Does China's Exchange-Rate Policy Matter?

Over at the Wall Street Journal's op-ed page, Matthew Slaughter says that Americans should not care about the magnitude of reserve asset purchases by the People's Bank of China or about the level of the PBoC's peg of the yuan to the dollar. These policy actions, Slaughter says, are not connected with the large and growing American goods-and-services trade deficit vis-a-vis China: "Economic theory and data are very clear.... [This] has no long-run effect on real economic outcoems such as output and trade flows."

Yuan Worries: Fact 1: China runs a large and growing trade surplus with the United States. In 2006, the goods-trade surplus exceeded $232 billion. This was an increase from 2005 of $31 billion, an amount larger than the entire deficit just 12 years ago. Fact 2: China focuses its monetary policy on fixing the exchange value of its currency, the yuan, relative to the U.S. dollar.

Many policymakers and pundits connect these two facts by asserting that an unfairly low value of the dollar-yuan peg is causing the massive bilateral trade imbalance. The 109th Congress introduced 27 pieces of anti-China trade legislation. The current Congress already has over a dozen such bills, many aiming to force an overhaul of China's exchange-rate regime. And late last week dozens of House members were poised to file a Section 301 petition, asking the U.S. Trade Representative to investigate undervaluation of the Chinese yuan.

These misgivings about the dollar-yuan peg are misplaced. 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...

And Greg Mankiw applauds Slaughter:

Greg Mankiw's Blog: Slaughter on the Yuan: The dollar-yuan exchange rate is an economic fetish of many people unschooled in basic economics (a topic previously discussed here.) In today's Wall Street Journal (subscription required), Dartmouth economist Matthew Slaughter, fresh from a stint at the CEA, tries to bring some rationality to the issue...

This sends both Milton Friedman and John Maynard Keynes spinning in their graves: Uncle Milton because the thing he disliked most about his successors at Chicago was their claim of "policy irrelevance"--that as long as monetary (including exchange rate) policy was predictable, it didn't matter what it was: production and employment and saving would be the same--which is the claim that Matthew Slaughter is making here. And Uncle Maynard for the same substantive reasons, although he put it more strongly because he was a more forceful debater than Milton Friedman:

Keynes: Tract on Monetary Reform: Now "in the long run" this is probably true. If, after the American Civil War, the American dollar had been stabilized... ten per cent below its present value... [the American money stock today] and [the American price level today] would now be just ten per cent greater than they actually are [with no effect on production and empo.... But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

In actual experience, a[ny] change in [monetary or exchange rate policy] is liable to have a reaction both on [the velocity of money] and on [production and employment]...

For the details, because I have been slow in weblogging today I can simply turn the microphone over to the mysterious and vowelless knzn:

Economics and...: Aaaargh!!! (Slaughter on China): Why do economists writing about China pretend not to know the difference between sterilized and non-sterilized [foreign exchange] intervention [policy]? 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).... [I]f the central bank is truly trying to "control one nominal price" with "sovereign monetary policy" the level of [foreign exchange] 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...

This policy conflict could end in one of several ways:

1. A sudden large burst of inflation in China, as the PBoC finds that it can no longer maintain both the current exchange-rate peg and a stable effective money stock, and sacrifices the second to the first.
2. A sudden large rise in the value of the yuan, as the PBoC finds that it can no longer maintain both the current exchange-rate peg and a stable effective money stock, and sacrifices the first to the second.
3. Slow and gradual versions of (1) and (2) as holders of nominal yuan assets in the first case and nominal dollar assets in the second let their wealth be gradually but substantially be eroded without ever taking steps to cut their losses.
4. Something more unpleasant.

It's frustrating: Matthew Slaughter's assertions are based on his assumption that full long-run monetary and price-level adjustment has already taken place, yet the pace and magnitude of Chiana's reserve accumulation (and Japan's) are very strong signs that the PBoC and the BoJ are blocking monetary and price-level adjustment--and that is the problem. To state that if we assume that the problem doesn't exist then we conclude we don't have a problem is just not very helpful. And not one in a hundred readers of the WSJ op-ed page will be able to diagnose just how Slaughter's piece is a misleading tautology.

