I am trying to understand how inflation contributes to trade defecits and the negative impacts inflation has on trade, who it hurts, and who benefits (especially when looking at US China relations). I have been reading this article:
But I am still very confused. How does inflation fit in with the big picture of trade? References to books specifically dealing with this topic would be great too. Thanks!
Bottom line: Inflation means giving people money when they have not worked for it, meaning they have not produced anything. So that they take what everyone else has worked hard for. For example, Michelle Obama needs a new dress. So she prints new money and buys it. Less dresses are available for everyone else, so by supply and demand, the price everyone else has to pay for a dress goes up. Same thing with everyone else who gets free money that the govt prints, be it banks, arms manufacturers, union pals, govt workers, whoever it is.
If enough inflation goes on, we get hyperinflation, where people spend their money as soon they get it, causing prices to jump ridiculously.
All that is how inflation works with in a country.
How does it work between two countries? The same way. The effect is the same because it has the same cause, the law of supply and demand. Just as more printed dollars means the dollar is worth less in the USA, so too the dollars are worth less in China, and everywhere. So that , to use a simple example, if before one dollar was worth one yuan, now one dollar is worth only half a yaun.
This has two outcomes. First, all Chinese goods now cost double for Americans. So that all 350 million people in the USA will be able to buy only half as many Chinese things as they used to. Their standard of living goes down. They are poorer. Second, the Chinese are in the reverse situation. A $10,000 car, which used to cost them 10,000 yuan, now costs them half that. So they can buy more for their money. And they will. Which means, for Americans, that their cars will go up in price again. There are less cars for sale here, so that by supply and demand, price goes up for all 350 million people.
There is one small group of Americans that might think they are improving their lot by all this happening, if they are stupid. Exporters. As we explained, the car companies, for example, will be able to sell more cars to China. They think business is booming. Look how many cars we sold to them Chinese.
But little do they realize that although they sold more cars, they are getting paid less per car. They are getting paid 5,00 yuan instead of 10,000. Now it’s true they are getting the same dollar amount per car, but those dollars have lost purchasing power.
The funny thing is, the politicians in both the US and China think the very opposite is true, They think that whoever inflates more wins. Because like the foolish exporters we talked about, they realize the country that inflates exports more, but do not realize that the exporting country is getting paid less for their goods.
Which means good made in America [if America inflates], though more expensive for Americans, are cheaper for the Chinese. They can take their Chinese money and buy more with it. So that whoever inflates more loses, and the other side gains.
A word might be in place here to explain about exports and imports in general. The question is, which country is doing better, one that exports more or one that imports more? The answer is “It depends”, as we will explain.
The meracntilists thought that exporting is great. Their thinking was that wealth means gold coins. If you export more than you import, you bring gold coins into the country, since all business was paid for in gold.
Luckily for everyone, Adam Smith came along and explained that you cannot eat gold coins. They are an intermediate step to getting what you really want, goodies. Filling your coffers with gold and ending it there is basically starving yourself.
So people woke up and realized that the purpose of money is to buy stuff. The purpose of exporting is to get money from abroad that you could spend abroad on things you want. The purpose of exporting is to import.
This is doubly true nowadays, when nobody uses gold for money. If we export to China, what do we get in return? Not gold, not dollars, but paper Chinese money. The only thing we can do with that Chinese money is to buy Chinese goods. So even those who thought the purpose of exporting is to get gold, must nowadays realize the purpose is to get Chinese food from China.
As a consequence of this line of thinking, we realize that it does not matter if you export more than you import, or vice versa. Because whoever exports more just winds up with paper money of the other country, which he can only spend by importing from the other country. So that every export will lead to an import, and vice versa.
Finally, there is one new wrinkle that has been introduced in the last twenty years which changes the picture completely. Until now we have been talking about two countries that both have roughly an equal amount of goods to trade with each other. In that situation all we said above about exports and imports is true.
But a new wrinkle has been introduced, mainly the Chinese wrinkling up their nose at what we have to offer. Due to taxes and unions and over-regualtion, we have stopped producing things people want at a price they want. So that the Chinese sell us their stuff in exchange for paper dollars, but do not spend those dollars on US goods. What they do is, insane as this may sound, lend the money right back to the US govt and to US citizens. What they hope to gain by this unclear, but they are doing it. [Actually what they gain is the warm fuzzy feeling that they are exporting. Which is good for their exporters, but bad for everyone else. The Chinese peasant makes TVs, only to see them sail away to America in exchange for nothing].
Every month for years and years we have been buying tens of billions of dollars more from them than they are buying from us. We owe them the difference, which is in the trillions by now. So right now we are in great shape from all this. We consume what they make, and give them paper dollars in return that they do nothing with. Insanely, the American govt wants this to stop, and the Chinese govt wants it keep on going. Each side is fighting tooth and nail to hurt its own citizens.
One day of course, the Chinese will wake up. They will realize that they are hurting themselves,and will stop. When that happens, they gain, and we lose. Our shelves will be empty and theirs will be full.
An excellent write-up!
To nitpick:
Because whoever exports more just winds up with paper money of the other country, which he can only spend by importing from the other country.
This is only partially true, as some third country may want this paper money to get goods from the other country… And the length this chain is not limited, so more than three countries may be involved. This is quite similar to emergence of money in interpersonal exchange, up to existence of a few preferred paper currencies (USD and, to a lesser extent, EUR).
Thank you for that detailed reply. It really cleared a lot of stuff up. I have one confusion though:
The US is acting as an inflator, so currently we should be hurting from this policy. But it seems like you are saying that this is good and our government wants to stop it. I am not sure what you mean here. Is this because China is an even greater inflator?
