My recent post on China elicited lots of comments:

1.  Some argued that China steals far more jobs from the US than northern Europe, despite the bigger current account surplus in northern Europe.  This argument seems based on a sort of crude mercantilist model that even Paul Krugman couldn’t stomach.  If there is any respectable argument that CA surpluses steal jobs (and I doubt there is) it is based on the impact on world saving, not whether that particular country happens to sell lots of goods to the US.  I could easily argue the opposite, that if we didn’t buy low tech goods from China, we’d buy them from other Asian countries.  But if Germany didn’t sell turbines to China, the Chinese would buy those turbines from the US.  That argument would also be bogus, despite is superficial plausibility.  Again, in the Keynesian model it’s the impact on world saving that matters, nothing else.

2.  A second argument was that the Chinese surplus reflected government policy decisions.  They did acknowledge this was true of Norway, but suggested that a Sovereign Wealth Fund was a valid way of addressing the oil bonanza.  But as this study of the Nordic countries shows, the high savings rates do reflect government policies:

The fiscal performance of the four leading Scandinavian economies, both prior to and during the Great Recession, has been outstanding. The headline budget deficits for all four economies peaked below three percent of GDP – compared with 11 percent of GDP in the US and the UK. The underlying budget balance – adjusting for the economic cycle – remained in surplus in three of the Scandinavian economies and was only slightly negative in Norway. The comparable US and UK deficits were nearly nine percent of GDP. Much of this success can be attributed to pro-market reforms, such as the introduction of fiscal rules, following the early 1990s Scandinavian economic crisis.

The northern European countries also tax consumption more heavily than savings.  I don’t know all the details, but they have lower corporate taxes than the US, and some have no capital gains taxes, while others have no inheritance taxes.

3.  I also find the rhetoric used by many commenters in the media and/or comment sections to be extremely repulsive.  There’s a sort of  “if we get tough with the Chinese they’ll bend to our will” theme.  Replace ‘Chinese’ with ‘Africans’ and see how that sounds.  In all of American history I can think of only one example where punitive trade barriers against foreign countries were appropriate; Japan and Germany during WWII.  Otherwise sanctions usually make problems worse, not better.  In WWII we wanted sanctions to hurt their economies, but that shouldn’t be our policy in anything but the most dire scenario.

4.  I also got criticism for pulling the race card.  I see a steady stream of criticism directed at East Asia, which is far greater than what’s directed at Europe.  When I was young the rhetoric against Japan was on a completely different level of viciousness from what was directed at Germany, despite the fact that Germany also ran large deficits.  So there is nothing new about the focus on China, despite Northern Europe’s much larger CA surplus.  Many American protectionists claim that countries like Korea “cheated,” that they only got rich via mercantilist trade policies.  This despite the fact that Korea ran persistent trade deficits during its high growth years (1970s and 1980s).  Facts don’t matter, all that matters is that we perceive the East Asians to be untrustworthy, so they must be cheating at trade.  Otherwise how could they be joining the developed world?  Nor does the lack of trade barriers in Hong Kong and Singapore matter, critics will find some obscure way they indirectly intervene in trade, as if Western countries aren’t riddled with similar interventionist policies.

5.  If we are going to put tariffs on countries whose reckless governmental policies are hurting the rest of the world, why not put tariffs on Greece and Italy?  And how about the US?  Doesn’t our global warming policy hurt the world?  How about our decision to launch a war against Iraq?  How about our reckless banking policies, which helped trigger a world-wide financial crisis?  How about the Fed’s tight money policy?  As David Beckworth points out, the Fed is a monetary superpower, whose actions affect the rest of the world much more than the policies of other central banks.  Don’t we need to be “taught a lesson” just like the Chinese?

6.  The only even semi-respectable argument against China’s CA surplus is the Keynesian paradox of thrift argument used by Krugman.  What’s so comical about this situation is that the average “man on the street” China-basher would be totally perplexed by the claim that saving is bad.   “You mean we are attacking the Chinese for being too thrifty, not following the foolhardy low-saving policies of our government?”  Yup.

