So, I'm reading through the New York Times this morning and I find this Chris Lohr piece (Maybe Japan Was Just a Warmup) comparing the US's challenges in trade policy with China with those experienced in the 1980s with Japan, and right at the end of the piece I find this passage:
Mr. Bergsten estimates that the renminbi is undervalued by 20 percent or more — the Chinese central bank’s purchases of dollars depress the Chinese exchange rate and the subsequent lower value of the renminbi makes Chinese exports less costly abroad. “It’s an across-the-board export subsidy,” he says.
And all of a sudden lightbulbs start exploding all through my head. I had never really thought before about the mechanism the Chinese use to undervalue their currency, but this point makes total sense to me. And the implications for US domestic policy are immense.
More on the flip...
I've done a lot of traveling in my life, and I've had to spend a lot of time dealing with the minutiae of exchanging money. I've been in places where the exchange rate is set freely, fluctuating (like the price of gasoline in the US) on a daily basis, and I've been in others where the rate is fixed by the government and never changes at all. A lot of countries set a band of values within which the rate is allowed to fluctuate, can't go higher than a certain amount nor lower than a certain amount but its value between those amounts is set essentially by market forces.
I had always assumed the renminbi was undervalued as a result of government fiat -- that Beijing had simply fixed a value for its currency substantially below what economists had calculated should be its actual value. Naturally, an undervalued currency would lead to an artificially higher export rate, and the US -- which buys more from China than it sells -- has a reason to complain about an artificially low exchange rate.
The expert quoted in the Times, C. Fred Bergsten, director of the Peterson Institute for International Economics, makes an entirely different case, however. China's currency is undervalued, he says, because China buys a lot of dollars. Well, those of us who follow the news already know that China buys a lot of dollars, and we also know why China buys them. It's because they're for sale.
In fact, a few years ago here on dkos we used to worry that China holds so many US dollars it could provoke a collapse in the value of the US currency if it chose to sell them all at once. After a while, we figured out such a move would hurt China almost as much as the US and we pretty much stopped worrying about it.
Why are so many dollars for sale? Well, the Treasury sells dollars in order to finance the budget deficit:
If Treasury outflows consistently exceeded inflows, the money supply would steadily increase and create unacceptable inflationary pressures. Therefore the Treasury recaptures all of its spending on average. It does so with taxes and the net sale of securities when there is a shortfall in tax revenues. In effect the Treasury pays for its deficit spending by issuing securities rather than base money (emphasis added).
Now, I've actually known this for a long time: the Chinese purchases of US securities have made it possible for the US to continue to run large budget deficits year after year. What I had never thought about before today, though, is that those same purchases have had the net effect of devaluing the Chinese currency.
Here's the dynamic:
1 The US government runs a budget deficit
2 The US government sells securities to finance its budget deficit
3 China, which has a lot of cash on hand due to a large trade deficit, buys US securities
4 The Chinese currency is devalued
5 Because of its devalued currency, China can increase its exports
6 China has more cash on hand to buy even more US securities
See, I could never understand why the US budget deficit had suddenly become such a big issue in US politics. Yes, large deficits over time are unsustainable, but right now in the middle of a huge economic crisis the deficit actually has a stimulative effect. It actually helps us get out of the economic mess we're in. So why is the president forming a bipartisan commission to address the deficit? Why is chopping Social Security suddenly the thing to do, even though progressives (though apparently no one else) know Social Security actually doesn't contribute to the deficit? What is the underlying interest here driving the debate? It didn't make sense to me.
Well, linking the US budget deficit to China's rise to great power status -- not through the Chinese accumulation of cash reserves, but through the depressive effect those reserves have on the value of its currency and therefore on China's ability to continue to use exports to drive its impressive domestic industrial growth -- provides the motive I was lacking before.
It's pretty basic stuff, really. I'd just never thought about it before.