Chin Music for China

Last month, two guys known for being handy with slide-rules were trash-talking about balls and bats. Paul Krugman of Princeton University proposed policy hardball over China manipulating its currency. Stephen Roach of Morgan Stanley said that was wrong and suggested taking the bat to Krugman.

Look, I may have been the last pick of every ball team I ever played on, but I have been in Chinese business and finance since 1986 and I have some things to interject between the heavy hitters.

For years we have heard the words “currency manipulation” and “China” together so often that they sound as natural as “Mantle and Maris”. But the yuan was stable from 1994 to 2005, it rose almost 20% against the dollar in the next three years, and has been stable since then. Stability like this is not most people’s idea of “manipulation.”

Those who talk about China manipulating its currency are trying to de-legitimize its fixed exchange rate system, but it is legal and valid. The articles of agreement of the International Monetary Fund permit nations to choose fixed exchange rate systems. When the United States pressured the IMF to condemn China’s arrangements, the IMF responded with the brush-back. In 2005, Managing Director Rodrigo de Rato said there’s no evidence of manipulation for competitive gain: “There is a strong argument by the Chinese authorities that their main objective . . . is the stability of the economy.”

Still, the criticism of the Chinese returns with a regularity that it is more Groundhog Day than Opening Day. In 2004, Senator Chuck Schumer said that “many economists estimate that the yuan is now undervalued by between 15 and 40 percent.” In 2009, he said, “China’s currency remains between 21 and 40 percent undervalued against the dollar.”

What happened between 2004 and 2009? As we’ve seen, the Chinese currency appreciated against the dollar. Since the currencies of other countries appreciated about as much, it did not change the context of the US-China trading relationship. The American side can therefore keep on claiming up to 40% undervaluation of the yuan as the dollar drops.

Let's focus on that point. The US dollar has declined in this decade against other currencies in response to American economic conditions and policies that drive it down. Yet the American view is that the yuan is manipulated just because it tracks the dollar’s slide.

It’s wrong-headed, as is the implicit American view that exports will rise if we just weaken the dollar enough. If exchange rates were the key factor in trade competitiveness, then Mexican imports would have streaked ahead of Chinese in the US market at times of peso weakness and Zimbabwe would be the biggest bat in world trade.

Worse frustration is to come. Partly in response to US pressure, partly for its own good reasons, China will alter its currency peg – yet absent other major structural changes, this will not swing the trade balance.

American exporters export, whatever the exchange rate. In the most recent reported quarter, exports accounted for a big 1/3 of the value of goods produced. No one with an idle plant in Paterson NJ is basing the decision to restart production mainly on the Chinese yuan exchange rate.

However, goods production is down to just 23% of GDP. The US economy has gone post-industrial. Clearly our trading partners only buy our manufactures to the extent that we manufacture. They buy none of the output of our government sector. They buy some services, but in a recession they too have less need of services in which American business specializes.

Here’s a difference between Chinese and American business today. A Chinese entrepreneur might as well try his hand at manufacturing, but the American thinks long and hard before taking up the regulatory and tax burdens of making a product for sale.

It's one reason serviceable industrial parks hereabouts rent to ballet schools, medical offices, day care centers, basketball clinics, gymnastics facilities, skate parks, art studios, martial arts gyms, fitness centers, houses of worship, schools, and even government offices, but less and less to industry.

China's scouts might look at Japan’s play since the last time it contended, and conclude China has little to gain by playing ball with the Americans. There was a huge rise in the value of the yen from 250 to the dollar in 1985 to 90 in 2009. However, this neither stopped the US from placing trade restrictions on Japan, nor dissuaded the Japanese from investing heavily here. And after all that, America runs about the same trade deficit with Japan now as it did in 1985.

At that time, by the way, one Chinese yuan bought 75 Japanese yen. In 2009, it bought only 13, but despite that, Japan still runs a trade surplus with China.

In neither situation was the exchange rate the key factor.

