… and How About a Higher Yuan?

Another day, another Paul Krugman post blaming China for US unemployment. And maybe he’s right. But it would be nice to see some numbers.

On the same lines as my earlier post about the effect of dollar devaluation on aggregate demand, we can make a rough estimate of trade elasticities to calculate the effect of a Chinese revaluation.

Unfortunately, there aren’t many recent estimates of bilateral trade elasticities between the US and China. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn’t affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is a very high 4.0; then a 20 percent appreciation of the Chinese currency still boosts US demand by less than 1 percent of GDP.

And of course, those are all wildly optimistic assumptions. My own simple error-correction model, using 1993-2010 data on US imports from China and the relative CPI-deflated bilateral exchange rate, gives an import elasticity of just 0.17. [1] If the real figure is in that range, then a Chinese appreciation of 20 percent will reduce our imports from China by just 0.03 percent of GDP — and of course much of even that tiny demand shift will be to goods from other low-wage exporters.

I don’t claim my estimate is correct. But is it too much to ask that Krugman tell us what estimates he is using, that have convinced him that the best way to help US workers is to foment a trade war with China?

[1] This is a real exchange-rate elasticity, not a price elasticity, so it accounts for incomplete passthrough and offsetting movements in Chinese real wages. It assumes, however, that changes in the nominal exchange rate don’t affect inflation in either country; to that extent, it’s more likely an overestimate than an underestimate

How Much Would a Lower Dollar Boost Demand?

Lots of economists of the liberal Keynesian persuasion (Paul Krugman, Dean Baker, Robert Blecker [1] — very smart guys all) think dollar devaluation is an important step in getting back toward full employment in the US. But have any of them backed this up with a quantitative analysis of how much a lower dollar would raise demand for American goods?

It’s not an easy question, of course, but a first cut is not that complicated. There are four variables, two each for imports and exports: How much a given change in the dollar moves prices in the destination country (the passthrough rate), and how much demand for traded goods responds to a change in price (the price elasticity.) [2] We can’t observe these relationships directly, of course, so we have to estimate them based on historical data on trade flows and exchange rates. Once we choose values of them, it’s straightforward to calculate the effect of a given exchange rate change. And the short answer to this post’s title is, Not much.

For passthrough, estimates are quite consistent that dollar changes are passed through more or less one for one to US export prices, but considerably less to US import prices. (In other words, US exporters set prices based solely on domestic costs, but exporters to the US “price to market”.) The OECD macro model uses a value of 0.33 for import passthrough at a two-year horizon; a simple OLS regression of changes in import prices on the trade-weighted exchange rate yields basically the same value. Estimates of import price elasticity are almost always less than unity. Here are a few: Kwack et al., 0.93; Crane, Crowley and Quayyum, 0.47 to 0.63; Mann and Plück, 0.28; Marquez, 0.63 to 0.92. [3] (Studies that use the real exchange rate rather than import prices almost all find import elasticities smaller than 0.25, which also supports a passthrough rate of about one-third.) So a reasonable assumption for import price elasticity would be about 0.75; there is no support for a larger value than 1.0. Estimated export elasticities vary more widely, but most fall between 0.5 and 1.0.

So let’s use values near the midpoint of the published estimates. Let’s say import passthrough of 0.33, import price elasticity of 0.75, and export passthrough and price elasticity both of 1.0. And let’s assume initial trade flows at their average levels of the 2000s — imports of 15 percent of GDP and exports at 10.5 percent of GDP. Given those assumptions, what happens if the dollar falls by 20 percent? The answer is, US net exports increase by 1.9 percent of GDP.

1.9 percent of GDP might sound like a lot (it’s about $300 billion). But keep in mind, these are long-run elasticities — in general, it takes as much as two years for price movements to have their full effect on trade. And the fall in the dollar also can’t happen overnight, at least not without severe disruptions to financial markets. So we are talking about an annual boost to demand of somewhere between 0.5 and 1.0 percent of GDP, for two to three years. And then, of course, the stimulus ends, unless the depreciation continues indefinitely. This is less than half the size of the stimulus passed last January (altho to be fair, increased demand for tradables will certainly have a higher multiplier than the tax cuts that made up a large share of the Obama stimulus.) The employment effect woul probably be of the same magnitude — a reduction of the unemployment rate by between 0.5 and 1.0 points.

