Krugman vs. Krugman

I don't get Krugman's logic here:

Things are different for a country that shares a currency with other countries. Ireland can raise employment by cutting wages of Irish workers relative to German workers. But America, with its floating dollar, gains nothing — nothing at all — from overall wage cuts. All we get is a magnified real debt burden.

If that's the case, then why worry about China's currency peg, as he has done for years now? Either their peg helps boost American employment (at the zero lower bound), or it's of no concern for employment. Or Krugman is wrong.

This Is What Adjustment Looks Like (An Ongoing Series)

Increasing inflation in China causes a real exchange rate appreciation. Michael Pettis:

[T]he month-on-month increase in prices suggests that inflation is running at just under 13% annually, although month-on-month numbers are always suspect because they don’t correct for seasonality and one or two big numbers can have a disproportionate effect. Still, although the CPI inflation number was below market expectations it is nonetheless well above the PBoC’s comfort level, which is officially 4%. In December the year-on-year rise in prices was 4.6%.

This stubbornly high inflation number, coupled with good growth numbers and a surge in exports will, I suspect, give Beijing the sense that it has room to tighten, so I expect that we will continue to see measures such as interest-rate and minimum-reserve-requirement hikes to slow down economic growth. In keeping with this on Friday the PBoC announced yet another 50-basis-point hike in minimum reserves (making it the fifth hike in five months).

But will these measures bite? My guess is that they will at first, but that when they do they will be quickly reversed. Any real attempt to reduce the sources of overheating will cause economic growth to slow too quickly, and Beijing will change its mind, especially if, as I expect, inflation peaks soon and starts to decline.

Let’s face it – most Chinese growth is the result of overheated investment, and removing the sources of overheating without eliminating growth is going to prove impossible. I have been making the same argument for at least two or three years, and so far we have seen how Beijing veers between stomping on the gas when the economy slows precipitously and stomping on the brakes when it then grows too quickly. I don’t believe anything has changed.

More at the link.

This Is What Adjustment Looks Like

The real exchange rate -- including domestic inflation -- is still the appropriate measure:

The [Chinese] central bank has been pumping out currency at an ever-accelerating pace over the past decade to limit the renminbi’s appreciation against the dollar. That strategy has helped preserve a competitive advantage of Chinese exporters by keeping their prices relatively low on global markets — while also protecting the jobs of tens of millions of Chinese workers in export factories.

Now, though, that cheap currency policy seems to be reaching its limits. The extra renminbi are feeding inflation. That is starting to undermine exporters’ price competitiveness — just as a stronger renminbi would do if Beijing was not intervening to begin with. ...

Inflation in China is not just the result of China’s currency market intervention, although Mr. Hu and other economists describe it as the biggest single cause. Another cause is aggressive lending by Chinese banks, despite repeated demands by regulators to slow things down.

Meanwhile, David Leonhardt tries to play down currency concerns in advance of Hu Jintao's visit to the U.S.:

For the United States, the No. 1 problem with China’s economy is probably intellectual property theft. Technology companies, for example, continue to notice Chinese government agencies downloading software updates for programs they have never bought, at least not legally.

No wonder China has become the world’s second-largest market for computer hardware sales — but is only the eighth-largest for software sales.

Next on the list, say people who work in China or do business there, is the myriad protectionist barriers China has put up. These barriers make this country’s recent efforts at “buy American” protectionism look minor league. In some cases, Beijing has insisted that products sold in China must not only be made there but be conceived and designed there. The policy goes by the name “indigenous innovation. ...


The most relevant comparison of two currencies is one that is adjusted for inflation in the two countries. When inflation is higher in one country, as in China today, it means that country’s products are becoming more expensive — and imports into the country become relatively cheaper. In effect, the real price of Chinese-made goods is rising faster than the exchange rate suggests.

Without taking inflation into account, the renminbi has risen 3 percent against the dollar since last summer, when China began letting it rise. Once inflation is accounted for, the real increase has been about 5 percent. At that pace, the renminbi could erase its artificial undervaluation — as some economists estimate it — in less than two years.

Developing.

Hegemony and Currency Wars

Apologies for the lack of posts lately. Real work has gotten in the way.

Over the past few weeks I've been thinking about the Fed's actions over the past few years. At the height of the crisis the Fed moved to shore up the integrity of the banking sector and immediately lowered the funds rate to practically 0%. It also engaged in a first round of quantitative easing -- by increasing the size of its balance sheet -- and qualitative easing -- by increasing the riskiness of its balance sheet. Most observers agree that these actions prevented the Great Decession from becoming another Great Depression.

Since early-2009, the recession has worsened but the Fed has mostly kept policy stable. This has led to complaints from many ideological corners; Scott Sumner and Paul Krugman don't agree on much, but they do agree that the Fed isn't doing enough. Some have expressed bemusement that "Helicopter Ben" Bernanke, student of the Great Depression, hasn't done more to prevent the worsening of the recession. After all, he famously said of the Fed's role in abetting the Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton [Friedman] and Anna [Schwartz]: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

So why has he let the U.S. economy stagnate? Why has he let other countries devalue their currencies with no U.S. response? Why hasn't he learned from history?

Perhaps he has. I have no reason to think this is true, but perhaps Bernanke is influenced by another scholar of the Depression - Charles Kindleberger. Kindleberger argued that the Great Depression became a cataclysmic international event because of the unwillingness of the U.S. and inability of the U.K. to supply public goods to stabilize the international system. Those public goods include maintenance of a system of stable exchange rates and open markets:

"As with exchange depreciation to raise domestic prices, the gain for one country was a loss for all," Kindleberger writes. "With tariff retaliation and competitive depreciation, mutual losses were certain."

In other words, perhaps Bernanke is acting as the world's central banker. If Bernanke believes that a U.S.-led currency war would have adverse consequences for the global economy, then perhaps he is willing to prolong the U.S. recovery in order to prevent a large global downturn. Such a deterioration of the global economy would also affect the negatively affect the U.S. of course. So while, ceteris paribus, a dollar devaluation would help the U.S., ceteris is not paribus. A U.S. devaluation would prompt a series of actions in Frankfurt, Tokyo, and Beijing. The resulting exchange rate instability would spook financial markets and hamper trade. Cries for protectionism would grow louder, and the net effect would be sharply negative.

