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well, China's rate may not be "fixed" in the in the traditional way, but it certainly does not float.

Just because a government can adjust a roughly fixed rate, that doesn't mean that it no longer a fixed rate, and hence "flexible". I mean, the reasoning is absurd. Any pegged country can choose to change the rate of their peg, therefore there are no pegged currencies in the world and all exchange rates are "flexible"

You're just bastardizing the terms. By your weird definition any exchange rate that can be changed by the government is "flexible" even if it is in reality fixed, like China's.

your definition of flexible exchange rate is kind of bizarre.

So, if a country has its currency pegged, but can chose to change the rate of the peg, the exchange rate is therefore flexible? So there is pretty much no such thing as a fixed rate whatsoever, because it can always be changed by the government? You're bastardizing the definition of a fixed rate in order to make your point stronger.

It is quite obvious that China would fall under a fixed rate regime, but please don't take my word for it. Shoot an Email to Brad Setser if you want a second opinion.

guh.. sorry for the double post.. I thought the first one got lost. typepad comments are acting up. please feel free to delete one of them and this post

NIck, there is quite a bit of literature out there talking about the U.S. balance of payments deficit, and lamenting the inability of the U.S. to devalue because of Bretton Woods II, a sort of de facto fixed exchange rate regime with many countries pegged to the U.S. dollar.
I don't find measuring shares of trade by adding exports and imports very telling. China is a big piece of world trade for U.S. manufacturing on the import side. Manufacturing matters in what is going on right now.
By the way, the free rider argument Krugman invokes never impressed me as much as the exorbitant privilege argument about the dollar as a reserve currency. In fact the use of a national money as international money is number one on my list of what went wrong leading up to the current crisis of financial capitalism. if only the Keynes plan had been adopted in 1944.

bob: we could have a very enjoyable (and very worthwhile) discussion about what "flexible" exchange rates means. But in this particular context, if they adjust the peg, then it's certainly not fixed, and if they adjust the peg in the same direction and by the same amount (in response to a change in US fiscal policy) as would happen if it were flexible, then for the purposes of my argument it is 'as if' it were flexible.

But I'm not saying it is flexible. I'm saying it is not obvious whether it is closer to fixed or flexible in this context.

Yes, adjusting a fixed exchange rate in response to circumstances is an oxymoron.

bob's got a point.

But my guess is Nick is implicitly talking not about US-China trade, but US-Canada :-P.

china's exchange rate has effectively been fixed for the last six months, if not a bit longer. there is almost no movement v the dollar. I would argue that the best forward looking assumption is that the current "repeg" doesn't change.

bob: yes, I've been having a few TypePad problems too. I'm going to leave both your comments up, because they are slightly different, and both good, and needed saying.

duncan: I've recently been trying to get my head around some of those questions, in particular the differences between now and the 1930's, when they had the gold standard, and we don't now. Also the reserve currency question now. I hope to post on it when I've got my head clearer. But it is clear that under the gold standard, before countries started to devalue, both monetary policy and fiscal policy were very different in their effects than they are now. And the fiscal externalities Paul Krugman is talking about were very real and important. These differences between now and the 1930's give me grounds for optimism.

Yes, China has a bigger share of imports. I used the (imports+exports) measure because a change in the exchange rate will generally affect both imports and exports. What matters theoretically is both the import and export shares, and the elasticities. Since I don't know the elasticities, the import+export share is the best I can do.

bsetser: (Brad?): what matters though is not your unconditional forecast, but your conditional forecasts under these two circumstances:

1. Assuming a big US fiscal expansion which causes a big US recovery
2. Assuming no US fiscal expansion and no US recovery
(Assume the same Chinese fiscal policy in both cases)

If you give the same answer to both, then it's fixed.

But even if China really does have fixed exchange rates vs the US$. A lot of world trade takes place at flexible exchange rates. Why design a policy based on US/China and apply it to the whole world? What about Canada/China? Canada/US. US/Europe? etc.

