The US Dollar Renminbi Standard Myth

Another bizarre mercantilist claim today is that the world monetary system operates on a supposed “USD-Renminbi” standard.

(From Tradingeconomics.com)

Such claim has been anchored on supposed “trade imbalances”, particularly US trade deficits, from where the world evolves only around only two nations, the United States and China. From such premise it is easy to dismiss this as false choice.

A further assumption is that central bankers of both nations have only been fixated on each other’s economy while ignoring the rest of world.

Nevertheless here a few charts to dispel such myths

Based on merchandise trade, it would be a mistake to assume that both these countries equally been trade oriented.

The fact is that the US despite the deficits, external trade in goods account for only a little over 20% of the economy. This makes the US essentially relatively a closed economy.

Meanwhile China’s merchandise trade is about half their economy. In contrast Germany’s external trade accounts for more than 70%. 

Germany largest share among the three squares with the EU’s position as the largest trading bloc. (Wikipedia)

To further add, China accounts as the second largest trading partner to the United States. (US Bureau of Commerce)

Also in terms of trade deficit with the US, while it is true that China has the largest surplus, there are many other countries that maintains where the US has a deficit. (US Bureau of Commerce) Add all to the 9 largest trading partners with surpluses these will easily overshadow China. A further implication is that should protectionist measures be imposed on China, US deficits will only shift to these countries.

Yet for those blinded by deficits, they fail to also account that China’s exports have been (51%) owned by foreign owned companies based on China.

In reality, the obsession towards trade deficits are misleading for the simple reason that trade deficits are balanced out by capital account (Mark Perry)

To quote Professor Mark Perry (bold original)

As a direct consequence of our current account deficits, the U.S. economy has been the beneficiary of more than $8 trillion worth of capital inflows from foreigners since 1980. Because the Balance of Payment accounts are based on double-entry bookkeeping, the annual current account and capital account have to net to zero, so that any current account (trade) deficit (surplus) is offset one-to-one by a capital account surplus (deficit) and the balance of payments therefore always nets out to (equals) zero. And that's why it's called the "balance" of payments, because once we account for trade flows and capital flows, everything balances, and there are no deficits or surpluses on a net basis.

The other side of the coin is that China’s ownership of US debts has been overstated.

In reality, foreign ownership as a total of US treasuries account for only 25% (Wikipedia)…

…where China owns about 8% share of total foreign ownership as shown by the breakdown above. 

In terms of international currency reserves…

The Euro-USD constitutes 90% of global foreign exchange reserves. Add the pound sterling, yen and the swiss franc such would account for 95% of foreign reserves. (Wikipedia) In other words, global trade and banking reserves have hardly been about the Chinese yuan yet. Although China has been making inroads with other emerging markets (e.g. ASEAN, Brazil India Russia, Chile and even Africa) to use her currency as an international reserve.

China’s fixed currency has partly been accused for such relationship. But China’s currency has been fixed since 1994. If fixing currency to the US dollar has been about stealing jobs…

…then all these countries have been guilty

But then again, currency fixing or pegging has been adapted by these countries mostly to promote stability.

According to Investopedia.com

The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Other reasons have been for expanding trade network externalities and importing policy credibility, (University of California) aside from lack of depth in their respective domestic and sophistication in domestic financial markets. 

Bottom line: As I have been pointing out, US trade balance, aside from the conditions of the US dollar has mostly been a function of domestic boom bust cycles, the Triffin dilemma (frictions arising from the collision of international and domestic interests based on short and long term objectives) and many other domestic interventionists policies. 

There has not been a single factor. (Fallacy of a single cause)

Financialization of the US has been an outgrowth of these from which trade deficits have been funded through the growth of financial industry. Wikipedia points to the “greater role arising from the issuance of fiat currency untethered to gold or other commodities, as well as the “end of the post-World War Two Bretton Woods system of fixed international exchange rates and the dollar peg to gold in August 1971”. 

Neither has supposed trade imbalances been deliberately caused by China.

Boom bust cycles, for instance, draw in lots of resources and labor to malinvested areas where during a booming phase distorts the price mechanism and distribution and production process via overvaluing wages, the domestic currency, asset prices, welfare (pensions), fake profits and etc....

Once a bust arrives these policies induced boom becomes key sources of retrenchment.

Mercantilists have been flagrantly blind to this.

Finally as I pointed out, Ben Bernanke has not been targeting the exchange rate for his latest QE. This means, if you believe his uprightness, then he acknowledges that the issue has been local, particularly putting a floor on asset prices and hardly about foreign (devaluation).

