The lao wan tong: Nobel economics laureate Robert Mundell on the US Dollar and the Chinese Yuan

From the Far Eastern Economic review, June 2007 Issue

 

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Satisfy China’s Demand for Money
June 2007

by Hugo Restall 

As the audience at the Asia Society’s May gala dinner in Hong Kong sips their coffee, the moderator allows one more question from the audience for Nobel economics laureate Robert Mundell. A Chinese gentleman stands to ask how much longer the U.S. dollar would remain the world’s reserve currency. The query seems like the perfect set-up for the world’s foremost expert on monetary policy and a well-known “friend of China” to predict the rise to preeminence of China’s currency.

Robert Mundell

But Prof. Mundell bats the question away without hesitation. China, he explains, is still far behind the U.S. in terms of economic strength and stability. “I think the dollar era is going to last a long time … perhaps another hundred years.”

The answer is a fitting end to an evening in which the conventional wisdom has been set on its ear. 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.

So what about China’s stock-market bubble, should the People’s Bank try to pop it? China could include asset prices in its index of prices if it wanted to target price stability. But the problems with the market require deeper reform. As long as the international monetary environment is stable, pegging the yuan to the dollar offers the opportunity to target the broadest possible index of prices, effectively the goods of the whole world. It’s difficult to improve on that, even if China had its own Alan Greenspan.

Full convertibility is not on the cards as long as the primary objective of the Communist Party is maintaining power, not the welfare of China’s citizens, Prof. Mundell admits. But he advises the Party bosses to progressively relax the controls to help take the pressure off the balance of payments.

However, in the unlikely event that the yuan were suddenly made fully convertible, Prof. Mundell predicts that the value of the currency would fall, not rise. That’s because many Chinese savers would naturally like to have the security of keeping at least some portion of their wealth in foreign currency. The incentive would be to move this money quickly, in case the government slammed the door shut. As with the experience of the United Kingdom in 1947, when the Bank of England saw its reserves evaporate in a matter of weeks, this becomes a self-fulfilling prophecy, and capital controls have to be reinstated. The movement to full convertibility is fraught with danger and must be approached cautiously.

Even the abandonment of sterilization would have to be undertaken gradually, Prof. Mundell advises, in order to avoid scaring the markets: “I wouldn’t suddenly change what they are doing, just slow it down and phase it out over a year or so period.” Policy makers don’t have to be transparent in their thinking. “Even if you have gotten on to the wrong theory, you can’t just reverse course, you have to find another reason for changing.”

Given Prof. Mundell’s many trips to China, and the fact that he is on the same wavelength as the leadership on keeping the value of the yuan stable, it would appear that he has some influence within the leadership. He was given a “green card” by the government two years ago which gives him the permanent right to live and work in the country. And he says he is considering buying an apartment in Beijing and shifting his son to a school there.

But at the same time he remains skeptical of the quality of China’s top economists, choosing to focus more on the next generation. He has lent his name to a business school in the capital, as well as a financial magazine. And he’s working on getting a screenplay set in China produced. One senses that, even though he helped found the supply-side school that informed the policies of Ronald Reagan, Prof. Mundell is too much of an independent mind to ever become a government’s go-to economist. He’s having too much fun as a lao wan tong.

Mr. Restall is the editor of the REVIEW.