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Saturday, August 2, 2003

CHINA'S GROWING ECONOMY: A THREAT TO THE US OR AN OPPORTUNITY? Version Three

Like the previous article on the EU and the US, this one --- on China's economy and its impact on the US, including its growing trade surplus with us (over $100 billion, much bigger than Japan's bilateral surplus) --- is essentially a series of observations, with extensive revisions, that the buggy prof left yesterday at another web site devoted to economics and political economy, Arnold Kling's Econ Log. Go to the topic for August 1 entitled "China Menace?" After linking to three very different articles on the Chinese economy and how it affects the US, Kling asked why it is that journalists tend in his view to see the growth of foreign economies as a threat to US prosperity, whereas economists --- he's a Chicago Ph.D in the discipline --- see it differently, thinking of the mutual benefits that free trade bring to economies that practice it. The three articles that Arnold linked can be found there, and to make it easier in the future to get hold of them --- one in the Washington Post, another in the Wall Street Journal, the third in Foreign Policy --- here's the permanent link for "China Menace".

What the Argument Here Seeks to Show

Good question, this one about China. Any effective answer needs to distinguish between the short- and long-run impact of China's rising trade surplus with the US. In the short-run, the surge in Chinese imports --- along with their concentration in certain industries --- is causing more trouble for those affected industries and with US GDP growth and manufacturing jobs than is desirable. Fortunately, as we'll see, there are ways to handle this surge and bring some relief to the affected industries without resorting to permanent protection; even the WTO rules allow for import-relief in such circumstances, and there are additional policies the US government either already has in operation or can develop for further relief.

That's the short-run situation.

In the long-run, China's growing wealth and the size of its market can be considered an opportunity for the US --- business and labor alike . . . doubly so because China's economic future, for the next two or three decades, is not likely to lie in advanced cutting-edge technologies --- our big strength. By the same token, China's continued technological backwardness compared to us --- or even Japan or Taiwan or South Korea --- will further dampen its leadership's ambitions to make China a regional hegemon or global great power, particularly in any militarist ways. Something else too. The more the Chinese economy integrates into the wider global economy, the more likely any resort to aggressive behavior by Beijing to assert itself in Pacific Asia will likely be seen by its political leaders as doubly costly, engendering prudence and caution in its diplomacy.



The Short-Run Impact: A Clear Problem

Some statistics will help put the argument here in rounder perspective. Right now, our bilateral deficit with China in trade --- which is heavily concentrated in certain industries --- is running well over $100 billion a year, and rising. Last year, 2002, that was almost 40% of the $266 billion of exports that China sold around the world. Can it go on, this torrid pace of imports into the US market at a time when we are suffering from a jobless recovery, with unemployment up from 4.0% at the start of 2001 to around 6.2% in the summer of 2003, almost two full years after the short and shallow recession of that earlier year officially ended? And, for good measure, at a time too during which the US has lost another 2.3 million manufacturing jobs?

By contrast, our trade deficit with Japan --- which has been around $60 - $75 billion for a few years --- began shrinking at the start of the year, and was 21% down from what it was a year ago. All this, mind you, despite the strenuous attempt by the Japanese Ministry of Finance to keep the Yen from rising against the dollar by buying almost $80 billion worth of Yen in exchange markets. (Note that the Ministry of Finance has been only partially successful here; between May 2002 and May 2003, the Yen climbed 7% against the dollar, cutting into the profits of Japanese firms selling in the US market.) From that angle, then, the rising trade deficit with China looks like continuining into the future --- the opposite of the Japanese case, where US imports account for about 25% of Japan's total export-sales in the world.

 

Sidebar Theoretical Comments, by way of clarification.

[1] The balance of payments is ordinarily divided into two main parts: current account and capital account.

