A little over a week ago, Scott Sumner wrote a post complaining that I had not yet given him a definition of currency manipulation. That complaint was a little bit surprising to me, because I have been writing about currency manipulation off and on for almost five years already on this blog (here’s my first, my second, and a more recent one). Now, in all modesty, I think some of those posts were pretty good and explained the concept of currency manipulation fairly clearly, so I’m not sure why Scott keeps insisting on the need for a definition. I am more than happy to accommodate him, but before doing so, I want to respond to some comments that he made in his post.
Scott began by quoting at length from my most recent post in which I responded to his criticism of my contention that China has in the past — but probably not the more recent past — engaged in currency manipulation. My basic argument – buttressed by an extended quotation from the world’s greatest living international-trade theorist, Max Corden — was that although nominal exchange rates are determined by monetary-policy choices, such as exchange-rate pegs or targets or nominal quantities of money, while real exchange rates are determined by real forces of resource endowments, technology, and consumer preferences, it is possible for monetary policy — either deliberately or inadvertently — to affect real exchange rates. This did not seem like a controversial argument to make, but Scott isn’t buying it.
Scott examines the following passage from my quotation of Corden:
A nominal devaluation will devalue the real exchange rate if there is some rigidity or sluggishness either in the prices of non-tradables or in nominal wages. The nominal devaluation will then raise the prices of tradables relative to wage costs and to labour-intensive non-tradables. Thus it protects tradables.
And he finds it wanting.
I can’t figure out what that means. Taken literally it seems to imply that a nominal depreciation that is associated with a real depreciation is a form of protectionism. But that’s obviously nonsense. So what is he claiming? We know the nominal exchange rate doesn’t matter; only the real rate matters. But currency manipulation can’t be just a depreciation in the real exchange rate, as real exchange rates move around for all sorts of reasons. If a revolution broke out in Indonesia tomorrow, I don’t doubt that the real value [of] their currency would plummet. But no one would accuse Indonesia of currency manipulation.
There is I think some confusion in the way Scott interprets what Corden said. Corden says that if monetary policy is used to depreciate the real exchange rate, then it may be that the monetary policy had a protectionist intent. Scott’s response is that there are many reasons why a real exchange rate could depreciate, and most of them have nothing to do with any protectionist intent. If there is a revolution in Indonesia, the Indonesian real exchange rate will depreciate. Scott asks whether Indonesian revolutionaries are currency manipulators. My answer is: not unless there is a plausible argument that the revolution was intended to cause the real exchange rate to depreciate, and that the a revolution is a moderately efficient way of benefitting those Indonesians who would gain from a depreciated exchange rate. I think it would be hard to make even a remotely plausible argument that starting a revolution would be a good way for Indonesian industrialists to capture the rents from their revolutionary protectionist strategy. But if Scott wants to make such an argument, I am willing to hear him out.
Scott considers another example.
How about a decline in the real exchange rate caused by government policy? Maybe, but I don’t recall anyone accusing the Norwegians of currency manipulation when they set up a sovereign wealth fund for their oil riches. That’s a government policy that encourages national saving and hence boosts the current account. Nor was Australia accused of currency manipulation when they did tax reform in the late 1990s.
OK, fair enough. There are government policies that can affect the real exchange rate. Is every government policy that reduces the real exchange rate protectionist? No. The reduction of the real exchange rate may be a by-product, an incidental consequence, of a policy adopted for reasons that have nothing to do with protectionism. The world is a complicated place to live in.
Then referring to a passage of mine in which I made a similar point, Scott comments.
The term ‘motive’ seems to play a role in the passage above:
If the motive for the real devaluation was to protect tradables, then the current account surplus will be only a by-product, leading to more accumulation of foreign exchange reserves than the country’s monetary authority really wanted. Alternatively, if the motive for the real devaluation was to build up the foreign-exchange reserves – or to stop their decline – then the protection of tradables will be the by-product.
Scott doesn’t like talking about “motives.”
As an economist, references to “motives” make me very uncomfortable. Let’s take the example of China. Did China’s government try to reduce the real value of the yuan because they saw what happened during the 1997 SE Asia crisis, and wanted a big war chest in case they faced a balance of payments crisis? Or did they do the weak yuan policy to shift resources from domestic industries to tradable goods industries? I have absolutely no idea, nor do I see why it matters. Surely if a concept of currency manipulation has any coherent meaning, it cannot depend on the motive of the policymakers in a particular country? We aren’t mind readers. This is especially true if we are to believe that currency manipulation hurts other countries, as its proponent seem to suggest. How will it be identified?
Scott is mixing up a lot of different issues here, so let me try to sort them out. There are indeed two plausible explanations for China’s vast accumulation of foreign-exchange reserves in the 1990s and in the 20 aughts. One is a precautionary build-up of foreign-exchange reserves to be available in the event of a financial crisis; the other is exchange-rate protection, aka currency manipulation. It’s true; we can’t read the minds of the policy makers, but we can make reasonable assessments of the relative plausibility of either hypothesis, based on the size of the accumulation, the policy steps that were taken to implement and facilitate the accumulation, the public pronouncements of relevant officials, and, if we had access to them, the internal documents upon which policy-makers relied in reaching their decisions. Now obviously, the Chinese government is not about to share their internal documents with me or any outside investigator, but that is a choice made by the Chinese, not some inherent deficiency in the evidence upon which a diligent researcher could potentially rely in making a determination about the motivation for Chinese policy decisions. As an economic historian of considerable accomplishment, Scott is well aware of the kind of evidence that is relevant to evaluating the motives of policy makers, so I can’t help but suspect that Scott is playfully engaging in a bit of rhetorical obfuscation here.
