Fiscal Stimulus, exchange rates and the temptation of protectionism

Dissecting the protectionism argument

In the planning of Obama’s recovery and re-investment package, there were provisions to purchase ‘only American’ goods and services, such as American steel for construction projects. This ‘only American’ hails memories of protectionist acts such as the Smoot-Hawley tariff of the 1930s that exercised a 30% tariff on all imports to the US. In fact, one of the reasons the Great Depression was prolonged was due to a protectionist stance practised across the world, with trade plummeting, and only returning to pre-crisis levels 20 years later.

The idea of protectionism stems from the idea that imports is a leakage, and that a fiscal stimulus will lose effect if it is contracting foreigners in the projects. The Keynesian ‘complex’ multiplier, with a fixed price level and interest rates, is:
To understand whether protectionism makes sense, we need to look at the Balance of Payments Equilibrium equation, or BP curve. This curve models the pairs of income and interest rates required to fulfil the following condition:

The main problems with understanding open-economy effects are to do more with the capital account effects. Given we are in a liquidity trap (where interest rates have reached the 0 lower bound), we can consider interest rates as rigid. The first implication of rigid interest rates is an invariant capital account, in other words, the saving investment imbalance is rigid. Given the capital account is rigid, the current account must adjust to offset the capital account. What protectionist policies do is to increase the trade surplus/reduce the trade deficit for a given level of exchange rates. This means we have a situation where the BP curve is not in equilibrium. What happens is that the exchange rate adjusts upwards, increasing imports (as they become relatively cheaper) and reducing exports (as they become relatively more expensive) until the current account equals the capital account again. We can model this using the S-I, X-M model, where S-I represents the capital account deficit and X-M represents the current account surplus.
It is important to note that the differential X-M is the same, which means that both the volume of imports and exports has dropped by equivalent amounts. Consequently, protectionism does not achieve its desired goal of achieving greater effects of fiscal stimulus- as the gains of reduced imports come at the expense of reduced exports.

Is fiscal stimulus mitigated by trade flows?

Now we ask ourselves, suppose we do not have the protectionist stance. We now have two problems of the fiscal stimulus.

i) The immediate problem is that any increase in domestic demand from the stimulus will filter through to demand for foreign goods.
ii) Perhaps more importantly, the treasury securities issued by the Government to overseas borrowers strengthens the dollar and leads to a potential crowding out of exports

Both i) and ii) are ways in which fiscal stimulus can cause offsetting trade flows to mitigate the multiplier effect. Nick Rowe provides an explanation for why such an argument does not make sense, and claims that all of the increase in demand will translate to increase in domestic absorption, not increases in demand for foreign goods. In his argument he makes the case for a depreciation of the dollar rather than the appreciation suggested in ii).

Rowe believes that the capital account is fixed, that is, the variables that affect the capital account, namely the domestic and foreign interest rates, are 0, and has the assumption of static expectations, that is, the expected depreciation is 0. This makes sense given the expected depreciation is equal to the interest rate differential, which is assumed constant. Thus any fiscal stimulus will be affected by the BP curve constraint.

CA=Current Account KA=Capital Account
Given that GDP= domestic absorption+Net Exports
Where Net exports=CA, then CA= -KA, which is fixed.

Now the fiscal stimulus will cause income to increase, leading to a deterioration of the current account. Thus, given that the KA is fixed, another variable needs to respond to offset the reduced CA, namely, depreciation of the currency. Thus the increase in imports is offset by depreciation such that X-M stays constant, and we will find that there is effectively 0 crowding out of net exports. Thus Nick Rowe’s analysis shows clearly that, contrary to normal times, a fiscal stimulus can result in depreciation.

Now, his argument is lop-sided, as to have a depreciation of the currency, and yet keep expected depreciation 0 via static exchange rates, doesn’t make sense! Krugman gives a more realistic view, in which he says that short-run changes in trade account may not affect the exchange rate in the long-run. According to his theory, exchange rates stabilise around a long-run exchange rate, where expected depreciation is correlated to the differential between the spot exchange rate and the long-run exchange rate.



Given that i and i* are 0 (in the liquidity trap situation), the exchange rate is dependent on the long-run value. However, it is still possible for short-term changes in the exchange rate to occur due to changes in the trade account. Thus there is a case for Fiscal Policy in the current scenario as trade flows may not necessarily offset the increases in government spending.

The need for fiscal coordination

Krugman believes that coordinated fiscal policy is optimal. He feels it works best in a situation like the European Monetary Union (EMU), where the bang per buck (additional income per dollar of deficit) is much higher with a coordinated fiscal expansion than an individual expansion. This makes sense in the EMU, where 2/3rds of a nation’s imports come from other EMU nations, and being fixed in exchange rate, there are no devaluation games to be played between EMU countries, with no exchange rate correction taking place in response to fiscal stimulus.

Krugman then uses the idea of a EU expansion to vouch for a coordinated expansion across the world, with the implicit assumption of the world being under fixed-exchange rate regimes in a liquidity trap situation (with everyone acting in synchronised fashion to ease interest rates towards 0, exchange rates follow suit).However, using the idea of fixed exchange rates, Krugman raises an interesting economic case for protectionism- he cites it as a second best solution, a ‘Nash equilibrium’ if you like, where a sub-optimal equilibrium is reached because of the risk attached of one country practicing fiscal stimulus at the expense of the other country who receives its benefits without a fiscal stimulus of its own. The idea is that a large-scale protectionism might get the economy closer to full-employment with expansionary fiscal policy having more effect- however it distorts trade incentives and results in comparative disadvantage.

I think the fact that protectionism in the Great Depression led to a period of reduced trade for decades means we should not follow the same path. If we disrupt and discourage trade and capital flows, then much of the integration of financial and goods markets will evaporate and there will be a slowdown in growth as developing countries acquire less technological transfer, and developed countries no longer reap the benefits of importing labour intensive products from developing countries. Comparative Advantage and financial market integration have been integral to the growth of the world in the past 50 years, and we should not reverse the progress made.