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:

1. Why is a strong RMB necessary to simultaneously increase consumption and reduce inflation in China?
2. Why would interest rates in the US rise if China adopted a “strong RMB” policy?
3. 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?