Krugman’s blog, 8/12/15

There were two posts yesterday.  The first was “China Bites the Cherry:”

Are you staring to have the feeling that when it comes to economic policy Xi-who-must-be-obeyed has no idea what he’s doing?

China’s decision to devalue the renminbi had some economic logic behind it. As David Beckworth rightly points out, it’s not just about gaining a competitive advantage. China clearly has a weakening economy, whatever the official numbers may say, and would like to use monetary stimulus. But monetary autonomy and a fixed exchange rate don’t go well together; China’s capital controls give it some leeway, but it is nonetheless suffering from a lot of capital flight — and it wants to liberalize the capital account in pursuit of reserve-currency status. (A foolish goal, but that’s a subject for another day.)

So it would make sense on purely economic grounds for China to move to a free float, and gain the freedom to use monetary policy that, say, Japan has.

But it’s important to understand how that works. When Japan loosens money, it creates an incentive to move funds abroad, causing the yen to fall. This process only stops once the yen has fallen enough that investors consider it undervalued, and are willing to buy Japanese securities in the expectation of a future yen rise. Exchange rate overshooting is an essential part of the story.

China, however, did not let the renminbi float, nor did it devalue by enough to persuade investors that any future move was likely to be up. Instead, it only devalued a little.

This is what Charlie Kindleberger used to call “taking the first bite of the cherry”. (Nobody takes just one bite out of a cherry.) China has now demonstrated that its currency peg is no longer solid; but it has come nowhere near to devaluing enough to create expectations of future appreciation. This is a recipe for convincing investors that the future direction of the currency is down — which means that capital flight will accelerate (and apparently already has.)

Now what? China could just let the renminbi float; given the current state of the Chinese economy, that would surely mean a large depreciation. But this would greatly increase trade tensions and pose problems for foreign policy. Maybe that’s a tradeoff worth accepting, but nothing in events so far suggests that China’s leadership was prepared to take that step. Instead, they went for a small move that was sufficient to destabilize expectations while producing trivial benefits.

A reminder, then, of the lack of wisdom with which the world is governed.

Yesterday’s second post was “International Money Mania:”

China is claiming that it’s not devaluing the renminbi to gain competitive advantage, it’s adding flexibility to prepare for the yuan as an international reserve currency, becoming part of the basket in the IMF’s SDRs and all that. That’s highly implausible as a story about what’s happening right now; but it may be true that China’s urge to loosen capital controls is driven in part by its global-currency ambitions.

But why, exactly, should China be eager to manage an international reserve currency?

I mentioned one of Charlie Kindleberger’s aphorisms earlier today, about taking the first bite of the cherry; another was that “Anyone who spends too much time thinking about international money goes a bit mad.” What he meant by that is that there’s something about the subject of reserve currencies that makes people want to believe that it’s a really important issue — that the dollar’s special role is an important part of American power. So you have spectacles like John Kerry and Barack Obama declaring that one big risk from rejecting an Iran deal (which I very much support) would be a threat to the role of the dollar. Um, no — it wouldn’t, and anyway who cares?

What does America gain from the dollar’s special role? You often find people declaring that it’s only thanks to the special role of the dollar that the United States has been able to run persistent trade deficits — you see, people have to take our money. But even a quick glance at international balance of payments statistics shows you that countries whose currencies play no special role whatever are perfectly capable of running deficits over a long time; all that matters is that they be perceived as reliable debtors who offer good investment opportunities. Look at Australia, which is a much more consistent large-deficit country than we are:

So what are the advantages of owning a reserve currency? You do get to borrow in your own currency — but then, so do others; again, it’s about reliability rather than a special role. There’s nothing in the data suggesting that you can borrow more cheaply than other safe borrowers.

What you’re left with, basically, is seigniorage: the fact that some people outside your country hold your currency, which means that in effect America gets a zero-interest loan corresponding to the stash of dollar bills — or, mainly $100 bills — held in the hoards of tax evaders, drug dealers, and other friends around the world. In normal times this privilege is worth something like $20-30 billion a year; that’s not a tiny number, but it’s only a small fraction of one percent of GDP.

The point is that while reserve-currency status may have political symbolism attached, it’s essentially irrelevant as an economic goal — and definitely not worth distorting policy to achieve. Someone needs to tell the Chinese, you shall not crucify this country on a cross of SDRs.


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