Reply to Andy, Nick, et al, on Krugman
Because I teach several courses today, I don’t have time to respond to all the comments right now. But I skimmed those after my Krugman post and I really think almost everyone is looking at these issues in the wrong way. People are confusing historical claims with theoretical presumptions, and making distinctions between “natural” and “artificial” that are themselves . . . well, totally artificial and arbitrary.
Start with this statement by Paul Krugman:
You may see claims that China’s trade surplus has nothing to do with its currency policy; if so, that would be a first in world economic history.
That could mean several things:
1. Every time there is a trade surplus, there is an undervalued currency.
2. Every time there is an undervalued currency, there is a trade surplus.
3. The more undervalued the currency, ceteris paribus, the bigger the trade surplus
It seems to me that 99% of Krugman’s readers would assume he meant #1 or #2. But obviously both are wrong, even my critics seem to agree on that. (As I’m sure Krugman would.) After all, they define “undervalued” on the basis of government intervention in the foreign exchange market to depress exchange rates below their natural value. So to defend Krugman you have to assume he meant #3. And I imagine he did. But what a misleading way to make a point. He would then merely be saying that there is a theoretical presumption that undervalued currencies make surpluses bigger. But then why suggest there are no historical counterexamples? There is no real world evidence I could cite that would disprove that assertion. No matter how many countries I found with CA deficits, that were also depressing their currencies by buying foreign exchange, he could say that the action was still, ceteris paribus, making the CA deficit smaller. When you challenge people to find one real world example that would refute your argument, as Krugman does in that sentence, there is an assumption that he is asserting something more than a tautology. And I’m sure his readers read it that way. “Look, China has a big surplus, find me one of those that wasn’t caused by an undervalued currency.” If his defenders’ interpretation is correct, then his call to search the world for a counterexample is essentially meaningless.
An even bigger problem occurs when people try to differentiate between “good” surpluses due to “natural forces” and bad surpluses that are “artificial.” This is associated with confusion about the role played by China’s exchange rate peg. Here are some key points:
1. If China stopped pegging the yuan and let it float, but continued buying $100s of billions in foreign exchange every year, then China would continue to run large CA surpluses. The root cause is high Chinese saving (relative to investment) and the currency is merely the transmission mechanism. As an analogy, the root cause of less gasoline consumption in 1974 was OPEC producing less, and the transmission mechanism was the high price. OPEC didn’t even need to peg the price, just produce less.
2. If China stopped pegging the yuan, and stopped buying dollars, they would still run a huge CA surplus as long as the Chinese government found some other way to save a lot. Suppose they set up a Norwegian-style sovereign wealth fund, and bought $100s of billions worth of German, French and British equities each year. Nothing from the US. Chinese aggregate saving would still exceed aggregate investment, implying a big CA surplus. And the Chinese would not be interfering at all in the forex markets, as the term is usually defined.
3. Ah, but some of you laissez-faire types (who strangely support Krugman) will say that’s not pure enough, not virginal enough. The Chinese government is still involved in all that saving. It’s artificial. You’d say “saving should be done by the free markets, not governments.” You’d say only in that case is a CA surplus OK. Otherwise the exchange rate is still at an artificial level. Evil countries like China and Norway must be punished for all their governmental saving.
4. OK, the Chinese government stops intervening in the foreign exchange markets, and stops saving of any kind. But instead they set up a Singapore fiscal regime, and force all workers to set aside 31% of income into various private forced savings accounts. China would still save more than it invests, and still run a huge CA surplus. Indeed Singapore’s CA surplus is much bigger in relative terms than China’s. Is this OK? After all the Chinese government is not saving or intervening in the forex markets. It is private citizens doing the saving. I can just see people responding; “No, that high saving is still tainted, still artificial. To be truly virginal, truly free of sin, the country has to save without any government encouragement.”
5. I give up. Sorry for being so ridiculous, but I’m trying to make the point that we are thinking about the entire issue in the wrong way. Seriously, at what point on the preceding list does the distinction between natural and artificial become at all meaningful?
What I find so bizarre about these “natural” and “artificial” distinctions is that in trade theory they are almost universally viewed as bogus. If Korea exports cars to US at a low price, when is it evil? When they directly subsidize production? When the government builds schools that train automotive engineers? When they provide cheap land for car factories? Economists usually roll their eyes at those distinctions. All that matters is whether the US gains from being able to buy low-priced cars from Korea. Similarly, if foreign CA surpluses really did hurt us we should oppose them whatever their cause. To be fair, Krugman has criticized Germany’s free market surplus, arguing the German government needs to save less. So he clearly understands the point I am making. Where he and I disagree is that I don’t think foreign CA surpluses hurt us by reducing NGDP, because I believe NGDP is determined by monetary policy. So I’m not upset with either China or Germany, and I certainly don’t draw any moral distinctions between the two cases.
