Economist's View

China in the World: Growth, Adjustment, and Integration

Here's the video I mentioned in the post "Is China's Growth Model Sustainable":

The Chinese economy has developed at a remarkable pace over the last 30 years.  The integration of China into the world economy has led to extraordinary flows of foreign direct investment, infrastructure buildup, and an impressive export capacity.   As we look to the future, both domestic and international considerations bear on the capacity for China to continue on this robust course and for the world to adjust to China’s growth and changed role. The differences in philosophical, legal, and governance systems between China and the West suggest that the challenges will be formidable and that cooperation and mutual benefit will require extraordinary attention.

• Daniel A. Bell - Professor, Tsinghua University
• Jan Kregel - Senior scholar at the Levy Economics Institute of Bard College
• Huang Yiping - Professor of Economics, National School of Development, Peking University
• Yu Yongding - Director, Institute of World Economics and Politics, CASS
• Moderator: Xiao Geng - Director of Research and Senior Fellow, Fung  Global Institute

Is China's Growth Model Sustainable?

A few quick., unorganized thoughts as I wait for today's sessions to start:

As I noted in an earlier post, one of the things I wanted to learn about at this conference is the sustainability of China's growth model and its applicability to other countries. One of the big issues is China's ability to rebalance its economy toward more reliance on internal consumption and less on exports. It's a delicate process because of China's large reliance on export-led growth. If China reduces its exports, but isn't able to successfully replace it with domestic consumption, it could cause huge problems for the economy. Nevertheless, rebalancing is essential. A second issue is growing inequality and the social unrest that comes with it.

What surprised me is an argument from Huang Yiping, Professor of Economics, National School of Development, Peking University, that this process is already well underway. He claims that if you correct for the service component of GDP, which is under reported, consumption has already climbed from somewhere in the 40 percent range to 52 percent of the economy. In addition, according to his estimates -- which I found convincing -- inequality is falling as well. Then main reason for this is a labor shortage (believe it or not) that is driving up wages, a process that began around 2008. Thus, there has been a transfer from profits -- which flow to higher incomes -- to wages of those at the bottom of the distribution (the five year plan allows for a 13 percent per year increase in the minimum wage).

So the argument is that it is not only possible to rebalance the economy and reduce inequality, this is well underway. Still, there's a long way to go yet and it's far to soon to declare victory.

[The video for this session isn't available yet -- I'll post it when it is.]

'On the Reliability of Chinese Output Figures'

This Economic Letter from the SF Fed says we can trust recent economic data from China:

On the Reliability of Chinese Output Figures, by John Fernald, Israel Malkin, and Mark Spiegel, FRBSF Economic Letter: Some commentators have questioned whether China’s economy slowed more in 2012 than official gross domestic product figures indicate. However, the 2012 reported output and industrial production figures are consistent both with alternative Chinese indicators of the country’s economic activity, such as electricity production, and trade volume measures reported by non-Chinese sources. These alternative domestic and foreign sources provide no evidence that China’s economic growth was slower than official data indicate.

China Says It May Implement a Carbon Tax

China may implement a (modest) carbon tax:

Taxing Carbon, by Vikas Bajaj, NY Times: Long considered the biggest holdout in climate change negotiations, China said this week that the country would implement new taxes designed to curb greenhouse gas emissions. Officials in Beijing provided few details, but a report by the state-owned Xinhua news service suggested that the government is working on a relatively modest plan. ...

The Xinhua report ... did not say how big a tax the country would impose, but it pointed to a three-year-old proposal by government experts that would have levied a 10-yuan ($1.60) per ton tax on carbon in 2012 and raised it to 50-yuan ($8) a ton by 2020. Those prices are far below the $80 (500-yuan) a ton that some experts have suggested would be needed to achieve “climate stability,” and which would raise the cost of gasoline by about 70 American cents a gallon.

China’s plan will not make a serious dent in global warming, though the tax may still have some beneficial impact within the country, where air pollution is a serious problem. ...

Meanwhile, in the U.S., many members of Congress find the idea of carbon taxes totally anathema and think such taxes would wreck the economy. They might, however, want to consider a proposal promoted by Mr. Hansen that would take the money collected from carbon taxes — or carbon fees as he prefers to call them — and rebate it in full to individuals. That would help consumers pay for more expensive electricity and gasoline, while giving them an incentive to cut their use of energy and fossil fuels. It’s an elegant way to limit damage to the economy while giving people incentives to do what is right for the planet.

Contrary to what "many members of Congress" (i.e. many Republicans) claim, eliminating a market failure through a carbon tax moves the economy closer to the optimal growth path rather than further from it.

We Should Stop Blaming China For Our Economic Problems

Here's my contribution to the debate over China bashing:

We Should Stop Blaming China for our Economic Problems: The second presidential debate featured Mitt Romney and Barack Obama going nose to nose over who would be tougher on China and other countries over their unfair trade practices. But by adopting a narrative that places the blame for our problems on other countries, President Obama is playing into the hands of those who’d like to make significant cuts to social insurance programs that protect working class households. ...

Here's the bottom line:

Blaming our troubles on external causes and implying that all will be well once these causes are eliminated allows the wealthy winners from globalization to escape the taxes that are needed to provide the social protections workers need in the global economy, and to ensure that the gains from globalization are shared equitably. President Obama needs to make it clear that helping the working class will take a lot more than just forcing China to change its ways... [It] will require us to look inward at our own character as a nation instead of blaming others.

Pointing fingers at other countries and demanding change may be politically effective, but the real change begins at home.

[Read more]

'Fear-of-China Syndrome'

Paul Krugman tries, once again, to explain why there's no reason to fear that "terrible things will happen" if China stops purchasing our government bonds:

Wicksell Goes To China, by Paul Krugman: The idea that we are at the mercy of the Chinese — that terrible things would happen if they stopped buying our bonds — is very influential. Yet it’s just wrong.

Think of it this way: the argument that interest rates would soar if the Chinese bought fewer bonds is the same as the argument that interest rates would soar when the U.S. government sold more bonds — which, as you may recall, was the subject of fierce debate more than three years ago — and you know how that turned out.

Again, you can think of this in terms of Wicksell: we’re in a situation in which the incipient supply of savings — the amount that people would save at full employment — is greater than the incipient demand for investment. And this excess supply of savings leads to a depressed economy.

What China does by buying bonds is add to the excess savings — which makes our situation worse. (This is just another way of saying that the artificial trade surplus hurts our economy — just another way of stating the same thing). And we want them to do less of it; far from fearing that they will stop, we should welcome the prospect.

Yet this point isn’t even controversial — by and large, commentators aren’t even aware that fear-of-China syndrome might be in error.

The Great Divergence between China and Europe

This is from Dan Little:

The great divergence, by Dan Little: It has been ten years since Ken Pomeranz published The Great Divergence: China, Europe, and the Making of the Modern World Economy, a book that forced some real rethinking about the economic history in Europe and China. Along with Bin Wong in China Transformed: Historical Change and the Limits of European Experience, he called for a deep questioning of many of the basic premises of much twentieth century economic history, which was premised on the backwardness and stagnation of China and the dynamism of Western Europe. Industrial revolution and sustained economic growth were unique products of the west, and China was incapable of these transformations at the beginning of the modern epoch -- 1600, let us say.

So the central problematic for "European exceptionalism" was to identify some set of features of western society lacking in China that could account for takeoff. Was it merchant culture? Perhaps Newtonian science? Was it European family and reproductive behavior? Or perhaps it was some feature of Christianity?

Pomeranz doesn't like these theories. More basically, he doesn't accept the premise of European economic superiority in 1600, whether in institutions or ideology. He considers agriculture first and holds that Chinese agriculture was as productive in terms of land and labor as English farming; it was not undergoing involution through population increase; and it supported a rural standard of living that was competitive with that of Europe and England, his primary focus.

Pomeranz doesn't doubt that there were sharp differences in European and Chinese economic development in the 18th century. This is the "great divergence" to which he refers. But he doubts that there are grand socio-cultural explanations for this fact; instead he focuses on contingent conjunctival circumstances that gave England a lead that it maintained for 200 years. These include the fortuitous location of coal in Britain, the fact of New World wealth, and the returns if slave labor in North America. None of these is a deep systemic factor but rather a lucky break for Britain.

Bin Wong adds a different theme to the debate. He recognizes that Europe and China possessed complex political-economic systems that were different from each other. And he agrees that these systems had consequences for development. But he agrees with Pomeranz that neither system is inherently superior. And he calls for an economic history that pays attention to the differences as well as similarities. Each process of development can be illuminated by comparison to the other.

So where is the debate today? This was the focus of a productive conference at Tsinghua University in Beijing last week. Some of the primary contributors to economic history participated, including Robert Allen, Bozhong Li, and James Lee. It isn't possible to summarize the papers, but several themes emerged. The most basic is the need to bring substantially more factual detail to the debate. What we need at this point isn't more theorizing about large causes; it is more fine grained factual discovery across both Europe and China.

Three areas in particular have gotten much more factual in the debate in ten years. the first is agricultural productivity. Historians like Robert Allen and Bozhong Li have substantially sharpened our knowledge of the farm economies of England and China.

Second is the question of the historical standard of living in various places. Essentially this depends on price data, wage data, and a system for comparing consumption across countries. Here too there has been a great refinement of our knowledge. Robert Allen has contributed much of this.

Third is population behavior. The Malthusian theory of the difference between China and Europe is a stumbling block, and of course this theory was created in a fact-free universe. Now comparative historical demography has advanced a long way thanks to researchers like James Lee. The Eurasian Population and Family History Project has now refuted the Malthusian view.

A key idea in the Pomeranz debate is Philip Huang's idea the Chinese agriculture was "involutionary". The work provided by Bozhong Li demonstrates that this theory is simply incorrect when applied to the lower Yangzi River delta. Moreover, China's development after 1970 makes the theory implausible in any case. As Li pointed out at the conference, "It is inconceivable China's modern development could have occurred in the conditions of involution described in the debate." China was clearly not caught in an inescapable involutionary trap.

So there is work to be done still on the origins of the great transformation. And it is valuable for this work to take place with a global and comparative perspective. But most valuable will be detailed factual research that adds significantly to what we know about the past.

"Will Jobs Be Reshored from China?"

Timothy Taylor:

Will Jobs Be Reshored from China?, by Timothy Taylor: China is becoming a less attractive place for off-shoring of manufacturing. But the result isn't likely to be a large movement of jobs back to the United States. Instead, globally mobile manufacturers are likely to seek out alternative low-cost destinations. Michel Janssen, Erik Dorr, and Cort Jacoby of the Hackett Group discuss these issues in a report called "Reshoring Global Manufacturing: Myths and Realities." The subtitle is: "By next year, China’s cost advantage over manufacturers in industrialized nations and competing low-cost destinations will evaporate." The report is freely available here, with free registration.  ...

I was ... struck by some comments in the report about Apple's labor costs with the iPad and outsourcing to China. They emphasize that in some industries like furniture manufacturing, cost matters most. But in other industries, product quality, protection of intellectual property, time to market and ramp-up speed may matter more.

"The Chinese labor-cost component of an entry-level iPad retailing for $500 is estimated at $10, or 2% of revenue, while the profit margin is estimated at $150, or 30% of revenue. If Apple were to move production to the USA, and if one assumes that assembly costs would triple (to $30), it is conceivable that Apple could convince customers to pay for a large portion of the price increase based on the appeal of a “made in the USA” product. ... Furthermore, ...  such a move could substantially boost Apple’s corporate image. However, the U.S. lacks the sheer labor capacity that would be required in order to ramp up production of iPads at the speed needed to maintain the company’s edge in the hyper-competitive tablet and mobile device market. ... Thus one may assume that Apple’s manufacturing sourcing strategy is primarily motivated by scalability and supply chain risk, and only secondarily by total landed cost."

Fed Watch: Cash Exiting China

Tim Duy:

Cash Exiting China, by Tim Duy: Something that I have thinking about for a few weeks - and was reminded of reading Ryan Avent this morning - is the series of pieces at FT alphaville regarding the outflow of cash from China. See here and here and here. The thinking had been that the renminbi was a one-way bet as China moved forward with capital account liberalization as investors rushed to be part of the Chinese story. The growing exodus of cash, however, is calling that story into question.

Moreover, I am interested in how much of the outflow is attributable to a generalized rush to safety as a result of the European crisis versus how much is attributable to capital flight due to a a deteriorating economic environment inside China itself. I am reminded of this story from the Wall Street Journal earlier this year:

With a fortune of at least $1.6 million, Mr. Shi is part of the wealthy elite that benefited most from the Communist Party's brand of capitalism. He is riding the crest of arguably the biggest economic expansion in history.

And yet, while the party touts the economic success of the "Chinese model," many of its poster children are heading for the exits. They are in search of things money can't buy in China: Cleaner air, safer food, better education for their children. Some also express concern about government corruption and the safety of their assets.

Domestic money in China will be the first to head for the exit - insiders will always know more than outsiders about the underlying economic conditions. So the exodus of cash could indicate that the Chinese story is coming to a close - and that will have significant consequences for the global economy. It is another signal that emerging markets will not be supporting global demand anytime soon. I think the team at alphaville is right - this story is slipping under the radar while we all have our eyes focused on the farce in Europe. But it could be the real game changer in the global economy.

"Why a More Flexible Renminbi Still Matters"

A quick one while waiting for Bill Clinton to take the stage at the conference I'm attending. This is Ken Rogoff:

Why a More Flexible Renminbi Still Matters, by Kenneth Rogoff, Commentary, Project Syndicate: One of the most notable macroeconomic developments in recent years has been the sharp drop in China’s current-account surplus. The International Monetary Fund is now forecasting a 2012 surplus of just 2.3% of GDP, down from a pre-crisis peak of 10.1% of GDP in 2007, owing largely to a decline in China’s trade surplus – that is, the excess of the value of Chinese exports over that of its imports.

The drop has been a surprise to the many pundits and policy analysts who view China’s sustained massive trade surpluses as prima facie evidence that government intervention has been keeping the renminbi far below its unfettered “equilibrium” value. Does the dramatic fall in China’s surplus call that conventional wisdom into question? Should the United States, the IMF, and other players stop pressing China to move to a more flexible currency regime?

