Half baked: worse than raw
This is a blog post by Nobel pocket giant Paul Krugmantel (who seems to have become my de facto practice serve and volley backboard these days).
This time he's throwing light and logic on the US vs China exchange rate fuddlement. "Consider the real exchange rate", he says: Rx = E(Pu/Pc), where Rx is the dollar's "real" rate of exchange against Chinese products, E is the currency exchange rate (here, dollars over yuan, $/Y), Pc is China's price level and Pu the US price level.
Play around with this and you quickly discover what changes in any one or combo of these three variables do to the real "dollar" exchange rate Rx.
Here's Krug's crucial example: "appreciation of the yuan is a fall in E" -- i.e. yuan up against $ means $/Y falls, so Pu/Pc must rise in order to keep Rx constant, which of course must happen, because as Paul tells us ex cathedra,
[T]here is a “natural” level of the real exchange rate, determined by trade competitiveness and international capital flows. And the economy “wants” to get to that real exchange rate.Result: a dollar buys less Chinese goods, eh? Just the thing to close a trade gap... maybe. Gotta love that "natural" exchange rate, huh? Natural like Planck's constant. Can a disembodied dimensionless ratio buzzing in a void eat Peking duck? It's as if Paul had satire in mind, but hey, he don't, gang. He just speeds on completing his reification with this clincher:
"If you have a floating exchange rate you get there via a rise or fall in E... But if you have a pegged rate, there’s pressure on prices instead."Get there? Where's "there", Paul? Balanced trade, balanced payments, or some higher optimal meta-balanced balance? But okay, let him have his pretend time, and yup, if the formula defines the edges of this universe, by definition you can't get around it: either E changes or the ratio of Pu/Pc changes... and if you gotta change Pu/Pc to reduce Chinese imports and save our poor little Nell of a manufacturing sector, China's Pc has to rise faster or fall slower then our Pu, no?
Now that the basics are clear, Paul briars up the story some: China is "deliberately keeping E higher than it would be under floating" exchange rates. Heavens, yes, China is foul-pegging and foul-pegging so low, so very un-naturally low, shouldn't oughta naturally the great and powerful market forces driving the formula and handing down the golden ratio Rx as it were from Sinai, lead ineluctably to higher prices in China?
To bolster his parable, Paul notices two other instances of bad pegs leading to price level pressure: one up -- Germany in '72 (then a forex fiddle dollar pegger, albeit a relenting one, unlike China today); and one down -- poor Spain right now, trapped inside the hideous Euro vise and facing deadly deflationary pressures.
"So China [by maintaining its low peg] is basically trying to keep water from flowing downhill."So... well, ummm, Paul, then we got no sweat here, right? China can't do that, obviously, I mean make water go uphill. That's supernatural.
But... she's succeeding at this, no? And has been succeeeding at this for a decade or more.
Conclusion: something unnatural has been hatched here a ways back, and maybe not for the first time. So, Paul, maybe instead of silly just-so cherrypicking and formula facilizing, you oughta let this unnatural baby, this 666 of a baby, back into the bath tub and let it splash and glower at us like the demon it is. And let's give Baby a name: he's the trans-nat limited-liability hi-fi system, which by a concatenation of sluices, pumps, cisterns and levees, can make water flow uphill (specifically from north to south) and keep it flowing uphill till... well, till the moment comes when "letting spontaneous international market forces" run their "natural" gap-closing course is the better "collegial" trans-nat run or pass option.
There is no law of gravity for relative price levels, none, at least, that Trans-nat Man in his diabolic ingenuity can't overcome.
Moral of tale: spontaneous market forces are not about to rescue our utterly shitkicked industrial sector. So I suggest Paul put this Rx = E(Pu/Pc) half-baked cake back in the oven. It ain't ready to eat till the fat trading-profit demon now riding it gets caramelized away into brown drippings.
But then again -- when is the oven going to get get hot enough to do that?