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.

---

[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.

 

[Paul Ross]

I'm going to go out on a limb

In other words you can't see the forest for the trees.

I would surmise that is because you fall off out of your tree once too often!

[Toddsterpatriot]

After all the big talk about variance and standard deviation, that's all you've got? LOL!!

[LowCountryJoe]

I wonder, aloud, just how many standard deviations Mr. Ross is from the mean. When an uptick is a sign of weakness, when former CEA Chairman N. Gregory Mankiw's powerpoint clearly demonstrates how net exports are exactly equal to net capital outflow (as is the case in China with us), and when smoothing is needed to interpret a straightforward graph the proper protectionist way, I cannot imagine the standard errors and variances with Mr. Ross' thought processes.

[Toddsterpatriot]

I wonder, aloud, just how many standard deviations Mr. Ross is from the mean.

Poor Paul is from the anti-Lake Woebegone, where all the kids are below average. In his case, at least two standard deviations below average.

[1rudeboy]

I knocked almost $15 off my monthly phone bill by switching DSL carriers. How was I supposed to know that the difference was to be billed to jpsb?

[jpsb]

I am concidering going to Voice over IP, have you tried that? What do you think? Tomatovine has a very good deal at the moment.

[1rudeboy]

I heard that it has a tendency to drop-out at times, and you definitely need to have an alternate plan in place should you ever have the misfortune of needing to dial 911.

I will be experimenting with it myself in the next year or so.

[Paul Ross]

When an uptick is a sign of weakness

I never said that. You said it. You own it. LOL!

...when former CEA Chairman N. Gregory Mankiw's powerpoint clearly demonstrates how net exports are exactly equal to net capital outlfow (as is the case in China with us)...

Clearly you continue to misunderstand what Mankiw's ppt details. In fact, he is showing that GDP=C+I+G+NX.

So when Net Exports goes negative...GDP goes down. And that isn't the only thing.

So, Joe, if you subscribe to the theory that Net Capital Outflow = Net Exports , NCO=NX.... then you have to also accept Mankiw's claim that National Savings "S" = I + NCO (where I = Domestic Investment). Which means national savings "S" must also go down when NX (presumed equal to NCO) turns negative. There is no "requirement" either (as you previously opined) that "I" has to increase to balance the negative number.

Here is where I think you ran off the rails. Manckiw nowhere claims his equations have to maintain a static balance to maintain either savings or GDP. So a decline in savings results when NCO is reversed. Ergo, a trade imbalance is definitionally a dissavings... E.g., in plainer english... the country running a trade deficit loses national savings.

Capital inflow (Negative NCO) is not savings. In fact, it reduces it, and weakens our country. Your key misunderstanding and confusion.

I spotted your intellectual mistake a while back...you confuse net wealth for capital. It is not. Mankiw makes clear his position that it is merely additive to it...and in the case of a trade deficit, (negative NX) his equation, if prescriptive, means a Negative NCO...which subtracts from national savings...net wealth.

To try and further clarify Mankiw's equations, I would note that they are descriptive, not prescriptive. E.g., in the case of a negative NX, Capital inflow is not in fact, mandatory. It is, however, what is necessary for a balance to occur in the equation...but it doesn't have to be staticly balanced. It is a fluid, dynamic set of relationships...where any one variable is deformable...or discretionary. China, for example, doesn't have to buy our T-Bills...or any other debt instruments...nor do they have to buy any other assets of the U.S. All while merrily continuing to engage in a unilateral trade surplus against the U.S. [ Which according to Mankiw's equations directly increases their GDP, and Savings].

You previously evaded coming to grips with my posts and never responded to my earlier discovery that Mankiw explicitly observed in Image 19 and 20 that U.S. Domestic investment and national savings are collapsing with the trade deficit.

Explain those away. Your understanding of Mankiw's ppt was only partial...

And you have proved you don't know what you don't know. And that you are unwilling to learn.

[1rudeboy]

So when Net Exports goes negative...GDP goes down

If by "net exports going negative" you mean the trade deficit is increasing . . . the last time folks were howling about the trade deficit increasing was during the Reagan Administration, and our G.D.P. rose consistently and at a near constant rate during that period.

[Paul Ross]

...that's all you've got?

No, but it was all that was necessary to blow you out of your tree!

To celebrate your denoument...here is a blast from the past applying to your obvious source of inspiration...Bill Xlinton the prevaricator-in-chief:

George Washington's Story

(Weasel-word parsing. E.g., "If" after the Clinton years. Had Bill Clinton been George Washington...here is how one apocryphal story may have actually gone...)

Herein Released this morning for the first time is the complete transcript of the Cherry Tree Hearings.

"George?"

"Yes, father."

"George, I have a very serious question to ask you and I want you to promise you'll answer truthfully. Will you?"

"Yes, father."

"Good. now here is the question. Did you cut down my cherry tree?"

"No, father."

"You're quite sure?"

"Yes, father."

"Well, I'm afraid I'm very disappointed in you, George."

"Why, father?"

"Because 12 people saw you cut down the cherry tree with your little hatchet."

"Oh."

"In view of that, would you like to change your previous answer, George?"

"No, father. I believe the answer I gave you was legally accurate."

"You still insist you were telling me the truth?"

"In my own mind I was telling you the truth, yes father."

"What is that supposed to mean?"

"Well, you asked me if I had 'cut' down the tree. In my own mind, it seemed to me that 'cutting' is something one does with a knife or a sickle. In my own mind it seemed that , since I used my little hatchet, the relationship I had with the tree, while perhaps inappropriate, was not a 'cutting' relationship. I would call it a 'chopping' relationship."

