Tuesday, October 23, 2012

Things I Worry About: China, Geithner, Trade Wars, Collapse of International Trade

Q: Are we being harmed by a trade deficit?

A: We've run one since 1983 yet the economy still has grown. (See table, below.)

Q: Can we compete in foreign trade?
A: Yes. In 2009 we exported $1,554,718,000,000 of goods and services and imported $1,933,347,000,000.

Q: What will the appreciation of the yuan do to us?
A: It will make us poorer because consumer goods from China will be more expensive.

Q: Why are export jobs more important than import jobs?
A: They aren't. But no one sees the loss of jobs and businesses related to imports.

Q: Won't the balance of payment/deficits harm us?
A: The Chinese will have to use its hoard of dollars to buy stuff from us and finance our deficit.

click to enlarge

GDP scale on Right; Ex-Im on Left. Red=exports, blue=imports, green= balance of payments, tan=GDP

I have been reading a lot about trade deficits, free trade, China's renminbi ("the "People's Currency"), and global recovery. Many economists and commentators have targeted the yuan (I like the reactionary term "yuan") as the villain in this scenario. It's because the yuan is pegged to the dollar.

Here is the first argument, as framed by Nobel laureate, Paul Krugman:

China’s policy of keeping its currency, the renminbi, undervalued has become a significant drag on global economic recovery. Something must be done. … China was manipulating its currency — selling renminbi and buying foreign currencies, so as to keep the renminbi weak and China’s exports artificially competitive …

Krugman says that arguing with the Chinese will no doubt be futile because they won’t revalue. His solution, referring to a policy of the Nixon Administration in 1971 toerect trade barriers against trade partners:

At this point, it’s hard to see China changing its policies unless faced with the threat of similar action [as in 1971]— except that this time the surcharge would have to be much larger, say 25 percent.

I've dealt with Krugman's argument in another article, "Paul Smoot-Hawley Krugman." He is dead wrong. It is sufficient to say that his advice would set off competitive devaluations and possibly a tariff war which would be the economic equivalent of WWW III. The net result that if you think we've got deflation now (we do), a trade war would significantly accelerate the trend, and kill international trade.

The second argument is that an artificially low yuan gives China an advantage in world trade. By keeping their currency cheap, the price of Chinese goods on foreign markets makes them cheaper to buy. Because of this U.S. exporters are at a disadvantage because U.S. goods are more expensive than Chinese goods because of currency manipulation, and not market factors. Thus we must force the Chinese to let the yuan appreciate to make American exports competitive.

These are false arguments, they are irresponsible and dangerous for Americans, and the end result will be a lower standard of living for Americans. These arguments never look at the unforeseen and unintended consequences of such a policy. They also court disaster.

But Secretary Geithner doesn't see it that way. Nor does Professor Krugman.

They play a very dangerous high stakes game.

Here is Geithner's most recent explanation of such a policy to force the Chinese to revalue the yuan:

As part of the overall effort to rebalance global demand and sustain growth at a high level, policy adjustments are needed that measurably strengthen domestic demand in some countries and boost saving in others. These are also important to ensure robust job growth. In the United States, private savings has increased, the current account deficit has fallen, and the President has outlined a series of measures to reduce our fiscal deficit.

Countries with large external surpluses and floating exchange rates, such as Germany and Japan, face the challenge of encouraging more robust growth of domestic demand. Surplus economies with inflexible exchange rates should contribute to high and sustained global growth and rebalancing by combining policy efforts to strengthen domestic demand with greater exchange rate flexibility.

This is especially true in China. China’s strong fiscal and monetary response to the crisis enabled it to achieve economic growth of nearly 9 percent in 2009, contributing to global recovery. Now, however, China’s continued maintenance of a currency peg has required increasingly large volumes of currency intervention. Additionally, China’s inflexible exchange rate has made it difficult for other emerging market economies to let their currencies appreciate. A move by China to a more market-oriented exchange rate will make an essential contribution to global rebalancing.

Let me translate this for you. Here's what Geithner really said:

The U.S. has been printing money like crazy to inflate our way out of the recession but that hasn't worked because credit is still frozen regardless of what we at the Treasury and the Fed have tried. We've got a bunch of politicians hammering us to support their exporter constituents and President Obama is not going to stand up to them. We in the government believe America will gain jobs by increasing exports.

So, we are going to very loudly threaten to punish China by branding them as currency manipulators and try to force them to revalue the yuan (i.e., devalue the overvalued dollar versus the yuan). We cleverly call this a "rebalancing." We've got a big stick: tariffs against Chinese goods. We let Krugman take the lead on that one because we can't really threaten them publicly. Also I'll let Sarkozy beat them up at the next G-20. I'll look great back home.

No one here really believes that we'll have to do tariffs, but the Chinese need to believe we will to make them knuckle under. I just postponed Treasury's report to Congress branding them as currency manipulators because it got the Chinese to the table. Don't worry, they'll revalue enough to help exporters, the senators will go away and brag to their constituents that we've won, and we'll be better off with more export jobs. We'll still buy Chinese goods and they'll finance our deficit.

There is only one problem: What if China doesn't go along with Geithner's game plan?

China's economy is facing a real estate and municipal debt bubble of huge proportions, and their economy is, contrary to what they say, fragile. They relied on real estate to drive their economy last year, not exports. With the danger of the real estate bubble bursting, they can't afford to harm exports. And revaluing the yuan would do just that.

They have been pushing back. There has been a gusher of articles touting free trade coming from Xinhua, the official China news service. For example:

Chinese Premier Wen Jiabao said in an exclusive interview with Xinhua that some foreign countries kept asking China to appreciate its currency while using various protectionist measures against China. Their real motive was to contain China's growth, he said.

