One of the reasons why trade-related discussions can seem so off-the-mark, I think, is because the conditions governing international trade are much more complex than we often realize. The determinants of the international balance of trade basically include anything that affects domestic consumption and domestic production, which pretty much means nearly everything in economics. Among other things this means that there is a very wide range of government policies that can affect trade – sometimes explicitly and sometimes implicitly.
Unfortunately much of the analysis and debate doesn’t seem to get this. For example, many economists have pointed out that the bailout of GM is effectively a protectionist measure. I think it clearly has a trade impact, and this impact is “protectionist”, although not intended that way. What is missing from the discussion, I think, is a clear explanation of why it is effectively a protectionist measure. I would argue that the GM bailout has a trade impact because it affects in specific ways the balance between production and consumption in the US (and, of course, elsewhere), and since the US trade deficit is also the gap between US consumption and US production, to the extent that the bailout affects this gap it must affect the US trade balance.
In that case we can posit at least two obvious ways in which the bailout affects the gap. First, by effectively subsidizing the cost of producing GM cars, it increases automobile production in the US. Second, by allowing GM to retain the workers it would have otherwise fired, it increases consumption in the US by the amount which the retained GM workers spend on consumption, i.e. some large fraction (depending on their savings rate) of their wages. At first I was going to suggest that the relevant number was actually not their wages but the difference between their wages and their welfare payments, since most of the workers would presumably continue to earn some money after they were fired, but then it occurred to me that their welfare payments would have reduced other government spending, so perhaps it is not relevant (this is a subject of much disagreement between Keynesians and monetarists).
Since the GM bailout almost certainly increases production by more than it increases consumption, its direct impact is to reduce the US trade deficit (although to be complete we would also need to consider how the GM bailout affects GM’s competitors, many of whom produce cars in the US). However there are of course secondary impacts, the most important of which is the funding of the bailout. If funding the money used to bail out GM ended up crowding out investment in other production facilities, then the question becomes whether or not those other production facilities would have involved a more productive use of the money and, therefore, had a better impact, either in the short term or in the long-term on total US production. This is also part of the debate between Keynesians and monetarists.
So because we typically think of the currency and tariff policies as the main tools to affect trade – which usually means to boost net exports – much of the discussion surrounding trade policies tends to be limited to these two issues (although when the subject of “dumping” comes up the discussion becomes a lot more sophisticated). This leads to strange arguments. For example when I talk about an increase in trade frictions leading to an increase in trade protection, I am often countered by the argument that the WTO makes tariffs very difficult so that protection becomes almost impossible. This is manifestly not true, but more on that later. These, at any rate, are the two best-known trade-related policies:
¨ Currency policies, whose first-order impact is to determine the relative pricing of imports and exports, but there are also a series of second-order impacts that can be very important.
¨ Tariffs, especially import tariffs, whose first-order impact also determines the relative pricing of traded goods, usually imports.
To repeat, any policy that affects the relationship between production and consumption must affect the trade balance because the excess of production over consumption is the trade surplus (or deficit, of course, if consumption exceeds production). So currency policies affect the trade balance primarily by their impacts on diverting production and consumption. A country, for example, that devalues its currency, raises the cost of imported goods and so reduces the real value of wages. This of course usually causes total consumption to decline. At the same time it allows local producers who compete with imports, who might not have been as cost effective as foreigners at the previous exchange rate, to begin producing more goods for sale to the domestic market. The combination of reducing domestic consumption somewhat and increasing domestic production means that the trade deficit will decline or the trade surplus increase.
One thing that economists always point out, and contrary to the mercantilist view, is that this increases domestic employment, but it doesn’t necessarily improve local welfare. Remember that by devaluing its currency, a country is worsening the terms of trade for its own products – it must now produce more stuff locally for export to pay for the same amount of imports. It also results in a net reduction in total consumption. Currency policies often involve a tradeoff between employment and total welfare in the short term. Over the long term it is not always clear that this is true, however.
Trade tariffs work in very much the same way. Devaluing the currency by 10%, for example, has the same impact as putting a 10% subsidy, or negative tariff, on exports (the government pays exporters an amount equal to 10% of the value of their exports) and a 9.1% tariff on imports.
But, as I hope these examples show, it is not just tariff and currency policies that affect the trade balance. Anything that affects the gap between consumption and production also affects the balance of trade. These include:
¨ Corporate and personal income taxes. Personal income taxes reduce consumption by reducing disposable income. Corporate income taxes reduce production by raising costs for producers.
¨ Sales and other taxes. Depending on their impact they can also affect trade. The most obvious case is a sales tax which, by raising the cost of goods, reduces real wages and so reduces consumption.
The impact of taxes on trade are complicated by the fact that taxes represent a transfer of resources, so to understand fully their impact we also need to know what the government does with new tax revenues or how it finances reduced tax revenues. These can enhance or reduce either consumption or production. So, for example, if the government put into a place a sales tax (which reduces consumption) and used the proceeds to reduce corporate taxes (which increases production), it could cause a large positive move in the trade balance (and by positive I mean an increase in net exports).
There are a lot of other factors that impact trade, and I have randomly included the following, which I think are especially important, at least in China. Others can and will have others to add or may dispute some of my arguments.
¨ The level of worker’s wages. They impact trade in two ways – by affecting consumption via affecting the purchasing power of households, and by affecting production via the cost to businesses of labor, and they tend to work in the same way as far as the trade balance is concerned. Lowering wages reduces consumption and increase production, so as to have a positive impact on the trade balance. Needless to say many economists have pointed out that low wages in China are one of the reasons for the high trade surplus.
¨ Unemployment benefits. Unemployment benefits tend to cause consumption to decline more slowly than production when factories close, for obvious reasons, although of course we need to take into account how these benefits are funded. I would guess that when a country’s workers do not receive unemployment benefits, it tends to be “positive” for the trade balance.
¨ Subsidized costs to producers – electricity, oil, commodities, etc. Subsidizing the cost of production is a very effective way to increase exports since it directly increases production by increasing the returns to producers. It also has an impact, albeit usually much smaller, on increasing consumption via its impact on employment. Since these subsidies are financed by taxes, subsidies may also constrain consumption somewhat, depending on the nature of the taxes used to fund subsidies.
¨ Subsidized costs to consumers. This boosts consumption, of course, although with the same caveat as above – its net effect depends on how the subsidies are financed.
¨ Corporate lending rates. This should be included in “subsidized costs to producers” but I put it in a separate category because it is a very important type of subsidy, especially in China. Low interest rates for manufacturers of course make it much easier to borrow money to fund otherwise unprofitable production facilities, thereby increasing production (and increasing consumption somewhat by its impact on employment). If the lending is directed at non-manufacturing activities, such as to the service sector, it will not spur manufacturing production but will still increase consumption. As an aside, in my May 20 entry I discuss an HKMA study that argues that in China 100% of SOE profitability can be explained by interest subsidies which, I argue, actually understate the true value of those subsidies, suggesting that many SOEs would actually be value destroyers if it were not for subsidized financing. This is a very important reason for the Chinese trade surplus, in my opinion.
