...Archive for September 2006

Pegging Real Exchange Rates: A Synthetic Tariff?

Mystery-blogger knzn packs an avalanche of insights into a very brief discussion of why China’s policy of puchasing dollars to peg its nominal exchange rate has not led to real appreciation via inflation in China. knzn is quite critical of Charles Schumer and Lindsey Graham, who’ve written an op-ed in the Wall Street Journal (via Mark Thoma) today in defense of a proposal that amounts to a faint and distant threat of tariffs on Chinese goods. I am broadly sympathetic to Schumer and Graham’s proposal, despite considering myself a staunch free-trader, and I think their point largely stands, despite problems that knzn and Greg Mankiw highlight. I hope he will forgive me for abusing his insights in support of a position he may not much like. Here’s knzn:

China today is a special case for several reasons. First, there is a rapid flow of workers into the industrial sector, and this flow is helping to prevent the inflation that might ordinarily attend an undervalued currency. Second, much of China’s foreign exchange intervention is sterilized, which is to say, China is making attempts to slow down domestic sources of demand to compensate for the foreign demand occasioned by its weak currency. Third, China’s government is effectively running a very large surplus, which also tends to slow down domestic demand. Fourth, arguably, China is following policies that encourage a high level of private saving, which also tends to slow domestic demand.

knzn whizzes through this like it was nothing, but there’s a ton of interesting stuff here. knzn’s first reason is conventional wisdom, fine as far as it goes, and as the vowelless one notes, “if China has a lot of workers available to do these jobs, whereas the US has only a few (relatively speaking), why shouldn’t trade be set up to create jobs in China rather than the US?”

But knzn’s second point left me standing naked on the shoreline in wonder. Countries that manage their exchange rates are supposed to sterilize their interventions. It’s like Central Banking 101. If China’s central bank prints Yuan to buy dollars, it’s got to borrow some of those Yuan back to avoid flooding the market with newly printed Chinese bills, right? knzn is having none of it, and of course he’s absolutely right to note that sterilization is just a fancy word for what central banks do when they want to restrain domestic demand to avoid inflation. What I considered central bank prudence, knzn considers cheating, “[S]terilized intervention, might reasonably be considered an unfair trade practice (and probably a foolish practice as well).” Central banks may “naturally” want to prevent their exchange rate policy from causing inflation, but doing so in effect pegs the real, rather than nominal exchange rate. While pegging nominal exchange rates need not impede trade balance adjustments (because those adjustments can occur via changes in the price level), pegging real exchange rates blocks trade adjustment entirely.

knzn’s third point is also a shocker. He notes that China is “effectively” running a large surplus. But hold the phone. Isn’t China running a significant fiscal deficit? Well, yes, if you consider only tax revenues. But, if you consider a consolidated income statement that includes China’s central bank, China’s deficit would be dwarfed by the piles of foreign currency flying into the vaults, net of sterilization costs (and even net of significant presumed valuation losses). So is knzn is right to refer to this as “a very large surplus, which also tends to slow down domestic demand”? I think he’s only half right, in a very subtle way.

Imagine that China did no sterilization, and purchased dollars with freshly printed Yuan to maintain its peg. This would maximize the surplus achieved by China’s government (including central bank). But it would also be a very loose, a stimulative monetary policy that might provoke inflation, as China’s central bank would be increasing the money supply dramatically. An unsterilized peg then has two paradoxical and countervailing effects, amounting to a stimulus and tax at the same time. It taxes holders of domestic currency, by increasing the cost in local money of forign goods (an upward shift in the supply curve for imports). But it stimulates domestic demand for all goods. The net effect is almost certain inflation of the price of imported goods (relative to the price that would prevail without intervention), but a mix of real GDP growth (to the degree that there is “slack” in the economy ) and inflation in the domestic economy.

Now let’s put all this together. If China were simply pegging its currency without sterilizing, it would stimulate demand for nonimported goods and services, but it might also stimulate inflation, permitting real exchange rate adjustment. But, by adjusting the degree of sterilization, it can seek a sweet spot that grows unsterilized money at a level chosen to maximize real GDP without provoking inflation, preventing real adjustment. The net effect is a synthetic tariff, raising the price of foreign goods while stimulating the domestic economy and providing revenue to the state. It’s no wonder that China’s trade partners object.

Would “Cash, please” amount to protectionism?

