The International Economy magazine (Winter 2013) asks 16 authorities, “Can Changes in Exchange Rate Valuations Affect Trade Imbalances?“   It is referring to the claim in a recent book by Stanford economist Ron McKinnon that pressure on China to let the renminbi appreciate against the dollar is fundamentally misconceived because such a movement in the exchange rate would not reduce China’s trade surplus nor American’s trade deficit.  This is part of an old debate that pre-dates the rise of the China trade problem.  Ron has long claimed that exchange rates don’t determine trade balances because they are “instead” determined by national saving versus investment.   I thought Paul Krugman demolished the argument pretty effectively 25 years ago, with a textbook graph of internal balance versus external balance.   But evidently many still fall for the argument (including some of the experts in the TIE symposium).   So I try again:

Ron McKinnon has made many important contributions to international macroeconomics over the years. But on this issue, he is simply wrong.

It goes without saying that the current account is equal to the difference between national saving and investment. But it does not follow that we should try to improve the current account in the short run by increasing national saving. Under current conditions, that would send the United States back into recession.

The national saving identity is a tautology: it does not in itself imply causation. True, many of the big movements in the U.S. current account deficit can be explained by changes in national saving: the fiscal expansion of the early 1980s, the investment boom of the late 1990s, and the new fiscal expansion of the 2000s. But the important point is that we care about a lot of things besides just external balance (the trade balance and current account). We care at least as much about internal balance (growth, employment, and inflation). To say that an increase in the budget balance and national saving would improve the trade balance does not imply that this would be good policy or that it is the only way to improve the trade balance.

Of course we need to address the budget deficit in the long run, in balanced sensible ways.  But under current circumstances — a still-weak economy, high unemployment, low inflation, rock-bottom interest rates — a reduction in public or private spending would send the economy straight back into recession. That is why the fiscal cliff of January 1, 2013, was such a danger. To observe that the trade balance would have improved if the sharp fiscal contraction had gone fully into effect would have been small consolation for the self-inflicted recession.

The U.S. trade deficit and Chinese trade surplus have diminished and so are today not quite the problems that they were five years ago. But if improving the U.S. trade balance is considered an important goal, then a devaluation or depreciation of the currency is a better tool for the job. (This proposition does not violate the national saving propositions. Nor, on the other hand, does it justify China-bashing.) Because a real devaluation would also raise demand for U.S. products — admittedly with a lag — and thus move us closer to internal balance, it would be a far more appropriate tool for improving the current account under present-day conditions than would cutting national spending or raising taxes.

        The world is waiting to see whether China has successfully achieved a soft landing, slowing down the economy from its overheated state of a year ago to a more sustainable rate of growth. Some China-watchers fear it could hit the ground in a crash landing as have other Asian dragons before it. But others, particularly American politicians in this presidential election year, talk only about one thing: the trade balance.
        Here the important message is that long-term forces of adjustment are at work in the Chinese economy.  Foreign perceptions need to be adjusted as well. It is true that not long ago the yuan was substantially undervalued and China’s trade surpluses were very large. But the situation is changing.
        China’s trade surplus peaked at $300 billion in 2008, and has been declining ever since. In fact it even reported a trade deficit in the month of February ($31 billion, its largest deficit since 1998). It is not hard to see what is going on. Ever since the Middle Kingdom rejoined the world economy three decades ago, its trading partners have been snapping up exports of manufacturing goods, because low Chinese wages made them super-competitive on world markets.  It was known as the unbeatable “China price.”  But in recent years, following the laws of economics, relative prices have adjusted to the demand.
        The change can be captured by real exchange rate appreciation. This comprises in part nominal appreciation of the yuan against the dollar, and in part Chinese inflation. Government officials would have been better advised to let more of the real appreciation take the form of nominal appreciation (dollars per RMB). But since they didn’t, it has shown up as inflation instead. (See charts below, which show both nominal and real appreciation, against the dollar or against an index.)
        The natural process was delayed. In the first place, as is well-known, the authorities intervened to keep the exchange virtually fixed against the dollar, in the years 1995-2005 and 2008-2010. In the second place, workers in China’s increasingly productive coastal factories were not paid their full value. The economy has not completed its transition from Mao to market, after all. As a result of these two delaying mechanisms, Chinese continued to undersell the world.
        But then two things happened. First, the yuan was finally allowed to appreciate against the dollar during 2005-08 and 2010-11, by 25% cumulatively [=17% + 8%]. Second, and more importantly, labor shortages began to appear and Chinese workers at last began to win rapid wage increases. Major cities raised their minimum wages sharply over each of the last three years [FT, Jan. 5]: 22% on average in 2010 and 2011 (somewhat less this year, in response to slowing demand: 8.6 % in Beijing, 13% in Shenzhen and Shanghai).  Meanwhile another cost of business, land prices, rose even more rapidly.
        As a result, whereas all signs still pointed to a substantially undervalued yuan as recently as four or five years ago, this is no longer the case. One important measure of undervaluation — a comparison of China’s prices with what is normal given the country’s level of income (the so-called Balassa-Samuelson relationship) – showed the renminbi as undervalued against the dollar by as much as 36% on 2000 data (Frankel, 2005) .  Even after an improvement in the international  price data, Balassa-Samuelson regressions estimated the undervaluation at roughly 30% in 2005  and 25% as recently as 2009.   (Others had other ways of estimating undervaluation; see Goldstein, 2004, and those surveyed by Cline and Williamson, 2008.)   
       The renminbi’s real appreciation against the dollar over the last three years has amounted to 12%, reducing the degree of undervaluation by roughly half, depending on whether one measures it against the dollar or against all countries.  More is to be expected, as Chinese relative wages continue to rise.  In any case, China’s real exchange rate is already closer to this measure of equilibrium than are most countries’ exchange rates (Cheung, Chinn and Fuji, 2010).

