The truth behind trade
deficits
The
trade imbalance between China and America is in the news
ahead of the G20 summit in Seoul this weekend. All the
representatives from the deficit nations believe that
China keeps her exchange rate too low, and must let it
rise to correct trade imbalances. This approach is not
confirmed by historical experience.
If
a rising currency is meant to reduce a trade surplus,
then neither Germany nor Japan would have continued to
have their surpluses after the mark and yen were allowed
to float forty years ago; nor would the US and UK have
continued to have trade deficits as the dollar and pound
devalued. These outcomes are totally different from
those intended when currencies were unpegged, so as a
result of this experience cold water was poured on the
purchasing power theory behind exchange rate policies.
Purchasing power theory is useless to anyone who
operates in the real world, and this is certainly true
of Keynes’s analysis, and therefore that of all
economics professors who worship at his alter[i].
Paraphrasing slightly, Keynes contended that the
exchange rate should adjust so that domestic prices for
goods are similar to external prices: in other words, if
imports are cheaper than their domestic equivalents the
currency should fall. The Obama administration’s
approach to the deficit with China is entirely
consistent with this flawed approach.
Logically, if private sector purchases of goods are paid
for or financed through borrowings backed by real
savings, the private’s sector capital and trade accounts
between two countries must by definition balance,
irrespective of price levels. However, if one country’s
government injects money into its private sector
additional to savings, the trade balance will be lost.
This happens when a government expands money supply by
printing, or when banks expand the available credit over
and above actual savings. Armed with this excess money,
the private sector now has the means to run a deficit on
its balance of trade.
But
why should buyers of goods use this excess money to pay
higher prices for imports, in preference to domestic
equivalents in defiance of purchasing power parity
theory? For example, why do Americans persist in buying
German and Japanese cars when theirs are cheaper?
There are two reasons for this that Mr Keynes did not
take into account. The first reason is that price is
only one purchasing consideration; others such as
product utility and quality are part of a product’s
brand. And when you sell product by brand, value for
money goes out of the window. The second reason is that
manufacturers faced with an uneconomic proposition as a
result of currency movements do not cease to sell,
instead they innovate. Manufacturers that innovate will
invest heavily in both their production facilities and
brands, so that they remain competitive at higher rates
of exchange and offer better products. Ergo,
Japanese and German export strength despite a rising yen
or mark.
Naturally, faced with imported brands selling on quality
and utility, domestic manufacturers will try to compete
on price alone, being a natural response to a lower
exchange rate for the domestic currency. Price
competition is simple: don’t increase costs by spending
money on innovation and quality, or put another way,
restrict capital investment to the bare minimum.
This sums up the differences accumulated over time
between the manufacturing industries in a nation driven
by consumption, compared with similar industries in a
nation driven by savings. Excessive consumption by the
private sector is encouraged by disincentives to saving
and by the availability of easy credit to spend. This
describes the tax and monetary policies of both the US
and the UK governments, where tax is increasingly levied
on those with savings, and the value of savings is
constantly eroded by monetary inflation. Consequently
the private sectors in these countries fell out of the
savings habit long ago. In contrast, Germany, Japan and
now China have or had a strong savings habit that
persists in attitudes today. This imbalance between
consuming nations and saving nations is the real trade
problem, and it is being exacerbated by even more by
aggressive monetary expansion in the US and the UK. So
we can conclude that quantitative easing will ensure
trade imbalances will persist, irrespective of exchange
rates.
American officials do not share this view and blame
China for keeping her currency too low, unfairly tilting
the terms of trade in her favour. This reflects
Keynes’s invalid purchasing power parity approach, and
it ignores the considerable benefit to American
consumers of artificially cheapened goods, courtesy of
China’s currency subsidy. From a flow-or-funds
perspective, through currency intervention China has
financed both America’s excess consumption and a
matching level of the US government’s spending. In
other words, the US government has been complicit in the
arrangement and therefore has responsibility for it.
The
coincidence of twin trade and government deficits has
been sometimes noticed in the past, but the reasons for
it are entirely forgotten today. This is a pity, because
attempts to resolve these differences by forcing
currency revaluations miss the point entirely. Attempts
to push the dollar lower through monetary expansion will
only make America’s trade deficit persist, because as we
have seen above, the trade balance is driven by
increases in fiat money and excess credit, not the
exchange rate. Furthermore, if the American government
discarded theories of purchasing power parity, they
would understand that they need, above all, to put their
own house in order.
Until then, perhaps they should thank the Chinese for
subsidising America’s consumers rather than confronting
them needlessly.
10
November 2010
[i] See
Keynes’s Tract on Monetary Reform
particularly Chapter 3, The Theory of Money
and the Exchanges.
