The Doctrine of Immaculate Transfer
Dave Altig at the Atlanta Fed weighs in on Martin Feldstein’s much-quoted paper arguing that the United States and China will soon reduce or eliminate their current account imbalances. I think it’s worth saying a bit more about this, because there’s a common fallacy here — not one Feldstein has fallen into, but which many others do. And talking about that fallacy is also a way to see why current yuan policy is a problem for the world.
So, start with the basic accounting rule, which says that a trade deficit means that a country is spending more than it earns. What Feldstein is saying is that with US consumers starting to save more, and possibly with Chinese consumers starting to save less, these underlying imbalances may be en route to dwindling or even disappearing. Not so sure about Chinese saving, but given that premise, OK.
The fallacy comes in when you say, “Well, given that it’s all about spending imbalances, exchange rate policy has nothing to do with it.” This is what John Williamson of the Institute for International Economics once dubbed the Doctrine of Immaculate Transfer. (Uh-oh, Erick Erickson’s gonna come after me …) It’s a popular fallacy, especially at the WSJ, although I’m not sure if it rises to zombie status.
Anyway, imagine for simplicity that America and China are the only two countries in the world. And imagine that as consumer habits change, American spending falls by $400 billion while Chinese spending rises by $400 billion. Trade imbalance gone, right?
No, it’s not that easy. If US residents cut spending by $400 billion, most of that reduction — say 75 percent — will come in reduced spending on US-produced goods and services (even that Chinese pair of pajamas you buy at WalMart has a lot of US value-added in distribution and retailing.) So that’s $300 billion in reduced demand for US output. Meanwhile, a much smaller fraction — say 15 percent — of that extra Chinese spending will fall on US goods. So we’re talking about, say, a $240 billion net fall in spending on US goods and services; correspondingly, we’re talking about a $240 billion rise in demand for Chinese goods and services.
If that’s the end of the story, then the spending shift produces a depressed economy in America and major inflationary pressures in China.
What’s needed to make it come out right is something to make both American and Chinese consumers switch some of their spending toward American goods — something like a rise in the dollar value of the yuan, which makes Chinese goods relatively more expensive. So the redistribution of world spending and exchange rate adjustment are complements, not substitutes.
Now, what matters is the relative price of Chinese and American goods, so there’s another way to get there — a combination of inflation in China and deflation in America. But that’s unpleasant on both sides.
Worse, what if China tries to head off inflation by raising interest rates while America can’t reduce rates, since it’s already at the zero lower bound? Then the result is contractionary for the world as a whole.
Any resemblance between this story and actual characters is, of course, entirely intentional.
The point is that Feldstein’s argument, if correct — I’m not entirely sure about that — is actually an argument for yuan revaluation, not an argument that it won’t be necessary.
So, start with the basic accounting rule, which says that a trade deficit means that a country is spending more than it earns. What Feldstein is saying is that with US consumers starting to save more, and possibly with Chinese consumers starting to save less, these underlying imbalances may be en route to dwindling or even disappearing. Not so sure about Chinese saving, but given that premise, OK.
The fallacy comes in when you say, “Well, given that it’s all about spending imbalances, exchange rate policy has nothing to do with it.” This is what John Williamson of the Institute for International Economics once dubbed the Doctrine of Immaculate Transfer. (Uh-oh, Erick Erickson’s gonna come after me …) It’s a popular fallacy, especially at the WSJ, although I’m not sure if it rises to zombie status.
Anyway, imagine for simplicity that America and China are the only two countries in the world. And imagine that as consumer habits change, American spending falls by $400 billion while Chinese spending rises by $400 billion. Trade imbalance gone, right?
No, it’s not that easy. If US residents cut spending by $400 billion, most of that reduction — say 75 percent — will come in reduced spending on US-produced goods and services (even that Chinese pair of pajamas you buy at WalMart has a lot of US value-added in distribution and retailing.) So that’s $300 billion in reduced demand for US output. Meanwhile, a much smaller fraction — say 15 percent — of that extra Chinese spending will fall on US goods. So we’re talking about, say, a $240 billion net fall in spending on US goods and services; correspondingly, we’re talking about a $240 billion rise in demand for Chinese goods and services.
If that’s the end of the story, then the spending shift produces a depressed economy in America and major inflationary pressures in China.
What’s needed to make it come out right is something to make both American and Chinese consumers switch some of their spending toward American goods — something like a rise in the dollar value of the yuan, which makes Chinese goods relatively more expensive. So the redistribution of world spending and exchange rate adjustment are complements, not substitutes.Now, what matters is the relative price of Chinese and American goods, so there’s another way to get there — a combination of inflation in China and deflation in America. But that’s unpleasant on both sides.
Worse, what if China tries to head off inflation by raising interest rates while America can’t reduce rates, since it’s already at the zero lower bound? Then the result is contractionary for the world as a whole.
Any resemblance between this story and actual characters is, of course, entirely intentional.
The point is that Feldstein’s argument, if correct — I’m not entirely sure about that — is actually an argument for yuan revaluation, not an argument that it won’t be necessary.
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