A Tale of Two Dragons: China's Trade Surplus and Inflation

In Chinese mythology, dragons can bring prosperity or destruction to villages and empires. China currently faces two dragons: the trade surplus that brings prosperity to Chinese manufacturers and urban workers, and inflation, which threatens China's price stability. Bloomberg reports that China's trade surplus might be fueling China's inflation problems.

One possible explanation is that the increase in the trade surplus outpaces the increase in potential output. Net exports are one component of aggregate demand in China. An increase in net exports pushes the aggregate demand curve to the right. Potential output increases as China utilizes more of its work-force (labor-intensive growth) and increases its capital stock (capital-intensive growth). The graph below shows that the increase in potential output (LRAS1 to LRAS2) is less than the increase in aggregate demand (AD1 to AD2). Whenever the increase in aggregate demand exceeds the increase in potential output, inflation is sure to follow (for example, from SRAS1 to SRAS2).
1. China maintains a relatively fixed nominal exchange rate between the yuan and the U.S. dollar (nominal exchange rate = 8 yuan per U.S. dollar). The real exchange rate is the nominal exchange rate times the ratio between the U.S. price level and the Chinese price level. The real exchange rate also represents the cost of U.S. goods and services relative to Chinese goods and services. How does an increase in China's inflation rate affect the real exchange rate?

2. How does an increase in China's inflation rate affect the trade balance between the United States and China?

3. The People's Bank of China often keeps its nominal interest rate equal to the United States' nominal interest rate in order to maintain the fixed nominal exchange rate (interest rate parity). Can the Bank of China choose to fight inflation and keep the nominal exchange rate fixed?

Postwar Economics

You'd think that wartime devastation would bode ill for the economic prospects of Iraq's most war-torn cities. For example, you might expect that the Japanese cities of Hiroshima and Nagasaki, which were destroyed by nuclear weapons, would have experienced slower than usual economic growth in the decades following World War II.

Surprisingly, though, long-run economic growth is resilient to the damages of war. Edward Miguel and Gerard Roland, economists at UC Berkeley, examined bombing patterns in Vietnam and found that after a generation, the heavily bombed areas shared more or less identical economic indicators with areas subjected to far less or zero bombing.

So what, in particular, might we expect Iraq's postwar economy to look like in another generation? Austan Goolsbee proposes some answers to these questions in his latest New York Times column. Citing the Miguel-Roland study and others, Goolsbee suggests that the devastation of war, in and of itself, will have minimal bearing on Iraq's prospects for economic recovery. Instead, he argues that Iraq's artificial borders pose the biggest threat to prosperity because they force a contentious mix of ethnic and religious groups to live within the same national boundaries. Read Goolsbee's column to learn more about obstacles to economic recovery in post-war Iraq.

1. Miguel and Roland found no links between the intensity of wartime bombardment and long-term economic performance. What comparisons did they make in order to arrive at this conclusion?

2. The absence of a link between wartime devastation and economic stagnation does not suggest that war is "good" for the economy. Sure, spending during wartime and reconstruction can temporarily accelerate growth, but what are the opportunity costs of going to war or rebuilding afterwards? That is, what do nations forgo when they devote resources to war? Here's an archived entry about the costs of war.

3. Wartime destruction may not create long-term obstacles to economic prosperity, but history does raise some red flags about Iraq's borders. Consider the "Artificial States" hypothesis of economists Alberto Alesina, Janina Matuszeski, and William Easterly: National borders that (1) divide ethnic groups into separate countries or (2) appear unusually straight on the map typically enclose lots of internal ethnic and religious conflict. According to the column, what are the differences between natural and artificial borders? How are the post-war economic recoveries of Japan, Europe, and Vietnam consistent with the "Artificial States" hypothesis?

4. Although more straight-edged than some African nations, the British-drawn Iraqi borders surround a volatile mix of ethnic (Kurd and Arab) and religious (Sunni and Shia) divisions. According to Alesina, in what ways do ethnic (or religious) conflicts divert resources from the pursuit of economic prosperity? How is Iraq's mineral wealth likely to affect its internal ethnic and religious strife? Natural resources and governing institutions are two of the many determinants of economic growth. What does the "Artificial States" study suggest about the relative importance of each?

5. Given the evidence from the "Artificial States" study, what policies, if any, might moderate the internal strife of artificial states? Consider migration policies and the constitutional provision of authority among regional and national governments.

Tax Carbon, Not Income

Charles Wheelan--Yahoo! Finance columnist, author of Naked Economics: Undressing the Dismal Science, and public policy lecturer at Chicago's Harris School--has a knack for user-friendly explanations of economic ideas.

