Is a Cheap Currency Good?

In the comments section of my first post about the euro, reader Keith asks:

1. Isn't it better to have a cheap currency? You get to export more and bring in more money. A cheap currency hurts if you travel outside the country, but on the other hand, you have more money to spend because you export more.
   
   
2. Why has the US followed a strong dollar policy? It seems Japan has had the right idea by keeping their currency cheap.

The simple answer to the first question is that a cheap currency is good for the tradables sector (exports, potential exports, and industries that actually or potentially compete with imports) but bad for the notradables sector (everything else). It’s bad for the nontradables sector because the economy has limited resources, and the additional resources that get used in the tradables sector are no longer available for use in the nontradables sector. For example, China has a cheap currency, and it has thriving export industries, but it has really bad health care, presumably in part because people who could be training to be nurses find it more convenient to take factory jobs in the export sector.

There are any number of problems with the last paragraph. For one thing, Gabriel is probably going to complain about my cavalier use of the words “good” and “bad.” I’m pretty sure that, in a model with nominal rigidities, fixed capital, and search costs, a cheap currency can be shown to have good and bad welfare consequences (respectively) in the short run for people associated with those respective sectors. But I’m also quite sure that the proof would be a pain in the ass, and I expect that somebody (I have no idea who) has already done it, so I’m not going to attempt it. As for the long run, exchange rates are irrelevant because prices and wages adjust completely. (Well, not really irrelevant, because there is path-dependence: what happens in the particular short runs helps determine the long-run equilibrium. But that’s getting too deep for now.)

The second problem is that the phrase “limited resources,” while quite valid, is misleading. Resource limitations are not a simple, tight constraint. There is always some unemployment, and always some idle capacity, so there is always the opportunity to push on resource limitations. The problem is, when unemployment gets too low, or capacity utilization gets too high, then inflation starts to accelerate. And it’s never exactly clear how low is too low and how high is too high. If the country has plentiful slack resources, then a cheap currency is good for everybody. If the country is already overutilizing its resources, a cheap currency could be bad for everybody if it causes an inflationary spiral (but if the central bank is on its toes, this presumably won’t happen).

The third problem is that my China example is not a very good one. (Maybe someone else can think of a better example.) China’s health care problems have more to do with bad insurance markets than with potential nurses becoming factory workers. And China’s construction industry – also part of the nontradables sector – seems to be doing fine. China is quite an interesting case, though, because, on the one hand, it appears to have plenty of slack resources (people working inefficiently in agriculture who can easily take factory jobs) and therefore one might think that there is no disadvantage to a cheap currency. But on the other hand, it is beginning to experience an inflation problem, which would suggest that it is getting the worst disadvantage from a cheap currency. Part of the solution to this paradox, I think, is that China is trying to mobilize its slack resources too quickly and running into bottlenecks. And there’s also the issue of natural resources. I could go on and talk about China’s potentially destabilizing absorption of massive dollar reserves and about China’s possible attempt to exploit path dependence and so on, but I want to get to the second question.

So, why has the US followed a strong dollar policy? And should it? In the late 1990s, I think a strong dollar policy made sense (though Dean Baker disagrees). The reason it made sense is that the nontradables sector in the US was doing a lot of useful things – creating new technologies and investment goods to make US production more efficient in the future – and a weaker dollar would have forced a shift of resources out of the nontradables sector.

Today, though, I don’t think a strong dollar makes any sense, and I think most economists would agree. The economy is weak, and we may be going into a recession, so there are a lot of potential slack resources, and the nontradables sector in recent years has not been doing anything terribly useful with its marginal capacity (mostly building a lot more houses than we really need). That doesn’t necessarily mean, though, that a “strong dollar policy” is a bad idea, if a “strong dollar policy” just means a lot of cheerleading by the Treasury Secretary. I think most economists would agree, what we want is for the dollar to fall slowly, so as not to destabilize markets or cause a bout of inflation. But if investors expect the dollar to fall slowly, they will all sell their dollar assets, and the dollar will fall quickly. The solution, I suppose, is for Hank Paulson to keep saying we like a strong dollar and to convince a gradually decreasing number of suckers that he really means it, so they will wait before selling their dollar assets and prevent a free fall.


