Sunday, November 22, 2009

Currency and the Trade Deficit: Krugman v. Krugman

Nobel Laureate, and former Enron adviser, Paul Krugman is really worried about the US-China trade deficit and global trade imbalances more generally. He has now devoted two near-identical NYT op-eds to the issue, each essentially complaining that it's all China's fault.  Here's the latter Krugman column on the subject:
Despite huge trade surpluses and the desire of many investors to buy into this fast-growing economy — forces that should have strengthened the renminbi, China’s currency — Chinese authorities have kept that currency persistently weak. They’ve done this mainly by trading renminbi for dollars, which they have accumulated in vast quantities.

And in recent months China has carried out what amounts to a beggar-thy-neighbor devaluation, keeping the yuan-dollar exchange rate fixed even as the dollar has fallen sharply against other major currencies. This has given Chinese exporters a growing competitive advantage over their rivals, especially producers in other developing countries.

What makes China’s currency policy especially problematic is the depressed state of the world economy. Cheap money and fiscal stimulus seem to have averted a second Great Depression. But policy makers haven’t been able to generate enough spending, public or private, to make progress against mass unemployment. And China’s weak-currency policy exacerbates the problem, in effect siphoning much-needed demand away from the rest of the world into the pockets of artificially competitive Chinese exporters.

But why do I say that this problem is about to get much worse? Because for the past year the true scale of the China problem has been masked by temporary factors. Looking forward, we can expect to see both China’s trade surplus and America’s trade deficit surge....

Unfortunately, the Chinese don’t seem to get it: rather than face up to the need to change their currency policy, they’ve taken to lecturing the United States, telling us to raise interest rates and curb fiscal deficits — that is, to make our unemployment problem even worse.

And I’m not sure the Obama administration gets it, either. The administration’s statements on Chinese currency policy seem pro forma, lacking any sense of urgency.

That needs to change. I don’t begrudge Mr. Obama the banquets and the photo ops; they’re part of his job. But behind the scenes he better be warning the Chinese that they’re playing a dangerous game.
As Dan Drezner humorously points out, Krugman wrote the "exact same column" last month (that's nice work if you can get it).  In each case, he blames global macroeconomic imbalances on China's currency policy, and his recipe for reducing, or "re-balancing," the US-China trade deficit rests solely on the appreciation of China's currency against the dollar.  Such appreciation, so the theory goes, would make US goods relatively cheaper (especially as the Dollar declines against other currencies too) and Chinese goods relatively more expensive, and the trade deficit will magically shrink.  Presto!

For the time being, I'm going to put aside my doubts that the US-China trade deficit is the big problem right now.  I'm also not going to focus on the historical evidence (pointed out by me and a few others) that currency appreciation - including the RMB's - hasn't "cured" past trade imbalances.  Instead, let's just look at Krugman's theoretical argument that currency policy alone can "fix" the trade deficit.  Is that sound liberal economic theory?  Coming from a famous liberal columnist and Nobel Laureate in trade and economics, one would sure assume so.

Well, as my mom would say, you know what happens when we assume, now don't you?

A quick review of the literature calls Krugman's basic "currency-only" theory into question, even among liberal economists.  These folks say that currency policy alone cannot guarantee a change in trade balances.  Instead, they argue that any US government policy to reduce the trade deficit must involve a combination of currency depreciation and corresponding fiscal discipline.  Indeed, even Paul Krugman himself doesn't believe that currency policy alone can rebalance US trade.  Here he is in his 1997 treatise The Age of Diminished Expectations on the subject:
Unless we are prepared to raise domestic saving, which essentially means a sizable cut in the budget deficit, any attempt to reduce the trade deficit will come at the expense of higher interest rates and lower investment...

The orthodox recipe for reducing a trade deficit is to combine currency depreciation with fiscal austerity. The United States has been willing to try the first, but not the second. So we can legitimately ask whether it makes sense to try to do anything about the dollar until there are clear signs that a budget solution is in sight....

The textbook recipe for curing a trade deficit calls for a lower dollar combined with a lower budget deficit. If we have no intention of actually cutting the deficit anytime soon, then it's too soon to seek a lower dollar.
In other words, attempting to reduce the US trade deficit through currency policy is pointless - and maybe even very painful - unless the US government also stops spending with reckless abandon.  Yet twelve years after Krugman penned the above passage, he seems to have forgotten this economic "orthodoxy."  His op-eds make no mention of the necessary fiscal austerity that must accompany dollar depreciation (which is essentially what forced RMB appreciation is) in order to guarantee a rebalancing of the US trade deficit.  Instead, he blames China's undervalued currency, and by extension the overvalued dollar, for the US-China trade deficit and claims that RMB appreciation alone can achieve the trade rebalancing that America so desperately needs.  Indeed, Krugman today praises "cheap money and fiscal stimulus" and derides China's calls on the US to "curb fiscal deficits," despite the fact that he wrote a decade earlier that liberal fiscal policies would undermine any effects that currency changes would have on the trade deficit.  So what possibly could explain Krugman's curious change of heart?

It couldn't be that he's penned a boatload of columns (see, e.g., here, here, here and here) breathlessly imploring the government to print, borrow and spend money like Charles Barkley in a Las Vegas champagne room, could it?  No, that can't possibly be it because such a bush-league move not only would be disingenuous, but it also could lead a complicit White House to pursue policies that do nothing to change the trade deficit and instead create a devastating combination of "higher interest rates and lower investment." So I guess the economic "textbooks" must've changed since 1997, right?


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