Krugman favors Protectionism

It began with an NYT editorial by Paul Krugman, who appears to have a number of hobby horses that occupy most of his efforts – demanding more deficit spending, more money printing, raising taxes and bashing China for currency manipulation.


In short, he would have felt right at home – in the Hoover administration!  Let us see: more money printing, check – the Fed increased free bank reserves by over 400% during Hoover's term. More deficit spending, check – by 1933 Hoover had created what was at the time the biggest ever peace time deficit. Raising taxes, check – Hoover enacted one of the greatest tax increases in peace time ever as well, raising a vast array of taxes and creating or reviving a plethora of new ones. Lastly, we all know about his support for protectionist measures that helped nudge a severe recession over the cliff, turning it into a total economic collapse as global trade plunged.

The irony is of course that Krugman is extremely critical if Hoover, presumably because he never bothered to look at the facts and has swallowed the historical propaganda lie about 'Hoover the laissez faire president' hook line and sinker.  And yet, it is almost as though Hoover had received Krugman's advice through a time machine.

Now, don't get us wrong – we also tend to think that China's exchange rate policies are harmful – alas, they are mostly harmful for China. We are in fact critical of many of China's policies, from its 'credit inflation by government directive' to its internal price controls on a range of goods to its micro-management of industry, and we acknowledge that some of these policies reflect negatively on the rest of the world.



Tienanmen Square, Beijing

(Photo credit: fmh)



For instance, China's giant  money supply inflation and concurrent enactment of price controls, including the rigid exchange rate, spurs demand for commodities and raises their prices beyond where they would normally trade. However, this situation would only get worse if the exchange rate of the yuan were to appreciate as Krugman demands.

Note here that Krugman asserts that the yuan's exchange rate would increase if it were allowed to float as though that were an incontestable given (he does not explicitly demand a floating, fully convertible yuan however – he just wants China to keep 'manipulating' it, albeit in an upward direction):


“If discussion of Chinese currency policy seems confusing, it’s only because many people don’t want to face up to the stark, simple reality — namely, that China is deliberately keeping its currency artificially weak.”


How do we know whether the yuan is 'artificially weak'? As a matter of fact, we do not know that, and there are many arguments in favor of the yuan weakening if it were allowed to float. Number one on the list is the relative   pace of money supply inflation – China's has been far higher than that of the US for many years. The most recent data are:

China's M2, a broad measure of its money supply, was RMB 68.75 trillion at the end of August, up 19.2% compared with a year ago.

M1, which includes deposits in withdrawal-on-demand accounts and cash in circulation, rose 21.9% year on year to RMB 24.43 trillion last month.

The composition of China's M1 comes closest to the definition of US money TMS-1, or the narrow Austrian money supply measure as defined by Frank Shostak.  Note that the annualized growth of money TMS-1 in the US was only  2.4%as of July. Even if one uses the broader measure TMS-2 that includes savings deposits on the grounds that they can likewise be withdrawn on demand in practice, its year-on-year growth was 10.3% in the most recent  reporting period (July), less than half of the money supply growth reported by China.

In addition to these considerations, think about the fact that China's citizens had to live with a closed capital account for an eternity. How would they react if it were to be opened? We tend to think that citizens with large savings who have heretofore been forced to invest those savings within China – a major force in driving China's real estate bubble to absurd heights – would begin to divert a lot of capital to investments abroad. While we can not be certain how big a flood of money would leave China in the event, it's a good bet the markets are not prepared for it. The consensus is after all congruent with Krugman's assertion that the yuan is too weak.

Let us however step back for a moment from this discussion and for argument's sake accept the notion that the yuan's exchange rate is too low and would rise if left to float. How can that harm the US? Krugman asserts that a trade deficit is 'negative', but why should that be so? Trade is after all a voluntary economic activity. When people engage in trade, they do so because both parties to the trade deem it to their economic advantage.  It follows that there can be nothing 'negative' about this. China's merchants wouldn't sell their goods for dollars if they did not prefer these dollars over their merchandise, and conversely US consumers would not trade their dollars for Chinese merchandise if they thought the trade harmful to their economic well-being. Just because there is a national border between these sets of traders this basic economic fact is not magically suspended. If trade deficits were worth worrying about, why not also worry about the trade deficit between, say, New York and Philadelphia?

The fact that Krugman does not even mention this basic facet of trade anywhere in his articles is tantamount to a red alert. Frederic Bastiat   lampooned protectionism back in 1845 when he penned his 'Petition of the Candle Makers'. The candle makers are incensed that the light of the sun can be had for free. The sun's 'unfair trade advantage' surely needs to be curtailed somehow!