      In response to the new high level of costs in the factories of China’s coastal provinces, five types of adjustment are gradually taking place. First, some manufacturing is migrating inland, where wages and land prices are still relatively low. Second, some export operations are shifting to countries like Vietnam and Bangla Desh where wages are lower still. Third, Chinese companies are beginning to automate, substituting capital for labor. Fourth, they are moving into more sophisticated products, following the path blazed earlier by Japan, Korea, and other Asian countries in the “flying geese” formation. Fifth, multinational companies that had in the past moved some stages of their production process out of the US, or out of other high-wage countries, to China are now moving back (”reshoring”). Productivity is still higher in the US, after all. All five of these ways of reallocating resources represent the economic process operating as it should. A sixth seems still to lag behind, despite the consensus in favor of it: expansion of the services sector.
        None of this comes as news to most international observers of China. But many Western politicians (and, to be fair, their constituents) are unable to let go of the syllogism that seemed so unassailable just a decade ago: (1) The Chinese have joined the world economy; (2) their wages are $0.50 an hour; (3) there are a billion of them, and so (4) their exports will rise without limit: Chinese wages will never be bid up in line with the usual textbook laws of economics because the supply labor is infinitely elastic. But it turns out that the laws of economics do eventually apply after all — even in China.

       My next post will recall the precedent of Japan’s trade balance.

[A version of this post was published by Project Syndicate, which has the copyright.]

Chinese relative prices have risen as much (since 2009) via inflation as via RMB appreciation

(click her for larger image) 

References

     Chang, Gene Hsin, 2008, “Estimation of the Undervaluation of the Chinese Currency by a Non-linear Model,” Asia-Pacific Journal of Accounting & Economics Vol.15, No. 1, April, 29-40.

      Chang, Gene H. , 2012, “Theory and Refinement of the Enhanced-PPP Model for Estimation Equilibrium Exchange Rates — with Estimates for Valuations of Dollar, Yuan and Others”, SSRN abstract=1998477,  Feb. 2.

      Cheung, Yin-wong, Menzie Chinn and Eiji Fuji, 2010, “China’s Current Account and Exchange Rate,” in China’s Growing Role in World Trade, edited by Rob Feenstra and Shang-Jin Wei (University of Chicago Press, 2010).

     Cline, William, and John Williamson, 2008, ‘Estimates of the Equilibrium Exchange Rate of the Renminbi,” in Debating China’s Exchange Rate Policy, edited by M.Goldstein and N.Lardy (Peterson Institute for International Economics), 155-165.  

      Frankel, Jeffrey, 2005, “On the Renminbi,”  CESifo Forum, vol.6, no.3, Autumn (Ifo Institute for Economic Research, Munich): 16-21.

      Subramanian, Arvind, April 2010, “New PPP-Based Estimates of Renminbi Undervaluation and Policy Implications,” PB10-08, Peterson Institute for International Economics.