Nick Rowe asked:
Think back to your earlier analogy, that if all countries intervene in forex markets, and buy each others’ bonds, it is like every country doing QE. Which is good. But if the Bank of China can buy US bonds, but the Fed can’t buy Chinese bonds (because China won’t allow it), then it’s asymmetric.
I’m not quite sure what Nick is getting at here. If he is saying that if each the 20 biggest countries bought $100 billion in bonds from the next country to its west, or to its east, it would be like a global QE, then I agree. Of course the exact same effect would occur if they each country bought $100 billion of their own bonds. If China doesn’t want to sell us bonds, we can weaken the dollar against goods and services (which is all we care about) by buying German bonds, or even US bonds. It makes no difference. Of course that’s assuming the transactions affect the money supply. But there is no necessary effect of Chinese forex purchases on the Chinese money supply, as I presume they sterilize them to prevent inflation. Only if China’s peg forced it to buy more forex than they felt comfortable holding, would the Chinese purchases be monetized.
Another reason the exchange rate is very misleading is that people focus on the nominal rate, which the Chinese government pegs. But it is the real rate that matters. It is true that China can influence the real rate, but only by adjusting the amount of government saving. Which against shows it is the saving/investment relationship, not the exchange rate, that is the key to understanding CA surpluses.
Andy Harless said:
The argument would be that currencies are undervalued whenever governments collectively engage in reserve transactions that result in a (sufficiently large) net increase in the availability of that currency in foreign exchange markets. (Obviously if the US were to offset China’s dollar purchases by buying yuan, this would not be the case.)
That seems like a pretty good argument to me: if the value of the currency is what the private sector would determine it to be in the absence of official reserve transactions, then it is fairly valued (on the assumption that private markets are efficient enough to give it a fair valuation). If net official reserve transactions are reducing the actual market value of the currency relative to that “fair” market value, then it is undervalued.
First of all they aren’t buying dollars, they are buying bonds. Yes, they are bonds denominated in dollars, but it would make no difference whether they bought bonds denominated in euros, or Swedish kroner, or stocks denominated in euros. All that matters is the impact on Chinese national saving. Again, there are lots of countries that have governments buying forex, which also run CA deficits. Whether you run a surplus depends on the saving/investment balance. I am not denying that governments can influence that relationship, and I am not denying the Chinese government has influenced it (as has our government, by massively discouraging saving), what I am denying is that the “official reserve transactions” affect the CA surplus more than some other form of government saving.
In the previous post I said:
“The standard argument is that trade surpluses (actually CA surpluses) are caused by excesses of domestic saving over domestic investment.“
Andy Harless responded:
That doesn’t sound right to me. The level of the CA surplus is simultaneously determined with the levels of saving and investment, but the levels of one do not cause the levels of the other. If the quantity that a country wishes to invest and the quantity it wishes to save are both fixed (inelastic) at certain levels, then those quantities will determine the CA surplus, but they will do so largely by affecting the exchange rate. (For example, the excess saving will bid down domestic interest rates, thus making the domestic currency less attractive and causing it to depreciate, so that domestic goods become more attractive relative to foreign goods, thus inducing a CA surplus.) The exchange rate is still the proximate cause of the CA surplus. There is no “immaculate transfer.”
This is like the oil example. The OPEC cutback in production was the root cause of Americans’ driving less. If you want to call higher oil prices the “proximate cause,” that’s fine. I’d call it the transmission mechanism. Suppose OPEC had gradually increased prices in the 1970s and 1980s by making “National Parks” out of land they had previously intended to drill new wells in. That sounds very environmentally conscious, doesn’t it? But it would have had the same effect on prices as an “artificial” order to the oil companies to produce less. I’m saying those distinctions are meaningless. It doesn’t matter why oil production fell, only the fact that it did. Norway gets praised for its high national saving rate; “They are so wise to put their oil money into a sovereign wealth fund, unlike all those less civilized countries.” You know the things people say. But when China does the same thing, they are viewed as being “sinister.” Yes, the CA surpluses are probably not in China’s interest (unlike Norway), but that’s hardly a reason to punish the Chinese people.
So what am I missing here, as everyone seems to disagree with me?
Tags:
15. September 2010 at 12:51
Chinese saving is artificial in the sense that according to the preferences of Chinese people, government should lower taxes and save less.
15. September 2010 at 13:29
123, By that definition every single country in the world is a currency manipulator. US saving isn’t even close to what most Americans would want, or what we’d actually save if it wasn’t for all the US government distortions and taxes. So we are just as “artificial” as China.
Governments are deeply involved in the economies of every single country on Earth, even Hong Kong.
15. September 2010 at 13:30
What do the letters CA stand for?
15. September 2010 at 13:43
current account
15. September 2010 at 13:51
Scott, what about a win-win? China saves less, US saves more – both countries will get less “artificial”.
