Wednesday, February 3, 2010

Obama clueless on FX rates

This news item from Reuters is the latest example of how Obama, like most politicians, is utterly clueless about how economies work.
President Barack Obama said on Wednesday China and Asia would be a huge market for U.S. exports going forward but it would be important to address currency rates to ensure American goods were not facing a disadvantage. "One of the challenges that we've got to address internationally is currency rates and how they match up to make sure that our ... goods are not artificially inflated in price and their goods are artificially deflated in price," Obama told senators from his Democratic party.
Stripping aside the rhetoric, what Obama is saying is that the U.S. would be better off if the dollar weakened against the yuan. This is nothing but shoddy thinking. A weaker currency can never make an economy stronger. A weaker currency may make U.S. exports cheaper, but a weaker currency also makes imports more expensive. Devaluing one's currency is thus a fool's game, since it benefits one segment of society (exporters) but harms everyone else (consumers, who have to pay more for the imported goods they purchase).

China made a perfectly rational decision to start pegging its currency to the U.S. dollar in 1995. Targeting its currency is the mainstay of Chinese monetary policy, and that is perfectly acceptable, so long as you understand and accept that under a targeted exchange rate regime, the economy is forced to adjust if the exchange rate chosen is too strong or too weak. If the currency is pegged at a rate that is too weak (as Obama is alleging) then imports will be too expensive and inflation will tend to rise, and the price of goods and services will rise until the currency's artificial cheapness is offset. In the long run, pegging one's currency at a low level will only result in inflation and perhaps a temporary boost to exports.

The Chinese central bank first started targeting the yuan/dollar exchange rate in 1994; thus the economy has had 16 years to adjust. It's noteworthy that the Chinese have already revalued the yuan against the dollar significantly, by almost 28%, since 1994. It's highly unlikely, therefore, that the yuan is being pegged at a level that is artificially low. And even if it were, the passage of time will inevitably erode whatever "advantage" that is supposed to give to Chinese exporters.

The biggest problem the Chinese face with their exchange rate regime is that the currency they have chosen as a standard (the U.S. dollar) has suffered extreme changes in value against the other major currencies of the world. It does the Chinese little good to peg their currency to a standard that fluctuates, and in fact it only creates problems for its economy. For example, the dollar rose some 50% from 1995 to 2002, lifting the yuan with it, and that was the proximate cause of the deflation that China suffered from 1998 through 2002. The dollar subsequently lost over one-third of its value from 2002 to 2008, and this helps explain why Chinese inflation rose from zero in early 2003 to almost 9% in 2008. The main reason the Chinese have revalued their currency against the dollar is because the dollar has lost about 20% of its value against other major currencies since 1994.

The result of this so-called currency "manipulation" is a yuan that has been more stable relative to other currencies, and to gold, than the dollar. This stability, coupled with massive foreign currency reserves, has made the yuan a rock of stability. Revaluing the yuan would only make sense if the U.S. were to allow the dollar to continue to fall against all currencies. Is a dollar devaluation really what Obama wants? I hope not.

UPDATE: Just to be clear, I'm saying that the only way the Chinese are going to revalue the yuan against the dollar is if the U.S. first devalues the dollar against other major currencies. 


Benjamin Cole said...

I never completely agreed with the strong-dollar crowd.

I think first a person, a society or nation must think of itself as producers, not consumers. Call it supply-side pride.

If you don't produce, you won't consume (legitimately, anyway).

Obviously, we can export and attract tourists a lot more easily with a weak dollar. We can entice foreigners to invest in US plant and equipment.

Once manufacturing leaves, the technical skills and evolution of those skills leaves too.

You find the best engineers and scientists migrating to "where the action is."

Chinese engineers are not coming here anymore.

I would be satisfied with a long-term weak dollar philosophy.

I am more concerned that we wrongly tax productive behavior--the corporate income tax, the Social Security tax--than the strong or weak US dollar.

I confess to a bias--I have been involved in US manufacturing for 20 years. I watched an entire industry--furniture--just about get wiped out by Chinese imports.

They say this was good for the USA, but I am not so sure.

alstry said...


