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It’s certainly no secret that I’ve been a huge critic of China’s Dollar peg.  I’ve argued for a long time that it creates economic distortions that are very unbeneficial to the average Chinese citizen; as well as causing some harm to external economies, such as the United States.

In the past, I’ve focused a lot on how this policy creates overproduction.  It’s easy to see why this is the case, given that the most obvious result of the currency peg is a massive oversupply of real estate and other fixed assets, which have given rise to the concept of entire newly-constructed “ghost cities”.  Yet, let’s not forget about the other side of the equation: underconsumption.

Currencies and Pegs

A currency peg isn’t necessarily detrimental to a nation, but it can become a very tricky balancing act.  A small nation or an economically weak nation might adopt a US Dollar peg in order to convince foreigners to invest capital there. It could also help create some stability for a smaller nation.  However, a currency peg can also be a very dangerous instrument, since it is, more or less, a price control.  Not only is it a “price control”, but it’s a price control that affects the price of every single good and service in an entire national economy!

When a nation creates more wealth and becomes more productive, the natural market reaction is for the currency to strengthen.  This is simple to understand in a straightforward example.  Let’s say I’m a factory owner in an island economy, governed by an independent King.  I own all the land on the island and there are no other businesses.  Given this, we are heavily reliant on exporting our one and only product: widgets.  We are also heavily reliant on imports from other nations.

With my current machinery, I can produce 1,000 widgets, for $2 profit each.  That means I can earn $2,000 income from my property each year.  Now, let’s say a brilliant inventor creates a new manufacturing process that allows me to produce more widgets and at a lower price, and now I can produce 2,000 widgets for $1.5 profit each.  Suddenly, I can earn $3,000 income from the exact same property!  Assuming the amount of currency in circulation stays the same, and all other factors remain equal, then it stands to reason that the currency must strengthen in order to compensate for this economic gain.

But let’s say the King implemented a currency peg and left it unchanged after the productivity gain.  The problem with this peg is that it prevents the above process (wealth capture) from occurring, so while the technological and productivity gain might be made, the currency peg might actually prevent the currency from strengthening.  So instead of being able to use my greater wealth created from this productivity gain to pay workers more and buy more things for myself, I’m actually required to “export” away my productivity gain to other nations.

This is precisely what is happening to China, in a sense.   Trade liberalization has brought about major benefits to the Chinese economy.  Its producers have access to more markets, which allows them to sell their goods at a higher price and make greater profits.  This allows them to employ more people productively, as well.  As things started to improve, more foreigners were willing to invest in the Chinese economy, which allowed Chinese companies to buy more advanced technologies, which then allowed them to increase productivity.  This also increased economic wealth in the nation.

But starting around 1997, the Chinese government began to leave the peg unchanged in spite of these massive economic gains.  The Yuan should have strengthened, but instead, it stayed artificially weak, allowing the Chinese to export more goods and services, and requiring them to import less goods and services.  In affect, the peg acted as a subsidy for exports, but the economic gains were largely captured by two groups:  (1) capitalists in exporting industries, and (2) foreign purchasers.   Note, that #1 includes  foreign investors; and not necessarily just Chinese capitalists.

So there’s a real issue here.

The Brain Drain

This leads us to the “brain drain.” Since the peg artificially undervalued the Yuan, Chinese workers can not capture the full economic gains from their own labor.

Low-skilled labor is a commodity (or that is, “price taker”) and an abundance of low-skilled jobs are created in this type of economy, since it is essentially subsidized by the government and low-skilled laborers have fewer alternative options.  Since foreigners love buying the (artificially) cheap goods, it’s simple for exporting industries to increase production.  And since low-skilled labor have few alternative options, the owners are able to raise wages at a minimal rate (e.g. 1% – 3%), while real inflation might be significantly higher (e.g. 4% – 6%).  In other words, jobs are being created and maintained; they simply pay less “real income” as time goes on.

Higher-skilled labor is a different story.  As a highly-skilled laborer, one would have more alternative options including emigration to more developed nations like the United States and Canada.  In those nations, a highly-skilled laborer can potentially make significantly higher real wages. It might be more difficult for you to succeed in the US as an outsider than it would be to succeed in your home country, but nevertheless, the much greater income earning potential makes the risk worthwhile.  Indeed, it should not be shocking that the US has a record number of Chinese applicants to its professional schools; and that many of them want to stay in the US, rather than return to China.

This is a problem for China and is one of the many reasons why it has the largest gap between rich and poor in the entire world.  The “middle class” is, in a sense, a euphemism for “skilled labor”, and when your economy punishes skilled labor, they are much more likely to leave.  We saw this in the Soviet Union as doctors, accountants, and other members of skilled professions immigrated to the US and Western Europe.  We are seeing it in China, as well.

Human capital is highly important to a well-developed economy, and you can’t create a vibrant economy by chasing away your skilled labor force.

How It Affects the US

We often hear about how the currency peg harms American exports, but it’s often in a less clear way than people imagine.  Moreover, the harm to the US isn’t necessarily as significant as the harm to China.

For starters, it’s unlikely that China is directly taking a lot of jobs from the US.  The jobs being created in China in exporting industries are in low-skilled manufacturing.  This is not something the US can or should want to compete with China on.  Rather, it’s more likely that China’s trade subsidies (via the peg) have directly killed off jobs in Latin America and Southeast Asia.  However, the artificially strong Dollar that result does end up meaning that the US has less to export, since prices are too expensive.

There’s a caveat here:  remember that low-skilled labor is a commodity or “price-taker”.  High-skilled labor has more options. The US has more of the latter than the former, so in spite of artificially high prices, the US is actually able to compete fairly effectively in many high-skilled areas, such as semiconductors and consulting services.  And the people in these industries are able to purchase more with their stronger Dollars.

So, the Dollar peg does harm the US by creating economic misallocations, as well, but the US still receives the better end of the deal with subsidized goods.  The trade-off is fewer jobs at the bottom-end of the scale.

How the Peg Will Reverse Course

In spite of the fact that the Yuan is generally considered “undervalued”, this may have reversed course over the past few years.  Production and consumption are equally important to wealth creation.

Let’s say I decide to build a luxury resort.  It costs $10000 to build and I need to earn one-tenth of that figure each year in annual income to break-even economically given those costs.  In other words, I have to make $1,000 annually for the project to be worthwhile. Instead, let’s say it can only produce $300 in annual income.  In this instance, we could say that the real value of the property might only be $3,000 (based on our effective P/E ratio of 10) and that $7,000 in value was destroyed by the creation of this property.

This is what has been happening in China on a grand scale over the past several years.  As unoccupied cities have been built, value has been destroyed; and intuitively, the value of the currency should decline to reflect this.  So, in the end, what might end up happening is that China created great economic gains through trade, implemented a policy that exported some of those gains out, but also resulted in many of the gains being destroyed through malinvestment.  In essence, the Chinese people aren’t much better off than they were a few years ago (and maybe even worse off).

This is why currency pegs as a trade tool end up backfiring.  While they do create more exports, it’s at the expense of wealth exportation and destruction.

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