Nick - two nice followups to the Krugman piece. My follow-up is here:


"But my guess is Nick is implicitly talking not about US-China trade, but US-Canada :-P"

True, I'm also Canadian, so it is an important question for me. I can see good reason to grant Canada and Europe exemption from this clause, as we allow floating exchange rates, operate under equivalent human rights and environmental standards, and we are planning similar stimulus, so leakage would at least be reciprocal. I noticed that DeLong has posted John Ibbitson's article on this from the G&M, so it seems like it might be gaining some recognition as an issue.

However, I can understand why the American government would be hesitant to send their orders to a plant in China so long as China continues to manipulate its currency, undercutting American manufacturing. The difficult paradox is that a large part of the money being borrowed via Treasuries to fund the stimulus is a by-product of the currency peg (the need for Chinese to buy dollar assets like treasuries). So the US government is in a bit of a bind. The borrowing is like bailing a ship, but the hole in the bottom of it is the Chinese trade policy that has all but destroyed the American manufacturing base, while dumping money back in (savings glut) encouraging borrowing and bubbles. My own opinion is that in the current environment, demand for treasuries is so strong, and yields are so low that the US could probably borrow plenty of money at a decent rate even if Chinese purchases are greatly reduced.

A second question for bsetser (I should have thought of this the first time):

What is your conditional forecast for the China/US$ exchange rate in these two cases:
3. Assuming a big China fiscal expansion, and China's economy recovers.
4. Assuming no China fiscal expansion, and no China recovery.

Assume the same US and ROW fiscal policy in both cases.

If you have the same forecast for 3 and 4, then China has fixed exchange rates.

By the way, is it renminbi, or yuan?? (As you can see, I make no claims whatsoever to being an expert on Chinese monetary policy ;-) )

Nick, my conditional forecast is no change in either scenarios 1 or 2.

indeed, i would attach some small probability to a chinese deval in the scenario where a large us fiscal expansion drove a us recovery, as that scenario might be accompanied by a strengthening dollar (higher us rates, stronger us growth v the world) that pulled the rmb up v europe, and europe is now a more important market for china than the us.

the only scenario where i would assign a reasonable probability to a CNY (or renminbi) appreciation v the dollar is scenario 3. if scenario 3 coincided with dollar weakness and china was experiencing inflationary pressures, it might consider allowing the currency to appreciate v the dollar. but right now i wouldn't discount the argument inside china that the current slowdown is the PBOC's fault, as the PBOC allowed the CNY to appreciate and that caused exports to slow. It is false -- the CNY appreciation v the dollar never drove any nominal appreciation v a basket, as the CNYEUR was depreciating over this time. but there was a correlation with somewhat slower export growth as the US slowed and inflation in china picked up driving a real appreciation... and, well, the argument has political traction. especially when some portions of china's exports are labor intensive and there is a global jobs shortage ...

the counter argument that china's exports has so far held up better than others/ china's current account surplus is still growing doesn't have any traction in china.

bottom line: absent external pressure, i would expect the CNY to remain fixed v USD in most states of the world. the forward market now prices in a small depreciation incidentally. indeed, i would tend to expect most of asia to resist pressure to appreciate v the dollar until asian economies recover.

renminbi is literally the people's money, and it a common term for china's currency. yuan is I think the unit of account (same roots as won and yen). both are correct in most contexts.

and yes, bsetser = brad setser

Thanks Brad; that was very helpful.

Bob: remember one thing though, any country's central bank can fix its nominal exchange rate, but fixing its real exchange rate is another question. In the long run, relative price levels will adjust to fully offset any peg in the nominal exchange rate, so the real exchange rate is unaffected. I have been assuming fixed (or at least sticky) prices here, since this is short-run analysis. A country can affect its real exchange rate in the long run by changing its national savings (or investment). I see the long run low real exchange rate for the yuan (and trade surplus) as primarily a result of China's very high national savings. The cause of that very high national savings is another question, and one I don't really understand. The demographics and pension/health policies are probably part of it.

