It’s All the Yuan’s Fault

The Chinese currency, the Yuan, is the current whipping boy for the fact that the US is running an enormous Balance of Payments deficit on its Goods and Services account. This is the sub-category that gets all of the attention since the unions and big businesses are most affected. It has become an article of faith, or urban legend, that the Yuan is undervalued by 40% due to currency manipulation by the Chinese government. The implicit assumption is that if the Yuan were just permitted to find its true equilibrium value, assumed to be 4.8771 Yuan/$ based on the May 26th closing price of 6.8293 Yuan/$, then all of the manufacturing jobs that have disappeared over the past decade or so would return to American shores.

Not so fast. A little history will show the tenuousness of this assumed sequence of events. In the 1980s, Japan was the whipping boy for the decline in manufacturing jobs in the US. It is important to note that the issue that most vexes people (read: unions, politicians, newspaper columnists) is the decline of union jobs. Manufacturing output has continued to rise over time, by the way, although one would never realize it from the press reports. Using the 2002 annual average as the base, that is, setting it equal to 100.00, Industrial Production in the US rose from 60.9454 in January, 1985 to 112.3962 in December, 2007. It currently is 102.2666. From January, 1985 to December, 2007, then, output increased by more than 84%. It is down 9% due to the recession.

In January, 1985, the US-Japan exchange rate was 254.1829 Yen/$, that is, the US had what was considered to be a very strong currency. Japanese products didn’t cost all that much, relatively speaking. The Balance of Payments that January was -$3.868 billion. In December, 2007, the exchange rate was 112.4490/$. This means that Japanese goods now cost 2.26 times as much in US dollars as they did in 1985.  This nets out the effect of inflation in both countries.  The Balance of Payments was -$6.578 billion. As of March, 2010, the exchange rate was 90.7161 Yen/$. The Balance of Payments was -$5.317 billion. Hmm? Japanese goods became more expensive and, yet, we ratcheted up our consumption of them. This wasn’t supposed to happen, was it? What went wrong?

The fundamental problem is that the prognosticators either didn’t read their Adam Smith’s Wealth of Nations, or have forgotten it. Implicit, also, in their assumptions is the belief that the Chinese, like the Japanese were supposed to, won’t adjust to the new prevailing set of prices. They will be happy to have reduced demand for their production, thus accepting a lower standard of living. As can be seen from the Japanese-US results, the Japanese became much more productive, aggressively so. It is entirely likely that this situation will be repeated in China. In fact, since China is starting from a much lower base of productivity, they have the ability to make even greater proportional improvements in a short period of time. The end result of our browbeating the Chinese to revalue their currency to a rate that we would prefer is that we will have caused them to become an even more formidable competitor, especially in markets besides ours and theirs.

The other aspect that the pundits forget is that the US is not the only trading partner China has.  This is true for virtually every country.  A country buy inputs from some countries and sell finished goods to others.  Inputs and finished goods mean different things to different countries.  Australia is a net exporter of raw materials.  These are its finished goods.  Their inputs are the heavy equipment they acquire to mine the ores.  In China or Japan’s case, they acquire the ores and manufacture consumer products.  China and Japan will run trade deficits with countries like Australia, while running export surpluses with countries like the US.  The appreciation of the Yuan may reduce China’s overall balance of trade surplus but it doesn’t guarantee that the deficit with any specific country will be reduced.  As we saw with Japan, the enormous appreciation of the Yen did not make a difference to its trade balance with the US.

Our pundits seem to believe that one can legislate prosperity and cause the return of manufacturing jobs to the US regardless of the efficiency with which that output is produced. It is stunning how little we have learned from our previous attempts to legislate an economic nirvana. Ohio and Michigan lost many manufacturing jobs in the early 2000s. No one seems to have connected the dots and observed the relation between our imposing steel quotas, designed to protect a small number of steelworker jobs, and the ensuing uncompetitiveness of our much more numerous steel using industries. Successful firms and industries are those that have recognized that increased productivity is the only way to prosper in a world where consumers want the best quality for a given price, or the lowest price for a given quality.

Bashing China and its exchange rate policy will not improve our manufacturing employment base. It may, however, cause it to dwindle further. Be careful of what you wish for.

Posted by Jim