How do we know it’s true?

Another pompous post title signals more dime store philosophizing, but I promise to eventually get around to addressing a recent Free Exchange post that discussed my views on the yuan.

How do we know the theory of supply and demand is true?  Or the theory of comparative advantage?  As you may know, I think these are the wrong questions.  Being a good pragmatist, I think the real question is whether these models are useful.  I’m pretty sure they are, but if given a lie detector test I could probably only say I am 97% sure, not 100%.  There are studies that show price discrimination in seemingly competitive markets, or that show no impact from higher minimum wages in fairly competitive labor markets.  There are studies that show the US doesn’t export what you’d expect us to export based on the theory of comparative advantage.  Even so, I find the evidence in favor of these models to be far more persuasive, so I am pretty sure they are “truish.”

On Friday, US stock futures jumped sharply on news of the stronger than expected job market in November.  In contrast to S&D and/or comparative advantage, I am I more than 99% sure that the job figure caused the jump in stock prices right after the 8:30 announcement.

But the official ideology (at least where I studied) is that we can be certain S&D is true, whereas newspapers like the WSJ make fools of themselves when they claim to know why stock prices went up on a particular day.  Well the WSJ does often make a fool of itself, and often draws conclusions about the link between policy and stock prices on the slimmest of evidence.  But in principle, and if done thoughtfully and honestly, there is nothing wrong with that sort of inference.

Last night after reading the criticism of my “weak yuan saved the world” argument on Free Exchange, I picked up a copy of that blog’s parent magazine, The Economist and saw this article.

AN EASY but instructive way to bait an Indian economist is to credit the Chinese economy with coming to Asia’s rescue and arguably the world’s. It is, claims the economist, an example of anti-India bias. Why does India not get equal credit for robust growth? In all the frothy coverage about Asia’s amazing rebound, including in The Economist, where is India? “You’d think”, the economist complains, “that India isn’t even part of Asia.”

Then, a few pages later, I ran into the following story by an entirely different reporter:

Beijing also argues that it has done a lot to help global rebalancing. Thanks to its monetary and fiscal stimulus, domestic demand has contributed an incredible 12 percentage points to GDP growth this year, while net exports subtracted almost four percentage points. Its current-account surplus has almost halved to around 6% of GDP from 11% in 2007. Chinese policymakers accept that the yuan needs to appreciate over the longer term, but say now is the wrong time, because exports are still falling, by 14% over the past 12 months.  (Italics added.)

On the very next page, is a third story, this time by “Buttonwood“:

Meanwhile, the Chinese boom that seemed to revive the global economy is showing its dark side. Commodity prices are rising across the board, acting as a further tax on hard-pressed Western consumers (oil has roughly doubled since the start of the year).

Clearly there is a pretty widespread perception at The Economist that the Chinese recovery helped trigger a broader global recovery.  How did that perception develop?  Was it simply a matter of post hoc ergo propter hoc?  I don’t think so.  But first let’s take a closer look at the so-called “dark side” of the Chinese recovery–higher commodity prices.  I do understand that the US is a net oil importer, so there is a sense in which higher oil prices can act as a drag on the economy.  Nevertheless, I think this is an extremely misleading argument, which confuses supply shocks and demand shocks.

Last year the global crash caused oil prices to fall from $147 into the $30s.  After March 2009 oil (and other commodities) began to a vigorous recovery.  At the same time China and then Asia began a rapid economic recovery.  And at the same time the US and Europe saw dramatic gains in equity prices, and a sharp slowing in the rate that output was declining.  What can we make of all this?

Suppose in March of 2009 there had been no Asian recovery, and instead the price of oil soared because OPEC reduced oil output sharply enough to raise prices to $75.  (Note: I understand that actual output fell a bit, but this was a movement along a supply curve, I am referring here to a shift in supply.)  Those really would be “dark clouds” and would have depressed the US stock market.  Instead, the higher oil prices came from higher demand (or more probably expectations of increased demand over the next few months.)

My commenters used to be surprised when I said that I was praying for a return of $147 oil, as I think the most likely reason why that would happen is a brisk global recovery.   So how can we explain the positive correlation between oil prices and all sorts of US economic indicators like stock prices and the rate of change of GDP?  The answer is obvious, the positive impact of the factors causing the high oil prices dramatically outweigh the negatives that are directly caused by high oil prices. The recovery in China (and indeed many other developing countries like India and Brazil) had a positive impact on the US economy that dramatically outweighed the small negative associated with higher oil prices.  And of course the reverse occurred late last year when both commodity prices and output plummeted.