Matt Yglesias presented a graph showing that since 2005 the Chinese yuan has appreciated about 30% against the dollar. He added this comment:

That’s the nominal exchange rate. In real terms, the yuan is appreciating faster than that because Chinese have more inflation than the United States. This doesn’t mean there’s no problem here, but it should be acknowledged that the problem is getting less serious with every passing day.

If only it were true. There really isn’t any “problem” at all, but the perception is that the yuan is getting increasingly undervalued. Back in 2005, Chuck Schumer said the yuan was 27.5% undervalued, and he demanded a revaluation. China has more than complied with this request; the yuan has increased by nearly 30% in nominal terms and more than 50% in real terms. So is Chuck Schumer happy now? Not quite. He now insists the yuan is 32.5% undervalued, and demands another massive revaluation. All this despite the fact that the previous revaluation didn’t reduce the deficit by 1 cent; indeed the deficit got bigger.

Remember the high school bully that would pick on the nerdy kid? You know, the one that would promise to stop beating him up if he just did what the bully wanted. Then when the victim complied, the bully would just issue more demands, and keep picking on the poor boy. That’s Chuck Schumer.

I wonder if we’ll ever learn. We kept pressuring countries like Japan, Germany and Switzerland to appreciate their currencies. And then their currencies do appreciate very sharply. But the current account surpluses remain very large, because currency appreciation doesn’t address the root cause of those surpluses. Now we are engaged in the same fruitless quest with China. What a waste of time.

Off topic, But Christopher Mahoney just sent me a report from Goldman Sachs, which endorsed NGDP targeting.  Unfortunately, it’s proprietary information, so I can’t link to the report (which is excellent.)   But perhaps they’ll allow me to quote one passage:

A Different Interpretation of the Dual Mandate

While a shift to a nominal GDP level target would clearly be a big decision for the Fed, it would be quite consistent with the dual mandate to pursue maximum employment and low inflation. After all, nominal GDP is equal to the price level multiplied by real GDP, and real GDP in turn is very closely related to employment via “Okun’s law.” So there is a lot of common ground between a nominal GDP level target and a standard Taylor rule in which the desired stance of monetary policy depends on the deviations of inflation and unemployment from their target rates.

But a nominal GDP level target differs from a standard Taylor rule in two key respects:

1. Targeting the price level, not the rate of change.

In a nominal GDP level target, prices enter as a level, while in the standard Taylor rule they enter as a rate of change. There is a long literature on the relative merits and drawbacks of price level vs. inflation targeting, but many studies find that a level target is preferable. The key advantage of a price level target is that it reduces uncertainty about the future price level because the central bank commits to making up for past inflation under- and overshoots. This implies that households and businesses should rationally expect higher inflation following a period of economic weakness and sub-trend inflation. This should push down real interest rates and boost economic activity during times of weak growth.

2. A bigger weight on output/employment.

A nominal GDP level target increases the relative importance of output or employment. Under the standard Taylor rule, a decline in real GDP by 3% percentage points would call for the same monetary policy adjustment as a decline in inflation by 1 percentage point. But under a nominal GDP level target, a decline in real GDP by 3% would call for the same monetary policy adjustment as a decline in the price level (relative to trend) by as much as 3%. This is likely to mean greater responsiveness to output or employment relative to prices while the nominal GDP level target is in place.

Is such a shift desirable? At least currently, we believe the answer is yes because continued weakness in output and employment would increase the risk that part of the increase in unemployment will eventually turn structural. Fed Chairman Bernanke essentially made this case in his remarks at the 2011 Jackson Hole Symposium: “Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view.” If growth is faster in the near term, this will not only have a near-term but also a longer-term benefit by reducing the risk that unemployed workers become unemployable. This justifies putting more weight on the output and employment part of the dual mandate than under normal circumstances.

I don’t know if the Goldman Sachs endorsement will gain us any converts among the more populist right-wing internet Austrians, but nothing else has worked.

