How Much Will Currency Policies Affect Our Economy?

I’m enjoying watching the debate over China and currency play out on the blogs.  I don’t know the international trade economic literature, so I don’t know how to judge how much this will really help our economy.   JW Mason from the slackwire wrote a post for New Deal 2.0, How Much Will Currency Policies Really Affect Our Economy?, laying out an argument that it won’t change that much. I’m going to quote at length, you should read the original post (my bold):

A number of economists of the liberal Keynesian persuasion have been arguing recently that dollar devaluation is an important step in moving us back toward full employment. In principle, of course, a cheaper dollar should raise US exports and lower US imports. But what’s missing from many of these arguments is a concrete, quantitative analysis of how much a lower dollar would raise demand for American goods.

In the interest of starting a discussion, here is a very rough first cut. There are four parameters to worry about, two each for imports and exports: how much a given change in the dollar moves prices in the destination country (the passthrough rate), and how much demand for traded goods responds to a change in price (the price elasticity). We can’t observe these relationships directly, of course, so we have to estimate them based on historical data on trade flows and exchange rates. But once we assign values to them, it’s straightforward how to calculate the effect of a given exchange rate change. And the values reported in published studies suggest that the level of the dollar is a relatively minor factor in US unemployment.

For passthrough, estimates are quite consistent that dollar changes are passed through more or less one for one to US export prices, but considerably less to US import prices. (In other words, US exporters set prices based solely on domestic costs, but exporters to the US “price to market”.) The OECD’s global macro model uses a value of 0.33 for import passthrough at a two-year horizon; a simple OLS regression of changes in import prices on the trade-weighted exchange rate yields basically the same value. Estimates of import price elasticity are almost always less than unity. Here are a few: Kwack et al (2007), -0.93; Crane, Crowley and Quayyum (2007), -0.47 to -0.63; Mann and Plück (2005), -0.28; Marquez (1990), -0.63 to -0.92. (Studies that use the real exchange rate rather than import prices generally find import elasticities between -0.1 and -0.25, which is consistent with a passthrough rate of about one-third.) So a reasonable assumption for import price elasticity would be about -0.75; there is no support for a value beyond -1. Estimated export elasticities vary more widely, but most fall between -0.5 and -1.

So let’s use values near the midpoint of the published estimates. Let’s assume import passthrough of 0.33, import price elasticity of -0.75, export passthrough of 1 and price elasticity of -1. And let’s assume initial trade flows at their average levels of the 2000s — imports of 15 percent of GDP and exports at 10.5 percent of GDP. Given those assumptions, what happens if the dollar falls by 20 percent? The answer is, the US trade deficit shrinks by 1.9 percent of GDP.

That might sound like a lot. But keep in mind, these are long-run elasticities — in general, it takes as much as two years for price movements to have their full effect on trade. And the fall in the dollar also can’t happen overnight, at least not without severe disruptions to financial markets. So we are talking about an annual boost to demand of somewhere between 0.5 and 1.0 percent of GDP for two to three years. And then, of course, the stimulus ends unless the dollar keeps falling. This is less than half the size of the stimulus passed last January. (Although to be fair, increased demand for tradables should have a higher multiplier than the mix of direct spending, transfers and tax cuts that made up the Obama stimulus.) The employment effect would probably be of the same magnitude — a reduction of the unemployment rate by between 0.5 and 1.0 points.

So it’s not a trivial effect, but it’s also not the main thing we should be worried about if we want to get back to broadly-shared prosperity. We should remember, too, that a policy of boosting US demand by increasing net exports has costs that a policy of boosting domestic demand does not.

And what about China? At least as often as we hear calls for a lower dollar, we hear calls for China to allow its currency to rise. How much could that help?