15. September 2010 at 14:27
“If China stopped pegging the yuan, and stopped buying dollars, they would still run a huge CA surplus as long as the Chinese government found some other way to save a lot. Suppose they set up a Norwegian-style sovereign wealth fund, and bought $100s of billions worth of German, French and British equities each year. Nothing from the US. Chinese aggregate saving would still exceed aggregate investment, implying a big CA surplus. And the Chinese would not be interfering at all in the forex markets, as the term is usually defined.”
Not necessarily. They could buy all the foreign equities they want, but this could be offset by an inflow on capital account. In fact, the default offset transaction if the Chinese exchanged Yuan for the currency required to buy the equities is a Yuan capital inflow into the Chinese banking system. It’s an automatic capital account inflow. This is a straightforward balance sheet transaction – there is no associated saving.
Currently, saving is forced by the fact that PBOC buys dollars from exporters and directly impact the ultimate profile of the current account in doing so.
It’s the direct intervention in current account flows that influences saving – because it withdraws dollars that might otherwise be used to import.
15. September 2010 at 15:07
Benjamin: CA = Current Account.
15. September 2010 at 15:11
The savings that the Chinese currently have is about as natural as it gets, for their current costs of doing business must be about what ours were in the fifties. When I read stories of what companies in China recently provided for their employees, I could only think of the amenities that Phillips Petroleum provided for the neighborhood I lived in, 50 years ago.
Our government seems to have a slight case of projection, when it comes to the case of China and so-called artificial savings. At least the savings of the Chinese government must make sense to their people, for they know exactly where that money comes from. Whereas the potential savings our government may have gained from the big banks is a total mystery to many of us…and yet the small banks are still failing?
15. September 2010 at 15:14
Lorenzo: Thanks
FYI:
Dallas Fed
Dear Mr. Hoard:
The National Federation of Independent Bsuinesses (NFIB) recently released a report, and survey of their membership. A snippet from that report:
“Inflation? Not a threat. Far more owners have cut prices than raised them for 21 months in a row. Deflation? It certainly feels that way to a quarter of the owners reporting price declines for the goods and services they produce and sell.”
So small businesses report cutting, not raising prices.
Add to the above the report of the Boskin Commission in the 1990s, that found that the CPI and other government measures of inflation tend to overestimate inflation by 0.5 percent.
We may, in fact, be in deflation now, and we are certainly in deflation as far as small businesses are concerned.
Back to the NFIB, the same study found that weak sales is the biggest concern.
Given all of this, why is Richard Fisher pettifogging about inflation, and that more quantitative easing or aggregate demand will lead to inflation? Does Mr Fisher have any experience running a small business?
Benjamin Cole
15. September 2010 at 15:14
JKH: A Current Account surplus does indeed mean a Capital Account deficit. This does not, however, imply that somehow there is no saving. Rather the opposite. That is what countries who are net savers do, they run Capital Account deficits since more capital flows out than flows in. You seem to be missing Scott’s point about transmission mechanisms and underlying drivers. (The underlying driver being that China is a net saving nation, which resultant capital outflows can be expressed through various transmission mechanisms: but they will all involve Current Account surpluses and Capital Account deficits unless and until China stops being a net saving nation regardless of why it is a net saving nation.)
15. September 2010 at 15:56
Scott,
How currency intervention work if it is sterilized? Isn’t the quantity of currency the same in the end? I suppose that if the central bank bought a currency and sold bonds to sterilize, that would reduce the amount of foreign currency in circulation, even though the amount of domestic currency would remain the same. Is that correct?
Did you see that Japan intervened and claimed that it isn’t going to sterilize? The Nikkei jumped 2.4% on the news. Monetary policy isn’t that complicated!
http://news.yahoo.com/s/nm/20100915/bs_nm/us_japan_economy_intervention
15. September 2010 at 17:15
Scott, We have gone back in forth in the past about China, so I don’t think that I have anything new to tell you about this topic. I agree with you that there is no reason for us to complain about what China does about their nominal exchange rate. That is their own business. If a country wants to peg its currency to ours there is no reason for anyone to be upset about that. But in China’s case at least for 5 or 6 years when their CA surpluses were humongous, they were using the exchange rate mechanism as a means of saving and sterilizing dollar inflows which did reduce their real exchange rate by holding down internal wages and prices, which, given rapid increases in productivity should have been rising relative to US wages and prices at a fixed exchange rate. The solution to that problem is not for the yuan to appreciate which would mean deflation. With rapid growth, China could probably tolerate significant deflation without adverse consequences, but rapid appreciation of the yuan could cause faster deflation than even China could tolerate which would be disastrous for the world economy. Instead China should allow internal inflation while maintaining a stable dollar yuan exchange rate and allow the CA to come into balance automatically as imports increase.
15. September 2010 at 17:30
123, Yes, I’d like to see us save more and them save less. I’d also like to see Cuba become capitalist, but I don’t favor tariffs on Cuban products to pressure them.