Comments

[David]

So Greg Mankiw doesn't even know basic lower division economics . . . well, I guess I already knew that. It's amazing someone like that could get tenure. I even had to buy his textbook. Thankfully, the professor pretty much ignored it and we learned from his lectures and problem sets.

Brad, what does it take to get tenure nowadays? So many smart people don't get it, and yet plenty of mediocre minds do. It all seems so . . . random.

[Bill]

Here's a tangent. I'd like to poke fun at the people who were so upset about Argentina not being able to maintain its peso peg to the dollar. Now, the US essentially can't even peg its currency to the yuan. It sure is nice to have the currency of the realm. :-)

[Commenterlein]

David,

To conclude from Mankiw making an admittedly stupid mistake that Mankiw should not have gotten tenure and is a mediocre mind shows an impressive level of both ignorance and hubris. You could have correctly concluded that even very smart people sometimes make stupid mistakes, but instead you decided to prove to everyone that you are an idiot.

[David]

commenterlein,

To conclude from me making an admittedly stupid mistake that I am an idiot shows an impressive level of both ignorance and hubris. You could have correctly concluded that even very smart people sometimes make stupid mistakes, but instead you decided to prove to everyone that you are an even bigger idiot than I am.

[guest]

"A sudden large burst of inflation in China, as the PBoC finds that it can no longer maintain both the current exchange-rate peg and a stable effective money stock, and sacrifices the second to the first."

How can you have a "sudden large outburst of inflation" when hundreds of millions of peasants can flow into the manufacturing sector and drive down wages? This makes no sense.

[David]

The inflation may be due to costs other than wages for low skilled labor going up. In the major cities of China, rents are shooting through the roof. Raw materials costs are going up, too. Also, skilled labor, which is relatively scarce in China, may be getting higher wages.

[anne]

http://krugman.page.nytimes.com/b/a/258235.htm

May 15, 2007

Fixing Our Economy By Fixing Up Our Workers By Paul Krugman

...The pressure from China is greater because of the undervalued yuan. However, even with a big rise in China's currency, wages there would still be only 4 percent of U.S. levels, so currency issues are only a small part of the story.

[anne]

http://economistsview.typepad.com/economistsview/2007/05/paul_krugman_di.html

May 14, 2007

Paul Krugman: Divided Over Trade
Edited by Mark Thoma

Paul Krugman discusses the recent trade deal and whether the inclusion of provisions such as labor standards will prove to be a substantial benefit to U.S. workers:

NY Times: Nothing divides Democrats like international trade policy. That became clear last week, when the announcement of a deal on trade between Democratic leaders and the Bush administration caused many party activists to accuse the leadership of selling out.

The furor subsided a bit as details ... emerged... But the Democrats remain sharply divided between those who believe that globalization is driving down ... wages..., and those who believe that ... international is ... essential... What makes this divide so agonizing is that both sides are right.

Fears that low-wage competition is driving down U.S. wages have a real basis in both theory and fact. When we import labor-intensive manufactured goods..., the result is reduced demand for less-educated American workers, which leads ... to lower wages... And no, cheap consumer goods at Wal-Mart aren’t adequate compensation.

So imports from the third world, although they make the United States as a whole richer, make tens of millions of Americans poorer. How much poorer? In the mid-1990s ... economists, myself included, crunched the numbers and concluded that the ... effects ... on the wages of less-educated Americans were modest, not more than a few percent.

But... We’re buying a lot more from third-world countries today... Trade still isn’t the main source of rising economic inequality, but it’s a bigger factor than it was. So there is a dark side to globalization. The question, however, is what to do about it.

Should we go back to old-fashioned protectionism? That would have ugly consequences:... other wealthy countries would follow suit, closing off poor nations’ access to world markets.

Where would that leave Bangladesh, which is able to survive ... only because it can export clothing and other labor-intensive products? Where would it leave India ... if barriers to trade ... went back up?

And where would it leave Mexico? Whatever you think of Nafta, undoing the agreement could ... have disastrous economic and political consequences south of the border.

