It's the Global Economy, Stupid

Forcing China to float its currency would jack up prices at Wal-Mart. Do we really want that?

The following is an "Ahead of the Curve" column published May 20, 2005 on SmartMoney.com, where Luskin is a Contributing Editor.

In case you're wondering what ignited the stock market on Tuesday afternoon, launching the next leg up in the quiet rally that's been underway for a month now, it was just a piece of paper. The Treasury Department released a bureaucratic memorandum declaring that China isn't manipulating its currency — at least not quite. That's all it took.

Treasury is required to produce such a document regularly, under a 1998 trade law. The purpose is to certify that America's trading partners are playing fair and square with their currencies, and not using them to gain unfair advantage in international trade. Many analysts, including me, were worried that Treasury would take this opportunity to brand China an international monetary criminal, thus encouraging the growing forces of protectionism in this country.

As I've written in this column before, one of the reasons the stock market has been in the doldrums this year has been the rising risk of protectionist legislation. There's almost nothing worse than protectionism for any nation's economy. When we restrict the flow of goods and services across our borders, we raise prices to our consumers, we shrink our export markets, and we turn our backs on the opportunity to partner with other nations that do some things better than we do.

The biggest protectionist risk right now is legislation introduced in the Senate last month by Charles Schumer (D-NY) and Lindsey Graham (R-SC). It would slap a 27.5% tax on all goods entering the US from China, unless China agrees to remove all restrictions on the free-market trading of its currency, the yuan.

Schumer and Graham think that China makes its export goods artificially cheap by keeping the yuan artificially cheap, too. The result, according to the senators, is that US industries that compete with China can't possibly compete, so American workers are losing their jobs.

Well, let's suppose the senators are right. I don't like to think that anyone has lost his or her job, but the reality is that competitive forces within the American economy and the global economy cause job losses to happen all the time. It's called progress.

Think of the millions of people who used to work in the typewriter industry who are unemployed today. Is there anyone who thinks there should be legislation to outlaw the personal computer just to help those people get their jobs back?

In the case of China, as far as I'm concerned, we should be encouraging them to manipulate their currency even more. Let's have the yuan be as cheap as possible. Think of the bargains at Wal-Mart! That's no joke. While some American workers may have lost their jobs to Chinese imports, American consumers have had a field day. Do we really want the price of everything made in China to go up by 27.5%?

Even if it that happened, it probably wouldn't create a single job in the US. If Wal-Mart can't buy garments either made in China or made from Chinese textiles, then it would probably end up getting them from Malaysia — not South Carolina. But either way, the American consumer will be forced to pay more. And when you're forced to pay more for garments at Wal-Mart, you don't have as much money left over for other things such as, say, going to the movies. So what's the point of this protectionism anyhow? To create new jobs in Malaysia and destroy jobs in Hollywood?

But setting all that inconvenient reality aside for a moment, are the protectionists right that China is manipulating its currency? No, they're dead wrong.

What would it mean for a country to manipulate its currency? Here's an example. Suppose a country was in a recession, so its central bank set interest rates at absurdly low levels, and then kept them there even when the economy started to recover. That would create inflation, which would dramatically lower the value of that country's currency on foreign-exchange markets, making that country's exports more attractive to importers in other countries.

Is China doing that? No. We're doing that. What I described is precisely what our Federal Reserve has done over the past three years.

All China is doing is maintaining a fixed exchange rate between the yuan and the dollar — exactly the same rate that it has maintained for over 10 years. It's sort of like the old gold standard, under which you could always exchange a fixed number of dollars for an ounce of gold. But instead of gold, the Chinese use the US dollar.

So how can they manipulate their currency? They can't. Their hands are tied! No matter what they try to do, a dollar will always exchange for 8.28 yuan.

So why are the protectionists so agitated? Because no matter what we do, no matter how cheap we try to make the dollar, the yuan just follows the dollar like a dog on a short leash.

If Treasury's memorandum had branded China a currency manipulator, the Schumer/Graham bill would be sure to pass. And who knows where that would lead? Who knows what retaliations would come from China, or what other countries that trade with China might do along the same lines, in order to stay competitive with us (by making the same self-destructive mistakes we make).

As it is, Treasury's report left the door open for branding China a currency manipulator in the near future. So this is only a reprieve, not a full pardon. The protectionist Sword of Damocles still hangs over our head, though it's a little further away than it was before Tuesday afternoon.

