First, Matthew Slaughter of Dartmouth fired off a broadside in the WSJ (reproduced free of charge thanks to Greg Mankiw). His thesis: The yuan peg doesn't matter. Why? Because it's only a nominal exchange rate, and nominal exchange rates don't affect real trade.
Mankiw (Harvard) and the University of Oregon's Mark Thoma quickly agreed.
But anonymous econ blogger KNZN just as quickly fired back. He pointed out that China isn't just trying to control the exchange rate, it's trying to control inflation at the same time. That means China actually can control its real trade surplus - although to do so, it has to buy U.S. government bonds in massive and ever-increasing amounts.
Brad DeLong (Berkeley) agreed, and took it one step further: the current system, where China controls its exchange rate and buys U.S. bonds, has to end, and when it does, we'll get either massive inflation in China, a massive fall in the dollar, or "something more unpleasant." DeLong railed Slaughter for "assum[ing] that the problem doesn't exist then...conclud[ing] we don't have a problem."
Meanwhile, China reporter Richard McGregor wrote in the Financial Times about why it's very hard for China's leaders to actually change their policies. China's leaders are basically trying to control about five or six different things at once - exchange rates, bank deposits, foreign exchange reserves, inflation, foreign capital inflows, and bank lending. Those things, of course, are all related in complicated ways. So far, China's been able to keep the system going, but at the expense of its bazillions of workers - China actually creates fewer jobs than Brazil, even as inequality is skyrocketing.
The ever-verbose Brad Setser agreed, and warned ominously that these trends are only going to get worse in the next couple of years. China's trade surplus will get bigger and bigger, the Chinese government will keep building up more and more dollars, Chinese inequality will keep increasing, U.S. debt will keep going up, China's stock market (bubble) will keep charging upward, the U.S. trade deficit will keep skyrocketing, and who knows where it'll end?
(Note: Setser is verbose in the good way...)
In the Financial Times, economics editor Martin Wolf writes along the same lines - Asian economies (in particular, China) decided after the financial crisis of '97-'98 that undervalued exchange-rates and economies based on exports and investment were the safest path. That financial crisis happened because, basically, governments didn't have enough foreign exchange reserves to keep their exchange rates high. But what if today's Asian governments at some point can't accumulate enough reserves to keep their exchange rates low? Wolf promises to give his answer in his next column...
But Cleveland Fed researcher David Altig at macroblog isn't worried about that inevitable adjustment. At some point, he says, inflation will rise in China and force them to drop the yuan peg. Why, he asks, is that so worrisome?
Angry Bear blogger PGL says that China's peg isn't the real cause of our trade deficit anyway, it's that darn Bush budget deficit that's the problem.
Update: Greg Mankiw says that, while he believes (unlike Slaughter) that China can hold down its real exchange rate, he thinks that their doing so provides pure benefit to the United States. How? By letting us borrow money cheaply (from China's central bank), and by letting us buy lots of cheap Chinese stuff. China, he says, is only hurting itself.
Bonus round: If you just can't stop reading about China policy, check out this debate between economist Stephen Roach of Morgan Stanley and Desmond Lachman of the conservative American Enterprise Institute.
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