China's Economic Invasion: One Year Later

The Heritage Foundation ^ | 18. April 2006 | Tim Kane, Ph.D., Marc Miles, Ph.D., and Anthony Kim

[1rudeboy]

One year ago, the chorus of the consensus told America that the dollar’s exchange rate was due to fall in 2005. Under relentless assault from cheap Chinese imports and facing a record trade deficit, the dollar had nowhere to go but down. The influential Economist magazine went so far as to say, “[t]he deficit is unsustainable: sooner or later it will need to shrink, and that will involve a cheaper dollar.” Politicians and pundits predicted economic trauma at the hands of outsourcing. Time has proven them wrong. What the U.S. needed then and needs now is to stick to the reliable keys to growth: low tax rates, deregulation, limited government, and especially free trade.

 

A Dollar – Deficit Link?

The U.S. economy did set two records last year. First, 2005 saw a new record trade gap. Imports to the U.S. exceeded exports by $724 billion, or 5.8 percent of GDP. Second, more Americans were employed than ever before in history, arguing against those who preached doom and gloom.

 

The data continue to support our contention of last May that the trade deficit is not the signal to watch: “This is all wrong... Many economists and the weight of history suggest that the trade deficit, a symptom of investment capital inflows, is a sign of national economic strength.”[1]  Additionally, two papers published last spring pointed out the lack of a historical relationship between currency values and trade deficits.[2] Indeed, despite the widening trade gap, the dollar gained value against other currencies.

 

 

The January 5, 2006, Economist admits that the dollar pessimists “were all wrong.” Yet the conventional wisdom of “trade hawks” is again resurgent, arguing that trade deficits are unsustainable and the dollar cannot hold. Last week, the government reported the third deepest trade gap on record, with imports outweighing exports by $65.7 billion. Current exchange rates, however, appear normal compared with exchange rates over the last few decades.

 

Unless Congress moves from protectionist rhetoric to protectionist legislation, there is no reason to expect the dollar to slide significantly. Trade flows are the “tail of the dog,” as Fed Chairman Ben Bernanke once explained. From time to time the dollar does fall when the world’s investors lose confidence in the superiority of America’s institutions and markets. Sadly, congressional hostility to the U.A.E. port deal was a bipartisan embarrassment and isn’t likely to reassure the world that America is as free and fair as it proclaims. Equally troubling is the Schumer-Graham proposal in the U.S. Senate to place trade barriers on imports from China.

 

The Chinese Invasion

According to the last week’s data from the Department of Commerce, the U.S. trade deficit with China was $13.8 billion in February. In 2005, the U.S. trade deficit with China grew by 25 percent to $202 billion. That amounts to nearly twice the $103 billion bilateral deficit in 2002. The ratio of imports to exports with China is now 5 to 1, perfect for the “Chinese invasion” storyline. The U.S.-China deficit’s growth probably won’t continue, but not because it can’t. Consider these points:

• Mathematically, trade flows are balanced by investment flows. The bigger the trade deficit, the more capital flowing into the U.S. Chinese and other foreign investors prefer to trade their goods for America’s equity and debt. America is seen as the safest, surest investment bet in the world. That’s bad news?

• Realistically, trade represents voluntary exchange. Any “imbalance” is voluntary. As with trade between a consumer and a retailer at the local mall, the two consenting parties each benefit from the voluntary trade of goods for currency.

• Empirically, record trade deficits have coincided with positive economic news in the U.S.: record levels of employment, low unemployment rates, rising pay, and fast GDP growth. The argument that this is a debt-driven party is far less credible than the argument that imports are as economically valuable as exports.

• Pragmatically, much of the trade deficit with China represents re-importation by U.S. firms with factories overseas, such as General Motors, Motorola, and Boeing. Parts leave the U.S. and come back as more valuable assembled products. A 2005 National Bureau of Economic Research study[3]  reported that 90 percent of U.S. exports and imports flow through U.S. multi-national companies, with 50 percent flowing within a single firm. The lesson for Congress is that American companies, not just China, will be injured by protectionism.

