Will China once again save us from the Fed?

They’ve done it once already.   In late 2008 an excessively tight monetary policy in the US caused:

1.  Soaring real interest rates

2.  Soaring dollar/euro exchange rates

3.  Housing prices to fall in non-subprime areas

4.  Commercial real estate prices to fall sharply

5.  Plunging commodity prices

6.  TIPS spreads to briefly fall into negative territory

Of course all of these flashing red signs of ultra-tight money were completely ignored by 90% of our elite macroeconomists, who seemed to think the Fed was “doing all it could.”  Fortunately for the US, the Chinese took decisive monetary action, stopping their program of yuan appreciation.  As a result of a stable yuan and extremely fast productivity growth, the yuan effectively depreciated against the dollar in 2009.  China began an extremely fast recovery around March 2009, pulling the rest of East Asia, Australia, and parts of Latin America up with it.  China’s hunger for natural resources quickly stopped and reversed the sickening slide in commodity prices, which in the dark days of early 2009 had led to fears of a worldwide deflationary depression.  Then Chinese capital goods imports boosted economies like Germany.

Investors in the US quickly realized that if the world economy was beginning to recover, it was unlikely that the US would suffer a deep depression.  Hence stocks rallied strongly almost every time bullish data came out of China in the spring of 2009, even before the real economy in the US turned around in mid-year.  Of course the level of stock prices have remained far below 2007 peaks, as the Great Recession we have entered is bad enough, even if we avoided outright depression.

The Fed botched the spring 2010 eurozone crisis in the same way they botched the 2008 financial crisis—passively allowing increased demand for dollars to depress assets prices and economic growth.

Will China save us again?  September started off with a bang, as the Dow jumped several hundred points on the opening on news of strong growth in China.

Stocks rallied right out of the gate as investors welcomed a rebound in Chinese manufacturing and robust economic growth in Australia. The advance kicked into high gear following an unexpectedly strong report on U.S. manufacturing activity.

The manufacturing data boosted industrial names and companies in the materials sector. Caterpillar (CAT, Fortune 500), United Technologies (UTX, Fortune 500), Boeing (BA, Fortune 500) all gained between 2% and 4%. Energy producers Exxon (XOM, Fortune 500) and Chevron (CVX, Fortune 500) also rose as oil prices spiked 3%.

But the rally was broad-based. Six stocks gained for every one that fell on the New York Stock Exchange. All 30 Dow components closed higher, with Bank of America (BAC, Fortune 500) gaining over 6%.  (Italics added–showing it wasn’t just China plays.)

There had previously been fears that China was slowing on government attempts to slow real estate speculation.   Today I woke up to the following news:

NEW YORK (AP) — Stock futures rose sharply Monday as investors gained confidence in the banking sector following the passage of new global regulations and China’s economy continued its robust growth.

.   .   .

Fresh signs of strong economic expansion in China also added to market strength Monday. New economic reports showed growth in the world’s second-largest economy continues to accelerate at a time when economists were expecting it to slow. Strong growth in China is considered vital to a global recovery because if demand remains high there, it will offset sluggish growth in the U.S. where economic expansion is not as strong.

Thank God that China did not take Paul Krugman’s advice in 2009, and sharply revalue the yuan.  A weaker Chinese economy would be a disaster for the world economy, just as a weak US economy in 1932 and late 2008 (caused by a strong dollar) was a disaster for the world economy.  The income effect is far more powerful than the substitution effect.  Krugman has correctly diagnosed the key problem—monetary policymakers who are spinning their wheels because rates are zero, and who are too conservative to take unconventional steps.  But what he doesn’t seem to realize is that faster world growth speeds up the day when world real interest rates will be high enough to pull us out of the zero rate trap.   As Woodford and others have observed, current AD is powerfully affected by changes in future expected AD.

World AD and world growth are not a zero sum game.  Even at the zero bound. Chinese growth is good for China, and good for the global economy.

