Epic blog war between Ryan Avent of The Economist and Paul Krugman of the New York Times!
First Krugman wrote this column urging the U.S. to brand China a "currency manipulator".
Avent, a long-time defender of the "softly, softly" approach to China, wasn't too thrilled with this currency hawkishness:
[Krugman's] view of what ought to be done is perplexing. First, he calls on the Treasury department to label China an official currency manipulator. I'm not sure why he believes that anyone in China or America is confused about what the Obama adminstration thinks of the dollar peg. They've been quite clear. I'm also not sure what effect this is supposed to have...
Mr Krugman is careful to explain why we shouldn't fear that China, as a major creditor, has the leverage to punish America, but it seems as though he has given no thought at all to what leverage America has over China. Neither does he seem to pay the least mind to the potential fallout from such a reckless rush to a more aggressive approach to China. Perhaps the decision to impose these surcharges will have the desired effect. Or perhaps, the Chinese government will retaliate, touching off a trade war at the worst possible economic moment. The potential upside to Mr Krugman's recommendation is trifling; the potential downside is massive.And Mr Krugman seems entirely uninterested in the domestic political constraints facing China's leaders. He doesn't consider for a second the possibility that a bullying strategy on America's part might make China less likely to do what the administration wants. Why on earth would a nationalistic nation anxious to establish itself as great power want to come off to all observers as a weakling in the face of American bluster? Mr Krugman would paint China into a corner, forcing them to take steps detrimental to all involved.
The general tone of his column—focused on toughness, insensitive to the internal politics of foreign nations, blind to potential negative outcomes, reckless and impatient—is familiar. It looks like nothing so much as the argumentation deployed by the Bush adminstration as it rushed to war in Iraq. Mr Krugman was prescient and prudent in fighting back against that misguided policy. He would do well to stop for a moment, take a deep breath, and think again before urging America to "take a stand", damn the consequences.
He should respect China enough to know that its leaders understand that RMB appreciation is in their interest. And he should be humble enough to understand that patience and reserve is far more likely to lead to his desired outcome than ill-considered sabre rattling.
Krugman was unhappy with the Iraq analogy, and unleashed mighty sarcasm:
But now that he mentions it, it’s true, it’s true! My case for action is entirely based on dubious claims made by unstable informants with code names like “Curveball”, questionable evidence about things like aluminum tubes, and obviously forged letters allegedly from Niger. The actual, public facts and figures I cited have nothing to do with it.
And the real tell is the fact that I’m closely following arguments made by rabble-rousers like Fred Bergsten and the Institute for International Economics, which, um, is a big supporter of free trade and international cooperation … but nonetheless is just like PNAC.
Oh, and I’m showing disrespect for China’s leaders by not giving them credit for understanding the need for appreciation, even though they consistently say that no change in the exchange rate is warranted. The respectful thing would be to assume that everything they say in public about the issue is a lie.
Avent, meanwhile, continued his attempted rebuttal of Krugman's policy stance:
Let me briefly rephrase my argument and see if I can't provoke a more substantive answer from Mr Krugman. I agree with him that there would be some benefit to China, America, and the rest of the world if China allowed its currency to appreciate against the dollar. But it seems to me that this benefit is easily overstated; both China and America can trace their current account situations to significant structural imbalances, and even without an end to the dollar peg, America's trade balance with China has improved and continues to improve through the recovery. It also seems to me that an aggressive American push for currency revaluation is unlikely to work, because China's government does not want to be seen, at home and abroad, as a weakling in the face of American pressure. And there is a not insignificant risk that America's decision to "take a stand", and particularly to pursue a series of trade surcharges, would provoke a trade war with China which, given the current feeble state of the global economic recovery, could prove extremely costly. The downside risk to such a policy is quite large relative to the potential upside from Chinese revaluation.
What's more, I think China understands that it is in its interest to revalue and will do so eventually. Why do I think this? Well, China was more than willing to revalue before the onset of the global recession. Mr Krugman hints that I am the one being disrespectful to China for not taking its leadership at its word when they say that no change in the RMB exchange rate is warranted. But this is par for the course where currency levels are concerned. In America, it's a time-honoured tradition for leaders in Washington to declare that a strong dollar is warranted, good, right, proper, and so on, despite the fact that this clearly isn't the case. I suppose we could say that they're fools or liars, but we generally just note that this is something they say because they feel it is in their interest to do so, for political and economic reasons. Meanwhile, it isn't as though it's been ages since a Chinese official hinted that RMB appreciation was just a matter of time.