Seeing things from reality (than from political biases) gives us a better chance at being right in our investment positions.

Currency Manipulation and the Politics of Neo-Mercantilism

At the local stock market forum, the Stock Market Pilipinas I had been asked to comment about the currency manipulation charges hurled against China.

For starters, as per Wikipedia’s definition of currency intervention, otherwise known as exchange rate intervention or foreign exchange market intervention, is the purchase or the sale of the currency on the exchange market by the fiscal authority or the monetary authority, in order to influence the value of the domestic currency. (bold emphasis mine)

In brief, the employment of currency/foreign exchange/exchange rate interventions implies that both monetary and fiscal authorities of ALL nations are currency manipulators.

(chart from Bloomberg)

As evidence, considering that international reserves assets (excluding gold) are at record highs mainly through the expansion of central bank balance sheets (via unsterilized interventions) these means that all central banks have been manipulating their respective currencies.

The growth of central bank balance sheets includes Asia and the Philippines. (Bank of International Settlements)

Such concerted balance sheet expansions has also been reflected on the state of money supply growth. (chart from Mao Money, Mao Problems)

Fund manager David R. Kotok of Cumberland Advisors has a good narrative of why the growing concerns over dollar debasement are valid.

Mr. Kotok writes, (bold emphasis mine)

The dollar maintains its reserve currency status because it is the least worst of the major four currencies – the US dollar, the British pound, the Japanese yen, and the euro.  All four of these currencies are now suffering the effects of a stimulative, expansive, and QE-oriented monetary policy.

We must now add the Swiss franc as a major currency, since Switzerland and its central bank are embarked on a policy course of fixing the exchange rate between the franc and the euro at 1.2 to 1.  Hence the Swiss National Bank becomes an extension of the European Central Bank, and therefore its monetary policy is necessarily linked to that of the eurozone… 

When you add up these currencies and the others that are linked to them, you conclude that about 80% of the world’s capital markets are tied to one of them.  All of the major four are in QE of one sort or another.  All four are maintaining a shorter-term interest rate near zero, which explains the reduction of volatility in the shorter-term rate structure.  If all currencies yield about the same and are likely to continue doing so for a while, it becomes hard to distinguish a relative value among them; hence, volatility falls.

The other currencies of the world may have value-adding characteristics.  We see that in places like Canada, Sweden, and New Zealand.  But the capital-market size of those currencies, or even of a basket of them, is not sufficient to replace the dollar as the major reserve currency.  Thus the dollar wins as the least worst of the big guys.

Fear of dollar debasement is, however, well-founded.  The United States continues to run federal budget deficits at high percentages of GDP.  The US central bank has a policy of QE and has committed itself to an extension of the period during which it will preserve this expansive policy.  That timeframe is now estimated to be at least three years.  The central bank has specifically said it wants more inflation.  The real interest rates in US-dollar-denominated Treasury debt are negative.  This is a recipe for a weaker dollar.  The only reason that the dollar is not much weaker is that the other major central banks are engaged in similar policies.

Given the high concentration of exposure by the world’s banking system on these four major international reserves currencies (US dollar, British pound, Japanese Yen, and the euro), this means that policies of ancillary central banks has to adjust in accordance to the policies of these major international reserve currencies.

In short, policies by the US mostly dominate on the policies of global central banks. Alternatively this suggest that the US has been the world’s biggest 'currency manipulator'.

While it is also true that some peripheral currencies has differentiating factors as pointed above, the point is that these currencies don’t have enough market depth to replace the incumbent international reserve currencies.

As caveat, such premises remain conditional on the absence of a currency crisis. Abrupt changes to the current setting should be expected if or once a currency crisis should occur.

Yet the fundamental issue is to understand the role of role of central banks. As Mises Institute founder Llewellyn Rockwell Jr. recently wrote, (lewRockwell.com):

First, they serve as lenders of last resort, which in practice means bailouts for the big financial firms. Second, they coordinate the inflation of the money supply by establishing a uniform rate at which the banks inflate, thereby making the fractional-reserve banking system less unstable and more consistently profitable than it would be without a central bank (which, by the way, is why the banks themselves always clamor for a central bank). Finally, they allow governments, via inflation, to finance their operations far more cheaply and surreptitiously than they otherwise could.

The bottom line is that currency manipulation, through inflationism, is the essence of the paper money legal tender based central banking.

So what’s the hullabaloo over China as "currency manipulator"?

Well, “currency manipulation” has been no less than a popular sloganeering of “us against them” politics meant to attain political goals.

