Tag: trade deficit

Economists Ignore the Facts in Supporting Chinese Currency Legislation

The Chinese currency issue is in full bloom this week, as the House of Representatives passed the Currency Reform for Fair Trade Act of 2010 by a vote of 348-79 on Wednesday.  Though there is so much to criticize about the bill and about the layers upon layers of misinformation, myth, and subterfuge that brought us to this point, this post concerns the dubiousness of the bill’s central premise: that Yuan appreciation will significantly reduce the bilateral trade deficit.

That is the position of the Peterson Institute’s Fred Bergsten and Bill Cline.

The premise seems plausible enough.  At least, the economics textbooks tell us that as a nation’s currency appreciates, its people will consume more imports and foreigners will reduce consumption of that nation’s exports.  Hence, a stronger Yuan vis-à-vis the dollar would mean that the Chinese buy more from the United States and sell less to the United States, reducing the bilateral deficit.

But in March Cato published a short paper of mine titled “Appreciate This: Chinese Currency Rise Will Have a Negligible Effect on the Trade Deficit.”  The central argument of that paper was that our national obsession with the value of the Chinese currency is misplaced—a red herring, in fact.  I presented recent historical data showing that despite a 21 percent increase in the value of the Yuan between July 2005 and July 2008, the U.S. deficit with China increased from $202 billion to $268 billion, or by 33 percent.  U.S. exports to China increased (as would be expected) by $28 billion, but U.S. imports from China increased, as well (contrary to expectations based on the old textbooks), and by $94 billion, or 38.7 percent. 

In other words, in the face of a 21 percent increase in the Yuan’s value, the U.S. bilateral trade deficit with China increased by 33 percent—a fact that raises serious questions about the integrity of the testimony, discussion, and “debate” that preceded the House vote on Wednesday. 

How can the premise that Yuan appreciation will reduce the bilateral deficit still hold?  Why is so much credence given to economists with fancy models who project with certainty that an X% increase in the value of the Yuan will generate a Y% increase in economic growth, which will produce Z number of new jobs in the economy, when recent evidence plainly refutes those claims?  What is the value in holding hearings when conjecture matters more than fact?

Bergsten and Cline (in testimony and podcast, respectively) dismiss the counterintuitive relationship between currency and the trade deficit during 2005-2008 by suggesting that there is a long lag period to consider—two to three years, according to Bergsten; two years, according to Cline.  In other words, the impact on the trade deficit of Yuan appreciation in the period 2005-2008 would not be fully manifest until the period 2007-2010.  While lags are expected (economists speak of a J-curve effect that accounts for the process of adjustment to the new prices in both countries), a two- or three-year lag in an era of instant communications, cyberspace transactions, transnational production, and airtight supply chains is simply not credible.  It took only a matter of months for the financial meltdown in 2008 to spread to the real economy, which prompted an overnight crash in international trade volumes, as production orders were terminated, shutting down operations throughout supply chains across the globe.

The two- to three-year lag theory is convenient merely because it puts in play the data for 2009, when international trade tanked worldwide, and the Chinese global trade surplus and the U.S. deficit with China were cut in half.  If the two- to three-year lag theory were plausible, the U.S. trade deficit with China would be falling in 2010, not rising, as the steepest appreciation in the Yuan occurred in 2008.

There’s a more plausible theory than that.

In my paper, I went on to examine whether the increase in imports was attributable to American demand for Chinese goods being price inelastic.  In other words, if the price of Chinese goods to American consumers increased by 21 percent (on average) and Americans reduced their consumption of Chinese goods by less than 21 percent, then demand would be considered inelastic, the price effect would dominate, and total import value would rise (adding to the trade deficit).  There are plenty of reasons that American demand for Chinese goods is price inelastic including, most importantly, that there are limited substitutes for those goods.  Much of what Americans consume from China is not made in the United States anymore.  So facing limited alternatives, Americans are forced to absorb the higher prices (a fact that currency legislation supporters are undoubtedly unwilling to share with their constituents).  Of course, eventually American consumers might adjust their consumption habits (which speaks to the lag factor).

But closer examination of the data revealed something else.

The fact that a 21 percent increase in the value of the Yuan was met with a 38.7 percent increase in import value means that the quantity of Chinese imports demanded increased by nearly 15 percent after the price change.  Increased!  Higher prices being met with greater quantity demanded would seem to defy the law of demand.

