Economics in Plain English » Currency

Excuse me, China… could you lend us another billion? Understanding the imbalance of trade between China and the United States

Jason Welker — Mon, 07 Nov 2011 08:00:11 +0000

The $1.4 Trillion Question – James Fallows – the Atlantic

American consumers are a curious bunch. Up until 2007, the average savings rate in the United States fell as low as 1%, and during brief period was actually negative. What does negative savings actually mean? It means that Americans consume 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.

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 (In 2008 China 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 financial 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, 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:

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?
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?
How do American households benefit from China’s financing of the government’s budget deficits? In what way to they suffer from this arrangement?
Do you think America can continue to finance its budget deficits through the continued sale of debt to foreigners forever? Why or why not?

Stability – the greatest Swiss virtue?

Jason Welker — Tue, 06 Sep 2011 11:59:39 +0000

BBC News – Swiss National Bank acts to weaken strong franc

The Swiss pride themselves on their long history of stable democracy, domestic tranquility and international neutrality. The stability of the Swiss state and the Swiss economy is heralded as one of its greatest virtues. But in the last few months, particularly in the first two weeks of August, instability has been more the norm in the Swiss economy due to the rapid appreciation of the Swiss currency, the franc, against the euro and the US dollar, which I blogged about here a couple of weeks ago.

Well, as of this morning, the franc’s ascent looks like it has reached its end, and the value of the franc is set to be pegged at 1.20 francs per euro (or 0.83 euros per franc), which is about 8% below what it was trading at this morning.

The Swiss National Bank (SNB) has set a minimum exchange rate of 1.20 francs to the euro, saying the current value of the franc is a threat to the economy.

The SNB said it would enforce the minimum rate by buying foreign currency in unlimited quantities.

The move had an immediate effect, with the euro rising from about 1.10 francs before the announcement to 1.21 francs.

In a statement, the SNB said: “The current massive overvaluation of the Swiss franc poses an acute threat to the Swiss economy and carries the risk of a deflationary development.

“The Swiss National Bank is therefore aiming for a substantial and sustained weakening of the Swiss franc. With immediate effect, it will no longer tolerate a EUR/CHF exchange rate below the minimum rate of CHF 1.20.

“The SNB will enforce this minimum rate with the utmost determination and is prepared to buy foreign currency in unlimited quantities.”

Against the franc, the euro climbed 9%, the dollar rose 7.7% and sterling gained 7.8% within minutes of the announcment.

NPR’s Planet Money reported on the story from Berlin here:

The instability resulting from the franc’s 30% rise in the value against other major currencies throughout the year is primarily the effect it has had on Swiss exporters. Foreign consumers, who actually buy about 50% of Switzerland’s output, have seen the prices of Swiss goods rise as the value of their own currencies has declined against the franc, reducing demand abroad for Swiss exports, forcing firms in the Swiss export sector to reduce their labor force and otherwise cut costs to compensate for the falling demand for their products. The threat of rising unemployment and falling demand for its output caused the Swiss National Bank and the Swiss government great concern, leading to today’s announcement.

The “deflationary development” mentioned by the SNB refers to a situation in the Swiss economy where the strong franc makes imports appear ever more attractive (and cheaper) to Swiss consumers, and Swiss goods increasingly less attractive to foreign consumers, reducing the demand for Swiss goods overall and forcing Swiss firms to lay off workers and lower their costs and prices to compensate for falling demand. Lower prices for goods and services in Switzerland reduces the incentives for firms to invest in new capital, thus reducing the demand for labor further, threatening to push the Swiss economy into a demand deficient recession. Deflation, defined as a persistent fall in the average price levels of a nation’s goods and services, can result in a downward spiral characterized by rising unemployment, falling demand, lower prices, and increased layoffs in the export sector, further exacerbating the unemployment problem.

The SNB’s decision to peg the franc to the euro will assure that foreign consumers of Swiss goods will not see their prices continue to rise, and Swiss consumers of foreign goods will not see them get any cheaper in coming months, hopefully bringing Swiss households who have recently enjoyed cheap imports back to the Swiss market to buy more Swiss-made goods and services.

