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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save_the_rustbelt May 22, 2007 at 8:40 am

Yes, the little people shouldn't vote or anything. They should take their losses and just fade away.

Don, you know alot about economics, but not much about people or politics. Maybe you need to get out of the office more.

Don't worry about Paulson, he will bootlick the Chinese because it is good for Wall Street.

"But in the long run we will all be better off…….."… right? And we get to buy cheap stuff at Wal-Mart.

Those who never see any flaws in their own thinking are known, I believe, as fanatics.

Jon May 22, 2007 at 8:47 am

I'll ignore the rampaging ignorance in the first post and try and say something constructive…

This just goes to show the jingoistic tendencies of people in a country. It's absurd to think that the Chinese are harming us with trade. Last time I checked there was something known as "mutual gains from trade" as in everyone's better off. I guess that's too much to think that you protectionists will get it through your collective thick skull, you are really no better a person than a chinese laborer, better educated perhaps, but not any better. Why should anyone show you preference through economic policy? Because you wave a flag and say you love America and produce AMERICAN stuff. Sorry rustbelt, that isn't good enough for me.

Roy Gillson May 22, 2007 at 8:50 am

The dollar-yuan peg has effectively, temporarily, created a single currency zone between the capitalist US and communist China. While the reforming Chinese economy brings many benefits to the world (new cheap source of supply and added consumer demand), it has had no functioning capital system. There is no bankruptcy, banks have no economic-based lending policies and interest rates are set by central government.

The result is that a forced low real interest rate policy in China (real growth ten per cent) has resulted in abnormally low real interest rates in the US. Capital has flowed into the US system (i.e. ownership of US assets has transferred to China) while US citizens have bought lots of Chinese good-value products whose prices have been steadily declining.

The real value of the Yuan has been held down by this pegging system.

The gradual unwinding of this two systems, one currency, will have significant effects on the world economy.

Jon May 22, 2007 at 9:23 am

But Roy,

I could see the effect of a currency shock in the short run, but really in the big scheme of things, will gradual loosening of the yuan, which I believe will become a necessity for China as they truly begin to globalize, have that big of an effect on everyone? A new currency market will develop and the US dollar will have yet another major competitor in the currency arbitrage markets, but on the whole … lets just say that I think you'rebeing a bit fatalistic. SUre there will be an effect, but not as big of one as you think.

I'd rather see a freer China and eat the cost of the loosening Yuan in the Short Run.

eddie May 22, 2007 at 11:10 am

Suppose the Chinese government exercized its sovereign monetary policy by controlling the internal interest rate but did not peg the external exchange rate, allowing it to float freely as many advocate. Suppose that in such circumstances the external exchange rate would be higher in dollar-yuan terms as many assert ("the yuan is undervalued"). If the yuan really is undervalued, then its undervaluation is an artificial boon to Chinese exporters to America and American importers from China. It effects a subsidy of American consumers and some Chinese producers at the expense of Chinese consumers and some American producers. It also comes at the expense of Chinese currency holders via an inflation tax, since the government must print yuan to buy dollars in order to maintain the peg.

We rightly decry government distortion of trade in the forms of U.S. subsidies and tariffs. We should similarly decry those of the Chinese government. Not because they are hurting Americans – in fact, on the balance they help Americans – but because they inherently hurt everyone by causing inefficient allocation of scarce resources.

Slaughter argues that nominal exchange rates are irrelevant and only real exchange rates matter to trade. In an ideal market, that would be true. In an ideal market, a government could exercise its authority over monetary policy to set exchange rates, or interest rates, but not both. China is, of course, very far from an ideal market. The government not only sets both exchange rates and interest rates but also the price of cars, chickens, and college educations. The economic forces that would normally bring nominal exchange rates, local prices, and trade flows into balance are dysfunctional in China. The end result is that in China, as in all planned economies, there is a significant amount of deadweight loss.

That deadweight loss would be reduced if China allowed the yuan to float. It would be further reduced by eliminating capital controls and price controls… but we should encourage any step in the right direction.

Jon May 22, 2007 at 11:23 am


I don't disagree with you that we should encourage any step in the right direction but what is the best was to do that?

I don't think that having politicians on Capitol Hill screaming that China is trying to hurt us is the most effective way to get them to float their currency, the Chinese don're respond too well to threats of any kind.

