Monday, December 22, 2008

New Protectionism and Game Theory

The World Bank's Crisis Talk blog has a post today on the rise of protectionism in the midst of the crisis. Fears of Hawley-Smoot. The post is worth checking out more for the links to this The Economist article discussing the issue and this link to the stories of Russian protesters being arrested and beaten for demonstrating against new tariffs on foreign imported cars. (If you've ever been forced to drive a Russian car, you'd know why they're protesting).

It brought me to think about something Dani Rodrik wrote few weeks ago. When you design a fiscal stimulus package, like the Obama team is currently designing, you use some Keynesian multipliers to calculate how much of an increase in GDP you expect to see given an increase in government spending. One thing you have to factor in is the Marginal Propensity to Import. Because some of the new cash Americans get will end up buying foreign goods and "leak" from our economy.

You stop the "leaks" in two ways:
1. Decrease the marginal propensity to import by raising import prices through tariffs & quotas (or subsidize domestic industry to lower domestic prices or devalue the currency).
2. Get other nations to pass stimulus packages together, so that all of the "leaks" cancel out. As we buy more from the EU, they're buying more from us as well. Coordinated fiscal and monetary policy is very difficult.

Rodrik doesn't mention it, but both are classic game examples. Option #1 is a game with first-mover advantage. The first person to raise tariffs wins in the short run by stimulating the domestic economy. In the long run, all other countries will retaliate and we'll end up at a Nash equilibrium and lose out on gains from trade. All players have a time-inconsistency problem because they're faced with an incentive to cheat for short-run gain.

Option #2 is a game of first-mover disadvantage. For example, the EU might agree to a stimulus package, but reneg after the U.S. passes one. The EU economy gets stimulated at no cost through Americans with new cash buying European imports. Knowing that this would be the European response would make Congress less likely to pass a stimulus. We end up in another Nash equilibrium--no one passes a stimulus.

Option #1 is easy to do, and politically popular with interest groups. Option #2 is difficult to do for many reasons (including the above reason), and developing economies don't have the money to boost spending and/or cut taxes.

So, assuming a stimulus is absolutely necessary, Option #2 is impossible for the reasons mentioned and we can convince Congress not to be time-inconsistent on Option #1, the package has to be big enough to overcome the "leakage" that will occur as some of the stimulus money is spent on imports.
So, maybe this a reason why the projected dollar figure has grown over the past month.

Right now, the U.S. isn't raising its tariffs, but Russia and other developing countries are quickly throwing up trade barriers. China is pursuing an equivalent beggar-thy-neighbor approach by devaluing its currency. So, Option #1 is very difficult to resist and appears to be winning.

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