So now let’s return to the question of how we know the Chinese recovery helped end the sickening slide that was occurring all over the world last winter.  Forget about academic economists, they rarely pay attention to the nitty-gritty of international markets.  Think about economists who work for financial firms, and also reporters who cover the world economy.  They wake up every morning seeing news from all over the world, and the responses of the various financial markets.  Unfortunately this news is heterogeneous and hard to quantify, and it is often unclear exactly when the market becomes aware of the news.  Rarely do we have such controlled experiments as the 8:30 jobs announcements that occur the first Friday of each month.  Nevertheless, I think people can form relatively educated guesses about what is going on.  If the only good news of significance is surprisingly strong data out of China, and if the Hong Kong markets rises in response, and if this is followed by a strong opening on Wall Street that is widely seen as a reaction to strength in Asian markets, well then I submit that this information means something.  It is not definitive, but it is also not useless.  And if it happens repeatedly, and lots of other real world economists and financial reporters notice the pattern, then it is even more significant.  I’m at least 90% sure that the strong Chinese recovery played a significant role in reversing the dangerous deflationary expectations that were afflicting US equity markets last winter.

[BTW,  I am not arguing that the “conventional wisdom” is necessarily always right.  If there are no market signals, but just armchair theorizing, then I pay much less attention to conventional wisdom.  For instance, where is the evidence that Greenspan’s low interest rate policy blew up the sub-prime bubble?  I’m not saying it didn’t, but I don’t see how one could draw that conclusion merely by looking at asset markets.  I am much more interested in situations where it is relatively easy to see what sort of “news’ is triggering asset price changes in real time.]

Of course even if I am correct on this narrow point, it doesn’t prove that the Chinese weak yuan policy helped the US.  Arguably the Chinese recovery could have been due to their stimulus package, with the yuan playing only a minor role.  Of course if it played only a minor role in helping China, it is hard to see how it could have played a major role in hurting the West.  Even if expansionary monetary policy in China isn’t the positive sum game I assume it is, it surely isn’t a negative sum game.

In the second article in The Economist cited above, they didn’t just present the Chinese government’s side of the case, they also discussed the counterarguments in favor of a stronger yuan:

Foreigners argue that a stronger yuan would not only help reduce global imbalances, such as America’s trade deficit, but would also benefit China. It would help China regain control of its monetary policy. By pegging to the dollar, it is, in effect, importing America’s monetary policy, which is too loose for China’s fast growing economy. A stronger yuan would also help rebalance China’s economy, making it less dependent on exports, putting future growth on a more sustainable path.

With all due respect, those “foreigners” don’t have very good arguments.  Chinese exports have plummeted in the past 12 months.  Meanwhile its domestic economy has expanded rapidly.  So the rebalancing that is supposed needed is already occurring at a very fast rate, despite the stable yuan.  But what about the future, don’t they eventually need to start revaluing the yuan?  Yes, and the Chinese government has hinted that this will occur sometime next year.

As far as getting “control of its monetary policy” that is exactly why the stable yuan was needed.  If the Chinese had appreciated the yuan over the past year at the very time the Fed was adopting a deflationary monetary policy, then China risked even greater deflation than it already had.  Don’t believe me?  Have you checked out recent CPI data from Japan?  Remember how US officials kept pressuring Japan to have a strong yen?  How’d that work out?  Again, you’re probably thinking that China is different, that China is a fast-growing economy and that the Balassa-Samuelson effect implies the yuan should be appreciating.  And I entirely agree, when China is booming it is appropriate that they let the yuan appreciate.  BTW, if they don’t follow this advice it won’t hurt the US, it will simply mean a higher trend rate of inflation in China.

But it was only months ago that China was losing 10s of millions of jobs in its export industries.  And for most of 2009 China experienced deflation.  So the appropriate monetary policy for China was currency appreciation when it was booming 2005-08, a stable yuan during the recession 2008-10, and then more currency appreciation in the next boom 2010 – ????.

It is easy to visualize how a weak yuan can hurt the US, and hard to visualize how it can help.  As a result, people tend to overestimate the “terms of trade” impact, and underestimate the income effect.  Lots of factors enter the picture, including the effect of Chinese policy on other central banks.  Free Exchange concedes that I would have a pretty good point if the Fed and ECB had responding to the Chinese policy with greater monetary ease.  But then he said that was unlikely, as these central banks were stubbornly opposed to additional stimulus.  Interestingly, just a few days earlier, Free Exchange had made almost the opposite argument, that the weak dollar was one reason why the Fed was reluctant to ease further.  The clear implication was that if both Japan and the ECB decided to sharply devalue their currencies against the dollar, it would provide cover for greater ease by the Fed.  I wish that would happen.  Even so, I accept Free Exchange’s argument that China, by itself, is probably not significant enough to push other central banks into explicitly changing their policies.

But here’s what China can do, they can raise the world equilibrium real interest rate, and they can reduce fears that the entire world is plunging into a deflationary trap.  And if they do those things, then even if the Fed keeps its nominal interest rate target at zero, policy will effectively have eased, as the policy rate will be closer to the Wicksellian equilibrium rate.  Last fall the equity markets in the US and Europe realized all this at some level.  No, I don’t think traders wake up thinking about Wicksell.  But they instinctively understood that if one huge part of the world economy was recovering quickly (Asia) then the prospects for the West were far less bleak.  Call it folk wisdom.

