The US must erect tariffs against China unless they revalue
Yesterday, Ed sent me an article by James Fallows on some 2006 comments by Republican gubernatorial candidate Christine O’Donnell regarding the threat to the United States posed by China.
She said China had a "carefully thought out and strategic plan to take over America" and accused one opponent of appeasement for suggesting that the two countries were economically dependent and should find a way to be allies.
"That doesn’t work," she said. "There’s much I want to say."
Here are my thoughts on that subject.
In my view, this is one of the more sensible things she has said. Take a closer look at the latest import numbers from the west coast in the US. The data for the US on outbound containers (exports) and inbound containers (imports) points to significant on-going trade deterioration in the US in the months ahead. Because the second quarter reported U.S. trade deterioration was so great, it may have undershot a declining trend, so such trade deterioration may not surface in the next trade report. But it is there. Fiscal support to offset the declines in trade is non-existent (and likely to remain so given the likely future political configuration in Congress). We have gone from a very rapid pace of expansion in exports on a sequential and year on year basis to small declines in exports on a year on year basis and more severe declines on a sequential basis.
Why is U.S. trade deteriorating? In part because the rest of the world might be slowing. However, the more significant cause may well be China’s over investment in industrial tradeables and consequent pressures for greater Chinese exports and a greater degree of Chinese import substitution. In that regard, Japan is proving to be the lead indicator.
Worse yet, the deterioration we are now seeing in Japanese exports do not reflect the strength in the yen this year. The lags in trade are long. The threat to Japan from the rising yen is that Japanese corporations are forced by the strong yen to move their production platforms to lower cost economies and thereby hollow out Japan. It takes a long time to make these business investment decisions and act on them. To the extent that “hollowing out” is now hurting Japanese exports, it reflects 95 to 100 yen to the dollar and not 83 yen to the dollar. A further adverse impact on Japanese exports and industrial production from recent yen strength could be huge. Already exports are weak and industrial production is rolling over even though Japanese firms report they can live with 95 yen to the dollar. The majority of Japanese industrial firms say they cannot live with 85 yen to the dollar. The deterioration in Japanese exports and industrial production we are seeing now could be much worse, all other things being equal, if the yen stays above 85 to the dollar.
Worse yet, the new China mega investment boom is on-going. Only the shortest lead time projects are in production, which are now competing with Japan. But, there is a huge surge in new Chinese production ahead which will compete with and substitute for Japanese exports. Exchange rate considerations aside, the secular trend whereby emerging Asia and especially China are competitively advancing on Japan will undermine Japan’s exports and industrial production in the near to intermediate future.
There is a curiously perverse but symbiotic relationship that exists between China’s mercantilists and America’s finance capitalism. It may not be as conspiratorial as Ms O’Donnell suggests, but it’s a lot less benign than Fallows suggests. And it’s a whole lot worse than what the China apologists are saying (yes, Steve Roach, I’m talking about you). The whole "Bretton Woods II" process contributes to the financialization of our economy, as it continues to hollow out our manufacturing base. It represents an unholy alliance between Wall Street and China’s military, which is driving much of the investment in China because they are reaping so many material benefits. The problem, however, is that at some point Chinese credit expansion has no place to put its money. All of the targets have been saturated, which means that there will be overinvestment in all industries and to an incredible degree. This may well kill industry after industry. It appears to be happening already in Japan.
How can there be an encore? To avoid recession you have to keep the investment ratio up. But capex as a percentage of GDP in China is already off the charts – it is in excess of 50% of GDP. So the Chinese can build an additional round of capacity, which may be equal to ten times annual demand by next year, and fifteen times by the year after, in Of course, this process has its limits. When the ratio is this high it is very hard to keep it this high. There is a tendency for it to fall and it will fall faster if there is a trade war. But if it falls there will be a recession in China, so perhaps China is far more recession prone than anyone thinks. It may ultimately be recreating Japanese-like bubble conditions in its own country.
And what does this mean for Japan, which is the canary in the coal mine? With this kind of investment going on in China, the Japanese firms haven’t a chance to compete with the yen prevailing at this level. And China knows this so it continues to buy Japanese yen bonds, which keeps the currency high and basically destroys its main Asian competitor. It represents the ultimate revenge for Manchukuo and the Rape of Nanking. And this is a development that could move very fast because the excesses of investment in China are currently so great.
There is no question that China’s mercantilism is a product of our ham-handed approach to Asia during the 1997/98 crisis, Less appreciated, however, is Beijing’s role in creating that crisis via its cumulative 60% devaluation against the dollar from 1992-94. Very few people are looking at the direct impact of China’s trade policies and how it is beginning to hollow out other countries’ manufacturing bases. It’s not just the US. The Japanese economy is now at the cutting edge of this threat Can the US be far behind?
