A conversation with Paul Krugman

Introduction: Welcome to Eyes on the Economy by CIBC Capital Markets, a podcast series dedicated to addressing current issues in a concise format, helping to make sense of the evolving economic complexities, so that you can take action.

Avery Shenfeld: Hello, everyone. It’s my distinguished pleasure to have a professor of economics who I’m a huge fan of. Paul Krugman doesn’t need a lot of introduction, but it’s a cliche to say that and then launch into a long introduction. But as many of you know, he was a professor at distinguished universities like MIT and Princeton, a Nobel Prize winner in economics. And of note, that was for work on international trade, a subject that is very much on our minds these days. And a long time columnist for the New York Times. And now the author of a newsletter podcast that you’re free to subscribe to. I’ll let Paul give you the details of where to sign on, but I’m a regular reader. Thanks for joining us today, Paul. And I think we’ll launch right into the topic of the day on the minds of many of our clients here in Canada, which is where are we headed on this trade mess? I think it is clear that it is a mess. 99% of all economists would agree that a multi-way trade war with high tariffs is a bad idea for the economies of all concerned. Unfortunately for us, the other 1% of economists seem to work for the Trump administration, so that’s how we’ve got where we are. Where do you think we’re headed now on this?

Paul Krugman: Okay, and since you asked me to, let me just say I’m on Substack, paulkrugman.substack.com and I’m writing almost every day. It’s an amazing world now where you can basically self-publish. Okay, what’s really hard to scope out about the trade war and all of that is that it is not reflecting any easily predictable, sort of deep political economic forces. This is very much a personal thing. Trying to predict the future here is in large part about the mind of Donald Trump. And it’s probably worth understanding that the United States, there’s a quirk of the way US law is set up, which is that on most things, significant economic policy changes require a vote in Congress, and there’s a whole procedure. Even when you have a dominant party, there’s a limit to how much a president could do, at least on his own. But the existing trade law gives the president enormous discretion to set tariffs. We could get into that, but the point is that in practice, there’s supposed to be some studies and so on, butit’s all by people who report to the president. So if Donald Trump wants to impose a tariff, he can impose a tariff. And he’s been making extensive use of that privilege. So he’s trying to figure out what happens from here. A lot of it is, well, what do we think is going to go on in the mind of this one guy? It’s not as if he’s been captured by economists who think that this trade war is a good idea. It is that he has recruited the very small number of economists who think it’s a good idea. So this is all really on him. That said, I mean, there’s actually really strong reason to say that the downside of the trade war will become very apparent in the United States fairly soon, probably within two months, that we’ll really start to see sharp increases in consumer prices. We may even be seeing some empty shelves. It’s kind of one of those things where people don’t see it yet, but it’s kind of like the guy who jumped off the building and as he passes the 15th floor, he says, I’m doing okay so far. This is already in process because of the drastic decline in shipments to the United States. The ports are kind of empty already. It’s a good guess, by no means a certainty or even something that one can have a lot of confidence in, that there’ll be some backing off as the adverse consequences start to be felt. But we really don’t know what’s going to happen then.

Avery Shenfeld: One of the things that we are seeing is there seems to be a fixation on this number 10%. So when tariffs were set way above 10%, there was a 90-day pause for negotiations on some magical treaties that might be just a letter from each country, but they were then set back to 10%. And of course, now we saw a deal with the UK, if you can call that a deal, but it seemed to fixate on 10%. Is there some reasonable expectation then that perhaps the administration is thinking we can’t live with 30, 145% on China, can we live with 10?

