Monday, March 28, 2016

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.


Christophe Delsol said...

I agree with you Mr. Grannis. So who to vote for in November?

PS: Been reading your blog for years thank you for sharing your knowledge.

Oeconomicus said...


Introductory economic theory suggests market based prices are signals engendering the most efficient allocation of scarce resources.

My readings on the subject of China "manipulating" their currency (or any other country with their own currency), is they are most likely misallocating their own economic resources. This makes sense to me.

Can you elaborate on "currency manipulation?"

Should one think of currency prices the same way as any other market price?

Scott Grannis said...

Re China: First, I seriously doubt that China is "manipulating" its currency. But even if it were (i.e., keeping the yuan artificially low vis a vis the dollar), it would be to our advantage to trade with them.

For a good explanation, see Don Boudreaux:

If China wants to subsidize our purchases from them, they are stupid, but we would be stupid not to accept.

In general, the country that subsidizes its exports is the loser.

Currencies are not always market prices, especially in the case of China. China's central bank follows a managed peg regime, which means they set the price of the yuan and then hopes that the market will find an equilibrium around that price. They haven't been too successful doing this, which is why they built up huge forex reserves for 20 years, and since 2014 have been losing reserves. If China were keeping the yuan artificially cheap, by selling yuan and buying dollars, their reserves would be constantly increasing. But that has not been the case for the past year or so. If anything, the yuan may be a bit too strong still.

The dollar's price, in contrast, is fully determined by market forces.

Scott Grannis said...

Re: whom to vote for. Right now, I'm in agreement with David Goldman. See his very interesting recent article on this subject:

And if Trump is the only non-Hillary choice, then I think Don Luskin's article is worth reading:

Benjamin Cole said...

Good post.

However, we often hear that America should allow more skilled immigrants so as to keep our tech industry in Northern California.

But following the reasoning of this blog, it would be better to let the tech industry migrate to India for design and software, and to China for manufacturing.

We could then get all our tech goods from offshore in exchange for slips of paper.

Trump says that in fact we should allow the skilled immigrants in, to keep the tech industry in Northern California.

Michael Meyers said...

Love you blog....but I think you would have more sympathy for the US workers unemployed by that cheap Chinese goods...if you had not had a cushy job at Western Asset management, but rather worked in a New England textile factory. Ones perspective can change ones view completely.

Scott Grannis said...

MM: I think I have plenty of sympathy for those who lose their jobs, for whatever reason. Before I got that "cushy" job at Western Asset I spent 4 years in college and 4 years in graduate school. Along the way I lost three jobs because the companies I worked for couldn't compete. And before my job at Western became "cushy" I had put in another 10 years of on-the-job training, during which time I worked 10-12 hours per day. Yeah, I'm a cold-hearted SOB who's never suffered a day.

But you couldn't be expected to know that. What you overlook, however, is all the jobs that were created because cheap Chinese goods allowed consumers to spend more on other things. Econ 101 says that far more jobs were created than were lost. That is the nature of free markets and dynamic economies. That's the story of trade and progress, and it's been true for the entire course of modern civilization.

I don't feel in the least guilty for what I did or said, or for what happened to the very small percentage of the U.S. population that lost their jobs to cheap Chinese imports. As an economist I'm always looking to promote whatever raises living standards for the most people. I believe that a rising tide lifts all boats. I also believe that creative destruction is inevitable in the march to progress.

Sometimes life is unfair; get used to it.

Benjamin Cole said...

On the other hand, if the textile industry had followed the tech model, they should have said, "We need very cheap imported labor to compete."

And some sort of "textile bracero" program worked out, and very cheap labor imported into textile mills from India. Then we could have kept textiles in the Carolinas.

Funny, how the tech industry gets some points for its arguments, but the textile industry would have been laughed at,

So, is Don Trump right to subvert immigration law to get cheap imported skilled labor to the tech industry in Northern California? Trump wants to save domestic industry.

Interesting arguments.

steve said...

Total agreement Scott. The irony is that most of the DT supporters are the same people who shop at Walmart. Simply put, like the BS supporters, they are IGNORANT.

