Stop Giving Us Discounts!!

This is the plain English translation of the arguments against Chinese maintenance of a weak yuan in order to promote growth in its export sector. As noted by Nouriel Roubini, (See here ) what they are doing is channeling an export subsidy through their exchange rate and you could just as easily call it an import subsidy from our point of view. As noted previously in this blog, exhortations to China are unlikely to do much to change their exchange rate policy, but it should be noted that it is equally possible for us to change our exchange rate policy if we like. But there is symmetry here in that neither we nor the Chinese are likely to do so for precisely the same reason: Neither country cares to orient its exchange rate policy toward external issues – domestic affairs are paramount for us both.

Take the Chinese. They are experiencing extremely rapid growth in their export sector and though they may want to slow it down a bit they certainly don’t want to end it. There are myriad domestic political and economic imperatives to maintain high growth and problems in the U.S. are far less important to the bosses in Beijing than are the maintenance of their own power, stability and growth. Besides, the Americans are sending definitely mixed signals – We say we don’t want them to export so much to us but we keep right on buying, even while refusing to act on our own to correct any exchange rate imbalances.

Act on our own? Well of course. Exchange rates are always a two-sided phenomenon and just as they can (and many would argue should) engineer a yuan appreciation so too can we engineer a dollar depreciation. Dean Baker has argued for exactly this (See his blog here ) but it is very very unlikely to happen. To do it the Federal Reserve would have to stand ready to buy yuan until the yuan/dollar rate reached whatever level they chose. But there are two very important side-effects of doing this: First, we wouldn’t be depreciating against just the yuan but against all major freely floating currencies since arbitrage between, e.g. the euro and the yuan would ensure that this was the case. While this might in fact be desirable, the global readjustments that would ensue would be something of a Pandora’s Box and not something we would want to engage in on a unilateral basis. Second, such a move would be unambiguously inflationary. And not only has the Fed never enslaved the money supply to the exchange rate in the post Bretton Woods era, but it would be a cold day in hell when Bernanke and the gang voluntarily decided to add several points to our inflation rate. In short, domestic considerations trump foreign ones.

Put another way, the policy makers in both countries dislike the distributional and policy implications of the respective “cures” more than they dislike the distributional and policy implications of the status quo. But that is far different from pretending that there is nothing they can do about it because it is the other guy’s fault.