Yesterday Michael Spence, the 2001 Nobel laureate in economics, a senior fellow at the Hoover Institution, and a professor emeritus at Stanford University discussed out trade deficit with China. Here's what he had to say followed by the reactions of Brad DeLong and Brad Setser.
First, the editorial:
We Are All in It Together, by Michael Spence, Commentary, WSJ: In 2005, the People's Bank of China ... accumulated $200 billion of additional reserves and is well on its way to holding $1 trillion of reserves... The accumulation ... was the policy action that caused the value of the yuan to remain stable relative to the dollar.
Casual conversation and commentary lead most Americans to think that this accumulation of reserves corresponds to a large trade surplus in China, achieved by holding the value of their currency down. In fact, the Chinese trade surplus is not that large. It is well under 5% of GDP, smaller in percentage terms than the U.S. trade deficit.
The accumulation of reserves in China is not primarily a trade-surplus issue. In 2005, China's trade surplus was $50 billion. Net inbound foreign direct investment was another $50 billion. And then, notwithstanding capital controls, there was an additional, largely unwanted net capital inflow of $100 billion. ...
The combination ... (adding up to $200 billion) would have put strong upward pressure on the value of the currency, risking a sudden and steep loss of competitiveness. To prevent this China bought foreign and largely dollar-denominated assets. ...
China has modest inflation and a reasonable balance between demand and capacity, but is out of external balance. The policy is to maintain internal balance while simultaneously moving toward external balance without losing growth. This involves letting the exchange rate rise but at a measured pace, reducing the excessively high rate of domestic saving and stimulating domestic consumption to take up the slack created by any loss ... in exports. ...
Chinese policy makers understand that holding the exchange rate down and preventing this shifting mix runs the risk of locking the economy into a labor intensive export mode for too long. Letting the currency rise will put the right kind of pressure on the economy to evolve as incomes rise. ...[T]here is a lively internal debate about what the right speed is. ...
The U.S. position on China is politically driven and is partly right and partly incoherent.
The part that is right, and well understood in China, is that holding the yuan down removes pressure for the economy to evolve and keep up with development. Another point on which there is at least some agreement among professionals ... is that there is much to be done to increase the capacity, transparency and efficiency of the financial-services sectors in China, a necessary preliminary to safely ... removing capital controls. ...
The part of our foreign-policy stance that is incoherent is the implicit (sometimes explicit) notion or belief that our ... trade deficit with China is closely connected to China's policy of neutralizing the impact of the trade surplus and capital inflows...
Our trade deficit is the mirror image of the difference between domestic saving and domestic investment in the United States. As long as that difference persists, we will run a large deficit on current account. And that will be perceived as exporting jobs, at least in the sectors that are impacted...
Japan and China, for similar but somewhat different reasons, have a problem with high savings. The excess of savings relative to investment goes abroad. The U.S. has the opposite condition. We finance a deficit of savings relative to investment with foreign investment. Two of those large foreign investors are the central banks in Japan and China.
They could change their behavior in the near future, developing a sudden lack of willingness to buy additional dollar-denominated assets, but such a sudden change is very unlikely. ...[A] sudden shift away from accumulating reserves would cause the dollar to fall further, raise the value of their own currencies and reduce their export growth by an indeterminate amount. It would also force savings up or investment down -- or both -- in the U.S., producing with near certainty a recession here that would be exported world-wide... In this sense we are all in it together.
The graceful way out of this is gradual: an increase in U.S. savings relative to investment, a reduction in savings relative to investment in China and Japan, a probable further lowering of the market-determined value of the dollar in the short and medium term. As part of the process, it would be useful if we stopped pretending or alleging that China's exchange-rate policies are the root cause of our trade deficit.
If our savings rate is stubbornly stuck below our investment rate, and if China does allow its currency to revalue over time, then we will simply run a deficit with another collection of countries, and from a domestic point of view, nothing much will have changed...
Here's Brad Delong's reaction:
In Condemnation of One-Equation Economics, by Brad DeLong: I really don't like one-equation economics.
One-equation economics assumes that certain economic quantities are fixed in stone, examines one equation--usually an accounting identity--and concludes that somebody else's preferred policies will be ineffective and counterproductive. It does so by ignoring the fact that one of the aims or effects of the somebody else's policies will be to change the values of the economic quantities that are--by assumption and only by assumption--claimed to be fixed in stone.
Here's Stanford's Michael Spence. The one equation is the international savings-investment identity. The quantities assumed fixed are domestic saving and investment:
We Are All in It Together - WSJ.com: [I]t would be useful if we stopped pretending or alleging that China's exchange-rate policies are the root cause of our trade deficit.
