Economist's View

Have Production Subsidies Helped Chinese Exporters?

Do production subsidies work?:

Can production subsidies explain China’s export performance?, bySourafel Girma, Yundan Gong, Holger Görg, and Zhihong Yu, Vox EU: China’s exports are booming and – somewhat surprisingly – not just in labour-intensive goods. As Yale trade economist Peter Schott writes in his recent Vox column, China exports an astonishingly wide range of goods – including many in high-tech sectors (Schott 2008).

Although some economists argue that this is an illusion – that China’s sophisticated exports are just assembled from sophisticated imported components (Branstetter and Lardy 2006) – it is difficult to deny that some Chinese firms are making their mark in high-tech industries. According to the WTO 2007 report, China’s export unit value index for manufactured goods rose by 3.6% in 2006, signalling a move away from reliance on the cheap exports.

Pushing its industry up the value-added change is a clear goal of the Chinese government at both the central and local levels. Tax incentives and other policies, like production subsidies, are used to actively upgrade companies’ product structure. But have these policies had any effect? For example, Görg, Henry and Strobl (2008) provide firm-level evidence that Irish production subsidies boosted the exports of already existing exporters but found no evidence that subsidies induced firms to begin exporting.

Our recent study addresses this question for China by examining firm-level data encompassing nearly a half million firms (more than 1.3 million observations) over a six year period from 1999 to 2005 (Girma et al. 2008). Critically, we have rare information on production subsidies received by Chinese firms.[1]

Aid to Poor Countries: "Cruel Joke" Week

Is the opening paragraph serious?:

Bread and Bush-bashing, by Chris Patten, Project Syndicate: I feel a little sorry for President Bush. Whatever his other many failings, he has a pretty good record on aid to poor countries, particularly in healthcare. True to form, he recently announced a big increase in US food aid -- good for the hungry poor and good for American farmers. ...

What made me feel a little sorry for Bush was the reaction to his announcement. Bush referred to the reasons for shortages and price hikes. He did not dwell on the diversion of American corn from food to heavily subsidized bio-fuels. Nor did climate change feature prominently in his argument, although many experts suggest that this may be the cause of the droughts and floods that have ruined wheat harvests in Australia and vegetable oil production in Indonesia and Malaysia.

Bush pointed his finger primarily elsewhere. Food prices had responded to growing demand. In Asia, economic growth had stimulated food consumption. The Chinese and Indians were eating more and eating better. ...

What Bush said is of course true. ...

But many Indians are still wretchedly poor. Too many. They have a miserable diet -- not least when compared with Bush’s Texan neighbors. Grain consumption per head in India has remained static, and is less than one-fifth the figure for the US, where it has been rising. I do not imagine you will find too many vegetarians in Crawford, Texas, and the meat consumed by the average American is way ahead of the figure for any other country. Think of all those T-bone steaks.

Bush’s partial explanation of the world food crisis, accurate as far as it went, brought the anger of India’s media and of many politicians... According to India’s Defense Minister, A.K. Anthony, presumably an expert on butter as well as guns, Bush’s statement was “a cruel joke.”...

Later in the “cruel joke” week, Bush’s White House compounded the sin. According to Bush’s press spokesman, the growth in world demand for oil -- in Asia, for example -- was one of the causes of the high price of filling the tanks of gas-guzzling sports utility vehicles ... at America’s pumps.

Meanwhile, the US government papered over the fact that Americans, who make up less than 4 percent of the world’s population, own and drive 250 million of the world’s 520 million cars. More outrage around the world at American double standards.

Now, all this is more than the knock-about of international politics. One day soon, Bush and Cheney will be out of office. But we will still be left with the most difficult global issue we have ever faced: as more of us prosper, how do we deal fairly with some of the economic and environmental consequences?

What do we do about the bottom billion in the world who remain in grinding poverty while the rest of us live better and longer lives? How do we deal with equity on a global scale when we cannot even deal with it country by country?

This conundrum will lie at the heart of the diplomacy next year to find a successor to the Kyoto agreement. Can we prevent a calamitous increase in global warming in a way that is fair,... and that does not thwart legitimate hopes for a better life everywhere? We have never faced a more difficult political task.

Meanwhile, there is a food crisis to solve. We have already seen many examples of how not to deal with it. Stopping food exports is stupid. If we restrict market forces, there will be less food and higher prices. We should also avoid the cheap political trick of holding down what we pay to poor farmers in order to benefit poor city dwellers.

Why do governments do this? The answer is obvious: city dwellers riot; in the countryside, people just starve. The best way to deal with the problem is to subsidize food for the poor; we should not cut the price we pay farmers for growing it. ...

Here's the reason I asked. This is Africa, not India, but I don't suppose the story is any different:

Food Relief For Africa 'Insufficient,' GAO Says, by Anthony Faiola, Washington Post: Efforts by the United States and multilateral agencies including the World Bank to reduce hunger in sub-Saharan Africa have been "insufficient," with foreign aid to the region failing to flow into agricultural development projects vital to the ability of poor countries to feed themselves, according to a report to be released this morning by the U.S. Government Accountability Office. ...

The report, a draft copy of which was obtained by The Washington Post, additionally describes U.S. aid efforts in sub-Saharan Africa as fragmented and misdirected. It says, for instance, that a Bush administration initiative to "end hunger in Africa" launched in 2002 effectively amounted to a repackaging of existing programs and came with no new funding. ...

The report comes on the heels of another released by the GAO last year sharply criticizing U.S. food aid programs. That report called them "inherently inefficient" because they rely on the sale of American-grown food that is costly to transport overseas, as opposed to food purchased closer to the troubled regions themselves. ...

Do You Care?

How much should the well-being of people in other countries matter for domestic policy?:

China’s Class Divide, by Daniel A. Bell, Commentary, NY Times: ...Tsinghua is one of China’s most prestigious universities and it is known for its politically conservative orientation. President Hu Jintao is an alumnus, and most of my colleagues are Communist Party members, as are many of my students.

Yet the atmosphere is anything but conservative. The most popular lecturers tend to be the ones who openly criticize contemporary China. In private, students are quick to express frustration at Internet censorship and official propaganda. In class, student questions are often critical to the point that I need to introduce some “pro-government” views for balance.

Shortly after the uprisings in Tibet in March, I happened to lecture on Locke’s idea of constitutional democracy. A student asked if the “right to rebel” would justify the use of violence by Tibetans fighting for independence. In the interest of class time, I had to shut off the discussion. The next week we discussed Isaiah Berlin’s concept of freedom... Once again, I was forced into the strange position of cutting off debate before it got out of hand.

After the Sichuan earthquake, ..., I was due to lecture on John Rawls’s theory of justice. ... I tried hard to think of an example that the students could grapple with.

Finally I came up with a good one (or so I thought). According to Rawls, the state should give first consideration to the worst-off members of the community. But which “community” matters? Do the state’s obligations extend outside national boundaries? For example, the cyclone in Burma caused more deaths than the Chinese earthquake. Should China help the victims of the Burmese cyclone, even if it means less aid for the rescue mission in China?

When I finished, the class went unexpectedly silent, to the point that I could feel a certain amount of hostility. Finally a student said that of course the Chinese government should help the Chinese first. But why, I said? Another student said, it’s obvious, the victims are Chinese. “But why, why?” I asked, somewhat impatiently. Give me some reasons.

Some students spoke up. There is no global institution that could distribute aid in accordance with Rawls’s principles of justice. The Chinese people pay taxes to the Chinese state, so the state has special obligations to them. The Chinese state couldn’t do much for the Burmese people even if it wanted to.

I responded that the Burmese government is truly awful, blocking aid to its own people, and that the Chinese government could have some influence on it. ...[T]he bell rang. In the past, the ever-polite students would clap in appreciation before leaving. This time, there was no applause.

When I got home, I realized that I had trodden on sensitive territory. Chinese TV has been filled with scenes of death and devastation, of Chinese soldiers wading through mud and gore to help the victims. Every conversation is prefaced with concern about the victims. I sent an e-mail message to the class apologizing for the “wrong-headed” example...

A student wrote back saying, “It is not a wrong-headed example; we just have clear and strong identification.” That seems to go to the heart of what went wrong. It’s perfectly natural to care about people closer to home, especially in times of disaster. ...

