I’d like to welcome any new readers from China, who may have discovered this blog through the Netease version. I generally focus on U.S. monetary policy, but today I will discuss the Chinese yuan. I should also mention that I will have to slow down for a few weeks, in order to revise a manuscript on the Great Depression that I am trying to get published. If you are a new reader, there are plenty of older posts that discuss my view of how the current crisis has been misinterpreted. Those views are quickly sketched out in the very first post, “About the blog.” I will take a fairly long trip to China later this year—which might also lead to posts on topics related to China.
I’d like to consider the Chinese yuan from three perspectives:
1. Long run trends in the real exchange rate
2. The exchange rate and trade imbalances
3. The exchange rate and world aggregate demand
1. In my recent post on Estonia I discussed why very fast-growing economies tend to see their real exchange rate appreciate, due to what is called the “Balassa-Samuelson effect.” This can occur either through a higher market (or nominal) exchange rate, or through a higher rate of inflation. The intuition is simple. Low income countries tend to have a lower cost of living, due to relatively low productivity in traded goods. As they get richer their cost of living approaches developed country levels.
In my earlier trips to China I estimated the cost of living at barely a third of U.S. levels. I expect China to eventually become a developed economy, at which time its cost of living should be similar to that of the US. As a result, when the yuan was 8.28 to the dollar, I predicted the yuan would rise to about 3 to the dollar in the long run (perhaps 30 years.) This surprised some of my Chinese friends, but it has already risen to about 6.8 in just a few years, and still has a long way to go. I assumed the Chinese government preferred to make this transition through a higher nominal exchange rate, rather than high inflation. In 2005 they seem to have made that choice.
In recent years, the US and European governments have pressured China to revalue the yuan upward. Despite my views on the long run trend in the yuan, I think this is very bad advice, for both sides. Indeed it might be better if the yuan was slightly devalued in the short run. To see why, we have to consider two other issues that are widely misunderstood.
2. The US currently runs a large trade deficit with China. Many politicians in America seem to believe that deficit is caused by an undervalued yuan, and that the deficit hurts the US economy. I think both views are wrong. Like many other economists, I believe the trade deficit, or more precisely the current account deficit, simply reflects differential savings rates between the US and East Asia. Countries that save more than they invest (China) will run current account surpluses with countries that save less than they invest (i.e. the US.) The exchange rate does not cause imbalances, rather the real exchange rate moves to the level required to facilitate the necessary capital flows.
3. I would go even further than many other western economists and argue that the US and Europe might have actually benefited from a yuan devaluation late last year. To see why it will be necessary to move beyond the “zero-sum game” view of trade, the view that one country’s gains are another country’s loss. When there is a steep worldwide drop in aggregate demand (AD), or nominal GDP growth, all countries suffer. Any policy that is capable of boosting AD within China will also impact world AD, and thus has the potential of helping all countries. First I’ll consider two theoretical ways of thinking about this issue, and then I will provide an example of where the US did exactly what they are telling China not to do.
If China devalued the yuan, and that boosted China’s growth rate, it would also boost growth in countries that supply inputs to China. These include the more developed East Asian economies that supply manufactured inputs, capital goods exporters like the US and Germany, as well as commodity producers like Australia and Canada.
A more subtle, but potentially more important channel is through monetary policy. Right now US monetary policy is limited by the fact that nominal rates cannot be cut below zero. Although I have argued that there are other monetary policy channels, it would still help immensely if we could escape from the liquidity trap. Faster worldwide economic growth, even if outside the US, will tend to raise the Wicksellian equilibrium interest rate in world capital markets. If the equilibrium rate rose above zero percent, the current US fed funds target would become much more expansionary. If it seems strange that higher rates could be expansionary, recall that the upswing in the US stock market since March has coincided with rising interest rates (real and nominal) in the 5 and 10 year T-bond market. And this upswing also occurred about at the same time that many forecasters were becoming more optimistic about China’s growth rate for the rest of this year.
In 1933 the US tried the same sort of policy that I am now discussing in regards to China. We were deep in depression at that time, and decided to sharply devalue the dollar against gold (and implicitly against most other currencies.) The effect was immediate, and very positive. Aggregate demand rose sharply on higher inflation expectations, pushing up industrial production by an amazing 57% between March and July 1933. What many economists do not know, however, is that the dollar devaluation actually worsened our trade balance. Exports rose about 3%, but imports soared 20%. How did this happen? Exports were held down by the weak economies outside the US, whereas the rapid growth in American industrial production raised US imports of key inputs, exactly the transmission mechanism that I hypothesized for a devaluation of the yuan. In a deep slump, the income effect is often more powerful than the terms of trade effect.
There are many ironies in this story. Although Europeans tended to oppose the sharp US devaluation in 1933, their economies actually benefited from the robust recovery that followed the devaluation. Indeed if President Roosevelt had not made the mistake of introducing a high wage policy in July 1933, the Depression might have ended fairly quickly. Today many Western leaders seem to favor a higher yuan. But the last thing the world economy needs right now if for its most important growth engine to sputter because of a deflationary exchange rate policy.
Of course there are many political and economic factors that go into any exchange rate decision. I don’t know whether depreciating the yuan would be a good idea right now, all things considered. But I do think that western leaders make a mistake in pushing for a strong yuan, indeed I believe this is the same mistake they made with Japan in the 1990s. But today with the entire world in a deep recession, the policy could hurt more than just one country.
Fortunately, because China continues to experience rapid productivity growth, even the recent policy of stabilizing the yuan is increasingly stimulative over time. The Balassa-Samuelson effect is still in play and is gradually making China more competitive as its nominal exchange rate is currently fixed. This may well cause China to be the first major economy to recover from the worldwide recession. At some point in the future the yuan should and will resume its upward climb. But not yet. My purpose here is not to suggest exactly what should be done with the yuan, but to suggest a perspective that I think many in the West overlook.
PS. Although I tend to agree with the Chinese government on its yuan policy, this does not mean I always agree with their economic policies. I find Professor Yasheng Huang’s views on the need for faster economic reform in the countryside to be very persuasive. I hope to discuss other aspects of the Chinese economy when I have had a chance to study the issues more fully.
PPS. For those interested, here is a Netease page that includes both my blog and Greg Mankiw’s blog. (Also here.) I am told that I am described as a “famous professor.” That’s too polite (bie ke qi?) Perhaps I will end up being better known in China than the US.