Exchange rate policy and monetary policy

Michael Pettis has the best blog on the Chinese economy that I have been able to find.  If you are interested, you should check out his recent post on how the policy debate looks from within China (and yes there is vigorous debate inside China.)

But today I want to respond to one comment I don’t entirely agree with, which he made in a post in early January:

For those who remember the 1980s, when many policymakers in Japan insisted that Japan’s trade surplus had nothing to do with the value of the currency, and everything to do with domestic competitive advantages in manufacturing, it is a little weird seeing them now worry so much about the impact of a rising yen on their manufacturing sector and on the process of economic recovery.  Currencies do matter, I guess.

I’m paranoid.  Since I was one who didn’t think the value of the yen explained the 1980s surpluses, and who also strongly believes the strong yen has recently devastated their manufacturing sector, I naturally assumed he was talking about me (despite the fact that I’ve never even made any public statements about 1980s yen policy.)  The thing is, I don’t see any conflict at all. 

Here’s how I think about things.  The real exchange rate is not determined by the government, but rather by the propensities to save, invest, import, export, etc.  Beginning in the 1980s, Japan saved much more than they invested, so it was natural for them to run trade surpluses.  Indeed given their demographics, it would have been foolish to do anything else.  Even with all the surpluses they have run up, I have no idea how they are going to address their demographic time bomb.  All during this period their trading partner Australia was running massive current account deficits.  Whose shoes would you rather be in today?

[However I do agree with Mike Pettis that the Japanese government's explanation, that it was all due to their manufacturing prowess, was silly.  South Korea was running deficits at the same time.]

The nominal exchange rate is a completely different animal from the real rate.  Monetary policy determines the nominal rate.  That doesn’t mean the central bank should target nominal rates, indeed I favor NGDP targeting instead.  But let’s say the central bank isn’t targeting NGDP, indeed it doesn’t have any coherent monetary strategy.  It just drifts along with nominal rates stuck near zero.  What then?

In that case I’d say a sharp rise in the nominal value of the yen might be an indicator of an excessively tight monetary policy, that is, a monetary policy that was driving NGDP expectations sharply lower.  This would be even more true if there were other market indicators showing money was too tight, like falling stock and commodity prices, and (surprisingly) falling long term bond yields. 

The argument against my position is that the central bank can also control real exchange rates over a significant period of time, say at least several years.  I accept that, but I think persistent trade surpluses are an extremely long term issue, lasting over decades, and I don’t think monetary policy has real effects over a time frame of more than a few years.  I still think the classical dichotomy holds in the very long run.  Indeed the unwelcome deflation in Japan during the late 1990s, and again recently, is partly a reflection of the fact that Japanese monetary policy was pushing the real value of the yen up to unsustainable levels.  This forced the real exchange rate to adjust downward through painful price level adjustments.

As for the seeming inconsistency of my position, consider this analogy.  You are a development economist at the IMF.  You tell the Indian government, “Don’t think you can speed up the pace of economic development by merely printing money.  Development requires improvements in human capital, infrastructure, better institutions, etc.”  Then a few years later the IMF economist comes back and says “Egad, you drove India into a recession with your tight money policy!”  Was he being inconsistent, first arguing that printing money doesn’t make a country richer, and then arguing that tight money made it poorer?  Not really, there are theories appropriate for business cycles, and very different theories appropriate for long term economic growth (unless you are a RBC economist, in which case life is blissfully simple.)

PS.  If you want to know why I like his blog so much, consider this quotation from the same January 9th post:

Already some of my students whose parents own their own businesses have been telling me that Chinese speculative money held abroad is flowing back into the country.  One of my students from rich coastal city Wenzhou, the most free-wheeling and business-savvy city in China, and perhaps the world, just rolled his eyes when I asked him if his family and friends were tying to bring money into the country.  “Of course,” he said.  I didn’t get the impression that he thought mine was an especially astute question.

Meanwhile all the big guns in the “monetary alarmist” camp in China have been pounding the table (in the discreet way preferred of policymakers here) about the risks of monetary expansion.  As everyone now knows, the PBoC yesterday sold three-month bills at a higher interest rate for the first time in 19 weeks.  Long Chen, one of the students in my PBoC Shadow Committee seminar, reported to the class via email as soon as it happened: “Hey guys, the primary yield of 3M PBOC bill increased this week. Significant sign.”

Yes, although the increase was tiny, it may indeed be a significant sign that the PBoC no longer wants to wait and is starting to tighten conditions, although I can only add that conditions are so alarmingly loose that it would take an awful lot of tightening to get back just to “loose”, and it would be hard to do this without seriously undermining current growth and employment in the short term. 

