What Happens When Money Flows Uphill

Forbes: Helen H. Wang

Many people in the U. S. believe that the Chinese currency yuan is undervalued by 25-40 percent, which causes large trade deficits between the U. S. and China and costs hundreds of thousands of American jobs. Last month, the House of Representatives passed a bill that would allow the Commerce Department to impose tariffs on Chinese goods.

While there are many debates about the pros and cons of forcing the yuan to appreciate, few have paid attention to the root cause of America’s trade deficits. Stephen Roach pointed out that the United States has trade deficits with 90 countries around the world. The reason is that Americans don’t save. In 2009, America’s net saving rate was negative 2.3 percent. The United States has been borrowing from China and other countries to make up the gap.

To examine how America got itself into indebtedness, Nobel prize-winning economist Joseph Stiglitz argues that the current global financial system causes money to flow uphill from poor countries to rich countries, and it’s self-defeating.

Historically, reserves were held in the form of gold. After World War II, the U. S. dollar replaced gold as the reserve currency because of the dominance of the United States in the world economy. As a result, all the developing countries have their foreign exchange reserves in dollar-denominated assets. Especially since the 1997 Asian financial crisis, in which the International Monetary Fund demanded high interest rates to bail out banks, developing countries have stocked up on reserves for fear of losing their national economic sovereignty.

Because the reserves are held in strong economies’ currencies, the money is flowing uphill from poor countries to rich countries. The United States receives most of the benefits of the reserve system, with all of those dollar reserves acting as low-cost loans to the US.

Stiglitz predicted in his book, Making Globalization Work, that eventually reserve currencies such as dollar would depreciate, making them ill-suited for reserves. Reserve countries such as the United States are tempted to obtain low-cost loans and grow into debt, which causes instability in the world economy.  This is exactly what is happening to the dollar.

Clearly, America’s indebtedness and the weaker US dollar have become a major cause of global financial instability. As Stephen Roach suggested, anchoring yuan to the world’s reserve currency, the dollar, and allowing it to gradually appreciate is a reasonable strategy “to maintain financial stability in an all-too-unstable world.”

The world economy has increasingly become interrelated and interdependent. In particular, the US and Chinese economies are intermingled. Bilateral trade between the United States and China has increased dramatically, from $7.6 billion in 1985 to more than $400 billion in 2009. Any trade sanctions and retaliation between the two countries will be self-destructive.

Yes, large imbalances exist in both the Chinese and US economies. Interestingly, imbalances in both countries mirror each other. On a macroeconomic level, China produces more goods than it consumes. The United States consumes more than it produces. On a microeconomic level, China has a very high household saving rate, accounting for about 25 percent of its GDP. The United States has been overspending for many years.

Something needs to be done to rebalance both economies, and that process has already begun. In the United States, the global recession provided the incentive for people to spend less and save more. In China, the rise of the middle class is shifting the economy more towards consumption.

While the United States should pressure China to liberalize its exchange rate to reflect market forces over time, we must oppose any form of protectionism, as it is a recipe for disaster. Trade is the only way to keep growing our way out of our imbalances.

The United States and China have a lot to learn from each other. For overspenders, revisiting the virtue of frugality can help them get back to economic fundamentals, such as not spending beyond their means and saving for a rainy day. For oversavers, healthy spending provides another vehicle for robust economic growth. In China, it means improving the social safety net and reducing the need for saving.

As China’s and U. S. economies become more balanced, they will become even more interdependent as America exports more to China. This will produce more prosperity in both countries, yielding a virtuous circle of more growth, more interdependence, and more balance, driven in good measure by the growth of the Chinese middle class.

(This article is adapted from The Chinese Dream).

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