“Gentlemen: You are on the right track. You reject abstract theories and have little regard for abundance and low prices. You concern yourselves mainly with the fate of the producer. You wish to free him from foreign competition, that is, to reserve the domestic market for domestic industry. We come to offer you a wonderful opportunity for your — what shall we call it? Your theory? No, nothing is more deceptive than theory. Your doctrine? Your system? Your principle? But you dislike doctrines, you have a horror of systems, as for principles, you deny that there are any in political economy; therefore we shall call it your practice — your practice without theory and without principle. We are suffering from the ruinous competition of a rival who apparently works under conditions so far superior to our own for the production of light that he is flooding the domestic market with it at an incredibly low price; for the moment he appears, our sales cease, all the consumers turn to him, and a branch of French industry whose ramifications are innumerable is all at once reduced to complete stagnation. This rival, which is none other than the sun, is waging war on us so mercilessly we suspect he is being stirred up against us by perfidious Albion (excellent diplomacy nowadays!), particularly because he has for that haughty island a respect that he does not show for us.”


Replace 'perfidious Albion' with China, and you have Krugman. Krugman makes the same mistake he always makes – the one mark of a truly bad economist if you will – he neglects the 'unseen' effects of his policy advice. It may well be true that a small group of domestic producers would benefit from a higher yuan (which ones? We're not quite sure, actually…). Alas, every single consumer would suffer for their betterment by having to pay higher prices. This in turn means that consumers will either have to cut back on their consumption, or lower their rate of saving. It seems obvious that this entails a lower standard of living for everyone but the favored few. Since less money will be available for either consumption or saving, there will also be less money available for investment. Capital formation is thus likely to slow, further impinging on future growth.

In fact, we would go as far as asserting that the trade deficit Krugman is so worried about would not improve at all – all that would happen would be that rising prices for imported goods lead to a lower standard of living for US consumers for the (strictly temporary) benefit of a tiny minority of producers, who in turn would in the end likely be harmed as well by not having to face up to competition. This competition at present forces them to improve their methods of production or look for lines of business where they have a competitive advantage.

Consider in this context that Japan's exchange rate has  been a favored target of US protectionists for many decades – and the yen has in fact risen relentlessly against the US dollar for many decades as well – from 371 yen to the dollar in 1969 to 84 yen to the dollar today. Has Japan's trade surplus with the US disappeared? Have the US car makers, GM, Chrysler and Ford, who were the most vocal proponents of forcing Japan to revalue the yen anything at all to show for it? If we recall correctly, GM and Chrysler went bankrupt, while their Japanese rivals continued and continue to thrive. So even the argument that a small group of domestic producers would be 'helped' by a lower exchange rate can not be buttressed by empirical evidence.

For Reasons Unknown, Protectionism remains a 'Populist' Policy

Right after Krugman's editorial was published, the usual suspects descended on Washington, sensing an opportunity with elections coming closer. It is not quite fathomable to us why this is so, but protectionism remains a 'populist' policy – i.e. support for it is likely to garner votes. Most likely this is because most people simply do not think the ramifications properly through. Painting the foreign merchant as an 'enemy' who bleeds us dry is a ploy that always works – it is still fairly easy to convince people of this false doctrine.

Thus the Wall Street Journal reports 'U.S. Bill on China Gains Momentum'.


“With U.S.-China tensions rising on Capitol Hill, industry and labor groups are scrambling to shape the one bill aimed at China's currency policy that has a chance of success this election year. The bipartisan bill, which has 143 co-sponsors, would allow the U.S. to impose tariffs and other penalties on countries that undervalue their currency — with China a main target. Many U.S. businesses, policy makers and economists argue that the country keeps its currency artificially low against the U.S. dollar, giving its exports an unfair price advantage on the global market. The legislation, spearheaded by Rep. Tim Ryan (D., Ohio) and Rep. Tim Murphy (R., Pa.), was a focus of a House Ways and Means committee hearing Wednesday, one of three this week on China's exchange-rate policy. Treasury Secretary Timothy Geithner is slated to testify in two other hearings on Thursday.”


It appears that the economically illiterate political class is bowing to the lobbying efforts of domestic producers just as it bowed to the same efforts by the car makers in the context of Japan in previous decades. As we often mention, the obvious failure of an economic policy has historically seldom kept its supporters from demanding more of it. Whenever you hear the words 'fair' or 'unfair' uttered by  politicians, hold on to your wallet – someone is about to pinch some of its contents.


“China is fast becoming an election-year issue with anger running high among voters over continued economic weakness and high unemployment. Many lawmakers and their constituents blame what they view as China's unfair trade practices, including its currency policy.”


We will make what is really an easy prediction here:  if tariffs on Chinese imports are enacted, not a single US job will come back because of it. Let us just remember Hoover's great success in this regard with the Smooth-Hawley tariff, the aims of which were exactly the same – removing the perceived 'unfair trade advantage' of foreign competitors. Economic catastrophe was the result and unemployment soared. So what will they say when this effort fails? That the tariffs are not high enough?


