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.

Bloomberg.com: Economy - Korea Beef Deal Won’t Yield Trade Vote

Free trade: everyone either loves it or loves to hate it. South Korea and the US have been in negotiations for a landmark free trade agreement for years. Korea, however, has had a “beef” with US beef imports since 2003, when a case of Mad Cow Disease gave Korean officials the jitters and all imports were halted.

Even though Mad Cow has disappeared from American beef, the ban had remained, making it difficult for negotiators to come to any major agreements on the reduction of tariffs and other barriers to trade in other markets in which the US and Korea trade. Just last week, South Korea removed the beef ban, giving some analysts hope that a free trade deal may soon be agreed upon.

President Bush signed the agreement last year but has hesitated to pass it on to Congress; where certain Democratic politicians have refused to approve the agreement until S Korea removed the beef ban. Now that the ban has been lifted, however, it appears that the issues keeping an agreement from being reached may run deeper than the simple beef ban:

In addition, Ford Motor Co., unions and Democrats, including both Hillary Clinton and Barack Obama, all say the accord must be reworked to address what they call South Korea’s barriers to U.S. manufactured goods.

“I understand there are foreign policy considerations, but this is too important for us,” Stephen Biegun, vice president for government affairs at Ford said in an interview earlier this month. “We don’t see any sign that they are ready to change.”

Levin, who represents autoworkers in suburban Detroit, said the accord will need to be changed to address what he calls South Korea’s non-tariff barriers to U.S. manufactured goods, especially autos.

Clinton, in a response to questions from the Pennsylvania Fair Trade Coalition, said the agreement with South Korea “will cost America jobs.”

The S Korea / US Free Trade Agreement should bring a boost in trade between the two countries:

The U.S. is South Korea’s second-largest export market behind China, with shipments totaling $45.8 billion in 2007. Imports from the U.S. last year reached $37.2 billion. The trade agreement would eliminate or reduce tariffs on a wide range of goods including automobiles, vegetables and electronics.

Through free trade there are winners and losers. This is a theme we’ve explored in some depth already during our International Economics unit in AP Economics here at Shanghai American School. The winners, in the case of the S Korea/US FTA will likely be manufacturers in S Korea and service industries in the US. Judging by Ford Motor Company’s response to the FTA, we can assume that American manufacturers will be losers from the accord.

Does this make it bad, however? According to macroeconomic theory, no. The removal of tariffs on imports from S Korea will force American manufacturers to become more competitive and achieve greater efficiency, both which will result in a more efficient allocation of resources in both S Korea and the US. If Ford, for example, sells fewer cars because of in influx of high quality, affordable Korean automobiles, then Ford may be forced to shut down some of its plants in the US. This will lead to the loss of American jobs, just as Hillary Clinton claims it will.

But in the long-run, America as a whole should be better off for it. Manufacturers in the US will focus more on capital intensive goods such as industrial equipment, the manufacture of which requires highly skilled labor, which America has in abundance. In addition to industrial equipment and other high skilled manufactured goods, the US service sector should benefit from freer trade with S Korea.

With beef being resolved, the U.S. banks, insurance companies and other services companies that stand to gain the most from this accord are gearing up their lobbying efforts.

Beef “has been our biggest obstacle in having a meaningful dialogue on the benefits of this agreement,” said Matt Niemeyer, vice president for the business insurer ACE Ltd. and a former U.S. trade official. “It’s now time to work with Congress to find a way to move this important agreement this year.”

Another theme of our final AP Econ unit, I could say, is that politics and economics don’t always mix well. The opposition to the S Korea/US FTA among Congressional Democrats is more political than it is economic. Jobs will be lost, that’s true, but overall trade between two technologically advanced, developed countries like the US and S Korea should do more for improvements in efficiency and in resource allocation than it will in harm for a handful of American workers who may find themselves out of work due to greater demand for imported automobiles.

*A tariff on Korean automobiles results in the following outcomes:

• The quantity demanded of automobiles is less than it would be without a tariff (Q4 rather than Q3)
• The quantity supplied by American auto manufacturers is greater than it would be without the tariff (Q2 rather than Q1)
• The difference between Q2 and Q1 represents an overallocation of resources in America towards automobile manufacturing.
• The domestic quantity demanded exceeds the domestic quantity supplied. The difference (Q4 - Q2) is made up for by imports from S Korea.
  
• The government earns revenue equal to the area of the yellow rectangle (amount of tariff x number of cars imported)
• Society experiences a loss of efficiency (deadweight loss) equal to the combined areas of the green triangles Y and X. This is consumer surplus lost, accounted for by the higher price paid by American consumers imposed by the tariff.

In the model above, the removal of a tariff on Korean automobiles will result in a decrease in output by American firms from Q2 to Q1, an increase in imports from Q4 - Q2 to Q3 - Q1, and an increase in consumer surplus, efficiency, and better overall allocation of resources in America.

Discussion questions:

1. How does the graph illustrate the concept of “winners and losers from free trade”?
2. Who gains and who loses from free trade with the US within Korea?
3. Is it possible that a free trade agreement with Korea would actually create jobs in America? Explain…
4. Why do politicians oppose free trade deals that would result in such improvements in efficiency, allocation of resources, and even in the employment opportunities for American workers?

FT.com / Asia-Pacific / China - Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past when the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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Economics focus | From Mao to the mall | Economist.com

China, long acknowledged as the world’s factory, could suffer if falling demand for its exports in the US results in a decline in aggregate demand and GDP here as some economists believe it will. But not all economists agree on the importance of exports to China’s domestic economy:

The increase in net exports (exports minus imports) has never been the main source of China’s growth. It contributed two to three percentage points to annual GDP growth between 2005 and 2007, whereas domestic demand (consumption and investment) added eight to nine percentage points.

But the latest figures show that exports have become even less important as a driver of growth. The World Bank’s latest China Quarterly Update suggests that net exports contributed only 0.4 percentage points to GDP growth in the year to the fourth quarter of 2007 (see left-hand chart). Overall GDP growth slowed only modestly (to 11.2%) because of faster growth in domestic demand, which contributed an impressive 10.8 percentage points.

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Defining the macroeconomic problem - Paul Krugman - Op-Ed Columnist - New York Times Blog

Paul Krugman, economics columnist for the NYT, shares his views the true problem with the US macroeconomy. Krugman thinks that the source of instability today is too much consumer spending and too few exports in the last decade.

Basically, I’d say, the problem is twofold. First, in the mid-00s the U.S. economy got badly unbalanced — too much dependence on housing and housing-inflated consumer spending, too big a trade deficit.

The table here (from Krugman’s piece) shows the net change in consumer spending, investment (non-residential or business investment, and residential investment) and net exports between 2007 and the average for the last 20 years of the last century. Continue Reading »