Monday, 15 September 2008

Mad about mercantilism

Many critics of China's exchange rate policy label it as "mercantilist", meaning that its purpose is to promote net exports in order to increase the country's financial wealth at the expense of its trade partners. Countries running trade deficits with China complain (without a trace of irony about the bounded – ie up to balanced trade – mercantilism that their own position represents) about losing industry and employment to China. Although RebelEconomist does agree that it would be in China's own interest to allow its exchange rate to float increasingly freely, he would question whether complaints that China's currency policy is mercantilist and disadvantageous to its main trade partner, the USA, above all are justified.

First, it is hard to characterise China's exchange rate regime as mercantilist. While China does seem to have adopted an export-led economic development strategy, and is undoubtedly now worried about the impact on employment of a slowdown in exports if it allows its currency to appreciate sharply, China has not adjusted the exchange value of its currency to stimulate exports. The original motivation for the peg to the US dollar was to augment China's monetary stability following currency reform at the beginning of 1994, with a practically fixed exchange rate of 8.28 yuan to the dollar being maintained from then until 2005. This peg was held despite substantial real renminbi appreciation in the first few years due to relatively high Chinese inflation and pressure for a nominal devaluation in line with other Asian currencies during the Asia Crisis of 1997-98. And since July 21st 2005, when the renminbi was re-pegged to a currency basket apparently dominated by the US dollar, involving an immediate 2.1% appreciation, the renminbi has been allowed to steadily appreciate against the dollar. China's increasing competitiveness and consequently large trade surplus has been driven by productivity growth and the pricing strategies of its exporters rather than its exchange rate regime. This presumably explains why the US Treasury has declined to brand China a "currency manipulator".

Second, whatever the motivation for China's exchange rate policy, RebelEconomist is sceptical whether it necessarily gives China any economic advantage at the expense of the USA. On the contrary, RebelEconomist can think of two arguments why China's currency regime actually ought to be a disadvantage for China, and by implication, potentially advantageous for the USA.

To appreciate the first argument, a brief reminder of the operations involved in pegging an exchange rate may be helpful. Initially, in order to hold the exchange rate at the peg level, the authorities undertake to exchange as much of their currency for the peg currency as the market requires at that level. In China's case, this intervention usually obliges the authorities to buy foreign currency, mainly because, at the peg exchange rate, Chinese products are cheap in foreign markets, meaning that the supply of foreign currency from exporters selling their foreign currency revenue for renminbi outweighs demand for foreign exchange from Chinese importers needing to pay for imports. Also, the fact that the Chinese government restricts its citizens' freedom to buy foreign currency financial assets reduces Chinese demand for foreign currency. Then, in order to accommodate the currency flows generated by their intervention, the authorities normally buy and sell financial assets, typically bonds. In China's position, this entails selling bills to domestic banks to raise renminbi to sell, and buying mostly US government and agency bonds to invest the dollars that China buys. The bonds purchased are retained as foreign exchange reserves, allowing the foreign exchange intervention to be unwound if the market flows reverse. In theory, now that China holds more than enough foreign exchange reserves to meet any foreseeable need for reverse intervention, the Chinese government could spend some dollars on American products instead of bonds, but for strategic reasons, the US government bans American companies from selling China many of the type of defence and technological goods that the Chinese might like to buy. Naturally, the concentration of Chinese dollar investment in US government debt raises bond prices and therefore lowers the interest rates payable by the US government. In short, China's intervention involves under-pricing the goods that it sells to the US, and paying an excessive price for the US assets that it buys. This hardly seems like grounds for the Americans to complain.

The second argument against the idea that China's exchange rate policy gives them a competitive advantage applies regardless of how the policy is implemented. This argument, which appeals to RebelEconomist's mathematical pretensions, is simply that the currency peg imposes a restriction on the Chinese economy, and calculus teaches us that a constrained optimum cannot be superior to the unconstrained optimum.

The idea that mercantilism is a disadvantage to the mercantilist is not new. The British economists who did most to discredit mercantilism, such as Adam Smith and David Hume were arguing against the advocates of mercantilist policies for their own country, such as Thomas Mun. They drew their conclusions from somewhat different reasoning, however. Smith explained that the proceeds of trade are generally better spent on enhancing the productive capacity of a nation rather than being saved at low interest rates (admittedly, the key reserve asset when Smith was writing in the 18th century was gold) and Hume described how accumulated trade wealth could be expected to bid up domestic prices so that a trade surplus would prove unsustainable anyway.

Provided that America can organise itself to exploit this apparently irrational behaviour by China, such as in the ways that RebelEconomist has suggested in a previous post, China's exchange rate policy need not be a problem for the US. Even if particular American industries suffer from under-priced Chinese competition, the overall gain to the US economy from cheap imports and low-cost funding should provide the resources necessary to compensate or reassign people involved in those industries.


Howard Richman said...