Free Exchange is right about one thing, my analogy to the Great Depression was a weak one.  The dollar devaluation of 1933 did reduce the US trade surplus, as US imports rose rapidly.  But it also led to some hoarding of gold in places like France, as there were increased fears that other countries would devalue.  I still think that, on balance, FDR did the right thing.  But the arguments for a weak yuan in late 2008 were far more powerful, as there was no equivalent deflationary side effect as occurred with the foreign gold hoarding in 1933.

My friend Clark Johnson knows much more international finance than I do, and he tells me that the effects of currency depreciation on trade balances are generally disappointing.  When China started appreciating it currency in 2005 did US economists significantly reduce their forecasts of the US/China trade imbalance, or significantly increase their forecast of US GDP growth?  I don’t know the answer, but I very much doubt it.  US/Chinese trade simply isn’t that big a factor in a $15 trillion dollar US economy.  And likely changes in that trade balance in response to a 10% yuan appreciation are far smaller still.  And the changes in America’s total trade balance as output is shifted from China to other Asian countries is even smaller.   In contrast, the macroeconomic impact of stronger Asian growth on the world economy can be profound, especially if we are teetering on the edge of a liquidity trap.

I recall Krugman once saying that Japan’s big fiscal deficits kept it out of a big depression, and explain why their unemployment rate never got very high.  (That’s after he had earlier explained why their fiscal stimulus was relatively ineffective.)  But that’s not the real reason Japan escaped with merely a Great Recession.  The real reason is that during 1994-2008 Japan was able to export into economies that were not stuck in “liquidity traps,” indeed were mostly booming over that period.  Under those circumstances a demand-side Great Depression in Japan would have been bizarre, almost unthinkable.  (Supply-side is another story.)

So how is the US helped by the strong Chinese economy?  The direct effects don’t sound very impressive.  We do export some capital goods to China, and the quantity of these exports probably depend more on whether China is booming, than they do on the exact value of the yuan.  We also export capital goods to countries that are much more closely linked to the Chinese economy, such as Australia.  And if China pushes up the price of commodities, then (because of sticky wages) US commodity producers will tend to increase their output as well.  Nevertheless, I’ll bet someone could make the same argument against these factors that I made against the terms of trade impact of a weak yuan on the US economy.  It’s probably a relatively small share of GDP.  I suspect that the most important effect was much less visible, the fact that a stronger world economy tends to give monetary policy a bit more “traction” at the zero rate bound.  You may or may not buy my argument, but the equity markets certainly seemed to buy it, and they would have had an incentive to weigh all the pros and cons.

BTW, I do understand that part of the rise in equity markets was expectations of higher profits in China, but this can hardly explain a 60% rise in the Dow, much of which occurred in the first few months after China began recovering.

I’d like to conclude with two analogies, which might or might not help, but at least will give you a sense of where my intuition is coming from.

Analogy 1:  Recall the depression Argentina suffered at the end of the 1990s and the early 2000s.  The government was fairly right wing (by Argentine standards) and had pursued some neoliberal policies.  Then around 2002 a new left-wing government came in and pursued some rally bad statist policies.  And guess what, Argentina started growing at 8% a year, whereas RGDP had been falling under the previous neoliberal regime.  So what do the conservative real business cycle people think of all that?  I have no idea.  As for myself, the answer is easy.  The neoliberal government, while good in many ways, pursued a very deflationary monetary policy (because of a fear of repeating the mistakes of earlier Argentine governments who had devalued their way into hyperinflation.)  The new government did devalue sharply, and as NGDP rose rapidly, so did RGDP.  What’s the moral here?  Why does the bad government get rewarded with fast economic growth.  As James Tobin once said; “It takes a heap of Harberger triangles to fill an Okun’s gap.”

Analogy 2:  The previous analogy focused just on Argentina, and reflected my view that macro issues (world AD) are much more important that sectoral issues (US/China terms of trade.)  This one will address the alleged fairness issue.  Is China beggaring its neighbors?  When I was at Chicago I learned that again and again that an issue that at first glance looked distributional (say a mandate that companies provide X benefit to workers), was actually a pure efficiency issue, as any mandate would simply be passed along to workers in the form of lower cash wages.  My intuition tells me that this is equally true in trade.  Most disputes that seem to involving beggaring various neighbors are actually policies where countries shoot themselves in the foot, and impose net efficiency costs on themselves.  Indeed, even Free Exchange concedes that I would be right if the Western central banks responded appropriately to the Chinese monetary policy:

If America and Europe are feeling some pressure from Chinese devaluation, in the form of a squeeze on import-competing firms and domestic exporters, then the thing for them to do is crank up their own expansionary monetary policies””to do the equivalent of abandoning gold. But it’s quite plain that the European Central Bank and the Federal Reserve are more or less done with their large-scale expansionary measures. As a result, there is nothing standing between American and European workers and cheap Chinese imports except for their elected governments. And bad things happen when that is the case.