¨ Deposit rates. In last week’s entry this claim generated a certain amount of controversy in the comments section, but it is widely believed that in some countries, like China, reducing deposit rates causes savings to increase and consumption to decline. I discuss some possible reasons in my November 27 entry, the most important of which is probably that in high savings countries in which most savings are in the form of bank deposits, the interest earned on banking deposits is a significant fraction of total disposable income, and lowering deposit rates has an effect similar to lowering wages. Of course if this is true, low deposit rates are likely to reduce consumption, just as low lending rates to producers are likely to increase production. They may also increase production by reducing the opportunity cost for corporations of investing retained earnings.
¨ Other credit intervention – lending guarantees, directed lending, forbearance on addressing NPLs, etc. This is fairly complex since there are many ways to intervene in credit, but any policy which increases the provision of credit to manufacturers must increase production directly. It increases consumption somewhat too, as in the two previous cases, by creating employment and thus raising the total amount of wages paid. If the lending policy increases credit provision to consumers or the non-manufacturing sector, it increases consumption directly. Credit for infrastructure investment is a little more complex since it probably increases consumption today and production tomorrow.
¨ Special mention: cleaning up NPLs. This really belongs in the category above but in the case of China it deserves its own entry. There are two ways to recapitalize banks suffering from a surge in NPLs. One way is to recapitalize them directly. When the government does this is simply transfers money to the banks, as China did before the IPOs of the major banks. Depending on how these transfers are funded, they can have a variety of effects on production and consumption. The second way is to guarantee banking profitability by keeping a wide spread between lending and deposit rates. Policymakers may also keep lending rates very low in order to slow the accumulation of NPLs and make it easier for marginal borrowers to survive. As I discuss above, this can result in very low deposit rates, which constrains consumption, and very low lending rates, which increases production.
I focus a lot on various financial sector issues because it seems to me that it is through the banking system that policymakers can have their largest impact on the trade balance. By keeping rates excessively low (and remember that almost all interest rates in China are either fully controlled and set by the PBoC or very heavily affected by the controlled interest rates), policymakers can boost production and constrain consumption quite easily.
When production grows faster than consumption this necessarily forces an increase in the savings rates – which ties this entry into my previous entry. And of course by controlling the direction of credit, either directly or indirectly by implicit or explicit government guarantees, the government has a major say in the total amount of production. It is probably not a coincidence that in the countries that followed export-oriented growth policies, the so called Asian development model, interest rates and credit tended to be highly controlled either directly or indirectly by the government and regulators. These countries have all had “surprisingly” low interest rates and banking systems that channeled funding mostly into the manufacturing sector (when those countries had large informal banking sectors, as does China, the rates there tended to be much, much higher, suggesting that the controlled interest rates were far from an “equilibrium” level). I would argue that a controlled banking sector is a very important tool for trade policy.
Another one of the issues that this opens up is the distinction I have made many times between total consumption and net consumption. Notice that many policies increase both production and consumption. They usually do the latter by increasing employment. In many cases Chinese policies have been successful in boosting consumption in just this way. Since the world manifestly needs more consumption, as US household consumption declines precipitously, anything that boosts Chinese consumption should be a good thing, right?
Maybe not. What the world needs from China is not an increase in total consumption but rather an increase in net consumption – i.e. the excess of new consumption over new production – that is roughly in line with the decline in US net consumption. If consumption grows, but production grows just as fast, or even faster (and we can tell by looking at the trade balance corrected for various pricing effects and one-off purchases or sales), then the world imbalance is getting worse and the overcapacity problem will not have been addressed.
This means that many policies that may seem on the surface to be purely domestic policies are actually trade policies too, and legitimately subject to scrutiny and even criticism from abroad. This is clear from the GM bailout. I don’t believe that Congressmen agreed to the bailout because they wanted to engage in protectionist behavior. They did so because they wanted to protect American jobs, but they did so in a way that almost inevitably has a trade impact. The same thing is happening in China, but there is a real reluctance to consider that policies aimed, for example, at limiting unemployment among aluminum plant workers in Hunan (or is it Henan?) are not just internal matters but also international trade policies.
A quite brilliant post. It seems obvious that trade agreements and the WTO need to expand their scope, though politically that seems a tough sell.
An analogy would be to national policy makers and the WTO being akin to banks and regulators, over time the policy makers are clearly ‘innovating’ ways to change the balance of trade and the WTO regulations are becoming increasingly less effective.
Fantastic post, and very pertinent viz a viz aluminum. Its the only metal that hasn’t rallied and there is a good reason why: China has a mindblowing overcapacity problem that is a large part of the global overcapacity problem. SRB buying isn’t making things much better.
Would it be so much easier if governments just pulled back a little on the industrial policy and currency policy?
Quote: “many SOEs would actually be value destroyers if it were not for subsidized financing. This is clearly a very important reason for the Chinese trade surplus”
Any idea how much of China’s exports are produced by SoEs? I was under the impression that it’s mostly private companies and foreign-invested companies that do the exporting, but I’m not really sure about the big picture.
By the way, everyone seems to agree that the current investment binge is led by aggrsesive SoEs with access to cheap credit.
But strangely, the NBoS data for “manufacturing value-added” available until April 2009 shows that year-to-date value-added was growing very fast at private companies, but stagnated at SoEs.
So SoEs are apparently not ramping up production at all. Can it be that they are investing, but not producing? It sounds a bit strange.
Quote: “in high savings countries in which most savings are in the form of bank deposits, the interest earned on banking deposits is a significant fraction of total disposable income, and lowering deposit rates has an effect similar to lowering wages”
Empirically, I would argue that the effect is not particularly big:
Chinese bank deposits are roughly 150 % of GDP. Private households’ share of this could be anywhere in the range of 50 % to 100 % of GDP (my guesstimate).
So if real interest rates go up by 1 %, this would increase household income by 0.5 – 1.0 % of GDP.
Assuming that households choose to spend 50 % of this extra income (and save the other 50 % for the future), the overall effect on consumption would be 0.25 – 0.5 % of GDP.
And that doesn’t yet factor in that there is also a negative income effect, as higher lending rates impact corporate profits and therefore the value of equity holdings (but I agree that the effect of this may be small, as much of it is tied up in SoEs and anyway won’t find its way to private households anytime soon).
Anyway, you seem to have the impression that real interest-rates earned by Chinese savers are “too low”. So do you have an “appropriate/fair” real interest-rate in mind that Chinese savers should be getting instead? How much higher than current actual real-interest would that be?