Personally, I have mixed emotions about the franc’s peg with the euro. Of course, on one hand I have benefited greatly from the stronger franc, as an American working in Switzerland, earning swiss francs, the stronger currency has meant I can send the same amount of francs home as I always have, but it has translated into larger and larger quantities of dollars. Today, the dollar’s value has risen nearly 8%, meaning this month I will have a bit fewer dollars in my savings account in the United States as I would have before the peg.

As an employee in a Swiss firm, however, my continued employment depends on the continued demand for the service my school is providing, which is education to the children of multi-national corporations operating out of Switzerland. If the franc had continued to rise, the incentive for multi-nationals to locate their offices in Zurich would have become weaker over time, and more firms would have chosen to move their international employees to cities like Paris, London or Frankfurt, reducing demand for my school’s services and threating my own employment and income, just as those workers at other Swiss export firms’ jobs have been threatened in recent months.

Stability is a virtue the Swiss have always prided themselves on. Today’s announcement by the Swiss National Bank will bring greater stability to the Swiss economy, despite the disadvantages it brings to individuals who have enjoyed the benefits of a stronger franc in recent months.

The graph below explains how the SNB will enforce its currency peg against the euro:

Discussion Questions:

How will the weaker Swiss franc help the Swiss economy?
How will certain individuals in Switzerland be harmed by the weaker franc?
How might the weaker franc affect demand for enrollmente at Zurich International School?
What are two possible consequences of the Swiss National Bank making a promise to enforce a pegged exchange rate between the franc and the euro?
Why are pegged or fixed exchange rates sometimes considered less desirable than floating exchange rates, which is when a currency’s value is determined solely by supply and demand on foreign exchange markets?

“A glimmer of hope” – rising incomes in China lead to rising demand for US exports

Jason Welker — Mon, 11 Apr 2011 05:23:02 +0000

A nation’s balance of payments measures all the transactions between the residents of that nation and the residents of foreign nations, including the flow of money for the purchase of goods and services (measured in the current account) and the flow of financial or real assets (measured in the financial or capital account). The sale of exports counts as a positive in the current account, while the purchase of imports counts as a negative. In this way, a nation can have either a positive balance on its current account (a trade surplus) or a negative balance (a trade deficit).

The US has for decades run persistent deficits in its current account. As the world’s largest importer, Americans’ appetite for foreign goods has been unrivaled in the global economy. Of course, this is not to say that the US has not been a large exporter as well. In fact, the US is also one of the largest exporting nations, along with China, Germany and Japan, in the world. However, the total expenditures by Americans on imports has exceeded the country’s income from the sale of exports year after year, resulting in a net deficit in its current account.

So the news that rising incomes in China have fueled a boom in US export sales should come as a relief to US politicians and more importantly, firms in the American export industry:

Last year, American exports to China soared 32 percent to a record $91.9 billion.

A study by a trade group called the U.S.- China Business Council says China is now the world’s fastest-growing destination for American exports.

While United States exports to the rest of the world have grown 55 percent over the past decade, American exports to China have jumped 468 percent.

Most of those exports have come from California, Washington and Texas, which have shipped huge quantities of microchips, computer components and aircraft. But states that produce grain, chemicals and transportation equipment have also benefited.

China, which last year surpassed Japan to become the world’s second largest economy (measured by total output), is soon expected to become the world’s second largest importer as well:

And while much of what China imports is used to make goods that are then re-exported, like the Apple iPhone, Mr. Brasher says a growing share of what China imports from the United States, including cotton and grain as well as aircraft and automobiles, is staying in China.

“You know all those BMW X5 S.U.V.’s that are in China? They’re being imported from the U.S.,” Mr. Brasher said in a telephone interview Thursday. “They’re being made by a BMW factory in South Carolina.”

All this must be good news for the US, right? Growing exports to China must mean a smaller current account deficit, greater net exports and thus stronger aggregate demand, more employment and greater output in the United States. However, this may not be the case. While exports to China grow, the US economy’s recovery has led to a boost in the demand for imports from China as well. So, ironically, even as exports have grown 468 percent in the last decade, the US has still managed to maintain a stunningly large trade deficit with China:

Last year, China’s trade surplus with the United States was between $180 billion or $250 billion, according to various calculations.