Because of these concerns, even trade skeptics tend to shy away from ... outright protectionism, and to look for softer measures, which mainly come down to trying to push up foreign wages. The key element of the new trade deal is its inclusion of “labor standards”: countries ... will have to allow union organizing, while abolishing child and slave labor.

The Bush administration, by the way, opposed labor standards, not ... to keep imports cheap, ... it was afraid that America would end up being forced to improve its own labor policies. So the inclusion of these standards ... represents a real victory for workers.

Realistically, however, labor standards won’t do all that much for American workers. No matter how free third-world workers are to organize, they’re still going to be paid very little, and trade will continue to place pressure on U.S. wages.

So what’s the answer? I don’t think there is one, as long as the discussion is restricted to trade policy: all-out protectionism isn’t acceptable, and labor standards in trade agreements will help only a little.

By all means, let’s have strong labor standards in our pending trade agreements... But if Democrats really want to help American workers, they’ll have to do it with a pro-labor policy that relies on better tools than trade policy. Universal health care, paid for by taxing the economy’s winners, would be a good place to start.

[guest]

"In the major cities of China, rents are shooting through the roof. Raw materials costs are going up, too. Also, skilled labor, which is relatively scarce in China, may be getting higher wages."

These factors are all quite elastic, apart from land rents and commodities. But Chinese land is quite cheap as well, and the economy can adjust to higher commodity prices.

[David]

Chinese land is not cheap in the big cities. Yes, the economy can adjust to higher commodity prices, but, ceteris paribus, higher commodity prices make prices of manufactured goods go up.

Highly skilled labor is not "quite elastic". You can't double the number of engineers overnight. And, even if you double the number over ten years, by letting people further down their high school rankings get in to college, quality will go down. Also, a lot of China's best minds emigrate to the U.S.

[Robert Waldmann]

In the long run we will all be slaughtered.

Commenterlein that one does not get tenure at Harvard does not mean one has a mediocre mind. The smartest person I know did not get tenure at Harvard (I hasten to add that I don't know Paul Samuelson). Does Mankiw have a mediocre mind ? Don't make me laugh. Did he deserve tenure at Harvard ? Sure. Does one imply the other ? no way.

[David Wozney]

A “Federal Reserve Note” is not a U.S.A. dollar. In 1973, Public Law 93-110 defined the U.S.A. dollar as consisting of 1/42.2222 fine troy ounces of gold.

http://ocii.com/~dpwozney/usa.htm#Dollar

[Commenterlein]

Robert,

Could you kindly point me to where I claimed that not getting tenure at Harvard implies that one has a mediocre mind? Thank you.

And we seemingly agree that Mankiw has everything other than a mediocre mind, which is evidenced by his CV, his publications, the Clark medal, and to some extent also by him getting tenure at Harvard. There are very few people with tenure at Harvard Econ who are not also very smart.

C.

[guest]

"Yes, the economy can adjust to higher commodity prices, but, ceteris paribus, higher commodity prices make prices of manufactured goods go up."

This is irrelevant. The root issue is that forex pressures _cannot_ lead to a "sudden burst of inflation" unless the Chinese economy is at capacity. In other words, China has to absorb its agricultural surplus labor before its currency peg starts making a difference in real terms. This means that the whole debate about nominal vs. real undervaluation is pointless.

[RC]

Commenterlein and David,

I'm sure that Mankiw's body of work got him tenure and also the Clark Medal. The big trouble with smart people is when they start to believe that everything they think is smart. They become uncritical of their own thoughts and fall it the trap of hubris. I guess having a blog has made him much less critical of his own thoughts. Maybe someday he will try to provide some insight and not just try to fill in the blank spots in his blog.

[matt wilbert]

Re: the "burst of inflation"

Presumably there are capacity constraints on the Chinese economy other than labor. And I don't think a large labor force necessarily prevents inflation--wasn't there a lot of available labor in the US in the mid 1970's?

[Marc]

Hi Brad,

I was first surprised to see the reference to Keynes as "Uncle Maynard" --- I hadn't heard that before, and wondered if it was your turn of phrase.