Paul Krugman: Yeah, I mean, 10, it’s big enough that it doesn’t seem trivial, but it’s small enough that it’s not as, you know. Currently the United States has a 145% tariff on imports from China, which is prohibitive. That basically cuts off trade with China and that’s going to be really painful. So if that’s scaled, I don’t know what’s going to happen on the China tariff, but it’s probably going to still stay very high. But for everyone else, yeah, 10%, hard for Trump to go below 10% without looking like he’s given up, like he’s retreated. But on the other hand, higher than 10%, the costs multiply. It’s a little bit of arcane economic logic that says that the cost of a tariff is roughly proportional to the square of the tariff rate. So a 20% tariff is actually about four times as bad as a 10% tariff. Going to 10%, it’s kind of a focal point. What would be a good guess of what tariffs on most countries will look like after Trump has realized that he’s not going to be able to bully the world into giving him whatever it is he thinks he’s going to get, that 10 percent might be where they settle. Which, by the way, by the standards, if you had said to somebody three years ago, we’re going to have 10 percent tariffs on everybody, they would said, my God, that’s a hugely destructive protectionist policy, and it is, relative to where we were before, 10% is a lot less than 145. So it’s probably a good guess at where we might end up.

Avery Shenfeld: I think that prior to the election, I recall in some of your columns or writing talking about a number like that and suggesting that the inflation consequences, maybe the GDP consequences, at least for the U.S., would not be that horrific if we did have that sort of level of tariffs.

Paul Krugman: Well, OK. It kind of looks like we might end up, and this is again, nobody really knows, right? Who knows what’s going on there? During the campaign, Trump talked about 10% on everybody and 60% on China. And it looks as if we might actually end up with something like that. Now, that’s not trivial. That’s if you sort of run that through the share of imports in US GDP and so it ends up being something like adding close to two percentage points to the inflation rate for one year. That’ll really, people will feel that. It’s possible that there’ll be more than that. And there may be a lot of disruptions. I mean, again, I think events are moving less faster than Trump realizes. He’s kind of, hasn’t quite grasped what the fact that very few shipments are arriving from China now is going to mean six weeks from now once that shows up on the shelves of the stores. Still, we’re talking about, let’s say, a 2% hit in terms of higher consumer prices, a 2% reduction in real wages. That’s a big number by normal standards, but it’s not hyperinflation. And it’s probably a number where after watching it a bit, the Federal Reserve will probably conclude this is a one-time hit and we should look through it and not raise interest rates to fight inflation, probably. But it could be worse than that.

Avery Shenfeld: Right. One of the things that concerns people here in Canada is that we’ve essentially been for many years now relying on the idea that if you have a treaty, you know, signed, sealed, delivered, including in this case, a treaty signed, sealed, and delivered by President Trump in his first term, that that sort of protects you from adverse shocks like this and also then provides some comfort to a company that say was going to put capital into a factory on this side of the border for purposes of serving the entire North American market. Do you think that just this episode, even if it’s somehow resolved, and in the case of Canada, we even negotiate down some of the tariffs that have been imposed, does that still leave us with this pall over investment that could have a longer term impact?

Paul Krugman: Yeah, that’s a very big part of the story. So we talked about short-term impact on consumer prices, and that’s relatively straightforward, but the longer-term impact on uncertainty, on willingness of corporations to make commitments is very large. If you go back and look at the story of NAFTA, NAFTA was agreed in the early 90s, then Trump basically added a few semicolons and renamed it and claimed it was his agreement. But a lot of the impact of that came not from tariff reductions, because tariffs within North America, to both tariffs between US and Canada and tariffs between US and Mexico, were already quite low by the time the treaty was signed. But what NAFTA gave people was certainty, or what they thought was certainty. That there weren’t going to be returns to large-scale protectionism, that the borders were going to remain more or less open to flows of goods and services. And that meant that you could do planning. It meant that you were willing to invest, particularly a lot of industry is really sort of North American rather than any country. You know, the auto companies, it’s the same auto companies in all three countries, and they’ve made decisions about where to locate plants, where to produce what, based upon the belief that it was an open market. It’s not only that they’re reluctant to make new investments that depend upon access to other markets, they’re also reluctant to make new investments that assume that the tariffs will stay in place. So if you were thinking about putting a plant in Mexico, I’ll say Mexico, was meant to say Canada, but it doesn’t matter. If you were thinking about putting a plant in Mexico, I’m a US guy, we don’t believe that you guys exist, right? But if you’re thinking about putting a plant in Mexico, you say, well, I don’t know. I mean, if it’s going to face 25% tariffs, I want to do that. But if you think about relocating that production to the United States, where it is more expensive to do something like, in the case of Mexico, something like wiring frames for cars, which is very labor intensive, you’ll say, well, what if I invest in doing that in the US and then the tariffs come off and I’ve made a big mistake because it would have been cheaper to do it in Mexico? So you end up with a kind of anything you do is running a substantial risk of just stranded investments, which means that you have a lot of companies sitting on their hands. And then even in the long run, probably a lot of inhibition of North American interregional trade because even if the tariffs come down, We now know that, you know, from the point of view of Trump and possibly, we don’t know what future administrations will be, but in terms of U.S. policy, making a solemn treaty is basically a suggestion, not a contract.