First of all, Wenzhou is crying out for a serious sociological study.  (Or has one been done?)  In a nation of fairly entrepreneurial people how can this one middle size city stand out so dramatically?  Their relative success within China is roughly comparable to that of what Thomas Sowell called “middlemen minorities” (Indians in Africa, Chinese in SE Asia, pre-war Jews in Eastern Europe, etc.)  And yet to us Americans the Chinese (or at least the 92% of them who are Han) seem a fairly homogenous group.  You won’t think China is a simple place after reading Pettis.  And he writes very well.

And how about that inside info from his former student!  Take a look at this graph showing how the Hong Kong stock market has done in the three weeks since he provided his money tightening tip on January 9th.  I know, I’m an EMH guy.  Still it never hurts to check your horoscope, and also Mike Pettis’ blog.



13 Responses to “Exchange rate policy and monetary policy”

  1. Gravatar of Doc Merlin Doc Merlin
    31. January 2010 at 20:54

    Excellent post.

    I particularly liked the bit about RBC, cycles, and long term growth. It made me think about growth and such, and that with a level NGDP growth path, we could concentrate on long term growth policy, instead of all this cyclical nonsense. The growth would be good for us as a nation, and ultimately good for the world as a whole.

  2. Gravatar of scott sumner scott sumner
    1. February 2010 at 05:35

    Doc, Exactly.

  3. Gravatar of OGT OGT
    1. February 2010 at 07:55

    Sumner- In the case of China, my understanding, mostly via Pettis, is that you have to understand the effect of the currency peg in tandem with the sterilization methods. If the printed RMB was exchanged for dollars were simply loosed into the economy, of course, the real exchange rate would quickly adjust via inflation. In this case the Chinese authorities put the weight of sterilization heavily on households, through state madated low real deposit rates and manipulation of the banking sector that lowers the cost of capitol for firms.

    In other words, by affecting the cost of capital and propensities to save and spend, sterilization methods reinforce the effect of the nominal currency peg.

  4. Gravatar of david glasner david glasner
    1. February 2010 at 09:35

    Scott, I agree with OGT’s comment. China has had rapidly increasing productivity and very high savings rates and has been running huge balance of payments surpluses at the pegged exchange rate. You say that governments cannot control the real exchange rate. According to you, shouldn’t China’s real exchange rate have risen rapidly over the past 5 years? Is there any evidence of a large appreciation in the real yuan dollar exchange rate or real yuan exchange rate against other currencies in general? If China uses a pegged exchange rate and sterilization of its balance of payments surplus to impose forced saving to maintain a low real exchange rate as part of its development strategy it can continue to do that as long as it is willing to keep accumulating FX reserves.

    OGT. I agree with your point, but I would simply rephrase. The currency peg is totally innocuous and benign. The real exchange rate will automatically adjust if China does not sterilize FX inflows. We should stop complaining about the peg and start complaining about sterilization. The peg is a red herring. On the contrary rapid appreciation of the yuan would risk deflation and a repeat of the Japan disaster which resulted from too rapid appreciation of the yen to placate US complaints about the weak yen.

  5. Gravatar of Marcus Nunes Marcus Nunes
    1. February 2010 at 09:50

    In a way the story of Japan since the 1970´s (flexible ER period) is the story of US bashing of Japan´s trade surplus. From early 1980 to early 85 the DM (just as example) depreciated more than 70% relative to the USD. The Yen “stayed put” over the same period. From early 85 to late 87 the DM appreciated 70%… and so did the Yen!!!
    The resulting fall off in growth from this appreciation (endaka-fukyo) encouraged policymakers to expand MS. And they welcomed the ensuing rise in stocks and property prices (which would help Japan to be less dependent on foreign demand). Their anti inflation obsession, however, was too high and soon they tightened and the “house of cards” fell dawn. And has remained down ever since.
    Luckily for most everyone China seem to solemnly ignore US “advice” for an appreciation of the yuan.

  6. Gravatar of StatsGuy StatsGuy
    1. February 2010 at 12:21

    I wish I’d run across Pettis a little earlier… But he cites some interesting stuff. Here’s one link he provides which gives a plain-as-day example of how bank regulation is effectively inseparable from monetary policy (a point that I recall you disagreeing with):

    Chovanec’s piece also is an excellent example of the critical importance of assets as a mechanism to time-arbitrage monetary policy. At least in China’s case, the money that’s created stays in China when it forces domestic lending. Presumably, this may stimulate domestic demand. (Although, when the central bank tightens and asset prices deflate, this can create distributional imbalances as we have some people who gained massively and a bunch of ‘bagholders’, including banks with bad assets that may later need to be bought up, and individual cash savers whose purchasing power is transferred to lucky or astute credit-funded speculators.)