“Several bills addressing China's currency policy have emerged in Congress in recent years but have made little headway. But both supporters and detractors of the Ryan-Murphy bill say it could have a real shot at passage this year.”


That is bad news indeed. Interestingly, there are quite a few US businesses that strongly oppose this bill:


“This is a very emotional issue for a lot of members and there is a great deal of frustration over whether China is playing fair," said Erin Ennis  of the U.S.-China Business Council, a group representing U.S. companies that do business in China, which opposes the bill. "It wouldn't surprise me if a measure like this would pass as a reflection of the frustration."”


Enacting far-reaching and frankly absurd economic legislation out of 'frustration' is probably not the hallmark of good policy-making. To illustrate the absurdity of this, demanding that China charge higher prices for its goods is akin to Wal-Mart's customers complaining to their local Wal-Mart about its 'everyday low prices' and demanding it charge them more – if that were to happen, Wal-Mart's managers would probably call in the men in white coats,  just in case.


“Business groups and labor unions have lined up on both sides of the measure. The Fair Currency Coalition — a Washington-based group representing manufacturers, labor and farmers — which backs the bill, has held summits to discuss the issue and raised the subject at candidate forums. The AFL-CIO, a coalition member, has coordinated meetings between manufacturing executives and members of Congress in Washington and members' home districts. "Our goal is to have the Chinese take our government seriously, and they understand action. This is action," said Bob Baugh, executive director of the AFL – CIO's industrial union council.  Meanwhile, the U.S.-China Business Council and 35 other major business groups, including the U.S. Chamber of Commerce, sent a letter Tuesday to House Ways and Means Committee Chairman Rep. Sander Levin (D., Mich.) and ranking member Rep. Dave Camp voicing opposition to the measure. The letter contends said the bill would violate the U.S. commitments under World Trade Organization rules, and that in any case there are better ways to address China's trade practices.”


Farmers and unions both would really do well to remember the effect the  Smooth-Hawley tariffs had on their constituencies. Never before and never since did more farmers go bankrupt than on that occasion. Never before and never since did more workers lose their jobs than on that occasion (admittedly Hoover's perverse policy of artificially keeping wage rates high during a major deflationary crash  played a major role in that as well).

Meanwhile, no doubt also reflecting the pressures of the impending election, Tim Geithner also piped up in a WSJ editorial, stating inter alia:


“China has made "very, very little" progress on letting the exchange rate of the yuan reflect market forces, Treasury Secretary Timothy Geithner said in remarks published in the Wall Street Journal on Monday.In an interview conducted on Friday, Geithner was asked if he was satisfied with China's progress on the yuan. He replied: "Of course not." "China took the very important step in June of signaling that they're going to let the exchange rate start to reflect market forces. But they've done very, very little, they've let it move very, very little in the interim. It's very important to us, and I think it's important to China, I think they recognize this, that you need to let it move up over a sustained period of time." Geithner is due to testify before the House of Representatives Ways and Means Committee on Thursday to present the Obama administration's latest view of what the United States should do to press China to reform its exchange rate practices.”


Now, we don't disagree that it would be best for all concerned if China let the yuan float and its exchange rate be subject to market forces. Geithner is quite correct that there has been 'little progress' in this regard. Alas, the firmly and widely held belief that a floating yuan is automatically tantamount to a rising yuan may actually turn out to be a misconception.

One thing seems certain to us: If the pressures of the election lead to hasty legislative action on the tariff front in an attempt to coerce China, it would be the first salvo in what is commonly called a 'trade war' and it will most assuredly produce none of the positive effects the supporters of protectionist measures are hoping for. It will definitely have a wide range of negative repercussions however, given that China also happens to be the biggest foreign creditor of the US. Note also that raising tariffs on Chinese goods would merely lead to production of the affected goods moving to other low cost countries not so afflicted. What then? Then a new version of Smooth-Hawley – raising tariffs more generally – would be the only way to keep the protectionist goals intact. And we know how that one worked out.



Speaking of China, the chart of the Shanghai composite stock index suddenly doesn't look so good anymore. While lateral support has held thus far, the recent sudden and sharp move lower indicates an increasing likelihood that the recent consolidation will resolve to the downside. This should be closely watched, given that the $SSEC has tended to lead the S&P 500 since 2007.



The Shanghai Composite: a sudden decline back to lateral support. If this support fails, it would have implications for stock markets elsewhere, as well as for industrial commodities – click for higher resolution.




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One Response to “China Bashing in High Gear Again”

  • Bearster:

    Thomas Rusticci, at George Mason University, has written and spoken extensively about the horrible effects of Smoot-Hawley… The consequences then were nothing less than a collapse in trade and production, ever-more desperate keynesian and fascist interventions, followed by the only thing that could “work” (I love that part from Bastiat about theory and principles): a world war.

    The only difference today is that now we can play world war with nukes. :(

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