It is not often I vehemently disagree with Michael Pettis at China Financial Markets regarding trade. This time I do. Interestingly, there are some points of his recent analysis that I strongly agree with.
Via Email, interspersed with my comments please consider the following point counterpoint discussion.
Expect Still More Trade Intervention
Last week’s Senate bill on Chinese currency intervention predictably enough brought out all the same old arguments about international trade, and just as predictably has widened the opposing positions in the debate. Unfortunately the difference between a good outcome, intelligently negotiated, and a bad outcome, is pretty large, but with each side hardening its position I think the likelihood of a good outcome, while never high, is declining further.
The biggest problem with the debate, I think, is the muddled thinking and half-baked arguments that characterize each side. For example many of those who believe China is cheating on trade go through complicated exercises to prove the currency is undervalued and should be sharply revalued, without considering other relevant factors.
The currency may well be undervalued, but it shouldn’t be the only issue taken into account. A significant rise in the RMB, especially if it is countered domestically by an expansion in credit at lower real rates, might actually make the global imbalances worse and, more worryingly, cause China’s debt burden and capital misallocation to rise. This would make China’s eventual adjustment far more difficult and would cause more damage to the global economy.
The focus should be more general – on shifting China’s economy towards the more labor-intensive and efficient sectors – and an appreciating RMB might actually make things worse, especially if it encourages hot money inflow. It is much better, I think, for China to raise interest rates, for example, than to raise the value of the RMB. We need an internal shift in which resources are transferred from the capital-intensive SOEs towards households as well as to the more labor intensive SMEs, and a rise in the RMB will adversely affect the SMEs far more than it affects the SOEs, and would be no more efficient than in shifting wealth to households than a revaluation.
In general I have no disagreements with the ideas presented above. However, if China raises interest rates, it will, without a doubt, place upward pressure on the valuation of the Yuan.
Interest rates are not the only factor in relative currency movements, but interest rates, and more importantly, rates of change in interest rates are two of the most important factors.
That said, I wholeheartedly endorse the idea that "complicated exercises to prove the Yuan is undervalued" are seriously misguided.
The other side of the debate is unfortunately even more muddled. The US-China Business Council, for example, issued a release on October 12 that exemplifies some of the major misunderstandings on trade. I realize that the USCBC is primarily an advocacy group, and so their arguments are aimed at supporting a position rather than adding to the debate, but I wonder if making arguments that are so easily refuted helps their cause.
The USBC makes two claims: first, that a revalued RMB will hurt US households, and second, that it will have no employment impact in the US. The first argument is incomplete and the second wrong. Here is what they said in their October 12 release.
USCBC believes that the currency legislation passed yesterday by the US Senate will do more harm than good. USCBC continues to advocate that China needs to move faster toward a market–determined exchange rate; passing tariff legislation on imports from China will not get us closer to this goal and will hit the pocketbooks of American households at a time they least can afford it. Limiting imports from China would not mean an increase in US employment or lower the trade deficit; we’ll just shift our imports to another overseas supplier. If this is intended to be a jobs bill, it is a jobs bill for Vietnam, Indonesia and Mexico.
For their first point, we should be clear. Tariffs will hurt the pocketbooks of American households as consumers, but it will not hurt American households as workers and will probably help them.
Muddled is the appropriate word.
On one hand Pettis is correct: US consumers will be hurt. However, Pettis is incorrect in his belief that tariffs create jobs.
Pettis ignores the unseen. For starters he assumes China will not retaliate. I suggest China may retaliate even if it is not in China's best interest to do so.
The Smoot-Hawley tariff act in the Great Depression certainly provides an example of what happens when trade wars start and global trade collapses.
Forget about all of that. Let's take a simple example from my post on October 2: Trade War Threat Looms Once Again; Senate Takes Up Bill to Punish China for Manipulating Currency; How Many Jobs Would Tariffs Create?
Tariffs Will Cost JobsPettis:
Anyone who thinks government officials can determine if and when currencies are "misaligned" has no economic sense, is engaging in populist rhetoric to buy votes, or both.
The clowns at the Economic Policy Institute think tariffs will create 2 million jobs and reduce the trade deficit by $120 billion.
I suggest tariffs will cost jobs. Manufacturing will not return to the US, nor will manufacturing of any sort, on account of tariffs. Wage differentials are too great and trade channels will simply shift (at great expense) to another country.
