Dealing with China

In 2012 the US had a trade deficit with China of $315.0B.  That is, the US exported $110.6 to China while importing $425.6B of goods and services[1].  This is an extraordinary imbalance and constitutes the largest single contributor to the total trade deficit of $735B that same year.

Why would China want to run such a huge trade surplus with the US? And why would the US allow such a situation to continue so long?  There has been much speculation about these reasons.  Mainly because in politics the announced reasons are often not the real reasons.  So, I will also speculate about these as well.

For the first question, the Chinese have been growing their economy at a furious rate of about 8-10%/year in a bid to become a technologically advanced, developed nation.

In order to do this they need to spur domestic development at a level that is much higher than in the developed countries.  To do so using only domestic resources and investment mechanisms would likely proceed at a slower rate simply due to the inherent difficulties in growing that quickly.  Instead, the Chinese are supplementing growth by exporting the excess production, mainly to the US.  Thus, the US provides the demand to spur growth that would not generally come at home in China so quickly.  The other reason, which may be the more important one, is that China wants to import advanced technology that is only available in the west, and in the US in particular.  Many of the deals China now makes are not to purchase goods and services from the US with its vast holdings of USD, but to buy US companies with technologies that they need.  Or, to enter into production agreements with US firms which requires the US company to share their technology with their Chinese counterpart.

Why the US would allow this?  From a national perspective this ongoing deficit is bad as it adds to the total deficit and reduces employment in manufacturing in the US.  Worse, it transfers important technology from US companies to Chinese ones, or transfers the whole company to China.  Who benefits from this situation?  Well, US companies that move manufacturing to China can reduce their manufacturing costs to generate larger profits, as long as the Chinese Yuan (CNY) remains low relative to the USD.  That's the key for US companies, a low Yuan.  If the Yuan rises in value relative to the USD then the advantages of manufacturing in China drop and will eventually disappear, and so will their out-sized profits.

China, it is well known, intervenes in the currency market to keep the Yuan low against the dollar.  This keeps their exports up and technology flowing in.  It also pleases US companies that import from China, as they can continue to generate large profits.  But this creates the trade imbalance that doesn't allow market forces to bring trade into balance, and continues all the dislocations to the economy that have occurred.  One would think that the advocates of free trade would be furious at this and vociferous in their demands for market exchange rates for the Yuan.  But, hardly a peep.  The US sends some trade delegates, and even the President, to ask for a floating Yuan, but nothing happens.  In response, Washington does nothing.  Why would the Chinese change anything if there are no consequences to their policies?

The traditional solution to this is again the tariff.  Imposing a tariff is the needed consequence to not allowing the Yuan to float.  To be clear, a tariff for this reason has nothing to do with trade imbalances that exist for reasons other than China's intervention in the Yuan currency market.  The sole reason is that the currency market is designed to work only when exchanges of currencies are due to market forces alone.  Intervention breaks this system, so either China needs to play by the rules or we need a new system.  Now, I'm not a fan of floating market currency systems, as they have many problems that have be previously discussed.  But, at a minimum, if we're going to use this system then all participants need to play by the rules.  Or else face consequences.

A significant tariff (in a previous post I suggested ~60% for general trade) should be applied to imports from China.  The Chinese might not like this, as it thwarts their plan for growth and technology acquisition, and US companies which import would certainly not like the immediate hit to their bottom line.  So, imposing a tariff would largely be a political fight.  But with such powerful foes like China and US corporations on one side, who will represent America's interests in this fight?


[1] http://en.wikipedia.org/wiki/List_of_the_largest_trading_partners_of_the_United_States#cite_note-2

Two kinds of growth

Much has been written about how China and other developing nations are growing much faster than the developed nations in general, and the US in particular.  The growth of China's GDP over the last decade has averaged nearly 10%, while that of the US has been below 3%. 

 

This difference, it is implied, is due to the superiority of the Chinese model over the US model, which is now seen as faltering.  I think this kind of comparison is unfounded.  There are really two kinds of growth which I will term: Innovative growth, and Catch-up growth.

Developed nations, like the US, are operating near their potential production.  Although recently the recession has put a major dent in this.  What being near potential production means is that the economy is at full employment using state-of-the-art technology and is producing the maximum possible output.  More importantly the per capita production is maximal.  Any increase in production has to come from either increases in efficiency of current methods or innovations of new methods of production.  And, in any case, the former is usually a form of the latter.  So, for an advanced developed nation like the US to grow it has to innovate.  Innovation is risky, expensive, and time consuming.  Innovation forms a cost to current consumption that promises an increase in future growth, albeit at an uncertain rate.  The rate of growth in a developed country is mainly determined by the rate of investment in innovation.

