December 13, 2008

Trade Deficit Arithmetic

My kids will tell you that 40 > 14. The Bush administration doesn't seem to care. The $14b auto bailout football should not be dominating the Treasury agenda today, because the real problem is in China's record $40b subsidy of the low Chinese yuan this month. That represents a rate of 480 billion dollars of disincentives for non-Chinese manufacturers every year.

Half a Trillion of Disincentives Per Year

No country in the history of the planet has ever run a trade surplus of the magnitude that China is running now. The massive imbalance means China is now burning $40b of U.S. dollars every month to subsidize their own manufacturers. In a balanced world those billions would have been paid to the best exporters outside of China in a fair trade for the best goods made in China.

Instead, the missing money provides a huge disincentive for non-Chinese businesses to make anything.

The WSJ headlines of the day are wringing their hands about the sudden 2.2% drop in Chinese exports - the first annual drop since June 2001, painful compared to the previous month's nearly 20% year-over-year rise. But these headlines miss the Chinese policy disaster underlying the numbers. The real story is in the far larger 17.9% drop in Chinese imports.

The fall in both imports and exports shows that world trade is sick. But the total gutting of imports points to the cause of the sickness: a severely broken Chinese trade policy that is only getting worse. The 17.9% drop in imports is financed on the back the Chinese consumer, and it also represents a huge disincentive for worldwide manufacturers at the worst possible moment in history.

That China is running the world's largest and fastest trade surplus in the face of a global economic collapse is the height of irresponsibility. Chinese currency manipulation hurts everybody. It means that the first half trillion that Obama hopes to spend in the U.S. to stimulate American industry next year will just get sucked into China instead.

China needs to stop accumulating foreign exchange reserves now.

As an autocracy run by elite communist party members, maybe China cannot help but put the short-term needs of business leader cronies ahead of the long-term aspirations of ordinary Chinese people. Or maybe Chinese leadership is just well-meaning but misguided. Chinese leaders might think the bias towards Chinese business is wise and far-sighted. But it is not.

China's $2 trillion "investment" in U.S. treasuries is utterly destructive.

Posted by David at December 13, 2008 06:27 AM

but if they stop to accumulate foreign exchange reserve (USD) they will also stop to invest in foreign assets (USD denominated assets like T-bonds).

not feasible for US.

Posted by: Kerub at December 13, 2008 10:54 AM

You have it backwards. Clearly the U.S. would do far better in both the short-term and long-term if China stopped buying $500 billion in T-bills per year. The U.S. economy needs *liquidity*, not buyers for T-bills. When China buys T-bills, they burn liquidity.

Another way to look at it: every dollar the Chinese government does not spend on U.S. treasuries is another dollar that the Chinese people have to spend on U.S. goods. If they can't find enough American goods that they want to buy, they will drive the yuan up until they do.

The mortgage bubble was caused by two effects that were both fueled by the Chinese foreign exchange reserve accumulation:

1. Artificially cheap credit in the U.S. Even when domestic investors didn't think it was smart to invest in U.S. consumer debt, foreign investors poured money willy-nilly into U.S. investment assets. This meant a decade of silly season on Wall Street: inventing crazy vehicles for investors with too much USD cash.

2. A penalty on manufacturing investment. You would think all the cheap capital would make it easy set up an export company in the U.S.. But you would be wrong, because exporters would need to compete against insanely cheap Chinese products subsidized by the cheap RMB. Companies like Apple, for example, that should be U.S. manufacturing powerhouses, would never consider actually making something in the U.S. The only rational thing to do, given the nutty USD-RMB exchange rate, is to make the iPhone in Shenzhen.

Posted by: David at December 13, 2008 01:05 PM

Our enormous trade deficit is rightly of growing concern to Americans. Since leading the global drive toward trade liberalization by signing the Global Agreement on Tariffs and Trade in 1947, America has been transformed from the weathiest nation on earth - its preeminent industrial power - into a skid row bum, literally begging the rest of the world for cash to keep us afloat. It's a disgusting spectacle. Our cumulative trade deficit since 1976, financed by a sell-off of American assets, exceeds $9 trillion. What will happen when those assets are depleted? Today's recession may be just a preview of what's to come.

Why? The American work force is the most productive on earth. Our product quality, though it may have fallen short at one time, is now on a par with the Japanese. Our workers have labored tirelessly to improve our competitiveness. Yet our deficit continues to grow. Our median wages and net worth have declined for decades. Our debt has soared.

Clearly, there is something amiss with "free trade." The concept of free trade is rooted in Ricardo's principle of comparative advantage. In 1817 Ricardo hypothesized that every nation benefits when it trades what it makes best for products made best by other nations. On the surface, it seems to make sense. But is it possible that this theory is flawed in some way? Is there something that Ricardo didn't consider?

At this point, I should introduce myself. I am author of a book titled "Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America." My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It's because these effects of an excessive population density - rising unemployment and poverty - are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

One need look no further than the U.S.'s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable - nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn't a problem, but rather that it's exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world's population.

Ricardo's principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

If you‘re interested in learning more about this important new economic theory, then I invite you to visit either of my web sites at and where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It's also available at

Please forgive me for the somewhat spammish nature of the previous paragraph, but I don't know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

Pete Murphy
Author, "Five Short Blasts"

Posted by: Pete Murphy at December 17, 2008 06:25 AM
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