Apparently, America could use China's help to rein in would-be nuclear power Iran. China, as a member of the United Nations Security Council and as Iran's biggest trading partner, seems to have some weight to throw around, diplomatically speaking. I bet if I thought really hard, I could come up with other areas where America needs a positive relationship with China. Sticking with international threat control, we could talk about North Korea. Or I might point out that China is now the world's largest emitter of carbon dioxide, and any deal to reduce the damaging effects of climate change must include an agreement with China as a willing partner.
If you're going to run the risk of alienating a country like China, you'd better have an extremely good reason for doing so. Not a likely-to-be-somewhat-beneficial reason. A really, really, extremely good reason. I'm still waiting to see some explication of why this particular stand is one America has to take—can't afford not to take. Citing China's trade surplus figures doesn't cut it. At present, the case for getting tough with China is riddled with holes.
Krugman, as requested, got extremely substantive:
I think it would be useful for me to explain how I think about the current China syndrome, and why I believe that most of the responses I hear are missing the point. In what follows, I’ll focus on three questions: the macroeconomics of Chinese currency intervention, the fallacies of elasticity pessimism (which I’ll explain when I get there), and the political economy issue of how to deal with Chinese intransigence.
1. Macroeconomics of intervention
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.
Although people don’t always think of it this way, what the Chinese government is doing here is engaging in massive capital export – artificially creating a huge deficit in China’s capital account. It’s able to do this in part because capital controls inhibit offsetting private capital inflows; but the key point is that China has a de facto policy of forcing capital flows out of the country.
Now, bear in mind the two basic balance of payments accounting identities:
Capital account + Current account = 0
Current account = Domestic savings – Domestic investment
By creating an artificial capital account deficit, China is, as a matter of arithmetic necessity, creating an artificial current account surplus. And by doing that, it is exporting savings to the rest of the world.
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.
Notice that I didn’t mention the value of the renminbi at all in this account. It’s there implicitly: a weak renminbi is the mechanism through which China’s capital-export policy gets translated into physical exports of goods. But you want to keep your eye on the ball: it’s the artificial capital exports that are the driving force here.
What this means, in particular, is that you can disregard people who offer calculations suggesting that by some criterion – say, Balassa-Samuelson adjusted purchasing power parity – the renminbi isn’t undervalued. We know that the renminbi is grossly undervalued, not through questionable estimates that can be endlessly debated, but on a PPE (proof of the pudding is in the eating) basis: the current value of the renminbi is consistent with massive artificial capital export, and that’s that.
2. Elasticity pessimism
One common response to demands for a rise in the renminbi is that it wouldn’t work: in the past a rising renminbi hasn’t reduced China’s surplus, the United States can’t produce the goods it now imports from China, etc..
People making these arguments may not know it, but they’re engaged in a modern version of the “elasticity pessimism” that was prevalent in the early postwar years, and used to defend the necessity of continuing foreign exchange controls. Then as now, the claim was that changing currency values would have little effect on trade flows, although back then it was used to argue against depreciations in deficit countries rather than appreciation in surplus countries.
There are several, mutually reinforcing answers to elasticity pessimism. The first is that if you think it through, it implies that the overall demand curve for a nation’s products is vertical or even upward-sloping. That’s possible in theory (income effects overwhelming substitution effects), but once you put it that way it seems highly unlikely.
The second is that we have lots of experience with currency depreciations – and they have invariably led to a rise in exports and the trade surplus. Consider the smaller East Asian nations in the aftermath of the 1997-1998 crisis, or Argentina after 2001, or even the United States after 2005, when the weak dollar set off an export boom. Is China really uniquely exempt from the rules that apply to everyone else?
Third, it’s really important not to get caught up in the fallacy of misplaced concreteness. If you can’t think offhand of ways U.S. production might replace imports, that’s probably because you just don’t know enough. There are already stories of “onshoring” as firms discover that overseas production isn’t worth the hidden costs; there would be many more if exchange rates were very different.
Fourth, it’s a mistake to focus only on direct China versus America competition. In many cases, Chinese exports compete with those of other developing nations. If the renminbi rises, those nations would become more competitive – and would also find their currencies appreciating against the dollar, offering new channels for onshoring. This may sound speculative, but it isn’t: remember, if China ends its artificial export of capital, that has to show up in trade flows one way or another.
Finally, don’t make too much of the lack of an obvious relationship between Chinese currency movements over the past few years and the trade balance. China is an economy in the process of rapid transformation – exactly the circumstances in which a real exchange rate that makes sense one year may be way off base just a few years later.
3. Political economy
The final argument I hear about the renminbi is that it’s useless to make demands, because the Chinese will just get their backs up, refusing to bow to external pressure. The right answer is, so?
