Reply to Economist.com: A theory of non-relativity

Yesterday’s online version of The Economist, also known as known as Free Exchange, did a nice piece on my recent China post.  They contrasted my views with those of Paul Krugman, and also asked a few questions.  Here I’ll try to respond to those questions, but first I’ll clarify exactly where Krugman and I differ.

First some areas where we agree.  Both Krugman and I see the biggest macro problem over the past 14 months as being the sharp fall in aggregate demand over most of the world.  We are both strong supporters of additional stimulus; indeed we are both among the diminishing band of economists who still favor additional stimulus.  We both strongly oppose monetary tightening by the Fed, ECB, and BOJ.  But there are also some key differences, which may have indirectly contributed to our opposing views on the Chinese Rmb.  In the US I favor additional monetary stimulus and oppose fiscal stimulus.  Krugman is not opposed to additional monetary stimulus, but doubts the effectiveness of such actions when the policy rate is near the zero bound.  

There is pretty general agreement that central banks have almost unlimited ability to depreciate their currency.  And most major central banks (including the Fed and the People’s Bank of China) have the resources necessary to sharply increase their nominal exchange rates, if they so desire.  So I agree that the Chinese government could appreciate the yuan in nominal terms.  Let’s put off the issue of saving rates and current account deficits for the moment, and grant Krugman’s assumption that the PBOC could also appreciate the real Chinese exchange rate, at least for a considerable period of time.  The question is whether it would be wise.  I think it would be bad for China, and bad for the world. 

However, my reasons are not what you might expect, as I look at the issue from a money/macro perspective, not a trade perspective.  If the Fed were to adopt a much more aggressively expansionary monetary policy, and if this led to a higher value of the Chinese yuan, I’d be in favor.  So why does it matter how the Chinese currency appreciates, as long as it appreciates?  Because an exchange rate is merely the relative value of two currencies, it tells us nothing about the absolute value of those currencies in terms of goods and services, which is much more important.  If the Fed adopted a much more expansionary monetary policy, and if the PBOC kept its policy stance the same, then world monetary policy would become more expansionary, and world aggregate demand would increase.  That would help everyone.

I’m going to go out on a limb and suggest that Paul Krugman very likely agrees with the preceding analysis, at least at a technical level.  So why is he calling on the PBOC to appreciate the yuan against the dollar (a tight money policy), rather than call on the Fed to depreciate the dollar against the yuan.  I think there are at least 4 explanations he might give:

[Update: A commenter named 'original anon' pointed out the preceding was misleading; the yuan rate is determined by the Chinese government.  I should have said "rather than call on the Fed to try to depreciate the dollar with a more expansionary policy."]

1.  Krugman might argue that we have already depreciated the dollar (against the euro and yen) and the Chinese have refused to play ball.  Rather than keep their exchange rate stable against a basket of currencies, they have let it fall by tying it to the falling dollar.  And I am sympathetic to this argument.  But the bottom line is that no matter how weak the dollar looks, it is not as weak as it needs to be in absolute terms, i.e. against goods and services.  Expected growth in prices and NGDP (my preferred indicator) is still too low.  So yes, the yuan is weak against the euro and yen, but the currency it is stable against (the dollar) is itself too strong.

2.  Krugman might argue: “Yes, it would be better to depreciate the dollar by making US monetary policy more expansionary, but at the zero rate bound that is not possible.”  (Or perhaps he’d argue that it is theoretically possible but would require extreme and risky unconventional policy steps that the Fed is too conservative to take.)  Much of this blog has been devoted to refuting that argument.  I think the Fed could stop paying interest on reserves, perhaps even impose an interest penalty on excess reserves.  And they could engage in quantitative easing (something they have not done during 2009, despite reports to the contrary.)  And by far the most important and powerful step would be to set an explicit nominal target, a trajectory for the price level or NGDP to grow over time. 

3.  Krugman might argue that because the Chinese economy is growing vigorously they don’t need any more stimulus, and they are stealing jobs from the rest of the world with a low yuan policy.  There might be a bit of truth to this argument, but I would argue the net effect of their action is much more likely to be positive.  A strong Chinese economy boosts world AD.  Furthermore, other countries are free to adjust their currencies appropriately.  The South Koreans responded to the Chinese policy by letting the won depreciate during the crisis.  (Don’t ask me about the BOJ, I have not understood one thing they’ve done since 1993.)  You might wonder whether this could lead to a currency war, each country trying to depreciate its currency against the others.  Maybe, but that is precisely what you’d like to see happen in a world economy where AD has collapsed because conservative central bankers don’t understand that their policies drive the expected rate of growth in nominal GDP.  Or perhaps I should say they don’t understand that this well established proposition applies not just in normal times, but also during financial crises.  Obviously competitive devaluations could get out of control, leading to excess demand.  But I’m with Krugman on this issue, the threat to the world economy for the next few years is too little AD, not too much.  And the markets seem to agree.  Not just the equity markets, which clearly favor monetary ease, but the indexed bond market, which shows very low inflation expectations over the next two years.  (BTW, if you think only a slightly nutty economist could recommend a round of competitive devaluations, consider this post by the respected Barry Eichengreen.)

4.  Krugman might argue that the Chinese could insulate their domestic economy from the impact of a yuan appreciation.  They could appreciate the yuan without tightening domestic monetary policy.  After all, they still have strong currency controls.  But these controls are not as strong as they seem.  In the late 1990s they were not able to prevent yuan overvaluation from causing Chinese deflation, and in the period leading up to 2005 they were not able to prevent inflows of hot money from driving inflation and asset prices higher.  I am not convinced the Chinese government has firm control over their real exchange rate, no matter how powerful it may look to outsiders.  Admittedly, their foreign exchange reserves have reached formidable levels.  But they are holding these reserves for a reason, and I wouldn’t expect them to easily give them up.  I am most concerned by the possibility that the Chinese government would try to offset a high yuan policy with a policy of easy credit from state-owned banks—which lend almost exclusively to the relative inefficient SOEs.   We have already seen a disturbing shift in the Chinese economy, as the export sector (comprised on smaller private firms) has recently shrunk, and instead the government has forced banks to massively expand their lending to SOEs.  A policy of currency appreciation combined with increased lending from state banks to SOEs would further set back Chinese market reforms. 

So far I have focused on only one issue, an issue where Krugman ‘s goals are similar to my own—the need for more stimulus, more aggregate demand.  But Krugman also raised a separate and much different issue, the so-called “imbalances” in the world economy—imbalances that were supposedly exposed by the recent crisis.  I just don’t buy this argument.  I’d like nothing more than to go back to the ‘imbalances” of mid-2008; with oil at $140 a barrel, the world economy strong, US unemployment in the mid-5% range, and a huge US current account deficit

If we do return to prosperity over the next few years, would it be a bad thing if the US current account deficit rose back up to 5% of GDP?  I don’t see why.  Or perhaps it would be more accurate to say that I don’t think either monetary policy, or exchange rate policy should try to “fix” this so-call imbalance.  I would favor a fiscal tax/spending system that was much more pro-saving, something along the lines of Singapore, but that is a different debate.