Working Man’s Blues: Employment Trends in Democrat States Lag

During the past winter of discontent, New Jersey Governor Chris Christie emerged as a model and example of political reform. A young Republican who routed a wealthy Democrat incumbent in a solidly blue state, Christie keeps on surprising. He is making a serious effort to rein in government expenditure, declaring that a "state of fiscal emergency exists in the State of New Jersey" and instituting deep cuts. It brings him into conflict with state workers whose lush packages are at the root of the problem, as well as the Democrat establishment whose patronage system created it. But taxpayers appreciate the governor’s position that they have already been milked dry, and seem willing to give spending discipline a try.

It is a changed day when developments in New Jersey furnish a positive example. In the December 30 2008 edition of the Wall Street Journal there was an arresting article entitled "New Jersey Is the Perfect Bad Example." In it, William McGurn showed that the government sector added 93% of all jobs created in New Jersey from 2000 to 2007.

The BLS data for the full ten years to February 2009 underscore McGurn’s findings and fill in some other unsettling information as well. The government employment growth was entirely at state and municipal employment level, and made for 91% of the increase in total NJ employment, while the federal government, the US Postal Service, and the Department of Defense all shed jobs. The goods producing sector is in a headlong free-fall, losing 138,600 jobs in the decade. One-third of manufacturing jobs disappeared. Now government workers outnumber manufacturing workers five-to-two, making a mockery of the old motto "Trenton Makes, The World Takes." One-third of Garden State workers now work for the government or in health care, which increasingly is much the same thing.

Does anyone imagine it is satisfactory or sustainable that an important state’s economy hardly generates employment outside the government sector?

McGurn’s work invited me to extend the analysis to goods-producing, service, and government employment in all states plus the District of Columbia. There is also the question of party political environment: he blamed New Jersey’s sorry state of affairs on its Democrat-dominated political culture and its high-taxing, heavily-regulating, pro-union, and anti-business ways, but does that bear up to analysis, and if so, does it apply more generally?

To try to get to grips with party politics in all states through time, I researched affiliations of the governor and two senators and the plurality of the House of Representatives delegations and the state senate and legislatures for each year since 1990. I assigned a +1 for a Republican in a year, and -1 for a Democrat, so a state that had a Republican governor in a year, with a Senator of each party, majority Democrat state senate and state legislature, and a Congressional delegation split exactly down the middle would +1 +1 -1 -1 -1 0 for a score of -1 for the year. The most solidly Democrat blue state would thus be -6 year after year, the firmest red Republican +6.

Two next door neighbors, Washington and Idaho, bracket the ranking of the 50 states plus DC by political complexion, from most Democrat to most Republican:

>> bluest: WA DC WV MA AR NJ CA MD IL HI DE
>> next: NY VT IA WI RI MI OR CT ME NC
>> middle: NM MN MT LA COPA NH ND IN TN
>> next: SD VA MS NV AL MO NE KS OK FL
>> reddest: KY OH AZ SC WY AK GA UT TX ID

The BLS employment data show that government is not just New Jersey's growth industry – it has been a growth industry in most states, blue or red. Only in a handful of places has government employment been static or falling: MA, MI, NY, DC, and RI. Yes, they are blue states. But most of them have another issue: in general, they are losing population. That is the dominant factor, not party in power.

The predominant pattern in the last ten years has been for employment in goods-producing industry to decline, in service-providing business to grow somewhat, and in government to grow fastest of the three. That pattern is seen in no fewer than thirty-seven states: AL, AK, AZ, AR, CA, CO, CT, DE, FL, GA, IL, IN, IA, KS, KY, MD, MS, MO, NE, NV, NH, NJ, NC, OH, OK, OR, PA, SD, TN, TX, UT, VT, VA, WA, WV, and WI (in MI government declined, but more slowly than other employment). Government grows at the expense of goods production. In the limit, this places fiscal drag on the economy, which reinforces the original destructive trend and makes it worse. That is New Jersey’s experience.