PS.  Some attribute strong Chinese growth to the stimulus package—and indeed that may have played a role (fiscal stimulus is easier to do in a 50% command economy.)  But a weak yuan was a sine qua non for a robust Chinese recovery.  China is more fragile than it appears to outsiders.  For instance, a strong yuan put deflationary pressure on the Chinese economy in the late 1990s.


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33 Responses to “Will China once again save us from the Fed?”

  1. Gravatar of Indy Indy
    13. September 2010 at 07:07

    After reading a lot of Michael Pettis (who’s now moved his blog to Roubini’s place) I wonder if there’s a good parallel between China’s current situation and the WWII US recovery.

    In WWII – we were essentially in something like a “50% Command Economy” – maybe more. Ordinary civilian consumption was rationed and could not legally expand even though prices were kept low and suppressed by strict controls while aggregate personal income and AD was skyrocketing due to the huge expansion in government hiring and expenditures. That aggregate income was mostly being derived from increased employment, because individual wages were also controlled. This situation is the archaic origin of the popularity of employer-provided health insurance in the US, since employers could not compete by offering higher pay and had to offer benefits instead (locked in when the tax code treated these benefits favorably to equivalent compensation).

    So people literally ended up with a lot of extra money they could not legally spend. Due to particular “social conditions” at the time, (war-time patriotism, a high-savings rate, trauma from the Depression, etc.) the government could rely on people to take all their extra savings and dump them into very low nominal-yield (2.9%) bonds – recycling the income into increased production.

    The government, therefore, was able to get labor at a discounted rate, an effective devaluation, because they didn’t have to exchange higher present purchasing power for greater effort, but only a promise of future purchasing power. When the war ended and the price-and-wage controls were relaxes, two extended periods of high-inflation effectively (and surprisingly, to the bond-savers) reneged on the promise of enhanced future purchasing power. Real 10-year returns on war bonds were -33%.

    The entire society had effectively been tricked (by money illusion?) into essentially gifting a large portion of all their extra effort and labor to the government. Perhaps there’s a “noble-lie” aspect to all of this, it was WWII, after all.

    Now let’s think about China, according to what I think Pettis’ assessment is. Command Economy? Check. Particular Societal Tendencies that lead people to, more or less automatically, suppress their own consumption in favor of high savings rates into very-low-nominal-yield bonds, in a currency which, due to the peg, in being steadily and continuously devalued in real purchasing power, the net effect being a subsidy from consumer to producer-exporters, a “coerced gift to the nation” for the benefit of future economic growth, total employment, and political stability.

    A government with that kind of power over their economy, and that kind of population, has tremendous room for maneuver.

    Question: Did 2008 America (free, open, and lightly-regulated economy, personal savings rate 2%), or does 2010-2011 America now, provide us with similar room for maneuver?

  2. Gravatar of Steve Steve
    13. September 2010 at 07:13

    Unrelated comment: do you know this paper?

    http://papers.nber.org/papers/w16350

    Sounds close to your ideas.

  3. Gravatar of Benjamin Cole Benjamin Cole
    13. September 2010 at 09:18

    Given global gluts of capital, I wonder if demand alone can raise interest rates.
    I wonder if we are entering a new era, in which heaps of capital mean that QE has to become a norm, no longer considered unconventional.
    After all, if a saver wants safety, such as a T-Bill, they may have to accept a negative real return.
    This may become normal as high-savings rate nations grow, and as pools of capital in the USA accumulate due to pensions, insurance companies (not counted as savings) and low tax rates on high net-worth people.
    Capital is everywhere, and if the world economy grows, this will only get exaggerated, especially in the USA, a default home for global capital.
    Frankly, I see the USA slipping into recession/deflation without some monetary stimulus. Remember, the Boskin Commission found that the CPI overestimates inflation perhaps by 0.5 percent. We may be in deflation now.

  4. Gravatar of lark lark
    13. September 2010 at 09:23

    The fly in your ointment is unemployment.

    ChiAmerica: China gets 10% growth and we get 10% unemployment.

    “…New reports show that during the recession American companies ramped up investment overseas for plants and new hires, as well as research and development “” even as they cut back domestically.

