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.