[Afterthought: I’m beginning to wonder, though, whether the dollar still is very much overvalued against the euro. It’s getting easy to imagine that, at a dollar/euro exchange rate not too far from the present level, once temporary effects wash out, the Euro Zone and the US could both end up with moderate trade deficits, rather than (as it has been recently) the US having a very large deficit and the Euro Zone having roughly balanced trade. Increasingly, the problem is not an overvalued dollar but undervalued currencies that happen to be pegged to the dollar but that perhaps at this point might almost as well be pegged to the euro.]

Why doesn’t Europe have a large trade deficit? (Part 2)

The first rule of this game is that you’re not allowed to answer, “Because Europe has a high savings rate.” The whole point of Paul Krugman’s post to which I linked in Part 1 (as well as this 1995 Krugman piece to which he links therein) is that there has to be some mechanism by which a higher savings rate leads to a smaller trade deficit (or a surplus). The usual mechanism is the exchange rate, but in this case, the dollar has not appreciated against the euro. (It has depreciated in nominal terms and probably mildly depreciated in real terms also.) You can’t just say that when people save more, they buy fewer imports: if this were the only mechanism, then an increased savings rate would necessarily lead to a huge recession, because people would also buy fewer domestic products. Once the central bank and the financial markets make the necessary adjustments to avoid that recession, they increase the demand for imports again, and we’re back where we started. Unless something else – such as the value of the currency – changes.

I’m somewhat disappointed that I haven’t yet seen an answer that is both convincing and conventional. Apparently, there is no easy story that explains the divergence in trade balances between the US and Europe. (When I say Europe, BTW, I mean the Euro Zone – since I’m speaking with reference to exchange rates. Steve Waldman points out that there is diversity within the Euro Zone, with Germany running a surplus and most of the others running deficits. At a pinch, I’ll make this whole discussion about Germany and say, “Why does Germany still have a trade surplus?”)

There were a couple of interesting unconventional answers that involve complementarity. Karl Smith (in a comment that he develops more fully on his own blog) suggests a complementarity between Asian production and US distribution. In this story, the major cause of the US trade deficit is what might be called the “Wal-Mart effect.” Imports have become cheap to buy in the US, not so much because they have become cheap to produce in Asia, but because US retailers have learned to operate on thinner margins. European retailers, on the other hand, have not.

A couple of people hinted at another possible complementarity: between European (i.e., German) exports and the Asian production process. If the Asian (Chinese) investment boom has created a specific demand for European (German) capital goods, then the resulting export demand could outweigh the effect of euro’s appreciation. It’s not entirely clear to me why it wouldn’t also create a demand for (presumably cheaper) US capital goods, but then I know very little about the details, so perhaps US capital goods just aren’t the kind that China needs.

Some people suggested various things, such as European protectionism and the VAT, that might help explain why Europe has in general had a stronger trade balance than the US, but as far as I can tell, they don’t explain why the US has developed a trade deficit over the past decade and Europe hasn’t. The VAT was there a decade ago, when the euro was weaker and Asia was less productive, so why didn’t Europe have a large trade surplus at that time?

Gabriel M. asks why it all matters. He wants the answer to boil down to welfare. Steve Waldman gives an answer which may help satisfy Gabriel. As for me, I don’t have an answer that boils down to welfare, because in this case I’m one of the agents trying to form my own expectations about exchange rates. The observation that the US is importing a lot more than it is exporting, and the presumed unwillingness of people outside the US to keep sending goods to the US without eventually receiving something in exchange, suggests to me that the dollar is overvalued. The fact that a similar argument cannot be made for Europe suggests that the euro is undervalued against the dollar. But I’m troubled because there is a piece of the puzzle that doesn’t seem to fit.

Why doesn’t Europe have a large trade deficit?

Paul Krugman (hat tip: Greg Mankiw) points out that, for national savings (and investment) to affect the trade balance, it first has to affect the exchange rate. (In particular, if the US had a higher savings rate, the trade deficit wouldn’t fall unless the dollar depreciated further, so it is absurd to blame the weak dollar on the low savings rate.) One of the implications of this realization is that one can talk about the immediate causes of trade imbalances without mentioning national savings or investment: the cause has to be either in the (real) exchange rate or in the business cycle.

In terms of exchange rates, it’s pretty easy to see why the US has a large trade deficit today. (For now I’ll leave out the oil issue, though that’s part of the explanation.) The Asian countries (and China in particular) have become dramatically more productive over the past decade. Therefore their prices for traded goods have fallen dramatically, but they have not allowed their currencies to appreciate commensurately. Consequently, the dollar is overvalued (in real terms) relative to those currencies today. Ergo, the US has a trade deficit.