Still, the combination of a weakening American dollar and China’s growing economic clout is likely to bode well for American exports. With China short of water and arable land, exports of crops to China jumped to $13.8 billion last year.

Study the graph below and answer the questions that follow.

Discussion Questions:

What is the primary determinant of demand for exports that has lead to the growth over the last decade seen in the graph above?
What types of goods has China primarily imported from the US in the past? As incomes in China rise, how will the composition of its imports from the US likely change?
How is it possible that the US current account deficit remains as large as it does (as much as $250 billion) despite the growth in exports to China?
The value of China’s currency, the RMB, is closely managed by the Chinese Central Bank to maintain a low exchange rate against the US dollar. How does maintaining a low value of its currency exacerbate the imbalance of trade between China and the US? How would allowing greater flexibility in the RMB’s value help reduce the large imbalance of trade between the two countries?
If the US spent $250 billion more on Chinese goods than China did on US goods in 2010, where did that $250 billion end up? What does China do with the money the US spends on its goods that it does not spend on US goods? Define the financial account and explain the relationship between a nation’s current account balance and its financial account balance.

Should Obama Send A Thank You Note To The Chinese?

Steve Latter — Sun, 09 Jan 2011 15:45:34 +0000

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 (ie, bonds and notes). For those that are not familiar with the foreign currency market, Chinese authorities buy the same U.S. Dollars provided by the U.S. to purchase Chinese products and, thus, leave or supply Chinese Yuan to the currency traders resulting in a decrease in the price of the now more plentiful Yuan and an increase in the price of the now more scarce dollar. The Chinese authorities intervene in the foreign currency market for the sole purpose of depreciating (weakening) the Yuan relative to the U.S. Dollar, thereby helping Chinese exporters to become more price competitive in global markets. It is estimated by many economists, that the Yuan may be overvalued versus the U.S. dollar by approximately 30% due to this foreign currency intervention by China.

So while it is true that this action taken by Chinese authorities clearly 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. Government to fund the record federal deficit spending expecting to total $1.3T in 2011 and providing American citizens with reduced prices on imports via the stronger dollar! More specifically, this currency intervention by Chinese authorities provides needed loanable funds back to the U.S. Government lowering borrowing costs or interest rates during this important U.S. economic recovery time. It also appears that US leaders are sending mixed messages to China as just last year, Secretary of State Hillary Clinton visited Beijing to encourage Chinese leaders to continue to purchase U.S. Government securities. This seems at odds with US officials cry for China to stop intervening in the foreign currency markets because by doing so needed federal deficit funding would dry up from the Chinese, forcing the US to borrow elsewhere and raise interest rates to entice that lending.

In summary, perhaps in the short term the United States should consider not pressuring China, as Treasury Secretary Tim Geihtner, Obama and the media have done regularly. Perhaps US officials should lay low, at least for awhile, and start pressuring the Chinese again in about three or four years, after the Government’s budget no longer calls for such large spending deficits.

Review Questions

What specifically are Chinese leaders doing to keep the Yuan weak against the U.S. dollar?
Why are Chinese leaders intervening in the foreign currency market?
Which parties, both American and Chinese, are helped and hurt by this intervention?
What would happen, other things equal to U.S. interest rates if Chinese authorities immediately stopped intervening in the currency market? Why?
What would be the immediate impact on the U.S. poor and working class if the Chinese immediately stopped intervening in the currency market?
What policy position would you take as President of the United States on this issue?

Exchange rates and trade: a delicate balancing act, currently out of balance!

Jason Welker — Mon, 22 Nov 2010 20:01:37 +0000

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:

Why does Europe care about China’s fixed exchange rate with the US dollar?
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?
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?
How does China maintain the RMB’s peg against the dollar without buying large quantities of US exports?

Exchange rates, currency manipulations, and the balance of trade

Jason Welker — Mon, 26 Oct 2009 07:10:10 +0000

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:

How does China continuing to undervalue its currency threaten the industrial economies of its largest trading partners?
What is China’s purpose for maintaining the low value of the RMB relative to the currencies of other nations?
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?