If our savings rate is stubbornly stuck below our investment rate, and if China does allow its currency to revalue over time, then we will simply run a deficit with another collection of countries, and from a domestic point of view, nothing much will have changed. Except that we won't have this subject to discuss with China anymore.
"If our savings rate is stubbornly stuck below our investment rate." If. If. If. As Michael Mussa likes to say in these circumstances: if my grandmother had wheels, she would be a bus.
If China's central bank ceases buying its $200 billion a year of dollar denominated assets, and if nothing shocks the behavior of other central bank or collection of private foreigners, two things will happen: (1) the value of the value of the dollar will fall, and (2) U.S. interest rates will rise. The fall in the value of the dollar will boost U.S. exports and diminish U.S. imports, and the trade deficit will shrink. And--as long as the Federal Reserve is successful in avoiding recession--the rise in interest rates will reduce investment inside the United States and also lower asset values, which will make homeowners and investors feel poorer and increase their savings. It will thus reduce the gap between savings and investment, and so diminish the capital inflow.
Only if investment is stubbornly unresponsive to changes in the price of hiring capital and if savings is stubbornly unresponsive to housing and financial market wealth will Spence's "if" be true. But does Spence argue that investment is unresponsive? Does he argue that savings are unresponsive? Does he argue that there will be some other shock to the economy--that, for example, the Federal Reserve will fail to maintain full employment and thus that savings will fall because of recessions? No. He says "if." And he only says "if."
Now Mike Spence might argue that the Wall Street Journal does not give him much space, and that even if the Wall Street Journal gave him more space his readers would not give him more time. He might argue that he has to compress and simplify his argument: make it "clearer than truth." He might say that he is not a philosopher discoursing to fellow philosophers walking outside in the sunlight, but rather addressing the ignorant chained in the underground cave, and that it is his job to cast shadows on the wall that will lead those chained underground to support the policies they would support if they could understand the issues, if they were philosophers strolling in the sunlight.
And, Spence might say, it is his job to use whatever means are necessary to keep his readers from supporting destructive policies. He has to cast a shadow on the wall of the cave to get them thinking that tariffs and quotas on imports from China are not a way to reduce America's trade deficit and boost overall fand manufacturing employment.
Point taken: whatever effects (and there would be some) tariffs and quotas on imports from China would have on the level and distribution of employment in the U.S. would be accompanied by much more destructive blowback consequences. Tariffs and and quotas on imports from China are not a good idea. Getting China to boost consumption and domestic absorption would be a good idea. Closing the U.S. budget deficit would be a good idea. Boosting U.S. private savings would be a good idea. But doing none of those and doing tariffs and quotas instead? Not a good idea.
However, lowering the level of the debate by asserting that the Chinese government's purchase of $200 billion a year of dollar-denominated bonds doesn't affect the U.S. trade balance--that is not a good idea either. Those of us who walk outside in the sunlight and see reality as it is have a moral responsibility to bring others out of the cave: to raise the level of the debate, rather than to focus on casting handshadows that ultimately cannot but mislead.
UPDATE: Greg Mankiw compliments Michael Spence's one-equation international economics:
Greg Mankiw's Blog: Spence on the Trade Deficit: Economist Michael Spence (erstwhile Harvard prof) has a nice piece on the U.S. trade deficit and the Chinese exchange rate in today's Wall Street Journal. His bottom line:it would be useful if we stopped pretending or alleging that China's exchange-rate policies are the root cause of our trade deficit. If our savings rate is stubbornly stuck below our investment rate, and if China does allow its currency to revalue over time, then we will simply run a deficit with another collection of countries, and from a domestic point of view, nothing much will have changed. Except that we won't have this subject to discuss with China anymore.
The linkage among saving, investment, and the trade deficit is a topic that will feature prominently in ec 10 this spring.
Here's Brad Setser:
Spence on China, by Brad Setser: Michael Spence has a Nobel prize in economics, a series of very prestigious academic appointments, friends on the Harvard faculty and access to the opinion page of the Wall Street Journal.
I, obviously, don’t have comparable qualifications -- or comparable access to the Wall Street Journal's oped page.
But I do try to follow the data coming out of China closely. I probably shouldn't say this, but it sure seemed to me that Dr. Spence got a few key facts wrong in his Wall Street Journal oped.
Spence writes: “In 2005, China’s trade surplus was $50 billion.” That seems off. The IMF reports a $134.2b goods surplus in 2005 (BoP basis) and a $9.4b services deficit, for a combined goods and services surplus of $124.8. See Table 2 of the Article IV. The simple (customs) goods trade surplus for China in 2005 was around $100b. Google it. It doesn't take long to find an article kind of like this.
