Free Trade and Exchange Rates

I’m all for moving the yuan toward a float more quickly, but this (from a Wall Street Journal commentary [hat tip to Mark Thoma] this morning by Senators Schumer and Graham) is just silly:

One of the fundamental tenets of free trade is that currencies should float -- or at the very least, move along with market forces. The reason for this is that a free-floating currency allows large trade imbalances to self-correct...

One of the fundamental tenets of free trade? So it’s impossible to have free trade under a fixed exchange rate regime? Come on, guys, you can do better. At the very least, it is widely recognized that exchange rate pegs can be an effective way to stabilize inflation when other methods don’t work or can’t be applied, and in that situation, it is critical to resist market forces that often don’t, at first, trust the stabilization.

More generally, in the presence of fixed exchange rates, large trade imbalances are ultimately expected to self-correct anyhow, through the mechanism of inflation. To maintain an undervalued currency, a nation normally has to follow an expansive monetary policy, which leads to rising prices and wages, making its products less competitive. Or, to look at it a little differently, the foreign demand occasioned by a weak currency strains the resources of the export sector and causes its prices and costs to rise, making its products less competitive.

China today is a special case for several reasons. First, there is a rapid flow of workers into the industrial sector, and this flow is helping to prevent the inflation that might ordinarily attend an undervalued currency. Second, much of China’s foreign exchange intervention is sterilized, which is to say, China is making attempts to slow down domestic sources of demand to compensate for the foreign demand occasioned by its weak currency. Third, China’s government is effectively running a very large surplus, which also tends to slow down domestic demand. Fourth, arguably, China is following policies that encourage a high level of private saving, which also tends to slow domestic demand.

The second of these factors, sterilized intervention, might reasonably be considered an unfair trade practice (and probably a foolish practice as well). The third and fourth factors, high public and private saving, respectively, while almost certainly “bad policy” from an international perspective, fall well outside the usual sphere of trade policy. As for the first factor, one has to wonder: if China has a lot of workers available to do these jobs, whereas the US has only a few (relatively speaking), why shouldn’t trade be set up to create jobs in China rather than the US?

Later on, Schumer and Graham assert:

Unfortunately, the Chinese appear to be content with the status quo. Their exports to the United States create millions of Chinese jobs and have allowed China to become the second-largest holder of U.S. government bonds in the world. They have no reason to change unless we send a very strong message that the status quo is not acceptable.

They make it sound like the Chinese enjoy accumulating US government bonds. I’m sure even the most conservative among the Chinese leaders are beginning to feel just slightly uncomfortable with the amount of US bonds they are accumulating – bonds which, when the eventual adjustment does come, will lose much of their value in terms of yuan. The Chinese clearly do have a reason to change; the problem is, those Chinese leaders who would advocate more rapid change have not as yet managed to make a strong enough case to those who don’t. Will pressure from the US help them make the case? Maybe, but it strikes me as rather a dangerous tactic.


UPDATE: Greg Mankiw makes the same point. I would note, though, that the specie-flow mechanism discussed by Hume isn’t quite working in this case, for reasons described above. To the extent that China is able to absorb ever-increasing amounts of US government securities, Hume’s mechanism may not apply.