Faced with that scenario, perhaps Bernanke has opted instead to try to stabilize markets and defuse an explosive global political economy by allowing other countries to beggar the U.S. some in the short run. Again, I don't know if this is the case, but it seems more persuasive to me than "Bernanke doesn't understand the monetarist lessons from the Depression".

It should be noted that Barry Eichengreen disagrees with Kindleberger about devaluations. Eichengreen argues that while competitive devaluations in the 1930s did beggar neighbors in the short run, they also constituted a large international monetary stimulus that helped pull the global economy out of the depression (after several years). More recently, Eichengreen has argued that this process is best done through multilateral policy coordination so as to avoid swings in exchange rates. Unfortunately this sort of coordination is basically impossible right now. The Prisoner's Dilemma that incentivizes beggar-thy-neighbor devaluations also incentivizes defection from a coordinated monetary policy.

Given that, perhaps Bernanke has chosen to follow Kindleberger's advice: provide as much liquidity as he can, work to maintain an open trading system and relatively-stable exchange rates, and allow other countries to devalue without U.S. reprisal. Perhaps that will cost the U.S. in the short run, but it can benefit the global economy over the longer run.

How Free Is Trade? How Free Should It Be?

Tim Duy says that tariff and non-tariff barriers (like quotas and subsidies) to trade are not the only pressing concern:

When I express concerns over free trade, I am really expressing immense frustration over an international financial architecture that sustains and maintains global imbalances that yield outcomes that I believe are very difficult to justify and yet are accepted due to a blind faith in free trade. In essence, the ability to manipulate capital flows has made a mockery of the free trade crowd. I know. I used to be in that crowd, and in many ways still am. But I can no longer wrap myself in the free trade flag to justify the negative impacts of financial account manipulation. And if the US cannot seriously address financial account manipulation on a global basis - and if the Pettis article is correct, the US Treasury will fall short of what is needed even with the announced adjustment to Chinese currency policy - what choices are you left with? Either accept continued economic stagnation, or act unilaterally on the current transactions (tariffs) or financial (reciprocative devaluation or capital controls) side of the accounts. None of which are pleasant options.

To which Kevin Grier responds:

Here are some points to consider:

1. The current global trading system is very very far away from free. To criticize any current outcome and blame it on free trade is simply incorrect (If you don't believe me, take a look at "Travels of a T-shirt" or "Misadventures of the Most Favored Nations").

2. The dollar doesn't have to adjust for relative prices to adjust. The relevant relative price is the real exchange rate. US exports can become more competitive with a fixed nominal exchange rate simply by US prices rising more slowly than those of their trading partners. Higher productivity growth in the US would produce this effect.

3. Everybody has a comparative advantage. Statements like "America apparently has little left in the comparative advantage department" are non sequiturs.

4. I do agree that financial account manipulation should be discouraged, but it is way too simplistic to say it's good for China and bad for the US. It's good for US consumers, especially low income consumers and it's bad for Chinese consumers, especially higher income consumers.

I agree to some extent with all of this, although I think that Duy's conclusion -- "Financial barriers to trade are a problem, so let's try to fix it by erecting other barriers to trade" -- doesn't get us very far. To me, the interesting questions arise from #s 1 and 4 in Grier's list. The current global trading system is very far away from free, and the patterns of protectionism are not coincidental. They have political causes, which we need to understand before we start advocating retaliation. First, the U.S. is not innocent of trade-distorting practices on the current or capital accounts (Duy acknowledges this), so it will be difficult to mount an international coalition to side with us against the Chinese. (This is a point that Krugman seems to not understand.) Can we really be sure that other states will have our back if we decide to really confront China? Do those countries want a devaluation of the dollar? If we go against China alone are we prepared to take the blowback while the economy is so weak?

Second, the current policy mix benefits some groups in China, Europe, and the U.S. and harms other groups. As Grier says, "it is way too simplistic to say it's good for China and bad for the U.S." Given that the U.S. low- and middle-income consumers benefit, and that consumption represents about 70% of the U.S. economy, why should we think that the U.S. would be better off in aggregate if the RMB spiked? Most Americans would become immediately (if temporarily) poorer, and it is doubtful that non-durable manufacturing jobs would come back to the U.S. anyway. Production would simply shift to Vietnam, or someplace else. The adjustment would take a little while, and involve some pain, but in five years the overall picture would probably look the same. In other words, it is likely that Chinese capital account manipulations hurt their fellow developing countries more than the U.S. Ending this manipulation would hurt low-income Americans (in the short run), hurt low-income Chinese (in the long run), benefit low-income Vietnamese (in the long run), and have little effect on the U.S. trade balance. I don't see how that's a "win".

Third, right now the U.S. needs capital inflows to fund budget deficits and investment. Keynesians complain that fiscal stimulus is "leaky" because of capital account manipulations, but don't acknowledge the corollary which is that deficit spending is also much less expensive for the same reason. In the current climate it is hard to see how such a policy would be economically successful.

Fourth, the status quo persists because it reflects the balance of power within these countries. U.S. trade policy is skewed towards low-income consumers and middle/high-income producers. Chinese trade policy is skewed towards low-income producers and high-income consumers. Does anyone think that's an accident? Does anyone think that a reversal of those dynamics will stand for very long? It would require a shift in interest-group power, and that seems very unlikely.

In the future, capital account distortions should be addressed just as current account distortions are: within the auspices of the WTO. That will be difficult to do for a host of reasons, especially because of the implications for domestic monetary autonomy, but it will be necessary. But I don't think the world is ready for that right now, and I don't think the initiation of a trade war is the right way to go about it.

What Do We Want?

Some commenters on my most recent post questioning the logic of Krugman's "Make War, Not Peace" attitude towards China raised some good points that I'd like to address. Ultimately, though, I think that Krugman and those who are sympathetic to him are just not sure about what they want to get out of a confrontation with China over its exchange rates. I'll explain what I mean as I go.

