Bruce Wilder is always a interesting read. Here you go….

China is not offering the world a comparative advantage in cheap labor; China is saving and investing 40+% of GDP and investing in world-class, high sunk-cost, capital-intensive manufacturing, which, actually uses relatively little labor. Those 80 million desperately poor Chinese Mundell is worried about, and still vaster pools in State enterprise and the domestic agriculture and service sectors, are hostage to the need to keep the domestic price structure low, with lots of people available to produce non-tradeable goods and services, so that even wages, which are low in international/exchange rate terms, will still attract the best and the brightest to export industries, and also allow them to live passably decent lives.

Wages in manufacturing are made low in international terms by the exchange rate policy, and those wages make investment in capital-intensive manufacturing profitable by compensating for the cost disadvantages of manufacturing in Chinese (skill deficits, infrastructure deficits, shortages of reliable electric power, transportation costs, communication problems, unreliable parts and industrial services supply, etc.).

Krugman is right that China kind of stumbled onto their current policy. It is a dynamic psuedo-equilibrium — all trade/exchange rate stability rests on the psuedo-equilibria of persistent dynamic balance, and not on any thing resembling a long-run static equilibrium (which is why the common practice of reasoning from a framework of long-run comparative statics can be so unreliable in its prediction of events).

China is working very hard to reduce the disattractions to manufacturing in China, which make ridiculously low wages necessary to attract investment; as they succeed, they will be willing and able to allow the yuan to rise relative to the dollar, AND they will be willing to allow wages to rise in Yuan-terms domestically, which will tend to drive up the domestic price structure, and with it, domestic Chinese consumption. A rising Yuan will aid the rise in domestic Chinese consumption, by reducing the cost of imported commodities, like oil, copper, etc.

China's economy is clothed in a fixed exchange rate policy, which makes it look like Clark Kent. The Chinese Clark Kent economy, valued at current exchange rates, is roughly equivalent to France in size. Using the x-ray vision of Purchasing Power Parity, we can see that, in fact, China is growing into Superman-on-steroids. Already, in PPP terms, China's economy is larger than Japan's and almost three times the size of Germany's!

Journalistic descriptions, framed by a comparative statics analysis, make smooth transitions sound more plausible than they are. China has been investing 40+% of GDP and growing at a rate of 8-9% per year for a remarkably long-time — not all of that investment has been wise; moreover, the policy of keeping the domestic price structure low, which is an intrinsic part of the exchange rate policy, means that there are vast pools of resources — whole regions of the country, large sectors of the economy — which are not part of this new world. Asset price inflation is out of control — you think house prices are inflated in northern Virginia or West LA, try Shanghai. China builds a city the size of Philadelphia every . . . wait for it . . . month(!). Not all that construction is wisely planned.

China is going to need to have a major recession at some point, maybe not soon, may not until 2010 or 2012, but when China adjusts, it will have to let the domestic price structure and resource allocation adjust as well as the international exchange rate. Managing a recession has got to be really scary for the Chinese political leadership, so, big surprise, they are putting it off.

I don't think exchange rate adjustment, whether it comes gradually over the next few years, as part of the currency basket policy of the Chinese, or as part of the Chinese recession/crisis of 2011, will be at all pleasant for the U.S. A rising yuan/falling dollar will mean rising commodity prices in the U.S., i.e. rising oil prices.

Marginal labor productivity in the U.S. is tied directly to energy consumption, so rising energy prices means falling labor compensation. In short, a falling dollar means falling wages.

Maybe a rising yuan will mean rising prices for manufactured goods at Wal-Mart, as well, but I doubt that this will go far enough or fast enough to help much in rustbelt Ohio; for one thing, the biggest price impact of Chinese re-valuation is likely to be on clothing, which the U.S. makes relatively little of, and the impact will mostly be to drive Wal-Mart and J C Penney to shop for clothing in India and Burma.

China is rapidly repairing the deficits, which made low wages necessary in high-value-added manufacture, and the repair of those deficits of infrastructure, etc., will more than offset the rise of wages in total manufacturing cost. Chinese manufacturing will become more vertically integrated, and less dependent on importing designs and parts from the West. The $50 of direct labor in a $1000 refrigerator is not going to be enough leverage to result in a shift of manufacturing refrigerators from China back to Michigan or Ohio, from an exchange rate change. Manufacturing, today, is all about sunk cost investments and increasing returns; once the plant has closed, all the exchange rate adjustment in the world will not help. Imported Chinese automobiles will eventually arrive to compete with the Japanese autos made in Tennessee, probably about the time GM and Ford finally close their doors.

As vertical integration replaces the pattern of importing tools and parts to do assembly for export, the Chinese will be a position to allow domestic consumption to rise, diverting some of the growth in manufacturing output from exports to domestic consumption. They might allow a smidgen more imports from the U.S. into the domestic market, but that effect will be offset by the reduction in the imports of designs and parts for the manufacture of export goods — the primary effect of increasing vertical integration.

Moreover, the Chinese are taking the advice to use their accumulated dollar reserves to invest internationally in distribution. The Chinese "multinational" is upon us. The Haiers and Lenovos, very shortly, are going to want higher margins and more of the rents, currently going to Sony and Wal-Mart and Dell and Hewlett-Packard.

When I add it all up — the expected shift in clothing trade, vertical integration reducing Chinese parts imports, the effect on commodity prices, the insensitivity of low labor/high sunk cost manufacturing to exchange rates — I don't see much reason to put faith in the comparative statics analysis that sees an exchange rate adjustment solving all of our problems. The Chinese may choose to soften the blow by buying airplanes from Boeing and paying a bit more to Disney and Microsoft, but I don't see anything that would offer hope to the rustbelt.

The U.S. is headed toward an unpleasant recession, after an unpleasant recovery. Under Bush, the U.S. has reduced our savings rate to negative numbers, and invested heavily in housing we don't need (much of the new construction in places no one can afford to drive to), in a health care sector already swollen to twice the size of European counterparts, and in the black hole of a stupendously costly war in Iraq. We cannot export our housing, no sane person would want our health care, and the only ones getting a return from our Iraq adventure are Halliburton, Exxon/Mobil and Dubai.

No amount of China envy justifies focusing on the dollar/yuan exchange rate. We've got bigger problems, and a rising yuan is only going to further reveal those problems.

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