The short answer is “no.” China’s economy is still plagued by massive imbalances, and moving to a more flexible exchange-rate regime would serve as a safety valve and shock absorber. ...[continue reading]...

"Chinese Premier Blasts Banks"

Are China's banks too big to be broken up?:

Chinese Premier Blasts Banks, by Dinny McMahon, Lingling Wei, and Andrew Galbraith, WSJ: Chinese Premier Wen Jiabao told a national audience on Tuesday that China's state-controlled banks are a "monopoly" that must be broken up...

In an evening broadcast on state-run China National Radio, Mr. Wen told an audience of business leaders that China's tightly controlled banking system needs to change. "Let me be frank. Our banks earn profit too easily. Why? Because a small number of large banks have a monopoly," said Mr. Wen... "To break the monopoly, we must allow private capital to flow into the finance sector." ...

Mr. Wen's push is part of a broader set of issues over China's growth, and came on the same day that Beijing unveiled programs intended to support the development of the country's capital markets and to spread international use of the yuan. Among them, China's security regulator said it would more than triple the amount that foreigners would be allowed to invest in China's heavily restricted financial markets to $80 billion. ...

Mr. Wen's remarks, in the export-oriented province of Fujian, are further indication that long-delayed economic reform is now at least a topic for public debate. ...

The major question is whether increasing rhetoric and new initiatives toward economic revisions will lead to broader reform. Prior efforts have faltered amid Beijing's drive to keep a tight rein on the economy and opposition from interest groups. ...

"Should The U.S. Take A Harder Stance On China's Currency?"

Joe Gagnon says the "best way to discourage currency manipulation is to tax it heavily":

Should The U.S. Take A Harder Stance On China's Currency?, by Joe Gagnon, Planet Money: ...Ben Bernanke recently said that Chinese currency manipulation "is blocking what might be a more normal recovery process." In fact, the problem goes beyond China to include many other emerging economies and even a few advanced economies. ... The evidence suggests that currency manipulators jointly have increased their trade balances by about $1 trillion relative to where they would have been in the absence of manipulation. Europe and the United States have suffered the corresponding decline in trade balances. ...

Based on estimates of the International Monetary Fund, the $1 trillion boost to European and US net exports from the ending of currency manipulation would return these economies to nearly full employment.

The best way to discourage currency manipulation is to tax it heavily. The taxes should apply to all purchases of European and US assets, including bank deposits, by governments that engage in currency manipulation. Unlike trade sanctions, such taxation is allowed under international law, and it also does not cause the economic distortions that trade sanctions cause. As I outlined recently with my colleague Gary Hufbauer, anti-money-laundering procedures now in place can prevent currency manipulators from hiding their investments through third parties.

One consequence of a reduction in currency manipulation would be a sharp drop in the values of the dollar and the euro in terms of the currencies of the manipulators. It is this exchange rate adjustment that would boost US and European exports, thereby generating jobs. ...

Paul Krugman: Will China Break?

Uh-oh?:

Will China Break?, by Paul Krugman, Commentary, NY Times: Consider the following picture: Recent growth has relied on a huge construction boom fueled by surging real estate prices, and exhibiting all the classic signs of a bubble. There was rapid growth in credit — with much of that growth taking place not through traditional banking but rather through unregulated “shadow banking” neither subject to government supervision nor backed by government guarantees. Now the bubble is bursting — and there are real reasons to fear financial and economic crisis.

Am I describing Japan at the end of the 1980s? Or am I describing America in 2007? I could be. But right now I’m talking about China, which is emerging as another danger spot in a world economy that really, really doesn’t need this right now. ...

The most striking thing about the Chinese economy over the past decade was the way household consumption, although rising, lagged behind overall growth. At this point consumer spending is only about 35 percent of G.D.P., about half the level in the United States.

So who’s buying the goods and services China produces? Part of the answer is, well, us:... China increasingly relied on trade surpluses to keep manufacturing afloat. But the bigger story from China’s point of view is investment spending, which has soared to almost half of G.D.P.

The obvious question is, with consumer demand relatively weak, what motivated all that investment? And the answer, to an important extent, is that it depended on an ever-inflating real estate bubble. ...

And there was another parallel with U.S. experience: as credit boomed, much of it came not from banks but from an unsupervised, unprotected shadow banking system..: in China as in America a few years ago, the financial system may be much more vulnerable than data on conventional banking reveal.

Now the bubble is visibly bursting. How much damage will it do to the Chinese economy — and the world? ...

For what it’s worth, statements about economic policy from Chinese officials don’t strike me as being especially clear-headed. In particular, the way China has been lashing out at foreigners — among other things, imposing a punitive tariff on imports of U.S.-made autos that will do nothing to help its economy but will help poison trade relations — does not sound like a mature government that knows what it’s doing. ...

I hope that I’m being needlessly alarmist here. But it’s impossible not to be worried: China’s story just sounds too much like the crack-ups we’ve already seen elsewhere. And a world economy already suffering from the mess in Europe really, really doesn’t need a new epicenter of crisis.

The Rise of the Renminbi as International Currency: Historical Precedents

Jeff Frankel:

The Rise of the Renminbi as International Currency: Historical Precedents, by Jeff Frankel: All of a sudden, the renminbi is being touted as the next big international currency. Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions. A RMB bond market has grown rapidly in Hong Kong, and one in RMB bank deposits. Some of China’s international trade is now invoiced in the currency. Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first.

Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b). ...

The dollar is one of three national currencies to have attained international status during the 20th century. The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73. (The euro, of course, did so after 1999.) In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot. It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded. ...

The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies. The Chinese government is actively promoting the international use of its currency. Neither Germany nor Japan, nor even the US, did that, at least not at first. In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization. One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.

In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments. In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large. These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.

It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence. Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier. But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system. That will not be enough to do it.

[This perspective note summarizes the argument in "Historical Precedents for the Internationalization of the RMB"...] ...

Paul Krugman: Holding China to Account

Improving our trade balance would help with the recovery:

Holding China to Account, by Paul Krugman, Commentary, NY Times: The dire state of the world economy reflects destructive actions on the part of many players. Still, the fact that so many have behaved badly shouldn’t stop us from holding individual bad actors to account.

And that’s what Senate leaders will be doing this week, as they take up legislation that would threaten sanctions against China and other currency manipulators.

Respectable opinion is aghast. But respectable opinion has been consistently wrong lately, and the currency issue is no exception.

Ask yourself: Why is it so hard to restore full employment? ... The answer is that we used to run much smaller trade deficits. A return to economic health would look much more achievable if we weren’t spending $500 billion more each year on imported goods and services than foreigners spent on our exports.

To get our trade deficit down, however, we need to make American products more competitive, which in practice means that we need the dollar’s value to fall in terms of other currencies. Yes, some people will shriek about “debasing” the dollar. But sensible policy makers have long known that sometimes a weaker currency means a stronger economy... Switzerland, for example, has intervened massively to keep the franc from getting too strong against the euro. ...

The United States, given its special global role, can’t and shouldn’t be equally aggressive. But given our economy’s desperate need for more jobs, a weaker dollar is very much in our national interest — and we can and should take action against countries that are keeping their currencies undervalued, and thereby standing in the way of a much-needed decline in our trade deficit.

That, above all, means China. ... And the reality of the unemployment disaster is also my answer to those who warn that getting tough with China might unleash a trade war or damage world commercial diplomacy. Those are real risks, although I think they’re exaggerated. But they need to be set against the fact — not the mere possibility — that high unemployment is inflicting tremendous cumulative damage as we speak.

Ben Bernanke, the chairman of the Federal Reserve, said it clearly last week: unemployment is a “national crisis,” with so many workers now among the long-term unemployed that the economy is at risk of suffering long-run as well as short-run damage.

And we can’t afford to neglect any important means of alleviating that national crisis. Holding China accountable won’t solve our economic problems on its own, but it can contribute to a solution — and it’s an action that’s long overdue.

Bhagwati: The Outsourcing Bogeyman

Jagdish Bhagwati says outsourcing myths are standing in the way of free trade initiatives ("If free trade is to regain the support of statesmen who now hesitate over liberalizing trade with developing countries, the myths that turn outsourcing into an epithet must be countered"). He says we shouldn't worry about outsourcing jobs because we can always use protectionism to save them:

there are manmade restrictions to outsourcing particular types of expertise: professional organizations often intervene to kill outsourcing simply by requiring credentials that only they can provide. Thus, foreign radiologists need US certification before they are allowed to read the x-rays sent from the US. Until recently, only two foreign firms qualified.

So no need to worry. If assembly line work is threatened by outsourcing, simple, just require US certification for the workers who produce these goods.

Don't get me wrong, I think free trade is almost always the best answer. But in supporting it, we shouldn't hide from the short-run distributional consequences that fall on some segments of the population. Acknowledging that the costs exist, and then addressing them is a much better route to preserving free trade inititatives.

"Would a Stronger Renminbi Narrow the US-China Trade Imbalance?"

The Liberty Street blog at the NY Fed says we should hope that China keeps growing:

Would a Stronger Renminbi Narrow the U.S.-China Trade Imbalance?, by Matthew Higgins and Thomas Klitgaard, Liberty Street Economics: The United States buys much more from China than it sells to China—an imbalance that accounts for almost half of our overall merchandise trade deficit. China's policy of keeping its exchange rate low is often cited as a key driver of that country's large overall trade surplus and of its bilateral surplus with the United States. ... In this post, we examine the thinking behind this view. We find that a stronger renminbi would have a relatively small near-term impact on the U.S. bilateral trade deficit with China and an even more modest impact on the overall U.S. deficit. ... To close the gap between them, a stronger renminbi would need to markedly raise U.S. exports and/or lower U.S. imports. Although we do not believe that this adjustment is likely in the near term,... the bilateral balance can be expected to shrink over the long run—owing largely to forces other than the renminbi. ...

U.S. imports from China currently exceed U.S. sales to China by a factor of 4 to 1. The implication of this ratio is that exports to China need to grow four times faster than imports merely to prevent the bilateral trade gap from widening. Can the bilateral trade deficit ever shrink, given this daunting math?

Yes, we think that the gap will shrink—but primarily as a consequence of the high rate of economic growth in China. We have already seen U.S. exports to China grow at a 20 to 30 percent pace in recent years, driven by the rapid expansion of that country's middle class and the resulting increase in demand for higher-end goods and services. We expect a similar pace of export growth for some time. A stronger renminbi could play an important supporting role in this process, even if it would not be the main driver. At the same time, the current share of Chinese goods in overall U.S. non-oil import spending—about 25 percent—is already so high that Chinese producers will find it increasingly challenging to make further gains in market share. Within a few years, growth in U.S. purchases from China is likely to settle at the much lower rate of growth seen in overall U.S. import spending.

"Within a few years" seems optimistic.

"Antidumping in Action"

When it becomes more expensive for producers in China to sell their goods in the US due to tariffs, bi-lateral exchange rate changes, increasing wage costs in China, etc., production does not necessarily move to the US:

Antidumping in Action, by Bill C: Today's Washington Post provides another example of our dysfunctional "Antidumping" rules in action. This case is about antidumping tariffs imposed on furniture imports from China:

But do tariffs work? In the case of bedroom furniture, they’ve clearly helped slow China’s export machine. In 2004, before tariffs went into force, China exported $1.2 billion worth of beds and such to the United States. The figure last year was just $691 million.

Over the same period, however, imports of the same goods from Vietnam — where wages and other costs are even lower than in China — have surged, rising from $151 million to $931 million. The loss of jobs in America, meanwhile, only accelerated.

This may be a case where the differential tariff treatment between Chinese and Vietnamese furniture which resulted from the antidumping case induced "trade diversion" - i.e., an efficiency loss because the trade preferences result in imports coming from someplace other than the low cost producer. However, in this example, it could also be the case that comparative advantage shifted to Vietnam as China's labor costs have risen.

Furthermore:

The only Americans getting more work as a result of the tariffs are Washington lawyers, who have been hired by both U.S. and Chinese companies. ...

"A Note on Trade"

On emore from Tim Duy:

A Note on Trade, by Tim Duy: US trade data were released today; Calculated Risk has the broad outlines of the report. As Ryan Avent notes, the non-petroleum balance points in the direction of rebalancing. I am hopeful this is correct, but add that we still lack clear evidence at this point. Indeed, since the end of the recession, non-petroleum trade has generally been a drag on the recovery – note trend #1 below:

The rebalancing story took a hit in the first half of 2010 as the trade deficit widened. That situation reversed in the second half of 2010, and the narrowing deficit helped propel final demand in the fourth quarter of last year. Since then, the rebalancing story has stalled on average. Now it appears we are arguably at something of a crossroads – will the general path of the US trade deficit follow path #1 or path#2? In other words, will the external sector be a drag or US demand, or a boost? I am cautiously optimistic ongoing general downward pressure on the dollar, in concert with policy changes and solid growth abroad, will sustain ongoing rebalancing.

That said, rising expectations of tighter monetary policy abroad serve as a reminder that the external environment could turn nasty. From Bloomberg:

Commodities sank, with gasoline falling the most in two years, U.S. stocks slid and the dollar rose as concern over Europe’s debt crisis deepened and inflation reports spurred speculation global interest rates will rise…

…The pound rallied as Bank of England Governor Mervyn King said inflation remains “uncomfortably high” and officials signaled they may raise rates later this year. Price gains in Germany and China topped estimates and Poland unexpectedly increased its benchmark rate. Concern about Europe’s debt crisis and prospects for higher borrowing costs damped enthusiasm for stocks even as earnings improved at companies from Macy’s Inc. (M) to A.P. Moeller-Maersk A/S and U.S. exports climbed to a record.

Policy in China needs to tighten to stave off actual inflation. Optimally, Chinese policy steps, such as allowing the renminbi to rise at a faster rate, would shift demand internally toward consumption and away from the investment and export industries, effectively allowing US production to satisfy Chinese demand. This week's US-China talks give room for optimism on this issue. This is a reasonable policy path for other emerging markets as well and, in my opinion, the only win-win path. Still, it is not guaranteed that such a transition can occur smoothly, especially if inflation is already deeply embedded in the Chinese economy. A messy transition could slow global growth and put upward pressure on the dollar.

