When teaching international trade to high school economics students, one of the challenges is understanding the pros and cons of trade surpluses and deficits. A country’s balance of trade refers to the net flow of revenues and expenditures goods and services between the country and its trading partners. In technical terms, this is known as the current account on a nation’s balance of payments. A country that spends more on imports than it earns from the sale of exports has a current account deficit. A nation that earns more from the sale of its goods and services to the rest of the world than it spends on imports has a current account surplus.

A common impressions among students is that a trade surplus is good and a trade deficit is bad. One challenge I face in teaching this topic is separating economic terms such as “suplus” and “deficit” from non-economic, normative concepts such as “good” and “bad”. In fact, a trade surplus is not always a good thing. To illustrate, I will look at the current account balances between China and the United States. In 2007, the US ran a trade deficit with China of $258 billion. While the US imported $321 billion of Chinese goods and services, it only earned $63 billion from the sale of exports to China. To most students, it would appear that China is “winning” in the game of trade, since it has such an enormous trade surplus with the United States. This, however, is not necessarily the case.

One way of looking at trade balances is that a nation with a substantial current account surplus is actually consuming less of its own output due to the high demand from abroad. As mentioned above, in 2007 Americans spent $321 billion on Chinese goods and services. China only produced $3.2 trillion of goods and services that year, meaning Americans actually consumed over 10% of the stuff produced in China! This represents Chinese output that is NOT being consumed by the Chinese. Additionally, since China imported far less from abroad than it sold, Chinese output being consumed abroad is far from made up for by Chinese consumption of foreign output. While this may sound like a good deal from the perspective of producers, who have a larger market due to trade, from the perspective of Chinese households it means they are consuming less than they are producing as a nation!

One of the goals of macroeconomics is to increase the standards of living of the nation’s people through an increase in the consumption of goods and services. In this regard trade deficit countries are actually better off than trade surplus countries, since they are actually consuming MORE than they are producing as a nation! A trade deficit country gets more than it gives, in a way, which sounds pretty good when if you consider total consumption to be an end in itself. A trade surplus country, on hte other hand, gives the rest of the world more than it gets in return (in terms of goods and services, that is).

Another consequence of running a large trade surplus is the build up of foreign exchange reserves. China, for instance, held over $1.3 trillion USD in its central bank in 2007, representing an enormous level of savings for the Chinese people, since these are dollars earned by the people of China (from their export sales to America), but not spent. These reserves represent a form of forced savings on the people of the nation.

The average Chinese consumer is also made worse off because the governments’ US dollar reserves are held intentionally to keep the value of the dollar high, thereby keeping the price of American and other nation’s imports prohibitively high for Chinese consumers. In this regard, China’s 50% national savings rate is a form of financial tyranny by the government perpetrated against the Chinese people, who, as consumers, would be much better off if the RMB were allowed to appreciate and imported goods and services could be more easily and affordably attained by Chinese households. Employment in the export sector might suffer but falls in exports would likely be made up for with gains in domestic consumption, meaning the overall effect on employment is likely to be mild upon a reductions in China’s trade surplus.

Furthermore, in order to maintain China’s trade surplus the Chinese government must keep the RMB weak. As already mentioned, one way it does this is by holding its US dollar reserves to keep the supply of dollars on foreign exchange markets low and its value high. Another way the Chinese central bank manipulates its currency is by constantly changing the level of interest rates to limit or encourage foreign capital flows into or out of the country, since such flows affect the Chinese currency’s value. If the Chinese central bank and government were to adopt a flexible exchange rate policy, which would help reduce the country’s trade surplus with the United States, this would allow the central bank to use monetary policy in the way it is meant to be used: to stimulate or contract the level of domestic consumption and investment. This week US Fed chairman Ben Bernanke spoke to the US Senate about China’s exchange rate controls, and made a similar point:

“Most economists agree the Chinese currency is undervalued and has been used to promote a more export-oriented economy. I think it would be good for the Chinese to allow more flexibility in their exchange rate.”

Letting its currency, the renminbi, appreciate would give China’s central bank more flexibility in monetary policy and help stimulate domestic demand and consumption, Mr. Bernanke said

China’s trade surplus does not necessarily benefit the country as a whole. Surpluses do keep export sector employment high, but result in a lower overall level of consumption among Chinese households and impose a higher than necessary level of savings on the nation. More balanced trade would increase the level of imported goods and services in China, increase real incomes as the value of the nation’s currency rises, and also allow for more inflows of foreign capital from abroad, further stimulating growth in China’s domestic economy.

One feature of Economics in Plain English several students and teachers have found helpful over the years is the Econ Help Desk, where readers can get questions about basic economic concepts answered personally by me.

Recently I received the following email from an AP Macroeconomics teacher in the United States:

I have a question about graphs that illustrate how trade preferences (specifically Supply and Demand shifts), affect P, Q and Pe on Supply-Demand GRAPHS of Currency Exchange.

In teaching my AP Macro students about this concept, I have reached a gap in our full understanding how to graph the Supply and Demand of Yen, or Euro (Price in USD).

For example, if the Price levels rise in the U.S., relative to Japan’s, and consequently, the U.S. demands more Japanese cars and stereos, the only label that we ever see for the x-axis is “Q” or Quantity, or Qe, a vertical line that represents the starting “market clearing price”, of .01USD=1Y. When DEMAND or SUPPLY shifts, the only change that I ever see labeled on the graphs is the Y-Price in USD of Yen, but descriptions simply talk about the Y=1.

When Demand or Supply shifts (in response to increased demand for Yen), and there is a new higher or lower USD Price for Yen, respectively, does the vertical line for Q simply shift outward (continuing to represent Y=1) at whatever the new Price Equilibrium becomes (simply meaning just more “1s” of them in circulation (at each new Pe market-clearing point)?

Thanks

Here is my response:

Hello, I will try to address your questions below.

Exchange rates can be determined by several factors, including relative price levels, relative interest rates, tastes and preferences of domestic and international consumers, relative income levels at home and abroad and speculation by currency traders. As you say, an increase in the price level of goods produced in United States (say, Fords), ceteris paribus, should lead to an increase in demand among American consumers for goods produced in Japan (say, Hondas), which now appear relatively cheaper. Demand for Yen increases among American households who wish to buy Japanese goods. The USD price of Yen then rises in the Yen market. Since Japanese holders of Yen now receive more USD for each Yen, they will provide more Yen (this is another way of saying with an increase in demand for Yen, the quantity supplied of Yen increases).

Theory would say that there is no increase in the supply of Yen following an increase in Demand by American consumers, only an increase in quantity supplied. The Yen clearly appreciates, as the USD/Yen exchange rate rises. Now, there is another side to this story. The Yen market refers to the market for Yen in the United States. Yen will appreciate in the United States. Simultaneously, USD will depreciate in Japan, as Americans buy more Japanese goods, they are supplying more USD in the USD market in Japan. Here the “price” or the exchange rate is Yen/USD. The Yen price of a USD will fall as the supply of USD increase as Americans exchange their dollars for Yen to buy the relatively cheap Japanese goods.

