U.S. & China: Exchange Rates Aren't the Problem
By Patrick Chovanec
When President Obama arrives in Shanghai tonight, one of the hottest issues on the table will be the exchange rate between the U.S. Dollar and China’s Renminbi. In the past few weeks, commentators like New York Times columnist Paul Krugman have argued that Obama’s top priority should be to pressure China into strengthening its currency, in order to “rebalance” the global economy. I disagree. A more flexible exchange rate – and the stronger Renminbi that would likely result – would be a step in the right direction. But it’s not a silver bullet, and would have little effect in the absence of more substantive economic reforms. In my view, the focus on currency is a huge distraction from far more pressing issues.
Krugman is correct that a rebalancing needs to take place. The current situation, in which China runs larger and larger trade surpluses, and lends the proceeds back to fuel ever-rising consumption in the United States, is not sustainable indefinitely, especially as the Chinese economy grows to rival America’s in size.
According to conventional economic theory, flexible exchange rates play a vital role in correcting such imbalances. When a Chinese exporter sells a product to the U.S., it receives dollars in return. Those dollars don’t just disappear; they stay in China until someone wants them to buy products from America or invest in American assets. For quite some time now, China sells more than it buys from the U.S., and brings in more capital than it invests abroad, which means that there aren’t enough people who want to use all the dollars that keep flowing in. Just like any other market, when the supply of something – in this case dollars – outstrips demand, its price should drop. The dollar depreciates, making U.S. goods cheaper and more attractive to Chinese consumers, while the Renminbi appreciates, making Chinese goods more expensive in America, eventually closing the gap in trade.
The Chinese government, though, isn’t letting that happen. Instead of letting those excess dollars sell for a lower price in Renminbi, it steps in and buys them at the current exchange rate, and holds them as reserves. By keeping the Renminbi artificially cheap, Krugman and other critics contend, China gains an unfair trade advantage. If only the Chinese would stop interfering, and allow the dollar to find its true level, American products would become more competitive and this dangerous imbalance would correct itself.
Sounds good, but the problem is we’ve been here before. In the early 1980s, Japan was running a chronic trade surplus with the United States, and accumulating dollar reserves on a massive scale. Economists argued that an undervalued Yen was to blame. So in September 1985, the central banks of the U.S., Japan, Britain, France, and West Germany agreed on what became known as the Plaza Accord. Over the course of the next two years, they intervened heavily in global currency markets to bring the value of the dollar down by over 50% against the Yen, from around 250 JPY/USD to 125.
The outcome baffled and frustrated economists. While the cheaper dollar had a significant effect in reducing America’s trade deficit with Europe, Japans’ trade surplus with the U.S. barely budged – in fact, it grew. How could this be? Why didn’t the new exchange
