Archive for the 'currency manipulation' Category

Eureka! Paul Krugman Discovers the Bank of France

Trying hard, but not entirely successfully, to contain his astonishment, Paul Krugman has a very good post (“France 1930, Germany 2013) inspired by Doug Irwin’s “very good” paper (see also this shorter version) “Did France Cause the Great Depression?” Here’s Krugman take away from Irwin’s paper.

[Irwin] points out that France, with its undervalued currency, soaked up a huge proportion of the world’s gold reserves in 1930-31, and suggests that France was responsible for about half the global deflation that took place over that period.

The thing is, France itself didn’t do that badly in the early stages of the Great Depression — again thanks to that undervalued currency. In fact, it was less affected than most other advanced countries (pdf) in 1929-31:

Krugman is on the right track here — certainly a hopeful sign — but he misses the distinction between an undervalued French franc, which, despite temporary adverse effects on other countries, would normally be self-correcting under the gold standard, and the explosive increase in demand for gold by the insane Bank of France after the franc was pegged at an undervalued parity against the dollar. Undervaluation of the franc began in December 1926 when Premier Raymond Poincare stabilized its value at about 25 francs to the dollar, the franc having fallen to 50 francs to the dollar in July when Poincare, a former prime minister, had been returned to office to deal with a worsening currency crisis. Undervaluation of the franc would have done no permanent damage to the world economy if the Bank of France had not used the resulting inflow of foreign exchange to accumulate gold, cashing in sterling- and dollar-denominated financial assets for gold. This was a step beyond classic exchange-rate protection (currency manipulation) whereby a country uses a combination of an undervalued exchange rate and a tight monetary policy to keep accumulating foreign-exchange reserves as a way of favoring its export and import-competing industries. Exchange-rate protection may have been one motivation for the French policy, but that objective did not require gold accumulation; it could have been achieved by accumulating foreign exchange reserves without demanding redemption of those reserves in terms of gold, as the Bank of France began doing aggressively in 1927. A more likely motivation for gold accumulation policy of the Bank of France seems to have been French resentment against a monetary system that, from the French perspective, granted a privileged status to the dollar and to sterling, allowing central banks to treat dollar- and sterling-denominated financial assets as official exchange reserves, thereby enabling issuers of dollar and sterling-denominated assets the ability to obtain funds on more favorable terms than issuers of instruments denominated in other currencies.

The world economy was able to withstand the French gold-accumulation policy in 1927-28, because the Federal Reserve was tolerating an outflow of gold, thereby accommodating to some degree the French demand for gold. But after the Fed raised its discount rate to 5% in 1928 and 6% in February 1929, gold began flowing into the US as well, causing gold to start appreciating (in other words, prices to start falling) in world markets by the summer of 1929. But rather than reverse course, the Bank of France and the Fed, despite reductions in their official lending rates, continued pursuing policies that caused huge amounts of gold to flow into the French and US vaults in 1930 and 1931. Hawtrey and Cassel, of course, had warned against such a scenario as early as 1919, and proposed measures to prevent or reverse the looming catastrophe before it took place and after it started, but with little success. For a more complete account of this sad story, and the failure of the economics profession, with a very few notable exceptions, to figure out what happened, see my paper with Ron Batchelder “Pre-Keynesian Monetary Theories of the Great Depression: Whatever Happened to Hawtrey and Cassel?”

As Krugman observes, the French economy did not do so badly in 1929-31, because it was viewed as the most stable, thrifty, and dynamic economy in Europe. But France looked good only because Britain and Germany were in even worse shape. Because France was better off the Britain and Germany, and because its currency was understood to be undervalued, the French franc was considered to be stable, and, thus, unlikely to be devalued. So, unlike sterling, the reichsmark, and the dollar, the franc was not subjected to speculative attacks, becoming instead a haven for capital seeking safety.

Interestingly, Krugman even shows some sympathetic understanding for the plight of the French:

Notice, by the way, that the French weren’t evil or malicious here — they were just adhering to their hard-money ideology in an environment where that had terrible adverse effects on other countries.