    Foreign subsidiaries of U.S. corporations increased their spending on research and development by more than 7% in 2008 from the previous year, pushing the total to nearly $37 billion. But these same multinational companies sliced R&D expenditures in the U.S. that year 2.2% to $199 billion, Commerce Department data showed.

    A similar but less dramatic difference was evident in hiring: Employment at these overseas units rose 1% in 2008 “” and a stunning 15% in China “” but was down 2% for the U.S. elements of the 2,200 multinational firms the Commerce Department studied.”

    http://www.latimes.com/business/la-fi-economy-rd-20100913,0,3957503,full.story

  5. Gravatar of Pat Pat
    13. September 2010 at 09:47

    Haven’t you been saying that tight money results in low interest rates? I’m confused by your point #1

  6. Gravatar of Wonks Anonymous Wonks Anonymous
    13. September 2010 at 11:12

    Pat, I think those are low nominal (rather than real) interest rates.

  7. Gravatar of Benjamin Cole Benjamin Cole
    13. September 2010 at 11:38

    BTW: See page A4 today’s paper WSJ. Evidently, more economists than not think the Fed will engage in QE in coming months. Maybe Sumner is getting through….more oddly, more economists than not say the Fed should abstain from QE….
    The Japan Wing is strong, but Sumner is making gains….

  8. Gravatar of Jim Glass Jim Glass
    13. September 2010 at 13:17

    Planning ahead for the worst, or at least the not best…

    Money is neutral in the long run.

    Assuming the Fed follows the lead of its “Japan Wing” and effectively pursues a policy of opportunistic disinflation, dropping inflation to its 1% target (maybe overshooting to 0.5% ?), how long will it be before “the long run” arrives and the economy returns to its normal course?

    Gotta figure out how to ladder my bond portfolio. 🙂

  9. Gravatar of Benjamin Cole Benjamin Cole
    13. September 2010 at 13:55

    Jim Glass:

    Yes, the “Japan Wing”! I love it. Start spreading it around.

    The “dithering Japan Wing” is even better.

  10. Gravatar of edeast edeast
    13. September 2010 at 14:36

    http://ftalphaville.ft.com/blog/2010/09/13/341646/a-nightmare-scenario/ with regards to the held-up fed nominations.

  11. Gravatar of JimP JimP
    13. September 2010 at 15:07

    edeast

    Its a typical Obama snooze

  12. Gravatar of JimP JimP
    13. September 2010 at 15:18

    Japanese deflation.

    Scott argues that Japan (the bank of, at least) desires deflation, and so is hitting their targets, Krugman sneers. But this article, and others I have seen, argue the case for Scott.

    http://www.ft.com/cms/s/0/6bdd4902-bd04-11df-954b-00144feab49a.html

  13. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. September 2010 at 15:54

    Scott,
    I was looking for the key point in your post and I think I may have found it:

    “Even at the zero bound. Chinese growth is good for China, and good for the global economy.”

    God bless you!

  14. Gravatar of JimP JimP
    13. September 2010 at 16:08

    On the lack of inflation.

    One has to wonder what Bernanke is smoking.

    http://economix.blogs.nytimes.com/2010/09/13/2010-a-year-of-falling-prices/

  15. Gravatar of Benjamin Cole Benjamin Cole
    13. September 2010 at 16:37

    Is Scott Sumner the powerful man behind the curtain?

    Yields Fall to Eisenhower Low in Pimco-BofA View of Fed Easing

    By Liz Capo McCormick – Sep 13, 2010 10:41 AM PT

    Sept 13 (Bloomberg)

    Bond investors are growing more convinced that Federal Reserve Chairman Ben. S. Bernanke will push Treasury yields down to the levels of the 1950s with another round of asset purchases.

    Goldman Sachs Group Inc. and Pacific Investment Management Co. project the Fed will resume quantitative easing by purchasing U.S. government debt as soon as this year to prevent what they see as a 25 percent chance the economy will slip back into a recession. Bank of America Corp. says the central bank will send the 10-year note yield to a record low of 1.75 percent in the first quarter of 2011.

