Wednesday, April 18, 2007

Don’t Just Float the Yuan

My earliest posts in this blog (see the archives from April and early May 2006) dealt largely with the subject of China’s artificially weak currency. The general thrust was that the weak-RMB policy was inefficient from a global point of view, contrary to China’s interest, and probably contrary to US interest as well despite the benefit to US consumers. Upon further thought, it seems to me that those posts stand in a somewhat ironic relation to my KNZN screen name. From a Keynesian point of view, if we take China’s other policies as given, allowing the yuan to appreciate seems like a distinctly bad idea for China and not necessarily a good one for the US.

By most accounts, the pace of capital investment in China is already so rapid as to be unhealthy. Meanwhile, despite some concerns about overheating, the inflation rate remains tame. So what would happen if China were to allow the yuan to appreciate? In terms of the components of national output, net exports would fall. There is no reason to expect a change in either consumption or government purchases. This means that China’s monetary authorities would face a choice: either push easy money to encourage increased private investment, or let national income fall (relative to its path under the current regime). If national income were to fall, standard Phillips curve theory suggests that the inflation rate would fall as well, possibly pushing China into an unpleasant deflation. Those possibilities don’t sound particularly pleasant.

There is also the possibility that “standard” Phillips curve theory doesn’t apply in this case. That is, China’s Phillips curve may be flat in its current range, so the result of an appreciation would be lower output at the same inflation rate. A flat Phillips curve is essentially a free lunch, so by advising China to allow appreciation without encouraging more rapid investment, we would be advising them to pass up the free lunch. Alternatively, maybe the Phillips curve is vertical, in which case deflation becomes the only alternative to more rapid investment in the case of an appreciation.

The US, on the other hand, is by most accounts (though not by mine) already near (if not at or above) full employment. By increasing net exports (which is to say, decreasing net imports), a stronger yuan would force the Fed to raise interest rates to discourage private investment, which is already not as strong as one might hope. (I’m assuming that the Fed agrees with the consensus and not with me, and since the US Phillips curve seems to be fairly flat right now, it will be a long time before the Fed – and the consensus – realizes its error. Alternatively, you can just assume that the consensus is right.)

So a good Keynesian ought not to advocate a mere floating of the yuan (unless of course that good Keynesian disagrees with the consensus that investment in China is currently too rapid). For China, a good Keynesian ought primarily to advocate a fiscal stimulus – lower taxes or more government spending, perhaps a publicly financed health insurance system that would reduce the need for precautionary saving by individuals. Once the fiscal stimulus is a done deal, it will hopefully be obvious to the Chinese that the currency needs to appreciate.

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21 Comments:

Anonymous Armis said...

Nice pic!
I'm not sure about all that macroeconomics but a good public health care system sounds about right.

Wed Apr 18, 01:17:00 PM EDT  
Blogger lukewarmforlevere said...

I saw your blog about 7 spots down when I looked up "float the yuan" in google. Because you are actually a reference on an incredibly important topic, I'll write something to make sure people are careful in reading this.

Here is a quick critique of what you wrote. First of all, I think it is dangerous to identify with just one point of view; Keynes is like the World Bank, effective in his own time period, but very outdated at this point. We need to improve upon what he said, and really think through our present day situation.

For example, your concluding thought (which is out of place with the rest of your post) talks about increasing the budget deficit and implementing a national public health service. I do not believe that the U.S. could possibly create a working universal health plan that will be good for the U.S. in the long run. Look at our past attempts with Social Security and our already awful health servose. Look at the failings in Sallie Mae; private businesses are the most efficient way to handle important "universal" projects. Lower taxes are almost always a good thing though. Agreed there. I mean that is why we started America.

So why should we float the yuan? Because imposing an artificial exchange rate is just going to be more detrimental to all sides in the long run. We need to get this over with already, and yes, it will not be good for anybody. But this is true, always.

Your phillips curve assessments are on par with theory; note that you meant "discourage private foreign investment" and not "discourage private investment." I would suggest that you acknowledge how this is a short-sighted analysis, and how it proposes left-field options instead of the obvious one, just float the yuan already.

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