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.

     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 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