Current account refers to the trade in goods and in services, plus a category dubbed "unilateral transfers" --- the latter covering things like foreign aid or money sent home by, say, Mexican workers in this country. Trade in goods refers to manufacturing products, agriculture, minerals, and fuels like oil and natural gas, and it is called "the trade balance." These days, the US exports about $1 trillion worth of such goods each year (around 10-11% of GDP) and imports around $1.3 - 1.4 trillion. The result is a trade deficit of about $300-400 billion a year. Trade in services --- a big category, with the US exporting about $300 billion a year while importing about $220 billion --- refers to international transportation like airline travel, tourism, financial services (banking, brokerage, insurance), advertising services, consulting services, construction by American companies abroad and vice versa, royalties and fees, profits on US movies and TV and books sold abroad, and profits by US multinationals brought back to the US from abroad and vice versa for foreign multinationals operating here). These days, it also includes unilateral transfers.



The capital account refers to both short-term and long-term capital outflows and inflows, private and governmental. Because of double-entry book-keeping --- all debit items have an offsetting credit item --- the bottom line of the US balance of payments each year is zero: all credit items equal all debit items. That also means that any current account deficit --- now running around $400 billion annually for the US --- is automatically offset by a corresponding surplus on capital account. Short-term capital investments are liquid, involving the purchase and sales of US financial assets like stock-market equities (GM for foreigners sending capital here, say, as opposed to Americans buying shares on the German stock market of BMW) and private and government bonds. These are normally called portfolio investment. Long-term capital investments refer to the purchases made by multinationals and others of fixed assets --- factories, buildings, residences, Hollywood studios --- that can't immediately find a buyer if the owner wants to sell them. Note that when an American buys BMW stock this way, say $1 million worth, that is regarded as an outflow of dollars and hence is a debit item in the balance of payments for the year: think of the American importing the BMW shares in the same way that other Americans are importing BMW sedans. Oppositely, when a German buys GM stock worth $1 million, that represents a $1 million inflow of foreign capital (in euros), with GM exporting the shares to the new German owner. Hence the export of GM shares is a credit item on capital account (short-term), which is actually recorded as an increase in US dollar-denominated liabilities to foreigners.

[2] Note that the causal relations between capital account surpluses and current account deficits --- or vice versa --- can be complex over the year.

A great deal of the capital inflow into the US from the EU, the Middle East, Asia, and elsewhere is what can be called "autonomous" investment: the foreign buyers of US financial assets --- including long-term multinationals investing here --- is motivated by their belief that these are better investments, with a wider range of choice and little inflation to erode the value of their investment, compared at the time to investing the money in their own countries or the bonds or equities of other countries. (Oppositely, needless to add, Americans investing abroad have a different view of the investment opportunities.) This inflow of investment capital from abroad then raises the price of the dollar compared to the euro or the Yen or any of the other currencies of the home countries where the foreign investors are located. In time, with a lag, the impact on the trade in goods and services --- current account --- follows automatically. Specifically, a much larger inflow of capital into the US economy than an outflow will therefore lead to a higher dollar than otherwise, and the higher price of the dollar compared to euros and Yen and Yuan and other currencies will then tend to dampen American exports to those countries while, simultaneously, encouraging more imports than otherwise. The upshot? Over the year, a greater deficit on the US current account will likely show up, or --- alternatively, rare in recent history for this country --- show up as a smaller current account surplus.

Inversely, there's what can be called "induced" investment that results from Americans importing more goods and services on current account than selling: it's more complicated to understand because of double-entry bookkeeping and the fact that the dollar is a huge investment and reserve currency in the world, as well as the main trading vehicle.

Essentially, though, in stripped-down terms, it boils down to this: when an American, Joe Six-Pack, buy a $50,000 Toyota, assume he writes a check to Toyota of Japan on his Bank of American account. Before the transaction, the Bank of America's own books would read, hypothetically, on the liabilities side of the ledger: "$50,000 owed to Joe Six-Pack, an American citizen" as Demand Deposts. After the transaction, the Bank of America's ledger on the liabilities side would now read: " - $50,000 owed to Joe Six-Pack," " + $50,000 owed to Toyota of Japan, a foreign firm" as Demand Deposits. As such, that $50,000 now enters the US Balance of Payments. After all, an American resident, Joe Six-Pack, has bought something from a foreign firm. Specifically, the +$50,000 is entered as the "credit" item on short-term capital account; it's the double-entry bookkeeping offset of the "debit" item on the current account of $50,000 that is recorded as a US citizen importing another Japanese car. Again, to make sense of this, think of the Bank of America exporting an IOU of $50,000 to Toyota of Japan.

