Chimerica has been a Chimera

This is a post I wrote at New Deal 2.0 on the potential for a disastrous trade war.

There has been a considerable amount of discussion about current account imbalances in light of last weekend’s failed G20 summit. For the most part, the meetings focused less on currency levels per se and more on the underlying trade imbalances. In particular, they discussed the threshold at which both surplus and deficit nations should work to mitigate the extremes implied by deficits/surpluses in excess of 4% of GDP.

Of course, one could argue that the focus on current account imbalances, rather than exchange rates per se, was simply a means by which the Americans could discuss China’s pegged rate regime so that Beijing didn’t appear to succumb to US pressure and “lose face”. But fundamentally, the US dollar/Chinese yuan exchange rate has long constituted a huge source of financial instability in the global financial architecture. Although today’s focus on China tends to highlight its huge and growing bilateral trade surpluses with the US (and to a lesser extent, the Euro bloc), less appreciated is the degree to which its exchange rate policies have historically impacted its Asian neighbours and continue to do so to this day. As recently as 1994, Beijing precipitously devalued the renminbi against the greenback, taking it from 5 to 8.4, a 60%+ devaluation. Even this action understates the magnitude of the change, since it was preceded by a period during which the country’s monetary and financial authorities embraced a policy in which the yuan declined some 60 percent against the dollar.

So much for the need for policy incrementalism, as the Chinese persistently respond today when confronted with calls for a substantial yuan revaluation! In the late 1990s, Beijing’s earlier policy of “beggar thy neighbour” might have engendered comparatively minimal disruption domestically, but it exported the economic dislocation to East Asia and Japan. The cost advantage of these devaluations, conferred on China’s exporters, significantly eroded the trade competitiveness of other East Asian and Japanese exporters. They therefore threw their collective current accounts into substantial deficit by the mid-1990s and set the stage for the Asian financial crisis of 1997 and Japan’s “lost decade.” (It also set the stage for Japan’s implementation of a zero-interest-rate policy, which ultimately provided the foundation for the so-called “yen carry trade” — another grave source of future financial instability.)

I have already argued that QE2 has minimal impact on the amount of new net dollars in existence. But the viscerally hostile Chinese response to the Fed’s policy suggests that they see in it echoes of their own policy of the early 1990s (in spite of the fact that the US has a freely floating exchange rate, not a currency peg).

Most defenders of Beijing justify the pegged rate regime on the grounds that it has helped to move the country up the technological curve and thereby enhance living standards. Perhaps, but India has done it without adopting a similarly mercantilist policy. In any event, the improvements of living standards facilitated by rapid export growth and income gains in China are still heavily skewed toward the exterior regions, rather than the interior of the country.

There could have been better ways for China to improve the living standards of its people. It is perfectly understandable why Beijing adopted the Asian mercantilist model, as it worked so well for the nations of Northeast and Southeast Asia. But it makes no sense for a country of 1.5 billion people with a huge domestic market that its manufacturers could potentially supply for decades. India also seems to have improved the living standards of its people, but it has adopted a much more balanced economic model (and correspondingly less trade friction with the US and EU).

Although Beijing no longer explicitly pegs its currency against the greenback, it does so against a basket of currencies of which the dollar is still the largest component. It therefore remains a pegged rate regime in all but name. This type of currency regime is generally not the best institutional structure for an economy because it entails a surrender of monetary/fiscal sovereignty and builds in an inherent financial fragility. In China’s case, the fragility has been somewhat masked by the fact that it continues to run trade surpluses but, as noted above, it has effectively “exported” the financial destabilization associated with currency pegs to its trading partners.

So what is the problem with a currency peg? A nation with a currency peg can run external deficits (on the current account) for a time, as long as there are sufficient foreign reserves so that the central bank does not need to contract the monetary base (its liabilities). In particular, if investment is targeted at productive ventures that build extra export capacity and if the nation has enough foreign reserves, then a current account deficit for a time can be beneficial in the longer term.

