The Yuan and the Hume Specie Flow Model
John Tamny wants to remind Lawrence Lindsey about the Hume Specie Flow Model:
To begin, just as Chinese authorities fix the yuan’s value, so too do U.S. authorities fix the dollar’s value. As the Journal’s George Melloan noted in a recent editorial, “no currency actually ‘floats.’” As opposed to commodities set by market forces, currencies today are merely paper concepts controlled by central banks through the creation of and extinguishment of that paper. That the above is true calls into question Lindsey’s assertion that the “Chinese clearly undervalue their exchange rate.” More realistically, the Chinese likely recognize that the yuan’s credibility will be best maintained if its value is mostly fixed against the world’s senior currency, the U.S. dollar. David Ranson and Arthur Laffer are but two economists who have said that absent the yuan’s tight relationship with the dollar, market forces would arguably drive the value of the former down. Regarding the exchange of goods between the two countries, Lindsey argues that the supposedly undervalued yuan creates “losers,” specifically the “American producers of goods that are now made in China.” Implicit here is the flawed assumption that changes in currency values impact the real price of anything. In truth, as 18th century philosopher David Hume wrote, “the greater or less plenty of money is of no consequence” in trade since the price of commodities always adjusts to any changes in a currency’s value.
In a April 2003 discussion of Argentina’s fixed exchange rate regime, Bloomberg provided this succinct description of the Hume specie flow mechanism:
The most important thing about the gold standard was that all countries were on the same system. And we have known from the days of British philosopher and economist David Hume that when several countries are on the gold standard there is an automatic mechanism that achieves equilibrium. This process, called Hume Specie Flow, dictates that gold will flow naturally from a country having higher prices to a country having lower prices. It is like the autonomic nervous system on the human body that unconsciously regulates vital body functions. But if only Argentina is on the gold standard, there is no place for the gold to flow. True enough, one country could base its currency on the value of gold, which would require that country to operate something like a gold currency board. The government would have to stand ready to exchange gold for pesos and pesos for gold on demand. Hence, it would be left with something very much like the currency board that blew up at the beginning of 2002.
Lindsey’s WSJ oped covered a variety of issues and was favorably received by Brad Setser in terms of the impact of Chinese policy on the U.S. economy:
Even if the US economy as a whole benefits from taking on external debt to finance consumption and real-estate led growth, China’s central bank is helping to determine which parts of the US economy are thriving, and which are not.
Don Boudreaux had another interesting take on U.S. concerns:
Without here getting into the question of whether or not Uncle Sam would be wise to pressure China to let the value of the yuan rise, Lindsey’s remarks imply that, even as conventionally reckoned, Americans’ savings rate is not irresponsibly low. If foreign governments are forcing their citizens to subsidize Americans’ consumption, what’s irrational or irresponsible about Americans relying upon these subsidies and, thus, consuming more and saving less? Put differently, if foreign-govenment monetary and trade policies truly are lowering the cost to Americans of consuming more today, it’s off-the-mark to lay the blame for Americans’ low saving rate on Americans’ irrationality, irresponsibility, myopia, stupidity, laziness, or crass materialism.
Brad takes us back to the issue that Tamny raised:
Most of Lindsey’s oped is devoted to explaining to the readers of the Wall Street Journal – or perhaps the editors of its oped page – why China’s de facto peg is bad even if fixed exchange rates generally are good. The argument is rather ingenious: basically, China’s fixed exchange rate reinforced government control over the rest of the economy: “The Chinese authorities are intent on maintaining a fixed exchange rate not to provide discipline to the People’s Bank of China, but to maintain state control over the economy.” It doesn’t really matter whether Lindsey’s specific argment that China’s peg reinforces state control is true; I suspect it is directed at providing a specific audience in the US an argument to use in US internal debates, not at China. Lindsey is trying to explain why it is OK to think that Argentina should have held on to its peg – or even dollarized – back in 2001 but that China should not stick steadfastly to its peg now.
Just as Argentina’s pegged exchange rate outlived its usefulness by 2001 with an overvalued peso and rising trade deficits, Brad Setser and Lawrence Lindsey appear to agree that the pegged yuan has led to an undervalued yuan and large trade surpluses. So given this Hume specie flow – why isn’t Chinese monetary growth and inflation leading to a self-correction as Tamny suggest should happen in theory?
Some of Tamny’s NRO colleagues seem to be under the illusion that Chinese monetary growth has been implicitly set by the U.S. Federal Reserve. Of course, this assertion is absurd given the fact that the Chinese monetary growth has greatly exceeded U.S. monetary growth over the past several years. But given the extent of reserve accumulation by the Chinese Central Bank – one might wonder why Chinese monetary growth has not been higher. Brad Setser answers sterilization. Then again – this sterilization has only been partial. But even with rapid monetary growth, China’s inflation rate has been very modest.
It’s nice to see Mr. Tamny has learned about the Hume Specie Flow mechanism, but he should be careful before he insists that this simple theory always works so perfectly in practice.
Update: Bruce Webb wants to know what Brad Setser means by “sterilization bonds”. Good question! Maybe Brad S’s comment to this post from Brad DeLong might help:
Sterilization implies that China offsets the increase in the money supply associated with higher dollar reserves by issuing renminbi sterilization bonds (selling reminbi bonds for reminbi cash) at current exchange rates. The PBoC ends up with a renminbi liability (the sterilization bond), and a dollar asset – its fx reserves.
Brad D. had linked to another Brad S. on the accumulation of international reserves by China’s Central Bank. As background, check the other Q&A comments to Brad D’s post. An interesting discussion – even if the National Review crowd has never bothered to read anything of the sort.