All of a sudden, the renminbi is being touted as the next big international currency.   Just in the last year or two, the Chinese currency has begun to internationalize along a number of dimensions.   RMB bank desposits are now available in Hong Kong.  A RMB bond market has grown rapidly there as well, with the issuers including major multinationals such as McDonald’s.   Some of China’s international trade is now invoiced in the currency.  Foreign central banks have been able to hold RMB since August 2010, with Malaysia going first. 

Some are now claiming that the renminbi could overtake the dollar for the number one slot in the international currency rankings within a decade (especially Subramanian 2011a, p.19; 2011b).   The basis of this prediction is, first, the likelihood that the Chinese economy will surpass the US economy in size and, second, the historical precedent when the dollar overtook the pound sterling as the number one international currency during the period after World War I.   

It used to be thought that international currency status was subject to much inertia (e.g., Krugman, 1984).  There was said to have been a long lag between the date when the US economy had passed the UK economy with respect to size (1872, by the criterion of GNP) and the time when the dollar had passed the pound (1946, by the criterion of shares in central banks’ holdings of reserves). 

The “new view,” represented in particular by Eichengreen (2011) and Eichengreen and Flandreau (2010), is that the lag was in fact rather short.  It took until World War I for the dollar to fulfill the criteria of an international currency.  Furthermore, the date when the dollar is said to have challenged the pound in importance has now been moved up to the mid-1920s.   The first point is right. If trade is the measure of size, the US first caught up with the UK during World War I.  The US did not even have a permanent central bank until 1913.  The other important criteria came soon thereafter:  creditor status for the country; the perceived prospects for the currency to remain strong in value; and deep, liquid, open financial markets.  (I have discussed the criteria in earlier papers.  Chinn and Frankel, 2007, evaluate them econometrically and give further references.)  The second point seems a matter of whether or not one wants to distinguish between the concept of “coming to rival” / “catching up with”  the pound (1920s) versus the phenomenon of definitively “pulling ahead” / “displacing” the pound (1945).  Under either interpretation, the dollar’s initial rise as an international currency was indeed rapid, once the conditions were in place. 

The dollar is one of three national currencies to have attained international status during the 20th century.  The other two were the yen and the mark, which became major international currencies after the breakup of the Bretton Woods system in 1971-73.  (The euro, of course, did so after 1999.)  In the early 1990s, both were spoken of as potential rivals of the dollar for the number one slot.  It is easy to forget it now, because Japan’s relative role has diminished since then and the mark has been superseded.  In retrospect, the two currencies’ shares in central bank reserves peaked as the 1990s began.

The current RMB phenomenon differs in an interesting way from the historical circumstances of the rise of the three earlier currencies.  The Chinese government is actively promoting the international use of its currency.   Neither Germany nor Japan, nor even the US, did that, at least not at first.   In all three cases, export interests, who stood to lose competitiveness if international demand for the currency were to rise, were much stronger than the financial sector, which might have supported internationalization.  One would expect the same fears of a stronger currency and its effects on manufacturing exports to dominate the calculations in China.

In the case of the mark and yen after 1973, internationalization came despite the reluctance of the German and Japanese governments.  In the case of the United States after 1914, a tiny elite promoted internationalization of the dollar despite the indifference or hostility to such a project in the nation at large.  These individuals, led by Benjamin Strong, the first president of the New York Fed, were the same ones who had conspired in 1910 to establish the Federal Reserve in the first place.

It is not yet clear that China’s new enthusiasm for internationalizing its currency includes a willingness to end financial repression in the domestic financial system, remove cross-border capital controls, and allow the RMB to appreciate, thus helping to shift the economy away from its export-dependence.  Perhaps a small elite will be able to accomplish these things, in the way that Strong did a century earlier.  But so far the government is only promoting international use of the RMB offshore, walled off from the domestic financial system.  That will not be enough to do it.

[This RIETI perspectives note summarizes the argument in "Historical Precedents for the Internationalization of the RMB," a paper that I have written for a workshop directed by Sebastian Mallaby, for the Council on Foreign Relations and the China Development Research Foundation.]

 Comments can be posted at the version on the Vox site or Seeking Alpha.

References

Chinn, Menzie, and Jeffrey Frankel , 2007, “Will the Euro Eventually Surpass the Dollar as Leading International Reserve Currency?” in  G7 Current Account Imbalances: Sustainability and Adjustment, edited by Richard Clarida (University of Chicago Press).  

