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.