When I lived in Australia in 1991 it was in a severe recession.  The Aussies I talked to were pessimistic about their future, and pointed to their big current account deficit.  I didn’t see any problem with a current account deficit.  Since 1991 Australia has had arguably the best macroeconomic performance of any major developed economy.  They are the only major developed economy to have had had zero recessions during this period (we’ve had two.)  And yet they have continued to run huge CA deficits year after year, roughly comparable to the US as a share of their economy.  Why did they get off so lightly in this crisis if a big CA deficit is the root cause of our problems?  When will they have their day of reckoning?  I doubt they will ever have a “day of reckoning;” the Australian CA deficit reflects differential patterns of saving and investment between Australia, whose population is growing fast through immigration, and countries like Japan, which has a declining population.  Some might argue that there is one big difference between Australia and the US; the Aussies generally don’t run large budget deficits.  Maybe so, but I don’t think Krugman would want to make this argument, as he thinks the US budget deficit is currently much too small.   

Krugman strongly disagrees with those (like me) who believe it is more useful to think of savings/investment patterns driving the current account, rather than exchange rates.  I wouldn’t deny that in the short run the Chinese government could stop accumulating assets and let the yuan appreciate.  And this decline in government saving might reduce the CA deficit in the short run, although history shows that CA deficits often stubbornly refuse to respond to exchange rate fixes.   But if these current account “imbalances” are a problem, they are a long term problem, not a cyclical problem.  And there is little evidence that fiddling with the nominal exchange rate can influence the long run real exchange rate.  If political pressure forced the Chinese government to appreciate the yuan in nominal terms, the gesture would be gradually eroded by offsetting deflation (just as in the late 1990s), as there are very strong reasons for the high savings rates of both the Chinese government and private sector.

Now let’s look at the questions from The Economist:

This is a very interesting take and worth considering. I have some questions, though. First, would appreciation of the renminbi against the dollar constitute general appreciation? There are other currencies in the world. The Wall Street Journal notes that RMB depreciation thanks to its dollar peg has meant appreciation of other Asian currencies, many of which are floating (or “floating”), against the RMB. (The Economist makes a similar point in the latest print edition.) In other words, how does the current world compare with one in which China allows its currency to float against the dollar but also targets a level of nominal GDP around 10% and adjusts monetary policy accordingly? Exchange rate policy may be a form of monetary policy, but that doesn’t mean it’s the optimal form of monetary policy.

Unless I am mistaken, most of the other Asian currencies have depreciated since mid-2008.  The obvious exception is Japan.  It is true that there has been some recent appreciation with the strong recovery in Asia (helped by their earlier depreciation), but I think that is appropriate given the recent differences in the relative performances of the US and the Asian economies (ex-Japan.)  It is interesting to compare Japan and South Korea, two relatively developed economies that both export capital goods to China.  Because the Korean won depreciated during the crisis last year, Korean NGDP hit an all time high in the 2nd quarter of 2009 (and I believe was also extremely strong in the 3rd quarter, just announced.)  At the same time the BOJ allowed the yen to appreciate sharply, and as a result its NGDP was 8% below its 2008 peak by 2009:2.  That’s nominal GDP, in case someone wants to look for “real factors” as an explanation.  Now I obviously would not argue that there is anything like a perfect correlation between changes in exchange rates and changes in NGDP.  In fact, real exchange rates more often appreciate in booming economies.  But Japan and Korea faced essentially the same external shock on 2008, and I think the vast difference in their NGDP growth rates since is at least partly due to the very different exchange rate policies, which in this particular case do reflect different monetary policies.  I’m not certain whether a stronger RMB would lead other Asian countries to appreciate their currencies.  But if it did so, it would magnify the contractionary impact of the Chinese action on world AD.  And there is obviously some tendency for countries to respond to exchange rate policies of their larger neighbors. 

Secondly, Mr Sumner suggests that China’s high savings rate is behind its current account surplus, rather than currency policy. Mr Krugman offers some thoughts on the matter here. I don’t know that this is much of a reason to favour or disfavour exchange rate adjustments.

I answered this question in my previous discussion.  To reiterate, I don’t see CA imbalances as being a “problem” (although they may be symptomatic of deeper problems in the economy.)  If Krugman is right that they represent a long term threat to the health of the world economy, then long term structural changes (i.e. encouraging savings in the US) are more likely to be effective than a policy of manipulating the nominal exchange rate.  Monetary policy has little impact on long term real exchange rates.

Is it right to credit China’s currency policy with cutting off the possibility of a deep recession? Mr Sumner has generally argued that monetary policy has been too tight, and as China’s dollar peg looks to him like a particularly substantial effort at monetary easing, it’s logical that he would conclude that the peg has been the decisive factor. I’m not sure most economists would agree. And again, is it the case that the current world is preferable to an alternative one, in which the Chinese allow their currency to float but also pursue a much more aggressive monetary policy?

I’d break this question down into two pieces.  Did the recovery in China that began in March dramatically reduce the chance of a deep depression?  I am convinced that it did.  Not only did US equity markets begin to rally at that time, but the Asian markets often seemed to be leading the way.  There were occasions in the spring where positive stories out of Asia seemed to be the only positive news impacting US markets.  The harder question is what caused the Chinese recovery.  I suppose at first glance the most visible Chinese stimulus was not its exchange rate policy, but rather its fiscal/monetary stimulus package, which largely consisted of loosening regulations on lending by state-owned banks.  This boosted the real estate market, and spending on government infrastructure such as high speed rail projects has also increased impressively.  This could be viewed as a point in Krugman’s favor.  But people underestimate the impact of monetary/exchange rate policies, because the effects often work in unexpected ways.  I mentioned in the earlier post that the US dollar devaluation had a very powerful effect on US real and nominal GDP after March 1933.  But none of this increase was attributable to changes in trade flows.  Instead all of it occurred as rising inflation expectations drove up asset prices and increased domestic aggregate demand.  Krugman has written approvingly of a 2008 AER paper by Eggertsson that made this argument.  Note that the rapid recovery in the spring of 1933 occurred before any significant fiscal stimulus had occurred.  And finally, weekly changes in the WPI and the Dow during 1933 were strongly correlated with dollar depreciation against gold.   If China had appreciated its currency this year then deflationary expectations in China might have become entrenched, threatening industries that are seemingly unrelated to trade, such as housing construction.

In the Krugman post linked two paragraphs above, the author notes that for America to return to full employment and reduce its trade deficit necessarily requires that either America experience deflation, other countries experience inflation, or the dollar depreciate. Mr Krugman says that central banks abroad will not allow inflation and deflation is very painful, so for adjustment to take place exchange rates must change. Another way of putting this might be to say that since central banks won’t allow inflation, the only way to get enough of a monetary policy boost to do any good is for a large economy to allow its currency to depreciate. Perhaps that is what Mr Sumner is saying.