Note that the $50,000 credit item on short-term capital --- which has emerged, remember, by the Bank of America reducing $50,000 worth of Demand Deposits owed to Joe Six-Pack and adding $50,000 owed to a foreign firm --- is precisely what we can call "induced" investment . . . in this case, Toyota increasing its holdings of Demand Deposits denominated in dollars with an American bank. Note, too, that from the Bank of America's viewpoint, it doesn't matter whether the $50,000 is owed to an American citizen or Japanese car firm: it can lend out the $50,000 --- minus the reserve-requirment set by the Federal Reserve (now 11%, I believe) --- to any credit-worthy business firm seeking a loan or any credit-worthy customer seeking a house-mortgage or loan to buy a car or SUV.

If, in turn, Toyota of Japan doesn't want the $50,000, it can exchange it for Yen in its Tokyo bank, say Sanyo. In that case, the Bank fo America's ledger on the liabililties side now reads: "-$50,000 owed to Toyota of Japan;" "+$50,000 owed to Sanyo Bank." And so on, up to the point where Sanyo can either exchange the $50,000 for Yen with the Japanese central bank or sell it in currency markets for euros or Yuan or whatever. Whoever ends up with the $50,000 or parts of it, the Bank of America's "Demand Deposits" will still read, "$25,000 owed to a German citizen, $15,000 owed to a Chinese firm, and $10,000 owed to a Mexican bank" . . . as, again, a hypothetical example. The total of $50,000 induced investment in the US is still available for the Bank of America to llend to American business firms, mortgage-seekers, or those wanting to borrow money to buy a Toyota or Ford or BMW.





[3] Whether a country like the US is running a global current account surplus or deficit with all its trade partners --- or happens to be in balance --- can be explained, theoretically, by whether or not national savings exceed national investment (private and public) or fall short of it. If national savings exceed national investment, then the country will export the excess savings on capital account and run a corresponding current account surplus with the rest of the world: that is, on a global basis with all its trading partners. That's the case of Japan for decades. By contrast, in a country like the US where national savings generally fall short of national investment --- something that's been the case for essentially two or three decades now --- we'll run a current account deficit: we will tend to experience a capital inflow to cover the gap between our intended savings and intended investment (to sustain the latter), and because the balance of payments across all categories involves double-entry book-keeping (all credits - debits on the bottom line equal zero), we then run an equivalent size balance of payments deficit with the rest of the world.



[4] Quickly note though. That's on a global basis. It's for all of the 100-plus countries with which Americans buy and sell goods, services, and various kinds of financial assets like equities, bonds, and ownership rights of factories and buildings and Hollywood studios.

By contrast, whether our bilateral trade deficit with Japan runs at $40 billion a year or $75 billion depends on far more specific trends and developments in Japan and the US, such as:

*the growth rates in GDP in both countries: if US GDP is rising far faster, then we will tend to import far more at the margin than Japan is;

*the regulatory environment, for instance differing environmental and health standards or customs evaluations or requirements regarding government purchases from domestic sources and the like;

*subsidies and various forms of protection --- including informal understandings that are rampant among corporations and their suppliers in Japan and China;

*and even on consumer habits: until the 1990s, for instance, the Japanese shied away from foreign goods except for certain European luxury goods: they even said in public opinion polls that they had this preference

Nor is that all. The size of a specific deficit with Japan or China will also depend on further influences, like

*intra-industry trade, such as when Japanese or US or German auto firms in this country buy from Japanese auto suppliers in Japan;

*and on the concrete policies of multinational firms like Honda or Toyota in buying from Japanese firms back home or from American suppliers or for that matter Toyota of Mexico as a supplier to Toyota of the US.

[5] And finally, of course --- as our comments about the Yuan and the Yen just noted --- the US trade deficit with Japan or China each year depends heavily on

*the exchange rate between the dollar and the Yen and the Yuan.