Nick - the high national savings rate is a result of the low exchange rate mechanism, not vice-versa. I think that's the important bit that your analysis is missing. That's how they are manipulating the real exchange rate in the long run.

Savings glut is a bit of a misnomer. It is not as if there are millions of Chinese grandpas stuffing away tons of money in their bank account. It's more like a forced savings scheme via the currency control system. The heavy currency controls, and forced savings being dumped into treasuries are necessary for China to fight the "invisible hand" that would force the changes you mentioned above. I don't think you realize the massive scope of what China does to keep its currency undervalued, and the lengths it goes to to counter the forces that would naturally push it up even in a fixed regime as you pointed out. they are very actively arm-wrestling the invisible hand.

My understanding of the Chinese system, gleaned partially from a conversation with Dean Baker last year, and partially from Brad is as follows:

1) you buy a pair of shoes that were made in China for $100 USD
2) In order to get to the factory, the money has to go through the government currency service.
3) The government keeps all the dollars, and gives the factory owner an amount of RMB that is actually worth considerably less in real terms than the $100 USD
4) In order to keep peg-related inflation within China under control, and keep the real exchange rate as low as possible, the government has to reinvest in US dollar assets like treasuries. On top of that there are very strict currency controls to avoid free exchange of the Chinese currency for any other currency. The exchange rate for RMB in the black market is better than what you get from the government.

So although people call it a savings glut, it is more like forced savings, or a government skim off of the purchasing power of everyone who works in their export industries. As you noted, there are all sorts of natural forces that should push this back towards a normal equilibrium in the long run, but China has figured out a very clever system to counteract almost all of those effects. The byproduct of that system is ever increasing purchases of treasuries, hence "high national savings". But they are forced savings, taken through the government controlled exchange service in order to keep the RMB and with it the purchasing power of Chinese workers as low as possible. The Chinese cheap labour "comparative advantage" mainly results from the government skimming off their purchasing power, and lending it back to America via treasuries.

does that sound about right to you Brad?

bob: that last comment was very helpful. I think I understand you now. I am going to think about it some more, then maybe re-state it in my own words, to make sure.

bob: yes, that was VERY helpful, because it not only helps me understand your previous comment, it also helps me understand why China's national savings could be so high (something I couldn't figure out before, because although I could see some reasons why private savings should be high, they didn't seem big enough reasons to explain all of it).

Consolidate the balance sheets of the government and central bank. If the government runs a very big surplus (through taxes, or whatever hidden taxes or revenue sources the government is using). It has to hold that flow of public savings in some form or other. Normally we assume the government will pay down the national debt, so it is using the surplus to buy back its own bonds. But in China (perhaps because there isn't a big stock of government bonds, or because it wants forex reserves, or some other reason??) the government decides instead to buy US T-bills. And it uses the Bank of China as its purchasing agent. Is that right?

A minor question: does it make any difference whether the government uses the surplus to buy US T-bills or buy back its own bonds instead? My guess is that with perfect capital mobility, it would make no difference. With imperfect capital mobility (China bonds are imperfect substitutes for US bonds) it does make a difference. Is that difference a part of your story, or just a minor complication?

one other thing that I should add, and a crucial part of the system:

If the factory owner is being paid in undervalued currency, how does he afford to buy fungible inputs like oil on the world market?

This is where the subsidy system comes in. China strategically subsidizes resources like oil (to make plastics) so that their manufacturers don't feel the effects of the their undervalued currency on import prices. On the other hand, imports of finished consumer goods are not subsidized, so a German company looking to sell Sham-wows in China is confronted with a consumer market that has puny purchasing power. Domestic manufacturers in China face a similar problem in selling to their own market.

The Chinese system basically makes consumer goods very expensive within the domestic market, but strategic resources and labour very cheap. That's the engine of their export machine as I see it.

correct me if I'm wrong, but given the huge trade surplus, and creditor nation status of China, I don't think that the government issues any bonds or has an outstanding debt at all. It just exchanges all the incoming foreign currency for Chinese currency, and invests the dollars in dollar denominated assets abroad.