Unfortunately, there aren’t as many good recent studies of bilateral trade elasticities between the US and China. And the BEA’s published series for Chinese import prices only goes back to 2003, which isn’t enough for reliable estimates. But common sense can get us quite a ways here. In recent years, US imports from China have run around 2 percent of GDP, and US exports to China a bit under 0.5 percent. So even if we assume that (1) a change in the nominal exchange rate is reflected one for one in the real exchange rate, i.e. that it doesn’t affect Chinese prices or wages at all; (2) a change in the real exchange rate is passed one for one into prices of Chinese imports in the US; (3) Chinese goods compete only with American-made goods, and not with those of other exporters; and (4) the price elasticity of US imports from China is an implausibly high 1.5; then a 20 percent appreciation of the Chinese currency only provides a boost to US demand of less than one half of one percent of GDP in total, spread out over several years…

This last point makes a focus on the Chinese peg particularly problematic as an explanation of US unemployment. If you are talking about reducing the value of the dollar against our trading partners as a whole, any resulting shift away from imports has to be to domestic goods. But presumably the closest substitutes for Chinese imports are usually other imports, not stuff made in the USA.

These are rough calculations and only intended to start a conversation. But it’s a conversation we very much need to have. Before we launch a trade war with China for the sake of American workers, we need more concrete answers on the size of the potential gains.

I don’t have much to contribute, but I do wonder if (a) these estimates are to a first-approximation correct and (b) it’s worth the political economy tail risk to achieve these gains? Thoughts?   My mind is still being made up here.

Mason also has a guess as to how Keynes would have and wouldn’t have approached the problem:

Historically-minded critics of China and other surplus countries often quote Keynes’ writings from the 1930s and ’40s, with their emphasis on the importance of “creditor adjustment”. The implication is that it’s China’s responsibility to reduce its net exports. But this is a misleading reading of Keynes. In fact, his concern was only ever to ensure that no country was prevented from pursuing full employment by the need to earn foreign exchange. The US, as the supplier of the world reserve currency, cannot face a balance of payments constraint; if we fail to pursue full employment, we have no one to blame but ourselves. If Keynes were alive today, I suspect he would be telling American policymakers to forget about China and focus all their efforts on boosting US demand — by public investment in infrastructure, by unconventional monetary stimulus, by paying people to dig holes and fill them up again if need be. Because he knew that the only reason to worry about the trade balance was to gain the freedom to pursue “a policy of an autonomous rate of interest, unimpeded by international preoccupations, and of a national investment program directed to the optimum level of domestic employment, which is twice blessed in the sense that it helps ourselves and our neighbors at the same time.”

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9 Responses to How Much Will Currency Policies Affect Our Economy?

  1. lark says:

    Our problem is severe and currency adjustment is essential – the sooner the better.

    We have lost 40% of our manufacturing jobs – since China joined the WTO in 2001. This is not simply the continuation of a preexisting trend. Scroll down to the second chart (of US Manufacturing Employment) to see us drop off a cliff after this sea change.

    This has hollowed out American ability to create profits from innovation:
    “The nation’s ability to turn ideas into products and profits at home has been eroded by manufacturing cuts so deep that entire supply chains have vanished, and with them skilled labor, component makers and specialized companies needed to bring scientific discoveries to market.

    Examples include A123 Systems Inc. in Massachusetts. With government support, the company is building plants in Michigan to produce its breakthrough lithium-ion batteries for electric cars, but as a start-up it had little choice but to rely on the technical and manufacturing capabilities of China to crank out products quickly to show potential customers.”,0,3957503,full.story

    We have exposed American workers to corporate and trade predators. This must stop.

    More from the LA Times article:
    “New reports show that during the recession American companies ramped up investment overseas for plants and new hires, as well as research and development — even as they cut back domestically.

    Foreign subsidiaries of U.S. corporations increased their spending on research and development by more than 7% in 2008 from the previous year, pushing the total to nearly $37 billion. But these same multinational companies sliced R&D expenditures in the U.S. that year 2.2% to $199 billion, Commerce Department data showed.

    A similar but less dramatic difference was evident in hiring: Employment at these overseas units rose 1% in 2008 — and a stunning 15% in China — but was down 2% for the U.S. elements of the 2,200 multinational firms the Commerce Department studied.

    Some of these jobs were lost to automation, but Obama and many independent economists said a big factor was the sharply different policy approaches of U.S. and foreign governments.