We should cheer the triumph of capitalism and its alleviation of poverty within China, as well as its benefits for American consumers and shareholders. The only point of debate is whether American workers’ wages are suffering due to trade with China, but there is no clear evidence of wages “racing to the bottom.” Instead, China is experiencing a severe labor shortage that is driving wages up rapidly in a “race to the top”—the level of free-market workers.

 

The real dangers to America are not free trade or China’s currency. That’s not to say there aren’t smart policies that should be taken to curb abuses of fair trade, rather that protectionism and currency haggling aren’t part of the smart mix. The real danger is that Congress will try to fix what is not broken and adopt a mercantilist policy of import limitation. Congress would do well to stick to the reliable keys to growth spelled out in The Heritage Foundation’s Index of Economic Freedom: strong property rights, low tax rates, low regulation, limited government, and especially free trade.

 

Tim Kane, Ph.D., is Director of, Marc Miles, Ph.D., is Senior Fellow in, and Anthony Kim is Research Associate in, the Center for International Trade and Economics at The Heritage Foundation.

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[1] Tim Kane, “The Brutal Price of a Dollar,” Heritage Foundation Backgrounder No. 1855, May 31, 2005, at http://www.heritage.org/Research/TradeandForeignAid/bg1855.cfm.

[2] See Ibid. and Tim Kane and Marc Miles, “Trade Deficits, Dollars, and China: Wrong Lessons Make Dangerous Policy,” Heritage Foundation WebMemo No. 743, May 12, 2005, at http://www.heritage.org/Research/Economy/wm743.cfm.

[3] A.B. Bernard, J.B. Jensen, and P.K. Schott, "Importers, Exporters and Multinationals: A Portrait of the Firms in the U.S. that Trade Goods," NBER Working Paper No. 11404, June 2005.

 

[ran15]

Yes as long as more foreigners want to invest in America, then Americans investing abroad we will run a trade deficit. People who want to eliminate our trade deficit would also eliminate the capital inflow to America.

And capital is what it takes to develop economically. In America even a longshot venture often can get funding. This is an engine of growth, as some of these make it and become the next google. Our main limitation relative to the world in my opinion is skilled labour. Which we could bring in much, much more legally if we wanted.

[LowCountryJoe]

Look Mr. Ross, at what I wrote on a thread from days long past:

Yes, and in spite of NX working against GDP (or Y), the I increases, as does the C, to the point where it offsets and, in fact, eclipses the drag that the negative NX created. That's the whole point of this study that I keep dragging out and that you keep failing to read. That's the reason why people trade with one another...to make themselves better off. They do not trade with one another to, as you believe, make themselves worse off. Yet that's the stupid argument that you keep trying to debate and I, and others, keep telling you that you're incorrect.

Did I ever claim that "I" alone offsets "NX"? No, because I believe that I wrote that "I" and "C" increased to offset and exceed the drain that the "NX" created.

Want more evidence that you'll either never check into [or, if you did, still fail to understand]? Look at this table from the BEA. Manipulate the data by selecting the "annual" option and by checking "get all years". Pay close attention to relationships in lines #6, #13, #2, and then finally #1. Now, you may suggest that #1 grows (and would grow) in spite of the drag created from #13, which is a fair enough proposition from someone who too challenged to see the real costs (opportunity costs) in any situation that stares them in the face. But then what do you say about the Griswold study (partially inspired by my data on the relationship between trade deficits and GDP which you've read at least a couple of times now but have only admitted to recently).

But, don't just look at this empirically. Let's look at it from a gut-check perspective. Let's do as you enjoy doing and look at this thing anecdotally. In this bit of folly, go back to the last little bit of blurb in the block quote - the reason why people trade with each other and then explain that one away.

[LowCountryJoe]

Capital inflow (Negative NCO) is not savings.

True!

In fact, it reduces it, and weakens our country. Your key misunderstanding and confusion.

Really, it weakens our country? Then why would you also complain if capital were to flow the other way? If Americans started buying Chinese debt and the domestic market started to hemorrhage jobs because growth started to slow because the "I" and "C" decreased. Maybe you wouldn't complain...maybe you'd enjoy seeing America's prosperity take a hit. No matter, I'm sure that you'd find something else to prattle on about without fully understanding the subject matter at hand.

[Toddsterpatriot]

Want more evidence that you'll either never check into [or, if you did, still fail to understand]?

