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Currency appreciation will not cure trade deficit

US House passed a currency bill by a wide margin, 348-79, yesterday to penalize China’s foreign-exchange practices.  The measure would allow, but not require, the U.S. to levy tariffs on countries that undervalue their currencies, which makes their goods cheaper relative to American products.

This is a highly politically-charged bill, right before the US’ mid-term election.  With high unemployment rate of nearly 10% at home,  blaming foreigners for one’s own backyard problem has always been the easiest solution for politicians in the past.

As I have done many analysis before, currency is not the the solution to America’s trade deficit problem, Japan’s experience back in 1980s is the best example.  Neither it’s the solution for the unemployment problem. The high unemployment rate was created by the most severe recession since WWII, and by the huge bubble in housing market.

Simple economics will tell when China’s exports become more expensive, US importers will, sooner or later, choose to import from other developing countries, whose exports will become cheaper and more competitive than China.  This is the so-called substitution effect.  In the end, China’s trade surplus will shrink with the US, but US’ overall trade deficit will not budge.  To solve the trade deficit problem,  US consumers really need to save more, or consume less.  The savings rate has already been rapidly increasing in the past couple of years.   Sounds painful, but this is a process the US economy has to go through.  Yesterday’s spendthrift means today’s frugality.

And by the way, who will get hurt most by the import tariff?  The US consumers.

What about China? China should stop subsidizing exports through lower currency or tax rebate.   Subsidizing exports is essentially shifting Chinese tax payer’s money and put it into American consumers’ pockets.   Good deal for America; bad deal for China.  The export subsidy will also distort resources allocation according to price signals, resulting in too much capital invested in the low-end export industry, with poor capital return.

Here is the latest video analysis from WSJ (quite heated):

update1:  10 am 09/30

I said above Yuan’s appreciation will shrink US trade deficit with China, but US total trade balance with the world won’t change much because of substitution effect.  Now looking at the the following two charts I’ve just made, I  even doubt that Yuan’s appreciation will shrink US-China trade deficit.

The first chart shows the cumulative trade deficit of US with China (in red), and Yuan-Dollar exchange rate (in black) from 2000 to 2009.  Yuan had depreciated by almost 17% from 2004 to 2007, but the US trade deficits with China just kept soaring.   Yuan’s appreciation did not solve the problem.

The second graph shows a similar story. The difference with the first chart is now I show the monthly trade deficits (not cumulative, in red). The blue line shows the 12-month moving average of the monthly number.  The trend was clearly upward despite Yuan’s 17%  appreciation during 2004-2007.    Again, currency appreciation did not solve the US trade deficit problem, and it just kept growing, only until the recent recession hit, it started to trend downward.

My educated guess is that, because Chinese price is so low, even with currency appreciation and higher goods prices than before, the demand for such goods did not decrease much.  In other words, American consumers may have a quite inelastic demand curve for Chinese goods.  After all, majority of Chinese exports are necessity goods, not the durables, nor the luxuries.

Gary Becker on China’s Long Term Prospect

Gary Becker just came back from China. And he shares his thoughts on the country's long-term growth prospect. Like many others, Becker sounds a little worried about the enlarging state-sector in Chinese economy.

China's Next Leap Forward

by Gary Becker

Mr. Becker, the 1992 Nobel economics laureate, is professor of economics at the University of Chicago and senior fellow at the Hoover Institution.

I just spent two weeks lecturing in China and Hong Kong, and discussing China's economic development with many economists, businessmen and government officials. China's progress since my first trip there in 1981 has been truly remarkable, and I expect considerable growth during the next decade. Nevertheless, China still faces many challenges if it is to move beyond middle-level income status into the exclusive club of high per capita income countries.

No country in the modern world has managed persistent economic growth without considerable reliance on private enterprise and decentralized private markets. All centrally planned economies failed to achieve sustained development, including the Soviet Union before its collapse, China before market reforms began in the late 1970s, and Cuba since Castro's revolution in the late 1950s.

China's private sector has led its dominance in textiles, electronics, and other consumer and producer goods. It's followed the model of the "Asian Tigers"—Hong Kong, Singapore, South Korea and Taiwan—and relied heavily on exports produced with cheap labor. In the process, China has accumulated enormous reserves, as Taiwan, Japan and other rapidly growing Asian economies did in past decades.

Poorer countries like China need not get everything "right" to grow rapidly through exports to richer countries. They need only have some strong sectors that use world markets to fuel overall growth. Japan's rapid growth from the 1960s-1980s was led by a highly efficient manufacturing sector. Yet at the same time Japan also had a large and inefficient service sector, and an agricultural sector that was riddled with subsidies and inefficient incentives.

Similarly, China's economy still has a glut of state-owned enterprises (SOEs) with excessive employment and low productivity. Their importance has fallen over time, but Chinese economists estimate that they still control about half of non-agricultural GDP (*SOE's share in manufacturing sector is much lower – my own note). One crucial example is the state-controlled financial sector that makes cheap loans to other large, inefficient and unprofitable state enterprises. China's economy also suffers from extensive price controls, restrictions on migration, and many other structural barriers to efficient growth.

http://si.wsj.net/public/resources/images/ED-AM304_becker_DV_20100928145648.jpg

Some democracies, like postwar Japan, have made the economic reforms needed for sustained economic progress. India, for example, experienced rapid growth after it began in 1991 to shed a socialist orientation and encourage private investment and private initiative. But economic progress has been swift under autocratic rule as well, including in Chile under Augusto Pinochet, Singapore under Lee Kuan Yew, and Taiwan under Chang Kai-shek. Usually, however, personal freedom has grown along with rapid economic progress in autocratic governments. Chile, Taiwan and South Korea, for example, all became vibrant democracies after they'd grown rapidly for a number of years.