When advocating for or defending a given policy, it’s not enough to say “other things equal” and assume that’s the case. It rarely is. Assuming that the ECB and the Fed are, for whatever political reason, unable to respond to Chinese devaluation with ambitious expansionary measures of their own, is China’s dollar peg a good idea? I do think China deserves something less than a pat on the back for saving the world economy, if they had to endanger the future of global trade to do it.

That seems like a pretty good argument, right?  I’m a pragmatist who is willing to look at second best arguments where appropriate.  But in the end I can’t quite buy this argument, even if everything I said about the benefits to the US of a weak yuan policy are wrong.  Here’s why.  Pretend I’m a slick lawyer representing China and this argument is raised.  Here’s how I respond:

1.  So you guys at the Fed and ECB agree that a weak yuan will help China’s economy.

2.  And you guys agree that China has suffered massive unemployment in export industries not from our own mistakes, but because of fallout from the sub-prime follies in America and some European countries.

3.  And you guys agree that if China did what was best for its own people and the West did the right thing as well, then all countries would benefit.

4.  And you guys are known for using your (supposedly) superior knowledge of complex financial/macro issues to lecture the rest of the world on policy.  So much so that terms like “Washington Consensus” were developed for the process.

5.   And now we are told that we can’t do the right thing for our own people, because if we do the rich country central banks will not do the right thing for its own people.

6.  And we are told that we must impose this suffering on our own people even though our per capita income is 1/6th western levels, and we lack a safety net for the 10s of millions of jobs lost in export industries.

Anyone wish to defend the other side?


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16 Responses to “How do we know it’s true?”

  1. Gravatar of Philo Philo
    6. December 2009 at 20:26

    The first few sentences of Scott’s post prompted the following comment. But this is absolutely my last: I hereby foreswear any further comments on philosophy!

    ——-

    From time to time Scott offers one or the other of two different theories of truth. One is: P is true if and only if *believing P is useful* (never mind for whom, exactly). The other is: P is true if and only if *society believes P* (never mind exactly which society is in question).

    Each of these theories is subject to an infinite regress. For, in the first case, *it is true *that believing P is useful** iff *believing *that believing P is useful* is useful*; and *it is true *that believing *that believing P is useful* is useful** iff *believing *that it is true *that believing *that believing P is useful* is useful* is useful**; etc. *ad infinitum*. In the second case, *it is true *that society believes P** iff *society believes *that society believes P**; and *it is true *that society believes *that society believes P*** iff *society believes *that society believes *that society believes P***; etc. *ad infinitum*.

    The potentially infinite complexity of the propositions that Scott would require people, or society, to believe in order that any proposition be true is objectionable.

    (There are, of course, other sound objections to these theories.)

    My (non-economist’s) verdict on TheMoneyIllusion: Economics brilliant and informative, philosophy not so good.

  2. Gravatar of MIke Sandifer MIke Sandifer
    6. December 2009 at 21:42

    To mention a point that was not a primary focus of this post, oil prices may have not had to be anywhere near $147/barrel. I offer a link to a video in which the economist Philip K. Verleger talks about the oil market and the factors that drove prices up. None of the factors mentioned had to do with peak oil or any such severe supply problem.

    http://www.youtube.com/watch?v=PfA4I3VclWg

    His presentation lasts about half-an-hour, after which he takes questions.

  3. Gravatar of MIke Sandifer MIke Sandifer
    6. December 2009 at 21:53

    Philo,

    Are you suggesting that there need necessarily be unresolvable infinite regression? My first thought is that because models and measurements of expectatons are not 100% reliable, there is a degradation of this phenomenon over time. I guess you could say there is a discounting factor.

    I think of it as holding one mirror up to another and looking at the mutual reflections as far as you want to see. They do not actually go on forever, except perhaps with respect to tiny quantum mechanical probabilities with no practical significance. The fact is that with each iteration, if you will, some photons are lost. This is due to imperfactions in the mirrors, air, the angles of entry, etc.

    So, there aren’t infinite regressions, but just your usual coplex, nonlinear dynamical phenomenon.

  4. Gravatar of Bob Murphy Bob Murphy
    6. December 2009 at 22:45

    Scott,

    A minor quibble with your statements about supply/demand not being true/false but rather useful/unhelpful:

    I think you’re right but for the wrong reason! (How’s that for pedantic disagreement?)

    I interpret you to be taking a Milton Friedmanesque position, that “yes the model isn’t really faithful to the real world, but it’s a useful approximation.”

    Is that what you’re saying? If so, then I think you are confusing things.

    “Supply and demand” is an analytical framework, a way of viewing the world. You couldn’t possibly test whether supply curves exist; you define them and boom! they all of a sudden exist.

    Now it’s true, it might not be a great way to think about prices, to go around applying supply and demand analysis. But we wouldn’t discard the “theory” of supply and demand one day because of some new experimental result. No, we would discard it because a better set of conceptual tools came along that allowed us to explain market prices in some superior way.

