The US Trade Deficit and Chinese Surpluses: Economics v Paranoia
Now that the recent turmoil in international markets has subsided for now attention is returning to the sinister machinations of Beijing and its silent war against the US economy. It is held by some -- in fact, by far too many -- that China is using currency manipulation to deliberately deindustrialise the US and force its manufacturers to export jobs, as evidenced by the US trade deficit. Moreover, China is threatening to use its dollar reserves to sink the US economy. Even without the paranoia some of the economic fallacies that underpin these charges are common currency among the populace, including congress which has more than its share of economic illiterates.
What is needed here is a little economic reasoning. First and foremost let us deal with the fact that the balance of payments -- of which the current account is a component -- is simply a record of the transactions that take place between the people of one country and those of other countries within a given time. When, for example, Wal-Mart orders millions of dollars worth of clothing from Chinese textile manufacturers it does so on behalf of millions of American consumers. It is their preferences that determine these transactions: not the preferences of Wal-Mart executives or Chinese government officials.
Only by going into the process of international exchange can we get some idea of what is really going on. In a free market economy based on sound monetary principles the problems we now have with capital flows and trade deficits would simply not appear. In such an economic environment an American who wanted to buy a Chinese product would order the good and instruct his bank to transfer money from his account to the Chinese trader's bank. The trade account would debit the imported good while crediting the monetary side of the transaction.
Having acquired dollars the Chinese trader would find himself in the position of using them to directly purchase American goods (bilateral trade) or the goods of other countries (multilateral trade). Sooner or later the dollars must return in the form of demand for US goods, including securities if requested. However, once countries abandon sound money principles in favour of loose monetary policies, then problems will definitely appear.
In today's world where fractional banking is considered a sound financial principle the central banks allow their respective banking systems to expand credit by creating phony deposits. And it is this credit expansion that fuels a good part of the US current account deficit -- of which the trade account is a component -- by raising aggregate spending in dollar terms. This encourages the demand for foreign goods. Now if Americans bought these goods directly the result would be a physical outflow of dollars but no debt. It would not be long -- assuming other countries were not inflating as fast as the US -- before the dollar began to depreciate. In reality dollars do not directly exchange for imports. The whole process basically takes place through the banking system
A loose monetary policy (credit expansion) lowers interest rates and raises nominal incomes. Now our American consumers expand their demand for foreign goods. American traders obtain money for the goods by borrowing from the banks who obligingly make the loans by creating deposits in the names of the exporters. These imports show up in the current account as debits while the exporters' newly-created deposits are counted as credits. This is because these exporters' deposits -- IOUs -- are seen as having been sold to them and are therefore exports.
What has happened is that the trade account has gone into deficit -- imports exceed exports -- while the capital account runs a surplus equal to the deficit because the deposits now count as foreign borrowings. It must be remembered that though the US banks created these borrowings ('empty' dollar deposits) they are the property of foreigners who exchanged their goods for them and who are at liberty to demand dollars at a moment's notice. It's perfectly clear that the longer this inflationary process continues the more the foreign debt and the trade deficit will grow. (While the CPI appears to be subdued the inflow of cheap imports is fatuously reported as keeping inflation at bay).
So how would, for instance, Chinese exporters use these deposits? They could buy American goods and assets, including corporate bonds, T-notes, etc. This is precisely what has happened. It must be borne in mind, however, that the situation is more complex than this. There is no doubt that the Chinese government -- using the People's Bank of China -- manipulates its own currency. As a rule a continuing rise in demand for Chinese goods by US consumers would exert an upward pressure on the yuan and hence a downward pressure on the dollar. The effect would be to raise the prices of Chinese goods in terms of dollars by appreciating the yuan.
Chinese exporters receive yuan from the PBOC in exchange for their dollars. This naturally adds to China's money supply. Additionally, it tries to maintain its dollar-peg by offering up more yuan for US dollars, which also adds to the money supply. This is not a costless exercise, particularly for a poor country, as China still is. Considering the vast sums involved this intervention in the currency market must, in my opinion, be accumulating severe imbalances. By imbalances I also include real factors, i.e., the capital structure. What this amounts to is that Chinese monetary and industry policy may have directed a considerable amount of the country's manufacturing in to satisfying foreign markets that may not be sustainable in the aftermath of a currency adjustment.
Along the same lines, an overvalued dollar may have had the opposite effect on US manufacturing, making it overly oriented toward domestic production. Unfortunately no amount of statistics one way or the other can at this stage tell us if this is so or not. Moreover, there is absolutely no way of telling what the structure of US manufacturing would have been in the absence of inflation. As for the 'threat' of China dropping US Treasuries, so what? Such a sale would not affect the US money supply. Any increase in interest rates because of such sales would be temporary. T-notes do not determine the rate of interest. (US interest rates, growth and China and The US dollar and China's impending recession, part II)
It is the intention of this article to try and make it clear that America is not under threat by the 21st century equivalent of the legendary Dr Fu Manchu. The situation is far more prosaic than that, though still very dangerous. What we are experiencing is a massive monetary disorder. Irrespective of what the economic commentariat says, current economic problems are due to a failure to understand the nature of inflation, money and capital. Until this situation is reversed I fear we are just going to continue to get more of the same.