Twofish's Blog

December 4, 2008

Brave New World – The Paradox of RMB exchange rates

Filed under: china, finance — Tags: , — twofish @ 2:36 am

I think there is a basic problem here in that the US wants China to do two contradictory things. The US wants China to boost domestic consumption, while at the same time lowering the trade deficit, and absent action by the US, can’t do both.

Either China expands its money supply or it contracts its money supply. If it wants people to spend, then it expands it money supply, but if it expands it money supply the RMB goes down, and you increase the trade deficit. If China contracts the money supply, then you decrease the trade deficit, but you also encourage domestic savings. Without action by the United States, there is just no way of getting to the desired state of affairs.

The basic problem is that anything that China does to encourage China to spend money on Chinese products also encourages Americans to spend money on Chinese products, and there is a one-way trap because Americans can use dollars to buy Chinese goods whereas Chinese can’t use RMB to buy US goods, and the People’s Bank of China can’t print dollars.

If China tries to reduce its US currency reserves, the only supply of RMB is in China.

Import barriers aren’t going to solve the problem because if you reduce the amount of Chinese goods entering the US, you reduce the dollars that Chinese can use to buy American goods. Having the PBC sell dollars and buy euro isn’t going to change the fundamental problem, it just shifts it from the US to Europe.

The only way I can see to get the desired goal of boosting Chinese consumption *and* shrinking the trade deficit is for China to expand the money supply to encourage spending, and for the US to expand it’s money supply enough more so that spending gets done on American goods.

The standard “beggar my neighbor” scenarios assume two mutually exchangeable currencies neither of which is a reserve currency, and I don’t think that they work in this situation where you have one non-convertible currency and the other which is a reserve currency.

What this means is that the US and China need to coordinate fiscal and monetary policies if the US gets what it wants, which means that we are really living in a brave new world.


1 Comment »

  1. You said, “Import barriers aren’t going to solve the problem because if you reduce the amount of Chinese goods entering the US, you reduce the dollars that Chinese can use to buy American goods.” Not true. If both imports and exports are reduced to zero, the U.S. wins big time because we end up with a balance of trade instead of a $350 billion per year deficit. That adds $350 billion to U.S. GDP.

    Also, you said, “The only way I can see to get the desired goal of boosting Chinese consumption and shrinking the trade deficit is for China to expand the money supply to encourage spending …” It won’t work. As in any nation that is grossly overpopulated, per capita consumption is limited by a lack of space for storing and using products.

    At this point, I should introduce myself. I am the author of a book titled “Five Short Blasts: A New Economic Theory Exposes The Fatal Flaw in Globalization and Its Consequences for America.” My theory is that, as population density rises beyond some optimum level, per capita consumption begins to decline. This occurs because, as people are forced to crowd together and conserve space, it becomes ever more impractical to own many products. Falling per capita consumption, in the face of rising productivity (per capita output, which always rises), inevitably yields rising unemployment and poverty.

    This theory has huge ramifications for U.S. policy toward population management (especially immigration policy) and trade. The implications for population policy may be obvious, but why trade? It’s because these effects of an excessive population density – rising unemployment and poverty – are actually imported when we attempt to engage in free trade in manufactured goods with a nation that is much more densely populated. Our economies combine. The work of manufacturing is spread evenly across the combined labor force. But, while the more densely populated nation gets free access to a healthy market, all we get in return is access to a market emaciated by over-crowding and low per capita consumption. The result is an automatic, irreversible trade deficit and loss of jobs, tantamount to economic suicide.

    One need look no further than the U.S.’s trade data for proof of this effect. Using 2006 data, an in-depth analysis reveals that, of our top twenty per capita trade deficits in manufactured goods (the trade deficit divided by the population of the country in question), eighteen are with nations much more densely populated than our own. Even more revealing, if the nations of the world are divided equally around the median population density, the U.S. had a trade surplus in manufactured goods of $17 billion with the half of nations below the median population density. With the half above the median, we had a $480 billion deficit!

    Our trade deficit with China is getting all of the attention these days. But, when expressed in per capita terms, our deficit with China in manufactured goods is rather unremarkable – nineteenth on the list. Our per capita deficit with other nations such as Japan, Germany, Mexico, Korea and others (all much more densely populated than the U.S.) is worse. My point is not that our deficit with China isn’t a problem, but rather that it’s exactly what we should have expected when we suddenly applied a trade policy that was a proven failure around the world to a country with one fifth of the world’s population.

    Ricardo’s principle of comparative advantage is overly simplistic and flawed because it does not take into consideration this population density effect and what happens when two nations grossly disparate in population density attempt to trade freely in manufactured goods. While free trade in natural resources and free trade in manufactured goods between nations of roughly equal population density is indeed beneficial, just as Ricardo predicts, it’s a sure-fire loser when attempting to trade freely in manufactured goods with a nation with an excessive population density.

    If you‘re interested in learning more about this important new economic theory, then I invite you to visit my web site at where you can read the preface, join in the blog discussion and, of course, buy the book if you like. (It’s also available at

    Please forgive me for the somewhat spammish nature of the previous paragraph, but I don’t know how else to inject this new theory into the debate about trade without drawing attention to the book that explains the theory.

    Pete Murphy
    Author, “Five Short Blasts”

    Comment by Pete Murphy — December 5, 2008 @ 9:02 pm

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