The “market-clearing price” in foreign exchange markets is the exchange rate that prevails in a floating exchanged rate system where exchange rates are determined solely by supply and demand by international consumers, investors, government, banks, and firms. Assume the Yen is trading for $0.01. If , following inflation in the United States and the corresponding increase in demand for Yen, the value of the Yen remained at $0.01, then the quantity demanded for Yen would exceed the quantity supplied. There would be shortages of Japanese goods in the United States, as Japanese goods are in greater demand yet their prices have not risen. In order to “clear the market” so to speak, the exchange rate must rise, to say $0.012. Now, a Yen’s worth of goods “costs” Americans 20% more than previous, making them less attractive over time. Likewise, a dollar’s worth of goods “costs” Japanese consumers 20% less, since the dollar is weaker in Japan.

As you can foresee, the floating value of the Yen should lead to relatively balanced trade between Japan and the US. The US current account will initially move towards deficit as inflation makes American goods more expensive, however, as demand for Japanese goods increases, the value of the Yen rises making Japanese goods more expensive, which will eventually reduce their appeal to American consumers who will once again begin consuming more American goods and importing less. Japanese will notice the weaker dollar makes US imports cheaper and begin importing more American products. The US current account should remain  balanced in the long-run in a floating exchange rate system.

I don’t know if you’ve had a look at my study guides on exchange rates and balance of payments, but those may help clarify graphically what I describe above:

• Unit 4: Exchange Rates
• Unit 4: Balance of Payments

I hope this clarifies your understanding of how relative price levels help determine exchange rates!

Best,
Jason

More misleading economic statements from uninformed people who have never taken an economics course!

What about, you say?

I’m glad you asked!

I often read and hear in the American press that the United States is creating a giant wealth transfer by buying oil from other countries. Those “wealth transfer” words imply to the typical citizen that somehow our U.S. money supply is leaving our country, never to return again, and somehow our country is pooer after the transaction than if we had produced the oil within our own country.

Yes, the other country becomes wealthier but it has nothing to do with the US currency we send them, for, after all, the US dollars are only useless paper in their own economies as the US dollars cannot be spent in their own economy, but rather those same US dollars can be used to gain access to the US goods and services that those countries covet! The US also becomes financially better off due to the “trade” as the US can aquire our culturally, covetable and inexpensive oil to fuel our cars and heat our homes, in return for the various US products and services traded to the countries from which we imported the oil. In effect, we have “traded”, just like the old western cowboys & indians, US goods for oil, and both countries are better off!

Let me clear about one thing, however; I am fairly confident that it is NOT in our best homeland security interest in purchasing such a large share of oil purchases from countries like Saudi Arabia and Venezuela, whose loyalty to our country is certainly questionable. Luckily, the U.S. produces 40% of its own oil consumed and the other 60% consumed is imported from many different countries. Canada and Mexico are the two largest import countries, which is pretty darn safe.

However, ignoring the aforementioned security issue, when we buy from any of these countries, both countries benefit equally and there is NO transfer of wealth. When the U.S. buys oil from another country those U.S. dollars paid on the oil purchase are immediately returned to the United States and are spent almost immediately in our country since the other country cannot use our dollars in their country. What is really happening is that both countries’ citizens GAIN (not lose!) equally as we are, in essence, trading one product for another for both countries to enjoy!

Let’s use an example. Let’s say the U.S. buys 1000 barrels of oil from Saudi Arabia. At today’s oil price per barrel of $75 that would mean the U.S. would pay Saudi Arabia $75,000 and Saudi Arabia would then, in turn, be forced to turn around and use the paper ($75,000 USD!) on say, a bunch of iPods from Apple. Yes, the Saudi’s are listening to “I Kissed a Girl” by Katy Perry with their IPods hidden under those smart head robes they wear! Ladies and gentlemen: that is why they call it trade: the essence of the transaction is that we have traded some of our iPods for some oil to fuel our cars and heat our homes. Both of us have gained! Katy Perry is hot on the charts and the Saudi’s are boogying in the streets, as US citizens can now drive freely to 7-Eleven for a Big Gulp and stay warm in the winter with the oil received in return.

Also, think of it this way: when an American buys a gallon of gas the money is, ultimately, going to an American business such as Apple! All spending of US dollars is spent back into our economy, and all spending of Saudi dollars (actually they call their currency the “dollar” also but it doesn’t look like ours!) benefit the Saudi economy.

Yes, trade is mutually beneficial. I would rather a warm home this winter and forego another Katy Perry song!

Questions for Discussion:

1. Have you ever realized why they call it “trade”? That each country cannot use the other country’s currency so, in essence, there is a simply a trade of only products and services.

2. The US has a large trade deficit with China and Japan. Why is China and Japan holding on to US dollars and not spending it back into the US? Have they thrown the US dollars away?

3. Do you believe that free trade is a win-win always? If not, why not? Why do nations interfere (tariffs, quotas, etc.) with trade if it is so beneficial?

Related Unit: IB Economics Unit 4.7 – Balance of Payments

Topic: The Marshall Lerner Condition and the J-Curve

Learning Goals/Objectives:

• For students to understand that the levels of price elasticity of demand for a country’s imports and exports determines whether a depreciation or devaluation of the country’s currency will move the nation’s balance of payments towards a surplus or a deficit.
• For students to understand the impact of time on the effect of a depreciation or devaluation of a nation’s currency on its balance of payments in the current account.
• For students to evaluate the argument that a country will always benefit from a weaker currency.

Success Indicators:

• Students will present their PowerPoint presentations of their exchange rate research, explaining how elasticity, exchange rates, and the balance of payments are related.
  
• Students will be able to outline their answers to three IB Economics examination questions relating to the Marshall Lerner Condition
  

Test of prior knowledge:

1. Define ‘price elasticity of demand’ and explain how it is measured.
2. With the use of examples, explain why some products have low price elasticity while others have a high elasticity. With the use of examples, explain why the price elasticity of demand for some goods changes over time
3. Explain how the depreciation of a country’s exchange rate might affect its current account balance.
   IS THIS ALWAYS THE CASE?
4. How might the PED for exports and imports influence the balance on the current account following a change in the value of a nation’s currency?

Process: Students should work in groups of four

• Each group chooses two countries
  • US and Canada
  • Switzerland and Great Britain
  • Euro area and Japan
  • Brazil and US
• Complete three pre-readings:
  • From BizEd:
    The Marshall Lerner Condition and The Economic Effects of a Devaluation
  • From Welker’s blog: The Marshall Lerner Condition and the J-Curve
    
• Using Yahoo Finance, research exchange rate data from the two countries two years ago up to today.
• Use Yahoo’s software to create two line graphs plotting the value of Country A’s currency against Country B’s, and Country B’s against Country A’s. For example:

The exchange rate of US dollars in Australia

The exchange rate of Australian dollars in the US:

• Finally, Create a PowerPoint presentation of your answers to the following questions. Include in the presentation the graph of the exchange rates created in the step above.