Eichengreen, Barry, 2011, Exorbitant Privilege: The Rise and Fall of the Dollar and the Future of the International Monetary System (Oxford University Press).

Eichengreen, Barry, and Marc Flandreau, 2010, “The Federal Reserve, the Bank of England and the Rise of the Dollar as an International Currency, 1914-39,” BIS WP no. 328, Nov.

Eichengreen, Barry, and Jeffrey Frankel, 1996, “The SDR, Reserve Currencies, and the Future of the International Monetary System” in The Future of the SDR in Light of Changes in the International Financial System, edited by M.Mussa, J.Boughton, and P.Isard (International Monetary Fund).

Krugman, Paul, 1984, “The International Role of the Dollar: Theory and Prospect,” in Exchange Rate Theory and Practice, edited by J.Bilson and R.Marston (University of Chicago Press), 261-78.

Subramanian, Arvind, 2011a, “Renminbi Rules: The Conditional Imminence of the Reserve Currency Transition,” (Petersen Institute for International Economics), September. 

Subramanian, Arvind, 2011b , Eclipse: Living in the Shadow of China’s Economic Dominance (Petersen Institute for International Economics), September. 

         December 31 is technically the end of the first decade of the 21^st century.  It is perhaps an appropriate time to review one’s predictions.    It seems to me that I got some things right over the last decade.  Indulge me while I review the predictions that came true, before turning to those that did not work out as well.

Stock market peak     At the end of the 1990s, I felt that the dizzying ascent of equity prices could not continue into the new decade, that there was “…a bubble component in the stock market”  (Nov. 20, 1999).   This was four months before the bubble burst in 2000.  So far so good.

The Euro        Also at the start of the decade, I thought the european currency was undervalued.   My prophesy: “… there will be a major appreciation of the euro against the dollar” (June 21, 2000).  Over the next eight years the euro in fact rose 60% in value.    (But ”I don’t mean to express an optimistic forecast regarding European economics or governance…. Europeans have made many mistakes, the leaders and public alike.” 2006.)

TIPS           I recommended Treasury Inflation-Protected Securities to my blog readers, early in what turned out to be a period of steep rise in their value.  (Feb. 2009.)

            The big economic story  of the decade of course was its second recession, the worst in 70 years, and the severe financial crisis that caused it.    A number of economists got important parts of the 2007-09 crisis right ahead of time (although nobody got all of it right).   I give credit in particular to Krugman, Shiller, Gramlich, Rajan, Borio and White at the BIS, Rogoff, and Roubini.  A 2009 paper identifies 12 commentators as having warned that the US housing market would end in a serious recession.

What parts of the crisis did I get right?

Severity of recession             After the tax cuts of 2001 and 2003, I predicted that spending growth and deficits would rise rather than fall, and that the legacy of high debt would mean that the next recession would be longer and more severe than past recessions:

 ”Good economic logic does not support the idea that Bush fiscal policies caused the weak economy of the last three years. Good economic logic supports, rather, a causal link between Bush fiscal policies and the next recession. The future downturn is likely to be far worse than the recent one…They also created long-range uncertainty that makes planning difficult (nobody from either party expects the relevant tax law to remain as it is currently written)… It is impossible to say when the next recession will come. But when it does, it is likely to be worse than the 2001 recession. Why? Precisely because we will enter it at a time when the budget deficit and national debt are already alarmingly high…Thus when the next recession hits, we will not have luxury of being able to cut taxes and increase spending as George II has done. … The resulting pain will make the economic travails of George II’s first term pale in comparison…”  (Oct. 30, 2003.  Also Dec.2003 and Nov.2004).    
That seems to me precisely what has happened.

Budget deficits   At the start of the decade:  “We need to think about using our budget surplus to provide for the retirement of the baby boom generation, not to blow it on a big tax cut” (May 16, 2001).  But of course the Administration chose the latter policy.   Like many others, I continued throughout the decade to warn that fiscal policy was irresponsible.  The “White House forecast of cutting budget deficit in half by 2009 will not be met,” and “Further, the much more serious deterioration will start after 2009.”  (May 24, 2006.)   Indeed.