Benjamin Cole said...

I find better deals in the dollar stores.

Frozen in the North said...

Scott excellent Analysis. BTW il you look at Germany's entry into the Euro you find a similar situation; while the rest of Europe was happy to see net wealth rise by entering into the Euro overvaluing their national currencies thereby giving their citizen a large wealth effect, on their savings and salaries, the German undervalued the D-mark. The effect is that over the past 20 years Germany has become Europe's leading manufacturer.

Now again, the analogy is imperfect, but the impact of a weak DM on entry into the Euro has conveyed an advantage to Germany, that has persisted over the year as wages in Germany slowly rise to the European average. Germany, like China has transferred (invested) in the rest of Europe, until,they had enough -- hence the 2008/10 European debt crisis.

Again, the perspective is interesting because unlike China/USA the exchange rate has been pegged in Europe, but the consequences are similar Germany's industrial base has grown while that of its European partners has been destroyed. China is in a different place because it was not a mature economy, but exchange rate differentials can/do damage economies, in Europe there has been limited transfer of wealth, but China has destroyed a large part of America's manufacturing base -- today America is either creates high paying service sector jobs (not a lot) or a large number of minimum wage jobs, which has destroyed America's middle class.

As for your successes, good for you; I would although never compare "summer jobs" with "thank you for working for us for 20 years -- now go away" as an understanding of the destruction brought upon America's economy (creative yes) but those who's livelihood that was destroyed for the greater good were not compensated for their losses...that has been the big failure of trade, those who lost out in trade economics, were left to rot, and were not compensated.

The coal industry has been very good at extracting payoffs to justify shutting down their business. The average American has not, unfortunately, been able to buy the necessary local, and national political influence to get these payoffs.

Lawyer in NJ said...

I wouldn't vote for Trump against anyone. He's at least as dangerous as Sanders, if not more so because of racially and ethically insensitive (if not much worse), anti-intellectual rhetoric. In such a hypothetical contest, I simply wouldn't vote.

But I have no problem voting for Hillary. The country was prosperous under Bill and almost certainly would be again.

NormanB said...

The best thing China (and other Asian countries) have done for us has been to send over their best and brightest. America was made for Asians. Their children are 2x more ready for college than Whites (and 15x more than Blacks). Even though they are discriminated against for medical school (their lowest acceptance rate at the average test score levels is 20% vs 28% for Whites) you hear nary a word from them. They should be screaming but they just keep chugging along. Further, there is hardly a need for law enforcement or incarceration as they have subatomic crime rates. Welcome, I say for a better and brighter America!

Lawyer in NJ said...

Oh, I overlooked Trump's serial sexism. What he has said about Cruz's wife (and I am no fan of Cruz) is beyond the bounds of decency for anyone not so insecure about their um, manhood.

Scott Grannis said...

NormanB: thanks, excellent contribution to the subject

Benjamin Cole said...

Lawyer in NJ---oh loosen up. Even Cruz doesn't always favor his wife over rivals.

And Hillary is a little warmonger In pantsuits.

Is it too late to draft Scott Grannis?

Christophe Delsol said...

Wow excellent performance from Cruz on CNN town hall!!!

Christophe Delsol said...

We are currently sifting from a manufacturing economy to a service sector economy. Think about farmers, laborers, construction workers to a society of agents, marketers, laywers, programmers, internet jobs ..etc...

It is amazing how the shifting our society's economy from the secondary sector to a tertiary sector can create issues for entire generations.
- Immigration issues
- Training/Education issues
- Wages issues
- Policies/Regulations
- Religion
- War
- Knowledge

Today we can comprends how all this functions and we can make quick and agile decisions/policies. Not decisions rooted in dogma and in ignorance sometimes century old.

We can do incredible stuff! Check this out: On December 21 2016 SpaceX actually made a rocket that lands back to earth in the upright position.

It is important for our political leaders to comprehend this and address the issues in a smart way (guys, we have the brains!). We need our leader to help us make this transition in the smartest possible way.

PS: Someone with high connections pass this note to our presidential candidates.

