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Thursday, July 12, 2007

Tim Duy: Some Thoughts on the Trade Deficit

Tim Duy discusses how reducing the trade deficit might impact workers:

Some Thoughts on the Trade Deficit, by Tim Duy: I can’t stop thinking about a recent piece by Brad DeLong on the Clinton/Obama support of punitive duties on China and the ensuing comments. DeLong writes:

Of course, then the candidates will be attacking US consumers (who will pay higher prices for imports), workers in the construction industry, US borrowers (who will then pay higher interest rates to domestic and foreign creditors), and US homeowners (who will see the higher interest rates push down housing prices and reduce their equity). The net short-run effect is surely a minus--it's not as though we desperately need to swap construction jobs for manufacturing jobs right now, and we surely don't need a more-rapid decline in housing prices right now.

Lifted from the comments, James Galbraith agrees:

Good for you. One might add: not a single job will return to the U.S. if China revalues. Firms in China will either adjust their prices, or if their profits are too badly squeezed, it's off to Vietnam they go.

This point, however, elicits some ire from the crowd. Brad Setser responds:

"Not a single job will return" -- wow, i thought most economists thought exchange rates had an impact on trade....

To which Dean Baker adds:

By the way, I love the idea that relative prices don't affect demand. Economists usually don't say such things except when they want to argue about trade.

I don’t think that any economist really believes that relative prices do not affect demand. The issue of demand itself, however, is not truly the end game of those pushing for RMB revaluation.  What is the end game?

The end game is a boost to US job growth via an improvement in the US trade deficit. On this point, however, you need to make three additional assumptions.  One is that if the Chinese lessen support for the RMB, their decreased demand for dollar denominated assets is not offset by an increased demand from some other source.  In other words, there is a substantial drop in US capital inflows. The second is that the change in import prices results in a substitution effect to US produced goods and only a minor income effect – because the mix of prices we face is higher, we reduce overall consumption. Decreasing demand for foreign goods does not necessarily imply an increasing demand for equivalent domestic goods. Maybe we just don’t buy the flat screen tv at all. Finally, that there is excess capacity in the US to satisfy the increased demand from the substitution effect.

I see DeLong’s comments as – rightly – challenging these assumptions and the ultimate argument that US workers would be better off if we were to suddenly reverse the trade deficit.  The trade deficit represents an excess of consumption over productive capacities. In the short run, productive capacity is essentially fixed, so a rapid narrowing of the trade gap requires a reduction of consumption.  How do you reduce consumption?  As DeLong implies, you raise prices on the things households buy and/or you strip households of the ability to consume. The latter is achieved by decreasing capital inflows that place upward pressure on (real) interest rates.

Sure, the change in relative prices will likely alter the mix of jobs, but, assuming we are near capacity, not result in a net increase in jobs.  Moreover, in the short run, some structural adjustment will need to occur in order to shift workers from swinging hammers to making flat screen TVs – is it easy to fire the guy swinging the hammer, but takes time to retrain him and construct the physical capital (the factory) for him to do his new job. (And I don’t understand why so many people seem to be eager to see the guy swinging the hammer fired in the first place.  He needs to be punished because Wall Street misdirected capital to residential housing?)

The bottom line is that any substantial reversal of the trade deficit in the short run is likely to occur only via import compression, and if you believe that this process will be a net benefit for US workers, I suggest reviewing the history of the Asian Financial Crisis for examples of economies that were forced to reverse their external imbalances in the short run.  Moreover, I really can’t see that the costs of adjustment are going to be born in Greenwich. More to the point, what I expect from a process that triggered a substantial shift in the trade accounts would be a realignment of prices, exchange rates, and interest rates that reduced consumption in the US primarily by getting a whole bunch of average people fired.

This is not meant to suggest there are no reasons for concern about the RMB or – more generally – the domestic impact of foreign accumulation of dollar assets. I am sympathetic to concerns that the productive capacities of the future may be misaligned with the demands placed on those capacities should/when the trade deficit does unwind (when foreign holders of dollars assets desire to convert those assets into goods and services). In Brad Setser’s view:

In any case, the issue isn't whether existing Chinese production will relocate to the US. It is whether the next generation of auto parts factories and furniture factories and auto assembly lines and chip fabs will be in the US or in China, whether Chinese consumers will have the external purchasing to buy more US and European goods, whether more electronic component assembly will migrate to china, whether Chinese steel exports will continue to increase and so on. Chinese exports are growing 30% y/y; unless the RMB changes, it is hard to see how that changes.

Brad DeLong looks to a longer term horizon, albeit he is less concerned about the US situation:

In the long run of three to five years, yes: The renminbi needs to become worth a lot more (primarily for China's sake). Pressure on China to adopt better policies is helpful (provided we don't shoot ourselves in the foot).

And I tend to believe that the 3-5 year horizon is the best way to accomplish Brad Setser’s goal:

The return of existing jobs isn't the issue; the issue is how adjustment will happen -- and [I[ would think left-leaning economists would prefer than the needed real depreciation of the $ v the RMB not come from a fall in nominal US wages and prices ...

But, I admit it seems like I have been hearing for years about how China needs to change policies for its own benefit. Apparently, Chinese officials have a different opinion. The long-term simply is becoming too long for some (we will, after all, all be dead). tinbox’s comment:

This is why many people are giving up on free-trade extremists. While you think something, perhaps even the Clinton/Obama proposal, needs to be done someday, it never seems to be just the right day.

The problem here is two-fold. One is that the train has left the station.  The size of the trade deficit is of such a magnitude that any significant short run reversal will be painful as noted above.  The second problem is that of all the things I have learned from Brad Setser, the most relevant to this situation is that the rest of the world really, really wants to accumulate dollar denominated assets. And as long as that inflow of capital persists, so does the trade deficit.

This is essentially an exogenous problem with few (no?) endogenous solutions.  Sure, one can talk about increasing household savings or running a federal budget surplus, both of which may be good policies in and of themselves, and a hedge against the possible disorderly external adjustment, but do not directly affect foreign purchases of dollar assets.  Foreigners do not need to buy US Treasury bonds, as China’s investment in Blackstone proves.  Assuming no change in external preferences, “getting our house in order” is likely to increase the pool of available savings until the real interest falls enough to induce households to once again substitute current consumption for future consumption. 

There appears to be limited policy solutions to the trade deficit (if a “solution” is even called for). Given the exogeneity of the issue, the only domestic policy solution is both a forbidden topic and one that I doubt could be effectively used at this point – capital controls to limit foreign purchases of dollar assets. Still, I don’t think that those who worry most about the trade deficit would enjoy the higher interest rates and reduced consumption that would result from such a policy.  Nor would they ultimately be happy with policies that set in motion a disorderly adjustment of the external accounts. [Comments welcome, email Tim at timduy@msn.com]

    Posted by on Thursday, July 12, 2007 at 03:24 PM in Economics, International Trade, Unemployment | Permalink  TrackBack (0)  Comments (42)

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