OK, so far it makes sense, but wait a minute: productivity growth in Europe has not been much faster than productivity growth in the US over the past decade. Prices of traded goods produced in Europe have not fallen. The euro has not, on balance, depreciated against the dollar. And Europe didn’t have a huge surplus with the US a decade ago (despite the booming US economy at the time). So if Asian goods are cheap today relative to US goods, then Asian goods must also be cheap relative to European goods. So why doesn’t Europe have a large trade deficit like the US?

If I get a chance, I’m going to download actual data on trade balances and exchange rates and see if I can figure this out. For now, though, it’s a puzzle. And it makes me wonder if we should start to get really worried about Europe’s trade balance now that the euro has appreciated dramatically against the dollar.

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.

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.

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.

Is the budget deficit destabilizing?

Hoping to avoid a descent into fiscal silliness, I am looking for reasons to be against the budget deficit. One possible reason is that the deficit has destabilizing effects on the international economy. It is surely true, to the extent that the deficit props up the dollar against floating currencies like the euro, that it sets up the dollar for a more precipitous fall – with more troublesome and unpredictable consequences – in the future.

On the other hand, the deficit may have a stabilizing effect on countries that (like China) effectively peg to the dollar or (like Japan) often intervene to keep their currencies weak. By pushing up US interest rates and thus making dollars more attractive to private investors, the budget deficit reduces the number of excess dollars that countries like China and Japan need to absorb. This presumably decreases the risk that such countries will eventually provoke instability by changing their minds about their massive dollar holdings.

So the answer to the question in the title of this post is only “maybe.” While it seems unlikely that the deficit has a net stabilizing effect (at least in today’s rapidly growing world economy), it is not clear that it has a net destabilizing effect.

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.

Distributional Effects of the Weak Yuan in the US

In general, having a strong currency (e.g. the dollar against the yuan) tends to benefit consumers and hurt producers. Consumers get more for their money, and producers face weaker demand (lower prices) because of the competition. In our society, most people are both producers and consumers. However, richer people tend to do more consumption than poorer people (in absolute terms, though not as a fraction of income), whereas richer people probably don’t, on average, do more production than poorer people. Consequently, the weak yuan tends to shift distribution from poorer to richer people in the US.

You might argue that only those producers who compete directly with the Chinese are hurt by the weak yuan. The problem is, though, that US workers – even those in different industries – compete with one another. If you get laid off because your job is being outsourced to China, and then you come and apply for my job, it makes my boss that much less likely to give me a raise.

US workers compete with other US workers, nationally, but US capitalists compete in a global capital market. Thus, even though capital is part of the production process, the capital side of production isn’t hurt (at least not in aggregate) by the weak yuan. Sure, if you have all your money in one domestic business, and the Chinese start making your product more cheaply, you’ve lost part of the value of your investment. But if you have a diversified portfolio of capital assets, you’ll take losses on some and gains on others. If the expected return on US capital goes down, you stop investing in the US and start investing abroad. Workers don’t have an analogous option.

Just as most consumers are also producers, most workers are also capitalists, but again it is a matter of degree. Poorer people, and younger people, tend to derive most (or all) of their income from labor, whereas richer people, and older people, derive a comparatively greater share from capital. Thus, again, the weak yuan tends to shift distribution from poorer to richer people in the US (and from younger to older people).

In a comment to one of his blog posts, Greg Mankiw implicitly made the counterargument that (1) consumers benefit in proportion not to the total amount that they consume but to the amount of Chinese goods they consume, and (2) Chinese goods are widely consumed by the poor and middle classes. (“Inexpensive goods from China are sold at Walmart…”) This becomes an empirical issue: I won’t concede that rich people consume a much smaller proportion of Chinese goods until someone shows me the evidence.

Another counterargument (also perhaps implicit in Greg’s comment) is that, even though the distributional shift may be toward the rich, the poor still end up better off. When I see real wages falling, I’m rather skeptical of this argument, too. Of course, we can’t blame falling US real wages primarily on the weak yuan, but I’m guessing it’s a factor.