  5. Gravatar of StatsGuy StatsGuy
    7. December 2009 at 06:28

    “Anyone wish to defend the other side?”

    The “other side” is not arguing that it’s in _China’s_ interest to appreciate the Yuan; anyone who believes in Mercantilism clearly thinks China is taking an advantageous position. If I were in power in China, I would be doing the same thing they are.

    The “other side” would argue that the US should, likewise, respond by taking measures to aggressively drop the value of the Dollar relative to the Yuan. But since the US does not use capital controls (and any global devaluation of the dollar has other impacts), a second-best solution would be to use trade policy. This presumes, of course, that global devaluation of the dollar would be bad… (and I’m not arguing that)

    Your _stronger_ argument is that China – recognizing that the US was not easing – was absolutely correct in not revaluing the Yuan. (Had the US engaged in appropriate monetary easing, things would have been different.)

    With regard to Japan, I think it’s a case of mis-diagnosing WHY the US dollar was too high (rather than blaming Japan for the Yen being too low). Recall, demand for dollars as a reserve currency (international storage of wealth) allowed the US to export dollars while keeping the dollar highly valued (but, this created future obligations). The mistake was blaming Japan, and Japan’s acquiesence implied tightening policy in excess of a healthy monetary policy in order to keep the Yen’s value up even though it lacked the equivalent status as a reserve currency.

  6. Gravatar of OGT OGT
    7. December 2009 at 07:27

    The other side of the argument is that monetary policy doesn’t a peg to expand the money supply. Revaluing the yuan will increase the buying power of Chinese consumers and allow them to purchase things other than unprocessed commodities from the world. There’s no reason they couldn’t have done an external revalue and a domestic “inflation” at the same time.

    China hasn’t increased consumer demand, they’ve increased investment. There’s a big difference, in essence they’re doubling down their bet on the US consumer.

    Here’s Pivot Capital Management giving on China’s investment boom, it’s not likely to end well:

    Given China’s importance to the thesis that emerging markets will lead the world economy out of its slump, we believe the coming slowdown in China has the potential to be a similar watershed event for world markets as the reversal of the US subprime and housing boom. The ramifications will be far-reaching across most asset classes, and will present major opportunities to exploit. There are three key reasons why we take this view:

    China’s expansion cycle surpassing historical precedents: It is widely believed that China is still in an early development phase and therefore in a position to expand capital spending for years to come. However, both in its duration and intensity, China’s capital spending boom is now outstripping previous great transformation periods.

    Policy actions not sustainable into 2010. This year’s burst in economic activity has been inflated by a front-loaded stimulus package and a surge in credit growth. Given their exceptional and forced nature we believe growth rates in government-driven lending and capital spending will collapse in 2010.

    Overcapacity and falling marginal returns on investment: Analysis of industrial capacity, urbanisation and infrastructure development shows that China’s industrialisation and structural modernisation are largely complete. Combine this with falling returns on investment, and it becomes obvious that China’s long-term investment needs are grossly overestimated.

    Via Naked Capital

    http://www.pivotcapital.com/research.html

  7. Gravatar of Joe Calhoun Joe Calhoun
    7. December 2009 at 10:00

    Scott,

    A lot of the rise in spot crude this year was driven by the contango in the market. It was very profitable to buy oil in the spot market, sell it in the futures market and store it for the length of the contract. The contango developed due to the freeze up in the credit markets. As the government poured money on the big banks, they used part of their new capital to buy and store oil. I suppose you could say they were doing it in anticipation of future demand from China, but the fact is they were doing it because the government gave them extra capital and it was profitable to do so.

    On exchange rates and trade deficits: it amazes me that we still have people who believe we can cure a chronic trade deficit by devaluing the dollar. We tried this with the Japanese in the 80s with the Plaza Accord and all we got was deflation in Japan and a stock market crash here. We tried it again with the Chinese and got….deflation in China and a stock market crash here. Hmmmm….maybe we should stop doing that; it fricking hurts.

    And last, did you see the BOJ had an emergency meeting and agreed to add monetary stimulus? http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6703032/Japan-steps-up-quantitative-easing-to-fight-deflation.html
    The yen promptly dropped and the Nikkei jumped big. It seems that now that they’ve busted the budget, they want the BOJ to step up:

    “Mr Hatoyama said he was delighted that the central bank had joined the battle against deflation, denying allegations of political pressure. However, it is clear that the Democrats are relying on the bank to maintain stimulus, given that the country has reached fiscal exhaustion. ”

    But maybe the BOJ doesn’t get it:

    “That is the slippery slope feared most at the Bank of Japan. “I have no intention of monetising government debt,” said Mr Shirakawa. ”

    Japan needs the BOJ to do exactly that and they need a supply side shock as well. It looks like they’ll get neither. What are your thoughts on the extra monetary ease?