In the spirit of Bastiat, consider the following analogy. Suppose that for years we had been buying bananas from Colombia for 10 cents a pound. American consumers got to eat lots of cheap tasty fruit, which don’t grow well in non-tropical countries. Then in 2018, Trump sends a team of investigators down to Colombia, and finds out that we’ve been scammed. It’s actually not a warm country, indeed quite cool due to its high elevation. The Colombian government had spent millions building giant greenhouses to grow bananas. We’ve been tricked into buying all these cheap bananas from Colombia, which artificially created a “competitive advantage” in the banana industry through subsidies.
Here’s my question: Why does it matter why the Colombian bananas were cheap? If we benefited from buying the bananas at 10 cents a pound, why would we care if the price reflected true competitive advantage or government subsidy? Does the US benefit from buying 10-cent bananas, or not?
Once again, there’s some tactical diversion taking place. The question at hand is whether a protectionist policy could, in principle, be implemented through monetary policy. The answer is clearly yes. But Scott is now inviting us to consider a different question: Do protectionist policies adopted by one country adversely affect people in other countries. The answer is: it depends. Since there are no bananas grown in the US, export subsidies by the Colombian government to their banana growers would not harm any Americans. However, if there were US banana growers who had invested in banana trees and other banana-growing assets, there would be Americans harmed by the Colombian subsidies. It is possible that the gains to American banana consumers might outweigh the losses to American banana growers, but then there would have to be some comparison of the relative gains and losses.
Now Scott comes back to his demand for a definition.
But that’s not all. Even if you convinced me that we should worry about interventionist policies in our trading partners, I’d still want a definition of currency manipulation. There are a billion ways that a foreign government could influence a real exchange rate. Which ones are “manipulation”? It’s meaningless to talk about China depreciating its currency, without explaining HOW. A currency is just a price, and reasoning from a currency change (real or nominal) is simply reasoning from a price change. Which specific actions constitute currency manipulation? I don’t want motives, I need verifiable actions. And [why] does this concept have to involve a current account surplus? Australia’s been running CA deficits for as long as I can remember. Suppose the Aussie government did enough “currency manipulation” to reduce their trend CA deficit from 4% of GDP to 2% of GDP. But it was still a deficit. Would that be “manipulation”. Why or why not?
OK, here it is: currency manipulation occurs when a government/monetary authority sets a particular nominal exchange-rate target which, it believes, will, at current domestic prices, give its export- and import-competing industries a competitive advantage over their foreign competitors, thereby generating a current account surplus. In addition, to prevent the influx of foreign cash associated with current account surplus from raising domestic non-tradable prices and undermining the competitive advantage of the protected tradable-goods sector, the government/monetary authority either restricts the amount of base money created or, more likely, increases reserve requirements imposed on the banking system to create a persistent excess demand for money, thereby ensuring a continuing current account surplus and accumulation of foreign exchange reserves and preserving the protected position of the tradable-goods sector.
Scott continues:
Should we care why a country has a big CA surplus? Suppose Switzerland has a big CA surplus due to high private saving rates, Singapore has a big CA surplus due to high public saving in common stocks, and China has a CA surplus due to high public saving in foreign exchange. What difference does it make? (And I haven’t even addressed Ricardian equivalence, which further clouds these distinctions.)
Whether we should care or not care about exchange-rate protection is a question no different from whether we should care about protection by tariffs or quotas. There is an argument for unilateral free trade, but most of the post-World-War II trend toward (somewhat) freer trade has been predicated on the idea of reciprocal reductions in trade barriers. If we believe in the reciprocal reduction of trade barriers, then it is not unreasonable to be concerned about trade barriers that are erected through currency manipulation as a substitute for the tarrifs, import quotas, and export subsidies prohibited under reciprocal trade agreements. If Scott is not interested in reciprocal trade agreements, that’s fine, but it is not unreasonable for those who are interested in reciprocal trade agreements to be concerned about covertly protectionist policies that are imposed as substitutes for tariffs, import quotas, and export subsidies.
We know that the only way that governments can affect the real exchange rate is by enacting policies that impact national saving or national investment. But almost all policies impact either national saving or national investment. So which of those count as manipulation? Is it merely policies that lead to the accumulation of foreign exchange? If so, then won’t you simply encourage countries to use some other technique for boosting national saving? An alternative policy that avoids having them be labeled currency manipulators?
In principle, there could be other policies aimed at increasing national savings that are protectionist in intent. One would have to look at each possible instance and evaluate it. At least that’s what would have to be done if one believes in reciprocal trade agreements.
There were some other points that Scott mentioned in his post that I will not address now, because the hour is late and I’m getting tired. Perhaps I’ll follow up with a short follow-up post in a day or so. Not promising though.
Uneasy Money 