So what happened?  Chinese exporters must have lowered their Yuan-denominated prices to keep their export prices steady. That would have been a completely rational response, enabled by the fact that Yuan appreciation reduces the cost of production for Chinese exporters—particularly those who rely on imported raw materials and components. According to a growing body of research, somewhere between one-third and one-half of the value of U.S. imports from China is actually Chinese value-added.  The other half to two-thirds reflects costs of material, labor, and overhead from other countries. China’s value-added operations still tend to be low-value manufacturing and assembly operations, thus most of the final value of Chinese exports was first imported into China.

Yuan appreciation not only bolsters the buying power of Chinese consumers, but it makes Chinese-based producers and assemblers more competitive because the relative prices of their imported inputs fall, reducing their costs of production. That reduction in cost can be passed on to foreign consumers in the form of lower export prices, which could mitigate entirely the intended effect of the currency adjustment, which is to reduce U.S. imports from China.

That process might very well explain what happened between 2005 and 2008, and is probably a reasonable indication of what to expect going forward.  Yet this elephant in the room continues to be wantonly ignored in the anlayses that push us toward provocative legislation.

It seems that the textbook discussion of currency and the trade account needs to be updated to account for the compelling facts of globalization.

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China Bill All about Saving Lawmakers’ Jobs

The House is expected to vote today on a bill that would allow U.S. companies to petition the Commerce Department for protective tariffs against imports from countries with “misaligned currencies.” Everybody knows the bill is aimed squarely at China.

Advocates of the legislation say it is about jobs, and they are partly right. The bill is about saving the jobs of incumbent lawmakers who are desperate to appear tough on China trade, which they blame for the loss of U.S. manufacturing jobs.

As my colleague Dan Ikenson and I have argued at length, in blog posts, op-eds, and longer studies,

Let’s hope cooler, wiser heads in the Senate and the White House save us from this election-season folly.

Media Feeds America’s Skepticism about Trade

As usual, Dan Griswold does an excellent job today correcting fallacies about trade and the trade deficit that continue to be perpetuated in the mainstream media (particularly at the Washington Post).  

I just want to add my two cents without belaboring any of Dan’s succinctly-made points.  (Besides, I’ve harped on and on and on and on and on about the problem of trade reporting this year.) It’s a shame that so much time and energy has to be diverted to cleaning up messes left by reporters and editors, who should know better by now.

The bottom line is that neither imports nor trade deficits cause U.S. job loss or slower economic growth.  If anything, the charts below (all compiled from BEA and BLS data) support the conclusion that imports and the trade deficit rise when the economy is growing and creating jobs, and they both fall when the economy is contracting and shedding jobs. 

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Is the Trade Gap to Blame for Slowing GDP Growth?

What had been a recurring story line buried in the business pages has now burst onto the front page: “Economic growth slowed by trade gap,” the Washington Post reports this morning in an above-the-fold headline.

The lead sets the stage for a story long on generalizations: “A widening U.S. trade deficit has become a substantial drag on economic growth as the country’s exports struggle to keep pace with the swelling sums that Americans are again spending on imported goods.”

The half truth in the story line is that exports fell by $2 billion in June compared to the month before, and that this has a negative effect on overall GDP growth. In our more globalized world, the rising wealth of our trading partners translates into more production in our own economy, and vice versa.

The fatal flaw of the story line (as I tackled recently here and at greater length here) is that it assumes that rising imports slow economic growth. That assumption, in turn, rests on a simplistic Keynesian view that if a portion of domestic demand is satisfied by spending on imports, that means less demand for domestically produced goods, thus less output and lower employment.

That view neglects the supply-side role of imports. More than half of what we import consists of goods consumed by producers—capital machinery, raw materials, parts and other intermediate inputs. Those imports help us produce more, not less. The Keynesian view also confuses cause and effect: Imports usually grow in response to RISING domestic demand. Consumers more eager to spend “swelling sums” on imports typically buy more domestically produced goods as well.

The bean counters at the Commerce Department “subtract” imports from GDP, not because those imports are a drag on growth, but to avoid double counting. If we want to count the number of widgets and other goods added to the economy in a quarter, we would obviously not count those that have been imported. But this does not mean the economy would have been that much larger if the widgets had not been imported.

The Post story adds to the misunderstanding by claiming: “At a basic level, trade deficits represent a loss of wealth for a country—money flowing abroad for goods and services produced elsewhere, supporting businesses and workers in other countries.”

This betrays a basic misunderstanding of wealth that Adam Smith exposed two centuries ago in The Wealth of Nations. Does wealth consist of money—pieces of green paper or blips on a computer or, in Smith’s day, bars of gold—or does it consist of the actual stuff that people produce to make their lives better, all those goods and services that we consume each year? Smith argued it was the latter. And in that case, a trade deficit at a basic level represents an inflow of wealth from the rest of the world—a cornucopia of cool stuff arriving everyday at our ports and stocking the shelves of our stores.