A possible counterargument

In my last post, I argued that China, with its high growth rate, has a comparative advantage in producing future goods and therefore should be running a trade deficit rather than a surplus. If there is a counterargument to be made, it would probably rest on the distinction between average productivity and marginal productivity. China’s average productivity is quite low compared to what it will be in the future. However, if the marginal factory worker in China is someone who otherwise would be sitting on a farm twiddling his thumbs, then, on the margin, productivity might be extremely high. In other words, if we demand a few more manufactured goods from China, and they take some otherwise useless person and put him to work in a factory, they have increased industrial production without giving anything up anything else (except the worker’s leisure). In that extreme case, if we ignore the worker’s foregone leisure, the marginal productivity would be infinite: the quantity produced goes up by some positive amount, while the total social cost of production goes up by zero. In that case, obviously, on the margin, China has a huge comparative advantage in producing present goods rather than future goods.

Something like this argument seems to be behind claims that China’s weak-yuan policy is useful to help “manage industrialization”. As a Keynesian, I’m vaguely sympathetic, but I think this argument misses some critical points. By most accounts, China is industrializing too quickly already. If there are really people sitting on farms twiddling their thumbs, surely the Chinese can come up with other useful things for them to do besides making toys for Americans. For example, how about training more of them to be doctors and nurses, or having them build new medical facilities, so that Chinese people can have better health care? Surely, if they put their mind to it, the Chinese government could think of a lot of domestic improvements that could be made by their newly available labor.

Essentially, China today is outsourcing its fiscal policy to American consumers. The communists have become so enamored of capitalism that they want to do everything the capitalist way. Traditional Keynesian fiscal policy is too socialist for them.

The Prosaic Economics of Currency Manipulation

I’m going to toss the two-country, two-sector, two-period model to which I referred in earlier   posts. The prose version of the argument about intertemporal comparative advantage turns out to be a lot simpler than what I said earlier.

Consider two countries, one still developing and the other already developed. Let’s call them the People’s Republic of Developing and the Developed States of America. They have two products, one called “current manufactured goods” and the other called “future manufactured goods”. Which country has the comparative advantage in producing future manufactured goods? If you recognize that developing countries tend to become rapidly more productive, while developed countries only slowly increase their already high productivity, it should be clear that the People’s Republic has the comparative advantage. Equivalently, the DSA has a comparative advantage in producing current manufactured goods. In the normal course of things, therefore, you would expect the DSA to sell current manufactured goods in exchange for future manufactured goods. In other words, the DSA should run a trade surplus, and the People’s Republic should run a trade deficit. (This is in fact the normal relationship between developing and developed countries and explains, for example, why superstar developing countries like South Korea used to run large trade deficits.)

So why is it that, in today’s world, the US runs a deficit, and China runs a surplus? Some might argue that it’s demographics. The US population is growing faster than China’s, so maybe the US actually has a comparative advantage in producing future goods. There are a couple of problems with this argument. First of all, both countries have a large nontradables sector which can employ the excess working population at any particular time, so it’s not as if all those extra workers in China today, or in the US in the future, will go to waste. Second, if you take into account both slower population growth and faster productivity growth, China’s total growth rate is still much faster than the US, and almost everyone expects that situation to continue for the foreseeable future.

A better explanation, I think, is that China is over-saving. Part of the reason for this over-saving is currency market intervention, whereby the People’s Bank of China saves newly minted money in the US. Part of the reason also is that taxes are too high, which forces Chinese people to save via their government. Part of the reason is that profits are high, and businesses tend to save their profits. Part of the reason is that the insurance system, particularly health insurance, is inadequate, so people have to save extra to allow for emergencies. Part of the reason is that the pension system is inadequate, so people have to save for a worst-case retirement scenario, and since all this saving pushes down returns on assets, the worst case gets even worse.

As I’ve said before, in the simple economics of it, China’s excess saving – including what is implemented through currency manipulation – clearly benefits the US. I’ve touched on reasons why Americans – in the not-so-simple economics of it – may actually be hurt, and my intention is to go into more detail later. When I get a round to it...

McKinnon’s Error

I’ve already made this point, but I’ll take today’s Wall Street Journal Op-Ed by Ronald McKinnon as an occasion to repeat it in different words. According to McKinnon, “…China's motivation for pegging its exchange has been to secure internal monetary stability…” This may indeed be the reason they adopted the peg over a decade ago, but it is clearly not the reason they are maintaining the peg today. If the peg were being used to anchor monetary policy, then monetary policy would still be focused on maintaining the peg. Instead, monetary policy is being pursued independently of the exchange peg, and the peg is being maintained by means of reserve accumulation. If the exchange rate is an anchor, then the rope attached to it is at least several miles long.