Of the four members of each group, two should prepare the section of the PowerPoint answering the following questions from the perspective of Country A and two from the perspective of Country B

Country A: ____________________ and ______________________

Country B: ____________________ and ______________________

Questions the PowerPoint should answer:

1. What is the Marshall Lerner Condition? Why is it important to consider the price elasticities of demand for exports and imports when examining the impact of a change in exchange rates on the current account balance?
   
2. Describe two periods of time from your line graph: One in which your country’s currency strengthened and one in which it weakened against the other country’s currency.
   
3. Using your knowledge of economics, explain TWO factors that may have caused the changes you have identified.
   
4. Given the changes identified, what would you predict would be happening to your country’s current account of the balance of payments over the three periods you specified above?
   
   1. Period 1: _______________________
      
   2. Period 2: _______________________
5. For both the periods of change, explain the impact of the change in exchange rates on the following:
   
   1. a firm that imports its raw materials from the other country
      
   2. a firm that exports its finished products to the other country
      
   3. consumers who buy imports from the other country
      
   4. a firm that produces good for the domestic market and competes with firms from the other country
      
6. Consider the impact of changes in the exchange rate on amount spent on imports and the revenue earned from exports (and thus, the current account balance). Assume the following for the three periods from your chart:
   
   1. Period 1: The price elasticity of demand for imports is 0.35 and the price elasticity of demand for exports is 0.55.
      
      1. Import spending will __________________
         
      2. Export revenue will __________________
         
      3. The current account will move towards DEFICIT or SURPLUS (identify which)
         
      4. Is the Marshall Lerner Condition met? Explain
         
   2. Period 2: The price elasticity of demand for imports is 0.5 and the price elasticity of demand for exports is 2.6.
      1. Import spending will __________________
      2. Export revenue will __________________
      3. The current account will move towards DEFICIT or SURPLUS (identify which)
      4. Is the Marshall Lerner Condition met? Explain
7. Think about the period in which your country’s currency weakened. Assume that the currency remains weak. How would the balance on the current account change over time following the depreciation of the country’s currency. Draw a J-Curve and explain its shape, referring to your country’s currency.
8. Look at the following article: ‘How Far Will the Dollar Fall?’ by Richard W. Rahn.
   1. Explain how the fall in the dollar might help to reduce the US trade deficit.
   2. Assess Dr Rahn’s argument that taxation and regulation are the principle causes of the potential for the limits to growth in the world economy.

You’re now prepared to consider the elasticity implications for balance of payments. Test your own understanding of the Marshall Lerner condition by answering the following IB questions:

1. With reference to the Marshall-Lerner condition, explain how the depreciation of a country’s exchange rate might affect its current account balance. (Total 10 marks)
2. An economy is currently experiencing a deficit on the current account of its balance of payments. The government is considering either allowing the exchange rate to fall or reducing aggregate demand. Evaluate the relative advantages and disadvantages of these two policies. (15 marks)
3. Explain how, in theory, balance of payments deficits and surpluses on current account are automatically adjusted under a system of flexible exchange rates. Illustrate your answer using supply and demand analysis. (Total 10 marks)

The above lesson was inspired by the Biz-Ed activity “International Trade: The Falling Dollar or Rising Pound?”

FT.com / Asia-Pacific – Renminbi at heart of trade imbalances.

“The Americans get the toys, the Chinese get the Treasuries and we get screwed.” Thus a European Union official once characterised the pattern of Beijing accumulating US assets by selling renminbis for dollars, while nothing stood in the way of a rapid and destabilising appreciation of the euro.

In a world of freely floating exchange rates trade imbalances between countries would ultimately be reduced and eliminated. At least, that’s the belief of those advocating a floating exchange rate between East Asian currencies and the United States.

Here’s how it is supposed to work:

• Cheap labor and cheap imports from China following China’s joining the world economy 30 years ago led to a rapid increase in demand for Chinese manufactured goods in the US, creating growth, jobs, and rising national income for China.
• A trade imbalance emerges between the US and China as US spending on imports increases more rapidly than America’s  sale of exports. If the Chinese currency were allowed to float freely on foreign exchange markets, however, this imbalance would be temporary, because…
• The US current account deficit means, literally, that Americans are supplying more of their dollars in the foreign exchange market, while demanding more Chinese RMB. The forces of supply and demand would naturally lead to an appreciation of the RMB and a depreciation of the dollar.
• The weaker dollar resulting from the trade deficit with China would eventually make Chinese goods less attractive to Americans. Despite their lower costs of production, the weak dollar makes imported Chinese goods more expensive and less appealing to the American consumer.
• The strong RMB, on the other hand, makes American produced goods and services cheaper to Chinese consumers, who begin to import more from the US at the same time that Americans demand fewer of China’s products.
• Through free-floating exchange rates, a current account imbalance is eventually reduced and eliminated as exchange rates adjust to the flows of goods and services between trading partners.

A graphical version of this story is told here:

This, of course, is precisely what has NOT happened, thanks to China’s strict management of the value of the RMB. In order to keep its currency weak, Beijing directly intervenes in foreign exchange markets, “by selling renmenbi for dollars” to accumulate American assets. As seen in the next graph, such interference has the effect of keeping the dollar strong against the RMB.

As any IB student knows, the Balance  of Payments between two countries includes not only the trade in goods and services, but also the flow of real and financial assets, such as government securities, stocks, real estate, factories, and so on, between the countries. China has actively promoted a policy of acquiring such American assets, which keeps demand for dollars strong in China, and supply of RMB high in America, without creating any jobs in manufacturing or services for Americans. China has financed America’s current account deficit by assuring it maintains a capital account surplus!

Put more simply, China has exported goods and services to America, while America has exported ownership of its real and financial assets to China. This is a major area of concern for US policy makers, who would like to see a more balanced current account between the two countries, since it is the export of goods and services that creates jobs for American workers, not the sale of bonds, stocks and real estate.

Discussion Questions:

1. Why does Europe care about China’s fixed exchange rate with the US dollar?
2. Do you believe that American demand for Chinese goods would actually decline if the RMB were allowed to appreciate against the dollar? Why or why not?
3. Besides American workers and firms, who else suffers from a weak Chinese currency? How could China actually benefit from allowing the RMB to strengthen against the dollar?
4. How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?

FT.com | The Economists’ Forum | Imbalances and undervalued exchange rates: Rehabilitating Keynes

In our year 2 IB Economics class, we are beginning the part of our International Trade unit on exchange rates and the balance of trade . While the market for a particular currency reflects many of the same characteristics as a product market (i.e. upward sloping supply curve, downward sloping demand curve), the consequences of a change the price of a currency (the exchange rate) is far more powerful than a change in the price of a particular good or service in a product market.

How does the value of a country’s currency affect that country’s balance of trade with other countries? To understand this important concept, we first need to know something about the process by which currencies are exchanged when two countries trade. Let’s look at an example:

When an American consumer wants to buy an iPod that was made in China she will have to pay for it in US dollars, since that’s what she earns her wages in from selling her labor in the resource market. Apple now has the consumer’s $300, which gets split up to cover all the costs the company faced in the manufacture, distribution, marketing and sale of the iPod. Part of that $300 (say $100) will go to the manager of the factory in China where it was made.