The very excellent Mark Thoma, under the title “Avoiding Protectionism“, quotes a very orthodox article from The Economist (subscription req’d). From that article…

The developed economies as a whole will still benefit hugely from trade with emerging economies. Increased competition and greater economies of scale will boost the growth in productivity and output. Consumers will enjoy lower prices and a greater variety of products, and shareholders will enjoy higher returns on capital. Although workers will continue to see their pay squeezed, they can still gain as consumers or as shareholders… [G]lobalisation is benefiting America’s economy… But in practice the average family has not seen such a gain because much of it has gone to those at the top or into profits. This explains the lack of support for globalisation from ordinary people. Unless a solution is found to sluggish real wages and rising inequality, there is a serious risk of a protectionist backlash. Rather than block change, governments need to ease the pain it inflicts in various ways: with a temporary social safety-net for those who lose their jobs; better education to equip workers for tomorrow’s jobs; and more flexible labour markets to encourage the creation of new jobs… More controversially, governments may need to redistribute the benefits of globalisation more fairly through the tax and benefits system.

As long-time readers may know, this sort of rehash of the “free trade” catechism makes my blood boil. Why? Because I am deeply, pro-free-trade and proglobalization, and this sort of palaver threatens to discredit these important projects for a generation, when the current nightmare masquerading as free trade unwinds. As Brad Setser has noted, what is at issue is not the globalization per se, but the form that globalization is now taking that is the problem. Under this globalization, not some Econ textbook idealization, The Economist‘s case simply does not hold. For example:

Consumers will enjoy lower prices and a greater variety of products, and shareholders will enjoy higher returns on capital. Although workers will continue to see their pay squeezed, they can still gain as consumers or as shareholders.

These statements have simply been untrue, empirically, for American workers in the last five years, and the future looks even bleaker. Despite remarkable efforts of Wal-Mart and heavily subsidized Asian exporters, the median US worker has not seen lower prices, relative to the value of her labor. Living as a typical American has grown more expensive, when measured in median-worker-hours, not less, despite that worker’s apparently increased productivity. And this during a period in which supply chain innovations and an artificially strong dollar (vis Asia) have blown strong, disinflationary headwinds. Should the US dollar reprice, the road will only get harder.

The median worker, having been unable to benefit from globalization as a consumer, can hardly be expected to do so as a shareholder. A rising real cost of living implies less savings, or what we observe in fact, dissaving. At the same time workers are losing the purchasing power of their labor, they are losing the ability to participate in increasing returns to capital.

I could rant on and on about the patronizing incoherence of The Economist piece. [*] But enough. Let’s get to the root of the problem: This globalization has proceeded in a manner that violates the assumptions of the traditional (and correct!) case for free trade. The problem is not that emerging market labor is “too cheap”, or that “the global capital-labor ratio” has shifted. It is that advanced countries, especially the United States, are not paying for the goods and services received with the current provision of goods and services in exchange, but instead with promisary notes that may or may not be honored in real terms. The real-economy case for free trade is based on the idea of each nation producing as much and as best as it can in the domains in which it has comparative advantage, and exchanging that production for what others produce well. The exaggerated use of credit in international exchange (visible in the stockpiled reserves of emerging market central banks and national investment funds) has turned this case on its head. Rather than shifting production in “advanced economies” to align with changing comparative advantage, credit-based globalization encourages a retreat from tradables production altogether, as no real goods or services need be exchanged to receive tradables from elsewhere. The traditional case for free trade is simply not compatable with a regime in which some countries persistly provide, and others persistently accept, credit in exchange for real goods and services.

Which leads me to the question that serves as the title of this essay. Advanced economies don’t necessarily need tariffs, or subsidies, or any of the traditional arsenal of policies that fall under the rubric and epithet of “protectionist”. All they need to do is insist, to others and to themselves, on “paying cash, not credit”. Although intuitive, this formulation is strictly speaking meaningless, since modern money is a form of debt. Perhaps a better way of stating this is that advanced economies should, in fact make broadly balanced trade a non-negotiable policy objective, not as a form of protectionism, but in order to uphold the assumptions and preconditions required to ensure that free trade is beneficial.

A balanced trade policy could, and might sometimes need to be, enforced through measures that look atavistically protectionist. But not usually. Policies like the one Warren Buffet has proposed would be reasonable. Or the US Fed’s famous “dual mandate” could simply be expanded to a “triple mandate”, in which balanced trade is an explicit objective. When Americans, directly or via governments, are buying too much on credit from trade partners — when US trade is deteriorating out of balance — the Fed should increase the cost of taking on more debt. (In the short run, that might conflict with the Fed’s other mandates. But in the long run, full employment requires an economy that produces tradables sufficient to pay for wage-earners imports.)

Free trade is a great idea, when it is real goods and services being traded, rather than promises which will either be painfully kept or painfully broken. We should give it a try.

[*] Okay, okay. One more rant. The article quotes a prestigious economist to the effect that education offers “advanced country” workers no protection, noting, “This may help to explain why the real median wage of American graduates has fallen by 6% since 2000, a bigger decline than in average wages.” But it concludes with that usual bromide of a suggestion, “better education to equip workers for tomorrow’s jobs”, in its litany of nonsolutions. Aaargh!!!!
Update History:
  • 19-Sep-2006, 8:30 p.m. EET: Took out some wordiness (“dishonest palaver” becomes palaver; “enormously important” becomes important).