Spence argues that “In fact, China’s trade surplus isn’t all that large. It is well under 5% of China’s GDP, smaller in percentage terms than the US trade deficit.”
That also seems off. Look at the data on China's current account surplus – a slightly broader measure of China’s external surplus than the trade surplus. China’s 2005 current account surplus was $161b, or 7.1% of its GDP – and its 2006 surplus is now estimated by the World Bank to be $222b, or 8.5% of China’s GDP. Both the 2005 and 2006 Chinese surpluses are larger as a percent of China’s GDP than the US current account deficit is as a percent of US GDP.
If you just look at China's trade surplus (BoP basis), it works out to around 5.5% in 2005 and probably 6.5-7% of China's GDP in 2006 -- numbers comparable to the US trade deficit. Spence’s graph shows China’s trade surplus through 2004. That seems a bit misleading to me: China’s trade surplus ballooned in 2005 and 2006, just when the graph ends. Spence's argument worked through 2004. It no longer does...
The rest of Spence’s article didn’t drive me absolutely crazy – as he notes, a gradual increase in US savings relative to US investment and a gradual fall in Chinese savings relative to investment and a “further lowering of the market-determined value of the dollar” will all be part of the overall adjustment process. ...
I deeply believe that the debate on China would be greatly facilitated if we dealt with China as it is, not as it used to be -- and the data presented in major financial dailies reflected China as it is now, not China as it used to be.
In 2006, China will export nearly $1 trillion of goods – up from around $266b back in 2001. ... Its current account surplus has soared, going from 1.3% of GDP in 2001 over that period to at least 8.5% of GDP in 2006 (and that is probably too low given the recent data for November). China’s saving rate has gone from around 35% of GDP in 2001 to around 50% of GDP in 2006...
Those are all huge changes. The argument that China’s overall trade surplus is a myth is two years out of date. The myth now is that China’s doesn’t run a big global surplus.
The real debate on China now isn't about whether China runs a surplus or not. It is over the connection between China's exchange rate policy and the recent surge in its savings rate and associated surge in its global surplus. Martin Wolf has highlighted this better than anyone. Wolf writes:
I do not think China’s savings are driving the real exchange rate and the current account but rather the other way round. I think the same is true in the US, too… .
China has a more or less fixed nominal exchange rate. It also has a target of very low inflation. The two together determine the real exchange rate. At this real exchange rate, there exists a current account surplus and corresponding savings rate that delivers satisfactory levels of activity. Now suppose that the current account surplus suddenly shot up one year, because of greater than expected export capacity. China’s authorities would be concerned about overheating. So what would they do? They would tell local authorities and state-owned enterprises to invest less. They would tell banks to advance less credit. They would sterilise the reserve accumulation. These policies would generate the surplus of savings over investment needed to accommodate the current account surplus without either excess or inadequate demand. The real exchange rate tail wags the savings dog.
Exactly the same thing applies to the US, but in reverse.“ Emphasis added.
Right now, it is possible to argue, as Martin Wolf does, that China's savings surplus stems from its exchange rate policies... It is possible to argue, as Ronald McKinnon does, that China's savings and current account surplus has nothing to do with China's exchange rate policy... It is possible to argue, as Dr. Buiter and a host of others do, that China should be running a 10% of GDP current account surplus at this stage of its development, and should be saving 50% of GDP and investing 40% of GDP... It is possible to argue that China should be saving and investing less and still running a large current account surplus. It is even possible to argue that China should be investing less -- and if that means an even larger current account surplus, so be it.
But I don't see how it is possible to argue that China doesn't really have a current account surplus right now. Even the Chinese Academy recognizes China has a large and growing surplus. The data has sort of spoken.
China alone now accounts for about 1/5 of the world’s current account surplus... China is clearly is an important contributor to overall imbalances – not the only one, but an important one. It is possible to argue that this imbalance is not worth worrying about, but not that it doesn't exist.
Sorry about the rant. When I saw numbers that I didn't recognize at the beginning of Spence's argument, it kind of got in the way of his broader argument -- at least for me.
Update: I am with Delong on this, not with folks like Spence, Roach and (at least occasionally) Roubini. I don't think the US savings and investment gap is independent of the willingness of China and the petrostates to finance the US at low rates. If China let its exchange rate move significantly and reduced its current account surplus, the US wouldn't ended up borrowing the same amount from other countries. It would end up borrowing less.
Update: Thoma Palley sends an email with a link to something he wrote on the saving shortage hypothesis of the trade deficit