The factory manager in Shanghai faces his own costs he must cover. He must pay rent on his factory space, interest on the loans he took out to acquire capital, and wages to the workers assembling iPods on his factory floor. The problem is, these costs are all in Chinese yuan, but he’s holding the US dollars that Apple paid him for his iPod. In order to cover his costs, the Chinese factory owner must take the $100 to a Chinese bank and swap it for RMB. The local bank that changes his money now hands the $100 over to China’s central bank (the PBOC) which prints and exchanges RMB to the bank at whatever the prevailing exchange rate is at the time.

Ultimately, China’s central bank will decide what to do with its holding of US dollars. Most of the dollars are loaned back to the United States through China’s purchase of US Treasury securities (the IOUs the US government sells to finance its deficits). China’s voracious demand for US dollar denominated assets keeps the demand for (and the the value of) dollars high on foreign exchange markets, meaning the RMB remains relatively cheap for Americans and therefore Chinese manufactured goods attractive.

China’s policy of exchange rate manipulation has upset many American politicians over the years, who often blame China for America’s shrinking manufacturing sector. A weak RMB means the cost of producing things like iPods in China is far lower than it would be in the US. By keeping demand for dollars high on the foreign exchange markets through its incessant demand for US treasury securities and other financial and real assets, while simultaneously hoarding vast reserves of US dollars in its central bank, thus keeping supply of dollars on foreign exchange markets low (see graph), China has prevented the RMB from appreciating, fueling the growth of the country’s export-manufacturing sector.

China’s currency manipulations may soon ilicit a response from the United States as president-elect Barack Obama takes office next year. Facing a recession and rising unemployment, combined with the recent appreciation of the US dollar, the pressure is on Obama to take immediate action to restore America’s manufacturing sector. According to the Financial Times blog “the Economists’ Forum”:

If the US economy takes a downturn and the dollar continues to strengthen, a resurgence of protectionist pressures is likely. This time around, these pressures could well take the form of unilateral action against competitive currencies. It is noteworthy that President-elect Obama has actively and repeatedly supported action against “currency manipulation.”

The “competitive currency” perceived to pose the greatest threat to America’s inustrial sector is certainly the Chinese RMB. Currency manipulation is a form of protectionism, which in a time of global economic slowdowns poses a larger threat than ever to both developed and developing nations’ economies alike. For this reason, the World Trade Organization may need to employ carrot and stick methods to create incentives for China to liberalize its currency controls and allow the RMB to strengthan against the dollar and other major currencies:

How would this new rule against undervalued exchange rates be incorporated in the WTO? Through negotiation. The (WTO) should place rules on undervalued exchange rates…. The US and EU have been the principal demandeurs for action by China in the past. But it is important to remember that until very recently, a number of developing countries—Brazil, Mexico, Korea, Turkey and South Africa—were affected by the competitive pressure from the undervalued (RMB). Indeed, some months ago, the Indian Prime Minister urged China to follow a more market-based exchange rate policy. For obvious reasons, more emerging market countries have not voiced their concerns, but it is possible that a coalition of affected countries could unite on this issue.

Clearly, Chinese concerns have to be addressed for any new rules to be crafted and commonly agreed… First, China’s major trading partners could pledge granting China the status of a “market economy” in the WTO contingent on it eliminating currency undervaluation and moving to a market-based system. This status would have significant value for China by shielding it against unilateral trade actions such as anti-dumping and countervailing duties by trading partners. Second, as part of radical governance reform of the IMF, which is desirable in itself, China should be offered a substantially larger voting share in the IMF commensurate with its economic status.

Discussion Questions:

1. How does China continuing to undervalue its currency threaten the industrial economies of its largest trading partners?
2. What is China’s purpose for maintaining the low value of the RMB relative to the currencies of other nations?
3. What would be a unilateral protectionist measure an Obama administration may advocate if the WTO refuses to take action against China’s currency manipulations? How would you advise president-elect Obama on the issue of whether to take protectionist action against China in the context of the current economic crisis in America?

Should President Obama consider writing a thank you note to Chinese leaders for artificially manipulating the Chinese Yuan in the foreign currency markets?

For many years now, Chinese authorities have artificially intervened in the foreign currency market by buying up U.S. dollars spent on Chinese products and, in turn, investing those same U.S. dollars in U.S. treasury securities. For those that are students of the foreign currency market, Chinese authorities buy U.S. Dollars and supply Chinese Yuan to the foreign currency markets for the sole purpose of depreciating (weakening) the Yuan relative to the U.S. Dollar, thereby helping Chinese exporters to become more price competitive.

So while it is true that this action taken by Chinese authorities depreciates the Yuan and appreciates the Dollar, thus, unfairly harming U.S. exporters; it is also hitting the “sweet spot” by sending those same U.S. dollars back to the U.S. federal government to fund the record federal deficit spending. This action by Chinese authorities helps keep U.S. interest rates lower than possible during this important U.S. economic recovery time and provides a great source of lending for U.S. government’s $800 Billion stimulus bill and the expensive Federal budget.

In summary, it seems to me that in the short term the United States should consider not complaining, as Treasury Secretary Tim Gheitner has done on several public occasions. Perhaps Gheitner should keep quiet for now and should start complaining again to the Chinese in about three or four years, after the proposed Obama budget no longer calls for such large deficits.

What do you think?

One of the greatest “ah-ha” moments in all of economics is when an economics’ student or citizen learns for the first time that every time a domestic buyer purchases a foreign product or import that those same U.S. dollars spent on the foreign product go to a U.S.-based company, not a foreign company. Yes, I am telling you that when you (or Wal-Mart) buy Chinese shirts, your same U.S. dollars spent quickly end up in the hands of, say, Apple, Microsoft, Garmin, or General Electric to increase U.S. employment, profits, and U.S. stock prices!

I decided to write this particular blog because of the fact that the recently passed $800 Billion U.S. stimulus bill has some “buy American” provisions within it. Based on an intuitive hunch, I believe that over 99% of adult Americans believe that these “protectionist” clauses somehow help our economy. Yes, the vast majority of U.S. adults believe that it is clearly more advantageous to “buy American” in order to keep the money or wealth within America in order to increase U.S. employment, profits, and U.S. stock prices. In true economic fact, however, if U.S. citizens “buy American” solely out of patriotism (and not because they think it is a superior product) they actually HURT America because the U.S. dollars spent out of patriotism on that American company are, therefore, unintentionally withheld from another more efficient and deserving American country via the “trade loop”.

Let me try to explain this “trade loop” in more detail so that I may actually be able to convince you of this amazing “180 degree” revelation: “Buy American” is Un-American

Let’s say that the United States (we’ll say Wal-Mart) decides to buy many shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying those same shirts from, say, a shirt manufacturer in Elon, North Carolina (USA). The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China! The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the U.S. currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has initially traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a global positioning system (GPS) from FleetMatics out of Waverly, Massachusetts (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid FleetMatics (USA) $400 directly!