The report was written by Jan Hatzius and Sven Jari Stehn

This will be a long post, as Paul Krugman’s recent piece on the yuan raises all sorts of different questions.  Let’s start with his assertion that an overvalued Chinese currency is restricting our ability to reflate our economy:

But given our economy’s desperate need for more jobs, a weaker dollar is very much in our national interest “” and we can and should take action against countries that are keeping their currencies undervalued, and thereby standing in the way of a much-needed decline in our trade deficit.

That, above all, means China.

But how do we know the yuan is undervalued?  Its current value is not out of line with predictions of the Balassa-Samuelson Theorem, which predicts that countries with higher per capita GDPs will have higher real exchange rates.  Krugman points to the huge Chinese trade surplus.  But is their surplus actually all that large?  After all, China is a very big country.  As I pointed out earlier, the Germanic/Nordic current account surplus is vastly larger, despite the fact that the countries lying between Switzerland and Norway have a combined population only a tenth as large as China’s.  The smaller East Asian countries also have vastly bigger surpluses on a per capita basis.   So why focus on China?

Another argument is that China’s surplus is in some sense “unnatural,” whereas the surplus of the Nordic bloc is natural, reflecting the decisions of the private sector.  There are several problems with this argument.  First, in all countries the level of savings is strongly influenced by fiscal policies.  For instance, Sweden has no inheritance tax, whereas Austria and Germany have no capital gains taxes.  These fiscal policies boost saving rates.  Singapore forces its citizens to save a large fraction of their income.  In contrast, China is a former communist country that lacks a sound social security system.  It makes a lot of sense for the Chinese government to have a high level of saving, especially given their approaching demographic time bomb.

But what about the charge that China is a currency manipulator?  Krugman’s too smart for that argument, I recall he once acknowledged that the real problem was Chinese government saving.  Indeed if the Chinese government continued to buy large quantities of foreign debt, the value of the yuan would stay “artificially” low, even without a formal currency peg.  So the “problem,” if there is a problem at all, is not fixed exchange rates, it’s that some countries save too much.  And for some odd reason Krugman adopts a stance that you’d expect from right-wingers—private saving good, public saving bad.

Some observers question whether we really know that China’s currency is undervalued. But they’re kidding, right? The flip side of the manipulation that keeps China’s currency undervalued is the accumulation of dollar reserves “” and those reserves now amount to a cool $3.2 trillion.

BTW,  Greg Mankiw offered a similar criticism of Fred Bergsten a few days ago.

Last year Paul Krugman made this observation about Switzerland (in criticism of one of my posts):

Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro “” and failed:

Later I showed that Krugman was wrong; Switzerland’s policy didn’t fail.  Now his tune seems to have changed.  Yes, I know some readers will point out there is no contradiction in the following, (and technically that’s true), but Krugman’s smart enough to know how most readers will interpret this:

To get our trade deficit down, however, we need to make American products more competitive, which in practice means that we need the dollar’s value to fall in terms of other currencies. Yes, some people will shriek about “debasing” the dollar. But sensible policy makers have long known that sometimes a weaker currency means a stronger economy, and have acted on that knowledge. Switzerland, for example, has intervened massively to keep the franc from getting too strong against the euro. Israel has intervened even more forcefully to weaken the shekel.

Yes, he doesn’t say the massive intervention “succeeded,” but it’d be a bit odd to argue for currency depreciation in the US by pointing to countries that tried to do currency depreciation, and “failed.”  BTW, the recent Swiss intervention has succeeded, so far.

What bothers me the most is Krugman’s assertion that China is “standing in the way” of an increase in US aggregate demand.  This makes the Chinese seem like some sort of enemy of the US, even though the private actions of those thrifty Nordics are doing us far more harm, according to Krugman’s model.  Even worse, it suggests that we are helpless victims, whereas even Krugman admits that the fundamental problem is that we don’t use monetary and fiscal policy to boost our own aggregate demand (AD.)  So the “harm” being done is only harmful if our policymakers ignore textbook advice to keep AD at an adequate level.  Yes, we are ignoring that textbook advice, but I’m having trouble seeing how that’s China’s fault.  Again, I’m not arguing that there is any logical inconsistency there, but I can’t imagine that many of Krugman’s readers will connect the dots as I have.  Most will assume that China really is “standing in the way,” not that we could offset any harm with the flip of a switch.