I've wondered about this - how much to care about people inside the US versus people in the rest of the world - when it comes to monetary and fiscal policy. Say, for example, the US is about to go into a recession and it can save itself, but in doing so it will make life much more difficult for developing countries. Should policymakers do what's best for the US even if it impacts other countries negatively, or do monetary and fiscal authorities have an obligation to consider the interests of other people in the world when they are making policy decisions? Shouldn't policymakers always do what's best for the US?

Yes, but policymakers are supposed to represent our interests, and if we care, on average, a lot about how our actions impact other people in the world, then policymakers should reflect that in their policy choices - that's what's best for us. Conversely, if we mostly care about ourselves, and the rest of the world matters little, then policymakers should reflect those preferences too and show little regard for the potential negative impact of domestic economic policy on other people in the world (except to the extent there are negative feedbacks effects).

But I'm less comfortable with that position. What's the argument against it, i.e. what's the argument for internalizing the negative economic externalities that hit other countries because of our policy choices even if we don't care very much about those countries?

Kenneth Rogoff: China May Be The Economy To Lose Sleep Over

What if China's economy goes into a slump, what then? Is there a significant possibility this could happen? Ken Rogoff says there is reason to worry:

China may yet be economy to lose sleep over, by Kenneth Rogoff, Commentary, Financial Times: Given the highly vulnerable state of the US and European economies, what would happen to global growth if the Chinese juggernaut also started sputtering? ...

China’s remarkable resilience to both the 2001 global recession and the 1997-98 Asian financial crisis has convinced almost everyone that another year of double-digit growth is all but inevitable. In fact, the odds of a significant growth recession in China – at least one year of sub-6 per cent growth – during the next couple of years are 50:50. With Chinese inflation spiking, notable backpedalling on market reforms and falling export demand, 2008 could be particularly challenging. ...

"Investing in China: Fool’s Gold?"

Thomas Palley sends his latest:

Investing in China: Fool’s Gold?, by Thomas I. Palley: Americans tend to disregard history. Henry Ford declared bluntly, “History is bunk,” while Gore Vidal calls the U.S. “the United States of Amnesia.” Usually, this disregard has few consequences, but sometimes not. That may be so with investing in China, where history suggests profits will be far below expectations, possibly making those investments fool’s gold.

China’s history is completely different from that of the United States and it has left deep imprints on China’s politics. Therein lies the trap for investors and policymakers who ignore history and wishfully think market forces will inevitably make China just like the United States.

Alex Tabarrok: "Reason to be Highly Optimistic about the Future"

Don't worry, things are going to turn out great:

Dismal Science Sees Upbeat Future, Alexander Tabarrok, Forbes: Forget the talk of recession. The world is about to enter a new era in which miracle drugs will conquer cancer and other killer diseases and technological and scientific advances will trigger unprecedented economic growth and global prosperity.

Pie in the sky optimism? Perhaps. But there are reasons to be optimistic, and they rest ... within the badly misnamed "dismal science," economics.

To understand why economics triggers such optimism, imagine that there are two deadly diseases. One disease is relatively rare, the other common. ... If you don't want to die, it's much better to have the common disease. ... The cost of developing drugs for rare and common diseases are about the same, but the revenues aren't ... larger markets mean more profits.

As a result, there are more drugs to treat diseases with a lot of patients than to treat rare diseases, and more drugs means greater life expectancy. Patients diagnosed with rare diseases ... are 45% more likely to die before age 55 than are patients diagnosed with more common diseases. So imagine this: If China and India were as wealthy as the U.S., the market for cancer drugs would be eight times larger than it is today. ...

Like pharmaceuticals, new computer chips, software and chemicals also require large research and development (R&D) expenditures. As India, China and other countries become wealthier, companies will increase their worldwide R&D investments. Most importantly, as markets expand, companies and countries will put to work the greatest asset of all for the betterment of mankind: brain power.

Amazingly, there are only about 6 million scientists and engineers in the entire world, nearly a quarter of whom are in the U.S. ... But if the world as a whole were as wealthy as the U.S..., there would be more than five times as many scientists and engineers worldwide.

People used to think that more population was bad for growth. In this view, people are stomachs--they eat, leaving less for everyone else. But once we realize the importance of ideas in the economy, people become brains--they innovate, creating more for everyone else. New ideas mean more growth, and even small changes in economic growth rates produce large economic and social benefits. ...

In the 20th century, two world wars diverted the energy of two generations from production to destruction. ... Communism isolated much of the world, reducing trade in goods and ideas--to everyone's detriment. World poverty meant that the U.S. and a few other countries shouldered the burdens of advancing knowledge nearly alone.

The battles of the 20th century were not fought in vain. Trade, development and the free flow of people and ideas are uniting all of humanity, maximizing the incentives and the means to produce new ideas. This gives us reason to be highly optimistic about the future.

Why Does India Lag Behind China?

Arvind Panagariya of Columbia University with "a discussion of how India could speed its transition to a modern economy":

What India must do to modernise, by Arvind Panagariya, Vox EU: A key advantage claimed for the outward-oriented development strategy is that it allows poor, labour-abundant countries to specialise in labour-intensive products and, thus make efficient use of limited capital stocks. To quote Anne O. Kruger (1985), “An export-oriented strategy permits countries to use the international market to exchange their own, relatively labour-intensive commodities for capital-intensive goods. They are thus able to take advantage of the division of labour and specialisation. This ability contrasts sharply with import-substitution policies under which labour-abundant developing countries produce the entire spectrum of manufacturing goods and experience high and rising capital/labour ratios.”

The experiences of South Korea, Taiwan, Brazil and most recently China offer broad support to this claim. Increasing shares of industry in GDP in general and of labour-intensive manufactures in particular accompanied the adoption of outward-oriented strategies in these countries. Exports of unskilled-labour-intensive products such as apparel, footwear, toys and numerous light manufactures expanded rapidly.

"The 'Browning' of African Technology"

G. Pascal Zachary says we are falling behind in Africa:

The “Browning” of African technology, by G. Pascal Zachary: A number of newspapers in Asia are carrying an essay I wrote recently for Project Syndicate..., which argues that many critical needs in Africa are being met and will be met going forward by Indians and Chinese. ...

Maybe Africa is no longer a “white man’s burden,” not because we have been persuaded by NYU professor William Easterley to abandon the continent, but rather because Chinese and Indians have supplanted (or will) Westerners in the task of “saving” Africa. The irony is delicious, and the practical implications enormous.   

While Westerners debate amongst themselves whether foreign-aid to Africa helps or hurts — a debate, I think, is increasingly irrelevant — Indians and Chinese are pragmatically (if not always effectively) engaging Africa. ...

The essay is here.

Paul Krugman: Dealing With the Dragon

Paul Krugman says we’re having the wrong discussion about foreign policy:

Dealing With the Dragon, by Paul Krugman, Commentary, NY Times: ...Almost all the foreign policy talk in this presidential campaign has been motivated, one way or another, by 9/11 and the war in Iraq. Yet it’s a very good bet that the biggest foreign policy issues for the next president will involve the Far East rather than the Middle East. In particular, the crucial questions are likely to involve the consequences of China’s economic growth.

Turn to any of several major concerns now facing America, and in each case it’s startling how large a role China plays.

Start with the soaring price of oil. Unlike the oil crises that followed the Yom Kippur War and the overthrow of the shah of Iran, this crisis wasn’t caused by events in the Middle East that disrupted world oil supply. Instead, it had its roots in Asia.

It’s true that the global supply of oil has been growing sluggishly... But the reason oil supply hasn’t been able to keep up with demand is surging oil consumption in newly industrializing economies — above all, in China. ... China has been responsible for about a third of the growth in world oil consumption. As a result, oil at $100 a barrel is, in large part, a made-in-China phenomenon.

Speaking of made in China, that brings us to a second issue. There’s growing concern in this country about the effects of globalization on wages, largely because imports ... from low-wage countries have surged, doubling as a share of G.D.P. since 1993. And more than half of that rise reflects ... industrial imports from China...

Last, but most important, is the issue of climate change, which will eventually be recognized as the most crucial problem facing America and the world — maybe not today, and maybe not tomorrow, but soon, and for the rest of our lives.