Which raises another question. What happens when both countries are inflating? Also, why would China want to peg their currency to the US dollar and what are the effects?
I am writing a paper on China and US relations, and I would love to write with a better understanding of the economics involved.
"The US is acting as an inflator, so currently we should be hurting from this policy. "
True, but China is inflating right along with us, on purpose, to make sure that the value of their money does NOT rise in relation to ours.
The result: Both countries are inflating. Thus in each country the average person is losing his purchasing power. Prices of American goods are rising for Americans because the US is inflating, and prices of Chinese goods are rising for the Chinese.
But the additional inflation, of Chines goods rising for us because our dollar has lost value relative to their yuan, that is not happening.
But it seems like you are saying that this is good
It is good for us short term. Like an unemployed broke alchoholic has it good if he finds suckers to lend him money. But it is bad long term for him because he doesn’t have a job and one day his pals will wise up and realize he will never pay them back. That is our situation a swell. We are living on what the Chinese will lend us, instead of manufacturing enough for our needs [=the drunk having a job].
EDIT: In other words, for the drunk the ideal situation is to get a job. For us, that means creating conditions that will improve our productivity, such as much less govt spending, much lower taxes, much less regulation, much less illegal power to unions.
As long he does not have a job, the drunk is better off having friends to sponge off from than starving. Which is our current situation. If we are not producing anywhere near what we have to, we are better off if the Chinese give us things for free.
The worst thing the drunk could do is stay unemployed, and bully his friends into NOT lending him money. Which is what our govt is doing.
and our government wants to stop it.
They do indeed want to stop it. They are yelling for the Chinese to stop inflating so that the Chinese money will be worth more relative to ours. WHich is bad for 350 million Americans, as described in the other post.
Why does the govt want this to happen if it is so bad? Maybe they think if Chinese products go up in price Americans will start “buying American”, thus helping US businesses. Also, they think correctly that this will increase Chinese purchases of American things, thus helping US business. But as explained in the other post, while their thinking is true, it hurts the country as a whole.
To understand this, let’s say the govt passed a law that everyone has to pay double for gasoline to help the gasoline companies. It helps the companies, but impoverishes everyone else. Same thing exactly. And if they pass a second law halving the price of American gasoline for Chinese buyers they increase the sales of gasoline to the Chinese, but are not making more profits.
In short, the govt is pushing for something that will hurt us all, and either thinks foolishly that it is trying to help, or knows what it is doing and is trying to help their buddies.
I am not sure what you mean here. Is this because China is an even greater inflator?
They are inflating in an effort to keep their money at the same exchange rate with ours. They think this is good for them, because it will keep their exports flowing here. But it is bad for them, as explained.
Which raises another question. What happens when both countries are inflating?
Explained at the beginning of this post.
Also, why would China want to peg their currency to the US dollar
To help their exports, as explained. They foolishly think that is important. Now exporting as normally done is indeed a great idea. By normally I mean when you export what you make best and import in return what the other country makes best. It’s called the Law of Comparative Advantage, which is way beyind the scope of this modest post. But that law is talking about when both countries are producing, not when one country is giving it’s stuff away in exchange for paper that will not buy anything. So, being new to economic thinking, after all they were Communists for decades, they might not get this. They may think exporting is what counts, under all circs. But as explained, it’s not even good for the exporters, really.
and what are the effects?
Effect is their stuff stays cheap for us and we can afford it. Other effects expalined at start of this post.
To Andris:
Your point is well taken. I think you agree that this does not change the analysis, that normally a net exporter will wind up importing the difference eventually, and vice versa.
I think you agree that this does not change the analysis, that normally a net exporter will wind up importing the difference eventually, and vice versa.
Right, I do not think this invalidates your analysis, it just complicates it.
If the direct effects of inflation (The Rothbardian Definition:Artificially increasing the supply of money and credit as opposed to increasing prices which is an effect of inflation.) weren’t bad enough, the indirect effects on the capital or productive structure of the economy are disasterous and really show why the amount of imports goes up as inflation increases. It is the insane logic of the oldest non-free market economic theory that being Mercantilism that states: Exports Good, Employment Good, Imports Bad, Unemployment Bad so the government must interfere to increase Exports and Employment while decreasing the other two. (Of course the opposite is true if your goal is to improve society as a whole by increasing the productive capacity. The logic is that imports create wealth by providing products and services that your local economy would have to provide otherwise. IN THE LONG RUN, this frees up resources to pursue other wealth creating activities that expands the productive capacity of society and therefore makes society wealthier and better off.)
Onto why imports tend to go up. The new inflation gets into the economy through a small subset of the population. So this subset gets an increase in real wealth relative to the rest of the population. Entrepreneurs see this fake wealth as real savings and take on projects (Like housing or dotcom businesses) that would not exist absent the inflation. Of course this new money eventually makes it through the economy forcing prices up. This leaves the inflators (Government and Banks) with two bad choices: 1. Stop creating inflation and reveal the investments as unprofitable thus having them liquidate and increasing unemployment or 2. Continue creating inflation and watch price increases accelerate. It is here that the amount imported can remain at the same levels or even go higher. When the real profitability is revealed and liquidations begin, these take time. At the same time there are real products and services demanded by consumers. So foreigners show up to supply these products and services. By the time the entrepreneurs can adjust the productive struction to meet this demand they find themselves way behind the foreign businesses. An example of this is the Big Three Auto Makers. They were beneficaries of lots of inflation (Cheap credit) and government help (Loans at below market interest rates or inflation) but each time the true demand showed itself these companies yielded market share and now are in a state of either government ownership or mostly bankrupt.