One day after striking back at Ryan Avent, Paul Krugman posted another essay on the Chinese yuan, and this one’s actually very thoughtful. In the end I still don’t agree, but I think he makes his case much more effectively. We seem to mostly differ on how we interpret two issues:
1. Nominal GDP determination (or AD if you prefer that terminology) in the US, and in particular what should be held constant when thinking about policy options.
2. The disparity between East Asian and American savings rates, and who’s to blame.
Let me start with where we agree. Krugman says:
Let me start with a proposition: the right way to think about China’s exchange rate is, initially, not to think about the exchange rate. Instead, you should focus on China’s currency intervention, in which the government buys foreign assets and sells domestic assets, on a massive scale.
I strongly agree. Let me first talk about an easier case, and then come around to China later. The right way to think about Japanese CA surpluses is not to think about the yen, but rather to think about the fact that the Japanese save more than they invest. In my previous post I discussed how we kept pressuring the Japanese to appreciate the yen, to “solve” their CA surplus problem. They did keep appreciating the yen, but for a while they were able to keep running CA surpluses because the Balassa-Samuelson effect kept kicking in. That is, they had fast productivity growth in export industries, which allowed them to appreciate the yen in real terms and keep running surpluses. After the early 1990s growth slowed sharply. Without the B-S effect, the only way to offset the effect of a higher yen was deflation, which meant that although the nominal yen kept appreciating, the real exchange rate for the yen leveled off. Deflation was my fear for China in late 2008 and 2009, but I agree that that danger is now past. The B-S effect would allow China to appreciate the real yuan, and even maintain a large CA surplus. Indeed I predict they will allow some appreciation later this year.
But here is my first important point, the Japanese case shows that it is possible to be pessimistic about the effects of currency appreciation for reasons that have nothing to do with what Krugman calls “elasticity pessimism.” Recall my earlier post on supply and demand, I said something like “never reason from a price change.” Never start an argument “if the price increases . . . , or if the interest rate increases . . . , or if the exchange rate increases . . .” Always start with the underlying force causing the price change. And I am pretty sure that if Krugman read this and understood my argument, he would agree with me. That’s why he started off by saying the issue isn’t the yuan, it’s the Chinese government’s massive purchases of foreign exchange. And conversely I would agree with him that if the Chinese government stopped buying hundreds of billions in foreign bonds, the real value of the yuan would rise and the Chinese CA deficit would get smaller. So what about my reference to 40 years of a rising yen failing to solve the Japanese CA deficit. Was it a red herring? No, it wasn’t intended as being an application of elasticity pessimism (although I could understand people reading it that way) it was meant to show that the underlying issue is Japanese saving exceeding Japanese investment, and that artificially changing the nominal value of the yen won’t make the imbalance go away. Krugman’s best argument would be that Japan’s imbalance reflects private decisions by the public, whereas China’s reflects a deliberate mercantilist policy by the government. I’ll address that issue, but first I’d like to deal with one other problem, high unemployment in the US.
Here Krugman’s explanation of the liquidity trap and monetary policy ineffectiveness is slightly more nuanced than in the previous post:
In normal times, you could argue that this policy provides benefits to the rest of the world, by reducing borrowing costs (although given what we did with those capital inflows, maybe not). But these aren’t normal times. We’re currently living in a world in which both central banks and governments are unable or unwilling to pursue sufficiently expansionary policies to eliminate mass unemployment; so it’s a paradox of thrift world, in which anyone who tries to save more reduces demand, reduces employment, and – because investment responds to excess capacity – ends up actually reducing investment. By exporting savings to the rest of the world, via an artificial current account surplus, China is making all of us poorer.