China is already, by some estimates, the world’s largest emitter of greenhouse gases. And as with oil demand, China plays a disproportionate role in emissions growth. In fact, between 2000 and 2005 China accounted for more than half the increase in the world’s emissions of carbon dioxide.

What this means is that any attempt to mitigate global warming will be woefully inadequate unless it includes China. ...

So what does all this tell us about the presidential race?

On the Republican side, foreign policy talk is all bluster and braggadocio. To listen to the G.O.P. candidates, you’d think it was still February 2003, when the national discourse was dominated by people who thought that American military might was sufficient to shock and awe the rest of the world into doing our bidding.

Memo: China has 50 times the population of Iraq.

The Democrats in general make far more sense. But among at least some of Barack Obama’s supporters there seems to be a belief that if their candidate is elected, the world’s problems will melt away in the face of his multicultural charisma.

Memo: It won’t work on the Chinese.

The truth is that China is too big to be bullied, and the Chinese are too cynical to be charmed. But while they are our competitors in important respects, they’re not our enemies, and they can be dealt with.

A lot of Americans, when they think about the next president’s foreign-policy qualifications, seem to be looking for a hero — someone who will stand tall against terrorists, or transform the world with his optimism.

But what they should be looking for is something more prosaic — a good negotiator, someone who can bargain effectively with some very tough customers and get the deals we need on energy, currency policy and carbon credits.

China’s Ability to Gain Technology from Foreign Firms

A colleague, Bruce Blonigen, and his co-author Alyson Ma say there's little evidence to support the view that "China extracts rents and technology from foreign competitors, thus allowing it to grow even faster and longer than most would have imagined possible." China has managed to attract considerable foreign investment, but that investment has only had a moderate impact on technology transfer and the sophistication of Chinese firms:

Will China soon be making not only cheaper, but also better, products than everyone else?, by Bruce Blonigen and Alyson C. Ma, Vox EU: The opening of China and its breathtaking ascendancy to major-player status in world markets has led to significant hand-wringing by the rest of the world on many fronts. The huge outflow of cheap unskilled-labour-intensive products from China and its ramifications for wages and welfare in both developed and other less-developed countries has been a primary concern.

Recently, new hand-wringing concerns have been raised by various commentators. As it turns out, the composition of China’s exports is much closer to that of OECD countries than its level of per-capita income would suggest.[1] This has substantial implications not only for China’s ability to sustain its growth, but also for real wages of all workers in developed countries, not just unskilled ones.

A significant factor behind this surprising export sophistication by China may be the role of industrial policy to promote technologically-advanced industries. While it is well known that the Chinese government has historically had preferential tax treatment and free trade zones for foreign firms, it also often negotiates technology transfer arrangements with foreign firms. These are either through restrictions that limit FDI to joint venturing with a domestic partner or simply offering quid pro quo arrangements of technology transfer from the foreign firm to domestic ones in exchange for the foreign firm’s ability to sell to the huge Chinese market.[2]

A prime example of how this may be successful is a case in the auto industry. The Chinese government has always required foreign automakers to partner with domestic producers. Shanghai Automotive (a Chinese-owned firm) recently announced plans to start up its own factory to produce a luxury sedan after jointly producing autos in China with General Motors and Volkswagen for many years.[3]

The X-factor in all of this is China’s large and growing domestic market. It may be precisely the pivotal factor allowing China the leverage to wring out important and significant technology transfer concessions from foreign firms. China’s predecessors (such as Japan, Korea, and Taiwan) did not have this same advantage when pursuing their own industrial policies for growth in previous decades. Thus, one wonders if the upcoming growth of China will make the previous Asian miracles look pedestrian.

While the scenario we have just laid out is plausible, recent evidence suggests otherwise. China’s ability to gain technology from foreign firms and develop its own productive sophistication has actually not been that significant.

Brad DeLong: Alignment Problem Shifts to China

Brad DeLong says that today, "the principal source of international economic disorder is made in China":

Alignment problem shifts to China, by J. Bradford DeLong, Commentary, Project Syndicate: Now that the dollar has dropped 43 percent from its high against the euro, the process of global financial rebalancing is seriously under way. ... At the moment, Europe is feeling most of the pain, as the euro's value has risen furthest and fastest against the dollar. But Latin America and Asia will start to feel distress as well, as the US sheds its decade-long role as the global economy's importer of last resort.

As long as imbalances of world trade and capital flows unwind slowly and smoothly, the magnitude of any global economic distress should be relatively small. Of course, it will not seem small to exporters and their workers who lose their US markets, or to Americans who lose access to cheap capital provided by foreigners.

Yes, the US might enter a small recession -- the odds are roughly 50-50... A formal recession, however, is not an overwhelming probability and is likely to be small.

The prospect of a truly hard landing -- one where global investors wake up one morning, suddenly realize the US current accounts cannot be sustained, dump dollars and crash the global economy -- is becoming less likely with each passing day.

Under two scenarios -- both concerning China -- the unwinding of global imbalances could cause regional if not global depression.

In the first scenario, China keeps up its attempt to maintain full employment ... not by stimulating domestic demand but by trying to boost exports further by keeping the yuan stable against the dollar and falling in value against the euro.

The effort to maintain the dollar-yuan exchange rate ... has already led to an enormous increase in the Chinese economy's financial liquidity. The consequences of this are now manifested in property and stock market inflation, but not yet in rampant and uncontrolled consumer price inflation -- at least for now.

But if China does not accelerate the yuan's revaluation, the world might see a large burst of consumer inflation in China in the next two or three years.

If so, the consequences will be a choice between stagflation on the one hand and the destructive run-away inflation of post-World War II Latin America on the other. The fall-out from this scenario, however, would be largely confined to Asia.

The second scenario is more dangerous for the entire world. In this scenario, once again China continues to attempt to maintain full employment by keeping the yuan undervalued. But this time, the Chinese government manages to restrain domestic inflation, so the US' trade deficit with Asia stops falling and starts rising again.

Five or six years hence, the world economy faces the danger of a sudden crash in the value of the dollar and the euro against Asian currencies.

Four years ago, I would have said that the principal source of international economic disorder was made in the US. That has passed as a result of the dollar's decline and the ebbing political strength of right-wing populist factions in the US that seek ever-greater redistribution to the rich fueled by ever-increasing tax cuts and ever-rising long-term deficits.

Today, the principal source of international economic disorder is made in China, owing to factions inside its government that hope to avoid a more rapid appreciation of the yuan's value. I cannot judge the strength of these factions, or whether they know that the falling US account deficit and dollar may reduce the urgency of adjustment in the rest of the world, but not in China.

Former US president Richard Nixon's treasury secretary, John Connally, once told a group of European leaders that while the dollar was the US currency, its misalignment was Europe's problem. Today, the misalignment of the dollar -- and the euro -- against the yuan and other Asian currencies is increasingly becoming Asia's problem.

Is Inflation a Threat to China's Stability?

In the comments at Martin Wolf's Forum, there is a very nice analysis of China's inflation problem from Yu Yongding:

Comment on "China: Inflation is not the big threat to stability" by Yu Yongding: It is fair to say that inflation is not immediate threat to China’s economic stability. However, there are many reasons for the Chinese government to worry about inflation.

First, China’s growth rate will be more than 11 percent in 2007. According to consensus until very recently, China’s potential growth rate was 8-9 percent. ... Perhaps, China’s productivity gain in recent years is great. However, ... it is hard to believe that China’s productivity ... has improved so dramatically that China’s potential growth rate has risen from 8 percent to 11 percent and will be able to maintain the current growth momentum without causing serious inflation. ... My guess is that there is excess demand in China and the excess demand is increasing. As a result, there is material inflation pressure on the economy.

Second, the recent food price hike cannot be entirely attributed to one-off external shocks. Virtually, prices of all inputs for food production, from feeding-stuff to fertilizer, have increased, which in turn may partially be attributed to demand-pull factors of the economy. ... Though the government will be able to contain the rise of food prices at a time via administrative methods, these factors are not one-off and will not go away automatically.

Third, inflation expectations have been established among the public. According to a recent survey by the PBoC, the public believed that inflation will deteriorate further. People have started to adjust their behavior correspondingly by withdrawing their deposits to buy shares and real estate, and pushing for more increases in wages and salaries. Therefore, at this stage, even if inflation is not a big threat to stability, worsening inflation expectations are.