Dear RebelEconomist,

Thanks for mentioning in your posting on Brad Setser's blog that you were responding to my arguments with this posting. Too bad you didn't mention our book when you were criticizing it. Trading Away Our Future is readily available (see

Some day, you will have to reread Adam Smith to find out what he is really saying about mercantilism. He is saying that mercantilism hurts the world economy as a whole. To him, mercantilism was the concept that accumulating gold should be the goal of economic policy. He was advocating, instead, that growth in GDP should be that measure. In other words, the wealth of a nation was its production, not its stock of gold.

You should also look at what Hume actually argued. He said that an inflow of gold drives up prices in the surplus country and drives prices down in the deficit country which tends to correct the trade imbalance.

Hume was correct about the mercantilism of his day, but did not anticipate modern mercantilism.

In fact, if the goal of the gold mercantilists were to build their industry (not their gold hoards), they could have practiced the same system that the modern mercantilists practice today by using the gold obtained from trade to buy assets in the trade deficit country.

It's also too bad you haven't yet checked Peking University Heng-Fu Zou's 1997 mathematical treatment of mercantilism, "Dynamic Analysis of the Vineer Model of Mercantilism. So you would have realized that your consumption argument was a short-term argument. Zou demonstrated that the modern form of mercantilism results in long-term gain in consumption for the practicing country even though in the short run it has less consumption.

The huge factor that you missed entirely in your analysis is the effect of mercantilism upon investment opportunities in the practicing country and the victim country. By holding its exchange rate approximately 40% below where it should be, China makes its products 40% less expensive to American consumers and American products 40% more expensive to Chinese consumers. As a result China gets investment while the United States does not, making Chinese products even less expensive to American consumers, compared to American products.

Seeing as the current US investment slump is causing our economy to go into economic stagnation, you really should look into the factors that are causing it.

Howard Richman

Jesse Richman said...

Dear RebelEconomist,

I wanted to follow up on what Howard wrote with a further comment. You wrote:

"The second argument against the idea that China's exchange rate policy gives them a competitive advantage applies regardless of how the policy is implemented. This argument, which appeals to RebelEconomist's mathematical pretensions, is simply that the currency peg imposes a restriction on the Chinese economy, and calculus teaches us that a constrained optimum cannot be superior to the unconstrained optimum."

I think you are misinterpreting the mathematical result you cite. The decision to peg its currency does probably create an inferior constrained optimum, but this is an inferior equilibrium in US/China trade, which imposes costs on both countries relative to open trade. Both countries would probably be better off with unconstrained trade. The costs of the constrained situation are allocated unevenly though. China appears to have paid short term costs for relative long term gains in terms industrial plant and production. The US draws short term benefits from cheap consumer goods, but at substantial long term costs. It is partly because of our fiscal and trade irresponsibility over the last decade that we may now be forced to "sell the family silver" as you suggest in a more recent post.

Jesse Richman

Anonymous said...

nice post!

RebelEconomist said...

Howard and Jesse,

Thank you both for your comments. It is a pleasure to debate these issues with people who express clear views. I would be happy to review your book if you send me a free copy.

I suspect that many of the arguments you make against mercantilism are reasonable, but do not allow for the possibility of intervention by the "victim" nation's government to neutralise, and perhaps even exploit, mercantilist policies. It is like a man rowing a dinghy complaining that the wind is making the sea choppy, when he would be richly compensated if only he would put up the sail. Howard provides one example himself when he says that mercantilism – which, as you know, nowadays involves buying debt rather than gold - has deterred investment in America. Surely there must be an opportunity being missed if investment is depressed when interest rates are low (assuming that low interest rates are a consequence of the debt purchases by foreign currency authorities). As I explained in a previous post, I believe that the US government could have made more of the reserve status of the dollar by selling more debt into the foreign demand and investing themselves, either in domestic infrastructure, which is arguably in a poor state in the USA, or in America's own foreign exchange reserves (so that now, to link with Jesse's comment, they would have more family silver to sell).

I agree with Jesse that China’s exchange rate peg represents a constraint on both countries in the short run, given that China restricts capital inflows (if not, the USA could respond in kind by buying renminbi assets to offset the exchange rate impact of Chinese intervention). In the longer term, however, if the US authorities consider that America is disadvantaged by China's pegged exchange rate policy, they are able to neutralise that exchange rate constraint, and even turn it to their relative advantage, by engineering a real depreciation by restraining American unit labour costs and producer prices to increase more slowly than in China. This is what Germany did to regain competitiveness in EMU. You might say that it would be impossible for the USA to increase its competitiveness in this way sufficiently rapidly to offset China's rapid productivity growth as it benefits from "catch up", but that would be tantamount to saying that China is winning the trade competition because it is becoming more efficient, not because it is manipulating the value of its currency. You might also consider that such austere policies would be politically impossible to implement in America, but if so that would not be China's fault.

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