The states that have experienced the greatest declines in employment in goods-producing industry are (worst first): RI, MI, NJ, CT, NY, NC, OH, ME, MA, and PA. These states are mostly unionized, mostly northeastern or midwestern, and mostly Democrat. The states that have done best in growing employment in goods-producing industry are (worst first): NE, CO, NM, SD, ID, MT, UT, WY, NV, and ND. Near runners-up were TX, AZ, and OK. These states are mostly right-to-work, mostly western, and mostly Republican. Only in strongly Republican Wyoming is employment growth in goods-producing industry consistently positive and higher than either services or government.

Employment in goods-producing industry need not be the holy grail of all economic policy. If someone leaves a job in the declining textile industry in North Carolina, retrains as a radiological technician and gets a better job in that field, no one argues that either that person or North Carolina are worse off.

The problem is when employment in the goods-producing sector as a whole is in total headlong decline. That means industry is giving up on a place. That means industry prefers to take its chances with an administration run by Chinese Communists than by Michigan Democrats.

Of course, productivity has improved the most in goods producing industry, meaning fewer workers are needed to do the same or greater work. This is good. But other things being equal, rising productivity itself should incentivize capital to form in a place and employ workers. If it is not enough, then workers are not sharing in the benefit of their productivity and other things are wrong. Politicians then must ask what else is needed to attract and retain industry. Republicans reliably ask that question. Democrats ask instead what other self-defeating social costs and regulations they can impose on job-creating enterprise, with the dismal results that are here to see.

And this is true despite meaningful regional variation: a Democrat is not the same wherever you go, and neither is a Republican. A Maine Republican is a very different animal than a Texas or Wyoming Republican; in fact, some say it is a RINO. A Mississippi Democrat in 2009 is not ever the same as a Massachusetts Democrat, nor does he necessarily resemble a Mississippi Democrat of twenty years ago.

And speaking of Massachusetts, in connection with the special election there on January 19, the Bay State was commonly referred to as "the blue t of all blue states." It turns out that this is incorrect, and not just because it put Scott Brown (R) into the Senate – Massachusetts is less blue than Washington DC, Washington state, and West Virginia.

Which way does causation run? Are the growth states of the West Republican because they are growth-oriented, or growth-oriented because they are Republican? I would like to think the effects are mutually reinforcing. It makes sense that employment grows in right-to-work states because it can, without restriction. The great Milton Friedman said, "Capital goes where it is welcome and stays where it is well treated."

This much seems clear: the high taxes, restrictive employment conditions, and regulatory activism of the Democrats are utterly failing the working man. In the Democrat fastness of the post-industrial Northeast and Midwest, workers have little to show for their long-term political investment in the party of Roosevelt and Johnson.

American Disease, 2010

Ann Elk: Where? Oh, what is my theory? This is it. My theory that belongs to me is as follows. This is how it goes. The next thing I'm going to say is my theory. Ready?

TV Interviewer: Yes.

Ann Elk: … This theory goes as follows and begins now. All brontosauruses are thin at one end; much, much thicker in the middle; and then thin again at the far end.

(From Monty Python’s Flying Circus)

I too have a theory, which is to say it is a theory and it is mine. I hope it’s a bit less silly than Ann Elk’s theory, but in any case let’s try it on. The next thing I’m going to say is actually not my theory, but another theory, which is someone else’s and got me to thinking about my theory.

This other theory is something called Dutch Disease, which is an economic diagnosis of the Netherlands’s loss of competitiveness in goods producing industries following a 1959 discovery of natural gas off its North Sea coast. In the simplest terms, this led to inflows of investment, which pumped up the exchange rate and altered terms of trade in such a way that exports became uncompetitive. In this perverse fashion, Dutch Disease describes how a lucky strike in natural resources creates not employment and growth but unemployment and stagnation.