    For decades, Washington has taken a largely hands-off, or laissez faire, approach, sometimes even adopting tax and other policies that critics said actively encourage the movement of manufacturing and other business activity overseas.

    By contrast, export giants such as Germany, Japan and South Korea have embraced government policies — and even pressure tactics — that push businesses to maintain operations at home.”

    The currency issue is not the only one that needs to be fixed to address China’s mercantile and protectionist policies, but it is an essential first step.

    • JW Mason says:


      You are absolutely right that the loss of manufacturing jobs in this country is a serious problem. I certainly did not intend to downplay it. (Altho I do think that we need to ensure that non-manufacturing jobs are good, too.) But the conventional wisdom that the sees causality run from a high dollar, to a current account deficit, to the decline of manufacturing, needs to be backed up empirically. If we want to rebuild manufacturing in this country we have to make sure we’ve fingered the rate culprit for its decline.

      Personally, I think the case against the strong dollar is not as clearcut as a lot of casual discussion suggests. For instance, if you look at the 1980s, you see more or less symmetric movements of the US-Japan exchange rate, with the yen appreciating about as much in the second half of the decade as the dollar did in the first half. But the responses of the tradable sectors in the two countries were not symmetric at all. Japanese firms did not go bankrupt and/or exit manufacturing at anything like the rate of US ones. The reasons for this are complex, obviously, but presumably some mix of a financial system that reliably financed temporary losses and/or productivity-boosting investment; a system of corporate governance that placed a higher value on the survival of the firm as such, rather than maximizing returns to external claimants; and robust domestic demand, must all have contributed to the greater resilience of Japanese tradables firms. On the other hand, in the late 1990s, when the US experienced a mix of major new investment opportunities, relaxed liquidity constraints and a critical mass of firms with long-term growth rather than financial objectives, we managed to have a very robust boom in investment (including quite a lot of manufacturing investment) without closing the current account deficit at all.

      So I think we have to consider it an open, empirical question both how much exchange rates affect trade flows, and how much trade flows affect output, employment and growth in the US. Obviously, I think the answer is, Not that much. but I could easily be wrong. The point of my post was simply to ask why those economists who do think the level of the dollar has a big effect on employment in the US, haven’t provided more quantitative evidence to back up that belief.

      • lark says:

        Your argument is that the urgency of the current situation does not matter. We need to wait for research to tell us what to do.

        Those results may never arrive, and anyway, I’m skeptical about economic research. We’ve just had to jettison a big chunk of fashionable economic theory. How much of that would ever have been falsified by studies? I’m not sure the approach, ‘Let’s wait and wait and wait and wait and wait…’ for the right research to tell us what to do is appropriate in the current circumstance.

        I find the notion that other countries derive their successful industrial policies from directives demonstrated by positive research results to be dubious. But perhaps you can share some examples, specific with countries / research / policy.

        My sense is, when the house is burning down, you search for a way to put the fire out. You may try more than one way. But you put policies into action and look for results, rather than send the problem to the lab.

        I urge you to look at the second chart (of US Manufacturing Employment).
        I would be interested in your response to this specific chart.

        I’m not even bringing up the issues of China’s multitude of mercantile and protectionist policies. Surely you know this information. But I am curious, how do you think markets work, if you don’t see that these policies are having any effect, specifically on employment?

  2. engineer27 says:

    Most true Keynesians are ignoring China for exactly the reasons Mason outlines: it doesn’t really matter. The issue (as they see it) is that there is an excess demand for safe assets, which includes dollars and dollar-denominated government bonds. Part of the excess demand for dollars is due to deleveraging. By definition, there is never enough money in the world for everyone to pay off their entire debts simultaneously (every dollar in circulation got there because someone borrowed it from the Federal Reserve). When everyone scrambles to pay down their debts, there is going to be a cash crunch regardless of exchange rates, government deficits, regulation, uncertainty, bank malfeasance, or any of the other culprits that may or may not share blame for slow growth. Faced with such a cash crunch, the Fed can and should ease it with “sufficient accommodation,” even to include unconventional intervention to add to the money in circulation. That’s a Keynesian argument (a Smithian one, too). If easy Fed monetary policy makes China work really hard to maintain its desired currency peg, too bad for them.