Such political goal has been subtly designed for the protection of the privileged business interests allied with the political class through trade restrictions or through the transformation “of the economy from roughly laissez-faire to centralized, coordinated statism” as the great dean of Austrian school of economics Murray N. Rothbard pointed out.

This is called neo-mercantilism.

In the 80s, rising Japan had been painted as a threat to American economic standings, such that hate and envy based politics echoed the call for neo-mercantilist protectionism, again from Professor Rothbard,

Protectionism, often refuted and seemingly abandoned, has returned, and with a vengeance. The Japanese, who bounced back from grievous losses in World War II to astound the world by producing innovative, high-quality products at low prices, are serving as the convenient butt of protectionist propaganda. Memories of wartime myths prove a heady brew, as protectionists warn about this new "Japanese imperialism," even "worse than Pearl Harbor." This "imperialism" turns out to consist of selling Americans wonderful TV sets, autos, microchips, etc., at prices more than competitive with American firms.

Is this "flood" of Japanese products really a menace, to be combated by the U.S. government? Or is the new Japan a godsend to American consumers? In taking our stand on this issue, we should recognize that all government action means coercion, so that calling upon the U.S. government to intervene means urging it to use force and violence to restrain peaceful trade. One trusts that the protectionists are not willing to pursue their logic of force to the ultimate in the form of another Hiroshima and Nagasaki.

With Japan suffering from a humongous bubble bust that has led to a lost decade, today such political bogeyman has shifted to China.

The mainstream (mostly representing captured interests) has used all sorts of highly flawed and deceptive technically based assumptions and theories as cheap labor theory, cheap currencies, global savings glut, global imbalances and others to divert or camouflage the public’s attention from the unintended consequences from serial interventionist domestic policies and bubble monetary policies by riling up or conjuring emotive nationalist or xenophobic sentiment.

Gullible public opinion are easily swayed due to either the dearth of economic understanding or because they are blinded from the obsession to politics.

As the great Ludwig von Mises pointed out (OMNIPOTENT GOVERNMENT p.183)

People favor discrimination and privileges because they do not realize that they themselves are consumers and as such must foot the bill. In the case of protectionism, for example, they believe that only the foreigners against whom the import duties discriminate are hurt. It is true the foreigners are hurt, but not they alone: the consumers who must pay higher prices suffer with them.

And part of that reality has not entirely been about achieving some dubious trading objectives but to expand credit, again for political goals.

Again the Professor von Mises, (Human Action)

While the size of the credit expansion that private banks and bankers are able to engineer on an unhampered market is strictly limited, the governments aim at the greatest possible amount of credit expansion. Credit expansion is the governments' foremost tool in their struggle against the market economy. In their hands it is the magic wand designed to conjure away the scarcity of capital goods, to lower the rate of interest or to abolish it altogether, to finance lavish government spending, to expropriate the capitalists, to contrive everlasting booms, and to make everybody prosperous.

The politics of neomercantilism exploits economic patsies and the politically blind in the name of nationalism for the benefit of political class, vested interest groups and or their cronies at the expense of society.

iPhone Shows How Trade Statistics are Flawed

I earlier pointed out that statistics hardly captures the realities of the swiftly shifting trade dynamics brought about by globalization as exemplified by the iPhone.

Here’s an update. From the Wall Street Journal Blog

The iPhone provides a good example of the problems with the way trade is currently calculated. The Apple device features hardware from all over the world, but because it’s manufactured in China that country gets credit for the entire wholesale export cost. According to research from Kenneth L. Kraemer of the University of California, Irvine, Greg Linden of University of California, Berkeley, and Jason Dedrick of Syracuse University, each iPhone sold in the U.S. adds $229 to the U.S.-China deficit. Based on 2011 cellphone activations from AT&T, Verizon and Sprint, Apple sold around 30 million iPhones in the U.S. last year — accounting for about $6.83 billion of the U.S.’s $282 billion 2011 trade deficit with China.

But the researchers note that such estimates overstate China’s contribution. Though the iPhone is assembled in China, most of its component parts come from elsewhere. Separate research by Yuqing Xing and Neal Detert for the Asian Development Bank Institute noted that for the iPhone 3G just about 3.6% of the wholesale price came from China, the rest could be attributed to inputs from companies in Japan, Germany, Korea and even the U.S. (Read more about that study here.)

The iPhone is just one example. This same phenomenon is happening all over the world in products ranging from cars to children’s toys. In an attempt to better gauge which countries are benefiting or losing the most through trade, the Organization for Economic Co-operation and Development and the World Trade Organization announced that they will be working on a project that identifies where value-added flows are coming from.