It is not clear that Europe, either the UK or Euro region, needs higher rates, but instead are being pulled in the trap of tightening policy in the face of a temporary commodity price shock. And it certainly seems clear that Ireland, Greece, and Portugal will be even more challenged to achieve fiscal and economic stability, guaranteeing a default or that euphemism for default, restructuring. The combination of higher interest rates and financial crisis should also prove to be dollar positive, thereby slowing the path toward rebalancing.

Of course, as Avent also notes, a complete rebalancing in which the overall US trade deficit falls to zero seems like an overwhelming challenge in the face of the US propensity for imported oil. Perhaps a more manageable trade deficit in non-petroleum products is the best we can hope for at this point.

In short, despite an improvement in the non-petroleum trade balance since the middle of 2011, rebalancing of the external accounts is not yet a certainty. Rebalancing continues to depend on the ability and willingness of the rest of the world to accept and manage the consequences of that rebalancing. Arguably, so far, so good, but the real tests may still be ahead.

Eichengreen: Slowing China

Barry Eichengreen warns that China's economy may be headed for a slowdown:

Slowing China, by Barry Eichengreen, Commentary, Project Syndicate: With the world’s rich countries still hung over from the financial crisis, the global economy has come to depend on emerging markets to drive growth. Increasingly, machinery exporters, energy suppliers, and raw-materials producers alike look to China and other fast-growing developing countries as the key source of incremental demand. ...

Chinese officials are convinced that a slowdown is coming. ....[I]n response to foreign and domestic pressure, China will have to rebalance its economy, placing less weight on manufacturing and exports and more on services and domestic spending. At some point Chinese workers will start demanding higher wages and shorter workweeks. More consumption will mean less investment. All of this implies slower growth. Chinese officials are well aware that these changes are coming. ...

So what is at issue is not whether Chinese growth will slow, but when. ... [A] significant slowdown in Chinese growth is imminent. The question is whether the world is ready, and whether other countries following in China’s footsteps will step up and provide the world with the economic dynamism for which we have come to depend on the People’s Republic.

All the more reason -- besides the risk of rising oil prices and other uncertainties -- to be wary of doing things now such as reducing the deficit or raising interest rates that might make it even harder for the economy to recover. There are enough potential headwinds in the air already.

"Why Egypt Should Worry China"

Barry Eichengreen:

Why Egypt Should Worry China, by Barry Eichengreen, Commentary, Project Syndicate: A strictly economic interpretation of events in Tunisia and Egypt would be too simplistic... That said, there is no question that the upheavals in both countries – and elsewhere in the Arab world – largely reflect their governments’ failure to share the wealth.

The problem is not ... economic growth. ... Annual growth since 1999 has averaged 5.1% in Egypt, and 4.6% in Tunisia... Rather, the problem is that the benefits of growth have failed to trickle down to disaffected youth. ... Corruption is widespread. Getting ahead depends on personal connections...

China might soon be facing similar problems... the warning signs are there. ...

First, there is the growing problem of unemployment and underemployment among university graduates. ... Indeed, the country is rife with reports of desperate university graduates unable to find productive employment. ...

Moreover, there is the problem of less-skilled and less-educated migrants from the countryside, who are consigned to second-class jobs in the cities. ...

Finally, China needs to get serious about its corruption problem. Personal connections, or guanxi, remain critical for getting ahead. Recent migrants from the countryside and graduates with degrees from second-tier universities sorely lack such connections. ...

If Chinese officials don’t move faster to ... head off potential sources of disaffection, they could eventually be confronted with an uprising of their own – an uprising far broader and more determined than the student protest that they crushed in Tiananmen Square in 1989.

Feldstein: The End of China’s Surplus,

Martin Feldstein argues that China's current-account surplus is likely to shrink dramatically over the next few years:

The End of China’s Surplus, by Martin Feldstein, Commentary, Project Syndicate: China’s current-account surplus ... is the largest in the world. ...China’s external surplus stands at $316 billion, or 6.1% of annual GDP.

Because the current-account surplus is denominated in foreign currencies, China must use these funds to invest abroad, primarily by purchasing government bonds issued by the United States and European countries. As a result, interest rates in those countries are lower than they would otherwise be.

That may all be about to change. ... It is possible that, before the end of the decade, China’s current-account surplus will move into deficit... If that happens, China will no longer be a net buyer of US and other foreign bonds, putting upward pressure on interest rates in those countries.

Although this scenario might now seem implausible, it is actually quite likely to occur. ... China’s national saving rate ... is now about 45% of its GDP, which is the highest rate in the world. But, looking ahead, the five-year plan will cause the saving rate to decline...

The plan calls for a shift to higher real wages so that household income will rise as a share of GDP. Moreover, state-owned enterprises will be required to pay out a larger portion of their earnings as dividends. And the government will increase its spending on consumption services like health care, education, and housing....

Since China’s current-account surplus is now 6% of its GDP, if the saving rate declines from the current 45% to less than 39% – still higher than any other country – the surplus will become a deficit.

This outlook for the current-account balance does not depend on what happens to the renminbi’s exchange rate... But the fall in domestic saving is likely to cause the Chinese government to allow the renminbi to appreciate more rapidly. Higher domestic consumer spending would otherwise create inflationary pressures. ... A stronger renminbi would ... cause a shift from exports to production for the domestic market, thereby shrinking the trade surplus, in addition to curbing inflation.

...Americans are eager for China to reduce its surplus and allow its currency to appreciate more rapidly. But they should be careful what they wish for, because a lower surplus and a stronger renminbi imply a day when China is no longer a net buyer of US government bonds. The US should start planning for that day now.

Plans are not action. I hope the Chinese government moves to raise the standard of living and to provide more social services, but I'll believe it when I see it happen. For now, interest rates remain very low -- markets are not worried about this -- and it's not the time to panic about the deficit, impose large budget cuts, and endanger the recovery.

The "Anti-Willie Sutton"

Bill Craighead at Twenty Cent Paradigms:

SOTU, by Bill Craighead: A couple of thoughts on the "State of the Union"-

As an economist, I don't find the rhetoric of "competitiveness" very appealing (see Paul Krugman's classic on this).  International trade is mutually beneficial* - not a zero sum struggle to beat other countries to the "good jobs."  From an economist's point of view, the rapid growth in China is a great story about an dramatic increase in human welfare.  However, while competitiveness rhetoric can be used to justify bad policies like subsidies and tariffs, Obama is employing it to promote policies like investment in infrastructure, basic research and education that are beneficial regardless of what is going on in other countries.  Though it is a mistake to feel threatened by the success of other countries, Obama seems to be exploiting this sentiment to embarrass us into getting our act together, which isn't entirely a bad thing.  He's like our national "Tiger mother."

Unfortunately, President Obama appears to have conceded the rhetorical war on two important fronts: global warming and the budget deficit.

On global warming, which is the most important policy issue we face, the President chose not to even mention it directly.  So much for having "adult conversations" in our politics...  Even if the towel has been thrown in on cap-and-trade, the administration does appear to be trying to confront the problem, sotto voce, in other, less efficient ways.  At least, that is how I interpret the call that 80% of energy should come from "clean sources" by 2035.

As for the deficit, the idea that the government is like a family that needs to "tighten its belt" seems to have won out.  That's simple, intuitive and wrong.  The basic principle of countercyclical fiscal policy - that when households are cutting back, government needs to step in and make up for it with offsetting spending increases or tax cuts - also seems simple and intuitive.  But apparently not enough so.  President Obama is a very good speech-maker, but has proven not to be enough of a great communicator to get the public thinking correctly about this.

It looks like we'll get some "cuts" and "freezes."  These may manage to be a drag on the recovery and damage some important government functions without making much of a dent in the real long run problem because domestic discretionary spending is a fairly small part of the overall budget (as Howard Gleckman says: "that makes Obama the anti-Willie Sutton. He is going whether the money isn’t").  It seems that we're done with counter-cyclical fiscal policy and its all up to the Fed now.  With 14.5 million still unemployed, that is a mistake, and a real shame.  While I hope (and believe) the President is correct in presuming the recovery will continue, it still could benefit from a fiscal push.

See also: Paul Krugman, ... and Ezra Klein.

*There are number of possible caveats on that, including that while a country as a whole benefits, some within it are hurt (Stolper-Samuelson theorem) and that a trade deficit can reduce aggregate demand which is bad for employment in the short-run.

Paul Krugman: China Goes to Nixon

Will China's currency policy lead to a "full-fledged" economic crisis?:

China Goes to Nixon, by paul Krugman, Commentary, NY Times: With Hu Jintao, China’s president, currently visiting the United States, stories about growing Chinese economic might are everywhere. And those stories are entirely true: ...it’s growing fast, and given its sheer size it’s well on the way to matching America as an economic superpower.

What’s also true, however, is that China has stumbled into a monetary muddle that’s getting worse with each passing month. ... The root cause ... is its weak-currency policy, which is feeding an artificially large trade surplus. As I’ve emphasized in the past, this policy hurts the rest of the world, increasing unemployment in many other countries, America included.

But a policy can be bad for us without being good for China. ...Chinese currency policy is a lose-lose proposition, simultaneously depressing employment here and producing an overheated, inflation-prone economy in China itself.

One way to think about what’s happening is that inflation is the market’s way of undoing currency manipulation. ... China’s leaders are, however, trying to prevent this outcome, not just to protect exporters’ interest, but because inflation is even more unpopular in China than it is elsewhere. ...

But for whatever reason — the power of export interests, refusal to do anything that looks like giving in to U.S. demands or sheer inability to think clearly — they’re not willing to deal with the root cause and let their currency rise. Instead, they are trying to control inflation by raising interest rates and restricting credit.

This is destructive from a global point of view: with much of the world economy still depressed, the last thing we need is major players pursuing tight-money policies. More to the point from China’s perspective, however, is that it’s not working. Credit limits are proving hard to enforce and are being further undermined by inflows of hot money from abroad.

With efforts to cool the economy falling short, China has been trying to limit inflation with price controls — a policy that rarely works. In particular, it’s a policy that failed dismally the last time it was tried here, during the Nixon administration. (And, yes, this means that right now China is going to Nixon.)

So what’s left? Well, China has turned to the blame game, accusing the Federal Reserve (wrongly) of creating the problem by printing too much money. But ... blaming the Fed ... won’t change U.S. monetary policy, nor will it do anything to tame China’s inflation monster.

Could all of this ... turn into a full-fledged crisis? If I didn’t know my economic history, I’d find the idea implausible. After all, the solution to China’s monetary muddle is both simple and obvious: just let the currency rise, already.

But I do know my economic history, which means that I know how often governments refuse, sometimes for many years, to do the obviously right thing — and especially when currency values are concerned. Usually they try to keep their currencies artificially strong rather than artificially weak; but it can be a big mess either way.

So our newest economic superpower may indeed be on its way to some kind of economic crisis, with collateral damage to the world as a whole. Did we need this?

"Making Peace in the US-China Trade War"

Dean Baker argues that mechanisms such as an "effective policy of work-sharing, like the one in Germany" can be used to redistribute the costs and benefits of China's currency policy so that "we need not be hostile to China," We won't, of course, do anything like this and the costs will continue to be concentrated rather than diffuse, but we could:

Making peace in the US-China trade war, by Dean Baker, Comment is Free: Trade disputes with China have been heating up lately, but there really is no reason for the hostility. Essentially, China's government is saying is that it has no better use for its money than subsidising the consumption of people in the United States and other wealthy countries, by propping up the value of the dollar. That may seem surprising..., but if this is what China's leaders insist, who are we to argue? ...

In effect, China is subsidising its exports to the United States. This is very generous of the Chinese government, since the United States can take advantage of China's generosity to enjoy a higher standard of living. Currently, our deficit with China is equal to 2% of GDP. This means that China is handing us goods and services that are worth roughly $280bn a year more than the value of goods and services we give them in exchange.

While this displaces a large amount of domestic production, we can ensure that the displacement does not result in unemployment by simply shortening working weeks. If everyone's working week was shortened by 2.0% (the equivalent of one week per year of vacation), we could keep the workforce fully employed even in the case of reduced demand.

This could be accomplished by having the government pay people to work shorter working weeks; in effect, paying unemployment benefits to cover a reduction in hours. This would spread the pain over many workers, rather than forcing a portion of the workforce to be completely unemployed. In this way, China could effectively subsidize the vacation of tens of millions of workers in the United States and elsewhere.

This may sound like a bad deal from China's standpoint, but it is a deal they insist upon. They have sometimes raised the question of whether they can expect to have debt to the United States lose value as a result of a falling dollar. The United States should take away this uncertainty.

China absolutely will lose money on its investments in government bonds. ... China's leaders should rest completely assured that when they ultimately sell these assets, they will be getting dollars that are worth substantially less than the dollars they bought. ...

So, we need not be hostile to China over its desire to give money to American consumers. An effective policy of work-sharing, like the one in Germany, can ensure that China's generosity leads to longer vacations, not unemployment. We should also take steps to ensure that our highest-paid workers are subjected to the same competition from China as our manufacturing workers.

And, in order to eliminate their uncertainty on this issue, we should assure the Chinese people and their government that they will be repaid in lower-valued dollars. However, if China's government thinks the best use of its money is to pay for longer vacations for workers in the United States, there is no reason for us to be upset.

Bhagwati: India or China?

Who will grow faster, China or India? Jagdish Bhagwati says it depends upon whether you adopt a short or long horizon. In the short-run, China has the advantage, but in the longer run, India has the advantage:

India or China?, by Jagdish Bhagwati, Commentary, NY Times: ...Will China grow faster than India...? In fact, this contest dates back to 1947, when India gained independence and democracy..., while China turned to Communism...

As it happened, however, both giants slept on – until the 1980’s in China and the early 1990’s in India – mainly because both countries embraced a counter-productive policy framework...

Reflecting flawed economic arguments, India embraced autarky in trade and rejected inflows of equity investment. It also witnessed economic interventionism on a massive scale... In China, the results were similar, as the political embrace of Communism meant going autarkic and giving the state a massive role in the economy.

After progressively dismantling their inefficient policy frameworks in favor of “liberal” reforms, the ... race was finally on. And ... China ... grew faster, because it changed its policy framework much faster than democracy permits. But there are good reasons to suspect that China’s authoritarian advantage will not endure.

First, while authoritarianism can accelerate reforms, it can also be a serious handicap. ... Moreover,... as growth accelerates, political aspirations are aroused. Will the Chinese authorities respond to them with ever greater repression,... creating discord and disruption, or will they accommodate new popular demands by moving to greater democracy? ...

