Exchange Rates and Trade Myths

I haven’t been able to post much recently, but will be back in the saddle later this week. The big economic news of the past week has been China’s decision to un-peg its currency from the dollar, allowing it to float and be determined by market forces, as the Obama administration (like the previous administration) has been insisting.

This will, of course, have no effect on our trade deficit with China, contrary to what the president, his economic advisors and, indeed, nearly everyone in the world expects. In theory, it will make Chinese exports more expensive in the U.S. In reality, it won’t. China’s manufacturers will simply improve their productivity and cut costs to compensate, holding the line on prices. And, in theory, it will make American exports more affordable to Chinese consumers. In reality, it won’t. The downward pressure on Chinese wages will offset any reduction in the prices of American imports. In summary, while the yuan move will have no effect on our balance of trade with China, it will certainly make life tougher for the Chinese, as well it should.

But this is all old ground I’ve plowed before. However, the news did trigger an epiphany of sorts for me. I’ve gone to great lengths to prove the relationship between population density and trade imbalances. Because of this, I’ve long maintained that trade imbalances have virtually nothing to do with low wages and currency valuations. But I haven’t produced the data to prove it. If it’s important to prove the relationship between population density and trade imbalances, is it not equally as important to disprove the usual suspects?

So, I’ll soon start a new series of posts. One will compare trade imbalances to per capita purchasing power parity, the most often-used parameter for comparing the purchasing power (or incomes) of the people of various nations. We’ll see whether there’s any relationship at all. Secondly, I’ll begin tracking the U.S. trade imbalance vs. currency exchange rate for a number of countries, including the yen, the euro, the Chinese yuan, the Mexican peso, and the Canadian and Australian dollars, among others. (I hope I’m not biting off more than I can chew.) In both cases, I expect to find either no relationship, or a weak relationship that’s dwarfed by the effects of population density. Regardless, I’ll report the facts and let the data speak for itself. This should be an interesting exercise. Stay tuned.

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