China.... consume or save?

"We're told that saving rather than consumption will ultimately lead to increased economic growth, as saving will encourage increased investment. However, some commentators insist that Mainland China take steps to increase domestic demand, which is the exact opposite. Why is that?" - Zheng

That's an excellent question! The issue with Mainland China is that it has developed very rapidly on the basis of ever increasing exports to the rest of the world. At the same time, the high level of domestic savings has financed increasing levels of foreign investment outside of China.

But this may be a fragile source of growth. There is growing resentment in some of the rest of the world as China's low-cost production drives foreign domestic producers out of business (irrational, in my view, since the rest of the world benefits on net from free trade with China), leading to increased talk of protectionism. (A by-product of China's massive trade surplus is its growing foreign currency reserves).

Also this makes China's continued development very dependent on the economic health of the rest of the world. Right now, with the US on the brink of recession, it is easy to see that this may not be in China's best interests.

Finally, and most importantly, China appears to be suffering from a serious imbalance. Why does the Chinese economy as a whole save up to 40% of total income (see here)- much higher than nearly any other economy? This suggests some structural problems that the Mainland Government would do well to try to rectify.

In sum, many commentators interpret China's high savings rate and massive trade surplus as symptoms that something is not right in the Mainland economy. It's the "something" that they'd like to see change, rather than the savings rate per se.

Compensating the losers fo Free Trade agreements...

When international trade opens up, there are inevitably winners and losers. Inefficient domestic producers can no longer compete with efficient foreign producers, and end up closing shop. A common refrain from the anti-globalisation lobby is that this alone is a sufficient reason to resist free trade.

Economists don't generally buy this story, because it inevitably results in less efficient use of resources: the ineifficient domestic producers continue their inefficient production. They may instead favour compensating the domestic producers for their financial loss.

But does that make sense? As Steve Landsburg argues (quoted by the Undercover Economist reports), we don't compensate inefficient losers in other economic spheres, so why should we when it comes to international trade? Read more here.

The Collateral Damage of Trade....

Yesterday I posted on the link between trade and disease. Trade results in other risks as well... like creating racial offense from poor translations!

Having read the english translation on the instructions of many items made in China over the years, I can see how easy it is for this to occur. In some cases, I've found that the instructions are worse help than my own intuition! I am sympathetic to this problem, as translation is inherently a tricky activity. I can still recall coming late to a French class many years ago and apologising in French. The class laughed. I'd mistakenly described myself as retarded (retarde) instead of late (retardataire)!

As China continues to develop and move further up the value chain, I am sure that this is a problem that will be consigned to history. It will become worthwhile for Chinese manufacturers to pay native English speakers or professional translaters to write their English language documentation and labels, rather than rely on cheap but inaccurate computer software.

Trading Diseases.....

Economic integration, in the form of the flow of goods, people, and capital is generally perceived to be unambiguous good to economists. Non-economists are sometimes more skeptical, pointing to increased carbon dioxide output due to shipping goods across the globe, and loss of cultural uniqueness as the world becomes increasingly homogenous.

The first of these could be easily rectified with an appropriately implemented carbon tax, while the second is very hard to quantify, or rectify. And since economic integration is a natural phenomena that occurs when individuals are able to freely trade with each other, it's impossible to argue that preventing such integration is not itself costly to society.

But there are other unintended effects of integration as well. Remember SARS? It started in southern China and spread into Hong Kong, one of the most globally integrated regions anywhere. From there it spread far and wide, with over 8,000 patients falling ill in 25 countries in short order.

An even more serious case of integration leading to the spread of disease can be found in Africa. According to a recent study from Emily Oster (thanks to Marginal Revolution for the link), "a doubling of exports leads to as much as a quadrupling in new HIV infections" in Africa. Increasing trade flows result in increased movements of transient workers, who themselves are high risk, and take their diseases with them.

I wouldn't interpret this as evidence that trade is bad per se- it's just one more component to weigh up when deciding how to steer an economy. And remember that HIV infections are just one component of economic welfare. Trade also allows many members of society to improve their living standards, and in poor parts of Africa, this is likely to have a large positive effect on overall health and welfare.

The current account and the exchange rate...

"What is the effect of the current account balance on the exchange rate?" - Vincent

To answer this question, let's take the case of a current account surplus. The current account is determined largely by the level of net exports- the other components of the current account (net factor payments and net transfers) are generally relatively small. So a current account surplus implies that exports are larger than imports.

