Stanley's blog

As the protectionist winds begin to flow eastwards cross the Atlantic, the number one target of the protagonists is the huge Chinese deficit with the United States and Europe.

Three questions need addressing: What is the reason for the deficit? What damage does it cause? How can the deficit be reduced?

Most of us find economics baffling as economists tend to have several different views on any given subject, and the trade deficit is no exception. This plays into the hand of populist and protectionist politicians who simplistically argue that a large trade deficit is bad and China is taking jobs from Europe. It is a very complex, multidimensional and multifaceted problem which arises out of globalisation. Very few products are made these days from beginning to end in one country.

There is, therefore, no consensual answer to any of these questions and any debate is likely to generate more heat than light. At the root of it is whether or not globalisation is a good thing, upon which discussion is pointless as it cannot be stopped. The extent to which and how it can be managed is another debating question.

Finally, benefits to Europe are overall benefits. There are winners and losers and there is no satisfactory method of compensating the losers.

Some of the factors which need to be taken into account are:

What is the reason for the deficit?

A trade deficit means, of course, that imports exceed exports. It is natural for a developed high-cost economy to run a deficit with a low-cost efficient economy; it’s the size of the deficit, and the fact that it is rising, that causes concern. However, it must be borne in mind that:
• in areas where Europe is generally uncompetitive (eg clothing and shoes), restrictions on Chinese imports would simply be replaced by imports from other Asian countries (Bangladesh, Vietnam…);
• some 60% of all exports from China are companies wholly or substantially owned by foreign companies.
• the added value accruing to China is usually very limited (probably to the order of 20%).
• a high profit accrues to European and US companies.
• lower consumer prices bring both direct and indirect benefits
• China’s purchase of US debt benefits the US economy.

Renminbi value

The US continues to apply pressure to Beijing to revalue the renminbi against the dollar. In fact, it has appreciated 16% since July 2005. However, during this same period, the renminbi has weakened some 10% against the euro, which is damaging to European competitivity. However, the problem is the weak dollar and not the strong renminbi. So long as the Chinese currency continues to track the dollar, nothing can be done about this.

What damage does it cause?

Clearly, the workers who lose their jobs due to loss of competitiveness will not be comforted by being told that their country overall benefits from importing low price merchandise.

It is hard to point to economic damage caused by the large trade deficit. The ‘damage’ is essentially political.

How can the deficit be reduced?

This is obvious. As Peter Mandelson says, the European objective is not to reduce Chinese imports but to increase European exports to China.

This means China giving European companies unfettered market access by removing all discrimination. This remains a bone of contention as Beijing insists that this market access exists, whereas European companies operating in China insist that it does not.

However, it is also time that our leaders spoke out and explained why the deficit itself is not a problem. If they think it is a problem, they should say why.

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  1. Mr. Crossick, the following is the standard reply that I leave for American blog posts on the subject of America’s trade deficit, but I think you may find it of interest as well, because the new economic theory I’ve proposed in my book is just as applicable to Europe as it is to America.

    Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth – its preeminent industrial power – into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It’s a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, is now approaching $9 trillion. What will happen when those assets are depleted? Today’s recession may be just a preview of what’s to come.

    Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

    Clearly, there is something amiss with “free trade.” The concept of free trade is rooted in Ricardo’s principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn’t consider?

    At this point, I should introduce myself. I am author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” To make a long story short, my theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

    This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

    One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

    Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. In fact, our largest per capita trade deficit in manufactured goods is with Ireland, a nation twice as densely populated as the U.S. Our per capita deficit with Ireland is twenty-five times worse than China’s. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one sixth of the world’s population.

    Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit my web site at OpenWindowPublishingCo.com where you can read the preface for free, join in the blog discussion and, of course, buy the book if you like. (It’s also available at Amazon.com.)

    Please forgive me for the somewhat “spammish” nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

    Pete Murphy
    Author, Five Short Blasts

  2. It is not true that the American workforce is the most competitive in the world. In fact, such a sentence has no real meaning, so it cannot be true or false. The trade deficit issue is similar to many fiscal illusions in a democracy when people vote differently with their money than with their ballot. The American and European trade deficit with China is not created by politicians but by the consumers who choose the cheaper Chinese alternative for the money they make in their workplace.