  8. Gravatar of pete pete
    7. December 2009 at 10:44

    Though China’s exports dropped, this is due to global trade slowing drastically. China has actually gained in their share of global exports as their exports drop less than that of their competitors. This makes me really question their use of exchange rate intervention, which essentially runs easy policy domestically while imposing tightening on the US (and arguably the rest of the world) while in fact the exchange rate adjustment should probably be going the other way around, as it would absent intervention. You argue, that’s fine, and the rest of the world should compensate by running easy policy in other ways. The results are not even…so policies that decrease rates in the US will boost interest rate sensitive sectors (housing, etc) while the distorted exchange rates hurt exchange rate sensitive sectors (manufacturing for export, etc). The opposite is true for China. What’s the big problem, as long as the net easing globally is the same?? I would argue that the extreme exchange rate policy of China is unsustainable over time, but sustainable for long enough to distort investment in a serious way, leaving us with underinvestment in industries that would be competitive at market exchange rate, overinvestment in housing and imports, and the opposite in China.

  9. Gravatar of Felix Felix
    7. December 2009 at 11:30

    What is the asymmetry that makes you think that yuan devaluing against dollar is good for AD and dollar devaluing against yuan is bad for AD?

    In your argument, one can really exchange the words “america” and “china” and “dollar” and “yuan” without any statement becoming more or less true.

    I think that devaluing relative to other currencies is completely different from devaluing against gold or cpi, because of the symmetry that is present in devaluing against other currencies but not in devaluing against gold or cpi.

  10. Gravatar of ssumner ssumner
    7. December 2009 at 12:18

    Philo, I apologize for my annoying forays into philosophy. The term ‘truth’ has many meanings. It may refer to things regarded as true. That is what I mean when I say that truth is what society believes. People called “realists” often insist there there is some sort of “objective truth” above and beyond what society thinks is true. A realist might say, “society believes X, but I think Y is really the case.” How do pragamtists explain that language? Perhaps realists mean “Society believes X, but I predict that in the future society will come to believe Y.” A pragmatist would say that that future society’s views are just as subjective as those of the current society, and also subject to further revision from a still more future society.

    Pragmatists may also equate truth with practical utility. A true statment is a useful statement. Not necessarily “useful” in an everyday sense, but perhaps merely useful in advancing a theoretial argument, or in making a model more elegant and coherent.

    Does this help? I’m guessing it doesn’t. This debate has consumed philosophy for 2500 years, and shows no sign of ending. I don’t think people are capable of resolving the meaning of the objective/subjective distinction. But I find the non-realist position more useful. I wouldn’t even know how to think about the issue of whether S&D is “really” true. But useful? Yes, this I can imagine.

    Mike, the more I find out about the oil market, the more convinced I am that real factors explain the high prices in 2008. There were several big changes that occurred after mid-2008 that reduced the price of oil. The most important was obviously the severe worldwide recession. If prices are still $75 is a severely depressed world economy, imagine where they would be if we were booming. In addition, China went from massively subsidizing the consumption of oil to taxing the consumption of oil in a very short period. That also made a difference. And the rapid progress in natural gas production in the past year has also played a role. Gas is a substitute for oil.

    Both the supply and demand for oil are very inelastic in the short run. So extreme price volatility is to be expected.

    Bob, You said;

    “‘Supply and demand’ is an analytical framework, a way of viewing the world. You couldn’t possibly test whether supply curves exist; you define them and boom! they all of a sudden exist.”

    Couldn’t possibly? That’s pretty strong. What if you got an NSF grant to buy a samll company in a competitive industry. And then introduced random shocks to the output of the small company. If the market price of the good was negative correlated with those randon quantity shocks, wouldn’t that prove the industry was not competitive, and henve there was no literal “supply curve.” I’m just thinking out loud.

    Statsguy, I’m not sure what you are arguing here. Free Exchange basically said China had a moral obligation to revalue. I presented a moral argument for China’s current policy—arguing that they were justified in their actions from a moral perspective. And I based that on 6 arguments. If all six arguments are “true” then doesn’t my conclusion follow? If not, why not?

    I’m also confused about your statment about the weak yen. The yen is too strong right now.

    Your second paragraph raises an interesting perspective that I hadn’t thought of. If the Fed had been aggressive enough to prevent a US recession, then China would have kept growing, and China probably would have kept appreciating the yuan. That’s definitely a win-win.

    OGT, You said;

    “The other side of the argument is that monetary policy doesn’t a peg to expand the money supply. Revaluing the yuan will increase the buying power of Chinese consumers and allow them to purchase things other than unprocessed commodities from the world. There’s no reason they couldn’t have done an external revalue and a domestic “inflation” at the same time.”

    They tried this in the late 1990s and it didn’t work. The other Asian currencies had fallen sharply, and that meant China’s yuan rose in trade-weighted terms. They tried to prevent deflation with domestic stimulus but failed. China has an amazingly competitive, amazingly price senstive economy. Unless you’ve been there it is hard to imagine how big a difference a few pennies makes on the demand for a product.