Finally, China’s growth must continue to depend on its exploitation of external markets, which makes it vulnerable.., hassles and hiccups for Chinese exports can be confidently expected.

Economic factors also militate against Chinese prospects. China was clearly able for many years to ... grow rapidly without facing a labor-supply constraint... But now,... labor is getting scarce and wages are rising. ...

By contrast, India has a far more abundant supply of labor,... so that, as India’s investment rate increases, labor will not be a constraint. India will thus become the new China of the past two decades.

Besides, in contrast to China, where economic reforms were quicker and more complete, India still has a way to go: privatization, labor-market reforms, and opening up the retail sector to larger, more efficient operators are all pending – and will give a further boost to India’s growth rate once they are implemented.

"Administrative Measures are Not Effective in Controlling Inflation"

The old raise the price by shrinking portion size trick:

During the sixty years of the People's Republic, we have learned that administrative measures are not effective in controlling inflation. For instance, the government often forbids university canteens from raising food prices, so prices do not change. Instead the portions get smaller. Unfortunately the government is doing the same again.

Paul Krugman: Rare and Foolish

China has a monopoly position in the production of many rare earth elements, and has "showed itself willing to exploit that monopoly to the fullest":

Rare and Foolish, by Paul Krugman, Commentary, NY Times: Last month a Chinese trawler operating in Japanese-controlled waters collided with two vessels of Japan’s Coast Guard. Japan detained the trawler’s captain; China responded by cutting off Japan’s access to crucial raw materials.

And there was nowhere else to turn: China accounts for 97 percent of the world’s supply of rare earths, minerals that play an essential role in many high-technology products, including military equipment. Sure enough, Japan soon let the captain go. ...

Some background: The rare earths ... play a crucial role in applications ranging from hybrid motors to fiber optics. Until the mid-1980s the United States dominated production, but then China moved in. ...

China has about a third of the world’s rare earth deposits. This relative abundance, combined with low extraction and processing costs — reflecting both low wages and weak environmental standards — allowed China’s producers to undercut the U.S. industry.

You really have to wonder why nobody raised an alarm while this was happening, if only on national security grounds. But policy makers simply stood by as the U.S. rare earth industry shut down. In at least one case, in 2003 — a time when, if you believed the Bush administration, considerations of national security governed every aspect of U.S. policy — the Chinese literally packed up all the equipment in a U.S. production facility and shipped it to China.

The result was a monopoly position... And ... China showed itself willing to exploit that monopoly to the fullest. The United Steelworkers recently filed a complaint against Chinese trade practices, stepping in where U.S. businesses fear to tread because they fear Chinese retaliation. The union put China’s imposition of export restrictions and taxes on rare earths — restrictions that give Chinese production in a number of industries an important competitive advantage — at the top of the list.

Then came the trawler event. Chinese restrictions on rare earth exports were already in violation of agreements China made before joining the World Trade Organization. But the embargo on rare earth exports to Japan was an even more blatant violation of international trade law.

Oh, and Chinese officials have not improved matters by insulting our intelligence, claiming that there was no official embargo. All of China’s rare earth exporters, they say — some of them foreign-owned — simultaneously decided to halt shipments because of their personal feelings toward Japan. Right.

So what are the lessons of the rare earth fracas?

First, and most obviously, the world needs to develop non-Chinese sources of these materials. There are extensive rare earth deposits in the United States and elsewhere. ...

Second, China’s response to the trawler incident is, I’m sorry to say, further evidence that the world’s newest economic superpower isn’t prepared to assume the responsibilities that go with that status.

Major economic powers, realizing that they have an important stake in the international system, are normally very hesitant about resorting to economic warfare, even in the face of severe provocation — witness the way U.S. policy makers have agonized and temporized over ... China’s grossly protectionist exchange-rate policy. China, however, showed no hesitation at all about using its trade muscle to get its way in a political dispute, in clear — if denied — violation of international trade law.

Couple the rare earth story with China’s behavior on other fronts — the state subsidies that help firms gain key contracts, the pressure on foreign companies to move production to China and, above all, that exchange-rate policy — and what you have is a portrait of a rogue economic superpower, unwilling to play by the rules. And the question is what the rest of us are going to do about it.

 

 

Currency Wars: China Should Impose Green Taxes on its Exports

This is both creative and unlikely:

Currency wars: China should impose green taxes on its exports, by Gérard Roland, Vox EU: US and European policymakers have been clamoring about starting a currency war against China to force it to appreciate its currency. Even Paul Krugman, whose economic insights have been so precious in the Great Recession, is loudly supporting the Levin bill giving the Obama administration more power to impose tariffs on Chinese imports. A lesson from the Great Depression was that moves to impose tariffs on one’s competitors spiral into a global trade war that brings international trade into a nosedive and leads to even more global economic misery.

Let us, for once, look at the issue calmly from the Chinese side. Exchange-rate policy is in the end not decided by the Chinese Central Bank but by the Politburo. The more they feel bullied into appreciating their currency, the more they will resist such calls. Their decision has nothing to do with the exact extent of under-appreciation of the Chinese currency and all to do with showing that China will not let itself be humiliated again by the west as during the opium wars and the period of territorial concessions. ... China will not let itself be bullied to submission... Doing so would immediately undermine the position of the current leaders.

The sad thing is that this tension has pushed China into a corner. It would be in the interest of the Chinese economy to let its currency appreciate. ... Unfortunately this is not going to happen because such a move would be interpreted as “yielding to the west” and thus politically unpalatable, and even suicidal, by the Chinese leaders.

There is a creative solution that would show genuine international leadership on the part of Chinese leaders: start imposing a green tax on Chinese exports. This would have the same effect as an import tariff imposed on the US side but the revenue would instead go to the Chinese government. If they use the tariff revenues solely for green investments to reduce Chinese carbon emissions, they would achieve two goals at the same time: 1) reduce the international currency tensions that risk leading to dangerous trade wars while saving face, 2) show international leadership in adjustment to climate change. China has, after all, become a main manufacturing hub in today’s world economy and it seems only normal that all countries that benefit from Chinese goods pay their part in reducing carbon emissions related to that manufacturing process. If Chinese leaders were bold and creative enough to make such a move, it would certainly not be enough to shame US politicians into doing something about climate change but it would further isolate the all-too-large-lunatic fringe in the US that claims that climate change is a hoax. It would certainly do a lot to show that Chinese leaders are able to think beyond the sole interests of their country and exercise some international leadership in one of the most important issues of the twenty-first century.

Paul Krugman: Taking On China

A "shot across the bow of U.S. officials":

Taking On China, by Paul Krugman, Commentary, NY Times: Serious people were appalled by Wednesday’s vote in the House of Representatives, where a huge bipartisan majority approved legislation, sponsored by Representative Sander Levin, that would potentially pave the way for sanctions against China over its currency policy. As a substantive matter, the bill was very mild; nonetheless, there were dire warnings of trade war and global economic disruption. Better, said respectable opinion, to pursue quiet diplomacy.

But serious people, who have been wrong about so many things since this crisis began ... are wrong on this issue, too. Diplomacy on China’s currency has gone nowhere, and will continue going nowhere unless backed by the threat of retaliation. The hype about trade war is unjustified — and, anyway, there are worse things than trade conflict. In a time of mass unemployment, made worse by China’s predatory currency policy, the possibility of a few new tariffs should be way down on our list of worries.

Let’s step back and look at the current state of the world.

Major advanced economies are still reeling from the effects of a burst housing bubble and the financial crisis that followed. ... The situation is quite different, however, in emerging economies. These economies have weathered the economic storm, they are fighting inflation rather than deflation, and they offer abundant investment opportunities. Naturally, capital from wealthier but depressed nations is flowing in their direction. And emerging nations could and should play an important role in helping the world economy as a whole pull out of its slump.

But China, the largest of these emerging economies, isn’t allowing this natural process to unfold. Restrictions on foreign investment limit the flow of private funds into China; meanwhile, the Chinese government is keeping the value of its currency ... artificially low..., in effect subsidizing its exports. And these subsidized exports are hurting employment in the rest of the world.

Chinese officials defend this policy with arguments that are both implausible and wildly inconsistent. ...

Meanwhile, about diplomacy: China’s government has shown no hint of helpfulness and seems to go out of its way to flaunt its contempt for U.S. negotiators. In June, the Chinese supposedly agreed to allow their currency to move toward a market-determined rate — which ... would have meant a sharp rise in the renminbi’s value. But, as of Thursday, China’s currency had risen about only 2 percent against the dollar — with most of that ... in just the past few weeks, clearly in anticipation of the vote on the Levin bill.

So what will the bill accomplish? It empowers U.S. officials to impose tariffs against Chinese exports subsidized by the artificially low renminbi, but it doesn’t require ... action. And judging from past experience, U.S. officials will not, in fact, take action — they’ll continue to make excuses, to tout imaginary diplomatic progress, and, in general, to confirm China’s belief that they are paper tigers.

The Levin bill is, then, a signal at best — and it’s at least as much a shot across the bow of U.S. officials as it is a signal to the Chinese. But it’s a step in the right direction.

For the truth is that U.S. policy makers have been incredibly, infuriatingly passive in the face of China’s bad behavior — especially because taking on China is one of the few policy options for tackling unemployment available to the Obama administration, given Republican obstructionism on everything else. The Levin bill probably won’t change that passivity. But it will, at least, start to build a fire under policy makers, bringing us closer to the day when, at long last, they are ready to act.

"The Easy and Legal Way to Stop Currency Manipulation"

Daniel Gros:

A reciprocity requirement: The easy and legal way to stop currency manipulation, by Daniel Gros, Vox EU: The endless discussions about global imbalances, and China’s supposedly self-serving exchange-rate policy, have for a long time, resembled discussions about the weather; everybody talked about it, but nobody did anything. This is now changing. ...

The US political system has become so frustrated by this situation that Congress is now seriously considering whether to label the country a “currency manipulator” and impose trade sanctions which would be illegal under WTO rules and threaten to throw the global trading system into turmoil.

But there is another way. The US (and Japan) could easily prevent the Chinese Central Bank from continuing its intervention policy without breaking any international commitment. The US and Japan only need to invoke the principle of reciprocity and declare that they will limit sales of their public debt henceforth to only include official institutions from countries in which they themselves are allowed to buy and hold public debt. Instead of the “moral suasion”, tried in vain by the Japanese, the Chinese authorities would just be told that they can buy more US T-bills Japanese bonds only if they allow foreigners to buy domestic Chinese debt.

Imposing such a “reciprocity” requirement on capital flows would be perfectly legal..., there are no legal constraints on the impositions of capital controls.

This “reciprocity” measure would of course be equivalent to a very specific form of controls on capital inflows. Capital controls are always somewhat leaky, but not in this case because the Chinese Central Bank would find it difficult to hide its huge investments going through western financial institutions. No reputable financial institution would dare to become a hidden intermediary for the Chinese given that no institution bidding for hundreds of billions of T-Bills would take the risk of secretly fronting the Chinese government...

As a practical matter the introduction of the reciprocity requirement should provide a grand fathering of the existing stocks of Chinese official assets abroad (already above $2,500 billion). However, the Central Bank of China would not be able to continue its interventionist policy – and that is what counts for foreign exchange markets.

The immediate objection is, “What if the Chinese react emotionally and dump their holdings of T-Bills and US agency debt on the market? Would that not disrupt the US government debt market?” This “dumping” is not as simple as it sounds. What assets would the Chinese Central Bank buy when it sells T-Bills? There are not many choices if the Chinese Central Bank wants to dispose of thousands of billions of dollars. Either it holds cash in the form of bank deposits (this would mean a massive refinancing of the US banking system) or it buys other US assets (which would mean a refinancing of the US private sector). Moreover, the reciprocity requirement could be extended to private debt instruments as well. But this is probably not necessary as the Chinese Central Bank is unlikely to invest hundreds of billions of dollars (or euro) in private assets. Buying euro assets would of course constitute an alternative, but this does not appear too attractive at present, and would be prevented by the Europeans adopting the same reciprocity requirement.

The US might hesitate to impose a reciprocity requirement for sales of its public debt because (in contrast to Japan) it needs foreign financing for its public sector deficit. But this also constitutes the litmus test for the sincerity of the US position which cannot have it both ways, i.e. Chinese financing of its external deficit and an end to currency intervention. The choice is now up to the US, it can easily stop Chinese interventions without violating any international commitment if it is willing to rely on domestic savings to finance its own fiscal deficits.

I don't think most members of Congress would be willing to take the large risk they would attach to imposing reciprocity. But how large are the risks? Paul Krugman:

given the fact that we’re in a liquidity trap, a decision by China to buy fewer of our bonds would actually be doing us a favor — it would weaken the dollar, and help our exports.

Here's the latest: 

House Is Likely to Pressure China to Raise Renminbi: The House is expected to give the Obama administration another tool in its diplomatic pouch to pressure China to let its currency rise in value, reflecting growing concern around the country over the loss of manufacturing jobs, persistently high unemployment and a rising trade deficit.

In what is likely to be one of Congress’s last significant measures before the election, the House will vote Wednesday on a symbolic but not insignificant measure threatening China with punitive tariffs on its imports to the United States. ...

But it is unclear whether the legislation, which faces cloudy prospects in the Senate, will succeed this time in prodding a China that has become more self-confident on the world stage. ...

 

“The legislation will strengthen the administration’s hand in its negotiations with China, but also risks provoking a strong backlash,” said Eswar S. Prasad ... of ... Cornell and a former head of the International Monetary Fund’s China division. “Ultimately its short-term effect is likely to be more symbolic than substantive.” ...

Professor Prasad ... warned that if the Congressional proposal went forward, China could retaliate by limiting American imports or denying American manufacturers and financial institutions “the coveted prize of access to rapidly growing Chinese markets.”

A policy that is "more symbolic than substantive" is my expectation as well.

Paul Krugman: China, Japan, America

What should the US do about China's currency policy?:

China, Japan, America, by Paul Krugman, Commentary, NY Times: Last week Japan’s minister of finance declared that he and his colleagues wanted a discussion with China about the latter’s purchases of Japanese bonds, to “examine its intention” — diplomat-speak for “Stop it right now.” The news made me want to bang my head against the wall in frustration.