Paying for exports requires domestic currency, and imports foreign currency. Thus an increase in exports will result in increased demand for domestic currency, and a decrease in imports in decreased demand for foreign currency (=supply of domestic currency)- so positive net exports imply upward pressure on the value of the currency, as the demand for domestic currency is increasing faster than the supply. Thus, to answer your question, a current account surplus will result in upward pressure on the currency. The arguments reverse for a current account deficit.

Empirically, there is not alway a clear link between the value of the currency and the current account, and even where there is, we often observe the exact reverse: after a lag, a decrease in the currency results in an increase in the current account, and vice versa. So what explains this link?

The explanation is that exchange rates are determined largely by capital account flows, rather than current account flows, as the former are much larger. Suppose there is a large capital outflow, for example. This will push down the value of the currency. But as the value of the currency decreases, exports become relatively cheaper and imports relatively more expensive. The direct effect of these price effects is to result in a decrease in the current account balance.

To put this another way, the current account balance may be defined as

CA = Price(exports) x Quantity(exports) - Price(imports) x Quantity(imports)

The effect of the currency depreciation on prices will decrease the current account surplus. But that is ignoring the quantity effects. Over time, trade flows adjust to the exchange rate change, and the quantity of relatively cheaper exports will rise, while the quantity of relatively more expensive imports will fall. After a year or more, the quantity effects will tend to be larger than the price effects, so that the current account will start to rise.

We typically refer to the relationship between exchange rates and trade flows as the "J-curve," since a depreciation results in an initially fall in net exports but an eventual rise, much like the letter J.

Mis-measuring Trade

While we're on the subject of mis-measurement, what do Mongolia, Papua New Guinea, Angola, and Libya all have in common? According to the World Trade Organisation they all trade a greater value of goods and services than they produce- see this link, for example.

This is news to me. The only way a country is likely to trade in excess of production is if it is a major re-exporter, like Hong Kong or Singapore. Yes it is possible for other countries to enjoy a trade:GDP ratio exceeding 100%- if you export every good and service you produce, and import every good and service you consume, the ratio could theoretically hit 200% without any re-exports- but I hardly think that is likely for the countries listed here.

If the ratio is incorrect, it is most likely due to mis-measurement of GDP, with the countries concerned exporting goods produced in the informal sector that slip under the radar of the statistics agency beancounters, and paying for imports with income earned in that same informal sector.

Thanks to Lolita for the pointer.

Paying for Inactivity, Indonesian Style

The Indonesian government have a cunning plan for making money. They'd like the rest of the world to pay them not to destroy the rest of their forests- $5-20 per hectare, to be precise. This might have almost made sense.... the forests in Indonesia are of benefit to the whole world, so the whole world can pay for their maintenance. It's the classic case of externality.

We could apply this same principle in many other areas. Let's pay fishermen not to fish (after all, they deplete the sea, to the detriment of all), farmers not to farm (that'd reduce chemical run-off that is harming world water supplies), and drivers to leave their cars at home (reducing congestion and pollution for everyone else).

But would this really work? I'm very skepical for several reasons. First Indonesia is a very corrupt country. According to Transparency International, Indonesia is ranked 130th out of 163 countries for corruption, on par with Zimbabwe and Ethiopia (in contrast, Hong Kong is ranked 15th, and China manages 70th). Does anyone really believe that this money will get past the government officials charged with administering it to actually help preserve the forests in Indonesia? If so, I have some snake oil I'd like to sell them.....

Second, this sets an alarming precedent. Paying people for not destroying their own environment would encourage more countries to follow suit. How much would the rich world be willing to pay Kenya if threatened with the eradication of elephants and lions? What's the difference between this and blackmailing the rest of the world with the destruction of your own future?

Third, there has to be a better way. How about using property rights, rather than paternalistic handouts, to encourage the indonesians to protect their own forests? It works in Niger, a country that is both poorer (on a PPP basis as well) and more corrupt than Indonesia, so couldn't it work in Indonesia too?

China Trade is Changing....

According to this story, the structure of Mainland China trade is changing. In the past, China imported intermediate goods from the rest of Asia, assembled them into final goods, and exported the final goods to the Western world. Thus China ran a massive trade surplus with the US, while running a trade deficit with most of Asia.