More confirmatory evidence where human action cannot be quantified.

This only validates Professor Ludwig von Mises who wrote

The impracticability of measurement is not due to the lack of technical methods for the establishment of measure. It is due to the absence of constant relations. If it were only caused by technical insufficiency, at least an approximate estimation would be possible in some cases. But the main fact is that there are no constant relations. Economics is not, as ignorant positivists repeat again and again, backward because it is not "quantitative." It is not quantitative and does not measure because there are no constants. Statistical figures referring to economic events are historical data. They tell us what happened in a nonrepeatable historical case. Physical events can be interpreted on the ground of our knowledge concerning constant relations established by experiments. Historical events are not open to such an interpretation.

To add, the deepening of the information age will further complicate trade dynamics as commerce will become increasingly more about niches and specialization or decentralization.

Lastly, the other implication is that using flawed trade statistics to argue for political actions (such as protectionism) is like shooting oneself in the foot.

The Myth of Cheap Currencies driving Trade Deficits

For mercantilists an oft repeated claim has been that China’s cheap currency equals US trade deficit. From such premise they advocate the policy recourse of protectionism

How valid is this?

From the Economist (bold highlights mine)

“the recent relationship between China's currency and America's trade deficit with China is not what China hawks in the Senate think it is. Rather than a cheap yuan leading to a flood of Chinese imports, the yuan has actually strengthened as the deficit has widened. There are many things American companies dislike about the way business is done in China: intellectual-property theft, the impossibility of winning government contracts, baffling rules on corporate ownership and so on. However the place for fixing these things is the World Trade Organisation, not Congress. President Obama's administration has already passed on two opportunities to label China a currency manipulator, out of a well-founded fear of sparking a trade war.”

Cheap currencies and export might is a post hoc ergo propter hoc fallacy. Having to hyperinflate their local currency in 2008, Zimbabwe should have been today the world’s premier exporter.

Next, relative currency values are just one of the many variables that affect trade. Among the other variables are specialization, proximity to markets, market niches, transaction costs, political and legal institutions, access to and quality of labor pool, taxes, and etc. etc. etc...

But for mercantilists the world can be seen only in the prism of reductio ad absurdum

Mercantilism has never about the truth, but about getting elected or or about imposing political control over others or about social signaling.

Video: Fiat Money Basics: The Root of the World's Imbalances

Here is a concise explanation of the mechanics of the legal tender based paper money system, a system that rewards the political and the banking class at the expense of everyone else.

Big Mac Index: Brazil’s Real Priciest, India’s Rupee Most Affordable

The Economist has an annual update of their Big Mac Index

The Economist writes, (bold emphasis mine)

THE Economist’s Big Mac index is a fun guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of a basket of goods and services around the world. At market exchange rates, a burger is 44% cheaper in China than in America. In other words, the raw Big Mac index suggests that the yuan is 44% undervalued against the dollar. But we have long warned that cheap burgers in China do not prove that the yuan is massively undervalued. Average prices should be lower in poor countries than in rich ones because labour costs are lower. The chart above shows a strong positive relationship between the dollar price of a Big Mac and GDP per person.

PPP signals where exchange rates should move in the long run. To estimate the current fair value of a currency we use the “line of best fit” between Big Mac prices and GDP per person. The difference between the price predicted for each country, given its average income, and its actual price offers a better guide to currency under- and overvaluation than the “raw” index. The beefed-up index suggests that the Brazilian real is the most overvalued currency in the world; the euro is also significantly overvalued. But the yuan now appears to be close to its fair value against the dollar—something for American politicians to chew over.

My two cents:

As per the Economist, the mercantilist’s imputation of the massive overvaluation of the Chinese yuan would be a mistake. I have been saying these here here and here. A China bubble bust would deflate and expose on these protectionists’ canard.

ASEAN, China and India remains as most undervalued in terms of local currency prices of Big Macs (original index).

The surprise is that the augmented GDP based Big Mac index reveals that Brazil’s real has topped the Eurozone as the world’s most overvalued currency

This reminds me of the great Ludwig von Mises who once wrote

the valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and demand for, money. Thus, even the richest country can have a bad currency and the poorest country a good one.

Below is an interactive graph from the Economist

Mark Twain and China’s Yuan

The brilliant nanotech investor and analyst Josh Wolfe of Forbes offers three invaluable investment insights premised on the maxims of literary and philosophy luminaries: F. Scott Fitzgerald, Mark Twain and Arthur Schopenhauer

The wisdom from the select quotes of the three wise men seem representative of openmindedness (Fitzgerald), the risks of overconfidence and comfort of crowds or the contrarian stance (Twain) and innovation (Schopenhauer).