I've kind of just using treasuries as shorthand here. Of the dollars that come in, some are used to buy imports (factory sends chinese currency through government, government settles transaction in dollars), some are used to subsidize certain imports, and the excess accumulates in forex dollar reserves, US T-Bill purchases, and foreign investments (although the Unical fiasco where the US government started blocking Chinese equity investments put a big damper on that).

whoops scratch that first paragraph, they do issue bonds and do have an outstanding debt. I haven't really thought about how that all works. I'll have to look into it

"So I think that my assumption, that the world has flexible exchange rates, is better than the opposite."

Yeah, but no one's holding a gun to our heads saying that we can only chose one extreme assumption or the other in doing our policy analysis for the real world. In the real world, if a free riding country starts to experience a strong increase in its exchange rate, it's more likely than not that they will eventually try to push it down if we're still in a severe global recession.

Also, with regard to your model, consumer and producer responses to changes in exchange rates can take substantial time. Consumers don't change their buying habits instantly in response to changes in exchange rates and neither do producers, who may be locked in by long term contracts. There is significant habit behavior. The external countries may still, even with the other strong assumptions of your model, be able to free ride increased demand for much, or even all, of the recession. Thus, it's much better to get together and negotiate coordinated global action in this and so many things.

Another example is increasing gasoline taxes. If the U.S. increased gasoline taxes by $1, this would be a strong blow to terrorism, by depressing oil prices, and thus money to terrorists and some of the worst authoritarian regimes in the world, but if all of the advanced countries got together and agreed to raise gas taxes by $1, all at once, this would have far more of an effect -- it would devastate oil prices, and really give an impetus to terrorist sponsoring countries to work with the rest of the world and become productive or else live in deep poverty.

Finally, let' be very clear; Paul Krugman has always been very strongly pro-trade. I'm sure he's well aware that any temporary protectionism could easily become long-term, causing tremendous cost in decreased economies of scale and efficient specialization, decreased competition and opportunity, increased cronyism, etc., etc.

I'll add to my fantasy treaty among the oil consuming nations to all increase gas taxes by $1 simultaneously, the agreement that all of the tax money will be spent on basic scientific research on alternative energy, solar, nuclear, wind, batteries, insulation, etc. What a tremendous blow that would strike against terrorism and negative behavior of some of the worst authoritarian regimes in the world, and of course against global warming.

Thanks Richard: Paragraph by paragraph:
1. Agreed. But it's perhaps best to start with two models from opposite extremes, then work our way towards some sort of middle. At least it's clearer that way. And it's so hard being clearly understood, in this game.
2. Agreed, but in my model, that wouldn't actually change the conclusions. If the short-run exchange rate elasticity of demand for net exports is smaller than in the long run, all that happens is that we get a bigger depreciation from an expansionary fiscal policy in the SR than in the LR.
3. Yep.
4. Yes, and I think I should have emphasised that more strongly. But PK did himself, in his response.

"What a tremendous blow that would strike against terrorism and negative behavior of some of the worst authoritarian regimes in the world, and of course against global warming."

Take it easy on Stephen. There are many many many valid criticisms of Conservatives but his increase of the prison economy size has been surprisingly minor and his position on terrorism (mild torture of a child soldier falsely charged using doctored USA documents as evidence). He knows last fall was a good time for the elderly to bargain hunt stocks and he knows no deficits ever!!

"So although people call it a savings glut, it is more like forced savings, or a government skim off of the purchasing power of everyone who works in their export industries. As you noted, there are all sorts of natural forces that should push this back towards a normal equilibrium in the long run, but China has figured out a very clever system to counteract almost all of those effects."--Bob


This is very interesting. But what about the majority of the Chinese people who don't work in export industries: Why do they save? Are they forced to save?

wjd123: Pity, we seem to have lost bob temporarily. I hope he comes back.

In the meantime, here is how I think your question should be answered:

National savings = government budget surplus + private savings.

In standard models, any country that has high national savings relative to investment will have a low real exchange rate and high net exports. Savings and investment determine both the exchange rate and the trade balance, not vice versa, in the long run.