JKH, Sure, the exchange controls also play a role, but that’s a given. We certainly don’t have a right to complain about Chinese exchange controls, given what happened in East Asia in 1997. But as long as the Chinese government saves a lot, and private saving is virtually forced by the structure of their economy, they will have CA surpluses. That’s true even if there are no exchange controls. Indeed removing them might cause Chinese individuals to buy foreign stocks and bonds, further depreciating the yuan. There are a million ways this can be done by China, many of which would seem to involve no direct forex intervention.
Rebecca, Instead of criticizing them for saving too much, we ought to save more.
Benjamin, Good point.
Lorenzo, Yes, the reason for the CA surplus is totally unimportant.
TravisA, If the Chinese government pays for forex with yuan, that would make the Chinese money supply go up, causing inflation. If they didn’t want that to happen. they’d then swap some other asset for the yuan. I’m actually not sure how they do it in China. In America we could swap T-bills from dollars, if we wanted to sterilize forex purchases.
Yes, I saw that Japanese story and planned a post. How would Krugman explain the rise in the Nikkei? Don’t Japanese investors understand that there is nothing the BOJ can do at the zero bound?
🙂
15. September 2010 at 17:38
David, Yes, but would you agree that a fiscal regime like Singapore’s has EXACTLY the same effect on the CA surplus, but escaped criticism partly because people think it is “natural” and not an “artificial” interference in the free market? Yet forcing people to save 31% of their income is just as artificial a way to raise a country’s saving rate as is pegging the currency and piling up forex reserves.
And ditto for the Norwegian sovereign wealth fund, which people actually PRAISE!!!
15. September 2010 at 19:16
Scott
Off topic but brilliantly performed! Should ask your students to write a critical essay of BOTH!
http://oinsurgente.org/2010/01/26/fear-the-boom-and-bust-a-hayek-vs-keynes-rap-anthem/
HT Drukeynesian
15. September 2010 at 19:17
Sorry
HT Drunkeynesian
15. September 2010 at 19:27
Owen,
I agree that deposit insurance doesn’t seem as if it’d make much of a different to account holders, as many people can’t even understand their credit card agreements, much less whether their bank is solvent, but that’s just a hunch.
15. September 2010 at 21:32
Mundell explains correctly that if the RMB truly floated, it would seriously devalue as most private savers in China would immediately divest into other currencies.
Note: There’s something disgusting about economists not simply saying China’s workers (and Germany’s) out perform American workers because they accept they have to work for less to get the work.
They properly price their labor, we don’t. Deal with it. Our labor force has a rude awakening coming – we should help them get there, not try and paper over it.
Marcus, that’s John Papola who comments here routinely – he did it with Russ Roberts help.
16. September 2010 at 01:18
Scott,
My point was that if the dollar is the primary currency for Chinese current account transactions and if the PBOC is systemically withdrawing dollars from the current account balance via FX intervention, then it is inevitable that this will drive the current account surplus up, which forces saving by accounting identity. This is driven by PBOC behaviour.
You can’t have net saving through the international capital account unless it is matched by a current account surplus – by accounting identity. Buying international equities has nothing to do with net saving unless it is at the same time offset by a current account surplus.
You can’t magically generate saving simply by choosing a particular international financial asset channel, because it can be offset immediately by reverse direction capital account flows, which in the first instance is automatic. The existing current account surplus is not driven by PBOC’s choice of treasuries as its preferred asset, but by its intervention in the FX market. If China uses mostly dollars to buy its imports, then the net accumulation of dollars by PBOC is a major behavioural factor in national saving. Conversely, private sector behaviour can’t reverse that national saving effect unless they convert more Yuan to dollars in order to buy more imports. And that is unlikely at current exchange rates, and with the net accumulation of dollars by PBOC.
16. September 2010 at 05:26
Marcus, Yes, I linked to that a few months back. It’s very good.
MikeSandifer, You said to Owen;
“I agree that deposit insurance doesn’t seem as if it’d make much of a different to account holders, as many people can’t even understand their credit card agreements, much less whether their bank is solvent, but that’s just a hunch.”
You just proved my point. Back in the 1920s people paid a lot of attention to the soundness of banks. Now they don’t bother educating themselves—they are completely ignorant (including me–why should I bother figuring out which banks are safe places to put money.) That’s the effect of FDIC.
Morgan, It is possible that Mundell is right, no one really knows. I am pleased to learn that one of my commenters has so much musical talent.
JKH, I’m not quite sure I understand. I presume you agree that it would make no difference if China swapped its T-bonds for euro-bonds. They’d still run a surplus. That means if they had never bought the T-bonds in the first place, but bought euro bonds, the same effect would occur. Indeed if they did all their trade in euro currency, but still pegged the dollar rate it would make no difference. I can’t emphasize enough that the CA surplus is about the excess of saving over investment. That’s not a theory, it’s an identity. It makes absolutely no difference how that excess occurs, what regulations are used, what incentives to save, what fiscal policies, what currency controls, etc. Any method the Chinese government uses to save hundreds of billions of dollars will lead to a CA surplus, as long as the rest of the communist system still operates as it currently does and the private sector is not able to easily dis-save as an offset.