Yes, the economic “punch line” is that all spending by the domestic nation on foreign products (imports), in turn, are spent immediately back to the domestic nation increasing the domestic nation’s employment, income, and standard of living. (Note; this is also shown and reported in a nation’s balance of payments schedule if you are skeptical about what you are reading!)

And, yes, let’s not forget about that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Any good economy promotes competition and I am excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity and/or quality), and hopefully get the next shirt contract from Wal-Mart! If not, well, that North Carolina firm may just have to close down. But remember, the key point, the $400 spent for the shirts went to Fleetmatics in Waverly, Massachusetts, in lieu of the Elon, North Carolina shirt manufacturer. If you would have “bought American” even though the Chinese shirts were preferable, you would have prevented the more effective U.S. business in Waverly from getting your U.S. dollars by giving them to the less efficient Elon manufacturer. In short, you would have contributed to American inefficiency and slowing productivity, hurting our country! And that is un-American!

Now, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy that GPS system from FleetMatics for $400. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received form U.S. import purchases. Said another way, China is not buying as many GPS’ as the US is buying shirts and, of course, we call that phenomenon the US trade deficit which immediately seems to speak “problem”. But it is really not as big a problem as most people think! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and be forced to use those U.S. dollars to buy that GPS system or build more plants to employ more Americans!

In summary, when citizens of any country in the world buy the product that is best for them based on a combination of quality and price, they will be taking the most patriotic action possible to help their own country they love so much! If a domestic citizen sees the foreign product as a better alternative to the domestic product, buy it! Your money spent will immediately find its way back through the “trade loop” to another business within your country!

Of course, this is why all economists from around the world know that international trade, and not protectionism, helps a country’s standard of living and promotes efficiency and rising standard of livings!

This post was originally published in November of 2007. While the analysis is still relevant, data is out of date.

Managing Globalization » Business Blog » International Herald Tribune » Blog Archive » Here’s that silver lining, finally

In IB Economics we’ve been studying concepts relating to balance of trade and exchange rates. The Marshall-Lerner Condition and the J-curve are two concepts that explain the relationship between a the exchange rate for a nation’s currency and the country’s balance of trade. (click on the graph to see a larger version)

Common sense might indicate that if a country’s currency (let’s say the US dollar) depreciates relative to other currencies, then this should lead to an improvement in the country’s balance of trade (economists call this the current account). The reasoning goes as such: a weaker dollar means foreigners will have to give up less of their money in order to get one dollar’s worth of American output. At the same time, since the dollar is worth less in foreign currency, imports become more expensive, as Americans have to fork over more dollars for a certain amount of another country’s output; hence, imports should decrease.

Fewer imports and more exports means an improvement in the country’s balance of trade, right? Well, not necessarily. What matters is not whether a country is importing less and exporting more, rather, whether the increase in income from exports exceeds the decrease in expenditures on imports. Here is where the Marshall-Lerner Condition can be applied.

The M-L condition examines the price elasticities of demand for exports and imports of a particular country. Say the US experiences a depreciation of its currency (as it has over the last year or so). If foreigners’ demand for exports from America is relatively elastic, then a slightly weaker dollar should cause a dramatic increase in foreign demand for American output, causing export income in the US to rise dramatically. On the other hand, if American’s demand for imports is highly price elastic, then a slightly weaker dollar should likewise cause Americans’ demand for imports to decrease drastically, reducing greatly American’s expenditures on imports. If the combined elasticities of demand for exports and imports is elastic (i.e. the coefficient is greater than 1), then a depreciation of a nations currency will shift its current account towards surplus. This is the Marshall-Lerner Condition.

Marshall-Lerner Condition: If PEDx + PEDm > 1, then a depreciation or a devaluation of a nation’s currency will shift the the balance on its current account towards surplus.

So what if the Marshall Lerner Condition is not met? Demand for exports and imports may not always be so responsive to changes in exchange rates. Imagine a scenario where a weaker dollar does little to change foreign demand for America’s output. In this case income from exports may actually decline (in real terms, since the dollar is weaker) as the dollar depreciates. Likewise, if Americans’ demand for imports is highly inelastic, then more expensive imports will only minimally affect Americans’ demand for imported goods, in which case expenditures on imports may actually rise as they become more expensive. In this case, where the elasticities of demand for exports and imports are highly inelastic, a depreciation of the currency will actually worsen a trade deficit. Americans’ import expenditures will go up while export income from abroad will decline shifting the current account further into deficit.

In the article above, some data is presented that points to evidence that in the US today, the Marshall-Lerner Condition is in fact being met:

“Exports in the year through September are up by 12 percent from 2006, while the dollar’s trade-weighted exchange rate dropped by only 6 percent. That means foreigners may actually be spending more – even in their own currencies – on American products. It’s a support that the American economy, and in turn the global economy, can really use right now.

Of course, this process isn’t helping the trade deficit too much, No one, it seems, can change Americans’ taste for foreign products. But it does show, for all to see, that the risks of an open economy are at least somewhat balanced by the benefits.”

An increase in exports of 12% in response to a 6% weakening of the dollar indicates a price elasticity of demand coefficient for America’s exports of 2, meaning foreigners are highly responsive to cheaper US goods.

We can assume that Americans’ demand for imports is highly inelastic, as the article hints at when it says, “imports to the United States, including oil, are still rising in volume and value.” If a 6% weaker dollar leads to an increase in expenditures on imports, then demand must be less than one. In order for M-L Condition to be met, PEDx+PEDm must be greater than 1. Clearly, with a PEDx of 2, the condition is met, and a weaker dollar in leading to an improvement in America’s balance of trade with the rest of the world.

Discussion Questions:

1. What is the J-curve effect? Based on the evidence from the article, where on the J-curve is the US right now?
2. Is America experiencing an improvement in or a worsening of its current account deficit?
3. What determinants of demand are fueling America’s ever-increasing expenditures on imports?
4. What should happen to the elasticity of demand for imports if the dollar remains weak in the long-run? How will this affect America’s position on the J-curve?

How high is China’s jobless rate? | The great wall of unemployed | The Economist

China Faces Unemployment Woes

Unemployment in China is a big deal. The legitimacy of the Chinese Communist Party hinges on its ability to assure  stable jobs and income growth for the 300 million “middle class” Chinese who live in the country’s cities. When the urbanites are unhappy, trouble ensues.

So a dip in economic growth rate into single digits, while we in the West may think of it as silly to fret about, is a major deal for China. Interestingly, according to the Economist newspaper, unemployment data in China is notoriously unreliable; in fact analysts have no clear idea of just how much unemployment there is:

Until the 1990s, the government more or less guaranteed full employment by providing every worker with an “iron rice bowl”—a job for life. But when soaring losses at state-owned firms forced the government to lay off about one-third of all state employees between 1996 and 2002, the official unemployment rate rose only slightly. Today it is 4% in urban areas, up from 3% in the mid-1990s.

