The US is “Taking on China”

by Andreas Hoffmann and Gunther Schnabl*

In a recent New York Times column Paul Krugman is “Taking on China” again. He argues that the Chinese dollar peg contributes to global imbalances, depressing US and world growth perspectives. Bashing China’s fixed exchange rate is also fashionable in academics. Bernanke blames China’s dollar peg for contributing to a “savings glut” that contributed to the US pre-crisis excesses. Dooley argues that China and other East Asian economies engage in mercantilist trade strategies. Bergsten wants to label China a “currency manipulator.”

We find these arguments unbalanced. Fixed exchange rates do not cause balance of payments misalignments themselves (see Hanke). Whereas with a floating exchange rate the monetary policy is determined by the central bank and the exchange rate is left to the market, a credible peg targets exchange rates and leaves money supply to market forces. Both systems allow for a market driven adjustment. Economies with underdeveloped goods and capital markets have been using pegs for decades to import macroeconomic and financial stability. The peg itself cannot be the problem.

The problem is that the Peoples Bank of China is forced to target both the exchange rate and money supply. As the huge foreign reserve accumulation expands the money supply beyond what is tolerable for domestic price and financial stability, the Chinese central bank mobs up surplus liquidity by increasing (inter alia) reserve requirements. The resulting real exchange rate stabilization distorts the goods market sector, as exports are subsidized.

In addition, to save costs and to prevent a rise in interest rates (which would attract new capital inflows) sterilization is done by coercion below market rates. This distorts financial markets as the resulting surplus demand for capital is allocated politically through the state controlled financial system in favor of the export sector.

Should China Float or Stop Sterilization? – If China floated the yuan, the export sector would collapse and unemployment would soar. Given unprecedented low world interest rates, signaling yuan appreciation would attract a tsunami of speculative money inflows seeking for easy profits from appreciation. This would step up inflation and asset prices, as it happened in Japan after the 1985 Plaza-appreciation (McKinnon and Schnabl). Stopping sterilization would open the door to bubbles and inflation as well because the US as anchor economy continues its very easy money policies. China is caught in a policy trap! Any policy move will cause unpleasant turbulences unless the US returns to inflation neutral policies.

Thus, the only way out of the dilemma would be a coordinated move by China and the US. The Federal Reserve would have to return to an inflation neutral policy stance to dry out the source of hot money inflows into China. China would have to stop non-market based sterilization to end the subsidies for the export sector. But instead of aiming at a cooperative exit – from what Hayek might have called “monetary nationalism” – to correct global imbalances, the US pushes for confrontation via economic sanctions. This may lead to minor yuan appreciations to please the US public, but does not solve the problem of two economies whose economic faith is inescapably intertwined.

*Andreas  Hoffmann is a doctoral candidate at the University of Leipzig and currently visiting the Department of Economics at New York University. Gunther Schnabl is professor of economic policy and  international economics at the University of  Leipzig.

15 thoughts on “The US is “Taking on China”

  1. Excellent post.

    If I may, I’d like to tease out something that I find implicit in what you have written. The “savings glut” is not independent of expansionary monetary policy by the Fed. The Bernanke saving glut is not an alternative expalanation of lwo inteerst rates., but a mechanism by which Fed policy exerts its influence.

    (This leaves unanswered the contention by both John Taylor and Steve Hanke that there was no savings glut. According to them, global savings did not actually increase during the housing boom.)

  2. The U.S. savings rate fell quite a lot during the housing boom thanks in part to low interest rates engineered by the Fed.
    China’s high savings rate was in part a cultural effect of its one-child policy, according to some commentators, as young males had cultural pressure to attract a mate and save to support their parents in their old age.

  3. Excellent post.

    The chinese saving glut is the very cause that sustained the US economy after the 2000 recession: with a 0% personal saving rate (private savings are higher, I think it’s due to retained profits), the US economy would have gone nowhere without a huge capital inflow from without. That’s a Fed-caused problem.

    The US economy cannot work with 0 personal saving, 2t$ private saving, 1t$ public deficit: it either needs to invest only the remaining 1t$, or it needs to import 1t$ from outside and keeps its productive structure afloat*.

    How credible is the US threat of sanctions in these conditions? Close to zero, unless the White House wants a total crumbling of the US economy, losing something less than 50% of available funds for domestic investment which come from outside (not only China). A protectionist US is just like a drunk who menaces its pub with a ban on alcohol: not credible.

    However, the problem with China is already one of a bubbling economy: malinvestment there is already a reality. I’ve been told of widespread unused capacity in steel processing and entire towns without inhabitants, for instance. China is the missing capital side of the Austrian boom that in the US has been confined to construction, and the capital flows from China to the US are the accounting epiphenomenon of malinvestment.

    * Data are much imprecise, only the magnitude is right. t$ is a trillion, of course. Everything can be found on Fred.