You see, senior American policy figures have repeatedly balked at doing anything about Chinese currency manipulation, at least in part out of fear that the Chinese would stop buying our bonds. Yet in the current environment, Chinese purchases of our bonds don’t help us — they hurt us. The Japanese understand that. Why don’t we?

Some background: If discussion of Chinese currency policy seems confusing, it’s only because many people don’t want to face up to the stark, simple reality — namely, that China is deliberately keeping its currency artificially weak.

The consequences of this policy are also stark and simple: in effect, China is taxing imports while subsidizing exports, feeding a huge trade surplus. ... And in a depressed world economy, any country running an artificial trade surplus is depriving other nations of much-needed sales and jobs. Again, anyone who asserts otherwise is claiming that China is somehow exempt from the economic logic that has always applied to everyone else.

So what should we be doing? U.S. officials have tried to reason with their Chinese counterparts, arguing that a stronger currency would be in China’s own interest. They’re right about that: an undervalued currency promotes inflation, erodes the real wages of Chinese workers and squanders Chinese resources. But while currency manipulation is bad for China as a whole, it’s good for politically influential Chinese companies — many of them state-owned. ...

Time and again, U.S. officials have announced progress on the currency issue; each time, it turns out that they’ve been had. ... Clearly, nothing will happen until or unless the United States shows that it’s willing to do what it normally does when another country subsidizes its exports: impose a temporary tariff that offsets the subsidy. So why has such action never been on the table?

One answer, as I’ve already suggested, is fear of what would happen if the Chinese stopped buying American bonds. But this fear is completely misplaced: in a world awash with excess savings, we don’t need China’s money...

It’s true that the dollar would fall if China decided to dump some American holdings. But this would actually help..., making our exports more competitive. Ask the Japanese, who want China to stop buying their bonds because those purchases are driving up the yen.

Aside from unjustified financial fears, there’s a more sinister cause of U.S. passivity: business fear of Chinese retaliation.

Consider a related issue: the clearly illegal subsidies China provides to its clean-energy industry. These subsidies should have led to a formal complaint from American businesses; in fact,... “multinational companies and trade associations in the clean energy business, as in many other industries, have been wary of filing trade cases, fearing Chinese officials’ reputation for retaliating ... and potentially denying market access to any company that takes sides against China.”

Similar intimidation has surely helped discourage action on the currency front. So this is a good time to remember that what’s good for multinational companies is often bad for America, especially its workers.

So here’s the question: Will U.S. policy makers let themselves be spooked by financial phantoms and bullied by business intimidation? Will they continue to do nothing in the face of policies that benefit Chinese special interests at the expense of both Chinese and American workers? Or will they finally, finally act? Stay tuned.

Rodrik: Is Chinese Mercantilism Good or Bad for Poor Countries?

Dani Rodrik argues that China's currency policy has hurt other developing countries, but "we should not hold China responsible for taking care of its own economic interests":

Is Chinese Mercantilism Good or Bad for Poor Countries?, by Dani Rodrik, Commentary, Project Syndicate: ...Discussion of China’s currency ... is viewed largely as a US-China issue, and the interests of poor countries get scarcely a hearing... Yet a noticeable rise in the renminbi’s value may have significant implications for developing countries. Whether they stand to gain or lose from a renminbi revaluation, however, is hotly contested. ...

 Strip away the technicalities, and the debate boils down to one fundamental question: what is the best, most sustainable growth model for low-income countries? Historically, poor regions of the world have often relied on ... exporting to other parts of the world primary products and natural resources such as agricultural produce or minerals. ...

But this model suffers from two fatal weaknesses. First, it depends heavily on rapid growth in foreign demand. When such demand falters, developing countries find themselves with ...  a protracted domestic crisis. Second, it does not stimulate economic diversification. Economies hooked on this model find themselves excessively specialized in primary products that promise little productivity growth.

Indeed, the central challenge of economic development is not foreign demand, but domestic structural change. The problem for poor countries is that they are not producing the right kinds of goods. ... The real exchange rate is of paramount importance here, as it determines the competitiveness and profitability of modern tradable activities. When developing nations are forced into overvalued currencies, entrepreneurship and investment in those activities are depressed.

From this perspective, China’s currency policies not only undercut the competitiveness of African and other poor regions’ industries; they also undermine those regions’ fundamental growth engines. What poor nations get out of Chinese mercantilism is, at best, temporary growth of the wrong kind.

Lest we blame China too much, though, we should remember that there is little that prevents developing countries from replicating the essentials of the Chinese model. They, too, could have used their exchange rates more actively in order to stimulate industrialization and growth. True, all countries in the world cannot simultaneously undervalue their currencies. But poor nations could have shifted the “burden” onto rich countries, where, economic logic suggests, it ought to be placed.

Instead, too many developing countries have allowed their currencies to become overvalued... And they have made little systematic use of explicit industrial policies that could act as a substitute for undervaluation.

Given this, perhaps we should not hold China responsible for taking care of its own economic interests, even if it has aggravated in the process the costs of other countries’ misguided currency policies.

I don't think I have anything to say about this that hasn't already been said, many times, and I'm running behind at the moment, so I am am going to leave comments to you. One question might be whether or not rich nations are, in fact, obligated to pay part of the "burden" for the development of poorer countries. If so, why, and if not, why not?

"Being a Hegemon is a Thankless Task"

Harold James:

Recession Geopolitics: ...It is as if China’s leaders were the star pupils in one of Kindleberger’s courses. Throughout the crisis, the Chinese economy continued to grow at an amazing pace, in part as a consequence of massive fiscal stimulus. When anyone wants an example of how effective a Keynesian counter-cyclical strategy can be, internationally as well as domestically, they need look no further than China’s four-trillion-renminbi stimulus of 2008-2009.

Apart from a six-month period after the September 2008 collapse of Lehman Brothers, in which trade finance stopped and the world did look as if it was close to Great Depression circumstances, China and other emerging markets helped those export-oriented industrial economies to recover. The surprising strength of the German economy, with more vigorous growth than at any time in the past 15 years, is due to the dynamism of emerging-market – particularly Chinese – demand, not only for investment goods, engineering products, and machine tools, but also for luxury consumer products. Germany’s high-end automobile producers are now operating at full capacity.

China also followed Kindleberger’s financial lessons. For a moment, it looked as if a contagious crisis, driven by fears of government over-indebtedness, would destroy the politically fragile compromise that European countries had carefully constructed over a 50-year period. The turning point in this spring’s euro panic came when big holders of reserve currencies signaled that they saw the need for the euro as an alternative to the increasingly problematic dollar and the equally vulnerable yen. China started to buy European Union governments’ bonds, and a high-profile Chinese team even went to Greece to buy under-priced real assets.

It was not just Europe that benefited from China’s willingness to take on the mantle of “lender of last resort.” The new-found dynamism of African economies is a consequence of the Chinese drive to build up and secure sources of raw materials.

But there is a problem with Kindleberger’s argument. Kindleberger, a kind and well-meaning man, could never see that the world is never entirely grateful to the country that saves it. Being a hegemon is a thankless task. ...

Mostly just curious to see what reaction this will bring. Comments?

Does China Prove That the Washington Consensus Works?

This might provide some amusement on a Friday afternoon. Stanford's Ronald McKinnon says China proves the Washington Consensus works. It comes via John Taylor, who comments:

Does China’s remarkable economic growth, its stability during the recent financial crisis, and its immense foreign aid/investment in Africa raise doubts about free market policies and provide evidence in favor of a more interventionist approach? In a new review paper, my colleague Ronald McKinnon says “Surprisingly no.” In fact, while many tout a "third way," China has followed quite closely the 10 liberal market-oriented rules commonly called the Washington Consensus after John Williamson wrote them down 20 years ago. McKinnon convincingly shows that “The Chinese economy itself has evolved step-by-step…into one that can be reasonably described by Williamson’s 10 rules!”

Some experts worry that U.S. influence is waning relative to China, and there is cause for worry, but McKinnon argues that “U.S. influence…can be largely recouped if its government returns to a hard version of its own 'Washington Consensus'— as China has done."

McKinnon also offers a fascinating political/economic analysis and explanation for China’s rapidly growing economic involvement in Africa.

It's interesting how, after so many years of dismissing Europe and China as inferior to the dynamic US economy -- we grew faster, could handle shocks better, had a much better financial system, had lower unemployment, etc., etc. -- the right is suddenly urging us to be more like Europe (deficits, Germany, etc.) and China (as below). Here's McKinnon's argument:

Review - China in Africa: the Washington Consensus versus the Beijing Consensus, by Ronald I. McKinnon: ...The Beijing Consensus versus the Washington Consensus In promoting growth in developing countries through foreign aid and investment, does the Beijing approach conflict with “Washington” guidelines used by the World Bank, International Monetary Fund, the OECD, and the United States itself?

The Beijing Consensus is hard to write down as a precise set of rules because of its pragmatism involving “a commitment to innovation and constant experimentation” (Ramo 2004)—as per the old Chinese saying “crossing a river by feeling the stones”. It is also associated with China’s specific commercial interests in, say, investing for extracting minerals on favorable terms—which enhances sustainability on both sides. In contrast, the Washington agencies in principle are more selfless (at least since the end of the Cold War) in aiming to raise per capita incomes and welfare in the recipient countries—but run the risk that aid recipients become permanent supplicants.

John Williamson (1990) did all a great favor by writing down the rules for what he called “The Washington Consensus” for developing countries to follow to absorb aid efficiently:

1. Fiscal policy discipline.
2. Redirection of public spending from subsidies (“especially in discriminate subsidies” toward broad-based provision of key pro-growth, pro-poor services like primary education, primary health care, and infrastructure;
3. Tax Reform—broadening the tax base and adopting moderate marginal tax rates:
4. Interest rates that are market determined and positive (but moderate) in real terms;
5. Competitive exchange rates;
6. Trade liberalization—with particular emphasis on the elimination of quantitative restrictions; any trade protection to be provided by low and relatively uniform tariffs;
7. Liberalization of inward foreign direct investment;
8. Privatization of state enterprises;
9. Deregulation—abolish regulations that impede market entry or restrict competition, except for those justified on safety, environmental and consumer protection grounds, and prudent oversight of financial institutions.
10. Legal security for property rights.

To provide perspective on these ten rules, the year 1990, when Williamson wrote, is important. It was just after the fall of the Berlin Wall and the complete collapse of confidence in Soviet-style socialism. The rules reflect the hegemonic confidence that most people then had in liberal market-oriented capitalism—think Ronald Reagan and Margaret Thatcher. But, 20 years later, should the meteoric rise of socialist China—both in its own remarkable growth in living standards, and in the effectiveness of its foreign “aid” to developing countries, undermine our confidence in Williamson’s Washington Consensus?

Surprisingly, no. The Chinese economy itself has evolved step-by-step (feeling the stones) into one that can be reasonably described by Williamson’s 10 rules! Chinese gradualism avoided the “big bang” approach to liberal capitalism, with the financial breakdowns that were so disastrous for Russia and some smaller Eastern European economies in the early 1990s, while retaining financial control in a model textbook sense (McKinnon 1993). So let us look again at Williamson’s 10 rules to see how well they fit China today in comparison to the United States.

"Push Back"

Tim Duy responds to Ryan Avent:

Push Back, by Tim Duy: Free Exchange pushes back on my concerns about the widening trade deficit and the declines in manufacturing capacity. I appreciate that - I am well aware that I am taking an unpopular position. Not quite so sure it is "lazy," but definitely unpopular.

Regarding my disbelief that higher paid grocery clerks are the answer to declining manufacturing capacity, Avent writes:

This is a lazy and unpersuasive assessment of what's involved in service sector activity. Obviously there is much more to service employment, including work in financial, information, education, and health services, much of which is (and will increasingly be) tradable.

True enough, I oversimplified service sector jobs. Maybe. Yes and no. To begin with, it is not exactly clear that the expansion of the financial sector has yielded a good outcome, unless you believe that greater financial volatility and widening income inequality is good. More importantly, Avent is arguing that service jobs are just as tradable as manufacturing jobs, and therefore a job is a job. Refer to Alan Blinder's hypothesis back in 2007:

We economists assure folks that things will be all right in the end. Both Americans and Indians will be better off. I think that's right. The basic principles of free trade that Adam Smith and David Ricardo taught us two centuries ago remain valid today: Just like people, nations benefit by specializing in the tasks they do best and trading with other nations for the rest. There's nothing new here theoretically.

But I would argue that there's something new about the coming transition to service offshoring. Those two powerful forces mentioned earlier -- technological advancement and the rise of China and India -- suggest that this particular transition will be large, lengthy and painful.

It's also going to be large. How large? In some recent research, I estimated that 30 million to 40 million U.S. jobs are potentially offshorable. These include scientists, mathematicians and editors on the high end and telephone operators, clerks and typists on the low end. Obviously, not all of these jobs are going to India, China or elsewhere. But many will.

Avent is essentially arguing that the US has a comparative advantage in service sector jobs. Blinder views these jobs as very vulnerable to offshoring, suggesting a lack of comparative advantage. If Blinder is right, then America apparently has little left in the comparative advantage department.

Avent continues:

As far as I can tell, Mr Duy seems to want to embrace a crash programme of protectionism against China. I don't know how this is supposed to boost America's long-term economic fortunes or what evidence he can present that it will. I don't know why Mr Duy is convinced that another spurt of manufacturing capacity growth, similar to that observed in the 1990s, isn't a possibility. And I have no idea why he is so confident that a return to the manufacturing economy observed in the immediate postwar decades—a time when technologies were vastly different, when the global economy was vastly different, and when a much larger share of the world's population lived in dire poverty—is a good idea.

I will deal with the protectionism argument later. I don't view American manufacturing as incapable of rebounding. But there are no price signals to prompt that rebound. That price signal should be delivered via currency values. The dollar should adjust to spur a net increase in export and import competing industries. It is not complicated. For some reason, however, that process is not happening. Something is interfering with the adjustment. That interference prompts American firms to expect that any new innovation needs a China strategy for production, if you believe the Andy Grove hypothesis.

Also, whenever you stick your neck out and say that manufacturing might be important, you suddenly get accused of being a barbarian trying to reinvent the 1950s. Of course manufacturing technology has fundamentally changed, as well as the mix of goods produced. But in the past, that productivity growth yielded more overall output and more manufacturing employment, even if the proportion of manufacturing jobs decreased relative to overall jobs. I can even buy into that story when capacity is rising and employment is stagnant. But something very different happened this decade. Capacity stagnated as millions of jobs were lost.