Hopefully China will tweak the way it manages its currency in some small and symbolic manner, just so it can be seen as "doing something." The Treasury's report gives them the breathing room to do that, and the dignity to appear to be doing it on their own initiative. Then Senators Schumer and Graham could claim credit, and the tide of protectionism would be turned back for at least another year or two.

When that plays out, the stock-market rally of the past month will accelerate yet again. Our esteemed senators may not know it, but the market does: China is an important partner in a prosperity that's now truly global. If we mess with China, we mess with prosperity — theirs and ours.

The problems with revaluation are outlined below. In short, revaluation may be a small part of the solution, but hardly the panacea for the trade deficit's ills.

The first problem is the US will simply import products from somewhere else, as Alan Greenspan noted on Friday. “So essentially what we will find is we are importing from a different area but we'll be importing the same goods," Greenspan said. (“from Reuter’s story Fed: No trade perk from China revaluation). This is a classic example of what product substitution, where purchasers will simply seek out the cheapest price for a good, regardless of the source. There is little to argue against this statement. All that is required is a single company to obtain a cost advantage from purchasing from another country, and all of that company’s competitors will have to follow suit in order to remain equally competitive.

The second problem will be an increase in import prices from China, which Greenspan also noted. “The effect will be a rise in domestic prices in the United States and as a consequence of that, we will have other impacts which I could trace through but I've fortunately run out of time in this question.” The reason is simple. Suppose a US company purchases a good that costs 8.2 Yuan for a dollar (which is the current exchange rate more or less). If the Yuan increases in value relative to the dollar, each dollar will purchase fewer Yuan. So, in our previous example, suppose the Yuan appreciates to 4.1 Yuan to the dollar. Now the company must use 2 dollars for the same product. The company will have to increase the prices it charges in the US to make-up for the higher exchange rate. As a result, US import prices from China will increase.

The third problem could be an increase in US interest rates. As the article “What do yuant from us?” from the Economist notes, “In order to maintain the peg, China is forced to buy loads of dollars, which are then dumped into US Treasury bonds, financing America’s hefty deficits. A sudden decline in Chinese demand for Treasuries would raise America’s borrowing costs, curbing Congress’s ability to dole out pork to constituents. Some economists fear that this would push interest rates up sharply enough to cause a sharp contraction in the debt markets (including the mortgages that are fuelling America’s housing boom) and the economy—though this is unlikely, since the Chinese government seems keen to ensure that any appreciation occurs gradually.” This is an extreme situation, and as the article points out, may not occur.

The final problem, notes the Economist is “China accounts for less than one-tenth of America’s trade, so even a 10% revaluation would only reduce the trade-weighted value of the dollar by 1%—not enough to produce any noticeable change in America’s current account.” The US has a trade imbalance with several countries, only one of which is China. In other words, China is part of the problem, but not the entire problem. However, because of the recent swelling of Chinese textile imports they are a convenient political target.

In short, Chinese revaluation may not be the panacea that politicians are selling it as. The relationship between the US and China is very complex, meaning a simple solution will probably not solve the problem. In fact, the tough talk from Washington may do more harm than good.

Hey Free Trader take a look at this

Statement for US-China Commission Hearing

May 19-20, 2005

Paul Craig Roberts

Offshore outsourcing is misunderstood by economists and policymakers. The phenomenon is misperceived as an extension of the mutual benefits of comparative advantage-based trade.

Comparative advantage has two necessary conditions, neither of which is met today. One condition is that capital is immobile internationally relative to traded goods. The other is that the trading countries have different opportunity costs of producing the traded goods. (The economic concept of opportunity cost is an in-kind measure; for example, the quantity of wine that is not produced in order to make a yard of cloth.)

The condition of capital immobility is required to insure that a country's capital seeks comparative advantage at home instead of absolute advantage abroad. Different internal cost ratios of producing one good in terms of another are necessary if low- and high-cost countries are to experience mutual gains from specializing and trading.

David Ricardo discovered comparative advantage when he investigated the question of why a country that could most cheaply produce all tradable goods would trade with a higher cost country.

Ricardo's answer is that the opportunity cost of producing one good in terms of the other was different in the two countries. He was able to show that total output would increase if each country specialized in the product in which it had relative advantage. He then showed that the increased output would be shared by the terms on which the countries would trade one product for the other.

In Ricardo's example, the different opportunity cost ratios of producing wine and cloth in the two countries are due to inherent differences in geography, climate and soil.

Modern production functions, however, are based on acquired knowledge. They operate the same in all countries. These production functions do not reflect country-specific inherent differences that result in different opportunity cost ratios on which comparative advantage depends.