Read them here

I’d like to make a brief comment on the Mark Twain situation applied to the Yuan

Mr. Wolfe writes, (bold emphasis mine)

Mark Twain said that: “it ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just aint’ so.”

Twain Situations are those where the consensus is near certain about something. But as Buffett has noted, you pay a high price for a cheery consensus. These are situations with payoff structures that Nassim Taleb would call Black Swans. The opposite of the consensus is often entirely unrecognized, unappreciated and massively underpriced. If they are wrong, it’s a massive blow-up. Buying puts and expressing a contrarian view, with cheap insurance may be ways to express this “Twain” view. And this is precisely where the prescient Cullen Thompson and Bienville Capital Management LLC has done along with Mark Hart of Corriente Advisors LLC (who correctly nailed the huge asymmetric payoff with a contrary to consensus view on subprime housing, when all others believed housing prices could only rise). Here is Thompson quoted in today’s WSJ:

“Given the magnitude of China’s credit problems, it’s at least a possibility the yuan drops sharply. The potential of the trade is so great, and when there’s cheap insurance in today’s environment it’s silly not to buy it”

Everybody I speak: politicians, pundits and principal investors all believe, nay they “know” that the Yuan is undervalued and must rise. It just must! And therein lies the opportunity.

Like Mr. Wolfe, I have been saying that the consensus expectations of an overvalued yuan have been misplaced.

That’s because the mainstream’s macro analysis and prescription over ‘global imbalances’ has been premised on flimsy and tenuous grounds.

First, global imbalances have been a diversion (if not a patent misdiagnose) from the true problem: the US dollar paper money system that abets inflationism and interventionism.

Second, the currency valve policy resolution is too oversimplistic and naive, which essentially views the global economy as homogenous.

Lastly, the excessive fixation over these two supposed cause and effect dynamic overlooks the bubble nature of China’s economy.

This reminds me of the Asian crisis where the Thai baht largely operating on a fixed or pegged exchange rate blew up as the Asian crisis emerged (above window).

China’s quasi pegged currency trend looks alot like the Thai baht prior to the Asian crisis (below window). [Charts courtesy of Thai Baht Tradingeconomics.com and Yuan forecastchart.com]

Inflationism only obscures the way the public reads or analyze markets.

As Murray N. Rothbard wrote,

Inflation has other disastrous effects. It distorts that keystone of our economy: business calculation.

Has China’s Competition For Brides Led To Global Imbalances?

Competition for brides, due to gender imbalance, has led to China’s huge savings. That’s according to a study reported by Wall Street Journal Blog.

Writes the Wall Street Journal, (bold emphasis original italics mine)

Too few brides may be contributing to China’s trade imbalance.

That’s because “desperate parents” are using education and wealth to make their sons stand out as catches in an increasingly competitive marriage market, Professor Wei said.

Speaking on a panel at the Council on Foreign Relations in New York on the U.S.-China trade imbalance, Professor Wei said that China’s efforts in the past ten years to step up the social safety net haven’t reassured consumers enough to ease their savings.

Most Chinese consumers save for their children and for retirement, Professor Wei said, a finding put forth in a paper he wrote with Xiaobo Zhang, “The Competitive Saving Motive: Evidence from Rising Sex Ratios and Savings Rates in China.”

Acknowledging that the marriage market was somewhat “outside macroeconomic thinking,” Professor Wei said that his research shows a “very clear pattern” of household savings rates — as well as entrepreneurship — rising as the competition for brides becomes more keen. He and Mr. Zhang, a senior research fellow at the International Food Policy Research Institute, elaborated on the phenomenon in another paper, published last month by the National Bureau of Economic Research, “Sex Ratios, Entrepreneurship, and Economic Growth in the People’s Republic of China.”

The most recent paper explains that areas in China with an acute imbalance of young men seeking wives tend to benefit economically from a high level of hard work and entrepreneurship. The authors attribute this initiative to the competitive marriage market. Young men who want to begin businesses have to turn to their families for start-up money; parents and relatives prepare for that by saving.

My comments:

While there may be some truth to this, which is why this study came about, this seems more of an example of Nassim Taleb’s narrative of Birds do not write books on birds

Think of the following event. A collection of priestly persons from Harvard or some such place lecture birds how to fly. The bird flies. They write books, articles, and reports that in fact the bird has obeyed them, an impeccable causal link. They even believe their own theories. Birds write no such books, conceivably because they are birds, so we never get their side of the story. Meanwhile, the priests broadcast theirs.