  3. Yes, consumers benefit from lower cost goods.

    What is ignored is that these lower cost goods can be obtained without a trade deficit.

    With equal trade as a national objective, imports will continue to come in – so long as an equal value of exports go out.

    The marginal differences between products produced overseas is inevitably less than the total cost of the locally produced product that remains unproduced due to excess imports. When a consumer buys a shirt for 20% less than the U.S. produced shirt, the Gross Domestic Product is reduced by 100% of the cost of the U.S. produced shirt.

    The choice is not between open borders and no imports. The choice is between the level of imports consistent with our ability to sell exports abroad versus continued loss of financial and business assets existing in the U.S.

    The U.S. can control the conditions under which imports come into the U.S. We cannot control what China does. Forget instructing them on anything – especially on something like opening ther borders to imports. They know exactly what they are doing. What they are doing is rapidly increasing their control of the resources of the world. They are quite happy with a trade surplus with the U.S.

  4. Looking at the history of the US dollar since the 1970’s, running a trade deficit is a problem. It will be hard to see for Europeans, though, because there are benefits for a while before it becomes problematic.

    At first, the trade deficit actually seems to be a boon. Your country is consuming more than it produces, and you are able to cover the difference because your currency is considered valuable by your trading partner. As long as your trading partner still wants your currency (because it can be spend for other commodities, like oil), you can continue to run this deficit without consequences. Yes, the cheap imports will force some of your industries into insolvency, but you can replace them with service industries that are, after all, more pleasant to work in and have fewer environmental hazards.

    So, all is well, and as your currency begins to circulate ever more outside of your borders, it becomes essential in the world market and other countries peg their currency to yours. This peg creates a constant market for your currency, and protects it against depreciation even as you print more and more of it to keep paying for your trade deficit.

    However, as you continue to export your currency over the years, there will eventually become a point where the vastness of the supply of your currency in circulation around the world means that other countries own more of it than you do, which means that they have more power to control its value than you do, except for your power to depreciate it by printing more of it.

    At some point it becomes questionable whether you will ever have the ability to service your debts except by printing more money, since you continue to consume more than you produce. In fact, the worse this situation becomes, the more you lose the power to balance trade because the demand for your currency forces your currency up artificially, and the only way to counteract this effect is to dilute its value yet again.

    Eventually we expect a collapse, where either there is an international crisis of confidence in your currency due to vast imbalance between its supply and your ability to pay it back, or else your money printing habit becomes so extreme that countries respond to the depreciation of their pegged currencies by buying other, more stable currencies instead. At that point, your currency will depreciate dramatically, your trade deficit will shrink (nobody wants the money that you’re offering for their goods anymore), and your standard of living will drop because the imports that you’ve been enjoying are suddenly more expensive.

    You might be able to delay this eventual economic rebalancing, the correction of your import bubble, by pulling political strings and by encouraging other countries to lend you ever greater sums of money. They will be reluctant to allow your currency to depreciate since they have so much of their wealth invested in it that they stand to lose a lot by allowing it to fail. But eventually, they must finally decide that they are throwing good money after bad.

    Well, this is my view of how things stand right now for the US economy, and it is also the likely future of the Euro if it is to become the world’s new reserve currency. I’m actually hoping that someone else has a different view of how things could play out, because it all seems too inevitable in this analysis, there must be some other possible twist that could lead things to a different conclusion.

  5. Nate: There is now a proposal from the Chinese Central Bank’s governor. What do you think of it?

    [WORDPRESS HASHCASH] The poster sent us ‘1055386704 which is not a hashcash value.

  6. Nate: A sensible proposal for discussion. The US dollar is a problem, particularly for China. We must move away from dependence on a single currency. But it will take time and patience

    [WORDPRESS HASHCASH] The poster sent us ‘1055386704 which is not a hashcash value.

  7. This is a hot issue!
    China is considered by many to promote exports and discourage imports by fixing its exchange rate towards the US dollar below the renminbi’s ‘real’ value. The support for the view that China’s currency manipulation explains its trade surplus (plus foreign investments and reserve accumulation) largely comes from exercises to determine the “right” exchange rate…

  8. Nice post! This is my first time i visit here. I found so many interesting stuff in your blog especially its discussion. From the tons of comments on your articles, I guess I am not the only one having all the enjoyment here! keep up the good work. Thanks!

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