Here’s how the initial phases of a confrontation would play out – this is actually Fred Bergsten’s scenario, and I think he’s right. First, the United States declares that China is a currency manipulator, and demands that China stop its massive intervention. If China refuses, the United States imposes a countervailing duty on Chinese exports, say 25 percent. The EU quickly follows suit, arguing that if it doesn’t, China’s surplus will be diverted to Europe. I don’t know what Japan does.
Suppose that China then digs in its heels, and refuses to budge. From the US-EU point of view, that’s OK! The problem is China’s surplus, not the value of the renminbi per se – and countervailing duties will do much of the job of eliminating that surplus, even if China refuses to move the exchange rate.
And precisely because the United States can get what it wants whatever China does, the odds are that China would soon give in.
Look, I know that many economists have a visceral dislike for this kind of confrontational policy. But you have to bear in mind that the really outlandish actor here is China: never before in history has a nation followed this drastic a mercantilist policy. And for those who counsel patience, arguing that China can eventually be brought around: the acute damage from China’s currency policy is happening now, while the world is still in a liquidity trap. Getting China to rethink that policy years from now, when (one can hope) advanced economies have returned to more or less full employment, is worth very little.
As I said in yesterday’s column, this has to stop.
And Avent responds gamely:
The question here is how much of China's excess saving can be attributed to the government's currency policy. The answer is: some. But that doesn't tell us that much...
And recall that from 2005 to 2008, the RMB appreciated by about a fifth. Other things equal, a dearer RMB would lead to less exported savings from China and a reduced current account deficit. But that doesn't mean no current account deficit. China has other, serious structural imbalances, like [the one-child policy that forces households to save more to provide for the elderly]...Revaluation won't make that go away...
I'm not arguing that there has been no effect to the RMB peg, and I'm not arguing that there would be no effect to revaluation. I'm merely arguing that the effect would be relatively small, given the other factors contributing to imbalances. [In the mid-2000s there was] no major shift in consumption's share of Chinese output despite a major episode of RMB appreciation...
From 2005, the dollar weakened steadily, which did lead to a big increase in exports. And yet, the American trade deficit held steady from 2005 to 2008, hovering around $60 billion. You can see why. Oil imports surged. So what does this suggest? That even when currency shifts are having their expected effect, other structural issues in the economy can swamp those impacts.
The point is that while there is certainly a relationship between China's capital-export policy and trade imbalances, that's not the only thing influencing trading patterns.
But still, other things equal, the world would prefer to see China let the RMB appreciate. But what can America do to generate this outcome?...This is a happy world, is it not, when Europe and America slap punitive import surcharges on China and China just sits there and takes it? What if China responds with tariffs of its own? What if it seeks to carve out its own regional trade bloc in Asia? What if it refuses to help America with Iran or North Korea? What if it occupies Taiwan? Where are the careful considerations of all the possible ways China might respond? Certainly we should be very aware of and concerned with these risks.
Especially since it was just one week ago that China central bank governor Zhou Xiaochuan said of the dollar peg that, "These kinds of policies sooner or later will be withdrawn."
So, to recap. In recent years, exchange rate shifts in China and America have not produced the changes in trade balances one might expect, suggesting that structural issues are an important reason for these persistent imbalances, further suggesting that the benefits of revaluation may not be that big. Meanwhile, despite China's currency policy, the Chinese trade balance has shrunk. An aggressive campaign to get China to revalue might not generate the desired results, and it might lead to unpredictable and costly retaliation from the Chinese government. And there is recent evidence that Chinese leaders are aware of the problems with the dollar peg and plan to adjust it, even in the absence of American action.
So why roll the dice? I appreciate Mr Krugman's discussion of the macroeconomic issues involved here, but he hasn't begun to address why it's vital to risk international comity over this.
Krugman expands on his point about the world being in a liquidity trap. Avent disagrees.
Meanwhile, Brad DeLong has studiously avoided taking a side, but has this post that's weakly in support of Krugman.
More recent: DeLong has a link to a video of a symposium where Krugman and others present the "get tough on China" case. Later, he links to Krugman's biggest post (still no commentary). Is this a sign that DeLong is tacitly coming around to Krugman's POV? I'm personally interested in the answer to this question, as DeLong is the blogger I trust most.
Martin Wolf has a column out that supports Krugman's position (which, in fact, Wolf has been advocating far longer than Krugman himself). Krugman adds:
As I read this debate, one thing that’s truly amazing is the way China defenders are recapitulating some old fallacies from, of all places, Latin America. Back in the 50s it was common for Latin economists to insist that getting realistic exchange rates wouldn’t solve their persistent balance of payments problems because imbalances were “structural” — now we’re hearing the same thing about China, with the only difference being that this time it’s a surplus, not a deficit, that is supposedly immune from the usual rules of supply and demand.