  7. Gravatar of Simon K Simon K
    1. February 2010 at 12:56

    I think the accepted lore about Wenzhou is that it lacked the kinds of “strategic resources” of interest to the various foreigners and political parties that ran China during its economic development, so they got a chance to develop an isolated, less dirigiste way of doing things that came into its own later. Seems a little too pat to me, but that’s the story.

  8. Gravatar of scott sumner scott sumner
    1. February 2010 at 13:39

    OGT, A few comments:

    1. First, even if you are correct, I wouldn’t change one word I wrote in this post about Japan. Unlike China, Japan did not have exchange controls.

    2. I don’t like the term “sterilization” here, as it causes confusion. The term was used in a totally different context under the gold standard, to describe monetary actions which impacted world monetary policy. To the extent that the Peoples Bank of China’s actions have any effect (and they are very minor) it would be to lower world interest rates. In contrast, under a gold standard sterilization raises world interest rates.

    3. I prefer to think about things this way. The Chinese government imposed exchange controls which make it difficult for Chinese to buy foreign assets (although Pettis says they are widely evaded.) But let’s say they work. Add in the fact that the PBOC buys $400 billion in foreign assets each year to build up its foreign reserves. I claim that if they do those things, they really don’t have any control over their real exhcage rate. I agree that those things do impact their real exchange rate, but not as much as most people think. The yuan is not undervalued just because prices are cheaper in China. Prices are supposed to be much cheaper in poor countries, and China is a poor country. Visit some place like Indonesia or Thailand or Vietnam and you’ll see the same thing.

    David, China’s real exchange rate has risin fast over the past 5 years. The nominal rate is up 20%, and the real rate has risen by more if you assume China has had higher inflation. I don’t know what the Chinese data shows, but the average Chinese person thinks they’ve had more inflation than we’ve had. I expect the yuan to start appreciating again later this year (as do many other experts) and keep rising around 5% per year for many more years. I think that is appropriate, but I also think they were wise to put the appreciation on hold when Fed incompetence drove the world economy into a deflationary ditch. Oops, I see my last point was off targetm, as you just said the same thing in the second part of your answer. Anyway, I agree.

    You said;

    “OGT. I agree with your point, but I would simply rephrase. The currency peg is totally innocuous and benign. The real exchange rate will automatically adjust if China does not sterilize FX inflows. We should stop complaining about the peg and start complaining about sterilization.”

    I strongly agree that the peg is innocuous. If people want to criticize China for saving too much that’s fine. They may be right, or they may be wrong. The Economist last week had a long article on Asian savings rates. The bottom line was that they saw the high savings Asian countries as doing the right thing, and the low saving Asian countries (Taiwan, Philippines) as having made a mistake. I can’t say whose right, but I also can’t imagine why we’d want to criticize China for saving a lot. First, its not something that has much effect on US. Second, they are better placed to understand how much they need to be saving (recall that they lack a social security system for 1.3 billion increasing wealthy people.) And third, since we seem to plan massive deficits as far as the eye can see, why shouldn’t we be happy that the low income Chinese are willing to lend us money for this borrowing orgy at very low interest rates?

    China grew 10.7% over the past year, that’s the single most important reason the world didn’t fall into depression. (That, and the fact that Obama rejected Krugman’s argument that the US should put trade barriers on Chinese products, or goods from countries that emit lots of carbon.)

    Overall I think everything you say is defensible. The yuan should not be strong enough to cause deflation, and you may be right about the Chinese saving too much. But I’m not convinced we know for sure.

    Marcus, I agree.

    Statsguy, Of course if he doesn’t repay the loan he might be executed. In the US you just go through chapter 11 and start over. In Texas you even keep you mansion.

    He’s talking about credit policy there, not monetary policy. I don’t know how the PBOC does things, the two policies might be intertwined. But they need not be.

    Simon, Yeah, now I remember hearing that two. And I agree that it sounds a bit too pat. Maybe it’s part of the story, but China’s a big place, with lots of equally isolated places. Probably a combination of factors explains it.

    Everyone, Don’t forget the post was about Japan. They didn’t have exchange controls, and I don’t think anyone can say Japan has saved too much over the past 30 years, indeed they’ve saved far too little. Any comments about whether I was right that Pettis confused cyclical and secular issues?

  9. Gravatar of david glasner david glasner
    1. February 2010 at 17:30

    Scott, I agree with you that prices are lower in poor countries than wealthy countries. That’s exactly the point. China is getting rich in a hurry and they are not letting domestic the domestic money supply and domestic prices rise to reflect the rapid growth in their productivity. There is nothing wrong with a high inflation rate in a rapidly expanding economy in which real wages are rising. I have no problem with a high voluntary savings rate. China has a high forced savings rate.

