Matthew Slaughter writes:
Fact 1: China runs a large and growing trade surplus with the United States. In 2006, the goods-trade surplus exceeded $232 billion. This was an increase from 2005 of $31 billion, an amount larger than the entire deficit just 12 years ago. Fact 2: China focuses its monetary policy on fixing the exchange value of its currency, the yuan, relative to the U.S. dollar. Many policymakers and pundits connect these two facts by asserting that an unfairly low value of the dollar-yuan peg is causing the massive bilateral trade imbalance. The 109th Congress introduced 27 pieces of anti-China trade legislation. … These misgivings about the dollar-yuan peg are misplaced. Economic theory and data are very clear here on two critical points. Controlling a nominal exchange rate is a form of sovereign monetary policy. And monetary policy, in turn, has no long-run effect on real economic outcomes such as output and trade flows.
That Greg Mankiw approves this is no surprise, but Mark Thoma was also in agreement. Sorry fellows – but time to turn the microphone over to KNZN. OK, sorry about his screaming Aaargh, but continue to listen anyway:
What the People’s Bank of China is doing is something quite different. Even as it maintains its effective dollar peg, it is attempting to cool the economy by raising interest rates. It is not controlling “one nominal price”; rather, it is attempting (with limited success) to control two things at once. It is trying to keep exports strong by keeping the currency weak, and at the same time, it is trying to reduce domestic demand by tightening domestic monetary policy. As a result, it is accumulating a huge, huge, huge quantity of dollar-denominated assets, and this rate of accumulation is clear evidence of a policy conflict. The conflict might be a bit more obvious if things were going in the other direction. If China were trying to peg the yuan too high rather than too low, while at the same time trying to stimulate, rather than cool, its domestic economy, it would be losing reserves rapidly. The process couldn’t continue, because it would run out of reserves. Then it would be forced either to abandon the peg or to tighten the domestic money supply dramatically. Because the process is now going in the opposite direction, there is no “crisis”, but otherwise what we are seeing is the exact inverse of conditions that would normally have led to a foreign exchange crisis. Of course, when a country does have a foreign exchange crisis, we don’t read economists saying that it is just “sovereign monetary policy” and nothing to worry about. When the process happens in reverse, though, apparently central banks can find plenty of apologists for their unsavory policies.
The whole policy debate is over China’s beggar-thy-neighbor Central Bank mercantilism that has caused its real exchange rate to be “too low”. The rationale for those trade protection proposals in Congress is to have our own beggar-thy-neighbor policies. While I would prefer that we rely on exchange rate realignment as opposed to trade protection, it seems two former members of Bush’s CEA are either ignorant of the real issue here – or choosing to ignore them.
In fairness, an exchange rate realignment is going to have only a small dent in our current account deficit unless we choose to also reverse the Bush fiscal fiasco which has lowered our national savings rate. I’m not holding my breathe for these two former Bush advisors to hammer their former boss on fiscal policy – but I will scream out a plea to our friend Mark Thoma not to go so soft on Slaughter.
Update: James Dorn is supposed to be a China specialist at Cato, which must explain his confusion here:
the balance of payments must always balance because of double-entry bookkeeping.
I guess Mr. Dorn thinks China has a policy of freely floating exchange. And I thought Slaughter was ignorant on the basics of this issue!
Update II: Brad DeLong suggests that Lord Keynes and Milton Friedman join the vowel-less economist blogger brigade in also screaming Aaaargh from their graves. Brads adds:
It’s frustrating: Matthew Slaughter’s assertions are based on his assumption that full long-run monetary and price-level adjustment has already taken place, yet the pace and magnitude of Chiana’s reserve accumulation (and Japan’s) are very strong signs that the PBoC and the BoJ are blocking monetary and price-level adjustment–and that is the problem. To state that if we assume that the problem doesn’t exist then we conclude we don’t have a problem is just not very helpful. And not one in a hundred readers of the WSJ op-ed page will be able to diagnose just how Slaughter’s piece is a misleading tautology.
It is frustrating to see a former member of the CEA writing something fit only for the National Review or the WSJ oped pages.