(As estimated above, I would argue that the “adequate rate” would need to be significantly higher in order to have a noticeable effect on household income)
You should also mention the subsidised cost of living. When food and energy prices are fixed it has an effect on the wages that are necessary. How else can one survive on $162 per month? Wages would be a lot less in the west if the cost of living was equally reduced.
Trade is something that is far to easy to manipulate, as history has repeatedly shown. It is time for the notion of balanced trade to enforced.
http://www.bls.gov/opub/mlr/2009/04/art3full.pdf
I don’t follow why decreased deposit rate consumption. Yes, I understand consumers lose the interest income, but aren’t they also dis-incentized to save, and so end up spending more of their remaining income? Is interest income such a large fraction of total income that there is still a net loss of consumption?
I think here: “One thing that economists always point out, and contrary to the mercantilist view, is that this increases domestic unemployment,” you mean “decreases” rather than “increases.”
Congratulations. One of your best posts in a series of extremely good ones, and one of the clearest discussions I have seen on trade related policies. I plan to reprint this for my students in my macro class. Thanks.
The points you raised in this post remind me of something you said awhile back about the nimbleness financiers to be able to circumvent any regulation that might have prevented their caviler use of excess liquidity.
The issue is the same here, it is easy to be in full compliance with WTO rules while at the same time engage in a number of activities that distort trade and violate the spirit.
OGT, I think it would be impossible for the WTO and other trade agreements to cover all the possible ways that policies can affect trade because many of these policies are very legitimately domestic policies too. No country – certainly not the US or China – would be willing to submit so much of their monetary and fiscal policy-making to an international regulator. I think we just have to live with and understand the fact that a much wider variety of policies have trade impacts than we might think.
Glenn, yes you are right. Subsidized housing is a kind of consumer subsidy and has various impacts on consumption and production. In this case I would argue that it effectively increases disposable income and so primarily increases consumption.
Ben, good catch. Thanks. I’ve changed it.
Thomas, the question is not how much SOE production is exported but rather how much of SOE production affects exports and imports. For example if an SOE produces a product that directly or indirectly substitutes for a foreign import, then any policy that affects its production costs also has a trade impact. Also if it produces a product (for example steel) that is purchased by Chinese exporters, or by Chinese companies engaged in import substitution, then it also is part of the relevant sector. In that sense much if not most of what SOEs produce falls into the relevant “tradable goods” sector. I haven’t looked through the numbers you cite but I would guess more interesting would be numbers from the banks that indicate the amount of credit being directed into the SOE or the manufacturing sector – and we should not think that this is just about SOEs. The key is not just that, according to the HKMA report, SOEs get better financing costs than other Chinese companies, but rather whether lending rates for Chinese manufacturers on average are below the “natural” level. Given that interest rates in the very large informal sector are several times as high as interest rates set by the formal banks, this suggests that, even adjusting for the higher riskiness of the clients of the informal banks, the equilibrium interest rate is probably much higher than the controlled rate.
In your second comment you raise some interesting questions. We hear that the informal banks pay deposit rates as high as 15% or more. Clearly there are all sorts of problems with using that as a benchmark, but very few developing countries with relatively free interest rate markets, even rapidly growing ones, have real deposit rates much below 6-10% and some have much higher. For much of 2007 and 2008 real deposit rates in China were negative. I haven’t really thought through your estimates, but even using your calculations these kind of numbers can have a very significant impact on household savings rates.
Furthermore, and this is to address Bruce’s point too, the relationship between savings rates and deposit rates also depends on the reason for saving. If many Chinese save for precautionary motives, as seems likely, then there can be a 1-for-1 correlation between changes in the deposit rate and changes in consumption. For example, take the student I mentioned in my November 27 entry. She told me that her aunt wanted to have saved a specific nominal amount of money for her son by the time he was ready to enter college (a very common reason for saving among many Chinese families).
In that case, according to her niece, my student, she implicitly set an amount by which every month she wants her total savings to raise. Let us say she wants to increase her savings by RMB 100 per month. If her interest income is RMB 40 per month, she then takes RMB 60 per month out of her wages. If interest income suddenly declines to RMB 35 per month, she needs to take an extra RMB 5 out of her income. This would also hold whenever the saver has an implicit or explicit target for the growth is total savings that he requires.
Quote Michael: “very few developing countries with relatively free interest rate markets, even rapidly growing ones, have real deposit rates much below 6-10% and some have much higher.”
I don’t know if they classify as “relatively free interest-rate markets”, but Thailand and Malaysia have had very low real deposit rates for quite a while now.
I also quickly checked data for the Philippines, and they appear to have real deposit rates just a bit above zero right now (5-6 % deposit rates vs. 4 % inflation).
And Indonesia, hardly a “stable” country, has current deposit rates of 6-8 %, and a current inflation of 6 %. Again, not exactly a high real deposit rate.
Are you saying all those countries should increase their interest-rates sharply to achieve real rates of 6-10 % for savers?
But let’s assume China decides to change its interest-rate policy by raising both deposit and lending rates by 5 percentage points to bring them closer to the range you mention.
If households do react in the way you think they might, this could increase private consumption by up to 2 % of GDP.
But wouldn’t such a massive increase in lending costs lead to a sharp drop in investment demand (as companies would take out a lot fewer loans, and would deposit much more of their cash-flow in bank deposits), which would most likely be significantly bigger than 2 % of GDP?
In other words: Even if household savings does go down as a consequence of higher real interest-rates, wouldn’t this make the short-term “savings glut” problem bigger, and lead to a significant contractionary effect on the Chinese economy?
I agree regarding your points about SoE production being sold to exporters and competing with potential imports.
Another point just occured to me: I suppose if official lending rates were raised, private companies might more easily be able to access funds “freed up” by lower demand from SoEs. In other words, it might mean higher funding costs for SoEs, but quite possibly lower funding costs for private enterprises.
You mention that informal banks pay deposit rates of 15 % and more. I wonder: Who are the people depositing money there? If Chinese households have the option of depositing money with informal banks at such high rates, why don’t they simply do it? Or do they fear the risk of government crackdowns and/or insolvency of the informal bank, which leads them to demand such high rates to compensate for their perceived risk?
Thomas, I would argue that Indonesia, Korea, Japan, Malaysia, and Thailand are all part of the same development-model group, so comparisons among them would tend to show the same results. They have all, to a greater or lesser extent, been followers of what I call the Asian development model, and to that extent all of these countries have bank-dominated systems in which interest rates were heavily controlled for policy reasons. Ronald McKinnon cites these as examples of “financial repression.” My point is that all of these countries, and not just China, have certain shared characteristics, and to a very large extent have followed similar credit polices. You would need to look at other developing countries with more “normal” characteristics – including the normal propensity of developing countries to run capital account deficits, not surpluses. Latin America, Africa, Eastern Europe, and Asians that followed other development paths would be the right comparisons, although we would need to make all sorts of difficult adjustments for risk and growth.