This appears to be changing, with China importing more raw materials and constructing the intermediate goods within its borders. If this process continues, China's continued growth will increasingly come at the expense of the rest of Asia, who will no longer assured of a large market for their intermediate goods.

However, an exploding trade surplus is neither efficient nor optimal for China in the long run. If China continues on its current development trajectory, I expect Mainland demand for finished goods imports to grow rapidly, as consumers demand access to the vast range of goods and services available elsewhere. The beneficiaries from this process will be final goods producers (such as Japan, Korea, and Europe), rather than the less developed intermediate goods producers who have done so well off China's growth to date.

See the full story here.

Exporting Junk

Mainland China has been in the international headlines recently, for some of the wrong reasons. Some goods exported from China are of poor quality, an in some cases are dangerous for their intended purpose. The media has focuses on the resulting dead pets and recalled toys.

Clearly there are quality issues with Mainland exports, but the response in the US in particular has indicated that maybe all trade with China should be subject to restrictions, as part of a popular move towards growing protectionism across the board. If China exports junk, then maybe it should be stopped!

Let's turn the tables on this argument for a moment. Yes, some of what China exports to the US may be junk. But China is not alone in this behaviour. As Daniel Gross of Slate points out, much of what the United States exports to China is also junk! See this story for more....

Is Increased Chinese demand for oil driving up the world price?

Not as much as you think. In part it's substituting in part of US demand. See this Marginal Revolution link for more.

"Big Brother" in America

I'm currently in Boston for a couple of days. In recent visits to the US, I've noticed a worrying trend. When you enter the border, you're bombarded with tight security requirements. They want your photo, your thumb print, as well as the opportunity to interrogate you on why on earth you are trying to enter their country.

Of course all these steps are perfectly acceptable and legitimate for any country, especially one that has faced terrorist attacks in recent years... although you wouldn't know that this were the reason from the official explanation for the tighter security. I listened with half an ear to the Homeland Security video played on the Cathay Pacific flight as we came in to land, which tried to sell these changes as increasing the efficiency of travel.... which it clearly does not! I guess a sales pitch of "we're going to take a close look at you because if you're a terrorist, we want to make your life hell! Otherwise, we hope you'll put up with the inconvenience. And have a nice day" might not appeal to all, but at least it would be honest. And when a government doesn't come clean about the real reasons for their actions, it leaves plenty of room for us to wonder what "big brother" is really up to.

More importantly, I fear that the changes are part of a more disturbing trend. Since 9/11, America has become more paranoid and less trusting of the rest of the world. Of course this is a two-way street... the Iraq debacle has left the rest of the world more paranoid and less trusting of America. However, I fear that this may start to have an increasing effect on the world economy. Not only are American's increasingly paranoid about people entering at the border, but they're paranoid about capital flows (remember when China tried to buy an American oil company?), free trade (loss of low skilled jobs to Asia), Russia, and most of all China. In a democracy, that will likely lead to a less open economy in future.

Openness is a sure driver of economic growth. It allows skilled migrants to move where their skills are most valued, ensuring maximum social return on their human capital; economies to specialise in producing the goods and services for which they have a comparative advantage, ensuring efficient resource usage; rapid technology diffusion, allowing poor countries to catch up more quickly to rich countries; and reduced levels of corruption, since corruption is essentially a tax on domestic firms, and puts them at a disadvantage relative to foreign competitors.

Paranoia, on the other hand, will lead to reduced efficieny and reduced growth. In the end, both America and the world economy will suffer the consequences.

The China "Threat"

Recent headlines have focused on the perceived "threat" of China to the rest of the world. Whenever an economy develops rapidly, it's ability to threaten other countries increases. But should the rest of the world be alarmed by China's growth?

Let's start with the assumption that the leadership of China is rational- which seems a plausible assumption. (They may have made mistakes in the past, but in general they seem to have learned from them. At the very least, their worst mistakes have not been repeated.) A rational government will not invade another unless it is in their interests to do so.

The more integrated that an economy is with the rest of the world, the less are the gains from any potential military action. In the case of China, these links are strong. The economy is heavily dependent on other developing countries as the source of inputs for production. In turn, it is heavily dependent on developed countries as markets in which to sell its output. Additionally it has huge capital outflows- in the case of official reserves, largely to the United States. The effect of all these factors is to increase the potential costs to China if it were to ever initiate military action.

