Trade models I don't teach - The "New Trade Theory"

I was going to have three posts on trade models - the two I teach, and the one I don't teach. But I realized that the middle model - the Heckscher-Ohlin model - is not different enough from the Ricardian model to merit its own post.

(Briefly, the Heckscher-Ohlin (HECK-sure o-LEAN) model tries to describe trade between rich and poor countries, by pointing out the fact that rich countries have a lot of equipment and machines and buildings and infrastructure (capital), while poor countries have a lot of cheap labor, so poor countries will make labor-intensive goods (e.g. clothing) while rich countries will make capital-intensive goods (e.g. cars). Fine. But the thing is, Heckscher-Ohlin treats each country like a single person, just like the basic Ricardian model, and so there can't be any negative externalities to trade...hence, the model assumes right off the bat that free trade is always and everywhere a good thing. Yawn.)

Instead, I want to discuss the "New Trade" model, invented by Krugman in 1979 and refined in 1991, for which (among other things) he won the Nobel prize a couple of years ago. This is the model that most economists actually use now to explain and predict trade. I am never asked to teach it in Econ 102, but that's only because it involves lots of math that most undergrads can't handle.

Krugman's model was developed in order to explain the fact that many trading partners produce very similar goods: Japan and America both produce cars, for example. The classic Ricardian theory of trade says that comparative advantage determines what gets imported and what gets exported, but the data seem to buck that. So Krugman brought in a different idea. People like variety, he said, so different countries will trade different varieties. Small initial differences between countries (example: Japan had no domestic oil reserves, and so focused more on smaller, more efficient cars) determine which variety gets produced where.

OK, so far, so good. Now, what about free trade? Unlike the Ricardian and Hecksher-Ohlin models, New Trade DOES have an externality. Specifically, since people like variety, the more variety I produce and sell, the more you can produce and sell as well. Each company becomes sort of like a monopolist, being the only producer of its own specialized variety of good. More trading countries means more global variety, making consumers better off everywhere.

Of course, this externality is purely a positive externality. Japan selling us cars is good because it allows us to focus on producing a different type of car. There is no negative side effect from increased trade, and so free trade, again, becomes by assumption the best possible policy, always and everywhere. The free trade orthodoxy is still baked into the cake.

In order to get a model that says that free trade might not be the best policy, we'd need to write down a model that has a negative externality to trade. Perhaps opening up trade allows companies to put their dirty factories in the country with the most lax pollution regulations, hurting the environment. Perhaps opening oneself up to trade creates financial instabilities because of international investment flows. Or perhaps countries can engage in "predatory" trade practices, to which the best response is a temporary trade war.

These models all exist (see links), but no one has yet paid them much attention. Instead, whether in the classroom or in our actual modeling, we continue to unquestioningly use models that assume that no trade restriction can ever be a good idea.

Now, I'm not saying these are bad models! And I am not saying that free trade is not, in fact, the optimal policy. What I am saying is that in every intro macro course, one of the first (and last) things we say is: "Macroeconomists agree on very few things, but they generally agree that free trade is good." And this is true, they do. But the reason that they agree is not that they've proven it. It's that they assumed it, and decided to use models that assumed it. When the inevitable chorus of economists turns out to cheerfully berate anyone who suggests "protectionism," they may be reveling in their rare opportunity to finally agree on something...but really what they are doing is drowning out dissent for the fun of it. Our profession-wide consensus comes at the expense of scientific honesty - and, if it turns out that the consensus is wrong, it has also come at the expense of American prosperity.