I don’t usually think of the Philippines in the “Asian development model” category, although I am not sure to what extent credit is heavily determined by policy, so they might be an interesting example, but I would caution that looking at a single point in time – and especially a very atypical point in the midst of crisis – might not be useful. It would be good to get a sense of what their real interest rates were during the past decade, and whether most Philippine savings is in the form of bank deposits. I never traded Philippine bonds, but it seems to me that peso-denominated government bonds, which were available to the public, had some pretty juicy yields.
@Michael
ok, if your point is not just China, but “Asian development model” vs. “other emerging markets”, you might well be right regarding higher vs. lower real interest rates.
Though I suspect that Asian governments would retort: “But our countries developed quite splendidly, whereas Latin America and Africa and most parts of Eastern Europe were struggling to keep up.”
Btw, you write the normal propensity of developing countries is “to run capital account surpluses”. Presumably you mean deficits, as the Asian countries did record surplusus, whereas the others didn’t, right?
Michael argues “
“What the world needs from China is not an increase in total consumption but rather an increase in net consumption . . . that is roughly in line with the decline in US net consumption.” I would only add: . . The decline in US and European net consumption which is not going to happen. The 5 TRILLION rmb “stimulus package” went mostly to SOEs to increase production. Michael earlier made the point that during the 30s it was the surplus countries which were forced to do most of the adjusting – I.e. reduce supply, which is of course what the govt is attempting to prevent. Will they succeed? No. Output will continue to fall, unemployment will continue to rise, consumption will NOT replace US and European imports; real interest rates will depend on prices – which should raise an interesting debate on this blog. Will prices rise or fall (or both)?
Michael- I agree that formal agreements limiting government’s ability to affect production/consumption are politically infeasible, and perhaps not desirable in a world without robust international organizations or norms.
But, given the obvious scope of innovation you’ve laid out in this area it is hard not to see the false sense of safety created by the WTO as anything but dangerous. Most observers in the US have falsely seen the US trade deficit as a ‘natural’ consequence of the ‘free market.’ Clearly, to a great degree this is not the case.
So, a sense of complacency allowed imbalances to build in this area, feedback to and from the financial system. It leads me to be more sympathetic to the idea of Balanced Trade, at least as a general policy goal.
I realize their are intertemporal issues around demographic change. But trade surpluses seem a clumsy way to deal with workforces decline. At the least, in those cases parameters on the investment of the surplus should be set with deficit countries and the policy should be made explicit to the declining population country’s trading partners.
very good post michael. i’d like to see one explaining the whole ‘inflate the debt’ thing. do you think it’s possible? i don’t see what can hold bernanke down. even if the dollar gives in, the US has the resources to go it alone. you import inflation only through your raw material inputs and those can be sourced in dollars (or dollar linked currencies) easily. i think.
Michael,
Excellent and comprehensive thoughts, as always.
There is one other key channel by which GM’s bankruptcy could be deemed to be protectionist.
The US government is putting an additional $50bn, or so, into GM. This increases the US debt, and will increase long run inflationary expectations — assuming taxes are not expected to be raised to pay for it.
(Of course, if expectations of future tax increase are Ricardian equivalant, then this will negatively affect consumption).
China, as the largest holder of US debt, will shoulder the incremental inflationary risk. The future RMB value of China’s US debt (in real terms) just fell.
Fx reserves do not represent domestic wealth, but they do represent a way in which the US is bailing out its own firms at the expense of others, including China, in violation of “free market principals”.
respectfully yours,
Nick
The analysis seems to miss two important issues: accumulation of assets, and fiscal policy.
Policies that encourage or cause the accumulation of assets within the country can increase employment and increase production while reducing the trade surplus. You state “the relationship between production and consumption must affect the trade balance because the excess of production over consumption is the trade surplus.” Your equation really does not appear correct. For example, if the government of China purchased a million tons of aluminum, put it on ships, and sunk them in the sea that would be consumption (an idea suggested by Twofish to increase consumption). However, if instead they took the metal and made it into a large pile of ingots in the desert to be retrieved at some distant future date when aluminum is in short supply, that would not be consumption (at least according to my dictionary). Again looking at your equation: production-consumption = trade surplus. Where does the aluminum in my example fit? I think that the proper equation is production – consumption – accumulation = trade surplus. By accumulation I mean real assets within the country not paper assets, debt of other countries, or assets in other countries. I think that this is an important issue because developing/increasing real assets within China and other persistent trade surplus countries is one way that they can reduce their trade surpluses and associated worldwide financial imbalances while increasing employment, production, and creation/accumulation of real wealth.
The second item is fiscal policy, which I do not see mentioned anywhere. The net government deficit or surplus is directly related to the trade surplus or deficit. If the government were to borrow and spend most or all the net savings of individuals and businesses in the country, the trade surplus would necessarily trend towards zero.
I think this is maybe the worst article I have read of your Michael because it misses the key point. All the nonsense that we are told affects trade does to some point, but there is only one thing that keeps trade imbalanced over the long term and that is credit. The exchange rates between currencies is more banker games than it has much to do with countries. But, if Country A is running a surplus with Country B and it has 2 credit policies, lend to build more structure to sell to country B and lend money to Country B so it can buy more goods from Country A, then it is at the mercy of expanding trade with Country B. If the consumers in Country B didn’t have credit, they couldn’t spend beyond their nations capacity to earn in the international arena.
G. Stegan, in the post above comes close in that deficit spending has a lot to do with this, but the truth is that the position of reserve allowed the US to become the credit machine for the world. Deficit spending in a country that possesses the reserve currency only aids and abets the export of credit for the import of goods. The great secret none of us are told, which creates the confusion is that there is a void between money created and money owed to the creators and that void is called interest. Thus the deficits become necessary to continue the game. If the game was more along the lines of Austrian economics, these imbalances would never arise to the point we see them today. If the compound interest equation would withstand the test of time, we would have several billion quadrillion dollars in the world by now.
Professor Pettis: Thank you for your insightful post.
The history of value destruction via the Asian Developmental Model is a theme you noted earlier c.f. A. Young and then P. Krugman.
For interesting though dated empirical studies, see Pomerleano, M. (1998), “The East Asia Crisis and Corporate Finances: The Untold Micro Story”, World Bank Working Paper No.1. 1990; and Farrell, D., and Lund S. (2006), “Putting Capital to Work”, The Far East Economic Review, pp. 5-10, May.
Huge value destruction by state controlled banks is a big reason for current financial reform efforts by the CBRC.