OK, “unable or unwilling” is better than “unable.” But I’d prefer simply ”unwilling.” Still, I get his point. We don’t live in a perfect world, and we don’t have the more expansionary monetary policy that Krugman and I would both prefer. So what’s wrong with going after China as a sort of second best policy? Here’s why it rubs me the wrong way. First we are told that we must make all sorts of interventions in our financial system, and bail out GM and AIG, because otherwise we’ll have a depression. Or we need to run up trillion dollar deficits. When I suggest the real problem is not (mostly) subprime loans, but rather bad monetary policy that caused NGDP to fall at the fastest rate since 1938, people constantly throw up their hands and say “there’s nothing we can do about those stubborn central bankers.” So we have to adopt suboptimal financial system bailouts, auto bailouts, and massive deficits that will hurt our efficiency down the road, all because monetary policy isn’t doing its job. It like when you are at the zero bound all the laws of economics go out the window. We can justify all sorts of bailouts because we have to worry about declines in velocity (even though a forward-looking monetary policy can deal with falling velocity.) And we have to have big deficits because we’re told Bernanke won’t consider a 3% inflation target. And now we are being told we must risk a trade war. All because in the General Theory Keynes showed that in a liquidity trap mercantilist policies might actually “work” as beggar-thy-neighbor policies.
My response is that there are a million different shocks that could cause NGDP to fall. One is a financial crisis, another is trade. But we simply have to stop treating the symptoms of the problem and attack the root cause. It is the central bank’s job to keep NGDP growth at a slow but steady rate. If they don’t do their job I just don’t see how we can keep fixing the problem with all these second best policies, whether they are fiscal stimulus, bank bailouts, or threats of protectionism. As someone once said, “the problem with second best policies is that they are usually implemented by third best economists and achieve fourth best results.” If the central bank is doing its job, then Chinese policies that look mercantilist to the average voter or average politician, will be nothing more than a source of low cost capital for the US economy. And if they don’t do their job . . . well then one way or another we are in deep trouble, and don’t expect bank bailouts and trillion dollar deficits and trade wars with China to stop unemployment from rising to 10%. It’s like putting a band-aid on a deep knife wound.
So that’s the backdrop to my analysis of China’s trade policies, it’s not our problem, it’s their decision. But even so, is there any possible justification for their weak yuan policy, or is it just naked mercantilism? The honest answer is that I don’t know. I don’t doubt that export growth is one motivation for their policy, but I also think China’s critics are too quick to dismiss how their policies fit into a broader East Asian pattern of high saving rates.
Suppose China’s government began a new policy. They announced their government would spend $500 billion each year adding to their foreign reserves, but would no longer peg the yuan. Would that satisfy China’s critics? Probably not, as Krugman noted the real issue is the Chinese accumulation of dollars, not the exchange rate per se. If you are buying foreign reserves at a massive rate it is quite possible to lift exchange controls and let the currency float, and yet still end up with what most people would regard as an overvalued currency. So the real question is whether China is justified in holding large and increasing quantities of foreign reserves.
I’d like to point out that there are many commonalities between China and 5 other East Asian economies; Japan, Taiwan, HK, Singapore and South Korea. One of those similarities is that they all have huge stocks of foreign reserves. In per capita terms China’s CA surplus is by far the smallest of any of the six East Asian powerhouse exporters. The most recent data I could find in The Economist shows China’s CA surplus as $284.4 billion whereas the other five economies combine for a $286.7 billion surplus. So if Krugman is right, those five economies actually are doing more damage to the world economy than China, which has 7 times the population and a modestly larger (PPP) GDP than other other five economies.
Krugman might respond that the other five economies are fairly wealthy, and have very low birthrates, so it makes sense for them to save a lot. Their surpluses reflect the natural forces of their economy. China is a developing country, and like South Korea in the 1970s and 1980s might be better off running deficits, and borrowing against future income. There are many ways in which the government could use those funds to address domestic challenges. Instead they accumulate massive stocks of foreign exchange, which help neither us nor the Chinese people. I think that would be a respectable argument, but there are other considerations as well. China faces a looming demographic nightmare that Korea did not face in the 1970s. It is likely that in a few decades China will be much richer than today. The hundreds of millions of Chinese that will then be retiring will expect to be provided with decent pensions. Yet the Chinese social security system is woefully underfunded. You can make a strong argument that the Chinese government should be setting aside a lot of money right now, in light of the fiscal challenges that they will face in the future.
