Wednesday, May 10, 2006

Weak Yuan in the Long Run?

In a comment on an earlier post, reader mvpy points out that labor’s share of national income has a very robust tendency to revert to its mean over time. How, mvpy suggests, can I therefore argue that the weak yuan policy can have lasting effects on US income distribution?

The answer is, I can’t. Even on theoretical grounds, there is no reason (generally) to think that the weak yuan policy would have long-run effects on anything. (The exception – not accounted for in traditional theory – is path-dependence – the effect of the past on the future. For example, the weak yuan may make it profitable to build factories in China. If the yuan subsequently strengthens, but those factories have already been built, it may still be profitable to run them.)

Let’s be clear on this: exchange rates are a short-run phenomenon. In the long run, if China maintains the weak yuan, the strong demand in China will cause inflation, and the weak demand in the US will cause deflation (relatively speaking). The ultimate result is that it will no longer be cheaper to buy things in China than in the US. This phenomenon is known as “real appreciation,” and, in the long run, it renders exchange rate policy irrelevant.

The concern I have is that the long run may take a lot longer to arrive this time around. Ordinarily, when exchange rates are out of whack, it is because some country is trying to defend its currency at an unrealistically high value. To avoid running out of exchange reserves, that country has to tighten monetary policy, which has a deflationary impact and hastens the real depreciation of its currency.

China is in the opposite situation, and the picture is not symmetric. China does not have to worry about running out of reserves. Therefore, China can sterilize its foreign exchange intervention to blunt the inflationary impact. China need not follow a loose monetary policy, so the real appreciation may be a long time in coming. So (though again I hesitate to blame the low labor share in the US predominantly on China’s exchange rate) don’t be too surprised if labor’s share remains away from its mean for a lot longer than usual.

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14 Comments:

Anonymous mvpy said...

(The exception – not accounted for in traditional theory – is path-dependence – the effect of the past on the future.

Also, a strong dollar can force productivity changes in US companies, to make themselves more competititve. Here, again, changes can last forever. I heard this happened during the strong dollar period in the 80s.


and the weak demand in the US will cause deflation (relatively speaking).

Disinflation would be more accurate. Exports to China are only a tiny part of the US demand story. And, look, the FED would step in, in any case.

"This phenomenon is known as “real appreciation,”"

No, its just PPP; reversion of the real exchange rate to 1. Real appreciation would be an actual, appreciation of the real exchange rate. But youve just argued to the contrary; that this cant happen in the long run. (And, mind you, knzn, PPP is a Pretty Poor
Predictor).

so the real appreciation may be a long time in coming.

In the long run, knzn, youll be dead. And in Bretton Woods, I thought this went on for ages.

"don’t be too surprised if labor’s share remains away from its mean for a lot longer than usual."

And, now, you go in for the kill. I dont think this happened in the 80s with the strong dollar. The lag is not at all unusual. Also, if youre concerned with welfare, then, lots of works also own capital via stocks etc. In this sense, its not big deal, regardless (but, again, I doubt your prognostication).

So, relax and chill out, knzn.

Wed May 10, 11:05:00 AM EDT  
Anonymous mvpy said...

One more thing: Chinese policy keeping the yuan low has also kept US interest rates low since they purchase Treasuries.

And what about welfare there?

Thats a de facto distribution from capitalists (the rich buying bonds) to the poor. Why the poor? Cos it leads to more capital accumulation which raises labor demand and productivity.

So, knzn, take that in your little pipe and smoke it.

Wed May 10, 05:13:00 PM EDT  
Blogger knzn said...

mvpy, Your second comment is valid in theory, but this time around, things don’t seem to be working out according to the theory. For reasons that are not clear to me (as I discuss in an earlier post), the low interest rates have not produced low overall capital returns. Nor have they produced high investment, except in the housing sector. If someone had asked me ten years ago, I might have said that buying US bonds was a good way to help US workers, but apparently I would have been wrong. (Actually, part of the reason for the divergence between interest rates and capital returns is the windfall oil profits, which are due in part to China’s policy of subsidizing fuel consumption – part of what is delaying the onset of inflation in China.)

I don’t understand what you say about the real exchange rate in your first comment. Any time there’s an appreciation of the real exchange rate, that’s a “real appreciation”. This includes nominal appreciation without changes in relative price levels, and it includes changes in relative price levels without changes in the nominal exchange rate. The latter did happen to some extent, admittedly not quickly, during Bretton Woods, and theory says it should happen now, but given China’s sterilization, probably even more slowly.

(As for workers owning capital, I recognized that all along, but I also recognize that poorer people get a much smaller fraction of their income from capital than richer people do. I said that explicitly in the earlier post, but here I’m using the word “workers” loosely to mean “people – typically not from the high end of the income distribution – who get the bulk, though not necessarily all, of their income from labor.”)

Thu May 11, 12:35:00 PM EDT  
Anonymous mv=py said...

"things don’t seem to be working out according to the theory."

Time, knzn. Time. The medium run can be a long time coming, you know.

"If someone had asked me ten years ago, I might have said that buying US bonds was a good way to help US workers"

Only if those bonds are used to finance investment, that is, theyre corporate bonds. Buying Treasuries signifies crowding out and is detrimental to US workers. (I have little faith in gov investment. Bridges to nowhere and all that. )



"I don’t understand what you say about the real exchange rate in your first comment."
Mea culpa. I thought you meant a permanently rising real exchange rate, which of course doesnt make sense by PPP.



"but given China’s sterilization,"

I thought it was mostly unsterilized intervention. Chinas growing so fast it doesnt have to sterilize.

"As for workers owning capital, I recognized that all along,"

Knzn, this workers/capitalists dichotomy you obsess about is really quite Marxian. Honestly.

Really, have you ever gotten a job from a poor man. I doubt it. Who provides the funds for innovation etc. And who benefits from innovation? Have you, knzn?

See, knzn, in the grand scheme of things, this worker/capitalist thing is largely irrelevant. Its just class-warfare, thats all. To repeat, I think you ought to think about more consequential issues.

Since everyone benefits in any case. Catch my drift?

Now, knzn, go chew on that for a while.

Thu May 11, 06:56:00 PM EDT  
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