China, India and Deflation
By Arnold Kling
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.
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?