But persistent current account deficits become particularly problematic for a nation running a currency board. The nation faces the continual drain of its foreign reserves, which has two impacts. First, the peg comes under pressure. Second, the central bank has to contract the monetary base, which has a negative impact on aggregate demand. A sharp deterioration in the current account can quickly create a crisis because the economy has engineered a sharp domestic contraction (normally, by sharply raising interest rates) to reduce imports, but also risks running out of reserves and occasionally has to default on foreign currency debt (either public or private).

While the higher rates may attract foreign capital inflow, they are also deflationary. Proponents of this arrangement argue that deflation starts a process of internal devaluation (wages and prices fall) and increases the competitiveness of the export sector. But it is clear that currency peg arrangements, which eliminate the capacity of the central bank to run discretionary monetary policy, lead to pro-cyclical policy outcomes. So in boom times, with exports strong, the monetary base expands and interest rates fall. Monetary policy reinforces the demand boom.

But if exports fall and thus aggregate demand weakens and/or foreign capital outflow occurs, then the monetary base contracts and interest rates rise, causing a further contraction. Moreover, when times are bad, the treasury may not be able to fund its current budget position (if in deficit). So fiscal policy has to contract, which worsens the situation.

Clearly this is not a problem for Beijing today, as it runs a huge current account surplus. But if it were to revalue its currency and retain the peg (rather than let it float), a future major collapse in export growth would be highly problematic because it would engender a loss of capacity to build foreign currency reserves and support local demand.

Needless to say, China’s peg has NOT been particularly helpful to the US as a whole, either. In general the dollar-yuan peg has helped to perpetuate a weirdly destructive symbiotic relationship between China’s military, which seems to be making lots of money from the speculative enterprises that persistently pop up in the US, and Wall Street, which has become a major beneficiary as the agent that recycles these capital flows back to the US. In the meantime, the peg displaces US workers via low-cost Chinese labour facilitated by technological advances, which drives further outsourcing by US corporations. To offset the impact, the US government has consciously built up its “FIRE” (finance, insurance and real estate) sector, which has “leveraged” the rest of the economy as its employment and profits grew at a faster pace (it received 40% of the nation’s profits before the bust). Leaving aside the issue of “productive” versus “unproductive” labour, it certainly appears in retrospect that the FIRE sector has played an outsized role in the US economy, in effect offsetting the loss of manufacturing capacity. The “market” is now trying to downsize the FIRE sector, but current policy seems designed to resist that. All efforts are aimed at keeping leverage high as the Fed and Treasury try to get banks to lend again — as if another private debt bubble is the cure for what ails the economy.

That all might begin to change. After observing the latest G20 fiasco, it is conceivable that American government will feel that it has no choice but to move toward tariffs, especially as fiscal policy is likely to remain constrained by a hostile GOP-dominated Congress. The numerical targets on current account imbalances were the last warning shot to forestall the protectionist option. This has now failed.

Domestic US political considerations for the President and his party might well mandate a more radical tack. Consider the recent midterm election results. The Democrats sustained huge losses in the rust belt. These states have been traditionally Democratic. True, some went for Reagan in the 1980s, but Obama got them back in 2008 and thereby won the election. He needs this region. He can forget about the South: there, we have all kinds of constituencies that voted against him. He’ll never win over the Christian right, the plutocrats who narrowly vote their pocketbooks, and so forth. Obama needs to win back members of his disaffected base, especially younger voters who didn’t show up because they face a hopeless employment situation. But he won’t get this group back to the polls unless he focuses on jobs. The independents will also be hard to get back without this, because they too are disgusted by the government’s cronyism. But even if the President wins back a large number of disaffected independents and the youth vote, he still needs the rust belt. He therefore has to attack China, the outsourcing of jobs, and focus on Beijing’s currency (which he has recently called “undervalued”, potentially setting the stage to name China as a “currency manipulator” with the World Trade Organization). If Obama doesn’t do this, the Democrats should just wave a white flag in the next election and not waste money campaigning. This is the US political reality as long as the unemployment rate is above seven percent and Corporate America is nuts about cutting costs by moving to low wage platforms abroad. A trade war, complete with tariffs, could well prove inevitable.