As a general rule, exchange rates can be an effective anchor to prevent excessive inflation, because a nation with limited reserves will have to tighten monetary policy in order to maintain a peg in the face of reserve losses. The problem is, it doesn’t work in the other direction. There is no limit on China’s ability to accumulate new reserves, so the peg does not prevent China’s monetary policy from being much tighter than what would be needed to maintain the peg. If China is maintaining monetary stability (and I think they are, but that is debatable), they are doing so by a means other than the exchange peg. The only function of the exchange peg today is to shift demand to the export sector.

A couple of minor points about currency manipulation

Before I continue my series of posts about yuan-dollar manipulation, I want to deal with another couple of minor hydra-heads, which hopefully I can simply incapacitate without generating the usual multiplicative effect.

First is the use of the word “manipulation”. Some people would say that China is not “manipulating” its currency, just passively maintaining a peg to the dollar (or a slowly crawling peg to a basket of currencies that consists primarily of the dollar). This view might seem to cast doubt on the relevance of my assertion that “in a world without market failures, government intervention is always inefficient.” If China were maintaining its peg by means of monetary policy adjustments – the way such pegs are maintained in the textbook models – I would agree that this is not really a case of government intervention or manipulation.

But the reality is that China maintains its peg through direct intervention in the foreign exchange market while pursuing a monetary policy that often runs counter to its exchange rate objective. As a result, the People’s Bank of China accumulates large quantities of US Treasury notes and other US assets. Whether you want to call it “manipulation” is a semantic issue, but clearly the Chinese government is doing something that a purely passive government would not do: it is lending money. Depending on how you look at it, either the Chinese are following an active monetary policy that interferes with their passive exchange rate policy, or they are following an active exchange rate policy in spite of their sensible monetary policy. Either way, it constitutes government intervention. Though I recognize that other semantic conventions may be equally valid, I’ll continue to speak in terms of “currency manipulation”.

The second point is that the Chinese currency manipulation is partly just to compensate for another form of government intervention – capital controls. In other words, since China restricts its citizens from investing abroad, the government has to invest abroad to make up the difference. As I said in another post, a few economists think that, once China’s citizens fully realize their ability to invest abroad (beginning with the recent moves toward relaxation of capital controls), the government’s current currency policy will no longer require intervention. As I also said, those economists are a minority, and I am not one of them. Nonetheless it is important to keep in mind that not all of today’s yuan-dollar manipulation represents “net” government intervention.

Currency Manipulation, continued

I still haven’t bothered to solve my currency manipulation model, but I’m pretty confident in what it would show: in a world without market failure, attacking your own currency hurts your own country more than it helps your trading partners. And there was never any question that the manipulating country is the loser, and the trading partner is the winner. But when we look at the US and China, it’s quite clear that most of the support for currency manipulation is coming from the “loser”, China, while most of the opposition is coming from the “winner”, the US. Why?

Part of the answer is undoubtedly political. On both sides of the Pacific, there are both winners and losers within the population, and it happens that both the Chinese winners and the American losers are very important politically. For anyone who remembers the 2004 Presidential election (or anyone who studied the state-by-state results of the previous 10 Presidential elections), I can make this point about the US in just one word: Ohio. Although I know less about Chinese politics, I get the impression that marginal workers in the manufacturing sector are thought to be a potentially dangerous group.

But I really don’t think that’s the whole story. The fact is, we don’t live in a world without market failure. Human irrationality, sticky prices and wages, time to build, path-dependence, monopoly and monopsony power, pre-existing government distortions, externalities, missing markets, not to mention all the examples of market failure that I’ve forgotten – these things are not only present but, in my opinion, potentially important in understanding the US economic relationship with China. Moreover, the distribution issue discussed in the last paragraph is not just a political one: the US population, in aggregate, may benefit from China’s currency manipulation, but that doesn’t mean that the typical American benefits; if the benefit is sufficiently concentrated within the population, then the typical American can end up making a sacrifice for the benefit of the average American. (If you take a look at recent income distribution statistics, you may notice that the average American has been doing very well over the past few years, but the typical American – that is, the median American – has been losing ground.)

Trying to blog about the Yuan issue, I feel like Hercules battling the hydra. Every time I try to simplify the issue, it grows two more heads. I’ll have to deal with the latest heads in future posts.



