Recently, a rising chorus can be heard in the U.S. accusing China of “manipulating” the value of the RMB. In a recent op-ed, Krugman characterized Chinese policy as an “anti-stimulus” to the rest of the world. In an editorial op-ed, the NY Times staff accused China of playing a “beggar-thy-neighbor competitive devaluation” that is “threatening economies around the world … fueling huge trade deficits in the United States and Europe … [and] crowding out exports from other developing countries, threatening their hopes of recovery.” 130 Congressman sent letter to the Obama administration urging Obama to take action against the yuan.
In response, China has denied that its policy has caused harm to the world. In contrast, China has argued that a stable Yuan is a major factor that has kept the world from economic free fall today. The trade imbalance between the U.S. and China is caused more by stringent U.S. export restrictions than the value of the yuan.
I am not going to go over every economic theory there is about international trade (there are so many), but will make a few observations.
Has China been pursuing an unfair currency policy?
I do not think so. The value of the Yuan is currently fixed to the Dollar by the Chinese government. This is not intrinsically unfair. As a recent Wall Street Journal explained, there is no “free market” “fair” evaluation of currency as there is for consumer or commodity goods. The value of currencies are controlled by various central banks that in turn control the supply of currencies from around the world. According to the Wall Street Journal:
President Obama has picked up this theme, calling last week for Beijing to adopt “a more market-oriented exchange rate” that “would make an essential contribution to that global rebalancing effort.” Less diplomatically, 130 Members of Congress sent a letter to Treasury this week demanding that unless China lets the yuan rise in value, the U.S. should impose tariffs on Chinese goods. Just what the world needs: a trade war.
At the core of this argument is a basic misunderstanding of monetary policy. There is no free market in currencies, as there is in wheat or bananas. Currencies trade in global markets, but their supply is controlled by a cartel of central banks, which have a monopoly on money creation. The Federal Reserve controls the global supply of dollars and thus has far more influence over the greenback’s value than any other single actor.
A fixed exchange rate is also not some nefarious economic practice rare in human affairs. From the end of World War II through the early 1970s, most global currency rates were fixed under the Bretton-Woods monetary system created by Lord Keynes and Harry Dexter White. That system fell apart with the U.S.-inspired inflation of the 1970s, and much of the world moved to “floating rates.”
But numerous countries continue to peg their currencies to the dollar, and with the establishment of the euro most of Europe decided to move to a fixed-rate system. The reason isn’t to get some trade advantage against their neighbors but to gain the economic benefits of stable exchange rates—and in some cases a more stable monetary policy. A stable exchange rate eliminates a major source of uncertainty for investment decisions and trade and capital flows.
While the value of currencies is in large part controlled by central banks from around the world, private speculative trading can also greatly influence the value of currencies – at least in the short-term, as occurred in the Asian Financial Crisis of the late 1990’s. Currencies become akin to stocks – or commodities like gold or silver. Their values can be speculated up or down, with devastating effects on people, trade and the global economy. When the Asian Financial Crisis hit, there were no calls for “market valuation” of the yuan, only gratefulness that China kept its yuan stable.
There is no one answer regarding whether a fixed or a floating exchange rate system is better. At times, fixed currencies work better to foster international trade. At other times, a limited floating system (which is what the U.S. has) work better. But whatever the system, the end goal has always been to stabilize currency to foster international trade.
I don’t mind arguing about what the exchange rate between the RMB and Dollar should be, but reflexively arguing the merits of fixed vs. floating in terms of fair vs. unfair, good vs. evil, or right vs. wrong makes little sense to me.
What about purchase power – isn’t the Yuan undervalued in terms of purchasing power?
More recently, China has been accused of pursuing a “beggar-thy-neighbor” policy. Many in the U.S. have accused China’s currency to be severely undervalued. According to the Economist Big Mac Index, the yuan is alledgedly undervalued by as much as 49%.
This is absurd! According to Prof. McKinnon of Stanford, using the same index, the RMB was supposed to be “properly valued” in terms of purchasing power as of 2009, and now in 2010, the RMB is undervalued by as much as 49%???
[Aside: The Economist’s Big Mac index evaluates the value of currencies by comparing the price of MacDonald Big Macs sold in various currencies in markets around the world. The reality is however that so many other things go into the pricing of a Big Mac – including local taste, market segmentation, etc. I don’t think you should calculate the exchange rate of a currency – value of entire economies – based on price of a Big Mac!]
The truth is that in general there is no easy way to calculate the fair value of currency based purchasing power – even amongst developed economies. As Prof. McKinnon explained:
In a world of fluctuating exchange rates, nobody can have any accurate idea of what is a fair or “equilibrium” level for the exchange rate. … In economies open to foreign trade, Cassel suggested that, on average, exchange rates should line up so that country A’s currency has the same purchasing power over a representative basket of goods and services as that of country B.
