Slaughtering a Myth

by Don Boudreaux on May 22, 2007

in Myths and Fallacies, Trade

Dartmouth’s Matthew Slaughter has an outstanding essay in today’s edition of the Wall Street Journal, explaining why Americans ought not be so lathered-up about the value of the Chinese yuan.  Here are some of my favorite parts of Slaughter’s op-ed:

These misgivings about the dollar-yuan peg are misplaced. Economic
theory and data are very clear here on two critical points. Controlling
a nominal exchange rate is a form of sovereign monetary policy. And
monetary policy, in turn, has no long-run effect on real economic
outcomes such as output and trade flows
[emphasis added].


But hasn’t the nominal dollar-yuan peg unfairly driven
the long-run rise in trade imbalances? No. The exchange rate that
matters for trade flows is the real exchange rate — the nominal
exchange rate adjusted for local-currency output prices in both
countries. Supply-and-demand pressures in international markets can,
and do, alter not just nominal exchange rates, but also nominal prices
for goods and services. And these pressures driving the real exchange
rate, in turn, reflect the deep forces of comparative advantage such as
cross-country differences in technology, tastes and endowments of labor
and capital.

To demonstrate this critical point, look to Europe.
The yuan floats against European currencies such as the euro and the
pound. If nominal exchange rates were driving trade flows as commonly
alleged, then Chinese exports to the U.S. should have been growing
faster than to Europe. The data show something completely different,
however. In 1995, monthly Chinese exports to both destinations averaged
about $2 billion. By 2006, monthly Chinese exports to both destinations
were still the same, at about $17 billion. Plotted together over that
entire decade, these two series look nearly identical. This is because
the same real economic forces — e.g., China’s relative abundance of
less-skilled labor — have been driving both sets of trade flows.

Alas, to expect the likes of Senators Charles Schumer, Lindsey Graham, and Sherrod Brown — or even Treasury Secretary Hank Paulson — to grasp this reality and act consistently with it is too much to hope from persons in politics.  As Will Durant sadly observed near the end of his massive survey of several millennia of human civilization, "The triumph of imagination over reality is one of the humors of history."

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