First, Wise Bass and Anonymous questioned the importance of China for funding U.S. deficit spending. Wise Bass was correct to point out a (slight) error in my post, which is that I said that China was the largest purchaser of U.S. debt. This is not strictly true (anymore) if you include the Federal Reserve or all private buyers as a single group. Clearly, however, China is a very large purchaser of U.S. debt, as Krugman is quick to point out ("$1 billion a day"). In fact, if China wasn't an important buyer of U.S. debt, Krugman's point becomes even more wrong, because a change in Chinese policy would then have little effect on the U.S. But I think Krugman is right about this much, so if China exited the market for U.S. Treasuries it would certainly have a noticeable effect on interest rates.

Or would it? Commenter Adam thinks it may not:

It might actually be a good time to lean on China to absorb some of the re balancing costs that its current account surplus pushes exclusively to the US.

Capital is fleeing Europe at a massive rate, and there's no reason to think that the US is going to have a failed auction any time soon. China is the single largest holder of US debt, and a few years ago it really was buying a majority of new US issuance. But it is only a marginal player now. A Chinese strike on new issuance would have a small, short term effect on US interest rates, but the resulting "flight to safety" should ensure that it's a very small and very short lived.

So the PBoC could dump its holdings, but then the PBoC's technical insolvency (it earns about 1% on its reserves, but once the RMB appreciates, it will earn negative returns) will become a liquidity crisis. The ministry of finance would have to step in to recapitalize the central bank, which is something the central bankers dread more than anything else right now as we go into the 2012 political cycle.

The other option is a trade war, which nobody can win from but the US would loose a lot less than China. The deficit country might be forced to pay higher prices, get some inflation (not a problem right now for US), and consume less. But the surplus country takes a demand a supply hit, and growth will slow much more in China than in the US.

It's not perfect, but it's a reasonable card to threaten right now because there's a realistic chance that the US can take the hit. China needs to step up and correct its twin surpluses much more quickly than they have shown any interest in doing. Krugman is mostly right on this, IMHO.

There are a few parts to this, but before I jump in I'd like to point out that while Adam's advice makes some sense on its own, it is answering a different question than the one Krugman is asking. Adam is answering the question "How can we get China to pay for its share of a (needed) global macro re-alignment?" Krugman is asking the question "How can we make fiscal stimulus in the U.S. more effective right now?" Adam's answer would not help reduce American unemployment in the short run; it would likely exacerbate it, for reasons I'll get into in a bit. But then again, so would Krugman's.

First, I'm not sure that China's current account surplus shifts all of the costs of global macro re-alignment onto the U.S., for the basic reason that China's persistent current account surplus indicates that global macro re-alignment isn't happening. It is probably true that persistent imbalances have damaged the U.S. economy over the past decade, and it may be true that they will continue to damage the U.S. over the next decade. (Although the economists' favorite question -- "Compared to what?" -- is certainly applicable here.) Not all of this can be blamed on China, however, and taking a "we broke it, you fix it" attitude towards a still very poor country would be heartless as well as combative.

More to the point: in terms of fighting the current recession using a Keynesian framework, how could picking a fight with China help in the short run? In other words, Krugman is hoping for a situation in which China suffers lower growth and the U.S. incurs higher inflation and greater borrowing costs, because he thinks that will make U.S. fiscal stimulus more effective. Are we sure that would be good for either economy? Are we sure that a large RMB appreciation -- which would benefit U.S. exporters but hurt U.S. importers and consumers -- would really stimulate the U.S. economy? What makes us so sure that the gains to exporters and non-tradable producers will out-weigh the costs to importers and consumers? What makes us so sure that this gain will be larger than the loss from an interest rate increase that must occur when a larger supplier of funds exits a market? These are the questions that Krugman and his supporters should be answering.

The presence of a large current account deficit would seemingly indicate the opposite, because more of the American economy currently depends on imports than exports. The job losses the U.S. has recently seen have been largely in non-tradable sectors like construction, less-tradable services like finance, and less-skilled labor in retail and services. Those aren't going to come back if the RMB appreciates 10% against the dollar. Let's also remember that economic recoveries are often encouraged by more trade, even if these run up imbalances, rather than less. That is certainly one lesson to take from the interwar and Bretton Woods periods.

If the goal is to shrink the current account deficit, we can do that easily enough by importing fewer goods, thus making ourselves poorer. If the goal is to spur employment in exporting sectors, we can pursue beggar-thy-neighbor policies to make that happen. But if the goal is to raise our standards of living and boost overall employment, then cutting off imports seems completely counter-productive.

Second, suppose that what I just wrote was irrelevant. In other words, suppose short-run economic recovery was not our policy goal. Then Adam's advice starts to become a bit more logical. If we were ever going to strike at China to reshape our medium run outlook, now might be the time to do it. The world's demand for highly liquid, AAA assets is very high, and the U.S. remains in a very unique position to provide them. I still disagree that China is a "marginal player" in those markets now, and that argument violates the most basic assumption in Krugman's logic (which Adam says he agrees with), but picking a fight when the U.S. is strongest (i.e. less reliant on Chinese funds) might still make sense if the goal is to punish China.

That is, it might make sense if American political constituencies were interested in sacrificing employment and standards of living for the pleasure of knocking China down a few pegs, or scoring some short run relative gains, or correcting the trade imbalance for its own sake. It might even make sense if the American leadership was interested in any of those things. But neither is true. The American polity wants a quick economic turnaround, and the leadership wants a China that is integrated into the global economy, and more willing to take a responsible role in maintaining security and stability in Asia over the medium to long run. Neither of those things are likely to happen under the scenario that Krugman (or Adam) outlines.

The point I was trying to make in my previous post is that Krugman has confused his purposes. Confronting the Chinese right now along the lines Krugman wants might increase American relative power (or might not), but it will not help spur an economic recovery in the short run, which he has made clear is his ultimate goal. Nor will it help maintain order in the global political economy, which should be the ultimate goal of policymakers. It's a convoluted policy, with no clear goals and no reasonable expectations.

Riddle Me This

If Krugman wants another massive fiscal stimulus package funded by additional deficits, and he does, and he wants the Chinese to stop depressing the value of their currency by buying American debt, and he does, then where does he expect the funds for fiscal stimulus spending to come from? More precisely, if Krugman succeeds in removing the largest purchaser of American debt from the supply side of the funds equation ("$1 billion a day"), then why wouldn't he expect the cost of borrowing to increase massively? And why does he think this will be good for the national accounts?