Wen reiterated that China will never yield to external pressures on the exchange rate issue.

In essence, a country's exchange rate policy is a matter of sovereignty.

Foreign Ministry spokesperson Jiang Yu said Tuesday that the "exchange rate was not the major cause of the US trade deficit with China and the RMB's appreciation would not solve the Sino-US trade imbalance." She's right.

Morefrom Xinhua:

Chinese Premier Wen Jiabao said at Sunday's news conference that half of China's exports came from the processing trade -- where imported components were assembled at factories in China and 60 percent were made by foreign-funded companies or joint ventures with foreign partners.

"Therefore, to restrict trade with China is tantamount to causing difficulty for the businesses of your own countries," he said.

According to statistics provided by the Ministry of Commerce, 55.9 percent of China's exports were produced by foreign companies last year. The proportions were 83 percent and 75 percent respectively for high-tech products and electronic products.

And, over 90 percent of high-tech products exported to the US were made by foreign enterprises.

While China pegs its currency to the dollar, it doesn't do so against other currencies yet its exports have grown dramatically around the world, not just in the U.S. For example, its trade with the EU 27 was up 17% per year from 2004 through Q2 2009. The EU runs a deficit with China (€169 billion in 2008). We can conclude from this that the yuan-dollar exchange rate has not much to do with the fact we import a lot of Chinese goods.

Here is the reason that U.S. producers have not been able to compete with China: the goods we import from China cost more to manufacture here. It's quite simple. We need to compete in products where we have an advantage and that the Chinese and other countries will buy. The U.S. has priced itself out of the market for goods that the Chinese produce. This is the real reason the Chinese have piled up so many dollars. Even if the yuan were revalued, Chinese manufacturers would cut costs more in order to stay competitive. It's a losing game for us.

To force the Chinese to revalue the yuan would be, in effect, a tax on Americans. Chinese goods would become more expensive, yet there are few U.S. producers for most of these consumer goods. So, Americans will be made poorer by such U.S. policy and the economy will suffer as less dollars would be available for consumption.

The opposite effect is that China's citizens have to pay more for foreign goods. In effect, by keeping the yuan low and pegged to the dollar, our Chinese friends are subsidizing U.S. consumers. We should thank them for their mercantilist, centrally planned policies that favor us.

The other consequence is that the many U.S. companies which have goods partially made or assembled in China would be hit hard. U.S. manufacturers which sell products made from parts made in, or assembled in, China would see their cost go up, lose sales, revenues would slide, and be forced to layoff employees. Think about the many "U.S." products you buy that fit this definition: Dell (DELL), Apple (AAPL), HP (HPQ), Ford (F), GM, etcetera.

And what about U.S. companies importing and selling Chinese goods? Employees in the import and retail trades would be hurt as consumers cut back on purchases of more expensive goods. We would lose jobs, not gain them.

Why doesn't Mr. Geithner care about these jobs?

Eventually other low cost producers (Indonesia, India, Malaysia, Vietnam, Mexico) would step into the market made available by a revaluation, and at best, there would be little change in overall imports. Our balances of trade and payments would change very little.

But ... would a revaluation stimulate imports and save the world from recession?

To the extent we make things that would be competitive with China but for an overvalued yuan, theoretically, yes. Would this stimulate our exports and create jobs in export industries? Theoretically, yes. But ...

It would be at the expense of U.S. jobs related to imports. It would be at the expense of higher costs for most consumers who aren't in the export trade. It would negatively affect U.S. manufacturers whose parts are made in China or whose goods are assembled in China. It would cause us to lose jobs.

Would U.S. businesses be able to better compete in China since our products would be cheaper for Chinese buyers? Yes, theoretically. The problem is that it is very difficult to do business with or in China. They do not have well developed markets or the rule of law as in many capitalist countries. Right now (2009) we export $85 billion of goods and services to China and import $157 billion.

China makes it difficult for businesses that compete with local companies it wants to protect. What it wants is certain imports other than commodities. For example it wants technology and related services. But the U.S. would have to take off the national security list the technological products that we prohibit U.S. manufacturers from selling to them. Would Mr. Geithner be willing to do that? No.

Is China an important export market? Very much so, but it's not an easy market to penetrate.

Could we compete better in international markets against the Chinese? Yes, but only with the goods that we are aleady producing and which we already have an advantage over the Chinese. Here are the top 5 goods we exported in January (.pdf) (in millions): Chemicals (organic, inorganic, medicinal, n.e.s., plastics) $12,520; Electrical machinery $5,709; Vehicles $5,567; Aircraft $5,530; General industrial machinery $3,640. These are not the goods that China is exporting. To give you perspective, we exported $6,889 million of goods to China in January of $91,842 million of total exports.

A more expensive yuan is not a panacea and it has serious risks to U.S. companies and our economy.

Here's the downside: If things don't go according to Geithner's plan, and China doesn't revalue enough to please Congress, we will be forced to erects tariffs against Chinese goods. It's not as if politicians have a corner on the stupidity market, but trade wars have happened in the past, so don't think they will see the folly of their ways and recant at the last minute. China will reciprocate. Trade between the two countries will decline and China and America will be poorer for it. Trade wars have a tendency to escalate and spread throughout the world. Trade wars (starting with Smoot-Hawley) were one of the main causes of the Great Depression.

Instead of boosting the U.S. economy, there is a risk of plunging us into a depression. This is a dangerous lose-lose situation for everyone

Disclosure: No positions

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