Tuesday, January 18, 2011

Ah...if economics was only static

In today's NY Times, Mark Wu (law professor Harvard) writes that America's trade problem is not caused by the value of the Chinese RMB. He argues that we really do not compete against China because the products the US exports are different than the ones that China exports. He also points out that during the period 2005-2008 the RMB rose in value, but US exports to China did not increase. Parenthetically, the current account trade deficit also increased between the two countries during that period.

However, he ignores some basic economics. First, the change in value of the currency will make Chinese products more expensive in the US market if the Chinese vendors take payment in the RMB, or if they adjust dollar denominated prices to reflect the value of the RMB. It may in fact, be in the long run before the prices of imports adjust as businesses are slow to change prices. In fact the recession was effective at reducing the current account balance between the countries. Viewing the number from 2008 to 2009 the balance declined by over 15%.

Adjusting the currency value will help close the gap which us unsustainable in the long run. Professor Wu also ignores the GDP impact of the trade argument. To offset the current account balance there must be a capital account baalnce, meaning China has to do something with the dollars it gets from trade. Moving the dollars should weaken the dollar against all currencies. But if the Chinese artifically inflate the dollar, then the adjustment will not take place.

Economics is dynamic. You have to account for botht the flows and stocks to measure change. Professor Wu's mistake is not to account for the long term possibilities based on the currency value and to ignore the actions of Chinese government and business to deflate the value of their currency with respect to the dollar.

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