But the official rate excludes workers laid off by state-owned firms. Thus at the start of this decade, when lay-offs peaked, it hugely understated true unemployment. Over time, as laid-off workers have found jobs or left the labour force, the distortion will have shrunk. Another flaw is that the official unemployment statistics cover only people who are registered as urban dwellers. An estimated 130m migrant workers have moved from the country to the cities, but there is no formal record that they live there, so they are ignored by the statisticians. After adjusting the official figures for these two factors, several studies earlier this decade concluded that the true unemployment rate was above 10%—and might be even as high as 20%.

The textbook definition of unemployment is the percentage of the labor force actively seeking but unable to find a job. In China, however, the “labor force” only includes the 25% of the country’s population that lives in cities, and the massive number of workers who were fired from state-owned enterprises over the last decade are mysteriously excluded from official figures. 4% unemployment, the official number, puts most developed countries to shame, as it represents extremely low levels of unemployment.

Despite the fuzziness in the figures, one thing is for sure, slower economic growth, even though it is still expected to be between 8-9% this year, means fewer new jobs in China, hence the government’s recent slashing of interest rates to re-invigorate investment and spending in the economy.

…on November 26th the People’s Bank of China slashed rates by more than a percentage point—the most in 11 years—to boost growth. The slowing economy has led factories to cut jobs, and there are mounting fears that the swelling ranks of the unemployed might one day take to the streets and disrupt China’s economic miracle.

An interesting point made in this article is that even continued economic growth in China does not guarantee continued job growth. Basic economic theory holds that when a nation’s output is increasing, employment is also increasing, since growth in output implies increase demand for labor. China, however, is experiencing a different type of growth today than that of years past:

China is creating fewer new jobs than it used to. In the 1980s, each 1% increase in GDP led to a 0.3% rise in employment. Over the past decade, 1% GDP growth has yielded, on average, only a 0.1% gain in jobs. Growth has become less job-intensive, so the economy needs to grow faster to hold down unemployment.

One reason for this is that the government has favoured capital-intensive industries, such as steel and machinery, rather than services which create more jobs… China needs to shift the mix of its growth from industry, investment and exports to services and consumption. To adjust the structure of production requires a further strengthening of the yuan, raising the price of energy, scrapping distortions in the tax system which favour manufacturing, and removing various shackles on the services sector.

More labour-intensive growth would also boost incomes and consumption and so help to reduce China’s embarrassingly large trade surplus. But most important, by allowing more workers to enjoy the rewards of rapid growth, it could help to prevent future social unrest.

Discussion Questions:

1. How does China’s current account surplus result in fewer new jobs than a growth strategy based on domestic consumption would?
2. Why would a stronger RMB contribute to greater domestic job creation?
3. “More labour-intensive growth would boost incomes and consumption and so help to reduce China’s embarrassingly large trade surplus” Discuss this statement.
4. Philosophically speaking, why is there more pressure on the Chinese Communist Party to maintain high growth and low unemployment than there might be on a democratically elected party such as the Republicans in the United States?

The $1.4 Trillion Question – James Fallows – the Atlantic

What’s the deal with American consumers? How, exactly, does a nation’s average savings rate fall to 2%, then 1%, and then become negative, like in the US over the last couple of years? What does negative savings actually mean? It means that Americans consumer more than they actually produce.

On the micro level, the only way to consume beyond ones income is to borrow from someone else to pay for the additional consumption. In other words, savings must be negative for one to consume beyond his or her income. The US is a nation of borrowers, but from whom do we borrow? China, for one…

China is a nation of “savers”, where national savings averages 50% of income. What exactly does this mean? Well, just the opposite what negative savings means; rather than consuming more than it produces, the Chinese consume only about half of what it produces. Here’s how James Fallows, a Shanghai-based journalist, explains the China/US dilemma:

Any economist will say that Americans have been living better than they should—which is by definition the case when a nation’s total consumption is greater than its total production, as America’s now is. Economists will also point out that, despite the glitter of China’s big cities and the rise of its billionaire class, China’s people have been living far worse than they could. That’s what it means when a nation consumes only half of what it produces, as China does.

What happens to the rest of China’s output? Naturally, it’s shipped overseas for Americans and others in the West to consume. The irony is that the consumption of China’s products has been kept affordable and cheap thanks to the actions the Chinese government has taken to suppress the value of the RMB, thus keeping its products cheap and attractive to American consumers.

When the dollar is strong, the following (good) things happen: the price of food, fuel, imports, manufactured goods, and just about everything else (vacations in Europe!) goes down. The value of the stock market, real estate, and just about all other American assets goes up. Interest rates go down—for mortgage loans, credit-card debt, and commercial borrowing. Tax rates can be lower, since foreign lenders hold down the cost of financing the national debt. The only problem is that American-made goods become more expensive for foreigners, so the country’s exports are hurt.

When the dollar is weak, the following (bad) things happen: the price of food, fuel, imports, and so on (no more vacations in Europe) goes up. The value of the stock market, real estate, and just about all other American assets goes down. Interest rates are higher. Tax rates can be higher, to cover the increased cost of financing the national debt. The only benefit is that American-made goods become cheaper for foreigners, which helps create new jobs and can raise the value of export-oriented American firms (winemakers in California, producers of medical devices in New England).

Clearly, a strong dollar is good for America in many ways. The dollar’s strength in the last decade can be credited partially to the Chinese, who have been buying dollar denominated assets in record numbers over the last seven years.

By 1996, China amassed its first $100 billion in foreign assets, mainly held in U.S. dollars. (China considers these holdings a state secret, so all numbers come from analyses by outside experts.) By 2001, that sum doubled to about $200 billion… Since then, it has increased more than sixfold, by well over a trillion dollars, and China’s foreign reserves are now the largest in the world.

China’s purchase of American assets keeps demand for dollars on foreign exchange markets strong, thus the value of the dollar high relative to other currencies, allowing American firms and consumers the benefits of a strong dollars described above.

As we learn in AP Economics, a nation’s balance of payments consists of the current account, which measures the difference between a country’s expenditures on imports and its income from exports (China last year had a $232 billion current account surplus with the US, meaning the US bought more Chinese goods than China bought of American goods), and the capital account, which measures the difference between the inflows of foreign money for the purchase of real and financial assets at home and the outflows of currency for the purchase of foreign assets abroad. In the capital account, China maintains a deficit (meaning China holds more American financial and real assets than America does of China’s), to off-set its current account surplus.

The two accounts together, by definition, balance out… usually. Any deficit in the China’s capital account that does not cover the surplus in its current account can be held as foreign exchange reserves by the People’s Bank of China. The PBOC, however, prefers not to hold excess dollars in reserve, as the dollar’s value is continually eroded by inflation and depreciation; therefore it invests the hundreds of billions of excess dollars it receives from Americans’ purchase of Chinese goods back into the American economy, buying up American assets, with the aim of earning interest on these assets that exceed the inflation rates.

The “assets” the Chinese are using their large influx of dollars to buy are primarily US government bonds. The government issues these bonds to finance its budget deficits (when government spending is greater than tax revenue; this figure was projected at around $400 billion this year alone!), and the Chinese are happy to buy these bonds for a couple of reasons: They are secure investments, meaning that unless the US government collapses, the interest on US bonds is guaranteed income for China. That’s one reason; but the primary reason is that the purchase of these bonds puts US dollars that were originally spent by American consumers on Chinese imports right back into the hands of American consumers (via government spending or tax rebates), so they can continue buying more Chinese imports.