"Very well. I'll give you another chance, George. Listen very carefully. Did you chop down my cherry tree?"

"No, father."

"No? No? Why do you still say no?"

"Because, father, I cannot tell a lie. And in my own mind I did not 'chop down' your cherry tree."

"Well, what did you do, then?"

"I chopped it into two pieces and one piece fell to the ground."

"So you chopped it down."

"No, father, I merely chopped it. I did not cause that piece to fall down. The force of gravity caused it to fall down. Were it not for the force of gravity, over which I have absolutely no control, the tree, though segmented, would presumably still be up, not down."

"George, I'm losing patience with you. But I'm going to give you one last chance to tell the truth. Did you take your little hatchet and chop my cherry tree, which action on your part, combined with the force of gravity, caused the tree to fall down?"

"No, father."

"NO? NO? IT'S STILL NO? HOW CAN YOU STILL SAY NO?"

"I still say no because of my legendary regard for the truth, father. What is that object at which I am pointing with my finger?"

"It's the stump of the cherry tree you cut down."

"And isn't the stump part of the tree, father?"

"It sure is."

"In fact, isn't the stump the most important part of the tree, father, since, without a stump there would be no tree?"

"I guess so."

"Yet the stump is still standing. So when you asked me if I had chopped down the tree, my own mind said to me, 'George, you must tell the truth. And the truthful answer is no. You chopped, gravity caused part of the tree to fall down yet the most important part of the tree is still standing.'"

"I see."

"All I can suppose, father, is that those 12 people whose exaggerated claims allege they saw me 'cut down' the entire 'tree' were motivated not by a search for truth, but by some personal vendetta against me, perhaps because I am from Virginia."

"George, you're a real crafty little guy."

"Thank you father."

"Have you thought about what you want to be when you grow up?"

"Yes, father. If they ever build a White House I would like to occupy it as the first White House lawyer."

[Paul Ross]

...the last time folks were howling about the trade deficit increasing was during the Reagan Administration

Typical of liberals. The ones who made the problem. And still cover for their screw-ups even today. Usually get the history wrong. Deliberately revisionist.

Reagan inherited a massively faltering economy that took basically four years to get turned around. The trade deficits were already in the process of balooning when he took office...he just was on the receiving end of the "kick off" that Jimmy Carter had left him.

...and our G.D.P. rose consistently and at a near constant rate during that period.

Note: Your position represents a contradiction of the prescriptive claims that LowCountryJoe makes for the ppt of his favorite economist...Manckiw.

It just shows that in multivariate situations that one sufficiently positive factor can dominate so as to compensate for other adverse factors. The huge resurgence of domestic investment via defense spending. These triggered massive collateral investment and productivity increases as industry disseminated their new defense technology into civilian applications...which also jumped with the new technology... The defense production contracts greased the skids... The DOD also provided a massive jump on R&D spending, and we are communicating via one outgrowth of that. The mulitiplier effects of manufacturing helped kick the economy into a higher gear...

Eventually the new products which were streaming out of the U.S. production plants were so world-beating that by the end of the Reagan administration, we had essentially eliminated the trade deficit...this despite still relying on OPEC for oil ...and we had a large trade surplus in fact in manufactured goods to help offset that expensive imbalance in energy imports.

[1rudeboy]

Note: Your position represents a contradiction of the prescriptive claims that LowCountryJoe makes for the ppt of his favorite economist....

Not a "position." Fact. Whether or not it contradicts LCJ is something you must take-up with him.

[1rudeboy]

Furthermore, if the situation is multivariate, which it obviously is, how can you justify a declarative statement such as "So when Net Exports goes negative...GDP goes down?"

[Paul Ross]

Not a "position." Fact.

Actually, as I mentioned, the trade deficit fell by the end of his administration.

As Steven Calabresi* wrote, Reagan Belongs On King's Row

Whether or not it contradicts LCJ is something you must take-up with him.

It's you contradicting him. I dispute the genesis and import of your purported facts.

FYI--Mr. Calabresi is a professor of law at Northwestern University and National Co-Chairman of the Federalist Society.

[hedgetrimmer]

For instance, the ports bid would have given control of security at several major U.S. ports to Dubai Ports World, which is owned by the UAE government. Democrats and Republicans alike attacked the Bush administration's approval of the deal since it would place national security interests in the hands of a foreign government that many in Congress labelled as being an unreliable partner in the war on terrorism.
-- Khaleej Times

A fact voceriferously denied by the "free traders".

[Paul Ross]

Furthermore, if the situation is multivariate, which it obviously is, how can you justify a declarative statement such as "So when Net Exports goes negative...GDP goes down?"

So glad you asked that. I was pointing to lowjoe the impact on his much-beloved equations from Manckiw.

That was a hypothetical discussion (in part, except where Manckiw actually looks at charts showing the dramatic increases in the trade deficit).

We were discussing what follows by way of impact on the other side of the 'equation' from a change of one particular variable if you control for the others. LCJ keeps saying everything is all right with massive trade deficits, or Negative NX. Manckiw is most definitely not able to agree with that. National Savings, "S" (net wealth), and GDP (net income) both are adversely impacted.

[1rudeboy]

Source:

[1rudeboy]

Sorry, I accidentally pulled a hedgetrimmer.

Source: Cato

[Paul Ross]

Khaleej Times
A fact voceriferously denied by the "free traders".

I have been noting that the Indian Press overall was far more approving of security concerns taking precedence over commerce than was Wall Street.

Wall Street has some 'splainin to do to us Main Streeters.

[hedgetrimmer]

Khaleej Times