When I point out that the conditions on which the case for free trade is based are no longer met in today's world, economists either evade the issue or drag red herrings across the path. They talk about shifts in the terms of trade, about productivity gains abroad, and about the pervasiveness of factor mobility even in Ricardo's time. They equate the rise of the high speed Internet and collapse of world socialism, which made vast quantities of cheap labor available to first world capital, with innovations such as lower transport costs that turned previously non-traded goods into traded goods.

None of these arguments engages the issue. Ricardo imposed the condition of relative capital immobility internationally in order that specialization according to comparative advantage could occur. Otherwise, a country's capital would flow to absolute advantage abroad. When US firms substitute foreign labor for domestic labor in their production for domestic markets, capital is flowing to absolute advantage.

Factor mobility from Ricardo's time to the recent advent of offshore outsourcing was qualitatively different. Foreign investment was a way to evade tariffs, quotas, and high transport costs. Foreign investment was not geared toward offshore production for home markets. Ford and GM produced cars in Europe to sell to Europeans, not to export to America.

Economists assume that offshore production for home markets is trade because the goods count as imports when they enter the US. But what is being traded when a US firm closes its American factory, lays off its American work force, moves its capital and technology offshore and uses foreign labor to produce the identical product for the same US markets? This is not trade in the traditional sense with one country specializing in cloth, the other in wine, and sharing the gains.

The old free trade argument that US labor has nothing to fear from cheap foreign labor, because US labor works with more capital and better technology no longer holds when US firms provide the same capital and technology to foreign labor. The international mobility of capital and technology and the advent of production functions that operate the same regardless of location mean first world labor will be displaced in tradable goods and services until there is a global equalization of wages and living standards.

Indeed, one reason the facts of offshore outsourcing are evaded by so many economists is that they look with favor on the international redistribution of income and wealth that is occurring.

As the BLS payroll jobs statistics make clear,

the US has ceased to create jobs in tradable goods and services. The higher productivity, higher value-added jobs that provide upward mobility are missing from the data. Our most prestigious engineering schools report a marked decline in enrollments in computer and electrical engineering. Business Week magazine reports that US firms are now outsourcing R&D, design and innovation.

As I report each month following the BLS release, so far in the 21st century the US economy has been able to create jobs only in domestic nontradable services. Independent studies by economists at Northeastern University (reported in The Boston Globe by Charles Stein, Feb. 20, 2005) and by Edwin S. Rubenstein conclude that most of the new jobs in domestic services have gone to new legal and illegal immigrants. If these studies are correct, employment growth of native-born Americans has ceased in the 21st century.

In the 21st century, the US labor force has been acquiring the complexion of a third world country, with new jobs available only in domestic services. In contrast, China and India are acquiring high tech manufacturing and professional service jobs, the mark of first world countries.

How does the US gain from inability to create jobs in export and import-competitive goods and services?

How do Americans gain from the loss of the jobs, careers, and incomes associated with the production of the goods and services that they consume?

How do US firms gain, beyond the short-run advantage of CEO bonuses and share prices based on quarterly performance, from becoming brand names with a sales force marketing foreign made goods?

How does America as a whole gain when the US pays for the cheap foreign labor contained in the offshored goods and services (a major component of the rising trade deficit) a second time by handing over to foreigners more of its existing stock of assets? The "cheap Wal-Mart goods" are not cheap when properly measured.

How do US universities gain when there are no payoffs to a university degree? The BLS estimates that the vast majority of the new jobs that the economy is expected to create during the next ten years require no university education.

Where is patriotism when politicians turn a blind eye to the decimation of opportunity for native-born citizens.

What is the state of economic education in the US when economists cannot comprehend the reality that confronts them?

Economists are not even aware of the latest and most important work in international trade. In 2000 M.I.T. Press published Global Trade and Conflicting National Interests by Ralph E. Gomory and William J. Baumol. This important work, which does not directly address the offshore outsourcing issue, shows that the comparative advantage case for free trade is too unsophisticated to be correct even if its required conditions are met.

It will take economists a decade or longer to absorb this work. In the meantime, they are operating with a defective trade model that leads them to incorrect conclusions and disastrous policy advice.

Dr. Roberts has held a number of academic appointments and has contributed to numerous scholarly publications. He served as Assistant Secretary of the Treasury in the Reagan administration. His graduate economics education was at the University of Virginia, the University of California at Berkeley, and Oxford University.

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