Over time, accordingly --- if carried on long enough --- a float upward of the Yuan and Yen will definitely show up as a steady reduction in the US trade deficits with China and Japan, provided the declining rate of the dollar against their currencies doesn't lead to accelerating inflation in the US that offsets the price advantages of our exports and lead to a new surge of imports . . . a danger, in any case, that US monetary authorities can fully contain with proper anti-inflationary policies. By contrast, a dirty float by the Yen --- with the Ministry of Finance there selling Yen daily for dollars to keep the Yen from rising upward --- will maintain or increase the Japanese trade surplus with the US, all else held constant. Similarly, an undervalued fixed exchange rate like the Yuan --- pegged at 8.3 to the dollar --- can be spotted by the constant intervention of the Chinese government's equivalent of the US Treasury intervening daily to sell enough Yuan for dollars to prevent any upward formal revaluation of the Yuan/dollar rate. As we'll see, Beijing does this to the tune of selling about $300 million worth of Yuan daily to keep the rate fixed at 8.3 per dollar.

(Observe in passing, nothing more, that some economists argue that the exchange rate of any two countries' currencies --- say, Yen/dollar --- will tend toward purchasing power parity: the rate will settle at the point where the prices of goods and services in the two countries are equal to one another. The evidence for this claim is dubious. It also ignores the manipulation of the currency by, say, the Japanese or Chinese governments to keep their currencies from rising upward these days against the dollar.)

The following section will help clarify these theoretical matters.


 

The Short-Term Problem with China Clarified

By way of clarification, consider the following comments tossed out in rapid sequential order:

[1] For the time being, China's swelling trade balance with us --- concentrated in certain industries like textiles and wood furniture, maybe in the future metal products, much of it fueled by the highest levels of foreign direct investment inflows in the world for a developing country --- is causing too much havoc in these industries, especially at a time of a still depressed labor market and the impact regionally on the labor force in certain regions of the US, especially the south. Can any democratic government can stand by while a massive surge of imports creates excessive pressures for adjustment on important industries, especially if they're regionally concentrated and have political clout. That's true of the industries being hurt directly.

[2] The problem of effective adjustment is complicated by the sluggish job market nationally, with unemployment rising from around 4.7% or so in mid-2001 to 6.4% this last spring. The reasons for this unfortunate trend --- which may have peaked this last two months --- are set out in a mini-series on the short-term prospects of the US economy that you'll find at the buggy prof site. So far, four lengthy articles have appeared on the topic, with two or three more to come, and hence no need to rehearse them here. (New visitors to the buggy site will find them listed from July 14th on.)

[3] Manufacturing itself --- which employs around 12% of the US labor force --- has been a particularly sluggish sector of the economy from early 2001 on, despite some improved signs in the spring and summer of this year (not least to the rising impact of defense spending). True, manufacturing isn't privileged in our economy, nor should it be. The average wage in numerous service industries is higher, especially those in the high-tech communications and information areas as well as finance, medicine, the media, and education. Still, a sector that's so sluggish in its capital spending the last three years, with some improvement of late to be sure --- especially when Chinese and other Asian imports are surging in not least to the efforts of their governments to offset any rise in their currencies against the dollar by big continued purchases of dollars in currency markets --- could welcome some relief in the sectors being directed affected by this surge . . . though for the time being we're concerned only with the Chinese problem here.

On all three grounds then, for both humane and economic reasons, some relief seems in order.

 

What Kinds Specifically?

Three seem worth singling out: none encourages long-term protection of the affected US industries, let alone anything permanent. Our aim should be to provide for more effective, spun-out adjustment of a timely sort. Specifically:

[1] Import Relief. Protecting an industry being swamped by a flood of imports is allowed under WTO rules for safeguards . . . provided these safeguard measures include a scheme to make the industry or industries affected more competitive by streamlining and restructuring the industry in question. There seems to be a case for this in textiles and wood furniture, maybe one or two others. Any import tariffs would have to be conditioned on a clear scheme of effective adjustment and should last 24 -36 months. Keep in mind that there are clear criteria that the WTO for the safeguards to be applied. For instance, it found that the Bush safeguard measures and high tariffs around steel imposed in the summer of 2002 violated these criteria.