  3. ThomasL says:

    The China worry makes no sense when viewed from a wealth / standard-of-living position either. The basic argument is that the Chinese currency is currently too cheap, and that raising its value would help us. Theoretically it may help them, but it won’t help us. It is fairly obvious that something is wrong with that initial position by taking it to its extreme. More extreme than “too cheap” is free. If China, for peculiar reasons, decided to sell us tons of goods, rather than for “too few” dollars, for absolutely no dollars at all, everyone in the US would become a lot wealthier at their expense. We’d get all kinds of wonderful things for absolutely nothing in exchange. It would make no sense for China to impoverish themselves by consuming real resources in exchange for nothing, but hey, if they want to do it…

    Start working back up from free, and you find “too cheap.” If they really are keeping their currency undervalued (I’m not convinced) it may well harm them, but from the standpoint of the American consumer it is all upside.

    Some people argue that it still has downsides for the American manufacturer. The plan being that if the costs of Chinese imports were raised (by tariff, or by currency manipulation), it would make domestic production more competitive. Possibly so, but you don’t make all the purchasers of those products wealthier by making them spend more money than they used to do for the same goods, and the purchasers almost always far out number the manufacturers.

    You may increase employment, but you decrease the general wealth of the population. It is basically forced transfer from the currently employed to the currently unemployed [but soon to be employed in the new factories]. Well, that doesn’t make any more sense than just paying the unemployed more unemployment while they look for more competitive job. In fact, it is worse, because you’ll need to keep up your import tariffs/manipulations forever, else your new factory, which is profitable at the manipulated/protected rate (but unprofitable at the unprotected/natural rate) will close as soon as the manipulations cease, leaving a bunch of unemployed people again.

    • engineer27 says:

      Your comment is straight out of Adam Smith, except for on thing. Chinese currency is under internal pressure to appreciate, mostly because its workforce productivity is increasing so quickly, but also because all those new wage-earners want to acquire things with their new wages. Chinese policy of weaker currency hurts them most of all, since they experience price inflation. A possible way to counteract that tendency would be to push development farther out into the rural interior, where people are still extremely poor. But that is politically unpopular with the vested urban interests who have some clout (unlike the nouveau riche) — not to mention environmental issues, plus the fact that China wants self-sufficiency and thus needs to continue to grow its own food.

      So, the argument should really be that China should let its currency adjust because it is best for China, not because it is best for us (as you allude to with your reductio ad absurdum argument about “free” stuff). Unfortunately, while it would be good for China, good for us, and good for the rest of the world, it is not as good for Emperor Wen, so is unlikely to happen.

      • engineer27 says:

        Naked Capitalism posts an analysis of the PBOC’s recent interest rate policy. Highlights:
        “the government is probably trying to avoid the Japan mistake: loosening domestic monetary policy in order to reduce pressure for currency appreciation;
        therefore currency appreciation is likely to continue, if not accelerate…”

        “…wages are rising by 20% …. every business person in China agrees that it is happening. It is increasingly difficult to find additional workers and labour costs are skyrocketing.”

        Artificially devaluing the Yuan is causing inflation, so to “sterilize” its external manipulation it raises internal interest rates, then will keep money from flowing into the country with capital controls. It remains to be seen whether interest rates high enough to arrest the inflationary spiral will be consistent with 10% annual growth that many say is needed to keep China from imploding (my guess is no).

  4. Pingback: Weekly Link Round-up for October 22, 2010 | Blueleaf

  5. JW Mason says:

    then will keep money from flowing into the country with capital controls.

    I don’t think this is right. My impression is that China has quite a few policies in place specifically to *encourage* net capital inflows. Which means it’s not at all clear that the net effect of government interventions is a lower, as opposed to a higher, RMB.

    And yes, there is upward pressure on wages in China. That’s a good thing! Most importantly, for Chinese workers themselves, but it also suggests that the export surplus is likely to diminish in coming years without any major departures in policy.

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