I would argue this is still an overestimate, since it ignores income effects, which are much stronger determinants of trade than exchange rates are — to the extent the US grows faster and its trading partners grow more slowly as a stronger US current account, that will tend to cancel out the initial improvement. I would also argue that the gain to US employment from this sort of rebalancing would be more than offset by the loss to our trade partners, who are much more likely to face balance of payments constraints on domestic demand.

But those are second-order issues. The real question is, why aren’t the economist calling for a lower dollar providing quantitative estimates of its effects, and explicitly stating their assumptions? Because on its face, the data suggests that an overvalued dollar plays only a modest role in US unemployment.

[1] I was going to include Peter Dorman on this list but I see that while he shares the IMO misplaced concern with global imbalances, he says, “Will a coordinated dollar devaluation do the trick? Maybe, if you can get coordination (no easy feat), but it is also possible that US capacity in tradables has deteriorated too far for price adjustment alone to succeed.” Which is a more realistic view of the matter than the one Krugman seems to hold. On the other hand, Dorman was also writing just a couple years ago about The Coming Dollar Crash. That dog that didn’t bark is something I’ll hopefully be writing about in a future post.

[2] Many studies collapse passthrough and price elasticity into a single measure of real exchange rate elasticity. While this is a standard approach — about half the published papers take it — I would argue it’s not the right one for either analytic or policy purposes. Analytically, the real exchange rate elasticity doesn’t distinguish between the behavior of buyers and sellers: A low value could mean either that consumers are not responsive to price, or that sellers are holding price stable in the face of exchange rate changes. And on the other side, it’s the nominal, not real, exchange rate that’s accessible to policy. Policy-induced movements in the nominal exchange rate only translate into movements in the real rate if we assume that price levels (and real wages, if we’re deflating by labor costs) don’t respond to movements in the exchange rate, which is not generally a safe assumption.

[3] Price elasticities are all negative of course. I’m omitting the negative sign for simplicity.

What Does a Credit Crunch Look Like?

What doesn’t it look like? Krugman has a picture:

His point here is right, for sure: Business investment is being held back by weak demand, not lack of credit. Would Tufte approve of that graph, tho? (It looks like one of those images of disk usage you get when you defragment your hard drive.) And more importantly: Why does it start in 1986?

It’s an arbitrary date, and an especially weird one to pick in this context, because of what happens if you go back just a couple years. You call that a credit crunch, mate? Now this is a credit crunch:

See that spike over on the left? That’s a country full of businessmen screaming as Papa Volcker stomps on their necks. (To be fair, it’s their workers he was mainly interested in strangling, but the credit squeeze for business was no less real for that.) And that’s what a credit crunch looks like.

Does fiscal policy need to be paid for in advance?

Let’s be clear: Paul Krugman is a national treasure. On fiscal policy – and politics generally – he has been saying exactly what should be said, clearly and forcefully, and just as important, from a platform that people can’t ignore. No one of remotely his stature has been as clear or consistent a critic of the Administration from the left. That said, his economics can be … problematic. I don’t know if it’s just because I’m interested in trade, or if, ironically but perhaps more likely, it’s because it’s where he made most of his own contributions, but it’s on international economics that Krugman seems most committed to orthodoxy, and correspondingly out of tune with reality. Case in point: This blog post, where he notes, correctly, that the most consistent expansionary response to the crisis has been in Asia, and then goes on to endorse the suggestion of David Pilling (in the Financial Times) that today’s Asian stimulus is the reward for fiscal rectitude in previous years:

Deficit spending is what you should do only when the economy is depressed and interest rates are at or near the zero lower bound. When times are good, you should be paying debt down. Pilling: “The scale of Asia’s stimulus may have matched, even surpassed, the west. But the context has been entirely different. Asian governments had plumped-up their fiscal cushions after the 1997 crisis, building a formidable pool of reserves. … when the crunch came, they had the wherewithal to spend.”

