Foreign Reserve Accumulation by China, Russia, Korea, etc. is a disservice to their countries

China leads the world in the total amount of foreign reserves. It also is the fastest accumulator of them. The biggest beneficiary of this is the US. The Chinese buy US Government backed bonds (treasuries and mortgage bonds issued by Fannie and Freddie) with those reserves.

What would Adam Smith say to this?

As we are all well aware-China has become the manufacturing hub of the world. China sells the world loads of finished goods-toys, machinery, auto parts, computer parts, digital cameras, home furnishings...well, just about all finished goods which we spend our money on. The complexity of these goods is increasing as well. There are Chinese made cars in Chile nowadays.

What China gets for selling all these goods? It accumulates US Government bonds. Smith clearly explained that capital at home is the best use for a nation-it employs the maximum number of they country's citizens. Capital is sent abroad by private individuals to increase returns-but a Government doing this is silly from a job generation perspective. Another way to look at this is that China effectively subsidizes all these finished goods it sells to the US. It exchanges the hard work and labor of it's own citizens for useless paper currency paying some small interest. It keeps Americans employed-giving a nice gift of manufactured items for free use.

All emerging market nations do this-they could generate far more employment at home if they didn't keep these massive piles of monies in the US, UK, European Union etc.

The emerging markets justify their FX holdings for defending their currency, and their high liquidity. They actually keep their own countries poorer.

What should they do? Market based currency rates are a first step-but capital already accumulated by these nations should move into buying things which their countries need. Raw materials or machinery to improve productivity of their citizens. They should buy iron-ore, coal, nuclear energy plants, etc. That is not the same as investing in resource stocks in Australia---that will again employ Australians. They should keep buying the commodities produced by Australian producers and bringing them home so the home market has no shortage of basic materials like coal, iron-ore, copper, etc. They should spend that money in buying more aircraft and other techologies which will make production smoother. Then the labor of China can work on those materials and generate the finished goods it is so capable of doing in even larger amounts.

Smith also mentioned about the uselessness of controlling the amount of money supply in the country by changing interest rates. The amount of money necessary to circulate goods in a country is an unimportant part of the country's economy. Imagine a world without paper dollars or yuans-will we not trade things-goods and services, anyway? Sure we would. It just wont be that convenient, but we still would trade goods.

Chinese finished goods should be traded for raw materials and other things which Chinese citizens need---not paper US dollars and Euros. That doesn't help China-it actually hurts it-because precious capital is kept outside, preventing better division of labor. The least they can do is to flood China with raw materials.

A small export based economy justifies some foreign reserve holdings to prevent excessive currency fluctuations-but nothing more than that.

Any Government which holds foreign reserves as "investments" does it at the expense of it's own country. Adam Smith would be amused if he saw how national Governments exchange the hard labor of their citizens for paper emitted by foreign governments, in the name of liquidity. Smith also explained how you never buy money for it's own sake-money (or Government bonds) has no use, but to be sold again for buying other goods--goods for consumption, goods for increasing productiving, raw materials. A paper wealth increase in China's foreign reserves because the US Government pays interest on them doesn't do squat for China-unless that interest and capital is spent to bring something useful back home.
Eventually these emerging market economies need to stop accumulating reserves so they can become developed countries faster.

Sanjay

Basics of Economics -1 (not understood well by most people)

The basics of economics, as laid out by Adam Smith in The Wealth of Nations (seems like the only book worth reading in economics to me) are missed by most people-including many well known economists and financial planners and bankers.

Here's my understanding of some key points of Economics, thanks to Adam Smith.

1. Society progressed by increased division of labor-specialization leads to more efficient production.
2. For division of labor to come about, you need capital (think tools-workers need tools to work on to produce more). As capital in a society progresses, division of labor also progresses alongside it. More capital in a society leads to more efficient division of labor.
3. Efforts of Government should be directed to increase production of things. This brings down their costs (increases surplus production)-leading to more exchanges.
4. Parsimony and savings result in accumulation of capital and should be encouraged. Consumption of goods should be discouraged. Consumption should only be a percentage of net capital gained-so that there is continual accumulation of capital in the society. This is well understood when considering a single individual-a man who saves comes out ahead-someone who consumes only a small portion of their capital has a brighter future.

There's more to The Wealth of Nations than this-but these are some of the most important points.

Consumption can be looked at as the return of goods to their basic forms which have no resale value-carbon and CO2 for coal and oil, wood and glass turning into living room decorations with little resale value, etc. This is similar to the treatment of Hayek in his order of goods-higher order goods being the more basic commodities, and lower order goods being the more finished products. I like to think of the order of goods in reverse-because the "evolution" of goods is easier for me to understand that way-lower order goods being turned to higher order goods by the work of man, using capital (tools) and labor ( man hours).

An example of how everyone has got it all wrong with the $168 billion stimulus package in the US earlier in the year.

The package is often said to boost consumption and therefore economic growth. See News release here today, for example. That is not right. Why?

If you give me money to buy more apples, does that increase automatically the amount of apple production or the net production of society? No. Consumption is a drain on capital. It leads to destruction of capital. You don't want a society to consume more---you want it to produce more and save more. That $168 Billion should be used by judicious people to invest more in improving their specializations, getting better jobs, etc-in other words, improving division of labor to increase net production (goods and services is an arbitrary distinction-services can be looked at as intangible goods). Consumption does not increase economic growth-it is economic growth which increases consumption. They have it backwards there. As the net production of a society grows, assuming a fixed percentage is being consumed-the consumed portion keeps on increasing in time.

-Sanjay

"Economy slowing due to high oil and commodity prices" is a strange statement

When economists and central banks and finance ministers say that the economy, global or their local, is slowing because of higher oil and commodity prices-they show that they understand economics very very little.

Are oil and commodities like wheat, rice and copper not produced by humans? It is not like some extra terrestrials have been giving us our raw materials. The energy sector has the biggest weighting in the SP 500, and many commodity and energy producing nations are quite happy to see higher energy and metal and agricultural product prices. What is called economy here is the economy of the the finished good sectors, of entertainment, of expensive real estate in NYC and London and Mumbai, which suffer when there's not enough raw materials to work on.

Economy includes all sectors-including oil, wheat, copper, everything produced by humans. Keep that in mind when you analyze meaning of financial news-and u will realize how most of it is plain crap.

Sanjay