A few years ago, before I started my second-year course on geopolitics and the energy business, I taught in HBS’s first-year required political economy course. In it, we had two cases on the collapse of Bretton Woods. One of the teaching points of the Bretton Woods cases was that small countries effectively give up control of monetary policy when they fix their exchange rate. During the class, I put up the following 1970 quote from Time magazine, which sums up the economics pretty well:
Foreign central banks have no practical alternative but to support the value of the dollar by absorbing any surplus dollars that are offered in their own market places. If the Bank of France, for example, failed to do this, the resulting glut of dollars in the hands of French bankers and businessmen would cause the value of the dollar to fall in France and the value of French francs to soar. This would raise the export price of Citroëns, Camembert and other French products, hurting sales abroad. To avoid all that, the Bank of France buys up surplus dollars. But in order to make those purchases it must increase the supply of French francs in circulation. Thus, France and other foreign governments correctly complain that they are forced to adopt inflationary policies to cope with the dollar flow.
People forget this now but it was actually France, not Germany, what blew up the system. (Which is not to say that Germany would not have blown it up, if France hadn’t taken the lead.) It was De Gaulle who said, “There can be no other criterion, no other standard than gold. Yes, gold ... which has no nationality and which is eternally and universally accepted as the unalterable fiduciary value par excellence.”
A fixed exchange rate is (outside Venezuela) a promise by a central bank to swap one currency for another at a fixed price. If that promise is credible than nobody has any incentive to make a deal at any other price, for the simple reason that one of the parties could always get a better deal at the central bank. In France’s case, back in the day, everyone wanted to buy its exports. So they took their dollars, and swapped ‘em for francs at the Banque de France. Where did the Banque de France get the francs? It printed them! That is what central banks do; they cannot hold their own currency as an asset, any more than a company can buy up its own debt and book it on the asset side of the balance sheet.
Well, the People’s Bank of China (PBC) today is piling up bajillions of dollars in its vaults. In theory it would have to print bajillions of yuan for that. In practice, the Chinese government sterilizes the inflow by forcing the banks to buy government bonds. In essence, a Chinese exporter turns over his or her dollars to the PBC for yuan accounts at a Chinese commercial bank. (They have to do this, by law.) The government, however, forces the commercial banks (which are mostly state-owned) to use the yuan deposited in them to buy central bank-issued bonds. An utterly stylized way of thinking about it would be:
- The central bank prints yuan in exchange for dollars.
- The yuan are deposited in commercial banks.
- The commercial banks lend the yuan back to the central bank in exchange for bonds.
And voila, inflation is kept under control.
The point, however, is that the inflationary pressure is caused by the fixed exchange rate. Only now the Chinese are claiming that their fear of inflation is a reason to keep the fixed exchange rate! Whaa? Paul Krugman and Dean Baker point out allowing the yuan to appreciate would reduce import prices, and thus lower inflation. This post is reinforcing their arguments by pointing out that the pileup of reserves — which an appreciation of yuan would slow or stop — also causes inflationary pressure. In short, Chinese policy makes no sense in terms of inflation.
I am coming around to the unfortunate conclusion that it may be time to credibly threaten to slap some pretty significant tariffs on Chinese goods. Right now, that country is acting as an international demand suck, earning foreign income and then sitting on it. Sure, it is nice that they invest those reserves in Treasury bonds ... but with American savings rates rising and interest rates as flat as they can get, now is the time for them to start buying less.
I find this sort of thing irritating. I found it irritating when the Chinese government, which quite successfully engages in massive buy-Chinese policies (google “State Council Document 18”) criticized the buy-American provisions of the stimulus. That was small beans, however. The Chinese government right now is playing with fire in refusing to allow its exchange rate to appreciate. During the Great Depression, countries imposed tariffs in lieu of devaluation. The U.S. can’t unilaterally devalue the dollar against the yuan without Chinese cooperation. The implication is left as an exercise for the reader.
(To be fair, the Eichengreen and Irwin paper makes a very different point. Unlike the countries hit by the Great Depression, the U.S. is a gigantic economy, and the fixed exchange rate with China does not impose deflationary pressure that the Fed cannot fight. But it does reduce aggregate demand, and it is a growing problem. I hope the Chinese see the light before we slap tariffs on ‘em.)