One of Stephen Roach's oft-made points is that most U.S. elites believe that the trade deficit is someone else's (mainly China's) fault, and that it is they who will have to change, not us.

I have tried and can't think of a good reason why China, if it is acting purely in its own interest, would want to abandon the peg. The peg stabilizes FDI flows, makes it easier to plan purchases of raw materials (which are mainly dollar-denominated), keeps Wal-Mart a happy business partner, and screws Japan. An extremely bright person--I think he was one of Credit Suisse's lead economists--told me a few months ago that he thought one of the main reasons China has experienced so much less economic volatility than the 19th-century U.S. (another rapidly developing great industrial power) is the peg.

There is just the merest chance that those who believe we have leverage vis a vis China are befogged by overweening neoimperial arrogance. Employ the means at our disposal, and it's a MADD, MADD world: they'd recess and see social chaos; we'd see explosive consumer goods inflation and soaring interest rates. Which might finally get the Wal-Mart consumer off his/her collective political duff, and threaten corporate oligarchy.

I think both sides just keep staring at each other.

-NM

I know very little about international economics, so this question is likely to be very naive. Nevertheless, I'd like to get an answer:

Assume that the dominate view that Chinese yuan is undervalued is correct. It seems to me that this still does not necessarily lead to the conclusion that Chinese yuan will have to be appreciated some day: Why can't the Chinese just run a higher rate of inflation, such as 3 percentage points higher, than the US for the next decade or so? This should more or less solve the problem, shouldn't it?

The Chinese are keeping the peg in order to deter Bush from attacking Iran and/or NK. Bush will refuse to submit to such blackmail, so sometime in 2005 expect an attack followed immediately by a complete currency collapse. Then things will get really interesting here at home.

pat-

If Chinese labor costs (an inflationary force) were to increase, then yes, the situation could eventually resolve itself, even if the dollar and yuan were to stay pegged. Their exports would rise in price over here, ours would become more competitive over there, and the trade balance between the two countries would even out.

But why should they increase (what's the cause, what's the motivation?). Unionization? Almost unimaginable.

I think we are talking decades here.

-NM

My thing is that China needs more in the way of raw materials and some finished products and the US needs more in the way of financial capital. China does not get *that* much of the raw materials and finished products from the dollar zone. What's more, assume that china has growing good and transparent governance, then it should start attracting a heckava lot more financing.

This is a metastate, not a long term trend. We just don't know how long it will be. One year, five years whatever. I do have a trump card in saying that it will be less than five years before china has to revalue. George W. Bush is our president. So long as the U.S. persists in trying to pop the metastate by demanding ever more capital to finance debts, it makes it progressively harder for china to maintain it if they choose to.

NM,

Thanks for helping. But what I have in mind is printing money (inflation is a monetary phenomenon in the long term) rather than increasing unionization, although nominal wage will also increase as higher inflation pushing up the cost of living for workers. My question is whether or not inflation is a substitute for currency revaluation -- if it is, one can make many arguments that slightly higher, yet controled inflation is a better alternative to currency revaluation, at least from the point of view of the Chinese government.

Maybe China is governed by men who are not motivated by narrow economics but by nationalism and history. The west may not remember the Opium wars, but their kids will learn of them in their schools, and everyone can recall the diplomatic fury unleashed in the recent plane incident. A few years back what westerners call a display of democracy is evidently recalled by Chinese as a time when the authorities and the People's Army had to intervene because a number of young people behaved rudely toward high governbment officials!

Who will take bets they are just kidding about TaiWan.

About a month ago there was a news story that Asian banks had a flutter of fear for a day or so because there was a rumour that China was unloading American securities. The Chinese let it run for a day and then announced this was all a misunderstanding and they were just increasing their purchases of other countries' securities, not dumping American ones. One does not get to see their Government stats, so who can say. But does that not look like a reminder to the other Asian countries as to who is now in charge? And does it not echo exactly the way that would have been communicated in the days of Empire? Who can doubt the sheer love of exercising raw power.