The puzzling thing is that the OECD, WB and Bosworth and Collins find that TFP and ROE in China have been quite good since around the late 1990s. So did value destruction turn the corner since around 2002 in China?
The HKMA study (by ex-colleagues) singles out “subsidised credit” as an overlooked culprit. Probably true.
I have not yet read the HKMA study but there may be a survivors sample bias. As the SOEs sector has been radically downsized and restructured (plus privatisation of smaller entities) since the late 1990s — such studies should be made with matched samples. Judging from Xiao, Geng (2005), “What is special about Enterprise Performance in North-East People’s Republic of China? Dynamics of Privatization, Profitability and Productivity during the Reform Era”, ADB-I Discussion Paper No. 28 — such an approach might give less pessimistic views over value destruction.
Another relevant factor might be supercharged economic growth and export dumping after 2002. Ideally profits data should be cyclically adjusted (i.e. like a full employment unemployment rate) — if we could figure out what the PRC’s underlying potential growth rate is — but for that we would need reliable and credible National Accounts data. best regards, James
Thomas, Asian governments might very well make that retort, but I am not sure what the relevance would be. The point of my post was not to wave the flag of the Latin American development model, or to argue that the Asian development model has underperformed. It was simply to consider some of the conditions that underlie the success of the model and to suggest that at least some of these are likely to be challenged in the next few years. And yes, I did mean capital “deficits”, and have changed it. Thanks.
MN (and Nick) I am not sure what you mean by “inflate the debt.” Are you talking abut US dollar inflation, or US dollar depreciation? These may be related but they are quite different. I think there is always a temptation when the debt burden gets unbearable for a government to inflate its way out, but perhaps unlike many others I do not think the US is facing an unbearable burden yet, and I think the experience of the late 1970s and early 1980s will limit the eagerness of policymakers to go the inflation route. Inflation may be relatively easy to ignite but it is very difficult and painful to extinguish. That doesn’t mean that inflation cannot happen, but I would argue that the jury is still out, and that it will depend largely on the response of the US and other central banks once credit stabilizes.
G. Stephen, yes you are right that the consumption/production equation has to be adjusted by changes in inventory, but I have ignored that mainly because over the longish term these changes should work out to zero, and I was necessarily writing at a fairly abstract level. In fact elsewhere I have often written that the first place we are likely to see the ill-effects of the adjustment are in rising inventory levels. As for your second point, I deal with fiscal policy both when I discuss consumption (which was never intended to mean only household consumption, but also includes business and government consumption) and when I discuss taxes.
Mannfm, I think you may be identifying an arithmetic identity and converting it into a causal one. Trade imbalances are not really caused by credit imbalances. They often result in credit imbalances (at least they do after we all went off gold) because trade surpluses must be recycled. For example I don’t think the PBoC made a credit decision to lend to the US because it wanted to generate large trade surpluses. It entered into a number of policies that willingly or unwillingly led to massive trade surpluses, and it had to recycle the proceeds. The PBoC would have loved to reduce the amount it was lending but it could not do so as long as it ran large and growing surpluses.
Mannfm,
Michael Pettis is either a lot smarter than I am or merely a lot more polite. Besides finding it a little rude I find your comment incomprehensible. In your example, contrary to what you say, Country A is not able to choose either to to use the proceeds of the trade surplus to invest in domestic production or to lend to country B. It has already lent or otherwise invested the proceeds in country B. The trade and balancing capital account transactions must occur simultaneously.
Michael.
Perhaps you missed the point. By “accumulation” I mean increase of real assets/wealth within the country. Changes to normal business inventories would be a minor/short term component. The aluminum example is intended to be more in the nature of “saving” for a distant rainy day when it will be needed. Accumulation of stockpiles when there is surplus production (low prices) could be a strategy for smoothing the business cycle. However, the primary accumulation I had in mind (and that seems to be missing from your equation) is permanent real assets, such as roads, bridges, dams, power plants, parks, permanent improvements to land, high polluting inefficient or unsafe factories replaced with low polluting efficient safe factories, homes (new and improvements to existing), hospitals, irrigation systems, railroads, restoration of damaged or polluted land, etc. It could be argued that accumultion might also include some other intangible assets like organizational structures, educated and healthy population, intellectual property(knowledge), etc.
Manny is dead on. All the other factors that effect trade are itty-bitty when examined apart from the impact of credit. The deregulation of the credit market is not much different than me putting 50 lbs of food on the floor for my yellow labrador retriever. GM is another good example such as it used to be I had to obtain financing from the local bank (8-9% interest + principal) to buy a new pickup truck, gradually all of this changed so I could lease a new truck every 24 months for 1.9% interest + principal – residual value which resulted in a much lower payment and a new vehicle every 24 months. Automotive dealerships were popping up like Starbucks. Point in case is an unsustainable rate of automotive consumption on the back of loose credit policies.
Equity lines of credit are another good example of handing over the tools of balancing trade to the consumer. Equity lines of credit opened the floodgates of new credit that purchased the types goods which imbalance trade; interest rates should have at the very least been higher for consumables over assets.
John says “Country A is not able to choose either to use the proceeds of the trade surplus to invest in domestic production or to lend to country B. It has already lent or otherwise invested the proceeds in country B. The trade and balancing capital account transactions must occur simultaneously”. – This makes no sense as the tax revenue generated by Country A and the credit policy of Country A can be directed into its own production infrastructure.
Manny, not only did the position of reserve allow the US to become the credit machine for the world, the low interest Yen expanded into substantial global carry trades to also inflate higher assets prices, where higher asset prices bloated equity lines of credit. I agree that the Austrian model would not support trade imbalances anywhere near the level of today. I have no doubt that the US Federal Reserve had sufficient tools to regulate credit appropriately in balancing trade, but they failed miserably!
In a globalized world, almost anything economic action has trade ramifications. I would add domestic policy, such as environmental, trade union, zoning, transportation, health care, etc.
Also, the ability of the financial sector to transform local actions into global effects, with associated lack of transparency, increases the challenge.
In a strange way, globalization results in trade policy becoming more less effective over time, resulting in involuntary protectionism via policy.
Either the world must *standardize* on a set of policies (e.g., EU), or we must be resigned to having little control over the domestic impact of trade. I fear we are going to be given the standardization *cure*.
