Paul Krugman recently discussed the charge that QE2 is stoking inflation in the developing world:

Oh, and what about Ben Bernanke? Well, to the extent that emerging markets are insisting on a fixed exchange rate against the dollar in the face of obvious overvaluation, that contributes to the boom and hence to demand. But I don’t think it’s reasonable to demand that the Fed stop fighting US unemployment in order to keep Chinese currency manipulation from leading to cotton hoarding by Chinese farmers.

He’s right, all the Chinese would have to do is raise the value of the yuan.  You might argue that this would slow their economy.  But if inflation is shooting upward they need to slow the (nominal) economy.

For China to blame the US for its inflation, when they refused to cut back on the number of Treasury bonds they bought as a way of tightening monetary policy and boosting the yuan, would be like the US blaming China for high unemployment, when we refused to buy more Treasury bonds to weaken the dollar and boost the prices of commodities, stocks, TIPS and foreign currencies.  Bernanke and company showed in November that they are quite capable of taking affirmative steps to solve our own problems (although I’d like to see even bigger steps.)  Now China needs to show the same can-do spirit, and stop blaming foreigners for its problems.

BTW, it’s good to see Krugman talking about how the Fed is “fighting unemployment.”  A clear message to all those old Keynesians who whine that there is nothing monetary policy can do once rates hit zero.  Their hero FDR didn’t whine that there was nothing he could do about deflation because rates were at zero.  He engaged in level targeting—set a goal of getting prices back up to 1926 levels.  And he got prices rising fast.

Doing Bastiat-style reductio ad absurdum arguments seems to get more difficult each day.  A few week ago I tried to satirize the view that China was the Great Satan of international imbalances, pointing out that the combined current account surpluses of tiny Switzerland and Norway (population 13 million)  is nearly half as large as China’s $289 billion CA surplus (population 1.35 billion.)  Indeed a relatively small block of countries lying between Switzerland to the south and Norway to the north have a combined CA surplus of $397 billion, and a population of only 125 million.

So I was quite startled to see an article in the Swedish press with the following headline:

Sweden ‘threatens the global economy’: study

An American think tank has criticised Sweden for maintaining a constant current account surplus and urged the country to undertake measures to stimulate domestic demand.

“Sweden has not taken sufficient measures to reduce its current account surplus,” non-profit New America Foundation, a non-profit, non-partisan US-based think tank, wrote in a statement on Thursday.

“Its fiscal policy should be more expansionary; it should encourage currency appreciation; and it should open its domestic market to foreign goods.”

I’m worried to death that I have made some sort of terrible mistake.  I know that I have a few Swedish readers; please tell me I haven’t accidentally cited a Swedish version of The Onion, so I can quickly erase this post.

Seriously, I actually respect the New American Foundation much more than the neo-mercantilists who obsess over China.  At least they have the courage of their convictions, and at least they’ve bothered to look at the data.  However I’m not quite sure about the charge that Sweden doesn’t have an open domestic market; doesn’t Sweden have relatively low trade barriers?

There are a couple important principles in international economics:

1.  National boundaries are not necessarily meaningful when evaluating the influence of a particular regional economy.  The GDP of Czechoslovakia did not suddenly change when the country split in two–nor did the impact of its economy on the rest of the world.

2.  When a country’s economy impacts the US, it usually doesn’t matter whether the impact is “natural” or “artificial.”  For instance, suppose we had been gladly importing Ecuadorean bananas for decades, naively thinking that any country named after the equator must be warm.  Then we found out that the weather in Ecuador was actually quite cool (due to high altitude), and that bananas could only be grown there because the government was heavily subsidizing production in greenhouses.  Of course most red-blooded Americans would be outraged by this discovery, as it would indicate that we were a bunch of patsies who had been victimized by the Ecuadorean “dumping” of subsidized goods.  A few economists might argue, however, that if cheap bananas are good for the US, it doesn’t really matter why they are cheap.

With these concepts in mind, I decided to investigate where these so-called international “imbalances” are actually located.  Keep in mind that I don’t think imbalances are of any importance.  But others clearly do—so at least we ought to be aware of the stylized facts being discussed.  I used data from the back page of The Economist, and divided the world up into key regions:

1.  Nordic region:  Population 125 m.  CA surplus = $397.3 b.   (Of which Germany is nearly 2/3 the population, but less than 1/2 the surplus.)