However, prices will rise, sales will slow, and the squeeze on consumers will accelerate. Here is a simple example: Let's assume a 35% tariff on underwear. How many jobs will return to the US ? 50? 100? Any?
Let' be generous and assume 500 (although the answer is most likely zero). In return for those 500 jobs, everyone in the United States has to pay 35% more for underwear? Is that a good trade-off?
Clearly the answer is no, but it is much worse than that. We also need to address the question "how many jobs would be lost because underwear is 35% higher?"
Whatever additional money is spent on underwear by 300 million Americans will come at the expense of those consumers spending less on something else, perhaps eating out, perhaps buying toys, or perhaps buying shirts.
To save 500 or whatever manufacturing jobs, everyone buying underwear will cut back on something else. Those cutbacks will have a real effect on shipment of goods (trucking), eating out, recreation, etc., just to benefit underwear manufacturers.
Magnify the underwear example by the vast numbers of idiotic lawsuits from manufacturers that will stem from a law that only requires some bureaucrat to figure out if a currency is misaligned. Then figure out how much bureaucratic expense and waste will that cause?
Lindsey Graham and Mitt Romney are definitely on the wrong side of this issue.
If Congress is foolish enough to pass such a law, and president Obama is foolish enough to sign it, expect to lose a half million jobs minimum because of it. Depending on retaliations and how things escalated, 2 million jobs lost would not be surprising in the least.
The truth is that I am very pessimistic about the evolution of trade over the next few years. If we are going to do better, at the very least we need to accept two pretty straightforward claims that both basic trade theory and economic history confirm pretty overwhelmingly:
1. Trade intervention is bad for global growth, and the world would be poorer, not richer, if international trade collapsed. Trade liberalization is one of the great economic achievements of the past three or four decades and we should recognize that in the current environment it is very vulnerable to reversal.
2. Diversified economies with high unemployment and large current account deficits generally benefit, at the expense of their trade partners, from trade intervention, while surplus countries have almost no real ability to retaliate. In fact it is very hard to find significant examples in history in which an increase in tariffs or a devaluation of the currency did not cause employment growth for a diversified country with a large trade deficit. It is easy, however, to remember cases in which trade intervention resulted in relative outperformance.
Pettis is correct to be pessimistic on trade. Moreover, I wholeheartedly endorse his first point above He should have stopped there because I vehemently disagree with point number two.
There are all kinds of things one can look at in the short term and say "see it worked".
Cash-for-clunkers caused a spike in car sales. Tax credits for housing caused a temporary spike in home prices now taken back and then some. Fannie Mae and Freddie Mac supported growth in housing until things collapsed. Under FDIC there were no bank failures for decades then there were 700.
One needs to be extremely careful in analyzing short-term benefits vs. long-term unseen costs of government interference into free markets.
It is only "easy" to find "cases in which trade intervention resulted in relative outperformance" when one ignores long-term consequences and one ignores what may have happened anyway.
Sometimes government steps in and does something that is credited with a recovery, that would have happened anyway.
Take GM. Obama is bragging about the recovery. I suggest GM would have gone bankrupt (just as it did) and recovered (just as it did) without government help. In fact, government "help" delayed the bankruptcy of GM (at taxpayer expense), and thus delayed the recovery of GM.
Bankruptcy does not mean "out of business". Most major companies restructure and there is no reason to believe GM would not have restructured (or that Ford would not have picked up an equivalent number of jobs).
If protectionists refuse to accept the first claim, and anti-protectionists refuse to accept the second claim, I really don’t see how we can possibly arrive at a globally optimal outcome. Trade will continue to contract as deficit countries discover that trade intervention does indeed work, just as Keynes claimed, to shift the unemployment burden of adjustment from deficit countries to surplus countries.
Sigh. Pettis ruined an otherwise good paragraph with an ill-advised reference to Keynes.
Keynesian economics has never worked and it never will, except in the short term, and except by ignoring enormous long-term fiscal damage of Keynesian clowns who think they can manipulate markets to desired results.
Proof is in the pudding. We have had economic crisis after economic crisis, with ever-increasing amplitude spawned by a combination of Keynesian and Monetarist policies.
Keynes is to be mocked, not praised.
Trade surpluses must contract.
China’s real trade surplus may actually be lower than reported. My friend Victor Shih believes that the trade numbers may be seriously distorted by under- and over-invoicing related to speculative capital inflows.