Then there's this conclusion to his most recent column:

China needs to stop giving us the runaround and deliver real change. And if it refuses, it’s time to talk about trade sanctions.

Is it good for economic recovery to pay more to borrow than we have to, pay more for imports than we have to, and shut off access to a very large and growing market for our exporters by triggering a trade war? Of course not.

Usually when I disagree with anyone, especially someone as intelligent as Krugman, I can at least see where they're coming from. Not this time. I really cannot reconcile his anti-China invective with his pro-Keynes dogma. It just makes no sense.

Breaking News: China to Do Something About Exchange Rates

The sort-of sarcastic title above is in reference to this:

At 7am this morning US East Coast time, the People's Bank of China published an announcement on its website that appears to signal the change everyone has been expecting. Chinese version here, with a posting date two minutes earlier. It begins:
Further Reform the RMB Exchange Rate Regime and Enhance the RMB Exchange Rate Flexibility

In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People´s Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.

What does "enhance the RMB exchange rate flexibility" mean? Beats me, but we should hear more details before the upcoming G20 meetings:

The statement, from a bank spokesman, gave no details of when China would allow its currency to appreciate and by how much. But the timing of its release, just before the leaders of the world's largest economies gather for a G20 meeting in Toronto, appeared clearly aimed at taking pressure off Beijing over the issue. Many countries, including the United States, have criticized China's fixed exchange rate, which critics say was keeping the value of Chinese exports artificially low. ...

The move was immediately welcomed by the White House, which saw it as a vindication of President Obama's nonconfrontational policy of trying to quietly negotiate over the exchange rate.

(bold added)

In other words, the Obama administration is saying "Shut up, Krugman". (This is also a small vindication for those of us who have opposed Krugman's China-bashing over and over again.)

But the statement from the People's Bank is purposefully vague, and there are basically no details of what China is and is not prepared to do. "Enhance flexibility" would seemingly indicate that China's "managed float" will be a bit less managed, and this will lead to some appreciation of the RMB relative to the dollar and euro. The proof of that will be in the pudding, so before we come to any judgments it will be better to see just what sort of "flexibility" Beijing has in mind, and how they end up implementing it.

Still, this could be significant news.

China's Choice: How to Adjust

The United States wants China to allow the value of its currency to appreciate. This would make Chinese exports to the United States relatively more expensive, which would reduce the quantity demanded. It would also make U.S. exports to China less expensive, which should increase the quantity demanded and thus create more jobs in exporting sectors. If the reduction in the quantity demanded of Chinese exports and in the increase in the quantity demanded of U.S. exports is large enough, the current account deficit in the U.S. will narrow, the capital outflows from China will shrink, the global economy will be brought into greater balance, and the risk of a future financial crisis caused by the inflation of asset bubbles by the influx of foreign capital will be lessened.

China does not want this. China wants to keep its currency weak in order to keep the quantity of its exports demanded very high. This, in turn, boosts domestic employment in the exporting sectors. Given the still-very-large numbers of unemployed or underemployed Chinese with very poor standards of living, this is an understandable goal.

But one by-product of keeping the exchange rate low in the face of a trade imbalance is that it puts upward-pressure on domestic prices. Krugman explains:

Consider the real exchange rate, defined as RX = EP*/P, where E is the exchange rate measured as the domestic currency price of foreign currency (so an appreciation of the renminbi is a fall in E), P* is the foreign price level, and P the domestic price level. Basic international macro says that there is a “natural” level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy “wants” to get to that real exchange rate.

If you have a floating exchange rate, you get there via a rise or fall in E. But if you have a pegged rate, there’s pressure on prices instead. By deliberately keeping E higher than it would be under floating, China is creating pressures for P to rise; the inflationary pressures are directly related to the exchange rate policy.

This is exactly right. Now that inflation in China may be well over 10%, Chinese officials are growing concerned. The savings rate in China is very high -- around 40% -- and many Chinese investors are hedging against inflation by buying tangible assets like housing. This may be leading to a property bubble in China. Moreover, high inflation hurts poorer Chinese (i.e. those who consume most of their income) by reducing their standard of living. Add to that the fact that China's currency is pegged to the dollar, so it has actually depreciated with the dollar relative to the yen and euro in the past year, and pressure is mounting for the Chinese leadership to adjust upwards the RMB's peg to the dollar.

What would be the effect of this? So long as China doesn't couple a currency appreciation with trade protection, it would increase the purchasing power of Chinese consumers and improve standards of living. Some employment in exporting sectors might be lost, but gains in employment in importing and nontraded sectors would offset some or all of that effect. Also, a stronger currency would likely attract more foreign direct investment, which could lead to domestic employment. If China also took steps to strengthen the social safety net it could reduce national savings rates, which would lead to more domestic consumption and thus more domestic employment. Moving towards currency convertibility could give China more influence in international financial markets, especially regionally.

This is the path that China will have to take eventually. The tradeoff between growing inflation + asset bubbles on the one hand and competitiveness in traded goods will only be resolved by either moving away from an open trading system or from an undervalued currency. China has been able to have it both ways for more than a decade now, but all good things (from their perspective) must come to an end.

Hegemonic Instability Theory

This passage from Martin Wolf got me thinking:

China’s exchange rate regime and structural policies are, indeed, of concern to the world. So, too, are the policies of other significant powers. What would happen if the deficit countries did slash spending relative to incomes while their trading partners were determined to sustain their own excess of output over incomes and export the difference? Answer: a depression. What would happen if deficit countries sustained domestic demand with massive and open-ended fiscal deficits? Answer: a wave of fiscal crises.

Neither answer is acceptable; we need co-operative adjustment. Without it, protectionism in deficit countries is inevitable. We are watching a slow-motion train wreck. We must stop it before it is too late.

For some reason this brought to mind Charles Kindleberger, who argued, in The World in Depression, that the role of the stabilizer in managing the global economy can be summed up by the following five tasks:

1. maintaining a relatively open market for distress goods;
2. providing countercyclical, or at least stable, long-term lending;
3. policing a relatively stable system of exchange rates;
4. ensuring the coordination of macroeconomic policies;
5. acting as a lender of last resort by discounting or otherwise providing liquidity in a financial crisis.

