Wednesday, November 18, 2009

Whither Chimerica?

I’m trying to figure out what becomes of Niall Ferguson’s Chimerica. The US and China are locked in a tight embrace. But, as described below, I think the Chinese are better positioned to break away and leave us hurting.

My analysis depends on a certain view of the creation of money. Unfortunately, I don’t know anything “official” about how money is created. I only know what I think about how money is created. So, it only seems fair that I say how I think things work.

In the days of the gold standard, a guy with a gold bar went to the Treasury and said “Here’s some gold; give me some money.” The Treasury gave the guy some money and put the gold in its vault. The guy then put the money in the bank, and the bank lent it out to borrowers.

The money the bank had to lend was “backed by gold.” But there is only so much gold, and a growing economy needs more capital than the gold supply can support at a fixed price. Of course, there is no a priori reason why gold should be the only thing backing currency. German money after Weimar was backed by land. Saudi money is effectively backed by oil (and dollars). And if tangible assets can back money, why not intangibles like an ongoing business? Or an idea and a business plan? When I get money, I don’t care what specific thing of value stands behind it. So long as the money will buy something of value, the money is, well, money.

A well-known Soviet-era joke explained Soviet economics as follows: “We pretend to work, and they pretend to pay us.” Soviet Russians had lots of rubles, but they couldn’t buy anything with them; there was nothing to buy. So, were the rubles really money? Robert Frost wrote that home is where, when you have to go there, they have to take you in. Money, I think, is what, if you have to spend it, they will recognize as payment. All the Soviet Union had, once the price of oil fell, was the ability to force people to pretend to work. Not much value there.

Guys like Ron Paul criticize our financial system by claiming that so-called “fiat money” is worthless because it isn’t backed by anything tangible. They are right that it isn’t backed by anything tangible. But they are wrong to think it matters. What matters is whether anyone who receives a dollar believes that America has something worth a dollar available for sale. The problem with fiat money is not that it isn’t actually backed by real value, but that there is no way to be sure that it is so backed, so the temptation to issue it without any backing is politically overwhelming.

That temptation is exacerbated if a major recipient of your currency actually doesn’t care whether it will buy anything. That, I think, is how China views the dollar, and why the Chinese are not about to revalue their currency or sell dollars any time soon. (But may eventually do both.) And it is why we are not hesitating to print dollars unbacked by assets and products, dollars that others may soon reject.


China doesn’t care what the dollar is worth because China is using the dollar to keep score in its newly competitive economic regime. China’s goal is to become self-sufficient in just about anything it could buy from the US. Buying stuff from us is the last thing on their minds, so what the dollars can actually buy is of no moment to them. They are happy to own zero-interest T-bills that produce a negative return if that will keep their factories humming.

China faces the daunting problem of booting up a capitalist society. Chinese entrepreneurs need customers above all, and the US has the most and best to offer. We provide a demand for quantity and quality, both essential to the long-term success of any enterprise. We are, in effect, the judges in their game of “So You Think You Can Run a Business.” We buy the outputs of their most effective companies, and that’s (a) how they know who those companies are, and (b) how their people and the rest of the world know that the yuan is “backed” by the productive capacity of a real economic engine.

The Chinese pay us for service as judges by selling us stuff at artificially low prices and lending the money back to us at artificially low interest rates. Such largesse is not, however, without consequences: we have lost jobs to cheap imports and borrowed too many cheap dollars at both the private and public levels. But that’s not China’s lookout. And, as described later on, cheap labor is cheap labor, whether or not it is even further subsidized by a cheap currency.

To understand China’s indifference to the value of the dollar, try this thought experiment. Suppose the Chinese government announced that Chinese exporters no longer needed actually to export their goods to America. Instead, Chinese companies can simply dump their outputs in the ocean and receive yuan equal in value at the official exchange rate to the dollars the company would have collected if the goods had been sold in America. (Think cash for clunkers.)

Why would this not work? Certainly, it would stimulate outputs, and thus jobs, and it would give Chinese workers and entrepreneurs money to spend. One reason it would not work is that there is no way to prove that Americans would have bought a merchant’s products at the price he says he could have sold them. As they say about upsets in the world of sports, that’s why they play the game. So, without regard to whether China actually needs to get dollars for the yuan it issues, the American consumer serves a valuable purpose just by buying one Chinese company’s outputs rather than anyone else’s. They play the game, and what we buy from them is their score. The winner has actually proven an ability to produce desirable goods at a good price, and that means that the yuan issued to it with respect to its sales are “backed” by productive capacity, whether or not they are also backed by the dollars the Chinese government gets for them.

Now let’s look at how important it is that the Chinese actually get those dollars, or, more realistically, whether those dollars hold their value or earn a positive investment return. Instead of the merchants destroying the goods in our experiment, suppose they have to make real sales, but that the Chinese government destroys the dollars it gets for the yuan it issues. (After all, lending to us at zero interest is as close to burning the money as the Chinese can realistically come.) The only real issue for the Chinese is whether the yuan issued on account of the goods sold to the US would be respected by those asked to accept it.

