No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Fifteen: Issues in International Economics 378 To see how active government policy distorts market results, let’s first imagine a world without active government trade policies and what happens with an initial trade imbalance. In Figure 15.8 , we have a simplified illustration of David Hume’s Price- Specie Flow mechanism. Yes, this is a simplified example. England and France don’t use gold anymore, their monetary symbol isn’t a $, and England doesn’t issue Treasury Bills for short-term debt like the US—but the economics is all the same. We’re abstracting away from irrelevant aspects to hopefully help you understand the essence of monetary sterilization ! In Hume’s model, the classical gold standard would automatically correct any trade imbalance without government intervention. We have two trading partners, England and France, and they are in initial trade balance where imports match exports and with an equilibrium level of gold in the economy, with “Big Mac” purchasing power parity of $3. In Step 2 of Figure 15.8 , let’s say there is a mercantilist policy in France that gives a one-time subsidy for French corn that allows French farmers to sell their corn more cheaply than English corn. When this happens, English citizens will buy more corn from France, exporting some of their gold in payment for the corn. When that happens, France will find that it has more gold (represented in Figure 15.8 by $$$$) in its economy, but there are no more goods. So the market will tend to bid up the prices of goods in France, as additional gold without additional goods to purchase is inflationary. The Big Mac’s price in France will rise from $3 to $4. On the other side, England now has less gold circulating in the economy. Fewer dollars (represented by $$) chasing the same amount of goods will lead to deflation, and the price of the Big Mac in England will come down to $2. These price differentials (which will propagate throughout the two economies—not just Big Macs!) will change consumer and entrepreneurial behavior. If there are no government limitations on trade flows, entrepreneurs will find it profitable to import goods from England at the cheaper gold prices and sell them in the French market at the higher prices. Consumers will hear about the cheap prices in England and decide to vacation there. The end result in Step 3 will be for French gold to flow back into England, and English goods to be exported back into France until we get parity in tradable goods prices. At the end, Big Macs must sell for $3 in each country! Of course, the whole reason that France subsidized the farmers in the first place was that they wanted more gold in the treasury. Rather than seeing gold in its economic function as a facilitator of exchange, they see it as a store of wealth. But if the government doesn’t prohibit gold circulating as a medium of exchange, gold will tend to flow back Figure 15.8, Hume’s Price-Specie Flow. Any trade imbalance will tend to create monetary forces to correct the imbalance, if the government allows those forces to operate. The problem is that the imbalances are desired by some special interest; hence it is very difficult to get political support for a “laissez-faire” policy. See discussion in text for how this corrective mechanism operates. Step 1: Equilibrium Hume’s Price-Specie Flow England $$$ France $$$ exports $3 “Big Mac” $3 “Big Mac” exports Step 2: France subsidizes farmers England $$ France $$$$ exports $4 “Big Mac” $2 “Big Mac” Gold Step 3: Monetary force reverse trade flows England $$$ France $$$ $3 “Big Mac” $3 “Big Mac” exports Monetary sterilization: the process of ensuring monetary inflows into a country do not change domestic production. This usually occurs through the issuing of bonds to sop up, or “sterilize” the incoming money flow.