Wednesday, January 26, 2011

It Takes Two To Tango

Martin Wolfs reports on the concerns President Hu Jintao of China shared on his recent trip to the United States
“The current international currency system is the product of the past.” Thus did Hu Jintao, China’s president, raise doubts about the role of the US dollar in the global monetary system on the eve of last week’s state visit to Washington. Moreover, he added, “the monetary policy of the United States has a major impact on global liquidity and capital flows and therefore, the liquidity of the US dollar should be kept at a reasonable and stable level.” He is right on both points.

In criticising US fiscal and monetary policies and, in particular, the Federal Reserve’s policy of “quantitative easing”, Mr Hu was following a well-trodden path. In the 1960s, Valéry Giscard d’Estaing, then French finance minister, complained about the dollar’s “exorbitant privilege”. John Connally, US Treasury secretary under Richard Nixon, answered when he described the dollar as “our currency, but your problem”. The French and now the Chinese desire exchange rate stability but detest the inevitable result: an open-ended commitment to buying as many dollars as the US creates. 
As Wolf later notes, the obvious solution is for China to stop purchasing dollars and allow its currency to appreciate.  China, however, is loathe to do this because it would put a damper on its export-driven growth strategy.  As a result, Chinese monetary authorities have to create more yuans to buy up the new QE2 dollars in order to maintain the crawling yuan-dollar peg.  The actual and expected increase in yuan, in turn, is contributing to the rise in China's inflation rate. In short, China is importing the Fed's QE2-driven monetary policy.  While QE2 may be good for the U.S. economy, it seems a stretch to think its optimal for an economy with 10% annual real growth.  Yet the Chinese government continues to allow Fed monetary policy to shape its domestic monetary conditions.  So before casting blame, China should remember it can always end this monetary dance with the United States and walk away.  After all, it take two to tango.

P.S. If China doesn't walk away from this monetary dance with the United States, then the resulting inflationary pressures will eventually lead to a real appreciation of the yuan that the Chinese government is trying to avoid in the first place.  One way or the other, there will ultimately come about a meaningful rebalancing of the global economy. 


  1. When Bernanke recently announced on 60 Minutes that he was not "increasing the money supply", I suggested to someone that he must have expected that the money from their open market operations to be stuffed into a matress somewhere. It turns out that there is indeed a mattress, and it is made in China.

  2. "While QE2 may be good for the U.S. economy, it seems a stretch to think its optimal for an economy with 10% annual real growth"

    David, this is a very telling comment. First, we must ask ourselves why China has 10% annual real growth.

    Secondly, it seems from your comment that you hold that much of the apparent excess demand for money that the Fed is "accommodating" is due to the Chinese shadowing our monetary policy. But this can only frustrate the restoration of the desired level of cash balances here in the U.S.. So in what sense do you see this as being good for the U.S. economy other than empowering the U.S. government to run up huge fiscal deficits?

    Finally, I might interpret your admission as also admitting the almost impossible task of a central bank to properly match changing demands for money, even with a Selgin-type NGDP rule. As you can see, for it to work in this instance, you must also consider the Chinese GPD, otherwise the Fed policy is inflationary somewhere, even if that inflation does not immediately show up in the U.S.

    As they say, its five o'clock somewhere. I can hardly see how this is good.

  3. I have wondered about monetary policy in a world with open-ish borders.
    Capital, goods, services flow easily, and labor can flow into the USA.
    I still wonder if the USA is somewhat innoculated againt inflation, as we just import goods, services, labor and capital when there is demand, thus tamping downinflation. A growth economy in the USA feeds itself globally.

    A weaker dollar thus might be somewhat inflationray, but due to global competition probably not.

    This means Bernanke can print money until the plates melt, and that means China will have to print boodles if they want to peg the yuan.

    My guess is look for inflation in the high single digits in China, but in the low single digits in USA. I think both nations go into growth booms in the next cycle, starting about now.

  4. K Sralla:

    While it is true China is willing to purchase an inordinate amount of our dollars, I wouldn't call this a true excess dollar demand problem. But yes, it does make it more challenging to accommodate the real excess money demand problem in the U.S. However, this does does not mean the Fed cannot do it. There was a lot of discussion on my recent balance sheet recession post on this issue of how the excess money demand issue plays out given an open-economy framework. See the comments there.

    Finally, China or no China, I think the bigger issue to which you allude is Hayek's "fatal conceit", the belief that (in this case) the Fed actually knows enough to properly fix the excess money demand problem rather than making it worse. It is a good point that I need to be reminded of more often.

  5. Benjamin:

    There is a literature on "exchange rate pass-through" that looks at this issue. Where many countries see their currency deprecations pass through to higher domestic prices, it is less so in the US. There are various reasons given for this. One is that foreign producers don't want to lose market share in the most important economy on the planet and thus are willing to take a profit hit.