The Naked Economist has a modest policy proposal for Presidential hopefuls, Democrat or Republican: Tax carbon, not income. Wheelan proposes a revenue neutral tax policy: Increase taxes on carbon-based energy, like gas and coal, reduce income and payroll taxes, and engineer the changes in such a way that government tax revenues remain the same. Americans might balk at paying even higher prices at the pump, but under Wheelan's proposal they'd write smaller checks to the IRS. Wheelan makes the case for revenue neutral energy tax reform in his latest Yahoo! Finance column.

1. How would the carbon tax change our behavior--the cars and appliances we buy, our driving habits, the way and extent to which we heat or cool our homes? According to Wheelan, what are some environmental and geo-political benefits of the carbon tax? How do payroll and income tax cuts affect our incentive to work?

2. Negative externalities occur when we do stuff that's bad for other people without compensating them for the inconvenience. To what extent would a carbon tax reduce negative externalities associated with fossil fuel consumption?

3. A tax is regressive when the share of your income devoted to the tax declines as your income rises. Since lower-income households tend to spend a greater share of their income on energy than higher-income households, the carbon tax would be regressive. How could policymakers reduce the regressive impact of the carbon tax when cutting income and payroll tax rates?

4. How would our long-term response to carbon taxes present problems for the revenue neutrality of Wheelan's proposal? (In econ jargon: how does the price elasticity of demand for carbon- based energy change as time passes?)

A Convenient Falsehood?

Global warming is in the news a lot lately, not least because of "An Inconvenient Truth," a documentary about Al Gore's position on the subject. Ten years ago, the discussion about global warming centered on whether it exists; a broad scientific consensus now seems to have concluded that it does. Therefore, the question now under discussion is: What should we do about it?

Bjorn Lomborg's answer is: not much. Lomborg, an associate professor of statistics at the University of Aarhus in Denmark and the author of "The Skeptical Environmentalist," organized a conference called the "Copenhagen Consensus." In 2004 he invited a number of notable economists, including four Nobel laureates, to discuss the greatest challenges facing humanity--and to evaluate the relative costs of meeting them. A few weeks ago, he followed this up with a group of U.N. ambassadors. To each group he posed the classic economists' question: in a world of scarcity, what is the best use of resources? A more prosaic way of posing the same question: given a certain amount of money to "do good" with--say, $50 billion--what is the most effective use of that money?

Both the economists and the U.N. ambassadors ranked combating climate change at the bottom of the list. Their logic was that the other potential uses of resources--providing sanitation to combat malaria, giving relief to post-conflict regions to help reduce the risk of repeat conflict, etc.--had a much higher benefit than directing resources to combat climate change. For example, according to Lomborg, the panels found that:

Forty dollars of good would be achieved for every dollar spent on HIV/Aids prevention. In other words, a dollar's worth of condoms in the right place would bring benefits an Aids-affected community would value at $40…Spending the world's limited resources combating climate change would achieve good, but would cost more than it would achieve. That money could be better spent elsewhere.

Lomborg is, of course, right that resources are scarce, and that the costs and benefits of any action should be carefully considered. He may even be right that in monetary terms, other, more immediate projects have a bigger bang for the buck. But there is a valid counterargument.

On the Environmental Protection Agency's web site on global warming, there's a section designed for kids. It poses the problem of climate change as follows:

Sometimes little things can turn into big things. Think about brushing your teeth. If you don't brush for one day, chances are nothing bad will happen. But if you don't brush your teeth for one month, you may develop a cavity. It's the same thing with global temperatures. If temperatures rise above normal levels for a few days, it's no big deal – the Earth will stay more or less the same. But if temperatures continue to rise over a longer period of time, then the Earth may experience some problems.

Lomborg's argument, in short, comes down to this: on any given day, there are better things to do than go to the dentist. The appropriate counterargument is: yes, but if you never go to the dentist, your teeth rot.

1. Apart from global warming, what do you think is the single most important issue facing the nation and the world? If you had $50 billion to spend on that and on measures to combat global warming, how would you allocate those resources?

2. One of the necessary conditions of examining climate change is developing some way of comparing current costs and future benefits. Economists usually do this by discounting--that is, multiplying future benefits by a factor less than one to calculate the "present value" of those benefits today. How would a change in this discount factor affect the relative merits of different programs? If the discount factor were higher (closer to 1), would combating global warming have had a higher ranking by the Copenhagen Consensus? How would you compare the costs of combating global warming with the benefits?

