China’s currency: Krugman vs. Herman

Over the past couple of days, economist Paul Krugman has spent an increasing amount of digital ink on the topic of China’s currency, and in particular, its value and the Chinese governments unwillingness, or intransigence in the face of global pressure to allow the RMB to appreciate naturally against other currencies.

Krugman’s argues that the US, and by default Europe, should turn the tables on China and enact trade penalties should the Chinese continue to forestall a significant appreciation of the RMB.

His argument in favour of punitive measures follows that an appreciation is necessary for the following reasons:

A)    As it stands, an unnatural RMB allows for the mass export of Chinese capital which leaves the rest of the world poorer.

B)    The appreciation of the RMB would allow for a surge in American exports.

C)    America has China over the barrel thanks to the bind the Chinese find themselves given their ownership of trillions in USD reserves.

He finishes his argument by noting that “never before has a nation followed this drastic a mercantilist policy.”

Now setting aside historical precedent, namely the Opium Wars, British attempts to limit manufacturing and industry in its colonies, or more recently, American-led IP conditionality at the WTO, there are a couple of important counter arguments to Krugman’s claims.

First, Krugman explains that Chinese capital exports leave the world poorer by creating a disincentive to invest and thus lower employment and lower demand. However, tightened capital exports are by no means a solution. In fact, if the Chinese stopped buying USD treasuries, the cost of borrowing would increase, leading to a simultaneous drop in investment, employment and demand. Krugman rightly identifies the paradox of thrift at play, yet incorrectly points the finger at the Chinese when the real issue is that the US government (as well as European ones) has failed to properly and adequately fill the investment and financing gap that a structurally-driven long-term recession has created.

Second, while Krugman believes that the appreciation of the RMB would automatically lead to an increase in US exports, thanks to a cheaper USD and thus more expensive Chinese imports / more competitive US exports, history isn’t as clear as he’d make us think. The most relevant comparison for the situation the Chinese and the world finds itself in is likely the early 1980s and the trade surplus amassed by Germany and Japan. As a result, the US forced the 1985 Plaza Accords on both nations, setting off a 40% appreciation in the Japanese Yen.

Low and behold, however, US exports to Japan didn’t budge as a combination of  Japanese competition policy and Japanese outsourcing to the rest of Asia, kept US imports out of Japan. Japanese exports to the US didn’t decline either.

Finally, while one can easily understand the long-term impacts of China’s undervalued currency on American and, more broadly speaking, Western economic competitiveness, we might want to put ourselves in the shoes of the Chinese and ask ourselves what we’d do then.

A stronger RMB puts the export-oriented  growth that has propelled China since the early 1980s at risk. Given internal targets that place necessary growth at 8 to 10% in order to create enough jobs to forestall social upheaval, any move that seriously risks attaining that growth seems silly enough.

One could argue that bankrupting your biggest consumers in the US and Western Europe is equally silly. Remember, however, that increasingly these markets play a smaller and smaller role in China’s export economy.

In 2008, over fifty percent of China’s exports went to the developing world. Perhaps more important, while exports to the developed world grew by just 10%  in the fourth quarter of 2009, they grew by over 50% to India, Brazil, Mexico and ASEAN. As this figure grows with economic growth across Asia, Africa and Latin America, so too will China’s ability to wean itself off of Western consumers.

And finally, while Krugman argues that China is keeping the rest of the world from growing, is that actually oh-so-wrong?  The world has long been ruled by those few countries with power. They write the rules, the others follow. That power tends to favour those with strong economies.

Low and behold China is slowly emerging as a rule maker, while the US is gradually losing its ability to dictate global economic policy.

The result is an increasing call from the US for economic fairness, for balance and for a fair chance to compete in global markets.

Yet hasn’t the Third World been calling for the same since the 1970s? Yet unfair trade practices, debilitating conditionalities and significant advantages to US and EU exporters and producers haven’t been altered.

Sure, it’s nice to think that we should all be equal. But equality has never existed. It seems to be against human nature. So perhaps it’s our turn to be on the side of the rule takers while China and others rise to become rule makers.

We certainly won’t like it but if we put ourselves in China’s shoes for an instant we might start to understand why they’re not likely to play nice.

