The best thing that happened to the world economy in 1933 was that FDR sharply devalued the dollar against gold. Prices and output started rising rapidly, and the US began to suck in a lot more imports from the rest of the world. Our trade surplus got smaller. Even better, this policy inspired other countries to devalue as well. Paul Krugman knows all this, and often cites FDR’s actions with approval.
The best thing that happened to the world economy this year, indeed just about the only good thing, was the V-shaped recovery in Asia, almost certainly led by China. This recovery was aided by the Chinese government’s decision to stop appreciating its currency. The Asian growth spurt was also a major factor behind the recovery in the US, which began in asset markets in March and spread to the real economy a few months ago (although we need a much faster recovery.) Paul Krugman does not seem to know this, indeed he is now arguing that the Chinese need to reverse the very policies that provided green shoots to the world economy in the dark days last winter. Here is what Krugman has to say:
Although there has been a lot of doomsaying about the falling dollar, that decline is actually both natural and desirable. America needs a weaker dollar to help reduce its trade deficit, and it’s getting that weaker dollar as nervous investors, who flocked into the presumed safety of U.S. debt at the peak of the crisis, have started putting their money to work elsewhere.
But China has been keeping its currency pegged to the dollar — which means that a country with a huge trade surplus and a rapidly recovering economy, a country whose currency should be rising in value, is in effect engineering a large devaluation instead.
And that’s a particularly bad thing to do at a time when the world economy remains deeply depressed due to inadequate overall demand. By pursuing a weak-currency policy, China is siphoning some of that inadequate demand away from other nations, which is hurting growth almost everywhere. The biggest victims, by the way, are probably workers in other poor countries. In normal times, I’d be among the first to reject claims that China is stealing other peoples’ jobs, but right now it’s the simple truth.
Do you see where Krugman goes wrong? He is mixing up two very different issues. One is the question of international payments accounts, which is a zero sum game. The other is the broader macro problem of a depressed world economy, which is anything but a zero sum game. Krugman is a very skilled macroeconomist, and it is rare to see him make this error. A cynic might argue it shows the increasing extent to which the General Theory is affecting on his analytical skills. But first we need to consider what is really going on here.
In 1933 FDR was not trying to depreciate the dollar against other currencies, he was trying to depreciate it against goods and services. Krugman and I agree that we should be trying to do the same today. But if the Chinese were to appreciate their currency they would be imposing deflationary monetary policy on their economy. Krugman might reply that China is not an open market and that the Chinese could sterilize any impact and thus prevent a deflationary shock to their economy. But is that really true? When the real Chinese exchange rate appreciated in the late 1990s (due to the SE Asian crisis, and the fact that the yuan was pegged to a strengthening dollar) China experienced a very unwelcome period of deflation, which slowed real growth quite sharply (and probably more than the official statistics showed.) They didn’t seem able to prevent this impact, despite the fact that they have exchange controls. After China joined the WTO in 2002 their economy took off, and by 2005 inflation was becoming such an acute problem (due to the Balassa-Samuelson effect combined with the dollar peg) that China decided to strongly appreciate the yuan. It was their only option for preventing a return to the high inflation of the early 1990s.
It is a mistake to think about exchange rate policy as trade policy, it is fundamentally a form of monetary policy. China’s current account surplus is driven by its high saving rate, and changing the nominal exchange rate won’t have any significant effect as long as the savings rate remains high. In fairness to Krugman, he might argue that part of that saving is Chinese government accumulation of foreign assets, and that he has in mind both a much stronger yuan and less government saving. But even if this were done the impact on the world economy would be trivial compared to the effect of monetary policies on aggregate demand.
When you think about exchange rates from a trade perspective, they seem like a zero sum game. If the dollar goes up the yuan goes down, and vice versa. But from a monetary perspective things look much different. It is possible for both the yuan and the dollar to simultaneously appreciate, or depreciate, against goods and services. For any given US monetary policy, a decision to appreciate the yuan is a decision to tighten monetary policy in a country whose PPP economy is $8 trillion dollars, and that means tighter monetary policy at the world level, and lower world aggregate demand.
A recent post by David Beckworth addressed an interesting “problem” facing countries trying to back out of the extremely loose monetary policies that have been adopted by almost all central banks. If they do so by raising interest rates then they risk an appreciation of their currencies, which could in turn depress their already weak economies. So is this a problem? Go back and look again at what I just wrote. Do you see the error that I (purposely) made? I said money is loose all over the world. But of course it isn’t—rather nominal rates are low. In fact, money is too tight almost everywhere. We need central banks to set higher NGDP growth targets (or inflation targets.) In my next post I plan to say good things about Krugman’s recent strong opposition to any move toward tighter money in the US. In fact I’d go further; tighter money would be a mistake almost anywhere in the world. So here is how I interpret the dilemma noted by Beckworth. US policy is still far too tight for reasons discussed in this post by Bill Woolsey; we are far below the NGDP trend line, even using a 3% trend. If other countries try to tighten a bit and their currencies appreciate, that is the forex market’s way of telling those governments: “You are making a mistake, 2% interest rates might seem an expansionary policy, but given the current position of the equilibrium Wicksellian real interest rate they are actually much too contractionary for your economy.”
Not only should China be trying to depreciate its currency, but almost all countries should be trying to do so—against goods and services. Fortunately, as Krugman points out the Chinese don’t have to do very much. Because of their rapid productivity growth, even holding their exchange rate steady is equivalent to depreciation in terms of its impact on aggregate demand. This is why China recovered first, and as it sucked in imports of commodities this demand shock started to spread beyond its borders. Forget about trade balances; look at commodity prices. China stopped the world spiral into deflation, and began raising the Wicksellian equilibrium interest rate after March 2009. It turned expectations around. That made US monetary policy slightly more expansionary, even at the zero bound, and began shifting expectations here as well. When China started to recover the tail risk of a deep world depression was essentially chopped off.
[Yes, China is now recovering briskly, so maybe a higher yuan would be appropriate at some point. But neither inflation nor NGDP growth is particularly high in China, and their export industries are still extremely depressed. It is up to the Chinese to decide when a stronger yuan would be appropriate to prevent excessive nominal spending. (And of course the bigger problem is how to transition to more activity in the countryside and private sector, and less in the bloated urban SOEs.)]
Because the growth that comes from rising AD strikes our intuition as a sort of “something for nothing” process, we are especially likely to fall into the mistake of thinking in zero sum game terms whenever examining international economic linkages. Common sense suggests that a low yuan cannot help both China and the rest of the world. One country’s trade balance improvement is offset by another’s deterioration. But when you remember that an exchange rate is also a price of money and that the price of money affects both domestic and world AD, things look much different. If during normal times the US suddenly adopted an ultra-tight monetary policy, then the US dollar would appreciate and we’d go into a deep recession. But the rest of the world wouldn’t boom, they’d also suffer an economic slowdown despite the fact that their currencies depreciated against the dollar. Indeed this is roughly what happened between the US and Europe last July through November, when the dollar was appreciating against the euro and US monetary policy had become highly deflationary. Just one more example of “the money illusion.” Krugman usually has razor sharp analytical skills; it is unusual for him to miss this point.
As Barry Eichengreen pointed out a few months ago, a series of competitive devaluations might be just what the world needs. (Just as it was exactly what the world needed in the 1930s.)