The Basic Problem Isn't China's Exchange Rate Policy, It's Our Deficit
Much has been made recently of the Administrations fruitless attempts to get the Chinese to revalue their currency to help cure the $100 billion bilateral trade surplus they are running with us. There are two main problems with this:
- It reflects a complete misunderstanding of what really is the problem with our current account.
- It won't work
Why is it that we have a huge and growing current account deficit? The popular press (and apparently the Bush White House) seem to believe it is because particular countries engage in aggressive pricing by keeping their exchange rates too low. They may be doing that but this entirely begs the question of WHY we have a huge deficit in our international payments. Simply put, it is because we are spending more than we make. As long as we do that we are going to need foreigners to lend us money to cover the difference. The fact is that if we face increased prices for Chinese imports we may consume a little less of what they send us, but we will also consume a bit more of everything else. The net result isn't going to cure our basic problem.
Suppose we actually did manage to get the Chinese to revalue by, say, 20%. Our imports from China would then rise in price by somewhere between zero and 20% depending on the shape of the supply and demand curves for these goods. What would this do to us? There would be a small income effect because the part of our total consumption that comes from China would be a bit more expensive. There would also be a substitution effect as we divert some of our spending from Chinese goods to those from other sources. That means that the composition of our trade balance might change a bit, but if we continue to spend money at the rate that we do, and continue to save as little as we do, the gap between income and spending won't change very much in the end. If you need proof of this on a personal basis, ask yourself this: Is your next purchase decision dependent on whether imports from China cost 10% more?
The main point is that if we continue to save at very low rates in the private sector while the government runs deficits on the order of $375 billion and up, we are going to have deficits on our current account regardless of what the Chinese do or don't do to their currency. Private sector savings decisions are a very slow moving variable - they don't change quickly from year to year. It is clear that the opposite is true in terms of public sector savings - We have seen a massive change from a surplus to a huge deficit in the three years since Bush took office. The implication of this is that our current account balance is directly influenced by our current reckless fiscal policy. That is why quarterly current account deficits are now more than double what they were as recently as 1999.
The Administration has economists who know all this perfectly well. Greg Mankiw knows it. His predecessor Glenn Hubbard knew it. Any economist not currently on the White House payroll will tell you the same thing. Why haven't they been listened to? One suspects that the Administration is more interested in posturing and fixing blame elsewhere (Why not the Chinese? They aren't going to be voting next year.) than in reversing their misguided tax cuts and spending binge of the past couple of years.
However, there is a mechanism that will get us our relative devaluation against our trading partners' currencies at some point whether they do anything about it or not. Last year we had a current account deficit of $478 billion. It is on track to be even larger in 2003. That means that there are going to be another half trillion dollars out in the world just this year alone. My economics books tell me that when the supply of something keeps rising, and the demand doesn't change all that much, then the price will eventually fall. So get ready for the US dollar to depreciate. Lets just hope that the Administration's irresponsibility doesn't lead to a precipitate crash rather than a "soft landing". Either way, it's a good bet to put a larger percentage of your personal portfolio into Euros. I have.