America, my theory proposes, has a version of that, only the resource is money. I want to name the problem “American Disease,” but I read in an article by Bryan Caplan that that's the name of a syndrome of Americans living beyond their means. Actually the problem I pose is closely related, just as H1N1 influenza is closely related to other strains of the flu. Perhaps I can say “American Disease, 2010” to differentiate it from old established strains, or should I call it “California Disease” to reflect the fact that the disease has advanced furthest in the Golden State?

America is a country with real natural resources, of course, but the high costs of extraction and environmental compliance and restrictions on land use places them increasingly out of reach. In the days when the country did produce resources and processed them into manufactured goods which foreigners bought, the U.S. generated a vast amount of wealth, much of which was invested in buildings and infrastructure. These remain visible in the present day, residual wealth as monuments to our peak of economic power.

(Exactly the same is true of Argentina, by the way, which was the wealthiest country in the world 100 years ago and still has the buildings and boulevards to prove it, even though Mr. Juan Peron and the generals set the country on an unusual course from first world to third world status.)

Now, even after the financial crisis, America’s most important industry is finance, broadly defined. The financial industry differs from the auto industry and the chemicals industry in one interesting respect. The auto industry inputs steel, glass, and plastic and outputs autos; the chemicals industry inputs primary and intermediate materials and outputs finished chemical products – in other words, they work on raw and intermediate goods and change them into something else. Most industries do this. But the finance industry has money both as input and output – it changes money’s form but not its nature in its processes. Money is both the input and the output, the resource base and the finished product.

The American finance industry is competitive, one of the nation’s success stories in terms of services exports. Our political class, which increasingly impedes us from taking coal out of our mountains, irrigating our farmlands, and manufacturing products with processes that are not squeaky clean, has long promoted clean, non-polluting financial services, and it has prospered as the industry prospered.

However, I believe that too much money in an economy based on financial services has given us a condition akin to Dutch Disease. It could probably be shown that the maintenance of the U.S. as a financial center has made the American dollar stronger than it would otherwise have been, reducing our competitiveness in global markets for tradeable goods and services. Moreover, the high level of compensation in the financial industry and supporting services has probably driven up wages and benefits right across the U.S. labor economy, another blow to the competitiveness of any entrepreneur bold enough to defy the odds and manufacture a product for sale in America.

While the American political class stands in the way of development of our (real) natural resources and domestic manufacturing, it does see the residual financial wealth of the nation as a resource that it can cut and drill and strip mine – endlessly, in fact, as it recognizes no restraint on the size of resource, but treats it as effectively infinite. The people entrusted to run the country give no thought to the necessary diminution of the resource as taxes, penalties, and compliance costs leave less and less to reinvest, even as the potential returns on investment are inevitably being reduced. They use static models that fail to capture the fact that producers will not produce – or innovate, or hire – out of sheer altruism and public spirit while the returns on their capital and labor are collapsing.

The impoverishment of the United States by the Argentine model is thus well under way.

Oh, and why do I say California has the most advanced case of the “American Disease, 2010?” Well, just look at the Golden State. There is oil offshore, but its development is not permitted. Manufacturing is being driven out. And the Central Valley is experiencing 40% unemployment in agriculture in order to protect mudfish habitat; but California's fiscal position continues to deteriorate as its political class absolutely will not live within its means, as dictated by the state’s reduced economic circumstances.

As California is the United States only more so, California’s political class is America’s in microcosm, with all its pathologies subjected to magnification.

The mindlessness with which the American money resource is to be run down puts me in mind of a passage from Atlas Shrugged:

As they proclaim their right to consume the unearned, and blank out the question of who's to produce it—so they proclaim that there is no law of identity, that nothing exists but change, and blank out the fact that change presupposes the concepts of what changes, from what and to what, that, without the law of identity no such concept as 'change' is possible. As they rob an industrialist while denying his value, so they seek to seize power over all of existence while denying that existence exists.

