My preceding blog-post discussed the process whereby the undervalued renminbi and large Chinese trade surplus have begun to adjust in earnest, over the last three years.

        The adjustment in the Chinese trade balance is reminiscent of Japan with a 30-year lag, like other aspects of the US-China relationshkp (though not all).  Japan’s balance of trade in goods and services went into deficit in 2011, for the first time since 1980.  Special factors have played a role in the last year, including high oil prices and the effects of the tsunami in March 2011.  But the downward trend in the trade balance is clear.   Even the current account temporarily showed a deficit in January.  (Because Japan has long been the world’s largest creditor, a large surplus in investment income is usually enough to change any trade deficit into a surplus on the overall current account.)

           This development has received relatively little attention in the United States.  This is curious in the respect that two decades ago the Japanese trade balance, which then was in substantial surplus, was the subject of intense focus and worry.  At the time, some influential foreign commentators warned that Japan had discovered a superior model of “the capitalist developmental state,” featuring strategic trade policy among other attractions, and that the rest of us had better emulate them.  Either that or the Japanese were cheating and we had better stop them.  

          Most economists did not share the views of these “revisionists,” but argued rather that the trade balances were determined by macroeconomics: Japan’s current account was so high because its national saving rate was so high.  The best explanation for the high Japanese saving rate, in turn, was not cultural differences or government policies, but rather demographics.  The Japanese population was relatively young then compared to other advanced economies, but it was rapidly aging, as the result of a decline in the birth rate since the 1940s and an increase in longevity.  In 1980, 9% of the population was age 65 or older; now this ratio is more than 23%, one of the very highest in the world.   As a consequence, Japanese citizens who 30 years ago were saving for their retirement are now dissaving, precisely as economic theory predicted. (E.g., Horioka, 1986, 1992.)    Household saving has declined from 14% of disposable income twenty years ago to 2%.   The trade and current account balances have now come down as well.    

       The downward trend in Japan’s saving rate and trade balance illustrate again that the laws of international economics eventually work, even in Asia.

[This post, and the one preceding it, were together published as an op-ed by Project Syndicate.]

 References

Jeffrey Frankel, 1993, “The Japanese financial system and the cost of capital,” in Japanese Capital Markets, edited by Shinji Takagi (Basil Blackwell Inc.): 21-77.

Charles Yuji Horioka, 1992, “Future trends in Japan’s saving rate and the implications thereof for Japan’s external imbalance,”  Japan and the World Economy, Vol. 3, Issue 4, April: 307-330.

        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.

Obama’s slogan for the SOTU last night, “An Economy Built to Last,” was a way of referring to one of the accomplishments of his first years: successfully reviving the auto industry, which many had said couldn’t be done without nationalizing it.   References to other accomplishments were stated more quickly, such as national security (withdrawal from Iraq, disposing of Osama bin Laden) or more obliquely, such as health care reform, financial reform, and arresting the freefall of the economy that Obama inherited in January 2009 (via fiscal stimulus and TARP - both of which are not especially popular programs).

I realize of course that some will not view these as true “accomplishments.”  They will argue that we should have let the auto industry go bankrupt, or should have spent another 10 years in Iraq, or that bin Laden was deprived of his human rights, or that the Dodd-Frank bill went too far in financial regulation (or not far enough), or that a federal effort to reduce unnecessary hospital infections constitutes “socialism” or “death panels.”  But most Americans wanted these policies.

Evidently the President also has in mind reducing American dependence on imported oil.  And slowing the big rise in income inequality, in part by allowing to expire on schedule the tax cuts on the top earners like Mitt Romney that ten years ago brought their tax rates down to 15%.

To me, the phrase “built to last” suggests that the medium-term goal is economic growth that resembles the record expansion of the late 1990s, which was driven by expanding exports, technology, and private sector employment. This would be an improvement over the unsustainable finance-based economic expansion of the 2002-2007, or those of the 1960s, 70s or 80s;  they were built on easy monetary or fiscal policy and an expanding government sector, and thus contained the seeds of their own destruction when inflation, debts and asset prices got out of control.

