Friday, April 21, 2006

The Prosaic Economics of Currency Manipulation

I’m going to toss the two-country, two-sector, two-period model to which I referred in earlier   posts. The prose version of the argument about intertemporal comparative advantage turns out to be a lot simpler than what I said earlier.

Consider two countries, one still developing and the other already developed. Let’s call them the People’s Republic of Developing and the Developed States of America. They have two products, one called “current manufactured goods” and the other called “future manufactured goods”. Which country has the comparative advantage in producing future manufactured goods? If you recognize that developing countries tend to become rapidly more productive, while developed countries only slowly increase their already high productivity, it should be clear that the People’s Republic has the comparative advantage. Equivalently, the DSA has a comparative advantage in producing current manufactured goods. In the normal course of things, therefore, you would expect the DSA to sell current manufactured goods in exchange for future manufactured goods. In other words, the DSA should run a trade surplus, and the People’s Republic should run a trade deficit. (This is in fact the normal relationship between developing and developed countries and explains, for example, why superstar developing countries like South Korea used to run large trade deficits.)

So why is it that, in today’s world, the US runs a deficit, and China runs a surplus? Some might argue that it’s demographics. The US population is growing faster than China’s, so maybe the US actually has a comparative advantage in producing future goods. There are a couple of problems with this argument. First of all, both countries have a large nontradables sector which can employ the excess working population at any particular time, so it’s not as if all those extra workers in China today, or in the US in the future, will go to waste. Second, if you take into account both slower population growth and faster productivity growth, China’s total growth rate is still much faster than the US, and almost everyone expects that situation to continue for the foreseeable future.

A better explanation, I think, is that China is over-saving. Part of the reason for this over-saving is currency market intervention, whereby the People’s Bank of China saves newly minted money in the US. Part of the reason also is that taxes are too high, which forces Chinese people to save via their government. Part of the reason is that profits are high, and businesses tend to save their profits. Part of the reason is that the insurance system, particularly health insurance, is inadequate, so people have to save extra to allow for emergencies. Part of the reason is that the pension system is inadequate, so people have to save for a worst-case retirement scenario, and since all this saving pushes down returns on assets, the worst case gets even worse.

As I’ve said before, in the simple economics of it, China’s excess saving – including what is implemented through currency manipulation – clearly benefits the US. I’ve touched on reasons why Americans – in the not-so-simple economics of it – may actually be hurt, and my intention is to go into more detail later. When I get a round to it...

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11 Comments:

Anonymous mvpy said...

They have two products, one called “current manufactured goods” and the other called “future manufactured goods”. Which country has the comparative advantage in producing future manufactured goods?

Im not sure, knzn. Isnt it the other way round. Like the way Asian countries copy production techniques from the West etc. Leaving the West to concentrate on biotech, these "future goods".

"First of all, both countries have a large nontradables sector which can employ the excess working population at any particular time, so it’s not as if all those extra workers in China today, or in the US in the future, will go to waste."

I think not. China has a tiny nontradable sector. As countries develop services rise relative to all else.

"Part of the reason for this over-saving is currency market intervention, whereby the People’s Bank of China saves newly minted money in the US"

If I give 100 dollars to a Chinese exporter. And suppose he sells them to the central bank of china in exchange for yuan. The central bank just print the yuan. Then he spends the yuan in china. And the central bank buys us treasuries.

Knzn, its semantic point, I suppose, but wheres the saving? The Chinese man spends all the yuan in China, right?


Marty Feldstein has an article in Foreign Affairs about these issues. Might be worth looking at.

Fri Apr 21, 01:56:00 PM EDT  
Blogger knzn said...

mvpy:

“If I give 100 dollars to a Chinese exporter. And suppose he sells them to the central bank of china in exchange for yuan. The central bank just print the yuan. Then he spends the yuan in china. And the central bank buys us treasuries.

Knzn, its semantic point, I suppose, but wheres the saving? The Chinese man spends all the yuan in China, right?”

If the intervention is unsterilized, yes, but in practice it is partially sterilized. I would argue that, on a “velocity-adjusted” basis, it is fully sterilized. They PBoC needs to slow down domestic demand just enough to make room for the additional export production. In the end, in real terms, a certain amount of production is shifted from domestic use to export, and there is a Treasury note to offset the domestic use they’ve given up. That’s saving.

I will think about your other points. The bottom line is, though, China’s production is growing much faster than the US, so it must be getting easier for them to produce stuff, more rapidly than it’s getting easier for the US. Hence optimal trade would produce stuff in the US now, where it’s comparatively (and absolutely) easy, and in China in the future, where it will be comparatively (but not absolutely) easy.

Fri Apr 21, 02:33:00 PM EDT  
Anonymous mvpy said...

knzn,
Thank you again knzn.

Regarding your points, you are, of course, referring to conditional convergence or catch up which is straighforward. But your analysis seems to intimate that the Chinese have higher productivity than the US. But its higher productivity growth, not productivity per se. Its only the latter thatd give them an absolute advantage in the "future goods" you're talking about.
Actually, theres another thing called "leapfrogging" that might accord with your analysis, though. Put simply, the Chinese would be able to develop new techniques whereas, in the US, we're still stuck with old methodologies etc; "stuck in our old ways", as it were. However, with a country as large as China wheres theres still much impoverishment, this doesnt seem that plausible.

Anyhow, knzn, have a nice day.

Fri Apr 21, 09:02:00 PM EDT  
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