The Marshall-Lerner Condition, the J-curve, and the US trade deficit

Jason Welker — Fri, 12 Dec 2008 01:45:29 +0000

For a video lesson on the Marshall Lerner Condition and the J-curve, click here: The Marshall-Lerner Condition (HL Only) | The Economics Classroom

Read the following article before reading the blog post below:
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:

What is the J-curve effect? Based on the evidence from the article, where on the J-curve is the US right now?
Is America experiencing an improvement in or a worsening of its current account deficit?
What determinants of demand are fueling America’s ever-increasing expenditures on imports?
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?

Are you prepared for the new alternate currency?

Jason Welker — Thu, 04 Dec 2008 15:51:07 +0000

xkcd – A Webcomic – Alternate Currency

How the weak British Pound made my Himalayan ski fantasy a reality!

Jason Welker — Tue, 02 Dec 2008 19:54:39 +0000

BBC NEWS | Business | Sterling rebounds from sharp fall

Americans, are you planning a vacation anytime soon? If so, why not visit LOVELY Great Britain! Why, you ask, would ANYONE want to visit the UK in during this wet, cold season? Well, here’s why I’m buying British this year:

I recently booked a Himalayan ski tour in Indian Kashmir organized by a British company. The price? 1400 GBP, which only three months ago was the equivalent of $2800 US! Today, with the newly weak British Pound, my ski trip to India will only cost me $2100*. In the span of just a few months, the dollar price of this amazing Himalayan ski adventure has fallen by $700! Naturally, Americans like myself now have an incentive to buy British!

POUND STERLING v UNITED STATES DOLLAR: December 2007 – December 2008

What has caused the slide of the Pound in recent months? Here’s the complicated answer:

“The environment of very weak sentiment regarding the domestic economic picture and potential rate cuts alongside equity volatility is keeping sterling very much on the defensive,” said Jeremy Stretch, strategist at Rabobank.

Strategists get paid lots of money to say stuff that 99% of people don’t understand the first time they read it. I get paid very little money to help those people better understand it, specifically, my students. Here’s what Mr. Stretch is trying to say:

A weak economy in Great Britain leads foreign investors to believe that the Bank of England may lower interest rates in the near future. Why would Britain’s central bank lower interest rates? Because lower interest rates create an incentive for consumers and businesses to take out loans from banks and spend money in the economy, which should create new jobs and help prevent a recession in the UK.

If the bank does lower interest rates, this puts “the sterling on the defensive”, in other words, leads to a weakening of the British Pound, as foreign investors looking to put their money where they can earn a decent return on it will be less likely to save in the UK when interest rates fall. “Equity volatility” is a fancy way of saying British stocks have been performing poorly, decreasing their attraction to foreign investors. When saving in British banks becomes less attractive due to expected interest rate cuts, and buying British stocks becomes risky due to their volatility, investors turn to the safest investment in the world, which is… can you guess? United States government bonds!

So how’s this all relate to exchange rates, you ask? Let’s leave this question for readers to answer and discuss in the comments:

Discussion Questions:

How does the expected drop in British interest rates affect the demand for British pounds on foreign exchange markets? What does this do to the value of the pound?
Why does the stability and safety of US government bonds lead to a strengthening of the dollar in times of global economic slowdowns?
How has the recession in the United States further contributed to the weakening of the British pound?

*In fact, I’m too poor to take a ski trip to India this year, I will have to settle for the puny peaks here in the Swiss Alps!

A Wealth Transfer When A Country Buys Imported Oil? No Way!

Steve Latter — Fri, 12 Sep 2008 22:38:54 +0000

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!

Purchasing Power Parity – “for the inebriated masses”

Jason Welker — Sun, 01 Jun 2008 15:46:10 +0000

pintprice.com – the price of beer anywhere in the world

The theory of purchasing power parity (or PPP) holds that in the long run, the price of a particular basket of goods should adjust across countries and currencies to “cost” the same amount regardless of the currency the goods are denominated in. In other words, one dollar should buy the same amount of “stuff” in the US as it does in Mexico, China, the Netherlands or anywhere else in the world. If a dollar buys MORE in one of these countries once it’s been converted to the local currency, it implies that the local currency is undervalued and should adjust in the long run to achieve parity in the amount it can purchase in dollar terms.

