Losing the Battle, Winning the War?

Guest Author:  Menzie Chinn is Professor of Public Affairs and Economics, Robert M. La Follette School of Public Affairs, University of Wisconsin, Madison, WI – Vita

Sub-Title:  The Economic Implications of the G-20 Meeting’s Aftermath.  Originally posted November 13 at Econbrowser.

The narrative emerging in the wake of the G-20 meetings is that, not only is the rest of the world angry at us over quantitative easing, but we also achieved none of our diplomatic objectives regarding rebalancing (the coverage seemed particularly negative on CNBC). [1] [2] [3] In addition, the outcome has been taken as a harbinger of the end of US dominance over economic policymaking, to the extent the US no longer has the intellectual high ground (given the failure to regulate the financial system in a sensible way) and the relative decline in economic weight.

Effective Economics versus Meaningful Communiques, and Strategic Interactions

I think one important point is to realize that achieving economic goals and diplomatic successes are not always the same. From a diplomatic standpoint, it would have been useful to have agreement that countries should limit current account balances, as in the US proposal. It might have been economically useful, to the extent that this put additional pressure on China to take more rapid action to rein in their current account surplus by way of exchange rate appreciation, and restructuring of the economy. Of course, at the panel I was on several weeks ago [4], PBoC deputy governor had already made a commitment to putting the Chinese CA/GDP ratio on a glide path towards reduction (but not necessarily as a share of world GDP), so it’s not clear what economic impact an agreement would have made.

I have also been thinking about the anger with which the policymakers and economists in the rest-of-the-world (as well as certain US politicians [5]) have greeted QE2 with. In some ways, the fact that they are angry speaks volumes about the effectiveness or ineffectiveness of QE2. (In other words, to criticize QE2 as having no effect, and then to be angry that it is being undertaken, are internally inconsistent views.)

My view is that anger at the US position is currently being driven by an understanding that QE2 has been surprisingly effective at depreciating the dollar, and that the rest-of-the-world has limited scope in countering that depreciation. In a game theoretic context, we usually think of competitive devaluation as a form of the prisoner’s dilemma, where the devalue option dominates the no-devalue option, and both parties end up with a devalued currency, but no net improvement because countries cannot all devalue against each other.

Figure 1: Log nominal value of US dollar against broad basket of currencies (blue), and log real value (red). November observation for nominal rate pertains to 11/5/2010. Downward direction denotes deprecation. NBER recession dates shaded gray. Source: Federal Reserve Board, NBER and author’s calculations. However, because of the radically different post-recession economic conditions facing the US and China, the payoff matrix has changed. The US gains by allowing the currency to depreciate against the rest-of-the-world, but the Chinese (and to a lesser extent the other BRICs) have competing goals of maintaining rapid growth, high exports, and stable inflation. This point has become apparent as inflation has surged in China. [6] The conflicting goals Chinese policymakers face can be illustrated by reference to the Mundell-Fleming model. (See this post for detail).

Figure 2: Tightening of monetary policy. Interest rates rise from i1 to i2, due to decrease in money supply which shifts in the LM curve. Source: Econbrowser (March 2007).The Chinese can raise interest rates in order to stabilize inflation by cooling off the economy. However, that interest rate increase would exacerbate the capital inflow that would tend to appreciate the CNY. That in turn implies even greater forex intervention by PBoC, which in turn requires even greater sterilization measures, either by issuing more PBoC bonds, or by raising reserve requirements. The US measures to push down long term rates via QE2 have made that option more difficult.

If the Chinese are unable to rein in inflation via sterilization measures (and other administrative measures to cool off the economy), then the Chinese real exchange rate will appreciate, even if the nominal does not move. Recall the definition of the real exchange rate (in logs):

q = s – p + pUS

Where s is the log exchange rate expressed as CNY per USD, p is the log Chinese price level, and pUS is the log US price level, and q is the log real exchange rate; up is depreciation of the CNY. As p rises, q falls. This argument is merely an assertion that the monetary approach to the balance of payments holds in the long run.