"How Does China Compete with Developed Countries?"

Does trade with China mean the loss of our manufacturing sector? Not according to Peter Schott. This is from Vox EU:

How does China compete with developed countries?, by Peter K. Schott, Vox EU: Public discussion about the competitiveness of Chinese exports on world markets is often misleading. Since misconceptions are often at the root of bad policy, it’s worth reviewing what recent research tells us about the relative sophistication of Chinese products and the potential effects of China’s growth on firms and workers in developed economies.

Basic economics tells us that countries with very cheap labour like China ought to specialise in relatively unsophisticated goods like t-shirts and toys, while more developed economies like Germany or Japan should concentrate on more skill- and capital-intensive products like pharmaceuticals and supercomputers. As trade barriers and other trade costs fall, countries will cede production of goods at odds with their comparative advantage to free up resources that can be used to produce goods in which they are most competitive.

The extent to which countries at different levels of development specialise in different sets of goods has important implications for workers in developed economies. That is because specialisation influences how directly high-wage workers in developed countries compete with lower-wage workers in developed economies. If Germany and China produce and export the same mix of goods, then reductions in the world price of those goods driven by trade liberalisation and Chinese growth must reduce wages in the developed economies – the much-feared “race to the bottom”. On the other hand, if China produces toys but Germany does not, German workers gain from the growth of China’s toy industry: their wages remain high because they are determined by goods that China does not produce, while the decline in toy prices increases the amount of income they can devote to other goods and services.

A surprising fact that emerges from the analysis of detailed trade statistics is that developed economies tend to remain active in import product markets even as developing countries move in.[1] In the US import market, for example, the share of all possible manufacturing products imported from the developed economies of the OECD over the last 35 years has remained constant at nearly 100%, even as the share imported from China jumped from 9% to an unprecedented 85%. These trends present a puzzle: if Chinese competition is so fierce, why didn’t it push the OECD countries out of more US import markets?

Thomas Palley: Inflation, Chinese Style

Thomas Palley sends along his latest on China's battle against inflation, and the broader consequences of its anti-inflation strategy. William Polley says that Palley "gets it right":

Inflation, Chinese Style, by Thomas Palley: China’s government recently announced inflation hit a ten-year high of 6.5 percent in August. This increase in inflation is directly related to global trade imbalances, yet China is trying to control inflation without addressing that problem. That carries two consequences. First, it is doubtful this strategy can work, which likely augurs rising Chinese inflation. Second, the strategy aims to shift the onus of global trade adjustment on the U.S., which may come back to haunt China and the global economy.

China’s current inflation is a textbook case of prolonged under-valuation of a fixed exchange rate in tandem with export-led growth. As such, significant exchange rate revaluation should be a central element of its anti-inflation policy. However, instead of making such an adjustment China’s authorities are hoping to control inflation by exclusive reliance on tighter domestic monetary policy. It is doubtful this strategy can succeed because it leaves intact the inflationary impulse from China’s trade surplus and under-valued exchange rate.

One important contributing factor in China’s inflation is the rise in global commodity prices, including oil and base metals, which are now feeding through into prices. Food prices are also on the rise owing to increased global prices for wheat and corn. Furthermore, China has been hit by a virulent outbreak of swine flu that has decimated its hog population, driving up the price of pork, which is China’s favored meat.

In coastal areas, which have been the hub of China’s export-led growth, wages have started rising in response to rising living costs and in response to the gradual elimination of extreme surplus labor conditions.

Most importantly, China is beset by significant asset price inflation that borders on an asset price bubble. This asset price inflation is the product of massive expansion of the money supply caused by China’s trade surplus. Dollars earned by Chinese exporters have flowed back to China and been converted into local money by the central bank, which has bought dollars at the fixed exchange rate to prevent appreciation. Holders of these money balances have then bought stocks and real estate to gain higher returns and to protect against potential inflation. This has driven up real estate prices, triggering a massive construction boom that has in turn caused inflation.

The implication is clear. China is suffering from imported inflation caused by higher global commodity prices, domestic demand inflation caused by excess demand in export industries, and asset price inflation due to an increased money supply caused by China’s trade surplus.

The under-valued exchange rate is a key culprit since it contributes to excess demand in export sectors and it also drives the money supply increase via the trade surplus – which has hit new record highs in 2007. That suggests significant exchange rate revaluation should be a central component of China’s anti-inflation strategy. Moreover, revaluation would also diminish the impact of global commodity price inflation because commodities are priced in dollars so that a revaluation lowers their domestic price in renminbi.

Instead, China has chosen to rely exclusively on monetary tightening, raising interest rates and reserve requirements on bank deposits. This strategy is unlikely to work. First, there is already significant asset inflation and extensive debt-financed speculative investment, which means the monetary authorities are constrained from sufficiently meaningful tightening for fear of triggering a financial collapse.

Second, raising reserve requirements on bank deposits lowers the return on deposits and makes them less attractive. That provides an incentive for depositors to spend their money or invest elsewhere, which spurs more inflation.

Third, and most importantly, continuation of China’s under-valued exchange rate means continuing trade surpluses and large foreign direct investment inflows, which means further monetary expansion in China.

Putting the pieces together, the picture is one of rising Chinese inflation, and with that comes the risk of inflation-triggered social and political problems. In this regard it is worth recalling that the Tiananmen Square disturbances of May 1989 were in part caused by industrial worker unrest over erosion of living standards by inflation.

As for the global economy, China’s anti-inflation policy and continued refusal to adjust its exchange rate places the burden of trade imbalance adjustment squarely on the U.S. This adjustment will likely happen via recession and there are signs that process may already be underway. This is a sub-optimal approach, which is bad for all.

Will Consumers in the U.S. Force Change in China?

Can "the fickle American consumer" bring about change in China?:

China's new revolutionaries: U.S. consumers, by Nathan Gardels, Commentary, LA Times: Who would have thought that tainted pet food and toys would threaten to unravel the authoritarian export model of Chinese growth that the brutal Tiananmen Square crackdown in 1989 was partly meant to secure? China's then "paramount leader" Deng Xiaoping, who had been purged during the Cultural Revolution, could well imagine how political upheaval would derail China's stable path to prosperity. But it surely never entered his mind, nor that of his descendant comrades, that the fickle American consumer would one day become, as the students in the square wanted to be, the agent of revolutionary change in China.

In the name of sovereignty, China's leaders for a long time have gotten away with suppressing their own citizens while ignoring the get-gloriously-rich-quick corruption that has thrived in the absence of the rule of law. But, thanks to globalization, China's export reliance on the U.S. market has imported the political demands of the U.S. consumer into the equation. Americans won't hesitate to cut the import lifeline and shift away from Chinese products that might poison their children or kill their pets.

Unlike organized labor or human rights groups, consumers don't have to mobilize to effect change; they only have to stop spending. And their bargaining agents -- Wal-Mart, Target, Toys R Us -- have immensely more clout than the AFL-CIO and Amnesty International in fostering change in China.

Ironically, the United States' "most favored nation" trade treatment for China (and its later entry into the World Trade Organization), which labor and human rights groups so virulently opposed in the past, has become a Trojan horse. China's future is now so linked to the American consumer that Beijing will be forced to curb corruption and strengthen regulation through the rule of law or face the certain doom of its export-led growth. ...

For consumers to trust Chinese products, they must trust regulation of those products. And regulation cannot be trusted without the rule of law, which doesn't bend to bribery, fraud and quanxi (connections). ...

[T]he ultimate paradox of Deng's soft totalitarianism is that privatizing people's lives will ultimately deprive the authorities of their power. As more people come to enjoy private freedom, fewer will abide it being taken away. Globalization, it seems, has accelerated this process by forging a kind of objective coalition of the growing Chinese middle class and the American consumer in favor of the rule of law. ...

Savvy consumers are not likely to buy China's response of prosecuting or executing high-level officials -- "killing the chicken to scare the monkey." They simply want the lead removed from their children's toys or they will take their purchases elsewhere.

Of course, a move toward the reliable rule of law is not democracy, but it is a big step on the long march in that direction.

Some years ago, the once-famous but now forgotten dissident, Wei Jingsheng, lamented how the attention of global public opinion and that of most Chinese had shifted "from Democracy Wall [where Wei was arrested for putting up posters calling for democratic political reforms] to the shopping mall."

