China to Let Yuan Rise. Don’t Get too Excited.

http://www.reuters.com/article/2013/11/20/us-china-reform-idUSBRE9AJ09Y20131120

As reported this morning by Reuters in the above-linked article, it seems that China wants to allow its currency to rise further and faster in value.  Many have blamed China’s control of its currency – keeping it artificially low – for America’s enormous trade deficit with China.  A weak currency makes imported American products more expensive for Chinese consumers, and the correspondingly stronger dollar makes imports from China cheaper for American consumers, resulting in the large trade deficit, or so economists would have us believe.  So this should be great news for American manufacturers, right?

Not so fast.  I’ll use this news story to make the point once again that currency exchange rates have absolutely nothing to do with trade imbalances.  For every example you give me where a trade imbalance has responded to a change in currency exchange rate as economists would predict, I can give you an example of where exactly the opposite has happened.  Our trade imbalance with China is a perfect example.  In 2005, when China let the yuan begin to rise from its long-fixed rate of 8.6 yuan per dollar, our trade deficit with China was about $200 billion per year.  Today, the yuan has risen by 29% to 6.09 per dollar but, instead of falling, our trade deficit with China has soared to by 60% to $320 billion per year.  Here’s a chart:  China Trade vs Exchange Rate-3.

Economists reply that this is because the yuan is still too cheap.  Hogwash.  Either there is a relationship between exchange rate and trade balance or there isn’t.  If there were, then a change in exchange rate would have some effect – if not reversing the trade imbalance, then at least slowing its growth.  There’s simply no evidence of that here.

No doubt, a stronger yuan will put the squeeze on Chinese companies, cutting into their profits.  But no company faced with such a situation simply throws up its hands and concedes the market to its foreign competition.  It responds by cutting costs and improving efficiencies in order to maintain market share.  Thus, the trade imbalance remains.

The real driver behind our trade imbalance with China is the large discrepancy in population density between the two countries.  With a density four times that of the U.S., China’s per capita consumption is stunted by over-crowding.  When the economies of two nations are combined through free trade, the work of manufacturing is spread evenly across the combined population (jobs naturally flow to where labor is in the greatest state of over-supply), while the disparity in consumption remains.  The result is an inescapable shift in manufacturing to the more densely populated nation.  This is precisely what we’ve witnessed with China – a shift in manufacturing to that nation without a corresponding growth in their consumption.

A study of exchange rates vs. trade imbalances for all nations of the world finds no correlation whatsoever between the two, but yields a strong correlation between population density and trade imbalances.  The lesson to be learned is that free trade between nations grossly disparate in population density, as in the case of trade with China, simply doesn’t work.  A massive trade deficit is inescapable.  We see the exact same situation in trade with other densely populated nations like Japan, Germany, South Korea, Taiwan and a host of others.  The only hope for restoring a sustainable balance of trade is a return to the use of tariffs.  And the only hope of that ever happening is that economists pull their hands out of the sand and begin to ponder the full range of economic implications of population growth.

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