Of course, even if you think that dollars are the ultimate measure of wealth, obsession with the trade deficit ignores the fact that those dollars spent on imports quickly return to the United States. If they are not used to buy our goods and services, they are buying our assets—real estate, stocks, Treasury bonds, and so on. The “loss of wealth” supposedly represented by the trade deficit is almost exactly offset every year by a “gain of wealth” represented by the net inflow of dollars in the form of capital investment from the rest of the world.

Besides being wrong in its basic economics, making the trade deficit the scapegoat for slow growth poses a double danger for economic policy:

Danger no. 1 is that it tempts politicians to reach for the snake oil of protectionism to create jobs. If only we could stop the flood of imported goods, Americans would make more of those same goods themselves, creating millions of jobs. In reality, higher trade barriers impose a host of offsetting costs on the economy, resulting in lower output.

Danger no. 2 of blaming the trade deficit is that it diverts attention from policies that are far more plausible culprits in dampening growth. Politicians find it much easier to blame imported consumer goods from China for slower GDP growth than huge looming tax increases, expensive new health care mandates, a depressed housing sector, and a generally anti-business climate in Washington.

The trade gap should be the least of our worries.

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More Nonsense about the Trade Deficit

It has become conventional wisdom that a rising trade deficit is bad news for the economy. This week’s announcement of an expanding deficit in June prompted such headlines today as this one in the news pages of the Wall Street Journal: “Wider Trade Gap Signals Weak Growth.” As my colleague David Boaz blogged earlier today, the trade deficit is even blamed for daily swings in the stock market.

I’ve been studying and writing about the trade deficit for years, and devoted a whole chapter of my 2009 Cato book Mad about Trade to the subject, and I keep coming back to a basic question: If the trade deficit signals weak growth, why does the U.S. economy seem to perform so much better during periods when the trade deficit is growing, and so much worse when the trade deficit is shrinking?

Think back to the 1990s, the “goldilocks economy” when growth was strong, jobs plentiful, and inflation low. That was also a time of rising trade deficits. In fact, the trade gap grew for eight years in a row, rising from $77 billion in 1991 to $455 billion in 2000. In that same period, the unemployment rate dropped from 7.3 to 3.9 percent.

Again, in the middle of the George W. Bush presidency, the trade gap grew for five straight years, during a period when the economy expanded and the unemployment rate fell from 5.7 to 4.4 percent.

In contrast, the trade deficit invariably shrinks during periods of recession. The trade deficit fell by more than half from 2007 to 2009 as domestic demand and imports plunged and unemployment soared. Sagging domestic demand means fewer imports.

Of course, I’m not arguing that a bigger trade deficit stimulates the economy. I am arguing, contrary to the conventional wisdom reflected in this morning’s headlines, that an expanding trade deficit does not appear to be a drag on growth. In fact, the plain evidence is that an expanding trade deficit is more often than not a signal of stronger growth.

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Explaining Mr. Market

A banner Washington Post headline (page 11, print edition; slightly different online) reads:

Stocks plunge as trade deficit widens

Of course, they could have gone with

Stocks plunge as Linda McMahon wins Senate nomination

Or my favorite:

Stocks plunge as Cardinals sweep Reds

Since national trade deficits are not much more meaningful than baseball scores, it’s unlikely that this month’s report drove stocks down.

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The Letter Is Different, but the Spirit Still Lives

An update from my post yesterday about the bill to establish a Commission to End the Trade Deficit (now called the “Emergency Trade Deficit Commission”): apparently the bill that passed the House was different from the bill initially considered, and to which I linked (and commented). My apologies.

The bill that was passed had many of the most egregious provisions and provocative wording stripped out. There was no talk of eliminating the trade deficit, for example. And the provision that would have prohibited congressional consideration of any trade deal before the Commission reported is, thankfully, gone too. But I would suggest that the underlying message of the bill — that individuals cannot be trusted to make their own decisions about which products to buy, and from where — is intact. There are plenty of references to “improving trade balances,” “enhancing the competitiveness of U.S. manufacturers,” and environmental and labor standards.  I stand by comments about those sentiments.

Maybe a commission is a useful way of distracting members of Congress from actually doing anything, and certainly this bill is less offensive than the original, but it still betrays an unwillingness of some members of Congress to let consumers and firms make decisions without a commission studying, reporting on, and possibly correcting them.

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