3. One of the greatest challenges to the U.S. economy is the skyrocketing cost of health care. As with global warming, part of the health care challenge is that we have bad habits--like eating burgers and fries--that, added up over the course of a lifetime, result in serious conditions like heart disease. However, the immediate taste benefit of eating any particular burger may be much greater than the incremental health cost of eating that burger. Similarly, for you, the benefits of driving to work on any given day outweigh the costs to the environment--but when taken in total, the costs of everyone driving to work every day for decades on end mount up to serious problems. What methods do people use to develop healthier lifestyles? Could those methods be applied to the problem of global warming?

Dollars for Trawlers

Trawlers are boats that drag large nets along the bottom of the ocean in an effort to catch ground-fish like cod, haddock, and flounder. As a recent National Public Radio (NPR) story reports, trawler captains along California's central coast made a killing in the early 1980s. Predictably, other trawlers arrived on the scene to get in on the exceptional profits. Dragging a big, weighted net along the ocean floor is not without its environmental impacts. A permit system prevented over-fishing, but the environmental consequences for the seafloor escalated even as a combination of restricted fishing, competition from new trawlers, and rising fuel costs weakened the earnings of central coast trawler captains.

Enter the Nature Conservancy.

The Nature Conservancy offered to buy fishing permits and trawler boats. After purchasing permits the Conservancy can retire permits entirely or lease them back to the fisherman with a legal constraint on the fisherman's vessel that prohibits trawling. Either way, the trawler buy-out program reduces trawling--those captains who lease permits from the Conservancy are free to fish for permitted species so long as they swear off trawling. The program illustrates an important point. Frequently, the most efficient use of a resource--in this case the seafloor--is its conservation.

1. Fishermen who lease permits from the Conservancy can catch as many fish as the permits allow, provided they use non-trawling techniques. As the NPR story mentions, the federal government is also stepping up efforts to protect swaths of seafloor from trawling.

How will the reduction of trawling along the coast affect the price that California fishermen receive for their catch of ground-fish (the types of fish most commonly caught by trawler nets)? How does the trawler buy-out program affect the trawler captains who choose not to sell their boats or permits to the Conservancy? Do you think the combination of federal regulations and private trawler buy-outs will lead to newer, less environmentally intrusive methods for harvesting ground-fish?

2. The Conservancy's trawler buy-out program is a market-based solution to a negative environmental externality (neither the trawler captains nor the fish consumers incur the environmental costs of seafloor disruption). The government's role is limited to enforcing the contracts between the Conservancy and the fishermen.

How does the Conservancy's approach to conservation differ from that of other environmental groups?

3. Other examples of market-based efforts to curb environmental degradation include greenhouse gas credit buy-outs (see a related Marketplace story here). In what ways are systems of exchangeable permits and credits more efficient vehicles for conservation than government regulations that cap harvests or emissions on a firm-by-firm basis?

Go here for more information on the Nature Conservancy's trawler buy-out program.

China's Demographic Dilemma

As growing numbers of elderly Chinese workers retire from the workplace to the mahjong table, China's pension system and labor markets are in for disruption.

Aplia Econ Blog readers know about the difficulties facing public pension systems in aging OECD countries (archived entry here). But the falling ratio of active Chinese workers to retirees highlights another dilemma: labor shortages and rising wages in China's labor-intensive manufacturing sector. A few months ago, Aplia Econ Blog examined a New York Times article detailing the demand-side contribution to rising wages in the Chinese labor market (archived entry here). A recent Times article explores the effects of an aging Chinese population on the supply side of the labor market.


1. China adopted a planned birth policy in 1979. The "one-child policy" made it very financially unattractive for parents to have more than one child. The planned birth policy significantly lowered the fertility rate (the average number of child births per woman of child-bearing age) in China's urban areas. How do China's population policies help to explain the looming pension and labor market dilemmas?

2. The article mentions that China's household registration system restricts internal migration. The planned birth policy had a much smaller impact on fertility rates in China's rural areas. As a result, many young workers reside in the countryside where average wages are below urban levels. How would abolition of the household registration system affect urban labor markets? Might relaxing internal migration restrictions (short of total abolition) relieve the pressure on wages in China's urban industrial centers?

3. Urban prosperity in China continues to widen the income gap between urban and rural Chinese. In the absence of any internal migration reforms, what will happen to income inequality as the ratio of workers to retirees continues to fall in urban areas?

4. According to the article, how will rising wages in China's urban areas affect industries in Vietnam, Bangladesh, and India? What will happen to America's yawning trade deficit with China if the aging urban population causes wages in China's manufacturing industries to rise?

Topics: China, Labor markets, Aging populations, Trade, Income inequality