I’d also point out, without having time to track down the references, that the global macro aspects of the situation are reminiscent of the late 1920s, when the US was simultaneously insisting that European nations repay their dollar debts and that they not be allowed to export more to earn the dollars. That didn’t end well.
In response, Avent returns to the idea that the Chinese are keeping their currency undervalued for domestic political reasons. But Yglesias, surprisingly, agrees with Wolf, who argues that Germany is (almost) as mercantilist as China - apparently, angering the Germans is less of a worry for Matt than angering the Chinese.
Yglesias also thinks we should try printing a ton of money before we try imposing tariffs on Chinese goods. I agree with this. But really, whether we try one or the other depends on whether people are more afraid of hyperinflation or "protectionism"...and my guess is that people are, rationally or irrationally, more afraid of hyperinflation, making tariffs more feasible than massive money-printing.
Meanwhile, Arvind Subramanian reminds us that China's currency peg hurts other developing nations even more than it hurts the U.S., and recommends multilateral rather than unilateral efforts to force China to drop the peg.
Michael Pettis, in a very good (and very long) blog post, discusses the probable fallout from a U.S. decision to "get tough" on China's currency policy. Somewhat bizarrely, Avent praises this post, even though Pettis largely seems to agree with Krugman that china's currency policy is very bad for the U.S., that the U.S. could force China to revalue, and that a trade war wouldn't be very damaging to America under current economic conditions. Did Avent read the whole post?
Dan Drezner agrees with Avent that Krugman has become a "neocon". To me, this sounds a bit hysterical; when one side starts flinging insults, it's generally a good sign that they feel outmaneuvered on substance (see: Glenn Beck).
Here is a long blog post in support of Avent (which I think makes Avent's argument better than he does himself), and another in support of Krugman, with some numerical examples.
...(pant, pant)...
As readers of this blog will guess, I pretty much agree with Krugman.
First of all, I think Krugman understates the negative effects of China's currency peg in non-liquidity-trap (i.e. normal) times. Massive politically-motivated investment/saving/financial decisions, like China's surplus accumulation, massively distort financial markets, and enable giant bubbles and liquidity crises and disasters that "rational" (i.e. profit-driven) financial markets would be less likely to stumble into.
Avent, for his part, doesn't really address most of Krugman's numerous and well-argued points about the yuan peg being a very bad thing. His point about "structural imbalances" is mostly hand-waving (he'd do well to read up on the Balassa-Samuelson effect if he really wants to make this case). And his point about the 2005 yuan appreciation not reducing America's overall trade deficit ignores A) the fact that our trade deficit does usually decrease when countries let their currency strengthen against the dollar, B) Krugman's point about how things are different in a liquidity trap (i.e. a depression), and C) The fact that, on a trade-weighted basis, China's currency continued to depreciate against its trading partners even during 2005-2008. As for his argument that A) we're not in a liquidity trap, and B) it doesn't matter if we are in one...well, let's just say I trust the expert over the pundit on this point.
One gets the impression that he doesn't deeply understand the economics of the issue (not a first for The Economist's "economics" blog, sadly), and is mostly just thinking about the politics. Avent's argument is that trying to pressure China to revalue their currency will make them less likely to do so; however, in the mid-2000s, the U.S. did exert pressure on China, and they did revalue the yuan somewhat, so history seems to agree with Krugman. And as for the idea that angering China is something we must avoid at all costs...well, for reasons known and unknown, China already seems to be angry with us, so that ship seems to have sailed.
One interesting thing about this dust-up is that it represents the first big schism among the core of smart, thoughtful, economics-focused liberal bloggers that has risen to thought-leadership over the past few years (Krugman, DeLong, Yglesias, Klein, and Avent). The "don't anger the Dragon" viewpoint - i.e. that being friends with China trumps all other concerns - was stated early on by DeLong and has been the standard view among this set, but Krugman has decisively broken with this consensus. Let's see if he can win over any of the others...
The Senate, for its part, apparently agrees with Krugman (though a good deal of protectionist special-interest pressure is probably involved as well). The Economist, and the "we heart low labor costs" crowd are finding themselves with fewer and fewer allies.
Update: Here's another, more concise summary of the intellectual battle over China's currency.
Update: Stephen Roach suggests hitting Krugman with a bat. For reals. Krugman, to his credit, is polite and restrained in his response, but unfortunately doesn't go into the specifics of why increasing savings won't cancel out a currency peg (the reason is that currency pegs involve capital controls). Avent actually defends Krugman from Roach, arguing that China should drop its peg, but that tariffs are not the right way to make China do that.
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