Market underestimation of risk        I was dubious of the “Great Moderation.”   By 2006, I was warning frequently of serious risks facing the economy, arguing that even though the odds of each sort of possible setback were small in any given year, the cumulative probability that at least one of them would hit the economy over the next couple of years was relatively high.  (May 24, 2006.)  The markets were underestimating this risk:
 ”How can the implied volatility in options prices be so low?  Perhaps investors are judging risk solely from the statistics of recent history, and not from a forward-looking open-eyed consideration of the risks facing the global economy.”  (Nov. 2006.)    “The implicit volatilities in options prices are substantially too low, and will rise.  … market estimates of risk are lower than they should be.  … the market is basing its perception of risk on recent history, not on a forward-looking assessment of the risks facing the US and global economies.    Such risks include further falls in housing or rises in oil, a hard landing for the dollar, and geopolitical risks arising from the Middle East.”   (Jan.12, 2007. And again, May 14, 2007.)     
The VIX (the CBOE index of market-expected volatility) was close to 10 when that was written.  It was to go as high as 80 when the full financial crisis hit in 2008.

The carry trade “should be reversing.” (Jan.12, 2007.)    Market perceptions of risk had “fallen to irrational lows, as reflected in the low interest rates at which governments of developing countries, unqualified American homebuyers and high-risk businesses could borrow money.” (Nov.19, 2007, and Jan. 2008.)   

International crises    When asked “Have financial developments made the International Monetary Fund obsolete?” my answer was “The IMF is by no means obsolete. …. It is foolhardy to think, just because emerging market spreads have been very low recently, that there will be no more crises in the future.”    (March 1, 2007)   I identified Hungary and other Eastern European countries as particularly vulnerable.  (Jan. 2008.)

The coming financial crash       The comments I made at a Cato conference held in November 2006, shortly before the sub-prime mortgage crisis hit in 2007, look good now:

 ”The Greenspan Fed probably erred by providing too much liquidity in 2001-2004….If the Fed erred in keeping interest rates so low so long after the 2001 recession, what cost are we paying? None yet; but dangers lie in the future. It is not that I am especially worried about inflation at the moment. … what cost do I fear might come from the extraordinarily easy monetary policy of 2001-04? As the Bank for International Settlements points out, some of the biggest financial crashes and some of the longest recession periods have followed liquidity-fed booms that never did show up as goods inflation, but rather as asset inflation…”     (In Responding to Crises, Cato Journal, Spring 2007.)

Housing          Of the various asset markets, housing was the area where policy had most clearly gone awry.    I had long thought “that some people were being pushed to buy houses who couldn’t afford it, that (mirabile dictu) there was such a thing as too high a rate of national homeownership, and that the default rate would shoot up as soon as real interest rates rose or house prices stopped rising.”   (March 26, 2007.)    “Many people bought houses they could not afford unless prices continued to rise rapidly or real interest rates remained extraordinarily low, which predictably did not happen.”  (April 28, 2007.)     

The start of the recession     “[A]t the time of writing [Jan. 2008], the United States appeared to be poised on the brink of recession….A coming recession may be more severe and long-lasting than the last one in 2001….”   By May 2008 I had figured out that a recession was indeed probably underway– at a time when some Administration officials were still ruling it out and indeed GDP figures appeared to show positive growth in the first part of that year.   

Banking crisis resolution       When the Obama Administration announced its revised form of the Bush Administration’s Troubled Asset Relief Program, I argued that maybe they actually knew what they were doing and that the plan should be given a chance to work.  (March 23, 2009.)  I felt pretty isolated.  Others attacked the plan, from both left and right.  They expected Tim Geithner’s stress tests to be phony.  The critics were sure that the taxpayer would end up paying hundreds of billions of dollars to bail out the banks.  They wanted either to nationalize the banks or leave everything to the free market.  As things developed, however, financial collapse was averted without nationalization and the banks have since repaid the Treasury with interest.   

The trough      Financial markets stabilized in the first half of 2009.  Turnarounds in the rates of growth and job loss led me to believe in the summer of 2009 that the economy had probably hit bottom by then.   This turns out in fact to have been the case: The record shows that the recession ended that June.