I am with you on this one...a weak dollar would only hurt America in the long run.

The bigger concern is whether America has spent down its savings to drive short term consumption and illusory growth.

It is time we focus on production as revenues are evaporating all around America....and getting much worse on the margin.

The continued drop-off in state general revenue collections has led to additional spending restrictions this year, the state budget office said Tuesday.

Through seven months of fiscal 2010, general revenue collections total $3.88 billion, down 12.5 percent compared to the same period in fiscal 2009.

Collections for January totaled $561.2 million, a 22.4 percent decrease from January 200.

And it is not just is practically every state in America as our savings runs dry.

If the state budget were a giant tire, now would be a good time to send someone out for a bigger patch.

Already facing a revenue shortfall of about $65 million one quarter of the way through the two-year budget cycle, state officials will have to plug another $45 million hole now that the New Hampshire Supreme Court has rejected the state’s bid to tap into the treasury of the state’s medical insurance underwriter.

Instant said...
This comment has been removed by the author.
Instant said...

I think Scot, you don't understand this time. Chinese will not change their exchange rate easily by political pressure. The reason Obama blames undervalued Yuan is that he wants to find a scapegoat. It is the Politic, Stupid. :-)

A weak dollar may help to attract manufacturing back to the U.S. I am totally against minimum wages law. Only lower the effective wages by devaluing the dollar can save the manufacturing sector.

Scott Grannis said...

instant: Like you, I see no reason for the Chinese to revalue the yuan just because Obama wants them to. But if Obama and the Fed want a significantly weaker dollar, then I would fully expect the Chinese to revalue their currency. Meanwhile, I don't believe that a weaker dollar would boost or save the manufacturing sector. A weaker currency is never a good thing in my book.

Cabodog said...

Scott, off topic, but interested in your thoughts about the government's bashing of Toyota. Could it be political? Rewards for the UAW's support of the dems? Punishment for Toyota's non-union assembly lines (and closing last year of their only union assembly line)?

Just thinking they're being pretty harsh with Toyota; even saying things and then retracting statements.

W.E. Heasley said...

Mr. Grannis:

FX and Obama. That’s straight out. Milton Friedman he is not. Civic class graduate? That is questionable.

2010.…..we are entering the six year of the Carter Administration, and the unfinished business of the Nixon administration.

The Lantern said...

It doesn't sound like Obama is advocating a weak dollar broadly, but rather addressing the current imbalance specifically between the U.S. and China (without singling them out). I don't think many people believe the current account imbalance is healthy for either side. The Chinese people are unable to afford U.S. goods (resulting in piracy and other issues), and China's FX reserves plough into US Treasuries keeping our longer term rates artificially low (see housing bubble).

What would be wrong with a market-based exchange regime in China that would equilibrate these imbalances? It would seem to help rebalance China's economy and eliminate some of the bubble-contributing issues that their fixed exchange rate caused. I think it could be good for both countries' living standards in the intermediate and long run.


Scott Grannis said...

Cabodog: That questions like yours come up speaks volumes about this administration's attitude toward business, unfortunately.

Scott Grannis said...

Lantern: There is nothing wrong with bilateral trade or capital account "imbalances." In fact, the worst thing about trade imbalances is that it makes politicians absolutely desperate to "do something" to fix it. That's where the problems arise.

If China were to float the yuan, they would have to adopt another monetary policy regime to control inflation. That's not impossible at all, but it would represent a major change, and it would result in increased uncertainty for some time. There is no a priori reason for them to do this, other than to bow to U.S. demands, so I doubt it will happen.

Public Library said...

As a "free market" guy, how can you credibly say there is no reason for China to adopt a floating currency regime?

"That's not impossible at all, but it would represent a major change, and it would result in increased uncertainty for some time."

Well isn't that what free markets are all about???????

Scott Grannis said...

There is no consensus among economists on the issue of fixed vs. floating exchange rates. Both regimes have the advantages and disadvantages. There is no a priori reason to think that China would be better off if they switched to a floating regime.