2.  China:  Population 1350 m.  CA surplus =$289.1 b.

3.  Japan:  Population 127 m.  CA surplus = $180.9 b.

4.  Five dragons:  Population 110 m.  CA surplus = $153.3 b.

5.  Russia:  Population 145 m.   CA surplus = $84.2 b.

6.  Club Med:  Population 255 m.   CA deficit = $266.3 b.

7.  Anglo bloc:  Population 420 m.   CA deficit = $556.0 b.  (Of which the US is roughly 3/4s of both categories.)

[The Nordic bloc includes Norway, Sweden, Denmark, Holland, Germany and Switzerland.  Perhaps “Protestant” might be a better term.  Club Med includes France, Spain, Italy, Greece and Turkey.  The five dragons are Korea, Taiwan, Malaysia, Singapore and HK.  The Anglo bloc includes the US, Canada, Britain and Australia.  The Economist did not list small countries like Ireland and New Zealand.  CA is ‘current account.’]

So if CA surpluses are to be viewed as a problem, then there is no one more villainous that the Norwegians and the Swiss.  Both countries have CA surpluses of roughly $10,000 per capita.  That’s about $40,000 for the average family of four in each country.  There are lots of countries where average incomes aren’t even that high.  China has a surplus of about $215/person.  The average Norwegian and Swiss worker is nearly 50 times as destructive of US jobs as the average Chinese worker.   All those xenophobic campaign commercials should be depicting blue-eyed blonds making skis and cuckoo clocks.  That’s where our jobs are going!

I know what you are thinking; “The Nordic countries play by the rules; they don’t have their governments buy lots of foreign financial assets in order to run up massive CA surpluses.”  Ever heard of Norway’s Sovereign Wealth Fund?  Note that the 5 little Nordic countries combine for a $220 billion surplus, with a combined population smaller than South Korea.

Do any of these “imbalances” actually hurt the US?  Of course not, the Fed determines our NGDP.  But I thought it would be interesting to identify the villains, in case you do think it is a problem.  BTW, the other countries on The Economist list tend to have much smaller imbalances.  These are the big ones.

PS.  I used the CA balance.  Some might argue that it is the trade balance that really matters, as it correlates with jobs.  The CA includes income from investments.  If so, China shrinks to a $182.9 b. surplus and Germany rises to $208.2 b. while Russia soars to $151.6 b.  China is just another big country in trade balance terms.

HT:  Bastiat

The following is related to my most recent essay at The Economist.

I suppose it’s presumptuous for me to pontificate on Bretton Woods II, given I found out the meaning of the term only a few weeks ago.  But heh, that’s never stopped me before.  Here’s Wikipedia:

Bretton Woods II was an informal designation for the system of currency relations which developed during the 2000s. As described by political economist Daniel Drezner, “Under this system, the U.S. is running massive current account deficits to be the source of export-led growth for other countries. To fund this deficit, central banks, particularly those on the Pacific Rim, are buying up dollars and dollar-denominated assets.”

Well at least I was aware of the phenomenon.

There’s been a lot of recent discussion of whether Bretton Woods II is about to fall apart, with this post by Tim Duy being perhaps the most authoritative:

The inability of global leaders to address global current account imbalances now truly threatens global financial stability.  Perhaps this was inevitable – the dollar has not depreciated to a degree commensurate with the financial crisis.  Moreover, as the global economy stabilized the old imbalances made a comeback, sucking stimulus from the US economy and leaving US labor markets crippled.  The latter prompts the US Federal Reserve to initiate a policy stance that will undoubtedly resonate throughout the  globe.  As a result we could now be standing witness to the final end of Bretton Woods 2.  And a bloody end it may be.

I don’t know whether Bretton Woods II is about to collapse or not.  But I am skeptical of much of the discussion of global imbalances, which in my view focuses far too much on currency/trade questions, and far too little on savings/investment imbalances.  Before considering Duy’s views, I’d first like to address an argument recently made by Michael Pettis:

For that reason I am always puzzled by people who say that devaluing the dollar will have no impact on the US trade deficit because the problem is low savings relative to investment.  No, that is not the problem.  That is simply one of the definitions of a current account deficit.  But if the dollar devalues, and consumer prices rise, US consumption is likely to decline.  In addition, to the extent that any of the stuff Americans used to import before the devaluation is now produced domestically (not all, but any), then US production must rise.  Since savings is equal to production minus consumption, the US savings rate must automatically rise.