Just wondering, would Krugman ever invoke adherence to a hard-money ideology as a mitigating factor in passing judgment on a Republican?

Krugman concludes by comparing Germany today with France in 1930.

Obviously the details are different, but I would argue that Germany is playing a somewhat similar role today — not as drastic, but with less excuse. For Germany is an economic hegemon in a way France never was; it has responsibilities, which it isn’t meeting.

Indeed, there are similarities, but there is a crucial difference in the mechanism by which damage is being inflicted: the world price level in 1930, under the gold standard, was determined by the value of gold. An increase in the demand for gold by central banks necessarily raised the value of gold, causing deflation for all countries either on the gold standard or maintaining a fixed exchange rate against a gold-standard currency. By accumulating gold, nearly quadrupling its gold reserves between 1926 and 1932, the Bank of France was a mighty deflationary force, inflicting immense damage on the international economy. Today, the Eurozone price level does not depend on the independent policy actions of any national central bank, including that of Germany. The Eurozone price level is rather determined by the policy choices of a nominally independent European Central Bank. But the ECB is clearly unable to any adopt policy not approved by the German government and its leader Mrs. Merkel, and Mrs. Merkel has rejected any policy that would raise prices in the Eurozone to a level consistent with full employment. Though the mechanism by which Mrs. Merkel and her government are now inflicting damage on the Eurozone is different from the mechanism by which the insane Bank of France inflicted damage during the Great Depression, the damage is just as pointless and just as inexcusable. But as the damage caused by Mrs. Merkel, in relative terms at any rate, seems somewhat smaller in magnitude than that caused by the insane Bank of France, I would not judge her more harshly than I would the Bank of France — insanity being, in matters of monetary policy, no defense.

HT: ChargerCarl

Japan Still Has Me Worried

Last Thursday night, I dashed off a post in response to accusations being made by Chinese and South Korean critics of Abenomics that Japan is now engaging in currency manipulation. When I started writing, I thought that I was going to dismiss such accusations, because Prime Minister Abe has made an increased inflation target an explicit goal of his monetary policy, and instructed the newly installed Governor of the Bank of Japan to meet that target. However, despite the 25% depreciation of the yen against the dollar since it became clear last fall that Mr. Abe, running on a platform of monetary stimulation, would be elected Prime Minister, prices in Japan have not risen.

It was also disturbing that there were news reports last week that some members of the Board of Governors of the Bank of Japan voiced doubts that the 2% inflation target would be met.

Some of the members of the Bank of Japan (BOJ) board were doubtful about achieving the 2% inflation target projected by the bank within the two-year time frame, according to the latest minutes of the policy meeting.

Why a 25% decline in the value of the yen in six months would not be enough to raise the rate of inflation to at least 2% is not immediately obvious to me. In 1933 when FDR devalued the dollar by 40%, the producer price index quickly jumped 10-15% in three months.

Moreover, the practice of currency manipulation, i.e., maintaining an undervalued exchange rate while operating a tight monetary policy to induce a chronic current-account surplus and a rapid buildup of foreign-exchange reserves, was a key element of the Japanese growth strategy in the 1950s and 1960s, later copied by South Korea and Taiwan and the other Asian Tigers, before being perfected by China over the past decade. So despite wanting to defend the new Japanese monetary policy as a model for the rest of the world, I couldn’t conclude, admittedly based on pretty incomplete information, that Japan had not reverted back to its old currency-manipulating habits.

My expression of agnosticism invited some pushback from Scott Sumner who quickly fired off a comment saying:

I don’t follow this. Why aren’t you looking at the Japanese CA balance?

To which I responded:

Scott, Answer 1, CA depends on many things; FX reserves depends on what the CB wants. Answer 2, I’m lazy. Answer 3, also sleep deprived.