Now, especially as the spotlight of next summer's Olympics approaches, it seems the tables may be turning again.

"The Furor in China is Everywhere"

An email I received today:

Dear Prof. Thoma..., I have been deeply disturbed and distressed about the recent news from China. Although NYT has some reports on it: 

• Reports of Forced Labor at Brick Kilns Unsettle China
• Fast-Growing China Says Little of Child Slavery’s Role
• China Tries to Contain Scandal Over Slave Labor With Arrests and Apology

For other western media coverage, see:

• Media Coverage of the Brick Kiln Case

But for the English version of an interview with the reporter who helped to make the case public, see:

• How The Reporter Found The Shanxi Brick Kiln Slaves

But the furor in China is everywhere. Ordinary people are deeply shocked and disillusioned at the government's inaction and indifference to basic human rights!!! I am so sad to see my own country come to this day, I cry every time I think of the poor kids and their parents, who have nowhere to seek justice. This is just the tip of the iceberg. Over the internet people are saying that such horrific abduction of people is everywhere. It is not a labor dispute. It is a reflection of a very sick society that would pursue wealth at all cost. I can't believe this is my country!

I am going to China soon and I will have chance to see more of people's reaction to it. The world can't stay silent on THIS! I'd like to hear your and your reader's opinion on it. My own impression of the central government is that they are not sincere in truly solving it. At least the governor of the ShanXi province has to be fired! The PM has to apologize to all the victims.

Thomas Palley: The Profit vs. Country Dilemma

Thomas Palley, fresh from his battles for heterodox points of view in economics, sends along his latest. Thomas and I don't always see eye to eye on matters of international trade, and as he notes in his email, this is a "very different take from that of Brad DeLong regarding the significance of China's investment in the Blackstone Group":

The Profit vs. Country Dilemma, by Thomas I. Palley: Vladimir Ilyich Ulyanov, alias Lenin, was the leader of the 1917 Bolshevik revolution in Russia. One of his best known quotes is “The capitalists will sell us the rope with which we will hang them.” Today, Lenin must be chuckling in his Moscow mausoleum as he watches US business dealings with China.

Lenin’s sarcastic quip identified how desire for profit can sometimes undermine class interest. In today’s era of globalization a similar logic can hold for the national interest. Thus, with corporations looking to maximize their global profits, what is good for profit can sometimes be bad for country.

US – China relations provide a case study of the “profit vs. country” dilemma. Current US – China economic relations are marked by huge trade deficits and a steady migration of manufacturing to China. This structure was established in the 1990s at the behest of multi-national corporations and big retailers such as Wal-Mart. The former saw China as providing an unequaled low cost production platform from which to export to the US, while the latter saw China as a source of low cost imports.

Together, these business interests pushed permanent normal trading relations for China, and they also explain the US Treasury’s willingness to accept China’s under-valued exchange rate. That is because an under-valued yuan holds down the cost of goods sourced from China and increases profits on production exported from China.

Martin Wolf's Economists' Forum: The Right Way to Respond to China's Exploding Surpluses

In a recent column, "The right way to respond to China's exploding surpluses," Martin Wolf argues that:

...[T]he most important high-level dialogue in international economics ... is the “strategic dialogue” between China and the US. ... This, to his credit, Hank Paulson, the US Treasury secretary, has recognised. But his bilateral approach will fail. ..

He also notes China's saving rate, argues it is too high, and asks:

So what is to be done? The answer seems simple: save less and let the nominal exchange rate appreciate faster, to eliminate possible inflationary consequences of such a policy shift. The Chinese government can easily afford to spend more on health and education ... [and] a modest pension system for those now alive. Moreover, the bulk of Chinese savings are not by households but by the government and corporations, many of which are owned by the government itself... Savings then are a policy choice, not a given. At 50 per cent of GDP, they also look far too high. ...

Mr Paulson is quite right to approach this question as a discussion of mutual interests. But it is almost inconceivable that the Chinese will grant what will appear to be one-sided concessions to demands from the “sole superpower”. That would be far too humiliating. The Chinese will need, instead, to participate as equals in a wider global dialogue... The obvious move is to replace the G7 with a group of four – the US, eurozone, Japan and China. ...

Jagdish Bhagwati comments (comments are open links):

Jagdish Bhagwati: Martin Wolf may well be right. Bilateral talks rarely work with big players, especially when the US wants the big players to do something they do not want to do. This was the lesson the US learnt, and now seems to have forgotten, in trying to impose managed trade targets on Japan, using Section 301, during the years of Japan-bashing.

But I also wonder what sense it makes for secretary Paulson, an enormous improvement over his predecessor, to keep asking China for financial reforms. That is something the Chinese must decide for themselves, in their evaluation of their own interest. Why is Secretary Paulson so interested in this? One might cynically think that it is part of what I have called the Treasury-Wall Street complex: is what is good for Goldman Sachs also good for the US and, what is more pertinent, for the world economy? I wonder.

Martin Wolf agrees:

Martin Wolf: Jagdish is right: too many US Treasury secretaries think they are secretary for Wall Street. It is a mistake, I think, even politically. It is certainly a narrow view of the US, let alone the global, interest.

Charles Wyplosz:

Charles Wyplosz: Martin makes two important points: China’s current surplus is driven by very high savings and the US cannot give orders ...

If savings is the problem, and it is, what good would a renminbi appreciation do? There are some theories that exchange rate appreciation can reduce saving, but the magnitude of the effect is, at best, minute. The inescapable conclusion is that we should stop pestering the Chinese with calls for appreciation and threats of designating them as currency manipulators... There is no doubt that the renminbi is not a free floating currency, but there is no international obligation to let all currencies float. Maybe the renminbi is somewhat undervalued, but that cannot be the ground for aggressive diplomacy. If it is undervalued..., all that will happen is real revaluation through inflation. Not a great idea, I agree, but that is China’s problem. Let them make that choice as an independent nation. ...

Much of this huge saving is invested locally, which largely explains one of the most spectacular growth performances mankind ever witnessed... Not all of it can be invested. ... So calling for Chinese firms to invest their savings is a bit disingenuous. Sure, the government could spend more, especially on infrastructure, health and social programmes. It is good to pass this sound advice to the Chinese authorities, but then it is for them to decide.

In the meantime, what can they do with this mass of savings that cannot be absorbed domestically? Invest abroad. Not in US Treasuries, but in profitable corporations. This is what they just set out to do with the creation of the State Investment Company...

Roland Vaubel adds:

Roland Vaubel: I agree with Martin that the Chinese are making a mistake. We do not know whether China is saving too much. But we do know that China is not investing its savings efficiently. The problem is not just that foreign exchange reserves are low yielding assets. The Chinese central bank prevents the country from importing capital on a net basis... However, an emerging economy like China ought to be a net capital importer. In particular, it should not export capital to capital-abundant countries like the US. It is this misallocation of the world capital stock which economists should be concerned about.

China’s policy of offsetting private capital imports with official capital exports may be viewed as an attempt to import foreign technology without importing foreign capital on a net basis. Is China’s accumulation of foreign exchange reserves merely the unwanted by-product of an export-oriented exchange rate policy? Is it not also the deliberate but misguided strategy of a proud but economically backward people to get hold of the technological achievements of the West without becoming indebted to and dependent on it? The Chinese, or more precisely their political leaders, want our technology but not our capital.

A small part of Andrew Smithers' comment:

Andrew Smithers: I agree with Martin that China is unlikely to accelerate the rise in its nominal exchange rate because of external pressure. I suspect, however, that this applies whether the forum for that pressure is bilateral discussions with the US or multilateral ones including the EU. ...

Ronald McKinnon:

Ronald McKinnon: Martin is wrong to emphasise one-sided saving adjustment by China - or, I would add, other high-saving Asian economies... Attempts at one-sided adjustment by East Asia will be frustrated unless American absorption falls relative to income, ie, net saving increases. This is not a theoretical proposition but comes from the balance of payments identity linking the national income accounts on both sides. ...

To be effective, any international agreement must be two-sided. The US agrees to reduce absorption by, say, raising taxes while the Asian countries do the reverse. Such an agreement may seem fanciful and unlikely, but it is the only way the global imbalance can be eliminated.

