Tel pere, tel fils...(Hmmm edition)

Thank you, President Hu
China's inaction is the best America can hope for.
James K Galbraith and Warren Mosler


The US trade deficit just hit $686 billion (annual rate), prompting yet another round of hand-wringing, especially about American indebtedness to China. In a recent comment, economist Thomas Palley blamed the trade deficit for the alleged weakness of American economic growth, and China specifically for fueling the housing bubble by keeping US long-term interest rates low. Echoing this view, President Bush implored President Hu to do something. Mercifully, Hu promised no particular action.

Suppose (let's say) China decided NOT to sell us the $200-odd billion in goods they sold us last year. What would happen? Immediately, inflation would escalate, as exactly that many billions of dollars sought goods no longer for sale. Our Federal Reserve would respond with higher interest rates, and Congress might cut spending and raise taxes. We'd be out the goods, and China out the money. Would anyone be better off? Of course not.

Or suppose China decided to spend its dollar hoard, said to be nearing a trillion dollars, on oil, wheat, machinery and the good life. Inflation would then ignite as a boom in world prices for whatever China decided to buy. Once again, American living standards would fall - and our policy makers would again react quickly, making matters worse.

The conclusion is obvious. China does America a huge favor by shipping goods and hoarding the securities we hold for them in return. This has real costs for China, even though the Chinese do it for their own good reasons - it helps them manage their massive ongoing urbanization. But however you count it, the benefit to America and Americans is enormous.

Ah, but might it all come to a crashing end? Well, yes, it might. And some day the sun will explode and the universe collapse under the weight of the cold dark matter. But that's no reason to bring on the apocalypse if it can be postponed. So long as China wishes to sell goods and accumulate assets, why not accommodate and enjoy? Nothing stops them from giving or us from receiving, in mutual agreement.

Especially, in contrast to much rhetoric, there is no limit to the amount China can lend us, because in fact they aren't 'lending' at all. When a US consumer buys a cell phone with a credit card, for instance, she borrows the funds from a domestic bank. That credit creation provides the dollars that are paid to (say) Motorola (China). China then may exchange the dollars for a Treasury bond. That's purely an American portfolio shift. No 'foreign capital' is involved.

The net result: we do not depend on foreign savings to fund our trade deficit. As a matter of accounting and not theory, domestic credit funds foreign savings. The foreign sector depends on the US consumer's sustained ability to borrow, so that she can continue to purchase the goods they wish to sell to us, in exchange for the financial assets we hold for them. The only resources committed from China are the labor and components which built the phone in the first place.

And if some day they have two trillion in U.S. securities instead of one trillion, how exactly will that change the relationship between our countries, from what it is now? If some day China chooses to stop exporting above its imports, that will be because it needs the goods at home - not because it has more US securities than it wants.

What about national security? Those who fret over lost capacity in strategic sectors overlook a simple solution. Why can't the US government buy strategic goods from home producers, paying the premium necessary to maintain the desired domestic facilities? This is far less destructive than imposing inflationary tariffs or quotas, to keep out cheaper foreign products (such as steel) used by domestic manufacturers (such as of automobiles).

Finally, do imports cost American jobs? Yes they do, and those hurt by expanding trade should get help. But any failure to replace jobs lost to trade with better jobs is also entirely domestic. It lies in our failure to fund the new jobs we need for Americans willing and able to work. These can be private or public: that's a political choice. The US needs up-dated infrastructure, public spaces, cultural centers open and affordable to all; it needs better schools and the possibility for ordinary working people to live decent lives while working shorter hours; it needs stronger prevention and better preparation for disasters like Hurricane Katrina. China's willingness to furnish toys and TVs and cell phones at low cost makes it easier, not harder, to meet all of these needs. And if we fail to rise to that challenge, we have only ourselves to blame.

The 'innocent fraud' of 'borrowing from abroad' to fund our trade deficit diverts attention from real problems to false ones. And should one day those false problems disappear, then the real problems would become much worse. So, let's hope they don't, and in the meanwhile, we might say a word of thanks to the Chinese, instead of blaming them for what they do.

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According to the IMF and OECD definitions, direct investment reflects the aim of obtaining
a lasting interest by a resident entity of one economy (direct investor) in an enterprise that is
resident in another economy (the direct investment enterprise). The “lasting interest” implies
the existence of a long-term relationship between the direct investor and the direct
investment enterprise and a significant degree of influence on the management of the latter.
Direct investment involves both the initial transaction establishing the relationship between
the investor and the enterprise and all subsequent capital transactions between them and
among affiliated enterprises4, both incorporated and unincorporated. It should be noted that
capital transactions which do not give rise to any settlement, e.g. an interchange of shares among affiliated companies, must also be recorded in the Balance of Payments and in the
IIP.

The fifth Edition of the IMF’s Balance of Payment Manual defines the owner of 10% or
more of a company’s capital as a direct investor. This guideline is not a fast rule, as it
acknowledges that smaller percentage may entail a controlling interest in the company
(and, conversely, that a share of more than 10% may not signify control). But the IMF
recommends using this percentage as the basic dividing line between direct investment and portfolio investment in the form of shareholdings.

Thus, when a non-resident who previously had no equity in a resident enterprise purchases 10% or more of the shares of that enterprise from a resident, the price of equity holdings acquired should be recorded as direct investment. From this moment, any further capital transactions between these two companies should be recorded as a direct investment. When a non-resident holds less than 10% of the shares of an enterprise as portfolio investment, and subsequently acquires additional shares resulting in a direct investment (10% of more), only the purchase of additional shares is recorded as direct investment in the Balance of Payments.

 The holdings that were acquired previously should not be reclassified from portfolio to direct investment in the Balance of Payments but the total holdings should be reclassified in the IIP.

Concerning the terms direct investor and direct investment enterprise, the IMF and the
OECD define them as follows. A direct investor may be an individual, an incorporated or
unincorporated private or public enterprise, a government, a group of related individuals, or a group of related incorporated and/or unincorporated enterprises which have a direct
investment enterprise, operating in a country other than the country of residence of the
direct investor. A direct investment enterprise is an incorporated or unincorporated
enterprise in which a foreign investor owns 10% or more of the ordinary shares or voting
power of an incorporated enterprise or the equivalent of an unincorporated enterprise.

Direct investment enterprises may be subsidiaries, associates or branches. A subsidiary is
an incorporated enterprise in which the foreign investor controls directly or indirectly
(through another subsidiary) more than 50% of the shareholders’ voting power. An
associate is an enterprise where the direct investor and its subsidiaries control between
10% and 50% of the voting shares. A branch is a wholly or jointly owned unincorporated
enterprise.