Wednesday, November 18, 2009

Paul Krugman On Chinese Currency Policy

Before I continue, I should immediately say (to pre-empt misunderstandings) that I think China should make the yuan stronger. Not however, for the reasons most pundits argue but rather because China needs to rein in the obvious inflationary excesses of their current boom, and currency appreciation would be one way of achieving that.

And furthermore, yuan appreciation would reduce the political pressure for barriers against Chinese imports.

However, the arguments used by many pundits to argue for Chinese currency appreciation are very misleading and dangerous. Case in point is Paul Krugman's latest column. Almost all of his columns and blog posts contain errors, and I don't have the time or will to try to correct them all. But the latest one was unusually misleading even for being Krugman.

First he writes:

"Some background: Most of the world’s major currencies “float” against one another. That is, their relative values move up or down depending on market forces. That doesn’t necessarily mean that governments pursue pure hands-off policies: countries sometimes limit capital outflows when there’s a run on their currency (as Iceland did last year) or take steps to discourage hot-money inflows when they fear that speculators love their economies not wisely but too well (which is what Brazil is doing right now). But these days most nations try to keep the value of their currency in line with long-term economic fundamentals.

China is the great exception."

First of all, while it is true that today, most major currencies float against each other, quite a lot of countries throughout the world pegs their currency against other currencies (Usually the U.S. dollar or the euro), including for example Hong Kong, Saudi Arabia and a lot of European countries. And during many periods in world history, for example during the classical gold standard or during the Bretton-Woods system, fixed exchange rates have been the rule. Fixed exchange rates are in other words definitely not something the Chinese just came up with, it was the standard system for most of the time since start of the Industrial Revolution.

And since exchange rates aren't affected by just direct measures to affect the exchange rates, but also by for example interest rate policy, floating exchange rates aren't really market based. Only a pure gold (or other commodity) based currency can be entirely market based.

Nor are they ruled by "economic fundamentals" (whatever that is supposed to mean), as is evident by for example the fact that weak economic reports in America usually leads to a stronger dollar (and that stronger reports usually leads to a weaker dollar).

Furthermore, while the yuan may be pegged to the U.S. dollar, it has in fact been floating against all other currencies (well, except others that are pegged to the USD) in the exact same way as the USD. The yuan appreciated dramatically late last year and early this year against most currencies, and has since depreciated against most currencies.

Moving on to the next paragraph:

"And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.

What makes China’s currency policy especially problematic is the depressed state of the world economy. Cheap money and fiscal stimulus seem to have averted a second Great Depression. But policy makers haven’t been able to generate enough spending, public or private, to make progress against mass unemployment. And China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters."

What Krugman overlooks is first of all that the dollar, and also the yuan, is still generally stronger than when China ended the yuan's appreciation against the dollar, meaning that compared to the beginning of that policy shift, the yuan has appreciated against most currencies.

And secondly, and more importantly, because the dollar and the yuan have moved up and down in the same way, any accusation against China holds for the United States as well. If China has pursued a "beggar-thy-neighbor devaluation" policy then so has the United States.

Krugman later discusses the recent increase in the trade deficit:

" Looking forward, we can expect to see both China’s trade surplus and America’s trade deficit surge.

That, at any rate, is the argument made in a new paper by Richard Baldwin and Daria Taglioni of the Graduate Institute, Geneva. As they note, trade imbalances, both China’s surplus and America’s deficit, have recently been much smaller than they were a few years ago. But, they argue, “these global imbalance improvements are mostly illusory — the transitory side effect of the greatest trade collapse the world has ever seen.”

Indeed, the 2008-9 plunge in world trade was one for the record books. What it mainly reflected was the fact that modern trade is dominated by sales of durable manufactured goods — and in the face of severe financial crisis and its attendant uncertainty, both consumers and corporations postponed purchases of anything that wasn’t needed immediately. How did this reduce the U.S. trade deficit? Imports of goods like automobiles collapsed; so did some U.S. exports; but because we came into the crisis importing much more than we exported, the net effect was a smaller trade gap.

But with the financial crisis abating, this process is going into reverse. Last week’s U.S. trade report showed a sharp increase in the trade deficit between August and September. And there will be many more reports along those lines."

Krugman tries to imply that the great drop in the trade deficit was simply a matter of falling trade volumes, but that is not true. Between May 2008 and May 2009 (the month with the lowest trade deficit) exports dropped 21% and imports 31%. The truth is that the drop in the trade deficit reflected the sharp drop in domestic demand.

And similarly, the increase in the trade deficit since then reflects largely the effect of the so-called "stimulus package". While Krugman's Keynesian models won't recognize that fiscal stimulus will reduce net exports (meaning increase trade deficits in the case of America), that is what happens in the real world, reducing the so-called "fiscal multipliers" significantly below the fantasy levels indicated by Keynesian models. And in case you wonder, trade barriers wouldn't really improve thse "fiscal multipliers" because while it would reduce the trade deficit increasing effect, it would on the other hand increase the price increasing effect.

So, while a stronger yuan would be in China's best interest because it would contain domestic inflation and foreign protectionism, it wouldn't help improve the American economy or job market.