This might be of interest………
China’s dubious earnings numbers
“The less damning of the two is issued under the auspices of the Hong Kong Monetary Authority and written by Giovanni Ferri, of Italy’s University of Bari, and Li-Gang Liu of BBVA, a bank. It argues that the profits of China’s large state-owned companies are entirely a product of subsidised financing by state banks, which lets them borrow much more cheaply than private or foreign firms (see chart).”
http://www.economist.com/finance/displaystory.cfm?story_id=13751636
Michael you said “Trade imbalances are not really caused by credit imbalances. They often result in credit imbalances (at least they do after we all went off gold) because trade surpluses must be recycled. For example I don’t think the PBoC made a credit decision to lend to the US because it wanted to generate large trade surpluses. It entered into a number of policies that willingly or unwillingly led to massive trade surpluses, and it had to recycle the proceeds. The PBoC would have loved to reduce the amount it was lending but it could not do so as long as it ran large and growing surpluses.”
So basically what you are saying is that the PBOC was chained to the consumption and credit expansion of the US, therefore the credit imbalance was caused by the trade imbalance and the policies that led to this trade surplus may not have been deliberate?
Anyone who has read author Jared Diamond’s works is familiar how the influence of geography can determine the fate of societies. Trade imbalances begin with geography, Agriculture in Eurasia (the Middle East had by far the best collection of plant and animal species suitable for domestication) Saudi Oil Fields, South African Gold Mines just to name a few.
In China’s case the geographical imbalance is its population. Obviously the Chinese government has harnessed this advantage by contracting it out to produce goods for a global export market. The policies that have employed millions of Chinese have created a massive concentration of wealth and power for the Chinese government and Elites. Why would the powers to be want to slow down the trade surplus when they are the largest beneficiaries, as long as the population is manageable?
At the end of the day all the sophisticated, intellectual, deceitful credit instruments are nothing more than tools used to exploit the geographical imbalances that already exist. Saying that the PBOC would love to reduce the amount it is lending to the US is like saying it would love to keep a Ponzi scheme going without taking new money in, fully knowing that the money is running out.
Quote Michael: “The great secret none of us are told, which creates the confusion is that there is a void between money created and money owed to the creators and that void is called interest.”
Which only becomes a problem if real interest is above zero (or rather: above the sustainable rate of economic growth).
@G.Stegen
What you call “accumulation” seems to be another word for “infrastructure investments” (based on the examples you give). Or do I misinterpret you?
Just a few thoughts…………..
Think about the effects if the US Treasury were to issue a new concept of debt to surplus countries like China, where the Treasury note is only redeemable for US goods and services.
-increase US employment
-boost domestic consumption and employment in China
-reduce US government subsidy
-prompt the Chinese government to invest into healthcare, environmental and other technologies which improve their standard of living and human rights.
Simply accumulating US Treasury $’s increases instability and makes no commitment towards the reciprocation of trade.
G. Stegen, I need to think a little more about your example, but I think the accumulation of commodities for future production can be seen as a form of reserve accumulation. Infrastructure spending of course is different, but I am not sure about its relevance in this discussion. Let me think about that a little more.
Stoneweapon, I don’t think I implied at all that “the PBOC was chained to the consumption and credit expansion of the US.” In fact I am more usually criticized for arguing almost the opposite, so at least it is refreshing.
The point that I think John Wax was making, and if that is his point I fully agree, is that trade and credit imbalances occur simultaneously and it is not at all obvious that causality must always run in one direction. I don’t want to get into directions of causality here yet, but to think the global trade balances are determined only by credit and consumption shifts in the US means, among other (implausible) things, that trade policies in exporting countries have no impact on trade balances. That is theoretically possible, of course, but it would mean that an awful lot of countries who have implicitly or explicitly engaged in various types of industrial and trade policy, including those discussed in Alexander Hamilton’s Report to the Manufacturers (in my opinion the best brief ever in favor of trade policy) were wholly misguided. It would also suggest that the temporary surge in the US trade deficit in the mid-1980s, which seemed to revert after the Plaza Accords, had nothing to do either with Japanese policies or with the Plaza Accord but was wholly a function of unexplained volatility in US consumption and credit habits. I find that a little hard to believe. The US matters to the world, of course, but I think quite a few other countries are capable of generating their own history.
Thomas, it was mannfm who said that, not me. frankly I am not sure what that means.
Michael, I had to read this post and the comments a few times to see where you were going and how this fits into your overall Minsky framework, but congratulations. This is truly excellent.
Actually, I was attributing the impact of trade imbalances as China’s choice in reference to John’s point.
For example:
-Chen sells $10M of steel plate to Ben
-Ben debits his Citibank line of credit to pay Chen
-Chen purchases $1M in US Treasuries
-Chen pays $1M in US denominated expenses
-Chen exchanges $3M into various foreign currencies for other expenses and investments
-Chen exchanges $4M into Chinese Yuan through PBOC, and pays wages, overhead and taxes
-PBOC purchases $4M in US Treasuries and other investments to hold as assets on its balance sheet.
-Tax revenue builds infrastructure to mostly benefit Chen.
-US steel competitors lobby the government for tariffs on Chinese imported steel
-Ben increases his line of credit with Citibank to increase his purchases before tariffs take effect.
John says “Country A is not able to choose either to use the proceeds of the trade surplus to invest in domestic production or to lend to country B. It has already lent or otherwise invested the proceeds in country B. The trade and balancing capital account transactions must occur simultaneously”.
Michael says “The point that I think John Wax was making, and if that is his point I fully agree, is that trade and credit imbalances occur simultaneously and it is not at all obvious that causality must always run in one direction. I don’t want to get into directions of causality here yet, but to think the global trade balances are determined only by credit and consumption shifts in the US means, among other (implausible) things, that trade policies in exporting countries have no impact on trade balances”.
If we assume Chen is part of Country A, then obviously he would want to increase productivity, so he will reinvest accordingly contributing to a trade imbalance with part of Country B (Ben). Ben is more than thrilled to continue importing its steel as long as it is more profitable than producing steel in the US.
Not being able to choose what to do with the proceeds of the trade surplus because the transaction is simultaneous still makes no sense to me unless Chen sold $10M in steel to Ben for one big fat IOU, Chen would be cash poor and out of business in no time. Countries don’t lend 100% of their proceeds; they lend only a portion and choose what to do with the balance. The credit machine fuels the velocity of these types of trade imbalances; an increase in credit available to the Ben translates into increased production and sales for Chen.
Credit imbalances start with geography and end with the inability to pay if the savings glut of these imbalances fails to circulate or reciprocate.
A relevant argument in relation to Micheal’s “it’s not just currency”
I’d be curious to see how a 40% appreciation of the Renminbi would impact China’s trade surplus?
“Is China Having It Both Ways”?
by Arvind Subramanian, Peterson Institute for International Economics
Post on the Wall Street Journal’s Real Time Economics
March 25, 2009
“China made headlines across the globe this week with its call for the establishment of a new currency to replace the dollar as the world’s reserve currency. The impeccable timing, just prior to the London G-20 summit, has allowed China to articulate the concern as a systemic one.