Arguably, the U.S. has performed each of these quite well since the end of the Cold War. Also arguably, it is a combination of these that has led to the recent financial crisis and global recession. What do I mean? Well, the U.S. has kept open a market for goods, which has led to the export-oriented industrialization in Asia but has also created the massive macroeconomic imbalances that led to the crisis. The U.S. has also led to a system of (mostly) stable exchange rates, esp. in regards to China which pegs directly to the dollar, and the Chimerican macroeconomy has been symbiotic and well-coordinated for quite some time. These, also, led to a huge current account deficit in the U.S. America hasn't strayed from providing global liquidity either, although China has done its best to sop much of it up and spend it in American debt markets. This, too, was a large part of the economic crisis.

My point? Perhaps the U.S. should have provided less of an open market for excess goods, or fought the fixed valuation of the yuan to the dollar. Perhaps the U.S. should have actively tried not to coordinate so well with China, and instead competed more directly in export markets (or refused entry into the WTO until China had a managed-floating exchange rate, or levied tariffs on China for the same reason, etc.). Perhaps, by trying to act as a stabilizer, the U.S. actually facilitated the conditions that lead to instability. Perhaps the U.S. should have been just a bit more isolationist, a bit more closed, and a bit more uncooperative.

I'm not saying that Kindleberger is wrong, but I think there is something of a paradox here. Are the actions that the hegemon should take during global recessions the opposite of what they should do during expansions? I'm not sure. But something is definitely missing from Kindleberger's account: an exit strategy. Policies that are appropriate during downturns are not always appropriate during normal times, and policymakers generally aren't nimble enough to simply reverse course after the crisis has passed. Unwinding is hard, takes a long time, and can cause new crises if not done properly. It's a fine line to walk, and so far most states don't seem to be very good at it.

Thoughts?

(ht: Angry Bear)

Who Adjusts?

Now that things have slowed down a bit, regular posting should resume. There's been a lot going on in the past few weeks, but I'm going to let most of it pass since I'm late to the party.

In a recent e-mail, Dr. Oatley mentioned that he thought that my regular postings on financial regulation were somewhat missing the point: the real blame for the economic crisis lies with the large external imbalances that have been building over the past decade. Even though I think that regulatory regimes are interesting and important, I think Dr. Oatley is exactly right to emphasize macroeconomic factors. So I was interested to read ECB Executive Board member Lorenzo Bini Smaghi's recent take on the same topic:

A strengthening of the IMF was agreed after the Asian crisis in the 1990’s, and the G-7 summit in Cologne in 1999 mandated the Fund to play a strong surveillance role to ensure greater transparency and encourage early adjustment by countries with unsustainable balance-of-payments positions.

But, over the last decade, the expectations raised by this mandate have not been met. Some emerging economies did not let their currencies float but, instead, continued to peg them at undervalued exchange rates in order to promote their exports and build up reserves as a form of insurance in case of crisis.

Moreover, the IMF has not succeeded in convincing countries to pursue macroeconomic policies consistent with sustainable current-account positions. Nor have advanced economies, particularly the United States, taken IMF advice fully into consideration. The accumulation of large surpluses, especially in emerging Asian economies and oil-exporting countries, enabled the US to finance its current-account deficit. It also lowered long-term interest rates in the US and made monetary conditions there more expansionary.

In the context of this testy exchange, "some emerging economies" can only mean China. And I suppose it's not surprising that an ECB official would deflect blame from EU countries despite the fact that Germany, for example, also ran large current account surpluses in the run-up to the crisis.

But is it right to criticize the IMF for not succeeding "in convincing countries to pursue macroeconomic policies consistent with sustainable current-account positions"? Not really. Until a crisis hits, the IMF is basically powerless. It can monitor behaviors and help boost transparency, but it has little formal authority to coerce states into allowing their currencies to float, say. How exactly is the IMF supposed to "convince" states to stop acting in their own self-interest? Smaghi doesn't provide an answer, but doesn't see much help coming from multilateralism, arguing that emerging economies that want a larger role in the IMF mostly want to weaken conditionality while increasing access to cheap credit.

Gee, it almost sounds like the global economy needs maintenance from a strong state. But Smaghi never proposes that Europe step into the breach. Actually, he never mentions Europe, or even a single European country, at all. Instead, the U.S. and China are somehow expected to voluntarily cede authority to the IMF while eschewing domestic political concerns to bring their current and capital accounts into balance. Well, color me skeptical.

Interestingly enough, the quickest, easiest feasible way to moderate imbalances is a higher peg for the yuan against the dollar. But this isn't necessarily something that Europe would like to see. So if the U.S. and China act more prudently, it may come at the expense of the Eurozone. What would Smaghi say then?

The Dollar Is China's Problem

J. Paul Getty once said: "If you owe the bank $100 that's your problem. If you owe the bank $100 million, that's the bank's problem." In modern times it could rephrased: "If the U.S. owes China $100bn, that's the U.S.'s problem. If the U.S. owes China $2tn (and growing), that's China's problem." The question is what can be done about it.

As Kenneth Rogoff notes, the current U.S./China imbalance resembles the U.S./Europe imbalances of the 1960s-70s. Europe didn't do so well in that deal, as the inflation of the 1970s eroded much of the dollar's value. But the issue is bigger now, and affects more than just China:

In the run-up to the financial crisis, the US external deficit was soaking up almost 70% of the excess funds saved by China, Japan, Germany, Russia, Saudi Arabia, and all the countries with current-account surpluses combined. But, rather than taking significant action, the US continued to grease the wheels of its financial sector. Europeans, who were called on to improve productivity and raise domestic demand, reformed their economies at a glacial pace, while China maintained its export-led growth strategy.

He says a dollar crisis is not imminent, but is "certainly a huge risk over the next 5 to 10 years". Recall that before the financial crisis Nouriel Roubini and Paul Krugman (among many others) were predicting a dollar crisis, and the U.S. now faces a much worse fiscal position than it did before the crisis. So there are legitimate reasons for worry, but Rogoff says this is China's problem, and only China can fix it:

Any real change in the near term must come from China, which increasingly has the most to lose from a dollar debacle. So far, China has looked to external markets so that exporters can achieve the economies of scale needed to improve quality and move up the value chain. But there is no reason in principle that Chinese planners cannot follow the same model in reorienting the economy to a more domestic-demand-led growth strategy.