Again, I don’t think exchange rate manipulation can solve these long run problems.  If we get more pro-saving policies in the US, that should lead to the appropriate adjustments in real exchange rates over time.  If all countries target inflation at 2%, then those adjustments will occur through nominal exchange rate changes.  If countries fix their currency to the dollar, then the adjustment will occur through higher inflation in places like China.  In the long run there is really no other way to address this problem.  The final two sentences inappropriately mix up two issues.  I am saying that we need more aggregate demand, and thus more inflation.  Indeed people often forget that inflation is one of the objectives of both monetary and fiscal stimulus.  So currency depreciation is only appropriate if required to get inflation expectations over the next two years up close to 2%.  (Currently the two year inflation forecasts in both the futures and TIPS markets are well below 1%.)  In my view it is the Fed, not the Treasury, which determines the fate of the dollar.  So if the Fed is opposed to boosting inflation up to 2%, then there is not much the Treasury can do in terms of ‘talking down the dollar.”  The Fed ought to be in favor of more stimulus, and indeed some FOMC members have said this.  But others have recently sent out hawkish signals, so policy is hopelessly non-transparent.  Would the Fed like to raise 2-year inflation expectations up from 1/2 % to 2%?  I haven’t the faintest idea.  And that’s not good.

Mr Krugman implicitly argues that a recovery which allows imbalances to persist is no recovery at all. Mr Sumner obviously thinks that exchange rate levels are irrelevant to imbalances. And I suppose I’m struggling to square the two views.

That’s not quite my view. I do think that currency manipulation can have a short run impact on trade imbalances.  But that is not the problem that Krugman was addressing.  Long run changes in savings and investment can lead to changes in the current account, which will generally require an adjustment in the real exchange rate.  So I would never claim that exchange rates are irrelevant, just that they are not an effective policy tool for solving real problems.

HT:  Marcus


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39 Responses to “Reply to Economist.com: A theory of non-relativity”

  1. Gravatar of original anon original anon
    27. October 2009 at 05:51

    “So why is he calling on the PBOC to appreciate the Yuan against the dollar (a tight money policy), rather than call on the Fed to depreciate the dollar against the Yuan.”

    The Fed can’t depreciate the dollar against the Yuan. The dollar is a floating rate currency. The Yuan is essentially a fixed rate currency. Its FX rate is determined by PBOC. The Fed can’t force a nominal FX change of its own volition.

    Or are you suggesting that if the Fed continues to depreciate the dollar against the Euro, PBOC as a result will revalue the Yuan against the dollar. Why would you think this?

  2. Gravatar of ssumner ssumner
    27. October 2009 at 06:14

    I agree. Thanks for pointing that out. I should have said “why not call on the Fed to try to depreciate the dollar against the yuan.” My point is that it would be a worthwhile exercise regardless of how China responded. You are right, perhaps they wouldn’t respond with an appreciation against the dollar–but it could still be an effective policy if it depreciated the dollar against goods and services. That should be our target, not one particular exchange rate. By the way, in 2005-07 the Chinese did respond to an expansionary Fed policy be appreciating the yuan, so it is not inconceivable that it could happen again.

  3. Gravatar of StatsGuy StatsGuy
    27. October 2009 at 06:24

    from the article:

    “is it the case that the current world is preferable to an alternative one, in which the Chinese allow their currency to float but also pursue a much more aggressive monetary policy?”

    That, I think, is the real question…

    You write:

    “If China had appreciated its currency this year then deflationary expectations might have become entrenched, threatening industries that are seemingly unrelated to trade, such as housing construction.”

    But that’s not the argument… The argument is that China should have allowed its currency to appreciate vs. the dollar, and then independently used monetary tools to ensure sufficient monetary growth of its own currency. How would this have led to deflationary expectations in the US? I think it would have yielded better overall results, and avoided the huge distortions from the carry trades we’re now seeing.

    Arguably, there are different _types_ of inflation, which are dependent on _where_ the new money enters the economy. The type of inflation that is driven by the carry trades may not be ideal.

  4. Gravatar of ssumner ssumner
    27. October 2009 at 06:38

    I hope these problems aren’t indicative of the whole post. I just did an update clarify the problematic sentence mentioned by original anon. Then I just added the words “in China” to the sentence mentioned by statsguy, to clarify that I thought Chinese appreciation could lead to deflationary expectations in China, not the US.

    Statsguy. I did address the issue of an independent Chinese monetary policy cobined with yuan appreciation in several places:

    1. I said real exchange rate movements in China in the late 1990s, and in 2005, cast doubt on the view that China could simultaneously target the exchange rate and domestic demand.

    2. I pointed out that evidence from the US in the Great Depression suggests that exchange rates dominate traditional monetary and fiscal stimulus.

    3. I pointed out that the policy you suggest would further worsen structural imbalances within China (policy is already tilting toward SOEs and away from private firms.) A yuan appreciation combined with doemstic monetary stimulus would make that distortion much worse.

  5. Gravatar of original anon original anon
    27. October 2009 at 08:25

    “I wouldn’t deny that in the short run the Chinese government could stop accumulating assets and let the yuan appreciate. And this decline in government saving might reduce the CA deficit in the short run, although history shows that CA deficits often stubbornly refuse to respond to exchange rate fixes. “

    Maybe this is just a diversionary technical detail, but I’d explain it a little differently. In the short run, the Chinese government has no alternative but to accumulate short term assets as the offset to its current account surplus. Again this is because it is the monopoly supplier of FX transactions – most current account transactions are settled in dollars, and exporters must sell net dollars to PBOC. The net inflow of dollars on current account can’t end up with the private sector because of this. Moreover, PBOC simply decides where to price the dollars against Yuan. If it wants to fix at current rates, it will. If it wants to devalue or revalue, it will. But the important thing is that the flow of dollars doesn’t affect PBOC’s monopoly pricing power on dollar/Yuan. And it has to take in those dollars.

    What PBOC can do if it wants is change the currency mix of its reserves. It can sell dollars it has taken in from exporters for Euros, for example. But interestingly, this won’t have any direct effect on the dollar/Yuan exchange rate, because that has already been set prior to selling the dollars for Euros. And selling dollars for Euros in itself has no effect on the dollar/Yuan rate that PBOC has set.

    Bottom line is that the Chinese government can’t decide to stop accumulating assets unless it completely opens up on capital controls and allows the private sector to invest dollars overseas. And also, because PBOC is a monopoly supplier of dollar/Yuan FX transactions, it is a price maker while this institutional setup is in place, and it doesn’t necessarily have to change pricing due to a change in the magnitude of flows – in the short run.

  6. Gravatar of ssumner ssumner
    27. October 2009 at 09:23

    original anon, Since you probably know more about this issue than I do, let me respond with a comment, and then a few questions.

    1. I agree about the option of swapping dollar assets for euro assets, and I also agree than such a move would have little impact on the dollar/yuan rate.