Avery Shenfeld: No, and these new deals, as you saw with the one with the UK, are a piece of paper, maybe an email. I’m not even sure there’s anything on paper, but they’re clearly not formal trade deals that we’re talking about here.

Paul Krugman: Yeah, and we’re actually having a conversation the day after that deal, more like a concept of a plan of a deal. We’re talking the day after that was announced, and already there are news items crossing my desk that say, oh, Trump also wants some changes in UK digital taxes, and some of his people are talking about UK value-added taxes. so, UK may have thought that it had at least something that settled the issue, but it looks as if already new demands are being piled on top of it. And that’s going to be the way of things from now on.

Avery Shenfeld: So this brings us to Canada’s negotiating strategy, which we’re just, I think, our new Prime Minister, Carney, who is fortunately a solid economist. So we have someone who knows and understands these issues trying to play the Canadian side of this. But there is obviously a risk in Canada’s case that if we don’t get what we want with Plan A, what do we do with Plan B? I mean, what can a country like Canada do that is historically so dependent on this integrated manufacturing sector with the US?

Paul Krugman: Yeah, and Canada is, you know, of all the countries out there, Canada and Mexico, but maybe Canada even more than Mexico is peculiarly vulnerable. It’s just geography. Canada is a big country geographically, but almost everybody lives fairly close to the US border. And I sometimes say that think of this narrow strip across the top. I sometimes say that Canada is closer to the United States than it is to itself.

Avery Shenfeld: That’s actually very true for interprovincial trade. Most of the provinces are farther from a typical province than their largest U.S. trading partner.

Paul Krugman: Yeah, if you’re British Columbia and you’re thinking about California versus Ontario, California is both bigger and closer. Actually, I have an international economics textbook that has a map that explains all of that and does the trade flows. So it’s difficult for Canada to reorient itself. Not impossible, because in the modern world, transportation costs are mostly quite low, and there are other costs to distance, But could Eastern Canada reorient itself towards trade with Europe and Western Canada towards trade with Asia? The answer is yes to some extent. It’s not impossible, but it will be costly. Some things really can’t. But that kind of goes both ways. So oil from the tar sands really has no outlet except the U.S. Midwest. On the other hand, the U.S. Midwest doesn’t have a great alternative to Canadian tar sand oil. Hydropower from Quebec is going to go to New England or nowhere. But on other hand, New England doesn’t have real alternatives. So, I mean, you really have to ask how down and dirty does this get? If it really gets to something that is really pulling out all the stops on both sides, which I actually, even though I’m a pessimist here, I don’t think that’s going to happen because I think at some point just corporate America will scream stop. But if it does get to that, then in a weird way, Canada has some of the advantages that China has. We’ve been saying that if there’s a full knockdown trade war between the US and China, then it starts involving less cutting off the other guy’s exports and more denying the other guy access to imports. So in China, we’re talking about they’re already cutting off sales of rare earths and various kinds of industrial inputs could be on the line. And China, it gets to that point, China is actually in a stronger position because as many people have been saying, it’s actually a lot easier to replace lost export jobs through fiscal stimulus that is to build up a manufacturing capacity you don’t have. And if you look at Canada versus the US, particularly that whole, the Canadian trade surplus with the United States is entirely energy. It’s entirely oil and hydroelectricity. A lot easier for Canada to try and compensate people who have lost jobs because of loss of access to US markets than it is for the United States to replace those the oil to Midwestern refineries and the electricity to the New England power grid. So, you know, I don’t think it’ll get that far, but if it really gets harsh, United States might be somewhat surprised at how ugly it gets.