    You quoted this:

    “Overcapacity and falling marginal returns on investment: Analysis of industrial capacity, urbanisation and infrastructure development shows that China’s industrialisation and structural modernisation are largely complete.”

    Sorry, but that just seems bizarre. China’s per capita GDP is 1/6th Western levels. Their infrastructure is woefully inadequate for a modern economy. Most Chinese are poor peasants. How can this be true? As for the rest, I can’t say. They may be right that China will slow next year. I doubt it, but concede that the business cycle is unforecastable, so anything is possible.

    Joe, You said;

    “A lot of the rise in spot crude this year was driven by the contango in the market. It was very profitable to buy oil in the spot market, sell it in the futures market and store it for the length of the contract. The contango developed due to the freeze up in the credit markets. As the government poured money on the big banks, they used part of their new capital to buy and store oil. I suppose you could say they were doing it in anticipation of future demand from China, but the fact is they were doing it because the government gave them extra capital and it was profitable to do so.”

    I am not sure I agree. Both spot and futures prices have risen sharply since March. I had thought that speculation can sort of move prices around, but can’t raise prices in the present and at all future dates. Is there any theory that justifies this view? (I’m no expert on speculation, so I may be wrong.) But wouldn’t storage of oil reduce future expected prices?

    You said;

    “But maybe the BOJ doesn’t get it:

    “That is the slippery slope feared most at the Bank of Japan. “I have no intention of monetising government debt,” said Mr Shirakawa. “

    Japan needs the BOJ to do exactly that and they need a supply side shock as well. It looks like they’ll get neither. What are your thoughts on the extra monetary ease?”

    I do think they need more ease, but oddly don’t think it necessarily need mean monetizing the debt. Suppose they had an aggresive NGDP target that boosted NGDP by 3% per year. If is very possible that the real demand for base money (now enormous in Japan) would react to the mild inflation by falling more than NGDP rose. Thus the currency/NGDP ratio might fall from 20% to 15%. In that case the absolute amount of base money would actually fall for many years.

    Pete, You can’t just look at exports. My argument also depends on imports. Obviously if China’s surplus with the rest of the world fell sharply, then Chinese imports fell much less than Chinese exports. This subtracted from China’s GDP (4% points) and added an equivalent amount to the rest of the world’s GDP.

    I think the last part of your comment is simply wrong. China has little or nothing to do with structure of the US economy. We aren’t suddenly going to make the stuff we buy from China if they raise their exchange rate. We’d just buy it from another Asian country. Our current account deficit reflects our low saving rate, not the Chinese exchange rate.

    China’s trade with the US is far too small to have a significant impact on the US industrial structure, especially as much of china’s exports are low tech goods. Maybe we should be more like Germany–but fiddling with the yuan won’t get us there. Germany faces the same yuan and has a massive trade surplus (overall.) It is the overall figures that are key, not the bilateral.

  11. Gravatar of StatsGuy StatsGuy
    7. December 2009 at 12:41

    If the other side is “moral obligation”, I can’t defend it, but I do hope you don’t take Free Exchange as the sole representative of the other side.

    With regard the low Yen, I’m referring to that currency prior to when it was appreciated in response to US urging, many years ago.

    Felix has a good point with regard to devlauation vs. Gold compared to devaluation vs. a single floating currency. Curious as to your response.

    Naked Cap from OGT: “China’s industrialisation and structural modernisation are largely complete”

    Wow… bold statement.

  12. Gravatar of ssumner ssumner
    7. December 2009 at 14:26

    Felix, Good question. An exchange rate is determined by two countries, not one. Sometimes we lose sight of that, as China seems to be controlling the dollar/yuan rate. But in practice it is more complicated. China has certain domestic macro goals for inflation and GDP. When it looks like their economy is overheating they raise their exchange rate target. So the US can devalue the dollar against the yuan with a suitably expansionary monetary policy. Say the US adopted a monetary policy capable of boosting our NGDP rapidly, so that we recovered from the recession quickly and then NGDP increased at a steady rate thereafter. Or suppose we had had an expansionary enough policy to avoid recession altogether. In that case, if we had had 5% NGDP growth this year, instead of negative growth, then China would have been faced with two choices; economic overheating or yuan appreciation. I am almost certain they would have made the same choice that they made between 2005-08, they would have appreciated the yuan.

    For any given Chinese monetary policy, right now I favor a more expansionary US monetary policy. That would mean a weaker dollar. For any given US monetary policy I would advocate a more expansionary monetary policy in China (although they are rapidly approaching the end of their recession, so my answer might be different in six months.) That would mean a weaker yuan. Except that I think China is doing better than the US in AD terms, so a stable yuan is about right.