    2. I am a bit confused about your view that the Chinese government is essentially forced to accumulate assets in the short term, due to the current account surplus. Let’s suppose the Chinese decided to simply stop accumulating assets, not just dollar assets, but stopped any further additions to their stock of foreign exchange reserves. Let’s also assume that let the Rmb float (upward.) Am I correct in assuming that in a normal country with an open capital market, in the very short run the reserves that the central bank had been accumulating would now be accumulated by private speculators? This would occur because real trade flows change slowly, so once the exchange rate had risen to its expected long run level, it wouldn’t rise much further (due to intertemporal arbitrage–i.e. the interest partiy condition.) Instead the currenct account surplus would be financed by private investors until the real trade flows adjusted to reflect the fact that the government was no longer piling up assets and thus financing the surplus. Is this right? Are you then arguing that because China doesn’t have an open capital account, private speculators could not fulfill this role? In that case a sudden decision by the PBOC to stop accumulating international reserves would throw the market in chaos. The real trade flows would be forced to adjust almost immediately, and I suppose this would show up as trade literally shutting down because of a lack of foreign exchange. Is that the argument? If so, it makes sense to me. If you had another argument in mind, where did I go wrong?

    If that is your argument, then I agree that my short run scenario is a bit misleading. Although fortunately it doesn’t invalidate my core argument.

  7. Gravatar of original anon original anon
    27. October 2009 at 10:22

    Yes. In a normal country with an open capital market, exporters would sell their dollars through the FX market or invest them themselves. The private sector would invest the dollars (i.e. dollar financial assets) one way or another.

    I’m saying that a sudden decision by PBOC to stop buying dollars would require a complete institutional restructuring of the FX market in China. I’m not saying that can’t happen, but it reflects a larger institutional decision that is required in order for PBOC to step away from intervening in the dollar market at all. So, yes, chaos would ensue, unless that larger institutional change is made in order to open up the FX market and the dollar capital market in China more permanently. As things stand, PBOC has tight policy and operational control over dollar flows. And remember that the Yuan also is not traded internationally as part of this control.

    So we agree. And it wasn’t meant to be a comment on your core argument.

  8. Gravatar of StatsGuy StatsGuy
    27. October 2009 at 10:27

    ssumner:

    All of the arguments you present are reasons why China would not _want_ to revalue; NOT reasons why they should not (from a global perspective). They are close to a defense of modern day mercantilism. (Who are you and what have you done with the real Scott Sumner?!?)

    points 1 & 2) Because exchange rates are so powerful, China can more effectively stimulate demand through undervaluation of its currency than other PBOC actions… but this is the zero sum/beggar thy neighbor argument, since this type of stimulus (unless it is driven by real changes in the money supply that would cause the real value of the Yuan to depreciate) requires that China supply a too-large-share of US consumption and also keep imports from the US relatively low.

    On the other hand, China should be able to sufficiently support demand if the PBOC _and_ the Fed provided necessary action. If the PBOC let the Yuan float and then provided monetary stimulus, then the currency would devalue anyway… And the US might be forced to follow suit. In that scenario, we get competitive devaluation (which may even cancel out) – which you’ve said is a good thing in a low AD environment because it’s a self-reinforcing mechanism that drives global monetary expansion. But if your argument is that the PBOC doesn’t trust the Fed to act with half a brain, then I must concede your point.

    3) Again, this argument explains why their policies are good for China, not for the world. You are basically saying that China’s best tool for supporting the private sector is export-led growth (e.g. supplying the US market) because it simply can’t provide internal demand to drive private sector growth (due to structural problems). Again, that’s quasi-mercantilism.

    Finally, because the US can’t independently devalue vs. the Yuan since it lets the dollar float (but can increase the supply of money), US monetary action simply forces dollars into hard value-stores that (after the anticipated revaluation of the Yuan) will retain more value in a global sense. Indeed, cheap US interest rates mean one can borrow dollars to do this (and instead of simply preserving value, one can actually make a profit). This is the Carry Trade, and this has put the Fed in a catch 22 – the _expectation_ of future devaluation is deadly. (you might be thinking that this is a good thing since it supports prices, but the price support is _very_ uneven, which creates immense problems)

    All the US can really do is try to devalue the dollar vs. the rest of the world. Since the Yuan is linked, this makes the cost of dollar-priced inputs increasingly expensive, even as Chinese firms continue to draw the same prices for their exports to the US. Eventually, the slice of revenue that Chinese firms get for buying inputs and converting them to exports (to the US) would shrink to such a degree that they would cease accumulating reserves, and actually divest their reserves in order to subsidize US consumption. But the other effects of driving the dollar that low clearly scare the Fed (then again, what doesn’t?).

  9. Gravatar of Bill Woolsey Bill Woolsey
    27. October 2009 at 11:01

    Scott:

    I think that the way the Chinese government stops accumulating dollar assets is buy RMB assets. The notion that the Chinese central bank must accumulate dollar assets is exactly the same as saying that an ordinary bank must respond to currency deposits by increasing excess reserves. Well, yes. But then what? The process by which the Chinese central bank gets rid of dollar assets is just like the money multiplier.

    What has to happen is that the quantity of money, inflation and/or real output in China must expand enough so that the Chinese want to use the dollars to purchase foreign goods. Or, Chinese goods are too expensive for foreigners.

    Now, I don’t understand exactly how capital controls work in China. Perhaps there is no way that anyone can turn RMB into dollars in order to avoid expected Chinese inflation, but that would be the short run way that this process gets dollar assets out of the hands of the Bank of China.

  10. Gravatar of Bill Woolsey Bill Woolsey
    27. October 2009 at 11:09

    Scott:

    The goal of monetary and fiscal policy is more inflation?

    How about a return on nominal expenditure to target?

    My view is that any inflation is an unfortunate side effect.

    You know, trying to talk their language is never going to work. Their target “CPI inflation from the current price level by changing the target for the fed funds rate” is just wrong headed. OK, things worked OK for a time, but the approach breaks down horribly from time to time.

  11. Gravatar of original anon original anon
    27. October 2009 at 11:09

    PBOC can stop accumulating assets, dollar or otherwise, if the current account adjusts, but that’s not the short run story. In the short run, PBOC issues Yuan in exchange for net dollars from exporters.

    I see no linkage with the idea of a domestic Yuan multiplier.

  12. Gravatar of original anon original anon
    27. October 2009 at 11:28

    Experiment:

    Let the world consist of Europe, the US, and China.
    Define E as a “currency easing unit”.

    Suppose the US dollar depreciates (eases) by 2E against the Euro.
    If China stays fixed against the dollar, the Yuan also eases by 2E against the Euro.
    The Euro tightens by -4E against the other two.
    The system is net flat, but there has been a joint US/China easing at the expense of Europe.

    Suppose now China revalues against the dollar by 1E.

    The CUMULATIVE result:

    The dollar eases by 1E against the Yuan.
    The dollar eases by 2E against the Euro.
    Total dollar ease is 3E, which is an additional 1E compared to the first case.
    The Yuan tightens by -1E against the dollar and eases by 1E against the Euro.
    Total Yuan ease is zero, which is 2E less than the first case.
    The Euro tightens by -3E against the other two, which is 1E better than the first case.
    The system remains net flat, but each of the US and Europe have experienced additional easing at the expense of China, compared to the first case.

