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April 25, 2006
Misreading Hume
Brad DeLong reads John Tamny. Fortunately it wasn't during his morning coffee, or he would have probably had to clean the monitor.
Tamny:
To begin, just as Chinese authorities fix the yuan's value, so too do U.S. authorities fix the dollar's value. As the Journal's George Melloan noted in a recent editorial, "no currency actually 'floats.'" As opposed to commodities set by market forces, currencies today are merely paper concepts controlled by central banks through the creation of and extinguishment of that paper.
That the above is true calls into question Lindsey's assertion that the "Chinese clearly undervalue their exchange rate."
DeLong:
The above is not true. If it were true, it would not "call into question" Lindsey's assertion. This year it looks like China will spend $250 billion trying to keep the value of the renminibi low: that's the reason for Lindsey's assertion.
Actually, it gets worse. Tamny continues...
Regarding the exchange of goods between the two countries, Lindsey argues that the supposedly undervalued yuan creates “losers,” specifically the “American producers of goods that are now made in China.” Implicit here is the flawed assumption that changes in currency values impact the real price of anything.
In truth, as 18th century philosopher David Hume wrote, “the greater or less plenty of money is of no consequence” in trade since the price of commodities always adjusts to any changes in a currency’s value. Nixon Treasury Secretary John Connally articulated the same in pointing out that money itself “cannot produce, increase efficiency, or open markets abroad.”
If China adheres to Lindsey’s compromise and revalues the yuan upward, the imported commodity inputs used to create the goods they sell us would simply become cheaper in nominal terms. Conversely, U.S. producers would hardly gain from a devaluation of the dollar given the same market forces that apply to the Chinese in what is a world economy.
Correcting the errors here is an undergraduate exercise and is left to the reader. The upshot of his claim is that the value of the yuan is of no real consequence. Keep that in mind as he continues...
Lindsey also argued that in “resisting revaluation, [Chinese president Hu Jintao] is making China poorer.” More realistically, Mr. Hu is intimately aware of what happened to Japan the last time the U.S. political elite engaged in one of its periodic protectionist episodes. The “revaluation” we forced on Japan through the 1985 Plaza Accord caused it to sink into a 15-year deflation from which it is only now in recovery.
Can't have it both ways, Mr. Tamny. Either currency values have real effects or they don't. One of the things that Tamny is forgetting is that capital controls throw a wrench into Hume's price-specie flow mechanism. So, while China has been slowly removing the capital controls, Hume's mechanism is unlikely to work perfectly. He's also glossing over a lot of monetary economics here.
Tamny concludes...
Rather than engage in wealth-reducing currency revaluations, the U.S. and China should seek a tight link between the two in order to ensure the kind of stability that will cause our trading relationship to continue to grow.
The yuan is undervalued. The undervaluation of the yuan has had and continues to have real effects. I'm not sure why Tamny wants to deny this. I'm not sure why he wants to "seek a tight relationship" between the dollar and the yuan when market forces are pushing in the other direction. That seems like a losing battle, and one that relies on inconsistent logic. I continue to assert that while the yuan is destined to become less undervalued, the risks associated with moving too quickly outweigh the risks of moving too slowly. Protectionism isn't the answer, but the status quo is unacceptable as well. That China held its exchange rate fixed against the dollar for so long was, I believe, an important factor in their rapid growth. But they are entering a new stage of development--one in which a hard peg is not necessarily the best option. A gradual adjustment to that next stage is in both our interests. Denying that to score political points is no better than proposing a tariff to achieve the same ends. A mature trade relationship with China will have a flexible exchange rate. Hopefully we will avoid repeating some past mistakes on the way there.
UPDATE: PGL at Angry Bear has more.
Posted by William Polley at April 25, 2006 01:16 AM
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Comments
It is a shame that Brad had closed his contest before he read Tamny's oped!
Posted by: pgl at April 25, 2006 06:58 PM