I’m sorry, but this is just wrong. First of all, let’s look at stimulus spending and earlier fiscal stances in various Asian countries:

Country Fiscal stimulus 2008 Average fiscal surplus, 1998-2007 Average fiscal surplus, 2003-2007
Malaysia 0.9 -1.72 -1.72
India 1.5 -5.50 -2.93
Indonesia 2.7 10.04 10.04
Australia 4.4 -3.00 -1.65
Philippines 4.5 -0.69 -0.69
Korea, Rep. of 5.4 0.98 1.20
New Zealand 5.9 -2.10 -2.23
Thailand 7.7 -4.80


Singapore 8 -1.34 -1.93
China 13.5 2.70 4.69
Japan 14.6 -0.80 -0.95

See that striking correlation between prior surpluses and stimulus spending? Yeah, me neither. It’s true that some countries, like China and Korea, show prior surpluses and big stimulus. But others that are pursuing expansionary policy have had fiscal deficits for years, like Japan (as Krugman should know as well as anyone.) Empirically, the Krugman-Pilling argument that in Asia, fiscal surpluses paved the way for fiscal stimulus just does not hold up.
No, what’s allowed Asian countries to respond aggressively to the crisis is not their (mostly nonexistent) fiscal surpluses, but their current account surpluses. Unlike in past crises (or lots of countries in the current crisis, especially on the periphery of Europe) they are not dependent on private capital inflows, so they are under no pressure to undertake contractionary policy to maintain external balance. The case of Korea is exemplary. True, it was running a fiscal surplus prior to the crisis — but it was also running a fiscal surplus in the mid-1990s prior to the Asian Crisis, to which it responded with brutal austerity. The difference was that the current account was in deficit then, and in surplus this time. The fiscal position was irrelevant.(Incidentally, Pilling literally does not seem to realize there is a difference between a current account surplus and a fiscal surplus. That’s why he’s able to write something like “Asian governments had plumped-up their fiscal cushions after the 1997 crisis, building a formidable pool of reserves,” without realizing it’s a non sequitur.)What about the larger argument, that good Keynesian governments should engage in the precautionary accumulation of financial assets in good times to finance demand-boosting spending in bad times? Krugman himself admits that the Bush deficits are not a binding constraint on fiscal policy today, which is rather a blow to his argument. More broadly, it’s far from clear that there is any meaningful sense in which the existing level of public debt affects the space for fiscal policy. The argument for prudential saving might apply to the government of a premodern or underdeveloped country, which rests on a narrow fiscal base; but if substantial excess capacity exists in an industrialized country the government always can mobilize it. (Matt Yglesias gets this, even if Krugman does not.) As for the traditional Keynesian argument for federal surpluses in boom times, it has nothing to do with precautionary accumulation of financial assets, and everything to do with preventing aggregate demand from running ahead of aggregate supply.In the end, I suspect this idea of paid-in-advance Keynesianism says less about his intellectual weaknesses than about his institutional commitments. As a certified big-name economist, you have to make some concessions to orthodoxy if you don’t want to see your intellectual capital devalued. And what orthodoxy demands now — above all from those who want more expansionary policy — is gestures of somber concern with future deficits. (If not austerity today, at least austerity tomorrow.) With a few honorable exceptions, even left-leaning economists seem happy to comply.

Krugman and China

So, what’s he on about?

There’s a lot of heat, but surprisingly little light. Is the objection to the renminbi peg as such, or is it just he thinks a different peg would be better? Better for who — the US, China, the world? Why is he so sure that the current account imbalance between the US and China is due to the peg? And what general principles for currency value and trade flows, if any, underwrite the argument in this specific case?

One thing he’s got right, at least — the US current account deficit with China is big. The US c.a. deficit in January was about $40 billion, or 3 percent of GDP. (That’s down from 5 percent of GDP in 2008, and 7 percent in 2005-06.) China accounted for $18 billion of that ($17 billion if you include Hong Kong, with which the US runs a surplus), or about 40 percent of the total. At the height of the c.a. deficit, in mid-2006, China accounted for about a third of it. The rise in China’s share is largely accounted for by the fall in oil prices; in recent years China has consistently accounted for about half the non-OPEC deficit. So if you are worried about the current account deficit, you should worry about the deficit with China.