[I believe Stan Fischer started it by referring to his colleagues as "Brother ..." (and "Sister ... "), as if they were fellow members of some monastic order. I forget who it was who began calling older members of our profession "Uncle" (and "Aunt"). It might have been Frank Hahn, referring to Joan Robinson. It might not...]

To check, I googled "Uncle Maynard," and was at first satisfied that this was uncommon, since no hits on the first page referred to Keynes. But this method is surprisingly not robust: the first three results of a google search for "Uncle Miltie" are for Milton Berle! I plan to check this result further by asking my grandmother who is "Uncle Miltie."

Secondly, I was surprised that you say that Uncle Maynard was a more forceful debater than Uncle Miltie. Sure, we think of Keynes as a forceful debater, but I recall reading that Friedman was considered the most powerful debater at Chicago, and that the first time anyone had an argument with him, they came away surprised that such a short man packed such a lethal punch.

Thirdly, I think by now I know a bit about how "monetary policy works," but I don't understand the vowelless economist's claim. I think he wrongly identifies a disequilibrium problem, when the real problem is that the goals of China's monetary authority might change.

First, raising interest rates and having tight money at home isn't inconsistent with trying to keep up your exchange rate. It's the standard textbook model that raising the domestic interest rate increases demand for the domestic currency and appreciates the exchange rate.

Secondly, you can claim that it doesn't meet the definition of equilibrium for the change in foreign reserves to be perpetually nonzero. So that could be true tautologically. But sometimes that plainly makes no sense. If you have a successful currency board and economic growth, you'll want to perpetually acquire more reserves so that the money stock can grow at least as fast as output.

Thirdly, the concern is really stability, not short run vs long run adjustment dynamics. And China's policy is stable, in that policy makers could keep acquiring dollars forever, if that forever remained their preference. If they were losing reserves, the peg would collapse. But nothing stops them from acquiring dollar claims in perpetuity, or even using US currency as the foundation for the Three Gorges Dam.

The problem, then, is that China will probably not want to hold dollar claims forever without redeeming them. It's the choice to turn this stock of savings into consumption that will could inflation, or the need to revalue the yuan. Either we get demand-pull inflation, or a revaluation to maintain monetary stability, or a combination of these things.

[johntoff]

Can Dr. DeLong (or someone else) please comment as to why the BoJ's policy is adopting the same "conflicted" policy as is China. The BoJ's policy of supressing the yen's value is fairly passive (allowing primarily domestic carry traders to do the job) and the yen that go out as a result of the carry most likely just U-turn into foreign investments in Japanese real estate and other assets. In addition, Japan's massive current account surplus seems to be doing little or nothing to stimulate domestic final demand in Japan.

Thanks.

[guest]

"And I don't think a large labor force necessarily prevents inflation--wasn't there a lot of available labor in the US in the mid 1970's?"

The mid-1970's stagflation was due to monetary expansion by the Federal Reserve after the end of Bretton Woods fixed-rate system. This is very different to Chinese situation, which has pegged exchange rates with direct price-level adjustment.

[save_the_rustbelt]

Does China's Exchange-Rate Policy Matter?

To the former American manufacturing workers who are now working at Wal-Mart or operating lawn services, it really matters.

[Admiral Tirpitz]

Low wages are not necessarily the same as low production prices. I have a friend whose family owns a steel-bending factory up in northern China. They pay as much in soft-money bribes to local officials on a monthly basis as they pay their entire labor force. That works out to about $10,000 USD per month flowing in the pockets of a low-level county official from a single factory alone. I visited the town and would guess there are about 100 of these factories in this small town alone.

Once you understand the political dynamic coordinating Chinese economic development, the mystery of rising prices and stagnating wages is somewhat done away with. Who cares about the peasantry? The language itself mocks them

There reality is that there is plenty of money in China, but not much trickles down to the common people. Revenue flows within the country concentrate in the hands of those with regulatory oversight over the productive industries. It is impossible to compete effectively without engaging in corruption of some sort. This partly why there is no domestic pressure for cracking down. If you're making money, you don't want to eliminate the loopholes you're using to get by, even if the system is enriching the state much more than yourself.

