China's gift to us: cheap goods

When it comes to trade with China, Donald Trump has it all wrong. The Chinese haven't been taking advantage of us by running a huge trade deficit, they have been giving us a huge gift in the form of ever-cheaper goods (e.g., iPhones, HDTVs). And what did they do with all the money we paid them for those cheap goods? Well, they ended up investing it all here, mostly in Treasury notes. So, at the end of the day we got lots of cheap stuff, and we got to keep our money to boot. Sounds like a sweet deal to me.

The last time the Chinese devalued their currency big-time was at the beginning of 1994, when the yuan plunged almost overnight from 5.8 to 8.7 to the dollar. Following that one concerted move, which was designed to kickstart China's goal of becoming a major exporter and economic player, the Chinese adopted a pegged/managed exchange rate policy, a legitimate monetary policy strategy. In a currency peg regime, the central bank buys up any net inflows of foreign currency in order to keep those inflows from pushing up the value of its currency. Similarly, the central bank must sell foreign currency whenever there are net foreign currency outflows which would otherwise push down the value of its currency. Rising foreign exchange reserves are thus indicative of capital inflows, whereas a decline in forex reserves signals capital outflows.

As the chart above shows, China's currency rose in stages from 1994 through 2014, driven by a continuous influx of foreign capital which the central bank bought up, accumulating some $4 trillion in forex reserves as a result, most of which was invested in Treasury notes. In effect, the money we paid China for its wonderfully cheap durable goods was reinvested right back into the U.S. economy by the Chinese central bank.

Since mid-2014, capital has been leaving the country, and the central bank has been selling its reserves, which have fallen from a high of $4 trillion to $3.2 trillion as of the end of last month. Why have capital flows reversed? Because China is no longer a magnet for foreign capital. China's economic growth rate has slowed as its economy has matured, so there is no longer a mad dash on the part of global capital to invest in China. In addition, the government has been relaxing capital controls, making it easier for money to leave, in preparation for the yuan's acceptance as a major currency by the IMF. 

Since 1994, the net effect of China's exchange rate policy was a doubling of the real value of the yuan vis a vis the currencies of its trading partners, as the chart above shows. That's right: for the better part of more than 20 years China's currency has been adjusted higher—not lower—against other currencies, after taking into account relative differences in inflation. China became an exporting and manufacturing powerhouse not because it cheapened its currency to unfairly compete, but because it worked hard to become a world-class manufacturer. China became a world class exporter in spite of the fact that its currency was steadily appreciating for two decades. This is not unfair competition, its healthy economic development. The productivity of Chinese workers has skyrocketed, as have the living standards of the Chinese people. And what's good for China is good for the world.

Most of what China has exported is what we call durable goods. China managed to make fantastic and innovative products in an ever-cheaper fashion, and the benefits of that productivity miracle were shared by all the world's consumers. Since China first launched its exporting and manufacturing boom in 1995, cheap imports have resulted in a continuous decline in the price of durable goods in the U.S., which shows up in the blue line in the chart above. Since 1995, durable goods prices on average have fallen by one-third. That's the first time in recorded history that durable goods prices in the U.S. have declined on a sustained basis. Meanwhile, the prices of other things—services and nondurable goods—have continued to rise.

The story is relatively simple: technology, coupled with the rise of China's manufacturing prowess, has driven down the prices of manufactured goods and boosted the productivity of labor. Labor is more productive today, thanks to computers, technology, and the internet. It takes less and less input from people to make more and better things as a result.

As the chart above also shows, durable goods prices have fallen by one third over the past 20-some years, while the prices of services (a reasonable proxy for labor costs) have risen by over two thirds and non-durable goods prices have increased by over 40%. This has led to the most amazing change in relative prices in modern times, and it's a gift that keeps on giving to the vast majority of the world's population: a typical wage in the U.S. today buys two and a half times as much in the way of durable goods as it did 22 years ago (i.e., 1.69/.6 = 2.5), and there is no sign that this won't continue. Wow.

Memo to Trump: slapping a huge tariff on Chinese imports would only serve to make durable goods more expensive, to the detriment on all consumers, in a misguided attempt to attract some manufacturing jobs back here from China. You don't make the U.S. economy stronger by making durable goods more expensive. If we want more jobs in the U.S., all we need to do is make the U.S. more attractive to capital, and we can do that by drastically reducing the taxes on capital. That's the win-win solution. Increase the after-tax returns to capital invested in the U.S., and you will see more capital invested, and with more capital, perforce come more jobs.

I should add that monetary policy has had little if anything to do with durable goods deflation. It's all about China opening up its billions of people to the global marketplace, the blossoming of international trade, and the technological wonders released by the combination of ever-more-powerful computer chips and incredible software technology.

This is not something to fear, this is something to celebrate.