Peggage

Commenter Junkfarm asks:

Noah: Knowing next to nothing about economics, let me ask you: what is the economic rationale in having a foreign country peg their currency to the dollar?

Well, that's a good question, and the short answer is nobody knows (the other short answer is read Brad Setser's blog).

First off, there are two types of countries that peg their currencies to the dollar - 1) oil exporters (mostly in the Middle East), and 2) China.

As for why the oil exporters peg to the dollar, I honestly have no idea. It might be that if oil prices suddenly collapse (as they occasionally do), a dollar peg would allow the oil exporters to avoid a big drop in consumption (because their currency would then be overvalued). The downside is that if oil prices spike, they get massive inflation (because their currency is then undervalued and it's harder for them to buy imports). That's what's happening now, and so the Gulf countries are thinking of dropping their peg (Problem with doing that? To keep a peg, you have to buy lots of assets of the country you peg to, so the Gulf countries will take a big hit on those assets if they drop the peg).

China is the more interesting case. Some people say China's dollar peg is a form of "vendor finance" - lending the U.S. and Europe cheap money so we'll buy more of their stuff, propping up employment in the export sector and avoiding civil unrest. Others see China's peg as a way of avoiding a financial crisis like the one that hit Asia in 1997 - those countries had massively overvalued currencies, which then collapsed, so by keeping their currency undervalued, the Chinese can avoid that particular disaster. Others, like Dani Rodrik, think that intentionally undervalued currencies are the key to rapid economic growth.

The downsides of China's peg are the same as for the Gulf countries - 1) inflation, and 2) the danger of taking big losses on all the reserves (U.S. bonds) that you have to hold to keep your currency pegged. So far, Chinese inflation has been contained by a ton of poor people moving from the farms to the city, and offering their labor for dirt-cheap prices. But with rural surplus labor starting to run out, that counterbalancing effect may be on the way out, which is one reason Chinese inflation is now a moderate 7-8% instead of the low 0-3% it had been in recent years. And if China drops its peg now to fight inflation, all those U.S. bonds it's holding will suddenly be worth a lot less.

That's the basic conventional view. So what do I think? I think there's two other forces at work besides those already mentioned. First, I think policymakers tend to "cross the river by feeling for the stones" (a Chinese expression, actually), and if a peg seems to work for a while, politicians will be reluctant to drop it. The second reason is that all those trillions of dollars of U.S. bonds sitting in Chinese government vaults gives China a lot of political leverage over its biggest rival.

Does that diatribe dissolve your dilemma, Junkfarm?