, or a drying of up the sources of foreign investment that the government would need to finance an expansionary fiscal policy.

It also makes the heroic assumption that there would be no retaliation on the part of U.S. trading partners, thereby causing our export markets to dry up. How'd the Smoot-Hawley tariff work out on that dimension? How many serious economists are willing to argue that it made the Great Depression better?

[Bill H]

The first paragraph in my previous comment is a quote from the original post.

[Justin Rietz]

Re: going off the gold standard. Mark is correct - the gold standard didn't fail, but rather inflationary policies made it impossible to stay on a gold standard. Per Dani's comment, to simply say that countries that dropped the gold standard first recovered first is merely to note a correlation, not necessarily a causation (it didn't work for the UK). There were many other factors at play. And while there may be a short-run boost from inflation, in the medium to long run,it causes problems.

Regarding Keynesian policies: we don't have an aggregate demand shortage, we have an aggregate savings shortage. Increased savings pushes downards on interest rates and provides funds for business investment. After the World Trade Center attacks, Greenspan flooded the market with dollars, resulting in a consumer spending spree and an inflationary asset bubble. It was unsustainable, and the economy is unfortunately now paying the price.

I expect to see a continued deflation / deleveraging for a while, but then fairly high inflation in the not to distant future (commodity shortages will most likey add to price pressures, though this isn't inflation per se). Throughout history, any time a country prints as much money as the U.S. is currently doing, the final outcome is high inflation.

As a side note, for several years many Austrian school economists have been predicting (accurately) that this exact pattern of boom/bust would occur and what the result would be. The nailed not only that it would occur, but when it would occur and how it would occur.

[Dave Levy]

Martin Wolf has a column in this week's FT, which complements Dani's post. Essentially, the only way this is going to work is if Surplus countries (China, Japan, Germany, and the Oil exporters) spend money on domestic demand that will fuel our ability to export our way out of this mess. I think it would come in two successive forms:

1) Infrastructure Spending (but more practical and less speculative than what Dubai has become) that would require US know-how and capital equipment support.

2) Consumer Durables, which hopefully would come from the US. If they came from their home countries, that would be fine, because then our producers would "fill in the gap" for our demand, fueling our own increase in domestic demand.

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[Justin Rietz]

Correction: the UK did experience some short term benefit from going off the gold standard.

[mrrunangun]

"a globally coordinated fiscal stimulus, which requires in turn that we provide the developing countries with the liquidity and fiscal resources needed to get on board."
Who is we? Should the USA "quantitatively ease" more money into the hands of the LDCs or should we borrow more from the Saudis and Chinese so we can give it to them? Any evidence that the Chinese or Saudis might give away their own money to the LDCs?

[Tanya White]

Despite his references to mercantilism, the mature Keynes of the General Theory through to Bretton Woods and beyond did not favour "Keynesianism in one country". Instead, he wanted international coordination of Keynesian policies and an international economic architecture that enabled countries to pursue domestic policies with reduced exchange risks - and all this was to be combined with a high degree of freedom of trade. It would be a good idea to read Donald Markwell's detailed historical exposition of Keynes' thinking on this.

[Global Chessboard]

The real question is whether we're ready to make fair SDR allocations to emerging markets. For instance, looking at China's accumulation of $2 trillion and more in forex reserves, how much SDR allocation will that warrant?

[Per Kurowski]

Dani says “the requisite remedy: a globally coordinated fiscal stimulus, which requires in turn that we provide the developing countries with the liquidity and fiscal resources needed to get on board.”

To get on board on what? China and India getting on board of ever more cars?

[Global Chessboard]

My view is that the gold standard itself was the problem, which prevented Keynesian economics from succeeding. As the total material products of a civilization increase the total of the gold remains the same. A financial architecture based on allocated property rights in gold thus fails to reflect the increased value of the products of the civilization. The systemic deflationary environment caused by a gold standard nullified any attempts to improve returns on equity through leveraging, even in relatively mature industries like railroads. In the absence of a gold standard, and in the absence of today's operative us dollar standard there are no limits to the success of monetary expansion. But man will always compete with man to accumulate something that has limited supply, and store that as an indication of future wealth.