You still don't understand how Paul operates, do you? First, he'll post a chart that shows there is no relationship between higher trade deficits and a weaker dollar. Then, when his obvious confusion is pointed out, he'll say things like, "It just shows that in multivariate situations that one sufficiently positive factor can dominate so as to compensate for other adverse factors", to make it sound like he was correct when he misread the chart.

I guess multivariate situations can turn a lack of a relationship into a relationship. Maybe if Paul understood that a third variable, besides trade deficit and exchange rate, is the desirability of investing in America, he wouldn't make such silly mistakes?

Willie Green was similarly blind when it came to looking at all the variables in the GDP equation. It must be something in the brain of a protectionist that makes them so easily distracted. They're probably a great audience for a magician (Paul Craig Roberts, Pat Buchanan, etc.) because they always look at the hand the magician waves up in the air, while he pulls a handkerchief out of his pocket with the other hand.

It's easier for them to be amazed by the illusion than to think and see the truth. Easier for them to point and yell, "Traitor, you bought goods from country XYZ", than to realize than trade benefits the buyer and the seller.

[Paul Ross]

Dated and obsolete view of China's trade posture. Actually they had net trade surplus against the world of $100 billion last year, as noted in Asia Times of March 31, 2006:

Critics of Beijing's existing currency policy note that an artificially low yuan has allowed China's overall trade surplus to explode, reaching $102 billion in 2005. Some leading global economists have estimated that this year's trade surplus will reach between $100 billion and $110 billion. A surplus this year would contribute to China's enormous foreign-exchange reserves, pushing them well over the $1 trillion mark and past the current world leader, Japan

[Paul Ross]

You cannot show that C or I increases as a result of the massively negative NX. There are multivariate factors you don't recognize. And then to prove your point...you fail utterly.

Here again you show you fail to comprehend who and what your evidence is, and its limitations.

First, it wasn't a 'study'. Repeat: Daniel Griswold did not produce a "study". He basically did an opinion piece with highly select components that he construed to bolster his casuist assertions. Assertions that support his own skewed indifference to trade deficits.

That is what he is paid to produce. And when you look at his selections, you start seeing gaping misrepresentations. Garbage in, garbage out.

Griswold's conclusions don't apply as generic economic principals as you and he infers. I.e., trade deficits don't produce net increases Consumption and Income. Nor does the opposite, trade surpluses mean a decline in GDP. E.g., contrarily to Griswold, China runs a whopping trade surplus. And its economic growth rate smashes past the U.S. rate of growth. No connection there?

The common sense conclusion is that we have been able to grow IN SPITE of our subsidy of China's growth.

Griswold's universe is bounded by any excuse, absolutely any, that casts our monstrous trade deficit in minimalist hues.

Clearly the lack of understanding is on the apologists for the deficit's.

[Toddsterpatriot]

E.g., contrarily to Griswold, China runs a whopping trade surplus. And its economic growth rate smashes past the U.S. rate of growth. No connection there?

Germany and Japan also run a whopping trade surplus. If you look at their rate of growth it is much lower than the U.S. rate of growth. Sounds like another example of you seeing a relationship where one does not exist.

[A. Pole]

If by "investment" we mean buying already existing assets and lending on interest it is BAD NEWS!

I don't know how it worked in the Communist Poland of your childhood

At that time the Polish assets were not for sale. After privatization/piratization most of the valuable assets were sold to German or French corporations or even governments at fire sale prices.

Now Poland has capitalism without capital with profits going outside.

[Toddsterpatriot]

Now Poland has capitalism without capital with profits going outside.

That's good! I know that you think profit is evil. I wouldn't want Poland to be corrupted by the profit motive. Maybe they should bring back Communism, for the children.

[LowCountryJoe]

China subsiizes our growth. If one country saves while the other consumes, the saver is postponing their consumption until a later time. They save and the lend us money so that we can consume with it or expand with it. The more consumption, the higher the standard of living.

China is a positive NX overall but it is significantly reduced because she carries trade deficits with other countries that chip into the positive NX number. Much of China's growth can be attributed to them liberalizing their economy and going more toward the Hong Kong model of growth. When they liberalized their backward @$$ [I write it this way for fear that you'll go tattle to the moderator] economy they also experience (and continue to experience) the catch-up effect. These two factors at work are why China can have rapid growth rates in spite of the fact that their positive "NX" is lowering their potential "I" and "C" year after year while they're exporting their capital to us [remember Paul, NCO=NX].