There may well be problems with the current dollar standard that underpins the world’s financial system. The dollar standard may also have had a role to play in the current crisis. But China’s real reasons are national: It fears the loss in the value of its reserves of $2 trillion from a sharp dollar decline. And that threat of dollar decline has suddenly become more immediate because of the dramatically increased vulnerability of the US government’s balance sheet.
But is China trying to have it both ways? It is seeing itself as the victim of the dollar standard when it has been, for a long time, a beneficiary and promoter of this standard.
Today’s problem is simply the natural culmination of China’s deliberate development strategy of mercantilism. To assess whether China’s fears are justified requires a benefit-cost analysis of the mercantilism employed by Chinese leaders.
China’s development strategy has been simple and focused: export at any and all costs. To achieve this, China has maintained an undervalued exchange rate. This mercantilist strategy has empirical backing. Recent academic research (for example, by Harvard’s Dani Rodrik) supports the view that undervalued exchange rates can provide a means of escape from underdevelopment and can be an engine of long-run growth. So China’s development strategy has been sensible.
But undervalued exchange rates and the resulting rapid increase in export growth has also led to large current account surpluses. The Chinese authorities have intervened in foreign exchange markets to keep the currency from appreciating, leading to a massive build-up of foreign exchange reserves. It is important to understand that this reserve build-up has been a consequence of the Chinese development strategy of mercantilism. Had the currency been allowed to appreciate, its current account surpluses would have been lower, and China would not have this pile of reserves to “worry” about.
The costs of mercantilism are essentially what China fears now: a substantial capital loss on the value of its foreign exchange reserves of $2 trillion. This risk, always understood as inevitable, has become urgent because the dramatic deterioration of the US fiscal balance has brought forward the date of dollar decline. Suppose that the eventual dollar decline and reequilibration of the yuan result in a 20 percent capital loss. This would amount to $400 billion or roughly 10 percent of Chinese GDP.
But are these financial losses outweighed by the mercantilist growth benefits? Suppose that China cares about growth rather than consumption (we want to do the calculus in terms of the revealed preference of China’s leadership). Suppose too that undervaluation in China has worked and has generated higher growth over a period of time than would otherwise have been the case.
For China, let us for the sake of argument assume (conservatively) that mercantilism led to a higher annual productivity growth rate of 1 percent for a period of 10 years (this is consistent with the estimates in papers by Rodrik and others). This extra productivity growth results, after ten years, in a level of GDP that is higher by 10 percent than it would have been otherwise. One year of this GDP gain is lost in the depreciation of the reserves. But this higher GDP is a permanent benefit that occurs every year and extends well beyond the ten year period. Precise quantification of the net benefits depends on many assumptions but the broad orders of magnitude are clear: The total GDP boost from mercantilism is substantially greater than the financial costs.
So, China should recognize the following. It deliberately chose a mercantilist strategy. That strategy yielded tremendous benefits in precisely the terms valued by the Chinese leadership. But it also entailed financial costs that are intrinsic to, and indeed the flip side of, the growth benefits. So while its calls for reevaluating the current dollar standard are welcome, they should not become an attempt by China to avoid these financial costs. These costs are unavoidable and moreover they are only a fraction of the growth benefits that it derived.
The world these days is finding it hard enough to bail out debtors. It would be something else if the world’s largest creditor also had to be bailed out, which seems to be the real motivation behind the Chinese call to change the dollar standard.
China and the United States are now like Siamese twins “leaking into each other,” in the words of Salman Rushdie, through trade and capital flows. China chose this embrace with its eyes open as part of a bargain. It has enjoyed the benefits. It is now trying to avoid the costs by splitting off. But that is neither desirable nor should it be made possible”.
http://www.piie.com/publications/opeds/oped.cfm?ResearchID=1163
“By keeping its own currency undervalued, China has also deterred a number of other Asian countries from letting their currencies rise very much (if at all) against the dollar for fear of losing competitive position against China. Hence China’s currency policy has taken much of Asia out of the international adjustment process. This is critical because Asia accounts for about half the global surpluses that are the counterparts of the US current account deficit”
“About one quarter of all of China’s economic growth in the past two years has stemmed from the continued sharp rise in its trade surplus. China is thus overtly exporting unemployment to other countries and apparently sees its currency undervaluation as an off-budget export and job subsidy that, at least to date, has avoided effective international sanction”.
“China needs to adopt policies to promote an opposite adjustment, reducing its uniquely high national saving rate by increasing domestic consumption. China can increase domestic spending directly through higher government expenditures on health care, pensions and education. Such new government programs are needed for purely internal reasons because of the unrest in China that has resulted from the demise of state-owned enterprises that provided these benefits in previous times. They would also reduce the precautionary motive for household saving in China; this would boost private as well as government demand, contributing importantly to the needed international adjustment”.
http://www.iie.com/publications/papers/paper.cfm?ResearchID=747
If the main source of the high savings rate is the corporate and government sectors of the economy, this author is being too polite. The working class of China is effectively being oppressed of its right to be rewarded via currency appreciation or purchasing power in return for their contribution to economic growth. This kind of oppression leads to underdevelopment.
Mercantilism – (interesting last paragraph)
http://en.wikipedia.org/wiki/
“The Austrian lawyer and scholar Philipp Wilhelm von Hornick, in his Austria Over All, If She Only Will of 1684, detailed a nine-point program of what he deemed effective national economy, which sums up the tenets of mercantilism comprehensively:[5]
• That every inch of a country’s soil be utilized for agriculture, mining or manufacturing.
• That all raw materials found in a country be used in domestic manufacture, since finished goods have a higher value than raw materials.
• That a large, working population be encouraged.
• That all export of gold and silver be prohibited and all domestic money be kept in circulation.
• That all imports of foreign goods be discouraged as much as possible.
• That where certain imports are indispensable they be obtained at first hand, in exchange for other domestic goods instead of gold and silver.
• That as much as possible, imports be confined to raw materials that can be finished [in the home country].
• That opportunities be constantly sought for selling a country’s surplus manufactures to foreigners, so far as necessary, for gold and silver.
• That no importation be allowed if such foods are sufficiently and suitably supplied at home.
Mercantilist domestic policy was more fragmented than its trade policy. While Adam Smith portrayed mercantilism as supportive of strict controls over the economy, many mercantilists disagreed. The early modern era was one of letters patent and government-imposed monopolies; some mercantilists supported these, but others acknowledged the corruption and inefficiency of such systems. Many mercantilists also realized that the inevitable results of quotas[disambiguation needed] and price ceilings were black markets.
One notion mercantilists widely agreed upon was the need for economic oppression of the working population; laborers and farmers were to live at the “margins of subsistence”. The goal was to maximize production, with no concern for consumption. Extra money, free time, or education for the “lower classes” was seen to inevitably lead to vice and laziness, and would result in harm to the economy.[10]
Professor Pettis: A fascinating discussion, except for the sour grapes from manfm 11.