I don’t think the desire of every Chinese family to save is about securing a “bride”.

If this is true then once a groom marries, the couple tends to wind down savings as the incentive to acquire a bride has already been achieved. But of course the argument extends to the next generation, thus becomes circular.

Marriage is just a part of our manifold social activities, surely there many other factors involved such the state of undeveloped capital markets, uncertainties over health, cultural quirks, and government policies among many others.

The above is also a good example of the predilection to aggregate people with numbers and of the experts’ tendency to fall for the clustering illusion trap-seeing patterns where there is none.

Moreover, the study also puts into context Jessica Hagy’s graph of social signalling here.

Of course for me global imbalances is no more than another charade where experts try to pass the blame of their national policies to the others.

This is aside from the folly of applying reductio ad absurdum arguments into people’s trading activities, which has been seen and argued in the context of politics, based on statistical figures rather than trading activities as seen from the human dimensions.

Bottom line: Patterns or correlations does not imply causation.

How Statistics Don’t Measure Up To ‘Global Imbalances’

People’s way of conducting commerce has always been changing, i.e. from agriculture to industrial and now to the information age. However statistics used by vested interest groups to promote certain policies don’t.

Presently global trading platform has been shifting towards a supply chain network.

This from Xinhua,

Measuring global trade in line with the principle of "the country of origin" fails to reflect the complexities of global commerce where the design, manufacturing and assembly of products involves several countries, experts said...

"The concept of country of origin for manufactured goods has gradually become obsolete," said Pascal Lamy, director-general of the WTO, in a speech to the French Senate in October.

"What we call 'made in China' is indeed assembled in China, but what makes up the commercial value of the product comes from the numerous countries," said Lamy.

"For instance, every time an iPod is imported to the U.S., the totality of its declared customs value (150 U.S. dollars) is ascribed as if it were an import from China," said Lamy, adding that "In fact, according to American researchers, less than 10 of the 150 dollars actually come from China and all the rest is just reexportation."...

This means that current trade data used and extrapolated by the mainstream does not accurately account for the genuine picture.

From the same article... (bold highlights mine)

Sheng Guangzu, head of China's General Administration of Customs, told Xinhua in an interview in April that much of China's trade surplus was "transferred" from foreign-funded enterprises operating in China.

In the first 11 months this year, exports of foreign-funded enterprises totaled 779.14 billion U.S. dollars, accounting for 54.7 percent of China's total exports, according to China's customs authorities.

The data also showed that, during the same period, foreign-funded firms generated 112.51 billion U.S. dollars of trade surplus, accounting for 66 percent of China's total surplus.

In short, 'global imbalances' are not what they are projected to be.

The take away is that those arguing about global imbalances, aimed at advancing the cause of mercantilism via protectionism and inflationism, using old statistics are either missing the big picture by unwittingly parroting popular misperceptions or deliberately engaged in economic sophistry.

As Mark Twain rightly pointed out: There are three kinds of lies: lies, damned lies and statistics.

iPhone Shows Why Global Imbalances Will Remain

Mercantilists are simply wrong.

The are mistaken in arguing for the "currency valve" policy option to address global ‘imbalances’. That’s because these mercantilists read or interpret trade as operating simplistically in an “aggregate” manner.

Yet as this study based on the iPhone’s business process shows, trade hasn’t been that simple.

Trade has been swiftly evolving in such a way that has deepened the role of specialization (division of labor) and national comparative advantages which has affected how “imbalances” are being shaped.

To add, current statistical aggregates tend to overlook many important data points which have been used for policy analysis. This makes many of these politically sensitive data unreliable.

Illustration from Wall Street Journal Blog

The following conclusion from Yuqing Xing And Neal Detert on their paper “How iPhone Widens the US Trade Deficits with PRC” (all bold emphasis mine)

In this paper, we use the iPhone as a case to show that even high-tech products invented by American companies will not increase US exports, but to the contrary exacerbate US trade deficits.

Unprecedented globalization, well organized global production networks, and low transportation costs all contribute to rational firms such as Apple making business decisions that contributed directly to the US trade deficit reduction.

Global production networks and highly specialized production processes apparently reverse trade patterns: developing countries such as PRC export high-tech goods—like the iPhone—while industrialized countries such as the US import the hightech goods they themselves invented. High-tech products such as iPhones in this context do not help increase the US exports, but instead contribute to trade deficits.