In a developing country like China, the state of technology is generally far behind that of the developed countries.  That's pretty much the definition of developed and less-developed nations.  So, for that country to develop further it must first acquire existing technologies from the developed countries and implement them domestically.  The developing country must catch up technologically with the developed countries.  Importing technology is much simpler, cheaper, less risky, and less time consuming than creating new innovation themselves.  So, the developing country can grow much faster than the developed country.

The real issue for the US is that investment in innovation and new production has fallen, which limits the rate of growth of the economy.  But, even when those pick up again, a growth rate much above 3% is unlikely due to the need for massive investment in innovation to spur such high growth rates.  A massive level of investment does not seem likely without some government mandate for some great national cause.

The effects of imposing tarrifs on trade

Today tariffs average a mere 1.3% [1], which is quite low by historical levels, where tariffs have more typically been in the 10%-30% range.  What would be the effect of raising the average tariff to 10%?  The US imported $2299B of goods and services in 2012 [2], and exports of $1564B in the same year [3], so we'll use these number for a simple analysis.

What effect would that 10% tariff have on the balance of trade?  This is a complicated question but one for which we can make some simple estimates.  A recent study of the effects of trade barriers [4] finds that "The elasticity of imports to the domestic cost of importing is about 0.50, and that of exports to the domestic cost of exporting is about 0.48. That is, a 10% reduction in the cost associated with importing (exporting) would increase imports (exports) by about 5% (4.8%)."  Per country details vary but we can nonetheless use these values to estimate the effect of changes in tariffs on the level of imports and exports for the US.  An increase in tariffs acts the same way.  That is, for imports an increase in the tariff of 10% will decrease the amount of imports by 5%.  A tariff is just a percentage increase in price of an imported good.

Elasticity is a bit difficult for many people to understand.  But it basically says if I perturb one value a little bit, how much does the other value change?  In the case of imports a small change in price causes half as much change in imports.  A key concept here is that elasticity is only valid for small changes in values.  Even the change of 10% in price is probably a bit unrealistic, but it will nonetheless give us some idea of how imports are changing with price.

Balancing trade requires that the level of imports equals the level of exports.  So, to decrease the level of imports to that of the level of exports in 2012 is a drop from $2299B to $1564B, which is a large reduction of imports of 32%.  Given the elasticity factor of tariffs for imports of 0.50, this means the tariff increase needed on imports to achieve this goal is 32%/0.50 = 64%.  This is a large tariff by historical standards, and in practice this amount may not be needed as the actual adjusting of trade is not so simply defined by the elasticity.

The complexities of trade suggest that an incremental approach to tariff be taken.  Start by increasing the tariff to 10% one year and see the effects.  Perhaps increase the tariff again the next year and see the effects.  Continue increasing the tariff until trade comes to a balance.  Or in the case of the US, a surplus is generated, which is needed to pay down the years of accumulated trade deficits.

A second benefit of the tariff is raising revenue for the government.  A simple application of the tariff assuming no change in imports for a 10% tariff  to all of the new level of imports of $2184B it would produce $218.4B of revenue for the US government, which is $190B more than the government collected would have collected.  Tariffs reduce the tax burden on Americans and helps balance the budget as well as affecting trade.


Still using general references due to the government shutdown
[1] http://en.wikipedia.org/wiki/Tariffs_in_United_States_history
[2] https://www.cia.gov/library/publications/the-world-factbook/rankorder/2087rank.html
[3] https://www.cia.gov/library/publications/the-world-factbook/rankorder/2078rank.html
[4] Hoekman, Bernard & Nicita, Alessandro, 2011. "Trade Policy, Trade Costs, and Developing Country Trade," World Development, Elsevier, vol. 39(12), pages 2069-2079.

Balancing trade by tariff is a Keynsian approach

The previous policy recommendation of balancing trade by the use of tariffs, when the market mechanism are not working in a rapid enough manner to balance trade on its own, is a kind of Keynesian response to the problem.

The problem addressed by Keynesian economics is a recession, where unemployment is high and production is below the potential production levels.  The market forces will, in the long run, bring the production levels up and the unemployment levels down, but not in a timely manner that is acceptable to society.  And as Keynes said "in the long run, we are all dead".  Instead, Keynes argued that the government needs to take an active role in returning the economy to a level of its potential output and employment to normal levels.

Similarly, the imbalance of trade over long periods, and in particular, the running of trade deficits over those long periods, also causes economic dislocations that are adverse to the economic prosperity of society and long term economic growth.  Thus, the government must also take an active approach in dealing with the long term trade deficits by taking actions which will move trade back to a state of balance.  The government needs to approach long term trade imbalances with the same urgency as it does recessions.