Well, I’m sticking with answer 1, but as I am somewhat less sleep deprived than I was last Thursday, I will just add this tidbit from Bloomberg.com

Japan‘s current-account surplus rose in March to the highest level in a year as a depreciating yen boosted repatriated earnings and brightened the outlook for the nation’s exports.

The excess in the widest measure of trade was 1.25 trillion yen ($12.4 billion), the Ministry of Finance said in Tokyo today. That exceeded the 1.22 trillion yen median estimate of 23 economists surveyed by Bloomberg News.

Prime Minister Shinzo Abe’s revamp of Japan’s central bank to focus on ending deflation paid off when the yen today slid past 101 for the first time since 2009, helping exporters such as Toyota Motor Corp. (7203), which now sees its highest annual profit in six years. Sustaining a current-account surplus may help to maintain confidence in the nation’s finances as Abe wrestles with a debt burden more than twice the size of the economy.

“The currency’s depreciation is buoying Japan’s income from overseas investment at a pretty solid pace,” said Long Hanhua Wang, an economist at Royal Bank of Scotland Group Plc in Tokyo. “A weaker yen provides support for Japanese exports.”

The cost of a weaker yen is higher import costs, reflected in a ninth straight trade deficit in March. The current-account surplus was 4 percent lower than the same month last year and the income surplus widened to 1.7 trillion yen, the highest level since March 2010, the ministry said.

So contrary to what one would expect if the depreciation of the yen were the result of an inflationary monetary policy causing increased domestic spending, thereby increasing imports and reducing exports, Japan’s current account surplus is approaching its highest level in a year.

Then, on his blog, responding to a commenter who indicated that he was worried by my suggestion that Japan might be engaging in currency manipulation, Scott made the following comment.

Travis, I had trouble following David’s post. What exactly is he worried about? I don’t think the Japanese are manipulating their currency, but so what if they were?

OK, Scott, here is what I am worried about. The reason that currency debasement is a good and virtuous and praiseworthy thing to do in a depression is that by debasing your currency you cause private economic agents to increase their spending. But under currency manipulation, the desirable depreciation of the exchange rate is counteracted by tight monetary policy designed to curtail, not to increase, spending, the point of currency manipulation being to divert spending by domestic and foreign consumers from the rest of the world to the tradable-goods producers of the currency-manipulating country. Unlike straightforward currency debasement, currency manipulation involves no aggregate change in spending, but shifts spending from the rest of the world to the currency manipulator. I don’t think that that is a good thing. And if that is what Japan is doing – I am not saying, based on one month’s worth of data, that they are, but I am afradi that they may be reverting to their old habits – then I think you should be worried as well.

Is Japan a Currency Manipulator?

In his Wednesday column (“Japan’s bumpy road to recovery“) in the Financial Times, the estimable Martin Wolf provided a sober assessment of the recent gyrations of the Japanese bond and stock markets and the yen. I was especially struck by this passage.

[C]riticism over the decline in the yen is coming from abroad. Many, particularly in east Asia, agree with the warning from David Li of Tsinghua University that, far from a rise in Japanese inflation, “the world has merely seen a sharp devaluation of the yen. This devaluation is both unfair on other countries and unsustainable.” In a letter to the FT, Takashi Ito from Tokyo responded: “I just find it unbearable that countries that have debased or manipulated their currency can accuse Japan of depreciating the yen”. This does begin to look like a currency war.

In a couple of posts last November about whether China was engaging in currency manipulation, I first gave China a qualified pass and then reversed my position after looking a bit more closely into the way in which the Chinese central bank (PBoC) was imposing high reserve requirements on commercial banks when creating deposits, thereby effectively sterilizing inflows of foreign exchange, or more accurately forcing the inflow of foreign exchange as a condition for expanding the domestic Chinese money supply to meet the burgeoning domestic Chinese demand to hold cash.