It would be a huge mistake to reach for the wrong variable, the exchange rate, to solve the saving imbalance. Exchange rate changes have no predictable effect on saving behaviour on either side. But exchange rate changes can still be very destabilising in a macroeconomic sense. ...

And, Brad Setser:

Brad Setser: I agree with the core of Martin Wolf’s policy recommendation: rather than holding the renminbi down and using policy to restrain domestic demand, China should allow the RMB to appreciate and take policy stems to stimulate domestic demand. ... So long as net exports are contributing so strongly to growth, stimulating domestic demand risks true overheating, so exchange rate adjustment seems to be a necessary part of the broader adjustment. ...

The argument that exchange rate changes won’t have an impact on savings/ investment gaps and thus won’t generate adjustment is an important one. However, my read of the recent evidence suggests a bit more grounds for optimism that Dr McKinnon's assessment. There do seem to be potential links between changes in exchange rates and changes in the savings and investment balance. ...

Given the scale of China’s direct financing of the US (...Chinese purchases of the US assets will finance about one-third of the United States savings deficit), there also seems to be a rather direct channel through which changes in China’s savings surplus would put pressure on the US to reduce its own savings deficit.

China and the Olympic Games: The Greatest National Coming-Out Party in History?

I hadn't realized the full significance of the 2008 Summer Olympic Games in Beijing:

China, the Olympic Games, and global leadership, by Orville Schell, Project Syndicate: The whole world, it seems, views China as the next great global power. A trip to Beijing does little to dispel that impression. Out of the welter of dust, noise, welders' sparks, flotillas of cement mixers and construction cranes, the setting for the 2008 Summer Olympic Games is taking shape. A visitor feels inconsequential in the chaotic vastness of this epic undertaking.

But looking down on the scene from the half-finished Morgan Center, the luxury apartment complex (where annual rents are $800,000) and seven-star hotel that is arising beside the Olympic site, one is awestruck not only by the project's grandeur, but by its design daring... China's leaders view the Olympics not only as a national celebration, but also as the greatest national coming-out party in history.

Feeling the Promethean energy unleashed in Beijing, it is easy to believe in China's aspirations to restore itself to a position of global wealth and power. ... But, to become a truly "great nation," China must make two great leaps. First, it must become more comfortable playing an active and constructive international role. China is now deeply involved in the world, especially the Third World, because of trade. But it maintains a 19th-century notion of sovereignty - namely, that a country's national territory, its leaders have an absolute right to do whatever they want without outside "interference." This view is not only out of step with international trends, but it also inhibits China from playing a useful role in world crises.

China's leaders fear that if they begin to pronounce on the domestic record of other nations, much less join in sanctions or United Nations peacekeeping missions, they will help establish a precedent that would allow others to intrude on domestic Chinese affairs. But the Chinese government has just had a wake-up call in Sudan, from which China imports 50 percent of its oil. After doing little to pressure Sudanese strongman Omar al-Bashir into admitting UN peacekeepers to stem the killing in Darfur, China suddenly found the promise of an unsullied Olympics at risk.

The actress Mia Farrow, for example, suggested that the 2008 Olympics might be remembered as "the genocide games." This got the Chinese leadership's attention. In a matter of days, an emissary was dispatched and Bashir relented. It was an important moment in China's evolution from a defensive to an offensive player on the international scene.

China's second challenge concerns its hybrid capitalist-Leninist system of governance, which may not function well enough without democratic feedback and the rule of law. Party leaders may not become sufficiently attuned to the needs of China's people to respond to problems like corruption, environmental degradation, or peasant unrest before crises make them unsolvable.

Although hardly democrats, President Hu Jintao and Premier Wen Jiabao already are expending large of amounts of time and resources on divisive social problems in the countryside, where ... income growth has lagged. Hu and Wen have cancelled national agricultural taxes, made rural schooling free, launched a new rural medical insurance plan, and guaranteed that, since there is still no title for holding private agricultural land, peasants are entitled to renew their long-term leases.

So China may be edging toward a whole new way of interacting with the world and dealing with its people; its curious authoritarian capitalism may be inching toward some new, and possibly viable, model for long-term development. But, as Mao always noted, theory should not be confused with practice, and the sustainability of such a model remains untested. Indeed, no state run by a Communist Party has yet managed to reform itself sufficiently to modernize and develop successfully. In this, China is a both pioneer and a developmental curiosity.

What kind of nation China aspires to be, and where it is ultimately headed, is still something of a conundrum. ... Beneath the surface are many threatening cracks. But to drive past the Olympic Green in Beijing will help make many Chinese believe that perhaps the center will hold in this unprecedented and unusual experiment of nation building.

I wish I had a better sense of how the geopolitics of an emerging China will play out.

Jeffrey Sachs: China's Lessons for the World Bank

Jeff Sachs says the World Bank needs to learn the lessons provided by China's approach to economic development:

China's lessons for the World Bank, by Jeffrey Sachs, Project Syndicate: The China Daily recently ran a front-page story recounting how Paul Wolfowitz used threats and vulgarities to pressure senior World Bank staff. ... At the same time, while the Wolfowitz scandal unfolded, China was playing host to the Africa Development Bank (ADB)... This is a vivid metaphor for today's world: while the World Bank is caught up in corruption and controversy, China skilfully raises its geopolitical profile in the developing world.

China's rising power is, of course, based heavily on its remarkable economic success. ... I had the chance to participate in high-level meetings between Chinese and African officials at the ADB meetings. The advice that the African leaders received from their Chinese counterparts was sound, and much more practical than what they typically get from the World Bank.

Chinese officials stressed the crucial role of public investments, especially in agriculture and infrastructure, to lay the basis for private-sector-led growth. In a hungry and poor rural economy, as China was in the 1970s and as most of Africa is today, a key starting point is to raise farm productivity. Peasant farmers need the benefits of fertiliser, irrigation, and high-yield seeds, all of which were a core part of China's economic takeoff.

Two other critical investments are also needed: roads and electricity... Farmers might be able to increase their output, but it won't be able to reach the cities, and the cities won't be able to provide the countryside with inputs. The officials stressed how the government has taken pains to ensure that the power grid and transportation network reaches every village in China.

Of course, the African leaders were most appreciative of the next message: China is prepared to help Africa in substantial ways in agriculture, roads, power, health, and education. And the African leaders already know that this is not an empty boast. All over Africa, China is financing and constructing basic infrastructure. During the meeting, the Chinese leaders emphasised their readiness to support agricultural research as well. They described new high-yield rice varieties, which they are prepared to share...

All of this illustrates what is wrong with the World Bank, even aside from Wolfowitz's failed leadership. Unlike the Chinese, the bank has too often forgotten the most basic lessons of development, preferring to lecture the poor and force them to privatise basic infrastructure, rather than to help the poor to invest in infrastructure and other crucial sectors.

The bank's failures began in the early 1980s, when, under the ideological sway of President Ronald Reagan and prime minister Margaret Thatcher, it tried to get Africa and other poor regions to cut back or close down government investments and services. For 25 years, the bank tried to get governments out of agriculture, leaving impoverished peasants to fend for themselves. The result has been a disaster in Africa... The bank also pushed for privatisation of national health systems, water utilities, and road and power networks, and grossly underfinanced these critical sectors.

This extreme free-market ideology, also called "structural adjustment", went against the practical lessons of development successes in China and the rest of Asia. Practical development strategy recognises that public investments - in agriculture, health, education, and infrastructure - are necessary complements to private investments. The World Bank has instead wrongly seen such vital public investments as an enemy of private-sector development.

Whenever the bank's extreme free-market ideology failed, it has blamed the poor for corruption, mismanagement, or lack of initiative. This was Wolfowitz's approach, too. Instead of focusing the bank's attention on helping the poorest countries to improve their infrastructure, he launched a crusade against corruption. Ironically, of course, his stance became untenable when his own misdeeds came to light. ...

The good news is that African governments are getting the message on how to spur economic growth, and are also getting crucial help from China and other partners that are less wedded to extreme free-market ideology than the World Bank. ...

The Wolfowitz debacle should be a wake-up call to the World Bank: it must no longer be controlled by ideology. If that happens, the bank can still do justice to the bold vision of a world of shared prosperity that prompted its creation after the second world war.