Indeed, as inadequate as the current economic recovery has been, the expansion of private sector jobs over the two years has exceeded the rate during the Bush Administration (when the government sector was the primary source of what limited job creation there was).  This comparison holds even if one excludes the two recessions at the beginning and end of the 8-year Bush period, as the graph shows.

[TV clip, Post Mortem on the State of the Union Message," BNN," 2012.]

Libyans have a new lease on life, a feeling that, at long last, they are the masters of their own fate. Perhaps Iraqis, after a decade of warfare, feel the same way. Both countries are oil producers, and there is widespread expectation among their citizens that that wealth will be a big advantage in rebuilding their societies.

Meanwhile, in Africa, Ghana has begun pumping oil for the first time, and Uganda is about to do so as well. Indeed, from West Africa to Mongolia, countries are experiencing windfalls from new sources of oil and mineral wealth. Adding to the euphoria are the historic highs that oil and mineral prices have reached on world markets over the last four years.

Many countries have been in this position before, exhilarated by natural-resource bonanzas, only to see the boom end in disappointment and the opportunity squandered with little payoff in terms of a better quality of life for their people. But, whether in Libya or Ghana, these countries’ current leaders have an advantage: most are well aware of history, and want to know how to avoid the infamous natural-resource “curse.”

To prescribe a cure, one must first diagnose the illness. Why do oil riches turn out to be a curse as often as they are a blessing?

Economists have identified six pitfalls that can afflict natural-resource exporters: commodity-price volatility, crowding out of manufacturing, “Dutch disease” (a booming export industry causes rapid currency appreciation , which undermines other exporters’ competitiveness), excessively rapid resource depletion, inhibition of institutional development, and civil war.

Oil prices are especially volatile, as the large swings over the last five years remind us. The recent oil boom could easily turn to bust, especially if global economic activity slows.

Volatility itself is costly, leaving economies unable to respond effectively to price signals. Temporary commodity booms typically pull workers, capital, and land away from fledgling manufacturing sectors and production of other internationally traded goods. This reallocation can damage long-term economic development if those sectors are the ones that nurture learning by doing and fuel broader productivity gains.

The problem is not just that workers, capital, and land are sucked into the booming commodity sector. They also are frequently lured away from manufacturing by booms in construction and other non-tradable goods and services. The pattern also includes an exuberant expansion of government spending, which can result in bloated public payrolls and large infrastructure projects, both of which are found to be unsustainable when oil prices fall. If the manufacturing sector has been “hollowed out” in the meantime, so much the worse.

Another pitfall is excessively rapid depletion of oil or mineral deposits, in violation of optimal rates of saving, let alone preservation of the environment.   

Even if high oil revenues turn out to be permanent, pitfalls nonetheless abound. Governments that can finance themselves simply by retaining physical control over the oil or mineral deposits located within their borders often fail in the long run to develop institutions that are conducive to economic development.  Such countries evolve a hierarchical authoritarian society where the only incentive is to compete for privileged access to commodity rents. In the extreme case, this competition can take the form of civil war. In a country without resource wealth, by contrast, elites have little alternative but to nurture a decentralized economy in which individuals have incentives to work and save. These are the economies that industrialize.

What can countries do to ensure that natural resources are a blessing rather than a curse?  Some policies and institutions have been tried and failed. These include, in particular, attempts to suppress artificially the fluctuations of the global marketplace by imposing price controls, export controls, marketing boards, and cartels.

But some countries have succeeded, and their strategies could be useful models for Libya, Iraq, Ghana, Mongolia, and others to emulate. These include: hedging export earnings - for example, via the oil options market, as Mexico does; ensuring countercyclical fiscal policy - for example via Chile’s kind of structural budget rule; and delegating sovereign wealth funds to professional managers, as Botswana’s Pula Fund does.

