Who's Afraid of the Mercantilists?
Ever since Adam Smith and David Ricardo, mainstream economists have mocked mercantilists. Economic historians are not so dismissive. They remind us no nation has ever industrialised without some sort of trade barrier. Even Britain, the ideological birthplace of free trade, imposed tariffs on Indian textiles in the 18th century, protecting Lancashire manufacturers from competition and perhaps sparking the industrial revolution. Export led growth and industrial policy have brought jobs and prosperity to 19th century Germany, 20th century Japan, and now 21st century China. The key difference between mercantilists and free traders is one of outlook. Free traders see consumption as the goal of the economy. Mercantilists believe it is production.
For the last forty years, the global
economy has been based on an arrangement between producers and consumers,
between creditors and debtors. Certain
nations, such as China, Japan and Germany, are mercantilist. They work hard and
produce more than they consume. Every year they sell more goods and services to
other countries than they import from
them. For mercantilists, the key to economic happiness is a trade surplus. Other nations, such as the US, the UK, Spain
and Greece have trade deficits with the creditor nations. That means that every
year, they are able to consume more than they produce. They are the
grasshoppers of the world economy. Germany and China, on the other hand, are the ants. By producing more than they consume, they
save. And those savings don’t stay at home but rather are lent to
the consuming nations, which use them to buy manufactured goods from the
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Why do the mercantilists allow such an unequal pact? Jobs. We get cheap goods and services, they get jobs. Our intuition tells us that power should be in the hands of the producers. The free traders should be the supplicants, desperate for specialty steel and consumer electronics, desperate for loans so they can live beyond their means. But surprisingly, control of the relationship, even if they don’t realise it, lies with the consuming nations.
Science moves forward by explaining anomalies, explaining events that according to existing theory should not be, so riddle me this. The United States is richer, more developed, has more capital than China. China is growing much faster. According to standard development theory and all the macroeconomic textbooks, capital should flow from the slower growing United States, seeking higher yielding investment opportunities in China. Instead capital is flowing uphill from labour rich China to capital rich America, from the fast growing less developed nation to the stagnant, sclerotic economy to the North.
Today, US Treasury bills, where the Chinese Central Bank parks its trillions, pay under 0.5%. The Chinese economy, even as it is slowing down to a mere 7.5% growth rate, still should provide more profitable investment opportunities. Why don’t the Chinese keep their money at home? During the boom, the period called at that time (but not so much any more) the Great Moderation, self-satisfied apologists for the status quo told us that the Chinese desire to invest in America spoke to the West’s deep, liquid, and safe financial markets. The tranquillity and safety of our financial system is not as obvious these days. It is not inconceivable, should the dollar devalue, that the Chinese will take a spectacular hit on their dollar investments. So why are the Chinese even more desperate to lend us money than we are to borrow it?
You know the answer. They lend us money so we can afford to buy their goods. The mechanism isn’t identical to Sears and Roebuck extending credit to Nebraska farm families in 1911 so they could buy sewing machines with no money down but the essence is the same. Mail order catalogues sold goods on credit because otherwise they could not move their stock. The Chinese Central Bank sells renminbi and buys dollar denominated bonds in order to keep their currency undervalued, which in turn keeps their manufacturing exports cheaper. Were they not to buy US bonds, Chinese export sales would plummet.
The Japanese and Germans did it in the 1950s, the South Koreans did it in the 1980s, it is the classic strategy behind export led growth, to maintain an undervalued currency so that exports are cheap while your domestic market is safe from foreign competition. Tariffs have become passé in most of the world but a cheap currency does the same trick. By lending America money, China lowers the value of the renminbi, thus stimulating exports and so allowing the Chinese labour markets to absorb the 30 million new workers a year fleeing rural poverty.
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Who needs whom? Every month Americans purchase between 30 and 40 billion dollars worth of manufactured goods from China. It sells them barely $9 billion worth of goods and services, less than a third as much as it buys. Meanwhile, the US owes China close to 10% of GDP. The Chinese government alone owns over $1 trillion of US government bonds. In practical terms, the US government budget deficit is financed by Chinese money. Without cheap Chinese goods, US inflation rate would be higher. Without their loans, so would interest rates. This implies that America should kowtow to China but the story is more complicated.
Imagine, for whatever reason, that the $500 billion a year trade between China and the US evaporated overnight. In America, prices at Wal-Mart would skyrocket, Americans would have to pay more for clothes and flat screen TVs but in China, factories would close, jobs would terminate, and political turmoil would ensue. Without demand from Europe and America, without an ever growing export sector absorbing rural labour, without new jobs for those peasants who don’t want to be peasants any more, the Chinese government could begin to lose legitimacy. The Chinese Communist Party retains the allegiance of the people because it has promised and delivered economic growth. Americans would grumble if they had to pay more for cotton goods but American democracy would undoubtedly survive. The Chinese Communist Party might just not. Today the producers need the consumers more than the other way around.
Within Europe, Germany plays the same role as China in the world economy. During the boom, German banks lent money to the southern European nations that then used those funds to stimulate demand and purchase German manufactures. Without those loans, factories in Stuttgart would be idle. A break up of the euro will be more devastating to German workers than to Spanish consumers. Should the euro dissolve into its constituent parts, the southern periphery will immediately become much more competitive in world markets. The revived D Mark, no longer held down by Spanish weakness, would appreciate dramatically, bad news for Germany’s manufacturing export sector. Remember, during the fall and winter of 2008, when the real estate bubble popped and the financial system tottered on the brink of disaster, it wasn’t the bubble economies of the US and Great Britain that contracted the most, it was economies like Germany and China which sold manufactures to the bubble nations.
In the 18th and early 19th century, Great Britain suffered a terrible balance of trade deficit with China. British consumers desperately craved Chinese tea and adored their manufactures but China was uninterested in anything the British had to sell. All the Chinese wanted was silver (this of course was the inspiration for the Opium Wars). The West got tea and porcelain and silk and lacquer ware. In return the Chinese received shiny bits of metal. Today, the exchange seems similar. We get stuff, they get T-bills, bits denominated in foreign currency. Our natural intuition is that the creditor has the whip hand but that assumption may well be out of date. These days, China needs America, Germany needs Spain, more than the other way around. Don’t fear the mercantilists.