The previous post examined the time scale of the long term run of trade deficits and found that the deficits had continued for many decades, and it would be at least 50 years, and probably much longer, before any market mechanism caused anual trade to return to a balanced condition.  This did not include the additional time needed to run surpluses to pay down the accumulated trade debt, which we can only assume would be a similar time scale of decades.  It also looked at the time scale of the beginning of adverse effects of these deficits and found that they start to occur in only one to few years, which is much less than the time scale over which the market actions are operating   Thus, some action needed by the federal government to counter these trade deficits and return trade to a balanced condition within a few years of the beginning of persistent trade deficits.

The Great Depression showed that government intervention is required when the difference between what the economy could do and what it is doing is great.  Similarly, the Great Recession has shown that the government can't ignore trade when dealing with a recession, but needs to address trade imbalances when they become persistent to avoid the harmful dislocations that long term deficits produce.

Trillion dollar coin and bonds have a markedly different effect on the money supply

Much has been made of issuing a "trillion dollar platinum coin" as a part of a solution for the current budget crisis.  While such an action is possible it will produce monetary outcomes which are significantly different than if the government sold an additional $1 trillion in bonds as it usually does to finance its deficit spending.

The difference comes down to what is money?  In the case of the US it is the US dollar.  A bond, while having value and a use in exchanges, is not money.  Thus, adding bonds to the market does not increase the amount of money in circulation.  Adding $1 trillion does add to the money supply.  But the change to the money supply does not end there.  The US banking system is a fractional reserve system in which the vast majority of money is created not by the government, but by the banks.

Under a fractional reserve system the amount of money is largely determined by the so called money multiplier, which is derived from the reserve requirements in effect at the time.  Currently, this is about 10% of deposits, which indicates that the money multiplier is about 10x the amount of the monetary base.  This mean that for every dollar of monetary base, or high-powered money, the total money supply (M1) will increase by 10 dollars through bank lending.  The monetary base is created by the government mostly through the purchasing of bonds by the Fed.

The issuing of bond by the government doesn't change the money supply, but the issuing of a trillion dollar coin not only changes the money supply directly, but induces a multiplier effect because the trillion dollars will add to the monetary base.   Therefore, the trillion dollars deposited in the treasury account will add 10 trillion dollars to the money supply (M1) as the government spends that money.  This won't happen immediately, as the government won't actually spend that trillion dollars at once, but will leak into the financial system as the government uses those funds to pay its bills.

This addition to the money supply is, of course, of crucial interest to the Fed as its job is to regulate the money supply.  It could react to the addition to the monetary base in many ways.  1) it could reduce its own purchases of bonds, 2) it could increase the reserve requirements such the the money multiplier is reduced from the current value, 3) it could use its recently formed mechanism of paying interest on reserves held at the Fed by banks to induce the banks to leave the extra money in their Fed accounts so as to not lend it out.

One important benefit to the government of issuing the trillion dollars is that it won't have to pay interest on it as it would if it had issued a trillion dollars in bonds.  This adds up to a big savings for the American people over time.

Tariffs as a mechanism to balance trade

We've seen that the US is running a large trade imbalance and that this has been ongoing for decades and will likely continue for many years if not decades in the future.  That this represents a significant balance of unsettled trade.  That the expected mechanisms of the market have not rectified this imbalance  even though decades have past, and that distortions in our economy have occurred after only a few years of such trade imbalances.  Some of these distortions have been detrimental to the US, such as the loss of many manufacturing businesses and their associated jobs, and the build up of the trade debt itself which one day needs to be repaid by settling the debt.  That this trade debt can only be settled by producing goods and services here in the US that will be sent overseas to the holders of this trade debt.  In other words, the lack of settlement of trade over the last few decades has shown that that market mechanism are too slow to resolve the imbalance before adverse effects show up in the economy.  This suggests that some mechanism is needed to resolve the imbalance over this shorter timescale of one to few years.  We just can't wait for markets to do their thing.  We have to act in the mean time.

Let me introduce you to the tariff.  This has been the traditional mechanism for regulating trade that has been used since the inception of the US.  But today this word seems to provoke howls of anguish and scoffs from many as being backward and an indication that the author is merely naive and doesn't understand all the advantages to all sides of free trade and markets.  To which I say, I'm not even talking about free trade or markets, that is a discussion for the future.  The situation today is that we don't even have trade.   What we have is multi-currency purchase and sales that are unbalanced.  That a trade is only complete when it is settled, and we have seen that trade is not being settled, and hasn't been for decades.  Only after we have actual trade, i.e. settlement, can we have a discussion about the merits of regulated vs. free trade.  Instead, I'm suggesting tariffs as a mechanism to force the settlement of trade so as to thus prevent the economic dislocations in the short term of a year to years that we are now experiencing.

