Alasdair Macleod – 10 November 2010
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.
[i] See Keynes’s Tract on Monetary Reform particularly Chapter 3, The Theory of Money and the Exchanges.