Ed wrote in response:
So, you’re a protectionist, then? Are you throwing your hat in the ring with Krugman?
Here’s what I say to this question:
I’m totally with Krugman on this. I want a full employment policy, not a "free trade" policy per se. It’s impossible to speak about "free trade" when it doesn’t apply both ways. Free trade is another one of these neo-liberal myths, largely predicated on the notion that we need China to "fund" our deficits. That’s nonsense. We continually read that nations with current account deficits (CAD) are living beyond their means and are being bailed out by foreign savings.
A CAD can only occur if the foreign sector desires to accumulate financial (or other) assets denominated in the currency of issue of the country with the CAD. China makes that choice. I would rather go for higher tariffs than a forced revaluation of the RMB, as I don’t think that the promotion of exports per se is a good policy for the US. We seem to be fixated on this idea of reducing domestic wages, often through fiscal and monetary austerity measures that keep unemployment high. The best way to stabilise the exchange rate is to build sustainable growth through high employment with stable prices and appropriate productivity improvements, which is what I want to do. A low wage, export-led growth strategy sacrifices domestic policy independence to the exchange rate – a policy stance that at best favours a small segment of the population.
Fiscal discipline has not helped developing countries to deal with financial crises, unemployment, or poverty even if they have reduced inflation pressures.
As far as China goes, it is creating a huge potential global discontinuity with its current form of predatory mercantilism. I just saw an interesting piece from Morgan Stanley. The analyst thinks that the capital per capita ratio in China excludes the possibility of a fixed investment bust there. But in fact, there have been many fixed investment busts throughout history. They all had capital per capita ratios that were a fraction of that of Japan today. Does that mean they should not have had these busts? More recently the emerging Asian economies of the Asian crisis of the late 1990s all had capital per head levels that were a fraction of that of Japan, but they all had very high ratios of fixed investment to GDP and these ratios fell and contributed in a big way to that crisis.
I could see people arguing that China is a dirigiste economy and therefore will not have the same propensity for a fixed investment bust that other economies in history have had. or that the dirigiste Chinese economy will manage to increase other kinds of spending to offset a future decline in fixed investment in tradeables. These are serious possibilities. But the ratio of capital per capita seems to me to be irrelevant to such fixed investment led cyclical dynamics. When one talks of capital per capita or better yet per worker one approaches growth theory. If you apply simple growth theory to China the risks of a fixed investment bust become very great. Remember in growth theory the capital stock must in equilibrium grow at the same rate as productivity augmented labor units. In the case of China owing to the single child policy work force growth will soon fall to zero. Now the growth of the labor force in the modern sector is higher because of the migration of surplus labor from subsistence agriculture. But that rate of migration must now slow as the stock of such workers has diminished and as food production starts to become a constraint on growth. In any case the growth rate of labor units before productivity augmentation must slow to a crawl. Now the rate of productivity is a function of the rate of advance of an economy on the technological frontier. For countries at the frontier productivity gains are limited by the rate of technological progress. For emerging economies which can leapfrog from a capital stock characteristic of an earlier stage of economic development to the current technological frontier productivity gains can be much higher on an annual basis, but the closer a developing economy gets to the technological frontier the more its productivity rate must fall to that of the economies at the frontier. There is no doubt that the Chinese economy has been fast advancing on that frontier, which means that annual productivity gains must be falling. So maybe the growth rate of hours worked has fallen from four percent to two percent and will soon be one percent. And maybe the rate of productivity has fallen from six percent to four percent and will be three percent. That means the equilibrium growth rate of the economy has fallen and will fall further. It follows that the equilibrium growth rate of the capital stock will have to eventually fall commensurately. The lower the warranted growth rate of the capital stock the lower the ratio of fixed investment to GDP.
Now that is not what has happened in China. The ratio of fixed investment to GDP has risen. but that is because the authorities have directed the allocation of resources to raise it. In effect they have had recourse to capital deepening in order to maintain the growth rate given the slowing in the growth of productivity augmented labor units. You can do that for a while, but it represents an ever increasing departure from the growth equilibrium.
What happens in these situations in that people don’t realize the emergence of a new equilibrium until the capital deepening becomes unsustainable. Then there is a fixed investment bust and a deep recession and the economies come out of it with a much lower economic growth rate and a much lower ratio of fixed investment to GDP This is what happened in Japan from the 1980s to now, and what happened to the tigers from the early 1990s to now.
Paul Krugman wrote a piece on emerging Asia in the mid 1990s predicting the Asian crisis based entirely on the unsustainability of this process of capital deepening and he was proved correct. in the case of the tigers they were small enough economies that they could engineer a low exchange rate export path of recovery from that recession. But China has so invaded global tradeables markets that she might not be able to do what the tigers did then.