In addition, conventional trade statistics greatly inflate bilateral trade deficits between a country used as export-platform by multinational firms and its destination countries. In the case of iPhone trade, China actually contributed only 3.8% of the United States’ US$1.9 billion trade deficit, the rest was simply a transfer from Japan, Korea, and Taipei,China.

If the US high-tech companies, such as the Apple, are willing to share their profits with low skilled American workers by keeping assembling jobs in the US, it would be more effective in reducing the US trade deficits than targeting the exchange rate policy of PRC.

University of Michigan Professor Mark J. Perry has a nice illustration of the composition or breakdown of revenues of the iPhone per location/geography as shown above.

He also notes that

“only about $6.54 (a little more than than 1%) of the full $600 retail price of an iPhone goes to China and more than 60% goes directly to Apple and other American companies (see chart above), according to a "teardown report" by iSuppli that was featured in a July New York Times article. It also doesn't mean that your purchase of an iPhone contributed very much to the U.S. trade deficit, even though that's what the government trade statistics tell us.”

So despite being assembled or "made in China" most of the profits still accrue to the US.

Bottom line: Globalization equals “imbalances”. That’s because of the fast evolving supply chain platforms or networks which has been determining the trading patterns globally.

Yet interventionist policies based on easy fixes are likely to backfire since they do not address the business and micro realities of trade.

Why Mercantilists Are Wrong (Again)

The Chinese yuan may not be as undervalued as expected by present day mercantilists.

According to the Economist, (bold highlights mine)

The yuan may well still be undervalued but our index suggests American manufacturing should have less to fear from Chinese competition than it did five years ago. Until June 2009 appreciation was largely because of the stronger yuan. Since then it is largely because China’s unit labour costs have grown much faster than America’s. Employers in China’s coastal factories have suffered labour shortages and strikes. America’s factories have reported strong productivity gains as they have wrung more out of the workers that survived the recession (although those gains will be hard to repeat).

Of course, China and America do not trade only with each other. China’s big surpluses and America’s big deficits depend on the real exchange rate between them and all of their trading partners. But calculating that would require timely estimates of unit labour costs for all of China’s trading partners. That is a bit too laborious.

The Economist is correct to point out implicitly how wrong present day mercantilists unduly fixate on China’s currency as the main mechanism for global trade.

These mercantilists allude to trade imbalances as the root of all economic problems and thus recommend policies grounded on ‘restoring balance’ via curtailing trade or applying protectionism (tariff, and controls) or inflationism (currency wars)

Yet the mercantilist perspective deliberately neglects or disregards all other variables or factors which mistakenly presume that the world operates in a “ceteris paribus” or an imaginary two nation world of US and China. Yes, they love to fantasize a world beyond or outside of reality.

Contrary to the mercantilist orthodoxy, trades imbalances are NOT the problem. Instead trade imbalances account for as symptoms of evolving geopolitical and world economic conditions and patterns which had been brought upon by present policies.

One of which is the Triffin Dilemma, which according to the Wikipedia.org, is the paradox by which “the country issuing the global reserve currency must be willing to run large trade deficits in order to supply the world with enough of its currency to fulfill world demand for foreign exchange reserves”.

Another is globalization.

Importantly, trade imbalancess signify as outcomes from voluntary action and not of government mechanistically engaged in trade for no apparent reason at all.

It is individuals who buy or sell services even if it is done with other individuals abroad.

Yet the mercantilist logic goes:

If I frequent my favorite pizza parlor, whose food I savor, which means I repeatedly incur a deficit with the pizza parlor, then the pizza parlor should be forced by edict to obtain my services (as a stock market agent) even if they refuse to get involved in the stock markets in order to balance our trade. By doing so, my favorite Pizza Parlor would only serve to people who they are willing to balance out which alternatively means going out of business. This circular reasoning by the mercantilists is all patent nonsense.

Individuals conduct trade to fulfil specific needs. And the division of labor and comparative advantages channelled via voluntary exchange is what allows our needs to be met. Territorial or geographic boundaries does not change this perspective.

And forcing people to balance trade would result to REDUCED trades, which ultimately leads to impoverishment via higher prices, shortages, diminished of choice of available products, inferior qualities and etc.