Today, the US runs a massive trade deficit in the hundreds of billions of USD per year.  In 2011 the trade deficit totaled USD 785B [1], with China contributing the largest portion of this at USD 315B in 2012 [2].  Efforts to get China to reduce its trade surplus with the US by letting its currency, the Renminbi (CNY), float so as to let market mechanism presumably drive up the value of the Renminbi relative to the USD, have come to naught.[3]

How would a tariff help?  Well, the immediate reason for the deficit is that consumers in the US purchase a good made overseas, from say China, because it is cheaper than the good made in USA.  NB. that this doesn't mean the good is cheaper in terms of value, that is of relative values of goods and services.  Only that the price in terms of money is less for the imported good.  So, to reduce the amount of imported goods that consumers buy, the thing to do is raise their prices so that domestically produced goods are cheaper or at least the same price.  The easiest, and most traditional, way to do this is by imposing a tariff on the imported goods.  That is, a fee on each import paid by the importer to the government for the privilege of importing the good.  Typically, the cost of that fee is directly added to the price of the imported good, so the price to the consumer goes up about the same amount.  Thus, a significant tariff on imports would lower imports and reduce the trade deficit.  The tariff can be progressively increased as needed to achieve a balance of trade.   Balanced trade means that settlement is occurring.

Before anyone shouts "protectionism", let me say that has nothing to do with this particular tariff.  The sole purpose is to balance trade.    Only then can we discuss trade policy itself, and the merits of protection vs. Laissez-faire policies.

But other nations will retaliate some may say, and we will have a trade war.  We won't have a trade war or retaliation if the US emphasizes that the purpose of the tariff is merely to balance trade.  And that the tariff will be reduced as trade is balanced on its own.  That if other conditions like exchange rates are allowed to change to create balanced trade then the tariff will not be needed at all.

In other words, every nation has the right to balanced trade.  And the right to enforce mechanisms that will ensure balanced trade over periods short enough to prevent any economic distortions that a lack of balance may cause.

In practice, the tariff for the US would need to drive trade to a surplus of large size for many years as a massive trade debt exists that needs to be paid off through settlement.  This would constitute a shift from the USD 700billon+/yr deficits today to something comparable of trade surpluses, say USD 500billion/yr.  That's a shift of over USD 1trillion in trade!  This would bring back all those lost manufacturing jobs and spawn a renaissance of growth in America.

The US has suffered from trade deficits for too long.  Now is the time to implement mechanisms, like tariffs, that will rebalance trade so our economy can return to a normal state of operation.


NB. due to the government shutdown I'm using sources from others sites that have aggregated this data.
[1] http://en.wikipedia.org/wiki/List_of_countries_by_net_exports
[2] http://en.wikipedia.org/wiki/List_of_the_largest_trading_partners_of_the_United_States
[3] http://en.wikipedia.org/wiki/Renminbi_currency_value

Gov Shutdown

Well, it's been more than a week.  And everyone is speculating when it will end.  Only a true anarchist would want it to continue much longer, but how and when it will end is not so clear.  For that is what we are heading for without a functioning government, anarchy.

Those who look a bit further into the future see the upcoming borrowing ceiling as a more serious issue as the government will start to run out of money by the middle of October.   By the end of the month the government would be out of all tricks and resources and would need to either default or selectively pay the bills.  As selective paying of bills a minefield in itself, probably the course of action will be to not pay anything.  This would, as many have pointed out, have serious repercussions for the US reputation and credit worthiness.  But, more importantly the confidence in the soundness of a US bond will be shattered.  US debt is considered so secure that the interest rate on it is considered the standard of risk free return on investment.  All other investments are compared to US debt when deciding whether the risk/reward is worth the premium of return above that which could be had from parking the funds in US debt.  Thus the entire worldwide financial planning system would be shaken.  Still, a few missed payments may not have such a dramatic effect if the government is funded shortly thereafter and any who suffered losses were made whole by receiving their payments with some extra interest.

But more seriously, and I have to give credit to the President that he sees this, is that the threat and action of shutting down the government is being used to try to create yet another way to legislate, outside of the standard Constitutional process.  "Obamancare", the law that opponents want to overturn was passed by the standard lawmaking process.  Those who supported and opposed the legislation put up their arguments, their influence, and their votes.  In spite of all opposition, the bill passed and became law in the United States.  Opponents, not happy to have lost by the Constitutional lawmaking process see shutting down the government as a mechanism to get their way after all.  If they were to succeed this would enshrine a new form of coercion as a mechanism to enact or repeal laws outside the standard Constitutional framework.  Ultimately, the President has to stand firm to prevent this radical alteration in our lawmaking process