Mundell points out that even ending currency controls might not cause the yuan to rise. Chinese private citizens might buy foreign assets.
16. September 2010 at 06:32
I agree with much of what you wrote here. On Singapore for example, yes their CA surplus may be bigger relative to population due to the forced savings issues. But, size is a tremendous variable here. Path ways to development that are open to countries with 5 million people are not open to countries with 1.3 billion it is too destabilizing to the international financial system. That’s just tough.
Actually, China’s system has served them relatively well, though the
articiallygovernment influenced extra low cost of capital seems to be starting to lead to more malinvestment. But, given the size of the economy it is time to graduate.16. September 2010 at 06:34
Scott, Again the 97 percent rule applies (but maybe only approximately). Fiscal measures that result in forced savings can reduce the real exchange rate and have protectionist results. But isn’t those an implicit monetary policy that is required to sustain the fiscal policy? I don’t have an immediate answer to that one. At any rate, I agree that the outrage over China’s “currency manipulation” is overblown, there has also been a fair amount of criticism of Germany for not increasing domestic demand and trying to export its way into a recovery. I don’t really think that anything Singapore matters to Americans or even Europeans.
16. September 2010 at 06:36
The third sentence in my previous post should have begun “But isn’t there an implicit monetary policy . . .”
16. September 2010 at 09:04
From Scott’s reply to JKH:
“if they had never bought the T-bonds in the first place, but bought euro bonds, the same effect would occur. Indeed if they did all their trade in euro currency, but still pegged the dollar rate it would make no difference.”
It would make a big difference, because it would strengthen the euro relative to the dollar, thus giving Europe a trade deficit with the US. To accumulate euro bonds, China would have to buy euros, and to continue pegging to the dollar without accumulating dollar bonds, it would have to accumulate a truly huge amount of euro bonds.
“I can’t emphasize enough that the CA surplus is about the excess of saving over investment. That’s not a theory, it’s an identity.”
It’s an identity, not a causal relationship. One could just as well say that the excess of saving over investment is about the CA surplus. The direction of causation is ambiguous, and it would be more accurate to say that there are certain policies which cause both a CA surplus and an excess of saving over investment, rather than suggesting that the policies cause an excess of saving over investment which then causes a CA surplus. Thus, when you say,
“Any method the Chinese government uses to save hundreds of billions of dollars will lead to a CA surplus,”
it would be just as valid to say, “Any method that the Chinese government uses to produce a large CA surplus will lead to its saving hundreds of billions of dollars.” Why focus on the saving-investment relationship rather than on the current account balance?
You do have a point that there are other policies that would result in a CA surplus without being viewed as artificial, but I would argue that the real issue is what kind of foreign assets China buys with its excess savings. If it buys bonds, then — whether or not it has an explicit peg — it is effectively manipulating the foreign exchange market by exchanging assets denominated in renmenbi for assets denominated in other currencies. If it buys stock, then it is acquiring real assets — assets whose value is not tied to the value of a currency — and it is not manipulating the foreign exchange market. The practical difference is that buying stock provides a significant stimulus to foreign economies, while buying bonds (when the interest rates are already near zero) provides very little.
China’s capital account deficit has to be mirrored by a capital account surplus in the rest of the world — so the rest of the world must either save less or invest more. If China buys foreign bonds, the result is that the rest of the world saves less (by reducing income, so there is less to save). If China were to buy stock, the result would be that the rest of the world invests more.
I’m not sure how Singapore invests its excess savings, but there is a big difference between buying bonds to support an exchange rate peg and forcing people to buy generic foreign assets.
16. September 2010 at 12:10
Hi Scott.
Four points.
1) You may find this interesting:
http://opinion.financialpost.com/2010/06/28/chinas-currency-a-true-yuan-fix/
2) If China reduces its purchase of dollar-denominated assets, it will have to increase its purchase of assets denominated in other currencies. If it started, for example, to purchase yen-denominated assets, the yen would rise relative to other currencies including the US dollar and thus Japan might be inclined to intervene to buy US dollars or dollar-denominated assets. China would in effect still be buying US dollare-denominated assets through Japan.
I am presuming therefore that the furor is not really about the make-up of China’s portfolio of foreign assets but, as you say (in effect), the magnitude of that portfolio. On the forced savings issue, it is my understanding that private saving is or would be high in any case due to a) the lack of a social safety net, and b) the legacy of living in a totalitarian state for decades (major regime uncertainty). The question then becomes to what extent there are state-derived distortions that would limit the ability of the Chinese private sector to absorb the excess savings. Thus, what appear to be complaints about the yuan may in fact really be complaints that China is not a capitalist country with relatively free markets and sound market-supporting institutions or that the process of liberalization is not proceeding rapidly enough. Is that really going to be the test going-forward as to whether a foreign country is playing fair?