Update: Here are two related discussion from Dani Rodrik:

Can anyone be in favor of corruption?, by Dani Rodrik: I don't know, but I certainly am not. However, this is different from believing that corruption is the most serious problem facing developing countries. Many development newbies suffer from the corruption obsession, the view that anti-corruption policies ("governance reform") is the most direct route to achieving growth and equity. Wolfowitz  exhibited severe symptoms of this, and much of the commentary around his departure has been marked by a similar misunderstanding. ...

I am not sure that it is good policy for the Bank to prioritize corruption--as a rule--over other problems that developing nations face. As I have stressed in my work with Ricardo Hausmann and Andres Velasco, the binding constraint on growth differs from country to country. In some cases (Zimbabwe?), governance problems are indeed the most serious binding constraint. In many others, the problems lie elsewhere--in low savings, poorly functioning financial markets, low entrepreneurship, poor infrastructure, and myriad other syndromes of underdevelopment.

Let me make a bolder claim.  A development strategy that focused on anti-corruption in China would not have produced anything like the growth rate that this country has experienced since 1978, nor would it have resulted in 400 million plus fewer people in extreme poverty.   

More on corruption in China, by Dani Rodrik: I mentioned in a recent post that a single-minded pursuit of anti-corruption would have probably derailed high growth in China. Bert Hofman, who is the lead economist of the World Bank in Beijing, sent me the following comment, which I thought would be useful to share with everyone.

Sure enough, an anti-corruption strategy is not a development strategy, but not having the first may derail the latter. China is actually a case where rather stern action against corruption kept rent seeking in check, rents that were abound in a gradually reforming former centrally planned state.China's central party disciplinary inspection committee and State procoratorate are credible threats against corruption: last year, according to the Procurator Office, a total of more than 40,000 government employees (0.1 percent of total) were investigated for corruption, of which 29,000 were brought to court. Perhaps as important as the control of rent seeking has been the dissipation of some of the rents through decentralization, which gave investors at least some option to avoid predatory governments. Some of the rents that did accrue were officially condoned--e.g. by means of extrabudgetary funds, which depended largely on the entrepreneurial success of local  governments, and which were at least in part used for personnel emoluments.

Focus on Yuan "Misplaced and Counterproductive"

Matthew Slaughter, a member of the Council of Economic Advisers from 2005 to 2007, says we should quit focusing on China's exchange rate policy and focus instead on real problems.

Yuan Worries, by Matthew J. Slaughter, Commentary, WSJ:
Fact 1: China runs a large and growing trade surplus with the United States. ... Fact 2: China focuses its monetary policy on fixing the exchange value of its currency, the yuan, relative to the U.S. dollar.

Many policymakers and pundits connect these two facts by asserting that an unfairly low value of the dollar-yuan peg is causing the massive bilateral trade imbalance. ... These misgivings about the dollar-yuan peg are misplaced. Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Like all other central banks, the People's Bank of China uses its monopoly power over minting its money to control one nominal price. Since 1994 the PBOC has chosen to closely target the dollar-yuan price. In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet.

Many central banks today use their sovereign power to fix a nominal short-term interest rate rather than a nominal exchange rate. The U.S. Federal Reserve targets the federal-funds rate; the European Central Bank targets the main refinancing operations rate; and the Bank of Japan targets the overnight call rate. But exchange-rate targets are by no means uncommon..., in 2005, 55.6% of the world's countries fixed their exchange rates. ...

To select a policy target, each central bank must evaluate how alternatives might (or might not) influence its monetary-policy goals. Chinese capital markets today lack many of the microeconomic institutions that transmit changes in short-term interest rates into the broader economy... This may well be one reason the PBOC maintains its exchange-rate target: An interest-rate target might weaken its linkages to the real economy. And just like other central banks, the PBOC has been adjusting its target nominal price gradually, without dramatic changes that can have adverse short-run impacts.

But hasn't the nominal dollar-yuan peg unfairly driven the long-run rise in trade imbalances? No. The exchange rate that matters for trade flows is the real exchange rate... Supply-and-demand pressures in international markets can, and do, alter ... the real exchange rate...

To demonstrate this critical point, look to Europe. The yuan floats against European currencies such as the euro and the pound. If nominal exchange rates were driving trade flows as commonly alleged, then Chinese exports to the U.S. should have been growing faster than to Europe. The data show something completely different... Plotted together over that entire decade, these two series look nearly identical. This is because the same real economic forces -- e.g., China's relative abundance of less-skilled labor -- have been driving both sets of trade flows.

Put it this way: In a counter-factual world where over the past decade China allowed the yuan to float against the dollar, the U.S. would still have run a large and growing trade deficit with China. The real economic forces of comparative advantage that drive trade flows operate regardless of which nominal prices central banks choose to fix.

This week the U.S. government hosts Chinese officials for the second round of the Strategic Economic Dialogue. ... In China, further capital-market reform is needed to support economic growth... Here at home, the large aggregate gains the U.S. has realized from freer trade and investment with China have also generated hardship, too. Many American workers, firms and communities have been hurt, not helped, by Chinese competition.

Issues like these are legitimate and real. But focusing on the dollar-yuan peg is a misplaced and counterproductive way to address them. ... Stop fixating on the fix.

I think this is right. Devoting lots of time, energy, and political capital to China's interest peg policy is not an effective use of our policy resources. Even if we are successful at beating down the peg, not much will be gained and there are other more pressing issues to worry about.

Update: knzn says Aaaargh!!!

Aaaargh!!! (Slaughter on China), by knzn: Why do economists writing about China pretend not to know the difference between sterilized and non-sterilized intervention? We’ve been through this before, but the latest case in point is Matthew Slaughter, writing in the Wall Street Journal (and cited uncritically by Greg Mankiw and Mark Thoma)...

Update: Brad Delong has even more comments critical of Slaughter's analysis. I don't disagree with the critiques, but I don't want to debate this too much because it will make it seem as though this is important for workers.  It's not - it might help a little, but this is not where I'd focus political energy (though Brad is worried about a slightly different issue, the source of imbalances and the potential for growing imbalances to unwind quickly). If the administration is successful and China does amend its currency policy, it may get more credit for helping workers than is due. I still believe (as I said above) that forcing China to change this policy will not do much to help American workers. Here's Paul Krugman on that point:

Fixing Our Economy By Fixing Up Our Workers, by Paul Krugman, Money Talks: ...The pressure from China is greater because of the undervalued yuan. However, even with a big rise in China's currency, wages there would still be only 4 percent of U.S. levels, so currency issues are only a small part of the story.

Update: David Altig says, in conclusion to a longer post analyzing this issue, that:

I may be completely misinterpreting things, but it seems to me that the point is simply that the peg alone cannot be the biggest issue in the discussion.  I guess the disagreement here may be that the Slaughter piece puts more emphasis on the strains that trade-related adjustments in resource allocation inevitably bring, while pgl (and DeLong and knzn, I guess) are more concerned about distortions in resource allocation associated with questionable trade restrictions, capital controls, bad economic policy in the U.S., and so on.  Fair enough. But none of that is about the yuan peg per se, and I think Matthew Slaughter was right to say so.

Is China One of the War's Winners?

This discusses the rise of China as an alternative to the U.S. as an economic and political model. [I'm about to go on a long road trip, so I don't have time to do much with this - I'll have to leave that to comments. That's also true of the two posts that follow on Iraq vs. Vietnam and on assortative marriage, both of which were also put up rather quickly]:

A Shining Model of Wealth Without Liberty, by James Mann, Commentary, Washington Post: The Iraq war isn't over, but one thing's already clear: China won.

As the United States has been bleeding popularity and influence around the world, China has been gaining both. That's largely because it has been coming into its own as the first full-blown alternative since the end of the Cold War to Washington's model of free markets and democracy. ...

For authoritarian leaders around the world seeking to maintain their grip on power, China increasingly serves as a blueprint. We're used to thinking of China as an economic miracle, but it's also becoming a political model. Beijing has shown dictators that they don't have to choose between power and profit; they can have both. ... And the result is ominous for the cause of freedom around the world. China's single-party state offers continuing hope not only to such largely isolated dictatorships as Burma, Zimbabwe, Syria and North Korea but also to some key U.S. friends who themselves resist calls for democracy (say, Egypt or Pakistan) and to our neighbors in Cuba and Venezuela.

