Chinese-U.S. Exchange Rates and Knowledge Capital Flows:Why We Feel Poorer

The short summary:   The Chinese policy of buying dollars can be best understood as an indirect purchase of U.S. knowledge capital–technology and business know-how.  That, in a nutshell, is why we feel poorer today. Unless the Obama Administration understands the link between the undervalued yuan and the global  flows of knowledge capital,  negotiations with China are doomed to fail.  

Viewed in the usual economic light, Chinese exchange rate policy in recent years looks like a gift to the U.S..   By buying up dollars to keep the yuan low, China–still a poor country– is effectively lending money to the U.S.–still a rich country–to buy Chinese products.  According to the official statistics, the U.S. has run a cumulative $1.4 trillion trade deficit with China since 2005. But over the same period, Chinese ownership of  dollar-denominated financial assets in the U.S. has risen by $1.3 trillion.

To put it another way, the conventional statistics seem to be saying that  the U.S. is getting $350+ billion a year in cheap clothing, electronics products, and toys at no real cost today.  What’s not to like? 

But if this explanation was really correct–if  that purchase of dollars  was a gift from China–the U.S. would  be feeling happy and prosperous right now.  We have received all of these cheap goods and services, without having to give up very many of our own resources.  

But of course, the U.S. doesn’t feel rich and happy right now–we feel poorer, while the Chinese are feeling more prosperous. How can we explain this?

The  reason why the Chinese purchase of dollars seems like a gift is  because we have a 20th century statistical system trying to track a 21st century  global economy. We can do a decent job tracking the flows of goods and services and a passable job tracking financial flows.  But there is no statistical agency tracking global knowledge capital flows–and that’s where the real story is. Take a look at this diagram.

The first three boxes represent the conventional view: The U.S. gets cheap goods and services, and then pays for them by selling financial  assets.

But that leaves out the  the transfer of knowledge capital  from the U.S. to China. In effect, the Chinese purchase of dollars is a mammoth subsidy for the transfer of technology and business-know into China.  

Consider this. When China keeps the yuan low, that’s an inducement for U.S.-based companies to set up factories and research facilities in China, both for sale in China and for imports back to the U.S. .  And that, in turn, requires a transfer of  technology and business know-how from the U.S. to China.

My favorite example is furniture makers.  Over the years, U.S. furniture makers had accumulated this vast storehouse of knowledge–for example, how to make  coatings on dining room tables that are less likely to chip or discolor from heat or liquids. That’s one of the differences between a low-quality and a high-quality table.

As the manufacturing of furniture was offshored to China, the knowledge capital had to be transferred as well.   And that, in turn, helped turn the Chinese furniture industry into a global exporting powerhouse.

Now, let’s stop and make  three points here. First, we need to compliment China. It is not easy to absorb knowledge capital from the outside and make good use of it.  Frankly, all sorts of other countries could have tried the same exchange rate trick, and it wouldn’t have worked for them.

Second, the transfer of knowledge capital to China doesn’t mean that the same knowledge capital  disappears in the U.S. However, our knowledge capital  does become less valuable because there is more global competition–and that’s why we feel poorer. (see my earlier post on the writedown of knowledge capital)

Third, what’s needed from Washington is a sophisticated  response that both focuses on rebuilding our own knowledge capital, while at the same time slowing down the exchange-rate knowledge capital pump. More to come on this.

Comments

  1. Sigh, sad to see you peddling this protectionist bunkum. Of course we transfer knowledge there, they have cheaper labor and can make it cheaper, which all consumers benefit from. Americans feel poorer? After the great rise in household wealth for decades, just cuz it’s now gone down a little during the recession? That’s like someone whining cuz they had to sack the butler. The only effect of slowing down the pump is to make most Americans poorer for the temporary benefit of a few US car and furniture makers, like the supremely idiotic Cash for Clunkers program. As for rebuilding knowledge capital, the twits in govt can’t balance their budget, forget about their incentivizing anything to do with “knowledge capital.”

    • Mike Mandel says:

      You are not disagreeing with me, you know.

    • Perhaps not with your premise but certainly with your final conclusion that what’s needed is to slow the pump and rebuild.

    • Moreover, I’m not sure what exactly we can do as a response. I guess we could target the Chinese manipulation of monetary policy, but we can’t exactly stop companies from getting set up in china voluntarily, even if they end up being forced to hand over their trade secrets in the process.

      • Mike Mandel says:

        I think a lot of companies are getting the idea that they are giving away their essential business know-how.