    Derivatives show investors are betting on lower yields at a rate not seen since the Fed began buying Treasuries in March 2009, even after companies in the U.S. added more jobs than forecast and manufacturing expanded faster than estimated in August. Policy makers are attempting to push borrowing costs lower and investors into higher-yielding assets such as corporate debt to help sustain the expansion and spur hiring.

    “The Fed will have to be proactive and do quantitative easing as growth slides,” said Priya Misra, head of U.S. rates strategy at Bank of America Merrill Lynch in New York. “The Fed will be aggressive with their purchases because they don’t want to run the risk of it not working and them losing credibility.”

  16. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. September 2010 at 16:47

    Benjamin Cole,
    You wrote:
    “Is Scott Sumner the powerful man behind the curtain?”

    Do you mean the Wizard of Oz for our time? I’ll vote for it. Count me in.

  17. Gravatar of OGT OGT
    13. September 2010 at 17:36

    I don’t quite get this part of your post, “For instance, a strong yuan put deflationary pressure on the Chinese economy in the late 1990s.” That seems like an odd statement coming from you. Couldn’t the PBOC offset any deflationary pressure by aiming for a higher NGDP value?

    I agree that China probably can’t revalue quickly, because of the structural problems in their economy caused by their reliance on an export lead development path. But, the structural mismatch between production and end demand in their economy is probably the world’s single largest structural problem, and I doubt the developed world will return to a stable growth path until it is eased.

  18. Gravatar of scott sumner scott sumner
    13. September 2010 at 17:38

    Indy, That’s an interesting comparison. It certainly seems like both economies suppressed consumption.

    Steve, Yes, Doug sent me a copy. That is a good paper.

    Benjamin, You raise a good point–will we get enough NGDP growth to avoid the Japan scenario? I still think the odds are we will, but the deflation risk is worrisome. My best guess is that the recovery will be much too long, but we will eventually move above zero rates (unlike Japan.)

    lark; You said;

    “The fly in your ointment is unemployment.
    ChiAmerica: China gets 10% growth and we get 10% unemployment.
    “…New reports show that during the recession American companies ramped up investment overseas for plants and new hires, as well as research and development “” even as they cut back domestically.”

    That doesn’t really explain anything, as they had 10% growth back in 1987, when we had less than 5% unemployment. China didn’t cause US NGDP to fall sharply in late 2008, we caused our own problems. BTW, more of their savings comes here, than vice versa.

    Pat, Tight money causes low nominal rates. Real rates may rise initially, although they too often fall in the long run. The rise in real rates that I describe occurred between July and November 2008.

    Benjamin, I hope they are right. But QE alone might not do much. It also depends on the signals the Fed sends. Will they commit to higher inflation? Or a lower IOR?

    Jim Glass, If I knew that I’d be rich.

    edeast, It’s a scandal they haven’t been confirmed, and it’s a scandal that Obama waited a year to nominate them. And I don’t think any of the three are qualified, but they are just as qualified as those already on the Board, so there is no reason not to confirm them.

    JimP, At least they are hopeful about the US.

    Benjamin, Well that cheered me up a bit. But recall that low rates can also be a sign of economic weakness, so who knows.

    Mark, But just don’t follow the yellow brick road (i.e. gold standard.) Bernanke needs to put on his silver slippers and click them together three times. BTW, wasn’t the guy behind the curtain kind of a fraud?

  19. Gravatar of scott sumner scott sumner
    13. September 2010 at 17:42

    OGT, You said;

    “I don’t quite get this part of your post, “For instance, a strong yuan put deflationary pressure on the Chinese economy in the late 1990s.” That seems like an odd statement coming from you. Couldn’t the PBOC offset any deflationary pressure by aiming for a higher NGDP value?”

    That’s the point, they found it difficult to offset the strong yuan, and Chinese growth rates slowed (probably more than the official data showed.) The could have devalued the yuan, but that would have been very unpopular with their trading partners. In the end, they grew out of the problem.

    I don’t believe China’s trade surplus is anywhere near big enough to cause significant problems for the world economy. It’s a little bigger than Russia’s trade surplus, and a little smaller than Germany’s.

