Sunday, September 19, 2010

A Parable About US

A Long Time Ago

Once upon a time there were two countries, the US and China. Workers in the US produced corn and wheat (which they consumed for calories and the pleasure of diversity) and some workers built houses for their countrymen to live in. A marginal calorie of corn required a great deal more labor to produce than did a marginal calorie of wheat, and corn required less skill to produce. China also made these things, but workers in China were poorly educated and poorly equpped and produced less corn and wheat than US workers. Unfortunately, China had a pathological Dictator named Mao, who insisted that China be self sufficient and forbade his people from trading with the US. Then Mao died.

China Discovers the Market

A new Chinese leader named Zhao Ziyang got the idea that China could become wealthier if it traded with the US. He reasoned that Chinese workers could specialize in producing corn, which was labor intensive and simple to produce, and sell it to the US in exchange for wheat, which Chinese workers struggled to produce. The US would desire to trade with China because trade would enable both countries to increase their overall consumption of corn and wheat. Zhao, entirely on his own, discovered David Ricardo’s Law of Comparative Advantage –arguably the most profound insight of economics. Moreover, Zhao wanted to allow US firms to set up wheat growing operations in China, so that Chinese workers, over time, could develop the skills to grow wheat as efficiently as did US workers. Over time, as China climbed the ‘technological ladder’ there would be new opportunities for mutually beneficial trade with the US. Zhao was a genius.

Zhao convinced his patron – the Grand Poobah of post Mao China, Deng Xiaoping - to allow China to open to trade. This was no small feat, as China had never, in its three millennia history, sought trade with the outside world, and contemporary Chinese harbored much mistrust of foreigners – a result of the shock of Western military incursion into the supposedly impregnable ‘Middle Kingdom’ in the Opium Wars. As Zhao predicted, the ‘opening’ of China unleashed a period of the most rapid economic growth, benefitting the largest number of people, in human history.

Zhao believed the mainspring of growth was economic freedom and that its sustenance required political freedom. On his own, Zhao derived the insights of Adam Smith and his intellectual progeny, Milton Friedman and F.A. Hayek, among others. Zhao was a genius. In its absence, he foresaw an explosion of corruption, as entrepreneurs, loaded with wealth earned from trade, bribed government officials, who still controlled much in the domestic economy, to grant them monopolies. To prevent an outbreak of ‘Robber Baronism’, and the social dis-content it would engender, Zhao pleaded with Deng to move China towards a system like the US, in which government’s involvement in the economy was limited and democratic elections of its leaders and an independent judiciary placed a check on corruption.

Then students staged a protest in Tiananmen Square. They wanted a more open society. Zhao empathized with the students, but Deng feared them. Where Zhao saw an opportunity for the leadership to bond with the vanguard of the next generation, Deng foresaw instability – a perennial fear in China- and a challenge to the leadership of the Party. Zhao refused to call out the Red Guards to shoot down the protestors. Zhao was placed under permanent House Arrest.

China Embraces Mercantilism

China continued to trade and grow. As ever more workers moved into producing corn for export to the US, the Party flourished; as long as workers prospered they would remain content and docile. Deng stated a modern version of the Grand Inquisitor’s tradeoff of bread for freedom: “To be rich is glorious”. But the Party now staked all of its legitimacy on delivering growth and could not risk a recession. Moreover, the post-Zhao leadership embraced a discredited idea – that by accumulating wealth from foreigners it was making its own country wealthier. Thus China embarked on a policy of Mercantilism, in which it subsidized the price of corn to increase sales to the US (and employment in export industries) and accumulated the Dollars it received as payment for its corn, and instead of importing wheat from the US, employed its own workers in producing wheat. In this way, China kept its labor force fully employed and accumulated wealth. Its Dollars did not stay idle either, it lent them back to the US so that it could earn a return on its stock of wealth.

In the US, meanwhile, employment in corn production declined, as Chinese imports displaced US production, but –initially during Zhao’s reign – the decline in corn production was matched by an increase in wheat production, as wheat was exported to China. So US workers moved into wheat production. Between the two countries the total output of corn and wheat increased. This was a balanced, Ricardian trade.

But then China began to accumulate wealth and trade became unbalanced; China did not import wheat, but instead leant back to the US dollars earned from its export of corn. This flood into the US of Chinese savings pushed down interest rates and encouraged homebuilders to build more homes – a lot more homes. This was so because, at a lower interest rate, a homebuyer could pay a higher price for his home without increasing his monthly home payment. Added to this was a sophisticated idea that people never defaulted on their home loans – to explain this highfalutin idea would require a Ph.D in Rocket Science, so I will skip it here – so more people were qualified to borrow money to purchase their homes; the market into which homes could be sold was expanded. Thus, the workers displaced from growing wheat found employment building homes. Everything seemed to be going along swimmingly: the Chinese were fully employed –earning ever more money and accumulating wealth and US workers were fully employed and consuming more than ever. Life was good for both countries. But this was not an arrangement founded on mutually beneficial trade in goods.

The Law of Gravity Still Holds – A Day of Reckoning

And then something went awry. It was not the lowly workers who got it wrong, but the geniuses. It turned out - shocking, I tell you! – that the theorists screwed up. Homeowners, particularly those with no income to pay their mortgages, could indeed default –and they did. And with that, the whole house of cards began to unravel. Workers in Homebuilding lost their jobs; banks, constrained by their losses in home-lending, stopped lending to wheat growers, so employment in wheat declined, and US households cut back their imports of Chinese corn, which threatened to plunge China into the abyss. Moreover, China began to worry that its holdings of US Dollars might become worth – less.

Now the governments of the US and China are flailing about, acknowledging the errors of the past, but unable to break the habit. Both governments are in a desperate scramble to pump employment in whatever activities, it doesn’t much matter where. But of course – and contra Keynes- in the long run it does matter.

What To Do About Trade?

Zhao and Ricardo had it right. Trade can increase the pot, so everyone in the game benefits – enormously. Closing the game would be a disaster. But we need to play by a different set of rules going forward. Trade must be balanced. There is no room for Mercantilism. The lesson here is that unbalanced trade amplifies imbalances in domestic economies.

Keynes, who had so many ideas - some good, some bad (and all of them interesting) - gave us the prescription. He knew that unbalanced trade was dangerous. The Great Depression was exacerbated by unbalanced trade in which surplus countries hoarded their gold – there was a Gold Standard in the 1930’s –and inflicted deflation onto deficit countries. He was concerned that such hoarding never occurs again. So he proposed, in the aftermath of the Second World War, that the IMF be granted powers to penalize countries that built up large trade surpluses, to parallel its powers to compel restructuring of the economies of those countries who ran chronic deficits.

Keynes’ idea was scuppered by the US, who was the pre-eminent exporting country at the time and was not going to subject itself to penalties. Keynes was right ‘in the long run’ and certainly the US should reconsider its position.

1 comment:

  1. Keynes was writing in the 1930's. Has Economic understanding made no progress since then? What evidence do we actually have that Keynes was correct, or even diagnosing the problem correctly?

    As described above, you are confusing a mechanical problem in monetary regulation - the influence of the gold standard on the money supply, with a trade problem. In that the ability to correctly price goods across currencies is at issue, that is important - but perhaps the question you should really be trying to explore is why the monetary system failed to correct the trade imbalances by adjusting relative prices over time? Was this failure peculiar to the gold standard, and is the failure today actually deriving from the same cause (leveraged effects on the money and loan supplies arising from gold transfers within the banking systems) which seems a little unlikely given the changes to the banking system since then, or something else?