I'm partial to the view that it is better for smaller countries and economies to have a fixed rate regime rather than floating, since that can significantly reduce the risk of investing in their country, and that in turn should boost the economy over the long run. This seems to be the logic that the Chinese have followed.

But the Chinese have at times allowed the currency to float up. So they have something of a hybrid system. I don't see the problem in doing this.

Going to a completely floating rate regime would indeed require some serious changes and adjustments for the Chinese. It would increase the uncertainty of money policy (how would they implement it, would they make a mistake and target the wrong thing? etc). It would also introduce downside currency risk that they don't have today. There are costs involved in such a change. It's not obvious to me or, I suspect, the Chinese that the benefits to changing justify the costs.

Public Library said...

A floating currency regime allows a government to see real-time how they are manging their economies. This is the beauty of free markets.

Obviously for a Communist China, the more perceived control, the better. However, this will have unintended and uncontrollable circumstances.

Managing your currency is a derivative of managing your economy and if you cannot get the first right, good luck trying to manage the second.

You obviously do not believe the currency market should be a free market for everyone. Just the countries who can afford to subsidize the others.

Scott Grannis said...

I don't agree that floating currencies gives governments real time info on how they are managing their economies. A floating currency can go up or down depending on what is happening in other economies, for example.

A fixed currency regime requires that the economy adjust to changes in external forces. This is not always good, but it is the tradeoff for eliminating currency risk.

The main thing to remember: a central bank has only three policy choices, and each one can be effective if implemented correctly: controlling an interest rate, controlling the money supply, or controlling the exchange rate.

Managing a currency is actually very easy; the central bank simply buys or sells currency in the market in order to keep the rate on target. It has nothing to do with managing the economy.

The Lantern said...

"Managing a currency is actually very easy; the central bank simply buys or sells currency in the market in order to keep the rate on target"

Wouldn't you caveat this to say that managing a weak currency is very easy (as domestic currency is unlimited)? Keeping a fixed exchange rate strong is difficult because you can run out of reserves.

That is just one problem with fixing exchange rates. It does help shelter an export sector and can be good for fledgling economies, but at this level-- for an economy the size of China's-- it's time to change in my view. It will be good for their people after the brief adjustment is causes...

Scott Grannis said...

Lantern: With all the reserves China has, they are highly unlikely to run into any problems.

But your point is important nonetheless. If a country with a pegged exchange rate has trouble maintaining the peg because downward pressure on their currency exhausts the central banks reserves (the CB would have to buy the local currency in exchange for FX-denominated reserves), then someone has made a mistake along the way. Long before reserves were exhausted, the reduction in reserves should cause a significant contraction in the supply of domestic currency. This would naturally arrest the market's desire to continue selling the currency.

Argentina's dollar peg failed not because the peg is a faulty policy tool, but because the CB did not allow the decline in reserves to shrink the domestic money supply. Steve Hanke has effectively demonstrated that all failures of pegged exchange rates (including currency boards) can be ultimately traced to bad or faulty implementation.

A related issue: would you agree that a gold standard, properly implemented, is good? If so, why would pegging a currency to gold be any different from pegging it to, say, the euro or a basket of currencies?

lotusboy said...

What more proof do you need that the Yuan is artificially low than the fact the Chinese hold so much U.S. dollar denominated debt? Wouldn't the Yuan would be a heckuva lot more valuable if the Chinese hadn't converted Yuan into dollars to buy 6% of our entire national debt. There would be a few more jobs here if Chinese stuff wasn't so cheap, and there would be a few more peasants toiling in the soil in China instead of working at factories.

Business model is this: China takes poor peasants from the countryside, pays them next to nothing, and they make low tech stuff. A widget costs them $10 to make in this manner. It sells the widget for $20 to Walmart. Walmart marks it up to $30. Walmart used to buy the widget from a factory in North Carolina for $25. Everybody is happy except a few unemployed factory workers in North Carolina, but most North Carolinians are generally quite happy because they go to Walmart and see last years Widgets being blown out for $28. The smart North Carolinians start flipping real estate and learn yoga.