Besides, contrary to conventional mercantilists expectations, exports ALONE do NOT make a country prosperous. This mercantilist perspective, which aims to increase ‘surpluses’ by fiat or protectionism, actually confuses wealth with money and have long been demolished by Adam Smith (bold highlights mine)

I thought it necessary, though at the hazard of being tedious, to examine at full length this popular notion that wealth consists in money, or in gold and silver. Money in common language, as I have already observed, frequently signifies wealth, and this ambiguity of expression has rendered this popular notion so familiar to us that even they who are convinced of its absurdity are very apt to forget their own principles, and in the course of their reasonings to take it for granted as a certain and undeniable truth. Some of the best English writers upon commerce set out with observing that the wealth of a country consists, not in its gold and silver only, but in its lands, houses, and consumable goods of all different kinds. In the course of their reasonings, however, the lands, houses, and consumable goods seem to slip out of their memory, and the strain of their argument frequently supposes that all wealth consists in gold and silver, and that to multiply those metals is the great object of national industry and commerce.

The two principles being established, however, that wealth consisted in gold and silver, and that those metals could be brought into a country which had no mines only by the balance of trade, or by exporting to a greater value than it imported, it necessarily became the great object of political economy to diminish as much as possible the importation of foreign goods for home consumption, and to increase as much as possible the exportation of the produce of domestic industry. Its two great engines for enriching the country, therefore, were restraints upon importation, and encouragements to exportation.

In short, wealth is acquired through capital accumulation via savings and investment and expressed through voluntary exchange.

In truth, the undeserved obsession towards trade imbalances represent as selective perception and data mining applied by modern day mercantilists in order to justify all sorts of interventionism. They apply fallacious ‘cart before the horse’ reasoning.

Seen from the bigger picture trade deficits are part of the international transactions that can be seen from Balance of Payment (BOP) data where trade deficits are fundamentally offset by capital flows.

Professor Mark J. Perry points out that under double-entry accounting, debits have to equal credits, which applies to BOP accounting:

BOP = CURRENT ACCOUNT + CAPITAL ACCOUNT = CREDITS - DEBITS = 0

Professor Perry additionally writes,

The current account and capital account are the two main components of the U.S. Balance of Payments (BOP), which is a record of all international transactions for both: a) trade flows and b) capital flows in a given period. Every international transaction (e.g. export, import, U.S. investment abroad, foreign investment in the U.S.) is recorded on a double-entry accounting basis, so that each transaction involves both a debit and credit.

Professor Perry further notes that alarmism over deficits are unwarranted for the following reasons: (bold highlights mine)

1. There are no BOP deficits once we account for all international transactions, both for: a) goods and services, and b) financial transactions. For all of the one-sided coverage in the press about the "trade deficit," you would almost never even know that there is an offsetting "capital surplus" or "capital inflow." It's important for the general public to understand that trade deficits are offset by capital inflows on almost a 1:1 basis, resulting in a "balance of payments" for international transactions. When the public constantly hears about "trade deficits" without any understanding of the offsetting surplus, that economic ignorance allows politicians and special interest groups to exploit the general public, by advancing and promoting protectionist trade policies aimed to reduce the "trade deficit," or by refusing to approve trade agreements between Chile, Panama and Korea, etc.

2. The "trade deficit" generates so much negative coverage, that the significant advantages of capital inflows from abroad get frequently overlooked. Since 1980, the U.S. has attracted almost $8 trillion of foreign investment, which has provided much-needed equity capital that has allowed U.S. companies to start or expand, has provided much-needed debt capital that has also funded the expansion of American companies, along with providing debt capital for U.S. consumers in the form of mortgages, student loans, and car loans. Some of the $8 trillion of investment includes billions of dollars of Foreign Direct Investment, which has funded thousands of new projects in the U.S. (Toyota factories for example) and created hundreds of thousands of jobs.

This goes to show that “imbalances” serve more as political talking points meant to promote dogmatism than of observing factual operating circumstances.

Moreover what matters most is what mercantilists refuse to bring up in the imbalance debate: what seems to ail the US, isn’t China, but the entitlement mentality effected by the political leadership through inflationary policies (such as the recent housing bubble).

The negative effects of inflationism can be broken down into the following

-diverts resources to one that is not desired by the markets.

-crowds out the private sector

-generates systemic malinvestments.

-causes overvaluation in assets or the currency.

-misallocates the distribution of economic weighting towards areas preferred by government at the expense of the consumers.

-raises the costs of living.

-distorts corporate profitability and income streams

-raises the cost of doing business which translates to reduced competitiveness

-destabilizes the economy from the boom bust cycle which eventually leads to a consumption of capital.

The mercantalism-inflationist agenda does the opposite of what it intends to accomplish.

Applying real life examples, if the mercantilists-inflationists school is correct then Zimbabwe, North Korea, Cuba and Burma should have been the most prosperous countries (having been closed economies).

Ironically, the opposite is true, nations that have been economically free, are those whom have been prosperous.

Unfortunately reality isn’t what mercantilists are concerned with. Political religion is.