Something related has happened in China. The degree of personal freedom in China today is enormously greater than in 1981, when the vast majority of the population had essentially no personal freedoms. The Internet, in particular, has given hundreds of millions of Chinese access to all kinds of information, including what happens in democracies, and various criticisms of their government's policies. The government actively tries to censor the Internet, but these censors are easily bypassed. Students and others say they readily "climb the wall" by using cheap software (appropriately, made in America) that gives them direct access to the Internet in Hong Kong and hence avoids the censors.

I do not know how soon China will evolve into a political system with competing parties, or whether China will continue to have effective leadership under its single-party structure. But as the economy continues to develop it will be impossible to prevent personal freedoms from expanding, including the freedom to criticize economic and social policies.

Global markets allow poor countries to grow rapidly for a while, but it is far more difficult to grow beyond middle-income levels. Much has been made of the fact that a month ago China's aggregate GDP surpassed that of Japan. But all that means is China's per capita income is about 10% of Japan's, since China's population is about 10 times that of Japan. Despite its great economic advances, China still has a long way to go to become a rich country.

China's locally owned government enterprises have been more efficient than national enterprises. This is mainly because local government enterprises have to compete against each other, whereas national enterprises often receive monopoly positions. But competition among government enterprises is a partial substitute for competition among privately owned enterprises. If China wants to continue to grow rapidly it will have to reduce the scope of the SOEs, especially the national ones, and greatly expand the private sector in finance, telecommunications and many other fields.

Developing countries improve their technological base by importing technologies and knowledge developed in advanced countries. China has encouraged direct foreign investment in part to get access to the technologies of Japan, the U.S., Germany and other nations. Using technologies developed by others is still important after countries advance to middle-income levels, but these countries must then also develop more of their own technologies to advance much further.

To accomplish this transition, China has been promoting university enrollments and a growing R&D sector. University attendance in China has grown greatly since the late 1990s, propelled by rapid increases in the earnings of individuals with higher education. China is innovating more, but it is still a long way behind the U.S., Japan and other rich countries.

As for China's currency, it's true that the yuan is considerably undervalued due to Beijing's continued intervention in foreign-exchange markets. But the undervalued yuan is a gift to American and other consumers outside China because it makes goods produced in China much cheaper.

In effect, China sells goods cheaply to the rest of the world and receives in return U.S. and other paper assets that pay almost no interest, and will depreciate in value when inflation rates increase in the U.S. These are the main reasons why China should move toward floating the yuan.

Many Chinese officials believe that substantial yuan appreciation will make the SOEs even less competitive, thereby increasing unemployment and social unrest as these enterprises contract. Yet an undervalued currency not only leads to a further accumulation of paper assets but also weakens the incentives of Chinese companies to cater to domestic consumption—which is remarkably weak—and to upgrade their exports to higher quality products.

There is tremendous pride and enthusiasm among Chinese regarding their economic achievements, and a growing confidence that China is returning to its great-country status of centuries ago. This is reflected in the enormous energy of its professionals, entrepreneurs and workers...

What leads to success?

In case you are still wandering…facing hard choices…

Stephen Roach Interview

Interview of Stephen Roach, former Chief Economist at Morgan Stanley, Chairman of Morgan Stanley Asia, and now a professor at Yale University. He’s teaching Chinese Economy there.

A tale of two recoveries

Compare the recent recovery to 1981-1982 recession. (source: WSJ)

It’s official: The Great Recession ended 15 months ago, in June 2009. That was the word Monday from the economists at the National Bureau of Economic Research, the outfit that tracks the U.S. business cycle based on a variety of economic variables.

By their calculations, the downturn that began in December 2007 lasted 18 months, or the longest on record since the 43-month plunge of the Great Depression. On the other hand, the recession was only two months longer than the 16-month downturns of 1973-1975 and 1981-82, the two other most serious post-World War II periods of falling economic growth. The 2007-2009 downturn was painful but not extraordinary in historical context.

[2nber]

What is different about this period is the relative weakness of the economic recovery. As the nearby chart shows, in 1983 the recovery surpassed its previous peak in gross domestic product very rapidly from the recession’s trough. Growth rose by 4.5% in 1983, 7.2% in 1984 and 4.1% in 1985, and it kept climbing through the rest of the 1980s. This is the kind of recovery you would expect coming out of a severe recession, since the deeper the trough the steeper the rebound.

This time, even after a year of recovery through June 2010, real GDP remained 1.3% below its previous peak in the fourth quarter of 2007, according to the NBER sages. The current recovery peaked with 5% growth in the last quarter of 2009 but has decelerated in 2010—to 1.6% in the second quarter. This tepid growth, in turn, has contributed to the sorry state of job creation, slow business investment and the overall sense of malaise.

Robert Barro on Tax and Incentives

Interview of Harvard economist, Bob Barro, who explains why Bush tax cuts should be extended too all income groups.

What’s it like working in the White House?

(ht: Greg Mankiw)

Allan Meltzer: We don’t need more excess reserves!

Allan Meltzer, author of several books on the history of US Federal Reserve, said with over 1 trillion $ excess reserves sitting on bank’s balance sheet, it would be stupid to add another 1 trillion dollars.

More monetary easing won’t be effective, the key is to remove the uncertainties in the economy so businesses can start investing again. Too much cash held by corporations, too little investment.

How to turn your ipod touch into an iphone

Some neat invention from China.  So far, Apple has not cried foul. China’s disassemble-reassemble imitations have been running wild – when will China innovate on its own?

Big move in currency market again

Fear of Fed’s another round of quantitative easing, Euro shot up to the highest level since April,

and Gold is reaching $1300 per ounce.

And Chinese Yuan is also gradually appreciating against USD, now at 6.70 Yuan per USD. Just one week ago, it was at 6.78.