Aaaargh!!! (Slaughter on China)

Why do economists writing about China pretend not to know the difference between sterilized and non-sterilized intervention? We’ve been through this before, but the latest case in point is Matthew Slaughter, writing in the Wall Street Journal (and cited uncritically by Greg Mankiw and Mark Thoma):

Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.

Like all other central banks, the People's Bank of China uses its monopoly power over minting its money to control one nominal price. Since 1994 the PBOC has chosen to closely target the dollar-yuan price. In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet.

Under the standard paradigm, a central bank maintains a fixed exchange rate by adjusting interest rates so as to attract enough capital to keep its level of foreign reserves roughly constant. In the very short run, the level of reserves fluctuates, but if the central bank is truly trying “control one nominal price” with “sovereign monetary policy,” the level of reserves should not show a dramatic trend over time. As its level of foreign reserves increases, the central bank should recognize the increased demand for money and satisfy that demand by adding domestic reserves to the banking system. That’s the way “monetary policy” works.

What the People’s Bank of China is doing is something quite different. Even as it maintains its effective dollar peg, it is attempting to cool the economy by raising interest rates. It is not controlling “one nominal price”; rather, it is attempting (with limited success) to control two things at once. It is trying to keep exports strong by keeping the currency weak, and at the same time, it is trying to reduce domestic demand by tightening domestic monetary policy. As a result, it is accumulating a huge, huge, huge quantity of dollar-denominated assets, and this rate of accumulation is clear evidence of a policy conflict.

The conflict might be a bit more obvious if things were going in the other direction. If China were trying to peg the yuan too high rather than too low, while at the same time trying to stimulate, rather than cool, its domestic economy, it would be losing reserves rapidly. The process couldn’t continue, because it would run out of reserves. Then it would be forced either to abandon the peg or to tighten the domestic money supply dramatically. Because the process is now going in the opposite direction, there is no “crisis”, but otherwise what we are seeing is the exact inverse of conditions that would normally have led to a foreign exchange crisis. Of course, when a country does have a foreign exchange crisis, we don’t read economists saying that it is just “sovereign monetary policy” and nothing to worry about. When the process happens in reverse, though, apparently central banks can find plenty of apologists for their unsavory policies.

The Blinder Approach

OK, Alan Blinder, there’s something here I don’t understand. I get the point that things may get tough for a lot of American workers over the next 30 years. I get the point that this makes the case for providing better social insurance stronger than it used to be. I get the point that it makes the case for encouraging more research and development stronger than it used to be. I get the point that it makes the general case for facilitating more and better education and training stronger than it used to be. But here’s what I don’t get:

…we need to rethink our education system so that it turns out more people who are trained for the jobs that will remain in the United States. … many electronic service jobs will move offshore, whereas personal service jobs will not. Here are a few examples. Tax accounting is easily offshorable; onsite auditing is not. Computer programming is offshorable; computer repair is not. Architects could be endangered, but builders aren't. Were it not for stiff regulations, radiology would be offshorable; but pediatrics and geriatrics aren't. Lawyers who write contracts can do so at a distance and deliver them electronically; litigators who argue cases in court cannot.

So apparently we want to train people for onsite auditing, computer repair, building, pediatrics, geriatrics, litigation, and similar occupations. But why? Don’t we already have enough – or at least almost enough – auditors, computer repair people, builders, pediatricians, geriatricians, and litigators? Is there any reason to expect that offshoring will increase demand for those occupations? What model do you have in mind wherein foreign competition increases the demand for non-tradable services?

In my crass Mundell-Fleming conception, here’s what happens when offshoring occurs. Suppose a lot of people from India learn to do American tax accounting, computer programming, architecture, and so on, undercutting American service producers. A bunch of American accountants, programmers, architects, and such will lose their jobs. The Fed will notice the slack labor markets and cut interest rates. As a result, the dollar will depreciate, causing an increase in demand for some other American products. Which products, exactly, we don’t know, but they have to be products that are exportable – not auditing, computer repair, and building, and pediatrics. There will be excess demand for certain kinds of workers, but not, ultimately, for the categories of workers whose jobs can’t move offshore.

I grant you that we do not live in a small country with perfectly substitutable assets, so things won’t happen exactly the way I suggested. There will be a temporary demand for certain non-tradable services – specifically the ones that are interest-rate sensitive, like building. That, in fact, is already happening, or perhaps has just finished happening. But today I think one might be rather glad to have passed up the opportunity to train for a job in the construction industry. In the longer run, surely we cannot expect that foreigners will be willing to finance ever higher amounts of non-tradable services for Americans. Perhaps we can maintain a large trade deficit, but surely we can’t keep running ever larger trade deficits, to create ever greater demand for domestic non-tradable services.

So do we need to rethink our educational system? Perhaps, but as to how, exactly, I have no idea. I don’t understand why we would want to restructure it to turn out more people trained for non-tradable service jobs.

The Paradox of Thrift and Monetary Policy

Kash Mansori of The Street Light and Mark Thoma of Economist’s View argue that now may be a bad time to cut the US budget deficit, given the relatively slow economy and the risk of a recession. pgl of Angry Bear argues (in a post whose title I stole) that now is as good a time as any, provided that the Fed does its job. pgl's argument seems pretty solid, but there are a few possible reasons one might consider deficit-cutting dangerous:

1. From the time of implementation, fiscal policy operates with a shorter lag than monetary policy. Usually, there are long political lags before fiscal policy gets implemented, but during that period there is also uncertainty. The Fed would not be able to respond to a deficit cut until it could be confident about its taking place. That might be too late to prevent a recession.
   
   
2. Interest rate cuts would weaken the dollar, and dollar weakness could exert an inflationary effect independently of its stimulus effect, causing the Fed to be excessively cautious using this type of stimulus. Deficit borrowing, by contrast, would tend to keep interest rates high, thus keeping the dollar from collapsing. (On the other hand, deficit cuts might increase confidence in the dollar, in which case investors might continue to demand dollars even at a lower interest rate.)
   
   
3. Does the Fed have enough ammunition to fight, reliably, the depressing effects of a substantial increase in national saving? You might remember that, back in 2000, interest rates were higher than they are today, perhaps giving the impression that the Fed had plenty of room to cut them; yet three years later, the Fed was starting to debate the types of unconventional policies that might be necessary if short-term interest rates approached zero. With the international savings glut still on and plenty of room for retrenchment by US consumers, I wouldn’t want to be overconfident about the impossibility of a liquidity trap.
   
   
4. Although the world economy is growing rapidly, its potential seems to be growing even faster. The stimulus from the US budget deficit and consumer spending is helping the world make up this gap. US monetary policy would not provide such a stimulus for the world economy.
   

OK, have you got any better reasons? I’d be curious to know how Kash and Mark look at this.