Even worse, Krugman’s appealing to people who completely reject his AD-view of the recession, which these days isn’t just Pat Buchanan, but rather 90% of the public, and 90% of the “Very Serious People.”  Don’t believe me?  Go ask around and see how many people think our unemployment problem could be solved with an increase in the inflation target to 4%.

Here’s an especially odd juxtaposition:

And the reality of the unemployment disaster is also my answer to those who warn that getting tough with China might unleash a trade war or damage world commercial diplomacy. Those are real risks, although I think they’re exaggerated. But they need to be set against the fact “” not the mere possibility “” that high unemployment is inflicting tremendous cumulative damage as we speak.

Ben Bernanke, the chairman of the Federal Reserve, said it clearly last week: unemployment is a “national crisis,” with so many workers now among the long-term unemployed that the economy is at risk of suffering long-run as well as short-run damage.

China bashing helps, if it helps at all, by boosting AD.  No one claims it boosts the supply-side of our economy.  So Krugman cites Ben Bernanke in defense of the argument that we need more AD to reduce unemployment; even though Ben Bernanke is the guy that controls AD, and who defends current Fed policy as being appropriate, and who opposes higher inflation despite the fact that any attempt to boost AD (especially tariffs on Chinese goods) will mean higher inflation.

Perhaps in his heart of hearts Bernanke favors easier money.  But people should be cited on the basis of their publicly expressed policy views.  This may sound grotesque, but right now the Fed’s publicly expressed policy is to keep inflation steady, which means they are officially committed to offsetting any boost to AD from more expensive Chinese imports.  Good luck with trying an end run around the Fed (as I’ve been correctly warning since late 2008.)

Here’s what we know:

1.   An appreciation of the Chinese currency is contractionary for China, perhaps costing millions of jobs and slowing growth sharply, just as a strong yuan in 1998 sharply slowed Chinese growth.

2.  Both China and the world seem to be teetering on the edge of another recession.

3.  In March 2009 many observers, and many market participants, predicted a depression.  Then China began to recovery rapidly, boosting world trade, and easing fears of an outright worldwide depression.

4.  If the Fed follows its announced policy of inflation targeting, the contractionary effect of China’s action on world output will not be offset by any expansionary effects on the US.  Yes, they may not follow a strict inflation target, and hence it’s possible the action will have some expansionary effect here.  But the only effect that’s certain is the contractionary effect in China.

5. If China went to a policy of complete laissez faire, it’s possible (albeit unlikely) that so many Chinese would rush to get money out of the country, and into houses in Vancouver/LA/Sydney, that the yuan would depreciate.  Especially if China does go into recession.

6.  From a liberal utilitarian perspective, trade barriers on Chinese imports are completely unjustified, even if Krugman is 100% right in his analysis.  Chinese workers are several orders of magnitude poorer than US workers, and our safety net seems almost Nordic in comparison to the Chinese safety net.

The most distressing aspect of Krugman’s post is its nationalistic tone:

. . . standing up for our national interests.

The worst mistake the world could make right now is to descend into nationalistic posturing.  We can all see what’s going on in Europe, and we all know how nationalism can end up hurting everyone.  The last thing we should be doing right now is pointing fingers at foreigners.

We have the ability to solve our own AD problem; now we need to get on with doing it.  If the Senate wants to do something constructive, give the Fed a mandate consistent with what the Senate wants the Fed to accomplish.  If the Senate wants more AD, don’t try to take it out of the pockets of Chinese workers.  Let’s do it the way economics textbooks say it should be done, with Federal Reserve targeting of prices or NGDP.

Don’t make policy based on zero sum thinking.  The world needs growth, not trade wars.

