Economic Fallacy I: Harmful Currency Undervaluation?
This is the first article in the “Economic Fallacies” series. An economic fallacy is a concept of economic policy or a statement of “fact” or the proposition of an economic “law” which often sound very convincing while being at least incomplete if not utterly false and thus leading to ineffective, wrong, counter-productive, in short: to mostly harmful economic policies.
One of the more dangerous concepts is the myth of the effects of currency undervaluation, i.e. currency pegs at an exchange rate that tries to keep a currency lower than an unfettered market exchange would effectuate.
(See more statistical material in our References section!)
Unfortunately in almost all areas of economic reasoning one finds arguments and statements of “fact” that are motivated by the self-interests of the parties promulgating them rather than representing a truth or an economic law (whether the interested parties are aware of the falsity won’t matter in the end, but we may safely assume they are largely convinced to be wise and equitable).
So if one party, e.g. a government through some trade attaché or special envoy maintains that a certain “hostile” government or central bank kept its currency at an artificially low parity to theirs, because the allegers think that another, higher, exchange rate would be better for “their” trade and industry, that need not be the truth, it could even be quite the opposite. There certainly is no “natural exchange rate” that can be determined by some mathematical formula, it can only be observed in the marketplace.
The best or at least easiest, least controversial way to ascertain if there is an exchange rate disparity would be to see at what rates these two currencies are exchanged in a free market, or, if one does not officially exist, if there is a so-called “black” market and take its deviating inofficial exchange rate as a measure.
But we need not deal with the question if such allegation in a specific case were true, let’s assume it were so and a government were able, over a long period of time, to artificially distort the market exchange rate and, as that is the most frequent complaint, at “too low” a rate. Since in a system where exchange rates between all other currencies could fluctuate freely, a government that wanted to constantly push its currency away from a natural equilibrium and keep it there “no matter what”, would have constantly and likely at an ever increasing pace and with ever increasing volume to intervene at the currency market, i.e. sell its own currency against the currency it wants to keep the “unnatural” peg to. In all probability the currency it wants to strengthen (by weakening its own) will be more liquid, more widely used and accepted than its own, in other words, it would choose not an unimportant currency for attack but one of the leading currencies, and in fact most allegations against unfair currency “dumping” concern unfair, i.e. too low pegs to the US Dollar. That must be a costly and in the long run unsustainable effort and in fact all such schemes in history broke down in the long run much to the detriment of the perpetrators or their people. CrisisMaven believes that while this is observable behaviour it is still unwise and that over the total period from begin to end (when the strategy breaks down or has to be abandoned) costs to the perpetrators are considerably higher than their potential gains, they “get hoisted on their own petard”, which adds to the strength of the argument against “anti-dumping” retaliation. Yet this is not the backbone of the argument at hand, but may be dealt with in a future Economic Fallacy post.
Now, if a country were successful in continually holding its currency at an unjustifiably low peg, whom would that harm more – itself or the country whose currency it targets?
The argument of parties demanding retaliation e.g. in the form of import quota or tariffs is quite simple and as many simplistic rationales therefore quite popular and convincing:
A low currency peg will make exports cheaper (in the other, buying or importing country’s currency) than at the “correct” exchange rate and that means more such “subsidised” goods will be imported into the importing country.
Refutations and Relativisations
- “Help! – Imports are artificially cheap.” So what? Would you rather have a more expensive or a cheaper TV set or toy (or drywall or vacuum cleaner or computer or scanner, or, or …)? Obviously that benefits anyone who wants those goods while it harms no one who is not interested in those products.
- “Help! – Our own competing factories are outbid, we’re loosing jobs.” Wrong! While you would indeed expect that companies who are selling competing products in the same marketplace probably would be at a disadvantage, that misrepresents the total monetary effect cheaper imports have: your national consumers spend less on those imported goods than they otherwise would have. With the money saved they do one of two things: they either buy more products than they could otherwise afford and/or they save more. If they spend more, then stores and some other domestic manufacturers also stand to gain. If they save more, then esp. domestic credit becomes cheaper, thus enabling the exact same class of people, domestic manufacturers and workers, who so loudly complained about these beneficial imports, to build cheaper or more factories and become stronger competitors in the marketplace both at home as well as globally.
And if an employer in the “unfairly flooded” country can now afford two computer workstations for the price of one it may, e.g. if it were a training provider, now be able to sell two seats in a seminar against only half the number before that and with more abundant facilities both seats will mean cheaper training for the domestic workforce than if the aggressive underbidder nation had restrained its exports or a tariff or quota had restrained imports, resp. kept prices at a more “healthy” higher level. You get the general idea.
What we refuted for the time being are assumptions about “negative” effects that would come to pass if the original allegation that each undervalued currency would automatically cause its exports to become “unfairly” cheap were true.
