Nobel Laureate Robert Mundell is regarded by some as "The Father of the Euro" because of his earlier work on optimum currency areas (though some regard the late Wim Duisenberg as more worthy of the honor). More recently, he has become an adviser to the Chinese authorities on the prickly matter of the yuan's exchange rate. It seems he is rather popular there because he favors a gradualist approach similar to that propounded by these authorities. In this piece from the Far Eastern Economic Review, Mundell offers a novel idea to his interviewer: China can (and should) print more money without necessarily causing troubling bouts of inflation. What's more, doing so will likely create more local demand and reduce China's humongous current account surplus that has protectionists the world over crying murder, bloody murder (it's just a shot away):
The high U.S. trade deficit, widely supposed to be unsustainable, is not only sustainable, Prof. Mundell argues, it is necessary to the functioning of the global economy. China’s high balance of payments surplus and pressure on the yuan could be resolved quite easily by ending the central bank’s sterilization—the practice of following up its interventions in the foreign-currency market by issuing bonds, thereby preventing the money supply from increasing too fast. And no, this wouldn’t lead to a big jump in inflation.
On this last score, Prof. Mundell has a few economists in the audience scratching their heads. Is the economist known as the “father of the euro” for his work on optimal currency areas just being provocative? After all, he has a bit of a reputation as what the Chinese would call a lao wan tong, a playful old child. The 74-year-old Columbia University economics professor has appeared on the television show Late Night With David Letterman to tell “Yo Mama” jokes and recite hip-hop lyrics. He owns a 12th-century castle in Siena, Italy, once occupied by Pandolfo the Magnificent, and his nine-year-old son attends international school in Florence.
So the next day I meet with Prof. Mundell in the coffee shop of his hotel to try to get to the bottom of this last point. The standard economic theory tells you that if the money supply rises, so should inflation. And the professor had a big hand in writing that theory, so what gives?
First a brief explanation. Without sterilization, China would essentially be running a currency board system, much like in Hong Kong. When people want to convert more foreign currency into Hong Kong dollars than the other way around, the government stands ready to make the trade, creating new Hong Kong dollars and depositing the foreign currency into reserves. The money supply increases, and if this outstrips the growth in the economy, the usual outcome is too much money chasing too few goods—inflation. For instance, in the mid-1990s inflation in Hong Kong ran much higher than in the U.S.
Prof. Mundell himself pioneered the explanation for this, the “impossible trinity.” In its simplest form, no economy can have free capital flows, a fixed exchange rate and control over its own monetary policy, i.e. stable interest rates or stable prices, all at the same time. Economies with a currency board like Hong Kong enjoy the first two, but can’t regulate the local economy separately from the one they have pegged to, and so may suffer bouts of inflation and deflation through the business cycle.
But, he poses, what if extra yuan did not send consumption of Chinese goods into overdrive, but merely satisfied the desire to hold yuan and yuan-denominated assets? China’s domestic economy is becoming wealthier and its citizens are saving in record amounts, wealth that cannot easily go abroad because of capital controls and so is invested in production capacity far beyond the needs of domestic consumption. Meanwhile, the largest portion of the increase in reserves is driven not by the trade surplus but by inward investment. The upward pressure on yuan has become self-perpetuating, especially since the shift to a slowly appreciating peg in 2005. Holding the yuan has become a one-way bet.
In other words, look at the yuan as a commodity, and China’s balance of payments surplus as a case of demand outstripping supply: “If you create money in an equilibrium situation, the additional money makes disequilibrium, and people spend more and that involves more imports, and potentially inflation. But if you print money to fill an excess demand for money, there is no inflation that comes from that.”
By sterilizing, the central bank prevents the supply from rising fast enough to satisfy the demand, perpetuating the imbalance. Raising the required reserve ratio of the banks has the same effect. Ease off the sterilization and monetary tightening, Prof. Mundell predicts, and the demand for yuan will soon be sated.
As in an equilibrium, one result would be increased domestic demand and imports, reducing the trade deficit. But with no shortage of problems on the horizon, it’s unlikely that domestic prices would rise across the board, and prices of some goods might actually decrease as companies achieve greater economies of scale. Since the trade surplus will decline, political tension with the U.S. will also ease.
There is precedent to justify such optimism, Prof. Mundell explains. In the early 1980s, after Paul Volker’s Federal Reserve tightened interest rates and vanquished the runaway inflation of the 1970s, the U.S. economy passed through a sharp recession and then began to recover. When confidence in growth prospects and the value of the dollar was restored, the desire of Americans and foreigners to hold the currency increased. The money supply began to grow at a phenomenal rate, and some, including Milton Friedman, predicted on this basis that inflation would reappear. But Prof. Mundell diagnosed it differently: “What was happening was the expectation of disinflation was increasing the demand for money.” And in fact not only did inflation fail to re-emerge, but disinflation continued through the 1980s.
So is China in the same boat today? Consider that the People’s Bank of China is already not doing a very good job of sterilization. One standard measure of money supply, M2, is growing at 17%, compared to GDP growth of about 11%. And yet inflation remains very low. In fact, in recent periods when growth has slowed, deflationary pressures have emerged.
This fact is obscured by a lot of blather about the Chinese economy “overheating.” Yet the hallmark of overheating, as Prof. Mundell observes, is an excess of demand leading to bottlenecks in many markets. If anything, China still suffers from weak domestic demand. And while there are a few isolated bottlenecks in the economy, in general there are plenty of inputs available to increase production.
This confused terminology is not the only way in which the experience of developed countries is misapplied to China. In the U.S., for example, the Federal Reserve usually regulates the economy largely by setting the interest rate at which banks lend to each other and through the buying and selling of bonds, and practically never by administrative means or intervening in the foreign-currency markets. In China, it is the opposite; the management of the exchange rate is the central bank’s chief impact on the economy. Setting interest rates is mostly for show, and has little meaning.