Finally, some promising ideas have virtually never been tried at all: linking bonds to oil prices instead of dollars, to protect against the risk of a price decline; choosing Product Price Targeting as an alternative to either inflation targeting or exchange-rate targeting, to play the role of anchor for monetary policy; and distributing oil revenues on a nationwide per capita basis, to ensure that they do not wind up in elites’ Swiss bank accounts.

Leaders have free will. Oil exporters need not be prisoners of a curse that has befallen others. Countries can choose to use their resource bonanzas for the long-term economic advancement of their peoples.

[This column originally appeared at Project Syndicate.  Comments can be posted there.]

Under French President Nicolas Sarkozy’s leadership, the G-20 has made addressing food-price volatility a top priority this year, with member states’ agriculture ministers meeting recently in Paris to come up with solutions. The choice of priorities has turned out to be timely: world food prices reached a record high earlier in 2011, recalling a similar price spike in 2008.

Consumers are hurting worldwide, especially the poor, for whom food takes a major bite out of household budgets. Popular discontent over food prices has fueled political instability in some countries, most notably in Egypt and Tunisia. Even agricultural producers would prefer some price stability over the wild ups and downs of the last five years.

The G-20’s efforts will culminate in the Cannes Summit in November. But, when it comes to specific policies, caution will be very much in order, for there is a long history of measures aimed at reducing commodity-price volatility that have ended up doing more harm than good.

For example, some inflation-targeting central banks have reacted to increases in prices of imported commodities by tightening monetary policy and thereby increasing the value of the currency. But adverse movements in the terms of trade must be accommodated; they cannot be fought with monetary policy.

Producing countries have also tried to contain price volatility by forming international cartels. But these have seldom worked.  

In theory, government stockpiles might be able to smooth price fluctuations, releasing commodities in times of shortage and adding to stocks when prices are low.   A free-marketer will point out that they can undermine the incentive for the private sector to hold stockpiles.  A valid response is that this incentive is undermined regardless, because political economy never allows “hoarders” to “price gouge” in times of food crisis.    It all depends on how stockpiles are administered.  The record in practice is not encouraging.

In rich countries, where the primary producing sector usually has political power, stockpiles of food products are used as a means of keeping prices high rather than low. The European Union’s Common Agricultural Policy is a classic example – and has been disastrous for EU budgets, economic efficiency, and consumer pocketbooks.

In many developing countries, on the other hand, farmers lack political power.  Some African countries adopted commodity boards for coffee and cocoa at the time of independence. Although the original rationale was to buy the crop in years of excess supply and sell in years of excess demand, thereby stabilizing prices, in practice the price paid to cocoa and coffee farmers, who were politically weak, was always below the world price.  In response, production fell.

Politicians often seek to shield consumers through price controls on staple foods and energy.  But the artificially suppressed price usually requires rationing to domestic households. (Shortages and long lines can fuel political rage as well as higher prices can.). Otherwise, the policy can require increased imports in order to satisfy the excess demand, and so can raise the world price even more.

If the country is a producer of the commodity in question, it may use export controls  to insulate domestic consumers from increases in the world price. In 2008, India capped rice exports, and Argentina did the same for wheat exports, as did Russia in 2010.

Export restrictions in producing countries and price controls in importing countries both serve to exacerbate the magnitude of the world price upswing, owing to the artificially reduced quantity that is still internationally traded. If producing and consuming countries in grain markets could cooperatively agree to refrain from such government intervention, working through the World Trade Organization, world price volatility could be lower.

In the meantime, some obvious steps should be taken.  It is too bad that the G20 attempt to do away with bio-fuel subsidies has failed, so far. Ethanol subsidies, such as those paid to American corn farmers, do not accomplish policymakers’ avowed environmental goals, but do divert grain and thus help drive up world food prices. By now this should be clear to everybody. But one cannot really expect the G-20 agriculture ministers to be able to fix the problem. After all, their constituents, the farmers, are the ones pocketing the money. The US, it must be said, is the biggest obstacle here.

What the G-20 farm ministers — meeting for the first time June 23 — have agreed is to forge an Agricultural Market Information System to improve transparency in agricultural markets, including information about production, stocks, and prices. More complete and timely information might indeed help.