Now, why do people trade with one another Paul?

[LowCountryJoe]

LMAO! Capitalism is bad - the non-value adding workers of the world our forced to disunite and carry their chains around looking for bleeding heart populists to help them get reattach.

[Paul Ross]

If you look at their rate of growth it is much lower than the U.S. rate of growth. Sounds like another example of you seeing a relationship where one does not exist.

Wrong. They also have a huge welfare state, unlike China, a drag that undermines their economies. The trade surplus is all that keeps them afloat. So it isn't that their is not a relationship...it is just that it is swamped by a multivariant situation that you remain blissfully...and willfully...oblivious to.

[Toddsterpatriot]

They also have a huge welfare state,

Japan has a huge welfare state? I don't suppose you have a link that backs up your assertion? If you cut and paste, try to keep it under 10,000 words. Thanks.

Are you still claiming that China's $1.8 trillion GDP means they're doing better than the U.S. with our $13 trillion GDP?

[Paul Ross]

China subsiizes our growth

Which growth would that be in the U.S.? Manufacturing? Obviously not. Profligate U.S. Federal Budgets? Obviously so. They are giving the drunk an extra drink. More poison. And it continues to subsidize the "hydraulic forces" of relocation of industries which is not yet complete.

Now, why do people trade with one another Paul?

What about industrial and technology usurpation do you not understand? We are handing them the basis of our superiority on a silver platter...and paying them for the privilege of their taking it.

[Paul Ross]

Japan has a huge welfare state?

Not in the sense of Sweden, but yes, they do a lot that is classified as welfare state promotional activity, with massive restrictions...and subsidies... that favor mom and pop stores, small agrarian farms, life-time employment etc. Note this study's (and its a real study, not like lowcountryjoes) conclusions:

The results of this study indicate that the low level of social inequality derived from the long-standing policies of the Jiminto governments to protect self employers and to invest in public works as well as the life-time employment practice of the Japanese firms. Such policies and practice could be implemented only because market-oriented social forces were dominant for a long time in the Japanese society. Since people had to take part in the labor market to get more equally treated, Japan exhibited the characteristics of the liberal welfare state.

[Toddsterpatriot]

Not in the sense of Sweden, but yes, they do a lot that is classified as welfare state promotional activity, with massive restrictions...and subsidies... that favor mom and pop stores, small agrarian farms, life-time employment etc.

So these activities undermine their economy? Then why do you and other protectionists want the US to do some of the same things?

Note this study's (and its a real study, not like lowcountryjoes) conclusions:

I think you've misinterpreted the conclusion of your "real" study.

Japan, notwithstanding its marvelous economic achievement, has remained a welfare laggard among advanced industrial democracies. Since Japan has lagged far behind other countries in welfare state development,

I read this as Japan has less of a welfare state. You want to take another swing or are you going to stick to your original conclusion?

You're still avoiding my question, do you think China's $1.8 trillion economy is better than our $13 trillion economy?

[Paul Ross]

So these activities undermine their economy? Then why do you and other protectionists want the US to do some of the same things?

Nope. Never did. Typical of you however, to constantly misstate what your opponent "wants." Do you even know how to be honest?

[Paul Ross]

... the long-standing policies of the Jiminto governments to protect self employers and to invest in public works as well as the life-time employment practice of the Japanese firms.

That is a welfare state. They are less overtly redistributionary with expenditures, but they are nonetheless a welfare state.

[Paul Ross]

You're still avoiding my question, do you think China's $1.8 trillion economy is better than our $13 trillion economy?

Gee, didn't you call it just a trillion dollar Chinese economy just a year or two ago?!

Maybe you want to take "another swing" at that?

[Mase]

I read this as Japan has less of a welfare state

You're just missing another one of the many multivariant systems that, apparently, are only visible to Paul. The rest of us know that Japan has little in the way of welfare state development despite Paul's pronouncements to the contrary. It seems the multivariant system has become Paul's standard defense and is invoked any time the facts have, yet again, proven him wrong.