One popular measure of purchasing power parity, devised by the folks at the Economist magazine’s intelligence unit, is the Big Mac Index, which measures the price of McDonald’s Big Macs in over 100 countries where they can be purchased. You can read more about this index here.

The Economist magazine recently reported on an new alternative to its own PPP index, “the Price of a Pint”:

Barflies around the world provide a useful service for their beer-drinking comrades at PintPrice.com. The prices of pints of lager are compared on the basis of anecdotal evidence from beer-drinkers around the world, so figures are regularly updated. There are some surprising results. Beer in Zambia and Burundi seems eye-wateringly expensive considering that they are among the world’s poorest countries. The French overseas départments of Guadeloupe and Martinique charge just about as much as in mainland France. Beer-loving America and Britain fall somewhere in the middle. Happily for sports fans at the Beijing Olympics, a pint in China is just $2.46.

I thought it might be useful to some of our graduating seniors planning their summer vacations or gap years. Pay close attention to the data in this table.

(source: http://www.economist.com/displayStory.cfm?story_id=11333131)

So, if cheap beer is a priority in your vacation decision, it looks like North Korea and Myanmar are ideal destinations. I must say, I am relieved to see that Switzerland, my own new home, is not in the top ten… but it is far from cheap.

The website will tell you the average price of a pint of beer in any country in the world, and then break it down to cities within each country. In Zurich, my soon to be home, a pint costs the equivalent of $6.57 US. Compared to my hometown of Seattle, Washington, where a pint goes for $3.25, that’s exactly double the price! Surprisingly, however, a pint of beer here in Shanghai goes for a shocking $5.15, more than double the Chinese average of $2.35.

Apparently, the price of beer has more to do with the local supply and demand than with relative exchange rates. Where the Big Mac Index offers a rather genuine approach to determining purchasing power parity (since the Big Mac is an identical product sold by the same restaurant facing similar costs in over 100 countries), a pint of beer is a bit more subjective a measure of PPP. Quality of beers clearly differ in locales as diverse as North Korea and Luxembourg, not to mention the incomes of beer drinkers, the number of domestic brewers, excise and value added taxes, consumers’ price elasticities of demand, and so on.

As summer vacation approaches, however, vacation planners may care to take into account the “Price of a Pint” index of purchasing power parity. Clearly, one’s dollars will go much further at bars in some places than others.

I know what you 18 year old American high school grads are thinking, “Mexico or Canada?” You’ll just have to follow the link to find out!

(Disclaimer: Mr. Welker is in no way encouraging his former students to travel to certain places based solely on the cheap price of beer there, merely to avoid places where beer is clearly out of their price range!)

Reflections on the weak dollar

Jason Welker — Thu, 22 May 2008 07:22:38 +0000

I recently received an email from Sean Stoner, who writes a great blog, Maslow Forgot About Beer. I had previously commented on a post Sean wrote about McCain and Clinton’s proposed gas tax holiday, which is how he found my blog. Sean wanted to know my views on the weak dollar:

Jason,

What do you believe is the most direct cause(s) of the weakening of the dollar? Is it the trade deficit and/or spending deficits along with increased borrowing overseas? Is it offshoring? Tax cuts? And how direct is the causality of this to oil and commodity prices?

Of course I’ll give you full credit in the post for educating me more on this subject. Thanks in advance !

Sean

Below is my reply. I am posting it here for posterity, and because I think it may include one possible explanation of the weak dollar within the grasp of IB and AP Econ students:

Hi Sean,

Keep in mind, I’m no expert here, only a high school economics teacher… but let me just share a few thoughts about one cause of the weak dollar.

I think something you’ve forgotten to mention in your email is the role that the mortgage crisis has had on the dollar. Much of the debt from the sub-prime mortgage market was held by overseas investors. As home foreclosures picked up late last year, confidence in these mortgage-backed securities plummeted and demand for these American assets fell, thus demand for dollars among foreign investors has fallen with it, depreciating the dollar.

I think the housing market is at the core of a lot of our woes right now. In my econ class we talk about the “wealth effect” of falling home prices on consumer spending. Besides disposable income, the main determinant of overall consumption in the economy is the level of “wealth” among households. Of course, Americans’ greatest source of wealth is their homes… and the reason home prices have fallen is a simple supply and demand story, which is within the grasps of anyone who knows how supply and demand interact to determine price in a marketplace.

