from Follow the Money

DeLong on the global economy

DeLong’s powerpoint notes are certainly worth checking out. The side by side graphs showing real GDP growth and then employment growth (or the lack thereof) elegantly tell the story of the 2002-2004 recovery.

However, I have a few comments on DeLong’s China slide.Professor DeLong makes two arguments. One is that the spectacular rise in China’s exports has largely come from changes in intra-Asian electronic trade, with more electronic components now being sent to China for final assembly. The other is to remember the principle of comparative advantage: The U.S. will have a comparative advantage over China in the production of something.

Actually, it is pretty obvious that we do have a comparative advantage over China in one thing -- the production of budget deficits. I am being serious. To run a budget deficit, you have to be able to sell debt, and we are selling a lot of debt to China. 2004 US exports of goods to China are likely to be around $40 billion. China’s reserves are likely to rise by over $100 billion this year, and globally, the BIS reports that 2/3s of all reserve assets are in dollars. That would imply that the US is likely to export $67 billion of dollar assets to the Bank of China. In other words, our current comparative advantage is in the production of financial assets for sale abroad!

A brief aside. The data on China’s holdings of Treasuries shows a slightly slower pace of increase than I calculated above. China’s holdings of Treasuries fell a bit in January and February, likely because of plan to recapitalize state banks, but its holdings have since risen by about $20 billion. That would works out to an increase of about $40 billion for the year -- less than the $70 billion I inferred from data on the growth in China’s reserves. China may be holding more agency bonds, may be hiding the size of its holdings of Treasuries by going through intermediaries, or just perhaps, may be holding fewer of its assets in dollars. But even at $40 billion, US exports of treasury bills to China will match US exports of goods to China in 2004.

DeLong’s broader argument gets part of the story right, but, in my view, not all the story. It is true that between 2000 and 2003, a lot of the growth in China’s exports to the US simply displaced other Asian exports. Overall US imports from the Pacific Rim were around $420 billion in 2000, and still around $420 billion in 2003 (US imports were roughly flat overall during this period, as imports fell sharply in 2001, both because of the recession and lower oil prices, and then picked up). However, looking forward, I suspect China will increasingly be moving into other markets. 2004 exports from the Pacific Rim are set to rise by $70 billion, to $490, driven by a $50 billion increase in imports from China -- i.e. East Asia as a whole is increasing its share of the rapidly expanding US market for imports. Going forward, barring any major changes, overall imports from East Asia will keep on rising -- i.e. Chinese goods will displace imports from other regions (say textiles) or US production, not just other East Asian production. Afterall, a $1.5 trillion or so economy that exports a ton and is investing 40% or more of its GDP has to keep moving into new markets.

DeLong is right to note that the US has to have a competitive advantage in something. China is earning a ton of dollars selling goods to the US, and those dollars have be used, not just hoarded. Recently, China has used those dollars to buy Treasury bills (and, no doubt, also to buy oil), but that is probably not the long-term solution. The problem, it seems to me, is that no one in the US really seems to have a good sense of where our future comparative advantage will be. I have not heard of many new investments in the US that are premised on supplying the growing Chinese market. Usually, the anecdotes are of the opposite -- US firms moving to China to supply the US market.

Now I suspect that some of those firms are making a mistake, at least if they are assuming that China will retain all of its current cost advantage over the United States. If you are investing in a Chinese plant that will be at peak production between 2008 and 2010, and you are betting that the renminbi/ dollar will remain in the 8.2 range, then you are betting that the US will be able to run trade deficits of 8% of GDP or more in 2008. That seems implausible to me. Smart investors in China should assume significant real appreciation going forward.

But my bigger concern is the absence of investment in US export sectors. Indeed, I recently heard that the US capital stock is -- or perhaps was -- falling. Investment here in the US, by US and foreign owned firms, fell sharply in the last recession, and did not keep up with depreciation. Interesting.

It is fairly clear that the development of China as a manufacturing powerhouse is a potential boon to resource exporting countries -- countries like Australia and Canada as well as Russia, Brazil, Chile and Argentina -- at least so long as commodity production does not get ahead of demand. Parts of the US may benefit as well. The midwest may compete successfully with Brazil for China’s soybean market, maybe even for its pork market. But I suspect that the US will not be able to thrive solely by exporting natural resources, i.e. we won’t become Canada.

One option is to export to the resource heavy/ labor scarce countries that are clearly benefitting from the new China trade. There is nothing wrong with triangular trade. China imports from Brazil and exports to the US and the US imports from China and exports to Brazil. Another option is to find industrial or service sectors here in the US that does have a comparative advantage over China.

The problem is that no one seems to have a good idea what they are, or to be investing in them now. No doubt, such sectors will emerge, particularly as China’s exchange rate adjusts, as it must. But the process of discovering where our comparative advantage lies and reorienting our economy to exploit that niche may well take time, and probably won’t be painless.

Of course, so long as China --and for that matter Japan -- is willing to buy an ever increasing number of US treasury bills, we can continue to specialize in budget deficits, and put off our day of reckoning!