After all, can anyone give a coherent account of why, exactly, the USA went into Iraq, or a rational explanation of their current economic moves (one cannot reasonably say "policies"). Why should China be any more rational?

I think economic macro analysis should start with the assumption that for the forseeable future the very worst possible moves will be what each country will do, starting with the United States.

It is not yet the summer of 1914, but it surely is getting warmers.

I don't know much about economics, but that article was very scary. Bush's policies could lead to a world economic collapse?

What is China's motivation for keeping the yuan pegged right now? I understand lower prices for Chinese exports, but what are the other advantages for keeping the yuan low? What are the advantages to upping the peg or letting it float?

Pat:

There is something named the "impossible triangle" (or another similar name), stating that three things are not compatible: a pegged exchange rate, an open capital market and an independent monetary policy.

Since China has +/- open capital markets, and a pegged exchange rate, it can't have an independent monetary policy, one that could produce inflation.

Huffy,

Thank you for your comments. Can I flip your reasoning to say that if they want to maintain their peg, they have to allow higher inflation? After all, this is happening right now -- the huge amount of capital inflow is causing Chinese inflation rate to climb. And can I conclude that this acedamic conviction that Chinese will have to appreciate yuan eventually is in fact incorrect -- Chinese can choose between higher inflaiton or higher yuan? Of course, reasonable people can still disagree which choice is more costly (to the Chinese or to the US). But my question is whether or not it is inevitable that yuan will appreciate, and your answer suggests there are in fact two possibilities (assuming they maintain open capital markets). Do you agree with my interpretation?

IANAPE (...Professional Economist), so I can only speculate. First of all, they would not allow for higher inflation, but rather engeneer it, since if the yuan is undervalued, there woud be deflationary pressure on it. The massive buying of US treasuries should be inflationary, putting more yuan on the market.

On the whole, I am not very familiar with the tools to create inflation, but the central bank could lower interest rates or "print money" by buying chinese government debt. It would be interesting, if there is an example of a modern government actively engeneering inflation - reminds me of PKs former favorite meme, namely letting the bank of Japan produce inflation.

Greetings, Huffy

"that China's State Council doesn't realize what the long-run costs of its policy are, and even if ti did realize them might think the money well-spent"

The question one must always ask oneself when considering this question is: looking over the last 150 years or so of Chinese history, if you were going to sell the Chinese government a comprehensive insurance policy against economic (GDP) losses due to social/political instability, what would you price it at?

The currency peg is almost certainly a bargain.

Huffy,

Thanks for the discussion. You've been very helpful.

I wonder if I could just make a small comment on China. Their preferred tool to control over-investment (including those capital inflows Pat mentions as inflationary) has long been monetary - raising banks solvency ratios etc. I'd wager they stick to what they know has worked before rather than change now.

More generally, China treads a fine line between economic growth and social/political calm (as Michael Robinson implies above). The NY Times has a worthy multimedia presentation covering this. Any discussion suggesting debasing/revaluing the currency probably should give a nod to the impact on this dynamic.

Finally, I'd suggest the longer the headlines are filled with "US pushes China for revaluation" type proclamations the less likely it will happen soon. The Chinese themselves have said they won't be "bullied" so it's fairly easy to believe they'll do it when the general perception is that nobody "made" them do it.

The Chinese central bank essentially has two degrees of freedom on this issue. They can print Yuan to buy dollars and they can sell debt to accumulate Yuan.

To maintain their peg, they must print Yuan to buy dollars. This increases their money supply, which if done faster than GDP growth justifies, leads to inflation. This also causes their dollar foreign exchange reserves to rise. They are basically buying the dollar high now, and if they ever have to sell, will cause them to sell low. Buy high, sell low is not exactly the path to wealth.

They can remove Yuan from the system in order to decrease the money supply, and lower inflation, by selling government debt (Sterilization). This increases the public debt of China and causes their interest rates to rise. The rise in interest rates discourages private investment.

China is not getting a free ride on the dollar peg. Economics is after all called the Dismal Science, there are no free rides.

China will abandon the peg if they believe that the benefits of it are worth less than the consequences of keeping it.

Paul