In Defense of the Francois-Baughman Analysis of the Trump Tariffs

Dr. Joseph Francois and Laura M. Baughman are being criticized for writing:

This policy brief examines the potential net impacts on U.S. jobs across all industries of the proposed steel and aluminum tariffs applied to targeted steel and aluminum imports from all countries. It does not take into account any potential retaliation against U.S. exports; only of the tariffs themselves. We find that the tariffs would indeed have positive impacts on U.S. steel and aluminum producers, but negative impacts on producers who use steel and aluminum, both imported and domestically-produced. Those impacts, both positive and negative, would ripple through the economy. We find: The tariffs would increase U.S. iron and steel employment and non-ferrous metals (primarily aluminum) employment by 33,464 jobs, but cost 179,334 jobs throughout the rest of the economy, for a net loss of nearly 146,000 jobs ..

How did they arrive at this alarming conclusion?

We base our analysis on the Global Trade Analysis Project (GTAP) database. The GTAP database covers international trade and economy-wide inter-industry relationships and national income accounts, as well as tariffs, some nontariff barriers and other taxes. This includes value-chain related linkages across industries and borders. These data are included in a computer-based model of production and trade known as a “computable general equilibrium” (CGE) model. This is the same model used by the Commerce Department to arrive at the tariff rates it argues will yield increases in U.S. steel production sufficient to bring the industry to 80 percent capacity utilization… In addition to economy-wide impacts, we focused on the impacts of imposing the tariffs on the U.S. workforce. For the analysis conducted here, we treat wages as “sticky,” meaning changes in demand for labor (positive or negative) are first reflected in changes in employment rather than changes in wages. This is appropriate for an examination of the immediate impacts of the tariffs on workers.

In other words, they concede that these are short-term impacts and their model has Keynesian features. For some reason, this offends Robert Scott of the Economic Policy Institute (EPI):

This EPI report explains why the actual economic impact of the tariffs will be quite minor, and why Francois and Baughman’s 2018 study should be treated as an odd outlier in studies of tariffs, and not as a study to guide policy decisions. Our key findings are: The Francois and Baughman (2018) results are driven overwhelmingly by a nonstandard modeling assumption: that growth in the U.S. economy is constrained by aggregate demand. This is not how the vast majority of trade modeling analyses are done. Even with the assumption of demand-constrained growth, the Francois and Baughman (2018) results are totally implausible. There is no credible evidence that these tariffs could drag on growth in demand anywhere near enough to generate employment losses as large as the authors report…While Francois and Baughman (2018) look at the effects of raising tariffs on steel and aluminum, the textbook case for arguing that lowering tariffs will boost economic efficiency relies on the assumption that the economy operates at full employment, meaning that overall economic growth is constrained only by growth in the economy’s productive capacity and not by spending decisions made by households, businesses, and government. This means that economic growth is not constrained by too-slow growth in aggregate demand. This full employment assumption lies behind the vast majority of analyses of trade policy and is a necessary condition for many of the findings that lower tariffs boost economic efficiency. Such full employment modeling would imply extremely modest economic losses from the steel and aluminum tariffs. The standard rule-of-thumb for converting tariff increases into economic losses is: [0.5*(t/(1+t))^2*m*e]. Here, t is the percentage tariff, m is the share of imports in the nation’s gross domestic product (GDP), and e is the elasticity of demand for imports with respect to price.

First of all it would have been nice had this EPI discussion given Paul Krugman credit of this “standard rule-of-thumb”. But since when has the EPI embraced the New Classical macroeconomics model? To be fair, I have made similar arguments that trade policy has no net aggregate demand effects. For example, my post on Navarro’s Nonsense on Net Exports dusted off the Mundell-Fleming IS-LM-BP model:

My concern was that Navarro was all Keynesian with no consideration of where output was relative to potential GDP or the impacts on potential GDP. Navarro proposed using some sort of trade protection to raise net exports by $500 billion per year. That might have a big aggregate demand impact under the assumptions of fixed exchange rates and fixed interest rates, which of course is the most basic Keynesian model that Navarro both mocks and uses. One can wonder whether the output gap now is really that large. Of course, I have suggested that perhaps the output gap may indeed be as much as 5 percent but other economists suggest it is smaller. Scott is noting, however, the Trump wants to increase defense spending and massively cut taxes which push aggregate demand so high that the Federal Reserve would have to raise interest rates. We should also note how various policy positions work in a standard Mundell-Fleming model.

One of the implications of this model is that any expenditure-switching policy such as reducing imports will so appreciate the currency that export demand falls as much imports rise. Of course the EPI has often dismissed this conclusion on the grounds that we do not live in an idealized world of freely floating exchange rates. Then again – even Keynesian economists would argue that a well designed monetary policy could offset any negative aggregate demand effects – providing we do not hit that liquidity trap again. So yea – I have argued for a full employment modeling in the past. But what worries me is that Trump’s follies may match or rival the macroeconomic mess we had during the early years of the reign of St. Reagan. To suggest that in such an environment that we should ignore aggregate demand effects is something I would have never expected from the EPI.