    China’s revaluation thus redistributes global easing in favour of both the US and Europe compared to the fixed dollar/Yuan case, which was still positive for the US, but bad for Europe. Perhaps Krugman was looking for this effect?

  13. Gravatar of ssumner ssumner
    27. October 2009 at 16:54

    Anon, Thanks for clearing that up.

    statsguy, you said;

    “points 1 & 2) Because exchange rates are so powerful, China can more effectively stimulate demand through undervaluation of its currency than other PBOC actions… but this is the zero sum/beggar thy neighbor argument, since this type of stimulus (unless it is driven by real changes in the money supply that would cause the real value of the Yuan to depreciate) requires that China supply a too-large-share of US consumption and also keep imports from the US relatively low.”

    I’m confused by this on many levels. If it really were a mercantalist policy, it would hurt China, not the US. But you talk as if it hurts the US. It’s China’s decision if they want to lend us trillions of dollars, rather than use the funds to build up their own economy. I am not a mercantilist, and hence I don’t believe Chinese trade surpluses cost us jobs. I favor a low yuan not because it helps their exports, but because it reduces deflation, and thus boosts world AD. And there doesn’t need to be an immediate increase in the money supply (although there certainly is in this case.)

    The Chinese money supply has been soaring at something like 30% recently, so I don’t think that is an issue.

    I have no problem with a floating yuan, combined with an easy money policy that prevents appreciation.

    You said;

    “3) Again, this argument explains why their policies are good for China, not for the world. You are basically saying that China’s best tool for supporting the private sector is export-led growth (e.g. supplying the US market) because it simply can’t provide internal demand to drive private sector growth (due to structural problems). Again, that’s quasi-mercantilism.”

    No, I favor reform of the SOEs. But until they do that, the exporters are where China’s comparative advantage lies, not its SOEs. There is nothing mercantilist in my argument.

    All this talk about the dollar is making things way too complicated. Just get expected NGDP growing on target and forget about the dollar.

    Bill, I agree in the long run. And even in the short run they can do this. But I think that original anon is right, if they stopped suddenly, with no open capital markets to pick up the slack, there would be chaos in the tradeable goods sector.

    Bill#2, I’d like to never again mention the term inflation for the rest of my life. But if I never describe my views in that language, I bet The Economist would never link to me. I always try to mention the implications in terms of NGDP as well. But I do basically agree with you.

    original anon, That policy mix might make some sense. But that’s not really what Krugman is doing. He is not calling on some countries to ease by the same amount as others tighten. He is calling for China to tighten, regardless of what others do. He has indicated that he expects no further moves toward monetary ease from the major central banks. So a Chinese revaluation would be “negative E” in net terms.

  14. Gravatar of StatsGuy StatsGuy
    28. October 2009 at 05:47

    ssumner:

    “All this talk about the dollar is making things way too complicated. Just get expected NGDP growing on target and forget about the dollar.”

    Those things are deeply related because of the carry trades. (I know I sound like a broken record.) With the benefit of some sleep, I tried to lay out the argument step-by-step:

    http://blogsandwikis.bentley.edu/themoneyillusion/?p=2688#comment-9031

    “…hence I don’t believe Chinese trade surpluses cost us jobs.”

    Well, I guess I do… Or more accurately, I think the over-valued dollar has at the margin shifted job creation in the US into finance and to domestic-focused areas since the 80s (notably retail, housing, service sector). (I say at the margin, because there were other effects propagating such shifts too.) I believe these consumption-focused sectoral concentrations have been unhealthy in the long term due to endogenous growth dynamics (a la Paul Romer).

    If you don’t believe, then clearly there’s no inconsistency in your arguments – and the free trade/strategic trade/endogenous growth argument is too big to have here.

    “I have no problem with a floating yuan, combined with an easy money policy that prevents appreciation.”

    …very happy to end on a point of agreement. And let me make clear that I am _not_ arguing the low-value-Yuan peg is worse than a fair-value-Yuan with tight money.

  15. Gravatar of OGT OGT
    28. October 2009 at 07:53

    You keep writing about ‘aggregate demand,’ but the current problem is a global lack of net demand. Most of the Chinese stimulus has gone to projects that will increase the net demand gap, steel production, container ships, etc.

    I am also not entirely clear on how you conceptualize the driver of the savings/consumption balance, which you claim drives the CA balance. Surely tax and other policies have a role in this balance, but I believe exchange rate controls do as well by effecting the relative prices of goods and services and acting as a subsidy for certain forms of production and a tax on certain forms of consumption. It may be true that this would not tbe the case if China used its reserves to purchase things other than financial instruments in the US, but that is their only practical option given the size of their reserve accumulation.

    StatsGuy- Keep up the broken record, your comments on the carry trade have been enlightening. I have been thinking of the reserve status of the dollar as a financialized version of the Economist’s ‘Dutch Disease,’ for a while now. Not sure it totally fits, but it does provide a frame work to think about the secular shifts in the US economy.

  16. Gravatar of Doc Merlin Doc Merlin
    28. October 2009 at 16:11

    @OGT

    Yes, the Dutch Disease example is apt, and its not just monetary either. I think the Dollar being overvalued is a much smaller effect on the shift away from manufacturing than the growth of regulation has been.

    In particular, environmental regulation makes it much, much easier to start any sort of manufacturing in east asia than in the US. If you combine this with anti-union policies china, vietnam, etc have, and the fact that these countries have a much smaller “paper wall” preventing starting business, it is no contest.

  17. Gravatar of ssumner ssumner
    28. October 2009 at 17:16

    Statsguy, let me say right up front that I haven’t studied strategic trade theory or modern growth theory. But I was under the impression that it was about increasing returns and high tech industires, not whether we bought our shoes and toys from China rather than Mexico.

    I also thought the argument was not that trade cost us jobs, but rather that it lowered RGDP, buy leading us to concentrate in the wrong industry. BTW, keep in mind that if China had not run up large surpluses, we would have run large deficits anyway. The two “problems” or “imbalances” are almost completely unrelated. Much of the Chinese “surplus” is nothing more than Korean and Taiwanese goods re-routed through China.

    When our trade deficit peaked at 6% of GDP around 2007 we had 4.4% unemployment, so where were the lost jobs? What would our unemployment rate have been if we’d had a big trade surplus like Germany? BTW, Germany’s unemployment was about 8%, despite their massive trade surplus.

    Of course our trade deficit is not much smaller, but I see that as bad news, as sympotmatic of a weak economy that can no longer afford to buy a lot of neat gadgets from overseas.

    OGT, I’m not sure what you mean by “net demand”. When I speak of AD I mean NGDP, or total nominal spending on final goods and services.

    The CA balance is defined as national saving minus national investment. Many factors influence saving and investment, but I don’t think exchange rates have much effect. A general rule in economics is never reason from a price change. Never say the price went up therefore . . . or the interest rate went up therefore . . . or the exchange rate went up therefore . . . All of those statements will end up being false. Instead, look for the factors that caused the price change.