3) Further to 2), do Western governments with massive government deficits projected from now to infinity really want China to purchase fewer yen/dollar/euro denominated bonds?
4) If China allows the yuan to appreciate, this will presuambly involve monetary tightening. Inflation will fall relative to that in the US and yuan-denominated prices of Chinese exports will fall relative to what they would have been. Won’t that latter effect offset, to greater or lesser degree, any impact of the exchange rate change on US producers’ competitiveness?
16. September 2010 at 12:44
Andy Harless said:
“the real issue is what kind of foreign assets China buys with its excess savings. If it buys bonds, then “” whether or not it has an explicit peg “” it is effectively manipulating the foreign exchange market by exchanging assets denominated in renmenbi for assets denominated in other currencies. If it buys stock, then it is acquiring real assets “” assets whose value is not tied to the value of a currency “” and it is not manipulating the foreign exchange market.”
Hi Andy. I would have thought that the exchange rate impact of foreign asset purchases derives from the fact that, in effect, one has to purchase the currency in which the asset is denominated before one can buy the asset. Consequently, the exchange rate impact of buying stocks traded in US dollars and US-dollar denominated bonds is the same. Both stocks and bonds are essentially claims on cash flows of different profiles and I think one could argue that, for practical purposes, the claim on underlying assets may be as clear in the case of bonds (via the ordering of claims under bankruptcy or the securing to a particular asset class) as with stocks. But, in any case, the difference between stocks and bonds with respect to the nature of the claim one is purchasing seems to me to be irrelevant for purposes of determining the exchange rate effect.
16. September 2010 at 13:41
Scott,
“I can’t emphasize enough that the CA surplus is about the excess of saving over investment. That’s not a theory, it’s an identity.”
I tend to agree with identities happily, as a regular check on my own sanity. I don’t think I’ve said anything that contradicts that particular one.
“I presume you agree that it would make no difference if China swapped its T-bonds for euro-bonds. They’d still run a surplus. That means if they had never bought the T-bonds in the first place, but bought euro bonds, the same effect would occur. Indeed if they did all their trade in euro currency, but still pegged the dollar rate it would make no difference.”
If you are comparing alternative asset strategies for PBOC, I agree. There would be secondary FX effects in attempting to peg a dollar/Yuan rate while selling the dollars bought from exporters for other currencies in which to invest, but that’s secondary to the primary point that it is a feasible alternative in terms of the flow of funds.
“Any method the Chinese government uses to save hundreds of billions of dollars will lead to a CA surplus, as long as the rest of the communist system still operates as it currently does and the private sector is not able to easily dis-save as an offset.”
This is where I begin to disagree with your analysis.
Take the existing situation where PBOC is a net buyer of dollars. It is not the Chinese government or PBOC that is saving. PBOC is buyer dollars for Yuan and conducting a financial intermediation role, which is not a saving role. The banks and others in turn are conducting financial intermediation by holding reserves and other PBOC liabilities in exchange for deposit liabilities and other types of private sector liabilities. The ultimate destination of these various intermediation channels is a range of private sector assets. To the degree that PBOC holdings of dollar assets correlate with a cumulative current account surplus (the correlation is high but not perfect), the ultimate destination of this financial intermediation process is private sector saving equivalent to that surplus.
The dollar buying action of the PBOC has a tremendous effect on the current account surplus and the saving associated with it. If PBOC sets an intervention price such that the trend is to accumulate net dollars, it means that dollars are being vacuumed from the current account such that the private sector (exporters initially) is willing to exchange them for Yuan. This exchange significantly reduces the availability of dollars for offsetting import transactions. Sure the private sector can come in after and bid PBOC for dollars, but they’re far less likely to do that in any size, given the heft of the central bank in putting in such a strong bid for them from exporters in the first place. Dollars become relatively expensive because of PBOC intervention. Roughly speaking, at the margin, people just don’t want to come into PBOC to bid for dollars in order to buy imports.
Accordingly, to the degree that the private sector ends up with Yuan sourced from PBOC, and is content to stay with Yuan, there is no way that this Yuan supply can contribute to a reversal of current account surplus and related saving. That is also the identity at work.
To the degree to which PBOC EFFECTIVELY constrains the ultimate supply of dollars to the private sector, and to the degree to which PBOC ACTUALLY hoards dollars in exchange for Yuan, the PBOC has a tremendous effect on the current account outcome.
There is nothing whatsoever in my description that contradicts the basic identity that the current account surplus is the excess of saving over investment.
16. September 2010 at 14:45
JKH:
(1) Dollars for yuan is not the only possible currency exchange.
(2) There has to be the surplus of yuan to be used for purchasing in the first place. Sure, China can just print them, but that will show up in declining exchange rates or (if the yuan is pegged) increasing difficulty in finding buyers at the official rate (and a burgeoning gap between official and black market exchange rates).
(3) So, if I am to make sense of what you are saying, you seem to be claiming that foreign exchange patterns are driving saving. That seems moderately unlikely. For either governments or private agents.