Greg Mankiw’s “The Savers-Spenders Theory of Fiscal Policy”

Greg Mankiw, Harvard prof, former CEA chair, and most importantly famed econblogger wrote this very fine paper several years back. Though there’s a bit of math, overall the paper is very common-sensical, and quite readable. Here’s my favorite bit:

Proposition 3: Government debt increases steady-state inequality.

Although… government debt does not affect the steady-state capital stock and national income, government debt does influence the distribution of income and consumption in the savers-spenders model… A higher level of debt means a higher level of taxation to pay for the interest payments on the debt. The taxes fall on both spenders and savers, but the interest payments go entirely to the savers. Thus, a higher level of debt raises the steady-state income and consumption of the savers and lowers the steady-state income and consumption and the spenders. The spenders, however, already had lower income and consumption than the savers (for only the savers earn capital income). Thus, a higher level of debt raises steady-state inequality in income and consumption.

This is a very straightforward argument: The government borrowing today to tax tomorrow is a non-event, if the monies not taxed today are all invested at a return that precisely covers the deferred taxation. But if “savers” invest the funds not taxed while “spenders” consume more than they would have, the savers are left unaffected but the spenders are left worse off when the bill comes due. (In Mankiw’s model, savers are not unaffected, but positively gain, as higher current consumption by spenders and government yields rising returns to savers, who invest and earn more than they otherwise would have.)

Given all the recent sturm und drang over inequality and the degree to which it can be accounted for by public policy, I’m surprised that this argument hasn’t featured more prominently. Given the United States’ current fiscal policy and the concern over inequality today, you’d think the idea of deficits exacerbating inequality would really bite.

Some comments:

  1. The effect that Mankiw describes would be lagged: deficit spending now yields greater inequality over time.
  2. It is somewhat insidious, in that deficit spending today increases consumption equality today, as typically poorer spenders consume more than they otherwise would, and live more like wealthier savers.
  3. To counteract this effect, having a progressive tax system isn’t enough. A government that causes inequality through deficit spending would have to increase the progressivity of taxation in proportion to its borrowing in order to undo the increased inequality. Progressivity here would mean adjusting effective tax rates paid by cohorts. (The proportion of total taxes paid by spenders would increase even without policy changes, as a reflection of growing inequality.)

I’d love to see Mankiw extend his model to include not only domestic spenders and savers, but also foreign savers not subject to many US taxes. Also, if monetization of government debt is permitted as an alternative to (or a form of) taxation, how would that affect the relative wealth of domestic spenders, domestic savers, and foreign savers?

Note: Mankiw issued a minor correction for this paper, though it does not affect the argument discussed above.

Some Recent(-ish) Inequality Posts

Beyond spite and envy…

Some of the best and brightest econbloggers are having a debate on whether there are negative externalities associated with wealth inequality, and whether these might merit government intervention to remedy. Unfortunately, the debate has gotten lost in a colorful, but unhelpful, discussion of “spite” (on the part of rich people) and “envy” (on the part of the poor). However entertaining this may be, it quite misses the point.

Very large wealth inequality has a huge, tangible negative externally in all existing political systems that has nothing to do with idiosyncratic emotional reactions. Wealth inequality leads to large, utility-destroying errors in public policy.

In the real world, under democratic capitalism, stalinist communism, feudal monarchies, you name it, there is a strong correlation between actual wealth and political power. (Under some systems this might be masked by differing institutions of wealth and property, but facts on the ground proved Comrade Stalin to have a nicer car than Comrade Sven.) Correlation is not causation: In some systems political power precedes wealth, and in others wealth brings with it the capacity to garner influence. Nevertheless, the relationship is strong, everywhere. The wealthy always have disproportionate political power.

Wealthy people — and I mean the best intentioned wealthy people, not the corrupt — make political decisions to improve the world as they see it. The greater the degree of wealth inequality, the greater the difference between the world those at the very top experience and the experience of the vast majority. This leads to errors in judgement, policy changes that improve the world the rich live in while harming the world that the not-so-rich inhabit, and very large utility losses when the not-so-rich are numerous. The best intentioned of the wealthy may try to mitigate this by reading, thinking about the less fortunate, etc. etc. But these exercises are a poor substitute for experiencing the world as most people experience it, and suffering the consequences of poor leadership directly. And power correlates with wealth much more than it correlates with diligence and skill in understanding the world beyond ones own experience.

Utility losses due to misguided generalizations of their own experience by the wealthy and powerful may be inevitable. But quantities matter. A society in which “the wealthy” represent a large fraction of the population who live not to differently from the less wealthy will make fewer and less costly errors than one in which a realtively small, very wealthy group lives very differently from the rest.

From the great spite and envy debate…