But speculation is not necessarily destabilizing. Sarkozy is right that leverage is not necessarily good just because the free market allows it.  And that speculators occasionally act in a destabilizing way. But speculators more often act as detectors of changes in economic fundamentals and provide the signals that smooth fluctuations. In other words, they often are a stabilizing force.

The French have not yet been able to obtain agreement from the other G-20 members on measures aimed at regulating commodity speculators, such as limits on the size of their investment positions. I hope it stays that way. Shooting the messenger is no way to respond to the message.

[This op-ed appeared via Project Syndicate.  Comments can be posted at that site.]

         My last blog post listed some policies and institutions with which various small countries around the world have had success — innovations that might be worthy of emulation by others.  Of course there are plenty of other examples of policies and institutions that have been tried and that are to be avoided.    The area of agricultural policy is rife with them.   Many start with a confused invoking of the need for “food security.”

          The recent run-up in wheat prices is a good example.   Robert Paarlberg wrote an excellent column in the Financial Times recently, titled “How grain markets sow the spikes they fear.”   Grain producing countries point to the high volatility of prices on world markets and the need for food security when imposing taxes on exports of their own grain supplies, or outright bans, as Russia did in July.    The motive, of course, is to keep grain affordable for domestic consumers.  But the effect of such export controls is precisely to cause the price rise that is feared, because it removes some net supply from the world market.    (The same could be said when grain importing countries react to high prices by enacting price controls, because that adds some net demand to the world market.)   

            The current run-up in grain prices is reminiscent of the even higher spike in food prices in 2008.   As Paarlberg argues, many of the other explanations that were put forward for that episode don’t fit this time.   The importance of export controls is now clearer.

            In 2008 Argentina imposed export tariffs to prevent its grain farmers from taking advantage of high world prices.   (This case seemed particularly irrational in that, unlike the usual case, the strongest political pressures came from the growers, not the consumers.)    At the same time, on the other side of the world, India put on export controls to prevent its rice farmers from selling their product on world markets to take advantage of high rice prices.   Controls imposed by Argentina, India, and others were important contributing factors to the global spike in food prices.

            Are governments indeed being completely irrational?   The commodities we are talking about are staples in the consumption of ordinary households.   For simplicity, let’s assume it is an absolute constraint that governments cannot allow grain prices to go above a certain threshold.    Perhaps there will be riots in the streets otherwise.  In this case might it make sense to put on export controls when the price threatens to go above that level?   One can see the motivation in the short run.   But, thinking in the long run, across complete cycles, controls are not a good answer.  

            One can imagine various sensible long-term policies that might assure that this constraint is not violated, such as stockpiling, although in practice many policies sold as “food security” are not in fact applied in a sensible way.

            One solution may be for major countries that are active in the market for wheat or rice to get together and agree not to impose controls.   The result would be to stabilize prices: no more alternation of price spikes and price collapses.  Each country could then rely more on the world market to cover shortfalls than it can now, when trade is made less dependable by the threat of controls by others.   The case of rice controls was nailed in a paper on food security written last year by two students in Harvard’s MPAID program (Masters in International Development), Naoko Koyama Blanc and Diva Singh.  In their model, it can indeed under certain conditions be rational for India to follow the practice of imposing controls when the price goes up, under a regime where volatility is high because others impose controls.  But it would be more rational for India to negotiate a no-controls regime with other countries, because under that regime volatility would be lower, the controls would not be needed, and everyone would be better off.   

The National Journal asks for reactions to a recent blog post by Greg Mankiw regarding the reasons why US investment has fallen sharply. 

I agree with Greg that the dominant empirical fact about investment is its procyclical volatility (the main reason investment has been depressed for the last two years is that the economy has been depressed), and also that the recent credit crunch made it worse.   But I don’t agree with a third item on his list: “the policy environment seems adverse to business.”   As in many areas, it is when we get to the politics that I disagree. 

Greg cites trade policy, fiscal imbalances, and energy costs, in support of his proposition that the current policy environment is anti-business.    Let’s consider each of the three.