The highlighting of this tradeoff by US actions might just induce the Chinese policymakers to accelerate measures to re-balance in a way external diplomatic pressure (from the US, the other G-20) did not.

Why Is the Exchange Rate Moving So Much?

As I noted earlier [6], there is some mystery why the impact on the exchange rate has been so much more marked than that on long term rates. As several observers have observed [Delong] [Krugman], QE2 is fairly small in quantitative magnitude, and in terms of implied impact on duration adjusted interest rates. Theory suggests offsetting inflation and liquidity effects from open market operations, so the impact on observed nominal rates could in principle be small (and in either direction).

I think a large chunk of the impact comes from the fact that QE2 signals additional information about the willingness of the monetary authorities to undertake actions to stimulate the economy, perhaps by future injections [7]. I will also observe that the likelihood of a sensible fiscal policy declined after the mid-term elections (that is the US will more likely undertake contractionary fiscal policy by not offsetting state spending reductions), so that from a simple Mundell-Fleming model, we should expect dollar depreciation.

What about Capital Controls?

There has been substantial discussion of whether capital controls can limit the capital inflows into emerging markets, thereby loosening the choice between exchange rate stability and monetary autonomy (i.e., “the trilemma”, as discussed here and here). I believe that capital controls can be effective, particularly in the short term, in reducing and changing the composition of capital inflows. Whether capital controls can be effective over the longer term in stemming these inflows to a substantial degree remains open. (see for instance the recent IMF paper here [pdf]).

Of course, if extensive capital controls are combined with financial repression, and pervasive controls over the rest of the economy, then capital flows can be controlled, as in China. Even then, capital controls only allow reserve accumulation/decumulation to loosen the binds of the trilemma. [8]


Figure 3: drawn from Figure 4 in Aizenman, Chinn, Ito (2008).The Bigger Game
The depreciation game between the US and the other G-20 countries is imbedded in other games. Moreover, the game is repeated (the dollar depreciation is one-shot, with repercussions into the future). Perhaps more importantly from my perspective, strategic interactions involving macro policies are imbedded in a larger game involving other policies including those related to trade. GI/Free Exchange discusses whether trade protection and depreciation are complements or substitutes. My colleague Mark Copelovitch, along with UW Professor Jon Pevehouse, has undertaken some systematic research on the subject of exchange rate regime choice and protection (presentation here), which suggests that they are substitutes.

Thinking in the context of the current game, China could retaliate, although not necessarily by using tariffs (rare metals comes to mind). We’ll have to wait and see; however, to the extent that China relies more profoundly on access to US markets than the US relies on access to Chinese markets (still), I’m dubious they will follow this path with full force.Posted by Menzie Chinn at November 13, 2010 12:32 PM

Concluding Thoughts

None of the foregoing should be taken to mean that failure to come to an agreement on a formal statement restricting current account imbalances was a good thing. Certainly it would have been preferable to have an additional lever to induce more rapid action on the Chinese yuan. But it’s always important to recall what the economic fundamentals are, and right now it appears that the scope remains for the US to induce additional expenditure switching.

Hence, the US has, either intentionally or unintentionally, “pulled the trigger” (after all, it’s not clear Bernanke was thinking about the dollar, as opposed to domestic economic activity); we are now using our special position as a key reserve currency to depreciate our currency at exactly the time when other key countries (the BRICs) are not fully able to counter, since their output gaps are positive, and stronger currencies would help them counter inflationary pressures [9]

One last speculation. The other countries facing a negative output gap (primarily other advanced countries) will face the same incentives as the US, and so will more likely try to depreciate their currencies. It’s true that this will tend to negate the US depreciation — but to the extent that this induces greater monetary easing in those countries, this is a positive outcome.

Some words of caution about overinterpretation from Simon Evenett. Richard Portes also assesses the macro implications of the Seoul meetings. Paletta/RTE parses the words.

Update, 9:30am Pacific, 11/14: The game is afoot: “China to consider hot money policies: report,” Reuters 11/14/2010.

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