China’s Currency & USA’s Problems
Well, it looks like the US has really begun to fall into the red. Reading through the Wall Street Journal today in full, it would seem like the problem mainly lies with China. Is it really China’s fault, though?
US Net Investment Income Goes Negative
In an article titled “U.S. Foreign Debt Shows Its Teeth As Rates Climb”, the true measure of the debtor / creditor status of the US is explained, what the article calls net investment income. Net investment income is defined as Income from investments abroad – payments to foreign creditors. Net investment income has been positive for years, but this is now changing, as they outline in the article:
Now, however, the easy money is coming to an end. As interest rates rise, America’s debt payments are starting to climb — so much so that for the first time in at least 90 years, the U.S. is paying noticeably more to its foreign creditors than it receives from its investments abroad. The gap reached $2.5 billion in the second quarter of 2006. In effect, the U.S. made a quarterly debt payment of about $22 for each American household, a turnaround from the $31 in net investment income per household it received a year earlier.
How could net investment income remain positive for so long with the current account trending down for so long? According to the article, the difference mainly lies in the spread between rates of return that US investments abroad average vs. the rates of return that the average holder of US investments earn. This is explained well by the article, as follows:
Most economists, however, see a more prosaic explanation: Foreigners have been willing to accept a much lower return on relatively safe U.S. investments than U.S. investors have earned on their assets abroad. Take, for example, China, which since 2001 has invested some $250 billion in U.S. Treasury bonds yielding around 5% or less — part of a strategy to boost its exports by keeping its currency cheap in relation to the dollar.
By contrast, U.S. direct investments abroad — which would include things like glass maker Corning Inc.’s liquid-crystal display plants in Taiwan or Intel Corp.’s chip-making subsidiary in Ireland — have returned an average 8% since 2001, according to U.S. Commerce Department data. Meanwhile, U.S. investors in emerging-market stock funds earned an average annual return on their investments of 22.3%, according to financial-research firm Morningstar Inc. (The Commerce Department counts only part of that as income).
But the article goes on to say that the large gap of returns on investment can’t be sustained forever, as foreigners will either demand higher interest payments for holding an ever increasing amount of US debt (which they would seem unlikely to do as this will dramatically reduce the value of the debt they hold currently), or shift into other higher yielding investments. Either ‘solution’ would put a major burden on US consumers, who would have to either work harder to maintain the same standard of living, or buckle down and pay off the outstanding current account deficit to bring things back into balance.
Of course, all of this is occurring at the same time as a number of other related challenges face the US economy. The housing market has reached a peak and looks like it will only go down from here for many years to come. Oil may come down in the short term but in the long term we are likely to face energy prices that are about in line with what we see today. These three factors (high consumer and government debt levels, the housing bubble, and high oil prices), when combined, make for an explosive situation that will not be easily resolved.
Two Solutions to US’ Problems
In my opinion, there are two possible solutions: Very high inflation and all its attendant costs, or buckling down and reducing our consumption as a nation by very large amounts while paying off the outstanding debt. Or a combination of the two. High inflation would lower the value of the large amounts of debt that foreigners and US consumers hold, making a deflating of the housing bubble not as painful since nominal values could stay at about the same level or go higher as real prices plummet, and making it much easier for the US to service foreign debt payments. If inflation does not shoot up, or worse turns into deflation, we are in for an even more painful experience over the next five to ten years as the weight of the debt that foreigners and home owners hold will be crushing.
Pointing the Finger at China
So back to the pointing of the finger at China. There are a large amount of people that believe China keeps her currency at an artificially low value, thereby causing US consumers to consume more Chinese made goods & lose jobs to China. This argument is not without merit, but it doesn’t place a strong enough emphasis on the benefits to the US consumer in the form of lower prices. Unfortunately, these benefits seem to be of short duration, as we as a nation are watching our wealth slowly trickle away in the form of a widening current account balance.
The truth is complicated, but it seems to be that if the Chinese yuan dramatically appreciated in value, in the short term the US consumer would be devastated. They would have to cut back dramatically in their spending, and many more would likely lose their homes than is going to be the case already. China would also suffer a serious economic slowdown, if not *gasp*, a recession. It seems unlikely, yes, and the more likely solution seems to be a gradual revaluation of the Chinese currency with an inflation guided policy by the Fed.
Revalue the Yuan: What about the Costs to the US Economy?
The strange thing is that so many people call for the revaluation now. The consequences of this are seldom fully mentioned, instead stemming the losses of manufacturing jobs is cited as the main reason and result for such an action. What isn’t mentioned are the attendant immediate costs to the rest of the economy. From the Wall Street Journal today as well:
We appreciate that China’s banking system is not yet ready for a fully floating currency, but we also agree with most mainstream trade economists that gradual currency appreciation is possible without disrupting their “harmonious society.” We have been patient and reasonable, but the time for patience has run out. The workers and manufacturers in our states rightfully demand a level playing field. To those who say we should do nothing, we ask: How much longer are they willing to wait?
Unfortunately, the Chinese appear to be content with the status quo. Their exports to the United States create millions of Chinese jobs and have allowed China to become the second-largest holder of U.S. government bonds in the world. They have no reason to change unless we send a very strong message that the status quo is not acceptable.
Again, China is blamed for the US’ current situation. The question is, should the blame really lie with China or should we instead look within and at our own consumption habits? No one forced the plasma screen TV or new set of furniture from IKEA onto you that likely came from China (and that a fair portion of US consumers financed through mortgage equity financing). If the US had a sacrifice now & save mentality, we would not be in the mess we are in right now, in terms of either the current account deficit or the skyrocketing costs of houses.
It is an unfortunate reality that US workers are not competitive for quite a few manufacturing jobs. Revaluing the Chinese currency would only provide a slowing of the bleeding that is occurring in this industry, it will not bring back lost jobs. The key to America’s future is not forcing China to do things they are unwilling to do, it is buckling down, saving as much as one is able to, and using this extra money in intelligent, productive investments (and to pay off outstanding debt).
The US Should Live Within Its Means
We are still the most wealthy nation by an enormous margin. Instead of slowly pissing away this advantage through momentary pleasures and buying things we in no way need, we should be educating ourselves on the importance of living within our means and investing to make the world both a better & more productive place. And buying bigger houses for ever higher (soon to be ever lower, in real terms for a long, long time) prices, does not cut it as an intelligent investment or living within one’s means. For a much better argument on this entire subject, see what the world’s most successful capital allocator has to say here.