  10. Gravatar of OGT OGT
    2. February 2010 at 05:56

    The nominal exchange peg is just an overseas extension of the Chinese government’s capital control system, which helps induce savers to accept near zero real interest rates. So, instead of sterilization we can use Ken Rogoff’s term, financial repression, which sounds more dramatic.

    As to Japan in the eighties, I am not really familiar with how their currency interventions were structured. Were they importing a monetary policy from the US that was too loose for them in the eighties then swung back too tight? Every central bank is familiar with the concept of real exchange rates and inflation so I’d be surprised if they didn’t have some distortion cooked up to mitigate the effects of their intervention.

    In any case, their demographic hurdles outstrip even their monetary hurdles, though I suspect we’ll see some interesting capital-replacement of labor, such as robot bear nurses:

  11. Gravatar of StatsGuy StatsGuy
    2. February 2010 at 07:44


    “As to Japan in the eighties, I am not really familiar with how their currency interventions were structured.”

    I don’t know that Japan’s currency action in the 80s was at all like China’s. By early 70s, Japan was off of fixed exchange, and direct intervention via buying/selling dollars proved limited in efficacy. In the 80s, the Yen was also dealing with Volker’s interest rate spike, which drew capital flows to the US (and help cause the credit whiplash in Latin America) and kept the Yen low, leading to an export spike and massive 80s export led growth (along with US lack of investment domestically, which was – again – largely due to the overvalued dollar).

    Late 80s, the world looked at the US and Japan, and decided the US was doomed, and we saw a massive capital flow into Japan (and a Yen “bubble”). Real estate in Tokyo, etc. Then the bust in the late 90s and zombie banks…

    Comparing Japan to China is very strange – entirely different economies. (Like comparing Japan, a nation with almost no commodity resources, to Australia…) Post 60s, Japan was never as active in managing currency. And in the 60s, Japan never had the clout (in a cold war environment) to ignore US diplomacy on currency. US charges about trade were mostly about structural barriers (e.g. integrated vertical distribution networks, kieretsu). Hence, MOSS and SII under Reagan/Bush I.

    Japan was not in the unemployment/social instability trap of China either – in the 80s it had very high employment and very wealthy citizens. Total currency deflated GDP value briefly exceeded the US at some point (whatever that means). Per capita, even more impressive. China, on a per capita basis, is not yet close. Nor, btw, was the US economy as open to imports in the 70s/80s as now. The mere existence of Walmart as a company changes the structural dynamics of trade flows.

  12. Gravatar of jsalvatier jsalvatier
    2. February 2010 at 17:16

    I wonder if you could talk about this:

    There has been talk about different countries in the EU entering and exiting recession at different times (for example: Your monetary theory doesn’t seem to allow this for regions which use the same currency. If recessions are caused by excess money demand, then as long as people in regions can lend to each other, they should not have recessions at different times. Do you dispute that regions which use the same currency have recessions at different times (I don’t know the government statistics to say one way or the other). Am I misunderstanding something?

  13. Gravatar of ssumner ssumner
    3. February 2010 at 12:05

    David, I agree that China is getting richer, and I expect their exchange rate will soon resume the strong appreciation it had from 2005-08. I was referring somewhat to the level of income in China, which is still lower than Mexico, despite rapid growth.

    I actually do favor forced saving, as an alternative to high taxes. Singapore is an example. I’d rather be forced to save money into a 401k or a health saving account than be forced to pay taxes to support social security or medicare. But I agree that Chinese policy falls far short of the ideal. They are certainly not even close to being as efficiently run as Singapore.

    OGT, I certainly have mixed feelings about China. It’s is still a half communist country, which has all sorts of bad policies. But we seem to complain about the wrong policies. We complain about their exchange rate when we should be complaining about how the Chinese treat the people in their rural areas. We first need to figure out one thing, is our advice aimed at helping us or helping them? If it is helping us, then the Chinese quite rightly ignore it. They are much poorer and much more populous than us. The West colonized China and treated it very poorly. The last thing the Chinese should worry about is any small impact their currency policies might have on the US (and I doubt they have any significant negative effect.)

    If we are trying to help them with our advice, tell them to privatize SOEs, to give rural workers the right to move, the right to sell their land. Forget about exchange rates.

    Stastguy, I mostly agree. Certainly China and Japan are very different. The only slight diagreement is that I think the strong dollar in the mid-1980s had more to do with strong real growth unleashed by Reagan’s supply side policies, coupled with a dramtic growth slowdown in Europe. Tight money shouldn’t cause the dollar to rise so high. Something similar happened around 2000, when strong US growth pushed up the dollar.

    jsalvatier. The same thing happened in the US. The recession began as a very mild recession, and was limited to areas that had specific sectoral problems. These included Michigan, and the subprime housing areas. Then it spread nationwide after August 2008. That was the part caused by tight money. I assume something similar happened in Europe.

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