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4 Comments on “China’s currency: Krugman vs. Herman”

  1. wfrost says:

    I am really beginning to believe that Krugman is just wallowing in self-pity or something equally unproductive. He can’t honestly believe that the trade relationship is so bad that we should risk paralyzing the global economy in an effort to reassert our masculinity.

  2. Denis says:

    “So perhaps its our turn to be on the side of the rule takers while China and others rise to become rule makers” strikes me as one of those quotes that might come back to haunt you if you ever run for office :).

    There’s one central issue I always come back to when it comes to the trade imbalance / currency issues. When I studied international trade, the most interesting discussion was around the factor abundance theory. In short, many developed economies have an abundance of capital (and a shortage of labor), while many developing economies have an abundance of labor (and shortage of capital).

    In turn, as I believe the argument goes, trade amounts to the developed nations exporting capital-intensive goods, while importing labor-intensive ones. Developing nations do the opposite. Everyone, in theory, ends up better off.

    But this is where I see a problem in the global economy. Once upon a time, nations had pretty strict rules around protecting IP, etc. that led to more productive capital. If these still existed today, if an American company like (say) Dell developed an innovative, capital intensive way to do X, they implemented these in their home country, and traded with foreign ones. This innovative use of capital created a competitive advantage, which, in many cases, should also help the local labor market by pushing up wages (for skilled workers at least).

    More and more, capital and “trade secrets” flow across borders – if a company like Dell innovates, they can use the innovation to optimize production anywhere in the world. So a solution developed in (say) the U.S. can be used in (say) China.

    As that happens, the entire concept of factor trading fades away, doesn’t it? If you use the simple model of only two inputs, capital and labor, and capital can flow freely across borders, you can’t really trade one for the other. In turn, whatever country can bring the lowest labor costs (that meets the skill and education requirements, etc.) to the table will end up producing everything… kind of like China today.

    So that’s a long preamble to say I am in the camp that China needs to let it’s currency appreciate. In a world where (ideally) capital flows across borders, it’s an absolute necessity in order for trade to work in the long-term.

    And on somewhat a side note, it’s always a little fascinating that “exporting” is viewed as the route to wealth – and funny watching everyone try to be a net exporter simultaneously. If you sat two people down, and one person made stuff, and the other consumed it, the latter would be considered better off. Sit two countries down, one makes stuff, and the other consumers it, and the former is seen as better off.

    Let the currency appreciate, thus letting more people in China consume more things, and they might just be better off as net exports decline. And when people talk about letting the rest of the world grow, maybe a solution will arise that makes everyone happy – notably nations less developed then China moving up a few notches. After all, if China is a long-term net exporter to developing nations, and export-led growth IS the route upwards, how is anyone else going to move up?

  3. DH says:

    I don’t disagree with the basic premise of your argument, Denis.

    China needs trade partners, and can only get them (sustainably), if they help create and maintain those markets. Currency appreciation that in theory allows others to trade profitably will be one method of doing so.

    However, don’t also forget, that as other developing country exports tend to be resource based, and USD priced, they’ll actually lose in the balance as the USD devalues and developing country revenue per qty plummets along with it. So unless there’s a new pricing structure in other currencies, the developing country markets that are of growing importance to China might actually be able to purchase less from China with an appreciation.

    Beyond that, what is really at issue here isn’t the question of comparative advantage and the necessity of trade, but rather the political economy of China’s rising power and its ability to dictate the terms of its global engagement.

    While the US wants a rapid and immediate appreciation, China now has the ability to dictate its monetary policy as it sees fit. China will inevitably raise the value of the RMB, if only to control internal inflation, but the question is when and by how much. In the 20th century such questions were unnecessary as the rules were written from Washington and Brussels. Today, they’re increasingly written across a dozen or so capitals, and China’s decision will be made with China’s long-term interests at heart.

    As I wrote previously about Japan, China wants to ensure that it doesn’t suffer the same fate as Japan – and instead, develop a very gradual transitional plan that allows for the diversification of its internal economy before playing by the rules of the major powers.

    Such a view is rather antithetical to the world of global governance we’ve known for the past 60 years but I think it’s increasingly going to represent how the next 20 or 30 will go.


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