Where is the inflation in China?

 I have been resisting it, mostly because I don’t want to have to go back and reclassify all the China-related posts, but I have to add a China tag to this blog.  Ugh.

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:

1. The central bank prints yuan in exchange for dollars.
2. The yuan are deposited in commercial banks.
3. 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.)

Thoughts?

Comments

[Bernard Guerrero]

Why worry about this? They're apparently still willing to keep sending us useful stuff in exchange for that green paper they're stockpiling. Unless they've figured out a way to eat the stuff, Stein's Law will come into effect sooner or later.

Speaking of which, an amusing cite of same.

[Noel Maurer]

There are four reasons why you should worry. Stein's Law, in fact, is behind three of them. Breaking it down, in order of urgency:

(1) Demand suck. Right now, China is the equivalent of a person with a very high savings rate. With the U.S. stuck in a liquidity trap, that's a serious problem. Either the federal government needs to run a higher deficit than it otherwise would in order to counteract the contractionary effect of China's exchange rate policy, or American unemployment will be higher than it otherwise would be. This is a twofer: plenty of human suffering in the United States or a worsening of the country's long-term fiscal position.

(This reason only applies as long as we're below full employment; the other three will persist and in fact worsen as the economy recovers.)

(2) Eastern bubbles. Here theory and anecdote align: you would expect asset prices to rise in China, and that seems to be happening. (Note the emphasis.) We just lived through the unexpected effects of an asset bubble pop in the United States --- hell, in three states of the United States --- and it would be a big risk to let that happen again, particularly in a place with as weak and impenetrable a financial system as China.

(3) Stein's law. A slow unwinding of global economic imbalances would be good. The current recession gives the world an easy opportunity, but the Chinese government is refusing to let the unbalances unwind. We therefore run the risk of a panicky and depressive unwinding in the future, and the longer we wait, the higher the chances of that bad outcome. See point (2) above, and this post.

(4) Hysteresis. It isn't easy to shift workers from nontradables into tradables when the tradable factories have shut down and the human capital has deteriorated or disappeared. Stein's Law says that the U.S. is going to have to do just that at some point. The more of our manufacturing base we lose, the longer and more painful that transition will be. See point (3) above.

I am not yet in favor of threatening China with tariffs (which probably means imposing them) because as of late-2009 I am as afraid of the political consequences of that policy as I am of the economic consequences of allowing the Chinese to continue to peg their currency at a exchange rate lower than the one it would take in a free float. (I almost wrote "artificially low rate," but my inner pedant stopped me.)

Nonetheless, I am quite worried. I hope that Beijing changes its mind soon, and returns to its 2005-08 policy of measured appreciation.

[Bernard Guerrero]

Nit: This isn't a "liquidity trap" in the original sense of the term, just the ZIRP boundary. We still have QE (MBS purchases, etc.)

But anyway....your worries seem to me to boil down to a desire for a very specific shape to the required adjustment. That is, quick but smooth rather than prolonged or abrupt. Is that stating it correctly?

I'm sort of sympathetic to argument #4, but I keep wondering if the existing capital, human and otherwise, is of the correct type anyway. Are we suddenly going to start cranking out plastic toys in the bazillions?

As to #2 & #3, what makes you think that slowing the growth of China's export-oriented sector won't result in massive upheaval anyway? How many jobs do they need to generate every year in order to keep the hinterland happy? (Possibly this is what you mean by the "political consequences of that policy".)

[Noel Maurer]

Not sure what you mean by the original sense of a liquidity trap, but we're in total agreement on the substance. (Davis down at the 27!)

You have the argument, except for point (1). That one is simply that Chinese policy is slowing the U.S. recovery. I don't think it's determinative, though, just annoying.

I'll be ... ah, can't post and watch football.

[Noel Maurer]

I'll try to post while watching football.

Briefly: Stein's law. China needs to shift out of tradables, same as the U.S. needs to shift into them. It will be a very bad thing if that occurs abruptly. Better then, that Beijing go back to the nicely ... wow! Hella throw for Chicago, 27 yards there! ... gradual appreciation policy that it followed in 2005-08.

Instead, they're increasing the risk of a sudden dislocation in the future, whether by an abrupt revaluation, high domestic inflation, or American tariffs.

They may be worried that their recovery is still too fragile, but that would be more believable if they were just saying that. But they're not. Instead we get weird statements about inflation and accusations that the U.S. wants to keep China down.

Holy cow! Another amazing Chicago catch! Day-yam.

So I'm worried. The Chinese could announce an appreciation rate of 3% per year, pending recovery, or something. Instead we get no indication that they think of 2005-08 as anything other than a mistake.

The unpredictable political consequences of tariffs were just that ... unpredictable! Instability in China, anger at the United States, the collapse of the WTO, weird spiteful reactions, who knows? It could get spooky. So unless the situation gets really dire, I don't approve.

But I also don't approve of prolonging our recession, devastating our manufacturing base, and punting on a looming international financial crisis when the United States has enough of a long-term fiscal problem to trouble us.

Something is going to give in the next five years. I'm hoping it's the yuan value of the dollar what gives, slowly, rather than American tariffs or Chinese inflation.

[Bernard Guerrero]

"Something is going to give in the next five years."

Undoubtedly. Though I believe we were of an opinion that something was gonna give 5 years ago, too.

[Noel Maurer]

In all seriousness, we were right! What gave wasn't what we expected --- the housing bubble popped --- but the fallout caused U.S. savings rates to rise. Problem is, unless Chinese spending also rises, an opportunity to unwind global unbalances will be lost. I talked briefly about that in the "balance of terror" post, I think.

[David Allen]

Long comment:

This is from Morgan Stanley's Global Economic Forum, 12/18 post: 2010 Outlook: From Exit to Exit

"A Goldilocks Scenario in 2010: Muted Inflationary Pressures

"Despite strong headline GDP growth, concern about possible high inflation in China in 2010 is unwarranted, in our view. We forecast average CPI inflation at about 2.5% in 2010. Of note, we caution that predicting high inflation in 2010, based on the strong growth of monetary aggregates so far this year, could err on the side of being too simplistic and mechanical.

• First, the strong headline M2 growth in 2009 substantially overstates the true underlying monetary expansion, as it fails to account for the change in M2 caused by the shift in asset allocation by households between cash and stocks. We estimate that the growth rate of adjusted M2 - the rate that truly reflects the underlying economic transactions - is much lower than suggested by the high growth of headline M2 (see China Economics: Worried About Inflation? Get Money Right First, October 19, 2009).

• Second, generally weak export growth, which we think could be a proxy for the output gap in China, will remain a strong headwind containing inflationary pressures. These two demand-side factors combined would suggest that the 2000-01 situation - featuring relatively high money growth but relatively low inflation - is likely to be repeated in 2010.

• Third, from the supply side, while our commodities research team expects commodities prices to rise steadily in 2010, they do not foresee a significant surge in prices. They project crude oil at about US$85 per barrel in 2010 (see Crude Oil: Balances to Tighten Again by 2012, September 13, 2009). Assuming the cost pressures stemming from these supply-side shocks are able to pass through the supply chain to be reflected in the corresponding price increase of downstream products without much constraint from the demand side, we forecast a similar trajectory of CPI inflation for 2010 to the one derived from demand-side analysis (see China Economics: Inflation Outlook in 2010: A Supply-Side Perspective, November 1, 2009)."

Dunno. Seems more like hope than analysis to me.

[David Allen]

Do you follow Econbrowser.com? James Hamilton is discussing the same question there.