After my first discussion of currency manipulation, Scott Sumner responded with some very insightful comments of his own in which he pointed out that the current account surplus (an inflow of cash) corresponds to the difference between domestic savings and domestic investment. Scott makes the point succinctly:
There are two views of current account surpluses. One is that they reflect “undervalued” currencies. Another is that they reflect saving/investment imbalances. Thus the CA surplus is the capital account deficit, which is (by definition) domestic saving minus domestic investment.
The difference is that when an undervalued currency leads to a current account surplus, the surplus itself tends to be self-correcting, because, under fixed exchange rates, the current account surplus leads (unless sterilized) to an increase of the domestic money stock, thereby raising domestic prices, with the process continuing until the currency ceases to be undervalued. A current account surplus caused by an imbalance between domestic saving and domestic investment is potentially more long-lasting, inasmuch as it depends on the relationship between the saving propensities of the community and the investment opportunities available to the community, a relationship that will not necessarily be altered as a consequence of the current account surplus.
From this observation, Scott infers that it is not really monetary policy, but a high savings rate, that causes an undervalued currency.
Actual Chinese exchange rate manipulation usually involves three factors:
1. More Chinese government saving.
2. The saving is done by the central bank.
3. The central bank keeps the nominal exchange rate pegged.
But only the first is important. If the Chinese government saves a huge percentage of GDP, and total Chinese saving rises above total Chinese investment, then by definition China has a CA surplus. And this surplus would occur even if the exchange rate were floating, and if the purchases were done by the Chinese Treasury, not its central bank. That’s why you often see huge CA surpluses in countries that don’t have pegged exchange rates (Switzerland (prior to the recent peg), Singapore, Norway, etc). They have government policies which involve either enormous government saving (Singapore and Norway) or policies that encourage private saving (Switzerland.) It should also be noted that government saving does not automatically produce a CA surplus. Australia is a notable counterexample. The Aussie government does some saving, but the private sector engages in massive borrowing from the rest of the world, so they still end up with a large CA deficit.
I think that Scott is largely correct, but he does overlook some important aspects of Chinese policy that distinguish it from other countries with high savings rates. First, Scott already observed that it is not savings alone that determines the current account surplus; it is the difference between domestic savings and domestic investment. China has a very high savings rate, but why is China’s domestic saving being channeled into holdings of American treasury notes yielding minimal nominal interest and negative real interest rather than domestic investment projects? While the other high-savings countries mentioned by Scott, are small wealthy countries with limited domestic investment opportunities, China is a vast poor and underdeveloped country with very extensive domestic investment opportunities. So one has to wonder why more Chinese domestic savings is not being channeled directly into financing Chinese investment opportunities.
In my follow-up post to the one Scott was commenting on, I pointed out the role of high Chinese reserve requirements on domestic bank deposits in sterilizing foreign cash inflows. As China develops and its economy expands, with income and output increasing at rates of 10% a year or more, the volume of market transactions is probably increasing even more rapidly than income, implying a very rapid increase in the demand to hold cash and deposits. By imposing high reserve requirements on deposits and choosing to let its holdings of domestic assets grow at a much slower rate than the expansion of its liabilities (the monetary base), the Chinese central bank has prevented the Chinese public from satisfying their growing demand for money except through an export surplus with which to obtain foreign assets that can be exchanged with the Chinese central bank for the desired additions to their holdings of deposits.
Now It is true, as Scott points out, that an export surplus could be achieved by other means, and all of the alternatives would ultimately involve increasing domestic saving above domestic investment. But that does not mean that there is nothing distinctive about the use of monetary policy as the instrument by which the export surplus and the excess of domestic saving over domestic investment (corresponding to the increase in desired holdings of the monetary base) is achieved. The point is that China is using monetary policy to pursue a protectionist policy favoring its tradable goods industries and disadvantaging the tradable goods industries of other countries including the US. It is true that a similar result would follow from an alternative set of policies that increased the Chinese savings relative to Chinese domestic investment, but it is not obvious that other policies aimed at increasing Chinese savings would not tend to increase Chinese domestic investment, leaving the overall effect on the Chinese tradable goods sector in doubt.
So it seems clear to me that Chinese monetary policy is protectionist, but Scott questions whether the US should care about that.
In the end none of this should matter, as the job situation in the US is determined by two factors:
1. US supply-side policies
2. US NGDP growth (i.e. monetary policy.)
After all, in a strict welfare sense, it would seem that China is doing us a favor by selling their products to us cheaply. Why should we complain about that? US employment depends on US nominal GDP, and with an independent monetary authority, the US can control nominal GDP and employment.
But it seems to me that this sort of analysis may be a bit too Ricardian, in the sense that it focuses mainly on long-run equilibrium tendencies. In fact there are transitional effects on US tradable goods industries and the factors of production specific to those industries. When those industries become unprofitable because of Chinese competition, the redundant factors of production bear heavy personal and economic costs. Second, if China uses protectionism to compete by keeping its real wages low, then low Chinese wages may tend to amplify downward pressure on real wages in the US compared to a non-protectionist Chinese policy. If so, Chinese protectionism may be exacerbating income inequality in the US. Theoretically, I think that the effects could go either way, but I don’t think that the concerns can be dismissed so easily. If countries have agreed not to follow protectionist policies, it seems to me that they should not be able to avoid blame for policies that are protectionist simply by saying that the same or similar effects would have been achieved by a sufficiently large excess of domestic savings over domestic investment.