So to answer the question whether Japan has been manipulating its currency to drive down the value of the yen, the place to start is to look at what has happened to Japanese foreign-exchange holdings. If Japan has been manipulating its currency, then the reduction in the external value of the yen would be accompanied by an inflow of foreign exchange. The chart below suggests that Japanese holdings of foreign exchange have decreased somewhat over the past six months.

japan_forex_reserves

However, this item from Bloomberg suggests that the reduction in foreign exchange reserves may have been achieved simply by swapping foreign exchange reserves for different foreign assets which, for purposes of determining whether Japan is manipulating its currency, would be a wash.

Japan plans to use its foreign- exchange reserves to buy bonds issued by the European Stabilitylity Mechanism and euro-area sovereigns, as the nation seeks to weaken its currency, Finance Minister Taro Aso said.

“The financial stability of Europe will help the stability of foreign-exchange rates, including the yen,” Aso told reporters today at a briefing in Tokyo. “From this perspective, Japan plans to buy ESM bonds,” he said. The purchase amount is undecided, Aso said.

The move may help Prime Minister Shinzo Abe temper criticism of Japan’s currency policies from trading partners such as the U.S. The yen has fallen around 8 percent against the dollar since mid-November on Abe’s pledge to reverse more than a decade of deflation as his Liberal Democratic Party won an election victory last month.

“The Europeans would be happy to see Japan buy ESM bonds, so Japan can avoid criticism from abroad and at the same time achieve its objective,” said Masaaki Kanno, chief economist at JPMorgan Securities Japan Co. and a former central bank official.

So I regret to say that my initial quick look at the currency manipulation issue does not allow me to absolve Japan of the charge of being a currency manipulator.

It was, in fact, something of a puzzle that, despite the increase in Japanese real GDP of 3.5% in the first quarter, the implicit Japanese price deflator declined in the first quarter. If Japan is not using currency depreciation as a tool to create inflation, then its policy is in fact perverse and will lead to disaster. It would also explain why doubts are increasing that Japan will be able to reach its 2% inflation target.

I hope that I’m wrong, but, after the high hopes engendered by the advent of Abenomics, I am starting to get an uneasy feeling about what is happening there. I invite others more skillful in understanding the intricacies of foreign exchange reserves and central bank balance sheets to weigh in and enlighten us about the policy of the BoJ.

Currency Manipulation: Is It Just About Saving?

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.

More on Currency Manipulation

My previous post on currency manipulation elicited some excellent comments and responses, helping me, I hope, to gain a better understanding of the subject than I started with. What seemed to me the most important point to emerge from the comments was that the Chinese central bank (PBC) imposes high reserve requirements on banks creating deposits. Thus, the creation of deposits by the Chinese banking system implies a derived demand for reserves that must be held with the PBC either to satisfy the legal reserve requirement or to satisfy the banks’ own liquidity demand for reserves. Focusing directly on the derived demand of the banking system to hold reserves is a better way to think about whether the Chinese are engaging in currency manipulation and sterilization than the simple framework of my previous post. Let me try to explain why.

In my previous post, I argued that currency manipulation is tantamount to the sterilization of foreign cash inflows triggered by the export surplus associated with an undervalued currency. Thanks to an undervalued yuan, Chinese exporters enjoy a competitive advantage in international markets, the resulting export surplus inducing an inflow of foreign cash to finance that surplus. But neither that surplus, nor the undervaluation of the yuan that underlies it, is sustainable unless the inflow of foreign cash is sterilized. Otherwise, the cash inflow, causing a corresponding increase in the Chinese money supply, would raise the Chinese price level until the competitive advantage of Chinese exporters was eroded. Sterilization, usually conceived of as open-market sales of domestic assets held by the central bank, counteracts the automatic increase in the domestic money supply and in the domestic price level caused by the exchange of domestic for foreign currency. But this argument implies (or, at least, so I argued) that sterilization is not occurring unless the central bank is running down its holdings of domestic assets to offset the increase in its holdings of foreign exchange. So I suggested that, unless the Chinese central holdings of domestic assets had been falling, it appeared that the PBC was not actually engaging in sterilization. Looking at balance sheets of the PBC since 1999, I found that 2009 was the only year in which the holdings of domestic assets by the PBC actually declined. So I tentatively concluded that there seemed to be no evidence that, despite its prodigious accumulation of foreign exchange reserves, the PBC had been sterilizing inflows of foreign cash triggered by persistent Chinese export surpluses.

