Economics Riddle Solution

Several blogs ago the audience was asked what China did with the extra money it receives from having more imports than exports. The technical name for this extra moneythe trade gap, which is hundreds of billions of dollars.

The correct answer is that there are several things it can do, a couple of things it has done, and several things it may do to combat the recession.

First there are things China can do with the extra money. The first thing it can do, which The Bernanke Files has discussed at length, is use the extra money to pay its employees higher wages. The problem with this, of course, is that the USA buys goods from China because their wages are so low! Raising wages would hurt China's most important sector: manufacturing.

Second, China could use the extra money it receives to build up its infrastructure. Highways, ports, buildings, schools, regulators, boats, airports etc. could be built with the extra money. However, this raises two things: the demand for labor and (therefore) wages. Again this hurts their economy because China's economy is built on the assumption of low wages. Also, this kind of spending, when unwarranted, creates bubbles by producing things, like boats, that are not needed by the market participants.

Third, China can and does purchase American T-Bonds at an extroardinary rate. This serves three purposes: it keeps Chinese wages low, it diversifies China's government because the T-Bond is a very safe investment, and it gives American's more money and therefore higher wages. Higher wages and more money give American's more fuel to purchase Chinese goods! This full circle of US cash to China for goods, that same cash back to America so we can buy more goods is very important to the Chinese growth model. Actually, all high exporting countries (Germany, Brazil, India, Vietnam) follow this same model.

Finally, it can use this money to subsidize a certain sector of the economy. For example, China can lend the extra cash to very large manufacturing corporations to make sure they keep making STUFF that Americans buy. But what happens when Americans quit purchasing the STUFF, and China keeps making the STUFF?

It is also important to remember that China receives extra cash from another source: local Chinese citizens that want to SAVE money. Since China wants to stifle local Chinese citizens from buying too much (so that imports do not go too high and other reasons) they can either give the citizens high interest rates so that the Chinese have more incentive to save money, or they can ration goods (like USA did during WWII...hmm, we were the lending nation back then, think theres a correlation?), explicitly by direct rationing or implicitly by keeping wages low and credit card restrictions high.

So basically China has used its own citizen's money to, well, screw over most of the Chinese citizens. Of course, China does this because they believe that in the long run it will pay off.

The next economics riddle should be "So what happens when America goes into a recession and quits buying Chinese goods but China passes a huge stimulus bill and keeps making the goods anyways?" But, this will be such a depressing subject I will save Bernanke fans everywhere a lot of grief and just answer briefly: Nothing good.