    Doc Merlin, Almost every country in the world has been losing manufacturing jobs, including China. The cause is the same everywhere, and the same as in agriculture in earlier decades—mechanization. We are headed for only a tiny percentage of workers being in manufacturing. But the output will continue to rise. Output in US manufacturing has risen much faster than in most other industrial countries during recent decades.

  18. Gravatar of Doc Merlin Doc Merlin
    28. October 2009 at 17:18

    Hrm, I should clarify. I didn’t separate the two ideas I was writing about. The Dutch Disease statement and the sentences about regulation are separate ideas.

    When I said the Dutch Disease for the US wasn’t just monetary, I meant that welfare payments, subsidies, and fiscal stimulus also had similar effects. In a different topic on this blog I tried to make a similar point about monetary stimulus being a sort of intra-national Dutch Disease, but I don’t think it was understood.

    Monetary stimulus ends up acting like a dutch disease and crowding out other industries in favor of banking, government (dependent on which direction the money goes), and/or criminal enterprise (Scott’s point about QE and tax evasion) . This is why I was so insistent in earlier discussions that in a good monetary system, it should be possible for almost anyone to increase the money supply.

    Whatever industry can expand the money supply will be favored. Let me provide an example that will help explain: under a well managed gold standard, gold miners expand the money supply by digging up gold and selling it to the money creating authority for dollars. This means that gold mining and businesses that work with gold mining get favored over other businesses, because business the gold mining business does automatically expands its money supply. Every time another business offers a product or service, it increases the demand for dollars, and thus makes what every one does cost a tiny bit more.

    Under our current system, the state’s and Bank’s actions expand the number of dollars, so their actions are favored. This creates a sort of intra-national version of the Dutch Disease. However, the disease is made a lot worse and international, by the Dollar’s status as reserve currency.

  19. Gravatar of Doc Merlin Doc Merlin
    28. October 2009 at 17:21

    “Doc Merlin, Almost every country in the world has been losing manufacturing jobs, including China. The cause is the same everywhere, and the same as in agriculture in earlier decades—mechanization. We are headed for only a tiny percentage of workers being in manufacturing. But the output will continue to rise. Output in US manufacturing has risen much faster than in most other industrial countries during recent decades.”

    Scott, My choice of words was poor. I wasn’t referring to manufacturing jobs, but the manufacturing sector as a whole as opposed to banking and government. I agree that most of the job loss is due to technological improvements and is a good thing in the long run.

  20. Gravatar of Doc Merlin Doc Merlin
    28. October 2009 at 17:26

    I should add to my statements about monetary policy, that I don’t think the US is the only country with this problem. It seems fairly global.

  21. Gravatar of StatsGuy StatsGuy
    28. October 2009 at 21:38

    Let me say up front, btw, that this blog has been the best lesson in Macro and monetary policy I’ve ever had.

    Re: Dutch Disease, etc…

    I’ve made a similar argument on Baseline a few months ago…

    http://baselinescenario.com/2009/04/26/guest-post-too-big-to-fail-and-three-other-narratives/#comment-12033

    The basic argument is that the dollarization trend (e.g. other countries absorbing large dollar reserves, and even using dollars in their domestic economies) has created an exogenous and sustained demand for dollars in excess of their normal demand to buy imports from the US. This has created a 20 year period of overvaluation of the currency – overvaluation in the sense of “what happens when the exogenous demand for dollars ends, or even reverses?” Which is now happening as countries shift out of dollar reserves. But industries that _were_ profitable when the dollar had a lower value died over the past 20 years, and are not coming back quickly.

    In the short/medium term, high dollar valuation increased the US capacity to consume. No one will argue this is bad in the short term (except displaced workers). In the long run, the fear is a “hollowing out” due to a loss of key industries that are hard to re-establish (due to endogenous growth dynamics).

    In a sense, the US was “exporting” dollars, as if dollars were themselves valuable (and they were! especially for economies that had destroyed their currencies). But that was not really a sustainable export, was it?

    ssumner: “if China had not run up large surpluses, we would have run large deficits anyway”

    I don’t want this to become a bash China fest – I blame Reagan/Dubya strong dollar/fiscal deficits a lot more than I blame China. Having said that, by financing US imports, China helped keep rates too-low, which some people would argue sustained excess consumption and underproduction for much longer than would have occurred otherwise. Some go so far as to blame the housing bubble on low rates due to Chinese financing (I think that’s a small part of the story, and China certainly got burned by that as their reserves – their national savings in a sense – plummeted in value).

    All in all, I think the US might be better off if China had not soaked up US reserves (and, by extension, kept the Yuan undervalued for so long relative to the dollar). I know this does not align with free trade theory (who would turn away cheap consumption!).

    Re: Strategic Trade and Endogenous Growth Theory… not going to blather on, but I will note that my sneakers were made in Mexico and my kids toys all over; the computer I’m typing on? China.

  22. Gravatar of Doc Merlin Doc Merlin
    29. October 2009 at 01:58

    @StatsGuy
    I agree this blog is great.

  23. Gravatar of jean jean
    29. October 2009 at 02:00

    Isn’t it true that at least one central bank has to buy other things than foreign currencies?
    When a foreign central buy some dollars, it in fact asks the Fed to do their asset management in their place. But I am ok to say that developping countries and small countries may have no other options.

  24. Gravatar of original anon original anon
    29. October 2009 at 11:18

    “Original anon, That policy mix might make some sense. But that’s not really what Krugman is doing. He is not calling on some countries to ease by the same amount as others tighten. He is calling for China to tighten, regardless of what others do. He has indicated that he expects no further moves toward monetary ease from the major central banks. So a Chinese revaluation would be “negative E” in net terms.”

    Given that the US dollar is a floating rate currency, currency easing as I’ve defined it is imposed by the market. That’s what’s been happening recently through dollar depreciation. I’m not sure Krugman is so opposed to US dollar depreciation, so long as its gradual rather than cliff diving. Maybe I’ve missed it, but I’d be interested if you’ve picked up on something different. In fact, dollar depreciation is consistent with his concern that global imbalances be corrected.

    What he is suggesting with respect to the Yuan is in effect a more orderly approach to the correction of global imbalances. In contrast to the free float market priced dollar, the Yuan is a fixed rate currency whose price level is determined by PBOC rather than by the market. To the degree that further dollar depreciation is possible, then Krugman’s call for Yuan tightening makes all the more sense, as per my example above. It basically redistributes global easing marginally in favour of the US and eases up on the tightening that would otherwise by imposed on Europe by further dollar weakness – again as per my example. In other words, China’s tightening against the dollar serves to diversify global currency effects from what they otherwise would be. The existing Yuan fix has the effect of concentrating currency effects outside of China, which is not good for the correction of global imbalances.

    So I think that Krugman very much has the risk of further dollar depreciation in back of mind when he suggests a strategy of Yuan currency tightening (pegging higher against the dollar) by PBOC.