Somehow this did not seem right, and I now think that I understand why not. The answer is that reserve requirements imposed by the PBC increase the demand for reserves by the Chinese banking system. (See here.) The Chinese reserve requirements on the largest banks were until recently as high as 21.5% of deposits (apparently the percentage is the same for both time deposits and demand deposits). The required reserve ratio is the highest in the world. Thus, if Chinese banks create 1 million yuan in deposits, they are required to hold approximately 200,000 yuan in reserves at the PBC. That 200,000 increase in reserves must come from somewhere. If the PBC does not create those reserves from domestic credit, the only way that they can be obtained by the banks (in the aggregate) is by obtaining foreign exchange with which to satisfy their requirement. So given a 20% reserve requirement, unless the PBC undertakes net purchases of domestic assets equal to at least 200,000 yuan, it is effectively sterilizing the inflows of foreign exchange. So in my previous post, using the wrong criterion for determining whether sterilization was taking place, I had it backwards. The criterion for whether sterilization has occurred is whether bank reserves have increased over time by a significantly greater percentage than the increase in the domestic asset holdings of the PBC, not, as I had thought, whether those holdings of the PBC have declined.

In fact it is even more complicated than that, because the required-reserve ratio has fluctuated over time, the required-reserve ratio having roughly tripled between 2001 and 2010, so that the domestic asset holdings of the PBC would have had to increase more than proportionately to the increase in reserves to avoid effective sterilization. Given that the reserves held by banking system with the PBC at the end of 2010 were almost 8 times as large as they had been at the end of 2001, while the required reserve ratio over the period roughly tripled, the domestic asset holdings of the PBC should have increased more than twice as fast as bank reserves over the same period, an increase of, say, 20-fold, if not more. In the event, the domestic asset holdings of the PBC at the end of 2010 were just 2.2 times greater than they were at the end of 2001, so the inference of effective sterilization seems all but inescapable.

Why does the existence of reserve requirements mean that, unless the domestic asset holdings of the central bank increase at least as fast as reserves, sterilization is taking place? The answer is that the existence of a reserve requirement means that an increase in deposits implies a roughly equal percentage increase in reserves. If the additional reserves are not forthcoming from domestic sources, the domestic asset holdings of the central bank not having increased as fast as did required reserves, the needed reserves can be obtained from abroad only by way of an export surplus. Thus, an increase in the demand of the public to hold deposits cannot be accommodated unless the required reserves can be obtained from some source. If the central bank does not make the reserves available by purchasing domestic assets, then the only other mechanism by which the increased demand for deposits can be accommodated is through an export surplus, the surplus being achieved by restricting domestic spending, thereby increasing exports and reducing imports. The economic consequences of the central bank not purchasing domestic assets when required reserves increase are the same as if the central bank sold some of its holdings of domestic assets when required reserves were unchanged.

The more general point is that one cannot assume that the inflow of foreign exchange corresponding to an export surplus is determined solely by the magnitude of domestic currency undervaluation. It is also a function of monetary policy. The tighter is monetary policy, the larger the export surplus, the export surplus serving as the mechanism by which the public increases their holdings of cash. Unfortunately, most discussions treat the export surplus as if it were determined solely by the exchange rate, making it seem as if an easier monetary policy would have little or no effect on the export surplus.

