The “Simple” Economics of Currency Manipulation

I had forgotten how complicated economics becomes when you try to do it rigorously.

I want to explain why, in a “simple” world – meaning one without market failures – currency manipulation is inefficient. The easy answer is that, in a world without market failures, government intervention is always inefficient. But that answer is unsatisfying. (Some might say that real currency manipulation is impossible in a world without market failures, because prices will adjust to bring real exchange rates back to a market level. However, it is clearly possible for governments to accumulate reserve assets on which they will earn income, and this process must have real effects.) The more detailed answer is anything but simple.

Why is currency manipulation bad? Because it distorts the intertemporal terms of trade. Why is distortion of the intertemporal terms of trade bad? Two reasons. First, it distorts consumption decisions by reducing consumption when the currency is weak and increasing consumption when the currency is strong. Second, it distorts production decisions by shifting production into the tradables sector when the currency is weak and into the nontradables sector when the currency is strong. So, in a country whose government is attacking its own currency, the tradables sector will operate inefficiently at the margin, while in its trading partner the nontradables sector will operate inefficiently at the margin. Later, when the manipulation stops, the situation will reverse itself. In the end, total production could have been increased if the non-manipulating country had originally produced more tradables.

That explanation is already complicated, and the prose is somewhat ragged around the edges. The story does seem to fit well with the situation between the US and China today. In the US, nontradable industries like construction and health care are struggling to find workers and materials, obviously not being very efficient at the margin, while tradable industries like manufacturing are leaving both workers and physical capacity idle, apparently foregoing increases in production that could be very efficient. I’m less clear on what’s happening in China, but I get the impression that manufacturing is expanding at an unhealthy pace, while the health care industry is producing less than what would be healthy for the typical Chinese citizen.

I tried to put this explanation into a rigorous form, using the simplest possible assumptions in a two-country, two-sector, two-period model, to show that the manipulating country loses more than the trading partner gains. But there’s just too damn many equations, and it’s not worth the trouble of solving them. I wanted to make what I thought was a simple point, but it seems to require a whole research project.