  25. Gravatar of Doc Merlin Doc Merlin
    29. October 2009 at 13:20

    @Jean

    The Fed doesn’t really have to buy assets at all. It does buy them as a way of getting money into the system, but even if it had zero assets it would still function. Maybe I am misunderstanding your question.

  26. Gravatar of jean jean
    29. October 2009 at 14:12

    @Doc Merlin:
    Of course, the Fed can print money. But then, to whom should the Fed give the money? And, central banks want their policy to be a bit reversible.

    My point is that if ECB buys dollar and Fed buys euro, there is no additionnal money in the system.

  27. Gravatar of Doc Merlin Doc Merlin
    29. October 2009 at 21:41

    @Jean

    Got yah, generally the central banks give the money to regular (non central) banks and then they loan it out. All the money doesn’t just go to other central banks although a sizable fraction does. People then deposit some of their money that originated from the loans they got from the banks into banks and a large fraction of that money gets re-loaned.

    Again, did I answer your question, or am I missing the point entirely.

  28. Gravatar of jean jean
    30. October 2009 at 02:24

    @Doc Merlin:
    Yes, this answers my question.

  29. Gravatar of Scott Sumner Scott Sumner
    30. October 2009 at 10:36

    Doc Merlin, In my view the Fed is the only one that creates dollars. Banks and borrowers and depositors can jointly create credit, but credit is very different from money. The Fed creates the monetary base, and normally derives about $40 billion a year from this activity. It is a tax on moneyholders, which gives the government about 0.3% of GDP. In contrast, other taxes provide about 30% of GDP.

    Statsguy, I think you and I have a slightly different view of the current account deficit. Suppose we start with national production and “consumption” (or absorbtion, including domestic investment) both at 100. So our trade is balanced. Then we start running a CA deficit of 5% of GDP, because other countries like to hold our dollars and/or Treasury debt. In your description it seems like domestic consumption (or absorbtion) stays at 100, and domestic production falls to 95. Hence many jobs are lost. In my view domestic production stays at 100 (full employment) but domestic consumption (or absorbtion) rises to 105. If I am right then as the process unwinds we should be able to keep production at 100, but gradually lower consumption.

    Another argument you may be making is that production would stay at 100, but we’d lose manufacturing jobs and gain service jobs. Perhaps, but monetary policy shouldn’t have any long run effect, so the only policies that could address that would be fiscal/tax policies. Perhaps if we encouraged more saving, then investment would be higher, and so would manufacturing output. Hence your criticism of the Reagan deficits. That’s something I’d have to think about a bit more, I’m not sure how I feel about that argument as a long run proposition (if that is your argument.)

    Doc and statsguy, Thanks for the compliments. Interacting with good commenters has helped me to constantly refine my views. BTW, In my new post I’ve even become a paleontologist. :)

    Jean, I think you might be thinking of a related issue. Not all central banks can simply peg their currency to one another. At least one central bank must determine the absolute value of its currency in terms of goods and services it can buy, not just the relative value in terms of other currencies. But as to your specific question, every single central bank could hold the reserves of other currencies.

    original anon, You said;

    “Given that the US dollar is a floating rate currency, currency easing as I’ve defined it is imposed by the market. That’s what’s been happening recently through dollar depreciation. I’m not sure Krugman is so opposed to US dollar depreciation, so long as its gradual rather than cliff diving. Maybe I’ve missed it, but I’d be interested if you’ve picked up on something different. In fact, dollar depreciation is consistent with his concern that global imbalances be corrected.”

    Krugman can be maddeningly difficult to pin down. In a sense you are right, he is not opposed to dollar depreciation. When people ask him “why not depreciate the dollar to get out of the liquidity trap” he responds that it is not politically feasible for the biggest country to seem to beggar-thy-neighbor to its smaller neighbors. And in a sense he is right. Of course if we do something else like QE, and if the QE is effective, then it will have the effect of depreciating the dollar. So this issue is partly psychological–how do other countries interpret our actions? But in the end I still think it is reasonable for me to assume that his policy advice to China is ceteris paribus advice, as he doesn’t think the Fed can do much more as a practical matter, even if he would not be opposed to them doing more if they could.

    I think (and I believe Krugman might also look at things this way) than the dollar depreciation needs to be treated separately from the Chinese question. I see his advice as being somewhat nationalistic, and I wonder whether a Chinese Paul Krugman with identical positive views about economic causality would offer the same advice to the PBOC. My hunch would be that a Chinese Krugman would say “if those Westerners are too stupid to have more expansionary monetary policies, and too stupid to either set an explicit inflation target or do adequate fiscal stimulus, then we need to protect our own economy against deflation by avoiding a revaluation of the yuan. Of course to prove this you’d have to find a Chinese economist with Krugman-like views, and ask him or her what they think.

    BTW, from an idealistic utilitarian point of view, the damage to human welfare caused by our deflationary policies are probably ten times greater in China than in America. The cost of losing a job over there can be pretty devastating, and a lot more jobs have been lost there than here.

  30. Gravatar of original anon original anon
    30. October 2009 at 10:55

    Ha! “A Chinese Krugman”.

    Great title and topic for a post!

    And sure to get his attention!

  31. Gravatar of Doc Merlin Doc Merlin
    30. October 2009 at 14:38

    So, in your view, could the Fed not create any money just credit?
    So it loans money to the banks, the banks loan it out to others, etc etc, but there isn’t any money.

    If this is possible what makes money different from credit? Is it that credit must be balanced by a liability in a ledger somewhere while money isn’t balanced by anything?

    I’m curious about the credit/money distinction.

  32. Gravatar of Doc Merlin Doc Merlin
    30. October 2009 at 14:45

    Er, in case its not clear, I mean a hypothetical fed creating credit not money.

    Also if the overnight rate is zero or well below inflation, what does that mean?

  33. Gravatar of jean jean
    31. October 2009 at 05:33

    @ssumner:
    As Doc Merlin stated, I confused money and base money. So, as you pointed, central banks could perfectly hold only foreign currency denominated assets. So you’re right: beggar thy neighbor policies are the best things that can happen right now.
    (Personal anecdote: I am French and I remember have been taught in high school history course that New Deal had been roughly right but competitive devaluations had been very bad for every one. How wrong… That’s really absurd when you know how self-suicidal 1935 Laval’s deflation in France had been)

    Btw, it can be dangerous to use a different terminology (you use money for base money (M0) and credit for “non central bank money” (Mi-M0) ), even if the usual terminology is a bit misleading (I know that Schumpeter used your terminlogy) and leads to a proliferation of monetary cranks (because they think that non central banks are able to earn seignoriage.).

  34. Gravatar of jean jean
    31. October 2009 at 05:49

    About asteroids, it seems that several studies indicate that it should not be surprising that several asteroids arrived in a small range of time. Solar system is in fact marginally stable and a moderate disturbancy can lead to a lot of change. That what may have happened 65-70 millions years ago: several asteroids have been disturbed from their original orbit and some of them then crashed on the earth.