As you may know, I’ve never liked arguments that “reason from a price change”:

1.  Next year the price of oil will be higher, therefore we can expect consumers to . . .

2.  Interest rates will fall therefore we can expect investment to . . .

3.  The dollar will fall therefore we can expect exports to . . .

This is often a misuse of basic supply and demand theory.  There is no necessary correlation between a price change and a quantity change; it entirely depends on why the price changed.  Was it more supply, or more demand?  Now that doesn’t mean Pettis is wrong here, he probably assumed a particular cause of the price change in the back of his mind.  But we need to start with that fundamental cause.

Often when people talk about the need for the US to devalue the dollar, they imagine it occurring through an expansionary monetary policy.  But monetary policy doesn’t have real effects in the long run, so it can’t solve secular problems.  There is no particular reason to expect that having the Fed devalue the dollar would “improve” the US trade balance:

1.  In the long run money is neutral; hence the real exchange rate is unaffected.

2.  In the short run the trade balance might get worse due to the J-curve effect.

3.  If monetary stimulus has a business cycle effect, then the trade balance might get worse if the stimulus creates a boom in the US.

So while Pettis might be right, I don’t have much confidence that the sort of dollar depreciation people are currently discussing would materially affect the US trade balance.  The most “beggar-thy-neighbor” policy in American history was probably the massive devaluation of 1933, and the trade deficit initially got worse.

Of course it may be the case that a country adjusts its currency value by altering the savings/investment equation.  For instance, many people are calling on China to revalue it’s yuan by purchasing fewer foreign bonds.  That doesn’t necessarily reduce Chinese saving (it depends what else the Chinese government does) but there are certainly scenarios where it might.

On the other hand I don’t have much confidence that a laissez-faire attitude in China would materially affect the US trade balance in the long run.  Remember that if China removed all currency controls, it would also be much easier for Chinese citizens to invest overseas.  I think we need to see China in a broader East Asian context.  One reason I could foresee Bretton Woods II being around for a long time is that East Asia is very different from the West, and those differences will become much more important over time, as East Asian wealth skyrockets.  (The term “skyrocket” is not hyperbole, Chinese wealth is set to rise dramatically.)  All of East Asia seems to be moving toward ultra-low birth rates and economies that are structured to produce high saving rates.  I don’t know if Singapore intervenes to weaken their currency, but given the extraordinary high savings rates there you’d expect a big CA surplus even if the government wasn’t accumulating foreign reserves.  The exact same thing occurs if the Singapore public buys the assets, and puts them in retirement accounts.

Over the next few decades China will get much richer.  As it does so, I’d expect its economy to resemble other East Asian countries more than the US.  And that will be true even if their government ends its weak yuan policy.  To take just one trivial example, I’d expect far more Chinese citizens to be speculating in property in LA, Vancouver and Sydney, than Westerners buying vacation homes in Shanghai or Hainan.

The East Asian economy is set to become extremely large in 20 or 30 years.  Given the enormous structural differences from our economy, I think it quite likely that the imbalances will become even larger in absolute terms.  When I lived in Australia in 1991, many Aussies were worried that their huge CA deficits were unsustainable, and also the cause of their recession.  They haven’t had a recession since, and they have continued to run very large deficits.  I see no reason why this “unsustainable” trend cannot continue for many more decades.

This is not to suggest that I disagree with Pettis’ policy recommendations, indeed I think his views on restructuring the Chinese economy make a lot of sense.  He also seems to share my view that while moderate yuan appreciation would be desirable, a sudden and sharp appreciation might be counterproductive:

This is why I worry that we are putting too much pressure on the renminbi.  There are many ways for China to rebalance, and they all involve the same process of transferring income from producers to households.  Raising the value of the renminbi, for example, increases the real value of household income in China by reducing the cost of imports.

It balances this by lowering the profitability of exporters.  The net result is that if it is done carefully, the household income share of China’s GDP rises when the renminbi is revalued, and with it consumption rises too.  Since China must export the difference between what it produces and what it consumes or invests, raising the value of the currency also reduces China’s trade surplus.

But what would happen if China were to raise the currency too quickly?  In that case the profitability of the export sector would decline so quickly that exporters would be forced either into bankruptcy or into moving their facilities abroad to lower-wage countries.  Either way, they would have to fire local workers.

Tim Duy also seems skeptical of those who put all the focus on Chinese surpluses:

But I don’t want to make this piece about China.  It is more than China at this point.  It became more than China the instant US Federal Reserve policymakers woke up one morning and decided they needed to take the dual mandate seriously.  And seriously means quantitative easing.  Brad DeLong suggests that when the Fed actually acts on November 3, it will be too little too late.  But if it is too little, more will be forthcoming.

Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2.  November 3, 2010.  Mark it on your calendars.

So perhaps Bretton Woods does not end because foreign governments are unwilling to bear ever increasing levels of currency and interest rate risk or due to the collapse of private intermediaries in the US, but because it has delivered the threat of deflation to the US, and that provokes a substantial response from the Federal Reserve.  A side effect of the next round of quantitative easing is an attack on the strong dollar policy.

Even if we could boost US demand by bashing China (and I doubt we could) there is a much better way; boost NGDP with a more expansionary monetary policy.  Where I differ with Duy is that I don’t think it will permanently end Bretton Woods II.  Yes, there may be some short term reduction in imbalances, but once the US recovers I have trouble seeing why we would not revert to running large deficits.  In my view there are only two permanent ways to address the US CA deficit; raise the US saving rate through fiscal reforms, or depress investment by adopting demand and supply-side policies that impoverish the country.  I think you know which approach I prefer.

BTW, David Beckworth posted on this earlier, and he shares my skepticism about the end of BWII.  Bill Woolsey also has a good post on exchange rates.

HT:  Marcus Nunes

Paul Krugman has gotten a lot of flack from people who noticed that he seems to have a double standard.  He argues that the US should threaten China with trade sanctions, in order to force them to revalue the yuan.  In earlier posts he acknowledged that a strong yuan would not be a problem under normal circumstances, as the US could simply offset the negative impact on AD with an easier money policy.  (Note to commenters; this argument is unrelated to the fact that the yuan is pegged to the dollar.)

Krugman also argues that the US and Europe are stuck in liquidity traps, and hence monetary policy cannot be used to offset the effects of the undervalued yuan.  But when Europeans complained that monetary stimulus in the US was weakening the dollar and hurting their export industries, he made this sarcastic comment:

In other words, how dare you act to protect your economy from deflation and double-digit unemployment? By doing so, you make our inappropriate tight-money policy even more destructive!

I thought his retort was great, and said so.  But I think you can see the problem.  Suddenly the concerns of the country with the strong currency are brushed aside; they should just adopt their own monetary stimulus.  What happened to the idea that monetary stimulus doesn’t have any effect at the zero bound?  And if the Europeans can do that in response to the weak dollar, why can’t we do that in response to the weak yuan?

In a new post Krugman acknowledges the critics, but fails to dig himself out of the hole he’s in.  To his credit, he doesn’t mention the yuan peg, which is a phony issue raised by some of my commenters.  That’s not the problem in Krugman’s view– the problem is that the Fed can’t raise AD because we are at the zero bound.  So how does he defend himself?  He changes the subject, arguing that we have much more reason to complain about the weak yuan than the Europeans have to complain about the weak dollar:

In various comments and other places I keep seeing people compare European complaints about the weak dollar to American complaints about the undervalued renminbi. It’s a false equivalence, which should be obvious if you think about the basics of the situation.

What the United States is doing is an expansionary monetary policy in the face of a depressed economy and threats of deflation; what else do you expect us to do? Now, one effect of that policy, if it isn’t matched abroad, is a weaker dollar “” but that’s not the goal of the policy.

But even if he is right (and I’ve argued he’s wrong for all sorts of reasons), this argument does not rebut the charge that he changes the argument when the US is the country in the hot seat.  We critics do understand that one might be able to make a stronger argument for a weak dollar than for a weak yuan.  What we complain about is that he assumes the ECB can do nothing to boost AD when the issue is China, but when there are complaints against the US depreciating the dollar the liquidity trap seems to vanish into thin air.  That’s the double standard.  Krugman’s smart enough to know he has a weakness there, and so he also makes this argument:

What about the argument that America can offset any effects from China’s policies through looser money? Well, I don’t really get why some commentators can’t grasp the distinction between the proposition “quantitative easing is worth trying, and would probably help” and the proposition “quantitative easing will allow the Fed to do whatever is needed, never mind the zero lower bound.” I subscribe to the first, not the second.

This is a game he’s been playing from the beginning.  When it suits his purpose to claim monetary policy can do nothing (i.e. calling for fiscal stimulus or bashing the Chinese) he does so.  When it suits his purpose to claim that monetary policy still has unused ammunition (as when he’s bashing the Fed, or bashing the ECB) suddenly monetary policy can do much more.  His only way out is to confuse the issue—maybe it’s a 50/50 proposition.  Maybe monetary stimulus will work, maybe it won’t.  But notice how when he attacks China it’s all about the 50% chance it won’t work, and when he attacks the ECB it’s all about the 50% chance it will work.