Trade.  I wasn’t happy in September when the White House put tariffs on imports of Chinese tires.  But President Obama, despite the pressures of the most severe recession since the 1930s, has yet to succumb to any protectionist measures as big or as blatantly in violation of international trade agreements as were Ronald Reagan’s quotas on Japanese auto imports or George W. Bush’s tariffs on steel imports, in response to the 1981-82 and 2001 recessions, respectively.  (Greg, of course, was the Chair of Bush’s Council of Economic Advisers.)

Budget.   Most of us think that the $787 billion fiscal stimulus and the distasteful banking rescues were necessary responses to the recession.   But let’s address the serious question of the bleak longer term fiscal outlook. It is known to those who look carefully at the budget numbers that Obama’s recent actions are a distant 4th on the list of contributors.   (OMB, CBO, GAO and respected private economists.)   #1 in the long term (by far) are the future costs of Social Security and Medicare, the approach of which we have been watching for several decades.    #2 are the effects of Bush’s tax cuts and spending increases (including foreign wars and the expansion of Medicare benefits, among other things).    Substantially smaller is #3, the loss of tax revenues from the recession that began December 2007.   A distant #4, as I say, is the recent fiscal stimulus.  (The banking layouts are being repaid, usually with a high return for the Treasury – as the Administration had predicted, to critics’ ridicule.)   I believe that as the recovery becomes better established Obama will, as he says, take much more serious steps than his predecessor in the direction of long-run fiscal consolidation.   But only time will tell. 

Energy costs.  Greg Mankiw in fact believes that a system of energy taxes or cap-and-trade would increase the efficiency of the economy, even though it would raise the relative price of energy.  (This is all the more true if the comparison is to past policies of subsidizing oil and other fossil fuels.)   Greg founded the Pigou Club on this principle, and I heartily congratulate him for it. 

I am skeptical that investment is currently depressed by perceptions of an anti-business climate.    But if the average businessperson does in fact have the perception that recent Democratic administrations have been worse for business than Republican administrations, I suggest setting aside campaign rhetoric and looking at actual history.   Start with the fact that, in the graph in Greg’s blog post, investment growth was substantially higher during the Clinton Administration than during the Reagan or Bush Administrations.   Investment will recover when the economy does.

The international press reports, “At Climate Talks, Danger to Free Trade Mounts.”

The Copenhagen negotiations have essentially failed to include, among the many topics covered, one that will be critical in the coming years:   the question of import tariffs or other trade penalties that individual countries apply against the products of other countries that they deem too carbon-intensive.    Such border measures are already in EU and US legislation (the Waxman-Markey bill, not yet passed by the Senate).    Properly designed, they could turn out to be the missing instrument needed to get each country to cut emissions without fear of others taking unfair advantage, via leakage.   More likely, national politics will turn them into protectionist barriers.

Actions taken multilaterally would probably make the difference as to whether border measures are used for good or ill.  Here is my personal ranking of five possible scenarios.

1. Best choice — a system of multilateral sanctions as part of a new “Copenhagen Protocol” or other treaty, following the precedent of trade sanctions in the Montreal Protocol on Stratospheric Ozone Depletion.

     2.   Next-best choice — national import penalties adopted under multilateral guidelines:

• (i) Measures can only be applied by participants in good standing.
• (ii) Judgments to be made by technical experts, not politicians.
• (iii) Interventions in only a ½ dozen of the most relevant sectors.

   3. Third-best choice — no border measures at all.

   4.  Fourth choice — each country chooses trade barriers as it sees fit.

   5.  Worst choice: national measures are subsidies to adversely affected firms, which may take the form of free emission permits (as is contemplated in EU provisions).    These do nothing to limit carbon leakage.  They function simply as bribes to those industries lucky enough to receive them, in return for political support.

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.]

          We often hear the question “isn’t this economic crisis becoming as bad as the Great Depression?” Economists can offer a variety of reassurances, but each of them is quite circumscribed:
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