In China, national savings were high because the budget surplus is high. Private savings are a smaller part of the story. Even though the percentage of personal disposable income is fairly high (because of savings for old age and sickness, with little government pension or healthcare), personal income is not very high. Most government revenue comes from hidden taxes on export industries, rather than regular taxes.

hey all, I'm still kicking around.
Nick, that sounds right to me. Probably a lot better and cleaner than I would have explained it myself.

Greg Mankiw has an article in the NYT today on this issue, which I strongly disagree with. He contends that we shouldn't rock the boat, because, as I noted above, the Treasury purchases that are funding the stimulus bill are largely a byproduct of the currency peg.

It’s No Time for Protectionism

Since when is it "protectionist" to advocate floating exchange rates????? guh. Anyways, here's Mankiw:

"So when the Treasury secretary complains about the undervalued yuan, his message to the Chinese boils down to this: Stop lending us money."

He thinks that the Chinese trade policy is unrelated to our current problems:

"Olivier Blanchard, the chief economist of the International Monetary Fund, had it right when he said: “It is probably not the right time to focus on the Chinese exchange rate, given that it is not a central element of the world crisis. There are many other things we should be thinking about.”"

Olivier Blanchard and Mankiw are both wrong. Almost everything that has gone wrong in the last decade can be linked directly to the massive distortionary effects of China's peg:

1) Over-borrowing/low savings rate - China forcefully drove down American interest rates thus encouraged borrowing and discouraged savings
2) Financial Engineering/excessive risk-taking - the reason that so many of these risky "AAA" products were created was because the yields on treasuries and GSE debt were driven so low by the Chinese demand
3) Decimated manufacturing - this one speaks for itself
4) Deflation - In the past it was thought to be a benefit that Wal-Mart etc. basically imported deflation ("lower prices everyday"), while the Chinese government dutifully mopped up/neutralized all the dollars. This allowed the Fed to pursue wildly expansionary policies, without the inflation that would usually occur. Now however, we could really use that inflation, but Chinese trade continues to exert a deflationary force on the American economy, rendering monetary policy useless right down to the zero bound.

Mankiw and Blanchard are right to point out that America needs Chinese lending right now, but they do not realize that US-China trade relations are at the very core of what is wrong with the economy. Nouriel Roubini, Brad Setser, Hank Paulson, Dean Baker, Chinese government officials, and countless others recognized these issues as early as 2003-2004, and since 2005 there has basically been a consensus between American and Chinese to do the right thing and gradually move towards a fair value yuan. As Brad Setser noted above, the crisis has brought this much needed process to a screeching halt, and imbeciles like Mankiw think that we should actually applaud this backslide because, hey, we get cheap tee-shirts out of the deal. unbelievable.

The backslide on the Chinese currency undervaluation is FAR FAR more disastrous that any moves towards protectionism. The Chinese issue was the whole reason that Hank Paulson was brought in. He was supposed to be massaging the process, but it all fell apart before we got close to a fair valuation. There will be no solution to our current situation without BW3 or a Chinese revaluation. Geithner realizes this, Paulson knew this, the Council on Foreign Relations hired Setser because they realized this - everyone knows it, and many have known it for years. Yet here is Mankiw in the NYT, cheerleading a backslide on the most important free trade issue of our time.

If there is one thing that Geithner should have every single economist's full support on, it is the issue of the Chinese currency manipulation. You simply cannot call yourself a supporter of free markets and free trade, yet turn a blind eye to Chinese currency manipulation, protectionist tariffs, subsidy systems, etc. etc.

here's a little more information on the national savings rate in China if anyone is interested:

Understanding High Saving Rate in China
Xinhua He Senior Fellow 1 , Yongfu Cao Assistant Research Fellow 2
1 Institute of World Economics and Politics, Chinese Academy of Social Sciences, Beijing, China. Email: xinhuahe@vip.sina.com. 2 Institute of World Economics and Politics, Chinese Academy of Social Sciences, Beijing, China. Email: caoyongfu@eyou.com.