  20. Gravatar of Mark A. Sadowski Mark A. Sadowski
    13. September 2010 at 18:00

    Scott,
    HaHa! I never meant to imply you were a fraud. Only that I wish you would supplant the frauds who are there currently.

    Put on your silver slippers and click them together three times and take us where you know we want to go.

  21. Gravatar of 123 – TheMoneyDemand Blog 123 - TheMoneyDemand Blog
    14. September 2010 at 04:19

    Scott,
    ECB has got its own Kocherlakota too:
    http://themoneydemand.blogspot.com/2010/09/really-good-links-global-imbalances-tim.html

  22. Gravatar of OGT OGT
    14. September 2010 at 05:08

    Sumner- OK, is this a case of a determined Central Bank being unable to hit its target?

    Your trade figures are off, as Michael Pettis notes the Chinese surplus is the greatest as a precentage of GDP since at least 1900, and possible in history. Here’s the figures for 2009, China’s suplus is more than twice its nearest rival, nearly three times Germany’s and four times Russia’s.

    http://en.wikipedia.org/wiki/List_of_sovereign_states_by_current_account_balance

    I am not sure we should take the story of China’s growth as an engine of world GDP growth too seriously, so much of it’s activity is a pass through for end demand in the rest of the world. It makes it seem more like an indicator of world growth rather than a driver of it, though one could get a better sense looking at the figures ex-CAB.

  23. Gravatar of ssumner ssumner
    14. September 2010 at 08:01

    Mark, I’ll try.

    123, Thanks, that doesn’t surprise me.

    OGT, My figures are accurate. I said trade surplus not current account surplus. I presume trade surplus better reflects the stuctural imbalances that you were worried about. CA balances include lots of financial flows that seem unrelated to structural problems with the distribution or production.

    China is by far the world’s biggest consumer of most commodities, no other country even comes close. It also imports lots of capital goods from countries like Germany. It’s economy is several times bigger than it appears, if you adjust for the absurdly low price level in China. And it grows much faster than the other big economy—the US. In absolute terms, China’s economy expands each year by 3 times as much as our economy.

    Even if you take Pettis’s CA figures, $290 billion is a trivial share of world GDP (which must be close to $100 trillion in PPP terms.)

  24. Gravatar of Ted Ted
    14. September 2010 at 08:51

    I agree with Krugman that greater consumption and a lower deficit would help us. But to get that result by a rapid appreciation of the yuan would seem mistaken. As you mentioned, this would induce low growth expectations in China, which would seem to lead to a lower Wicksellian natural rate and that wouldn’t be particularly helpful for us.

    But what I really wanted to say was let’s just accept that for the sake of argument that a yuan appreciation would be beneficial as we want to increase aggregate demand in the U.S. But then, why should we try harassing China who we are unlikely to have much leverage over? Why shouldn’t we harass our Federal Reserve, which we would obviously have far more leverage over? Wouldn’t it just make more sense for Congress to drag in our Fed officials and question them rather then lecture the Chinese on their special-interest oriented exchange rate policy? As an aside,as this point, I think our deference to central bank independence has become absurd. I obviously want an independent central bank, but there is a difference between political insulation and complete unaccountability of a branch of the federal government that is not acting in the public’s interest.

  25. Gravatar of Benjamin Cole Benjamin Cole
    14. September 2010 at 10:02

    Scott-

    I am still struggling to understand monetary policy (give me another 20 years).
    I guess I think aggressive QE would get noticed and speak for itself. Jeez, we have 24/7 econ-business chatter now.

    It would be interesting if the Fed said “You are going to get inflation if you want it or not, because we are printing money baby.”

    I can almost assure everybody that if the Fed promised inflation, real estate would take off (from its depression).

    Somehow, the aggressive monetary policy argument must be made appealing to conservatives, who (wrongly) conflate loose fiscal policy with aggressive monetary policy. (Even the words we use, like “easy money” are bound to upset conservatives.)