Employment in Manufacturing & Government & the Deficit with China

Around the 20th of January, I heard a couple of talkers on business news and talk radio note that government employment had exceeded manufacturing employment in the United States. When I looked into it, I found the origin of this meme at a blogpost of Fabius Maximus entitled America passes a milestone!, with interesting charts and analysis. The charts are from subscription site Contrary Investor. Instapundit, Dr. Melissa Clouthier and Citizen Paine are among the analysts who picked up the story from Fabius, and well done to him.

But I wanted to see the original data, and I found it on one of my favorite sources for primary material, the website of the Bureau of Labor Statistics, for which the relevant interactive dialog box is here.

It is the work of a few minutes to find that, yes indeed, according to BLS, the non-seasonally-adjusted figure for workers employed in the goods producing sector of the US economy was set preliminarily at 21,404,000 for 2008, down from 22,221,000 in 2007, while the comparable employment-in-government figures were 22,457,000 preliminarily for 2008, up from 22,203,000 in 2007.

The services sector is bigger than both put together, with a preliminary 115,648,000 employed for the year 2008.

It was two days after Fabius's article that Timothy Geithner had his confirmation hearings in the Senate Finance Committee. One of the hostile Senators, Jim Bunning (R-KY), roasted Geithner over the US-China trade and financial relationship. He got started in his opening statement:

Thank you, Mr. Chairman.

The financial crisis we are experiencing today did not happen overnight and it could have been avoided. As Mr. Greenspan now admits, the easy monetary policy that he and Mr. Geithner championed at the Federal Reserve created an asset bubble. Large capital inflows from countries like China, for the purpose of keeping its currency low, contributed to the bubble and they went unchecked. But, the collapse of the bubble would not have been so devastating if Mr. Geithner had been effective in his role as a regulator. . . .

. . . and in questioning he was if anything tougher, blaming Chinese manufacturers and workers, in effect, for the financial crisis in which we now find ourselves. This, I believe, is a dangerous new aspect of international financial and trade relations, as I stated in my posting of January 26.

It strikes me that there is a direct line between the manufacturing implosion and the current account deficit with China and certain other trading partners, if anyone just cared to draw it. And there's not a thing Mr. Geithner could have done about it in his role as a regulator.

The capital inflows that so trouble Senator Bunning are just the flip side of America's trade deficit with that country. It's a matter of double-entry accounting identities, rather than any cunning device to "keep its currency low."

It can be shown -- I have done the work, and will put it here at some point -- that a portion of the trade deficit with China is really with American companies who have investments there.

Nevertheless, it is clear that the US economy has gone post-industrial.

Our trading partners will not buy our manufactures if we do not manufacture.

They will buy very little of the output of our large and growing government sector.

They will buy some of our services, but of course in these times of financial crisis and straitened circumstances, they too have less need of the financial and creative services in which American business specializes.

Our trading partners will buy hardly any of the spa, tanning, psychotherapy, handyman, coaching, self-actualization, pet grooming, personal-shopping, kitchen-designing, dog-walking, SAT-essay tutoring, Search Engine Optimization consulting, skateboard training, party-planning, eBay-auctioning, credit-counseling, baby-sitting and similar personal services in which a huge number of Americans now occupy themselves and try to scratch a living.

An entrepreneurial Chinese person might as well try his hand at manufacturing. An entrepreneurial American might as well shoot himself in the head as try his hand at manufacturing. The thought of going into the business of manufacturing a product for sale, with all the nightmares of taxation and regulation that go with that in the United States in the year 2009, is not for the faint-hearted among the business-minded.

And that is why perfectly serviceable industrial parks near my home in New Jersey are rented out to ballet schools, medical offices, day care centers, basketball clinics, gymnastics facilities, skate parks, senior centers, art studios, martial arts gyms, fitness centers, churches, mosques, schools, and even government offices, but hardly at all to industry.

If this cannot be changed -- and if anything the anti-manufacturing tide is still at the flood stage -- then how can the US current account deficit be anything but a huge long-term structural problem for us?

The Household Initiative Plan is posted at Household Initiative Plan Blog