The point is similar to one I made almost a year ago when I criticized F. A. Hayek’s 1932 defense of the monetary policy of the insane Bank of France. Hayek acknowledged that the gold holdings of the Bank of France had increased by a huge amount in the late 1920s and early 1930s, but, nevertheless, absolved the Bank of France of any blame for the Great Depression, because the quantity of money in France had increased by as much as the increase in gold reserves of the Bank of France.  To Hayek this meant that the Bank of France had done “all that was necessary for the gold standard to function.” This was a complete misunderstanding on Hayek’s part of how the gold standard operated, because what the Bank of France had done was to block every mechanism for increasing the quantity of money in France except the importation of gold. If the Bank of France had not embarked on its insane policy of gold accumulation, the quantity of money in France would have been more or less the same as it turned out to be, but France would have imported less gold, alleviating the upward pressure being applied to the real value of gold, or stated equivalently alleviating the downward pressure on the prices of everything else, a pressure largely caused by insane French policy of gold accumulation.

The consequences of the Chinese sterilization policy for the world economy are not nearly as disastrous as those of the French gold accumulation from 1928 to 1932, because the Chinese policy does not thereby impose deflation on any other country. The effects of Chinese sterilization and currency manipulation are more complex than those of French gold accumulation. I’ll try to at least make a start on analyzing those effects in an upcoming post addressing the comments of Scott Sumner on my previous post.

On the Manipulation of Currencies

Mitt Romney is promising to declare China a currency manipulator on “day one” of his new administration. Why? Ostensibly, because Mr. Romney, like so many others, believes that the Chinese are somehow interfering with the foreign-exchange markets and holding the exchange rate of their currency (confusingly called both the yuan and the remnibi) below its “true” value. But the other day, Mary Anastasia O’Grady, a member of the editorial board of the avidly pro-Romeny Wall Street Journal, wrote an op-ed piece (“Ben Bernanke: Currency Manipulator” ) charging that Bernanke is no less a currency manipulator than those nasty Chinese Communists. Why? Well, that was not exactly clear, but it seemed to have something to do with the fact that Mr. Bernanke, seeking to increase the pace of our current anemic recovery, is conducting a policy of monetary expansion to speed the recovery.

So, is what Mr. Bernanke is doing (or supposed to be doing) really the same as what the Chinese are doing (or supposed to be doing)?

Well, obviously it is not. What the Chinese are accused of doing is manipulating the yuan’s exchange rate by, somehow, intervening in the foreign-exchange market to prevent the yuan from rising to its “equilibrium” value against the dollar. The allegation against Mr. Bernanke is that he is causing the exchange rate of the dollar to fall against other currencies by increasing the quantity of dollars in circulation. But given the number of dollars in circulation, the foreign-exchange market is establishing a price that reflects the “equilibrium” value of dollars against any other currency. Mr. Bernanke is not setting the value of the dollar in foreign-exchange markets, as the Chinese are accused of doing to the dollar/yuan exchange rate. Even if he wanted to control the exchange value of the dollar, it is not directly within Mr. Bernanke’s power to control the value that participants in the foreign-exchange markets attach to the dollar relative to other currencies.

But perhaps this is too narrow a view of what Mr. Bernanke is up to. If the Chinese government wants the yuan to have a certain exchange value against the dollar and other currencies, all it has to do is to create (or withdraw) enough yuan to ensure that the value of yuan on the foreign-exchange markets falls (or rises) to its target. In the limit, the Chinese government could peg its exchange rate against the dollar (or against any other currency or any basket of currencies) by offering to buy and sell dollars (or any other currency or any basket of currencies) in unlimited quantities at the pegged rate with the yuan. Does that qualify as currency manipulation? For a very long time, pegged or fixed exchange rates in which countries maintained fixed exchange rates against all other currencies was the rule, not the exception, except that the pegged rate was most often a fixed price for gold or silver rather than a fixed price for a particular currency. No one ever said that simply maintaining a fixed exchange rate between one currency and another or between one currency and a real commodity is a form of currency manipulation. And for some 40 years, since the demise of the Bretton Woods system, the Wall Street Journal editorial page has been tirelessly advocating restoration of a system of fixed exchange rates, or, ideally, restoration of a gold standard. And now the Journal is talking about currency manipulation?

