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Thesis & Antithesis

A critical perspective on energy, international politics & current affairs

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greekdefaultwatch@gmail.com Natural gas consultant by day, blogger on the Greek economy by night. Trained as an economist and political scientist. I believe in common sense and in data, and my aim is to offer insight written in language that is clear and convincing.

07 July 2007

A Buck for Chuck

In my darker and more cynical moments, I imagine making a campaign contribution to Chuck Schumer, the democratic senator from New York. The amount I would give him would cover the cost of an economics course in a local school because a man obsessed with legislating on economic policy should not be illiterate in economics.

My first encounter with Mr. Schumer was a few years back when he wrote an op-ed in the New York Times challenging comparative advantage (January 6, 2004). According to Mr. Schumer, the theory is outdated because David Ricardo, the theory’s exponent, had assumed factors of production to be immobile. As Mr. Schumer wrote, “Comparative advantage is undermined if the factors of production can relocate to wherever they are most productive: in today's case, to a relatively few countries with abundant cheap labor.”

Comparative advantage leaves much to be desired. It does not explain, for example, what causes countries to differ in their productivities, hence taking as a given a variable that should be explained. And developing countries often specialize in the production of primary goods, thus losing out on the dynamic gains from trade. But Ricardo’s central insight remains: a country benefits from trade even if it is less productive than its trade partners. Factor mobility does not invalidate that point. In fact, trade in goods acts similarly as trade in factors of production. And anyway, factors of production are nowhere nearly as mobile as Mr. Schumer claims.

Now Mr. Schumer is back again. For years he has been musing, along with Senator Graham, about imposing a 27.5% tariff on Chinese goods if China does not revalue its currency. This campaign has been abandoned in favor of implementing trade measures against countries that manipulate their currencies. Mr. Schumer claims the plan is not directed at China (in an article co-authored with three other senators): “our bipartisan legislation is not to punish any one country but to encourage all countries to follow international rules.” But China is the bill’s more immediate and likely target.

Mr. Schumer is an economic looney toon, not to be taken really seriously. But his legislation has drawn support from both Senators Barack Obama and Hillary Clinton, two democratic frontrunners for the presidency. And the legislation is seen as responding to growing anxiety in the United States about free trade. If nothing else, it reveals just how fragile free trade remains to politicians who are keen to exploit voter anxiety (although actual legislation, thankfully, often lags behind).

The most obvious drawback with this legislation is that determining exchange rate manipulation is extremely difficult. Anyone working with exchange rates will admit that predicting exchange rate movements is nearly impossible; economic theories are no better than guessing in being able to forecast exchange rates. Hence, judging what a “fair” value for a currency should be is nearly impossible.

It is equally unclear how much exchange rate movements affect trade flows. According to economic theory, an appreciating currency makes imports cheaper and exports more expensive. If the Chinese Yuan were to appreciate, China’s imports would increase and its exports would shrink. Reality is different, however. The obvious statistic to cite is from the Yuan itself: since allowed to “float,” it has gone from 8.28 ¥/$ to 7.59 ¥/$, but China’s trade surplus with the United States has grown from $162bn in 2004 to $233bn in 2006.

The same is true about the US trade deficit with the Euro area, where the dollar has depreciated more dramatically. After 2003, when the $/€ rate was in parity, the US bilateral trade deficit in goods went from $78bn to $93bn in 2006, despite a drop of nearly a third in $/€ rate. (The deficit stabilized somewhat in 2006). Prices respond slowly and imperfectly to exchange rate changes, making deficits less correlated with exchange rates. An appreciating Yuan, in other words, would bring uncertain changes to the US-China bilateral trade deficit. (Those interested to read more on this issue can look at the IMF’s World Economic Outlook, April 2006, p. 114-115).

Nor is China alone is to blame for the US trade deficit. In 2006, the bilateral US deficit with China was $233 billion, while the overall trade deficit was $838 billion - China accounted for just a quarter of the total. More importantly, US trade with Asia has remained constant over time, with 25% of US exports going to Asia and 36% of US imports coming from Asia in the past five years. The trade with China reflects a shift in production processes – trade that used to be with other Asian countries is now channeled through China.

The truth is that America’s trade deficit reflects underlying economic realities, especially low savings and high spending in the United States, and high savings and low spending in China. The flow of money from China to the United States would be expected to persist as long as these economic fundamentals remained.

The question is whether legislation is the optimum way to address these imbalances. (A more fundamental question is whether imbalances need to be addressed in the first place, but I will stay away from that question for now.) The senators note that, “A little pressure can go a long way to encouraging the right policies.” This is surely naïve: legislation is much more likely to encourage either reciprocal retaliation or, at the very least, a stubborn Chinese reaction.

It is really discouraging to see how much economic debates are detached from economic reality, though this is to be expected, more so in an election period. Trade raises important policy questions, but dealing with them is made no easier by politicians who ignore basic tenets of economic theory and fact. These misconceptions are numerous and above I have just touched on a few. More to come in later posts.

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