The Chinese demand for dollar denominated financial assets, including government bonds, corporate stocks and bonds, and real assets like real estate, factories, buildings and so on, has resulted in a long period of a strong dollar. If the Chinese ever decided to stem the flow of dollars into American assets, the dollar’s value would plummet to record lows, leading to high inflation and eventually a balancing of America’s enormous current account deficit with China and the rest of the world.

However, a falling dollar is the last thing China wants to see happen, for two reasons: One, it would make Chinese imports more expensive thus less attractive to American households, thus harming Chinese manufacturers and slowing growth in China. Two, US dollars are an asset to China. Its $1.4 billion of US debt would evaporate if the dollar took a major plunge. To China, this would represent a loss of national wealth; in effect all that “savings” that makes China so unique would disappear as the dollar dived relative to the RMB. For these reasons, it seems likely that China will continue to be a willing buyer of America’s debt, thus the financier of Americans’ insanely high consumptive lifestyle.

Discussion Questions:

1. Many people in America are terrified that the Chinese might dump their dollar holdings. What would happen to the value of the US dollar if China decided to change its foreign reserves to another currency?
2. Why is it very unlikely that China will do this? In other words, how does the status quo benefit China as well as the US?
3. How do American households benefit from China’s financing of the government’s budget deficits? In what way to they suffer from this arrangement?
4. Do you think America can continue to finance its budget deficits through the continued sale of debt to foreigners forever? Why or why not?

More misleading economic statements from uninformed people who have never taken an economics course!

What about, you say?

I’m glad you asked!

It seems like I continuously read and hear in the American press that the United States is creating a giant wealth transfer by buying oil from other countries. Those “wealth transfer” words imply to the typical citizen that somehow our U.S. money supply is leaving our country, never to return again, and somehow our country is then poorer after the transaction and the country we imported from is now richer!

That is only a half-truth! Yes, the other country becomes richer, but we grow richer also by an equal amount! Both countries always gain economically from trade!

Let’s first get a few things straight before I elaborate: I am not happy either as gas prices rise ($3.50 a gallon in the U.S. as of this writing, although down from over $4.00 recently). I am also not happy that a fairly large share of oil purchases are from countries like Saudi Arabia and Venezuela whose loyalty to our country is certainly questionable. Luckily, the U.S. produces 40% of its own oil consumed and the other 60% consumed is imported from many different countries with 85% of our imports coming from 15 countries with Canada and Mexico being the largest two.

However, when we buy from any of these countries, both countries benefit equally and there is NO transfer of wealth. When the U.S. buys oil from any other country those U.S. dollars paid on the purchase are immediately returned to the United States and are spent almost immediately in our country since the other country cannot use our dollars in their country. What is really happening is that both countries’ citizens GAIN (not lose!) equally as we are, in essence, trading one product for another for both countries to enjoy!

Let’s use an example. Let’s say the U.S. buys 1000 barrels of oil from Saudi Arabia. At today’s price per barrel of $100 that would mean the U.S. would pay Saudi Arabia $100,000 and Saudi Arabia would then, in turn, be forced to turn around and use the paper ($100,00 USD!) on say, a bunch of iPods from Apple. Yes, the Saudi’s are listening to “I Kissed a Girl” by Katy Perry with their IPods under those smart head robes they wear! Ladies and gentlemen: that is why they call it trade: the essence of the transaction is that we have traded some of our iPods for some oil to fuel our cars and heat our homes. Both of us have gained! Katy Perry is hot on the charts and the Saudi’s “got their hands in the air”, and we can now drive to 7-Eleven for a Big Gulp and stay warm in the winter.

Also, think of it this way: when an American buys a gallon of gas the money is, in substance, going to an American business such as Apple! All spending of US dollars is spent back into our economy, and all spending of Saudi dollars (actually they call their currency the “dollar” also but it doesn’t look like ours!) benefit the Saudi economy.

Yes, trade is mutually beneficial. I would rather a warm home this winter and forego another Katy Perry song!

Is international trade really as good for a nation’s standard of living as economists say? And, what the heck is comparative advantage anyway? And what about the foreign currency market and those confusing supply & demand curves? Yes, the quest to understand the economic benefits of international trade is enough to make any citizen or first-year economic student vomit, tremble, get a headache, or at least curse.

Having been an AP Economics’ teacher for 8 years now, I must candidly admit that it took me a few years of study and research to try to reduce international trade to pure simplicity and understanding. Let me give it a shot below. I love simplicity.

The average “Joe Citizen” in almost any country in the world is suspicious of trade, and rightfully so, since he reads or observes factories being closed, jobs lost, and the feeling that somehow his country is going down the toilet as his own home fills up with foreign-made products. Unfortunately, what Joe Citizen does not understand is that the money his own nation is spending for those foreign products (imports) is spent right back into the pockets of his own country, increasing employment and income.

Let’s take a single, real-world, international trade example being careful to accurately explain the whole economic story:

Let’s say that the United States (we’ll say Wal-Mart) decides to buy several shirts costing $400 from a Chinese shirt manufacturer, in lieu of buying those same shirts from a shirt manufacturer in Elon, North Carolina (USA). As a US AP Economics’ teacher I am one of about only 47 Americans in Fairfax County Virginia, which not coincidentally ties to the number of AP Students I taught this year, that quickly understand that the decision to purchase the shirts from China, in lieu of the US manufacturer in North Carolina, is actually BETTER for America and will make my home country better off in the long run! What? Mr. Latter, are you Benedict Arnold, the American traitor, reincarnated?

Let me explain how the US benefits (and China too!) in simple terms ignoring foreign currency transactions, which will just confuse the discussion and cause the student to lose sight of what is really happening:

The first key point is that when Wal-Mart buys the shirts from China for $400 it can only pay China with US dollars. Why? Because Wal-Mart has only US dollars! It has no Chinese currency (Yuan). It literally drains its bank account of US dollars that are transferred/paid to China!

The second key point is that when China receives that same $400 US dollars for the shirts, China cannot, unfortunately, spend any of the $400 in its own economy since only the Yuan is accepted as a medium of exchange in China! China is now forced to either throw the currency away (not advised!), or immediately spend the money back to the USA (advised!).

In summary, China has actually traded a product (shirts!) for paper (US dollars!), and those US dollars cannot be spent in China. For China to receive any value at all for the shirts it sent to America, China must now spend the $400 back into the US economy for, say, a global positioning system (GPS) from FleetMatics out of Waverly, Massachusetts (USA). Cutting through to simplicity, in essence, it’s almost as if Wal-Mart (USA) just paid FleetMatics (USA) $400 directly for the shirts!

Yes, the “punch line” is that all home-currency spending by the domestic nation on foreign products (imports), in turn, are spent right back to the domestic nation increasing the domestic nation’s employment, income, and standard of living. (Note; this is shown in a nation’s balance of payments schedule which always nets to zero, but, yuk, who cares about that right now with summer coming!)