  35. Gravatar of ssumner ssumner
    31. October 2009 at 07:16

    Doc, I think the Fed creates money, not credit. I don’t know the exact distinction, but I regard credit as both an asset and a liability. Money is just an asset. I define money as the medium of account (gold, cash, etc.)

    Doc#2, If the interest rate is below expected inflation, then it usually means the real economy is very weak, hence the equilibrium real rate has fallen below zero.

    jean, I agree that terminology is a problem in monetary theory. Economists look at the issue in many different ways, and hence define terms differently.

    Your description of French education is quite interesting. It is true that the 1931 UK devaluation made things more difficult for France, and others. But it is also true that the 1926 French decision to return to gold at a devalued level made things more difficult for Britain. The entire system was screwed up, and so competitive devaluations were destroying a system that was itself very dysfunctional. I agree with you that France hung on too long with deflationary policies.

    I didn’t know that about asteroids, so I guess that makes the coincidence somewhat less impressive.

  36. Gravatar of Doc Merlin Doc Merlin
    31. October 2009 at 13:46

    “Doc, I think the Fed creates money, not credit. I don’t know the exact distinction, but I regard credit as both an asset and a liability. Money is just an asset. ”

    Under your definition above, it seems, that the fed creates credit through its discount window. It charges eligible borrowers a % to borrow money. It also pays money in the form of dividends to its stockholders (6% dividend rate, and before someone asks, no it is not publicly traded, the dividend is payed to member banks who are required to own a certain amount of shares). They also buy certain types of assets, which creates money directly without creating liabilities.

    Or is it because the fed doesn’t create liabilities for itself when it lends money out (even though it creates liabilities for someone else) that you say it is creating money not credit?

    Hrm, actually the distinction between money and credit is an important one as they have different long run effects on a society.

  37. Gravatar of Michael Pettis Michael Pettis
    2. November 2009 at 04:44

    Scott, sorry I came to this so late. I think you are right to focus on the savings/investment imbalance, but I would defend Krugman by arguing that the undervalued currency is part of that imbalance by helping to force up the savings rate. As I see it, the Chinese growth model has included a number of policies that have systematically transferred income from the household sector to subsidize the productive sector, especially the tradable goods sector. This explains to me both the high growth in GDP and the lagging growth in household income, the difference being, of course, a rising savings rate. These policies include most importantly financial repression, but also lagging wage growth via anti-labor measures, direct energy and land subsidies, a deteriorating social safety net. It also includes an undervalued exchange rate, which reduces the real value of wages and directly increases the profitability of the tradable goods sector. Revaluing the currency is not the total solution, but a part of the rebalancing solution that must reverse the implicit subsidies. Chinese consumption won’t grow any more quickly that household income grows, and the point is to return to households a greater share of the national income.

  38. Gravatar of ssumner ssumner
    2. November 2009 at 06:18

    Doc Merlin, You can think of money as a Fed liability if it is merely a temporary injection, such as a discount loan that is not expected to be rolled over. But if the Fed permanently increases the money supply (which is the sort of monetary policy that is usually assumed in analysis), then there really is no liability. But I should add that this is partly a debate over semantics. What matters is how people analyze the impact of monetary policy, not what they call it.

    Michael, Thanks for the reply. I have a couple of responses:

    1. I am not as impressed by Chinese growth as are many observers. I see it as a rebound from the extraordinary anti-growth policies of Mao. Based on its entrepreneurial cultural traditions, China is an outlier in it’s poverty. The other fairly similar cultures (Japan, S. Korea, Taiwan, HK, Singapore) are much richer, with the obvious exception of the unreformed N. Korean economy. As a result I am not impressed with the Chinese growth model, and don’t agree that all of the items you mentioned are actually assisting growth. For instance, distortions such as energy subsidies almost certainly reduce the growth rate of GDP (properly measured) by encouraging massive waste. And a much more market-oriented financial system would increase growth by enabling the more entreprenueurial small businesses to more easily get credit. But we end up in much the same place, regardless of how we characterize these policies. I’d also like to see them ended. And I would add that I would also like to see China gradually reduce it’s policies of accumulating massive foreign reserves. I believe that S. Korea grew even faster than China in the 1960s-1980s, and did so partly by not wasting a lot of export revenues on accumulating T-bonds, but rather used them to buy more capital goods. As I recall from our earlier discussion you were skeptical of how effectively the Chinese could use those resources, and I agree. They really need the sort of market reforms advocated by Yasheng Huang, (and if I read you correctly, reforms you also support.)

    2. My problem with the Krugman piece is that he is confusing nominal and real exchange rates. The only set of policies that would do both what I want, and what you and Krugman seem to favor (and to some extent I favor as well) is a policy of raising the real value of the yuan and lowering its nominal value. Most economists are used to thinking of the exchange rates from a trade perspective, and hence ignore the real/nominal distinction. But let’s suppose the Chinese wanted both:
    a. faster NGDP growth (as I want)
    b. A smaller current account surplus (as Krugman wants)

    The only way to get both would be by doing two things. One, have the Chinese government gradually stop accumulating foreign reserves (or immediately stop if they are willing to open up the capital account, so private capital flows can prevent a sudden foreign exchange crisis.) By ending the accumulation of foreign reserves, government saving would decrease and the Chinese real exchange rate would appreciate. Then you would need a second policy to depreciate the nominal excahnge rate as the real rate was increasing. And of course that requires Chinese inflation, which in turn requires a much more expansionary monetary policy. (They had deflation in 2009.)

    I would end with a couple observations. I don’t think Krugman thought about this issue from the point of view of the need for more AD in China, and how Chinese monetary policy affects world AD. Thus I think he was supporting a higher yuan in both nominal and real terms, as in practice the Chinese would be unlikely to have done enough offsetting inflation to prevent the higher yuan from hurting their AD.

    I also think the Chinese did a little bit of what I was calling for. They did have domestic stimulus, which meant that the overvalued yuan did not hurt world AD in the way many assumed who just looked at the nominal value of the yuan, and weren’t thinking about monetary policy issues. But unfortunately the stimulus was not neutral, not simply money injections aimed at boosting NGDP, but rather were strongly skewed toward the less efficient parts of the Chinese economy. And that is what really worries me, I worry that if we pressured the Chinese to revalue the yuan in real terms, it would also rise in nominal terms, and their economy would get even more distorted as they pumped up the government sector and starved the more efficient export sector. But in the long run I’d like to move away from both, I think you are right that they should re-orient toward domestic consumption and services. I just think that China first needs a recovery through monetary expansion, and then needs to rebalance its economy through market reforms, and a Singapore-style social insurance system.

    BTW, I did get to D-22, and I mentioned our visit in a post while I was in China. I have been enjoying the Carsick Cars new CD. I hope your US tour goes well.

  39. Gravatar of Abigail Simpson Abigail Simpson
    15. August 2011 at 10:48

    What a crazy week the DOW had last week. I cannot recall another week where there were such big jumps everyday. Now today another big 160 point jump upwards (so far). Crazy.

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