Those yuan are fiat money, but lots of countries issue fiat money. The yuan are nominally backed by the dollars received, but they are, I submit, also, increasingly (and more importantly) backed by the entrepreneurial infrastructure and labor of the Chinese people. Real factories will have produced real goods for this money, proving that the money can be spent on real products from real factories. So, what’s the difference to Chinese yuan-holders whether the dollars received for the exported goods are overvalued when received or become more so in the Chinese government’s hands? More and more, it is the Chinese economy, not the dollars, that make the yuan credible. Thanks to our willingness to buy good Chinese products, the Chinese workers do not have to pretend to work, and the Chinese government does not have to pretend to (provide the money) to pay them. No wonder the Chinese government has no interest in revaluing their currency: getting more dollars for less product might make economic sense, but it makes no political sense at all.

So we and the Chinese are for now co-dependent. We are addicted to their products, and they are addicted to our custom. Which of us, if either, will get over our addiction? China, I think. The very prosperity that China seeks to create must inevitably lead to consumption there. Even modest consumption would be significant. One little car in each of 1.2 billion garages, a chicken in every one of 1.2 billion pots, is a lot of consumption. When their own consumers are buying their own outputs, we won’t be so valued a customer, and the yuan will be allowed to appreciate against the dollar (again, “destroying” China’s dollar reserves, as in our experiment).

Chinese prosperity can cure China’s addiction to American customers. But what will we do when the Chinese don’t need us to buy from? One possibility is that like a bee, we will simply move on to the next flower. Other countries may want to emulate China’s entrepreneurial path, starting as China did with no indigenous consumer class. But the Chinese flower may be unique. The sheer number of people, the policy coherence, the level of education, the cultural work ethic may all have conspired to make China a once-in-a-century opportunity for economic symbiosis. There may well be a place that doesn’t care what the dollar is worth, but it probably won’t be able to absorb as many dollars as we have become accustomed to printing. (And we will still be attached to the oil teat, exacerbating the trade deficit. We desperately need an energy policy that provides certainty that home-grown energy will not be rendered uneconomic by global action.)

What makes our situation so troubling is that the villain in the piece is something most of us, including me, think of as usually benign: international trade. I like the idea of comparative advantage. When two economies have comparative advantages in mutually desirable goods, trade between them is good for both. But the law of comparative advantage ignores the effect of trade on displaced workers. Trade may be advantageous to the traders precisely because it displaces workers. Of course, the gains from trade can create capital that then reemploys the workers at higher wages. But that’s a contingent event: sometimes it happens, sometimes it doesn’t. And when one trading partner’s comparative advantage arises from its people’s willingness to live poorly (broadly defined to include preferring poverty to torture or death), the other partner’s workers are likely to be dragged down to that level if they hope to stay employed.

I’m not making a moralistic argument about how our trading partners treat their people. That argument is available, but there are counters to it that don’t need to be addressed if the argument isn’t made. Whatever one may think of slavery as a form of economic specialization, one ought not to volunteer for it lightly. A national trade policy that costs jobs here because labor of equivalent skill is cheaper elsewhere is a mistake: such practices create a race to the bottom; we get stuff cheaper, but we can afford less of it. And “trade” in which they send us stuff and we send them money is not “trade” at all.

To understand the ramifications of dealing with cheap labor sources one need only apply the classic comparative advantage paradigm. If England sells Portugal wool and Portugal sells England wine, there are fewer vineyards in England and fewer sheep farms in Portugal. Presumably, the people who would have produced English wine or Portuguese wool are busy making English wool or Portuguese wine. But if the Third World sells us all of the labor-intensive goods we need, we can only sell them capital-intensive ones. A country cannot sustain a workforce by selling only capital-intensive goods. Such a country becomes a land of rich entrepreneurs (and bankers) and underemployed proletarians. Sound like any place you know?

We have to stop living for deals. We need jobs not bargains. We need protectionism, not because it’s “good” or because free trade is “bad.” We need it because the Chinese – and everyone else with coolie like labor – should not be allowed to exploit a comparative advantage in labor per se. Any comparative advantage they can get from geography or innovation or education or organization is fine. But we ought not to compete on whose workers are willing to live worst.

I understand that if we impose tariffs or quotas on Chinese goods, we may have a trade war. But that assumes that we are not already in one and losing it. If our trade imbalance with China goes away because they don’t import from us, I believe that our domestic consumers will more than pick up the slack over time, and the stronger dollar will enable us to maintain low interest rates permanently. I know Smoot-Hawley is said (increasingly by people who don’t know anything about the matter) to have made the Depression worse, but that idea seems to have been largely discredited by a host of economists with the perspective that only time permits. China will not revalue the yuan voluntarily, and even if it does revalue it, other cheap-labor states will fill any void created unless we impose real quotas that enable well-run American companies to employ well-educated and well-paid workers. Otherwise, what good are cheap toys?

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