Today’s debate about the yuan

In his "Economic Scene" column for the New York Times, Tyler Cowen makes a counterintuitive argument: Contrary to popular opinion, China may be good for our trade balance. American consumers seem determined to spend money, and Chinese businessmen have made the bill cheaper. It is not the case that China is simply draining the United States of money. Most of the growth in Chinese exports to the United States has come from switching manufacturing and assembly from other, more expensive, Asian countries. In 1985, China, Japan, Hong Kong, Taiwan and South Korea accounted for 52.3 percent of America?s trade deficit. By 2005, this percentage had fallen to 40.9 percent, in part because of cost savings from buying Chinese.... The Chinese keep the yuan low, relative to the dollar, by buying up United States Treasury securities; as of early 2006, the Chinese central bank held up to $470 billion in Treasury securities. This huge accumulation of relatively low-yielding assets is the investment strategy of risk-averse bureaucrats, but it may bring longer-term benefits. Those assets can someday be sold or otherwise transferred to underdiversified Chinese financial institutions. The accumulation gives the Chinese a stake in American prosperity and signals that the Chinese are committed to long-term participation in the global economy. On the American side, the Treasury market is more liquid and the budget deficit can be financed at lower cost. The yuan should not, as matters stand, float freely with free capital movements. Large quantities of Chinese savings, currently restricted to the domestic currency, would probably flee the country, worsening the serious solvency problems at Chinese banks. The Chinese must first clean up their banking system before they can have free capital markets. Contrary to the conventional wisdom, a market-determined value for the yuan might well be lower than today?s exchange rate, not higher.... Revaluation advocates claim that the Chinese need a stronger currency to prevent their economy from ?overheating.? China may indeed not be stable. But it is unlikely that the United States government can successfully micromanage another country of 1.3 billion people into a soft landing. Chinese economic data is very poor and Americans do not have a good record in advising transition economies. The Chinese recipe for economic growth, which encouraged exports, seems to be working, although it ran counter to efforts by American economists and policy makers to promote the privatization of state-owned companies. The climb of the Chinese economy out of Communism and into prosperity has brought the world, and the United States, a free lunch. Consumer goods of many kinds are cheaper and the Chinese are likely to generate many scientific and technical innovations. Steering the value of the Chinese currency ? from Washington ? is unlikely to increase those gains. The United States should not be spending its international political capital on yuan revaluation, which is at best a nonevent. This column has caused something of a ripple in the economics portion of the blogosphere. See Greg Mankiw for a supportive post. For more critical takes see Brad DeLong and particularly Brad Setser (Cowen responds to Setser here). I had to write about this issue in a white paper for U.S. Trade Strategy, so a few quick thoughts on the matter: 1) Debating about what happens to the yuan if China liberalizes its capital markets is pretty much a red herring at this point, because it's not happening anytime soon. I lean towards Tyler's view that the yuan would likely fall, because the amount of Chinese savings that would leave would dwarf the amount of investment capital that would flow in (one of the scarier facts about the Chinese economy is that to my knowledge no one has any idea of how to gauge the efficiency of recent Chinese investments). Again, though, it's a red herring. 2) The debate boils down to whether you believe a small shift in the trade balance, which would be caused by a small revaluation of the yuan, is worth the large amounts of political and diplomatic capital required to get China to move. The Brads think the answer is yes, because any nudge towards reducing global imbalances is a good thing, and such a reduction would prevent U.S. overinvestment in nontradables. Tyler thinks that U.S.policymakers should swallow a dose of humble pie and recognize that given the current domestic political economy of China, us nudging them to devalue might make sense in theory but not practice. On this point I'm moe sympathetic to the Brads, but in the end concur with Tyler that no poicy wonks have been willing to acknowledge the downsides of a devaluation gone wrong. Those scare me just as much as the long-term imbalances. I fully expect my readers to weigh in on the matter.