Avent continues:

This is simply a very empty and disappointing view of the evolution of economic activity. Mr Duy is implying that there is only so much producing of good stuff that can go on, and America used to have most of it and now China is taking it all and America needs to fight to get it back. He's wrong. The movement of some kinds of economic activity to China is creating new opportunities in America. America's problem isn't that some jobs are leaving. It's that it's doing a poor job of preparing its workers to take advantage of the new opportunities.

If that is true, then there should be millions of jobs available to soak up the workers released from manufacturing, and wages should be soaring because we have a structural flaw in economy - the skills of the released workers do not match those needed by expanding sectors. That structural flaw should be sufficient to encourage workers to gain more education and employers to provide more on the job training. While I am sure that is true in a few sectors, in aggregate real wages and nonfarm payrolls have been stagnant for a decade. Where are these high wage paying jobs? Or even median wage paying jobs at this point? Silly me, I actually believe the unapologetic and unquestioning supporters of free trade need to answer this question. We are millions of jobs below trend, and we have lost millions of jobs in manufacturing - the manufacturing of goods that we still consume, no less. Moreover, these two trends occurred in the same decade, in concert with a third trend - the sharp rise in foreign official reserve accumulation. How can you not be even allowed to suggest that there just might be a connection?

As always, questioning the nature of trade patterns this decade means you are an ignorant protectionist. Blinder tried to get ahead of this argument:

What else is to be done? Trade protection won't work. You can't block electrons from crossing national borders. Because U.S. labor cannot compete on price, we must reemphasize the things that have kept us on top of the economic food chain for so long: technology, innovation, entrepreneurship, adaptability and the like. That means more science and engineering, more spending on R&D, keeping our capital markets big and vibrant, and not letting ourselves get locked into "sunset" industries.

What is amusing about the whole analysis is that I believe free trade works, but I also believe we don't really have free trade. In reality, foreign central banks manipulate currency levels such they accumulate massive amounts of foreign exchange reserves that effectively recycle Dollars back into the US to support consumption activities, and thus impact the dynamics of trade flows in an obviously mercantilistic fashion. This has been accomplished with the full acceptance and even cooperation of the US Treasury. It was an outcome of the strong Dollar policy, and it is why China has not been named a currency manipulator since 1994. But those central banks are immune from criticism on free trade because they interfere in the financial side of the external accounts, not the current transactions side. Indeed, one cannot even question the negative impacts of this dynamic. Avent essentially falls back on the same argument I lamented about last week:

... every right minded economist and policymaker knows unequivocally that free trade is good, and to even question that assumption makes one an ignorant heretic who has never heard of Smoot-Hawley. Therefore, the examination ends. Manufacturing's decline simply cannot be a problem if it is consequence of international trade because everyone knows international trade is good.

Another version of this argument: International trade is driven by comparative advantage. If manufacturing jobs are lost from international trade, is must be the result of a relative comparative disadvantage. The financial side of the account is irrelevant.

If you fall back on the pro-free trade argument that service sector jobs will compensate for the offshoring in manufacturing, you ignore the fact that the currency manipulation that impacted manufacturing will have the same impact on the service sector jobs if they are truly tradable. If service sector jobs are just as offshorable as manufacturing jobs, then Blinder's prescription is destined to fail unless there is a concerted, sustained effort to control the accumulation of reserves among foreign central banks.

I very much recommend Michael Pettis for an another view of what I consider to be the same problem:

...As net capital exporters try desperately to maintain or increase their capital exports, and deficit Europe sees net capital imports collapse, the only way the world can achieve balance without a sharp contraction in the capital-exporting countries is if US net capital imports surge. And at first they will surge. Foreigners, in other words, will buy more dollar assets, including USG bonds, than before.

But remember that an increase in net US imports of capital is just the flip side of an increase in the US current account deficit. This means that the US trade deficit will inexorably rise as Germany, Japan and China try to keep up their capital exports and as European capital imports drop.

I have little doubt that as the US trade deficit rises, a lot of finger-wagging analysts will excoriate US households for resuming their spendthrift ways, but of course the decline in US savings and the increase in the US trade deficit will have nothing to do with any change in consumer psychology or cultural behavior. It will be the automatic and necessary consequence of the capital tug-of-war taking place abroad.

The US, in other words, is not likely to face the “nuclear option” of a Chinese disruption of the US Treasury bond market. It is far more likely to be swamped by a tsunami of foreign capital. This tsunami will bring with it a corresponding surge in the US trade deficit and, with it, a rise in US unemployment. It will also force the US Treasury to increase the fiscal deficit as more of the jobs created by its spending leak abroad.[Emphasis added]

Therein lies the problem. A reduction in net foreign capital inflows means a welcome decline in the US trade deficit, but the US is likely to see just the opposite. Foreign capital will push desperately into US markets and as an automatic consequence the US trade deficit will surge. So the problem isn’t too little capital inflow or a sudden boycott of USG bonds. On the contrary, the US will see too much capital inflow.

All this may turn out to be very bad for the US economy, but in the past massive capital recycling has usually been very good for asset markets. Might we see a surge in the US asset markets, at least until next year when Congress starts getting tough on the trade deficit? I would be willing to bet that we do.

The patterns of capital flows and how those flows have impacted production and consumption location outcomes is a critically important issue. Even more so if the flows into the US are simply supporting consumption spending via fiscal deficits but creating relatively few jobs because that spending is quickly directed overseas, and the pace of that direction accelerates as industrial capacity contracts. Yet if you even suggest the shift in production outcomes is creating very serious and long lasting problems, your thoughts are considered "fairly poorly reasoned."

Bottom Line: When I express concerns over free trade, I am really expressing immense frustration over an international financial architecture that sustains and maintains global imbalances that yield outcomes that I believe are very difficult to justify and yet are accepted due to a blind faith in free trade. In essence, the ability to manipulate capital flows has made a mockery of the free trade crowd. I know. I used to be in that crowd, and in many ways still am. But I can no longer wrap myself in the free trade flag to justify the negative impacts of financial account manipulation. And if the US cannot seriously address financial account manipulation on a global basis - and if the Pettis article is correct, the US Treasury will fall short of what is needed even with the announced adjustment to Chinese currency policy - what choices are you left with? Either accept continued economic stagnation, or act unilaterally on the current transactions (tariffs) or financial (reciprocative devaluation or capital controls) side of the accounts. None of which are pleasant options.

Paul Krugman: The Renminbi Runaround

Paul Krugman says "China needs to stop giving us the runaround and deliver real change" in its currency policy:

The Renminbi Runaround, by Paul Krugman, Commentary, NY Times: Last weekend China announced a change in its currency policy, a move clearly intended to head off pressure from the United States and other countries at this weekend’s G-20 summit meeting. Unfortunately, the new policy doesn’t address the real issue, which is that China has been promoting its exports at the rest of the world’s expense.

In fact, far from representing a step in the right direction, the Chinese announcement was an exercise in bad faith... In short, they’re playing games.

To understand what’s going on, we need to get back to the basics of the situation. China’s exchange-rate policy is neither complicated nor unprecedented, except for its sheer scale. It’s a classic example of a government keeping the foreign-currency value of its money artificially low by ... buying foreign currency. ...

There have been all sorts of calculations purporting to show that the renminbi isn’t really undervalued, or at least not by much. But if the renminbi isn’t deeply undervalued, why has China had to buy around $1 billion a day of foreign currency to keep it from rising?

The effect of this currency undervaluation is twofold: it makes Chinese goods artificially cheap to foreigners, while making foreign goods artificially expensive to the Chinese. That is, it’s as if China were simultaneously subsidizing its exports and placing a protective tariff on its imports.

This policy is very damaging at a time when much of the world economy remains deeply depressed. In normal times, you could argue that Chinese purchases of U.S. bonds, while distorting trade, were at least supplying us with cheap credit... But right now we’re awash in cheap credit; what’s lacking is sufficient demand for goods and services to generate the jobs we need. And China, by running an artificial trade surplus, is aggravating that problem.

This does not, by the way, mean that China gains from its currency policy. The undervalued renminbi is good for politically influential export companies. But these companies hoard cash rather than passing on the benefits to their workers, hence the recent wave of strikes. Meanwhile, the weak renminbi creates inflationary pressures and diverts a huge fraction of China’s national income into the purchase of foreign assets with a very low rate of return.

So where does last week’s policy announcement fit into all this? Well, China has allowed the renminbi to rise — but barely. As of Thursday, the currency was only about half a percent higher than its typical level before the announcement. ... Chinese officials are still making statements denying that a rise in their currency will do anything to reduce trade imbalances, and ... suggest a rise of only about 2 percent ... by the end of this year. This is basically a joke.

What the Chinese have done, they claim, is to increase the “flexibility” of their exchange rate: it’s moving around more from day to day than it did in the past, sometimes up, sometimes down.

Of course, Chinese policy makers know perfectly well that although U.S. officials have indeed called for more currency flexibility, that was just a diplomatic euphemism for what America, and the world,... has the right to demand...: a much stronger renminbi. Having the currency bob up or down slightly makes no difference to the fundamentals.

So what comes next? China’s government is clearly trying to string the rest of us along, putting off action until something — it’s hard to say what — comes up.

That’s not acceptable. China needs to stop giving us the runaround and deliver real change. And if it refuses, it’s time to talk about trade sanctions.

Fed Watch: China, Day One

Tim Duy follows up on his post expressing skepticism about China's announcement that it intends to increase the RMB exchange rate flexibility:

China, Day One, by Tim Duy: My skepticism was valid for at least a day. Market participants quickly lost interest in the Chinese revaluation story, with stock ending down for the day:

“The announcement out of China elicited an emotional response from the market,” said Alan Gayle, senior investment strategist at RidgeWorth Investments in Richmond, Virginia, which oversees $63 billion. “A closer look at the announcement suggests China’s approach is very gradual and it is continuing at its own pace. It’s a less dramatic move when looked at more closely.”

The muted reaction was not limited to equities:

Treasuries pared losses on speculation the drop in debt in response to China’s decision to allow a more flexible yuan was too big to be sustained.

“The market is coming to the conclusion that it had overreacted to the news out of China,” said Charles Comiskey, head of Treasury trading at Bank of Nova Scotia in New York. “The policy and what it ultimately means is an open question. It’s so vague.”

The yuan "surged" to just below its existing trading range, while the parity rate was adjusted slightly in response to Monday's moves. This fostered a yuan decline:

China’s yuan declined the most since December 2008 on speculation the central bank will encourage more two-way fluctuations in the exchange rate after it pledged to expand flexibility.

The People’s Bank of China set the reference rate for yuan trading 0.43 percent stronger, the biggest gain in five years, reflecting appreciation yesterday. China’s reforms don’t necessarily mean the currency will appreciate, the official People’s Daily reported yesterday.

“There is bigger two-way fluctuation, which is quite normal,” said Lu Zhengwei, an economist at Industrial Bank Co. in Shanghai. “The reference rate shows it is now based on market demand and supply, and no longer strictly controlled.”

The yuan declined 0.2 percent to 6.8111 per dollar as of 10:17 a.m. in Shanghai, from 6.7976 yesterday, according to the China Foreign Exchange Trade system. That was the biggest loss since December 2008. It strengthened as much as 0.1 percent to 6.79 earlier today.

In any event, the today's market response to the Chinese announcement suggests that this is a considerably less dramatic event than the press would like you to believe. Of course, the press is being spoon-fed the news by Washington. From the Wall Street Journal:

President Barack Obama, badly in need of good news, got some over the weekend from the most unlikely of sources: China, which said it would allow the value of its currency to rise, thereby answering the single most fervent prayer U.S. officials utter when seeking divine intervention to help with America's big trade deficit.

...the two moves show that the U.S.-Chinese relationship has a healthier glow than it did just a few months ago, when the two nations were arguing about global warming, a visit by the Dalai Lama to the White House and American arms sales to Taiwan.

More importantly, the steps suggest a certain maturing of China's view of its role in global affairs—and a more deft touch by the Obama administration in coaxing China into playing that role responsibly.

Note the spin - China's decision represents a "maturing," aided by the "deft touch" of the Obama Administration. Now, what did China exactly do to "mature?" China has not unpegged their currency. At best, they resumed a crawling peg policy put on hiatus two years ago. At worst, they simply uttered empty words that have no real economic relevance, whose only intention was to divert attention from China at the upcoming G20 meeting, allowing for a full court press on Germany. German Chancellor Angel Merkel should take a hint and issue the following statement: "The focus of German fiscal policy will be consistent with G20 goals of promoting global growth." Of course, German policymakers believe that means fiscal austerity, but no matter. It is the words that are important. Actions less so.

The PR overload suggests the Administration is desperately in need of a "win," no matter how trivial. After all, there is a hole in the Gulf of Mexico that is leaking oil uncontrollably, creating an environmental disaster that may rival what, Chernobyl? And it is clear the Administration was late in the game realizing the magnitude of the crisis. Meanwhile, unemployment hovers around 10%, and no one expects it to be much different in six months. While likely sustainable, economic growth is anemic compared to previous recoveries from deep recessions, and appears to guarantee a substantial output gap for years to come. The Administration has no real plan to close that gap, nor do they appear particularly troubled by it. Policymakers can’t even push through a low cost jobs bill.

But these are lesser problems. The full effort of American power can instead come to bear on Chinese currency policy and walk away with a monumental commitment to allow the dollar-renminbi rate to fluctuate within its existing trading band and perhaps appreciate imperceptibly.

While China appears willing to adjust the parity rate, changes are likely to be more window dressing than anything else. The industrial base shifted from the US to China over the past twenty years, a transition aided by the Clinton Administration's commitment to a strong dollar, and it is not going to come rushing back for a for percentage points of currency value. The structural shift has happened, and it won't reverse easily. Still, the story is not over yet. With this much praise, the Administration is clearly looking for something else from China. Further support on Iran? North Korea? Time will tell.

Tim Duy: China Moves. Or Not.