    If the message could go out, “An aggressive monetary policy, a Growth Hawk policy obviates the need for deficits,” then it would have more appeal to right-wingers.

    Just a thought.

    Let me tell you, words matter. Personally, I think the dithering Japan Wing of the Fed needs both a shot of whiskey and testosterone.

  26. Gravatar of Pat Pat
    14. September 2010 at 10:35

    “Tight money causes low nominal rates. Real rates may rise initially, although they too often fall in the long run. The rise in real rates that I describe occurred between July and November 2008.”

    How does low nominal rates cause real rates to soar initially?

  27. Gravatar of Joe Calhoun Joe Calhoun
    14. September 2010 at 12:12

    Okay, Scott now I’m really confused. In your last post you told me definitively that there was no downside to dollar volatility. In truth I didn’t respond because I thought I must have confused your blog with another one. Since I’ve been reading here, you’ve talked about using market indicators to assess monetary policy and the dollar is surely one of (I’d say the main) those market indicators.

    So, now in this post you return to the theme that the rapidly rising dollar in late 2008 was deflationary and had predictable consequences. And that the Chinese saved the world by refusing to go along and providing effective monetary stimulus by stopping the appreciation of the Yuan. Am I missing something or did currency volatility have a pretty big downside?

    So which is it? Dollar volatility has no downside? Or it has drastic downside? Are we just dealing with semantics here? You are saying that volatile monetary policy is what produces the bad outcomes and not currency volatility? But how do you get currency volatility without volatile monetary policy?

  28. Gravatar of Joe Calhoun Joe Calhoun
    14. September 2010 at 12:18

    Scott, another thought. If China was able to rescue the world economy by stopping the appreciation of the Yuan, how much of a role did the previous appreciation play in causing the crash? In other words did the official US policy of bullying the Chinese into appreciating the Yuan indirectly cause the crisis? Were we hoisted on our own weak currency petard?

  29. Gravatar of OGT OGT
    14. September 2010 at 16:30

    Sumner- I am slightly surprised you didn’t address my first question. Your research has lead you to believe that a determined Central Bank shouldn’t have any trouble offsetting the price shock of a changing relative exchange rate, correct?

    Why is this case different? Institutional constraints? Underdeveloped finance sector?

    Also, I don’t understand the logic behind adjusting international trade flows by PPP, international balances and debts are settled at exchange rate terms, not in Big Macs or hair cuts.

    Here’s Pettis on both the scope and intractability of Chinese structural imbalance:

    “In order to rebalance China’s economy, which still depends heavily on exports, Beijing must raise its very low consumption share of GDP. That share declined from 46 percent of GDP in 2000 to an unprecedented low of 41 percent in 2003 –and then shrank further to an astonishing 38 percent in 2006, finally falling below 36 percent in 2009. (In August, Credit Suisse released a study by the China Reform Foundation’s Wang Xiaolu, which suggested that if we include China’s unrecorded economy — market activity that isn’t reflected in official data — the consumption share is even lower.)
    Chinese policymakers aren’t blind to the urgency of reversing this decline. A low consumption share is the obverse of China’s excessive reliance on export surpluses and investment. Unless domestic consumption expands dramatically, China can continue growing rapidly only by increasing investment well beyond what is economically useful or by forcing larger trade surpluses onto a reluctant world.
    In order to get consumption to generate 47 to 50 percent of GDP in ten years, every year consumption needs to grow faster than GDP by 3 to 4 percentage points, something it has never been able to do. If China continues growing at 7 to 9 percent for the next decade, as many analysts are projecting, consumption must grow by 10 to 14 percent, much faster than it ever has in post-reform Chinese history. Yet all projections show China growing more slowly than it ever has during these next ten years.
    The other, smaller (but rapidly growing) school of thought argues the model itself prohibits high consumption: growth is high because consumption is low. China cannot enjoy the double-digit GDP growth generated by low wages, cheap capital, and an undervalued currency and still have strong domestic consumer demand. This school has been arguing for five years that the measures Beijing has taken to boost consumption growth will fail because they do not address the underlying cause. ”

    http://www.foreignpolicy.com/articles/2010/08/19/china_s_japanese_future?page=full

    If this surplus were spread out randomly it might be less of a concern, but given its reserve currency status and de facto currency union with China, the surplus (and net increase in debt) will end up in the US even if the products don’t.