But should you worry about the current account deficit? And does worrying about the deficit with China mean worrying about Chinese “manipulation” of the renminbi?

To take the second question first, it’s far from clear that the currency peg is responsible for the deficit. One reason the US deficit with China is so big is that US trade with China is so big — China is by far the largest recipient of US exports outside of North America. Yes, China’s exports to the US are four times greater than its imports from the US, an outlier among major trade partners, but countries like Germany, Japan and India regularly see ratios in excess of two to one, and their currencies float freely. So at the least, it’s clearly not true that laissez-faire in the foreign exchange markets guarantees balanced trade — which would be a strange thing for Krugman to believe in any case.

But of course, it could be true that the vagaries of the foreign-exchange markets, demand for US assets, or government policy can all keep a currency away from its trade-balancing level. So set aside the loaded language of manipulation, which suggests there is something inherently immoral or dishonest about currency pegs — which have, after all, been the norm in international trade for much longer than floating currencies, and are used by lots of other countries beside China today. Is it the case that a higher renminbi would narrow the US deficit with China?

There is a long tradition, going back at least to Keynes, that doubts whether trade flows are sufficiently responsive to exchange rates to make them an effective way of achieving balanced trade.[1] In the short run, the elasticity pessimists are clearly right that income changes, not exchange rates, are the decisive influence on trade — casual examination of the trade statistics shows that exports to and imports from any given country tend strongly to move together, whereas they should move in opposite directions if exchange rates were dominant. Nor is this surprising — in the short run most trade is contractually committed; over the medium run market share is expensive enough that sellers absorb some part of exchange rate movements in profit margins rather than adjusting prices, and even when prices do adjust few close substitutes are available for many traded goods, especially intermediate goods. Thus the familiar J-curve, where the short- or medium-run effect of an exchange rate change is in the “wrong” direction.

But in the long run, surely, prices are decisive? Maybe, maybe not. Krugman brings up “the smaller East Asian nations in the aftermath of the 1997-1998 crisis” as if they were an obvious case of exchange rate effects. It is true that those countries did devalue their currencies during the crisis, and did see sharp improvements in their current account in the following years. But they didn’t just devalue; they also saw dramatic falls in domestic income and consumption. How do we know if it was the devaluations or the contractions that led to the improved trade balances? Well, take Indonesia and Korea as examples (I pick them because they are in the OECD international trade database.) In both, the improvement in the current account balance (from a $250 million to a $2.7 billion surplus 1996-2000, and from a $2.4 billion deficit to a $3 billion surplus 1996-98, respectively) came entirely from declining imports. Indonesian exports were no higher at the end of 1999 than at the beginning of 1997 — but imports had fallen by half. That looks a lot more like an income effect than a price effect to me.

Still, in the very long run exchange rates presumably do have a major effect on trade flows. But it matters how long the long run is. If the problem with the current account deficit is its anti-stimulus effect, and not the broader “global imbalances,” then a solution that only helps five years from now, and makes things worse in the next year or two, is no solution at all. (Someone should ask Prof. Krugman how long he thinks it would take for a renminbi revaluation to have a net positive effect on the US current account.) But set that aside. Let’s say that a change in Chinese policy would lead to a higher renminbi, and that that would narrow the US deficit with China, and fast enough to work as fiscal policy. Should we care? And does the answer depend who “we” are?