Chuck Reynolds said...

Well said. I am no Trump fan, but Trump is bluffing. In all honesty, I think he started this campaign as a publicity stunt and did not expect it to take off like it has, which is why he is so ill-prepared. I trust that he will have the country's best interests at heart, and will surround himself with the right experts as I see other businessmen do. It is very odd that the antiestablishment candidate is a guy that funded the establishment, but we will see how this shakes out. I think we will be in good hands as long as Hillary is defeated.

steve said...

I have voted republican for 40 years but if DT gets the nomination, I will not vote for president. I'll vote for the senate and house in my state (NH). I understand that this is a de facto vote for the democrat but so be it. I am dismayed when DT supporters state that they'll vote for him because they assume his trade policies will be blocked by congress. So they'll rely on the "establishment" to block DT's main policy issue! I agree with Romney that IF DT's trade policy were enforced it would lead to recession. We NEED free and unencumbered trade.

JBH said...

Where are the nascent industries, firms, and jobs that die stillborn because predecessor industries have been offshored? You haven't seen them have you? It always starts with textiles, yet never ends there. Lost IT jobs are the latest in a long line. This is a terminal violation of the hidden assumptions of Ricardian comparative advantage. Nor is it the only one. See Ian Fletcher's book -- the gold standard on this subject. The cumulative trade deficit with NAFTA alone -- 20 years 1995 to 2014 -- is $1.7 trillion. No corporation can survive such hemorrhaging in the long-run. And the BEA statisticians will tell you the USA is one big corporation -- with of course very deep pockets sown by our ancestors. And, what of the debt-servicing into perpetuity on this $1.7 trillion?

Free trade is a mantra. If the assumptions hold it is win-win. They hold only partially in today's context. What the US has experienced since NAFTA is on net they win, we lose. Revenue minus cost is our measurement of profits, the bottom line. Exports minus imports are perfectly analogous (US showing year after year of negative profits). Have we forgotten what the great Peter Drucker said about profits as the cost of surviving in the future? The US is importing savings from abroad -- seed corn -- and then instead of planting it we consume it in the form of cheap goods from KMart. No thought at all to 100% certain lost future production! Which has oh so slowly eviscerated the potential of this once great nation.

What is not taken into account is time. Austrians get it, Keynsians don’t. The real world economy is a complex dynamic mechanism that constantly evolves. Dynamic is the operative word. Your grandchildren's excellent jobs are vanishing. That is, they will never come into being. Yet not 1 out of 100 think through to this final result. Many other assumptions of Ricardian theory are being violated too. It's like decades of Paul Samuelson telling students the debt does not matter because we owe it to ourselves. Pernicious nonsense only a handful saw through. Yet since around 2000 the chickens have indeed come home to roost. More arrive every day. One-third of net job creation since the 2007 cycle peak is in restaurants and bars! These are chicken plucking jobs, while domestically domiciled corporate chieftains who benefit from trade sit at the high table in China eating fried quail. Read Fletcher (or familiarize yourself with US trade and tariff history in the 1800s) and wake up ...

Scott Grannis said...

JBH: I encourage you to broaden your understanding of the issue of trade and the balance of payments. If there is any subject on which virtually all economists (with the exception of the Paul Krugman of today as opposed to the Paul Krugman whose excellent work earned him a Nobel) agree, it is that free trade is a good thing for the vast majority of people. In short, your concerns are not well-founded.

You could start by reading Don Boudreaux on the subjects of trade and the balance of payments; he has hundreds of posts and examples. Reading him is a quick and dirty way of receiving a graduate education in the basic logic of economics:

Lawyer in NJ said...


Lawyer in NJ---oh loosen up. Even Cruz doesn't always favor his wife over rivals.

Well...maybe, but aren't we all permitted to say things to or about our loved ones that would cause a war if a stranger said it?

And Hillary is a little warmonger In pantsuits.

Whatever she is, she isn't about tell Japan to go nuclear, or boost the Russians by disbanding NATO, as Drumpf has said he would.

So I won't let the perfect be the enemy of the good.

William McKibbin said...