[2] Help for Laid-off Workers. We can also increase our trade-adjustment assistance to beleaguered industries and the laid-off workers affected. Fortunately --- as a recent buggy article here noted --- we've learned some things since the origins of this policy back in the mid-1970s to make it more efficient: above all, instead of press-ganging laid-off workers into government-sponsored or government-subsidized training programs that go nowhere, paying for 18-24 months the difference between new wages for the formerly laid-off workers in new jobs and what they were earning before. A large number opt for their own retraining and upgraded education, with beneficial results.

[3] Generating More US Economic Growth. Above all, there's a need --- it can't be exaggerated --- to boost Aggregate Demand to increase GDP growth and bring unemployment down to somewhere around 5.0% in the next 18 months. A booming economy and booming job-market are, in the end, indispensable antidotes to job-pessimism and growing pressures for protection.

[4] Pressure on China To Revalue or Float the Yuan Fixed at 8.3 Yuan/$, the Chinese currency would automatically rise considerably in value if the currency were allowed to float or at least be formally revalued 30-40%. Right now, China seems to be spending about $300 million of Yuan daily to keep the exchange rate at that 8.3 level. That artificially low value of the Yuan keeps the export spigot to the US running excessively with ever greater force. Equally bad for many US hard--pressed industries, the rest of the Pacific Asian countries then sell their own currencies to keep their exchange rate vis-a-vis the dollar (and the Yuan) from rising too. Obviously, if it had its own way, the Chinese government isn't about to let the Yuan rise; its low value is what's helping fuel its huge export surge here. For a good article on this, see Business Week.

 

Immediately, a pair of questions follows.

First, can the US government find a way to pressure Beijing to revalue the Yen or let it float? In principle yes, including the threat of import safeguards --- exactly what we did with steel last year despite the WTO's recent preliminary finding against the US when the EU took the dispute to it. (The EU officials indicate clearly they don't want a trade conflict and are seeking ways to find an effective compromise).

That leads to the second question: does the Bush administration have the will to confront Beijing on this issue? Here the response isn't so straightforward. On the one hand, Washington's diplomatic concerns are running in the opposite direction, requiring Beijing's active cooperation in bringing pressure on North Korea to end its nuclear programs and its own diplomatic posturing and threats. On the other hand, with an election looming fifteen months ahead, Bush and his advisors know full well that unless the economy is barreling along at around 4.0 - 4.5% growth until November 2004, swiftly bringing unemployment down toward 5.0 - 5.5% with good prospects for further job creation, Bush's re-election will at best be problematic . . . depending largely on who the Democrats are wise enough to put forward as his opponent.

Right now, it's hard to divine what the administration will do. In the meantime, the first three measures of relief await a more vigorous campaign by the government to do something effective.



 

The Long-Run: China's Growing Wealth As An Opportunity for the US

THIS PART NEEDS TO BE REVISED (SANTA BARBARA TIME, 5:00 PM, Saturday, August 2nd)

In the long-run, China growing wealth and living standards will very likely benefit the US economy: it will create a large and prosperous market for all the products --- good and services --- that we will likely to continue having a noticeable edge in . . . mainly high-tech, high-productive industries. That is what David is driving at when he refers to creative destruction: the need to let increasingly uncompetitive, low-productive industries shrink or disappear, precisely in order to free capital, managerial talent, and skilled labor (including scientists and engineers) move to more promising, more competitive industries . . . almost always, as it happens, more technologically advanced.

It's a term I myself have used in a lengthy reply to one of the visitors at my web site, http://www.thebuggyprofessor.org (see the article for Sunday, July 27, 2003).

And, still in the long-run --- say, the next two or three decades (the maximum beyond which any half-way reasonable projecting is impossible, what with the speed of change these days and the uncertainties surrounding China's political stability and future) --- China will lucky to be much more advanced technologically than Taiwan or South Korea today. There are all sorts of constraints on its doing better --- not least the ungodly mess in its financial system (especially the banks), the social turmoil connected with further reductions in the bankrupt state-sector, the fragmentation within the domestic market, and the sheer wastage of much of the investment today and for two decades behind huge trade barriers in industries that won't prove competitive internationally. Another big constraint: lack of managerial talent, a large drawback. Yet another: the problems of intellectual property rights, which make technological innovation and entrepreneurial firms based on it all the less likely, what with the inability of start-ups and inventors to capture any of the initial profits as they're stolen away by others.

All this in the long run.