  30. Gravatar of scott sumner scott sumner
    16. September 2010 at 04:54

    Ted, That’s an excellent point, and I just don’t see why Krugman can’t see it.

    Benjamin, Yes, emphasizing how faster NGDP growth will reduce the deficit is a good idea.

    Pat, Low nominal rates don’t cause high real rates, but they can be associated with high real rates, as they obviously were in 2008. Tight money caused a spike in real rates.

    Joe Calhoun, I see why you are confused. I meant that a volatile dollar does not have a donwnside if other macro variables are stable, like TIPS spreads.

    Regarding 2008, I pointed out that a sharp rise in the dollar was one of 7 indicators of tight money. I didn’t emphasize any causal role for the dollar, although there certainly might have been one.

    So I should be clearer—dollar volatility by itself, if associated with stable inflation and or NGDP growth, is not a problem. If money is too tight and inflation is falling, one indicator may be a rising dollar. I don’t recall the context of our original discussion. It may have been where I argued the Fed should target NGDP, and not worry about the dollar.

    Here is an exact analogy. I also listed falling commodity prices as an indicator of tight money. But falling commodity prices are not, by themselves, a problem. Only if associated with falling inflation and NGDP.

    The modest appreciation of the yuan 2005-08 didn’t cause the crisis, because it did not substantially slow Chinese growth. The reason China had to stop the policy is that the dollar suddenly got much stronger in late 2008. You can’t just look at the yuan, you also have to look at the currency to which it is pegged.

    OGT, You said;

    “Sumner- I am slightly surprised you didn’t address my first question. Your research has lead you to believe that a determined Central Bank shouldn’t have any trouble offsetting the price shock of a changing relative exchange rate, correct?”

    No, just the opposite. Exchange rate policy IS monetary policy. If the Japanese raised the yen from 90 to 60 to the dollar, there would be nothing the BOJ could do to prevent massive deflation in Japan. You may be thinking of relative price changes. I agree that tight money can offset an oil shock, and prevent inflation from rising.

    You asked;

    “Also, I don’t understand the logic behind adjusting international trade flows by PPP, international balances and debts are settled at exchange rate terms, not in Big Macs or hair cuts.”

    I think you are referring to the ratio of the CA surplus to world GDP. That was Pettis’ idea. If you are going to do it, you need to measure world GDP properly, in real terms.

    You said;

    “If this surplus were spread out randomly it might be less of a concern, but given its reserve currency status and de facto currency union with China, the surplus (and net increase in debt) will end up in the US even if the products don’t.”

    Even Pettis acknowledges that it is a mistake to focus on bilateral imbalances. Our trade deficit with China is not caused by China’s overall surplus, they are unrelated issues. If China didn’t exist we’d buy all those sneakers and toys from other Asian countries. Indeed many of our “Chinese” imports are disguised imports of components from Korea, Taiwan, etc. China gets blamed for the full value, but only does a small amount of value added in assembly. Measured on a VA basis, our China deficit would be far smaller, and our deficit with other East Asian countries far bigger.

    Finally, our trade deficit is NOT A PROBLEM.

  31. Gravatar of OGT OGT
    16. September 2010 at 05:52

    Sumner you said: “No, just the opposite. Exchange rate policy IS monetary policy.”

    This is, I think, the source of many of your analytical mistakes on this issue. If exchange rate interventions are sterilized in the home market, it is not monetary policy it is trade policy. Economists who have studied the issue like Robert Aliber have found that a system of financial repression such as the one in China can effectively neutralize the inflatioinary effects of nominal currency pegs and hold down the real exchange rate.

    Sumner you said: “I think you are referring to the ratio of the CA surplus to world GDP. That was Pettis’ idea. If you are going to do it, you need to measure world GDP properly, in real terms.”

