Is it possible for U.S to regain its trade balance? If at all possible, How?

As discussed in my previous post, “Why Yuan Devaluation won’t work?”, the problem can be easily understood with the lens of “International product life cycle” theory. The well established firms (as wisely put, the “nationless” firms) have started moving out to third world countries (will be more appropriate to call migrated) to achieve their objective, namely profit optimization, by availing low cost inputs.

In the era of globalization, no firm can retain its competitiveness by having its base in developed economies where factor costs are so high. It is true that companies like Apple need not have to go for low cost production and can command the premium they want. But this is true only if you are targeting high end customers who are ready to pay premium for the luxury they desire. It is obvious that only few companies have the R&D, capacity and vision to stay put healthy in this section and most other firms try to retain their position by covering up their weakness of low quality products through the volumes, i.e., by manufacturing in large scale catering to the needs of the majority middle/ lower income group. (A point to note, Even the premium product maker, Apple itself, outsources the manufacturing process to take the advantage of the low factor cost in China)

It makes no business sense for the firms to have their manufacturing base in U.S if you discount the other costs involved in Exports-Imports, Freights etc. In ideal scenario with minimal transaction cost, it makes perfect business sense to outsource most of the production work to the low cost countries and retain only the processes which involves lot of machinery and less of humans.

So how can they counter the heavy imports? They can add some more value to the goods they imported and export it back to the emerging economies. But as we have already seen, the products produced in western world can compete only in high income segment. So this option of adding value and re-exporting is not feasible. Then what is the solution? When the U.S opened up its economy for free trade, it also should have freed up the labor market. With the current defensive policies of the governments like minimum wage, etc., the American firms tend to lose their competitiveness vis-a-vis the companies having base in the emerging economies. It can only worsen their economy to tempt these giants to move out to get a cost advantage and that is what happening now, resulting in huge trade deficits in U.S. It now tries to solve the structural problem just by manipulating the currency, asking the China to devalue its currency.

Another problem with the U.S is its own currency. U.S, with its dollar being the reserve currency it is in a very similar position to that of Greece. Just how Greece cannot devalue its currency (The Euro which it shares with other member nation) and rebalance its economy, U.S also cannot easily devalue its currency so easily. Only way it can lose its value is losing the confidence in it, which can be very lethal making the issue very tricky.

Does it mean China is a winner in this game? No! China has its own structural issues. Just like how U.S firms have the problem of serving the high end customers in terms of the value it generates through its products, China’s problem lies in the purchasing power of its customers, who unfortunately are not its citizens rather U.S’s citizens. So it is not enough that China takes care of its citizens, but also have to take care of U.S’ citizens by supplying it with low-cost debt for its survival, in whose absence both the economies have to collapse.

Why is this imbalance? Shouldn’t there be a mechanism (invisible hand) which corrects situation? Exactly, that is what happening. But in a painful way. The Chinese can keep on subsidizing the U.S only to an extent. After which it can’t sustain and let the Yuan appreciate, thereby making its citizens wealthier (Pain for the U.S because, all the goods they enjoy at low cost will become costlier to the extent of their imports from China and Yuan’s appreciation. This may lead to further repercussions in the economy) But for that to happen, a lot of structural needs to be done, to let the citizens reap the benefits of the hard work they have put for decades while the currency appreciates. Else, the dispersion of benefits will be skewed, resulting in China returning back to square one with its citizens not having much purchasing power. It has to replay the game starting with export again. So it won’t let the Yuan appreciate so easily. It demands lot of patience in planning and execution and will take its own time so as not to hurt its economy.

Once the currencies regains its balance, the factor costs of inputs will also regain some balance and it will make business sense for the firms to come back and until then, the U.S will continue to have deficits.

Note: In the discussion, I have ignored the transaction and freight costs involved in exports and imports. In reality, the firms will return well before the currencies exactly balance each other.