Is China's announcement that it intends to increase the RMB exchange rate flexibility "more smoke than fire"?:

China Moves. Or Not., by Tim Duy: Futures markets are abuzz with excitement over the Chinese currency proclamation issued this weekend. The announcement was quickly hailed by observers worldwide as a major policy shift, yet I am inclined to side with the analysis provided by Yves Smith - the statement leaves plenty of wiggle room, and never really promises to do much of anything. At the moment, the Chinese announcement feels like more smoke than fire.

The Wall Street Journal's initial reporting was just want the Bejing and Washington wanted you to believe:

China's decision to abandon its currency peg is a victory of pragmatism over divisive politics, the result of careful diplomacy by leaders in Beijing and in Washington, each side vulnerable to powerful domestic lobbies.

In the end, both sides agreed that a more flexible exchange rate was good for China, good for the U.S. and good for the global economy. Yet timing was everything.

The implication is that hard-working policymakers on both sides of the Pacific have risked all to foster the greater good. But what exactly has changed? From the Chinese statement:

It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.

In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market

What exactly will be the basket of currencies? On what timetable? Is this really a change? And why not widen the floating bands? I see no commitments here, vague or otherwise. Of course, there are not meant to be. From the Wall Street Journal:

Yet, by returning the yuan to a managed float against a basket of currencies, Beijing won't have to cede too much in the near term when it comes to the bilateral dollar/yuan rate. The euro's weakness-the yuan is up 14% against the euro this year-should mitigate the speed of any yuan appreciation against the dollar.

Looks like China is picking a policy direction that requires little deviation from current policy. Nor do they even admit there is a need for significant change. The Chinese announcement appears to preclude the possibility of meaningful adjustments.

China´s external trade is steadily becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010. With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist.

Is "large-scale" 5%? 10%? 20%? The tone of subsequent reporting changed as journalists not sourced directly by Washington and Bejing began to realize the thinness of the Chinese announcement. From the Wall Street Journal:

China's announcement that it will let its currency appreciate puts it in a strong position going into a summit of the Group of 20 on Saturday, but does little to ease pressure from the U.S. Congress.

...But China's announcement was short on details about how much it would let the yuan appreciate. In Brazil, the central bank governor, Henrique Meirelles, said he welcomed the Chinese announcement, but wanted to see results. "It is necessary to await further developments," he said in a statement.

Is the Chinese announcement anything more than an effort to buy time ahead of next weekend's G-20 meeting? The yuan was likely to be a primary topic, but the announcement now provides cover for Chinese officials, pushing the attention on fiscal policy in Germany and Japan. A clever diplomatic trick, but will China follow through with anything more than a token rate change? They need to, as Congress will not be held at bay much longer:

In the U.S., New York Democratic Sen. Charles Schumer, who has spent a decade ramping up pressure on China over currency issues, remains skeptical that Beijing's announcement will make an appreciable difference. On Sunday, reacting to Chinese suggestions that change would be gradual, Mr. Schumer said he would move forward on legislation to penalize China for undervaluing its currency.

"Just a day after there was much hoopla about the Chinese finally changing their policy, they are already backing off," he said in a statement.

Schumer's skepticism is justified. Where is the yuan going, and how quickly will it get there? Estimates are all over the map. From Bloomberg:

The yuan’s appreciation may be limited to 1.9 percent against the dollar this year, a survey of economists showed. The currency will climb to 6.7 per dollar by Dec. 31, according to the median estimate of 14 analysts.

Later in the same article:

“We can’t exclude the possibility of yuan depreciation,” said Shen Jianguang, Mizuho Securities Asia Ltd.’s chief economist for Greater China, who said a 2.5 percent drop is possible this year if the dollar-euro rate is unchanged.

From the Wall Street Journal:

U.S. government officials expect a slow, steady increase, similar to the way China boosted the value of the yuan between 2005 and 2008.

Another opinion from the same article:

Eswar Prasad, a Cornell University economist who was formerly the IMF's top China expert, said the size of the increase during the coming month will give a hint at the "trajectory" Beijing is anticipating.

He says that in periods of economic calm, China "is comfortable with" an increase in the value of the yuan of about 10% to 15% a year.

Congress will be closely watching for any signs of foot dragging on the part of China. I am not confident they will tolerate anything less than a 15% move this year. Note too that China is not the only one buying time with this announcement. US Treasury Secretary Timothy Geithner can now release the delayed report on currency practices, which will surely not label China a manipulator. That hot potato can go back into the oven for another six months. Geithner is clearly betting the Chinese will have shown enough results between now and then to placate Congress. If not, Congress will start sharpening the knives; the tolerance for Chinese resistance will be almost negligible of this announcement is revealed to be nothing more than smoke and mirrors.

Bottom Line: On the surface, the Chinese announcement looks like just what the doctor ordered - a step toward a meaningful effort at rebalancing global activity. But the details are thin, very, very thin. Thin enough that one can reasonably look straight through the statement and conclude it is little more than an effort to keep China off the hot seat at the next G20 meeting. Time will tell if China actually intends a substantial change in currency policy. I hope this is in fact their intention, as the probability of a disastrous trade war will skyrocket if Congress believes they have been the victim of a classic bait and switch.

Update: Reality sets in quickly. From the Wall Street Journal:

China kept the yuan's exchange rate unchanged against the dollar Monday, surprising markets after announcing over the weekend it was unhitching its de facto peg.

Underscoring its vow to move gradually in liberalizing its rigid foreign-exchange regime, the central bank set the yuan's central parity rate, an official reference level for daily trading, at 6.8275 yuan to the dollar, exactly the same as Friday's central parity rate. The fixing put the yuan slightly weaker than Friday's close in over-the-counter trading of 6.8262 yuan to the dollar.

Eichengreen: China Needs a Service-Sector Revolution

With wages increasing in China, which has effects similar to a currency appreciation, will it be possible for China make the transition to an economy where the domestic service sector expands to take up the slack created as manufactured goods become more expensive and hence more difficult to export?:

China Needs a Service-Sector Revolution, by Barry Eichengreen, Commentary, Project Syndicate: China is getting its exchange-rate adjustment whether it likes it or not. While Chinese officials continue to mull the right time to let the renminbi rise, manufacturing workers are voting with their feet – and their picket lines.

Honda has offered its transmission-factory workers in China a 24% wage increase to head off a crippling strike. Foxconn, the Taiwanese contract manufacturer for Apple and Dell, has announced wage increases of as much as 70%. Shenzhen, to head off trouble, has announced a 16% increase in the minimum wage. Beijing’s municipal authorities have preemptively boosted the city’s minimum wage by 20%.

The result will be to raise the prices of China’s exports and fuel demand for imports. The effect will be much the same as a currency appreciation. ... With exports of manufactures becoming more expensive, China will have to ... move ... toward the model of a more mature economy, in which employment is increasingly concentrated in the service sector. ...

But the bad news is that the transition now being asked of China – to shift toward services without experiencing a significant decline in economy-wide productivity growth – is unprecedented in Asia. Every high-growth, manufacturing-intensive Asian economy that has attempted it has suffered a massive slowdown. ...

Why is this? In countries that have traditionally emphasized manufacturing, the underdeveloped service sector is dominated by small enterprises – mom and pop stores. These lack the scale to be efficient...

In both Korea and Japan, large firms’ entry into the service sector is impeded by restrictive regulation, for which small producers are an influential lobby. ... Foreign firms that are carriers of innovative organizational knowledge and technology are barred from coming in. Accountants, architects, attorneys, and engineers all then jump on the bandwagon, using restrictive licensing requirements to limit supply, competition, and foreign entry.

One can well imagine Chinese shopkeepers, butchers, and health-care workers following this example. The results would be devastating. ... Employing workers in sectors where their productivity is stagnant would not be a recipe for social stability. China needs to avoid the pattern by which past neglect of the service sector creates a class of incumbents who use political means to maintain their position. Perhaps China will succeed in avoiding this fate. Here at least may be one not-so-grim advantage to not being a democracy.

Update: The People's Bank of China announces plans to enhance the RMB exchange rate flexibility.

Should China allow the Yuan to Rise?

At The Economist's Guest Network, we were asked:

Should China allow the yuan to rise? Is a stronger yuan the most important route to global rebalancing? And should addressing imbalances currently be a top global policy priority?

My response is here. There several are more here from Roach, Pettis, Bordo, Calvo, and Subramanian, and more responses may be posted later.

"Dealing With Chermany"

Paul Krugman says it's time to get tough with Germany and China:

Dealing With Chermany, by Paul Krugman: So here’s where we are: China has done nothing to change its policy of massive currency manipulation, and its exports are surging. Meanwhile, Europe is going wild for fiscal austerity. Angela Merkel says that budget cuts will make Germany more competitive — but competitive against whom, exactly?

You know the answer, don’t you? Yep: everyone is counting on the US to become the consumer of last resort, sucking in imports thanks to a weak euro and a manipulated renminbi. Oh, and while they rely on US demand to make up for their own contractionary policies, they’ll lecture us on how irresponsible we’re being, running those budget and current account deficits.

This is not going to work — and the United States has to take steps to protect itself.

Let’s start with China. Back in April we were told to lay off on the currency manipulation charges; the grownups would work something out with China. How’s that going, exactly?

Yes, threatening an anti-dumping duty would be a big step, and might pose some risks. But doing nothing is not an acceptable option. The economic recovery is in great danger of stalling — and if it does, the consequences will be a lot worse than a diplomatic tiff.

And it’s also important to send a message to the Germans: we are not going to let them export the consequences of their obsession with austerity.

Nicely, nicely isn’t working. Time to get tough.

Random Thoughts on China

Just a couple of thoughts before I head to the airport for the long flight home. Someone once told me that China is an interesting mix of the very old and the very new -- there's very little in the middle. And that does seem to be true. It is due to the abrupt transition that has been made, most places do not develop so rapidly and hence have middle-aged parts, not just old and new, and the pace of the transition shows. There are inevitable growing pains associated with development that is this rapid.

My casual observation both from all the government presentations on the economy I heard from various government ministers over the last two days and from walking around is that the economic development mirrors this pattern that. There is the new and efficient, and there are the old ways of doing things that are much less modern and much less efficient. There's very little in the middle. As I said on a tweet yesterday while strolling around, although growth of output has been high, it seems to me that there are still many, many people playing "small ball" economically, and hence there is still quite a bit or room for productivity to increase.

Anyway, glad I had the opportunity to come here and see what is happening first hand, particularly the ability to hear from and talk to people from the agencies in charge of economic development (though most of them were involved in one way or another with job creation and development, so I didn't hear all about all the issues they face). I am in the heart of Beijing, fairly close to the Forbidden City -- you don't see many cranes, etc. constructing new buildings since this area is already pretty densely developed -- so I may not have gotten a very good sense of the old-new balance (even so, there is lots of construction in evidence, mostly old buildings being gutted or raised to make room for something else). All in all, it's a pretty interesting place. I saw no signs of anything but full spreed ahead,

Looks like the next conference is Budapest in June. That will be interesting too. If someone had told me that starting a blog would lead to world travel on other people's dimes, I would have laughed. But it has. And all I can say is huh. Cool. Didn't expect that.

I am not looking forward to getting to the airport 2 hours early, my 12 hour flight, 6 hour layover in SF, and then the 1 hour flight to Eugene (and on the way here, one plane was delayed an extra three hours). But clicking my heels together and wishing I was back in Kansas (OK, Oregon) won't get it done, so I guess I don't have much choice. So I'd better get going -- maybe I can connect at the airport. If not, and I'm pretty much out of the international data plan I got before coming, no more internet until SF. I hope I don't get tremors from the withdrawal (I have two posts that I set before I left to publish later tonight).

Apologies for writing so little the last several days. The opportunity cost was giving up the chance to use the few free hours I had to see (a little bit of) Bejing, and I decided MU/P was higher for sight-seeing than for most anything else. But Tim Duy did a pretty good job picking up the slack, so I owe him a thanks.

On the Road Again

I am traveling to China today (Beijing) to talk at a conference about US fiscal policy during the crisis, and have no idea about my ability to connect here once I arrive. I assume it won't be a problem, but just in case -- and because I won't have as much time as usual -- I have things set to post automatically until I get back.

Update: Finally here. Here are the slides for my presentation today.

Google is different here, but if I log onto the VPN at school I can get to the regular version. Sometimes my blog won't come up if I'm not logged in to the VPN, but not always, so not sure what's up. Blogs hosted by Google on blogger seem to be missing, and other blogs on TypePad don't always load either (though they do show up on Google unlike the blogs on blogger). With VPN though, no troubles. Anyone know the current state of blog access here?

"The 'Real' Causes of China’s Trade Surplus"

Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti argue, based upon their forthcoming AER article, that although China has accumulated nearly two and a half trillion in reserves in the last two decades, "it is wrong, and even dangerous, to blame this on a manipulation of the exchange rate." They argue that the existence of credit market imperfections leading to the need for high levels of internal savings provides a better explanation:

The “real” causes of China’s trade surplus, by Zheng Song, Kjetil Storesletten, and Fabrizio Zilibotti, Vox EU: Over the last two decades, China has run large trade surpluses. Its foreign reserves swelled from $21 billion in 1992 (5% of its annual GDP) to $2.4 trillion in June 2009 (close to 50% of its GDP). The effect of this gigantic build up of reserves has been a source of growing public attention in the context of the debate on global imbalances. This debate has gained momentum during the global crisis. Lobbyists and politicians voice the popular concern that by swamping western markets with its products, China contributes to the failure of domestic firms and job losses. The call for protectionism is mounting.

Did China engineer a trade surplus?

A common argument, especially in the US, is that the culprit of global imbalances is the exchange rate manipulation carried out by the Chinese authorities, who peg the renminbi to the dollar at a low value. According to Fred Bergsten, head of the Peterson Institute for International Economics, the renminbi is undervalued by at least 25% to 40%. This "hostile" policy raises calls for robust retaliation.

While economists have so far opposed any measure that might ignite a vicious cycle of trade retaliations and protectionism, even their front is cracking. Krugman (2010) advocated using the threat of a 25% import surcharge to force China to revalue. Last month, 130 lawmakers signed a letter asking the US Treasury to increase tariffs on Chinese-made imports. On 12 April 2010, Barack Obama openly criticized the Chinese exchange-rate policy in front of Hu Jintao, arguing that currencies should "roughly" track the market so that no country has an advantage in trade. Meanwhile, Senator Charles Schumer called for high tariffs against Chinese imports in order to force Beijing to revalue its currency.