So it’s all very confusing. To get a better handle on the question of currency manipulation, I suggest going back to a classic statement of the basic issue by none other than John Maynard Keynes in a book, A Tract on Monetary Reform, that he published in 1923, when the world was trying to figure out how to reconstruct an international system of monetary arrangements to replace the prewar international gold standard, which had been one of the first casualties of the outbreak of World War I.

Since . . . the rate of exchange of a country’s currency with the currency of the rest of the world (assuming for the sake of simplicity that there is only one external currency) depends on the relation between the internal price level and the external price level [i.e., the price level of the rest of the world], it follows that the exchange cannot be stable unless both internal and external price levels remain stable. If, therefore, the external price level lies outside our control, we must submit either to our own internal price level or to our exchange rate being pulled about by external influences. If the external price level is unstable, we cannot keep both our own price level and our exchanges stable. And we are compelled to choose.

I like to call this proposition – that a country can control either its internal price level or the exchange rate of its currency, but cannot control both — Keynes’s Law, though Keynes did not discover it and was not the first to articulate it (but no one else did so as succinctly and powerfully as he). So, according to Keynes, whether a country pegs its exchange rate or controls its internal price level would not matter if the price level in the rest of the world were stable, because in that case for any internal price level there would be a corresponding exchange rate and for every exchange rate there would be a corresponding internal price level. For a country to reduce its own exchange rate to promote exports would not work, because the low exchange rate would cause its internal prices to rise correspondingly, thereby eliminating any competitive advantage for its products in international trade. This principle, closely related to the idea of purchasing power parity (a concept developed by Gustav Cassel), implies that currency manipulation is not really possible, except for transitory periods, because prices adjust to nullify any temporary competitive advantage associated with a weak, or undervalued, currency. An alternative way of stating the principle is that a country can control its nominal exchange rate, but cannot control its real exchange rate, i.e, the exchange rate adjusted for price-level differences. If exchange rates and price levels tend to adjust to maintain purchasing power parity across currency areas, currency manipulation is an exercise in futility.

That, at any rate, is what the theory says. But for any proposition derived from economic theory, it is usually possible to come up with exceptions by altering the assumptions. Now for Keynes’s Law, there are two mechanisms causing prices to rise faster in a country with an undervalued currency than they do elsewhere. First, price arbitrage between internationally traded products tends to equalize prices in all locations after adjusting for exchange rate differentials. If it is cheaper for Americans to buy wheat in Winnipeg than in Wichita at the current exchange rate between the US and Canadian dollars, Americans will buy wheat in Winnipeg rather than Wichita forcing the Wichita price down until buying wheat in Wichita is again economical. But the arbitrage mechanism works rapidly only for internationally traded commodities like wheat. Many commodities, especially factors of production, like land and labor, are not tradable, so that price differentials induced by an undervalued exchange rate cannot be eliminated by direct arbitrage. But there is another mechanism operating to force prices in the country with an undervalued exchange rate to rise faster than elsewhere, which is that the competitive advantage from an undervalued currency induces an inflow of cash from other countries importing those cheap products, the foreign cash influx, having been exchanged for domestic cash, becoming an additional cause of rising domestic prices. The influx of cash won’t stop until purchasing power parity is achieved, and the competitive advantage eliminated.

What could prevent this automatic adjustment process from eliminating the competitive advantage created by an undervalued currency? In principle, it would be possible to interrupt the process of international arbitrage tending to equalize the prices of internationally traded products by imposing tariffs or quotas on imports or by imposing exchange controls on the movement of capital across borders. All of those restrictions or taxes on international transactions prevent the price equalization implied by Keynes’s Law and purchasing power parity from actually occurring. But after the steady trend of liberalization since World War II, these restrictions, though plenty remain, are less important than they used to be, and a web of international agreements, codified by the International Trade Organization, makes resorting to them a lot trickier than it used to be.

