Someone Talking Sense About Exchange Rates, For Once

Nobel Laureate Michael Spence on CNYUSD:

The Exchange-Rate Delusion

MILAN – If one looks at the trade patterns of the global economy’s two biggest players, two facts leap out. One is that, while the United States runs a trade deficit with almost everyone, including Canada, Mexico, China, Germany, France, Japan, South Korea, and Taiwan, not to mention the oil-exporting countries, the largest deficit is with China. If trade data were re-calculated to reflect the country of origin of various components of value-added, the general picture would not change, but the relative magnitudes would: higher US deficits with Germany, South Korea, Taiwan, and Japan, and a dramatically lower deficit with China.

The second fact is that Japan, South Korea, and Taiwan – all relatively high-income economies – have a large trade surplus with China. Germany has relatively balanced trade with China, even recording a modest bilateral surplus in the post-crisis period.

The US has a persistent overall trade deficit that fluctuates in the range of 3-6% of GDP. But, while the total reflects bilateral deficits with just about everyone, the US Congress is obsessed with China, and appears convinced that the primary cause of the problem lies in Chinese manipulation of the renminbi’s exchange rate.

One problem with this view is that it cannot account for the stark differences between the US and Japan, Germany, and South Korea...The final-assembly links of global-value added chains will leave China for countries at earlier stages of economic development, such as Bangladesh, where incomes are lower (though without producing much change in the balance with the US).

A somewhat more sensible concern might be that the dollar’s reserve-currency status causes it to be “over-valued” with respect to every currency, not just the renminbi. That could create additional pressure on the tradable part of the US economy, and thus might help to explain why the US tradable sector has not generated net employment for two decades…

…In fact, the employment generated by the tradable sector has been in services at the upper end of the distributions of value-added per person, education, and income. As a result, growth and employment in the tradable sector have gone separate ways, with healthy growth and stagnant employment. In Germany, by contrast, the tradable sector is an employment engine. The same is true of Japan...

…The focus on currencies as a cause of the West’s economic woes, while not entirely misplaced, has been excessive. Developing countries have learned over time that real income growth and employment expansion are driven by productivity gains, not exchange-rate movements…

…None of this is peculiar to developing countries. Underinvestment has long-term costs and consequences everywhere. Excess consumption merely hides these costs temporarily…

…As long as America economic policy remains focused primarily on deficits, domestic demand, exchange rates, and backsliding on trade openness, its investment deficiencies will remain unaddressed. That means that its employment and income-distribution problems will remain unaddressed as well.

The short version: the US trade deficit won’t be solved by the adjustment of exchange rates alone. Forcing China – or for that matter, the rest of East Asia – to accelerate exchange rate appreciation against the USD doesn’t address the fundamental problem of over consumption and insufficient savings in the US. Production just shifts somewhere else, and the deficit continues.

It’s like taking an inflated balloon and squeezing it in one spot; the air just shifts to the un-squeezed part of the balloon and you don’t affect the overall volume of air inside.

Unfortunately, Congress either fails to understand or chooses to ignore the underlying problem in favour of political brownie points that they presume would be more popular or understandable to voters. Problem is, while China bashing might be popular, it won’t bring back lost jobs or dying industries.