Predictions gone wrong          Needless to say, I got plenty wrong in the decade as well.   For one thing, I kept expecting U.S. long-term interest rates to rise, because of the alarming long-term fiscal profile. Yet the bond market correction never came.   For another thing, based on econometric estimation of reserve currency holdings, Menzie Chinn and I projected that the euro might eventually rival the dollar in international currency use by 2015 or 2022.    It now seems unlikely.   I certainly thought that the sort of financial crisis that began in the U.S. in 2007-08 would be accompanied by a fall in the dollar.  Yet flows into the U.S. showed that the dollar is still a safe haven.  For this reason I abandoned my euro-bullishness, even before the mismanaged Greek crisis in early 2010.

My most spectacularly wrong predictions were all in the area of politics.  I had thought that if any presidential candidate gained the White House without winning the popular vote, his entire term would be consumed by divisive efforts to reform the Electoral College.   (This did not happen after January 2001.)   I had thought that if a high-casualty international terrorist attack hit the U.S. (September 11, 2001), American foreign policy would thereafter become ruled less by jingoism and more by expertise.  (Not!)   In 2008 I suspected that a Democrat who was perceived as a northern liberal could not be elected president.   (Wrong again.)  

In the coming decade, I resolve to eschew political forecasts, and stick to economics.

[Comments can be posted on the Belfer site.]

     Robert Zoellick put a few sentences about gold toward the end of a column in today’s FT that are drawing a lot of attention.   I doubt very much if the World Bank President has in mind a return to the gold standard, but goldbugs and critics alike are talking as if he does.

      Even if one placed overwhelming weight on the objective of price stability — enough weight to contemplate a rigid straightjacket for monetary policy — gold would not be a suitable anchor.   The economy would be hostage to the vagaries of the world gold market, as it was in the 19^th century:   suffering inflation during periods of gold discoveries and deflation during periods of gold drought.   This is well-known.   I am confident Zoellick understands it.   (He and I were in the same macroeconomics seminar at Swarthmore College in the 1970s.)

      I think he is making another point.  The world is moving away from a monetary system in which the dollar is the overwhelmingly dominant international reserve asset.  The dollar’s share of international reserves has been declining ever since Richard Nixon unilaterally ended the Bretton Woods system in 1971.   The dollar’s unique role is not an eternal god-given constant of the universe, any more than it was for pound sterling.  The US currency of course replaced the pound in the first half of the 20^th century, with a lag of 25 years or more after the US surpassed the UK economically.

      Will some asset replace the dollar, then?  No, not a single asset.  But we are probably moving to a system where there will be as many as a half dozen international reserve assets.  First, there is the euro.  Despite the serious troubles facing it this year, the euro has been a competitor for the dollar since it came into being 11 years ago.  Both the yen and the Swiss franc have to some extent played safe haven roles during the last three years of global financial turmoil.  The pound is not out completely.   Some day the renminbi will be added to the roster of major international currencies, when China’s financial markets are sufficiently developed and open.    Even the SDR (special drawing right) came back from the dead in 2009.

      And, yes, gold too has re-joined the world monetary system.  Gold was seen as an anachronism as recently as a couple of years ago.  The world’s central banks had been gradually selling off their stocks.   But all that changed in 2009.  The People’s Bank of China, the Reserve Bank of India and other central banks in Asia have bought gold.  Understandably, they want to diversify their reserves.    It appears that central banks have stopped selling gold even among advanced countries and that aggregate gold reserves have risen over the last year.   This is a multiple reserve asset system.      

[For those interested in gold and other mineral commodities, I have some relevant writings.  Others' views on Zoellick are at the New York Times.]

The field of International Monetary Economics is not without its own cycles and fads.

In a speech at the European Central Bank over the summer, “On Global Currencies,” I identified eight concepts that I saw as having recently “peaked” and eight more that I saw as newly rising in relevance. Those that I viewed as losing traction were: the G-7, global savings glut, corners hypothesis, proliferating currency unions, inflation targeting (narrowly defined), exorbitant privilege, Bretton Woods II, and currency manipulation. Those that I saw as receiving increased emphasis now and in the future were: the G-20, the IMF, SDR, credit cycle, reserves, intermediate exchange rate regimes, commodity currencies, and multiple international currency system.

A condensed version appears this month in Finance and Development, from the IMF, titled “What’s ‘In’ and What’s ‘Out’ in Global Money.”  I boil the list down to five concepts that I pronounce “on the way out” and five more that I see as replacing them:

• The G-7 has been rendered largely obsolete by its lack of representation of developing countries, and thus in the course of 2009 has been overtaken by the G-20.