The simplest way of looking at the demand effects of the deficit is that every dollar of “anti-stimulus” in the US is balanced by a dollar of stimulus in China. And to be honest, it’s hard to find much beyond that simple level in Krugman’s stuff on China. He seems to be saying the reniminbi should be revalued so that the US gets more, and China less, of a fixed pool of global demand. Now, I am not as allergic to mercantilist-type arguments as most people. But why on the world should China go along with this? And why, from behind the veil of ignorance, should we-in-general want them to? [2]

In a recent blog post, Krugman had an interesting answer to this question — interesting because it’s so clearly wrong. He writes, “the global macro aspects of the situation are reminiscent of the late 1920s, when the US was simultaneously insisting that European nations repay their dollar debts and that they not be allowed to export more to earn the dollars. That didn’t end well.” There are two key differences, ,though. First, China accepts payment in dollars — it doesn’t insist on its own currency.[3] And second, China has no problem exporting capital to match its current account surplus, unlike the US in the 20s, when our surplus was offset by politically contentious loans related to WWI reparations and highly unstable private flows. These two factors mean that while debtors then found themselves forced to accept domestic deflation and contraction, the US is under no corresponding pressure. As long as China is willing to finance the US deficit with low-interest loans to the US, the deficit need have no negative effects for this country; and as soon as they stop financing it, it will go away — as Krugman rightly stresses, China’s trade surplus and capital exports are two sides of the same coin.

Let’s take a step back.

Imagine that China appeared out of the blue one day and began selling stuff to the US. But instead of buying stuff in return, they simply lend their dollar earnings to the US government, i.e. bought Treasury bonds. This reduces demand for producers of US goods. But now suppose the US government increases its total borrowing by the amount of the Chinese bond purchases, and uses the increment for domestic purchases. Supply and demand for bonds among non-China buyers are unchanged, so there is no reason for interest rates to move. The stimulus of the additional government spending exactly offsets the anti-stimulus of the Chinese imports, so there is no inflation. And the offsetting goods and capital flows between the US and China mean there is no pressure on the dollar. At the end of the day, domestic output and employment are unchanged, and domestic consumption is increased by the amount of Chinese imports. In short, to exactly the extent that the imbalance with China reduces private domestic demand, it removes the constraints on expansion of public domestic demand.[4] This is the fundamental difference between the position of the US today and the position of countries on the gold standard or equivalent systems, as in the 1920s. In the latter case there is no mechanism to guarantee offsetting capital flows to trade imbalances, so countries can find themselves facing a foreign exchange constraint on output and growth.

And now we are coming toward the point of this very long post. Krugman calls Chinese capital exports “artificial,” by which he means — well, what, exactly? That they are undertaken by government? that they are not motivated by returns? that they correspond to a big current account surplus? It isn’t clear. Nor is it clear what he thinks a world of “natural” flows would look like. More balanced trade overall? or just a more favorable balance for the United States? And finally, why should we support a policy whose benefits to American workers are offset by costs to (much poorer) workers elsewhere?

Let’s turn back to that previous era of global imbalances, the 1920s and 30s — whose lessons, I think, Krugman gets wrong. It’s well known that when countries left the gold standard and devalued their currencies, their economic performance dramatically improved. But was this from the stimulus of an improved current account,as Krugman imagines the US would enjoy following a renminbi revaluation? Not at all. As Peter Temin and Barry Eichengreen both emphasize, countries that devalued did not, on balance, experience any improvement in their current account at all! Rather, the devaluations allowed them to achieve the same external balance at a higher level of income. Removing the foreign exchange constraint allowed national governments to take much more aggressive steps to boost domestic demand — mainly through looser monetary policy once central banks no longer had to defend the peg to gold. In effect, going off gold enabled a movement from a low-employment to a high-employment equilibrium by allowing countries to reflate one at a time, instead of needing a coordinated expansion; but trade flows at the beginning and end of the process were basically the same.

The key point is that what matters is not the balance of trade between any particular countries, but the presence or absence of a foreign exchange constraint. If a country can offset adverse movements in its current account with expansions of public, or private, domestic demand, i.e. if a worsening current account is reliably offset by capital inflows or if it can settle international claims in its own currency (of course both are true of the United States), then deficits need have no effect on output or employment. But some countries must restrict domestic demand to keep any current account deficit at a level they can finance; adverse movements in those countries’ current account reduce output and employment without any corresponding gains elsewhere. Thus the deflationary bias of the gold standard. This was the decisive consideration for Keynes in the design of postwar international financial arrangements: No country should be prevented from pursuing full employment by a foreign exchange constraint. [5]