And, yes, let’s not forget that Elon, North Carolina shirt maker that did not get the original $400 from Wal-Mart in our above example! Our nation loves competition (ready for the Olympics?) and I am excited to see if that North Carolina shirt manufacturer can “raise their game” (increase productivity), and hopefully get the next shirt contract from Wal-Mart or some other firm! If not, well, that North Carolina firm may just have to close down.

If you are still reading this post at this point, you may be thinking the following if you have a little economics’ background: “But the US has a growing trade deficit with China, so China may not immediately buy that GPS system from FleetMatics for $400”. And, you are correct, but that is also not a problem for either the United States or China. What China is really doing right now is deciding to temporarily save or invest a minority percentage of their US dollars received back into America in lieu of buying US products. Said another way, China is not buying as many GPS’ as the US is buying shirts and, of course, we call that phenomenon the US trade deficit which immediately seems to speak “problem”. But it is really no problem at all! China is still spending their “saved” US dollars back into the US economy, but in different ways. China is saving and investing some of those US dollars directly into the United States economy by building plants in America, buying US stock to fund American companies’ expansions, and temporarily saving some of their dollars, for future US purchases, by buying US bonds to help the US government pay for the war in Iraq, the war against terrorism, and several other US government initiatives necessitating borrowing. Eventually, China will sell these US bonds and buy that GPS system or build more plants to employ more Americans!

Now one last thing. Promise! Let’s get back to why trade is really so economically advantageous to any nation that pursues it. And by advantageous, I mean how it increases our incomes and standards of living. In one word, the answer is “productivity”. If we go back to the original example of the US buying shirts from China and China taking the US dollars to buy the GPS, we remember that the shirt manufacturer from North Carolina was “left out in the cold” because Wal-Mart did not buy the shirts from them. We can logically conclude that perhaps some Chinese manufacturer of GPS systems was “left out in the cold” because some Chinese business elected to buy from FleetMatics in the USA, and not the Chinese GPS manufacturer. Wow, I love global competition! What a great way to incent businesses in both the USA and China to compete against each other and increase their productivity and conserve our nations’ scarce resources, increase our choice, and lower our costs!

Discussion Questions:

1. Which basic economic principles underly the emergence of international trade as a global economic force.
2. Who are the winners and losers of trade between the US and China as explained above?
3. Why do you think free trade is such a controversial topic among certain groups of Americans an other Western nations’ people?

FT.com / World / Americas – US economy threatens Dominican Republic

Trade based on comparative advantage… the theory originally articulated by Adam Smith, later fine-tuned by David Ricardo, the theory that suggests that if each nation specializes its economic activity on the products for which it faces the lowest opportunity cost, then trades with its neighbors, total world output and efficiency can be maximized: today this theory represents the philosophical underpinning of all free trade agreements signed between and among the nations of the world.

Through trade, countries can exchange their extra output with other nations for the goods specialized in by others, enabling all nations to enjoy a level of consumption beyond what they’d be able to achieve if they tried to produce all goods domestically.

For many developing countries, with their abundance of either land or labor, comparative advantages tend to lie in either agricultural goods or low-skilled manufactured goods. Since global prices for food are highly unstable and dependency on healthy harvests, good weather, and stable rainfall are all highly risky endeavors for a poor country, developing nations prefer to foster the growth of manufacturing sectors in their path towards economic development.

Strategies for economic growth available to developing nations include export-oriented and inward-oriented growth. A country like the Dominican Republic, the largest economy in the Caribbean, has pursued a predominantly export-oriented growth strategy, promoting through “free zones” the growth of a textile industry aimed at producing goods for consumers in developed countries, primarily the US.

To the Domincans, producing textiles for export to America has successfully given the people of this poor nation a grip on a rung of the ladder towards economic development. The import of capital has taken previously unproductive workers out of agriculture and put them into an industry where productivity, thus income, has risen, leading to improvements in living standards. Export-led growth, however, runs some serious risks of its own, as is being realized by the people of the Dominican Republic today.

It had been clear for some time that Luis Caraballo’s textile factory, in one of the Dominican Republic’s largest “free zones”, was struggling.

Finally, last December, he closed the factory gates for the last time: cut-throat competition from China and Vietnam, a weakening US dollar and unsustainable costs had become too much.

Once a hot destination for American companies looking for a cheap place to “off-shore” production of labor intensive textiles, the Dominican Republic today faces new competition, and is finding its comparative advantage slip slowly away from textiles…

The Dominican Republic depends heavily on the US, which is the destination of more than 85 per cent of exports. But textile exports – these days accounting for less than a third of total exports – fell by 32 per cent over 2007.

Although other countries in the Caribbean are also suffering from Asian competition – with Chinese textile exports to the US tripling between 2000 and 2005, while Vietnam’s multiplied almost 117 times – the Dominican Republic has been worst hit.

Here’s the thing: a nation’s comparative advantage may shift over time (from land to labor to capital intensive goods) as the structure of the global economy evolves. Once an economy like the Dominican Republic’s has undergone a period of structural adjustment, away from agriculture and towards industry, the flow of low wage workers from farm to factory begins to slow to a trickle, leading to rising wages and increased competition from countries with more abundant supplies of cheap labor.

The challenge for policy makers is to manage the structural changes as they come, minimizing the deleterious impact such global shifts of productive resources has on the citizens of a country like the D.R. Clearly, it is in the country’s interest to prepare its citizens for a “new economy”, one in which skilled labor will play a larger role. The problem is, this requires a solid education system, which the D.R., it turns out, does not yet have:

There is widespread acceptance of the need to develop a better-educated workforce, but so far education spending has been inadequate.

“The government simply doesn’t have enough resources,” said Mr Montás. About 40 per cent of its budget goes on debt obligations and another 15 per cent is dished out through subsidies. Just 1.5 per cent goes towards education.

It also turns out that this is a balance of payments story:

Mr Montás calculated that for every percentage point the US economy contracted, the Dominican Republic’s GDP would shrink by 0.4 per cent.

Not only will exporters be hit, but also the huge tourism sector and remittance flows…

One possible result of the decline in exports and flows of remittances from the US will be a depreciation of the D.R. peso, as demand for pesos by Americans falls. A weaker peso might make the country’s exports attractive once again, assuming the exchange rate is allowed to adjust on foreign exchange markets. A weaker peso should help slow the decline in the D.R.’s exports to the US, at least until new competition emerges, perhaps elsewhere in Asia, maybe even from Africa or other Latin American countries.

In all likelihood, given the increased competition from Asian textile manufacturers, continued economic growth in the Dominican Republic will depend on the country’s ability to educate and train its workforce to adapt to a more capital, technology and information-based economy, which, if successful, will eventually lead to rising incomes and higher standards of living for the people of the this rising Caribbean nation.

Comparative advantages evolve with the emergence of new competition among developing and developed countries. The negative impacts this evolution has on a particular economy can be managed if wise policy actions are taken to assure a country’s workforce is educated and trained to participate in tomorrow’s economy, rather than yesterday’s or today’s.