The China model has emerged from the confluence of two independent developments over the past decade. Each stands on its own, yet the interaction between the two has been especially toxic for democratic values.

First has been the failure of U.S. foreign policy, symbolized above all by the war in Iraq. Over the past decade, U.S. foreign policy has been dominated by a school of thought that emphasizes military power and has tied the spread of democracy to the use of force. Not only has this failed, it has also undermined support for democracy. U.S. attempts to export free markets and political liberty by force have ... eroded our appeal and clout worldwide.

The second key development has been the staying power and economic success of the Chinese Communist Party. In the years immediately after the crackdown on pro-democracy protesters around Tiananmen Square on June 4, 1989, Western pundits predicted that the Chinese government had one foot on a banana peel. ... Instead, China's economy expanded by a factor of nine, and the Communist Party remains firmly in control. ...

China's stability has belied the hopes and forecasts of Western leaders that growing prosperity would significantly alter the country's one-party political system. Over the past decade, presidents, prime ministers and others have frequently offered a soothing scenario about how China will inexorably move toward freedom and democracy. ... Not quite.

The optimists assume that once a country becomes more affluent, its emerging middle class will press for democratic change. But in China, the middle class (itself still tiny as a proportion of the overall population) supports or at least goes along with the existing political order; after all, that order made it middle class in the first place. The ruling party allows urban elites the freedom to wear and buy what they want, to see the world, to have affairs, to invest and to profit mightily; in return, the elites don't challenge the Communist Party's hold on power. Moreover, China's new business community is hardly independent of the party; in effect, it is the party, linked to China's power structure through financial connections or family ties.

In economic terms, China doesn't fit into the standard model of a free-market system, either. American magazines and television programs have for years joyously proclaimed that China has "gone capitalist" -- a supposed sign (along with the proliferation of McDonald's, Kentucky Fried Chicken and Starbucks) that the Chinese are becoming like us. In fact, the fast-growing economic system that China is developing is quite different from the American model -- a fact not lost on other countries. ... China has ... been so good at attracting outside investment and fueling economic growth that the German magazine Der Spiegel recently asked, "Does Communism Work After All?"

Of course, the Chinese model doesn't really work for, say, Burma; China is unique because of its sheer size and the allure of its massive markets, which no other country can match. Still, repressive regimes elsewhere are increasingly looking to Beijing. And often the sympathy flows both ways: China has, in recent years, helped to prop up Zimbabwe, Sudan, Uzbekistan, Cuba and North Korea.

So what can U.S. leaders do to turn things around? The most important change is a conceptual one. We need to get beyond the arid framework of seeing every policy dispute involving China as a choice between "engagement" and "isolation." Those loaded words set up a false selection and have little meaning anymore, if they ever did. With the third-biggest trading economy in the world, China is already engaged.

We also need to get beyond the notion that our trade, investment and interaction with China are going to transform its political system. Any serious policy must be based on China as it is, not on our mistaken assumption that prosperity and liberty inevitably go hand in hand. Trade and investment should be evaluated for their economic costs and benefits to the United States, not for their political impact on China. ...

Above all, we should approach China through the lens of our national interest. That includes not just security and prosperity but our interest in a world with open political systems and the freedom to dissent. If we don't take China's new model as seriously as the rest of the world does, we could find that we're the ones on the wrong side of history.

Robert Samuelson: China's Trade Time Bomb

I'm weary of the free-trade argument today. If you're so inclined, have at it - I'm going to sit this one out:

China's Trade Time Bomb by Robert J. Samuelson, Commentary, Washington Post: It sometimes seems as if almost everything we buy comes from China: DVD players, computers, shoes, toys, socks. This is, of course, a myth. In 2006, imports from China totaled $288 billion, about 16 percent of all U.S. imports and equal to only 2 percent of America's $13.2 trillion economic output (gross domestic product). Does that mean we don't have a trade problem with China? Not exactly.

China is already the world's third-largest trading nation and seems destined to become the largest. On its present course, it threatens to wreck the entire post-World War II trading system. Constructed largely by the United States, that system has flourished because its benefits are widely shared. Since 1950, global trade has expanded by a factor of 25. By contrast, China's trade is mercantilist: It's designed to benefit China even if it harms its trading partners.

There's a huge gap in philosophy. By accident or design, China has embraced export-led economic growth. The centerpiece is a wildly undervalued exchange rate. ... The resulting competitive advantage props up exports, production and jobs. ...

Despite popular impressions, China's trade offensive hasn't yet seriously harmed most other economies. For example, ... that hasn't stymied job creation; the U.S. unemployment rate is 4.5 percent. And world economic growth has accelerated.

But what's been true in the past may not be true in the future. The huge U.S. trade deficits, fed by Americans' ravenous appetite for consumer goods and heavy borrowing against rising home values, stimulated economies elsewhere, including China's. Now that stimulus is fading as U.S. home prices weaken and consumers grow more cautious. For China to expand production, demand must come from its own consumers or other nations... There's the rub.

Update: PGL has lots more to say about this. As he says in an email, "OK, you outsourced that one to this Angrybear."

Capitalism and Democracy in China

George Will sounds a pessimistic note on the emergence of democracy in China:

Real Change In China?, by George F. Will, Commentary, Washington Post: The phrase "regime change" is associated with the doctrine of preventive war as applied to Iraq. But another sort of regime change has been the crux of U.S. policy toward China through most of the 35 years since President Richard Nixon's opening to that nation in 1972.

Since the Tiananmen Square massacre in 1989, the objective of U.S. policy has been ... the steady subversion of China's repressive regime. The cure for communism is supposed to be commerce with the capitalist world...

The theory, which is more than wishful thinking, is that capitalism ineluctably brings about an ever-broader dispersal of information and decision-making, and requires an ethic of trust and a legal regime of promise-keeping (contracts). Those who subscribe to this theory can take some comfort from China's recent strengthening of protections of private property, which gives a sphere of sovereignty to individuals whose appetite for sovereignty, once whetted, might become a demand for a politics of popular sovereignty.

But suppose this is not so. Suppose James Mann is right to dismiss all this as the Soothing Scenario. In his new book, ... Mann [argues] business and other advocates of the Soothing Scenario use what Mann calls "the lexicon of dismissal" to refute skeptics like him: Skeptics are being "provocative" when they engage in "China bashing" that reflects a "Cold War mentality." But although the theory is that "engagement" with China will change China, Mann wonders: Who is changing whom?

The Soothing Scenario says: Tyranny requires intellectual autarky and the conscription of the public's consciousness, which is impossible now that nations are porous to cellphones and the Internet. But Mann says companies such as Microsoft, Google and Yahoo are cooperating with the government's censorship and security monitoring.

Mann warns against "McDonald's triumphalism," the belief that because the Chinese increasingly eat like us, they are becoming like us. That is related to "the Starbucks fallacy" -- the hope that as the Chinese become accustomed to many choices of coffee, they will demand more political choices.

His most disturbing thesis is that "the newly enriched, Starbucks-sipping, apartment-buying, car-driving denizens" of the large cities that American visitors to China see will be not the vanguard of democracy but the opposition to it. There may be 300 million such denizens, but there are 1 billion mostly rural and very poor Chinese. Will the minority prospering economically under a Leninist regime think majority rule is in their interest?

Mann is rightly disdainful of many meretricious and economically motivated arguments that American elites offer for the Soothing Scenario. In his polemical mood, however, he probably underestimates the autonomous and transformative power of today's commercial culture. ...

I'm more hopeful for China than that. Here's more on this topic:

• Economics and Democracy: James Galbraith reviews two books on the link between economics and democracy:
• Capitalism and Democracy: Has capitalism planted the seeds of inevitable democracy in China?:Will China’s Capitalist Revolution Turn Democratic, by Minxin Pei, Project Syndicate: Communist China has experienced a monumental capitalist revolution in the last two decades ... But if ... you think that so much capitalist development must also have brought more democracy to China, think again.
• Does Capitalism Need Democracy to Survive?: Brad DeLong finds Robert Reich thinking more about China: China: Capitalism Doesn't Require Democracy : by Robert B. Reich

And, closely related:

• Econoblog: Is Democracy the Best Setting For Strong Economic Growth?: This WSJ Econoblog features Ed Glaeser and Daro