Please Don't Sell Us Your Goods So Cheaply!

As the weak economic recovery continues, a natural response of individuals is to seek out a scapegoat to blame for the problems. One potential scapegoat that has garnered significant attention the past couple years is China. The problem, as stated by many pundits, politicians and economists, is that China has intentionally undervalued its currency. Supposedly this action not only steals jobs from Americans but also impairs our economic growth. Attempting to right these wrongs, Congress is once again proposing to formally label China a currency manipulator and impose import tariffs. Although this proposal has been debated numerous times previously (and failed to pass each time), an unacceptably high unemployment rate heading into a presidential election year has created some urgency for action. Unfortunately the actual effects of currency manipulation have been substantially misrepresented and passing this legislation will almost certainly hurt employment and economic growth.

To better understand the effects of currency manipulation, it’s important to offer a brief comment about currency valuations more generally. Currencies have value for two primary reasons: the ability to purchase goods and to pay taxes. A currency’s value is based on the amount of goods it can purchase. When multiple currencies are involved, an exchange rate provides a measure by which to compare the purchasing power of two different currencies. If exchange rates were left entirely to markets, the values would be primarily affected by changes in the supply of each currency and the supply of goods. In reality, exchange rates are also impacted by interest rates, inflation, and speculation. At a basic level, exchange rates help balance international trade and reduce transaction costs.

Many Americans are currently taking issue with China’s policy of pegging their currency, the renimbi (or yuan), to the US dollar at a below market level. China accomplishes this feat by increasing the supply of their own currency and buying US dollars. Based on these simple actions, it seems obvious that China is manipulating the value of its’ currency. However, if we consider the actions of other governments around the globe, it becomes clear that practically all governments manipulate the supply of their own currency and interest rates. In fact, the US government has been very active in recent years, increasing the supply of dollars and holding interest rates effectively at zero percent. From this standpoint, practically all countries are currency manipulators.

Getting back to China and the policy debate, maintaining an undervalued currency makes one countries’ goods effectively cheaper. The idea behind this policy is to encourage businesses involved in exporting goods and reduce competition from abroad. To date, this policy has been very effective for China in stimulating exports and preventing imports, as displayed by their sizable trade surplus. Delving a bit deeper, a significant portion of China’s exports are manufactured goods. The primary American argument made against China’s currency policy is therefore based on the notion that China is stealing American jobs, specifically within the manufacturing sector.

While I don’t dispute that US manufacturing jobs are most directly hurt by China’s policy, focusing on the lost jobs ignores all other less obvious effects. From the perspective of US consumers, China is intentionally offering products at below market prices. When Americans purchase goods made in China, the cost is therefore less than that expected in a “free” market, hence US consumers are technically saving money. A question not frequently considered is, what happens to the extra dollars Americans save from buying cheap Chinese goods? Apart from a small amount of saving, these funds are largely used in other means of consumption. If some of this demand goes towards American goods or services, than new jobs will be created to counter those lost in manufacturing. Although it is far easier to explain direct job losses in manufacturing, the positive effects on consumption and demand almost certainly outweigh those costs.

A fascinating aspect of tax and trade policy is the ability to achieve similar outcomes through entirely different measures. Using the Senate’s current bill as an example, one of the proposals is to charge an import tax on Chinese goods. This policy increases the price of those goods, reducing the difference between US and Chinese goods. Another way of achieving this result is directly subsidizing American production of those goods currently being imported from China. Under this plan, tax revenue lowers the price of US goods, thereby shrinking the price discrepancy between the two countries. In both cases, most Americans will spend more of their income for the same amount of goods. While these options attack the “problem” from different angles, the economic effects on Americans is basically identical. Despite this fact, my guess is most Americans would oppose a bill explicitly subsidizing a small group of manufacturers using everyone’s tax dollars.

The situations described above reflect a market with only two competing nations, which is certainly not reflective of today’s global economy. In relation to proposed legislation, it’s important to consider how this alters the effects. America remains the global super power in terms of its economic wealth and is still largely unrivaled. Based on wealth and numerous regulations, the cost of living (in dollars) in the US is much higher that most other countries. China, with a much lower cost of living, is primarily competing with other developing nations to sell its exports to Americans. Raising the cost of Chinese imports is therefore much more likely to shift demand to another developing nation than increase domestic demand. Unless import tariffs are applied broadly to all nations (which would be a terrible policy), US manufacturing jobs will remain expensive on the global market.