  2. Michael, your analysis seems perceptive and well stated. I might add that the failure of 95% of wages to keep pace with stated inflation over the last decade is surely a factor in feeling poorer, perhaps not felt strongly until aggravated by the decline in net worth associated with the financial meltdown and the housing bust.

    I join you in congratulating the people of China (if a bit grudgingly since I retain a sense of coercion on the part of the multi-nationals regarding the largely uncompensated knowledge transfer from Americans). The sophisticated response required to set things right in the view of many Americans I fear demands sheer genius, as the politics around the obvious means are fierce, and a more gracious path has yet to be conceptualized, to my knowledge. The closest I can recall was the Milton Friedman notion that emerging nations would buy furiously from us, which never came true, and hounding the Chinese to join the ranks of the wantonly materialistic does not lend a feeling of grace anyway. I will be more than impressed if you or anyone else can envision a better path.

    I believe that the nation’s debt to China is only about $800 billion, so I am guessing that the sovereign wealth fund must constitute another $500 billion, not a trivial amount to be injected into U.S. markets. It raises the specter of wreaking havoc if the yuan ever completes the divorce from the dollar, particularly if derivatives are included. Perhaps you will make a habit of tracking that for us.

  3. Brian Bergfeld says:

    Imagine the Chinese suddenly lost all the knowledge capital the US has ever exported to them.

    Would this be a good thing or a bad thing for the US?

    • Mike Mandel says:

      Excellent question. Can I answer a different one? I consider the rapid industrialization and growth of China over the past 10-20 years to be one of the great miracles of economic history. So I wouldn’t take their current knowledge capital away from them. I think the best solution is for the U.S. to step up the rate of investment in physical, human, and knowledge capital, while slowing down the rate of export of knowledge capital from a gusher to a stream.

      • Brian Bergfeld says:

        Well put.

        Despite its successes, though, China is still very poor compared to the US. If we think the flow of knowledge capital from the US has contributed to China’s economic miracle, why stop it now? They still have a long way to go. Let’s keep the miracle going!

  4. I followed the link from FTAlphaville.

    Nice try at making a clever point, but I think you are confused. If the purpose of an undervalued renminbi was to attact FDI into China and steal US technology, then the Chinese would not want to encourage their industry to export to the US since that would increase the intervention effort required to keep the renminbi weak.

    No, I think the answer to why the US is feeling poorer is more simple than that. The US is feeling poorer because its current account deficit largely comprised consumption goods, meaning that the US failed to build a stock of assets to match the assets – largely debt – that it sold to foreigners. Americans are beginning to understand that they have committed themselves to many years of real resources transfers to China, with no extra income to provide for those transfers. As I wrote on my blog a couple of years ago (http://reservedplace.blogspot.com/2008/04/us-economic-policy-shot-in-foot-2.html), Chinese currency intervention was potentially a gift to the US, but they blew it. I don’t doubt that the Chinese use FDI to rip off techology, but I do not think that is associated with the US current account deficit – I dare say the Chinese rip off German technology too, and I believe that the Germans have a current account surplus with China.

    • Mike Mandel says:

      > The US is feeling poorer because its current account deficit largely comprised consumption goods, meaning that the US failed to build a stock of assets to match the assets – largely debt – that it sold to foreigners.
      > Chinese currency intervention was potentially a gift to the US, but they blew it.

      I think you are saying the same thing I am, only from a different angle. It wouldn’t have made sense for the U.S. to invest in producing the same goods that were being offshored. We would have had to use the money saved on cheaper consumer goods to invest in the production of knowledge capital.

      > Chinese would not want to encourage their industry to export to the US since that would increase the intervention effort required to keep the renminbi weak.

      That doesn’t follow, since most of the foreign investment in China thus far has been for the purposes of export.

    • “I dare say the Chinese rip off German technology too, andI believe that the Germans have a current account surplus with China.”

      As Michael Pettis emphasizes, it is wrong to consider trade under the angle of bilateral relations only. Maybe the Germans have a surplus with China, but the other part of their surplus is mainly with european countries which have a big deficit with China. When they will understand that these countries can’t pay their debts, they will realize that they too are not in such a good position as far as trade is concerned.

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Trackbacks

  1. [...] “The Chinese policy of buying dollars can be best understood as an indirect purchase of U.S. knowledge [...]

  2. [...] It is hard to put a price on the global flow of knowledge capital.  (Mandel on Innovation) [...]

  3. […] Chinese-U.S. Exchange Rates and Knowledge Capital Flows:Why We Feel Poorer (Mandel) […]

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