The exchange rate manipulation premise

The manipulation thesis rests on the simple postulate that the imbalance itself is evidence of a misalignment of the exchange rate. Letting market forces determine the exchange rate would restore trade balance.

This argument has weak foundations. What matters is the real exchange rate, not the nominal one. While the Chinese surplus has persisted for almost two decades, the real exchange rate has remained as flat as a pancake (see McKinnon 2006, Figure 3). A misaligned real exchange rate should feed domestic inflation, e.g., by increasing the demand of non-traded goods and stimulating domestic wage pressure. Yet, until very recently it does not appear as if China has experienced any major inflationary pressure – between 1997 and 2007 the inflation rate was on average about the same as in the US. Moreover, wages have grown slower than output per worker (see Banister 2007).

In a recent article on this site, Helmut Reisen (2010) shows that a large part of the alleged undervaluation of the renminbi can be attributed to the Balassa-Samuelson effect (i.e., the fact that non-traded goods do not follow the law of one price and are relatively cheap in developing countries). He concludes that "the undervaluation in 2008 of the renminbi was only 12% against the regression-fitted value for China's income level." This is by no means a large number: “Both India and South Africa (which had a current-account deficit) were more undervalued in 2008.” In summary, while it is reasonable to expect some appreciation of the real exchange rate in the years to come (through either inflation or adjustments in the nominal exchange rate), the government manipulation of the nominal exchange rate is unlikely to be the primary cause of the two-decades-long imbalance.

A “real” explanation: Growing like China

What, then, can account for the Chinese surplus? We believe that the answer lies in real (i.e., structural) factors rather than in nominal rigidities. Let us look at the imbalance from an asset flow perspective: 

Will Chinese Revaluation Create American Jobs?

An argument that revaluation of the renminbi/renembi won't have much effect on jobs in the US:

Will Chinese revaluation create American jobs?, by Simon J Evenett and Joseph Francois, Vox EU: Many in the US are pushing China to revalue the renminbi. Will that create US jobs? Traditional Keynesian analysis associates higher exports and lower imports with more jobs, but today’s world is more complex. Chinese parts and components feed into US firms’ global competitiveness. This column says a dearer renembi would boost the competitiveness of US exports to China but reduce US competitiveness everywhere else. A revaluation may be the right policy for other reasons, but its impact on US jobs is far from clear.

Undervaluation of China’s exchange rate is central to the debate on the right global policy mix in the aftermath of the economic crisis. Estimates of the undervaluation vary (from zero to 40%, Cheung, Chinn, and Fuji 2010) along with the reasons for focusing on the renembi:

• The IMF expresses concern about persistent capital account imbalances and asymmetries between surplus and deficit countries, with concern that imbalances contributed to past global financial instability and could so in future. The IMF also calls an exchange rate appreciation “essential” for China’s domestic macroeconomic situation (IMF 2010).
• Senior Brazilian and Indian officials call upon their Chinese counterparts to revalue the renminbi to mitigate competitiveness concerns.
• In the US, some call for revaluation as a means of redressing the bilateral imbalance with China and quickly creating US jobs.

In this column, we focus on the last issue; that is, whether it is realistic to expect a US jobs bonus to follow a Chinese revaluation. ...

With extensive global supply chains and outsourcing, a modest Chinese revaluation will ... raise costs for US firms and thus harm US competitiveness everywhere except in the Chinese market. This cost-raising effect mutes the current account improvement and, by our estimates, may result in 424,000 jobs losses in the US.

Findings such as these call for a rethink of aggressive foreign trade policy towards China, not just by the US but all those nations that supply and source parts and components to and from China as part of global supply chains.

And, rebuttal:

Estimating the effect of renminbi appreciation on US jobs: A comment on Francois' China result, by William R. Cline, Vox EU: Would appreciation of the renminbi actually destroy US jobs? This column discusses recent estimates that find that making intermediate inputs from China more expensive would hurt US global competitiveness. It argues that the direct effect of an improvement in the US trade balance would create far more jobs than might be lost to more expensive intermediate inputs.

In a recent study, Francois (2010) estimates that if China appreciated the renminbi by 10%, the US trade balance would rise by $100 billion but the number of US jobs would decline by 430,000. He uses a computable general equilibrium (CGE) model to make this calculation. He allows for below-full capacity and sticky wages so that it is possible for a change in the external balance to affect the level of employment. The paradoxical negative sign on employment as a consequence of the currency correction stems from the model specification that emphasizes induced losses of jobs throughout the economy that result as a consequence of the increase in costs of intermediate inputs imported from China and used in the US economy. Francois argues that the gain of employment in exports and import substitutes would be too small to offset the loss of jobs in the general economy; hence the net loss of 430,000 jobs. This column examines whether these results make sense. ...

This exercise suggests that something appears to have gone wrong in the Francois calculations. A reasonable approximation of his two opposing effects suggests that the 10% RMB appreciation would create 320,000 jobs from the US trade balance improvement and eliminate only 32,000 jobs from the induced effect of higher intermediate input costs to US manufacturing. ...

Even if the effect on US jobs is small, we should still care about the effect of China's currency policy on other developing countries. That's where China's currency policy is likely have the greatest effect in terms of shifting the location of manufacturing employment.

The effect of the policy on global imbalances and the potential impact on financial stability is also of concern. However, given the IMF's behavior toward countries that needed help in the past, it's hard to be critical of the desire to establish a reserve fund as insurance against having to turn to the IMF for help. That's why giving countries such as China a larger role in determining IMF policies could help with currency alignment problems. With a credible change in IMF policy, countries could get the help they need when troubles arise at a smaller cost than it takes to build up large reserve balances.

Eichengreen: Why China is Right on the Renminbi

Barry Eichengreen says that China's exchange rate policy is "exactly right":

Why China is Right on the Renminbi, by Barry Eichengreen, Commentary, Project Syndicate: After a period of high tension between the United States and China, culminating earlier this month in rumblings of an all-out trade war, it is now evident that ... China is finally prepared to let the renminbi resume its slow but steady upward march. ...

Some observers, including those most fearful of a trade war, will be relieved. Others, who see a substantially undervalued renminbi as a significant factor in US unemployment, will be disappointed by gradual adjustment. They would have preferred a sharp revaluation of perhaps 20%...

Still others dismiss the change in Chinese exchange-rate policy as beside the point. For them, the Chinese current-account surplus and its mirror image, the US current-account deficit, are the central problem. ... The US is running external deficits because of a national savings shortfall, which once reflected spendthrift households but now is the fault of a feckless government.

There is no reason, they conclude, why a change in the renminbi-dollar exchange rate should have a first-order impact on savings or investment in China, much less in the US. There is no reason, therefore, why it should have a first-order impact on the bilateral current-account balance, or, for that matter, on unemployment, which depends on the same saving and investment behavior.

In fact, both sets of critics have it wrong. China was right to wait in adjusting its exchange rate, and it is now right to move gradually rather than discontinuously. ...

China successfully navigated the crisis, avoiding a significant slowdown, by ramping up public spending. But, as a result, it now has no further scope for increasing public consumption or investment.

To be sure, building a social safety net, developing financial markets, and strengthening corporate governance to encourage state enterprises to pay out more of what they earn would encourage Chinese households to consume. But such reforms take years to complete. In the meantime, the rate of spending growth in China will not change dramatically.

As a result, Chinese policymakers have been waiting to see whether the recovery in the US is real. If it is, China’s exports will grow more rapidly. And if its exports grow more rapidly, they can allow the renminbi to rise. ...

Evidence that the US recovery will be sustained is mounting. As always, there is no guarantee. ... Because the increase in US spending on Chinese exports will be gradual, it also is appropriate for the adjustment in the renminbi-dollar exchange rate to be gradual. ...

Chinese officials have been on the receiving end of a lot of gratuitous advice. They have been wise to disregard it. In managing their exchange rate, they have gotten it exactly right.

"Brazil and India add to China Pressure"

Interesting development on China's currency policy:

Brazil and India add to China pressure, by Geoff Dyer, Financial Times: China is facing growing pressure from other developing countries to begin appreciating its currency, providing unexpected allies for the US in the diplomatic tussle over Beijing’s exchange rate policy. ...

Indian and Brazilian central bank presidents have made the most forceful statements yet by their countries about the case for a stronger Chinese currency.

While most of the public pressure on China has come from the US, the comments underline that a number of developing economies feel that China’s dollar peg has imposed costs on their economies. ...

Lee Hsien Loong, prime minister of Singapore, added his country’s voice to the debate last week, saying it was “in China’s own interests” with the financial crisis over to have a more flexible exchange rate.

Some in China have fended off US pressure for a stronger currency, describing it as a distraction from the real causes of the financial crisis. However, criticism from developing countries is not so easy to bat away. ...

The increase in criticism of China comes at a time of relative calm between Beijing and Washington over the issue, with many US officials and analysts assuming China has already decided to abandon its peg with the dollar over coming months. ...

I've been interested in how the crisis would affect the strategy of developing economies, in particular if we would see an increase in the number of countries abandoning Western-style development strategies that are, at their heart, market-based in favor of more centrally directed development such as in China.

However, part of China's development strategy includes its currency policy, and if both developed and developing countries begin to view these policies as coming at the expense of other nations, at the expense of developing nations in particular, there may be less willingness to pursue similar strategies (e.g. due to fear of retaliation in the form of trade restrictions imposed by nations that believe they are being harmed by the policy).

"Evaluating the Renminbi Manipulation"

Following up on the Joe Stiglitz post below this one, Martin Wolf has a different view. Unlike Stiglitz, he thinks that sanctions against China in retaliation for its currency policy are needed if China doesn't change its ways:

Evaluating the renminbi manipulation, by Martin Wolf, Commentary, Financial Times: The incumbent superpower has blinked in its confrontation with the rising one: the US Treasury has decided to postpone a report due by April 15 on whether China is an exchange-rate manipulator. ...

Is China a currency manipulator? Yes. ...China has controlled the appreciation of both nominal and real exchange rates. This surely is currency manipulation. It is also protectionist, being equivalent to a uniform tariff and export subsidy. Premier Wen Jiabao has protested against “depreciating one’s own currency, and attempting to pressure others to appreciate, for the purpose of increasing exports. In my view, that is protectionism”. The Chinese pot is calling the US kettle black.

Yet some economists deny this, offering four counter-arguments: first, while the intervention is huge, the distortion is small; second, the impact on the global balance of payments is modest; third, global “imbalances” do not matter; and, finally, the problem, albeit real, is being resolved. Let us consider each of these points in turn. ...[explains why he believes each point is wrong]...

I conclude that the renminbi is undervalued, that this is dangerous for the durability of global recovery and that China’s actions have not, so far, provided a durable solution. I conclude, too, that rebalancing is a necessary condition for sustainable recovery, changes in competitiveness are a necessary condition for rebalancing, real renminbi appreciation is necessary for changes in competitiveness, and a rise in the currency is necessary for real appreciation, given the Chinese desire to curb inflation.

The US was right to give talking a chance. But talk must lead to action. 

Also, please see this update from Paul Krugman:

Immaculate Transfer Strikes Again, by Paul Krugman: Oh, dear. Via Mark Thoma, I see that Joe Stiglitz has fallen victim to the doctrine of immaculate transfer...

[As Krugman explains here, Steven Roach - who is also mentioned by Martin Wolf - is another recent victim.]

Stiglitz: No Time for a Trade War

Joseph Stiglitz warns against unilateral sanctions against China in retaliation for its currency policy:

No Time for a Trade War, by Joseph E. Stiglitz, Commentary. Project Syndicate: The battle with the United States over China’s exchange rate continues. When the Great Recession began, many worried that protectionism would rear its ugly head. ... But ... protectionism was contained, partly due to the World Trade Organization.

Continuing economic weakness ... risks a new round of protectionism. In America, for example, more than one in six workers who would like a full-time job can’t find one.

These were among the risks associated with America’s insufficient stimulus, which was designed to placate members of Congress as much as it was to revive the economy. With soaring deficits, a second stimulus appears unlikely, and, with monetary policy at its limits and inflation hawks being barely kept at bay, there is little hope of help from that department, either. So protectionism is taking pride of place.

The US Treasury has been charged by Congress to assess whether China is a “currency manipulator.” ...[T]he very concept of “currency manipulation” itself is flawed: all governments take actions that directly or indirectly affect the exchange rate. Reckless budget deficits can lead to a weak currency; so can low interest rates. Until the recent crisis in Greece, the US benefited from a weak dollar/euro exchange rate. Should Europeans have accused the US of “manipulating” the exchange rate to expand exports at its expense?

Although US politicians focus on the bilateral trade deficit with China – which is persistently large – what matters is the multilateral balance. ... Many factors other than exchange rates affect a country’s trade balance.  A key determinant is national savings. America’s multilateral trade deficit will not be significantly narrowed until America saves significantly more...

Adjustment in the exchange rate is likely simply to shift to where America buys its textiles and apparel – from Bangladesh or Sri Lanka, rather than China. Meanwhile, an increase in the exchange rate is likely to contribute to inequality in China, as its poor farmers face increasing competition from America’s highly subsidized farms. This is the real trade distortion in the global economy – one in which millions of poor people in developing countries are hurt as America helps some of the world’s richest farmers.

During the 1997-1998 Asian financial crisis, the renminbi’s stability played an important role in stabilizing the region. So, too, the renminbi’s stability has helped the region maintain strong growth, from which the world as a whole benefits. ...

But exchange rates do affect the pattern of growth, and it is in China’s own interest to restructure and move away from high dependence on export-led growth. China recognizes that its currency needs to appreciate over the long run, and politicizing the speed at which it does so has been counterproductive. ...

Since China’s multilateral surplus is the economic issue..., the US should seek a multilateral, rules-based solution. Imposing unilateral duties after unilaterally labeling China a “currency manipulator” would undermine the multilateral system, with little payoff. China might respond by imposing duties on those American products effectively directly or indirectly subsidized by America’s massive bailouts of its banks and car companies.

No one wins from a trade war. So America should be wary of igniting one in the midst of an uncertain global recovery – as popular as it might be with politicians whose constituents are justly concerned about high unemployment, and as easy as it is to look for blame elsewhere. Unfortunately, this global crisis was made in America, and America must look inward...