Another consideration regarding US trade with China concerns the enormous sum of dollars that China receives for all its exports. As mentioned earlier, the value of currency stems from the ability to purchase goods and pay taxes. Clearly China has no use for dollars in paying taxes. Since China pegs their currency to the US dollar, the option of converting dollars into another currency is largely taken off the table. The remaining option, which China uses, involves investing their dollars in US dollar-denominated assets such as Treasuries. Many of the dollars used to purchase Chinese goods actually return to the US in the form of investment and are then spent employing other capital.

Looking beyond the potential impact on US manufacturing jobs, it’s fairly obvious that Americans incur large benefits from China’s currency policy. I think this point becomes even clearer when considering the policy’s effects on the Chinese people. In China, many workers are employed to manufacture goods largely consumed by Americans. The dollars obtained from these exports are then invested in the US. As the US runs large deficits and holds interest rates at zero, China’s dollar-denominated assets are losing value in real terms. Also, due to the currency peg, US monetary policy is effectively imported and currently enhancing inflationary pressures. For many Chinese workers, these policies are effectively suppressing their wages while pushing food and energy prices higher. In effect, China’s currency policy is now causing the real wages of individuals to decline.

Although my economic views favor free trade, I should note that negative consequences stemming from China’s currency policy do exist. By subsidizing their own exports, China has generated an incredibly large trade surplus in total and with the US. This policy increases economic dependence between nations. Partially due to China’s reliance on exports, when global demand falls (especially in the US and Europe), domestic demand is not strong enough to support current production. The result is a surplus of unwanted goods and significant losses on investment. As witnessed during the last recession, a stimulus package, three times the size of that enacted in the US (based on % of GDP), was needed to prevent economic contraction. Systemic risk is certainly increased by China’s trade policy.

In today’s world, policies are frequently established to correct specific problems while ignoring the wide-ranging consequences of those initiatives. Current claims about China stealing American jobs dismisses the massive benefits consumers obtain and overlooks the nature of shifting demand in global trade. During the 1930’s, countries on the gold standard erected tariffs to prevent losing capital to other nations. Global trade fell dramatically, further exacerbating the Great Depression. Creating new barriers to trades, while earning brownie points for some politicians, will only increase our economic struggles and make a sustainable recovery that much more difficult. Hopefully the current debate on China’s currency policy will prove only for show and not be foolishly enacted.

(Note: Don Boudreaux at Cafe Hayek has written a number of great posts on the same theme recently. For anyone interested in further examples of the benefits of China’s currency policy, I strongly suggest reading through his blog posts.)

Roberts: The Microeconomics of the Broken Window Fallacy

As a DC resident, last week I experienced both an earthquake and a hurricane. Thankfully neither resulted in significant injuries within the impacted areas and property damage was also less than some might have expected. These experiences have provided opportunity for several economists to once again discuss the economic effects of natural disasters. Earlier this year, when Japan was hit by a terrible earthquake and tsunami, numerous economists and market "experts" noted that the destruction would be positive for economic growth due to rebuilding efforts. Similar comments sprung up following Hurricane Irene's treacherous path across the eastern seaboard.

These discussions are precisely when better definitions of economic growth are needed apart from GDP. Based on my understanding, if someone's car was destroyed and they choose to replace the vehicle by purchasing another, that purchase adds to GDP, while the lost vehicle subtracts nothing. From a real world perspective, the person whose car was demolished is now worse off, since they still own only one car but are now out a significant sum of money. Meanwhile, the car salesman is only better off by the amount the other individual spent. On the whole the economy is not better off since the amount of goods remains the same. GDP therefore fails to account for the depreciation or destruction of asset value, which plays a significant role in establishing wealth and economic well-being.

Russ Roberts of Cafe Hayek, who helped create the "Fight of the Century" videos (linked below), provides a wonderful example of what's known as the broken window fallacy. His counterpart on the website, Don Boudreaux, also had a humorous retort to Peter Morici (Professor at University of Maryland) regarding this fallacy and his willingness to destroy property for payment in order to benefit others (http://cafehayek.com/2011/08/open-letter-to-peter-morici.html). I urge those not familiar with the argument to read the articles and determine which theory is more compelling.