HT:  Clark Johnson

Some articles point out one “bright spot” in this dismal day—the Fed succeeded in lowering long term yields.  They also raised short term yields, making the yield curve flatter.  You might want to get out your money textbook to find out what type of monetary policy causes a flatter yield curve.  According the an article by Sharon Kozicki at the Kansas City Fed:

The yield spread reflects the stance of monetary policy. According to this view, a low yield spread reflects relatively tight monetary policy and a high yield spread reflects relatively loose monetary policy.

The yield spread is the long rate minus the short rate.  Kozicki says the conventional view is that a lower yield spread means tighter money.  Today the Fed made the yield curve flatter.  You might think; “They know what they are doing; surely they wouldn’t tighten monetary policy.  Sumner must have things backward.”

OK, how would tight money affect the dollar?  Here’s the euro/dollar (the fall means the dollar soared after 2:15, or 6:15 London time):

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And here’s the Dow:

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So what do you think, monetary stimulus or monetary tightening?  The only thing that’s “twisted” is the Fed’s logic.  They are so obsessed with the Keynesian low interest rate approach to stimulus that they’ve completely lost their bearings and ended up tightening monetary policy.

PS.  I forgot to mention one other piece of “good news,” the Fed action sharply reduced oil prices.  Less inflation “worries.”

The recent Swiss devaluation has led to some interesting reactions in the blogosphere.  But one angle that I haven’t seen discussed is the relationship of the Swiss action and bubble theory.  I’m a believer in the EMH and hence skeptical of the idea of bubbles, a least as the term is usually interpreted.  But I’m in the minority, the vast majority of people think bubbles exist.  And if they do, then the recent move of the Swiss franc to near parity with the euro was surely a major bubble–as the currency appeared to be at a level that was unsustainable in the long run.

If the Swiss franc is wildly overvalued, then what should the Swiss do?  Because I don’t believe governments can identify bubbles, I’d be inclined to say they should do nothing.  But most people think bubbles are identifiable–indeed that’s a sine qua non for the existence of bubbles.  In that case the policy implications are clear–the Swiss government should buy massive quantities of foreign exchange, and then sell off the assets at a future date when the real exchange rate is at a more “reasonable” level.  The very rich Swiss would become even richer.  And because governments last indefinitely they can afford to wait out market irrationality, no matter how long it takes to dissipate.  BTW, this action need not involve monetary policy at all.

Now suppose Switzerland faces the threat of deflation, either due to an overvalued currency, or some other problem like currency hoarding.  What should the Swiss government do?  They should sell massive quantities of SF, until deflation is no longer expected.  BTW, this action need not involve the foreign exchange market at all.

As a practical matter the two actions I just describe will often be combined.  The Swiss will sell massive quantities of SF, and buy lots of foreign assets.  This would be appropriate if they think that Switzerland faces a threat of deflation and its currency is hugely overvalued.

Given my belief in the EMH, you might ask why I endorsed the Swiss intervention.  I don’t care at all about the overvaluation of the SF, my support was solely based on the assumption that the Swiss do face an actual risk of deflation.  I would also have supported a policy of price level targeting, or NGDP targeting.  I don’t much care if the Swiss end up winning or losing their bet on the SF.  The EMH says it’s a coin toss, and Switzerland’s a very rich country.  If they plan this game frequently, they’ll win as many as they lose.  Or if I’m wrong about the EMH, they’ll win way more than they lose.

Tyler Cowen had this to say about the action:

I am not unhappy but I am nervous.  Keep in mind the Swiss tried such pegs before, in 1973 and 1978, and neither lasted.  At some point limiting the appreciation of the Swiss franc implied more domestic price inflation than they were willing to tolerate (seven percent, in one instance, twelve percent in another).  You can argue about whether they should be, or should have been, nervous about seven percent price inflation but the point is that they were and indeed they might be again.

Fast forward to 2011.  It’s the Swiss saying “we can create money more decisively and more quickly than the speculators can bet against us, and keep it up.”  If the flight to safety continues, the Swiss can reap seigniorage by creating money but also there may be spillover into price inflation.  You can fix a nominal exchange rate but the market sets the real exchange rate through price movements and so Swiss exports could end up growing more expensive anyway, through the price adjustment channel.  If you’re holding and trading euros, and the Swiss central bank keeps churning francs into your hand at a good rate, at some point you will consider buying a chalet in Schwyz.