But is that so? There is a second effect of potentially equal magnitude that works to offset the effect of an “unnaturally cheap” exchange rate. If the currency helps you sell more it doesn’t at the same time help you buy more or would it? How does a country manufacture goods in a global world with international division of labour? It buys raw and intermediate materials at, all other things being equal, world market prices. Since its domestic currency buys less foreign currency as would be intrinsically “justified” (as the plaintiffs allege) that means that imported goods and services are more expensive for its domestic manufacturers. In other words: the cost of a produce manufactured for export at artificially low prices (as is alleged) is determined by and large by five factors:
- cost of components and raw materials,
- cost of labour,
- cost of means of production and
- price of land/rent.
Depending on what percentage of the end product exported is made of components and raw materials (1.) the cost price of the product will more and more be identical with a product manufactured in the importing country! If the product were made of 100% imported components and raw materials with no labour and rent etc. required, then the product for export would be the same cost price as one manufactured in the target country provided the same conditions prevailed there as well (no labour, no rent). If there were a difference it would be directly attributable to the remaining variable, productivity. Since transport costs come on top of that such produce would actually be uncompetitive abroad. Now, if reality and history are any guide, then productivity in (emerging) nations alleged of dumping as a rule is lower than that of the normally more developed importing countries. Whenever that condition holds true, the importing country would be at a comparative advantage: the lower export prices (via an undervalued currency) would be offset exactly by higher import prices in the “rogue” country for components and raw materials (via an undervalued currency that has lower purchasing power), provided, as stipulated, that rent and labour were zero and all components and raw materials were imported.
So if as a rule productivity is lower or equal at best in the country accused of unfair currency manipulation, then two possible causes for persistently lower manufacturing costs (in foreign currency prices!) remain: the cost of land (rent) and means of production or the cost of labour. The same reasoning about prices for imported components and raw materials applies to means of production (factories and machinery) just as much as to the dumping-priced end product, as they also are manufactured. So let’s concentrate on those factors that may definitely be country-specific:
- Assume rent is equal in both countries
If productivity is lower, then wages can hardly be equal to those in the importing country, since by and large wages are a function of productivity. So, to gain a meaningful comparative advantage (mind you: they have to cover costs of freight as well!), the wages in the exporting country need to be remarkably lower than in the country exported to. But there is a factor that works strongly against that prerequisite: workers need to consume and a considerable amount of goods consumed will also come from abroad and need to be imported at artificially “inflated” prices, so pressure on wages will be higher as if the currency were not artificially undervalued.
- Assume rent is not equal in both countries
Small wonder! If rents were even higher than in the country buying at “dumping” prices then the comparative advantage would dwindle or vanish completely, in fact, that country would cease to be an exporter that would be perceived as a threat worth complaining about.
So in all probability rents will be lower in exporting countries and that probably has a more sweeping effect on pricing an end product than components and raw materials, cost of labour being offset on one hand by comparably lower productivity and on the other by upward pressure on prices due to artificially high import prices. And that’s probably why not only domestic manufacturers choose to set up shop there and export to the importing nations but why equally companies from the net importing countries build factories in countries like China or Vietnam. Why would they do that if their exports would yield less than justified due to the “unfair”currency peg if no other offsetting factors such as land cost and lower wages would offset the unfair purchasing power effect? You can’t have it both ways in a convincing argument.
Apart from land prices real wages in developing countries and emerging nations tend to be lower also because they have not caught up with our Western perks, nice or even justified as they may seem to us, such as paid holidays, sick and maternity leave, pension schemes, redundancy pay or other income and social taxes. All that goes a long, long way to explain their real cost advantages before you need to resort to ambiguous currency valuation theories and tariffs that harm your own citizens more than it does importers.
Of course there are many more nooks and crannies to the unfair advantage and dumping accusation controversy, but at least CrisisMaven hopes to have shown that the most prominent one, that lower prices work only one-way, can’t be true so that, if anything, the “unfair advantage” has to be considerably lower than alleged and so low perhaps, that freight and interest expense for longer time to market would make any investor think twice were there not other, just, reasons for the comparative advantage.
Update 2010-03-25: CrisisMaven has elaborated a little more on the even bigger enigma of how China, allegedly selling at a loss if its currency is up to 40% “undervalued”, achieves the miracle of “cornering” the commodities market by buying at inflated (with its undervalued currency its purchasing power must reciprocally be below par) prices and still allegedly turn a profit and at the same time grow its economy at unprecedented speed in a guest post on Stockmarketsreview.com titled “Does China bashing follow a logical rationale?“.
Another related guest post by CrisisMaven:
[2010-03-26 = Friday, March 26, 2010] – “Should US Foreign or Trade Policy take China to Task over its Currency?” on USGovernmentBlog.com