Low interest rates during the late Greenspan era spurred a period of new home sales, which drove prices up, spurring a building frenzy which shifted supply out. As long as demand increased more rapidly than supply, the illusion that house prices would continually rise was believable, thus buyers could be convinced that an adjustable rate mortgage (ARM) was the perfect type of loan for them. But the rising prices were unsustainable, and when the Fed began increasing interest rates a few years ago, demand for new homes declined, right as inventory was at an all time high. Naturally, home prices began to stabilize then fall, and as the “adjustable” part of all those “sub-prime” ARMs kicked in, monthly payments became too much for some Americans to bear. In an attempt to liquidate their now unaffordable houses, millions of Americans put their homes for sale, while thousands began to default on their loans, both which combined to shift supply ever further outward, putting even more downward pressure on home prices.

The story continues from here: falling home prices mean less “wealth” which means less consumer spending which means less total output in the economy which means less demand for workers which means rising unemployment… aka, RECESSION! And that’s where we are today.

So, as you can see I think the housing market is at the core of our problems. The weak dollar too, as demand for American homeowners’ debt has declined among foreign investors. Now, in the face of a recession, the Fed has lowered interest rates once again to try and stimulate new spending and investment, further exacerbating the dollar’s decline, as lower returns in the US bond market divert investors out of dollars and into more secure investments, such as… you guessed it, OIL.

The falling dollar had encouraged investors to look for stable investments, such as commodities like oil, copper, coal, etc, driving demand and prices for these commodities up, contributing to the cost-push inflation that has accompanied America’s economics slowdown.

So yes, it’s all connected… rising unemployment, sluggish growth, rising price levels and falling real wages. At the core, however, is the housing market and the “irrational exuberance” that led to a speculative building and buying spree over the last six years: a bubble which began bursting late last year and continues to have a ripple effect across the economy.

Bush’s tax cuts and deficit spending just made this whole mess even worse. I did a blog post a while back about the trade deficit with China, budget deficits and the value of the dollar, you can read that here: “Excuse me China, could you lend us another billion?”

Okay, that’s all I’ve got for you today… I hope some of these observations are useful!

Best, Jason

China’s “silver bullet” – a strong RMB could solve her biggest economic woes…

Jason Welker — Mon, 19 May 2008 08:14:34 +0000

Asia Sentinel – The Answer for China’s Inflation
Two goals recently voiced by the Chinese leadership: increased consumer spending and reduced inflation. These are worthy goals for policymakers to pursue; if accomplished, they will mean increased well-being for the average Chinese household, which will enjoy more goods and services at lower prices.

The problem is, increased consumption usually means rising prices, as can be clearly illustrated in an aggregate demand / aggregate supply diagram. Household spending makes up somewhere around 40% of China’s GDP, exports, government spending and investment account for the rest. Whenever one component of total expenditures increase in the economy, all other things equal, the price level will rise.

Only two things could happen to make the Chinese leadership’s goal of increased consumer spending and stable prices a reality: either productivity in the economy must increase more rapidly than consumer spending, shifting aggregate supply outward, or another component of aggregate demand must be reduced more rapidly than consumption increases, offsetting the increase in overall expenditures cause by rising consumption.

So what magical combination of fiscal and monetary policy can be employed to both increase consumption and stabilize the price level? The answer may not rest purely in the realm of domestic macroeconomic policy-making, but rather in the foreign exchange markets, where a weak RMB has kept domestic consumption low and net exports (thus the price level) high. Allowing the RMB to appreciate should make “magic” happen and lead to rising domestic consumption and disinflation simultaneously:

A stronger currency, commensurate with China’s increased economic strength, would both tamp down inflation and allow Chinese consumers to buy more goods and services. However, for reasons not entirely clear to me, or few others for that matter, China’s leaders are resisting this simple and beneficial solution.

The Chinese leadership’s stated goal in prodding their citizens to spend more is to decrease their economy’s dependence on exports. If the Chinese, who currently save 50 percent of their incomes, saved less, more of their production would be consumed locally. As a result, China would be less vulnerable to economic downturns abroad. Without a vibrant domestic market, over-leveraged Americans will apparently remain China’s most important customers.