Of course the truth is it will work.  Indeed the entire discussion of how the Fed is depreciating the dollar makes no sense if we were really in a liquidity trap.  That’s because when you are in a liquidity trap monetary stimulus has no effect on the exchange rate.  So let’s get serious here–we all know that the Fed can offset China’s impact on NGDP if they want to.  Indeed they can raise NGDP at Zimbabwean rates if they really set their minds to it.  Krugman’s right that they are too conservative to do that–but that just means we have  no one but ourselves to blame for our unemployment.  The Chinese have every right to scold our Fed just as Krugman scolded the ECB.  (Ironically, the Chinese are doing the opposite!)

Earlier Krugman and I had a debate about whether the Bank of Japan had tried and failed to inflate, or had never really tried at all.  He takes the former view, which required him to make the deeply implausible argument that even a fiat money central bank might get stuck in a liquidity trap.  I pointed out that the BOJ had repeatedly tightened policy at any sign of even a tiny increase in the price level, hence it was no surprise that Japan fell back into deflation any time the inflation rate poked its head above zero.

I recall that Ryan Avent thought Krugman’s reply actually supported my argument.  Now Matt Yglesias has weighed in the the issue.  As you know, Yglesias’s Keynesian views on fiscal stimulus are much closer to Krugman’s than to mine.  But he is also a very smart and fair-minded progressive.  Here’s how he sees the evidence:

I heard from some readers, for example, that the Bank of Japan spent a lot of time trying to create inflation and failed. That’s not really what happened. Instead, the Bank of Japan spent a fair amount of time trying to fight deflationand had limited but real success. They always indicated, however, that they wanted “price stability” not inflation and certainly not catchup level targeting of anything. This kind of stop/start policymaking does exactly what it’s supposed to do””it prevents collapse without being unduly unorthodox””but it can’t really lift the price level or the economy. But that’s not to say policymakers don’t have the ability to say that unorthodox measures will remain in place until full employment resumes. Thus far, in both Japan and the US, they’ve simply chosen not to do so.

I can’t imagine how any fair-minded observer could look at all the evidence on the BOJ and reach any other conclusion.  This blows away Krugman’s argument about the US being victimized by China.  How can we claim to be a victim when we haven’t even tried to stimulate?  Especially as monetary policy can do the job almost costlessly.  And how do I know we haven’t made a good faith effort?  Because Krugman said so today!

There are multiple things wrong with that paragraph “” but what on earth would give one reason to consider our political system “responsive”? The truth is that we’re responding worse than Japan did.

Krugman’s right.  Our attempts to boost AD have been completely pathetic.  So why the heck are we blaming the Chinese for our failures?

Krugman’s right about one thing, we are in a recession and China isn’t.  So we need the stimulus more than they do.  But the issue is not how much unemployment China has now, but rather how many Chinese would lose their job if China sharply revalued the yuan. I favor a gradual appreciation in the yuan, and the Chinese government has recently resumed the policy of gradual appreciation that was conducted from 2005-08.  But here’s what China expert Michael Pettis says might have if there was a sharp appreciation in the yuan:

And so there is a good chance that the US will overreact, and will use the threat of tariffs to force the renminbi to appreciate much faster than China can absorb.

.   .   .

So after years of dragging its feet, postponing a rebalancing, and forcing rising trade surpluses onto the rest of the world, China may have to adjust its currency policies so quickly that it risks a sharp contraction at home.

Note that unlike me, Pettis agrees with Krugman’s argument that the weak yuan has hurt the US.  But he is still very concerned about the impact of a sharp revaluation.  Think about it.  How could such a policy help the US by sharply curbing our imports from China, without costing the jobs of many Chinese workers in the export sector?  China’s a very big country, I could easily foresee more jobs being lost in China’s export sector, than gained in the US (even if you accept the zero sum approach used by some protectionists.)

So even if you accept Krugman’s argument that yuan appreciation would help the US (and I don’t) he’s still asking a country with 1.3 billion mostly poor people to take a chance on a policy that Michael Pettis says could cause severe problems, all because of our failure to boost AD.  And even Krugman blames our own policymakers for that failure.   How can a progressive make that argument?

Yes, I know, I don’t get the fact that we can’t be 100% sure that monetary stimulus will work.  And can he or anyone else be 100% sure a sharp yuan revaluation wouldn’t cost China millions of jobs?  Especially given that China’s economy slowed sharply and experienced deflation after the yuan became overvalued in 1998?

HT: Master of None