• The corners hypothesis had become conventional wisdom by the end of the 1990s. This was the idea that all countries were or should be abandoning intermediate exchange rate regimes (bands, baskets, crawling pegs, adjustable pegs, and heavily managed floats) in favor of either the floating corner or the institutionally fixed corner (currency boards, dollarization, or monetary union). Since 2001 the tide has turned against the corners hypothesis, and far fewer economists would now assert it as a sweeping generalization.  Certainly a huge fraction of the members of the IMF continue to follow intermediate regimes.

• The language of “unfair currency manipulation,” has been in US law since 1988 and the IMF Articles of Agreement for longer. China during the years 2004-2008 was pretty much the first large country to face charges of unfairly manipulating its currency to keep it undervalued. But US Congressmen who have for years urged China to abandon its link to the dollar could well live to regret it, if they were to get their way and the People’s Bank of China did in fact stop buying US treasury bills. It is finally beginning to sink in among Americans that having China as its largest creditor carries with it some new constraints.  What concept is “on its way in,” to replace the idea that intervening to prevent one’s currency from appreciating is anathema?   Reserves.  Two short years ago, Western economists were lecturing surplus countries that they were acquiring too many reserves.  Today we see that the developing countries that have weathered the 2007-09 crisis the best are countries that had previously piled up the most reserves, other things equal.

• Most controversially, I assert that Inflation Targeting — narrowly defined, I hasten to add — has seen its best days. The definition of IT I have in mind is the proposition that the monetary authorities should set a target range for the increase in the CPI each year, and then should focus all their efforts on hitting it. This orthodoxy says that the central bankers should pay no attention to asset prices, the exchange rate, or commodity prices, except to the extent that they carry implications for the CPI. For large rich countries, it has become clear since 2007 that Alan Greenspan was wrong when he (plausibly) abjured all attempts to identify or discourage bubbles in real estate and stock markets. As a result, the credit cycle view of monetary policy has been resurrected , after a long period when only inflation was thought to matter. For smaller and developing countries, I would also argue that volatility in commodity prices has made it clear that monetary policy should let currencies depreciate, at least somewhat, when the terms of trade worsen, rather than the opposite as is implied by a strict interpretation of CPI targeting. For them, I would propose replacing the CPI target with a more production-oriented price index, such as a target for the PPI or even an export price index.

• The United States has benefited throughout the post-war period by an unlimited ability to borrow in dollars. A popular view two years ago, supported by some of the best scholars, was that the US had earned the dollar privilege by establishing a unique comparative advantage in supplying a saving-glut world with high-quality assets. Then the sub-prime mortgage crisis in 2007 revealed that US assets were not so high-quality after all. The dollar did retain the benefit of being the safe haven currency in 2008, as an exorbitant privilege — contrary to the predictions of those of us who had predicted that the unsustainable current account deficit would lead to a large depreciation. Nevertheless, some developments in the course of 2009 have suggested a global movement away from the unipolar dollar standard, and toward a new multiple international reserve system. These events include the gradual rise of the euro as an international currency to rival the dollar, the sudden and unexpected resurrection of the SDR from near-death, new interest in the yen and gold as safe haven assets (including among central banks), and the very first glimmerings of an international role for the RMB.

[Any readers wishing to post comments are referred to the Seeking Alpha version.]

The current visit of Secretary Tim Geithner to Beijing once again shines the spotlight on the Renminbi (RMB) and on demands by US politicians that the People’s Bank of China (the country’s central bank) abandon the peg to the dollar.  

Throughout the period 2003-2008, I, as some others, have thought that demands from American politicians of both parties that China loosen the dollar link have been misguided in a number of particulars.    They were misguided in thinking that an appreciation of the RMB would, alone, do much to boost US output or employment.  The demands were especially misguided in putting such high priority on the entire exchange rate issue, given that we need China’s help on more important things, such as preventing a nuclear-armed North Korea.   But my arguments during this period might reasonably have been viewed by non-wonks as quibbles.   After all, I did agree, along with a majority of other economists, that an increase in the flexibility of China’s exchange rate would be a good thing.

Now, in 2009, the situation has changed in some important ways.   Continued demands from American congressmen that China should stop intervening in foreign exchange market to keep the RMB fixed against the dollar have become especially foolish.  This is because of two developments over the last year.   