I would add that there seems to be a big difference between East Asian and Western attitudes toward saving. I think that there is a lot to be said for the high saving models developed by places like Singapore. Even though I am a libertarian, I’d much prefer the sort of high forced saving/low tax economy of Singapore to the low saving/high tax economy that we have in the West. Our fiscal situation reminds me of those guys who live week to week. Who say “I should be able to swing that vacation to South Beach as long as my transmission doesn’t blow out on me.” Yes, we should be able to just barely afford national health care as long as it doesn’t turn out to be much more expensive than expected, like Medicare turned out to be much more expensive than expected. And if things really get bad we can always add a VAT. Of course the Europeans already have a VAT, maybe they’re hoping some loose change will turn up under the cushions. Seriously, in about 20 years, when the West is struggling to deal with ever-increasing debts, I predict that the Singapore high saving/low tax model will look clearly superior to the Western model. So while there are many things I don’t like about the Chinese government, I am not willing to condemn them for setting aside a big pot of foreign exchange reserves. It’s their choice.
But let’s say I am wrong, suppose CA surpluses really do cause unemployment in the US. Should we put high tariffs on China, or on the gang of 5 smaller East Asian economies that collectively do even more damage? After all, those five countries are much richer and thus would suffer less in utilitarian terms from a US tariff. Krugman likes to mention that China’s surplus is one of the largest in world history, as a share of world GDP. But that’s only because China itself is very large. Suppose China split up and each province became a separate country (oops, there goes my check from the PRC.) Would we ignore their smaller surpluses the way we ignore Korea and Taiwan’s surpluses? I predict we would, and yet the geographic entity called “China” would still have the same impact on the world economy. So why single out China for punishment?
Here is an analogy. The average Chinese citizen emits about 1/4th the greenhouse gases that the average American emits. So they are much more responsible stewards of the environment than we are. Yet China has more than 4 times the US population, so their total emissions are slightly higher that US levels. Yet it would obviously be absurd for the US to put tariffs on Chinese goods because their total emissions were slightly higher–after all, our wasteful lifestyles are 4 times more carbon-intensive than theirs are.
Oh wait, I seem to recall that Krugman also recommended that China be singled out for a carbon tariff.
Do you see a pattern here? China is a very, very, big country. We all read about its 1.4 billion population, but I don’t know if that has really sunk in. It’s roughly the population of North and South America, and Western Europe, combined. The policies China adopts will have a bigger effect than the same policies pursued in smaller countries. We need to get used to the fact that we are living next to an elephant. That shouldn’t be so hard; the Canadians have been doing that for decades. I recently saw this line in someone’s blog:
It’s China’s world, we just live in it.
We haven’t quite reached that point, but we’re getting close. I get very frustrated when I read Western commentators talk about China as if they are addressing a naughty schoolboy. It’s not that they aren’t naughty at times, the problem is that there seems to be no awareness that it not “our world” anymore. These Asian countries shouldn’t be treated as children. We used to treat Japan the same way. The Economist recently pointed out that in 18 of the last 20 centuries more than half the world’s GDP was in Asia. And in a few more decades they will regain a majority of world GDP. Each year the world economy will look a little more like the typical Asian economy. Maybe it’s time we stopped lecturing them about saving too much, and ask ourselves whether we are saving too little.
PS. I just noticed that Krugman has another post, where he continues to claim that most of the world is in a liquidity trap. I strongly disagree with his view that the ECB is “trapped.” Yes, rates in Europe are pretty low, but they could be lower. The ECB is not refraining from a more expansionary policy because they aren’t able to, but rather because they don’t want to. Now you could argue that even if they cut rates to zero they would still be suffering suboptimal levels of AD. But the point is that they have interest rates exactly where they want them, they aren’t “trapped.” I agree that it is possible that Japan and the US and the UK might all want to do more, but even that isn’t certain. I recall that during the financial crisis the BOJ had a big debate about cutting rates by 0.25%, and compromised with a 0.20% cut. It’s funny how Krugman and I look at the same picture and see different factors as being essential. We both agree the major central banks are too reluctant to take unconventional steps, that they could in fact take. I take that as implying they aren’t trapped, Krugman focuses on the fact that conventional policies alone might not get the job done in countries where rates are pretty low. I focus on the fact that the ECB explicitly decided not to make rates even lower, and the US explicitly decided to pay interest on ERs. Refraining from paying interest in ERs would not be “unconventional,” rather the paying of interest was unconventional, and a contractionary unconventional policy.
Regarding the ECB, it is clear from their behavior during the crisis of late 2008 that interest rate bounds weren’t the problem, they did exactly what they wanted to do, which was to cut their target nominal rate at an agonizingly low speed.