The increase in economic ties is a tried and true check on military ambition. It lies at the heart of the increasing integration in Europe following World War II, which was just the last in a long series of intra-europe conflicts, spanning many centuries. I believe that it is also the largest check on Taiwan and Beijing; I cheer whenever I hear of increasing investment and trade flows between the two.

Much of the supposed "threat" from China appears to be manufactured by US politicians, playing to a domestic audience in the run-up to presidential elections. Novel Holdings chief Silas Chou, as quoted in the SCMP, sums up the remedy to this perceived threat quite nicely...

"Forget all that political bull****. If Americans would just come to China and make a bit of money, we'd have a happy relationship."

I think he's right. Maybe we should nominate Economics for the Nobel Peace Prize.

For a related view, read here.

Globalisation and lower prices

Does globalisation lead to lower prices? Probably not, at least in the long run, as Dani Rodrick argues. Ultimately the price level is determined by the rate of growth in the money supply. So monetary policy determines the average level of prices, independent of globalisation.

So what are the benefits to globalisation, if it doesn't result in cheaper prices? Marginal Revolution argues that globalisation should lead to increased levels of world output. Overall prices may not change, but relative prices will. Cheap imports from Mainland China make all other goods relatively more expensive. Rational consumers respond by cutting back on the relatively expensive goods, and consuming more of the cheap imports. This is the price mechanism at work. Under standard assumptions of consumer behaviour and rationality, they end up consuming more and enjoying higher levels of utility as a result.

Where does this increased output come from? In a market economy, relative prices reflect the relative resource cost of production. Cheaper goods from Mainland China are less costly to produce, and use fewer resources, than more expensive goods from elsewhere. Thus the changed consumption patterns result in more efficient resource usage, allowing total global GDP to rise.

This argument assumes that prices reflect resource costs. If prices were regulated by the government, rather than being set by the market, this mechanism may fail. And to the extent that resources are not correctly priced (do Mainland firms pay for the environmental costs that result from their production?), the result may be increased global GDP, but little increase in real global welfare.

Globalisation in the short run....

Globalisation may be good in the long run, but what about the short run? What measures should be taken to compensate local firms whose products cannot compete with developed economies?

In relation to the firm, absolutely nothing! For four good reasons.

1) Firms face all sorts of uncertainties. They may become uncompetitive because of
- Failure to adapt to changing tastes
- Failure to adopt new technology
- Increased domestic competition
- Increased foreign competition
- etc

Facing these risks and trying to remain profitable despite them is what being in business is all about. What is so special about the risk of foreign competition? If we’re going to help out firms by erecting trade barriers when they cannot compete, why not ban new technology to protect firms that fail to adopt that? In both cases, protection is costly for society.

2) “Moral Hazard.” If you have insurance against a fire, you’re less likely to take measures to prevent fires. In the case of fire insurance, such moral hazard is unavoidable. In our context, we can think of governments protecting firms as a form of insurance. If firms believe that the government will protect them, they have less incentive to adapt to changing tastes, adopt new technology, stay competitive, etc. As a result, they’re more likely to need the insurance! But ultimately their failure to try to minimize risks is inefficient.

3) Hysteresis. This term is usually used in economics in relation to unemployment: if the unemployment rate increases, then it may become very difficult to reduce it in future. The same idea applies here. Once a Government has taken steps to protect firms that ‘might’ have gone bankrupt without protection, in future the firm will come to depend on that protection. The firm most likely ‘will’ go bankrupt if that protection is ever removed! So once protection is put in place, it is very difficult to ever remove it. Given that you already agree that globalization is good in the long run, you must agree that protection is bad in the long run….. with hysteresis, it will also be bad in the short run!

4) Creative Destruction. As callous as it sounds, it is good for the economy if firms that cannot make a profit go bankrupt. A firm that cannot return a profit is actually destroying economic wealth by staying in operation. The total value of the inputs they use in production exceed the total value the market places on their output. Society is worse off the longer a wealth-destroying firm stays in operation! This argument applies to both the short and the long run.

Firms should be away of all the risks that they take, and take steps themselves to mitigate them- for example, by diversifying and adapting rapidly to the changing market place. This is efficient. But if the Government really wants to get involved, it should encourage such adjustment- by ensuring a flexible labour market, and maybe providing support for workers who find their skills no longer demanded by an evolving market place to retrain.

Imagine if the Hong Kong Government had decided to try to protect local manufacturers of mass produced goods from competition in Guangdong…..