    Pettis did that to put the CA surplus in a historical context. I suppose if one wanted to do the same PPP adjustment to the US surplus in 1929 or Japan’s surplus in 1989 one could. But, you’d be better off just excluding the percentage world GDP that is derived from goods and services that can not be readily traded across borders. (This does not mean goods that do not happen to be traded acorss borders, wheat is wheat and could be cosumed almost anywhere, so it conforms mostly to the law of one price, whereas land and haircuts do not). So I still think you over use and abuse PPP adjustments which give us an idea of comparable living standards, but not purchasing power in the international marketplace.

    Lastly, You said: “Even Pettis acknowledges that it is a mistake to focus on bilateral imbalances. Our trade deficit with China is not caused by China’s overall surplus, they are unrelated issues.”

    Of course, Pettis is right, and I fully understand that. However, world trade must balance, correct? If the Chinese government’s policies systematically shift resources to suppress consumption and boost savings and, thefrefore, the CA surplus, at least one other country must run a deficit, which in total will offset that surplus. Yes?

    In most ‘normal’ countries their ability to finance an offsetting deficit will be fairly limited, too much importing will cause the exchange rate to fall, for example. Ok, now if this surplus is relatively large and very persistent there is de facto one country will be able to take advantage of the bargain prices on offer, the US.

    This is because of the reserve currency of the dollar, the US effectively does not have a floating exchange rate in the sense of one that responds to the macroeconomic cnoditions of the US economy. This due to the large percentage of currencies pegged the USD (30% of our trading partners on a trade weighted basis), the senisivity of the Euro and Yen CB’s to dollar movements, and non-trade currency exchanges swamping trade related exchanges. It’s not that it’s a bilateral trade movement, it is water rolling down hill.

    Lastly, you said: “Finally, our trade deficit is NOT A PROBLEM”

    I assume you think this because you have a model in your head that believes our CAD is caused by our low savings rate? I think it is exactly the opposite.

  32. Gravatar of ssumner ssumner
    16. September 2010 at 18:23

    OGT, You said;

    “This is, I think, the source of many of your analytical mistakes on this issue. If exchange rate interventions are sterilized in the home market, it is not monetary policy it is trade policy. Economists who have studied the issue like Robert Aliber have found that a system of financial repression such as the one in China can effectively neutralize the inflatioinary effects of nominal currency pegs and hold down the real exchange rate.”

    I don’t see how this conflicts with anything I said. I was responding to an earlier comment you made that mischaracterized my views. You said I thought it would be easy for a central bank to offset the effects of a misaligned currency. And that is not my view. If Japan raised the yen to 60 do think the BOJ could easily offset the deflationary impact? That was my comment.

    I don’t understand your point about PPP. Pettis was trying to show that China’s surplus is large relative to world GDP. But it isn’t. The fact that it is larger than in some past years might be interesting, but I don’t see why it is important. The surplus is small relative to the world economy, however measured.

    I don’t see why the US dollar’s role as a reserve currency affects our CA deficit. I don’t see why our size makes it inevitable that we will run deficits any time China runs surpluses. The EU is just as big, and they don’t typically run CA deficits of any size.

    And I don’t see why deficits are a problem for individual countries, but not a problem for states within the US.

    You said;

    “I assume you think this because you have a model in your head that believes our CAD is caused by our low savings rate? I think it is exactly the opposite.”

    Free trade is not some model in my head, its been the standard economic model for 200 years. People have tried to overturn it, but no one has succeeded. You haven’t given me any reason to believe the US CA deficit is not caused by low US saving rates, which is the standard view among international economists. Saying we have the reserve currency doesn’t tell me anything about why Americans save less than they invest.

    You say the CAD causes the saving, but have no model of the CAD that I can see–we ran huge CAD even before China was a big factor. Is the whole world ganging up on us, but not Europe?

  33. Gravatar of Obama Lectures Wen Jiabao To Swiftly Revalue The Yuan | Asian Conservatives Obama Lectures Wen Jiabao To Swiftly Revalue The Yuan | Asian Conservatives
    24. September 2010 at 03:34

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