So where does that leave us? A new international financial architecture isn’t on the menu (and doesn’t seem to interest Krugman, anyway; for him the problem is all China.) But under the current system, it’s clear that the highest level of output and employment will be achieved if a simple condition is met: current account deficits are run by countries that can most easily finance them. Countries that can easily attract capital inflows and issue liabilities in their own currency should have exchange rates that result in deficits at full employment; countries without those characteristics should have “undervalued” exchange rates so they run surpluses at full employment. This preserves the flexibility of every country to manage domestic demand to preserve full employment. Expansionary fiscal or monetary policy leads to adverse movement of the current account. It’s no problem if this increases the deficit for countries that can finance a deficit, but for others this will rule out expansion unless they start from a position of surplus. And indeed this was one of the lessons of the Asian crisis — countries that found they could no longer count on private capital flows concluded they need to run large current account surpluses to ensure that their growth was not choked off by foreign exchange constraints.
Given that the US issues the global reserve currency, a world with a large US current account deficit will almost certainly see higher and more stable output than one in which the US current account is balanced. And given that the US does not face a foreign exchange constraint, our unemployment can’t be blamed on the Chinese – they’re not holding back domestic demand here.
Krugman is a smart guy: why doesn’t he recognize this? The answer, I think, goes back once again to Keynes. In chapter 23 of the General Theory, he writes:

When a country is growing in wealth somewhat rapidly, the further progress of this happy state of affairs is liable to be interrupted, in conditions of laissez-faire, by the insufficiency of the inducements to new investment. Given the social and political environment and the national characteristics which determine the propensity to consume, the well-being of a progressive state essentially depends, for the reasons we have already explained, on the sufficiency of such inducements. They may be found either in home investment or in foreign investment… Thus, in a society where there is no question of direct investment under the aegis of public authority, the economic objects, with which it is reasonable for the government to be preoccupied, are the domestic rate of interest and the balance of foreign trade.

Before the 20th century, there was “no question of direct investment under the aegis of public authority” simply because the public sector — apart from the military — was very small. Of course that’s not the case today – no technical reason why federal spending couldn’t increase by 10 percent of GDP if need be. The obstacles are political – as Krugman acknowledges when he stipulates that the Chinese surplus matters because in its trade partners, “both central banks and governments are unable or unwilling to pursue sufficiently expansionary policies to eliminate mass unemployment” (my emphasis).
The unwillingness of the US to pursue sufficiently expansionary policies is not a fact of nature. Given that unwillingness, Krugman (and Dean Baker, etc.) may be right that an improvement in the US current account is the most practical way to boost US demand – even if they exaggerate how quickly and reliably exchange rate changes will deliver it. But it’s neither a necessary nor a particularly good way of achieving this. The real problem is the inability of the US financial system to channel savings into productive investment, and the unwillingness of the state to step in in its stead. Too bad folks like Krugman are trying to shift the blame to China.

[1] Formally, Keynes and post-Keynesians like Davidson doubt that the Marshall-Lerner-Robinson condition is satisfied, i.e. that the elasticity of imports and exports with respect to exchange-rate changes sum to at least one.

[2] He actually does answer this question with respect to China, sort of. Might makes right: “Because the United States can get what it wants whatever China does, the odds are that China would soon give in.”

[3] In the real world the problem is that US government borrowing did not increase by as much as the capital inflows from China, with the result that Chinese purchases of Treasurys drove down the yield and forced more return-sensitive investors to look for similar assets elsewhere — thus the demand for asset-backed securities. This point is made by Perry Mehrling and by Daniel Gros. Neither draws the logical conclusion that the financial crisis might have been averted if the federal government had only borrowed more. Topic for another post.

[4] Countries other than the US are in more the gold-standard situation — they face the problem of earning the dollars to cover their deficit with China, or euros for their deficit with Germany.

[5] Since he doubted the effectiveness of exchange rates to provide the needed flexibility, the key goal for him was an automatic mechanism to provide the offsetting capital flows to deficit countries, without depending on either private investors or the governments of surplus countries.