Yes, China needs to strengthen its social safety net and to deepen domestic capital markets before consumption can take off. But, with consumption accounting for 35% of national income (compared to 70% in the US!), there is vast room to grow.

I'd add that some adjustment needs to come from Germany and other export-biased industrialized economies too, but Rogoff's point is sound: China desperately needs to develop its domestic market. This will hurt the U.S. some in the medium run as its borrowing costs go up, but it is a necessary transition.

Fortunately, we have a mechanism for gradual, relatively painless, macroeconomic adjustments: floating exchange rates. But that only works if the exchange rates are truly allowed to float. If they are not, then imbalances will continue to pile up until there is some sort of currency crisis, and then the adjustment becomes much more painful.

Right now almost every economic issue seems to be on the table, and this is the most pressing: the U.S. cannot continue to soak up all the excess savings in the world forever, and exporting countries need to reinvest some of those savings domestically. The global economy needs to transition, and there's no time like the present.

Rethinking China

The Economist says that the Great Adjustment is well underway in China:

The good news is that the [current account] surplus is already shrinking. The strong rebound in China’s economy in the second quarter—pushing GDP 7.9% higher than a year ago—came entirely from domestic demand. This sucked in more imports, while exports continued to slump. ...

China’s real domestic demand is likely to grow by at least 10% this year. In fact, the popular perception that China has always relied on export-led growth is rather misleading. Its current-account surplus did soar from 2005 onwards but until then was rather modest. And over the past ten years net exports accounted, on average, for only one-tenth of its growth.

So what's the bad news? The rising domestic demand comes from investment, not consumption:

The problem is more that the mix of domestic demand between consumption and investment is unbalanced, and becoming even more so. In 2008 private consumption accounted for only 35% of GDP, down from 49% in 1990 (see chart 2). By contrast, investment had risen from 35% to 44% of GDP. This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large. This is China’s most glaring economic imbalance.

Consumption makes up only 35% of Chinese GDP, compared to 70% in the U.S. The Chinese savings rate remains over 50% (!), and the vast majority of that comes from households and companies. Part of that comes from the fact that China has a very weak social safety net, but another part remains the undervaluation of the RMB, which hurts the purchasing power of Chinese consumers. From 2005 to early this year the RMB appreciated substantially against the dollar, but has since fallen back as China re-pegged to the dollar. One estimate quoted in the article claims that the RMB should appreciate by as much as 25% to reach trade-weighted parity with the dollar.

Still, China appears to have turned a corner in its transition away from an export-led growth model. Now the emphasis must become transitioning towards a greater role for domestic consumption.

ht: Mark Thoma

Differing Views on China

Obama and Geithner want structural adjustment of the Chinese economy and some upwards movement on the value of the RMB relative to the dollar.

Scott Sumner wants to see the RMB devalue against the dollar. Not a typical viewpoint (at least among non-economists), but he has some very good reasons.

In the first scenario, China stops funding the U.S. debt by buying Treasury bills. In the second, they continue that practice. For a very good article discussing the choice Beijing must make, see this piece by David Leonhardt.

Payback Time

Whew! And I thought the World Economic Forum would be boring this year. Instead, in separate appearances today, Russian President Puppetmaster Prime Minister Vladimir Putin and Chinese Premier Wen Jiabao took turns blasting the U.S.'s role in the current economic crisis:

The premiers of Russia and China slammed the U.S. economic system in speeches Wednesday, holding it responsible for the global economic crisis.

Both focused on the role of the U.S. dollar, with China's Premier Wen Jiabao calling for better regulation of major reserve currencies and Russia's Prime Minister Vladimir Putin calling over-reliance on the dollar "dangerous." ...

Mr. Wen's comments came just days after U.S. Treasury Secretary Timothy Geithner accused China of manipulating its currency for economic gain. The Chinese premier gently, but firmly warned that if Washington and Beijing chose confrontation, both would be losers.

It is certainly true that a confrontation between Washington and Beijing would turn ugly very quickly, but I was heretofore unaware that the proximate cause of the economic crisis was lax regulation of the dollar. All this time I thought that the relative strength of the dollar (esp. to the RMB and ruble) led to a structural misalignment that inflated financial markets and led to excessive risk-taking (and that the Chinese were actively complicit in this arrangement). Now I'm being told that the problem is that the dollar hasn't been "regulated" enough, although I'm not sure exactly what that means. Neither Russia nor China want the dollar to slip, and the dollar has held its value or increased against almost all of the world's currencies in recent times. So what are they talking about?

Once again, I think that these sorts of statements, like Mr. Geithner's from the other day, are best read as cheap talk intended for domestic political audiences; Mr. Wen and Mr. Putin both face political pressures at home which will only be exacerbated by the economic crisis. For them, scapegoating the U.S. is an easy and popular way to galvanize support. Of course, the same is true in the U.S., so I don't expect the Obama administration to curtail public denunciations of Chinese policies any time soon.

Canard Pekinois

Update: Link to the IMF WEO fixed.

Emmanuel-across-the-pond and my co-blogger Will have been discussing the dollar-renminbi exchange rate and current account adjustment. They both seem to accept (along with Congress and the Obama administration) that a devaluation of the dollar will correct the current account deficit. I think this conclusion is wrong. Moreover, I think that only political economy analysis can help us understand why the political elite are obsessed with the exchange rate. As we shall see, it has nothing to do with current account adjustment.

Correcting the US current account deficit with a dollar devaluation is like trying to eliminate a deficit in your household budget by cutting your hourly wage. Although it could work, it's a bad idea because it makes you poorer. It is a doubly bad idea because it might not work, either. Let's focus on why an hourly wage cut might eliminate the deficit in your household budget. Then we can think about the conditions that determine whether it will work.

