Tuesday, November 9, 2010

FLG Doesn't Think Matt Has Thought This Through

Matt Yglesias writes:
Now it is of course true that QE2 will have impact on other countries, and foreign policymakers should feel free to whine if they feel that America’s policy choices are inconveniencing them. But that doesn’t mean we should listen to them. In this regard I think it’s worth doing more than Kevin Drum does to distinguish Germany and China. The Germans are merely being hypocritical about this (that’s politics) but the Chinese are being nonsensical. Their problem with QE2 is that they’ve decided to subsidize politically powerful Chinese exporters by yoking their currency to ours in a way that leads them to import our monetary policy. Since they did that, they now want us to run a monetary policy that would be appropriate for China rather than a monetary policy that would be appropriate for the United States of America. But since the United States of America and China are very different places, economically speaking, it would be nuts of us to do this. Fortunately, China can unyoke itself from us any time it wants by letting its currency float more. They’re acting like this currency tether is something we’ve been begging them to do when in fact it’s something we’ve been begging them to stop.

A couple of things. First, FLG isn't sure the statement about importing American monetary policy holds. There's a trillema in international economics that states a country cannot simultaneously have a fixed exchange rate, open capital account, and an independent monetary policy. The US chose to forgo the fixed exchange rate, and so has an open captial account and independent monetary policy. Other countries, choose to fix the currency to the dollar or euro, keep an open capital account, and import the American or European monetary policy. China, chose a third way, as FLG mentioned over in the comments at A&J, they have a fixed exchange rate, but didn't open their captial account. Therefore, they can have an independent monetary policy.

Barry Eichengreen expressed it this way in 2005:
If the authorities wish to limit the rate of growth of bank credit and raise the level of interest rates relative to those prevailing abroad, they can simply issue sterilization bills, thereby sopping up the additional domestic liquidity, and issue directives to the banks instructing them to lend less, as they did in 2004.

Now, in fairness, there is a link, as Eichengreen mentions a little bit later in that paper:
Recent studies have confirmed the existence of a surprisingly strong link between monetary conditions in China and the United States. Ouyang and Rajan (2005) estimate the offset coefficient (the impact of a change in net domestic assets on net foreign assets) by twostage least squares on data starting in 1995, obtaining a coefficient of 0.5, indicating that about half of any domestic monetary impulse is offset by induced capital flows.

But that's only because the capital controls are somewhat porous. So, the Chinese could either float their currency or cramp down on capital flows.

Now, that brings us to the question of whether Matt's insouciance about China floating the currency is in America's interest.

Noah Millman raises some good questions about precisely that:
If the Chinese intend to let their currency float, and if the general assumption that a free-floating Yuan would appreciate significantly against the dollar, they should probably unload their Treasury holdings first, to avoid taking a big loss. Certainly, they should stop buying more of them. But America is producing debt at a prodigious rate. If what QE2 accomplishes is mostly to convince the Chinese to stop subsidizing low interest rates in America, leaving the Fed to basically pick up the slack, how is that going to improve the American economy? Wouldn’t we just wind up with higher inflation and higher nominal interest rates – i.e., stagflation?

FLG won't continue. This was mostly to say that Matt was only partially correct on the pass-through monetary policy and didn't think about the long-term ramifications of a switch to a floating currency.

This isn't to say that China shouldn't float their currency. Indeed, the Eichengreen paper FLG linked to makes precisely that case. (Largely because they're going to lose control of their captial account, and as the Chinese economy becomes less export dependent it would be better to manage the domestic economy via interest rates.)

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