The Microeconomics of the Broken Window Fallacy:
The Keynesian defense of breaking windows or the economic virtues of hurricanes would go something like this:

Yes, breaking windows is destructive. Yes, it reduces wealth. But when there are large amounts of unemployed resources, say in the glass business, then breaking windows is close to a free lunch. In a world of unemployed glaziers, breaking windows can jump-start the economy by putting the unemployed back to work. They will spend the money they receive for repairing the broken windows.

When confronted with the claim by those of us who like Bastiat, that the money to repair the windows will now be unavailable to spend on something else, the Keynesian responds like this:

But people are sitting on money that is doing nothing. The insurance company that will now pay back the homeowner whose house was damaged by the hurricane was sitting on piles of cash. That cash was sitting in the bank where the bank has excess reserves not being lent out, not being invested. So yes, breaking windows can improve the incomes of glaziers and start a process of recovery.

What do we respond, those of us who are enamored with Bastiat and who think he’s right?
I would re-state the Bastiat story and tell it a little differently than it is usually told. The usual point is that the money has to come from somewhere–we see the repaired window but ignore the things that don’t get built or bought. But I think a better way to tell the story is to point out that the RESOURCES have to come from somewhere. The hurricane increases the demand for glaziers and that is good for glaziers. But that is good for all glaziers, employed and unemployed. It pushes up the price of glass repair. That discourages some folks from having glass work done who otherwise would have done it. So there is some offset of the hurricane’s impact on glazier employment. And as the Hayek character says in “Fight of the Century“:
You see slack in some sectors as a “general glut”
But some sectors are healthy, only some in a rut
So spending’s not free – that’s the heart of the matter
Too much is wasted as cronies get fatter.
So while glaziers (and carpenters) may be unemployed, other sectors (such as the wood market) may not be having such problems. The hurricane has a big impact on the price of wood, discouraging a bunch of would-be demanders of wood from buying as much as they did before. Again, there’s an offset. The point is that “aggregate demand” doesn’t tell the whole story.
But the real problem with breaking windows is that it’s not productive. I know. That’s obvious. But think about what the words mean. Right now, there are a lot of unemployed construction workers. What does a hurricane do? A hurricane IS good for carpenters and glaziers and roofers. But it’s unproductive work. It gets the home owner back to the status quo. It doesn’t create anything new or valuable. I’m not saying the production is wasted. I’m saying it’s a repair. Why is that important?
Imagine a world where there hasn’t been a hurricane and I want to help the unemployed carpenter. Here are two ways to do so. One is to burn my house down and then call the carpenter and give him $100,000 to rebuild my house. Here is the second way. I call the carpenter and say, I feel bad that politicians artificially increased the demand for housing at the end of the 20th century, pulling you into an industry that cannot be sustained at its current leve. I feel bad that you’ve been unemployed for three years. So I’m going to give you $100,000.
Which of those two policies would have the bigger stimulative effect? The charity should have a bigger effect. No offsets from pushing up the price of lumber and so on. But giving people money doesn’t change the underlying problem that there are more carpenters than work available for them. Creating temporary work either by burning down houses deliberatively or accidentally through a hurricane doesn’t change the fact that there are too many carpenters and glaziers relative to demand.
So the hurricane will put carpenters back to work. But it would be even better if there had been no hurricane and people had just given them a check. Charity is more productive than destroying stuff and paying people to get back to square one.
But the charity approach is what we’ve been doing for the last few years. It’s called unemployment insurance. I know, it’s supposed to be stimulative but there’s no sign that it is. Why would it be? It doesn’t solve the problem that there are too many carpenters.
This is related what Arnold Kling calls “Patterns of Sustainable Specialization and Trade.” Repairing houses damaged by a hurricane isn’t sustainable. And if I just give carpenters money because I feel sorry for them, that isn’t trade. That’s charity. Both have the same stimulative effect–very little, because they don’t get at the underlying problem. Prosperity is the way we specialize and serve each other, creating products and services that we each value. Destruction cannot be the source of prosperity.