• i. price elasticity of demand for your labor: One might think that cutting your hourly wage would merely reduce your income. Yet, businesses might demand more of your labor at this lower wage so that total hours worked rise more rapidly than your hourly wage falls so that at the end of the (longer) work day you have higher total income. Hence, household earnings (exports) rise by cutting your hourly wage (devaluing).
• ii. price elasticity of your demand for consumption goods: Because everything you buy is now more expensive relative to your hourly wage, you consume less. Moreover, because your demand is highly sensitive to rising prices, the fall in the quantity you demand is greater than the price increase. Hence Quantity times Price yields a smaller total expenditure bill than at the prior real wage. Hence, household expenditures on goods from the outside (imports) fall.

Thus, with the right elasticities, you can balance your household budget by cutting your hourly wage. Your total earnings rise and your total expenditures fall. Yet, if demand by the world for your labor and yours for goods are price inelastic, then cutting your hourly wage just makes you poorer. If your demand for goods is inelastic (maybe you spend all of your income on food, shelter, and health care), you fall deeper into deficit.

Devaluing the dollar therefore makes us poorer. It might eliminate our current account deficit if demand for US imports and exports is highly price elastic. Or if demand is price inelastic, it could push us deeper into deficit. So, the question is, how price elastic is the demand for US imports and exports? The preponderance of evidence suggests that the answer is, "not very." To quote a relevant summary: "...price elasticities tend to be quite small...Thus, an exchange rate depreciation would weaken the trade balance as its negative effect on the terms of trade would outweigh its positive effect on trade volumes" (The IMF WEO linked above, at page 95). Devaluing the dollar will make us poorer and is more likely to worsen than improve the current account position. Devaluing thus seems to be a doubly bad idea.

All of which raises the political economy question: why does Congress want the Obama administration to implement a policy that will make us all poorer? I'll answer this in the next post. Until then, let me say that I think Congress' focus on the exchange rate misleads the public. I'll leave it to individual readers to decide whether the deception is intentional.

Why Adjust?

Teutonic Knight, a commenter at Seeking Alpha (where some IPE at UNC posts are syndicated) asks a very good question apropos of this post:

What is the real motivation or perceived benefits to the U.S. of asking to Chinese to re-evaluate the Yuan upward? If say the Yuan is up another 15% (not a hugh magnitude in my view to begin with) then the "cheap" Chinese household goods may just rise 10 to 15% in price.

China and the United States have had a trade imbalance for quite a long time. In theory, when one country (the U.S.) imports more goods from a country (China) than it exports to it, the value of the currency of the importing country (the dollar) sinks relative to the value of the currency of the exporting country (the yuan). At least, this is supposed to happen when the value of currencies is allowed to float. If the value of the dollar sinks relative to the yuan, then imports from China to the U.S. become more expensive, while exports from the U.S. to China become less expensive. Therefore, exports from the U.S. should rise while imports from China should fall. The price mechanism prevents countries from running persistent trade deficits that can have adverse long-run effects on employment.

In the real world version of this example, China has subsidized its exports to make them cheaper, and has then used the proceeds from the trade imbalance to buy U.S. Treasuries and other dollar-denominated assets, thus propping up the dollar and making Chinese imports even more attractive to U.S. consumers. For a long time, the U.S. was more than happy to oblige, because this made it possible for us to extend cheap credit to businesses and consumers without generating a lot of inflation. The U.S. was running at or near full employment, so there seemed to be little short-run downside. China was content with this state of affairs because it allowed them to employ millions of its impoverished citizens in labor-intensive exporting industries, thus raising standards of living for the most people in the shortest amount of time.

However, everyone knew that in the long run this trade imbalance was unsustainable. This is why people like Nouriel Roubini have been predicting a currency crisis in the U.S. for several years now: eventually the dollar was going to have to fall. According to Roubini and others, the bigger the trade imbalance became, and the larger the U.S. national debt grew, the more painful the inevitable transition was going to be. A gradual adjustment is always preferable to a sudden shock, so the U.S. has been cajoling the Chinese to let the yuan rise against the dollar in stages. The Chinese have done this, but the U.S. has been concerned that the process is going too slowly. The Chinese have been reticent to move too quickly and forego the employment gains in their exporting sector.

Now that the U.S. is well below full employment, the matter has become more urgent: we need the dollar to decline some in order to boost our exporting industries and spur employment. Despite interest rates close to zero, the dollar has actually gained value against many of the world's currencies since last Fall. Unfortunately, China is facing a slowdown as well, and they want to keep their employment levels from slipping, so they want to keep the yuan from rising much more in the short run.

And that's basically the state of things right now. It appears that we may be at an impasse. Structural adjustment is needed, but the U.S. is hesitant to force that adjustment through tariffs or capital controls, and China is hesitant to let the yuan fall much further.

Of course, this simplistic explanation ignores all other countries besides China and the U.S., and all other currencies besides the yuan and dollar. The full story is much more complicated, as Russia moves to devalue the rouble, France gets concerned about the shocking weakness of the British pound, and the Japanese yen rises against all major currencies, leading to rising unemployment in the Land of the Rising Sun. In a global recession, nearly all countries are incentivized to devalue their currencies in order to boost employment and stave off deflation. But such competitive devaluation can have devastating consequences for the global economy.

A Person Needs a Face; A Tree Needs Bark

Emmanuel from the mighty IPE Zone blasts me on two fronts: first for defending macroeconomists from Wilkinson, and second for not appreciating the importance of reputation to the Chinese (as recounted by Wikipedia, but two can play that game: the title of this post was taken from here). The first has nothing to do with second in my mind, but his combination of the two is intended to call my IPE chops into question. Emmanuel's argument sums up to, in Lolcatspeak, "Ur doin' it wrong".

I, too, am familiar with Cohen's writings on the US/UK IPE divide. And I, too, am fully aware of what he means by the "economism" of some American IPE types. Indeed, the primary reason why I am in IPE instead of economics proper is because I think that the utility of modern Econ is lessened by its, er, "stylization" of the world, and I'm sympathetic to arguments that make that point (that's not what Wilkinson was doing, however, and not really what Emmanuel is doing either). Anyway, I've got no horse in the UK vs. US debate, so I'm not hashing that out here. Emmanuel is surely right to point out that an economist might look at Geithner's quotes and conclude that he is merely restating the obvious. A political economist should look deeper, if she can. Geithner's statements were clearly intentional, so let's do what Emmanuel hasn't and read the subtext while considering the context.