If the speculators sense less than a perfectly credible commitment from the central bank, they will continue to bet on franc appreciation.  In other words, the Swiss are putting their central bank credibility on the line, at least in one direction.  And even if they stay credible, they may not much lower their real exchange rate over a somewhat longer run, so why should they be fully committed to credibility?

I think I understand Tyler’s argument, but am not sure quite what to make of it.  It might help to slightly change the policy, and then see how it affects things.  Suppose the SNB says they will buy foreign exchange in order to drive down the value of the SF until inflation expectations rise to 2%.  In that case, it wouldn’t be much of a problem if inflation started rising, the SNB could simply abandon the program and declare “mission accomplished.”  This suggests that the real problem is a specific commitment to peg the SF at 1.20.  The SNB might have to abandon the peg if inflation started moving in a direction that conflicted with their macro policy goals.

In another post Tyler Cowen makes this comment:

And here is Scott on the Swiss unlimited pledge, a real test of credibility theories.

Just as with QE2, it’s not clear what is being tested.  QE2 was certainly credible—markets reacted powerfully to the news.  But the policy didn’t pan out as the had hoped.  And the Swiss announcement yesterday was certainly credible.  If it wasn’t markets would not have reacted so strongly.  It’s important not to confuse credibility and fidelity.  For instance a Don Juan may be credible, but not faithful.

It might be instructive to compare the ways in which QE2 might fail, with the ways in which the SNB policy might fail.  QE2 might have failed because it was not credible, because it didn’t increase NGDP expectations.  In fact, it did not fail for that different reason.  The real problem was that Fed didn’t commit to enough QE to hit a particular NGDP target, they committed to $600 billion in QE2.  Both the Fed and the markets initially thought that would be enough to significantly boost NGDP growth.  If it did (which is unclear) all it did was to prevent an even steeper slowdown than what actually occurred.  On the other hand if the Fed had promised to do whatever it takes in the form of QE, and if it was believed, it might have failed because it later reneged on that promise.  The Don Juan problem.  That’s a problem some people worry about, but not me.  Central banks aren’t Don Juans.  They don’t have fidelity problems, they have commitment problems.

In my view people are making too much of an issue of the risk that the SNB may not end up adhering to the 1.20 currency peg.  The SNB frequently intervenes in the forex market, as described in this recent post.  During recent years there were several interventions that seemed to achieve the SNB’s objectives, and then were abandoned when no longer needed.  Mission accomplished.  The macro aggregates in Switzerland are about where the SNB wants them, but there is concern about future trends.  Thus they are taking a pre-emptive action.

This recent action may be abandoned because the SNB’s macroeconomic goals are achieved.  But I don’t see how that would be a source of embarrassment for the Swiss.  It’s inflation and NGDP that matter, not the exchange rate–which is merely a means to an end.

Here’s Matt Yglesias:

I continue to be fascinated by the fact that lots of issues in monetary policy that are controversial when you talk about “monetary policy” become uncontroversial when the subject switches to exchange rates. Everybody knows that currency depreciation expands aggregate demand. This is what the Swiss are talking about. This is what Americans are talking about when they complain about Chinese “currency manipulation.” And everyone agrees that a determined central bank can achieve whatever exchange rate goals it sets. So despite the apparent disagreement over whether or not a determined central bank can boost aggregate demand, everyone in fact seems to agree that it can””but only if we agree to talk about exchange rates rather than “aggregate demand.”

I’d hope “everyone agrees.”  But here’s Paul Krugman (from last year):

Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro “” and failed:

PS.  The other quasi-monetarists have had excellent posts on the Swiss move (Beckworth, Hendrickson, Glasner, Nunes, etc.)  I’m still jet lagged and struggling to catch up with all the news I missed, and what other bloggers have been saying.