The G20 Currency Accord Collapses Under the Weight of Its Own Contradictions

Cross-posted from New Deal 2.0.

Treasury Secretary Tim Geithner appeared fixated on US trade at last weekend's G20 Summit in South Korea. While it is misguided to focus solely on current account imbalances, there is a certain kind of perverse logic behind his thinking. Given that the US government is likely to cut back on spending in the near future, which won't do anything good for our consumption here at home, one can understand the Treasury Secretary's preoccupation with trade imbalances. In an economy that is far below full employment, higher exports could generate sufficient demand so that, as much as you might be exporting an increasing amount of your domestic output to increase the per capita consumption of foreigners, there is also an accompanying increase in US consumption because of the multiplier effects of more employment. Remember that per capita outputs, and per capita consumption, do not only rise because of imports, but also because we have more people employed. After all, while the Chinese are exporting ever more, they are also slowly increasing their own per capita consumption, especially as more and more of the disguised unemployed in the Chinese countryside become employed in the export sector.

But is the optimal policy truly to target current account imbalances? No. The right policy response is to work toward a full employment policy by vastly expanding fiscal policy. The US government is fully capable of doing this on its own without any global cooperation.

It is true that many of us have been saying for years that exports are a cost and imports a benefit, so therefore the US should maximize net imports. We have got absolutely no traction with this argument because it is a contingent statement, true only at full employment. So while we have suggested fiscal policies designed to get us to full employment, until the rate of unemployment is reduced substantially it is much harder to make the case that maximizing net imports is a good strategy in an economy that is far below its production possibility curve (i.e., far below full employment).

A sensibly constructed fiscal policy that incorporates a Job Guarantee program would be a great start. But let's be honest: It ain't gonna happen anytime soon, especially given the likely configuration of the future Congress after the midterm elections.

Failing a big fiscal response, then, there clearly is a big problem ahead for the US. The latest data from the US western ports indicates that the American economy has gone from a very rapid pace of expansion in exports on a sequential and year on year basis to small declines in exports on a year on year basis and more severe declines on a sequential basis. And a veritable tsunami of Chinese imports is now hitting our shores, the product of China's own substantial build-up of its export capacity last year (which is where their government deployed the majority of its fiscal resources).

Why is US trade deteriorating? In part because the rest of the global economy might be slowing. But the more significant cause is China's over-investment in industrial tradables and the consequent pressures for greater Chinese exports and a greater degree of Chinese import substitution. More restrictive fiscal policy, added to deteriorating trade accounts, likely equals higher unemployment. It seems almost inevitable that this will engender more than mere threats from the American government next year. Tariff increases appear to be in the cards.

The upshot is that Beijing is going to be hit with the collateral damage via a trade war. Their economy's dependence on export growth represents a clear and present danger. So the Chinese are doing themselves no favors by maintaining the pegged rate regime, which they should abandon as soon as possible -- largely for their sakes, not ours. Consider the following: According to the Hurun report on China's wealthiest individuals, 95% of those on the rich list earned their money by focusing on domestic consumption; just 5% are export moguls. Clearly, this domestic consumption sector wants to grow from the bottom up, but Chinese government policy currently prevents it from doing so.

That said, you can see why Beijing doesn't take kindly to the "helpful suggestions" from the US, which are riddled with contradictions. On the one hand, Congress and the Treasury are accusing China of currency manipulation designed to increase its net exports. Meanwhile, the Federal Reserve, via "QE2," is trying to force a run out of the dollar to appreciate the currencies of our trading partners so that the US can export its way out of its Great Recession.

Similarly, Beijing has been raising its rates on concerns that the Chinese economy is overheating. But our Treasury Secretary is urging them to increase their already booming domestic demand so that they can buy more US output. At the same time, Geithner wants countries with trade deficits like the US to boost saving and cut spending. Fine, except that it seems odd to add to an already booming economy in China while the US is slumping and Geithner talks about the desirability for us to rein in long term deficits and therefore reduce demand.

At a basic level, the incoherence in the American proposals is symptomatic of a broader policy making problem when one operates from a flawed paradigm. Policy makers like Tim Geithner have long been clueless on domestic federal budgets. This time around, however, his focus on current account imbalances might be logical, but only as the stupid outgrowth of a misguided understanding of public reserve accounting. In many respects it is nothing but a sideshow, one which conceals the fact that most of the policies of the Obama Administration are only making matters worse (such as turning a blind eye to fraud as part of financial "reform").

The irony, of course, is that when China does begin to enact policies that allow its population to fully consume the fruits of its own economic output, then we'll be paying a lot more for basic stuff. Remember how great it felt to be paying $5.00 per gallon for gas during the oil price spike in the summer of 2008? That's going to be child's play compared to what's ahead. But we aren't taking advantage of the gift that China is giving us. And things will only get worse, because we remain prisoners of a 19th century gold standard mentality.