I think that if we let themplay their hands thena ultimately they wil move toward floating their currency. Pushing them to do so might not be a very good idea.

eddie May 22, 2007 at 11:48 am

Jon – true enough, the political clamor and concern is misplaced. China's peg isn't hurting us. We have no reason to oppose it on defensive grounds.

My point (in part) was to dispute Slaughter's contention that China's peg is neutral. It's not neutral. It isn't hurting us, but it's not neutral. It's hurting China. Or rather, it's hurting the Chinese people. We should oppose the peg on humanitarian grounds, much as we oppose China's censorship of political speech.

Thomas E. Nugent May 22, 2007 at 11:51 am

Mr. Slaughter could have been helpful to us novices who require a little further explanation of "…In recent times, maintaining this target has required the PBOC to print yuan to buy dollars and thereby accumulate dollar-denominated assets on its balance sheet." For example why is the PBOC required to buy dollars? Who is selling them? Who holds all these yuan that the bank is "printing?" Is it a fact that Chinese exporters receive payment in dollars for their goods and services which they then turn in to the PBOC for yuan so that they can conduct domestic policy by allowing those exporters to get paid in yuan? At the end of the day, the PBOC has the dollars or Treasury bills and has facilitated exchange by providing currency to the public for their work. Did I miss something?

karennkc May 22, 2007 at 12:49 pm

I do not see the value of Blog Bits. They are obviously small bits taken out of a larger dialogue that the reader is not in on. Yesterday's (5-21-07) mentioned "The Fairness Doctrine" and I don't know what this is nor do I recall reading about it before in the Star.

And I would prefer to have the whole story on the "Organization of the Islamic Conference" from the Star – not from a blogger – as I have recently been enlightened to the fact that most of these right-wing kooks on the Internet dismiss the reporting in the Star and the MSM (main stream media) in general as they believe it has a liberally biased agenda.

"And as for the evidence, I see none that suggests that past policies in the name of helping the poor have actually done so," is just plain ignorant. I guess this writer has had the good fortune to be born into this unprecedented period of prosperity and lacks imagination enough to fully appreciate the reality of the great depression and the benefits derived from government programs to help ordinary Americans achieve their dreams of homeownership and a college education, among numerous others.

The Albatross May 22, 2007 at 1:19 pm

Come now, we must give "rusty" some credit; he managed to not mention "tenure" once. This really is big step for him. His senselss drivel is now entertaining again–the whole tenure dead horse had really ruined it for me for a while.

Jon May 22, 2007 at 2:13 pm

@ eddie:
Right you are. I guess I'm just having trouble with the idea of finding some way to shake our collective finger at china for hurting their people and yet give off the whole "OH but we want you to trade with us and by the way lower your trade barriers."

I do completely agree, I just find it to be a rather mixed message, one that probably won't get heard or cared about, even if it is heard.

Plus, despite the humanitarian issues, if China wants to attract US producers and products, pegging the Yuan ain't a bad way to do it, especially since Investment in things like plants and equipment will be on the rise. If they want to push to sustain economic growth, they have an effective plan.

@ Karennkc

Government programs create warped incentives, there's no two ways about it they just do. Couple that with the nanny state attitude and you have a recipe for economic lag and ultimately, failure the farther down that road you go.

Oh and just for your own edification, I'm paying my own way through private College (Hampden-Sydney College), so don't talk to me about "affording" college, I know it far better what it means to value an education, better than most people. And you know what, for all your vaunted Gov't programs, I didn't get a dime and I graduated High School with a 3.92 and a 1340 SAT and I got nothing, where's the incentive to work hard when all you have to do is just be poor to get money?

Roy Gillson May 23, 2007 at 4:54 am


I think you miss my point, which is about the transfer of real interest rates rather than the real exchange rate.

Most economic texts assume domestic real rates are set by the market and are reasonably stable within that system: the international adjustment is the real value of the currency.

In this case, there is no stable economic system within China to set real interest rates within the pegged joint currency. Chinese savings equal US borrowings and the real interest rate in the US, and indeed the world, is temporarily depressed. This has helped to cause an asset boom, based on real rates around 2% rather than the normal historic 3%. Real rates in a fast-growing economy like China's would normally, in a functioning capitalist economy, be somewhere between the global rate and the real rate of growth of that economy (10%).

The "subsidy" has been two-fold: an undervalued currency and low real interest rates to China; high asset prices and low goods prices to US consumers.

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