US economy and the China trade deficit
Gerard Jackson
There is no doubt that the US trade deficit with China is causing a lot of confusion as well as anguish. In an effort to cast more light on the subject Irwin M. Stelzer of the National Review only succeeded in sowing more confusion (Chinese Checkers: Chairman Greenspan tries to nudge the Chinese, muzzle trade protectionists, and admonish Bush –– all in a stroke, 11 October 2005).
Stelzer’s first mistake was to assume that because “Chinese ‘labor costs’ are so far below those in the United States that even a major upward revaluation of the yuan would be unlikely to stem the flow of textile and other products with a high labor component”. The problem here is that labour costs have nothing to do with the deficit. Stelzer seems to have fallen into the trap of thinking that labour costs are the determining factor. Seductive as this line of reasoning might be it is still wrong.
This argument rests on the error that labour and land are virtually the only factors of production. It is easy to see that if this were truly the case living standards everywhere would be at a subsistence level. What raises real wages is capital accumulation. Therefore it’s the capital structure that determines the height of real wages. This explains why free trade does not equalise wage rates while open borders do
If it is a case of ‘cheap labour’ versus ‘expensive labour’ then how was the nineteenth century British textile industry able to sell masses of cotton goods to India and China where labour was far cheaper because it was more abundant relative to the amount of capital? The cheap-labour argument fails to explain why free trade areas like Hong Kong and Singapore were able to prosper and continually raise living standards even though they were in a geographical region noted for its cheap labour. The same goes for Japan, South Korea and Taiwan.
The line of economic reasoning that explains wage rates also explains trade between the US and China.
The more capital per head of the population the higher will be wages rates as labour becomes increasingly scarce relative to capital. The death toll from the Black Death in the fourteenth century caused real wages to rocket in response to a massive decrease in the labour supply. Adam Smith commented on high real wages in the American colonies, once again the result of abundant land relative to the labour supply.
We come to the conclusion that the more capital labour has to work with the more productive labour becomes. However, as an economy becomes more capital intensive the rise in real wages causes labour intensive activities in the tradable sector to become less competitive as rising labour costs squeeze their profit margins.
We therefore find that it is not cheap foreign labour per se that causes these firms to shrink but the success of raising real wages at home. These firms respond by either moving into other lines of production or moving their operations offshore.
Like just about everything in economics, the situation is not so clear cut as I have made it out to be. The process I described works very well on a gold standard. However, the use of fiat money causes disequilibrium by adversely influencing trade flows. A loose monetary policy can distort prices in away that expands the flow of imports while at the same time encouraging firms to invest abroad. When the monetary brakes are slapped on a readjustment process then emerges. Nevertheless, the damage has been done. Unfortunately this possibility is never discussed in the media –– and certainly never in Australia.
In any case, China’s role in the US trade deficit has been greatly exaggerated. A recent report by the Centre for Economic Policy Research estimated that China is responsible for only about 8.5 per cent of the deterioration in America’s trade balance since 1995. Furthermore, the Center pointed out that
China is simply too small to be responsible for the US deficits or to be able to correct them. Since 1997 the US current account has deteriorated by $529 billion. Over the same period, China’s current account position improved by $35.6, or just seven per cent of the deterioration in the US position. This is small in absolute terms but also in relative terms, as China’s share of world GDP minus the US is 16.7 per cent.
It is at this point that we should look at money supply figures. From February 1997 to September 2005 M1 grew by 30 per cent. From January 2001 to January 2005 it grew by about 24 per cent. (Monetary figures are subject to revision –– usually upwards). I believe that this monetary expansion might very well have helped fuel the demand for Chinese imports.
Now it is true that China’s monetary expansion has been far more reckless than the Fed’s monetary policy. But a good part of its monetary expansion has been used to suck in imports of raw materials. Since 1990 alone its demand for ores and metals has increased by 1500 per cent.
We now turn to Stelzer’s second error, his belief that if “the Chinese authorities cut back their purchases of American IOUs” it could send the US into recession by raising interest rates. Let us first put this into perspective. China owns $225 billion in U.S. treasuries as against Japan’s $680. Moreover, compare this $225 billion against a GDP of about 12 trillion or 20 trillion plus if all business spending is accounted for.
Even more importantly, these Treasuries and other US assets that China acquired with its dollars are in fact US exports. It follows from this that it is not the so-called Chinese dollar balances that are maintaining the US currency because these dollars have come home, so to speak. This means they are no longer part of China’s demand for dollars. I am not saying that if it were to pass that China sold off its T-bonds their price would not fall and so raise interest rates, only that the situation would reverse itself.
What advocates of the gloomy Stelzer scenario overlook is that there would be no point in China increasing its demand for dollars, which is what a sell off implies, unless it is going to use them to buy other US assets. Of course, critics can claim that China could sell them off to foreigners. So what? This would only mean a change of ownership. If China correctly predicted a massive dollar devaluation that would be a different story. However, it would be the devaluation that caused the problem and not the sell-off.
The whole thing boils down to the Fed’s monetary policy, over which China has no control whatsoever.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 24 October 2005