Update: Another point regarding the “average American”: What conclusion you reach may depend on what quantity you are averaging. If you take average income, then, in the absence of market failure, the weak yuan policy clearly helps the US. But if the benefits go disproportionately to the rich while the costs fall disproportionately on the poor, then average welfare might be reduced. Because of diminishing marginal utility, a given amount of additional income is worth more to the poor than to the rich.

The “Simple” Economics of Currency Manipulation

I had forgotten how complicated economics becomes when you try to do it rigorously.

I want to explain why, in a “simple” world – meaning one without market failures – currency manipulation is inefficient. The easy answer is that, in a world without market failures, government intervention is always inefficient. But that answer is unsatisfying. (Some might say that real currency manipulation is impossible in a world without market failures, because prices will adjust to bring real exchange rates back to a market level. However, it is clearly possible for governments to accumulate reserve assets on which they will earn income, and this process must have real effects.) The more detailed answer is anything but simple.

Why is currency manipulation bad? Because it distorts the intertemporal terms of trade. Why is distortion of the intertemporal terms of trade bad? Two reasons. First, it distorts consumption decisions by reducing consumption when the currency is weak and increasing consumption when the currency is strong. Second, it distorts production decisions by shifting production into the tradables sector when the currency is weak and into the nontradables sector when the currency is strong. So, in a country whose government is attacking its own currency, the tradables sector will operate inefficiently at the margin, while in its trading partner the nontradables sector will operate inefficiently at the margin. Later, when the manipulation stops, the situation will reverse itself. In the end, total production could have been increased if the non-manipulating country had originally produced more tradables.

That explanation is already complicated, and the prose is somewhat ragged around the edges. The story does seem to fit well with the situation between the US and China today. In the US, nontradable industries like construction and health care are struggling to find workers and materials, obviously not being very efficient at the margin, while tradable industries like manufacturing are leaving both workers and physical capacity idle, apparently foregoing increases in production that could be very efficient. I’m less clear on what’s happening in China, but I get the impression that manufacturing is expanding at an unhealthy pace, while the health care industry is producing less than what would be healthy for the typical Chinese citizen.

I tried to put this explanation into a rigorous form, using the simplest possible assumptions in a two-country, two-sector, two-period model, to show that the manipulating country loses more than the trading partner gains. But there’s just too damn many equations, and it’s not worth the trouble of solving them. I wanted to make what I thought was a simple point, but it seems to require a whole research project.

China’s currency: what’s news?

From the “What’s News” column of Saturday’s Wall Street Journal: “China’s decision to liberalize its foreign-currency regime is unlikely to result immediately in a strengthening of the yuan. (Article on Page A4)”

And this is news? Am I missing something, or should the story have been, “The effect of China’s relaxation of capital controls has been widely misunderstood by potential Wall Street Journal readers.”?

The article is quite clear about what China did: “China’s central bank announced measures that will make it easier for individuals and companies to buy foreign currency – and then for the first time to invest those funds overseas in stocks and bonds through banks and brokerage firms.” The substance had already been reported in Friday’s “What’s News” column (along with any number of other places in the financial press): “China will allow companies and individuals to make significant investments abroad for the first time…”

In other words, people who previously had to hold their assets in yuan-denominated form will now be allowed to sell those yuan. (I know that’s an oversimplification, but that’s the gist of it.) OK, here’s a quiz: what happens to the price of something when people sell more of it? Does the price go up? (It’s been a few years since I was in school. Maybe I’ve missed some of the latest thinking on this topic.)

Assuming economics has not been completely turned on its head in the last 12 years (and that the yuan is not a Giffen good), it seems to me that the relaxation of capital controls cannot result in a strengthening of the yuan. What it will do, of course, is reduce the required amount of intervention by the Chinese to support the dollar’s current exchange rate against the yuan. Think of it as partially privatizing the job of supporting the dollar.

What the Chinese apparently hope is that, eventually, investment abroad by Chinese individuals and businesses will become so popular that the job of supporting the dollar (or other foreign currencies) can be “fully privatized.” At that point, the intervention will no longer be necessary, the currency can be made fully convertible, and nobody can continue to accuse the Chinese of manipulation. Some economists think that might actually happen.

Well, a few economists think so, anyway. Most, however, think that the Chinese will have to allow the yuan to appreciate significantly before they can stop their intervention. It is unclear whether yesterday’s action will hasten or delay such a change.