Arnold Kling  

China, India and Deflation

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Prashant Kothari forwarded an email from one of his readers that said,


I think global deflation is [in] the cards as long as we have free trade in goods and services. China is rapidly becoming a sophisticated manufacturer and there soon will be no reason not to outsource tradeables from China. As long as the Chinese yuan is tied to the USD, the world outside the US will experience deflation coming from low Chinese prices. India is doing the same thing in services - accounting and computer - to the rest of the world that China is doing in products. Until China and India are at GDP levels of roughly six times where they are now, I do not see this trend stopping.
Deflation means that first world investors will be forced to invest in the third world if they want to see real returns on their capital, especially equity.
Comments?

Here is how I think of the economics. Imagine that Asian and American labor were perfect substitutes, but America had much more capital. Start by assuming that there are trade barriers, so that American wages are higher.

Next, remove the trade barriers. Capital indeed should flow toward Asia, and Asian wages should rise relative to American wages. In the aggregate in the U.S., increased capital earnings will more than offset decreased labor earnings. The American standard of living as a whole will rise.

The term "general deflation" does not necessarily apply. The change in relative wages could take place in an inflationary or deflationary context, depending on monetary policy. I do not believe that in the face of a massive capital inflow the Asian monetary authority would find it practical to peg the exchange rate.

So much for theory. In the real world, these events will unfold very slowly, if at all. American and Asian workers are not perfect substitutes. Both China and India have the potential to fall into the statist trap that I believe afflicts Japan.

For Discussion. As international competition in white-collar work increases, do you think that the economic returns to education in the United States will rise, fall, or stay the same?



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Eric writes:

I think that global competition in white collar work will be the spark that ignites a new protectionist wave, in the US and all the developed nations.

It is one thing when the uneducated lose their factory jobs to globalization. The uneducated don't have much of a political voice.

But when programmers, accountants, and other professionals start to lose work, look out. These guys are politically hooked up. They will be throwing up barriers to trade that make Smoot-Hawley look like NAFTA.

The irony of BMW driving professionals being protectionist amuses me.

Eric writes:

Arnold, isn't India the country that invented the statist trap? Have they had ANY real economic growth since the British left? Indian entrepreneurs would probably kill to have mere-Japanese level statism!

It really remains to be seen whether the Indian Permit Raj will allow the deregulation needed to take India to the next level economically. Remember, economic growth is easy to come by at the initial stages of development, but many, many countries have a hard time sustaining growth over long periods of time (the Asian Tigers are the most recent examples).

The same could probably be said of China, but after 2 decades of strong economic growth, I give them the benefit of the doubt far more than I do India.

David Thomson writes:

“I think that global competition in white collar work will be the spark that ignites a new protectionist wave, in the US and all the developed nations.”

I am not quite as cynical as Eric. We cannot allow our white-collar professionals to be protected from foreign competition. I (perhaps naively) expect them to be willing to bite the bullet and act maturely when their earnings inevitably drop. In the long run, our overall economy will indeed benefit.

Eric Krieg writes:

David, my cynacism is based on experience.

Ever try to provide law related services? If you did, the legal profession would be all over you. Lawyers have enacted state laws that protect them from competition outside of their profession.

Ditto for doctors, to perhaps an even greater degree. Unlike lawyers, the doctors have control over the medical schools, and artificially limit the number of doctors who graduate.

The whole system of professional licensing is a way to limit competition. Believe me, I'm a licensed professional engineer, so I know.

Like I said, the professions are hooked up. They have their tentacles in the legislative process in ways that even the unions do not. If competition to the professions comes from abroad, there WILL be a new round of protectionism. I guarantee it.

David Thomson writes:

I may be overly optimistic, but I sense most professionals realize that they have no moral right to seek political assistance to protect their high incomes. After all, many of these elite educated folks readily understood the valid reasons behind the NAFTA agreement and its deleterious short term effects upon numerous low skilled laborers. If nothing else, we can always shame them into doing the right thing.

Responding to Eric's comments (post #2)

"Arnold, isn't India the country that invented the statist trap? Have they had ANY real economic growth since the British left?"

India's economic performance over the last 130 years -- with and without the British, has been in general woeful. However, the last two decades are showing some REAL economic growth. Check
http://www.prashantkothari.com/2003_02_01_prashantkothari_archive.html#88574250


"Economic growth is easy to come by at the initial stages of development, but many, many countries have a hard time sustaining growth over long periods of time (the Asian Tigers are the most recent examples)"

I think that even reaching where the Asian Tigers are at right now, is a huge, huge plus for India. Ramping up from THAT level onwards is a problem to be tackled ONCE India reaches the level where the Asian Tigers are today

Eric Krieg writes:

Prashant, I take your point about India reaching the level of development of the Asian tigers. But that wasn't my main argument.

My main argument is this: when an economy is starting from almost zero, high economic growth rates are easy to come by. It is simple math, when a very small number is in the denominator, you get large percentages.

This is why you have to take the dazzling economic growth rate numbers of a country like, say, China, with a grain of salt. Yes, the rates are high, but it is starting from such a low level that there is much progress still to be made.

The other point is that, when you get to a certain level, you cannot rely on simple mathmatics to sustain your high economic growth. Then the fundamentals come into play: education levels, infrastructure, regulation, taxation, corruption, etc.

I would say that India has the education part down, although I have no idea how broad based the education system is. But the other factors to economic growth are wowefully inadequate.

Believe it or not, but China is doing some interesting things infrastructure wise. They're doing a lot to improve their internal transportation system. And China also produces some excellent students at the high end of their education system, although, again, I have no idea how broad based their education system is.

Interestingly, China is pretty wide open regulation wise. You wouldn't think that a formerly Communist country would be so economically free. Of course, the flip side is that the business sector is brutally competitive, but that is the environment that produces world class companies. Thus, my optimism for China in the long term.

Brian in NYC writes:

I agree that Asian wages would eventually rise to US levels. Although you may have implied it, I think it should be made explicit that US wage rates would also have to decline until the two rates meet near an equilibrium point.

The problem with the US being compensated for falling wages by increasing capital earnings is that ownership of capital is not evenly distributed among the general population so the "compensation" may not be paid to those who are the most directly affected by the declining wages.

As far as economic returns on education falling or not growing - I think this is inevitable if wages decline in white-collar professions. However on the plus side this will put downward pressure on tuition inflation - at least on the upper end of academia. Since Ivys generally have such huge endowments, tuition is set at market price rather than by operating budget needs. So if you want your kids to go to an ivy, invest in Asian markets and you will get better investment returns and tuition inflation will slow. By my calculation I will be about $500 a month richer per child. But then in 18 years I may be sending them to Chinese schools.

David Thomson writes:

"I would say that India has the education part down, although I have no idea how broad based the education system is. But the other factors to economic growth are wowefully inadequate."

Some cynical Indians also remark that they can do well in every country but their own! India simply must rid itself of the last vestiges of socialism. It cannot possibly take the next serious step until doing so.

What was possibly the worst thing the United States ever did to India? Was it possibly the appointment of John Kenneth Galbraith as our ambassador during the Kennedy years?

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