[Mark]

Given US indebtedness there is a need for more Schacht ( http://en.wikipedia.org/wiki/Hjalmar_Schacht ) and less Keynes. Maybe Food Stamps could be the new Mefo Bills ( http://en.wikipedia.org/wiki/Mefo_bills ).

[Qingdao]

"...apply the requisite remedy: a globally coordinated fiscal stimulus, which requires in turn that we provide the developing countries with the liquidity and fiscal resources needed to get on board". Sec. Paulson was just in Beijing for 3 days - surely time enough to "coordinate a fiscal stimulus;" and surely the Chinese do not need "liquidity ... to get on board." My guess is they have no interest in "getting on board." I fear that people far less subtle than Prof. Rodrik will use his algebra to create the case for "a temporary fair trade tarif"; then the next time 6000 workers riot in Guandong they will be justifiably furious at the U.S. for causing their misery. Then of course Sec. Clinton will sternly lecture the brutes about human rights and ...

[Greg Ransom]

Tord,

The average macroeconomist doesn't know a lick of Keynes -- they've simply adopted his pseudo-scientific method, which pits one "aggregate" causally against another "aggregate" in a realm theoretically detached and causally contradicted by the actual causal mechanism of changing heterogeneous production goods, changing relative prices, and heterogeneous learning individuals.

And Hayek had Keynes dead to rights -- the man changed his spin with the political tides, and as each expedient construction was picked apart by his economic betters. The Keynes of 1936 has been decimated by empirical evidence and theoretical analysis -- contemporary macroeconomists simply choose to ignore this fact.

"Greg Ransom:
You are missing the vital point here. Keynes was talking about solutions for Depressions."

[Catherine Couch]

Merchantilism should be the new - old word on the lips of every talking head and radio mouthpiece (minus the gold standard element). Instead, protectionists are scoffed at and those that would promote "buy American" are treated like children who don't know any better. If anyone doubts that we are entering another depression resulting from a decreasing manufacturing base, I would love to show you a state called Michigan - and not just the auto industry. As our per capita income planes, we can watch in awe as the gdps of Mexico and China increase ten fold. Glad to be of service.

[Anarcho]

"And Hayek had Keynes dead to rights"

Shame, then, that he could not refute the critiques of Sraffa and Kaldor and so lost the 1930s debates on the business cycle. But never mind!

"the man changed his spin with the political tides, and as each expedient construction was picked apart by his economic betters."

Wow, impressive that even watered-down Keynesianism become the dominant economic theory after the war. His "economic betters" (I guess that would be the "Austrians"?) went to the sidelines, where they have (thankfully) remained...

[Beezer]

How about we restore lending standards to banking. Let them figure out how to remain solvent.

Next, let's rebuild our infrastructure for this century. Starting anytime now would be good.

While we're doing this, establish universal healthcare. In a better world, everyone would have access to basic healthcare.

If you come to our country and build a plant, you shall pay union wages and union benefits. If you're going to beggar us, at least have the civility to do it from afar, like in you're own country.

Forget unfettered globalization. Take things between nations on a case by case, and industry by industry basis. After all, each case is unique, in point of fact.

[reason]

Greg Ransom...
Strange isn't it how Keynesianism fucked things up in the 1930s. Oh wait!

[reason]

http://krugman.blogs.nytimes.com/2008/11/10/fiscal-fdr/

[reason]

Yes I know Greg Ransom you HATE Paul Krugman. Not only has he a Nobel prise (and you don't), he is almost always right!

[sindibad]

Dear Professor Rodrik,

I have to be really thankful for you for this and similar posts which have really illuminated my thinking on economics by showing me just how ridiculous and absurd Keynsian dogma is. If you mean this blog as a reductio ad absurdum of Keynsianism, then you've entirely succeeded.

[jean]

Paul Krugman seems to agree on the principle of externalities of the budget policy:

http://krugman.blogs.nytimes.com/2008/12/14/european-macro-algebra-wonkish/

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