That leaves another, less focused, method by which governments can offer protection from international competition to certain industries or groups. The method is precisely for the government and the monetary authority to do what Keynes’s Law says can’t be done:  to choose an exchange rate that undervalues the currency, thereby giving an extra advantage or profit cushion to all producers of tradable products (i.e., export industries and import-competing industries), perhaps spreading the benefits of protection more widely than governments, if their choices were not restricted by international agreements, would wish. However, to prevent the resulting inflow of foreign cash from driving up domestic prices and eliminating any competitive advantage, the monetary authority must sterilize the induced cash inflows by selling assets to mop up the domestic currency just issued in exchange for the foreign cash directed toward domestic exporters. (The classic analysis of such a policy was presented by Max Corden in his paper “Exchange Rate Protection,” reprinted in his Production, Growth, and Trade: Essays in International Economics.) But to borrow a concept from Austrian Business Cycle Theory, this may not be a sustainable long-run policy for a central bank, because maintaining the undervalued exchange rate would require the central bank to keep accumulating foreign-exchange reserves indefinitely, while selling off domestic assets to prevent the domestic money supply from increasing. The central bank might even run out of domestic assets with which to mop up the currency created to absorb the inflow of foreign cash. But in a rapidly expanding economy (like China’s), the demand for currency may be growing so rapidly that the domestic currency created in exchange for the inflow of foreign currency can be absorbed by the public without creating any significant upward pressure on prices necessitating a sell-off of domestic assets to prevent an outbreak of domestic inflation.

It is thus the growth in, and the changing composition of, the balance sheet of China’s central bank rather than the value of the dollar/yuan exchange rate that tells us whether the Chinese are engaging in currency manipulation. To get some perspective on how the balance sheet of Chinese central banks has been changing, consider that Chinese nominal GDP in 2009 was about 2.5 times as large as it was in 2003 while Chinese holdings of foreign exchange reserves in 2009 were more than 5 times greater than those holdings were in 2003. This means that the rate of growth (about 25% a year) in foreign-exchange reserves held by the Chinese central bank between 2003 and 2009 was more than twice as great as the rate of growth in Chinese nominal GDP over the same period. Over that period, the share of the total assets of the Chinese central bank represented by foreign exchange has grown from 48% in December 2003 to almost 80% in December 2010. Those changes are certainly consistent with the practice of currency manipulation.  However, except for 2009, there was no year since 2000 in which the holdings of domestic assets by the Chinese central bank actually fell, suggesting that there has been very little actual sterilization undertaken by the Chinese central bank.  If there has indeed been no (or almost no) actual sterilization by the Chinese central bank, then, despite my long-standing suspicions about what the Chinese have been doing, I cannot conclude that the Chinese have been engaging in currency manipulation. But perhaps one needs to look more closely at the details of how the balance sheet of the Chinese central bank has been changing over time.  I would welcome the thoughts of others on how to interpret evidence of how the balance sheet of the Chinese central bank has been changing.

At any rate, to come back to Mary Anastasia O’Grady’s assertion that Ben Bernanke is guilty of currency manipulation, her accusation, based on the fact that Bernanke is expanding the US money supply, is clearly incompatible with Max Corden’s exchange-rate-protection model. In Corden’s model, undervaluation is achieved by combining a tight monetary policy that sterilizes (by open-market sales!) the inflows induced by an undervalued exchange rate. But, according to Mrs. O’Grady, Bernanke is guilty of currency manipulation, because he is conducting open-market purchases, not open-market sales! So Mrs. O’Grady has got it exactly backwards.  But, then, what would you expect from a member of the Wall Street Journal editorial board?

PS  I have been falling way behind in responding to recent comments.  I hope to catch up over the weekend as well as write up something on medium of account vs. medium of exchange.

PPS  Thanks to my commenters for providing me with a lot of insight into how the Chinese operate their monetary and banking systems.  My frequent commenter J.P. Koning has an excellent post and a terrific visual chart on his blog Moneyness showing the behavior over time of the asset and liability sides of the Chinese central bank.  Scott Sumner has also added an excellent discussion of his own about what Chinese monetary policy is all about.  I am trying to assimilate the various responses and hope to have a further post on the subject in the next day or two.


About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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