China's Dollar Link Could Be a Depression Stopper
Nobody wants a trade war between two giant economies.
Tensions between the U.S. and China escalated recently when Treasury Secretary Timothy Geithner said during his Senate confirmation hearing that President Obama "believes that China is manipulating its currency." He went on to say that China and countries like it "cannot continue to get a free pass for undermining fair-trade principles."
This prompted Chinese Premier Wen Jiabao to mount a vigorous defense of China's existing exchange-rate policy. On a trip to Berlin late last month, Mr. Wen said there are "strong fluctuations in exchange rates between different currencies in the world . . . but China is not to blame for this." He pledged to keep the yuan at a "reasonable and balanced level."
Let's be clear here: First, there's no reason to believe that China does not desire a stable currency. Second, China bashing -- i.e., U.S. pressure to force Beijing to appreciate the yuan -- is misguided economic policy. Economists -- and the politicians they indoctrinate -- must discard the false theory that one can use changes in the exchange rate to control the net trade balance in a predictable way.
Instead of being an exchange-rate question, the huge trade imbalance between the two countries has two related causes: net "surplus" saving in China, i.e. domestic saving far beyond that which is needed to finance domestic investment; and an even bigger net saving deficiency in America. Since the collapse of the housing bubble in 2008-09, U.S. household consumption has plunged and saving has risen, depressing the global economy while reducing the U.S. trade deficit.
Contrary to widely held beliefs in both China and the U.S., a discrete appreciation of the yuan against the dollar would not reduce China's trade surplus or America's trade deficit. A discrete appreciation of the yuan could have the perverse effect of causing investment in China to slump, as firms see China becoming a higher-cost area. This could drive up China's already high net savings rate, thus increasing its trade surplus with the U.S.
Mr. Geithner's accusations notwithstanding, China has other reasons for wanting to keep the yuan-dollar rate stable. First, as long as the fixed rate is credible -- as it was between 1995 and 2004 at 8.28 yuan per dollar -- it serves as an effective monetary anchor for China's internal price level. After inflation had exploded to over 20% per year in 1993-95, the fixed-rate anchor helped China regain price-level stability. Second, Beijing's four trillion yuan ($586 billion) fiscal stimulus package, launched in November and likely to grow even larger, would be most effective if China's exchange rate is kept stable -- as it has been since last July.
So what should Beijing be doing now? In order to buoy China's and the world economy while further correcting the festering trade imbalance between China and the U.S., fiscal expansion in surplus-saving countries like China is desperately needed. Because massive U.S. fiscal expansion (as it appears we will soon have) would enlarge the U.S. trade deficit, better to convince the Chinese that they should do most of the fiscal stimulating.
Beijing knows that fiscal expansion in China would be most effective in buoying the Chinese economy when the exchange rate is stable. Thus having the Americans agree to stabilizing the yuan-dollar rate is the natural quid pro quo for China's engaging in a much greater fiscal expansion than the welcome half-trillion dollar amount announced last November.
Indeed, as the world goes into a severe economic downturn, the threat of beggar-thy-neighbor devaluations becomes acute -- as in the 1930s. Stabilizing the exchange rate between the world's two largest trading countries could be a useful fixed point for checking the devaluationist proclivities of other nations around the world.
Mr. McKinnon is a professor at Stanford University and a senior fellow at the Stanford Institution for Economic Policy Research.