  4. Andreas, Thanks. Sorry for the typos.

    China’s high savings rate is mostly the product of retained earnings by state-owned enterprises. The Chinese people are big consumers.

    Excellent point about malinvestment. People ask me where is the bubble due to Fed policy now, and I respond in Asian real estate.

    US and China are co-dependent.

  5. Krugman first changed albeit only for a while at the end of the 1980s when he started becoming vague about free trade.

    I assumed at the time that it was part of job application for chair of the council of economic advisors for 1992 democratic administration.

    He did not get the job, passed over for obscure academics for pandered to free trade theory. He then attacked pop internationalism at every turn.

    His New York Times writings were good until he became the first diagnosed sufferer of Bush derangement syndrome at the end of 2000. Bush derangement syndrome is the Left’s version of Clinton derangement syndrome.

    Calling for a trade war is a sorry end for a once fine critic of pop internationalism, monetary nationalism and rent seeking.

  6. @Jerry: we thank you for your favorable comment and the nice link.

    @Pietro: indeed, even though I am not sure about what came first: real stabilization or easy money policies. It now seems to be a vicious cycle which is hard to break up. And neither side seems to have an incentive to start. The US wants to keep refinancing debt cheaply and provide low cost credit. And China’s interests are clear.

  7. In my last post, “He did not get the job, passed over for obscure academics for pandered to free trade theory” should be “He did not get the job, passed over for obscure academics who pandered to free trade theory.”

  8. a real bad typing morning: “He did not get the job, passed over for obscure academics who pandered to strategic trade theory.”

  9. @jerry I fully share the view that the East Asian saving glut is not independent from US monetary policies. Indeed, expansionary US monetary policies have triggered much of the East Asian accumulation of US government bonds. Therefore more research is needed in tracing the direction of causality in global imbalances rather than just assuming East Asian policy action as exogenous.

  10. On gluts, I saw something a while ago that argued that lower U.S. rate of savings was a by-product of the great moderation. There is a reducing need for precautionary savings because there is more employment and other stability. Capital flowed into the USA because there were still many good investment opportunities.

    BTW 1: have you noticed how that otherwise cautious economists, by asking them to talk about savings, they become born again central planners, pretending to know what the optimal level of social savings is, and always it is always higher than whatever it is today. Whenever I am told that national savings are too low, I always ask how much higher should it be, and how is this higher number derived? From the look on their faces, they do not understand the reason for asking, or realised they have never thought about this! I have never got my answer.

    BTW 2: A few years ago, the IMF calculated the optimal current account deficit of the USA, found it was too low rather than too high, but still recommend that the USA cutback on its current account deficit!

  11. @ Jim

    Here we are not talking about an optimal level of savings, but about a conflict between China and the US. The US blames the Chinese of interventionism. This is not wrong in general. But from the Chinese point of view there is no other choice, at the moment.

    I do not know if US savings would be higher or Chinese savings lower otherwise – even though it is likely (given the incentives). It is about how to end an intervention in the market adjustment process that possibly contributes to imbalances (as claimed by many authors).

  12. We’re really grappling with two problems. First is the mammoth debt that has been incurred to China (and others). The U.S. needs to figure out a strategy for repaying all that debt without crippling its internal investment for a generation or two. Or we can just strategically default, though I doubt our government has the wherewithal to engineer default to a positive outcome.

    Second concern is all that investment going on in the emerging countries. In the long run that’s going to be a problem, since American labor is not competitive unless the competition is saddled with iron-age industrial technology and shoddy infrastructure. Nixon and later Clinton let the genies out of their bottles for a short-lived military hedge against the USSR. Now those countries’ economies have developed beyond what was minimally necessary to serve as export markets for U.S. goods. Talk about the bungle of the century.

    And don’t get me started on the extra 2 billion people consuming finite resources, driving their price up for folks over here.

    I’m afraid that war is the only possible outcome here. Americans won’t accept a ‘world average’ standard of living without a fight.

  13. O’Driscoll said: “China’s high savings rate is mostly the product of retained earnings by state-owned enterprises. The Chinese people are big consumers.”

    On The Economist and elsewhere I often read that high savings were due to the lack of a welfare state, but the point was never developed.

    Now I’ve found a paper which says that it is due to retained earnings by *private* firms:

    The argument of the paper is that due to financial market frictions, private firms need to save a lot out of retained earnings in order to grow.

  14. Here’s a question I’ve not seen answered by those who believe in the global savings glut theory. If there was a global savings glut and that savings flowing to the US is what caused the housing bubble, why did the dollar fall from 2002 until the crisis in the fall of 2008? If there was a glut it would seem to be a glut of dollars. As for the calls by our politicians to revalue or float the yuan, they should be careful what they wish for; the last time the Chinese allowed the Yuan to appreciate we got a global financial crisis. When we forced the Japanese to revalue the yen we got the crash of ’87 and the Japanese got 15 years of deflation. Not exactly an optimal outcome.

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