James Fallows, a man with a hundred times more awareness of Chinese culture than Emmanuel or I (or Wikipedia), says that the Chinese aren't "manipulating" the yuan, they are "managing" it. Emmanuel pointed out Paulson's recent similar semantic two-steps. Well, you say "po-TAY-to" and I say "po-TAH-to" but Geithner's point isn't substantively refuted. In fact, nobody is arguing that Geithner is wrong, only that he would have done better to keep his trap shut.

But who was Geithner's audience? Whose reputation was Geithner concerned with? Given the fact that he was speaking during his confirmation hearing in the U.S. Senate, his first audience was clearly domestic: he was speaking to the U.S. Congress and their constituents, and vague quasi-protectionism was a pretty major aspect of the recent election. Geithner was trying to indicate that Obama is committed to helping American workers, and considers Chinese jiggering of the RMB to boost (Chinese) domestic employment at the expense of US employment to be "unfair" to American workers. As I mentioned in my last post, this is a long-running theme in the US. The Obama administration has more direct lines of communication with the Chinese than a Senate confirmation hearing, so Geithner's rhetoric was clearly intended for domestic consumption. Felix Salmon fleshes the point out more clearly here.

Despite all that, surely Geither knew that the Chinese would be listening, which is probably why he said things like "the immediate goal should be for us to convince China to adopt a more aggressive stimulus package as we do our part to try to pass a stimulus package here at home." In other words, the first priority is to boost domestic demand in China, not to duel over currency valuations. Once again, this is a pretty noncontroversial statement: everyone agrees that Chinese domestic demand needs to grow with the rest of the economy. Geithner also strongly indicated that the Obama wants to work with, and not against, the Chinese. More than once, Geithner mentioned that Obama seeks more policy coordination and cooperation with the Chinese rather than less. In any case, neither Geithner nor Obama have indicated that they are prepared to take any retaliatory action against the Chinese (much to Emmanuel's chagrin, I'm sure!), so Geithner's comments are best read as cheap talk for the benefit of domestic audiences.

Were some Chinese feathers ruffled by the bluntness of Geithner's comments? Surely. Were Chinese policymakers aware of the proper context, meaning, and intent of Geithner's remarks? Undoubtedly. Are both governments using the incident to shore up domestic support? Unquestionably. Are more reasonable and substantive discussions between Chinese and American policymakers occurring behind closed doors? Indubitably. Does this represent any sort of change in the US/China relationship? I see no economic, political, sociological, or anthropological reason to think so.

Yawn.

Image created using the LOLcat builder.

Discounting Obama's 'Aggressive Attitude' Toward China

Some have taken note of Timothy Geithner's comments during his confirmation hearing suggesting that the Chinese are continuing to devalue the RMB to stimulate exports. The U.S. bond market tanked, supposedly fearing Chinese backlash in the form of a sell-off of U.S. Treasuries. Geithner also said that Obama will encourage China to engage in fiscal stimulus to try to boost lax Chinese domestic demand (psst: they're already doing it).

A few have freaked out, expecting a rising of tensions between the two nations that could culminate in a trade war, while one guy in England thinks that would be a good thing, as he expects the Great Salvific Trade War of 2009 as the best mechanism for producing needed structural adjustment.

But Salmon and Drezner both yawned; in the words of Drezner, Geithner merely "said out loud what everyone knows to be true." Salmon called Geithner's remarks "content-free". Still, it's important to notice the change in rhetoric, right?

Wrong. For one thing, this is nothing new from Obama: back in 2007, he cosponsored (with Hillary Clinton) Senate legislation to put tariffs on Chinese goods if they didn't allow the RMB to appreciate. For another, since mid-2006 Secretary Paulson has been harping on China's currency manipulations, most recently last month. The Chinese have shrugged off harsher statements than this for the past three years or more, and I don't see any reason to think that they won't do so now.

Now if Obama actually decides to actually slap tariffs on Chinese goods using the infamous 301 provision, then a few things could happen: China dumps Treasuries and the U.S. dollar sinks; China decides to further subsidize its export industry to offset the tariffs; or the WTO steps in and forces the U.S. to back down or accept tariffs on its own goods. None of these seem very likely to me, since China and America (nee Chimerica) still need each other to balance their supply-and-demand profiles. So put me in the "yawn" camp, until something actually changes.

The Great Adjustment, or The Way Things Oughtta Be

Matthew Yglesias sums up:

The way this is “supposed” to work is that Chinese people, being poor but growing rapidly, consume more than they produce. The current accounts balance out because savers in rich countries should be investing money in China — building up China’s capital stock and so forth. Investments in capital-poor developing countries “should” offer a high rate of return for developed world savers, and the injection of foreign capital should speed China’s growth. And for “China” you can substitute “Mexico” or “India” or what have you. The world, however, doesn’t actually work like that. Instead, China has been running persistent surpluses. And so have various energy-rich developing countries. So money keeps getting plowed into various US investments. But the US isn’t a poor, developing, capital-poor country. And so a lot of the investment in the United States seems to be going into speculative bubbles — first dot-com stocks, then MBS. Now people are buying up no-interest treasury bonds.

and quotes Brad DeLong:

If it weren’t for the fact that the furshlugginer dollar refuses to fall in value, the answer would be obvious: we will have a boom in import-competing manufacturing (and exports). But then the rest of the world has a long-run problem: if we decide to no longer be the world’s importer of last resort, than what serves as a locomotive to keep it near full employment?

But if the dollar doesn’t fall, then we have a long-run problem. The only answer I can think of is for the U.S. to then become the world’s largest private-equity fund: they lend us their money, and we then invest the money back in their economies–in industries and companies that then have a very high demand for U.S. high-tech goods and for U.S. services exports.

So an adjustment is needed, but we're not getting it. Asian central banks are continuing to buy gobs of U.S. Treasuries which keeps the value of the dollar high. And we're not investing the money back into Asian industries that demand U.S. goods and services. Instead, we're using the money to try to keep the bubble inflated, and so the adjustment is postponed.