Avery Shenfeld: Well, we have seen a bit of a dialing down of some of those tariffs. So the tariffs on energy, for example, disappeared and so on. And even if you look at aluminum, the US needs Canadian aluminum and doesn’t have the capacity. So we’re kind of hopeful that maybe they’ll realize that a tariff on aluminum makes little sense given that you’re going to import it anyway.

Paul Krugman: Yeah, that’s one of the real absurdities. I mean, when I talk about the absurdities of Trump trade policy, my prime example is actually that we imposed a Section 232, national security tariff on Canadian aluminum. First of all, I’m not sure that we’re worried about imperialist Canadian goals of conquest. And we really can’t, I mean, given sufficient time, but aluminum, we really don’t have the capacity to do without that Canadian aluminum, but there we are.

Avery Shenfeld: I do want to touch on one other issue in the US that has a spillover impact to global financial markets, which is the ongoing budget process that’s now in Congress, where obviously there’s a lot of pressure to pass big tax cuts, but a lot of disunity within the Republican Party on whether or not they can stomach the public resistance to some of the spending cuts they’re looking at. No one’s expecting the US budget deficit to drop anytime soon. But should markets be fearing a much larger deficit or do you think that Congress will ultimately sort of stand in the way of that one way or the other?

Paul Krugman: I think it will actually, I think it’s more likely that we will in fact get a large deficit than that we’ll have Congress stopping it. The idea is supposedly to be able to afford these tax cuts because we make huge cuts to the social safety net and also realize lots of revenue from tariffs. And the huge cuts will face a lot of resistance. I don’t know how much will happen. There will be some. But the fact of the matter is, mostly they’ve been focusing on Medicaid, which I guess Canadians are more aware of U.S. programs than we are of Canadian programs. But Medicaid, obviously, is the health insurance program for the poor. And it’s incredibly cruel. Three quarters of the public oppose these cuts to Medicaid. So this would be a real liability for Republicans if they do it, and that may stay their hand, but if they can’t find the spending cuts, then it really does, the tax cuts really do explode the budget deficit. And the budget deficit is kind of abstract. Everybody talks about it a lot. When it comes to actual voting, people tend to say, well, never mind that, I’m going to look at the more concrete issues, which in the past has been okay. The consequences haven’t really been large because the market has been willing to finance U.S. budget deficits. The question you have to ask now is, the U.S. has been able to be relaxed and somewhat irresponsible about its budgets because to some extent because of the US dollar playing an international role, though I think that’s overrated, but also just because the world thinks of us as ultimately a reliable country, a safe haven. The ultimate safe asset has been US government debt. If that stops being the market’s perception, and there are signs of a least a bit of skepticism about US credibility and at least hints of capital flight from the United States. If an exploding budget deficit hits skeptical international bond markets, then it can get really, really ugly.

Avery Shenfeld: Certainly our bond investor clients have been seeing a lot of volatility in the bond market after Trump was first elected. Ten year rates really soared almost to 5% and then came down. Seems to be some market comfort with the idea that those hawks on the fiscal side in a house at least will stand their ground, but you sound a bit skeptical on that.

Paul Krugman: You’ve rarely gone wrong in US politics by assuming that people who go on and on about the deficit don’t actually care. And when push comes to shove, they’ll always cave. You complain about the deficit in order to force cuts in social programs basically. And then if you can get the cuts in social programs, then you don’t worry about what the tax cuts do. So assuming that supposed deficit hawks are actually just hypocrites has been a good bet for the past 20 years. So it’s probably still true.

Avery Shenfeld: We’ll be watching for that. So I think we’ll wrap it up there. I want to thank Dr. Krugman for joining us today and our clients for joining us as well. Until next time, we’ll be keeping our eyes on the economy and calling it as we see it.

Paul Krugman: Thank you.

Outro: Please join us next time on the Eyes on the Economy where we will share our latest perspectives and outlook for the Canadian and US economy.

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