If he is right, the true surplus may actually be much lower than the reported number, and during times of capital flight it may be higher. We need to try to get a better measure of this before we conclude anything.
China’s trade surplus is definitely moving in the right direction, but the collapse in global demand made that inevitable. The question for the rest of the world is whether domestic adjustments in China are leading global rebalancing, or slowing it down.
I endorse that analysis.
Copper, copper everywhere
Speaking of commodities, over the course of the past decade copper prices seemed to have quintupled, driven in large part by surging investment, especially Chinese investment, with Chinese demand accounting for an astonishing 40% of global demand. China represents only 10% of global GDP, which means China consumes 6 times as much as the rest of the world per unit of GDP.
Since I expect growth rates to drop sharply, and investment growth rates to drop much more sharply, over the last three years I have been very bearish about medium-term prospects for copper prices. In fact copper has dropped by about 25% from its peak earlier this year. Some bulls attribute this drop mainly to reduced Chinese buying at such elevated prices.
In fact because of the sharp recent drop in copper prices, during my trip last week to the US a lot of people asked me whether I still thought copper prices would decline in the medium term. I generally replied that I expected prices would probably rise a little in the next few weeks and months, partly because I believe that Beijing would relax credit controls soon, and partly because Chinese buyers indeed had a very strong buy-on-the-dip mentality.
Longer term, however, I think the bear market in copper is far from over. We have not yet seen the expected real and sustained drop in Chinese infrastructure and real estate investment, which probably won’t happen for another year or two, and against that we have been seeing a lot of commodity stockpiling in China. This will reduce future demand even if investment growth does not slow.
China, it seems, is stockpiling a lot of copper. This, I think, is not a good balance sheet tactic. China’s advisors (many of them international copper traders, not coincidently) might tell them that given China’s voracious demand, stockpiling copper is a good hedge, but in fact it has to be seen as a purely speculative position.
Why? Because if China’s GDP indeed continues growing at very high rates over the next decade (or, more correctly and more implausibly, if investment growth rates remain high over the next decade), this copper stockpiling will have been a great trade. China will have locked in what turns out to have been relatively cheap copper.
But if Chinese investment growth does slow sharply, and copper prices drop just as sharply, this stockpiling will cause China to have locked in relatively expensive copper at exactly the wrong time – when copper-consuming companies are already struggling with lower growth. This is not how a hedge works, of course. A hedge is supposed to pay off when things are going badly, and to lose you money when things are going well.
Once again I side with Pettis.
It is not often I disagree with Pettis on much of anything other than the timing or sequence of events. For example: Earlier this year I suggested the Shanghai stock market would be weak this year but Pettis thought the market would be resilient until the regime change.
Perhaps I was lucky.
This time my disagreement with Pettis on trade is far more fundamental.
My friend (mentor and teacher) Pater Tenebrarum talks about social mood in The ‘Occupy Wall Street’ Protests. He also offers this comment on trade.
We do not have 'free trade', but rather 'managed trade', guided by the long refuted ideas of mercantilism on the part of many nations. Alas, the populist demand for protectionism always has and always will be inviting economic disaster.Protectionism Cannot Bring Prosperity
It is a demand that refuses to see the other side of the coin. Trade is not 'between nations' – it is between individuals. It is voluntary and it would not take place if not both parties to a trade were gaining from it.
What domestic producers lose in pricing advantage, consumers gain in the form of lower prices and rising living standards. Moreover, the money consumers save on account of being able to buy cheaper goods is then free for investment in other economic activities where a comparative advantage exists. It is not a coincidence that throughout history the richest places on earth were always the centers of free trade.
If protectionism could bring about prosperity, then the most isolated villages in the Hindu Kush would today be utopias of riches envied by all. They obviously are anything but.
I have learned immensely from Michael Pettis. I consider Pettis one of my teachers as well. However, I now disagree with his embrace of what I call "Keynesian silliness".
Instead I side with Tenebrarum. Simply put, "throughout history the richest places on earth were always the centers of free trade". That is all one needs to know.
Protectionism cannot bring prosperity. It never could and it never will . If protectionism seems to work in the short-term it is either by accident (lucky timing in which the market on its own accord may have done a similar thing) or by ignoring long-term consequences.
Mike "Mish" Shedlock
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