16. September 2010 at 15:54
Scott,
Andy Harless said:
“It would be just as valid to say, “Any method that the Chinese government uses to produce a large CA surplus will lead to its saving hundreds of billions of dollars.” Why focus on the saving-investment relationship rather than on the current account balance?”
I agree. That particular interpretation is very compatible with what I’ve outlined.
16. September 2010 at 15:57
Sorry – except that it’s not the government that’s saving, as I outlined also.
16. September 2010 at 17:20
OGT, I see no reason why China can’t follow the Singapore plan, they certainly don’t need to save any more, but it would be better to have the saving in private accounts rather than the government’s hands.
You said;
“Actually, China’s system has served them relatively well, though the government influenced extra low cost of capital seems to be starting to lead to more malinvestment. But, given the size of the economy it is time to graduate.”
Served them well? Compared to what? China is much poorer than Mexico, its not even close. They’ve gone from a mind-bogglingly inefficient system to a very inefficient system so they’ve gotten less poor. But they missed a big opportunity in the 1990s to follow the Zhejiang Province model. If they had, they’d be much richer now. Tiannanmen Square was a big setback for neoliberal reforms.
Yes, they need to graduate to some serious market reforms, or they will hit a wall before too long.
David; You said;
“Scott, Again the 97 percent rule applies (but maybe only approximately). Fiscal measures that result in forced savings can reduce the real exchange rate and have protectionist results.”
This must be the 3% where we disagree. The Singapore policy is not at all protectionist; indeed neither is the Chinese policy of a weak yuan. Protectionism occurs when tariffs drive a wedge between import and export prices. Currency manipulation doesn’t do that, so I don’t see how it can be called protectionist. In addition, protectionism reduces both imports and exports, whereas China’s policy actually increases exports.
You said;
“At any rate, I agree that the outrage over China’s “currency manipulation” is overblown, there has also been a fair amount of criticism of Germany for not increasing domestic demand and trying to export its way into a recovery. I don’t really think that anything Singapore matters to Americans or even Europeans.”
As far as I can see, most of the criticism of Germany came from one NYT blogger. And then when people pointed out that Germany was recovering faster than us, he frantically backpedaled and said Germany had actually done much MORE stimulus than us, they are actually the good guys here.
I agree that Singapore and Norway are small, but still, isn’t it odd that Norway is actually praised for doing the same thing as China? I could see how it could be ignored, but why is it praised for saving so much?
I see monetary and fiscal policy as being independent. I don’t think fiscal policy requires any particular monetary policy unless you are so broke you must print money to pay the bills.
Andy, You said;
“It would make a big difference, because it would strengthen the euro relative to the dollar, thus giving Europe a trade deficit with the US. To accumulate euro bonds, China would have to buy euros, and to continue pegging to the dollar without accumulating dollar bonds, it would have to accumulate a truly huge amount of euro bonds.”
A few points.
1. I was talking about China’s CA surplus, and its impact on the world economy, which is also what Krugman was concerned about.
2. I still think the effect would be almost identical either way. An increase in the demand for euros would be offset by the ECB increasing the supply, leaving the exchange rate unchanged. As an analogy, when there is a huge increase in the demand for dollars (as in the Soviet bloc after communism collapsed), then the Fed accommodates that increase by printing money, so that American macro variables are not affected. Huge amounts of dollars are held by people overseas, but shifts in that demand usually don’t affect the US inflation rate, as they are usually accommodated.
You said;
“You do have a point that there are other policies that would result in a CA surplus without being viewed as artificial, but I would argue that the real issue is what kind of foreign assets China buys with its excess savings. If it buys bonds, then “” whether or not it has an explicit peg “” it is effectively manipulating the foreign exchange market by exchanging assets denominated in renmenbi for assets denominated in other currencies. If it buys stock, then it is acquiring real assets “” assets whose value is not tied to the value of a currency “” and it is not manipulating the foreign exchange market. The practical difference is that buying stock provides a significant stimulus to foreign economies, while buying bonds (when the interest rates are already near zero) provides very little.”
I have to disagree here. In all the standard open economy macro models that I have seen, what matters is “asset demand.” I admit I am not an export on open economy macro, but I simply can’t imagine any important macro difference between the PBOC buying BMW stock or BMW bonds. Does anyone else know anything about these models?
I agree that an identity can be evaluated from either direction, but I find it far more useful to think in terms of the capital account from a S/I imbalance perspective. And I am hardly the only one. Unless I am mistaken, I thought this had become almost the standard way of thinking about the US current account deficits. We save too little relative to what we invest. This provides insights into possible policy solutions. If you think in terms of goods exports and imports, you’d be likely to suggest using monetary policy to devalue. But we know that monetary policy doesn’t change the long run real exchange rate, hence countries that tried to devalue their way out of chronic deficits are almost always disappointed.