    Here’s is how I interpret the pressure on China. I think people are implicitly saying “Look, given the current US and ECB policies, we want you to appreciate the yuan. To do think you’ll have to adopt a more contractionary monetary policy.” So I oppose a strong yuan achieved in that way. If the argument was this:

    “Look China, just keep your domestic monetary policy on its current track, and the US will adopt a boldly expansionary monetary policy. As it does so please let the yuan apprecate to reflect the effects of the Fed’s move.” Then I’d say “yes, in all circumstances the Chinese should let the yuan appreciate in that case.”

    Statsguy, Let me know what you think of my reply to felix.

    And now I understand your yen discussion, and agree.

  13. Gravatar of StatsGuy StatsGuy
    7. December 2009 at 15:41

    I think that basically hits the points. But I have to wonder what the real policy motives are in this whole affair. Does the US leadership _really_ want the dollar to decline? Does China (given that it’s holding large dollar reserves, and its earning power from fixed capital investments is measured in dollars vis-a-vis its bilateral trade surplus)?

    In other words, there’s an opportunity for a win-win, which requires the US to ease to permit the Yuan to appreciate – but no one seems to want that. Why?

    China, for example, has very strongly endorsed a strong dollar – going so far as to strongly recommend fiscal cuts AND monetary contraction in the US. Is it not an odd spectacle that both countries are trying to get the other country to jack its currency higher? (What does this say about the real beliefs about international economics and national power?)

    The deeper this goes, the more I keep returning to the dollar’s reserve currency status as a monkey-wrench messing up the macro works. The US has a huge amount of outstanding obligations (dollars abroad) which are held for the purpose of settling transactions and storing wealth. The US’ current purchasing power (and inflation rate) is linked to that demand for the dollar, both to buy US goods/services, and for settling accounts/storing wealth.

    Attempts to stimulate the US economy through the cash-balance mechanism (which you’ve described) create the _expectation_ that the dollar’s value will fall… and there’s a possible tipping point where holders of dollars may decide to exit those positions en masse (or so some claim – I wonder whether it’s really that discontinuous, given that we’ve seen a fairly smooth decline in US dollars as reserve currency as the Euro makes up the difference).

    In other words, this could be a unique situation in that expectations of increasing the supply of dollars actually decreases the demand – and I do not mean the market clearing price of dollars, but the actual demand curve. As finance matures, that demand curve is increasingly the outcome of an expectation game equillibrium (whereas historically it has been the outcome of structural features of the international environment, like the oil market). That could make the demand curve very unstable, with possibly a bimodal distribution.

    The Fed minutes suggest it has been acting largely due to this fear, but at the same time it has drastically underestimated the impact of its contractionary policy on US gdp growth and tax receipts (which has actually caused more damage to the dollar due to expectations of future monetization). I think they admitted this mistake – Bernanke basically admitted it in the hearings before the senate committee – but they still are overly concerned about the dollar’s valuation.

  14. Gravatar of Scott Sumner Scott Sumner
    8. December 2009 at 18:17

    Statsguy, You said,

    “China, for example, has very strongly endorsed a strong dollar – going so far as to strongly recommend fiscal cuts AND monetary contraction in the US. Is it not an odd spectacle that both countries are trying to get the other country to jack its currency higher? (What does this say about the real beliefs about international economics and national power?)”

    Yes, That is very ironic. And sad. You said;

    “The deeper this goes, the more I keep returning to the dollar’s reserve currency status as a monkey-wrench messing up the macro works. The US has a huge amount of outstanding obligations (dollars abroad) which are held for the purpose of settling transactions and storing wealth. The US’ current purchasing power (and inflation rate) is linked to that demand for the dollar, both to buy US goods/services, and for settling accounts/storing wealth.”

    I’ve never been convinced the US dollar role as a reserve is that important. Suppose the PBOC decides to exchange $400 billion in T-bonds for Japanese and German government bonds. Then all that happens is the German and Japanese bond prices adjust so that the former holders of those bonds now hold T-bonds. But the net US capital position would be unaffected. You’d just be moving bonds around, and slightly changing their prices.

    You said;

    “The Fed minutes suggest it has been acting largely due to this fear, but at the same time it has drastically underestimated the impact of its contractionary policy on US gdp growth and tax receipts (which has actually caused more damage to the dollar due to expectations of future monetization). I think they admitted this mistake – Bernanke basically admitted it in the hearings before the senate committee – but they still are overly concerned about the dollar’s valuation.”

    Do you have a link? I’d be interested in seeing his admission.

  15. Gravatar of serelax serelax
    30. June 2010 at 03:15

    I agree this real answer is whether these models are useful. I thing I’m pretty sure they are, but if given a lie detector test. I could probably only say I am 97% sure, not 100%. There are studies that show price discrimination in seemingly competitive markets,And that show no impact from higher minimum wages in fairly competitive labor markets. There are studies that show the US doesn’t export what you’d expect us to export based on the theory of comparative advantage.

  16. Gravatar of ssumner ssumner
    30. June 2010 at 05:54

    serelax, I agree, I think that’s a reasonable way of looking at things.

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