This paper presents a detailed analysis of the Chinese saving rate based on the flow of funds data. It finds that the most widely adopted view of precautionary saving, which is regarded as the top reason for maintaining a high saving rate in China, is misleading because this conclusion is drawn from the household survey data. In fact, the household saving rate has declined dramatically since the mid-1990s, as is observed from the flow of funds framework. The high national saving rate is attributed to the increasing shares of both government and corporation disposable incomes. Insufficient consumption demand is caused by the persistent decrease in percentage share of household to national disposable income. Government- directed income redistribution urgently needs to be improved to accelerate consumption, which in turn would make the Chinese economy less investment-led and help to reduce the current account surplus.

full article can be accessed here:


Thanks bob. That was interesting. Confirms what you and Brad are saying, I think.

And the Chinese are going to say HAHAHAHAHAHA.

Because despite what their officials say, it actually works for them! Of course they are going to manipulate things. Suuuure, they may give a concession or two to look cooperative, but impoverishing the USA is also a strategic imperative with value in itself.

Wealth is relative.

Only if you divide it by some reference number.

just to be clear, re: mandos comment, I don't think that either America or China is out to get anyone. The Chinese found a set of policies that worked, with strong growth and low inflation, and pursued them. At the same time Greenspan and Robert "high dollar" Rubin were pursuing the same goals in the USA, and according to the usual measures (as Nick points out in the new article, which I really enjoyed btw) they were achieving growth with low inflation, so it seemed to be working. China willingly skewed their economy towards exports, and America willing skewed theirs towards imports. It just happened to turn into a kind of self-reinforcing symbiotic relationship that probably wasn't entirely foreseen at the time. Now it is harming both countries.

The High Dollar: President Clinton's Unaffordable Tax Cut - By Dean Baker

In terms of dealing with the issue, I think that both countries interest is best served by moving towards a floating exchange rate. This would allow the Chinese middle class to really develop in the way that Japan did in the 70's by curing the deficient domestic demand. The transition towards a more balanced economy would be difficult, so I understand why the Chinese are hesitant in pursuing policies that would dampen the export industries and potentially cause social upheaval. It would be best to approach the issues by continuing the controlled yuan appreciation.

As for the complaint that the Chinese only gives the appearance of cooperation, the same can be said of Hank Paulson who for political reasons was forced to argue for a higher dollar one day, and a lower dollar the next, depending on the audience. It's a thorny issue in both countries.

It's not a complaint. It's perfectly in accordance with their duties. How could I complain?

And if you think it wasn't forseen or forseeable, well...

Brad Setser just posted a response to Mankiw's article:

"Is complaining about others’ protectionism protectionist?"

I thought that this bit was particularly salient, and echoes one of my earlier comments:

"Even now, the US isn’t in such dire need for financing that it has no option but to encourage China to hold its exchange rate down and in the process guarantee a captive Chinese market for US Treasury issuance.

The US Treasury can sell ten year debt in the market for less than 3%. That is a bit higher than a few years ago, but it is still a very low rate. So far demand for bonds has grown commensurately with bond issuance."

The argument made by Greg Mankiw, and Barkley Rosser over at Economist's View isn't very convincing when you take a look at current treasury yields. There's obviously no shortage of demand right now, so in that sense it is an ideal time to shift borrowing away from China.

a great link from Setser's article:

Bernanke speaking at Chinese Academy of Social Sciences, in 2006

The Chinese Economy: Progress and Challenges

Bob: I tend to agree with what you wrote above, except I would express it in terms of China needing to reduce national savings, instead of allowing a flexible exchange rate (though I understand seeing these as two sides of the same coin).

The mechanics, though, of how a high Chinese (or world) savings glut caused an asset *bubble* (as opposed to just low real interest rates and therefore high asset prices and high fundamental values) is still not clear to me.

But perhaps we should shift further discussion on this issue onto the "Greenspan and critics" post, since it's now more on topic there.

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