Chinese peasants are happy. Life in a factory is better than life on a farm. Chinese central planners are not necessarily interested in a free society, they're trying to keep people working and happy so they keep their jobs. They can keep their products attractive by keeping the price low, they can keep the price low by rolling the profits into U.S. treasuries. Thus, the demand for Yuan isn't so high. The resource inputs (oil, metal, etc.) are trivial compared to the labor involved.

I'm not complaining about any of this, I just see it differently. I'm no economist. I own walmart stock.

Scott Grannis said...

lotusboy: There is another way of looking at this. China is obviously generating huge sums of money by exporting all kinds of stuff that the world finds cheap. They aren't spending all the dollars they earn, however, so the Central Bank must buy up those dollars and issue yuan, otherwise the exchange rate would rise above its target. The supply of yuan in China is rising quite fast, in line with the country's swelling holdings of Treasuries. More yuan in China directly support a growing Chinese economy and rising living standards. This is not necessarily a bad thing for anyone.

The key question is this: why isn't China spending all of its export earnings? You think it's because the government is not allowing them to earn or spend enough, and is instead deciding to invest the money in Treasuries.

I think there is a case to be made that Chinese workers are advancing rapidly, and they are looking to the future and they want to save. The amount they want to save is huge relative to the size of the Chinese economy, but it is relatively small relative to the size of the US. economy. China has a rapidly maturing workforce, due to the one-child policy, whereas the US is the only developed country in the world that will experience a growing economy for many decades to come. China has an abundance of cheap labor and a surplus of savings; the US has a dearth of cheap labor and a shortage of savings. We make a perfect match.

The Chinese have almost no alternative: if they want to save, most of their savings must end up in the US market.

We actually have the best of all possible worlds, because we get cheap goods from China, and most of the money we spend on those goods stays in the US. The Chinese are terribly exposed to anything that might damage the US economy or the value of the dollar. I fear that we are taking unfair advantage of them, much as we took terrible advantage of the Japanese in the 1980s, when they invested gazillions of yen in our economy and then we devalued the dollar.

M Miller said...

Scott (all),

This action in Europe reminds me (very vaguely) of the banking crisis that occured in 1931/1932 with the Austrian banks, then the dispute with France and Germany, which precipitated the world-wide banking crisis which spilled over to the U.S. I doubt that happens again because of the cooperation and backstops we have in place, but it does raise eyebrows.

My biggest concern is whether we are in the early stages of an unraveling of the china economy. Its all about confidence in times of stress, is it not?

Could it be that large funds are preparing to extend the chain of crisis to profit from panic linked to a possible Chinese crisis (not necessarily will occur).

What are the chances of a China meltdown and wouldn't that have dire impact on the economy and markets far worse than 1998?

Common sense tells me that their stimulus of 5x greater than the U.S. and lack of exports (for an export country) should lead to an eventual collapse in SUSTAINABLE economic momentum.

I'm not a fear monger, but the China story has me worried over the next year. I don't want to be unprepared for another (Panic of 2008) repeating in 2010 with China.

Scott Grannis said...

M Miller: People have been expecting a collapse of the Chinese economy for as long as I can remember. I don't know enough about the country to argue strongly one way or another. I don't agree, however, with those who say that the Chinese are manipulating their currency. I think their monetary policy is generally good, with the main problem being that they have chosen the dollar to link to, and the dollar has been mismanaged by the Fed. So they are not entirely free of problems, but neither are they creating a massive problem that must end in crisis. Where they are likely to be making mistakes is in not allowing complete freedom in the economy, and in directing lending that may end up being inefficiently used. But surely the people are hard working and the economy is very dynamic; they have tapped into the magic of free market forces to a goodly extent. Turn people loose to pursue a higher standard of living in a country with largely free markets and a strong currency and I have to believe that things will turn out OK in the end.

Anonymous said...

You are absolutely right ... any under- or overvalued currency takes away or adds in imports what it takesaway or adds at exports. Only it structurally distorts the economy which of itself is a bad thing: Harmful Currency Undervaluation?. There will be much more hardship soon with a looming Chinese collapse bigger than the Soviet Union's.