The first development: in mid-2008, the top leaders in China decided to abandon the policy they had followed in 2007 – which had consisted of the long-desired evolution away from  the dollar peg and the placing of a substantial weight on the euro.  They changed horses in mid-stream:    After mid-2008 they returned to their old policy  of a fairly close peg to the dollar (similar to 2005-06).   Evidently the motivation for the return to the dollar was complaints from Chinese exporters who had lost competitiveness in 2007 as the euro and therefore the new basket appreciated against the dollar.  (Barry Naughton, 2008, gives a glimpse inside politburo politics.)  

Why, then, are American congressmen wrong to complain that the return of the dollar link has given American firms an additional price disadvantage in world markets?   The first reason on the list is that over the last year, the euro (surprisingly) depreciated against the dollar.  In other words, at precisely the moment when the RMB jumped back on the dollar horse, the dollar horse and the euro horse changed directions vis-à-vis each other.  If the Chinese authorities had kept the (loose) basket policy of 2007 instead of switching back to the dollar peg in 2008, the value of the RMB would be lower today, not higher, and dollar-based producers would be at a more of a competitive disadvantage, not less.

The second development is that, in early 2009, the stratospheric rate of rise of China’s foreign exchange reserves fell abruptly.  In some months, the PBoC actually lost reserves.   This means that an increase in exchange rate flexibility – in the extreme case, a move to floating – under current conditions might not result in an appreciation of the RMB, and might even result in a depreciation.  Again, that does not correspond to what the congressmen actually want, nor to the public opinion that they represent.

In the near future, we could see a return of substantial surpluses on China’s overall balance of payments and a return of the 38-year trend dollar depreciation.   In that case, intervention would once again imply suppressing RMB appreciation against the dollar.  But that leads us to the third point.

The third development, this spring, is the appearance in the dollar’s garden of the first “red shoots.”   Red as in deficits and red as in China.   For decades, the United States has been able to count on foreigner investors, and in a pinch foreign central banks more specifically, to buy dollars to finance US current account deficits.   In recent years, the PBoC has been the lead facilitator, piling up $2 trillion in reserves, most of it in dollars (the estimate is 70%).  Many argued that the United States could continue to enjoy this “exorbitant privilege” indefinitely.   But during the past two months we have seen the first signals that this might not continue forever.   The possibility that rating agencies might eventually downgrade US debt is in the air, and US longer-term interest rates have finally begun to rise. 

The most telling warning shots have come from Chinese officials.   Premier Wen in April expressed worry that US Treasury securities would lose value in the future;  that required an unprecedented public assurance from President Obama.   Then PBoC Governor Zhou in May proposed replacing the dollar as an international currency, with the SDR.   Another official told Americans that his countrymen “hate” having to hold a currency that they believe will lose value in the future as it has in the past.  Interpreted separately and literally, each of these statements raises interesting economic questions worthy of extended discussion.  Taken together, they constitute a simple wake-up call for oblivious Americans.   The message is that we are heavily and increasingly dependent on China to buy our treasury securities, at a time when big budget deficits lie in America’s recent past (the big debt that Obama inherited from George W. Bush), in America’s present (the record budget deficits caused by the current recession), and in America’s future (rising medical costs and the retirement of the baby boomers), .   If they and other Asian and commodity-exporting countries stop buying our treasuries, the result would almost certainly be a hard landing for the dollar.  I define a dollar hard landing as the combination of a big fall in its value together with a big increase in US interest rates.  The outcome might be stagflation.

As a general proposition, it is somewhat obtuse to make strident demands on one’s biggest creditor without taking any consideration of the change in the power relationship that debtor status entails.   It is especially obtuse to make the demand that the Chinese stop buying dollars, at the same time as we depend on them continuing to buy dollars to finance our deficits.    But demanding that they stop buying dollars is precisely what we have been doing for six years, every time we respond to trade concerns by demanding that they stop intervening to prevent the RMB from rising.

Fortunately, Secretary Geithner’s April decision not to declare China guilty of unfair currency manipulation, in Treasury’s semi-annual report, suggests that he understands the subtleties of the situation.   Now if those congressmen would just learn some economics…

[Any readers wishing to post comments are referred to the RGE Monitor version or Seeking Alpha version of this post.]

Tags: basket, China, dollar, exchange rate regime, renminbi, Schumer-Graham, ShangJin Wei, yuan
Posted in Asia, China, emerging markets, exchange rates, the dollar | Comments Off