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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.