Thursday, September 07, 2006

The Chinese Exchange Rate and US Borrowing

One cool thing about having my own blog is that I get to comment on Tyler Cowen even when he closes comments. (This is even better than bringing back deleted comments from Brad DeLong’s blog.)

Tyler Cowen argues against pushing for yuan revaluation on the grounds that revaluation would only tie the hands of the US:
The fundamental problem in the U.S., to the extent we have one, is our propensity to spend, especially given our long-run demographic position and our government's fiscal irresponsibility. I don't see how pressuring a more rapid change in one set of relative prices (namely U.S. vs. China), which are likely to change anyway, will cure that ailment in a significant way….

A key reason to be skeptical of yuan revaluation is that it tries to address a relative prices problem by shrinking the opportunity set facing the U.S. That is not obviously the right way to go. The point is not to claim that all elasticities are zero, but rather that a trade balance shift, through revaluation, really does require a loss of resources. What fact about the world would make that the best way to go?
What fact? Two words: sticky prices. Consider the four possibilities:
  1. Weak yuan + US borrows

  2. Strong yuan + US borrows

  3. Weak yuan + US does not borrow

  4. Strong yuan + US does not borrow
Which of these possibilities is optimal for the US? Tyler Cowen would probably choose #3, but he’s wrong. Not being a Keynesian, however, he won't appreciate why the correct answer is #4 (although Greg Mankiw should, so maybe he can tell me why I’m wrong).

Why not #3? Because if we choose what’s behind door #3, we get a huge and prolonged recession. A fiscal tightening, in the presence of a still-strong currency, will knock out the economy. (We kind of already tried that one back in 2000-2001. In that case the fiscal tightening came from the business sector, which continues to run a large surplus unto this very day. We have since had a recovery, a slow and painful one, brought about mostly by households and government, which are borrowing heavily, partly from China.) As long as China keeps our trade sector weak by keeping its currency weak, our optimal strategy is to borrow.

Furthermore, as long as the US is willing to borrow, it is in China’s interest (given the conservative preferences of its leaders) to keep its currency weak. If the US suddenly stopped borrowing, it would lower US interest rates and make dollars less attractive relative to yuan, forcing China to absorb incredibly huge numbers of dollars, and ultimately, I suspect, China would give up and let the yuan rise. As it is, the path of least resistance for China is to maintain the peg.

So there are two Nash equilibria, and we are stuck at the bad one. As long as the US borrows, it is optimal for China to peg. As long as China pegs, it is optimal for the US to borrow. Ultimately, both countries would be better off if the US stopped borrowing and China stopped pegging, but, as we say in Boston, you can’t get there from here.

I’m not sure how you get out of this bad equilibrium, but one possible way is by trying to change the preferences of China’s leaders, so that it will no longer be optimal for them to peg. I’m not sure how one goes about that, and Tyler Cowen may be right that political pressure is the wrong way, in which case I’ll concede the war but not the battle.

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14 Comments:

Anonymous Amileoj said...

Would something like Warren Buffet's scheme for import certificates have a chance of working -- without deflationary effects?

Not being a professional economist, I'm entirely out of my depth here, but the first time I read about this idea it struck me as an attempt to do unilaterally what Paul Davidson has proposed internationally, in the form of an international clearing union (following, I guess, a proposal of Keynes' own, at the Bretton Woods debates, that bore no fruit).

Fri Sep 08, 12:45:00 AM EDT  
Blogger Gabriel Mihalache said...

Wouldn't sticky nominal prices work in favor of the US since it gets low prices from China? Sticky prices would mean that for a time, at least, you'd have both cheap importants and a stronger yuan.

Also, I think there's a framing issue here... most people online talk as if the US is the active partner while China passively lending. That doesn't seem right... It's all China's doing, IMHO: it chose to keep its currency down, in order to sustain huge exports and so it needs to buy securities on a large scale.

So I think China is in the best position to undo what it did by slowly but surely letting the yuan float. Slow enough to let manufacturing and supply chains reconfigure.

Don't free floating exchange rates look better now? (For China, I mean.)

Fri Sep 08, 06:18:00 AM EDT  
Anonymous yc said...

knzn, I may be wrong but I think the huge foreign reserves (mainly in US$s) and securities are in fact hot potatoes to China. Perhaps there are non-economic factors that make China to peg and to accumulate more hot potatoes.
BTW, very good post.

gabriel, my answer to your question is yes, free floating is better for China. Why didn't China change to float? You offered the answer in your 3rd paragraph, I believe.

Fri Sep 08, 06:59:00 PM EDT  
Anonymous mpt said...

the bottom line is that the longer these imbalances persist, the more painful the ultimate correction will be. The dollar will depreciate signifigantly, inflation will be uncontrollable...almost a quarter century of economic policy decisions made for political expediency will come home to roost...it will not be pretty. When is the only question left at this point, the catalyst is always a widely overlooked risk. Its very probable that a systemic crisis will hit equity markets hard(think credit-def swaps resulting in portolio insurance delta covering a la 87) and I thinks sooner rather than later...the consumer will go even further in the tank, demand for asian manuf. goods will decrease, the cycle will be broken. We need a Volcker at this point in history, not Greensan-lite. Rates need to be jacked up now, it will be extremely painful but its effects will be much more benign than yrs down the road when growing entitlement programs and a stagnant economy result in a US gov default.

Mon Sep 11, 11:48:00 AM EDT  
Anonymous Anonymous said...

Morgan Stanley's Andy Xie highlights a similar idea to knzn's suboptimal Nash equilibrium between U.S. borrowers and Chinese manufacturers, under "The World on a Motorcycle":
http://www.morganstanley.com/GEFdata/digests/20060911-mon.html#anchor3

Mon Sep 11, 05:08:00 PM EDT  
Blogger Winslow R. said...

"If the US suddenly stopped borrowing, it would lower US interest rates"

Perhaps.


"and make dollars less attractive relative to yuan"

Only if Chinese purchases are for the interest rate returns rather than manipulating exchange rates.

" forcing China to absorb incredibly huge numbers of dollars, and ultimately, I suspect, China would give up and let the yuan rise."


If there are less dollars available (being created by deficit spending), why would the Chinese need to purchase more dollars to maintain exchange rates?

Thu Sep 21, 08:36:00 PM EDT  
Blogger knzn said...

Dollars aren’t created by deficit spending; they’re created by the banking system. Less deficit spending would induce the Fed to ease and create more dollars.

Tue Sep 26, 07:23:00 PM EDT  
Blogger Winslow R. said...

Thanks for the response as I'd like to align our frameworks.

"Dollars aren’t created by deficit spending;"

True, tsy secs are created by deficit spending which is the only thing the Fed purchases to create cash/reserves. So deficit spending creates the progenitors of paper dollars/reserves.


"they’re created by the banking system."

I think we agree paper dollars are created by the Fed for banks to meet the demand of bank customers if they desire to convert their bank money into cash. The banking system creates bank money (a deposit) which has a current private sector liability (a loan). Deficit spending creates future not current private sector liabilities.


"Less deficit spending would induce the Fed to ease and create more dollars. "

Less deficit spending would create less tsy secs (future tax liabilities). Less deficit spending slows the transfer of real wealth from the private to public sectors reducing economic activity.

When the Fed 'eases' it decreases the interest rate it charges for creating additional reserves (by its purchases of tsy secs with zero term paper).

Only if the private sector demands more dollars can the Fed respond - why it is a 'weak force'. The Gov with its ability to deficit spend and tax is a 'strong force'.

Thu Sep 28, 12:35:00 AM EDT  
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