October 22, 2010

It’s Complicated with: China

Electoral politics ignore the reality of U.S.—China economic relationship

If there’s one thing that Democrats and Republicans can agree on as this often bitterly fought campaign draws to a close, it’s this: We should blame China (and its American stooges) for everything. During the first week of October, at least 29 candidates from both major parties ran ads attacking their opponents for killing American jobs by supporting open trade with the Chinese, and others have used the same message in debates and public appearances. However, the candidates are mistaken; furthermore, their simplistic appeals obscure the real danger which China poses to the American economy.

The recent attacks on China reflect ignorance of both empirical evidence and economic theory. Declines in the number of Americans employed in manufacturing, which opponents of unrestricted trade with China and other emerging market economies frequently cite as evidence for their claim that the Chinese are taking American jobs, have been accompanied by constant or rising rates of manufacturing output. This would seem to suggest that most of the job losses result from improved productivity, not trade. Furthermore, the vast majority of economists support free trade; a 2006 survey found that 93 percent of economists considered most types of trade barriers harmful to economic well-being. The basis for this view is the principle of comparative advantage: The market should be accessible to as many producers as possible so that each one can specialize in what he or she is best at doing, thereby ensuring that resources are allocated as efficiently as possible.

In addition to promoting an incorrect understanding of an important economic issue, the misguided focus on job losses caused by trade with China has also distracted our attention from a serious threat that that country poses to our economy. Ironically, the real problem is not that the Chinese are taking American jobs but that they are giving us too much money. For at least the past two decades, China has been the most prominent of several emerging market economies that have been exporting steadily increasing amounts of goods to the United States. Normally, economic theory would predict that two effects would follow such a rise in exports. First, the yuan, the Chinese currency, would become more valuable in relation to the dollar, as Americans began buying more of it in order to purchase Chinese goods, thus allowing the Chinese to buy more foreign products. Second, as Chinese households acquired more dollars, they would spend more on American imports priced in dollars. However, neither has happened. The Chinese government has prevented the yuan from increasing in value, and Chinese consumers have saved much more of their additional income than economists expected. Therefore, Chinese financial institutions have found themselves sitting on a massive pile of dollars and have decided to make those dollars more valuable by investing them in the U.S.

As normally happens, the massive demand for investment products, generated by what Ben Bernanke, the chairman of the Federal Reserve, has called the “global savings glut,” has led to an eagerness on the part of the American financial sector to supply such products. Many economists, including Mr. Bernanke, believe that the incentive to create more and more investment vehicles to capture this massive pool of money played a major role in the creation of the risky securities that produced the recent financial crisis. Companies were so eager to profit from the dollars entering the U.S. from overseas that they neglected their usual standards concerning risk and credit-worthiness. Eventually, however, the risks they had taken became clear and the losses they suffered as a result seriously hampered their ability to lend, producing the economic difficulties from which we are only now gradually recovering. One might claim that this problem resulted from lax regulation, which the recent financial reform bill has strengthened. However, leaving aside the many flaws in the new law, even the best regulators can only do so much when confronted with a vast pool of capital, which encourages companies to innovate at an extremely high rate. We need to address the underlying financial imbalance.

There are several policies which could play a role in dealing with this problem. Many economists believe that Chinese households’ unusually high savings rates are caused by a desire to insure against risk, which flows from China’s minimal social safety net. In this case, encouraging the Chinese to improve their social insurance programs could play a role in addressing this problem. Furthermore, the wage stagnation which most Americans have experienced over the last several decades likely created a demand for loans in order to maintain a reasonably high standard of living. This, in turn, further strengthened the financial industry’s incentive to create investment vehicles to capture Chinese dollars. Finding a way to produce broad income growth could thus also be helpful in resolving this issue, in addition to its other benefits. Regardless of whether these solutions will work, however, this problem demands urgent attention, and it’s a shame that the current crop of candidates has largely ignored it.

Ajay Ravichandran is a third-year in the College majoring in Political Science.