The really interesting thing about all of this is that this sort of corruption was originally taking place at very local levels due to a lack of a formalized regulatory framework. Localities could do pretty much whatever they wanted. Now things are centralizing. If you look at recent State Council policy papers, you'll see that the government is whole-heartedly embracing neoliberal rhetoric to justify the establishment of regulatory barriers. New anti-competitive policies which are worked around through kick-backs and bribery legitimize the collection of processing fees as part of "regulating" a "healthy" marketplace. I'm not blaming neoliberals for the rent-seeking behavior of the Chinese state, but it is amazing how ideologically myopic most are to reality when they write about economic developments in China.

[Barkley Rosser]

johntoff,

Actually, it is probably the other way around, China is imitating the long-standing policyh of Japan. Yes, officially the Japanese yen has been floating for a long time, but it is known that the Ministry of Finance regularly intervenes in the forex market to make it into "dirty floating," and the extremely low Japanese interest rates have held the yen down.

Heck, Japan has been running a bilateral trade surplus with the US essentially forever, and in the past people used to freak out about it. Now they freak out about the Chinese one.

[Barkley Rosser]

johntoff,

Actually, it is probably the other way around, China is imitating the long-standing policyh of Japan. Yes, officially the Japanese yen has been floating for a long time, but it is known that the Ministry of Finance regularly intervenes in the forex market to make it into "dirty floating," and the extremely low Japanese interest rates have held the yen down.

Heck, Japan has been running a bilateral trade surplus with the US essentially forever, and in the past people used to freak out about it. Now they freak out about the Chinese one.

[China Law Blog]

Thanks for the clear explanations. If Uncle Miltie and JMK agree on something, it must be right. Right?

[RN]

Don't forget, this is yet another in the daily half-truth snow jobs propogated by hypocrite Greg Mankiw.

[David]

guest,

You wrote "The mid-1970's stagflation was due to monetary expansion by the Federal Reserve after the end of Bretton Woods fixed-rate system. This is very different to Chinese situation, which has pegged exchange rates with direct price-level adjustment."

The Chinese have to print a lot of money to maintain the peg at its present level, so there is quite a large monetary expansion in China.

There are many reasons for China to have inflation: higher commodity prices, shortage of highly skilled labor, monetary expansion, etc.. Inflation in China isn't a mystery.

[David]

RC,

I agree with you 100%

I admit that sometimes I also fall in to the trap of hubris; though I seem to recover much faster than Mankiw.

[David]

"Thanks for the clear explanations. If Uncle Miltie and JMK agree on something, it must be right. Right?"

It's definitely a good sign.

[jeffreydj]

The other day, William Greider wrote up an ex-VP of IBM named Gomorcy who is trying to advise the unwilling residents of Capitol Hill. According to Greider, Gomorcy's thesis is that the US needs to do two things, either one of which is inadequate alone. 1) to announce a policy of driving the trade deficit to zero, supposedly OK by WTO rules. 2) to rewrite the tax code to reward corporations that invest in domestic plant and personnel and stick it to the ones that ship our jobs overseas.

Sounds like an easy call to me, but congressmen don't wanna talk about it, and the Bush admin? Don't make me laugh.

I, for one, would dearly love to see this two-part idea gain some profile.

[Brian Wang]

If China maintains 7.1% growth from 2008 through 2020 and lets the yuan appreciate 7.5% per year then china passes the US (US growing at 3%.year) in about 2020.

The Carnegie endowment forecast 7.1% as the lowend of growth.
Their midrange was 8.1% and their high was 8.6%. China recently has been tracking at about 10 per year.

http://advancednano.blogspot.com/2007/05/chinas-economy-could-pass-usa-in-2020.html

the higher growth rates combined with currency appreciation would mean a pass as early as 2019. The growth rate would have to be 9.5% (combined with 7.5% currency appreciation) to move it to 2018.

The 2.9 RMB to 1 USD combined with relatively strong growth would have the Chinese economy passing the US (assuming about 3% growth for the US in the 2018-2025 timeframe.)