In poor countries with low wages, the prices of nontradable goods and services (such as haircuts) are much lower than the prices of nontradables in wealthy (high wage) countries— even though the prices of highly tradable goods such as textiles and automobiles are similar. So one dollar will have greater purchasing power in a poor country. But how much lower is “normal”?
Using data from more than one hundred countries, researchers at the University of Pennsylvania have made such a calculation by pricing out a common “international” basket of goods in each currency. They found that, at prevailing exchange rates, poor countries do have much lower price levels. But the data collecting is so onerous and expensive they can only construct “The Penn World Tables” once every ten years!
Forces having little to do with purchasing power can also influence the value of a currency – even “free-floating” ones like the Yen – as described in this economist article (requires subscription).
In the case of China, not only is comparing purchasing power against developed economies hard, it may actually not be conceptually possible for now. As this McKinsey report explains, China is still undergoing many basic reforms in its economy (land reform, reform of the energy sector, state-owned-enterprise reform, social welfare, among others). Until those reforms are complete, the price of many goods and services in China is not easily convertible. Any index derived from prices in China taken blindly on face value is sure to be meaningless.
Is the U.S. trade deficit with China a symptom of an undervalued yuan?
Most economists (as do leaders in China) understand that overall balance of account between nations is important for a sustainable global trade environment. But as I explained in an earlier post, deficit in balance of account between nations is caused by differences in investment and savings rates between economies, not the exchange rate.
Consider this basic thought exercise:
Suppose the Chinese yuan were to become cheaper by 50%, what would happen to the trade deficit?
1. Would the deficit decrease by half, with Americans buying exactly what they bought before and pocketing the savings from China’s currency devaluation?
2. Would the trade deficit remain the same as before, with lavish consumers consuming twice as much as before, consuming all the savings arising from China’s currency devaluation?
3. Would the deficit increase, with Americans buying more than twice as much goods as before?
I do not know the answer (the answer probably lies somewhere between the first and second scenario), but the point is not to answer which scenario would occur, but to contemplate the point that unless Americans are able to change investment / savings rate on an aggregate level, trade deficit is not going to change. As Prof. McKinnon emphasized, “[e]conomists—and the politicians they indoctrinate—must discard the false theory that one can use changes in the exchange rate to control the net trade balance in a predictable way.”
The situation regarding trade deficit is made more complex when we discuss deficits amongst groups of nations. China has trade deficits with South Korea, Japan, Latin America and 58 less-developed countries. When we have multilateral trade, bilateral trade deficit is not per se bad. Depending on the trade relationships amongst countries, it is possible for certain bilateral economies to register persistent trade deficits even though for each country the balance of accounts against the world is more balanced.
Has China been trading unfair?
Protectionist sentiments have been on the rise in the U.S. recently, with acrimonious accusations levied against China for not trading fair. The spat over China’s currency exchange rate is but the latest manifestation.
But the fact of the matter is that China and U.S. are at very different stages of economic developments. Even if the whole of the Chinese economy operates using the dollar only, many things will still appear inherently unfair.
People in China (and across the developing world for that matter) work more for less pay. Average wage in China is some 1/10 of that in the U.S. The labor standards, environmental standards, and social safety networks in China are all weaker than that in the U.S. Even between developed nations, differences in labor standards and fiscal policies (involving subsidies, currencies, etc.) between European nations, Japan and the U.S. still lead to regular trade disputes.
Does this mean the U.S. should disengage from international world – or at least reduce trade with developing nations like China until they come to the same standard as the U.S.?
I don’t think U.S. should disengage from globalization in the name of unfair wages or devalued currencies. There are costs and benefits to being a low wage country with an inexpensive currency. It is China’s prerogative to decide what role it wants to play in the global economy. I’d be flabbergasted if China is really pursuing a policy of purposely devaluing its currency. Why would any nation voluntarily want to devalue itself over an extended amount of time to be a slave to others? The path to riches is to move up the wage ladder, not down. I’ve never heard of a story of a pauper bootstrapping its way to riches by depressing its wages.
Whatever role China chooses to occupy in the international trade system, China will have certain advantages and disadvantages, and so will the U.S. People should not forget that the U.S. is still sole super power in the world and has advantages in people, technology, and infrastructure that no other country can match. The U.S. needs to start acting like itself again, instead of bickering about how unfair the world is.
We learn most about ourselves in harsh times. Differences will always exist in the world. Will we rise to see the inevitable differences amongst us to be a source of collective strength or will we find excuses to disengage from each other?