October 22, 2012
Paul Krugman and Ezra Klein both say, following Joe Gagnon, that the time for criticizing China for “currency manipulation” has passed. This is partly true in the sense that China’s currency has risen substantially in real terms against the dollar over the last few years. However this does not mean either that the relative value of the dollar and the yuan is now at a sustainable level or that China is not continuing as a matter of policy to prop up the dollar against its currency.
To see the former point, it is important to remember that China is a fast growing developing country. Ordinarily such countries are expected to run large trade deficits. The idea is that capital can be better used in fast growing countries like China than in slow growing wealthy countries. Since capital will get a higher return in developing countries, we expect capital to flow from rich countries to poor countries. The flow of capital would imply a trade deficit for developing countries. Effectively this trade deficit would allow developing countries to sustain consumption levels even as they build up their capital stock.
China, along with many other fast developing countries, is running a large trade surplus. This is not sustainable. To see this point imagine we have a developing country that is growing at the rate of 7 percent annually, the slower rate of growth that China is now seeing. Suppose it sustains a trade surplus of 3.5 percent of GDP, roughly the amount projected by the IMF for the next five years. For simplicity we’ll make the United States the only other country in the world and have it grow at a 2.5 percent annual rate.
If China and the U.S. start at the same size, after 20 years China’s annual trade surplus will be equal to 8.3 percent of U.S. GDP. To have sustained this surplus it will have bought an amount of assets that exceeds 100 percent of U.S. GDP in 2032. If we carry this out another twenty years then the annual deficit in the U.S. will be 19.5 percent of GDP and China’s holdings of U.S. assets will exceed 300 percent of 2052 GDP. Clearly this does not make sense and we will not see these sorts of deficits running in the wrong direction indefinitely.
As far as the second part, China is still accumulating U.S. assets as part of an official policy of pegging its exchange rate. In other words it is deliberately propping up the dollar against its currency.
The point that Gagnon makes is that China is not alone in this exercise and it is not even the biggest culprit, relative to the size of its economy. In this sense the China-bashing that Governor Romney and other politicians have practiced is inappropriate.
Nonetheless the United States should still view it as essential to further lower the value of the dollar against China’s yuan, along with other currencies. The yuan is key because other countries are likely to follow the value of the yuan with their currency as they did in 2005, the last time that China had a major revaluation of the yuan against the dollar.
It is also important to remember that the bad guys in this story are at least as likely to be sitting in corporate suites in the United States as in China or other developing countries. Major U.S. corporations like Walmart and General Electric have profited enormously from low-cost labor in China and elsewhere. They have little interest in seeing prices on the goods produced in the developing world rise and their profit margins fall.
The other part of this story is that we really have no choice about seeing the dollar fall, especially for those ferocious deficit hawks who want to see the United States balance its budget. It is an accounting identity that the trade surplus is equal to net national savings. This means that if we have a trade deficit, net national saving is negative. There is no way around this fact. The deficit hawks may not like it, in the same way that they may not like 2 plus 2 being equal to 4, but there is nothing they can do to change it.
If we have negative national saving, then either we have a budget deficit (negative public saving) or we have negative private saving, or some combination. At the moment, we have a large budget deficit that corresponds to our trade deficit. How could we have negative private saving?
In a dream world, we could see private investment go through the roof as we build up the capital stock at a record pace. That is not going to happen. The non-residential investment share of GDP has fluctuated in a fairly narrow range over the post-war period. If the deficit hawks tell you they have some elixir that makes it suddenly soar through the roof, then they have been smoking something funny. That ain’t going to happen.
The one way we know to get negative private savings is a housing bubble. That can lead to surge in residential construction, while the bubble generated equity will cause consumption to boom and household saving to plummet. What a great idea!
Okay, if we want to have something near a balanced budget without a bubble driving our economy then we have to get the dollar down to get our trade closer to balance. This is not an optional policy or a debatable point. It is a simple matter of logic. If you disagree, think about it more until you understand why there is no choice.
So by all means, let’s stop the China bashing. And let’s start talking seriously about getting the dollar down to level consistent with more balanced trade.
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