A strengthened yuan would lower the real costs of goods for domestic consumers and allow the Chinese themselves to compete more evenly with consumers in other nations to whom they currently send the fruits of their labor. As goods become more affordable in China, the Chinese would naturally consume more. A rising yuan would therefore kill two birds with one stone: it would reverse recent consumer price increases and it would induce Chinese consumers to buy their own products.

Some members of the US Congress estimated sometime last year that the Chinese currency was undervalued by 27%, leading certain politicians to call for an across the board tariff on all Chinese imports to the United States. Such protectionist sentiment was not uncommon 12 months ago, but as America faces its own economic slowdown, compounded by rising inflation and the falling value of the dollar, such calls for more taxes on imports have disappeared from Washington.

The sensible action for the Chinese to take in response to its own overheating economy (letting the RMB appreciate in order to relieve inflation and encourage domestic consumption) could spell economic doom for the US. As China adopts a “strong yuan” policy, its demand for US dollar-denominated financial assets, including government debt, will decline, reducing demand in the US bond market, lowering bond prices and driving up interest rates in the US. Higher US rates will discourage investment and consumption, exacerbating the slowdown already underway in America. Furthermore, reduced demand for US assets by China will cause demand for the dollar to slide in foreign exchange markets. Since much of American’s household spending is on imports, inflation will rise in America as not only Chinese goods, but all imports, are now more expensive to Americans.

Usually in economics class, we adopt the frame of mind that economics is not a zero-sum game. In other words, through free trade based on comparative advantage and specialization, individuals and nations will benefit due to increased total output, increased productivity, higher incomes, and greater variety of goods and services produced within and among communities and nations. In the case of China and the US today, on the other hand, we appear to be in a situation where increased consumption by Chinese may be achievable only at the expense of American consumers, who because of rising interest rates and a falling dollar, may be forced to live “within their means” for the first time in decades.

Discussion questions:

Why is a strong RMB necessary to simultaneously increase consumption and reduce inflation in China?
Why would interest rates in the US rise if China adopted a “strong RMB” policy?
Would Americans be better off without trade with China? What about the statement that Americans will be worse off if China is to achieve greater levels of domestic consumption?

More on exchange rates: Winners and losers of a strong British pound

Jason Welker — Mon, 28 Apr 2008 07:20:17 +0000

BBC NEWS | Business | Q&A: Strong pound – winners and losers

Here’s another great article to help you understand the advantages and disadvantages of a strong currency. The British pound reached an all time high against the dollar late last year ($2.08 per pound, or 48 pence per dollar!!). So who are the winners and losers from a strong British pound, anyway?

Here’s a quick run-down… to read about why, click the link and read the article.

Winners: Brits traveling and shopping in the US, US businesses, British airlines, British consumers, British drivers
Losers: Americans traveling in Britain, small businesses in the UK, British exporting firms, British airlines, shareholders in certain companies.

Discussion Questions:

Why may British airlines benefit AND lose with a stronger British pound?
Who else will benefit from the strengthening pound that is not mentioned by the article? Refer to your notes from class.
Who else will be harmed by the stronger pound that is not mentioned?

Does the weak dollar help US manufacturers?

Jason Welker — Mon, 28 Apr 2008 07:12:39 +0000

Yes, but it’s a bit more complicated than it might seem at first. This podcast looks at the impact of the falling dollar on the aerospace industry, in which manufacturing for the industry’s largest firms is sourced to hundreds of smaller companies each with factories in countless countries from North America to Europe to Asia.

The recent fluctuations in the US dollar exchange rate has wreaked havoc for firms located in the US and trying to compete in this competitive market. In some cases, the outcome has been positive, but as you’ll hear, not always.

Listen to this podcast then discuss the questions below:

Discussion Questions:

How has the weaker dollar helped the Connecticut firm Kamatics?
How has Kamatics been hurt by the weaker dollar?
Why do fluctuations in the dollar make “business more unstable”?
How does the impact of currency swings become more ambiguous “as the economies of the world become more intertwined”?
Why did EchoAir stop manufacturing products in Romania? What impact would a revaluation of the Chinese Yuan have on EchoAir’s current manufacturing decisions?