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Home Publications Blogs Beat the Press Prices Don't Matter: The Bizarre Case Against Lowering the Dollar/Yuan Exchange Rate

Prices Don't Matter: The Bizarre Case Against Lowering the Dollar/Yuan Exchange Rate

Tuesday, 18 January 2011 05:43

Harvard Law Professor Mark Wu argued that the value of the yuan against the dollar is no big deal in determining the U.S. trade balance in China in an NYT column. His argument is bizarre to say the least.

First he argues that the value of the yuan has little to do with the ability of the U.S. to export to China. He points out that exports to China grew at a more rapid rate in the years from 2002 to 2005 when the yuan did not appreciate than in the years from 2005 to 2008 when the value of the yuan rose by almost 20 percent against the dollar.

This is true, but the problem is that the very low base in 2002 makes percent change a very misleading measure. The increase in exports from 2002 to 2005 was $19.1 billion, from $22.1 billion to $41.2 billion. Exports increased by $28.5 billion from 2005 to 2008 to $69.7 billion. The more obvious metric would be the increase as a percent of U.S. GDP, which was considerably larger in the second period.

If one was just looking at percent changes then the near doubling of imports in the three years when the yuan did not rise in value is a striking contrast to the increase of just over 40 percent in the three years in which the yuan rose by 20 percent. Of course a full model would consider relative price changes and other factors, but it takes some serious data abuse to use export volumes to argue that exchange rates don't matter.

The other arguments are equally off-base. Wu claims that if the yuan rose against the dollar then we would simply import more from Cambodia, Vietnam and other countries. There are two problems with this argument. First the list of competing countries is not nearly large enough to replace China as a source of imports. If imports from China fell by a third, this would be roughly equal to Vietnam and Cambodia's combined GDP. The other flaw in this logic is that countries like Vietnam and Cambodia target the value of their currency against the yuan. When China abruptly raised the value of the yuan in 2005, a wide range of countries followed suit. It is likely that further increases in the yuan would also be matched by rises in other currencies leaving the relative valuation of their exports little changed. (If these countries were just interested in gaining more of a competitive advantage of the yuan, they could devalue their currency any day of the week.) 

The final point that Wu makes is that only 15 percent of our exports compete directly against Chinese exports in third markets. This is likely true, but by itself this is already a large volume of trade. Furthermore, this percentage is rising rapidly as China moves into more upscale manufacturing sectors. The share of exports that compete with Chinese goods likely would have been close to zero five years ago.

In short, there is not much of a case here. Economists generally believe that relative prices matter and the exchange rate is a major determinant of relative prices. (Do tariffs of 20 percent matter? The Chinese sure think so.) Mr. Wu's column gives us little reason to discard standard economics.

Comments (4)Add Comment
A little over-critical
written by Ben Ross, January 18, 2011 6:56
I read Wu's article a little differently - maybe a little differently from how he intended it. The message I drew is that American manufacturing has become so hollowed out that a shift in exchange rates is not enough to revive it - we need an active industrial policy too.
Real Relative Value of Renminbi-Dollar to Euro-Yen Exchange Rate
written by izzatzo, January 18, 2011 9:30
From the NYT article, this quote:
In addition, American companies in those industries are usually competing against European and Japanese firms rather than Chinese manufacturers. Ultimately, the dollar-euro and dollar-yen exchange rates may play more important roles in Chinese demand for American goods than the renminbi rate.

Exactly. When domestic production costs for goods exported to China decline in Europe or Japan compared to competing goods from the USA, this weakens the dollar relative to the euro or yen as China buys more exports at reduced real prices from Europe or Japan.

Even though the renminbi is pegged to the dollar and therefore falls with it in response to a rising euro or yen to the dollar, since the effect of exchange rates on real relative prices for global trade doesn't matter, it won't neutralize whatever real price reductions China receives through effective competition in export markets.

To prove the point, even if the renminbi was unpegged from the dollar and didn't fall with it, the Chinese would just save the difference under its new austerity policy rather than spend even more on cheaper exports, further rendering them immune to changes in exchange rates.
Always Beware of Arguments by Lawyers
written by paul, January 18, 2011 11:10
They always have some grain of truth that shades vast untruth. To argue that prices don't matter in economics is highly disingenuous.
Lawmakers who cannot add
written by Robert Oak, January 18, 2011 3:20
That's just ridiculous for anyone looking at the statistics, as you point out, or the math as well on currency manipulation. There was a new paper out, just a couple of days ago, which shows the current account, trade, deficit, GDP is going to be much more negatively impacted than what the IMF is projecting due to currency manipulation. I wrote up an overview http://www.economicpopulist.or...de-deficit with links to the paper. I wish other economists and reasonably aware layperson's would read this paper, write up their own views on it. To me, it has some dire warnings if China's currency manipulation is allowed to continue.

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.