Monday, July 25, 2005

So you wanna revalue the yuan?

Related previous post: Why China won't let the dollar slide too far

China announced Thursday that it will no longer peg the yuan to the dollar -- at least, not peg it as tightly. It's about a 2% appreciation in the yuan's value, from a tight band around 8.28 yuan to one dollar, to a looser band around 8.11 (up to .3% swing in daily trading). The alternative was the odious bill introduced by Senators Schumer and Graham, with enough support to override a veto: a 27.5% across-the-board tariff on Chinese exports to the U.S. if China didn't revalue the yuan higher. Are Schumer and Graham really this willing to sacrifice the American consumer for their economically ignorant politics? Tariffs don't work, not even to save domestic jobs.

Unfortunately there was too much support for the Schumer-Graham bill, enough to override a veto (assuming Bush would risk alienating voters who don't realize tariffs destroy more domestic jobs than they save). At least China saved face and both economies with this token gesture. David Malpass wrote in his latest National Review Online column that this is unlikely to have a big effect on U.S. trade with China, or even on the composition of China's foreign exchange reserves. Let's take China-U.S. trade in May 2005 (the latest month for which we have data) as an example. Chinese exports to the U.S. totalled $135.542 billion; U.S. exports to China totalled $76.116 billion (630 billion yuan). Had the yuan been pegged at the new 8.11 value, then all else being equal, Americans would have had to spend $138.4 billion to buy the same goods, while the Chinese would have had to spend only 617 billion yuan.

So yes, strengthening the yuan vis-a-vis the dollar will help bring China-U.S. trade into "balance," but do we really want that? Forcibly reducing the so-called "trade deficit" (which is nothing to worry about) will reduce American consumers' standard of living: they'll either spend more for the same Chinese goods, or spend the same on fewer Chinese goods. The former will ripple through the domestic economy as Americans will have to cut back on domestic goods and services, or on saving, which will eventually result in reduced employment (whether hours or layoffs) and reduced business investment (because of reduced savings).

The latter will boomerang when the Chinese, stung by that drop in income, must cut back on their purchases of U.S. goods and Treasury securities. That will hit the U.S. all over: workers who produce goods exported to China, the federal government that needs China to finance much of its latest budget deficits, and every American individual and business who borrows. (Low interest rates in the U.S. are not just because of Federal Reserve action, but because China is helping to prevent "crowding out" by lending so much money to the federal government.) During the resulting economic slump, Americans would cut back on spending, including on Chinese goods, which starts a new round. Each succeeding cycle is not quite as bad as the preceding one [edit: originally I said "slightly worse" when I meant to indicate the cycles are dwindling with each generation], so the "death spiral" will eventually end, like converging series in calculus. Still, a severe tariff, like the 1930 Hawley-Smoot Tariff or the Schumer-Graham bill, will impoverish everyone before the shocks are finished.

We can therefore dismiss outright the idea of fixing the trade deficit by devaluing the dollar. The gap with China is so wide that bridging just half of it requires that the dollar would have to massively depreciate vis-à-vis the yuan; that would cause catastrophes on both sides, then all over the world. And the Chinese may not buy more American exports just because they've become cheaper. Consider this: let's say that your grocer cut a particular item's price from $1.50 to $1, because his supplier cut the wholesale price. That doesn't necessarily mean you'll buy three items now when you only bought two before. We must factor in the buyer's marginal propensity to consume, and Steve Antler pointed out that the Chinese have an MPC of only 45 cents. "The rest is saved. Mostly here."

Larry Kudlow recently debunked the notion that free trade requires floating exchange rates: "In the U.S., the 50 states comprise a free-trade zone based on the dollar. Economist Arthur Laffer reminds me that New York and Mississippi may incur trade surpluses or deficits with each other, but they do not change the value of the dollar. This works very well." However, the usual trolls on his blog have vandalized his latest entry on the yuan, saying he can't be pro-market if he supports fixed exchange rates. The truth is that they are not mutually exclusive, and the critics don't realize that fully floating exchange rates would certainly result in an even weaker yuan. China buys many dollars to peg the yuan, but it then deposits those dollars in U.S. Treasury securities, which back its wreck of a banking system. Left up to floating exchange rates, the yuan would collapse, and China would experience massive capital flight.

The "Impossible Trinity" in macroeconomics is that a nation cannot simultaneously have independent monetary policy, free capital flows and fixed exchange rates. It can have any two, but not all three; choosing any two makes the third impossible. As the world's main economy and trading partner to nearly everyone, the U.S. needs its own monetary policy, and the free capital flows that facilitate foreign commerce and eventually prosperity. The strength of its economy makes floating exchange rates the least important of the three. China, on the other hand, is a developing economy full of growing pains, and sovereignty over its own monetary policy is not as important as a fixed exchange rate. Free capital flows are a must for China, obviously. Pegging the yuan to the dollar means it has adopted U.S. monetary policy, as Kudlow pointed out, and it also softened the Asian Crisis' impact on the Chinese economy.

Stephen Roach, unsurprisingly, welcomed the strengthened yuan as "unambiguously positive for the global economy," with repeated references to "the global adjustment process", "global rebalancing" and "massive imbalances." Roach can be a good corporate economist with some excellent insights, but as I've written before, he "complains incessantly" about global imbalances. I believe these imbalances aren't inherently bad, and I believe it's imbalances themselves that make it possible for economies to progress. What do entrepreneurs and arbitrageurs do, but recognize opportunities in an imbalanced economy?

Certainly some imbalances can't be sustained forever and will have to stop eventually, but Herb Stein specifically made his Law against those who argue we must take steps to stop them. Free market forces will stop them on their own, and if we try intervention, the cure can be as bad as the disease. Those wanting to intervene to "fix" the U.S. trade deficit warn that if nothing is done, we'll have higher inflation, higher interest rates and possibly crises in our banking system and stock markets. Yet the options of devaluing the dollar, present the very same problems.

A few years ago I'd have agreed with Roach, that the dollar needed a massive devaluation to be "in line" with other world currencies. I'd have even agreed with the more extreme position of Chuck Schumer, Lindsey Graham and other politicians, that China "unfairly" devalues its currency (though Roach has said currency is not how China competes). Back in college, I once argued that in a paper. Fortunately, Dr. O'Cleireacain, my senior thesis advisor, set me straight after he noticed I was starting to harp on the yuan.

But if you're a politician, attacking China and outsourcing will earn you points with voters. You can count on willing media like the New York Times and Washington Post to propagate the myth, especially with sprinkled anecdotes of American shops having to close because of "Chinese competition." The reality is that China needs the peg to maintain its own economic stability, which is in our interest too. And fooling around too much with the yuan's value for the sake of politics can wreak economic havoc on both sides -- not to mention it's part of trying to fix the non-problem problem of the trade deficit.

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