David Stinson, Those are all very good points. A few brief comments:
I mostly agree with Hanke, but would probably allow a modest, gradual, increase in the yuan to prevent high inflation.
On your last point, the question of whether a nominal appreciation leads to a long run real appreciation depends in part on whether they keep buying lots of assets. If they do, then money will have to tighten and you are right that disinflation will offset the appreciation. If they stop buying foreign assets, even the real yuan exchange rate will rise in the long run.
I agree with your response to Andy.
JKH, I didn’t mean that your argument was inconsistent with any identity, I was just making the point that the CA surplus was caused by Chinese government policies that increased the Chinese saving rate–and that’s assuming people like Krugman are correct. If the Chinese government is not causing this imbalance then he doesn’t have any argument at all. Whether the saving is the BPOC or the consolidated government sector isn’t really important, the key point is that the Chinese government has policies that lead to saving exceeding investment. That’s my only argument here.
BTW, I’ve seen estimates that about half of Chinese saving is public and half private, but I don’t recall the exact numbers.
17. September 2010 at 02:22
Should there even still be closed economy macro?
17. September 2010 at 07:53
Thanks for the reply Scott. I have been trying to get my head to work, so I can give you a proper response to your reply. But it won’t. Sorry. Maybe I should take the weekend off 🙂
17. September 2010 at 15:51
Scott,
Suppose the US Treasury were to begin issuing additional securities — on a scale, and with a maturity structure, comparable to those the Chinese are currently purchasing. And suppose that the proceeds from these new issues were used to purchase stock. Is it your position that this program would have no significant impact on aggregate demand in the US?
18. September 2010 at 03:48
Scott,
In relation to the current account surplus, it’s not the Chinese government or some part of it that’s doing the saving. The government is only intermediating non government saving via its consolidated balance sheet. In the case of FX intervention, government policy does have a direct effect on non government saving via the current account balance, because it affects a price (FX) that is critical to the current account balance.
With respect to Andy Harless’s last question, any policy that transforms/reduces non government portfolio risk through balance sheet management (e.g. issuing government debt to buy equities) is, in a rough manner of speaking, a variation on quantitative easing and should have some marginal effect on aggregate demand.
Conventional QE (buying treasuries and increasing reserves) should not be called QE.
It should be called DE (duration easing).
18. September 2010 at 06:04
OGT, Yes, to study world business cycles.
Andy, It depends on central bank policy. What is the “ceteris paribus” central bank policy for your thought experiment? If the answer is “inflation targeting,” which is what they actually seem to be doing now, then I’d say no effect on AD.
My argument is not that the Chinese CA surpluses could not impact American AD, there are Fed reaction functions where that would occur, and Krugman has indeed assumed one of those reaction functions. My argument is that this is our choice, it is the Fed, not China, that determines NGDP growth. Right now the Fed has decided we don’t need more NGDP, although they have also indicated they will produce more in the future if needed.
My earlier comments about stocks and bonds having a similar effect wasn’t in reference to AD, but rather the size of the CA surplus in China. If China saves much more than they invest they will have a large CA surplus regardless of whether the saving occurs as the government buys lots of foreign bonds, or as the government buys lots of foreign stocks (as in Singapore and Norway.)
JKH, You said;
“In relation to the current account surplus, it’s not the Chinese government or some part of it that’s doing the saving. The government is only intermediating non government saving via its consolidated balance sheet. In the case of FX intervention, government policy does have a direct effect on non government saving via the current account balance, because it affects a price (FX) that is critical to the current account balance.”
All the articles that I have read about China say exactly the opposite, that much of the saving is done by the government (including SOEs.) But even if you were right it wouldn’t change my argument, as if the government causes more private saving (as in Singapore) you get exactly the same effect on the CA.
I don’t think duration transformation is at all close to QE, at least if reserves pay no interest. If reserves pay interest then things change a bit.
18. September 2010 at 10:26
I disagreed with you up till Singapore.
You have again enlightened me, thanks!
18. September 2010 at 10:42
I’m not necessarily saying that stocks vs. bonds would affect China’s CA surplus. (I think it would, but that’s a separate point.) I was trying to explain how one can reasonably regard China’s surplus as unacceptable while regarding Singapore’s as acceptable. If China did the same amount of saving but acted like a private investor, it would have a greater proportion of real assets in its portfolio, and the real asset purchases would encourage investment (outside China), which would result in greater aggregate demand.
This argument is indeed premised on an assumption about foreign central bank reaction functions, one which I believe to reflect their actual behavior (though you apparently disagree). I grant that the Fed could change its reaction function in such a way as to render China’s choice of assets irrelevant to the expected level of aggregate demand in the US. But such a policy would carry certain risks, which could then be blamed on China.
19. September 2010 at 08:06
JL, You are welcome.
Andy, OK, I see your point. But of course that is not the criticism people are making of China–the criticism is that their CA surplus is too big, and that their exchange rate is too low. But if qualitative easing truly works, then yes, your point is correct.