If I understand your arguments — a globalised world is shifting the world order quickly towards a “Stolper-Samuelson” paradigm. Under this regime the distinction between trade, domestic and structural adjustment policies becomes blurred. Hence, one has to look at the complete array of policies to discern the impact on “Production vs Consumption”.
But if this gap depends on virtually “everything” what is the pecking order from “bad, badder to terrible” trade distorting measures? What should the criteria be based on: trade exposure? The markets’ speed of adjustment or other indicators (e.g. credit, debt/GDP)?
Would you give your top rankings to exchange rate manipulation, followed by capital controls or import quotas? Where would you rank government subsidies? Subsidised interest rates and bank vs the bail out of GM/Chrysler in terms of trade distorting measures?
Should we be giving equal stick to China’s support of its Aluminium industry vs. say US and EU agricultural policy?
best regards James
Chan,
I like how you put your question. I would like to see a top 10 list that we could almost agree on.
Micheal,
I am frustrated by the lack of consideration attributed to the level of impact credit markets have on trade/consumption in respect to where the impact of currency and tariffs stand.
I think too many of these other policies/factors that impact trade are more reactionary to credit flows, than being influential.
Credit seems to flow in the path of least resistance if it is not regulated towards balancing production and consumption, and the imbalance of the regulation of credit between countries intensifies the imbalance of trade.
How do you balance the flow of credit between production and consumption without resorting to protectionism?
http://english.caijing.com.cn/2009-06-04/110178076.html
Just been reading this article from Caijing. It mentions an “Inflation tax” that could result from current monetary policy in China. Has anyone got the May lending figures yet? I saw a rumour reported of 500bn RMB…
Seems to me that consumption and production must be equal in the long run, both from a domestic point of view and from an import/export point of view.
For example, if imports and exports are not equal then credit must accumulate somewhere in the system (e.g. US treasury bonds). As credit accumulates, this is equivalent to a growing I.O.U. tally (the promise of future payback) — such promises cannot grow forever if they are realistically going to be fulfilled. Either the system gets rebalanced and the debt is paid (which is to say that the I.O.U. promise is fulfilled) or a default occurs and the promise never gets paid back. The default (broken promise) represents a retrospective revaluation of past trade to enforce a value balance.
Let us suppose for the sake of argument, that inflation in the USA, and devaluation of the US dollar, causes China to lose half the real-world value of their US Treasury bonds (an arbitrary round-number figure). What this would do is retrospectively make all of the previous exports from China to the USA roughly half the price than they seemed at the time.
Thus forcibly zeroing out the balance of trade (import vs export) for the two countries.
Policies designed to swing the balance between production and consumption can only have a short-term effect, before some external event overrides the policy. The more determined the policy makers are to keep things out of balance for a long time, the bigger the eventual correction that comes along (typically, uncomfortable for the people concerned).
What government policy can do (on a long term basis) is increase or decrease the total trade (both import and export) between their particular country and the world (which is to say, government can encourage isolationism, or globalism as it sees fit). Protectionist policies that keep some particular production inside the country are merely isolationist policies in disguise.
I would argue that it is usually better for government policy to push the balance of trade toward being more balanced rather than less balanced. Given that it is going to balance sooner or later by force of nature; better to bring it into balance sooner, and better to do it in a controlled manner.
In Australia we have a floating currency which will push the trade towards a balance automatically, and it has been of great benefit to us. If our government wants to subsidize our manufacturing industry, any effect this has on import/export balance is absorbed by our floating dollar. If China is determined to stockpile minerals, our Australian dollar floats up and makes those minerals more expensive, while automatically encouraging the Australian people to buy more foreign goods.
Chan-lee, I don’t think we can rank them in any absolute sense because the direct and indirect amounts by which the policy affects the trade balance matter, and these are very hard to measure, but in China my instinct is that interest rates and credit policies have the most impact on the trade balance because they are very large numbers and they affect both consumption and production.
Posit a country in which the government runs loose monetary policy and channels most credit into infrastructure and investment, while simultaneously (implicitly) guaranteeing the credits and confiscating a significant part of household savings to subsidize corporate borrowing costs. That country would almost certainly run a large trade surplus. This is effectively what is happening in China. Lots of other things matter and I am sure a better economist than I could work out rough estimates of their impacts on the trade balance, although given the complexity of the measuring the primary impact and the even greater complexity of secondary impacts, I never put too much faith into these kinds of estimates.
Stoneweapon: “How do you balance the flow of credit between production and consumption without resorting to protectionism?”
That is indeed an interesting question. Assume a world of two countries and open trade. If they both run loose monetary policies, in both cases the financial system is likely to accommodate by creating credit. If one country directs most credit into production, and since production and consumption must balance, wouldn’t the financial system in the other country be forced into channeling most credit creation towards consumption.? Or vice versa?
Professor Pettis:
Thank you for your honest, albeit inevitably vague reply, given the huge problems of figuring out how the price mechanism works in a partially liberalised economy — in which a big lever of state control is credit allocation.
It would never the less be interesting to get your implicit feel for the “Pecking order”. My own starts like yours with the exchange rate — as it probably has the biggest leverage effect. This subset would include exchange rate intervention and sterilisation measures.
I would personally not put interest rates second — as they are only weakly market driven — but rather credit controls — via the MITI model.
After that, taking a shot in the dark I would place export subsidies (including myriad tax breaks, free infrastructure, cheap land in SEZ’s etc.) and import controls including NTBs and obvious biases in Government procurment policies.
I have no idea where to place capital controls — but they are clearly also important.
All these instruments are part of the arsenal of mercantilist policies that depress consumption (even though the levels are probably understated) and create chronic over investment.
Curiously, this may also be happening in higher education as you note in your latest post. I wonder what the market signals are for investing in higher education these days?
best regards JamesC
While there is a continuing focus on the managed renminbi in this debate, i feel the impact of the aggregation of the oil rich countries into the dollar sphere is underestimated. What distorting effect on the external purchasing power of the dollar may be attributed to the petrodollar status?
I ask this question as a German, who is with a degree of worry pondering the imbalances of western and southern Europe within the Euro sphere. Less competative southern countries are sharing a currency with more effective Germany and France, thereby living under a currency, which overstates their production efficiency and thus boosts unemployment. I suspect as the Euro is a sum of its parts it gave a corresponding competative advantage to Germany in recent years, as it had less purchasing power than the Mark would have retained and thus blessed Germany with an effectively depreciated currency in the world markets.
I consider this on topic here with regard to the trade balance, as i argue that the dollar has been as much overvalued externally by its incorporation of the oil producing sphere as the yuan may have been undervalued.