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September 13, 2006
Paulson v. Paulson

BEIJING
Yesterday's Wall Street Journal pre-view of Treasury Secretary Hank Paulson's China speech was encouraging. Paulson emphasized the long-term "generational" relationship that we must develop with China and emphatically rebuffed the ideas and promoters of protectionism.DSC00067b.JPG
at the Intl Finance Forum in "Great Epoch City"

But today's New York Times re-view of Paulson's speech is more ominous. The story is titled, "Treasury chief delivers new warning to China." It emphasizes the contentious dollar-yuan exchange rate issue, asserting that Paulson "used unusually forceful language in saying that China has kept the value of its currency artificially low relative to the dollar."

We talk about the dollar-yuan here because the success or failure of American technology and the world economy often depends on these currency and trade issues. Exchange rates may seem like arcane stuff, but when grandstanding politicians -- like Senators Lindsey Graham and Chuck Schumer -- threaten to blow up international trade, and thus our livelihoods and security, with their 27.5% tariff on China, we should all pay attention.

Today, Robert Mundell, John Rutledge and I discussed these issues at the International Finance Forum at the "Great Epoch City" 50 kilometers outside Beijing. Most of the central bankers and economists there were headed next to Singapore for this weekend's IMF meetings.

Recently a smart person asked me, "Why don't you guys believe in markets instead of bureaucrats?" He was referring to my view, and that of the economists I listen to most, that the fixed dollar-yuan exchange rate has been a good thing for both the U.S. and China. It has facilitated trade, provided stability during China's historic transformation, hastened China's move toward markets, freedom, and openness, and expanded the globe's "dollar area," thus enhancing U.S. wealth and power. Many other economists and politicians believe exclusively in free-floating exchange rates, which supposedly is the "free market" thing to think. Anyway, to my smart friend's question, I answered:

-- We DO believe in markets. I would much prefer the Fed use a market price approach to monetary policy, using real-time market prices of commodities, exchange rates, and bonds to determine interest rates, rather than the mish-mash of backward-looking data, guesswork, and thoroughly disproved theories (Philips Curve) that many Fed members currently use. Monetary policy, and thus the value of the dollar, is today determined by 12 bureaucrats.

-- When I put the question to Robert Mundell on Thursday as we were riding to the opening of the new Mundell University School of Finance in the Financial District here, he reacted strongly: "The money supply is controlled by two monopolies of central bankers in the two countries. There's no market in that."

-- China, in fact, uses the dollar link to reduce the influence of bureaucrats on monetary policy. In a nation as diverse and dynamic as China, imagine the factions that would attempt to wield influence on monetary policy if China conducted its "FOMC" deliberations as we do. China's sophisticated cities are radically different from the inland farm areas. The two areas would argue for vastly different monetary policies. China's strong (but shrinking) state sector also poses challenges because of the lack of real prices in the old socialist sectors of the economy. Think about the sausage-making process that is our own FOMC or that of the European Bank, where 600 bureaucrats try to determine the correct interest rate, and then compound that with all of China's special challenges of rapid transformation, and you can see how difficult it would be. The dollar-yuan link takes thousands of bureaucrats out of the process and radically simplifies decision making.

-- Bob Mundell states emphatically that if China eliminated its exchange controls today, the yuan would most likely fall, not rise, weaken, not appreciate. Tyler Cowen of George Mason U. agrees. And Greg Mankiw agrees with Cowen that: "The United States should not be spending its international political capital on yuan revaluation."

-- Bob Mundell says that for China a substantial rise in the yuan would be "no different from committing suicide." It would:

- lower agricultural prices in poor areas that are a major economic and social concern
- lower foreign direct investment (FDI)
- hinder Asian economic integration
- crash real estate prices here
- cause a depression in China and perhaps all of Asia
- possibly severely reduce global trade and economic well being

-- China is in the midst of opening its capital markets -- a very good thing. American financial companies are on the verge of entering this very attractive market. Why would we want to cause chaos here?

-- Tiny changes in the yuan, like the small appreciation over the last year, are not too much of a problem. It's not an ideal system, but it's not a disaster. But neither does it help the U.S. at all. On the other hand, if we went to free-floating, speculators could turn these anticipated small changes into a sudden, massive change. That would be a disaster.

-- We have encouraged other nations for years to link to the dollar, or "dollarize." Creating "dollar areas" has been great for free trade and for the U.S. Many of the oil-producing Middle Eastern nations, for example, more or less link their currencies to the dollar.

This is interesting because it flows to the next point:

-- High oil prices are responsible for the great majority of the recent increase in the U.S. trade deficit. Over the last 5 years, our trade deficit has gone from around $400 billion to around $800 billion. Most of this increase is due to expensive oil.

-- If our Treasury or Fed thought an inflationary/weak dollar would help reduce the trade deficit, they were exactly wrong. High prices for oil and commodities (large portions of which are produced abroad but still priced in dollars) are a direct result of the overly accommodative monetary policy. American companies and consumers have had to pay hugely inflated prices to import oil and commodities, resulting in much of the increased trade deficit. If the weak dollar policy was designed to reduce the trade deficit, it failed.

-- Since the oil nations are largely "responsible" for our trade deficit, are we demanding that Saudi Arabia, Iraq, Venezuela, Canada, and Mexico appreciate their currencies?

-- We attempted a similar strategy with Japan in the mid- to late 1980s when Japan Inc. was supposedly going to take over the world. We pushed them to dramatically strengthen the yen, hoping that would reduce our trade deficit with them. It did not work. Japan's trade surplus with us and others has persisted. But we did succeed in helping push Japan into 14 years worth of deflation and chronic recession. Only in the last two years has Japan begun to emerge from the economic downturn we helped set in motion in the late 80s.

-- By the way, Japan's chronic trade surpluses (capital deficits) are mostly due to lifecycle intergenerational issues. They have lots of old people who need secure investments like Treasury bonds. We have lots of young people and good investment opportunities who need capital. Our fast growing economy can buy lots of goods from around the world. Japan's old people send us their capital (the dollars we send them to buy their goods and capital equipment). We send them bonds.

DSC00045d.JPG

-- Our trade deficit with China is due to (1) China's real competitive shock to the world economy in terms of manufacturing; (2) its need for safe financial assets (Treasuries) to help smooth its massive financial transition; (3) our attractiveness as a home for capital; and (4) long-term trends that have made the U.S. a place where design, finance, marketing, and other services have replaced lots of manufacturing. It is not a currency issue.

-- Mundell made the important point that even the most fervent advocates of floating exchange rates, like Milton Friedman in the 1970s, used to view floating rates as a means to an end -- namely, the opening of closed capital markets -- not an end in themselves. He and Friedman have had interesting, honest, good natured debates over these issues. Today's advocates of floating rates, on the other hand, often seem to regard such a system as inherently virtuous regardless of the economic chaos they often cause.

-- We should be spending our political capital to encourage China to:

- protect intellectual property;
- expand property rights here, especially in inland regions; and
- move toward currency convertibility (China could do this at the current exchange rate within the next two years);
- ironically, our push to appreciate the yuan only delays the far more important act of convertibility.

I'm hoping the New York Times reporter didn't understand Sec. Paulson's new emphasis on the long-term U.S.-China relationship and that by this time next week, these mercantalist and protectionist ideas will enjoy even less credit than they do today.

-Bret Swanson

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